Every organization needs money in order to be able to finance their projects. In business companies there are two main sources of finance available, equity and debt. It is in the best interest of financial managers to select finance mediums that maximize shareholders wealth and improve the value of the firm. In the assignment our scope is to describe the latter finance mediums and outline its distinguishing characteristics. 1. 1 Corporate bonds The choice of long-term financing for a corporation mainly rests between equity and debt financing.
Corporate bonds form part of debt financing and are usually attained by firms in order to financing capital projects of a long-term nature. Several theorists contend that bonds are beneficial to the value of a company due to their inherent limitations. However noble laureates Modigliani and Miller contend that the choice of capital structure is irrelevant to the value of an organization and the gist of its assessment rests on the investment of profitable projects.
We will not enter into the detailed explanation of such theories in order to continue focused on bonds definition and illustration, which is the vital point of this assignment. 1. 1. 1 Reasons for issuing bonds The main source of debt, which a company issues, is a corporate bond. Companies tend to prefer to issue bonds rather than other finance options due to the following reasons: • Bond buyers usually offer finance for a longer term than banks. Banks frequently provide loans within a time frame of five to seven years.
If directors prefer a longer term, like for example twenty years, they have to shift to bonds. • Frequently bond issues are the lowest cost source of finance available for the firm. • Shareholders often prefer to keep their voting power and they dislike losing such power due to share issues for project finance purposes. 1. 1. 2 Mediums through which bonds are issued Bonds issues can be made either to the general public via a public offering or to limited electives like banks, insurances and more.
In public issue of bonds a bond indenture is prepared, which consists of a loan document that states the covenants1 between the bond buyers and the company. There are two categories of covenants, affirmative and negative. Affirmative covenants are promises the firm makes concerning things it will do. For example, the company will reveal in what project the money received will be invested. While, negative covenants are commitments covering for instance, that the organization will not change its corporate structure during the bond period and/or the firm will not dispose of significant assets as a security for the bondholders.
Situations of a bond public issue request the appointment of a corporate trustee with the obligation to monitor the bond covenant and protect the bond buyers form any loss arising due to illegal activities by the firm. The bondholders have legal claim in cases of negligence by the corporate trustee with respect to its obligations. The corporate trustee selected is usually a commercial bank. 1. 1. 3 Types of corporate bonds Corporate bonds are classified into different categories based on the type of security agreement the bondholders have with the firm.
The main bond categories are the following: • Mortgage bonds – are bonds that upon issue are secured by some real estate owned by the company, like for example administration offices, warehouse and more. Failure by the company to pay principal or interest payments in full or on time may lead to legal proceedings against the firm, which may eventually lead to bankruptcy. In such circumstances, the mortgage bondholders have the legal right to take the secured property and sell it on the open market to cover their unpaid debts.
In practice, sometimes a company issues more than one mortgage bond, which are secured by the same piece of property. In such situations the bonds are ranked in a specific order upon issue covering the way in which bond buyers will receive the property sales proceeds in cases of liquidation. For example, the first mortgage bonds will be paid before the second mortgage bonds in liquidation due to such ranking. • Collateral bonds – are bonds secured through high-quality forms of liquid resources like securities or receivables. In cases of liquidation collateral bondholders have the legal right on such resources.
• Equipment trust certificates – these are secured by lien against specific assets like stock or equipment in cases in bankruptcy. • Debentures – are the most common types of bonds, which are not covered by any type of security. However, in instances of liquidation these types of bonds are paid before the shareholders of the company. • Income bonds – this category of bonds differs from the other types of bonds in the sense that these bondholders cannot force the company into liquidation if it fails to pay the interest due on such bonds.
Indeed these bonds are usually offered with a high yield in order to encourage investors to invest. In addition, usually the indentures of these bonds forbid the company’s management to pay managerial bonuses and dividends if liquidity constraints will limit the payment of income bonds interests. It is worth nothing that even though bond indentures provide seniority issue ranks in cases of liquidation, bankruptcy courts are not legally bound to honor such commitments. Indeed in the United States judges have sometimes ignored such seniorities by using their sweeping powers, especially in cases of imposed settlements.
1. 1. 4 Interest rate risk The return given to bondholders is usually in the form of an interest payment, which is frequently paid semi-annually. Bonds are issued for a number of years and once they reach maturity life bondholders are re-paid the face value of their bond originally invested. Investors frequently regard bonds as a low risk safe investment because cash flows are reasonably certain and they have privileged rights over other investors in cases of liquidation.
However, during the bond’s life span, bonds can be traded in secondary financial markets. In this period, their value differs and can be higher or lower of their original face value depending on the interest rate charged by similar investments of the same risk. The impact of interest rate risk will also increase as the length of the maturity increases. For instance, a company has three types of corporate bonds at ? 1,000 par each, with different maturity stages as depicted in table 1. 1. The interest rate of such bonds is 9% paid semi-annually.