Equity vs Debt Essay

686 Words 3 Pages
Equity vs Debt Financial Statement Information - Debt and Equity Holders

Debtholders and equityholders as claimants to a firm’s future cashflows are interested in assessing risk.

Debtholders are primarily interested in assessing whether the firm’s cashflow will be sufficient to make interest and principal payments on a timely basis

The lower the probability of a cash shortfall, the lower the risk to the debtholder

Debtholders therefore gather information about the firm’s liquidity, debt capacity and liquidation value of assets

Equityholders are residual claimants of the firm’s cashflows.

Shareholders in effect, hold an option on the value of the firm’s assets, with the exercise price equal
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Wakeman (1981) argues that explanations offered by the ratings agencies, the timing of rating changes and ability of financial ratios to explain cross sectional variation suggest that ratings agencies use financial statement information.

Hand, Holthausen and Leftwich (1992) found that unanticipated ratings changes are associated with significant bond and share price effects, especially when bonds are being downgraded.

Bankruptcy Prediction
Creditors and equity investors alike are interested in knowing the likelihood of a firm experiencing financial distress.

A high probability of distress indicates both debt and equity are risky.

Investors factor this information into portfolio decisions.

Lenders use the financial information in lending decisions.

Therefore bankruptcy prediction is useful in an efficient capital market.

Beaver (1966) and Altman(1968) conducted early work on bankruptcy prediction.

They found that economically intuitive ratios like leverage, earnings before interest and tax over assets and working capital over assets are useful indicators of financial distress.

Altman’s models and his Zeta scores have been popular in the financial community due to their high degree of predictive accuracy.

Ohison disagrees with these models arguing their predictive ability is over-rated due to sample issues.

Altman and Spivack have compared the Zeta approach and the Value Line approach and

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