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Chapter 8: Problem 4

Suppose that a firm in which you have invested is losing money. Would you rather own the firm's stock or the firm's bonds? Briefly explain.

Short Answer

Expert verified
If a firm is losing money, you would be better off holding the firm's bonds rather than its stocks. This is because bondholders continue to receive interest payments, offering some level of income security, unlike stockholders who bear the brunt of losses.

Step by step solution

01

Analyzing the two investment options

First, clarify the nature of stocks and bonds. The holders of a firm's stocks are the firm's owners and are the ones who suffer when the firm is losing money. Their total return can even turn negative. On the other hand, the bondholders are simply lending money to the firm and they get a fixed return periodically in the form of interest.
02

Understanding the impact of the firm's performance

When a firm is losing money, the stockholders are directly affected because they might not receive dividends and the price of their shares will likely decrease. Bondholders, unless the firm goes bankrupt and fails to fulfill its obligations, still receive the agreed-upon interest rate on their bonds.
03

Making a decision based on the firm's losses

Given that the company is losing money, the safer option to invest in would be the firm's bonds. As a bondholder, you would continue to receive interest payments as long as the company can still pay its debt obligations, regardless of whether it's profitable or not.

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