debt

Question 1

Companies can obtain short-term debt funding by issuing (selling) securities such

Answer 1

commercial paper and bills of exchange.

Question 2

New Issues and Dilution

nTypes of dilution

Answer 2

¡Dilution of proportionate ownership—a shareholder’s reduction in proportionate ownership due to less-than-proportionate purchase of new shares.

¡Dilution of market value—loss in share value due to use of proceeds to invest in negative NPV projects.

¡Dilution of book value and earnings per share (EPS) —reduction in EPS due to sale of additional shares. This has no economic consequences.

Question 3

nTwo broad types of long-term debt:

Answer 3

¡Loans from banks and other financial intermediaries.

¡Funds raised by issuing marketable debt securities such as corporate bonds.

Question 4

Effect of debt on risk

Answer 4

increasing the amount of debt also increases the company’s financial risk –> rate of return required by shareholders.

Question 5

nEffect of debt on risk

what is financial risk

¡Financial risk effects:

Answer 5

¡Financial risk—risk attributable to the use of debt as a source of finance.

1. debt has a leverage effect - it increases the variability of returns to shareholders and increases the rate of return they require.
2. the greater is the risk of financial distress

Question 6

effect of debt on control?

Answer 6

lenders have no control over the company’s operations. Unlike shareholders, lenders have no voting rights

they have a large degree of potential control, which they can exert if the company breaches a loan agreement –> security on loan, appoint administrator to put company in receivership or appoint liquidator

Question 7

features of debenture

Answer 7

loan is secured by a charge over tangible property of the borrower

fixed interest

long-term from 1-5 years usually

the ownership of debentures may be transferable, so they can be listed on an exchange such as the ASX

Question 8

unsecured notes

Answer 8

holders are usually unsecured creditors who rank below any secured creditors for repayment of debt.

nRiskier than debentures.

nHigher interest rate than debentures.

interest rate on a note may vary by being linked to an indicator rate such as the bank-bill swap rate (BBSW) i.e. ‘floating-rate notes’

Question 9

Unsecured but may be secured by

Answer 9

nUnsecured but may be secured by a charge over intangible assets — Corporations Act 2001 does not allow use of term secured in such cases.

nMay use term bond to describe such securities if they are secured by intangibles and cannot be called debenture.

Question 10

corporate bonds

Answer 10

May use the term ‘bond’ as an alternative to ‘unsecured note’.

generally long-term, fixed-interest debt securities with coupon payments every 6 months, issued by non-government entities.

Question 11

difference between corporate bond and debenture?

Answer 11

a debenture is usually secured by a charge over tangible assets of the borrower, whereas a corporate bond may or may not be secured

debenture offers a fixed coupon rate, whereas a corporate bond may offer a fixed or floating coupon rate.

placed privately with institutional investors - do not need prospectus if placed with instutitonal investors

Question 12

nIssuing bonds offshore is preferred because of:

Answer 12

¡A greater capacity to absorb securities of lower credit quality.

¡Difference in term to maturity, amounts borrowed, and currency denomination.

Question 13

short-term debt

Answer 13

due within 12 months

Question 14

Australian companies’ major short-term borrowing choices are

Answer 14

¡Borrowing from banks and other financial institutions.

¡Issuing marketable (short-term) debt securities — commercial paper and bills of exchange.

¡Investment banks and credit unions.

Question 15

Short-term debt – Non-Marketable

describe bank overdraft

Answer 15

allows a company to run its current (cheque) account into deficit up to an agreed limit

Question 16

what is a commercial paper/promissory note

Answer 16

short-term, marketable debt security

-promise to pay face value at maturity (30-180 days)

discounters = initial purchases of commercial paper who may hold the paper until it matures or, more usually, sell it to other investors.

can be underwritten — banks and other financial institutions are usually involved.

Facilitate trading by having a credit rating from a ratings agency.

Question 17

Bills of Exchange

when may this be used?

Answer 17

A company will struggle to issue/sell a promissory note if it does not have a credit rating from a ratings agency –> bill of exchange

Question 18

Bills of Exchange

what is it

Answer 18

marketable short-term debt security in which one party (the drawer) directs another party (the acceptor) to pay a stated sum on a stated future date

acceptor (often bank) accepts the responsibility to pay the face value on the maturity date

• borrower pays a fee to the bank for this service and also agrees to reimburse the bank for paying the face value on the maturity date.

Question 19

who is involved in a bill of exchange?

Answer 19

the drawer - initiates the bill of exchange; borrower

acceptor (usually bank or financial institution) - agrees to pay the holder the bill’s face value on the maturity date to whoever owns the bill on the maturity date

discounter (financial intermediary or institution) - purchases bill from draw; lends funds

Question 20

bill of exchange

The discounter has the choice of

Answer 20

holding the bill until maturity, when payment will be received from the acceptor, or rediscounting (selling it in the secondary market) the bill.

Question 21

bill of exchange

if the discounter sells the bill, then?

Answer 21

the seller normally endorses the bill at the time of sale and accepts responsibility to pay the face value if there is default by the acceptor, drawer and earlier endorsers

Question 22

bill of exchange

On the bill’s maturity date the acceptor

Answer 22

pays the face value to the holder of the bill and the acceptor will require the drawer to reimburse the acceptor for this payment.

Question 23

bill of exchange

In the unlikely event that the acceptor is unable to pay

Answer 23

the face value, liability for payment falls next on the drawer. If the drawer is also unable to pay, each endorser becomes liable to pay subsequent endorsers; thus there is a ‘chain of protection’ consisting of all those entities that have endorsed the bill.

Question 24

diagram of bill of exchange

Answer 24

Question 25

bank accepted bill/ bank bill and non-bank bill

Answer 25

a bill of exchange accepted by the bank

non-bank bill: bill of exchange that has been neither accepted nor endorsed by a bank