Here's the explanation.

Why do companies issue stocks and shares?

Why would the founders of a company want to share the profits of their company with other people if they could keep all the profits themselves? The reason is that companies need to raise money to expand. To do this, companies either need to borrow money, or sell part of the company. This selling off part of the company is known as issuing stock.

What is debt financing?

This is when a company borrows money to expand by taking out a loan from a bank or by issuing bonds (where the company borrows money from bond holders for a fixed period of time). In either case, interest is payable. If you buy a debt investment in a company, you are guaranteed the return of your investment, known as the principal, together with the interest payments stated at the outset of the investment.

Equity financing

Issuing stock is known as equity financing. The advantages of issuing stock is that it does not require the company to pay back the money or to make interest payments  as in debt financing. All that shareholders in return for investing money is a company is the hope that one day the shares will be worth a lot more than they paid for them. When you decide to become a shareholder in a company, you accept the risk that the company may not increase in value and the value of your share might go down. In addition, if a company fails, as a part owner of the company, you claim on the assets is less that that of creditors.

This means that if a company goes into liquidation, the banks and bondholders have first claim on the assets. This is known as the concept of absolute priority. Shareholders stand to lose all their investment if a company fails. On the plus side, shareholders can make a lot of money if the company is successful. Think of all the lucky owners of Microsoft shares who bought when the company was in its early days.

Initial Public Offering

When a company firsts issues stock, this issue is know as the Initial Public Offering (IPO).

What is risk?

Investing in stocks and shares gives no guarantees. Some companies pay dividends, some do not. There is no obligation for a company to pay dividends either. If a company does not pay dividends, the only way the shareholder can make money is if the company increases in value.

The positive side of risk is that risk demands a greater return on your investment. For this reason, equities have historically outperformed other ‘safer’ investments such as bonds or savings accounts. Historically, investment in equities in the long term had an average return of about 10-12%.

Other relevant articles:

What are stocks and shares?
Investing in bonds
Investing in unit trusts
Cash investments - savings accounts
Premium bonds
Investing in property
Alternative investments

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