Question

Corporations can fund their operations in two ways—one with issuing stock and the other with long-term liabilities, including bonds. Discuss how stocks and bonds differ. (Hint – Include their place in the accounting equation and terms from the chapters.)

Need help with:

Discuss the costs involved with each, stocks and bonds.

Tell us why you think a company should use one or the other, or both.

Answer 1

Discuss how stocks and bonds differ

Stocks Are Categorized as Ownership Stakes while Bonds are categorized as Debt

Stocks and bonds are two different ways for an entity to raise money to fund or expand their operations. When a company issues stock, it is selling a piece of itself in exchange for cash.

Whereas when an entity issues a bond, it is issuing debt with the agreement to pay interest for the use of the money.

Stocks are simply shares of individual companies. Bonds, on the other hand, represent debt. A government, corporation, or other entity that needs to raise cash borrows money in the public market and subsequently pays interest on that loan to investors.

Since each share of stock represents an ownership stake in a company – meaning the owner shares in the profits and losses of the company - someone who invests in the stock can benefit if the company performs very well and its value increases over time. At the same time, he or she runs the risk that the company could perform poorly and the stock could go down – or, in the worst-case scenario (bankruptcy) – disappear altogether.

Whereas Bonds lack the powerful long-term return potential of stocks, but they are preferred by investors for whom income is a priority. Also, bonds are less risky than stocks. While their prices fluctuate in the market – sometimes quite substantially in the case of higher-risk market segments - the vast majority of bonds tend to pay back the full amount of principal at maturity, and there is much less risk of loss than there is with stocks.

In summary

Stocks are ownership of the organization whereas bonds are debt capital of the organization

Stock holder normally receives dividend whereas bond holder receives interest

Stock can be traded at any time whereas debt will be settled only at maturity

Dividend is volatile whereas interest is fixed amount

Stock holder can benefit from stock price appreciation whereas bond holder cant benefit as the price is fixed

Bond will be settled first in the case of liquidation whereas stock will be settled after settlement of all liabilities

Stock holder can participate and vote whereas bond holders cant participate and vote.

Place in the accounting equation

The stock is treated under equity whereas bond is treated under liability

Costs involved with each, stocks and bonds

Cost of stock are normally cost of underwriting shares, initial public offering cost, advertisement cost, brokerage charges and other relevant cost. In addition to that company incurs cost such as dividend to shareholders.

Cost of bonds are normally advertisement cost, brokerage charges and especially the interest charges to bond holders.

Why both debt and equity is important

Equity financing doesn't have to be repaid. Plus, share the risks and liabilities of company ownership with the new investors. Can use the cash flow generated to further grow the company or to diversify into other areas. Maintaining a low debt-to-equity ratio also puts in a better position to get a loan in the future when needed.

Debt financing allows to pay for new buildings, equipment and other assets used to grow business before earning the necessary funds. This can be a great way to pursue an aggressive growth strategy, especially if company has access to low interest rates. Closely related is the advantage of paying off debt in installments over a period of time. Relative to equity financing, also benefit by not relinquishing any ownership or control of the business.

Therefore combination of both equity and debt financing helps the organization to obtain finance. The equity finance amount is limited to owner’s access to funds in such a case high growth potential organization can pursue debt financing at low cost considering the extent of relationship with bank. The equity and debt combination is necessary at different stages of life cycle of the organization as per BCG matrix in the stages such as problem child equity financing is necessary on the other hand in the stages of star debt financing is essential and in the stages such as cash-cow debt financing is not necessary as profit generation is low. Therefore the optimum use of both debt and equity will maximize the wealth of the organization as per Modigliani & Miller concept