Study Unit 7

Question 1

Indenture

Answer 1

document that states terms of bond agreement
may require issuer to establish and maintain bond sinking fund
-objectives of pmts into fund is to segregate and accumulate assets to pay bond principal at maturity

Question 2

Advantages and disadvantages of bond to issuer

Answer 2

Advantages
interest paid on debt is deductible
maintain ctrl of firm

Disadvantages
pmt of interest and debt are legal obligations; if not enough cash flow to pay could become insolvent
legal req raises firm’s risk level; s/h demand higher cap rates on r/e, decreasing mkt price of stock
require collateral (restricts assets)
debt financing limited; cost of debt may rise rapidly

Question 3

Maturity Pattern Bonds

Answer 3

term- single maturity date at end of term

serial- matures in stated amnt at regular intervals

Question 4

Valuation Bonds

Answer 4

Variable (floating) rate- pay interest based on mkt conditions
zero-coupon or deep discount - no stated rate of interest, no periodic cash pmt, interest is the bond’s discount
commodity backed- payable at prices related to a commodity (i.e. gold)

Question 5

Redemption Provisions

Answer 5

Callable- able of issuer to repurchase at specific price before maturity (good when interest rates fall b/c issuer an replace high interest debt with lower interest rate); pay higher yield than non callable

Convertible-convert into equity security of issuer

Question 6

Call provisions

Answer 6

provisions on a bond allowing issuer to repurchase and retire bonds early

Question 7

Value proposition of callable bonds

Answer 7

favorable for issuer b/c can retire & pay debt earlier
-no more interest pmts

unfavorable for investor bc amnt rec’d when not retired is more than premium company pay to retire

Question 8

Securitization

Answer 8

Mtg bonds- backed by assets (real estate)

Debentures- backed by borrower’s general credit not specific collateral

Question 9

Ownership

Answer 9

Registered bonds- issued in name of holder; only holder receives interest and principal pmts

bearer bonds- not individually registered; interest and principal paid to whomever presents bond

Question 10

Priority

Answer 10

Subordinated debentures- junior securities with claims inferior to sr bonds

Question 11

Repayment provisions

Answer 11

income bonds- pay interest contingent on issuer’s profitability
revenue bonds- issued by govt and payable from specific revenue sources

Question 12

Bond discount vs premium

Answer 12

discount- stated rate (coupon) mkt rate

-investor pay more bc interest pmts are higher than available for mkt

Question 13

Leverage

Answer 13

relative amnt of FC in firm’s overall cost structure

-creates risk bc FC must be covered regardless of sales level

Question 14

Operating Leverage

Answer 14

firms’ cost of operating are fixed rather than variable
degree of op leverage (DOL) measures effect given level of fixed operating costs has on firm earnings

DOL=% change in earnings before interest & taxes (EBIT)/% change in sales

• help find best level of operating leverage to maximize EBIT
• firm w/ high FC more risky than firm w/ more VC

Question 15

Financial leverage

Answer 15

degree of debt (fixed financial costs) in the financial structure
degree of financial leverage (DFL)
DFL=% change in EPS/ % change in EBIT

high % of fixed financial costs, firm takes more risk to increase its EPS

Question 16

Degree of total (combined) leverage

Answer 16

DTL= DOL * DFL

high DTL has higher return for investors, but is more risky

Question 17

Disadvantages of issuers of common stock

Answer 17

cash dividends aren’t tax deductibe; paid out of after tax profits
new c/s sales dilute EPS to existing s/h
underwriting costs higher
too much equity raises avg cost of capital above optimal level

Question 18

Preemptive rights

Answer 18

common shareholder have right to purchase adtl stock issuance in proportion to current ownership %

Question 19

Dividend payout model for constant dividend

Answer 19

Price per share now = divident per share (constant)/req rate of return

P(0)=D/r

when dividend is constant & expected to be paid continuousy

Question 20

Constant growth model

Answer 20

dividend discount model
P(0)=D(0) (1+g) / r-g
P(0)=D(1)/r-g

Question 21

preferred stock

Answer 21

hybrid of debt & equity; has fixed charge, pmts not obligation

Question 22

Advantages of issuers of preferred stock

Answer 22

builds creditworthiness (form of equity)
control held by common s/h (no voting rights)
superior earning of firm reserved for common s/h
doesn’t req periodic pmts; failure to pay doesn’t lead to bankruptcy

Question 23

Disadvantages to issuers of preferred stock

Answer 23

cash dividend aren’t tax deductible

during rough economy, accumulated unpaid div create managerial and financial problems

Question 24

Future dividends of preferred stock

Answer 24

D=par value of preferred * preferred div rate
preferred stock price P(p)
P(p)= D(p)/r

Question 25

IPO (advantages & disadvantages)

Answer 25

advantage

• raise $
• establish value in mkt
• increase liquidity of firm’s stock

disadvantage

• cost of reporting req
• access to firm’s operating data by competitors
• access to net worth by s/h
• limitation on self-dealing by corporate insiders
• pressure from outside s/h for earnings growth
• stock prices don’t accurately reflect NW
• loss of control by mgt
• increased s/h service costs

Question 26

Types of leases

Answer 26

sale leaseback- alternative for raising capital; allow firms to acquire capital from sale of asset while retaining use

service or operating- both financing and maint services

financial- don’t provide maint, noncancelable and fully amortize cost of lease over term of basic lease contract (installment purchases)

Question 27

Capital lease

Answer 27

essentially the purchase of an asset
4 part test (meet at least 1)
-Bargain purchase option
-Lease term is at least 7% of useful economic life
-Title transfered at end of lease
-Minimum lease pmt (PV MLP =90% or more of FV of leased property)

Question 28

Operating lease

Answer 28

off B/S
rental contract
no entry recorded, expense as incurred

Question 29

Cost of capital used to discount FCF of LT projects

Answer 29

investments w/ RoR higher than cost of capital increase the value of the firm (s/h wealth)

Question 30

Risk for Investors

Answer 30

firm not legally obligated to pay return

if firm liquidates, creditors have priority

Question 31

3 components of financing structure

Answer 31

LT debt, preferred equity, common equity (r/e included)

RoR demanded is component cost for that form of capital

Question 32

Component cost for LT, preferred stock, common equity

Answer 32

LT
-Effective rate * (1-Marginal TR)

P.Stock (use dividend yield ratio)
-cash dividend on p stock/mkt price of p stock
mkt price = net proceeds from issuance (gross proceeds-flotation costs)
flotation costs reduce net proceeds rec’d and raise cost of capital
-alternative component cost= cash dividend on p stock/p stock mkt price-issuance cost

component cost of r/e is same for c/s
-cash dividend/mkt price

Question 33

WACC

Answer 33

composite RoR on its combined components of capital with weights based on target capital structure

WACC= E/V *R(E) +D/V*R(D) * (1-T)
R(E)=cost of equity
R(D)=cost of debt
E=mkt value of firm's equity
D=mkt value of firm's debt
T=Corp TR
V=D+E=Capital used to generate profits

Question 34

Optimal cap structure

Answer 34

minimize WACC
don’t focus just on increasing EPS
can’t ID this point, find optimal range

Question 35

Modigliani-Miller theore

Answer 35

no optimal cap structure
doesn’t matter if finance w/ all debt, all equity, or equity and debt bc no consequence to s/h wealth
-any increase in expected return from debt is offset by increase in RoR on equity from the risk
-debt to equity ratio not useful to s/h