Let’s consider for a moment how businesses structured as sole proprietorship and partnership raise capital to finance its business operations. Here are some common options:
- The owners (or partners) invest their own money out of their savings, credit cards, etc.
- They borrow from rich dad, rich-looking friends, and semi-rich relatives.
- Secure loan from banks and lending institutions.
They all sound very familiar, right? They are so simple and so easy to understand also to the point of being self-explanatory.
Large businesses structured as corporations can also do the same (except maybe borrow from friends and relatives)… plus some more.
Business Finance is one of the many areas where corporate businesses are superior to other forms of business structures. Like the Philippine Government, corporations need money from time to time.
Incidentally, this is also a chance for outside investors to make money. That is, if you ride on a corporation’s capital raising activity, you also stand the chance of making money by joining the venture and becoming an investor.
And the million-dollar question is, how do corporations go about raising capital?
Let’s count the ways.
1. By Issuing Bonds – They borrow money from you.
No matter how rich you think they are, there are times corporations still want some money — Other People’s Money (OPM) — from you, your friends and everyone else. Imagine that!
One of the ways they do it is by issuing a bond.
Essentially, a bond is a debt instrument issued by a corporation (or the government, for that matter) to the public for the purpose of raising capital. It is an “I-O-U” agreement made by the corporation to the investors.
In layman’s term, a bond is simply a loan, in which you are the lender and the corporation is the borrower. But in investment-speak, the right term they use are the following:
- lender (bondholder)
- borrower (bond issuer)
In other words, if you buy a bond issue from a particular corporation, you become a bondholder – not James Bond. 🙂
Since the company will be using your money, they in turn promise to pay you interests (called coupons) on specific dates, plus they will also return the original amount borrowed (called face value) at the specified maturity date.
And your job, Sir James, is to simply sit down and…
- Wait for each coupon to become due and cash it out at the bank.
- Wait for the maturity date and cash the whole amount that you lent out to them.
Simple enough to understand?
Well, there are many variations to the bond agreement, but basically that’s how it works. Let’s leave it that way for simplicity.
Now if you really want to play the role of James Bond, here’s an assignment you can do in your spare time: If corporations can borrow money from financial institutions like commercial banks, why on earth would they proceed with the hassle of issuing bonds? Besides, it’s the same story — they ask for your money, they promise to pay you back. What’s the difference?
2. By Issuing Shares of Stocks – Capitalists are welcome here.
When companies issue shares of stocks, they are inviting more investors to come in and join them as part owners of the business venture. When you buy shares of stocks, you become a stockholder — or shareholder — and you are part-owner of the business, too.
That’s cool, right?
Very cool, indeed. As a matter of fact, if you can accumulate enough shares of SM Investments Corporation – large enough to warrant having a coffee break, face-to-face with Henry Sy – that automatically gives you the bragging rights to call him “Hey Henry” instead of the more formal equivalent “Sir Henry.”
Well, the point is, as a shareholder, you are also a part owner of the business.
- You have a say on who sits at the Board of Directors (even if you don’t know anyone of them, much like your senators).
- You can examine the book of accounts (even if you don’t understand it at all — it’s okay to pretend).
- You earn money from the dividends (otherwise, what’s the point of being an investor?).
Enough about the cool stuff. Let’s get some serious money talk now.
There are basically two types of stocks:
- Shares don’t give voting rights. (Did I just say you can vote? Well, not with this type of stock.)
- These shares earn dividends at fixed rates. The company has a contractual obligation to pay it much like the interests on a bond.
- Preferred stockholders have the priority of claims against corporate assets such as when the company becomes bankrupt and the assets are liquidated.
When the assets of a company are liquidated, the order of payment is as follows:
- the creditors
- preferred stockholders
- common stockholders
There are actually many types of preferred shares, but let’s leave it out in other articles.
- has voting rights.
- may earn dividends, but it’s optional and will depend on the decision of the company’s board of directors.
- You may earn if the company’s stock value rises; may also lose when the opposite happens.
Given the information above, which type of stock do you want to own?
You may not know it yet, but your answer to that question determines your risk profile.
3. Through Self-Financing – Using The Company’s Profits.
Did you ever wonder what profitable companies do with their profit?
Well, here are some of the ways to use it:
- They distribute some to shareholders in the form of dividends. This is one way you can make money by owning shares of stocks.
- They plough back a portion of this profit and reinvest it in research and expansion. If the company performs well in these areas, the reward to you as a shareholder is that the value of your stocks may appreciate rapidly.
The second item – ploughing back or retention of profit – is what self-financing means.
The following are some of the advantages in doing this:
- The credit worthiness of the company is enhanced.
- Their dependence on external funding is minimized.
- The company can provide a stable dividend policy.
- Investors will love them.
A Worldly Question: Is it bad for a company to accumulate too much profit? Why and why not?
So, there you have it.
We have just discussed the basics of bonds and stocks and their characteristics as investment instruments. We’ve laid down the foundation that you can use in your foray into the world of bonds and stocks investments.
Your journey as an investor has just begun. Keep learning.