Securities as claims: debt, equity and priority
◈ 6 cardsA certificate is worth its promised cash flows, in rank order: creditors, then preferred, then common.
A security is a claim
A security is a claim on future cash flows. The paper it is printed on — or, today, the book-entry record at the depository — is not the value; the promised flows are. A bond is a claim to coupons and a principal; a share is a claim to whatever is left after everyone ahead of it has been paid. Price a security and you are pricing those flows, which is why the whole calculation half of this course is the present value of one stream or another.
Claims come in two families, and the paper tests the five attributes that separate them.
Debt versus equity on five attributes
| Debt (a creditor's claim) | Equity (an owner's claim) | |
|---|---|---|
| Payment | interest is a contractual obligation | dividends are discretionary |
| Amount | fixed by the contract | the residual after everyone else |
| Term | a maturity date | perpetual — no repayment date |
| Control | no vote | a vote (common shares) |
| Tax | interest is deductible to the issuer | dividends are paid from after-tax income |
The two lines that get mixed up are payment and tax. Interest must be paid — missing it is default — and it reduces the issuer's taxable income. A dividend is declared by the board when it chooses, and it is paid out of income that has already been taxed.
Worked example — the waterfall at Cobalt Ridge Mining
Cobalt Ridge Mining is wound up. The liquidator realises $800,000 from its assets. Outstanding: $600,000 of debt and $150,000 of preferred shares; the rest of the capital is common equity.
The claims are paid in priority order — a waterfall — and each layer takes the lesser of what it is owed and what is left:
Assets realised 800,000
Creditors min(800,000, 600,000) -600,000 paid in full
Remaining 200,000
Preferred min(200,000, 150,000) -150,000 paid in full
Common the residual 50,000Common shareholders receive $50,000 — not because anyone promised it, but because it was left.
Now raise the debt to $700,000 and rerun: creditors take 700,000, the preferred take min(100,000, 150,000) = 100,000 — a shortfall of 50,000 on their claim — and common receive 0. Nothing was promised to common, so nothing is owed; the preferred were promised 150,000 and simply ran out of assets. In Excel the three cells are =MIN(assets, debt), =MIN(assets - creditors, preferred) and =assets - creditors - preferred (floored at zero).
Where "preferred" sits
Preferred shares are preferred relative to common only. They rank after every creditor — secured, debenture, trade — and before common. A learner who hears "preferred" and places it ahead of the bonds has inverted the ladder, and that inversion is a standard distractor.
Value versus price
The value of a security is the present value of its promised flows. Its market price is the market's current estimate of that value. The two are usually close and never identical; the gap is where every later argument about efficiency lives. Par value, the figure printed on a bond, is a contractual amount — the principal — and neither a value nor a price.