UNIVERSITY OF SARAJEVO

SCHOOL OF ECONOMICS AND BUSINESS

LONG-TERM FINANCING:

STOCKS VS. BONDS

ESSEY PAPER

Subject: Financiar markets and instruments

Profesor: Džafer Alibegović PhD.
Student:Arijana Tirak 72685
Studies: FM/MM
Concentration:Financial management

SARAJEVO, DECEMBER 2018

Introducion

Imagine you are an entrepreneur with a successful young business and you just got a

brilliant idea that could be very profitable. Like any other idea it needs certain funds in

order to be realised and you decide that that idea will pay off in five years period. Let's

say you turn to several different banks and some of them turn you down while others give

you a unacceptably high interest rate. You are left with only a few options. Lets say for the

sake of this essey that you can not decide between issuing stocks or issuing bonds. Which

one should you choose? This essey focuses on the issuer's point of view, more specifically

their need for long term financing ( i.e. more than one year).

Both of them are securities. Securities are a claim on the issuer. Those who lack funds

issue securities in order to generate sufficient funds. Those who have excess funds buy

securites in order to earn returns i.e. to incease their welth. In order answer this queastion

first a brief theoretical backround for both stocks and bonds will be presented after which

a conclusion will be made.

Stocks

Stocks are olso known as equity securities. When an individual buys a share they get a

certain percentage of the ownership ower the company (depends on the number of issued

shares). The value of a company is the total value of all outstanding stock of the company.

An individual may buy a stock in order to earn a return from a stock. They can earn that

return in two ways. If the value of the stock incerases they can eidher sell it or receive

divident payment. Price of the stock is determined on the stock exhange. The more

demand or a stock of a certain company the higher is the price fo that stock.
Stock holders have certain rights, depending on the type of share they own. Common

stockholders have a right to vode and receive dividents. Prefered stock holders do not

have the right to vote, but their dividents have fixed values i.e. they receive the same

payment each month regardles of the movements in the stock market. Another right that

the prefered stock has is the priority over the claims of common shareholders. Also one

significant fact about stocks is that thay do not have a maturity date.

Bonds

Bonds are debt backed securities. A company promises to pay back to the investor the

specified amount at the specific date and often with periodic interest payment. This means

that unlike stocks, bonds have a maturity date. The cupon rate is the rate of interest that

the issuer must pay, and this periodic interest payment is called the cupon payment. This

rate is usually fixed and it is not dependent on the market interest rates. This rate is

determined by the creditworthiness of the company. The more risky the company of the

project is the higher the rate they have to pay. There are different agencies which rate the

riskiness of the bonds, such as Moody's or Poor's. If a rating agency estimates that the the

bond is to risky i.e. it is considered a junk bond, many potential investors will not be

willing to take the risk, but a few of them are ready to take on the risk if they are

compensated accordingly.

There are may types of bonds but in this essey I will focus on corporate bonds, since we

are talking about the view point of an entrepreneur. Corporate bonds are issued by

companes who need to borrow funs for one reason or another. Most corporate rates have

a face value of $1,000 and pay interest semiannually. Many companies offer a colateral if

they fail to make payments. Bond holders also have a residual claim on the company,

meaning in a case of the faliar of the copany they get paid from the residal asstes.
Unlike stockholders, bondholders do not have any ownership in the company. That can

cause a problem for the bondholder because a manager might put the needs of the

shareholders infront of the needs of bondholders. That is a reason why issuers of the bond

might be under restrictive covenants. Those are restrictions on the managers of the

issuing company such as issuing aditional debt or prohibition of mergers...

Conclusion

Now that the difference between stocks and bonds is clear, a certain conclusion can be

made. Since we are evaluating thease two securities from a view point of a company we

can analyse what these mean to the aforementioned entrepreneur.

If he choses to make his company public and issue shares he will have to give up part of

the ownership of the company and will have to listen to the bord of the directors etc. This

might not be the best option for a young company since it's net worh might not be that big

and it is still developing its managerial structure.

If he chooses to issue bonds he might be at a risk of those bonds being rated as junk. On

the other hand if he successfully sells all of the bonds be issued, after five years he is done

with the payments and he still owns the company.

In my honest opinion, this entrepreneur should issue bons insted of stocks. Altoug it is a

smart idea do diversify i.e. to issue both stocks and bonds, but since we are talking about

a new company it would be difficult them to issue and maintain both of them. Maybe in a

five years period the company will grow and the entrepreneur might have more options

to gather funds.

Reference

1.Williams, R.T. (2011). An Introduction to Trading in the Financial Markets

2. Diffen, 2018, Stocks vs. Bonds

Available at: https://www.diffen.com/difference/Bond_vs_Stock

3. Investopedia, James Chen, 2018, Stock

Available at: https://www.investopedia.com/terms/s/stock.asp

4. Investopedia, James Chen, 2018, Bonds

Available at: https://www.investopedia.com/terms/b/bond.asp