Chapter 10: Basics of Bonds

Bond Financing 1. Definition: Bond financing involves a company issuing bonds, which are debt instruments that represent a loan made by investors to the company. In return, the company agrees to pay back the bond's par value at a specific future date, along with periodic interest payments. 2. Key Characteristics: • • Par Value and Maturity Date: Bonds have a face or par value (the amount to be repaid at maturity) and a set maturity date. Interest Payments: Bonds typically require semiannual interest payments calculated as a percentage of the par value based on a specified contract rate. 3. Advantages: • • • No Ownership Dilution: Since bonds are debt, they don’t affect ownership or control over the company, unlike issuing stock which gives shareholders equity in the company. Tax Deductibility of Interest Payments: Interest on bonds is taxdeductible, which can reduce a company's tax liability. Potential for Increased Return on Equity (ROE): If a company earns a higher return with the borrowed funds than it pays in bond interest, it can increase ROE—a process called financial leverage. 4. Disadvantages: • • Fixed Obligation: Bonds require periodic interest payments and repayment of the principal at maturity. This can strain a company’s cash flow, especially during periods of low income. Risk of Decreased ROE: If the return from using the borrowed funds is less than the cost of the bond interest, it can decrease ROE. 5. Example of Bond Issuance and Trading: • For instance, a company issues $100,000 of 8%, two-year bonds at par value. It records interest payments semiannually, and the bonds may trade in the secondary market at a premium or discount based on market interest rates. Stock Financing 1. Definition: Stock financing involves a company issuing equity (shares of stock) to investors, which represents ownership in the company. This means shareholders become partial owners and are entitled to a share of the company's profits, typically through dividends. 2. Key Characteristics: • • Ownership and Voting Rights: Stockholders have ownership in the company and usually have voting rights on major decisions. No Mandatory Payments: Unlike bonds, stock does not require fixed payments. Dividends are paid at the discretion of the company and only when declared. 3. Advantages: • • Flexibility in Payments: Dividends are optional and can be adjusted based on company profits, which provides flexibility. No Repayment Obligation: There is no obligation to repay the equity; shareholders invest with the expectation of a return through dividends and stock value appreciation. 4. Disadvantages: • • • Dilution of Ownership: Issuing additional shares dilutes existing ownership, which may be unattractive to current shareholders. Potential Impact on Control: As more shares are issued, control over the company can shift if new shareholders acquire a large percentage of equity. No Tax Deductibility: Unlike bond interest, dividends are not taxdeductible, which can make equity financing more costly in terms of tax implications. Comparing Bond and Stock Financing in Practice Example Scenario: Consider a company evaluating whether to finance a $500,000 expansion with bonds (10% interest) or stock. If the company uses bond financing and earns more than the 10% interest on its expansion, the additional profits improve ROE due to financial leverage. However, if the project yields less than 10%, bond financing would decrease ROE because of the fixed interest costs. On the other hand, stock financing avoids mandatory payments but decreases each shareholder's claim on profits through dilution. In summary, bond financing is generally preferred when a company seeks to retain control, benefit from tax deductions on interest, and leverage potential high returns. Stock financing is favorable for companies that prefer flexibility in payments and aim to avoid additional debt obligations, even at the cost of diluting ownership.