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Term Definition

Definition: An investment that gives the buyer ownership in a corporation. There can be different types of ownership, but all corporations issue common stock. They may also issue preferred stock.

Example: Radiant Systems was incorporated in August of 1985. According to the documents it was required to complete and send to the government of the state where it incorporated, the only class of stock that would be offered was common stock. It issued 25 common shares to each of the four founders. The corporation was able to use money paid by the founders for the shares to get the business started.

Investeach explains: Back in the days before computers, buyers of stock would receive an attractive certificate for the type of stock that was bought. On it was printed the number of shares purchased. Now, when someone buys stock, its recorded in the stock broker's computer system. Search the Internet for an image of a stock certificate.

There are two primary ways for corporations to get money: sell part ownership to investors (by issuing stock) or borrow money from them (by issuing bonds). Stock is a much safer way to raise money when compared to selling bonds because:

* the money it receives never has to be paid back
* if it is not doing well, the corporation can reduce or even eliminate dividend payments to stockholders. If it had borrowed the money instead, the bondholders would remind the company that they are entitled to scheduled interest payments that must be paid

Note that from an investor's standpoint, this makes owning stock more risky than owning bonds. Another key difference is that if the corporation goes out of business, bondholders get in line in front of shareholders to be paid back what they invested with the cash the company gets when it sells off its assets. This process, known as liquidation, may leave little or nothing for stockholders.

The primary downside of issuing stock to raise money as opposed to borrowing it by selling bonds is that with each new share issued, the percentage of ownership existing stockholders have drops. They usually don't take too kindly to this effect, called dilution.

One might ask why all investors don't shun stocks for the safety of bonds. The big reason: bonds have limited "upside". An investor might earn 5% to 7% per year. It'll take a long time to grow one's wealth at this rate. It's a far cry from the chance to own a winning stock that doubles or triples in a couple of years.

A second negative for corporations when they issue stock is that dividend payments on that stock is not considered an expense of doing business. Therefore, it does not reduce the amount of a corporation's income (ie: profits) that will be taxed. This results in a bigger tax bill. Bond interest is "tax deductible" because the interest is an expense because it must be paid. The amount of interest paid is deducted from the corporation's income before the tax is computed.  The lower the income, the lower the tax.

Riddle me this:

1. What type of investment makes an investor an owner?
2. Which type of investment makes an investor a lender?
3. What are two types of stock?
4. Identify two reasons why selling stock is much safer for a corporation than borrowing money by selling bonds.
5. Explain where stockholders get in the line of investors to be paid back if the corporation goes out of business.
6. Explain why bond interest paid by a corporation is tax deductible but dividends paid are not.

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Financial Literacy for All!

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