List and Discuss Five Factors That May Be Employed to Determine

Question

Examlex · Accepted Answer

The Answer is There are 13 possible factors the students might select. These factors are:
Maturity Date
Debt instruments typically have a fixed maturity date, whereas equity instruments do not mature. Because they do mature, debt instruments set forth the redemption requirements. One of the requirements may be the establishment of a sinking fund in order to ensure that funds will be available for the redemption.
Claim on Assets
In the event the business is liquidated, creditors' claims take precedence over those of the owners. There are two possible interpretations of this factor. The first is that all claims other than the first priority are equity claims. The second is that all claims other than the last are creditor claims. The problem area includes all claims between these two interpretations: those claims that are subordinated to the first claim but take precedence over the last claim.
Claim on Income
A fixed dividend or interest rate has a preference over other dividend or interest payments. That it is cumulative in the event it is not paid for a particular period is said to indicate a debt security. On the other hand, a security that does not provide for a fixed rate, one that gives the holder the right to participate with common stockholders in any income distribution, or one whose claim is subordinate to other claims, may indicate an ownership interest.
Market Valuations
As long as a company is solvent, market valuations of its liabilities are unaffected by company performance. Conversely, the market price of equity securities is affected by the earnings of the company as well as by investor expectations regarding future dividend payments.
Voice in Management
A voting right is the most frequent evidence of a voice in the management of a corporation. This right is normally limited to common stockholders, but it may be extended to other investors if the company defaults on some predetermined conditions. For example, if interest is not paid when due or profits fall below a certain level, voting rights may be granted to other security holders, thus suggesting that the security in question has ownership characteristics.
Maturity Value
A liability has a fixed maturity value that does not change throughout its life. An ownership interest does not mature, except in the event of liquidation; consequently, it has no maturity value.
Intent of Parties
The courts have determined that the intent of the parties is one factor to be evaluated in ruling on the debt or equity nature of a particular security. Investor attitude and investment character are two sub-factors that help in making this determination. Investors may be divided into those who want safety and those who want capital growth, and the investments may be divided into those that provide either safety or an opportunity for capital gains or losses. If the investor was motivated to make a particular investment on the basis of safety and if the corporation included in the issue those features normally equated with safety, then the security may be debt rather than equity. However, if the investor was motivated to acquire the security by the possibility of capital growth and if the security offered the opportunity of capital growth, the security would be viewed as equity rather than debt.
Preemptive Right
By law, common stockholders have a preemptive right (the right to purchase common shares in a new stock offering by the corporation). If a security offers its holder a preemptive right, it may be considered to have an equity characteristic. Securities not carrying this right may be considered debt.
Conversion Features
A security that may be converted into common stock has at least the potential to become equity if it is not currently considered equity. Thus, the security, or perhaps its conversion feature, may be considered equity. A historical study of eventual conversion or liquidation may be useful in evaluating this particular factor.
Potential Dilution of Earnings per Share
This factor might be considered as a sub-factor of conversion because the conversion feature of a security is the most likely cause of dilution of earnings per share, other than a new issue of common stock. In any event, a security that has the potential to dilute earnings per share is assumed to have equity characteristics.
Right to Enforce Payments
From a legal point of view, creditors have the right to receive periodic interest at the agreed-upon date and to have the maturity value paid at the maturity date. The enforcement of this right may result in the corporation being placed in receivership. Owners have no such legal right; therefore, the existence of the right to enforce payment is an indication of a debt instrument.
Good Business Reasons for Issuing
Determining what constitutes good business reasons for issuing a security with certain features rather than one with different features presents a difficult problem. Two relevant sub=factors are the alternatives available and the amount of capitalization. Securities issued by a company in financial difficulty or with a low level of capitalization may be considered equity on the grounds that only those with an ownership interest would be willing to accept the risk, whereas securities issued by a company with a high level of capitalization may be viewed as debt.
Identity of Interest between Creditors and Owners
When the individuals who invest in debt securities are the same individuals, or family members, who hold the common stock, an ownership interest is implied.

List and Discuss Five Factors That May Be Employed to Determine

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