Residual claim

Every rupee a company earns, and every rupee it would raise by selling its assets in a failure, has a queue of people waiting for it. The residual claim is the last place in that queue — and it belongs to the equity shareholders.

The workbook puts it in one line: shareholders are ranked last both for profit sharing and for claiming a share of the company's assets.

"Residual" means whatever is left over. That cuts both ways. If the business does well, there is no cap on what is left, and all of it belongs to the equity holders. If it does badly, what is left can be nothing at all.

For profits. Dividends depend on the surplus available after meeting all costs, including interest on borrowings and tax. Preference dividends are paid before any equity dividend. The return to an equity investor depends on the company's future residual cash flows — "the profits remaining after every other claim has been paid".

For assets, if the business fails. The proceeds from liquidation are first paid to other claimants such as government, lenders and employees; any residual amount, if at all, goes to equity shareholders — after paying out preference shareholders, if any.

Why investors accept it. Since all residual benefits of deploying capital in a profitable business go to the equity investor, the return to equity is likely to be higher than to the debt investor. The residual position is the price of that upside.

Illustrative figures. Vardhan Engineering, with 1 crore equity shares, fails and its assets are sold.

Case A — assets realise Rs 50 crore.

Equity receives Rs 5 crore ÷ 1 crore shares = Rs 5 per share.

Case B — assets realise Rs 42 crore. Government, lenders and employees take Rs 40 crore. Preference shareholders get only Rs 2 crore of their Rs 5 crore. Equity shareholders receive nothing.

The upside of the same position. The workbook's example: borrow at 12 per cent, earn 14 per cent on the assets. Lenders receive 12 per cent and not a paisa more; the residual 2 per cent belongs to equity. Double the spread and the equity return rises; the lender's return does not.

Chapter 2 (Securities: Types, Features and Concepts of Asset Allocation and Investing) introduces residual claim under "Variable return and residual claim" in section 2.3.1, repeats the idea in 2.3.3 (returns depend on "future residual cash flows"), and contrasts it with debt's priority in section 2.4. Expect a ranking question ("in liquidation, equity shareholders are paid...?" — last, after preference shareholders) and statements on why equity is called risk capital.

• Preference shareholders come before equity, both for dividends and for return of capital. They are still behind lenders.
• "If at all." A residual claim can be worth zero; there is no minimum.
• Residual applies to profits as well as assets. Interest and tax come out before anything is available for equity.
• The workbook is not consistent on the order among the senior claimants. Section 2.3.1 lists "government, lenders and employees" together as paid before equity, without ranking them; section 2.4 says lenders receive their settlement "before other stakeholders such as employees and equity investors". The safe exam point is the one both passages agree on — equity is last, after preference shareholders.
• Residual does not mean small. In a profitable business the residual is uncapped, which is why equity returns are likely to exceed debt returns.