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Introduction to Bonds and Their Functions
Oct 19, 2024
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Review flashcards
Understanding Bonds
Definition of a Bond
A bond is a way for individuals to participate in lending to a company.
When you buy a bond, you become a partial lender to that company.
Example of a Company’s Financials
Assets
: The company has $10 million in assets.
Liabilities
: For simplicity, assume no liabilities.
Equity
: All $10 million is owned by the owners (equity).
Shares
: If there are 1 million shares, each share is worth $10.
Purpose of Issuing Bonds
Expansion Needs
: A company may want to expand and needs additional funds (e.g., $5 million for a factory).
Financing Options
:
Equity Financing
:
Issue more shares (e.g., 500,000 shares at $10 each) to raise $5 million.
Result: 1.5 million shares total, increased equity by $5 million.
Debt Financing (Bonds)
:
Borrow from a bank, resulting in $5 million in liabilities.
Using this debt to acquire the factory keeps the asset side of the balance sheet identical to the equity financing.
Key Differences Between Equity and Debt Financing
Equity Holders
:
Share in profits, but also share in risks.
More shareholders mean more people to split profits with.
Debt Holders (Bondholders)
:
Receive interest payments (considered an expense) before any profit distribution.
Interest payments are fixed and must be paid regardless of the company’s performance.
They do not share in the company's profits.
Issuing Bonds vs. Bank Loans
Instead of borrowing from one bank, a company can issue bonds to multiple investors.
Bonds are certificates with a
face value
(e.g., $1,000) and an
interest rate
(coupon rate).
For example, a bond might have:
10% Annual Coupon
: Paying $100 per year.
Maturity Date
: Date when the company repays the face value (e.g., in 2 years).
Bond Issuance Example
To raise $5 million, the company issues 5,000 bonds at $1,000 each.
Buying a Bond
:
When you buy a bond, you lend the company $1,000.
Interest payments (coupons) are typically paid semi-annually.
Payment Schedule for Bonds
For a 2-year bond with a 10% coupon:
Total payment: $100 per year.
Payments: $50 every six months.
Last payment includes the final $50 coupon plus the return of the principal ($1,000).
Conclusion
Issuing bonds is a method for companies to raise funds without giving away equity.
Bondholders receive fixed interest payments and principal repayment at maturity, while shareholders share in profits and risks.
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