Introduction

Mr. Stephenson and Mr. Brunel propose to build a railroad.

It will cost $2 million to build. They have only $100,00
between them and they can't persuade a band to put up the
$1.9 million needed.

Partnership
They propose to you as well as a couple of dozen other
investors a partnership. Each partner puts in, say, $50,000
and the rest is borrowed from a bank. Then, when the profits
start to roll in (after paying the bank interest) the partners
get an equal share. Of course, in addition Stephenson and
Brunel would take a salary to compensate them for giving
up time to manage the railway.
There are two drawbacks in partnerships. First, under
partnership law each partner is liable for all the debts on the
business. Business partners have been known to lose their
houses, furniture, everything, in order to pay off a business's
creditors. The second problem with partnership arises if one
of the partners wishes to leave (or dies). The leaving partner
is generally entitled to a fair share of the value of the
partnership. This can be terribly disruptive to a business, as
assets may have to be sold to pay the partner off. Indeed,
partnerships tend to be dissolved if one member wished to
leave and then a new partnership is created to carry on the
business thereafter. So the two issues partnerships have to
deal with are: the unlimited liability of the investors; and the
continuity of business in the case of investors wishing (or
forced) to disinvest.

Company or corporation
A company or corporation is set up as a 'separate person'
under the law. It is the company that enters legal agreements
such as bank loan contracts, not the owners of the company
shares. The company can have a perpetual life. So, if an
investor wishes to cash in his chips he does not have the
right to insist that the company liquidate its assets and pay
him his share. The company continues but the investor sells
his share in the company to another investor.
The introduction of limited liability was one of the most
important breakthroughs in the development of capitalism
and economic progress. Creditors quickly adjusted to the
new reality of lending without a guarantee other than from
the company. They become more expert and thorough in
assessing the risk of the loan going bad (credit risk) and they
called for more information; legislators helped by insisting
that companies publish key information.
Now, Stephenson and Brunel intend to create a company
with limited liability for the shareholders. The company will
issue 1.5 million shares. Each share will have a par value of
$1. Sometimes companies sell shares at the par value and
sometimes they sell them at greater than the par value. The
par value (also called the nominal or face value) is merely a
nominal figure, useful for record keeping, but unrelated to

the market value of a share. In the case of Stephenson and

Brunel Ltd, the shares are to be offered to investors at par.
The company also borrows $500,000 from a bank.

A money-making machine
Over the next two years the line is constructed, trains are
bought, stations built and the first paying passengers are
delighted. The company now has total assets of $2.3 million.
It also has bills it has not yet paid (trade creditors) of
$400,000 and bank debt of $500,000. The $1.4 million of
net assets (i.e., after deduction of liabilities, $2,300,000$400,000-$500,000) are owned by the ordinary
shareholders. Because Stephenson and Brunel Ltd has 1.5
million ordinary shares outstanding, each share has a claim
of 0.93 of net assets ($1,400,000 divided by 1,500,000
shares). A holder of 50,000 shares would be entitled to
$46,667 if the company were liquidated (assuming the assets
could be sold at balance sheet values). So you can see why
ordinary shares are often referred to as equities. Each share
represents an equal stake in the business, not just for
dividends but also for assets.
You might now be thinking youve made a big mistake in
buying these shares: you put in $50,000 and the assets of the
firm have declined by $0.07 per share. But you must not be
hasty in reaching a judgment. In buying a share you are
entitled to receive a portion of the future value generated by
the business, and a business is a lot more than the assets
shown on the balance sheet. What creates value is the
physical assets combined with a number of intangible
elements such as the strong strategic position of the firm, the
reservoir of experience of the managerial team, or the
special relationship the company forms with customers,
government, suppliers, etc.
Stephenson Brunel Ltd didnt just build a railway, it created
an economic franchise. That is, it put itself in a position that
gives it pricing power, whereby it can charge customers a
price far above the cost of providing the service. It has an
almost impregnable monopoly in providing rail transport in
the part of the country where it operates. Would-be
competitors simply cant challenge the company for its
customers (termed strong barriers to entry). As a result of
its economic franchise it is able to generate exceptional
long-run rates of return on the capital put into the business.

