Significance of Bonds in Capital Financing to Firms
Introduction:
A bond represents a form of financial instrument issued by corporations, governments, or municipalities to finance projects and operations. It offers investors an opportunity to loan companies or governments for an agreed period, which guarantees them a fixed-interest payment plan and a full payment for their initial investment (Brealey, Myers, & Marcus, 2012). Therefore, the issuer of bonds becomes a debtor, while the investors are creditors when it comes to this form of investment. Bonds, with its unique features, guarantees fewer risks to return on investment (R.O.I) compared to other types of securities. Different types of investment include purchasing of stocks which can get invested inform of preference or common shares. Stocks, which involve buying ownership in a company, usually promises higher returns on investment compared to bonds but are riskier. Such evaluation on the risk rewards makes bonds more viable than stocks. Hence, investors get advised to diversify their portfolio by investing in both forms of financial instruments to make the most returns out of their investments.
The paper will expound more on corporate bonds as a form of the financial instrument offered by companies to raise additional capital used in funding growth operations. Usually, bonds get categorized according to the period that they get offered and the fixed interest income that will get realized by the creditor. Corporate bonds typically get offered as short-term or long-term investments to investors. The least period that a corporate bond can get recognized as compliant with the financial regulations of the country is one year bond regarded as short-term bonds. Long term bonds can get invested to, for a period of 1 to 10 years. When it comes to corporate bonds, short-term contracts guarantee less return on investment to creditors compared to long-term bonds that are considered low risk. Long-term bonds can get affected by unforeseen market risks like high volatility of interest rates and inflation. Such market forces contribute to the reason why companies offer higher interest income for long-term bonds as compensation for the market risks associated.
Corporate Bonds in Capital Financing:
As stated earlier, corporations issue bonds to raise a targeted cash flow that could aid the company in funding its day to day operations. In default, bonds get associated with several characteristics that make it more attractive than other financial instruments. Firstly, and most importantly, bonds offer a fixed investment return that gets accrued over the period allocated for the offer (Brealey, Myers, & Marcus, 2012). At maturity, the actual principal (net present value) earned by creditors includes the initial investment and the fixed-timely payments of interest income. It is a common feature of most bonds, which guarantees an investor of return on investments. For example, treasury bills guarantee yields on its bonds by raising money in the form of taxes to pay the creditors, thus making them less risky. Therefore, for a bond to qualify as one, it must guarantee a principal value, amortized under an agreed time, and offer annual fixed income earnings. Bonds differ from preference and common shares as they offer interest payments while the other instruments provide dividend payments that cannot get guaranteed.
Likewise, another common feature among various types of bonds, preference, and common stocks is that they appear inversely proportional to the interest rate. If the interest rates are higher in the market, then prices of both bonds and stocks always fall, and when the interest rates decline, bond prices increase. The phenomenon can get explained that if the money market or economy is doing well, then investors do not buy bonds or stocks, and as a result, the prices fall. When the economy is struggling or under recession, investors are attracted to purchase such bonds or shares with a long-term view that their values will appreciate in future selling their bonds at a profitable future value. Distinctly, bonds offer investors chances to sell their investment before the maturity time gets realized. The characteristic makes bonds attractive to speculation investors or brokers to make a profit from the new and higher present value compared to the amount they invested in at the issuance of the bonds. Also, bonds and stocks offer opportunities to get publicly traded in the exchange market or privately by brokers and investors.
The valuation of bonds, referred to as yield to maturity, gets calculated for the time allocated from the issuance to the maturity of those bonds. It is worth noting that bond terms change from one to the next, depending on the contract coupons given by the issuer. Thus, yield to maturity gets offered as long-term bond discounted annually for the time allocated. Henceforth, the yield to maturity calculations is significant for investors to estimate the bond offer with the best returns on investment compared to the other bonds in the market offered at different interest rates and maturity periods (Lee et al. , 2016). Such yield to maturity calculations gets evaluated to observe the returns that a bond may offer concerning imminent changes that can occur to the current bond price. Most yields to maturity calculations estimate that the coupon rates might fall or increase by 1 percent as other market forces highly influence the level of interest rates in the economy. Therefore, yield to maturity helps an investor to determine the best bond portfolio they can invest in since the prices of bonds and interest rates are highly sensitive and susceptible to changes throughout the bond.
Corporates and other development investors offer bonds to the public to raise working capital that can finance their company objectives. Therefore, such firms must offer those bonds by evaluating the company goals and visions, the pros and cons of the bond type, and the risk rewards associated with them. For example, if a Retail Store B had projected that by the end of the year 2019, the supermarket would have 5 new stores around the country and it only achieved to open 2 new stores, then it appears appropriate in 2020 that the Retailer offers a public bond to raise money to fund the remaining 3 stores that the company had projected to achieve. In such a case, the bond got issued in line with the objectives of the Retailer to expand and construct 3 new stores. Supposedly, the new stores that were to get added in the 2019 plan and did not get realized maybe due to inadequate resources will in 2020 get funded by a public bond offered to achieve that.
