long term finance: equity and debt

Question 1

what are shareholders

Answer 1

considered the corporation’s owners
- normally have voting rights at the annual general meeting of the company
- protected by limited liability - (the most they can lose is the value of their investments

Question 2

what are equity holders

Answer 2

residual claimants to the firm’s cash flows
- entitled to receive payments from after-tax profits (dividends) at the firm’s discretion

Question 3

what are the 2 types of equity claim

Answer 3

1. common stock
2. preferred stock
   - preferential claim to dividends and assets compared to common stockholders
   - limited voting rights

Question 4

what are the sources of financing

Answer 4

1. angel investors
   - generally wealthy ppl interested in funding businesses they believe will provide attractive returns
2. venture capital firms
   - venture capitalists are individuals/ firms capable of making substantial investments in business that they view as having very high and rapid growth potential
3. institutional and corporate investors
   - invest through an initial public offering

Question 5

what industry do venture capital firms belong to

Answer 5

they belong to the private equity industry

Question 6

what are features of private equity funds

Answer 6

• they are limited-duration (typically 7-10 years)
• closed-end funds that invest primarily in equity stakes in companies

they typically
- hold large stakes in private companies
- are active in the management of their portfolio firms

Question 7

how are private equity funds structured as limited partnerships

Answer 7

• limited partnerships (investors, such as pension funds, endowments, investment funds) provide most (90+%) of the capital
• general partners are responsible for choosing and monitoring the funds investments

Question 8

distinguish between venture capital funds and leveraged buyout funds

Answer 8

venture capital funds - specialise in financing new firms

leveraged buyout funds - specialise in buying mature firms

Question 9

what happens in leveraged buyout funds

Answer 9

• a small group of investors acquires all of the company’s (private or public) capital
• the acquisition is financed mostly with debt backed by the target’s assets
• after the acquisition, the target becomes a private firm with a very high leverage

Question 10

how do venture capital investors exit their investment in a firm

Answer 10

1. mergers and acquisitions
   - start up is bought by another company
2. through an initial public offering
   - the firms equity is made available to the public for the first time

Question 11

what are public equity markets

Answer 11

corporations ‘go public’ when they raise equity finance by selling shares to the public for the first time through initial public offering

Question 12

what are the types of IPO

Answer 12

1. primary offering
   - new shares are issued to raise additional capital
2. secondary offering
   - existing large shareholders (like venture capital firms) cash in by selling part of their stake in the company

in practice, IPOs are often a mix of primary and secondary offerings

Question 13

what are IPO benefits

Answer 13

1. better access to capital (aided by liquidity and transparency of public markets)
2. diversify the initial investors
3. current equity holders usually sell a fraction of their shares
4. exit strategy for VCs and other investors

Question 14

what are IPO disadvantages

Answer 14

1. monetary costs
   - administrative costs
   - underwriting costs = fee that investment banks charge for their services
   - underpricing: IPO issue price &laquo_space;day one closing price
2. disclosure requirements
3. loss of control and freedom
   - dilution of ownership stake and greater regulatory oversight

Question 15

what are underwriters

Answer 15

in a typical IPO, the firm hires an investment banks who acts as the underwriter

they perform a number of functions
- like offering advice on the pricing of the issue
- preparation of documents
- marketing and selling the shares to selected investors
- sometimes guaranteeing the proceeds of the issue

can cost as much as 11% of the offer value

Question 16

what is IPO underpricing

Answer 16

underwriters may sell the new shares at a lower price than the valuation in order to attract investors
- but this represents a cost to the existing owners
- underpricing (measured by issue price - price at the end of day one) can be large

but
- can be difficult to get the issue price right
- too high an issue price = not enough shares sold

Question 17

what are seasoned equity offerings and what are 3 ways of making a SEO

Answer 17

a company already listed can raise additional equity by a seasoned equity offerings

1. general cash offer
   - sale of securities open to all investors
2. private placement
   - sale of securities to a limited number of investors without a public offering
3. rights issue
   - issue of securities offered only to current stockholders
   - an “X for Y” rights offer = for every Y shares u own, u have the option to buy X more shares from the company

