Financial Mgmt - Financing Options

Question 1

Cost of Retained Earnings

Answer 1

• Newly issued or “external” common equity is more costly than retained earnings because the company incurs issuance costs when raising new funds.
• Retained earnings will always be less costly than external equity financing because earnings retention does not involve the payment of issuance costs.
• The cost of retained earnings is the rate of return stockholders require on retained equity capital. The opportunity cost of retained funds will be positive.
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Question 2

Commercial Paper

Answer 2

• Commercial paper is normally issued with a short maturity period, usually 2 to 9 months.
• Commercial paper is unsecured.
• Commercial paper is issued by the corporation
• Commercial paper is typically issued by large corporations.
• Only very creditworthy firms can issue commercial paper.

Question 3

Secondary market

Answer 3

• Outstanding stocks of publicly owned companies are traded among investors in the secondary market. The original issuer receives no additional capital as a result of such trades.
• Firms raise capital by issuing new securities in the primary market.
• The over-the-counter market is the network of dealers that provides for trading in unlisted securities
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Question 4

Types of Bonds

Answer 4

• A convertible bond has a fixed interest rate and is convertible into stock. Therefore its market value fluctuates with both changes in prevailing interest rates and changes in the value of the stock.
• A callable bond has a fixed interest rate and its market value fluctuates with changes in prevailing interest rates.
• A zero-coupon rate bond increases in value as it approaches its maturity.
• A bond with a floating rate will generally hold a steady market value because its value will not change due to changes in prevailing interest rates.

Question 5

Trade Credit

Answer 5

Trade credit is the largest source of short-term financing for most small firms. It occurs automatically with the purchase of goods and services.

Question 6

Eurobonds

Answer 6

• Eurobonds are subject to less stringent registration requirements making them less costly to issue.
• Eurobonds carry foreign exchange risk to the investor.
• Eurobonds are not denominated in local currency.
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Question 7

Cost of Capital

Answer 7

• Cost of capital is used to evaluate sources of new funds.
• Cost of capital does not involve evaluating short-term funds.
• The theory underlying cost of capital is related to existing long-term financing and obtaining new long-term financing.

Question 8

Optimal Capital Structure

Answer 8

• Optimal capital structure results in the least weighted-average cost of capital.
• Optimal capital structure must consider the cost of debt and equity.

Question 9

Hedging Approach.

Answer 9

The strategy of matching asset and liability maturities is referred to as a hedging approach. The strategy helps ensure that funds are generated from the assets when the related liabilities are due.