Definition of Bonds
Bonds payable are a form of long-term debt, which include a formal agreement to pay interest semiannually and the principal amount at maturity. The interest is an expense that reduces the corporation's earnings and its taxable income.
Definition of Stock
Shares of common stock are ownership interests in a corporation. There is no promise to pay dividends nor is there a maturity date. The dividends (if any are paid) do not reduce earnings nor do they reduce the corporation's taxable income.
Advantages of Issuing Bonds Instead of Stock
There are several advantages of issuing bonds (or other debt) instead of issuing shares of common stock:
- Interest on bonds and other debt is deductible on the corporation's income tax return while the dividends on common stock are not deductible on the income tax return. Hence, if a corporation's incremental federal and state income tax rate is 30%, bond interest payments of $40,000 will reduce the income tax payments by $12,000 (30% of the $40,000 reduction in taxable income). If the bond interest rate is 6%, the after-tax interest cost is 4.2% [6% minus 1.8% (30% of 6%)].
- Since bonds are a form of debt, the existing stockholders' ownership interest in the corporation will not be diluted. Therefore, the future gains from use of the bond proceeds (minus the bond interest payments) will flow to the stockholders. This is related to the concept of leverage or trading on equity.