Equity and debt have different characteristics and suit different situations Let's look at them from the point of view of potential investors We start with a young executive, he or she has got some money available, they're looking to invest it They have a long investment horizon, this person won't be retiring for 30 or 40 years. Is looking to put it away This means they can afford to take high risks and thus hopefully get high returns They have less need for income in the intervening 30 or 40 years Because of their situation and their ability to take high risks and their ability to take no income in between This person can mostly invest in equity Now let's shift along the time horizon a little bit. Let's go towards someone who is at the end of their investment horizon Maybe a grandparent They now have a short investment horizon, they're going to need access to that cash soon They want low risk because they can't afford to make up for any losses over the long-term because they need the money now And they need a regular secure income Because of these characteristics, the low risk and the need for regular secure income They will mostly be investing in debt. Debt pays interest which will provide you with that secure income Now let's look at equity and debt from the other perspective, from the companies issuing the equity and debt to those investors we just saw We start with a startup company or a company going through an extremely high growth period This kind of company represents high risk to investors They could do very very well and they could provide lots of returns Alternatively they could fail Because they're startups, their cash flow is negative so they cannot make those secure regular payments out to debt holders, thus they can't support debt These companies will be mostly equity financed Again, let's go along the time horizon a little bit. Our start up's been trading for many years now and is now a mature business It's now low risk because its cash flow positive, the cash flows are very secure, the products are very stable It can now support debt And because it's profitable it can take advantage of the tax deductibility of interest If you're loss making, unfortunately not really much point So this company can now be mostly debt financed One extra characteristic that debt has is the leverage effect. And this exaggerates returns to equity holders Let's take an example of a house purchase. I'm looking to buy a house, it's gonna cost me 5. Unfortunately I've only got 2 of my own money So I go to the bank and I borrow 3 via a mortgage As time goes on, I try to pay down the debt. The house hasn't gone up in value but as I pay off some of that mortgage So down to 2. My equity goes up to 3, fantastic! So as debt decreases, the rest of the value must be equity I'll say that again, if the house is worth 5 and the mortgage is worth 2 The rest (equity) must be owned by me, must be 3 Now let's see what happens when we have a great result, the house goes up in value (capital appreciation) The house value has doubled to 10, fantastic! The mortgage, well we did pay off a little bit of that mortgage, it went down to 2 So who get's the rest of the value? Well the house went up in value, the debt did not change in value So the rest must be owed to the equity holders. So now let's see what's happened The house has doubled in value, we paid off a little bit of the mortgage And that 100% house increase translates to a 300% equity increase Admittedly involving a little bit of paying down the mortgage That's what we mean by the leverage effect Having debt means that any returns to equity holders in good times are exaggerated upwards But of course, if we were to have bad times and the house value were to go down Then the returns to equity holders would be exaggerated down