Shares and bonds as types of equity and debt financing

1. Shares are a type of equity financing. Buying a share/stock gives its holders part of the ownership of the company. They get an equity stake in the company. Shares generally entitle their owners to vote at a company’s Annual General Meeting (GB) or Annual Meeting of Stockholders (US), and to receive a proportion of distributed profits in the form of a dividend – or to receive a part of the company’s residual value if it goes into liquidation.

2. The most direct way is to buy stocks of a quoted/listed company yourself. You can also profit by buying shares of a mutual fund, which invests in the stocks for you. The secondary market for equity derivatives is the stock market, such as the New York Stock Exchange and the NASDAQ. You can also buy stocks of a new company before it hits the stock exchange. The shares of this Initial Public Offering (IPO) are bought from investment banks, like Goldman Sachs or Morgan Stanley. However, you usually have to have a lot of money, because these shares are sold in bulk quantities. Once they hit the stock market, their price usually goes up. However, you can't cash in for a certain period of time. By then, the stock price might have gone down below the initial price.

3. Companies wishing to raise more money for expansion can sometimes issue new shares, which are normally offered first to existing shareholders at less than their market price. This is knows as a rights issue. Companies sometimes also choose to capitalize part of their profit, i.e. turn it into capital, by issuing new shares to shareholders instead of paying dividends. This is known as a bonus issue. There are ordinary shares and preference shares. Ordinary shares are shares in a company that are owned by people who have a right to vote at the company’s meetings and to receive part of the company’s profits after the holders of preference shares have been paid. Preference shares are shares in a company that are owned by people who have the right to receive part of the company’s profits before the holders of ordinary shares. They also have the right to have their capital repaid if the company falls and has to close.

4. Bonds are a type of debt financing. They are issued in order to raise funds. They carry a fixed rate of interest which is called a coupon and have a defined term or maturity after which they are redeemed. They are traded by banks, pension funds, insurance companies and other institutions. Governments unlike companies do not have the option of issuing equities. Consequently they issue bonds when public spending exceeds receipts from income tax, VAT, and so on. Ratings companies, like Standard & Poor's, Moody's and Fitch's evaluate how likely it is the bond will be repaid. To insure a successful bond sale, borrowers must pay higher interest rates if their rating is below AAA. If the ratings are very low, they are known as junk bonds. Despite their risk, investors buy junk bonds because they offer a higher interest rate.

5. Corporate bonds are loans to a company. If the bonds are to a country, they are known as sovereign debt. Long-term government bonds are known as gilt-edged securities, or simply gilts, in Britain, and treasury bonds in the US. These are the safest bonds. The British and American central banks also sell and buy short-term (three month) treasury bills as a way of regulating the money supply. To reduce the money supply they sell these bills to commercial banks, and withdraw the cash received from circulation; to increase the money supply they buy them back, paying with newly created money which is put into circulation in this way, the so called quantitative easing takes place.

For companies, the advantage of debt financing over equity financing is that bond interest is tax deductible. In other words, a company deducts its interest payments from its profits before paying tax, whereas dividends are paid out of already-taxed profits. Apart from this ‘tax shield’, it is generally considered to be a sign of good health and anticipated higher future profits if a company borrows. On the other hand, increasing debt increases financial risk: bond interest has to be paid, even in a year without any profits from which to deduct it, and the principal has to be repaid when the debt matures, whereas companies are not obliged to pay dividends or repay share capital.

Дата добавления: 2015-10-30