5.5 Long-Term Financing Flashcards
In general, as a company increases the amount of short-term financing relative to long-term financing, the
A. Greater the risk that it will be unable to meet principal and interest payments.
B. Current ratio increases.
C. Leverage of the firm increases.
D. Likelihood of having idle liquid assets increases
A. Greater the risk that it will be unable to meet principal and interest payments.
An increase in the proportion of short-term financing will not affect a company’s degree of leverage, but risk is increased because of the need for frequent refinancing. Because the debtor company will be forced to meet principal and interest payments quickly, perhaps before expected funds from a new project have been generated, the danger of default is increased. Also, future interest rates are difficult to predict.
All of the following may allow a firm to set a lower coupon rate on a bond issued at par except a
A. Conversion option.
B. Higher rating from a bond rating agency.
C. Call provision.
D. Sinking fund.
C. Call provision.
A bond issued at par may carry a lower coupon rate than other similar bonds in the market if it has some feature that makes it more attractive to investors.
For example, a sink fund reduces default risk. Hence, investors may require a low risk premium and be willing to accept a lower coupon rate. Other features attractive to investors include covenants in the bond indenture that restrict risky undertakings by the issuer and an option to convert the debt instruments to equity securities. An improvement in a bond’s rating from AA to AAA (the highest possible) also justifies reduction in the risk premium and a lower coupon rate. However, a call provision is usually undesirable to investors. The issuer may take advantage of a decline in interest rates to recall the bond and stop paying interest before maturity.
Securities that contain a provision allowing the holder to exchange the securities for some specified number of common shares are
A. Leases
B. Stock purchase warrants
C. Retained earnings
D. Convertible securities
D. Convertible securities
Convertible securities are debt or preferred stock securities that contain a provision allowing the holder to convert the securities into some specified number of common shares after a specified time has elapsed.
A major use of warrants in financing is to
A. Permit the buy-back of bonds before maturity.
B. Avoid dilution of earnings per share.
C. Lower the cost of debt.
D. Maintain managerial control.
C. Lower the cost of debt.
Warrants are long-term options that give holders the right to buy common stock in the future at a specific price. If the market price goes up, the holders of warrants will exercise their rights to buy stock at the special price. If the market price does not exceed the exercise price, the warrants will lapse. Issuers of debt sometimes attach stock purchase warrants to debt instruments as an inducement to investors. The investor then has the security of fixed-return debt plus the possibility for large gains if stock prices increase significantly. If warrants are attached, debt can sell at an interest rate slightly lower than the market rate.
The following excerpt was taken from a company’s financial statements: “ . . . 10% convertible participating . . . $10,000,000.” What is most likely being referred to?
A. Bonds.
B. Share options.
C. Common shares.
D. Preferred shares.
D. Preferred shares.
Preferred shareholders have priority over common shareholders in the assets and earnings of the entity. If preferred dividends are cumulative, any past preferred dividends must be paid before any common dividends. Preferred shares may also be convertible into common shares, and it may be participating. For example, 10% fully participating preferred shares will receive additional distributions at the same rates as other shareholders if dividends paid to all shareholders exceed 10%.
