Question

III- Problem Buying Bonds or Stock
Calculate which is the best alternative between buying Bonds worth $ 1,200,000 earning 5% interest, or Buying Stock worth $ 1,200,000 earning a dividend of 5%
* Tax Rate 20%
* Apply the 3 cases A, B, C to evaluate the Stock

Answer 1

Let's take the case of evaluating stock as:

Case A- If a company earns a profit of $100,00,000 (assume)

Case B- If a company earns no profit no loss

Case C- If a company book a loss

• In Case A when company makes a profit of $1,00,00,000

Earnings before interest and tax =$1,00,00,000

(less)Interest =($1,200,000 * 5%) = ($60,000)

(less)Tax=(1,00,00,000* 20%) = ($20,00,000)

Earning after interest and tax = $ 7,940,000

If we buy bond,bondholder will receive interest ($1,200,000 * 5%)= $60,000

If we buy stock , Shareholder will receive dividend ($7,940,000 * 5%)= $3,97,000

so, in Case A we found that bond interest are fixed on the purchase price of bond , but the shareholders dividend are paid as per the earnings made by the company in that particular year after paying interest and taxes.

• In Case B when company makes no profit no loss

If we buy bond,bondholder will receive interest ($1,200,000 * 5%)= $60,000

If we buy stock , Shareholder will receive no dividend as the coompany did not earn any profit. Dividends are paid to the shareholders from the earnings or the profits. If a company doesn't earn profit no dividend wll be paid to the shareholders.

So, in Case B we saw that ,if a company earns profit than only shareholder will get dividend , but the bond holder will get the interest despite of no earnings in the company.

• In Case C when company books a loss

If we buy bond,bondholder will receive interest ($1,200,000 * 5%)= $60,000

If we buy stock , Shareholder will receive no dividend as the coompany occurs a loss. Dividends are paid to the shareholders from the earnings or the profits of the company. If a company books a loss no dividend wll be paid to the shareholders.

So, in Case C we saw that ,if a company books loss than shareholder will not get any dividend , but the bond holder will get the interest despite of loss in the company. If the company defaults in payment of interest to the bondholder within a specified period than it becomes difficult for the company to aquire future financing and leads to financial distress.

Both Buying stocks and buying bond have both merits and demerits respectively.

If we buy stock then we will become the owner of the company. we will enjoy the voting rights. But if the company doesnot make enough profit than it will not receive any dividend. No fixed earnings. If a company earns high profit they will receive high dividend . if no profit no dividend.

If we buy bonds then we will receive fixed interest payment despite of any profit or no profit. But the bondholder doesnot have any voting rights. neither the bondholder gets more interest if the company earns more income.

Thank you!