Final answer:
Debt involves borrowing money that must be repaid with interest and gives lenders priority in liquidation without ownership rights. Equity represents ownership in a corporation, offering potential for dividends and voting rights without repayment obligations, but with greater risk. Interest on debt is tax-deductible for corporations, while dividends on equity are not.
Step-by-step explanation:
To distinguish debt from equity, it's important to understand the rights of shareholders versus debtholders, the nature of cash flows, and the differences in taxation.
Debt typically refers to money that has been borrowed and must be paid back, often with interest. In the context of a corporation, this can take the form of loans or issued bonds. Debtholders are entitled to regular interest payments based on the coupon rate, and they have priority over shareholders in the event of company liquidation. However, debtholders do not have ownership rights in the company.
Equity, on the other hand, represents ownership in a corporation. Shareholders, as owners, have potential voting rights and are entitled to dividends, which are a share of the company's profits. Unlike debt, equity doesn't require repayment, but it comes with greater risk because dividends are not guaranteed and the value of equity can fluctuate with the market.
From a taxation perspective, interest payments on debt are tax-deductible for the corporation, while dividend payments to shareholders are not. This can be one of the financial advantages of taking on debt. Moreover, while equity can potentially offer higher returns, it typically entails greater risk compared to the more stable income from debt investments.
When a firm decides to access financial capital, it may choose to borrow from a bank, issue bonds, or issue stock. Borrowing or issuing bonds means committing to scheduled interest payments regardless of income. Issuing stock involves selling off ownership to the public and having accountability to shareholders and a board of directors.