Saturday, April 18, 2009

matching savers and borrowers: Debt and Equity(2)

Suppose that you take out a student loan to study business, and when you graduate, you land a Wall Street position paying $50,000 a year. The fact that you got such a good job does not mean that you have to pay back more than the agreed-upon loan amount. In general, in debt contract, a lender does not get more than the amount promised if the borrower does exceptionally well. The lender, however, may get less than the amount promised: if, for example, you cannot find a job and consequently can’t pay back your loan, the lender gets less than the full a mount of the loan. Lenders face the risk that borrowers will default, or not be able to repay all or part of their obligations. The second means of rising funds-equity-allows for variable payments from the borrower to the lender. A good example is common stock, which entitles stockholders in a business to get their share of the firm’s profits after all expenses, including payments of principle and interest to debthholders , have been settled . For example, if you own 100 shares of Bigco, which has 1 million shares outstanding, you own the right to 1\10,000 of the firm’s profits and assets.

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