Debt and Equity: "Fundamentally the Same Thing"

On January 22, 2007, I wrote a slightly confused blog entry called "in defense of leverage", which tried to explain that debt and equity are not nearly as different as people often think. Exactly one year later, on January 22, 2008, Steve Waldman finally got around to doing the job properly:

Creditors (people who lend to a firm) and equityholders (those who own stock) are fundamentally the same thing. Both are just investors, people who place money in the hands of a firm in hopes of getting it back later on, with a little something extra for their troubles. Whether one chooses to invest as a stockholder or bondholder is an idiosyncratic matter. Bondholders sacrifice potential upside for predictability and a legal right to enforce payments. Equityholders have no guaranteed payment schedule, but retain a potentially unlimited claim on a firm's future success. Firms pay bondholders according to a predetermined payment schedule, interest and principle. Equityholders are paid via dividends or share buybacks, but only when management is confident it has sufficient resources to pay debt obligations and fund firm operations. For those who grew up in the era of structured finanace, the equityholder/bondholder distinction is basically a primitive version of the tranching you'd find in a CDO. (There is the control thing that, as a historical quirk, usually goes exclusively to equityholders, but we'll put that aside for now. Creditors "own" a company as much as shareholders do, though the two groups have different sorts of rights associated with their claims.)

Read on for why this means we should abolish the tax-deductibility of business interest payments.