Tuesday, January 17, 2012

An ecomonics question: Equity vs. debt

Business schools have been preaching that equity is equivalent to debt. I'm not an economist, so perhaps I shouldn't venture into this debate, but I can't avoid strong feelings on this. Equity is not equivalent to debt. They have distinctly different consequences. (Edit: See a more expert contradicting argument below. Not a surprise. As I said, perhaps I shouldn't venture into this.)

Equity doesn't drive you into bankruptcy or foreclosure.

If there's an equivalent disadvantage in equity, I hope someone will tell me what it is. However, I wonder what could be equivalent, since bankruptcy can be existential crisis that leads to the extinction of a business. Can equity end a business? Can equity force a foreclosure? I don't see how.

I know about "opportunity cost" and how debt can allow you to take advantage of promising opportunities, but that's not equivalent to the danger of bankruptcy. I'm open to an explanation, but it has to be a compelling one.

1 comment:

Anonymous said...

As a graduate of a prestigious business school, I can state uncategorically that they do not either preach nor teach that debt and equity are equivalent. Maybe some hack biz skull somewhere does, but not is hardly the example.

Debt and Equity are on the same side of the balance sheet since they both default to credit balances while assets default to debit balances. That's the end of the relationship. Debt-to-equity ratios are critical analysis points for business health, although what is acceptable varies widely from business sector to business sector.

The one point at which debt does become equity is when a business has so much debt it must go bankrupt. At that point, the business's creditors become, in effect, its shareholder; they only get out what is available in the end.