Consider the following statements:

1. Statement I: As regards returns from an investment in a company, generally, bondholders are considered to be relatively at lower risk than stockholders.
2. Statement II: Bondholders are lenders to a company whereas stockholders are its owners.
3. Statement III: For repayment purpose, bondholders are prioritized over stockholders by a company.

Which one of the following is correct in respect of the above statements?

1. Both Statement II and Statement III are correct and both of them explain Statement I
2. Both Statement I and Statement II are correct and Statement I explains Statement II
3. Only one of the Statements II and III is correct and that explains Statement I
4. Neither Statement II nor Statement III is correct

Explanation

Option (a) is correct

• Equity (Share Certificate):
  • Represents ownership in a company.
  • Stockholders receive dividends from profits. If no profits, no dividends.
  • Equity holders are residual claimants, with the last claim on assets during liquidation.
  • Attractive during economic booms due to the likelihood of higher profits and dividends.
• Debt (Bond/Debenture):
  • Represents a loan to the company.
  • Bondholders receive fixed interest and principal, irrespective of the company’s profits.
  • They are creditors with the first claim on assets during liquidation.
  • Preferred during economic slowdowns due to assured returns.

Answer: (a) Both Statement II and Statement III are correct and both of them explain Statement I; Difficulty Level: Easy