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Chapter 10: Problem 12

What are the advantages and disadvantages of issuing bonds rather than common stock?

Short Answer

Expert verified
Issuing bonds avoids ownership dilution and offers tax benefits, but requires regular payments. Issuing stocks raises capital without debt but dilutes ownership.

Step by step solution

01

Understanding Bond Issuance

Bonds are a form of debt financing. When a company issues bonds, it is essentially borrowing money from investors with the promise to repay the principal, along with interest, at a later date.
02

Understanding Stock Issuance

Common stock issuance involves selling ownership shares of the company to investors. This means the company doesn't have to repay the funds or pay interest, but it dilutes ownership among all shareholders.
03

Analyzing Advantages of Bonds

Issuing bonds does not dilute ownership in the company, as it does not involve giving away a share of ownership like stocks do. Interest payments on bonds are tax-deductible, potentially reducing taxable income.
04

Analyzing Disadvantages of Bonds

Bonds require regular interest payments regardless of the company's financial situation, which can be a financial burden. Additionally, the principal amount must be repaid upon maturity.
05

Analyzing Advantages of Stocks

Issuing stock generates capital without incurring debt or requiring regular interest payments. This can be beneficial during uncertain times when cash flow might be unpredictable.
06

Analyzing Disadvantages of Stocks

Issuing stocks dilutes existing ownership and control over the company. Additionally, it may lead to increased pressure for short-term performance from shareholders.

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Key Concepts

These are the key concepts you need to understand to accurately answer the question.

Bond Issuance
Bond issuance is a strategy companies use to raise capital by borrowing money from investors. These investors act like lenders as they receive a promise of repayment with interest at a future date, known as the bond's maturity.
  • Interest Payments: Companies issue bonds with a defined interest rate, which is paid regularly to bondholders. These payments are usually tax-deductible, providing a tax benefit to the issuer.
  • Non-Dilutive: Unlike stock issuance, bonds don't mean giving up any ownership in the company. Existing ownership stakes remain intact, and control is not diluted.
However, bond issuance can be risky. Regular interest payments must be made regardless of financial performance. Also, the principal amount must be repaid at maturity, which can be a burden if the company's financial performance is not strong.
Stock Issuance
Stock issuance involves selling ownership shares, or common stock, to investors. This method raises capital without increasing the company's debt.
  • No Debt: Since stock issuance doesn't involve borrowing, companies do not have obligations to make interest payments or repay the capital.
  • Cash Flow Flexibility: There are no fixed repayment schedules like those with bonds. Thus, during financially uncertain times, companies can have more flexibility.
However, stock issuance dilutes ownership. New shareholders mean existing owners have less control. Moreover, it often leads to increased scrutiny from shareholders demanding short-term profitability.
Debt Financing
Debt financing refers to companies raising funds through borrowing. This is done by issuing bonds or taking loans.
  • Ownership Retained: Companies don't have to give up any ownership stake, preserving control for existing shareholders.
  • Tax Advantages: Interest payments provide a tax-shielded expense, potentially lowering taxable income.
Yet, the obligation remains to make regular interest and principal repayments. Failing to meet these could lead to financial distress. Debt also adds to the company's financial leverage, potentially intensifying financial risk during downturns.
Equity Financing
Equity financing involves raising capital through the sale of shares, providing permanent capital without the need to repay.
  • Debt-Free Capital: No obligations to repay principal or service debt means more financial freedom.
  • Funding Growth: Capital raised is often used for expansion or other growth initiatives without increasing financial liabilities.
However, it dilutes existing ownership, which can lead to less control over company decisions for original owners. Additionally, the influx of new shareholders can lead to higher expectations and pressures for consistent short-term returns.

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Most popular questions from this chapter

Installment Term Loan On December 31, 2017, James, Inc., borrowed \(\$ 500,000\) on an cight percent, ten-year mortgage note payable. The note is to be repaid in equal quarterly installments of \(\$ 18,278\) (beginning March 31,2018 ). Prepare journal entries to reflect (a) the issuance of the mortgage note payable, (b) the payment of the first installment on March 31,2018 , and (c) the payment of the second installment on June 30,2018 . Round amounts to the nearest dollar.

Accounting for Bonds Sold at a Discount The Peoples National Bank raised capital through the sale of \(\$ 100\) million face value of four percent coupon rate, ten-year bonds. The bonds paid interest semiannually and were sold at a time when equivalent risk-rated bonds carried a yield rate of six percent. a. Calculate the proceeds that The Peoples National Bank received from the sale of the six percent bonds. b. Calculate the interest expense on the bonds for the first year that the bonds are outstanding. c. Calculate the book value of the bonds at the end of the first year.

If the effective interest amortization method is used for bonds payable, how does the periodic interest expense change over the life of the bonds when they are issued (a) at a discount and (b) at a premium?

What do the following terms mean? (a) term loan, (b) bonds payable, (c) trustee, (d) secured bonds, (e) serial bonds, (f) call provision, ( \(g\) ) convertible bonds, ( \(h\) ) face value, (i) coupon rate, (j) bond discount, ( \(k\) ) bond premium, and (1) amortization of bond premium or discount.

Gordon Company signed a note payable on November 20. Gordon has a December 31 year-end. It paid the note, including interest, on the maturity date, February 20 . What accounts did Gordon debit and what account did it credit on February 20?
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