Question

Which of the following statements are disadvantages of using bonds to finance a corporation?

(i)    A default on the fixed interest payments may result in bankruptcy

(ii)   It lowers the rate of return to its shareholders

(iii) It creates conflicts between shareholders and bondholders

(iv)  It leads to higher tax payments

Answer 1

(i) and (iii) are disadvantages. A default on interest payments may result in bankruptcy. Issuing bonds may create conflicts between shareholders and bondholders because shareholders have an incentive to take risky projects in expectation of potentially high returns. However, these risky projects may be too risky for bondholders, who would like interest payments to be made on time and without default.

(ii) is incorrect. Issuing bonds may increase the rate of return to shareholders due to the effect of leverage

(iv) is incorrect. Interest is tax-deductible, thus lowering the tax expense