A major disadvantage resulting from the use of bonds is that: A. earnings per share may be lowered. B. bondholders have voting rights. C. interest must be paid on a periodic basis. D. taxes may increase. | Homework.Study.com (2024)

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A major disadvantage resulting from the use of bonds is that: A. earnings per share may be lowered. B. bondholders have voting rights. C. interest must be paid on a periodic basis. D. taxes may increase. | Homework.Study.com? ›

Answer and Explanation:

Which of the following is a disadvantage of bond financing? - Bonds require payment of periodic interest and the par value.

The answer is option E. A disadvantage of financing through bonds is the issuing company will pay periodic interest and its par value at maturity, so it is required to accumulate funds to pay these obligations, unlike equity financing, which pays dividends when the firm has enough funds.

The advantage of bond financing is that it helps in increasing the return on equity because when more debt is raised relative to equity for the overall capital, the return on equity ratio increases for the firm. Also, the interest paid on bonds or debt is tax deductible which helps in increasing the net income.

Bonds have some advantages over stocks, including relatively low volatility, high liquidity, legal protection, and various term structures. However, bonds are subject to interest rate risk, prepayment risk, credit risk, reinvestment risk, and liquidity risk.

Bonds do have some disadvantages: they are debt and can hurt a highly leveraged company, the corporation must pay the interest and principal when they are due, and the bondholders have a preference over shareholders upon liquidation.

Liability Another disadvantage of bond issuance is the obligation of the issuer to pay the investor the interest regardless of the company's financial status. In stocks, the company is not liable to the investors if the stocks are down, unlike in bonds, where the issuer has to pay the investor.

Given the numerous reasons a company's business can decline, stocks are typically riskier than bonds. However, with that higher risk can come higher returns. The market's average annual return is about 10%, not accounting for inflation.

If bond yields rise, existing bonds lose value. The change in bond values only relates to a bond's price on the open market, meaning if the bond is sold before maturity, the seller will obtain a higher or lower price for the bond compared to its face value, depending on current interest rates.

Do bonds lose value when interest rates rise? ›

Bond prices have an inverse relationship with interest rates. This means that when interest rates go up, bond prices go down and when interest rates go down, bond prices go up.

A disadvantage of bond financing is: Bonds pay periodic interest and the repayment of par value at maturity.

Risk #1: When interest rates fall, bond prices rise. Risk #2: Having to reinvest proceeds at a lower rate than what the funds were previously earning. Risk #3: When inflation increases dramatically, bonds can have a negative rate of return.

The other advantage of a bond fund is that interest payments can be automatically reinvested, which tends to lead to growth over time. All that said, bond funds aren't a guarantee—they can diminish in value, particularly in the short term, and investors can lose money, just as with stock funds.