Raising Capital and agency theory

Question 1

Define Capital Budgeting

Answer 1

Process used to analyse alternate investments and decide which ones to accept

Question 2

Define a firms capital structure

Answer 2

Mix of debt and equity used to finance the firm

Question 3

What is the role of a financial manager

Answer 3

Investment decisions - identifying good projects
Financing decisions - how to pay for the projects
Working Capital Management

Question 4

Detail the agency problem - separation of ownership and control

Answer 4

Shareholders own the firm, managers control it
Conflicts of interests: makes founder a partial owner
solution - corporate governance

Question 5

Characteristics of Debt capital

Answer 5

temporary contribution of capital by investors (paid back)
no voting rights
fixed and prior ranking to a return on/of capital
least risky type of investing for investors

Question 6

where do companies raise debt finance

Answer 6

Bank loans (preferred)
Domestic bond market
off shore market

Question 7

What types of debt are available to companies

Answer 7

Bank loans (indirect): overdraft, inventory loan, bridge loan, Term loans
Debt securities / capital markets (direct): Commercial paper, Bills of exchange, Debentures, Corporate bonds, Unsecured notes

Question 8

What voting rights do ordinary shares have

Answer 8

Full voting rights

Question 9

What is the shareholders residual claim

Answer 9

subordinated right to a return on capital
subordinated right to the return of capital (on liquidation)

Question 10

unlisted firms ways of raising equity

Answer 10

private equity: venture capital
initial public offering: listing shares for the first time

Question 11

listed firms ways of raising equity

Answer 11

private placement to a small group of investors
rights issue to existing shareholders
dividend reinvestment plan

Question 12

What are the 4 ways to raise equity

Answer 12

IPO
Private placement
rights issues
Dividend reinvestment plans

Question 13

2 ways that IPO price is determined

Answer 13

Fixed price offer
Book Building

Question 14

Describe the mechanism for a IPO based on a fixed price offer

Answer 14

Price is set, prospectus is sent out, and offers are received
Risks: price too high = uncertainty for issuer , price too low = money left on table , underwriting costs

Question 15

Describe the mechanism for a IPO based on building a book

Answer 15

Open pricing - bids taken from the market, final price is the clearing price that sells all shares
constrained open pricing - investors are invited to bid for shares within a predetermined price range, final price is determined by the level of demand from the investors

Question 16

Explanations of why IPO under pricing occurs

Answer 16

Winners curse - informational asymmetry
underwriter monopsony power - reduced price to improve client relations
lawsuit avoidance - insurance mechanism to prevent liability for investors loss

Question 17

definition of private placement

Answer 17

An issue of new shares to a limited number of investors (usually financial institutions)

Question 18

Advantages of a private placement

Answer 18

quicker to complete
lower issue costs
may not require a prospectus

Question 19

disadvantages of a private placement

Answer 19

shares issues at a discount which transfer wealth from the existing shareholders to new investors
dilutes control (voting rights) of existing shareholders

Question 20

Definition of a rights issue

Answer 20

offer by a company of new shares to its existing shareholders at fixed price on a pro-rata basis
each shareholder receives entitlement to new shares at fixed proportion of the number of shares they already held
issue price is usually a 10-30% discount
takes 2-3 months

Question 21

How might the announcement of a rights issue affect shareholders’ wealth

Answer 21

informational asymmetries: management knows more about the future prospectus of the firm than the market, rights issue acts as a signal that the stock is overpriced

Question 22

Do we prefer a rights issue over private placement

Answer 22

Legal constraints on private placements
rights issues preserve voting patterns
rights issue takes longer than private placements

Question 23

explain the dividend reinvestment plan

Answer 23

use part or all of a dividend to apply for new shares without transaction costs, usually at a 5-10% discount
substantial source of capital for major corporates

rationale: allows high dividend payout while lessening impact on cash outflows

Question 24

Reasons for underpricing

Answer 24

Winners curse
Investment banker monopsony power ( reduce marketing costs and boost client relationships)
lawsuit avoidance

Question 25

Definition: Private placement

Answer 25

An issue of new shares to a limited number of investors

Question 26

Advantages of Private placements

Answer 26

quicker to complete. lower issue costs. may not require a prospectus.

Question 27

disadvantages of Private placements

Answer 27

Shares issued at a discount transfer of wealth from existing shareholders to new investors. Dilute control (votes) of existing shareholders.

Question 28

Definition: Rights issue

Answer 28

Offer by a company of new shares to its existing shareholders at fixed price and on pro-rata basis. Each shareholder receives entitlement to new shares at a fixed proportion of the number of shares already held. Issue (or offer) price is usually at 10-30% discount to the share price at the time the issue is announced. Usually takes 2-3 months to complete

Question 29

Why might a rights issue affect shareholders wealth

Answer 29

Assuming all shareholders exercise rights, rights issue does not affect shareholders' wealth However, informational asymmetry implies that managers may issue shares when the stock is overvalued

Question 30

why prefer rights issues over private placements:

Answer 30

Legal constraints on private placements Rights issues preserves voting patterns

Question 31

Dividend reinvestment plan

Answer 31

Use part or all of a dividend to apply for new shares without transaction costs and usually at a discount (5- 10%) to the current market price. Allows high dividend payout while lessening impact on cash outflows.

Question 32

What does the CFO do

Answer 32

CFOs use financing and investment decisions to maximize shareholders' wealth.

Question 33

Method how to raise equity depends upon:

Answer 33

Costs: underwriting, Filing/legal fees Time to implement Transfer of votes/wealth

Question 34

What % of IPO's have a negative return on the first day

Answer 34

less than 10% 1:6 finishes at subscription price 1:100 doubles in value

Question 35

how does a rights issue affect shareholder wealth

Answer 35

Assuming all shareholders exercise rights, rights issue does not affect shareholders' wealth

Question 36

Why might Share price not necessarily fall to theoretical exrights price on ex-rights date

Answer 36

New information may affect the stock price on ex-rights date. General movement in share prices. The theoretical value R ignores the option characteristic of the right.

Question 37

2 types of underwriting commitment

Answer 37

"Firm Commitment" vs. "Best Efforts".

Question 38

underwritting spread

Answer 38

A typical spread is 7% of the issue price.

Question 39

role of the underwriter

Answer 39

underwriter bears risk if the issue is not fully subscribed. underwriting risk = risk of a shortfall Recommend issuing method + value securities Underwriters are investment banks and stockbroking firms.

Question 40

Explain the term "primary market."

Answer 40

The primary market is the financial market where new securities (like stocks or bonds) are issued and sold for the first time. Also known as the new issue market

Question 41

Explain the term "secondary market."

Answer 41

The secondary market is the financial market where previously issued securities are bought and sold among investors. The initial issuer does not receive any funds

Question 42

why prefer private placements over rights issues

Answer 42

Private placements are quicker and cheaper than rights issues

Question 43

List the advantages for a privately held company in going public

Answer 43

Access to Capital Enhanced Company Visibility & Credibility Liquidity for Shareholders Attract and Retain Talent (equity for employees) Valuation Transparency

Question 44

Advantages for financing with equity

Answer 44

No Mandatory Repayments lower financial risk Better for Start-ups and High-Risk Ventures Improves Creditworthiness (makes debt easier to come by later)

Question 45

Advantages for financing with debt

Answer 45

Interest is Tax-Deductible No Ownership Dilution Lower Cost ( debt is cheaper than equity) Discipline on Management (avoid wasteful spending)