How does issuing shares vs bonds affect ROI?

Written by jake lebrun
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How does issuing shares vs bonds affect ROI?
Issuing shares and bonds can have an effect on a company's ROI. (chart background image by Stasys Eidiejus from Fotolia.com)

Companies use various methods to raise capital, among them issuing shares and bonds. Always important, especially to publicly traded corporations, is the return on investment (ROI) of various activities. Before you can understand the impact of issuing shares and bonds on ROI, you must understand what each of these means.

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Shares

One method by which companies procure needed funding is issuing shares. In doing so, they give up partial ownership and control of the firm in exchange for capital. Financial professionals refer to this type of instrument as an "equity instrument." "Stock" is created in what is called an Initial Public Offering (IPO). Investment banks facilitate this procedure and help set the price for the shares upon issue. It is important to remember that once issued, the price of the shares fluctuates according to market forces and investors can buy and sell shares among themselves. Investors more highly value the shares of companies that do well, while the desire to rid themselves of the shares of lacklustre firms drives their price down. Shares also imbue the holder with a degree of control over the issuer.

Bonds

Unlike shares, bonds are "debt instruments." Companies (or governments) issue bonds in a manner similar to the issuance of shares. Like shares, bonds have a pre-determined price upon issue, but markets determine their price thereafter. Bonds differ in that they entitle the holder to specific returns. A periodic payment, usually once or twice a year, is made to the holder and when the bond "matures" the original face-value of the bond is paid to the current holder. Bonds, thus, are lower risk than shares, which can easily lose value precipitously. But, the upside of bonds is limited as well. If a company does extremely well, its shareholders will prosper while bondholders simply get what was promised via the terms of the bond issue. Bonds impart no control over the company to their holders.

ROI

ROI refers to "return on investment." This serves as an indication of an investment's efficiency. The formula for computing ROI is the difference between final investment value and initial investment valued divided by initial investment value. Thus an initial investment of £650, which grows to a value of £715 has a ROI of (£715 - £650) / £650 = .1 = 10 per cent. ROI is usually expressed as a percentage. The importance of ROI is that it measures the profitability (or cost) of an investment in proportional terms. A profit of £6,500 over the course of a year would be outrageously good for an investment of only £650 but would be pathetic for an investment of £0.6 million.

Strong companies

Because shares are equity instruments and bonds are debt instruments, it is difficult to compare their impact on ROI. The relative cost of each can only be definitively quantified after the performance of the company has been taken into account. Because issuance of shares is raising capital by giving away partial ownership of the firm, a firm that subsequently does very well will find this the more expensive option (reducing ROI). By contrast, by issuing bonds, the company retains full control of its operations and gets to retain all of its earnings beyond the debt generated by the bonds themselves. So the answer to the question in this instance is: issuance of shares has a stronger downward influence on ROI than does the issuance of bonds.

Weak companies

If the company does not do so well, however, the situation is reversed. By issuing common stock, the company must share its profit with the shareholders. This only holds if there is profit to share. When the company struggles, shares are relatively inexpensive. The shareholders share some of the pain. On the other hand, the bond issues commit the company to specific payments on a strict schedule. Whether the company prospers or not, it owes the bondholders, even if it has to declare bankruptcy to pay them. In poorly performing companies, issuance of debt instruments such as bonds has a stronger downward impact on ROI than does issuance of equity instruments like shares.

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