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FCNE20005 - CFDM > Lecture 3: Raising Capital: Debt, Hybrid Securities and Leasing > Flashcards

Lecture 3: Raising Capital: Debt, Hybrid Securities and Leasing Flashcards

1.) Characteristics of Debt 2.) Effects of Financial Leverage 3.) Debt and Equity within an Options Framework 4.) Hybrid Securities 5.) Operating leases and Financial leases 6.) Financial evaluation of leases 7.) Advantages and Disadvantages of leasing

1
Q

Define ‘debt’

A

Contribution of capital by lenders for a LIMITED period of time

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2
Q

What are key differences between debt and equity

A

Debt:

  • Non-Voting
  • Limited period
  • Fixed and Superior contractual right to return of capital and return ON capital (interest)
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3
Q

What is an investment grade bond

A

Low Probability of Default

S&P: >BBB-
Moody: >Baa3

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4
Q

What are debt covenants

A

Restrictions placed on the borrower of the debt (i.e. firms)

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5
Q

What are 3 properties of debt covenants

A
  1. ) Pledge assets to be maintained in good order
  2. ) Restrict additional borrowing & incursion of additional liabilities
  3. ) Restrict dividend payments
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6
Q

Why do we need debt covenants

A

To prevent wealth transfer from debt holders to shareholders

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7
Q

What are debts in Australia mostly consist of

A

Bank lending

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8
Q

What are the 2 key features that distinguishes bank and non-bank lending

A
  1. ) Monitoring

2. ) Concentration of Bank Lending

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9
Q

Discuss monitoring in relation to bank lending

A

+ve
1.) Constrains managers from conducting -NPV actions

  • ve
    1. ) Constrains managers from conducting +NPV actions
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10
Q

Discuss Concentration of Bank Lending in relation to bank lending

A

-ve:

  1. ) Monopoly
  2. ) Reduce financial flexibility of firms
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11
Q

What is business risk

A

Inherent risk that cannot and will never be eliminated. Faced by shareholders only if it is 100% equity financed.

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12
Q

What is financial risk

A

As long as the firm has debt, it has financial risk (even if 1% equity). Shareholders will face this if any debt financing.

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13
Q

What are the effects of financial leverage with a simple definition

A

Trade-off between risk and expected returns

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14
Q

If the company is failing, what are the effects of financial leverage on shareholders and explain

A

Since debtholders have to be paid first, less wealth is shared among shareholders.

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15
Q

If the company is doing well, what are the effects of financial leverage on shareholders and explain

A

Since debtholders have to be paid first, additional wealth is shared among shareholders.

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16
Q

If a company is failing but is going to conduct a high-risk action, what will happen to the share price? Explain.

A

It will rise. Volatility increase > Long call become more valued > Shareholders invest more

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17
Q

Under an options framework, what do shareholders hold

A

Long call (With X as debt)

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18
Q

Under an options framework, what do debtholders hold

A

Short Put (With X as debt)

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19
Q

What are hybrid securities

A

Securities with both debt and equity characteristics

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20
Q

How many kinds of hybrid securities are there?

A
  1. ) Convertibles. Notes (short-term) & Bonds (long-term)
  2. ) Preference Shares
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21
Q

What are convertibles

A

Initially issued as a debt (i.e. fixed-term at fixed-interest rate), with an option to convert into shares at a specified date

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22
Q

If I have a 10-year, 10% convertible with a FV of $20 at a 1-for-1 ratio, when should I convert?

A

Convert if the share price of the stock is >FV (i.e. $20).

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23
Q

What is the advantage of convertibles

A

Advantage:

It overcomes the negative signals associated with issuing ordinary shares

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24
Q

What is the disadvantage of convertibles

A

Disadvantage:

The interest rate of convertibles is less than that of debt

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25
Q

What are Preference Shares

A

Holders of Preference Shares have priority over ordinary share holders in dividends, & especially in the event of liquidation.

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26
Q

What are the 4 characteristics of MOST preference shares

A
  1. ) Cumulative
  2. ) Irredeemable
  3. ) Non-Participating
  4. ) Non-Voting

CINN

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27
Q

Cumulative vs Non-cumulative

A

Cumulative: must be paid any accumulated dividends over ordinary shareholders

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28
Q

Irredeemable vs Redeemable

A

Irredeemable: No maturity date

29
Q

Non-Participating vs Participating

A

Non-Participating: Not entitled to return in excess of stated dividend rate

30
Q

Non-Voting vs Voting

A

Non-Voting: Not entitled to vote

31
Q

What are 3 other preferences shares out there discussed in lecture

A
  1. ) Converting preference shares
  2. ) Reset preference shares
  3. ) Step-up preference shares
32
Q

What are Converting preference shares

A

Automatic conversion to ordinary shares after typically 5-10 years

33
Q

What are Reset preference shares

A

Dividend rate resets after a specified period

34
Q

What are Step-up preference shares

A

Variable dividend rate (idk)

35
Q

What is leasing

A

A form of finance ALTERNATIVE to borrowing funds from the market.

It is a contract where the lessor receives fixed payments from a lessee in return for asset use.

