Week 4 Important

Question 1

Explain why bond prices have an inverse relationship with interest rate movements.

par bond

Answer 1

Since the coupon rate of a bond is fixed until maturity, the price of a bond will vary according to interest rate movements in the market. If the coupon rate is the same as the market interest rate, then the bond will sell for its par value (i.e. a ‘par bond’).

Question 2

Explain why bond prices have an inverse relationship with interest rate movements.

premium bond

Answer 2

However, if the coupon rate is greater than the market interest rate, then there will be increased demand for the bond which causes an increase in the market price of the bond, resulting in the bond selling for a premium (i.e. a ‘premium bond’).

Question 3

Explain why bond prices have an inverse relationship with interest rate movements.

discount bond

Answer 3

Conversely, if the coupon rate is less than the market interest rate, then there will be decreased demand for the bond which causes a decrease in the market price of the bond, resulting in the bond selling for a discount (i.e. a ‘discount bond’).

Question 4

Explain why bond prices have an inverse relationship with interest rate movements.

conclusion

Answer 4

In this way, bond prices are said to have an inverse relationship with interest rate movements, with bonds prices increasing when market interest rates decline and bond prices decreasing when market interest rates rise.

Question 5

Debenture

Answer 5

A debenture is any unsecured long-term debt. Because these bonds are unsecured, the earning ability of the issuing corporation is of great concern to the bondholder. They are also viewed as being more risky than secured bonds and, as a result, must provide investors with a higher yield than secured bonds provide. Often the issuing firm attempts to provide some protection to the holder through the prohibition of any additional encumbrance of assets. This prohibits the future issuance of secured long-term debt that would further tie up the firm’s assets and leave the bondholders less protected. To the issuing firm, the major advantage of debentures is that no property has to be secured by them. This allows the firm to issue debt and still preserve some future borrowing power.

Question 6

Mortgage bond

Answer 6

A mortgage bond is a bond secured by a lien on real property. Typically, the value of the real property is greater than that of the mortgage bonds issued. This provides the mortgage bondholders with a margin of safety in the event the market value of the secured property declines. In the case of foreclosure, the trustees have the power to sell the secured property and use the proceeds to pay the bondholders. In the event that the proceeds from this sale do not cover the bonds, the bondholders become general creditors, similar to debenture bondholders, for the unpaid portion of the debt.

Question 7

Eurobonds

Answer 7

Eurobonds are bonds issued in a country different from the one in which the currency of the bond is denominated. For example, a bond that is issued in Europe or in Asia by an American company that pays interest and principal to the lender in U.S. dollars would be considered a Eurobond. Thus, even if the bond is not issued in Europe, it merely needs to be sold in a country different from the one in whose currency it is denominated to be considered a Eurobond.

Question 8

Zero coupon bonds

Answer 8

Zero coupon bonds are bonds that pay no coupon interest. They allow the issuing firm to issue bonds at a substantial discount from their $1,000 face value. The investor receives all of the return from the appreciation of the bond at maturity.

Question 9

Junk bonds

Answer 9

Junk bonds refer to any bond with a rating of BB or below. The major participants in this market are new firms that do not have an established record of performance. Many junk bonds have been issued to finance corporate buyouts.

Question 10

Describe the bondholder’s claim on the firm’s assets and income.

Answer 10

In the case of insolvency, claims of debt in general, including bonds, are honoured before those of both common stock and preferred stock. However, different types of debt may also have a hierarchy among themselves as to the order of their claim on assets. Bonds have a claim on income that comes ahead of common and preferred stock. If interest on bonds is not paid, the bond trustees can classify the firm insolvent and force it into bankruptcy. Thus, the bondholder’s claim on income is more likely to be honoured than that of common and preferred stockholders, whose dividends are paid at the discretion of the firm’s management.

Question 11

Filkins Farm Equipment needs to raise $4.5 million for expansion. It expects that five-year zero coupon bonds can be sold at a price of $567.44 for each $1000 bond.

How many $1000 par value zero coupon bonds would Filkins have to sell to raise the needed $4.5 million?

Answer 11

Number of zero coupon bonds
= Amount needed/Price per bond

= $4,500,000/$567.44
≈ 7,931 bonds

Question 12

Filkins Farm Equipment needs to raise $4.5 million for expansion. It expects that five-year zero coupon bonds can be sold at a price of $567.44 for each $1000 bond

What will be the burden of this bond issue on the future cash flows generated by Filkins? What will be the annual debt service costs?

Answer 12

In five years, Filkins will have to repay $4.5 million when the bond matures. However, because the debt is a zero-coupon bond, there will no interest payments in the meantime. Thus, the annual debt service costs are $0.