Likewise, bonds are offered by evaluating the pros and cons that are associated with a specific type of bond. For example, a zero-coupon rate bond is an advantage to the issuer as the bonds will only pay the initial amount paid by the borrower for the bonds when the maturity period elapses. On the other hand, a corporate bond offered at a higher interest rate implies that the issuer will have to pay annual payments as coupon returns to the creditors as compensation for their investment (Brealey, Myers, & Marcus, 2012). In the process, the company loses out on monies earned as income, which gets directed to paying creditors as interest payments for their bond investment. Most importantly, the issuers of bonds must evaluate the risk rewards associated with the type of bond they offer to their creditors. Corporations compared to the treasury or municipalities cannot charge taxes to pay creditors their interest incomes as contractually agreed. Therefore, when firms offer bonds, they have a risk of defaulting in timely payments of the annual interests or the net future value if they run bankrupt or consistently making losses. Henceforth, all these valuations must get conducted to ensure that the company does not risk getting rated as a high-risk company by offering a type of bond that is low risk and can comfortably afford to service.
Issuing bonds to raise funds for the company is a form of debt financing and affects the weighted average cost of capital (WACC) of the company (Folger, 2020). Any funds given to the company in the form of loans must get repaid after tax obligations get submitted at a cost that affects the working capital of the firm. For example, if a 3-year bond was discounted annually at 5 percent, then at year two, the interest rates increase to 7 percent due to inflation, the company will incur more costs to repay the same bond. It implies that after taxation, it will use more of its remaining funds to finance the repayment of the bond interest to its creditors. Thus, a rise in interest rates, which causes a fall in the price of bonds, indicates that the firm increases its cost of capital to its disadvantage. On the flip side, a lower interest rate of 4 percent is an advantage to the company as it will use lesser funds to repay the bond terms. Hence, a higher bond price is a plus to the issuer as they enjoy a reduced weighted cost of capital (WACC), which represents the money used in repayment of borrowers. When the prices of the bond get higher, it means the company’s value increased, implying higher profits, which after taxation, the firm is left with more funds to get spent as WACC lowering its costs significantly.
Capital budgeting decisions involve significant ideas undertaken by the management concerning the funds they have with them at hand that in future can get used to finance major projects or operations. Some of these major operations can include the acquisition of new assets, expansion operations, or the introduction of new technology to the firm. Due to the magnitude of such projects, significant decisions must occur to ensure that the right procedures and planning get done to avoid massive losses (Abor, 2017). Therefore, bonds can get used by firms to influence their budgetary allocations by estimating future cash flows by using forecasting techniques. Thus, it is critical that a firm evaluates and estimates the expected future cash inflows (returns on investment) versus the cash outflows (interest payments and taxes) of all the projects they were willing to fund with the issued bond. Hence, it remains crucial that the management gets its projections right on the best venture to engage in by estimating the one offering good returns and low risks before borrowing from the public in the form of bonds.
To effectively estimate the viability of a project, the company can make calculations of the net present value of the bond discounted in the given time to repay the creditors. Notably, future estimates must incorporate the risk factors that can affect the cost of capital invested from the bonds to get issued. Some of the risk factors that can affect high returns on investment include reduced sales income, corporate tax increment, or high-interest rates imposed by the federal government (Abor, 2017). Managers must evaluate all the risk factors involved with all the projects they are planning to budget for which ensures that they choose the most viable venture that they can finance with the money from the bond offer. Part of the forecasting includes choosing the project or venture that guarantees higher cash inflows and lower cash outflows. It helps to ensure the realization of the best return on investment both for the company (borrower) and the investor (the creditor).
Conclusion:
All financial instruments discussed in the paper offer profound significance on their role in helping corporations, governments, and municipalities raise funds to finance mega-projects that would have not otherwise got done without public engagement. Bonds, preference shares, and common stocks are vital in both equity and debt financing of entities that are willing to expand their operations. Therefore, more firms should issue bonds when running out of funds for financing their future goals and objectives. Likewise, investors (creditors) can invest in both bonds and stocks to spread their risk portfolio to gain the most out of their investment as all forms of financial instruments have their benefits and shortcomings. Henceforth, both issuers and creditors must forecast all the financial instruments on offer before investing in them to ensure that what they choose guarantees them the highest return on investment at the lowest risk.
References
Abor, J. Y. (2017). Evaluating Capital Investment Decisions: Capital Budgeting. In Entrepreneurial Finance for MSMEs (pp. 293-320). Palgrave Macmillan, Cham.
Brealey, R. A., Myers, S. C., & Marcus, A. J. (2012). Fundamentals of corporate finance. McGraw-Hill/Irwin.
Folger, J., 2020. Interest Rates And Other Factors That Affect WACC. [online] Investopedia. Available at: <https://www.investopedia.com/ask/answers/070114/how-do-interest-rates-affect-weighted-average-cost-capital-wacc-calculation.asp> [Accessed 15 April 2020].
Lee, A. C., Lee, J. C., & Lee, C. F. (2016). Valuation of Bonds and Stocks. World Scientific Book Chapters, 197-267.