WEEK 4 - Corporate Financing

Question 1

How do companies finance their investment?

Answer 1

Via internal funds (Profits, Depreciation) and external funds (New Equity,Borrowing)

Question 2

How much does internal funding make up in overall corporate financing in Germany, Japan and the UK?

Answer 2

More than 2/3 in Japan,Germany and UK

Question 3

Why is internal funding more convenient than external?

Answer 3

• Avoids the cost of issuing new securities or negotiating debt
• Shareholders happy if retained profits finance positive NPV projects (forgo dividends but stock has greater market value)

Question 4

What is the downside of a reliance on internal financing?

Answer 4

Losing risky but positive NPV projects

Question 5

How do you measure a companies debt?

Answer 5

Via the debt ratio

Which is the proportion of debt relative to the firm value

Question 6

How do you calculate Debt Ratio?

Answer 6

Value of Debt / Value of Debt +Value of Shares

Question 7

What is the Book Value?

Answer 7

Tells us how much capital the firm has raised from shareholders in the past (Accounting Value)

Question 8

What is the Market Value?

Answer 8

Measures the value that shareholders place on those shares today

Question 9

What is the truth behind the market value and book value of equity?

Answer 9

The market value of equity is often much larger than book value of equity

The market debt ratio often much lower than the book debt ratio

Question 10

What are stocks and shares held by investors called?

Answer 10

Issued and outstanding shares/stocks

Question 11

What are stocks and share bought back from investors called?

Answer 11

Issued but not outstanding shares/stocks

Question 12

What is common stock?

Answer 12

shares that can be bought by common shareholders

Question 13

What do shares refer to?

Answer 13

Refers to the ownership certificates of a particular company

Question 14

What do stocks refer to?

Answer 14

Refers to the ownership certificates of any company

i.e To the overall ownerships in one or more companies

Question 15

What kind of rights do regular shareholders have?

Answer 15

• Residual cash flow rights
• Residual control rights over firm’s affairs - Usually in widely held companies common shareholder stock limited or restricted to individual entitlement to vote i.e 1 share = 1 vote

Question 16

How do the voting procedures usually work?

Answer 16

• Shareholders vote
• Many require simple majority
• Some decisions require supermajority (75% of those eligible to vote) (e.g. mergers)

Question 17

How can companies change the classification of shares?

Answer 17

May have two classes of stock outstanding which differ in their right to vote

e.g Facebook releasing class A stocks (sold to public 1 share= 1 vote) and Class B stocks (1 share = 10 votes, held by founders)

Question 18

Why do stocks with superior voting power sell at a premium?

Answer 18

• Greater control rights grant larger private benefits
  i. e.
• Prevent challenge to his/her management position
• extra bargaining power in an acquisition
• secure a business advantage
• toss out bad management or force management to adopt policies that enhance shareholder value (these can also benefit all shareholders)

Question 19

What is a preferred stock?

Answer 19

Entitles the holder to a fixed dividend (fixed on time of issue), whose payment takes priority over that of ordinary share dividends.

• Do not grant ownership rights unless company fails to pay preferred stock then some voting rights

Question 20

What is the standard procedure when companies borrow money?

Answer 20

Promise to make regular interest payments and repay the principle (Limited Liability

Question 21

What is the unique feature of Debt for companies?

Answer 21

Borrowers can away from obligation to pay (i.e default) in exchange for assets of company.

Willing to do so if: Value of Assets < Value of Debt

Not straightforward -> Bankruptcy process

Question 22

What is a default risk?

Answer 22

term used to describe the likelihood that a firm will walk away from its obligation, voluntarily or involuntarily.

Question 23

Why are bond ratings issued on debt instruments?

Answer 23

To help investors assess the default risk of a firm

Question 24

What are some of the elements of holding debt (i.e. company owning you money)

Answer 24

Debt claim on cash flows is limited (to the interest and principal) =} no residual cash flow rights (contrary to equity).

no control rights (unless the firm defaults).
As lenders are not owners → no voting power.

Question 25

How can debt be seen as a disguised tax subsidy?

Answer 25

• Interest paid on pre-tax income

- Dividends paid on after- tax income

Question 26

Who hold the bulk of corporate debt?