Question 13

The Swift Company is planning to finance an expansion. The principal executives of the company agree that an industrial company such as theirs should finance growth by issuing ordinary shares rather than by taking on additional debt. Because they believe that the current price of Swift’s ordinary shares do not reflect the company’s true worth, they have decided to sell convertible bonds. Each convertible bond has a face value equal to $1000 and can be converted into 25 ordinary shares.

What would be the minimum share price that would make it beneficial for bondholders to convert their bonds? Ignore the effects of taxes or other costs.

Answer 13

The conversion price simply is the face (par) value of the bond divided by the conversion ratio; the conversion price for this issue is $1000/25 = $40. Therefore, it would be beneficial for investors to convert their bonds into ordinary shares when the share price is greater than $40 per share.

Question 14

The Swift Company is planning to finance an expansion. The principal executives of the company agree that an industrial company such as theirs should finance growth by issuing ordinary shares rather than by taking on additional debt. Because they believe that the current price of Swift’s ordinary shares do not reflect the company’s true worth, they have decided to sell convertible bonds. Each convertible bond has a face value equal to $1000 and can be converted into 25 ordinary shares

What would be the benefits of including a call provision with these bonds?.

Answer 14

The conversion feature would add some flexibility to the bonds as an investment. Investors might find it attractive to buy the bonds because they can later decide whether they prefer to remain bondholders or to convert and become stockholders.

Question 15

Suppose that five years ago CSL Limited sold a 15-year bond issue that had a $1000 par value and a 7 per cent coupon rate. Interest is paid semi-annually.

If the going interest rate has risen to 10 per cent, at what price would the bonds sell today?

Answer 15

813.07

Question 16

Suppose that five years ago CSL Limited sold a 15-year bond issue that had a $1000 par value and a 7 per cent coupon rate. Interest is paid semi-annually.

Suppose that the interest rate remained at 10 per cent for the next 10 years. What would happen to the price of the CSL Limited bonds over time?

Answer 16

The price of the bond will increase from $813.07 towards $1000, hitting $1000 (plus accrued interest) at the maturity date (assuming the firm does not default).

Question 17

Explain why preference shares are considered as a form of hybrid security.

Answer 17

Preference shares are considered as a form of ‘hybrid security’ because preference shares possess some features that are similar to bonds and some features that are similar to ordinary shares.

On the one hand, preference shares are similar to bonds in that fixed dividends must be paid to preference shareholders before dividends can be paid to ordinary shareholders. On the other hand, preference shares are similar to ordinary shares in that preference shares have no fixed maturity date and there is no obligation for companies to pay dividends to preference shareholders. In other words, companies can omit dividend payments to preference shareholders without the fear of defaulting and pushing the company into bankruptcy.

Question 18

Explain why a company’s ordinary shareholders are often referred to as its residual claimants.

Answer 18

As ‘residual claimants’, ordinary shareholders have residual claims to any earnings that remain only after: (i) interest payments are made to debtholders; (ii) corporate tax is paid to the government; and (iii) dividends are paid to preference shareholders.

Additionally, in the event a company becomes bankrupt, ordinary shareholders have residual claims to any assets that remain only after: (i) all claims by debtholders are settled; and (ii) all claims by preference shareholders are settled.

Question 19

Declaration date

Answer 19

Declaration date is the date on which the company’s board of directors publicly announces the amount and the specifics (such as the payment date) of the next dividend payment.

Question 20

Cum dividend

Answer 20

Cum dividend refers to the situation where the legal right to the next dividend payment accompanies a share. When investors purchase shares that are cum dividend, they are entitled to receive the next dividend payment on the payment date. Conversely, when shareholders sell shares that are cum dividend, they will not be entitled to receive the next dividend payment on the payment date.

Question 21

Ex-dividend date

Answer 21

Ex-dividend date is the date on which the legal right to the next dividend payment no longer accompanies a share. In Australia, the ex-dividend date occurs 4 business days prior to the record date when the company finalizes the list of shareholders that will receive the next dividend payment. Accordingly, shareholders that sell shares on or after the ex-dividend date will still be entitled to receive the next dividend payment on the payment date, although the new owner will not. Usually, shares that trade immediately after the ex-dividend date will be accompanied by a decline in the share price that is equivalent to the amount of the next dividend payment.

Question 22

Record date

Answer 22

Record date is the date on which the company determines the list of shareholders that will receive the next dividend payment. In Australia, the record date occurs 4 business days after the ex-dividend date.

Question 23

Payment date

Answer 23

Payment date is the date on which the company actually makes the dividend payments to the shareholders on its record.

