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Bonding with Stocks.

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In the first blog of what will hopefully be a long series, I will explain the differences between stocks and bonds. I found it a lot easier to understand the concept with a hypothetical situation and will therefore use the same here.

The Hypothetical Scenario

Assume that there is a company worth $1000 which is owned completely by one person. Also assume that business has been good lately and the owner wishes to expand his business(buy a new shop or set up a new factory etc) and has calculated that he needs an additional $100 to do so. He also foresees that the investment of $100 may potentially increase the size of his business by an additional $500 over the next 5 years, so that finally he will be in charge of a $1500 business. The owner also does not have the $100 cash to finance the project himself and so has to get someone else involved. To compare returns on investment from the investor’s point of view, I shall assume that money put in a bank earns an interest rate of 5% p.a.

The problem arises when this person cannot pay the $100 expansion bill himself and needs someone else to loan/give him the money. Some options are by taking a loan from a bank or by borrowing from family, but these methods have their limitations. The other avenues are to issue (a fancy term for “sell”) stocks and/or bonds.

Taking Stock…

The “stock” mechanism involves sale of part of the company to people who are interested in investing their money. The stockholders then become “members” of the company and have a right to vote on and decide the course of action for a company in some ways at least. So now for the mathematics…

Suppose the owner decides that he will issue 10 shares worth $10 each (giving a total of $100) to interested investors and in return they will gain 1% of his company for every share purchased. The amount of money the owner and the investors hold in the company, before and after the stock issue is summarised in the table below

Owner Investor(s)
Before issue $1000 $0
After Issue $900 $100
After 5 Years $1350 $150
ROI 6.19% 8.45%

In this transaction therefore, the owner initially accepts the loss of 10% of his company in favour of raising the cash for expansion which has the potential to increase his worth to $1350, giving him a return of 6.19%. The investors on the other hand, have seen their wealth increase from $100 to $150 dollars in 5 years, giving them a return of 8.45% which beats the returns they would get if they put their money in the bank(5%). The net result? Everyone is happy.

It is important to note that we may not always have a fairy tale ending as considered here. Its quite likely that the value of the company actually decreases, in which case everyone loses, but the owner is not really responsible for refunding the investors their money. The investors may exercise their afore-mentioned right to vote and change the policies of the company or even the person in charge, but they will still lose money. The investors therefore have to do their homework well and assess their risk accurately before investing.

The name is Bond…

Bonds are a slightly different mechanism in that the owner of the enterprise does not sell a part of his company but instead sells part of the debt he will incur to finance the new project he has in mind. Investors therefore do not really “own” part of the company and cannot exert any special influence on its functioning. Bonds also guarantee to pay out a certain return on investment and are thus a less risky investment. The mathematics of issuing bonds for the same company would be as follows…

The owner decides to issue 10 bonds at a price of $10 each to investors. He also promises to pay 6% of the original capital (no compounding) every year for the next 5 years after which the bond matures and the investors will get their original investment. The owner thus gets his $100 from the sale of the bonds. At the end of 5 years, the owner would have spent a total of $130($6 in interest for 5 years + return of original capital) to honour his side of the bond agreement. This leaves him with a net worth of $1370 and he retains full control of his company, which he can now operate in an unhindered fashion and keep all the future profits for himself. The investors as well, have earned a higher return on their money compared to banking it and are happy.

When compared to stocks, it is easy to see that the investors money is relatively safe when they invest in bonds. The bond issuer is responsible for returning the money as well as the interest and they generally do not break their word. The flip side of this safety is that the investors see smaller returns for their investment as compared to the stocks case. From what I have read, bonds are generally issued by governments while most companies will prefer using stocks to raise money.

Conclusion

This is a highly simplified explanation of stocks and bonds which is intended merely to illustrate the mechanisms of these two investment methods. I cannot include any more complexity because it would draw focus away from the main topic and frankly, I haven’t understood everything myself :). Comments/corrections from anyone who is more knowledgeable than me are therefore welcome.

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Written by clueso

April 24, 2008 at 10:04 pm

Posted in Uncategorized

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  1. Good one. Where are you doing the reading from?

    biswaroop

    April 25, 2008 at 1:55 pm

  2. I read about this a while ago and over a long period of time so I do not remember exactly where I got the info from. But one good site which I found for most finance-related matters is http://www.investopedia.com. They are quite comprehensive.

    In the future I will keep track of my sources properly 🙂

    clueso

    April 25, 2008 at 3:53 pm


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