a) Thedifferences between issuing shares and bonds as financial instruments as meansof acquiring funds for a company. Stock or shares are units of ownershipinterest in a corporation or financial asset that provide for an equaldistribution in any profits, if any are declared, in the form of dividends. Commonshares and preferred shares are the two main types of shares. When starting a corporation,owners may choose to issue common stock or preferred stock.
Most companiesissue common stock. The stock may benefit shareholders through appreciation anddividends, making common stock riskier than preferred stock. Common stock alsocomes with voting rights, which give shareholders more control over thebusiness. In addition, certain common stock comes with pre-emptive rights,ensuring that shareholders may buy new shares and maintain their percentage ofownership when the corporation issues new stock. In contrast, preferred stocknormally does not offer appreciation in value or voting rights in thecorporation.
However, the stock typically has set payment criteria; a dividendthat is paid out regularly, making the stock less risky than common stock. Commonly,preferred stock may be redeemed at a more beneficial price compared to commonstock. If the business files for bankruptcy and pays its lenders, preferredshareholders receive payment before common shareholders because preferred stocktakes priority over common stock. Infinancial markets, stock capital is raised by issuance and distribution ofshares by a corporation or joint-stock company.
Shares requires a company tosell a percentage of its interests to investors. Funds raised by the company byissuing shares is known as equity. This is where a company gives investorsshares in the company’s ownership in exchange for capital. Companies sellshares on the stock market or through a private offering. Equity financingdistributes ownership or equity among stockholders. The companies maydistribute a portion of any profits made to stockholders. Moreover, companies haveno repayment obligation, thus the risks fall on the investors or shareholders. However,the more shareholders a company has, the less decision-making power owners andmanagement have over a business’ operations.
On the other hand, a bond is a debtinvestment in which an investor loans money to an entity, usually corporate orgovernmental, which borrows the funds for a fixed period of time at a variableor fixed interest rate. Bonds are used by companies, municipalities, states andsovereign governments to raise money and finance a variety of projects andactivities. Bond owners are debtholders, or creditors, of the issuer. Whencompanies or other entities need to raise money to finance new projects,maintain ongoing operations, or refinance existing other debts, they may issuebonds directly to investors instead of taking loans from bank. The issuerissues a bond that contractually states the interest rate (coupon) that will bepaid and the time at which the loaned funds (bond principal) must be returned(maturity date). The issuance price of a bond is normally set at par, usually $100 or$1,000 face value per individual bond. The actual market price of a bonddepends on several factors including the credit quality of the issuer, thelength of time until expiration, and the coupon rate compared to the generalinterest rate environment at the time.
Shares represent an ownership interest in acorporation. Bonds are a form of long-term debt in which the issuingcorporation promises to pay the principal amount at a specific date. Shares paydividends to the owners, but only if the corporation declares a dividend.Dividends are a distribution of a corporation’s profits. Bonds pay interest tothe bondholders. In general, the bond contract requires that a fixed interestpayment be made every six months.
Every corporation has common stock. Somecorporations issue preferred stock in addition to its common stock. However,most corporations do not issue bonds. Stocks and bonds issued by the largestcorporations are usually traded on stock and bond exchange, while stocks andbonds of smaller corporations are usually held by investors and are nevertraded on an exchange. In addition, stocks are only issued bycorporations but bonds can be issued by either corporations or governmententities. Bonds are debt, while shares are equity.
This is an importantdistinction between the two securities. By purchasing share, an investorbecomes an owner in a corporation. Ownership includes voting rights and theright to share in any future profits whereas by purchasing bonds, an investorbecomes a creditor to the government or corporation. The major benefit of beinga creditor is that you have a higher claim on assets compared to shareholders. Inthe case of bankruptcy, a bondholder will get paid before a shareholder.
However, the bondholder does not share in the profits if a company does well.They are entitled only to the principal plus interest. Briefly, there isgenerally less risk in owning bonds than in owning stocks, but this comes atthe cost of a lower return. b) The termsof stock splits, bonus issues and right issues. Stock split is the issuance ofadditional shares by a company to its shareholders without collecting any contributionfrom them. Such issue increases the number of shares issued and outstandingwithout increasing the total balance of common stock and market capitalizationof the company.
The result of a stock split is to split the par value andmarket price per share. As a matter of fact, the sole purpose of the stocksplit is to reduce the market price per share to make it more attractive forinvestors. Stock splits are designed by companies concerning their intendedeffect on the market price. If a company wants to reduce its market price tohalf, it will issue 2-for-1 stock split which means the company shall issueadditional 1 share per 1 share currently issued and outstanding thereforedoubling the total number of shares. There might be a 3-for-2 stock split, forexample, which means that 3 shares are to be issued for each 2 shares ofcurrently issues shares.
The balance of equity account is not affected by stocksplit however, it just increases the number of shares and reduces par value.For example, Blue Ltd. has 2 million of $10 par value common stock issued andoutstanding which is currently trading at $300 per share.
