Advantages & Disadvantages of Issuing Bonds Instead of Capital Stock

Selling stock is a great way to raise capital. A stock represents a small piece of a company. If the firm does well, stockholders get dividends. If the firm does poorly, the stock falls in value. Bonds are a debt. Investors forward money to the firm and in exchange, get an IOU. The firm then pays a fixed rate -- if that is the nature of the bond -- back to the investor. These are the two main means of raising capital.

Features

Bonds permit a firm to raise cash without giving any control over to investors. In general, bonds are considered a safe investment -- partially due to their predictability -- and are fairly easy to sell. A firm with a good bond rating, basically its credit score, is always a safe bet.

Function

Raising money is the primary purpose of bonds. The firm raising money this way must pay the interest and principle on the bond. This puts some pressure on firms, and struggling companies can go into default, leaving the bond holder with worthless paper. On the other hand, a bond is predictable; it demands the same amount to be paid each month -- or quarter -- to the holders. Therefore, the payment can be budgeted far in advance. The bond's predictability makes dealing with this debt easier than the variable prices of stock.

Benefits

Firms can improve their credit rating by issuing a small, manageable number of bonds. If a firm is struggling with cash flow and performance issues, issuing a few bonds can work wonders for lifting the company's credit rating on the bond market. This will increase the attention and investment the firm can attract.

Effects

While bonds place the firm in debt, this debt can be beneficial to the company. However, if interest rates rise, and the bond is not a fixed-interest loan, the company is in trouble, having to pay both the principle and an ever-growing amount of interest. Fixed-rate bonds are pegged at a specific rate of interest, which makes those type of bonds easier for a firm to manage. Variable rates mean that the bond is at the mercy of the market and the fluctuations of interest rates. If there is no fear of inflation or interest-rate spikes, all bond forms are advantageous. But if a country is not economically stable, then bonds can be a very bad idea.

Considerations

The interest rate on bond debt is tax deductible. This is a huge advantage of issuing bonds. Technically, firms do not have to pay dividends on capital stock, since they can always use that extra cash to expand. The price is, of course, that people will avoid investing in such a firm, because investors want to see dividends. Therefore, variable dividends are, in essence, required. Paying dividends is not tax deductible.

References

• McGraw-Hill: Understanding Business
• RL Rouse Directory: Buying Bonds: Advantages And Disadvantages
• Accounting Scholar: Issuing Bonds Payable