The two main sources of finance are debt and equity.

These types of finance have very different characteristics. Let's look at some of them.

Starting with debt, the debtholders in a company are lenders you get many different types of debt, but let's keep things simple and think of debt as a loan obtained from a bank. That bank will receive interest as compensation for lending you that money. In addition the amount you borrowed the principal amount will need to be repaid to the bank at some point in the future.

Furthermore debtholders or debt providers are senior creditors in the capital structure. What does that mean? Well, if things were to go wrong and the company entered financial difficulty and had to be wound up. The debtholders would be repaid first before any money could be given to the shareholders.

Let's now look at equity. The equityholders are the shareholders and owners of the business. Shareholders may receive a dividend from the company.

However, unlike interest companies do not have to pay dividends.

Although some shareholders might expect them.

Also in contrast to debt there is no repayment of the capital amount that shareholders invest this makes equity a perpetual instrument for the company. In other words, there is no maturity date at which the company needs to repay the share capital.

Finally shareholders rank at the bottom of the capital structure in a company.

If the company were to be wound up shareholders would only receive anything that is left over after the debtholders have been repaid meaning that the shareholders have a residual claim on the business.

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 going to cost me 5.

Unfortunately, I've only got 2 of my own money equity.

So I go to a 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 say down to 2 my equity goes up to 3 fantastic. So as debt decreases the rest of the value of that house must be sitting in equity.

I'll say that again if the house is worth 5 and the mortgage the debt is worth 2 the rest the equity the part that's 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 gets the rest of the value. Well, the house went up in value, the debt did not change in value. So the wrist must be owed to the equity holders.

So now let's see what happened.

The house has doubled in value.

We paid off a little bit of the mortgage.

And that 100% house price increase an increase in value from 5 to 10.

Translate to a 300% Equity increase from 2 to 8 admittedly involving a little bit of paying down the mortgage.

That's what we mean by the leveraging 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.