Until a corporation can finance operations through profits, it must raise money from outside sources. A corporation can raise money in one of two ways: through equity or debt financing. Equity financing is the process of selling investors ownership in the company in exchange for funds. Issuing common stock is the traditional form of equity financing. Debt financing raises money from investors through borrowing. Instead of offering equity in the company, the corporation offers to pay interest on any money loaned by private investors. Investors buy bonds, which include a loan term and an interest rate. Every corporation must carefully weigh the advantages and disadvantages of debt over equity financing, as either form of financing can be appropriate under certain circumstances.
Bond financing does not dilute the current owners' interest in the company. Bondholders are paid interest in exchange for the use of their money and are not given equity in the company. Bondholders are creditors of the company, not owners. They have no right to vote and no impact on company affairs. Issuing bonds can be a advantageous way to raise money for operations without giving up control of the corporation.
Bonds are a debt obligation and a fixed cost that cannot be deferred. The interest payment on outstanding bonds is a business expense and must be paid first, before the corporation makes any discretionary use of its money. The obligation to make regular interest payments on outstanding bonds affects a corporation's cash flow, decreasing the amount of money it has for ordinary operations. A corporation with outstanding bonds has a greater risk that unforeseen changes in income will drive the corporation into bankruptcy, since the terms of outstanding bonds cannot be renegotiated. The higher the interest rate and the shorter the maturity of the corporation's outstanding bonds, the greater the risk that an inability to make interest payment will drive the company into bankruptcy.
Although the interest payment on bonds is a significant expense, it is also tax deductible. Consequently, a portion of the cost to finance operations through bonds is absorbed by the federal government.
Bonds are not shares of equity in the company. Consequently, a corporation's outstanding bonds are not part of its earnings per share calculation that affects the corporation's valuation and stock price. As long as a corporation is not overburdened with debt and remains able to meet its interest payments, bonds enable the corporation to raise money for operations without risking a decrease in stock price.
Bonds guarantee repayment of the principal amount of the loan upon maturity. In the event that a corporation is liquidated or sold, the bondholders are paid first, before shareholders. If the company is experiencing financial difficulties, it is possible there may be nothing left to distribute to shareholders after the bondholders have been paid.
To issue bonds, a corporation often must secure the bonds with a lien on assets. This ensures that bondholders are paid first from the sale of company assets before other creditors if the company is liquidated. If the corporation uses the bulk of its assets to secure bonds, it may not be able to obtain other outside financing when needed.
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