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Video transcript

in this video I want to give you a general idea of what a bond is and why a company might even issue them in the first place and just at a very high level a bond is essentially a way for someone to participate in lending to a company so you're a partial lender partial lender to a company and just to make that more concrete let's imagine some type of company that has ten million dollars in assets so these are its assets right they're assets and it has ten million dollars in assets and let's say just for the sake of simplicity it has no liabilities so all of that value all of that ten million dollars is what is owned by the owners or by the equity the owner's equity so this is ten million dollars ten million dollars in equity and if we had let's say a million shares I'll write it down if we have a million shares and if we believe this ten million dollar number that implies that each share is worth $10 per share now let's say this company is doing really well and it wants to expand it wants to increase its assets by five million dollars so it can go out and buy a five million dollar factory so it once let me draw it right here it wants another five million dollars in assets that it needs to build that factor or essentially a five million dollar factory and the question is how does it finance it well one way is that they could just issue more equity if they're able to get a price of $10 per share they could issue another 500,000 shares 500,000 shares at $10 per share and then that would essentially it produce five million dollars so this is scenario one they issue 500,000 shares at $10 a share they now have 1.5 million shares but these new owners gave them collectively 5 million dollars so this the equity would grow by 5 million dollars we now have 1.5 million shares so this would I'll be 1.5 million shares not 1 million and that new money from these new shareholders would go into the asset side and then we would use that to actually buy the factory what I just described is essentially issuing equity or financing via equity financing via equity or by issuing stock now the other way to do it is to borrow the money to borrow the money so let me redraw this company I'll leave this up here just so we can compare the two so once again we have 10 million dollars of assets that's our 10 million dollars of assets we have 10 million dollars of equity to start off with 10 million dollars of equity and instead of issuing stock to get the five million dollars we're going to borrow the money so we could we're essentially issuing debt so we issued we essentially we could go to a bank and say hey bank can I borrow five million dollars so we would have a five million dollar in liability it would be debt five million dollars of debt and the bank would give us five million dollars of cash that we can then go use to buy our factory so in either situation in either situation the asset side of our balance sheet looks at identical or the assets of the company identical we had our ten million dollars assets and now we have a factory but in this first situation I increased I was able to raise that money by increasing the number of shareholders by increasing the number of people that I have to split the profits of these of this of this company with in this situation I was able to raise the money by borrowing it so these the people that I'm borrowing this money from the people that I'm borrowing this money this is borrowed money borrowed money they don't get a cut of the profits of this company what they do is they get paid interest on their money that they're lending to us before these guys get any profits at all in fact that interest is considered an expense so these guys get interest get interest and even if this company does super super well and becomes very very profitable these guys only get their interest likewise if the company does really bad and these guys suffer as long as the company doesn't go bankrupt these guys are still going to get their interest so they're going to be a lot safer than well they don't get as much of the reward as the new equity holders would they also don't get as much of the risk now this is just straight up debt and you could just get this from any bank if they were willing to if they said oh you know you're a good safe company we're willing to lend you five million dollars but let's say that no bank wants to individually take on that risk so you say hey why don't instead of borrowing five million dollars from one entity why don't I buy it borrow it from five thousand entities so what I can do instead instead of borrowing it from one empty I could issue these certificates I could issue bonds and that's the topic of this video so I issue these certificates they have a face value of $1,000 $1,000 this is my face value face value or sometimes you'll hear the the notion of par value of par value and I'll say what interest I'm going to pay on it so let's say I say it has a 10% annual coupon annual coupon and it's actually called even though this is the interest I'm essentially going to pay $100 a year it's called a coupon because when they when bonds were first issued they would actually throw these little coupons on the bond itself and the owner of the certificate could rip off or cut off one of these coupons and then go to the person borrowing or the entity borrowing the money and get their actual interest payment so that's why it's actually called coupons but they don't actually attach those coupons anymore and it has some maturity date the date that not only will I pay your interest back but I'll pay the entire principal the entire face value so let's say the maturity maturity is in two years is in two years so in this situation in order to raise five million dollars I'm going to have to issue five thousand of these because five thousand times 1000 is five million so times five thousand so if you wanted to lend a thousand dollars to this company so that they could expand and if you think 10% is a good interest rate and it's a safe company you would essentially buy one of these bonds maybe you buy it for $1000 and when you buy that bond for $1,000 you are essentially lending this company that $1000 and if you did that five thousand times or if that happened five thousand times amongst a bunch of different people this company would be able to raise its five million dollars now just to be clear how the actual payments work the coupons tend to get paid semi-annually so let me draw a little timeline here and this tends to be the case in the US and Western Europe if this is today this is today this is in six months this is in twelve months or one year this is in eighteen months and this is in 24 months and I'm only going up to 24 months because I said this bond matures in 24 months so what is this if you own if you hold this bond this certificate what do you get well it's going to pay you 10% annually so a hundred dollars a year a hundred dollars per year but they actually pay the coupon semi-annually so you get 100 dollars a year but you get half of it every six months so you're going to get 50 dollars after six months you're going to get fifty dollars after twelve months or after another six months you're going to get another $50 here you're going to get a final $50 there and they're also going to have to pay you back the original amount of the loan they're also going to have to pay you the $1,000 so that last payments going to be the coupon of 50 plus the thousand dollars and so you will have essentially been getting this 10 percent annual interest now when the company does this they'll probably have to issue some type of new bond because all of a sudden they have to pay all of these people this huge lump sum of money if they haven't been able to earn it from the factory as yet and we could talk about that in a future video