Consider the following statements:

Statement I: As regards returns from an investment in a company, generally, bondholders are considered to be relatively at lower risk than stockholders.   

Statement II: Bondholders are lenders to a company, whereas stockholders are its owners.   

Statement III: For repayment purposes, bondholders are prioritised over stockholders by a company.   

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

  • Both Statement II and Statement III are correct and both of them explain Statement I   
  • Both Statement I and Statement II are correct and Statement I explains Statement II 
  • Only one of the Statements II and III is correct and that explains Statement I   
  • Neither Statement II nor Statement III is correct  

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

  • Companies raise long-term funds either by issuing bonds or by selling stocks.
    • When a company issues bonds, it is essentially borrowing money from investors, who are known as bondholders.
    • On the other hand, when a company issues stocks, it is selling ownership shares to investors called stockholders (or shareholders). 
    • Regarding returns from an investment in a company, generally, bondholders are considered to be relatively at lower risk than stockholders.
  • A stockholder is considered as the owner of the company with equity rights, while a bondholder is a creditor who lends money and holds no ownership in the company.
  • Bondholders are given repayment priority over stockholders because bonds are issued for a fixed term with a predetermined interest rate and are repayable at maturity. In contrast, capital from shares is not typically returned during the company’s lifetime, and returns to stockholders vary based on the company’s profits.
  • Thus, bondholders are considered as the relatively lower risk than stockholders because bondholders have no ownership stake; they have a legal right to fixed repayments and are prioritised over stockholders, who are the owners of the company and receive returns based on the profit of the company. Hence, Option a is correct:  Both Statement II and Statement III are correct, and both of them explain Statement I