Friday, February 8, 2013

Understanding Bond Financing







Bond Financing

Projects that demand large amounts of money often are funded from bond issuances. (Both for-profit and nonprofit companies, as well as governmental units, such as nations, states, cities, and school districts, issue bonds.) A bond Written promise to pay the bond’s par (or face) value and interest at a stated contract rate; often issued in denominations of $1,000. is its issuer’s written promise to pay an amount identified as the par value of the bond with interest.

The par value of a bondAmount the bond issuer agrees to pay at maturity and the amount on which cash interest payments are based; also called face amount or face value of a bond., also called the face amount or face value, is paid at a specified future date known as the bond’s maturity date. Most bonds also require the issuer to make semiannual interest payments. The amount of interest paid each period is determined by multiplying the par value of the bond by the bond’s contract rate of interest for that same period. This section explains both advantages and disadvantages of bond financing.

Advantages of Bonds There are three main advantages of bond financing:
  1. Bonds do not affect owner control. Equity financing reflects ownership in a company, whereas bond financing does not. A person who contributes $1,000 of a company’s $10,000 equity financing typically controls one-tenth of all owner decisions. A person who owns a $1,000, 11%, 20-year bond has no ownership right. This person, or bondholder, is to receive from the bond issuer 11% interest, or $110, each year the bond is outstanding and $1,000 when it matures in 20 years.
  2. Interest on bonds is tax deductible. Bond interest payments are tax deductible for the issuer, but equity payments (distributions) to owners are not. To illustrate, assume that a corporation with no bond financing earns $15,000 in income before paying taxes at a 40% tax rate, which amounts to $6,000 ($15,000 × 40%) in taxes. If a portion of its financing is in bonds, however, the resulting bond interest is deducted in computing taxable income. That is, if bond interest expense is $10,000, the taxes owed would be $2,000 ([$15,000 − $10,000] × 40%), which is less than the $6,000 owed with no bond financing.
  3. Bonds can increase return on equity. A company that earns a higher return with borrowed funds than it pays in interest on those funds increases its return on equity. This process is called financial leverage or trading on the equity.
To illustrate the third point, consider Magnum Co., which has $1 million in equity and is planning a $500,000 expansion to meet increasing demand for its product. Magnum predicts the $500,000 expansion will yield $125,000 in additional income before paying any interest. It currently earns $100,000 per year and has no interest expense. Magnum is considering three plans. Plan A is to not expand. Plan B is to expand and raise $500,000 from equity financing. Plan C is to expand and issue $500,000 of bonds that pay 10% annual interest ($50,000). Exhibit 14.1 shows how these three plans affect Magnum’s net income, equity, and return on equity (net income/equity). The owner(s) will earn a higher return on equity if expansion occurs. Moreover, the preferred expansion plan is to issue bonds. Projected net income under Plan C ($175,000) is smaller than under Plan B ($225,000), but the return on equity is larger because of less equity investment. Plan C has another advantage if income is taxable. This illustration reflects a general rule: Return on equity increases when the expected rate of return from the new assets is higher than the rate of interest expense on the debt financing.

Point: Financial leverage reflects issuance of bonds, notes, or preferred stock.
 
EXHIBIT 14.1Financing with Bonds versus Equity

Example: Compute return on equity for all three plans if Magnum currently earns $150,000 instead of $100,000.
Answer ($ 000s):



Disadvantages of Bonds The two main disadvantages of bond financing are these:
  1. Bonds can decrease return on equity. When a company earns a lower return with the borrowed funds than it pays in interest, it decreases its return on equity. This downside risk of financial leverage is more likely to arise when a company has periods of low income or net losses.
  2. Bonds require payment of both periodic interest and the par value at maturity. Bond payments can be especially burdensome when income and cash flow are low. Equity financing, in contrast, does not require any payments because cash withdrawals (dividends) are paid at the discretion of the owner (or board).
A company must weigh the risks and returns of the disadvantages and advantages of bond financing when deciding whether to issue bonds to finance operations.

Point: Debt financing is desirable when interest is tax deductible, when owner control is preferred, and when return on equity exceeds the debt’s interest rate.

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