Why Corporations Issue Bonds Rather Than Stocks
Corporations issue common and preferred stocks and bonds to raise capital. Stocks are perpetual securities that represent proportional ownership in a corporation. They may or may not pay dividends. Bonds are debt instruments issued for a specified period of time that pay interest. The decision to issue stocks or bonds is based on the different status and features of these securities.
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Dilution
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Since stock represents proportional ownership in a corporation, issuing more shares dilutes current owners’ stakes and earnings per share.
Some large current shareholders may object to a secondary offering because they don’t want to buy more stock but still want to keep their current ownership percentage the same.
Earnings per share (EPS) dilution negatively impacts the current stock price: the same amount of net income now has to be divided by a larger number of shares, increasing the current P/E (price-to-earnings ratio), thus making the stock more expensive (less valuable) to current and future investors.
Stock Price
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Corporations sell stock in a secondary offering when the stock price is high so that they can raise as much money as possible. Current investors often interpret the announcement as a sign that the stock price is as high as it can get and sell, sending the stock price down. (In most instances the stock decreases as soon as a secondary offering is announced.) The big shareholders may not be happy about the stock price decline, which they would blame on the management.
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Time Frame
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Stocks are perpetual securities; bonds have maturity dates. Issuing stock means sharing company ownership forever, whereas issuing a bond means borrowing for a specific period of time without changing the current ownership structure.
Interest Rates
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Corporations borrow when interest rates are low. Since interest is paid with pre-tax dollars while dividend is paid with after-tax dollars, the net cost of borrowing (or issuing bonds) to a corporation may be lower even if the amount of interest and dividends will be the same.
Supply and Demand
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A corporation hires an investment banker to advise it on the best way to raise capital. The investment banker must make sure that there is sufficient demand for the new security. Demand for various securities varies over time. Investors may have an appetite for stocks at one time and for bonds at another.
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References
- Photo Credit new york stock exchange image by Gary from Fotolia.com
