Question

This week we cover bond financing. Often times when large amount of funds are needed for a project or expansion, companies and governments seek financing to help pursue these projects. Define what a bond is and discuss the advantages and disadvantages of bond financing, such as those covered in your chapter. Consider discussing why a company might choose to issue a bond instead of stock, a form of equity financing.

Answer 1

• Bonds are a debt security under which the issuer owes the holders a debt and, depending on the terms of the
• bond, is obliged to pay them interest (the coupon) and or repay the principal at a later date, which is termed the maturity.
• The volatility of bonds (especially short and medium dated bonds) is lower than that of equities ( stocks ). Thus bonds are generally viewed as safer investments than stocks.
• Bonds are often liquid – it is often fairly easy for an institution to sell a large quantity of bonds without affecting the price much.
• Bondholders also enjoy a measure of legal protection: under the law of most countries, if a company goes bankrupt, its bondholders will often receive some money back (the recovery amount).
• There are also a variety of bonds to fit different needs of investors.

Types of Bonds

• Convertible bonds: A convertible bond is a type of bond that the holder can convert into shares of common stock in the issuing company or cash of equal value, at an agreed-upon price.
• Zero coupon bonds: A zero-coupon bond (also called a discount bond or deep discount bond) is a bond bought at a price lower than its face value, with the face value repaid at the time of maturity.
• inflation-linked bonds: Inflation-indexed bonds (also known as inflation-linked bonds or colloquially as linkers) are bonds where the principal is indexed to inflation. They are thus designed to cut out the inflation risk of an investment.

Advantages of Bonds

Bonds offer safety of principal and periodic interest income, which is the product of the stated interest rate or coupon rate and the principal or face value of the bond. Bonds are ideal investments for retirees who depend on the interest income for their living expenses and who cannot afford to lose any of their savings. Bond prices sometimes benefit from safe-haven buying, which occurs when investors move funds from volatile stock markets to the relative safety of bonds.

You can buy bonds directly through your broker or indirectly through bond mutual funds. You can also buy U.S. Treasury bonds directly from the department's TreasuryDirect website.

Disadvantages of Bonds

The disadvantages of bonds include rising interest rates, market volatility and credit risk. Bond prices rise when rates fall and fall when rates rise. Your bond portfolio could suffer market price losses in a rising rate environment. Bond market volatility could affect the prices of individual bonds, regardless of the issuers' underlying fundamentals.

Credit risk means that issuers could default on their interest and principal repayment obligations if they run into cash-flow problems. Some bonds have call provisions, which give issuers the right to buy them back before maturity. Issuers are more likely to exercise their early-redemption rights when interest rates are falling, so you then might have to reinvest the principal at lower rates.

Advantage of Issuing Bonds instead of obtaining financing from the Company's Owners

1). Bonds do not affect owner control

2). Interest is tax deductable

3).Bonds can increase return on equity if the company ears a higher rate of return with the borrowed funds that it pays on the interest of the bonds.