Difference between Stocks and Bonds
Bonds are quite different from stock. They offer guaranteed income in the form of annual interest payments and guaranteed repayment of the principal amount stated on the bond contract. These “guarantees” are limited of course, because of the limited liability of the owners (stockholders) of the corporation. Bondholders can force a corporation into receivership (that is, can force the corporation to be taken over by the courts and operated for the benefit of the creditors) if the corporation fails to make its interest payments on time or fails to pay off its bonds at their maturity dates.
Leverage
Accountants use the term ”leverage” to the use of the borrowed money to increase the average income of stockholders at the same time that the variability of the income increases. Suppose that stockholders have invested $100,000 in a corporation, and they can borrow money (issue bonds) by paying 10 percent of interest per year. They expect to earn 20 percent on those borrowed funds, but half the time they will earn 5 percent and half the time they will earn 35 percent.
Leverage and the Debt/Equity Ratio
Because the common stockholders are the ultimate residual claimants of the corporation (that is, they get paid last out of income or out of assets), common stockholders bear more risk than preferred stockholders or bondholders. This risk is reflected in the variability of income earned by common stockholders as compared to the income of bondholders and preferred stockholders. And the larger are the amounts of prior claims to income relative to the value of assets of a company, the more variable is income to the common stockholders.
We can see this by looking at a simple example. Suppose that a corporation has only bonds and common stock outstanding, with bonds earning 8 per cent interest per year.
The corporation balance sheet is assumed to look as follows:
Balance sheet
Assets $1,000 000 Bonds $500,000
Equity 500,000
(On the balance sheet, the term ”equity” refers to the stockholder’s interest in the firm). Equity is defined by equity = assets less liability. Since the only liability of the corporation is its bonds, equity = $1,000 000-$500 000=$500 000.
Suppose income before interest payments is $100,000 in Year One and $50,000 in Year Two. Then since bonds earn 8 percent interest per year, income (before taxes) for stockholders is given by:
Year One Year Two
Income before interest $ 100 000 $50,000
Interest (8% x$500,000) -40,000-40,000
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Income (before taxes)
for shareholders $60,000 $10,000
Note that income in Year Two is 50 percent of income in Year One but income (before taxes) available to stockholders in Year Two is only 1/6 (16.6 percent) of income available for stockholders in Year One. This shows that stockholder income is much more variable than is income (before interest) for the corporation.
Suppose the corporation had been organized with only $250,000 in bonds. This means that the owners would have invested $250,000 more themselves and borrowed 4250,000 less. The effect on variability of income is as follows:
Year One Year Two
Income before interest $ 100 000 $50,000
Interest (8% x$500,000) -20,000-20,000
Income (before taxes)
for shareholders $80,000 $30,000
With a larger equity and a smaller amount of debt (bonds) outstanding, income (before taxes) available for stockholders is less variable than before. With $250,000 of bonds, income before interest for the corporation in Year Two is 50 percent of income in Year One; and income (before taxes) available for stockholders in Year Two is 37,5 percent (3/8) of such income in Year One. And if we go to the extreme of no bond financing, then, since there are no interest costs, income (before taxes) available for stockholders is equal to income for the corporation. Both have the same variability.
From the point of view of the corporation’s stockholders it only makes sense for the corporation to borrow money by issuing bonds, if, on the average, the corporation will earn a higher rate of return on its borrowings than the interest rate it has to pay bondholders. In fact, there had better be a substantial difference between what the corporation can earn on borrowed funds and what it has to pay in interest because, as we have seen, one cost that stockholders bear when funds are borrowed is that the variability of the stockholders’ income increases.
The Initial Public Offering—Heaven or Hell?
As we’ve already mentioned, the “pot of gold at the end of the rainbow,” the goal of long-term strategies for the entrepreneur who doesn’t want to run a company for the rest of his or her working life is to sell it for a lot of money and retire to a beach in Tahiti or a golf course in Florida. While there are several ways to do that, selling the company to the investing public through a public offering of stock will typically bring the largest return to the sellers. The first time the company sells its shares in the public market, it’s called the initial public offering (IPO). So, for the classic entrepreneur, the IPO is the ultimate exit strategy.
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Unfortunately for the entrepreneur with beachfront dreams, the IPO isn’t quite as simple as selling all the shares and walking away dragging a bag full of money. The U.S. government, through the Securities and Exchange Commission (SEC), long ago decided that was a bad idea because too many owners were selling a pig in a poke to unwary public investors who found out too late their shares weren’t worth what they paid for them. Nowadays all the owners, including the professional investors, will remain owners after the IPO and their fortunes will rise and fall with the public stock price, making everyone interested in the same goal, consistent price appreciation.
The SEC aside, the prospect of selling shares over time, along with the likelihood that the company’s continued success will raise the stock price still further, makes the IPO the preferred exit strategy, if the company can get it. That’s a big “if,” because not every company that has investor backing makes a big enough splash to interest investment bankers. Remember the eight in 10 companies that don’t make it? And the one in 10 that makes it big? Well, that means that roughly 90% of the start-ups that get funded by professional investors will not likely be good enough to become IPO stocks—the actual numbers are even more daunting. And of those that do, many will deliver less stellar performance than projected in their IPO offering literature.
Some of them will sink to market prices below their IPO price, while others will languish with modest returns and sort of disappear into the haze without ever making a significant impact on the market.
Still, the exhilarating prospects of making it big in that breathtaking game gives company owners hope. Along the way, they are aided by the coaches and advisors, the investors, consultants, accountants, lawyers, and a variety of others, because everyone wants to play in the big game. And everyone believes it can happen to them—and no one knows for sure, until they take their shot.
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The first sale of equity in a company to the public is generally in the form of shares of common stock, through an investment banking firm.
Don’t Count on an IPO
It would be simple if any company could just go public. Unfortunately, it takes more than mere desire—and few succeed. The most likely candidates for an IPO are companies in industries that are hot—according to the whims of the stock market—and companies that are expected to reach revenues upwards of $100 million quickly.
However, new equity issues have not being a major source of funds for corporations for many years.Typically over the past 25 years, stock issues have accounted for only 2 and 5 years or 6 per cent of total sources of funds, internal financing represents 40 to 60 percent of the total, with debt financing making up the remainder. As we noted earlier, one major reason for this is that the tax laws tend to encourage reinvestment of profits rather than the paying out of profits in dividends.
Creditors
The creditors of a corporation are those individuals of business firms to whom the corporation owes money. They include laborers who have not been paid for their work or who have a claim against the corporation for future pension benefits; firms who have shipped goods to the corporation but have not been paid; banks and insurance companies who have made short-term (less than one year) loans to the corporation to cover temporary cash needs; and long- term creditors, including bondholders (holders of bonds, which are long-term credit instruments issued by a corporation. By long-term, we man that the repayment day is more than one year in the future.)To own a $ 1,000 bond issued, say, by AT&T(American Telephone and Telegraph) is to be a creditor of AT&T much as a bank is a creditor of that organization. The bond contract specifies the interest due per year to the bond holder; the date at which the bond matures (comes due); the amount to be paid by the corporation at the date of maturing of the bond; the assets (if any) to which the bondholder has prior claim in case of default, that is, in case the corporation fails to make its interest payment on time or its maturity payment; and any other provisions that limit the corporation’s ability to engage in financing operations (for example, provisions that limit payment of dividends unless the corporation has a “favorable” income statement or balance sheet, provisions that limit additional bond issues).
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