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The Advantages of Bond Financing

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  • 0:01 Using Bond Financing
  • 0:49 Bond Financing Basics
  • 2:23 Advantages of Bond Financing
  • 4:11 Lesson Summary
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Lesson Transcript
Instructor: Sherri Hartzell

Sherri has taught college business and communication courses. She also holds three degrees including communications, business, educational leadership/technology.

This lesson introduces you to the basics of bond financing, important vocabulary related to bond financing, and the financial advantages to the bond issuer. You will learn why bond issuances are a great way for companies to fund large projects.

Using Bond Financing

Sally Sweets has dreamed of sharing her passion for baking with the world ever since she got her first Easy Bake oven. At only 10 years old, she knew that she wanted to open a bakery where she could spend her days in chocolate, cookie, and custard heaven. After spending many years dreaming, she was ready to make her dream a reality. In order for Sally Sweets to begin building her bakery, she first had to figure out how she is going to pay for it.

As a recent college grad, Sally Sweets lacks the collateral to fund it herself, so she needs to explore her options. Sally Sweets quickly discovered a great way to fund this large project was through bond issuances, whereby the company sells bonds to an investor for a specific dollar amount and interest rate for a predetermined length of time.

Bond Financing Basics

A bond is basically an IOU issued by a company (in this case Sally Sweets Bakery) and purchased by an investor for cash with interest. Essentially, the borrower (Sally Sweets) agrees to pay whatever amount of money she borrows (let's say $50,000) plus interest. The initial amount borrowed (the $50,000) is also known as the par value of a bond, face value, or face amount, and is paid back by the borrower at a specific date in the future known as the bond's maturity date.

It is on this maturity date that the bond issuer must pay back the principle balance of the bond. The interest earned over the length of the bond (for example 20 years) is typically paid by the borrower in semiannual payments (every six months) to whoever issued the bond; this interest payment, known as a coupon, is received by the bondholder during the time between bond issuance and maturity. Here are the specifics of Sally Sweet's bond:

Par value of the bond = $50,000

Interest rate = 10%

Coupon amount = $5,000 annually or $2,500 every 6 months

Maturity date = 20 years from date the bond was issued

Total amount Sally Sweets will pay back = $150,000 ($100,000 in interest + $50,000 par value)

Advantages of Bond Financing

There are three main advantages of bond financing for those issuing the bond that I like to call money, power, and tax deduction.

Money refers to the first advantage of how bonds can increase return on equity though a process called financial leverage or trading on equity. These two terms refer to the degree to which a company is utilizing borrowed money. When a company is able to use borrowed money to help them make more money than they have to pay for borrowing that money (i.e. interest payments) it will have increased its return on equity.

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