Founder Desk
Investment, in the context of securities market, involves upfront commitment of a sum of money to earn returns on it over a period of time. It involves thorough analysis of the underlying security in terms of safety/risk, income and growth potential.
Security markets enable investors to deploy their surplus funds in investment instruments that are pre-defined for their features, issued under regulatory supervision, and in most cases liquid in the secondary markets. There are two broad types of securities that are issued by seekers of capital from investors: Equity and Debt. When a business needs capital to fund its operations and expansion, it makes a choice between these two types of securities.
Due to these fundamental differences in equity and debt securities, they are seen as two distinct asset classes between which investors make a choice. Equity represents a risky, long-term, growth oriented investment that can show a high volatility in performance, depending on how the underlying business is performing.
There is no assurance of return to the equity investor, since the value of the investment is bound to fluctuate. Debt represents a relatively lower risk, steady, income-oriented investment.
It generates a steady rate of return, provided the business remains profitable and does not default on its payments. Since all residual benefits of deploying capital in a profitable business go to the equity investor, the return to equity investor is likely to be higher than that of the debt investors.
For example, if a business borrows funds at 12% and is able to earn a return of 14% on the assets created by such borrowing, the debt investor receives only 12% as promised. But the excess 2% earned by the assets, benefits the equity investor. The downside also hurts the equity investor, who may not earn anything if the return is lower than the borrowing cost and if the business is failing.
Choosing between equity and debt is a trade-off. Investors desiring lower risk, and willing to accept a lower stable return choose debt; if they seek a higher return, they may not be able to earn it without taking on the additional risk of the equity investment. Most investors tend to allocate their capital between these two choices, depending on their expected return, their investing time period, their risk appetite and their needs.