[4] Corporate Financing Flashcards
What are the 3 main types of securities a corporation issues?
common stock, preferred stock, and debt
3 ways that companies fund investments?
In order of company preference
Internal Funding [Profits + Depreciation]
Borrowing/Debt Financing
New Equity/IPO
Internal funding is more convenient than external , why? x2
avoids the costs of issuing new securities or negotiating debt;
shareholders happy if retained profits finance +NPV projects
(they forego dividends but the stock has a greater market value).
Why do Managers rely on internal funding?
managers are too averse to external funding (and risk) they tend to rely too much on internal funds (losing risky but
+NPV projects).
Debt Ratio:
Def
Equation
Value of debt Equation
debt ratio: proportion of debt relatively to the firm value
debt ratio = value of debt /
value of debt + value of shares
value of debt = current liabilities + long-term liabilities
What is book value of equity?
and what is market value equity?
What is larger?
What is lower the market or book ratio?
Book value: tells us how much capital the firm has raised from shareholders in the past (accounting value)
Market value: measures the value that shareholders place on those shares today.
The market value of equity is often much LARGER than the book value of equity
the market debt ratio is often much LOWER than
the book debt ratio (i.e. computed from the book balance sheet).
Stocks (or shares) held by investors are called
Stocks/shares that are bought back from investors are called
Whats the difference between stocks and shares?
Issued and Outstanding
Issued but not outstanding
Shares refers to the ownership certificates of a particular company;
Stocks refers to the ownership certificates of any company,
i.e. to the overall ownership in one or more companies.
For common stock,the privileged rights go to ..
What rights do shareholders have to cash flow and control?
How does this change for larger corporations?
the lenders eg; banks, bond-holders
Shareholders have residual (but ultimate) control rights over the firm’s affairs (e.g.: investment decisions, recruitment policy, decision to merge, etc.)
In widely held corporations, common stockholders control is limited or restricted to the individual entitlement to vote (owning few shares =} little impact on the outcome).
Cash flow and control rights are limited (or extinguished) in case the firm goes into bankruptcy.
How do stockholder exercise their control rights?
What do votes require to be approved?
Stockholders exercise their control rights by voting.
Many decisions require a simple majority vote to be approved.
Some decisions require a supermajority, e.g. 75% of those eligible to vote. (e.g. mergers)
Why do some stocks sell at a premium?
Stocks with superior voting power sell at a premium.
Greater control rights grant larger private benefits!
What are the benefits of greater control rightS? 3
Prevent challenge to his/her management position
extra bargaining power in an acquisition secure a business advantage
toss out bad management or force management to adopt policies that enhance shareholder value (these can also benefit all shareholders)
The dividend rate on preferred stocks is __ at the time of their issue.
They get __ over ___ stock when receiving dividends.
___ stockholders do not receive __ unless ___ stockholders receive theirs.
They do not give ownership rights… unless the company fails to ___ the ___ ___-.
In that case, preferred stockholders gain some __ __
fixed
priority, common
Common, dividends, preferred
pay the preferred dividend
voting rights
When companies borrow money, they promise to? x2
However, this ___ is limited.
Debt has the unique feature of allowing the ___(i.e., stockholders) to walk away from their ___ to __ (i.e., ___) in exchange for the ____ of the company.
They are willing to do so if?
But its not straight forward, have to account for ___ process
make regular interest payments
and to repay the principal
liability
borrowers , obligation, pay, default, assets
Value of Assets < Value of Debt
Bankruptcy
What is default risk?
What do bond ratings help?
Default risk is a term used to describe the likelihood that a firm will walk away from its obligation, voluntarily or involuntarily.
Bond ratings are issued on debt instruments to help investors assess the default risk of a firm.
What is debt claim limited to? Contrary to equity how?
What does equity offer that debt doesn’t? [unless?]
Debt claim on cash flows is limited (to the interest and principal) =} no residual cash flow rights (contrary to equity).
Debt offers no control rights (unless the firm defaults). As lenders are not owners → no voting power.
What can debt sometimes be seen as? and why?
Who holds the majority of corporate debt?
Debt can be seen as a disguised ‘tax subsidy’:
interest is paid on pre-tax income;
dividends are paid on after-tax income.
As with equity, financial institutions hold the vast majority of corporate debt (in the form of bonds).
Define the following:
Secured debt
Senior debt
Subordinated debt
Investment grade
Junk bonds
Callable bonds
Convertible Bond
Secured debt: debt that has first claim on specified collateral in the event of default.
Senior debt: debt a company must repay 1st if goes out of business.
Subordinated debt: debt that may be repaid in bankruptcy only after senior debt is repaid.
Investment grade: bonds rated Baa or above by Moody’s or BBB or above by S&P.
Junk Bond: bonds with a rating below Baa or BBB.
Callable bond: bonds that may be repurchased by firm before maturity at specified call price.
Convertible bond: bonds that give its owner (the lender) the option to exchange for a predetermined number of shares.
Should the company borrow short term (bank loan) or long term (issue bonds)? What does it depend on?
It depends on the time-horizon of the project to be financed:
finance a temporary increase in inventories → take out a short-term bank loan.
LR: cash needed to pay for expansion of plant, new building, new machinery,… → issue long-term bonds
Should the interest rate on loan be fixed or floating?
What are they normally, and what is this based off?
What about bonds?
Name for payments?
Normally bank loans carry floating rates (e.g.: LIBOR+1p.p.)
LIBOR: interest rate at which major international banks lend to each other
Bonds carry fixed payments (the coupons).
Should you borrow in domestic or foreign currency?
What does it depend on?
It depends on whether the company has overseas operations or not.
If it needs to spend in foreign currency, it makes sense to borrow foreign currency.
What may lender demand?
What does it depend on?
What may firms set aside? and what for?
Lenders may demand that their debt is senior (→ safer).
It depends on the lenders’ concerns about the risk associated with the loan (i.e., probability of default).
Firms may set aside some of its assets (collateral) for the protection of particular creditors.
if firm defaults on the loan, the bank can seize the collateral and use it to help pay off the debt.
What are convertible bonds?
What does this mean for those bondholders?
Should firm issue straight or convertible bonds?
What does it depend on?
Convertible bonds give its owner the option to exchange the bond for a predetermined number of shares.
There is no obligation for the bondholders to convert;
It depends on expectations about the firm’s share price:
expect an increase → can convert bonds with profit
expect a decrease → there is no obligation to convert
What are primary, secondary and OTC markets?
issued by corporations
(‘primary issues’ → primary market)
traded by investors
(‘secondary transactions’ → secondary market)
→ Regularly traded on organized stock exchanges
(New York, London, Hong Kong…)
In other cases there is no organized (or regular) exchange → over-the-counter (OTC) markets.
4 x Roles of the financial markets?
Payment Mechanism: allow individuals to make and receive payments quickly and safely over long distances.
Borrowing and Lending: allocate savings towards those who can best use them.
Pooling Risk: allow individuals to share risk
Information: about the ‘real’ value of securities and commodities (how much they worth) and allow estimation of rates of return that investors can expect on their savings.
SUMMARY
Corporations finance investments using ___or ___ funds.
Corporations prefer to use __ __-.
Debt ratio measures the ___ on ___ vs __ financing.
___ and ___ ___ differ for debt and equity holders.
Financial market links investor’s ___ to corporations’ ___.
internal, external
internal financing
reliance, debt vs equity
control, cashflow rights
Savings , investments
