Quote Originally Posted by patsy View Post
Snoopy – In your example of purchasing shares in a leveraged company ($50M equity, $50M debt), 10% of equity means, as you say, “owning” $5M of the company’s equity. In other words, you “own” $5M worth of assets. So far, so good.

However, owning $5M of assets or equity does not imply that you (as a shareholder) are responsible for paying the debt. Neither does the bank have any recourse on you as a shareholder for unpaid debt. The only entity that is responsible for debt repayment is “the firm” – that is a principle of limited liability. The only big caveat is when shareholders have provided a personal guarantee to a lender; this is common in small entrepreneurial companies. With this particular exception, you as a shareholder have no responsibility to repay the debt.
I agree with what you say above. However, as an investor I am more interested in a company that is a going concern. Not a company that is on the cusp of being 'wound up' by a bank.

Collectively as shareholders (and leaving a side the case of the shareholder with a personal guarantee to the lender) in a company we have no *obligation* to put in further capital or indeed pay the bank back any of its capital or interest on that capital. This is as you say in accordance with the principle of limited liability. However, consider what would happen if we shareholders of a business that was a 'good going concern' *chose* to make a collective decision not to pay our interest bill for a month.

We as shareholders would certainly be within our *legal rights* not to pay the bank their interest. But the bank would be very unhappy if we did that. So unhappy in fact that they would probably have caveats that entitled then to seize control of the company (which includes our precious shareholders equity) and force the company to pay them . So although we don't have to pay the bank, by law, it is *mutually beneficial* for both parties for we shareholders to do so. After all, we want to have an ongoing relatiuonship with our bank - do we not? And the bank do not want to step in and have the hassle of running what was our business just so they can get their own money back.

However, company debt impacts a shareholder in various ways:

1) Company earnings are reduced by interest and principal repayments to lenders (cashflows to lenders) thus reducing dividends (that is, cashflows to shareholders). This is so because lenders rank at a higher priority than shareholders
That is one way of looking at things. But companies do not go into debt for the express purpose of incurring costs and reducing dividends to shareholders. Rather they borrow to make a bigger better company that will be larger in scale than if reliant on shareholders equity alone and in "dollar terms" will *increase* return to shareholders.

2) ROE is a strict function of the “equity beta” (the company risk premium), which in turn is dependent on the level of debt. The more debt a firm takes on, the higher the beta will be of the equity in that business. Debt creates a fixed cost, interest expenses, that increases exposure to market risk.
ROE is dependent on company and market sector performance, which you might express as the 'company risk premium'. It is *also* dependent on the level of company debt which I would regard as a separate and independent variable.

The “share of the pie” (as you say) you are buying when purchasing shares is a share of the “equity pie”. As you correctly pointed out in your example, a 10% share of the “equity pie” is NOT 10% of the “company pie” – it is only 5% of the “company pie” in a 50:50 leveraged company. The other 45% percent in “owned” by other shareholders, and the other 50% is “owned” by lenders.
50% of 50:50 leveraged company is “owned” by lenders? You might want to clarify what you mean there.

If we take Telecom as a (real) example the FY2007 annual report shows total equity and liabilities of $8,276m (page 31). This includes total long term debt of $2,404m. Most of this long term debt ($1,921m) is in Euro Medium Term Notes (page 50, note 23). I am sure you would agree that

$1,921m/$8,276m= 23.2%

is a very substantial part of the company. Yet if you go to the list of 20 largest shareholders (page 98) you will not a single European based shareholder on that top 20 shareholding list. If the Euro Medium Term Note people "own" 23.2% of Telecom how is this possible?

The rights and responsibilities that you have as owner of 5% of the company pie do NOT include the responsibility for meeting debt obligations. The firm holds that responsibility. If it cannot pay debt, then it may raise more equity (thus diluting you).
Yes, or the firm may choose to raise new capital through a general rights issue in which case your equity is not diluted.

Your example of listing a house is flawed (assuming I understand what you mean correctly)
It was an example that was meant to make things clearer. But I think you are right it was a poor analogy. I'll stick to the subject at hand.

SNOOPY