Question

Four ways a corporation can raise capital are through bonds, common stock, preferred stock, and convertibles. Describe each method.

Short answer

Bonds, common stock, preferred stock, and convertibles are four ways a corporation can raise capital. Bonds are debt instruments where the corporation promises to pay interest and repay the principal at maturity. Common stock is an equity financing method where shares of ownership are issued, providing financial flexibility but diluting ownership. Preferred stock is a special class of shares with priority over common stock, carrying a lower cost of capital but lacking voting rights. Convertibles are hybrid securities that can be converted into common shares, offering lower capital raising costs but potential equity dilution.

Step-by-step solution

1. Bonds

Bonds are debt instruments issued by corporations to raise capital. They represent a loan from investors to the corporation. When a corporation issues bonds, it promises to pay the bondholders a specific interest rate, called the coupon rate, at regular intervals (usually semi-annually) and repay the principal amount borrowed at the bond's maturity date. The main advantage of bonds for corporations is that they can raise large amounts of capital at a relatively lower cost than equity financing, especially if the company has a good credit rating. The main disadvantage is that the corporation must meet its interest payment obligations and eventually pay back principal amount, regardless of its financial performance.

2. Common Stock

Common stock is a type of equity financing in which a corporation issues shares of ownership to raise capital. Shareholders who own common stock are entitled to certain rights, such as voting on important company decisions and receiving dividends if declared by the corporation. The main advantage for corporations in raising capital through common stock is that there are no fixed interest payments or repayment schedules, which provides financial flexibility. However, issuing common stock dilutes ownership and control for existing shareholders. Moreover, common stockholders have the lowest priority claim on assets and earnings in the event of bankruptcy or liquidation.

3. Preferred Stock

Preferred stock is another form of equity financing where a corporation issues a special class of shares that have certain privileges over common stock. Preferred stockholders usually have priority over common stockholders in receiving dividends and claims on assets in the event of bankruptcy or liquidation. The dividend rate for preferred stock is usually fixed and must be paid before any dividends are distributed to common stockholders. Preferred stock can be advantageous for corporations seeking to raise capital, as it carries a lower cost of capital than common stock and doesn't dilute equity ownership as much. However, preferred stockholders do not have voting rights like common stockholders.

4. Convertibles

Convertible securities are hybrid instruments that a corporation can issue to raise capital. They can be either bonds or preferred stock, but with a unique feature that allows investors to convert them into a fixed number of common shares at a specified conversion ratio. The major advantage of issuing convertibles is that it allows corporations to raise capital at a lower cost than issuing straight bonds or preferred stock because investors find the potential for future equity growth attractive. The main disadvantage is that it can lead to dilution of equity ownership when investors convert their securities into common stock.

Key concepts

Bonds

Bonds are a popular way for corporations to raise funds. Essentially, they are a form of debt, meaning the corporation borrows money from investors. In exchange, the corporation promises to pay back the principal amount along with interest, known as the coupon rate. This interest is typically paid twice a year.

• Advantages: Lower cost compared to equity financing if the company has a good credit rating. It allows corporations to raise significant capital.
• Disadvantages: Obligatory interest payments and repayment of the principal, which can be a burden if the company faces financial difficulties.

Bonds offer a secure income stream for investors but come with the risk of default if the corporation cannot meet its financial obligations.

Common Stock

Common stock represents ownership in a corporation and is a flexible way to raise capital. By issuing common stock, corporations can spread ownership among more shareholders. These shareholders have certain rights, such as voting on major corporate matters and potentially receiving dividends.

• Advantages: There are no fixed repayment schedules, providing financial flexibility. It does not require obligatory payments like interest.
• Disadvantages: Issuing common stock can dilute existing shareholders' ownership. In case of financial troubles, common stockholders are the last to receive any assets or earnings after creditors and preferred stockholders.

For investors, common stock offers potential growth through capital gains, though it's riskier as the last in line during liquidation.

Preferred Stock

Preferred stock is a different class of equity offering unique benefits over common stock. These shareholders have a higher claim on assets and earnings, particularly when it comes to receiving dividends. These dividends are often at a fixed rate and must be paid before common stock dividends.

• Advantages: Lower cost compared to common stock. Less dilution of ownership compared to common stock issuance.
• Disadvantages: Preferred stockholders typically do not have voting rights like common stockholders.

Preferred stock provides a more stable income stream for investors while maintaining some priority over common stock in corporate payouts.

Convertible Securities

Convertible securities are innovative tools combining qualities of both bonds or preferred stock and common stock. These securities give the holder the right to convert them into a specified number of shares of common stock. This feature attracts investors who see potential equity growth.

• Advantages: Lower cost of raising capital due to the appeal of convertible features. Provides companies with immediate access to capital.
• Disadvantages: Future dilution of equity when the securities are converted into common stock.

For corporations, convertible securities provide a way to offer a less risky investment initially while still accessing the possibility of equity financing.