Identify and discuss the advantages and disadvantages of bond financing.
If a company is looking for options to increase capital to expand their business or for any other purposes, two main ways to do it could be identified. Company could sell a part of ownership in a company in a form of stock. As a second option company could issue a bond and receive the loan in this form. Each way has both advantages and disadvantages, but let’s focuses on bond financing. A bond issuer's should pay a value called the par value of the bond plus interest.
Three main advantages of bond financing which could be identified are:
Owner control is not affected by bonds issuing. No matter how much you borrow, you will still maintain executive control of your company.
Tax deductible interest on bonds. Many municipal bonds are state taxes deductable. Moreover, some bonds also free from federal taxes. Lower taxes result in higher gains which is an additional reason for investing in bonds.
Gain return on equity with bond issuing. If a company earns a greater return using borrowed funds than it pays on those funds in interest, it increases company`s return on equity.
There are two main disadvantages of bond financing:
1. Lower return on equity with bond issuing. If a company earns a lower return using borrowed funds than it pays on those funds in interest, it decrease company`s return on equity. Such risk of financial leverage is likely to arise when a company during periods of net losses or low income.
2. Bonds require payment of the par value at maturity plus interest. Bond payments could be onerous when company`s cash flow is low.
Therefore, every company should take into account both advantages and disadvantages of bond financing because it could affect company`s financial stability.