Do you ever wonder how companies have the money to build new stores, develop new products, or perhaps even buy another company? Usually companies do not keep enough cash for these transactions sitting in their bank account – it needs to be raised from outside investors. There are two main ways a company can fund these endeavors: a bond issuance or a stock issuance.
For most people, the corporate bond market is often not as well known as the stock market, but it plays an equally important role in the finance world. Say a company like McDonald’s needs $1 million to open 10 new restaurants, but does not have enough cash to pay for it. Or, perhaps they do have enough cash available, but they prefer to save it or invest it in other areas of the business, rather than burning through all of it for this new restaurant expansion. In this scenario, the likely solution would be to issue debt. With the help of a major bank, like Goldman Sachs or Morgan Stanley, McDonald’s would issue (sell) $1 million worth of debt (bonds). The bonds are put into the financial market for investors around the world to buy. Each time a company sells bonds, there is a fixed maturity and interest rate pinned to the bonds. The maturity, which can range anywhere from a few months to 30 plus years, is the date when McDonald’s has to pay the investors back the full amount they borrowed.
The Long-term Cost of Debt
Why wouldn’t every company borrow large sums of money and just pay off years down the road? The answer is plain and simple: the interest rate. Lets say McDonald’s decides to issue 30-year bonds with a 2.5% semi-annual interest rate. This means that McDonald’s will have to pay their investors 2.5% ($25,000 in total) every six months for the next 30 years. At the end of the 30 years, they will pay back the full $1 million. The long-term cost of issuing this debt goes well beyond simply the initial $1 million they borrowed. Over the life of the bonds, McDonald’s will make sixty interest payments, a total of $1.5 million. That’s more than the amount they originally borrowed!
The only reason companies will issue debt is if the amount of profits they expect to make off of the borrowed money is greater than the long term cost of the bonds. Putting it into context, McDonald’s takes the $1 million it borrowed from investors and uses it to open 10 new restaurants across the country over the course of the next year. If McDonald’s can profit more than $2.5 million from these new restaurants over the next 30 years, then they would realize a return on their investment, since their profits were greater than the total long-term cost of the bonds and interest payments. For 10 McDonald’s stores over a 30-year timespan, they should easily double their investment, interest payments included.
Another way for a company to raise money is through a stock issuance. While the goal of raising money is the same as with bonds, the process is completely different. With a stock issuance, the business is giving up a percentage of ownership of their company in exchange for the sum of money they receive. Unlike bonds, there are no interest payments or repayment of the amount borrowed. Instead, because the investors now own a part of the company, they are entitled to a share of the profits equal to whatever percent they own. Profits are distributed to the shareholders through dividend payments, which are given at the discretion of the company. A company that is not yet well established or is experiencing high growth may opt to not pay dividends, and instead reinvest the company’s profits back into the business. Also unlike bonds, stocks have a perpetual existence, meaning their existence is for as long as the company is in business.
Common Stock vs. Preferred Stock
When a company is issuing stock, they have a choice between two different types of stock. Common stock, like its name suggests, is the more common of the two and is what you would own in a normal brokerage account. Preferred stock is less prevalent, and can be seen as a hybrid between common stock and bonds.
Preferred stock is similar to common stock, in that you are buying a share of ownership in the company and its existence is perpetual. However, you are paid dividends (usually a higher rate than the common stock) at regular intervals agreed upon before the issuance of the stock. Also, in the event of company bankruptcy, preferred stockholders have greater claim to the company’s earnings and assets than common stockholders. This means that if McDonalds goes out of business and is forced to sell all of its restaurants and other assets, the preferred stockholders will get their money back before common stockholders if there is not enough money to pay back everyone. Debt holders always get paid back first, then preferred shareholders, then common shareholders.
Who Can Buy Preferred Stock
Regular, guaranteed, and (usually) higher dividend payments, plus you get paid back first if the company goes bankrupt – who wouldn’t buy preferred stock over common stock? Preferred stock is not as prevalent as common stock, making it much harder to actually get these shares. If you look at the thirty largest U.S. companies based on their total stock value, only four have preferred stock outstanding. They are Wells Fargo (WFC), Citigroup (C), Bank of America (BAC), and J.P. Morgan (JPM). Powerhouses, such as Microsoft (MSFT) and Apple (AAPL), have never issued preferred stock.
