Don M. Chance
Financial Management Principle 18

Although there are many different types of securities issued by firms, the gains from issuing different types of securities are somewhat limited and largely based on the mistaken belief by some investors that these securities can be used to earn abnormal returns.

There are different types of equity, such as common stock, warrants, and preferred stock.  There are different types of common stock, such as voting and nonvoting common stock.  There are also many more different types of debt securities, such as bonds with sinking funds, callable bonds, convertible bonds, equipment trust certificates, and asset-backed bonds.  In addition, some financing can be obtained through leasing, which is a commitment to incur a fixed expense to obtain use of an asset and is almost the same as debt.

All of these instruments have advantages and disadvantages and costs and benefits.  Their appeal is often based on the notion that some investors want these specific types of securities and will pay attractive prices for them.  Their existence is something of a contradiction to the efficient market notion and the idea that capital structure does not matter.  If companies can creatively package claims in such a manner that an investor receives something he could not get otherwise, then this type of creative financing can benefit a company's shareholders.  But it is important to note that this benefit arises largely from a belief on the part of the investor who buys the security that he can earn an abnormal return from it.  Alternatively there may be some tax advantage to this special security.  But tax advantages are rarely long-lived.  In the long run, these securities exist primarily to meet the needs of investors who believe they can earn abnormal returns with them.  These investors are likely misguided.  But as long as they are misguided, companies should continue to exploit them by creating and using these types of securities.

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Last updated:  January 9, 2011