The managementthought that the share price is too high and it intends to reduce it to its1/3. The company would need to issue a 3-for-1 stock split which means that foreach of currently issued common shares the company shall issue 3 shares. Itwill increase the total number of shares issued and outstanding to 6 million (2million × 3) resulting in a par value of $3.33 ($10 ÷ 3) and a market price of$100 ($300 ÷ 33). Stock’sprice is affected by a stock split.
After a split, the stock price will bereduced since the number of shares outstanding has increased. For instance, ina 2-for-1 split, the share price will be divided equally into two (halved). Themarket capitalization remains constant even though the number of outstandingshares and the stock price changes.
Stock split is usually performed bycompanies that have seen their share price increase to levels that are too highor beyond the price levels of similar companies in their sector. The mainreason is to make shares appear more affordable to small investors despite thefact that the underlying value of the company has not changed. Besides, stocksplit can cause a stock price to increase, following the decrease immediatelyafter the split. Since many small investors buy the stock as they think thatthe stock is now more affordable, they end up boosting demand and drive upprices. Another reason for the price increase is that a stock split indirectlyshows that the company’s share price has been increasing and people believethat this growth will go on in the future, and lift demand and prices again.
Furthermore,a bonus issue, also known as a capitalization issue or a scrip issue is anoffer of free additional shares to existing shareholders. A corporation maygive out additional shares as an option to increase the dividend pay-out. As anillustration, a company may give one bonus share for every five shares held.Companies give out bonus shares to shareholders when companies are short ofcash and shareholders expect a regular income. Shareholders may sell the bonusshares and meet their liquidity needs. Issuing bonus shares does not involvecash flow. Bonus shares may also be issued to restructure company reserves. Itincreases the company’s share capital but not its net assets.
Bonus shares areissued based on each shareholder’s stake in the company. A 3-for-2 bonus issuegrants every shareholder three shares for every two shares they hold before theissue, which means a shareholder with 1,000 shares receives 1,500 bonus shares(1000 x 3 / 2 = 1500). Stocksplits and bonus shares have a lot of similarities and differences. When astock split takes place in a company, number of shares increases but theinvestment value remains the same. Companies normally declare a stock split asa way of infusing additional liquidity into shares, increasing the number ofshares trading and making shares more affordable to retail investors. No increaseor decrease in the company’s cash reserves takes place when a stock is split,but when a company issues bonus shares, the shares are paid for out of the cashreserves, and the reserves deplete. Last but not least, rights issueis when a company issues its existing shareholders a right to buy additionalshares in the company. The company will offer the shareholder a specific numberof shares at a specific price.
Time limit will be set by the company for theshareholder to buy the shares. Usually, shares are offered at a discountedprice to encourage existing shareholders to take the company up on their offer.If a shareholder does not take the company up on their rights issue, they havethe option to sell their rights on the stock market just like the way theywould sell ordinary shares. However, their shareholding in the company willbecome weak.
A company will offer more shares to its shareholders to gain extramoney for the company. Companies with poor cash flow usually use rights issueto increase cash flow and pay off existing debts. Sometimes, right issues areissued by companies with healthy balance sheets in order to fund research anddevelopment projects or to purchase new companies. Discounted shares issued bya company can be appealing but it is important to find out the reason for therights issue of shares. A company may be using the rights issue as a quick cashfix to pay off debts masking the real reason for the company’s cash flowfailing such as poor leadership. Hence, caution must be taken when offered witha rights issue. Theadvantage of raising money through a rights offering is that the company canbypass underwriting fees. In some cases, a company may use rights offering toraise money if there are no other viable financing alternatives.
This is normalduring economic slowdowns where banks become reluctant to lend to companies.The benefit of a rights offering to shareholders is that shares are generallyoffered at a discount. This discount can be quite high at times, it actually dependson how much a company feels the need to encourage its shareholders to beinvolved in the rights offering. In spite of that, a rights offering by a big,established company may be taken by the market as evidence that a company isstruggling. The reason is that rights offerings flood the market with moreshares, hence reducing the value of shares that are available. Shareholders canbecome disgruntled when their shares are diluted.
But, a rights offering ismeant to calm this concern because only existing shareholders are given theopportunity to buy additional shares. This is unless, shareholders decide tosell these rights. c) Characteristicsof convertible bonds and how can it be a good option for the company.Convertiblebonds are bonds that can be exchanged for, or converted into, common stock atthe option of the holder. Conversion does not bring in additional capital forthe issuing firm, rather, debt is simply replaced by common stock. Thisreduction of debt will strengthen the firm’s balance sheet and make it easierto raise additional capital. However, this effect represents a separate action.In many cases, a convertible bond is issued as a temporary substitute forcommon stock when the market price of a firm’s stock is depressed but isexpected to improve in the future.