This means that preferred stock is less frequently traded on the open market and harder for an individual investor to get his hands on. Also, preferred stock does not share in the upside of the company as much as common stock. Because preferred stock acts similar to bonds, in that it has fixed, regularly scheduled payments, the price of the stock is mainly derived from the value of these recurring dividends. This contrasts with common stock, where dividends are not always given or guaranteed, and the potential of the company’s future growth is weighed more heavily into the price of the stock. As a result, institutions are the typical buyers of preferred stock because they have much to lose by investing in riskier assets (common stock) without a guaranteed cashflow.
Selling Additional Stock
Often times a company, if they need more money, will sell addition shares later down the road after their original issuance. The process of selling the stock is the same as mentioned above, but the monetary valuation of the business will have most likely changed. Say the startup technology company originally sold 10% of their business for $100,000. This would value the company at $1 million. If a few years pass and the company needs money for a new product innovation, they might sell additional shares of stock. However, the business has grown and started earning a profit since its first issuance, which means its valuation for this new issuance would likely rise. Perhaps they sell another 10%, but since the company is more valuable, they could raise $200,000.
What Happens to the Original Stockholders
Selling additional shares of stock can come at a cost to the current stockholders because it reduces their proportional ownership in the business. This is called dilution. Putting it into context, consider the example of the startup technology company selling additional stock. If there were 10 original investors who collectively purchased 10% of business – for simplicity, assume they each got 1 share. Next, let’s assume that the additional 10% sold from the new issuance were bought by 10 different investors who also each receive 1 share. Originally, each investor owned 1 share out of the 10 shares total. Now, after the additional issuance, that same investor owns 1 share out of 20 total. This dilutes the shareholders proportional ownership in the company. This can cause the Earnings Per Share (EPS) and value of the stock to decrease.
A good example of this is Facebook (FB). When Facebook first had an IPO, when they issued two classes of stock – Class A shares and Class B shares. Class A and B shares are worth the same in terms of dividends and percentage of ownership in the company, but Class A shares trade on the normal stock exchanges, while Class B shares are all held by the founders, and do not trade at all (class B shares also get more votes). When Facebook wanted to raise more capital, they created a third class – Class C shares. Class C shares have the same ownership of the company (getting access to dividends), but they cannot vote in shareholder meetings. These Class C shares were created by simply giving every Class A and Class B shareholder one share of Class C stock for every other share they owned. To actually raise money, the Class B shareholders simply sold off some of their Class C shares on the open market – the profit from this sale raised the additional money used in the business.
Bonds vs. Stocks
There are many different factors that go into the decision of whether to raise money through bonds or stocks. With bonds, you know exactly what the long term cost will be to pay back the debt. This is typically more beneficial for big companies, like McDonald’s, who don’t want to give up any additional percent of ownership that would force them to share the profits with the shareholders for the remaining existence of the business. But, for example, say a startup technology company that has yet to even sell a product decides they want to raise money. Because they are still in the development phase, they do not know when or how much money they will earn, which could make it difficult to pay back bondholders on a fixed schedule. Instead they would opt to issue stock. While they would give up some ownership and future profits, they aren’t tied down by a large sum of debt they owe investors.
Debt to Equity Ratio
If a company has already issued bonds and stocks in the past, they will look at their existing capital structure to determine how to raise more money. One way to do this is through its debt to equity ratio, which is exactly what it sounds like. It is calculated by dividing the company’s total debt by its total stockholders equity. If a company already has a high debt to equity ratio, meaning the dollar value of bonds outstanding is high relative to the dollar amount of stock outstanding, then they may look to issue stock to avoid taking on more debt. Shareholder dilution is also a major factor in the decision-making process. A company may not want to de-value their existing shareholders by selling new shares, and instead opt to issue debt. Every time a company issues new shares, they need the current shareholders to approve it – convincing current shareholders to dilute their shares can be difficult.
A company’s debt to equity ratio is dependent on the industry they operate in. Companies in capital intensive industries, such as oil/gas or telecommunications, usually have higher debt to equity ratios because their daily operations and expansions require a great deal of cash that they can fund through multiple bond issuances. Also, industries with stable revenues, like utilities, often have high ratios because they know they’ll have enough money to pay back their bondholders in a timely manner. Industries that are not particularly capital intensive tend to have lower debt to equity ratios. This lesson is part of the PersonalFinanceLab curriculum library. Schools with a PersonalFinanceLab.com site license can get this lesson, plus our full library of 300 others, along with our budgeting game, stock game, and automatically-graded assessments for their classroom - complete with LMS integration and rostering support!
This lesson is part of the PersonalFinanceLab curriculum library. Schools with a PersonalFinanceLab.com site license can get this lesson, plus our full library of 300 others, along with our budgeting game, stock game, and automatically-graded assessments for their classroom - complete with LMS integration and rostering support!Learn More