Bonds payable are less costly than common stock because the bonds issued by a corporation contain a formal contract to pay the investor a fixed amount of interest every six months and to pay the face or principal amount when the bonds mature. The contract to pay these cash amounts to the investors makes bonds a less risky investment than common stock. Less risk for the investor means the investor will earn a smaller return—and the corporation will have a smaller cost. Some bonds might also provide collateral and some bonds might require that a sinking fund be established to set aside money to pay the bondholders when the bonds come due. These features will further reduce the investor’s risk and should further reduce the corporation’s cost.
Another reason why bonds are less costly than common stock is that the interest paid by the corporation will be deductible on the corporation’s income tax return. If a corporation’s combined federal and state income tax rate is 35%, then $100,000 of interest expense will save the corporation $35,000 of income taxes. This means that a corporation’s ultimate or net cost of a 10% bond is only 6.5%.
