Chapter 2.2® - Example of Return on Equity & Raising Capital through Bonds & Shares and its Effects on Return on Equity - Issuance of Common Shares versus Bonds Payable

• Part 2.1 - Issuing Bonds Payable & Long-Term Notes Payable, Advantages & Disadvantages of Bonds Payable, Par Value & Bond Certificates
• Part 2.2 - Example of Return on Equity & Raising Capital through Bonds & Shares and its Effects on Return on Equity - Issuance of Common Shares versus Bonds Payable
• Part 2.3 - Types of Bonds - Secured & Unsecured, Term & Serial bonds, Registered & Bearer bonds, Convertible & Callable bonds
• Part 2.4 - How Are Bonds Issue? How do you Trade Bonds? Bond Premiums & Discounts - Contract Rate versus Market Rates
• Part 2.5 - Issuing Bonds at Par (100% of Face Value) - Bonds Payable & Interest Expense Journal Entries, Issuing Bonds Between Interest Dates
• Part 2.6 - Pricing of Bonds - Present Value of a Bond Discount (Contract Rate is less than Effective Interest Rate) & Associated Journal Entries
• Part 2.7 - Balance Sheet Presentation of Bond Discount (Long Term Liabilities) & Amortizing a Bond Discount
• Part 2.8 - Straight Line Amortization Method of Bonds Payable & Bond Amortization Schedule versus Effective Interest Method of Bonds Amortization
• Part 2.9 - Pricing of Bonds - Present Value of a Bond Premium - Premium on Bonds Payable Journal Entry, Bond Premium Cash Flows & Repayment Upon Maturity
• Part 2.91 - Amortizing a Bond Premium Interest Expense – Straight Line Method & Effective Interest Method Example
• Part 2.92 - Accruing Bond Interest Expense - Journal Entry to Accrue Bond Interest Payable & Amortization of Bond Premium
• Part 2.93 - Retirement of Bonds at Maturity, Before Maturity and by Converting to Shares - Exercising a Bond Call Option, Book Market Value & Call Back Price
• Part 2.94 - Glossary of Bonds Payable Terms

Let’s consider Shab Networks Corp has income before tax of $200,000 and has no interest expense. The company has $1 million in equity and is planning a $500,000 expansion to meet increasing demand for its products/services. Shab Networks predicts this $500,000 investment will result in additional net income of $135,000 per year before paying interest or taxes. Shab Networks sat down with its board of directors and Controllers group to discuss this issue and considered 3 options:

Tabular Analysis of Income before Taxes & Interest Expense

The tabular analysis above shows the corporation will earn a higher return on equity (14.25%) if it expands by issuing $500,000 worth of bonds, even though its net income is lower than Option B, totalling $285,000 while Option B has net income of $335,000. Thus, the best option for this organization is option C which is to sell $500,000 worth of bonds and paying a 10% annual coupon rate with an interest payable of $50,000 per year.

This above graph shows the raise of $500,000 via common class stock (Option B) & its associated rate of return of 13.40%. It also shows raise of capital via bond issuance and its return of 14.25%. Note that the income is higher under Option B of common stock issuance ($335,000) while the issuance of bonds yields a net income of $285,000 however the return on equity calculation (net income / equity) is higher for Option C due to the $500,000 bond payable allocated to the liabilities section of the balance sheet, as opposed to it being put under shareholder's equity under Option B; you can verify this by checking the equity is $2,500,000 under Option B while it is $2,000,000 under Option C.