Question 24

Dividend Irrelevance Theory

Answer 24

Dividend Irrelevance Theory states that a company’s dividend policy is irrelevant and has no effect on the overall cost of capital nor the market value of the company. Specifically, Dividend Irrelevance Theory argues that the market value of a company is determined by the basic earning power and the business risk of the company. Therefore, the market value of a company depends only on the net income (or positive cashflows) produced by the company and not on how it splits its retained earnings between financing investments for future growth versus dividend payments to shareholders. As a result, Dividend Irrelevance Theory contends that investors are only concerned with the total returns they receive, and not whether they receive those returns in the form of dividends, capital gains or both.

Question 25

Practical Implication Dividend irrelevance theory

Answer 25

Since Dividend Irrelevance Theory argues that shareholders are not concerned with a company’s dividend policy, this implies that company managers can set any dividend policy without affecting the company’s share price.

Question 26

Dividend Relevance Theory

Answer 26

In contrast, Dividend Relevance Theory states that the market value of a company is affected by its dividend policy, with the optimal dividend policy being the one that maximizes the market value of the company. Specifically, Dividend Relevance Theory contends that a company’s dividend policy can affect its market value due to investor preferences for either dividends (as ‘bird-in-hand’ theory contends) or capital gains (as ‘tax preference’ theory contends)

Question 27

‘Bird-in-Hand’ Theory

Answer 27

The ‘Bird-in-Hand’ Theory argues that, since current dividend payments are more certain than future capital gains, investors would prefer to receive dividends today rather than receive capital gains in the future.

Question 28

‘Bird-in-Hand’ Theory practical implication

Answer 28

Since ‘Bird-in-Hand’ Theory argues that investors prefer to receive dividend payments today rather than capital gains in the future, this implies that company managers ought to set a high regular dividend payments policy so as to minimize the cost of equity and maximize the company’s share price.

Question 29

‘Tax Preference’ Theory

Answer 29

On the other hand, the ‘Tax Preference’ Theory argues that, since dividends are taxed immediately whereas capital gains are not taxed until the share is sold (with potentially indefinite deferral of tax), investors would prefer to defer tax by receiving capital gains in the future rather than receiving dividends today and being taxed immediately.

Question 30

‘Tax Preference’ Theory practical implication

Answer 30

Since ‘Tax Preference’ Theory argues that investors prefer to defer tax by receiving capital gains in the future rather than receiving dividends today, this implies that company managers should set a low regular dividend payments policy so as to minimize the cost of equity and maximize the company’s share price.

Question 31

Residual dividend policy

Answer 31

Residual dividend policy refers to a policy in which the company only makes dividend payments to shareholders when there is retained earnings left over after having financed all profitable investment opportunities. In other words, the residual dividend policy dictates that dividend payments to shareholders should only be paid out of leftover earnings.

Question 32

Residual dividend policy practical implication

Answer 32

Although the residual dividend policy minimizes the cost of capital for the company by reducing the need to raise funds through the issuance of new equity or shares (which represents the most expensive form of financing), the residual dividend policy will necessarily result in the variation of dividend payments to shareholders due to fluctuations in both the amount of retained earnings and the cost of pursuing profitable investment opportunities over time. Since investors value economic certainty, this variation or instability of dividend payments sends conflicting signals to investors that might, in turn, adversely affect the company’s share price.

Question 33

Constant payout ratio dividend policy

Answer 33

refers to the policy in which the company distributes a fixed proportion of its earnings to shareholders in the form of dividend payments (for example, if the board of directors declare a constant payout ratio of 30%, then, for every dollar of earnings, 30 cents will be paid out to shareholders as dividends).

Question 34

Constant payout ratio dividend policy practical implication

Answer 34

Although the dividend payout ratio remains constant over time, the dollar value of dividend payments will necessarily fluctuate as earnings change over time. Again, this fluctuation in dividend payments sends conflicting signals to investors that might, in turn, adversely affect the company’s share price.

Question 35

Stable dollar dividend policy

Answer 35

refers to the policy in which the company pays a fixed dollar amount of dividend payments to shareholders each year such that the annual dollar dividend is relatively predictable for investors.

Question 36

Stable dollar dividend policy practical implication

Answer 36

Since investors value economic certainty, the stability and predictability of dividend payments sends a positive signal to investors that will, in turn, help to attract more investors, thereby maintaining or boosting the company’s share price.

Question 37

Low regular dividend plus extras dividend policy

Answer 37

refers to the policy in which the company pays a low regular dollar dividend to shareholders plus an extra (or special) year-end dividend in prosperous years when the company is performing well financially.