If the company wants to ensure that aconvertible bond will be converted into common stock once stock prices rise,the original convertible will include a call provision. The firm will then callthe bond when the market price of the common stock rises to a point wherebondholders would prefer to convert the bonds rather than return them to thefirm. When the conversion takes place, the firm has effectively issued stock.Once the conversion is made, investors cannot convert back to bonds.
Aconversion feature permits the bondholder (investor) to exchange, or convert,the bond into shares of common stock at a fixed price. Investors have greaterflexibility with convertible bonds than with straight bonds, because they canchoose whether to hold the company’s bond or convert it into stock. One of themost important provisions of a convertible bond is the conversion ratio, whichis defined as the number of shares of stock that the convertible holderreceives upon conversion.
Related to the conversion ratio is the conversionprice, which is the effective price paid for the common stock obtained byconverting a convertible bond. For instance, a $1,000 convertible bond with aconversion ratio of 20 can be converted into 20 shares of common stock, so theconversion price is $50 = $1,000 / 20. If the market value of the stock risesabove $50 per share, it would be beneficial for the bondholder to convert thebond into stock. Convertiblebonds, also known as convertible securities can be used to take advantage ofsome of the benefits associated with both debt and equity. Debt with aconversion feature offers investors greater flexibility by providing them withthe opportunity to ultimately be either a debtholder or a stockholder.
Thus,such a feature generally allows the firm to sell debt with lower couponinterest rates and with fewer restrictive covenants than debt that does nothave this feature. Even though convertibles do not bring additional funds intothe firm at the time of conversion, they are nevertheless useful features thathelp the firm achieve “delayed equity financing” when conversion occurs.Convertibles generally are subordinated to mortgage bonds, bank loans, andother senior debt, so financing with these instruments leaves the company’saccess to “regular” debt unimpaired. In addition, convertibles provide a way ofeffectively selling common stock at prices higher than those prevailing whenthe issue was made.
Many companies actually want to sell common stock and notdebt, but they believe that the prices of their stocks are temporarilydepressed and too many shares would have to be sold to raise a given amount ofmoney. Such firms might use convertibles if they expect the prices of common stocksto rise sufficiently in the future to make conversion attractive. When theconversions take place, the firms have obtained “delayed equity financing” thateliminates the original debt. Convertiblebond is a type of debt security which can be converted into a predeterminedamount of the underlying company’s equity at certain times during the bond’slife, normally at the bondholders’ discretion.
This bond is a flexible financingoption for companies and is useful for companies, especially those with high risk/rewardprofiles. Convertibles bonds are issued by companies for some reasons. Issuingconvertible bonds help minimize negative investor interpretation of itscorporate actions. As an example, if a public company chooses to issue stock,the market often interprets this as a sign that the company’s share price isovervalued. In order to avoid this negative impression, company may choose toissue convertible bonds, which bondholders are likely to convert to equityanyway if the company continue to do well. Forinstance, Black Inc. issues a $1,000 face value convertible bond paying 4%interest with convertible ratio of 100 shares of the company for eachconvertible bond and a maturity of 10 years for $1,000. At the end of yearnine, which is the year before maturity, the investor is entitled to $1,000 inprincipal with additional $40 in interest payments, a total of $1,040 if thebond is not converted into equity.
However, after a successful quarter, thecompany’s shares are now trading at $11; hence, 100 shares of the company arenow worth $1,100 (100 shares x $11 share price), surpassing the value of the bond.By converting the bond into equity, the investor receives 100 shares in the process,the share can then be sold in the market for a total of $1,100.Convertiblebonds are issued because investors seek for a security that optimally proteststheir principal on the downside but also allows them to participate in theupside should the underlying company succeed.
For example, a start-up or relativelynew company, may have a risky project that loses a great deal of money on oneend but may lead the company into profitability and outsize growth. Aconvertible bond investor can get back some principal upon failure of the companybut can benefit from capital appreciation by converting the bonds into equityif the company is successful. Convertible bonds are a practical financingoption for companies and investors when the company’s success resembles abinary outcome. Moreover, convertible bonds allow companies issuing them tolower their borrowing costs.
From investor’s point of view, convertible bondhas a value-added component. Convertible bond is a bond with a stock option,particularly a call option, attached to it. Therefore, it tends to offer alower rate of return in exchange for the value of the option to trade the bondinto stock. Or else, the bond just pays interest to the investor for hiscapital investment. Ittakes time for the bondholders to trade their bonds for stock, so issuingconvertible bonds helps a corporation secure equity financing in a delayedmanner. This action will delay the common stock and earnings per sharedilution.
Because of the stock purchase option, corporations can sell bonds ata lower coupon rate compared to a standard bond. The higher the conversionfeature is worth, the lower the yield it will need to sell the bond. Moreoperating income is accessible to common stockholders until the bonds is convertedinto stocks, as convertible bondholders are entitled to only a small, fixedincome. Thus, allowing common stockholders to maintain voting control of thecorporation temporarily while using the investment income from the convertiblebondholders.