36
Q

Lessor vs Lessee

A

lessOr: o wner
lessee: user

37
Q

What are the 2 broad kinds of leases

A
  1. ) Operating lease

2. ) Finance lease

38
Q

What are differences between operating and finance lease

A
  1. ) Time: Operating (short-term) vs Finance (long-term i.e. most of life)
  2. ) Cancellability: Operating (Cancellable) vs Finance (Not Cancellable)
  3. ) Risks: Operating (with lessor) vs Finance (with lessee)
  4. ) Identity: Operating (Supplier) vs Finance (financial institutions)
39
Q

1 key idea to distinguish Operating and Finance leases

A

Operating: Rental Agreement; Finance: Loan Agreement

40
Q

What are the 3 types of finance leases

A
  1. ) Sale and Lease-back Agreements
  2. ) Leverged Lease
  3. ) Cross-border Lease
41
Q

What are Sale and Lease-back Agreements

A

The owner of the asset sells it to a financial institution and immediately leases it back.

42
Q

What are Leverged Leases

A

Lessor borrows most of the funds via equity and debt to acquire the asset and leases out to a lessee

43
Q

What are Cross-Border Leases

A

Lessee and Lessor are in different countries

44
Q

Are the companies in Australia typically lessors or lessees

A

Lessees

45
Q

When do we use cross-border leases

A

It is usually motivated by tax regulations

46
Q

In the financial evaluation of leases, which capacity does it take up?

A

Debt capacity. Use the cost of debt capital as an appropriate discount rate.

47
Q

What are the 6 components for a lessee to consider leasing

A

a.) Advantages

1a. ) Avoided cost of buying asset
2a. ) Lease Payments
3a. ) Residual payment that must be paid under lease

b.) Disadvantages

1b. ) Depreciation tax shield forgone for not acquiring asset
2b. ) Tax savings obtained from lease payments
3b. ) Tax saved from gain or loss of sale of asset

48
Q

Remember that the NPV calculations are only between LEASE vs PURCHASE, not ASSET SERVICES vs either

A

Just remember

49
Q

If the lease payments are higher, is it better or worse for the lessees

A

It is often worse due to less tax savings

50
Q

What are the advantages of leasing

A

TT

  1. ) Company Taxation
  2. ) Transaction Costs
51
Q

What are the disadvantages of leasing

A

1.) Agency Costs

52
Q

What are the invalid arguments regarding the pros and cons of leasing

A
  1. ) Conservation of Capital
  2. ) Off-balance sheet financing
  3. ) Cost of Capital
53
Q

Elaborate on the advantage “Company Taxation”

A

Lessor’s tax rate > Lessee’s tax rate:

Lessor can share advantage of greater tax savings with lessee by reducing lease payments.

No loser in this situation

54
Q

Elaborate on the advantage “Transaction Costs”

A

RCS

  1. ) Repossession of asset easier for Lessor than a secured lender
  2. ) Credit checks on standing of lessee not as thorough as a lender
  3. ) Simple, standardized contracts compared to borrowing
55
Q

Elaborate on the disadvantage “Agency Costs”

A

Leasing = Separation of ownership and control

Higher agency costs when leased asset may be easily damaged.

56
Q

Elaborate on the invalid argument “Conservation of Capital”

A

Leasing is often wrongly promoted as 100% debt financing but it is not.

57
Q

Elaborate on the invalid argument “Off-balance sheet financing”

A

Leases finance is a substitute for debt and accounting standards make leasing hard to go off-balance

58
Q

Elaborate on the invalid argument “Cost of Capital”

A

Discount rates are the same (Because there is no reason it should have different risk).

It is possible that i (lessor) < i (lessee) but that can only happen if the lessee assumes all risk of ownership and the differences should reflect this risk

59
Q

What are the 4 factors in leasing policies

A
  1. ) Sensitivity to use and maintenance
  2. ) General Assets
  3. ) Transaction costs & Flexibility
  4. ) Comparative Advantage in Asset Disposal
60
Q

Elaborate on the leasing policy “Sensitivity to use and maintenance”

A

Leasing: Separation of Ownership and Control

Lessee has less incentive to take care. Lessors will recognize (set higher payments).

The more sensitivity to use and maintenance, the less attractive leasing is.

61
Q

Elaborate on the leasing policy “General assets”

A

The more general the asset is, the more active its second-hand market.

> Easier to forecast disposal values & agree on lease terms

More incentive to buy specialized company-specific assets as they are more valued within their own company

62
Q

Elaborate on the leasing policy “Transaction costs + Flexibility”

A

Transaction Cost:
Lower transaction cost than buying and selling

Flexibility:

  • Search costs
  • Cost of assessing quality
63
Q

Elaborate on the leasing policy “Comparative Advantage in Asset Disposal”

A

Similar to “General Assets”. Especially good if the lessor is a manufacturer/distributor

Used Assets:
Can operate a specialized market

To Reuse Assets:
Able to repair and maintain assets

64
Q

What is a speculative grade

A

Not as good

S&P:

65
Q

Who does debt covenants protect

A

Though it prevents wealth transfer from debt to shareholders, it protects ALL parties.

66
Q

BONUS: When will the NPV of leasing = buying

A
  1. ) No transaction costs
  2. ) Information is freely available
    3) All parties (lessor & lessee) has the same Tc
67
Q

BONUS: When is leasing ESPECIALLY attractive

A
  1. ) Tax (Lessor) and Tax (Lessee) great difference
  2. ) High Depreciation Rate (Claim early tax savings)
  3. ) High Interest Rates (Lower PV)
68
Q

rate of return on ASSETS > rate of return on DEBT in a leveraged firm, what will happen to the rate of return to shareholders

A

The rate of return on EQUITY is INCREASED

69
Q

If the rate of return on ASSETS < rate of return on DEBT in a leveraged firm, what will happen to the rate of return to shareholders

A

The rate of return on EQUITY is DECREASED

FCNE20005 - CFDM (15 decks)

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