Dividends and retained earnings

The power of that franchise starts to become apparent in the
third year. The company makes a profit (earnings), after
paying interest and taxes, of $750,000. The directors now
have a choice to present to the equity holders (ordinary
shareholders). The company could retain all of its earnings
to invest in extending the network (retained earnings) or it
could pay out some (or all) of it to shareholders in the form
of dividends. Note that, whichever course of action is taken,
the money belongs to shareholders earnings retained in a

business are there because shareholders consent to their

money being left there.
Suppose that the directors (with the agreement of the
shareholders) decide on a 50 percent payout ratio, that is,
half of the earnings after tax are paid out in dividends. The
shareholders will receive a dividend of $0.25 per share
($375,000 divided by 1,500,000 shares).
The retained earnings of $375,000 increases shareholders
funds from $1,400,000 to $1,775,000. So, shareholders have
not only received a $0.25 dividend for each share they hold,
but the retained earnings have increased the asset value of
each share in the company from $0.93 to $1.18 ($1,775,000
divided by 1,500,000 shares).
It is crucial to note that $1.18 does not represent the value of
one share should you wish to sell. There will be plenty of
people willing to pay a lot more than this to buy the right to
receive all the future dividends from a company with such a
strong market position. There is every reason to believe that
the earnings and dividends per share will rise by large
percentages over the next decade or two. Perhaps someone
will pay $10 per share, or maybe even $100, for a fastgrowing company of this kind. Not bad, considering that
you paid only $1.

What if I want to sell?

Investors could buy or sell shares through members of the
stock exchange. The stock exchange performs two vital
roles to encourage investors to invest in industry. The first is
the operation of a primary market. This is where companies
sell shares to investors and then use the proceeds in their
businesses. Stock markets also provide a secondary market
where shares are traded between investors. An efficient and
trustworthy secondary market is needed to encourage
investors to buy shares in the primary market. Investors like
to know that there is a place they can go to sell shares
quickly, cheaply and without having to reduce the price, that
is, to sell at the going rate. In other words, investors need a
liquid market.

Bonds
If you wish to invest in a business but are unable to bring
yourself to take the risk associated with shares, a good
alternative is to purchase a corporate bond. A bond is a
long-term contract in which bondholders lend money to a
company. In return the company (usually) promises to pay
the bond owners a series of interest payments known as
coupons, until the bond matures. At maturity the bondholder
receives a specified principal sum called the par, face or
nominal value of the bond. The time to maturity is generally
between 7 and 30 years. Bonds are a form of debt finance
and are not ownership capital. The holders are not entitled to
vote at the company meetings. A lower rate of return is
offered on bonds than on shares because bond investors
have a number of safeguards that equity investors do not.
The interest on bonds is paid out before ordinary share

dividends are paid, so there is a greater certainty of

receiving a return than there is for equity holders. Also, if
the firm goes into liquidation, the bondholders are paid back
before shareholders receive anything.
Bonds are often traded in the secondary market of the stock
exchange or via bond dealers. So despite companies
obtaining long-term finance for years ahead, the investor
who provides that money can sell the bond to another
investor to liquidate his holding.

Capital structure
Capital structure is the proportion of debt to equity making
up the total finance supplied to the company.
The shareholders in a company such as Stephenson Brunel
Ltd may be more than happy for the company to borrow
some funds either from a bank or a bond issue due to the
leverage (or gearing) effect. To understand this, imagine
that the firm is now five years old and has long since paid
off all its bank borrowings. It has proposed a major new
investment in branch lines that will require $5 million of
new investment. It could go to its shareholders, selling them
additional shares through a rights issue to obtain all the extra
$5 million from them. But consider this: the investment is
expected to produce a return of 20 per cent per year on the
money invested: $1 million per year on the $5 million raised
from the shareholders. This is good, but the shareholders
could be made even better off by an alternative capital
structure. If the company obtained $1 million from equity
holders and $4 million from bondholders it could generate
much higher returns for its shareholders. If we assume that
bondholders require a return of 6 per cent per year, then the
benefit of financial leverage to shareholders can be seen.
The company creates $1 million of extra pre-interest income
per year. Of that $240,000 (6 per cent of $4 million) has to
go to pay the interest on bonds. That leaves $760,000 per
year for the equity holders, who only put up an extra $1
million a 76 per cent return per year!

Stocks and shares

The terms stocks and shares are used interchangeably
and confusingly in the financial press, particularly when
referring to the US markets. In the UK we define shares as
equity in companies. Stocks are financial instruments that
pay interest, such as bonds. However, in the USA shares are
also called common stocks and the shareholders are
sometimes referred to as stockholders. So when some
people use the term stocks they could be referring to either
bonds or shares.