Debt financing relates to a company’s liability, which needs to be paid at a later period while equity financing does not require repayment since it originates from the issuance of shares. Therefore, while debt is borrowed either internally or externally, equity is owned by the company. The limitation associated with debt financing is the short timeline tied to its repayment period. Equity financing is part of the firm's capital kept for an extended period. Moreover, there is a high risk associated with equity due to the volatility of the market as opposed to debt, which entails low risks. Returns on debt are fixed and secure while in equity financing, the returns are insecure and unpredictable. Equity exists only as shares and stock, while debt financing could come in different forms such as loans, bonds, and debentures.
Time Value of Money
The concept stems from the idea that money that an individual or a business holds at the moment has more worth than a similar amount in a future period. That is, the present value of a particular sum of money is more than the value of the same amount if considered in terms of future potential. In this case, money has the potential to earn an interest in different forms. Time value of money determines the nature of investments that people choose, including the purchase of bonds. When the government ventures issue bonds, those who purchase them are entitled to interest called coupon payments when the maturity period is attained. The decision of whether to purchase a bond emanates from the time value of money (Cockerham, 2018). Purchasers of bonds rely on the extent to which the coupon payment guarantees the maximum value at that specific moment.
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Market and Coupon Rates
Coupon and market rates ensure that there is a clear understanding of how bonds and debt securities behave in the market. A coupon rate comprises of the total yield that is paid to the owners on the face value each year. This rate is constant throughout the bond period. The market interest fluctuates in value based on the shifts in the market (Cockerham, 2018). It is not a guarantee that the market interests of a bond will remain stable or increase during the bond’s lifetime. In this case, market rates are based on possible speculations as opposed to coupon rates, which remain stable over the entire period until maturity. Both the market rate and the coupon rates impact each other. For example, an increase in market rates beyond the coupon rate could lead to a decline in the value of the associated bond.
Premium, Bonds at Par, and Discount
The first time a bond is issued, always referred to as a standard bond, its price is fixed at par value. However, this value continually changes when it starts to trade in the market. Such a scenario emanates from the usual trading phenomenon where new bonds are traded or presented on the initial market, and the previously sold bonds are traded on the subsequent markets. In instances when a bond is sold at a value that exceeds its original value, then the bond is a premium, which only occurs when the coupon rate is greater than the probable market rates as an interaction with the new bonds (Russo, 2018). Such a scenario is not always guaranteed. Therefore, when a bond trades below its initial par value, it is known as a discounted bond, and this takes place when the coupon rate is below the anticipated market rates.
References
Cockerham, R. (2018) Bond stated interest rate vs. market rates. Pocket Sense. Available at: https://pocketsense.com/bond-rate-vs-market-rate-7428784.html
Russo, R. (2018). What is the difference between premium bonds and discounted bonds? Rodgers Associates. Available at: https://rodgers-associates.com/blog/difference-premium-bonds-discount-bonds/
