Microsoft Word - Money, Banking, and Int Finance(scribd).docx

Kenneth R. Szulczyk

with an 11% coupon interest rate and 20-year maturity, then the bondholder has two legal rights.

Bondholder has a legal right to receive 11% or $110 interest each year while the bond is

outstanding. Furthermore, the bondholder has a legal right to receive $1,000 when the bond

matures in 20 years.

A corporation needing long-term funds may consider issuing additional shares of stock or

issuing new bonds. However, if the corporation issues new stock, then the existing stockholders

share control with new stockholders. Consequently, the stockholders lose part of control of the

corporation. On the other hand, the bondholders do not share in the management or earnings of

the corporation. Although the corporation must pay the bond interest, whether it earns profits or

losses, bonds reduce net income, thus lowering a corporation’s taxes. U.S. corporations pay

between 15 and 35 % of their net income in taxes. Nevertheless, bond interest payments are an

expense, which lowers the corporation’s net income. If a corporation issues new bonds, then the

common stockholders could increase their dividend earnings.

We show an example of a corporation expanding operations in Table 1. This corporation

had sold 300,000 shares of outstanding common stock to investors, and it needs $2 million to

expand its operations. After the expansion, the management estimates the company can earn

$1,000,000 annually. Consequently, the corporation has two plans. For Plan A, the corporation

issues 200,000 new shares of the corporation’s stock at $10 per share. For Plan B, the

corporation issues $2 million of bonds with a 10% interest rate. Hence, the interest expense

equals $200,000 per year.

Examining these two plans, Plan B results in a greater income per share for the shareholders

because the bond’s interest lowered the tax burden by $60,000. Thus, the stockholders retained

control of the corporation, and they potentially earn higher dividends per share by using bond

financing.

Table 1. A Corporation Finance an Expansion through Bonds or Stocks

Plan A Plan B
Earnings before bond interest and income taxes $1,000,000 $1,000,000
Deduct interest expense (200,000)
Income before corporation income taxes $1,000,000 $800,000
Deduct income taxes (assumed 40% rate) (400,000) (320,000)
Net income $600,000 $480,000

Plan A income per share (500,000 shares) $1.20
Plan B income per share (300,000 shares) $1.60

The Valuation of Bonds

Governments and corporations issue a variety of bonds with different characteristics and

cash flows. Consequently, we explain the main bonds, and the methods investors and analysts

use to value them. We show a discount bond in Figure 2 , and it is the simplest to calculate. This