Pretty much any activity a company performs -- from hiring workers to producing goods to building new facilities -- costs money.
Companies have a number of options for raising capital. Here are several popular methods:
- Retain earnings.
- Sell assets.
- Issue shares.
- Issue bonds.
When a company issues bonds, it's borrowing money from investors in exchange for interest payments and an IOU.
Advantages to issuing bonds
Let's look at some of the ways issuing bonds can be superior to those other ways of raising capital.
Retaining earnings: Issuing bonds allows a company to access capital much faster than if it first had to earn and save profits. As the saying goes, you have to spend money to make money.
Selling assets: To sell assets, a company needs to have assets it's willing to sell. Growing companies might decide to borrow money rather than selling assets because they're, well, growing and in the process of acquiring -- not selling -- assets. In down markets, on the other hand, a company may be reluctant to sell assets if it can't find a buyer willing to pay an acceptable price.
Issuing shares: Issuing bonds is much cheaper than issuing shares. When a company sells new shares, the value of its existing shares is diluted. Since shareholders take on more risk than bondholders (in the event of a bankruptcy they're further back in line to receive compensation), shareholders require a higher rate of return than do bond investors.
Issuing bonds offers tax benefits: One other advantage borrowing money has over retaining earnings or issuing shares is that it can reduce the amount of taxes a company owes. That's because the interest a company pays its lenders is counted as an expense, which means pre-tax profits are lower. Retaining earnings and issuing shares, on the other hand, may be more expensive to shareholders, but ironically they're not classified as expenses on an income statement.
Borrowing money may or may not provide tax advantages over selling assets. If the assets were sold for a gain, that gain is taxed, but if they were sold for a loss, the loss would offer its own tax benefits.
An example: From 2009 through 2014, oil prices rose from under $50 per barrel to more than $100. Linn Energy, a company that several years before had owned had owned just a few wells, made loads of acquisitions, investing over $10 billion to grow its assets. Today it drills for oil and gas all over the country.
To finance its incredible growth, Linn couldn't sit back, save, and reinvest its profits. Instead, Linn mostly relied on a combination of stock issues and debt. Linn raised almost $3.8 billion by issuing new shares. It also grew its bond debt load to $6.2 billion from just $250 million.
Disadvantages to issuing bonds
Of course, when a company borrows money, it needs to pay interest to its lenders on a regular basis.
Borrowing money can also be riskier than the alternatives. If a company borrows too much money, or if its fortunes change and it is no longer able to pay back its lenders, it might have to raise even more capital on painful terms or go bankrupt.
Let's return to our example above. As Linn grew dramatically with the help of its new borrowings, over those five years, it paid out over $2 billion in interest payments (including interest to its credit facility.) By mid-2014, energy prices began to collapse, and with it the operating income that Linn needed to pay its lenders. Shares fell more than 90% over the next year and a half as investors began fearing the possibility of bankruptcy.
For a company, bonds can offer cheap -- but potentially risky -- access to capital.
Debt vs. ... | Retained Earnings | Asset Sale | Share Issue |
|---|---|---|---|
Advantages | Faster, tax benefits | May not want to sell assets, possible tax benefits | Cheaper, tax benefits |
Disadvantages | Riskier, interest payments | Riskier, Interest Payments, possible tax disadvantage | Riskier, interest payments |
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