Question

How do bonds provide financing to corporations for their capital projects?

What are the key differences between using bonds to finance capital projects and using stock for that purpose?

Answer 1

Bonds represent long term liabilities for the business and are a form of borrowing. Under this source of Financing companies issue a bond to the investors as a loan which must be repaid over a specified time.

The key difference between Bond and equity is that bonds are external liabilities on the business while equity/stock represents owners funds. Bonds carry a fixed rate of interest which has to be paid irrespective of the level of earnings of the business. The cost of borrowing by using bonds as a means of Financing is lower since the interest payments are tax deductible. Return on equity is in the form of dividends which may or may not be paid depending upon the earnings of the business and the management policies. Moreover cost of equity is high due to lack of tax deductibility. This is because payment of dividend is an appropriation of profits and not an expense for the business.

Advantage of using equity over bonds is that the amount of money borrowed as equity is to be paid after payment of all external liabilities and may never be paid back. The face value of the bond however has to be paid by the company at the specified maturity date.