Corporate And Municipal Bond Interest In Terms of Cost of Capital Versus Investor Yields
According to Finance for Managers (2012), managers need to evaluate the capability of bonds to raise cash, just as investors view bonds to be an investment. If banks are unable to offer financing to support a project’s capital cost, the firm enters into an agreement to sell shares of the company to lenders in order to supply the funds (Ross, 2021).
Corporate Bond Interest In Terms of Cost of Capital Versus Investor Yields
Corporate bonds are debt instruments issued by firms to investors/lenders to raise finance. Companies make contracts with bondholders pledging to pay interest at certain future periods and the security’s nominal value at maturity (Heisinger & Hoyle, 2012).
According to Boundless Finance (n.d.), companies typically generate capital by issuing corporate bonds rather than seeking bank loans due to cheaper interest rates and more attractive terms. The cost of capital is comparable to the needed rate of return since the investor’s rate is now a cost imposed on the borrower (issuer). Essentially, the needed return equals the cost of capital for an investor. When there are several investors with variable rates of return, the Weighted Average Cost of Capital (WACC) is utilized. WACC is a metric that takes into consideration the percentage of total borrowed capital supplied by each type of investment as well as their needed rates.
Corporate bonds yield more than other fixed-income assets.Yield is the price needed to entice investors to invest in bonds, and it represents current market values on financial instruments of equivalent risk. Before accepting an offer, investors should investigate the credit risk of the firm or issuer because the issuer may default on their commitments. (D.R. Harper, 2022). More specifically, investors should consider the yield to maturity, which is the rate of return paid on a bond and is determined by the coupon rate, term of maturity, and market price. The borrower typically pays the coupon twice a year. Companies may also issue zero-coupon bonds, which pay no interest but are acquired at a discount and reimburse the bondholder at maturity. Corporate bonds are usually liquid and trade on the secondary market for a larger yield than dividends.
Municipal Bond Interest In Terms of Investor Yields.
Moskowitz (2022) stated that municipal bonds are issued by state or local governments to pay large projects such as road upkeep. Municipal bonds are issued by state, county, and local governments to support government initiatives such as road maintenance and other construction projects in a certain region. The majority of municipal bonds are exempt from federal taxes. Generally, investing in a public purpose municipal bond will exempt you from paying income taxes. Furthermore, municipal bonds have a lower default rate than corporate bonds.
The disadvantage for investors is that their yields are depending on cash flows generated by the project itself and taxes (Moskowitz, 2022). Investor yields may change if the project does not generate cash flow and people do not pay their taxes. The benefit of a municipal bond to investors is that the interest paid is not taxable, making it an excellent portfolio strategy (Moskowitz, 2022).
Conclusion
Municipal bonds are an appealing investment for managers and business owners, and they can be purchased as individual bonds, shares of bond funds, or shares of unit investment trusts. How to invest in municipal bonds depends on how much money the investor has to invest and his or her income level. Municipal bonds that are tax-free are often more appealing to high-income investors. On the other hand, the monetary policy, especially the direction of interest rates, has a considerable impact on bond yields. Bond yields are calculated by dividing the bond’s coupon payments by its market price; when bond prices rise, bond yields fall. Bond prices rise when interest rates fall, while bond yields decline. Rising interest rates, on the other hand, cause bond prices to fall and bond yields to rise. Therefore, managers need to assess and evaluate their business capacity and determine which bonds are suitable for their business.
References
Boundless. (n.d). Boundless Finance.
https://courses.lumenlearning.com/boundless-finance/chapter/the-basics-of-the-cost-of-capital/
Finance for Managers. (2012). Licensed under Creative Commons by-nc-sa 3.0.
https://my.uopeople.edu/pluginfile.php/546007/mod_page/content/17
Harper, D. R. (2022, October 30). Corporate bonds: An introduction to credit risk. Investopedia. Retrieved December 6, 2022, from https://www.investopedia.com/investing/corporate-bonds-introduction-to-credit-risk
Heisinger, K., & Hoyle, J. B. (n.d.). Accounting for Managers. https://2012books.lardbucket.org/books/accounting-for-managers/index.html
Moskowitz, D. (2022, July 18). A look at the pros and cons of Muni bonds. Investopedia. Retrieved December 6, 2022, from https://www.investopedia.com/articles/investing/040115/should-you-consider-muni-bonds.asp
Ross, S. (2021, May 23). Cost of capital vs. required rate of return: What’s the difference? Investopedia. Retrieved December 6, 2022, from https://www.investopedia.com/ask/answers/020415/what-difference-between-cost-capital-and-required-return.asp
Note:
This article is written based on University of The People Financial Management (BUS 5111) written assignment by Fristy Tania in December 2022
