In this video, we walk through 5 TCP practice questions teaching about the risks associated with investing in equity securities and corporate bonds. These questions are from TCP content area 1 on the AICPA CPA exam blueprints: Tax Compliance and Planning for Individuals and Personal Financial Planning.
The best way to use this video is to pause each time we get to a new question in the video, and then make your own attempt at the question before watching us go through it.
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Equity Securities and Corporate Bonds
Equity securities and corporate bonds represent two fundamental types of financial instruments used by companies to raise capital, each with distinct characteristics, benefits, and risks. Understanding these differences is crucial for investors and financial professionals.
Equity Securities
Equity securities, commonly known as stocks, represent ownership shares in a company. Ownership of equity securities means having a proportional stake in the company’s assets and earnings. These securities come in two main types: common and preferred stocks. Common stockholders typically have voting rights that allow them to vote on corporate policies and board elections. Preferred stockholders usually don’t have voting rights but receive dividend payments before common stockholders and have priority over them in the event of company liquidation.
Returns and Risks: The returns from equity securities are primarily in the form of dividends and capital gains. Dividends are paid out of the company’s profits, and their amount can vary based on the company’s performance. Capital gains occur when stockholders sell their stocks for more than the purchase price. However, the value of stocks can fluctuate widely due to market conditions, making them subject to significant market risk. For example, a stock investor in a tech startup can experience high volatility and potential substantial returns, but also significant losses if the company underperforms.
Corporate Bonds
Corporate bonds are debt securities issued by corporations to fund their operations, expansions, or projects. When investors purchase a corporate bond, they are essentially lending money to the issuing company. In return, the company commits to paying back the principal on a specified maturity date and making periodic interest payments, known as coupon payments, which are typically fixed.
Returns and Risks: The returns from corporate bonds are generally more stable and predictable than those from equity securities, consisting of regular interest payments. However, corporate bonds are not without risks. Interest rate risk is a primary concern, as rising interest rates can lead to a decrease in the market value of a bond. Credit risk is another significant risk, which addresses the company’s potential failure to fulfill its payment obligations. For example, bondholders in an automotive company might face increased credit risk during an industry downturn that affects the company’s ability to service its debt.
Comparison of Risks: While equity securities are more affected by market risk due to their dependence on company performance and market sentiments, corporate bonds are more susceptible to interest rate and credit risks. Both securities face liquidity risks, although this is generally more of a concern for lower-volume, less popular bonds or stocks.
Transferability and Liquidity: Equity securities are typically highly liquid, especially those listed on major stock exchanges. They can be bought and sold quickly in the market without significant loss of value, making them attractive for investors seeking flexibility. Corporate bonds can also be sold on the secondary market, but their liquidity can vary widely depending on the bond’s issuer, maturity, and market conditions.
Conclusion
Both equity securities and corporate bonds are vital tools for corporations to finance their operations and for investors to diversify their portfolios. However, the choice between investing in stocks or bonds depends on the individual’s risk tolerance, investment timeframe, and financial goals. Understanding the nature and risks associated with each type of security is essential for making informed investment decisions.