Answer 26

Financial Institutions in the form of bonds

Question 27

What is Secured debt?

Answer 27

debt that has first claim on specified collateral in the event of default.

Question 28

What is Senior Debt?

Answer 28

debt a company must repay 1st if goes out of business

Question 29

What is Subordinated Debt?

Answer 29

debt that may be repaid in bankruptcy only after senior debt is repaid

Question 30

What is Investment Grade?

Answer 30

bonds rated Baa or above by Moody’s or BBB or above by S&P.

Question 31

What is a Junk Bond?

Answer 31

bonds with a rating below Baa or BBB

Question 32

What is a Callable Bond?

Answer 32

bonds that may be repurchased by firm before

maturity at specified call price.

Question 33

What is a Convertible Bond?

Answer 33

bonds that give its owner (the lender) the option to exchange for a predetermined number of shares

Question 34

What are some of the questions that can be posed to a financial manager regarding debt?

Answer 34

1. Should the Company borrow short term (bank loans) or Long Term (Issue Bonds)
2. Should the interest rate on loan be fixed or floating?
3. Should borrow in domestic or foreign currency?
4. What promises should be made to the lender?
5. Should issue straight or convertible bonds?

Question 35

What is the answer to the first question in the financial manager question?
(Should the company borrow short term (bank loan) or long term (issue bonds)?)

Answer 35

It depends on the time-horizon of the project to be financed:

finance a temporary increase in inventories → take out a short-term bank loan.

cash needed to pay for expansion of plant, new building, new machinery,… → issue long-term bonds

Question 36

What is the answer to the second question in the financial manager questions?
( Should the interest rate on loan be fixed or floating?)

Answer 36

Normally bank loans carry floating rates (e.g.: LIBOR+1p.p.)

LIBOR: interest rate at which major international banks lend to each other

Bonds carry fixed payments (the coupons).

Question 37

What is the answer to the 3rd financial manager question?

(Should borrow in domestic or foreign currency?

Answer 37

It depends on whether the company has overseas operations or not.

If it needs to spend foreign currency, it makes sense to borrow foreign currency.

Question 38

What is the answer to the 4th financial manager question? (What promises should be made to the lender?)

Answer 38

It depends on the lenders’ concerns about the risk associated with the loan (i.e., probability of default).

Lenders may demand that their debt is senior (→ safer).
Firms may set aside some of its assets (collateral) for the protection of particular creditors.

if firm defaults on the loan, the bank can seize the collateral and use it to help pay off the debt.

Question 39

What is the answer to the 5th financial manager question?

Should issue straight or convertible bonds?

Answer 39

Convertible bonds give its owner the option to exchange the bond for a predetermined number of shares.

There is no obligation for the bondholders to convert;

It depends on expectations about the firm’s share price:
expect an increase → can convert bonds with profit
expect a decrease → there is no obligation to convert

Question 40

What is the link between financial markets and financial intermediaries?

Answer 40

SEE DIAGRAM IN NOTES

Question 41

What exactly are financial markets?

Answer 41

Where financial assets are:

- Issued by corporations 
(Primary issues -> Primary Market)
AND 
-Traded by investors 
(Secondary Transactions -> Secondary Market)

• In other cases no organised (or regular) exchange
  (OTC Markets)

Question 42

What are financial intermediaries?

Answer 42

Organisations that:

• Raise money/savings from investors
  AND
• Provide financing for individuals, companies and other organisations

Question 43

What are some of the other roles of financial markets and intermediaries?

Answer 43

Besides channelling savings to real investment:

• Payment Mechanism
• Borrowing and Lending
• Pooling risk
• Information

Question 44

What exactly does the Payment Mechanism do?

Answer 44

allow individuals to make and receive payments quickly and safely over long distances.

Question 45

What exactly does Borrowing and Lending do in regards to the role of financial markets and intermediaries?

Answer 45

allocate savings towards those who can best use them.

Question 46

What exactly does pooling risk do?

Answer 46

Allow individuals to share risk

Question 47

What exactly does Information do for the financial markets and intermediaries?

Answer 47

Know about the ‘real’ value of securities and commodities (how much they worth) and allow estimation of rates of return that investors can expect on their savings.