>>108244095Investors can form portfolios of different stocks.
Each company can be ranked on a two-dimensional plane of average returns and volatility. Which you can call risks versus returns.
Of the companies that are worth investing in, the higher risk will correspond to higher returns.
By 'diversifying' a portfolio, meaning to invest in different stocks whose success is not dependent on each other, investors can create portfolios with a risk that is functionally less than each of the component listings.
In the capitalist system capital is considered a production factor, the same as labour or land, and companies can calculate their 'cost of capital' like its wages and rent costs.
The capital can come from two sources, equity (investors) and debt (loans). Founders that supply their own materials at the creation of the firm are also investors.
By default, the cost of capital is the weighted average of the dividends and interest of loans depending on how much of the capital comes from each source.
But a lot of money a corporation handles is taxed twice, once when it earns it, and once when it rewards it to its stockholders, this is called the corporate tax. The corporate tax reduces the weight of loan interest in the cost of capital. Because money given as interest for loans isn't profit and money given as dividends for investments IS, the former forms a tax shield.
Because of these corporate taxes, corporations are incentivized to take on as much debt as possible to stay competitive. But if they go too far, they will default on their loans and go bankrupt.
Investors and chief officers have different incentives.
Investors care about the short term, and the profitability of a company.
Chief officers care about the long term, and their own prestige and career.
High debt can also help keep chief officers in line, keeping them from spending money on prestigious projects that do not increase profit or give themselves big bonuses.
