Chapter 2.1 ® - Issuing Bonds Payable & Long-Term Notes Payable, Advantages & Disadvantages of Bonds Payable, Par Value & Bond Certificates
Corporations can raise capital either by equity financing (issuing shares for cash) or by increasing retained earnings through profitable & efficient business operations. In this section, we will discuss how corporations can additionally raise cash; this is done through issuing bonds (also known as debt financing). Many corporations and even the Government issues bonds to raise cash to finance its operations. Examples include the US Treasury bonds or Bank of Canada bonds. In return for capital, corporations & the government promise to repay 100% of the amount + % of interest. We will also explore the basics of bonds, accounting for their issues & retirement, as well as accounting & reporting of bonds.
What is a Bond?
A bond is a written guarantee or promise to pay a certain amount as the par value of the bond along with interest at an annual interest rate. Thus, a bond is considered as a short or long term liability for a corporation. If the bond repayment period is greater than 1 year, it is considered as a long term liability; however if the maturity date is within 1 year, the bond is considered a short-term liability. The par value or face value of the bond is repaid back at a specified future date, also known as the maturity date. The total amount of interest paid each year is calculated by multiplying the face value of the bond x stated annual interest rate (also known as the contract rate or nominal rate/ coupon rate).
This interest can be paid quarterly (every 3 month), semi-annually (every 6 months) or annually (every 1 year). For instance, let’s assume 6 Tech Corp. issues a $10,000 bond with a contract interest rate of 8% to be paid quarterly. The annual interest is calculated as $10,000 x 8% = $800, and the quarterly payments are $800 x ¼ = $200. The document that states the bond issuer’s name, par value, contract or interest rate, maturity and all other relevant data is known as a bond certificate.
Advantages of Bonds
i) Bonds do not affect shareholder control over an organization. Stocks purchased on the stock market represent equity or ownership of the corporation, however bonds do not. Bondholders lend cash to an organization and mark a “Bond Payable” liability on their balance, and a Receivable on their finances/books.
ii) Interest on Bonds is Tax-Deductible – Interest paid on bonds is tax-deductible for an organization and represents a competitive advantage. However, dividends paid out by a corporation are not tax-deductible. This is so important, that an illustration sounds probable. Consider a corporation lends out a $2,000,000 bond to bondholders with a coupon rate of 10% paid annually. Thus, interest expense would be 10% x $2million = $200,000. Because Interest expense is tax deductible, the corporation would be able to deduct this $200,000 from its Net Income equalling $200,000 x 40% = $80,000. This results in a tax saving of $80,000, assuming an income tax rate of 40%!
Thus, the true cost of borrowing the bonds is 120,000 / $2,000,000 = 6%. This means the corporation is really paying out a net of 6% interest (after-tax) on its $2 million bonds payable. If the corporation however would have raised this capital via shares issuance, the $200,000 dividends paid out (assuming the same scenario with a dividend yield of 10%) would not be tax deductible and the true cost of borrowing for the organization would be 10%.
iii) Bonds increase return on equity – Bonds can increase financial leverage of an organization because when it earns higher interest with the borrowed funds through bonds issued than what it pays in interest, this increases its return on equity. Return on equity is net income available to common shareholders divided by common shareholders’ equity.
Disadvantages of Bonds
i) Bonds require repayment of both annual interest rate & principal at maturity – If a company does not maintain a good free cash flow, it might have difficulty making its interest payments & repaying the entire balance of the bonds at maturity may be even more difficult, and the company might have to refinance its line of credit to pay for this. Shares on the other hand do not require a company to pay out dividends; the company can choose to reinvest its dividend payments back into the expansion of the organization.
Ii) Bonds can decrease
return on equity – When a corporation earns a lower return
on investment or interest rate than what it is paying to its bondholders,
it is obviously losing money. This decreases return on equity and leads
to the company not being able to fulfill its interest payment obligations
and repaying the principal at maturity.