Stocks and bonds are two major sources of cash for corporations and represent diametrically opposed ends of the financing spectrum. While stock issuance adds shareholders to the business and creates additional owners, issuing bonds results in more debt. Whether stocks or bonds prove superior depends on the risks and rewards of the projects to be financed with the cash raised.
Return on Investment
Return on investment, or ROI, has wide-ranging applications in finance. When analyzing a corporation, average shareholders' equity represents the investment for which ROI should be calculated. Average shareholders' equity equals shareholders' equity at the beginning of the period, plus shareholders' equity at the end of the period, divided by two. To calculate the return on this average capital, the analyst divides the after-tax net profit by average shareholders' equity and multiplies the result by 100. This number is also referred to as return on average shareholders' equity and represents the rate at which money invested in a business is growing.
Bondholders lend money to the corporation. Therefore, like all lenders, they are owed a specific sum regardless of the company's profits. Failure to pay bondholders will have serious legal consequences, including seizure of assets or even bankruptcy. Issuing bonds to finance a project will increase ROI if the increase in profit resulting from the new investment exceeds interest paid to bondholders. Assume you raise $1,000,000 from bond sales and open a new retail outlet with the money, which brings in an extra $90,000 in annual profits. If the bondholders are paid less than $90,000 in interest per year, the bond issuance will elevate ROI.
Selling stock doesn't create a payment obligation. If the board of directors deems it more prudent not to pay shareholders, they have no recourse and must wait. However, when money is distributed to shareholders, it must be paid equally to new and longtime owners. More shares mean less profit per outstanding stock. If, for example, the company had $4,000,000 worth of shares before and sells an additional $1,000,000 in stock, the share base will increase from $4 million to $5 million or by 25 percent. The share sale will elevate ROI if the investments financed through stock sales increase profits by more than 25 percent.
The Better Decision
Whether a particular project should be financed through stock or bond sales depends on the kind of return expected. The finance department will analyze two distinct scenarios, based on future projections involving stock versus bond issuance. These scenarios must incorporate the accurate interest rate for the bonds, as well as how much stock the business can realistically sell. In addition to the math involved, the finance department's true expertise will become apparent in the accuracy of interest rate projections as well as the quantity of cash it thinks it can raise by going to bond versus stock investors. Which approach will maximize ROI depends on these figures.
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