Lecture 6: Financing

Question 1

What is financial management fundamentally about?

Answer 1

Providing layered information at different times for different purposes.

Question 2

What are the only four types of financing?

Answer 2

Inside financing

Outside financing

Equity financing (offering equity rights)

Debt financing (offering debt rights)

Question 3

What is self-financing?

Answer 3

Securing capital by retaining earnings instead of distributing them as profit.

Question 4

Where is self-financing reflected in financial statements?

Answer 4

As retained earnings in the statement of financial position.

Question 5

What legal requirement applies to self-financing in Switzerland?

Answer 5

Art. 671 CO mandates legal reserves must be formed from the profit of the year.

Question 6

What are the main advantages of self-financing?

Answer 6

Meets continuous capital needs

Independence from investors

Secures liquidity (no repayment obligations)

Question 7

What are the disadvantages of self-financing?

Answer 7

Equity (including retained earnings) is expensive

Dividends are not tax-deductible

Question 8

What does a decrease in the plowback ratio by 20% mean?

Answer 8

A larger portion of profit is being paid out as dividends.

Question 9

What are the short-term implications of a decreased plowback ratio?

Answer 9

Higher dividend payout may reflect market or investor demands

Less cash retained, potentially requiring alternate financing

Lower available self-financing

Question 10

What are the long-term implications of a decreased plowback ratio?

Answer 10

Ongoing trend may require new financing strategies

Need for investor relations work to shift expectations

Potential shareholder restructuring

Question 11

What does a negative plowback ratio over years indicate?

Answer 11

The company pays out more than it earns, which is unsustainable

It cannot offer dividends above profits

Its ability for self-financing is compromised

Question 12

What is the plowback ratio?

Answer 12

The percentage of a company’s profit that is retained (not paid out as dividends) and reinvested in the business.

It is the opposite of the payout ratio showing what percentage of the profit remains and retains within the company

Question 13

What does the Plowback ratio indicate?

Answer 13

The Plowback ratio indicates the self-financing ratio of a company.

Question 14

What does a high plowback ratio indicate?

Answer 14

The company is reinvesting most of its profit

Focused on growth and self-financing

Less is being paid out as dividends

Question 15

What does a low or negative plowback ratio indicate?

Answer 15

More (or all) profits are paid out as dividends

Less reinvestment in the business

Potential shortfall in internal financing

Question 16

What might a consistent negative plowback ratio suggest to analysts?

Answer 16

The company may not be reinvesting in itself

Possible long-term sustainability concerns

Might need outside financing to grow

Question 17

What distinguishes credit investors?

Answer 17

No management participation

Fixed return and repayment rights

Limited time capital provision

Question 18

What affects the interest rate on loans?

Answer 18

Duration of the loan and the company’s credit rating.

Question 19

What is a bond?

Answer 19

A long-term debt security where investors provide capital in return for regular interest and eventual principal repayment.

Question 20

What are commercial papers?

Answer 20

Short-term (30–270 days) securities issued by non-financial firms, sold at a discount.

Question 21

What is a warrant bond?

Answer 21

A bond with call options for shares; reduced interest due to added equity option.

Question 22

What is a convertible bond?

Answer 22

A bond that can be converted into equity; if converted, it becomes part of the company’s equity.

Question 23

What is a subordinate bond?

Answer 23

A bond with lower repayment priority in case of bankruptcy.

Question 24

What is participation capital?

Answer 24

Similar to shares but without voting rights.

Question 25

What defines equity financing?

Answer 25

Investors provide capital and receive ownership (and often voting rights) in return.

Question 26

What are the three types of share capital increases in Swiss law?

Answer 26

Ordinary Approved (authorized by shareholders, limited to 50%) Conditional (linked to convertible rights)

Question 27

What is a key risk with equity financing?

Answer 27

Once engaged with investors, it’s hard to exit those relationships.

Question 28

What is the pecking order for financing preferences?

Answer 28

Self-financing Credit financing Mezzanine (e.g., convertible bonds) Equity financing

Question 29

Why is equity the least preferred in the pecking order?

Answer 29

Highest transaction and indirect costs Negative market reaction due to signaling No tax benefits like debt (interest is tax-deductible)

Question 30

How does increasing debt affect WACC (cost of capital)?

Answer 30

Initially decreases due to tax shield Later increases as financial risk and interest rates rise

Question 31

What is the leverage effect?

Answer 31

The impact of replacing equity with debt: can increase ROE if interest is lower than ROE, but increases financial risk.

Question 32

Why does the WACC curve slope steeply at high debt levels?

Answer 32

Because cost of equity rises faster than the cost of debt.

Question 33

What is the Modigliani-Miller theorem on capital structure?

Answer 33

In a perfect market, WACC is unaffected by capital structure In practice, WACC first falls (due to tax benefits) then rises (due to bankruptcy risk)

Question 34

What does WACC stand for?

Answer 34

Weighted Average Cost of Capital

Question 35

What is the WACC?

Answer 35

WACC represents a company’s average cost of capital from all sources (debt and equity), weighted by their respective proportions in the capital structure.

Question 36

Why is WACC important?

Answer 36

It’s the minimum return a company must earn to satisfy investors. Used as a discount rate in valuation models like NPV or DCF. Helps in evaluating investment decisions.

Question 37

What happens to WACC as a company takes on more debt?

Answer 37

Initially, WACC may decrease due to tax benefits (interest tax shield). But too much debt increases financial risk, which raises the cost of equity and cost of debt, eventually increasing WACC.

Question 38

What is the leverage effect in relation to WACC?

Answer 38

Leverage can reduce WACC up to a point, but beyond that, increased risk leads to higher WACC due to rising investor demands for returns.