Question

How are bonds utilized by investors and by a company desiring to raise capital? Primary objective of the company , pros and cons of bonds, risk and return of bonds

Answer 1

Bond is less risky for investor but returns are less than cost of equity. This is because in case of liquidation bond holders are paid first followed by equity holders.

Bonds for company is cheaper form of financing but increases risk of the firm. The cost of debt is less because interest on debt payments are tax deductible. Debt reduces the overall cost of capital thereby increasing the firm value. Here the firm has to pay coupons as per conditions laid down by the bond agreement or pay interest and principal as per the terms of the loan.

Benefits of bond financing:
1. Cost of debt is very low due to the tax benefit it provides.
2. It can be borrowed to the level that it can provide optimum cost of the capital.

2 Drawbacks of bond financing:
1. It increases risk in the firm. Higher the leverage higher is the risk of default.
2. Higher debt can decrease the rating by credit rating agencies and hence incremental cost of debt might increase.

Risk of bond depends on credit rating. Lower the rating higher the risk, similarly higher the raing lower the risk. The return on bonds are lower than cost of equity and preferred shares