A corporation’s bonds payable are viewed as less costly than common stock because the bonds 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. This contract 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 payable also provide collateral while others could have a sinking fund to accumulate 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 a regular corporation will be deductible on the corporation’s income tax return. If a corporation’s combined federal and state income tax rate is 25% (21% federal + 4% state), then $100,000 of interest expense will save the corporation $25,000 of income taxes. This means that a corporation’s ultimate or net cost of a bond’s 10% rate is only 7.5%.
