Equity

The exam rarely asks “what is equity” directly; it tests the claim hierarchy and risk-return ranking that flows from the residual nature of the claim. The classic item gives you a liquidation waterfall and asks who is paid where — the full order runs secured creditors, then unsecured/subordinated debt, then preferred, then common, so common bears the most risk and carries the highest required return. A frequent trap pairs this with the cost-of-capital LOS: because common equity is riskiest (and, unlike interest, dividends are not tax-deductible), it is the most expensive source of financing, not the cheapest.

The sharp distinction students miss is that preferred stock is legally equity but economically bond-like — interest-rate-sensitive and senior to common — so don’t lump it with common when ranking risk. Reinforce the residual logic with one mechanism: a dividend is discretionary, declared by the board and never owed the way coupon interest is, which is precisely why equity holders demand the equity risk premium. Memory hook: equity is the residual claimant — riskiest in, but no ceiling on the reward.