Corporations in need of additional capital generally have two financing options: borrowing or issuing shares of stock. A business that chooses to borrow can issue several different corporate debt instruments to obtain the funds. These debt instruments commonly take the form of corporate bonds, commercial paper or traditional promissory notes.
Corporate Bond Basics
Just as you are able to purchase shares of stock on a public stock exchange, other markets exist that allow you to invest in corporate bonds. A corporate bond is essentially the same as a conventional loan. You lend the corporation money in exchange for periodic payments of interest and repayment of the principal on the bond’s maturity date. When a corporation issues a bond, it has a legal obligation to make these interest and principal payments, and the liability is reflected on its financial statements. The number of years a corporation has to repay the bond can vary, but corporations usually issue bonds for long-term financing, which means the principal does not come due for a number of years.
Bond Prices and Interest
Investing in corporate bonds comes with some risk because repayment of the principal is contingent on the company’s ability to earn future profits. Investors frequently evaluate this risk by referencing corporate credit ratings reported by firms such as Standard & Poor’s and Moody’s. If the corporation has a history of stable and consistent earnings and hasn’t defaulted on prior debt obligations, its credit rating will reflect this. The credit rating directly affects the rate of interest investors are willing to accept on each bond, and this influences the market price of the bond. In other words, if a corporation is fairly new or has a low credit rating, investors will not invest in its bonds unless the interest rate is high enough to compensate for the increased level of risk. If the bond’s stated rate of interest isn’t sufficient, it generally sells at a discount, which means that investors can purchase the bond for less than its face value or loan principal.
Corporations in need of quick, short-term financing to fund operations or purchase inventory may issue commercial paper rather than bonds. This approach has some advantages. The sale of commercial paper isn’t subject to the same government oversight as bonds, so the compliance costs associated with issuing bonds can be avoided. It also speeds up the inflow of capital to the corporation. Commercial paper is typically sold in larger denominations to institutional investors. A distinct feature of commercial paper is that the corporation must repay the loan in a rather short time – usually within three to six months.
Traditional Bank Loans
Corporations always have the option of obtaining a traditional bank loan by issuing a promissory note to the lending institution. The terms of a corporate bank loan are typically straightforward. The bank evaluates the company’s creditworthiness, establishes a maximum loan amount and interest rate, and then sets a fixed repayment schedule.
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