Bonds are one major source of financing for companies. They work almost like a loan, paying investors a small percentage during the loan's lifetime and repaying the principal when the loan matures. The effect on the company's financing activities lies with the bond's coupon payment, the price paid for the bonds, and the prevailing rates of interest and inflation.
Bond Financing
Bonds are one type of financing conducted by firms. The other is stocks. While stocks provide a piece of ownership of the firm with the possibility of profit sharing in the form of dividends, bonds are a type of loan. Bonds come in units, with each unit having a par value. The company pays the par value, often equal to $1,000, to the investor after the bond matures, which can be anything from two to 30 years from the time the bond is first issued. Before the par value is paid to the investor, the company will reward the investor with a coupon, which is an annual payment, expressed as an interest rate that's paid to the investor at least once a year. To invest in the bond, the investor must purchase it at its current market price.
The Bond Issuing Process
When a company decides to issue bonds, they're first issued to a number of lenders. The lenders then will sell these bonds to individual investors who'll then profit from the bond's yield, which is the ratio between the bond's price and its periodic coupon payment. The issuer, meanwhile, will either issue the bond at a discount or at a premium. Bonds sold at a discount have a coupon rate that's lower than the prevailing market rates, like those of U.S. Treasury bonds. Those sold at a premium have a higher coupon rate. Bond premiums and discounts serve to compensate for the additional risk taken on by investors.
Bonds Sold at a Premium
When investors purchase bonds at a premium, they're willing to pay a higher price for the bond. This is because investors will receive greater rewards from the bond during its lifetime. So, if a bond paid a coupon rate of five percent and the prevailing market interest rates are at four percent, investors likely will pay a price that's higher than the bond's par value. Let's say that investors pay $1,030 dollars for every 100 bonds worth $1,000 in par value. While the real return received from coupon payments diminishes after taking into account inflation, the company raises $103,000 from issuing the bonds but only owes $100,000 to the investors after the bonds mature. The net effect is a cash inflow of $3,000 for the company. This only applies if the inflation rate is greater than or equal to the coupon rate.
Bonds Sold at a Discount
While bonds sold at a premium generate a net cash inflow, bonds sold at a discount result in the opposite provided that the rate of inflation is less than or equal to the coupon rate. So, using the same example, let's assume now that the coupon rate is three percent. This results in investors buying the bonds at a discounted price of $95,000. While the company still owes investors the par value payment of $100,000 when the bonds mature, they suffer a liability of $5,000. Thus, the coupon rate of a bond has a considerably large impact on the financing activities of firms.
