Chapter 5 Flashcards
(46 cards)
What’s a debenture?
An unsecured loan certificate issued by a company.
Banked by general credit rather than assets.
(For companies with good credit rating)
Properties of preferred shares? (4 WACC-wise, 3 theory)
No Maturity Date.
Comes with issuing expenses.
Fixed dividend.
Dividend’s not tax-deductible.
Medium risk (dividends are always payable and market price of shares is fairly constant) Allow the expansion of equity base financing without diluting the position of common shareholders (e.g. voting power) Dividends depend on company financial rating and market interest rates (at time of issue)
Properties of common shares? (4 WACC-wise, 5 theory/bonus?)
No maturity date.
Comes with issuing expenses.
Variable dividend (based on profits and company policy).
Dividend’s not tax-deductible
High risk.
The shareholder is an owner of the company.
Shareholder has access to all of the profits of business, after preferred dividends have been distributed.
Shareholders elect Board of Directors, vote in major decisions, examine and approve financial statements, etc.
Larger equity bas improves the credit standing of the company
Market price is volatile: varies with the business financial performance, speculative nature of investors, health of economy
Properties of retained earnings? (1 WACC-wise, 2 theory)
**there’s a lot of info on slide that we never practiced; I think it’s bonus knowledge but I’m not sure
For WACC, Kre uses the same interest rate as what you calculated for common shares.
Part of net income reinvested in the business to finance new projects in the company.
Considered part of common equity financing.
Net Proceeds
Net amount of money the firm receives after issuing expenses.
(always lower than the price at which securities were sold, because of issuing expenses and sometimes a need to sell at a discount)
When a company goes bankrupt, in what order are loans paid back? (5)
1) Bank loans
2) Bonds
3) Debentures
4) Preferred Shares
5) Common Shares
(Banks obviously get really angry :P Then 2,3 and 4,5 are related. P/S gets paid before C/S, this could be why it’s less risk)
What are tax-deductible items?
1) Interest payments as they are paid (except for P/S and C/S)
2) Issuing expenses at time of issue
3) Discount at time of redemption
List 6 long term sources of funds
Debt:
- Bonds
- Debentures
- Bank Loans
Equity
- Common Shares
- Preferred Shares
- Retained Earnings
List 2 medium term sources of funds
Leasing, Term debt (notes payable)
List 2 short term sources of funds
Accounts payable, bank margin account
How are bonds and debentures issued?
Privately or publicly (by investment brokers), and entail issuing expenses
Name 3 characteristics of Bonds and Debenture
- Interest payments are tax deductible (hence the tax shield)
- Coupon rate depends of the financial rating of the company and the perceived risk involved
- In general, bonds and debentures are relatively low-risk (interest must be paid on schedule or the principal becomes due. relatively high priority for pay back in the case of bankruptcy)
What is the relationship between the market price of a common share and its par value?
Very little: the par value is the price at which the share was initially issued (often market price at time of issue). Market value is continually changing due to the business’s performance, supply and demand, and sometimes speculation.
Why is maintaining a certain level of common equity at a certain level important?
More common shares = more common equity, less need for financing through debt.
BUT
Having too many common shares can decrease earnings per share to the point that current and potential shareholders are no longer interested and supply exceeds demand, causing market prices to drop.
Spot measure of the cost of common equity
EPS/P = Earnings per Share / Market Price
*This is the reciprocal of price to earnings ratio.
3 factors that influence retained earnings policy
- Availability of new projects within company
- Investment options available to individual shareholders
- Tax rate on dividends received by shareholders
What are Net Proceeds?
The net monetary amount the firm receives for issued bonds or shares after issuing expenses have been paid to the responsible stock broker, and after discount/premium have been taken into account.
What is a lease?
Agreement whereby a finical institution purchases an asset and rents it out to a firm on a long-term basis.
Leasing expense is similar to renting expense
Tax deductible
Operatig costs paid by lessee
Maintenance costs responsibilities depend on contract terms.
Advantage and disadvantage of leasing
Advantage: Funds do not need to be raised to purchase the asset - debt and equity do not need to be raised
Disadvantage: higher annual fixed cost to the firm, leading to increased financial risk (remember FC/(p-vc))
What is term debt?
One to two year loans from financial institutions
Can be in the form of a line of credit (to finance short term capital requirements)
What are Accounts Payable?
The amount of money that is paid at the full 30 days after the invoicing of a bill (as opposed to paid at 10 days for a discount).
This allows the company used of the funds for an extra period of time.
Costly short-term source of funds
What is a line of credit?
Bank account in which the balance may become negative. Interest is charged on the balance.
Useful in financing working capital requirements.
Short-term source of funds
Cost of Capital (total for a company/multiple sources)
The weighted-average cost of all permanent sources of debt - the weighted average cost of the total amount of money obtained from the company from all permanent sources
Capital Structure
The particular mixture of debt and equity capital sources
Is determined based on market values, NOT par values
Most companies try to maintain a particular capital structure over the long term to minimize cost of capital (which is also affected by business risk)
