Bonds are issued for the exact same reason shares are issued: to increase funding for an organization. Bonds help compose the debt categorization of Gearing. Besides debt, the other primary source of gearing is equity. Unlike shares, bonds are issued by a substantially wider selection of organizations. Bonds can be issued by cities, states, provinces, governments, government agencies, and firms of varying sizes. Organizations which cannot issue shares utilize bonds to raise money from the public. Firms can issue both shares and bonds to raise financing.
A firm issuing equity and shares solves two large fundraising problems. The more equity a firm releases, the less value its equities have per share. Early investors suffer losses in both equity value and share control. A firm that can only issue equity to increase capital will quickly dilute its share value for previous shareholders. Bonds, on the other hand, are debt contracts, which require paying principal and interest. A firm that can only issue bonds to raise capital would quickly acquire large amounts of debt. The solution is to alternate both. Bonds are issued by firms which do not want to further dilute their equity. Shares are issued when a firm does not want to increase its debt, but still wishes to raise capital.
Additionally, Bonds can acquire capital from debt when banks do not want to loan directly to a firm, or when the bank would loan to the issuer at rates which are too expensive. Simply approach the general public directly by issuing bonds at a cheaper rate than the bank requires for investment. Bonds can also be customized as the issuer desires. If the issuer desires certain options or conditions, they can append them to the bond contract. Some of these options may reduce the desirability of the bond, so it will be required that options that reduce desirability are compensated with an increase in return. If these options deemed as preferential to the issuer are not offset with an increase in paid interest, these bonds will be avoided.
Bonds can also be issued to avoid short term problems beyond banking issues. Need to pay regulatory fines? Issue a bond to pay for it. Need to avoid downsizing operations? Issue bonds to fund them. Need to build a bridge without raising taxes on the middle class? Issue bonds to receive the money anyway. Need to raise money to pay for military operations during World War 2? Issue bonds to purchase rations for the army. Bonds can be quickly issued to acquire financing for many short term problems.
Bonds can also be used by issuers to match a specific project to specific fundraising. Issuers can also match the obligation to pay the bond to a project they are constructing. Any repayment of the bond will be paid only with revenue raised from the project. They simply write into your bond contract: “If the project raises revenue beyond the project’s cost, the bond will be repaid in full. If the project does not raise revenue matching or exceeding its cost, the bond will not be repaid in full”. This way, issuers align risks for a project to specific debt instruments and don’t suffer substantial losses if things go awry. You were notified in advance.
Measuring Gearing with Debt to Equity
A good way to measure gearing is using the debt to equity ratio. The debt to equity ratio measures the proportion that assets are funded by debt or by an equity investment, or shareholder’s funds. This measure can indicate future problems with a company’s stability, and solvency.
Debt allows firms to boost the asset base without diluting shareholder control or revenues. The return on assets increase generates profit, the debt generates interest costs. If the return on assets exceeds interest profit from debt financing will exceed the interest cost. If a business is doing well, debt can increase profits for shareholders. During upswings in business, there is a high chance of return on assets exceeding interest. During business downturns, there is a low chance of return on assets exceeding interest. This means that interest costs exceed profits from using debt, and earnings leave the business as interest payments. Debt boosts earnings during upswings and lowers earnings during downswings.
If the debt to equity ratio is high, borrowing has been the preferred method of gearing. The firm will generate greater profit per shareholder during the firm’s business cycle upswings. The interest payments eat a higher percentage of low profits if the trend goes sour. If the debt to equity ratio is low, the firm will not be using debt to boost profits during upswings, but will easily meet interest payments during downturns. The key to debt as a boost to return on assets is in moderation. A firm’s debt level should be in between the two measures, enough debt to comfortably boost profits, but not enough to sink the firm during market downswings.
Debt to equity should only be compared to other firms in the context of industry or competitors. Some industries require high capital investments into assets. These firms require heavy outlays into plant, property, and equipment. Manufacturing and Airlines are examples. These firms will typically have higher debt to equity levels. Other firms, like internet or service companies, do not require heavy capital investments into plant, property, and equipment. These firms will typically have low debt to equity levels. The comparison of debt to equity should only be made amongst firms in the same industry, but typically it is better to accept a moderate or low debt to equity than a higher level.
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