Raising Capital by Issuing Bonds
USINFO | 2014-01-03 10:55
Definition
Raising capital by issuing bonds is a popular alternative to selling shares, as it allows a company to avoid relinquishing ownership of part of the business. A bond is a loan in the form of a debt security. The authorized issuer (the borrower) owes the bondholder (the lender) a debt and has an obligation to repay the principal and the coupon (interest) on the maturity of the loan. Bonds enable the issuer to finance long-term investments with external funds.

The loan collateral may be the company’s land, buildings, or other physical assets that can be sold off if the issuer defaults on repayment of the principal. In today’s bond markets, however, a much wider range of assets can fulfill the function of collateral, such as receivables that produce a flow of income.

Advantages
●Taking on debt by issuing bonds is usually cheaper than either a bank overdraft or the cost of raising equity through a share issue. A major advantage is that the return on debt (interest) is tax-deductible, whereas the return on equity (dividends) is paid out of a company’s profits, which are taxed before dividend payments can be made to stockholders.

●Financing by raising debt is a useful way of monitoring a corporation’s overall health, as the ability to repay the debt reflects the overall financial stability of the company.

●Bonds offer a more secure return for investors—dividends are paid out purely at the discretion of the company, whereas interest on debt must be paid according to the set terms of the bond.

●Debt issuance can also be advantageous from a governance point of view. In the United States and United Kingdom, for example, creditors have no influence on the board or company policy—unlike stockholders, who often have the right to vote on policies and the appointment of directors. Financing through debt can thus be very useful for companies that do not want to relinquish control to others.

Disadvantages
●The risks for bondholders rise as more debt is issued.

●The debt covenants may prove too restrictive for the company. A company that is highly leveraged is more likely to face cash flowdifficulties as it has to meet the coupon payments regardless of its income. The cost of servicing the debt may rise beyond the ability to pay, either because of external events, such as falling income, or because of internal problems, such as poor company management. The company may find that it runs into solvency problems if the amount of debt becomes higher than the value of its realizable assets. Thus, the cost of debt rises as its proportion rises in relation to equity. The higher the debt-to-equity ratio, the greater the risk.

●If the company is publicly listed on a stock exchange, the risk to stockholders increases when debt is issued. This is due to the increased claims of the creditors, or bondholders, on the company’s capital and earnings, which must be used to service the debt before anything else. And if the company has problems servicing the debt, stockholders risk the loss of their equity in the case of bankruptcy.

Action Checklist
●Choose the right type of debt. For large investments, you generally have a choice of borrowing the principal from a creditor, usually a bank, or issuing bonds underwritten by the bank that can be sold to investors. If the bond can be retraded, it is beneficial for the bondholders as they can exit at the right moment, but the company still has access to the funds via new purchasers.

●Choose the right interest rate. Bonds usually have either a fixed interest rate for a specified period or a floating rate linked to an agreed index. Fixed-rate debt means that the issuer knows the exact cost across the debt’s lifetime and can budget for the principal and interest payments each year. Floating-rate debt usually has a mark-up over the base rate set by the central bank in charge of the currency that is being borrowed, meaning that the issuer may have to pay more if monetary policy is tightened andinterest rates rise during the period of the loan.

Dos and Don’ts

●Do
Do a full cost analysis to determine if debt will be cheaper for the company than equity.

Take into account that unexpected market volatility and inflation will affect the coupon level.

●Don’t
Don’t issue bonds if you think that meeting regular payments to the bondholders will overstretch your cash flow.
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