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

1. Expansion Needs: A company may want to expand and needs additional funds (e.g., $5 million for a factory).
2. 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.