Corporate Financing

Question 1

What is corporate financing?

Answer 1

Corporations invest in long term assets (property, plant, equipment etc) and in net-working capital (current assets minus current liabilities)

Question 2

Why is internal funding more convenient than external?

Answer 2

• Avoids costs of issuing new securities or negotiating debt

- Shareholders happy if retained profits finance positive NPV projects

Question 3

Debt ratio (definition and equation)

Answer 3

• Proportion of debt relative to firm value

Debt ratio = value of debt/(value of debt + value of shares)

Value of debt = current liabilities + long term liabilities

Question 4

Book value vs Market value

Answer 4

Book value = how much capital the firm has raised from shareholders in the past (accounting value)

Market value = the value that shareholders place on those shares today

Question 5

Voting procedures

Answer 5

• Stockholders exercise their control rights by voting

- Many decisions require a simple majority vote to be approved

Question 6

Classes of shares, why would there be more than one?

Answer 6

Usually only one but sometimes there are multiple

There are sometimes multiple with a ‘premium’ option which holds more voting power. These are usually owned by founders. This is because great control rights grant larger private benefit

Question 7

Default risk

Answer 7

The likelihood that a firm will walk away from its obligation, voluntarily or involuntary

Question 8

Secured debt

Answer 8

debt that has first claim on specified collateral in the event of default

Question 9

Senior debt

Answer 9

debt a company must repay first if it goes out of business

Question 10

Subordinated debt

Answer 10

debt that may be repaid in bankruptcy only after senior debt is repaid

Question 11

Investment Grade

Answer 11

bonds rated Baa or above by Moody’s or BBB and above by S&P

Question 12

Junk bond

Answer 12

bonds with a rating below Baa or BBB

Question 13

Callable Bond

Answer 13

bonds that may be repurchased by firms before maturity at specified call price

Question 14

Convertible bond

Answer 14

bond that give its owner the option to exchange for a predetermined number of shares

Question 15

Should the company borrow short term (bank loan) or long term (issue bonds) if it needs to finance a temporary increase in inventories?

Answer 15

Short term

Question 16

Should the interest rate on loan be fixed or floating?

bonds and bank loans

Answer 16

• Normally bank loans carry floating rates

- Bonds carry fixed payments

Question 17

Should you borrow in domestic or foreign currency?

Answer 17

• Depends on whether the company has overseas operations or not
• If it needs to spend foreign currency, it makes sense to borrow it

Question 18

What promises should be made to the lender?

Answer 18

It depends on the lenders’ concerns about the risk associated with the loan (i.e., probability of default).

Lenders may demand that their debt is senior (→ safer).

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.

Question 19

What are convertible bonds?

Depending on a change in share price, should the firm issue straight or convertible bonds?

Answer 19

• Convertible bonds give its owner the option to exchange the bond for a predetermined number of shares
• 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

Question 20

Financial Markets

Answer 20

Markets where:

• assets are issued by corporations
• assets are traded by investors
• assets are regularly traded on organised stock exchanges

Question 21

Financial intermediaries (banks)

Answer 21

Organisations that raise money/savings from investors and provide financing for individuals, companies and other organisations

Question 22

The Role of Financial Intermediaries

Answer 22

• Borrowing and Lending
• Payment Mechanism
• Pooling risk
• Information about the real value of securities and commodities

Question 23

Should the company borrow short term (bank loan) or long term (issue bonds) if cash is needed to pay for expansion of plant?

Answer 23

Long term