Topic 6 - Sources of Finance

Question 1

Ownership

Answer 1

the ownership of a corporation is split up into shares of stock collectively known as equity.
the ownership and control of a corporation are separate features.

Question 2

Control

Answer 2

Typically a small group of directors control a firm.
Board of Directors - elected by shareholders, have the ultimate decision making authority
CEO - manages the day to day decisions

Question 3

Agency Problems

Answer 3

when there is a conflict of interest between the agents and the principles (managers and shareholders).
people claim that because of the separation between ownership and control, that managers have less incentive to work in the interests of shareholders when this means working against their own self interest

Question 4

Solutions to the agency problem

Answer 4

• managerial compensation - tie managements compensation to firm performance to align the interests of shareholders and management
• shareholder feedback on performance of agent -by selling their shares, they can drive the stock price down

Question 5

internal sources of finance

Answer 5

Internal finance by putting profits back into the business rather than distributing them as dividends

Question 6

external sources of finance

Answer 6

Debt - Bonds, Bank loans
Equity - Common stock, preferred stock

Question 7

Common Stock

Answer 7

• These represent the equity share capital of a firm
• Ownership right - certificate
• Holders benefit from voting privileges, dividends, and limited liability
• No agreement of repayment

Question 8

Preferred Stock

Answer 8

• Stock that takes priority over common stock in regard to dividends
• No voting rights unless company misses a dividend payment

Question 9

Debt - as a source of finance

Answer 9

debt has to be repaid

Question 10

Advantages of Bank loan

Answer 10

A loan from a bank must be repaid with interest.
ADV - quick, flexible, available to small firms, low admin or legal costs

Question 11

Control: Debt v Equity

Answer 11

• bank loans don’t give the bank ownership
• bond holders don’t have ownership
• issuing shares means selling ownership

Question 12

Cost: Debt v Equity

Answer 12

• the cost of raising debt interest payments, which are fixed and relatively low
• interest is tax deductible
• generally debt is cheaper than equity
• the cost of equity is the expected return required by investors
• no tax advantage here because dividends aren’t tax deductible
• more expensive than debt because investors take on more risk

Question 13

Profits: Debt v Equity

Answer 13

• debt holders receive minimum profits
• equity holders can gain a huge profit in the form of dividends or high capital gain.

Question 14

Shock Absorption: Debt v Equity

Answer 14

• debt holders get interest payments as priority over dividends in the case of bankruptcy
• equity holders are last to receive money in the case of bankruptcy