Question 38

Low regular dividend plus extras dividend policy practical implication

Answer 38

The ‘low regular dividend plus extras’ dividend policy represents a compromise between the stable dollar dividend policy and the constant payout ratio dividend policy in that it provides the company with flexibility while ensuring that shareholders receive at least a minimum amount of dividend payment. Specifically, by identifying the year-end dividend as an ‘extra’, the company avoids signaling to investors that this is a permanent dividend, thereby providing the company with the flexibility to reduce or eliminate the year-end dividend in the future without adversely affecting its share price.

Question 39

Share repurchases (or share buy-backs)

Answer 39

refers to the distribution of earnings by a company to
its shareholders by purchasing its own shares from existing shareholders. There are two main
forms of share repurchases in Australia: (a) on-market repurchase; and (b) off-market

Question 40

On-market repurchase

Answer 40

On-market repurchase involves the company purchasing shares offered for sale by investors on the share market through the normal share market trading mechanism.

Question 41

Off-market repurchase

Answer 41

off-market repurchase involves the company making a formal offer to all existing shareholders to purchase shares from them based on the offer terms outlined in the offer document. As such, off-market repurchases are not processed through the normal share market trading mechanism.

Question 42

The primary reasons why a company would choose to engage in share repurchases to
repurchase its own shares include:

Answer 42

To distribute excess funds to shareholders especially when the company’s share price is perceived to be under-valued;

To adjust the company’s capital structure when the company has more equity than its target capital structure suggests;

To adjust for employee options or employee share-based compensation by reducing the dilution effect that occurs when employee options are exercised, thereby ensuring that the company’s overall issued capital does not change markedly;

To protect or defend against a hostile takeover attempt by: (a) driving up the share price, thus making it more costly for other parties to acquire the company; and (b) concentrating the ownership of the company’s shares in the hands of company management and/or other shareholder groups that wish to fend off the hostile takeover.

Question 43

From the perspective of company managers, the relative advantages of share repurchases compared to regular dividend payments are as follows:

Answer 43

To distribute excess cash to shareholders:

To distribute excess cash to shareholders:

To adjust for employee share-based compensation:

Signal to investors

Question 44

To distribute excess cash to shareholders:

Answer 44

Unlike regular dividend payments, share repurchases provide flexibility by allowing companies to distribute excess cash to shareholders without changing the amount of regular dividend payments.

Question 45

To distribute excess cash to shareholders:

Answer 45

Unlike regular dividend payments, share repurchases are an effective method to immediately change the company’s capital structure when the proportion of equity is substantially higher than the target capital structure prescribes.

Question 46

To adjust for employee share-based compensation:

Answer 46

Unlike regular dividend payments, share repurchases reduce the dilution effect that occurs when employee options are exercised, thereby minimizing the effect on the company’s share price.

Question 47

Signal to investors

Answer 47

Unlike regular dividend payments, share repurchases allow company managers to signal to investors that they perceive the company’s share price to be under-valued, and thus represent a bargain for investors to purchase.

Question 48

From the perspective of company managers, the relative disadvantages of share repurchases compared to regular dividend payments are as follows:

Answer 48

Company might overpay for shares:

Irregular interval between share repurchases:

Question 49

Company might overpay for shares:

Answer 49

With share repurchases, the company might end up paying too much for the purchased shares.
This is especially so when substantial amounts of shares are purchased on the market, which might in turn cause a marked increase in the company’s share price.

Question 50

Irregular interval between share repurchases:

Answer 50

Since the interval between share repurchases are generally irregular, participating investors cannot rely on the cash that they receive from share repurchases. As a result, some investors might prefer cash distribution through regular dividend payments rather than through share repurchases by the company.

Question 51

when the bond sells at a premium

Answer 51

8% < 10% (i.e. Bond would sell at premium) $1,134 $1,135.5 We can see that the bond’s value is greater when semi-annual interest is paid. This will always occur when the bond sells at a premium (i.e. investors required return is less than coupon rate)

Question 52

when the bond sells at par

Answer 52

We can see that the bond’s value is slightly less or equal when semi-annual interest is paid. This will always occur when the bond sells at par (i.e. investors required return is equal to coupon rate)

Question 53

when the bond sells at a discount

Answer 53

We can see that the bond’s value is lower when semi-annual interest is paid. This will always occur when the bond sells at a discount (i.e. market return is greater than the coupon rate)

Question 54

III. If Alice strongly believes that inflation will rise by 1% during the next six months, what is the most she should pay for the bond, assuming annual interest?

Answer 54

Usually, when an inflation rate increases by 1%, investors would require an additional 1% interest rate to cover their losses resulting in changes in the cost of living. That is, for a bond with a market rate of 8% before changes in inflation, the new required rate is 9%.