Question 18

what is debt

Answer 18

debt = a contract that sets out the features of a loan

Question 19

what are bonds

Answer 19

long-term securitised loans - they can be re-sold

• typically viewed by investors as lower risk than equity because
  1. legal obligation to pay interest and capital
  2. debt securities rank higher than equity when it comes to bankruptcy of the firm

Question 20

what are creditors/ debt holders

Answer 20

they typically receive legally obligated interest payments (fixed/ floating rates), and repayment of principal at maturity

Question 21

what are interest payments

Answer 21

generally paid out of pre-tax profits
- there is a tax advantage to a company using debt finance

Question 22

what are credit ratings

Answer 22

agencies provide ratings to indicate the likelihood of default
- top rating = AAA
- lowest rating = D

• generally there is a low probability of default for AAA rated bonds = earn investors a lower interest rate
• the risk of default increases as we go down the ratings and interest rate increases
• bonds rated BBB and above = investment grade bonds

Question 23

what’s unsecured vs secured debt

Answer 23

unsecured : no collateral - backed by the company’s creditworthiness

secured lender can serve collateral upon default
- like mortgage bonds : long term debt secured by a firm’s property
- asset backed bonds: securities backed by a portfolio of assets

Question 24

what is secured debt

Answer 24

backed by specific assets ( collateral) which lenders can claim in the event of default
- reduces the lender’s risk and often results in lower interest rates

Question 25

what is collateral

Answer 25

can include real estate, equipment, receivables, or other tangible or intangible assets
- if borrower defaults, the lender has the right to sell the collateral to recover their investment

Question 26

what is seniority

Answer 26

who gets paid first when the firm enters bankruptcy
senior> subordinated (junior)
secured > unsecured
debt holders > equity holders

Question 27

what are recovery rates

Answer 27

percentage an investor gets back if the debt defaults
- differ according to seniority with senior secured bonds yielding approx. 65%
- at the end of the recovery spectrum, junior subordinated loans yielding approx. 15% after recovery

Question 28

what are the repayment provisions

Answer 28

1. sinking fund
   - established to retire debt gradually before maturity
   - firm is obligated to make regular payments to the sinking fund
2. call provision
   - issuer has the right to repurchase the bond at a specific price on or after a specific date
   - the yield to call of a callable bond = its yield calculated under the assumption that the bond will be called on the earliest call date
3. convertible provision
   - gives the bondholders the tight to convert each bond into a pre specified number of shares

Question 29

what are debt covenants

Answer 29

debt covenants contained in a bond contract are restrictions imposed by bondholders on the activities of the borrower

positive covenants: specify actions that the firm must take
- like interest coverage ratio must be greater than 3

negative covenants: limit or forbid actions that the firm may take
- like restriction on dividend payments

Question 30

what is cost of equity

Answer 30

summing the present values of all expected dividend payments (to infinity)

its the minimum rate of return that the shareholders expect to get in order to buy ABC shares
- max price theyre willing to= P0 in the pricing equation
- min price = the discount rate in the dividend discount model ( required rate of return that compensates the investor for risk)

cost of equity is specific to a stream of cash flows
- assuming ABC is all equity financed
- if ABC changes its business ( changes its risk) = different cost of equity is specific
- if ABC is financed with both debt and equity, then cost of equity will be different

Question 31

what is the cost of debt

Answer 31

price of debt is determined by summing the present value of all cash flows received from holding the debt

• the discount rate is the return that investors require to deliver the fair price = cost of debt
• cost of debt = compensation for risk faced by the investor

Question 32

what is the cost of capital

Answer 32

overall cost of capital = weighted average of the cost of its equity and debt
- the weights are the relative market values of equity and debt
- use market values (not book values) to reflect the risk of the equity and debt as seen by investors

• there is a tax advantage to the firm from using debt as a source of financing as interest payments are paid out of pre-tax income

Question 33

what are the limitations of using WACC as a discount rate for capital budgeting

Answer 33

WACC is a measure of the return that satisfies both debt and equity holders when investing in new projects that have the same risk as the firm’s existing business

• certain assumptions must be met when using WACC
  1. risk of the new project = that of firms existing project
  2. financing of the company (proportions of debt and equity) will be the same when the new project is undertaken
  3. individual costs of debt and equity will not change over the lie of the new project