Brief Exercises
BE9.1 (LO 1) An icon reads, Finance. Bali Corp. has $10,000 in surplus funds to invest and is considering
investing in either Company A or Company B. Company A promises to return the $10,000 original
amount invested in three years’ time and pay a 2% annual return on the principal amount. Company B
does not promise to repay the original amount invested, but indicates that it is likely that the $10,000
investment will be worth more than $10,000 if Company B is profitable. Whether Bali will receive an
annual return on the investment depends on Company B’s cash flows and whether Company B’s board
of directors votes to distribute the cash.
A. Identify whether the potential investments are investments in debt or in equity securities.
B. Explain how you determined your answer.
Solution:
(a) The investment in Company A is an investment in a debt security, and the investment in
Company B is in an equity security.
(b) Bali Corp. is a creditor of Company A because Company A has a contractual obligation or liability
to repay the $10,000 borrowed, as well as interest on the borrowed funds. Therefore, Bali has invested
in another company’s debt.
Company B, on the other hand, does not have an obligation (and therefore does not have a liability) to
either repay the funds Bali invested or to provide a return to Bali on those funds. Instead, Bali has taken
on the risk of a residual shareholder by profiting if Company B does well and losing if Company B does
not do well. This is an equity interest in Company B.
