Question

Why is a bond considered to be a loan but a share of stock is not? Why do corporations issue both bonds and shares of stock?

Short answer

Bonds are considered loans because they require the issuer (borrower) to pay back the holder (lender) the principal amount plus interest. Shares of stock are not loans because they represent part ownership in a company with potential returns coming from dividends and appreciation of stock value, but no obligation for the company to pay back the invested amount. Corporations issue both bonds and shares of stocks as they serve differing financial needs: bonds for debt financing, meaning borrowing money, and stocks for equity financing, meaning selling part of the company ownership.

Step-by-step solution

Understanding Bonds

A bond is a financial instrument representing a loan made by an investor to a borrower. Corporations, municipalities, and governments commonly use bonds to finance projects and operations. The issuer of the bond is the borrower, and the holder of the bond (or the investor) is the lender. Once a bond is bought, the holder is assured of regular interest payments from the issuer at a predetermined rate (the coupon rate) and the repayment of the principal at bond's maturity date.

Understanding Stocks

A share of stock, on the other hand, represents a share in the ownership of a company. It signifies a claim on part of the company's assets and earnings. Unlike bond holders, shareholders do not lend money to the company and are not entitled to interest payments. However, they can potentially benefit from dividends, which are a portion of the company’s profits distributed to shareholders, and capital gains if the value of the stock appreciates.

Corporations Issuing Bonds and Stocks

Corporations issue both bonds and shares of stocks because each serves a different purpose. Bonds are debt financing instrument which allow companies to borrow large amounts of capital from investors, to be paid back with interest, which can be helpful during expansion or for projects that require large upfront investment. Stocks are equity financing instruments and by issuing stocks a company essentially sells a portion of its ownership or equity in exchange for capital. In this case, the company does not need to pay back the money raised but also relinquishes a portion of control and profits to the shareholders.

Key concepts

Bonds vs Stocks

When corporations seek to raise funds, they have two primary options: issuing bonds or stocks. But what exactly differentiates these two financial instruments?

Bonds, as described in the exercise, are forms of debt. When investors buy bonds, they're effectively lending money to the entity issuing the bonds in exchange for periodic interest payments and the return of the bond's face value at maturity. Bonds are thus a safer investment since they promise to repay the principal plus interest, thereby being considered loans.

Stocks represent equity in a company. Purchasing stock makes the investor one of the company's owners, albeit usually in a very small percentage. Stocks don't guarantee any payments; however, they have the potential for dividends and value appreciation. Unlike bondholders, stockholders have residual claims on a company's assets and may have voting rights that can influence company decisions. Stocks are not considered loans because they represent ownership stakes, rather than a debt obligation.

Corporate Finance

The realm of corporate finance pertains to the financial decisions businesses make and the tools and analysis utilized to make these decisions. It is essential for corporations to manage their finances efficiently to ensure they can fund operations, maximize profits, and plan for long-term growth. The choice between debt and equity financing is a crucial decision within corporate finance. Acquiring funds through issuing bonds (debt financing) maintains control of the company with the existing owners but comes with an obligation to pay back the borrowed sum along with interest. Alternatively, acquiring funds through selling stock (equity financing) may dilute ownership but doesn't obligate the company to repay the investors. Corporate finance teams must weigh these options carefully to sustain the company’s financial health.

Equity Financing

In the context of equity financing, a company raises capital by selling shares of its stock, essentially exchanging ownership interests for funds.

The attractiveness of equity financing lies in its no-obligation feature concerning repayment. Companies don't need to repay the capital or make regular interest payments, which can be beneficial if the company is not generating enough cash flow. However, this type of financing comes with the downside of ownership dilution. The more shares a company issues, the smaller the fraction of ownership each shareholder owns, which can also lead to reduced control over the company for the original owners. Stockholders become vested in the company's success, sharing both the potential upsides and the risks.

Debt Financing

Conversely, debt financing occurs when a company raises funds by selling bonds or taking out loans, promising to pay back the borrowed money over time with interest. This option allows companies to raise capital without giving up ownership stakes.

The advantages include tax benefits, as interest payments on debt are often tax-deductible, and retaining control, since bondholders are creditors and not owners, therefore, they don't have voting rights. The risks associated with debt financing include the mandatory payment obligations, which can strain cash flow, especially if a company's income is not stable or predictable. Additionally, too much debt can make a company less attractive to investors and potentially lead to financial distress or bankruptcy if it becomes unable to meet its debt obligations.