Question

How do bonds influence the cost of capital for a company?(Discuss with reference to the WACC)

Answer 1

Bonds are a form of debt financing.It is a widely used by many company who wants to finance their capital structure with the help of debt. Large companies can borrow money by selling bonds,but for a small business debt finance usually means loans and mortgages.

Bondholders are to be paid with fixed rate of interest which are tax deductible.When a company borrow money,it has to pay interest to the lender.That's the price it has to pay for using the lender's money.When interest rates are rising, it will have to pay more in interest ,and it's cost of capital rises.When interest rates fall,it will have to pay less for debt financing.One mitigating factor with debt financing is that the interest you pay is a tax deductible business expense,so every dollar you pay in interest can offset each dollar in revenue,reducing your taxable profit.

Weighted average cost of capital is a measure of cost of capital which is ascertained by weighting out different component of cost of capital and then multiplying it with respective cost. The companies which opts for bond financing wants to avail the benefit of interest rate tax shield and wants to fuel growth with the help of debt.These companies wants to maximize the overall return of the capital which beats the cost of debt.

The tax deductible benefits associated with interest rates payments makes bonds financing a highly lucrative option among corporate enterprises and it can significantly lower the overall weighted average cost of capital.