Disadvantages & Advantages in Using Bonds & Common Stock to Fund Corporate Debt
When companies need to borrow money they have a number of options at their disposal. Most businesses can simply go to a bank and open a line of credit or even take out a small business loan. But what if a company needs to raise billions of dollars and negotiating directly with a lending institution is out of the question? In this case large businesses generally issue corporate bonds or common stock to investors. Both forms of funding corporate debt have their advantages and disadvantages and every company must decide which option is preferable for its particular circumstances.
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Prevailing Interest Rates
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Prevailing lending indicators such as London Interbank Offer Rate (LIBOR) play a significant role in determining whether a company chooses to issue bonds or common stock to generate funds. If the prevailing interest rates are exceptionally high, over ten percent for example, a company with an average credit rating would most likely have to pay a dividend rate mirroring this. In this case the company may decide that the high dividend rate is a disadvantage and choose to issue common stock. Common stock issues provide companies with the advantage of not having to pay high dividends. Conversely, if prevailing interest rates are exceptionally low, companies may find advantages in issuing bonds.
Company Control
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Issuing stock may sound like a great way to avoid high interest rates and dividend payments, but company leadership must also weigh these benefits against the dilution of leadership and even company control. Every time a share of common stock is issued and sold it dilutes the ownership of the company for every equity holder in the company aside from the person that purchases that share. Many companies find this to be a major disadvantage of issuing common stock. Issuing corporate bond debt does dilute ownership of a company and many companies view this as an important advantage.
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Stock Market Conditions
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In times of economic uncertainty the stock market generally devalues. This has been a hallmark of every economic recessionary period in the US over the past century. If investors view the stock market as being undervalued, companies are unlikely to issue common stock to fund corporate debt. Issuing common stock in this type of economic climate is a disadvantage since low investor interest will drive down the price of the stock. When the stock market is undervalued companies often view issuing corporate bonds as being advantageous since regulatory bodies generally keep interest rates low in these situations to spur lending and investment.
Credit Rating
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For companies with a poor credit rating issuing corporate bonds can be a major disadvantage. Leading rating agencies such as Moody's, Standard & Poors and Finch investigate and rate the creditworthiness of large companies and assign a letter rating. If a company receives a poor rating investors will demand a premium to purchase this debt. This results in high dividend rates and disadvantageous costs compared with issuing common stock. In some situations a company with a poor credit rating may continue to enjoy a strong standing with equity investors making common stock issues much more cost-effective than bond debt.
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References
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