Where you are. Three modules have been about moving money: at rest on the two-tier map, in motion along domestic rails, and across borders through correspondent chains, netting hubs and the both-or-neither settlement that removes Herstatt risk. You have the miniledger as an importable library and you have used it to settle every one of those flows. This module turns to what all that plumbing exists to carry. Money moves because somebody is buying something, and the something is usually a claim on a business. This lesson opens the module with the only two claims there are.
A workshop, and two ways to pay for it
A firm needs 1,000 to buy a second workshop. Its founders have 400 of their own money already in the business and no more to give.
There are two people willing to help. The first says: I will give you the 1,000, and in return I want a share of the firm. If you prosper, my share is worth a fortune; if you fail, I get whatever is left after everybody else, which is usually nothing. I am not owed anything on any particular day.
The second says: I will lend you the 1,000. You owe it back in five years, with interest every year in the meantime, and you owe it whether the workshop prospers or burns down. I do not want a share and I do not want a vote. I want to be paid.
Both hand over exactly 1,000. The firm’s cash is identical either way. Everything else about the firm is now different, and that difference is what the rest of finance is built from.
The idea in one paragraph
There are two doors into a business, and every financial instrument you will meet in this course is a variation on one of them. Through the equity door, an investor buys a slice of whatever is left over after everyone else is paid, with no promise attached and, usually, a vote. Through the debt door, a lender buys a promise: a fixed schedule of payments, owed regardless of how the business does, and enforceable if it is missed. The whole difference lives in one word - seniority - which decides the order in which claims are paid on the worst day. Debt is paid first and gets no more than it was promised. Equity is paid last and keeps everything that is left. Every instrument in modules 4 and 5, from a plain bond to a sliced-up loan pool, is an attempt to slice that ordering more finely.
Both doors, on the same sheet
Module 1 taught you to read a business as a balance sheet, so read this one. The firm starts with a workshop worth 400 on the asset side and the founders’ stake of 400 on the equity side. It balances, as it must.
Now raise the 1,000 through the equity door. Cash goes up by 1,000 on the asset side. The founders’ 400 of equity becomes 1,400 of equity, because the new investor’s claim is an equity claim and sits beside theirs. Assets 1,400, equity 1,400.
Raise it through the debt door instead. Cash goes up by 1,000 exactly as before. But the other leg lands on the liability side: the firm now owes 1,000. Assets 1,400, liabilities 1,000, equity 400.
Why seniority is the whole story
Take the debt-funded firm and let the year go badly. The workshop and everything in it turns out to be worth 900, not 1,400. There is 900 to distribute against 1,000 owed to the lender and 400 of book equity.
The lender takes the 900 and is still owed 100. The shareholders take nothing. Their claim was never a claim on 400 of anything; it was a claim on whatever remained after the lender, and nothing remained.
Now let the year go well and the firm be worth 2,400. The lender gets 1,000 and not a penny more, because that is what was promised. The shareholders keep 1,400.
The vocabulary this opens
Once the two doors exist, the whole zoo becomes readable. A bond is the debt door, made tradeable, which is lesson 5. A share is the equity door, made tradeable, which is lesson 2. Preferred stock sits between them: paid before ordinary shares and after lenders. A convertible bond is the debt door with an option to walk through the equity door later. Securitisation, which module 5 builds, is the art of pooling loans and then cutting the pool into slices of different seniority, so that investors who want a promise and investors who want a slice can buy from the same pool.
The firm’s own choice between the doors has a name too, capital structure, and it is one of the oldest arguments in finance. This course does not settle it. It only insists that you can read any structure off a balance sheet, which is what the exercise does.
Check yourself
1. Both doors delivered exactly 1,000 of cash. Name three things that differ afterwards.
Who holds a claim (a new shareholder against a lender), what kind of claim it is (a residual slice against a fixed promise), and where it sits on the sheet (equity against liabilities). Add a fourth if you like: the equity-funded firm owes nothing on any particular date, and the debt-funded firm owes interest on a schedule whatever happens.
2. The debt-funded firm turns out to be worth 900. Who gets what, and why is the shareholders’ answer not “400”?
The lender takes the 900 and is still short 100. The shareholders get nothing. The 400 on the equity line was never a pot of money set aside for them; equity is the residual, defined as assets minus liabilities, so when assets fall below liabilities the residual is gone. That is what being paid last means.
3. A lender is offered a share of the profits instead of a higher interest rate. Why might it decline even if the expected value is identical?
Because its downside is not symmetric with its upside. A lender that takes losses like an owner but gains only what it was promised has bought the worst half of both doors. Either it wants the residual claim, in which case it should buy equity and be paid last, or it wants the promise, in which case it should hold the promise and price it properly.
4. Why does seniority need to be agreed in advance rather than settled when the money runs out?
Because on the day the money runs out there is nothing to negotiate with, and every claimant has the same incentive to grab first. A pre-agreed ranking is what makes the outcome computable in advance, which is exactly what lets a lender price the loan at all. The same logic runs module 5’s loss-absorbing stack: the order is fixed before anyone needs it.
Do this
Raise the same 1,000 twice, once through each door, and read the two balance sheets side by side.
python3 code/two_doors.pyThe starter builds the firm and leaves you raise_capital, which needs one balanced posting per door: equity raises put the second leg on shares issued, debt raises put it on bonds payable. The assertions check that both doors deliver identical cash and that only the claims differ. Success prints two balanced sheets and the line:
same cash through either door; the difference is who now has a claim, and whether it is a promise or a shareThe completed version is in solutions/two_doors.py.
What you can now do. You can take any financing arrangement, put it on a balance sheet, and say which door it came through and where it ranks when the money runs short. That is the skeleton this module hangs everything on: the next lesson takes the equity door and asks what a slice actually entitles you to, and lesson 5 takes the debt door and turns the promise into something you can trade.