Taxation & Long-term finance Flashcards
(143 cards)
1
Q
Personal taxation is imposed on the financial resources of an individual, such as
A
income, profits, inherited wealth, investment gains, and the value of assets held.
2
Q
________tax is the main source of tax revenue for most governments, and both employed and self-employed individuals pay _______tax
A
Income tax
3
Q
Governments may also introduce taxes on
A
capital gains, wealth taxes, and inheritance taxes.
4
Q
Capital gains tax is a tax on
A
the gain made from selling an asset for more than it was originally purchased for.
5
Q
Wealth tax is a tax on the
A
amount of wealth owned, such as property
6
Q
________ tax is a tax on the amount transferred on death.
A
Inheritance
7
Q
Taxing cash flows is a common practice in many countries, where taxation is limited to
A
cash flows that are indicative of cash being available to finance the tax payable.
8
Q
Governments seek to ensure that revenue flows are taxed only once in the hands of the recipients. However, if taxes are also levied on wealth or the value of specific assets, the revenue may be taxed _____________-
A
twice.
9
Q
Set out how taxable income is determined
A
Taxable income is determined as follows:
income earned
plus income in kind
plus gross investment income
less tax-free income
less tax-free expenditure
less allowance.
10
Q
Assume that the personal allowance is £10,000, and that the marginal tax rates are 20% for the
first £30,000, and 40% for taxable income above this. Calculate how much tax a single person
earning £50,000 will pay assuming there are no adjustments to total income. State the
proportion of total income that is paid in tax.
A
Solution
There is a personal allowance of £10,000, so the person is only taxed on £40,000 of income.
Tax rates Tax bands Tax due
Taxed @ 20% £30,000 £6,000
Taxed @ 40% £10,000 £4,000
Total £10,000
Total tax paid is 20% of total income. This is known as the average rate of tax
11
Q
The marginal tax rate is the percentage of
A
an additional unit of income that is taken in tax.
12
Q
Individuals are typically subject to capital gains tax on
A
chargeable gains
13
Q
Chargeable gains normally fall into the tax year of assessment during which
A
the gain is
realised that, again, the funds to pay the tax should be available
14
Q
Basic definition
A chargeable gain is typically defined as:
A
sale price purchase cost
The sale price can be reduced to reflect any costs associated with the sale. The purchase
cost can be increased by any costs associated with the purchase, and any expenditure
made to enhance the value of the asset during the period the asset was held. In normal
circumstances, the purchase cost would be the original cost of the asset.
15
Q
Companies are liable to corporate income tax on their taxable.______
A
profits
16
Q
Taxable profits include both _________(less allowable expenses) and _______________.
A
Taxable profits include both income (less allowable expenses) and capital gains.
17
Q
The starting point for a company’s tax assessment is ‘profit on ordinary activities before taxation’, which is calculated as
A
sales revenue less expenses plus non-trading income and interest.
18
Q
Corporation tax rates around the world vary considerably, and some countries give relief to shareholders to ensure that dividends are not
A
subject to both personal and corporate income tax.
19
Q
Governments may incentivize companies to retain and reinvest earnings to encourage economic growth by
A
levying higher taxes on dividends than on retained profits, or by allowing tax relief for new investment.
20
Q
The tax system can also be used to incentivize long-term investments such as
A
pension provision by granting tax relief on investment income and gains and imposing taxes on pension funds only when benefits are paid out to beneficiaries.
21
Q
What is Stamp Duty:
A
It is a tax imposed on contract documents.
It is paid by individuals based on the value of the property they buy.
For example, when an individual buys a house, he/she may pay stamp duty tax.
22
Q
Other categories of taxes levied on companies and individuals.
A
Inheritance Taxes and Property Taxes:
23
Q
It is a tax levied on expenditure, either in respect of general expenditure or specific types of expenditure.
A
Tax on Expenditure:
24
Q
A sales tax, such as VAT in the UK, is an example of a tax on
A
general expenditure.
25
Sales taxes are collected only at the point of
final sale to the consumer,
26
while VAT is collected at
each stage of the production process according to the value added at each stage.
27
explain Customs Duties and Excise Taxes:
Customs duties are taxes on imported goods, while excise taxes are duties levied on goods produced and sold within the country.
These taxes may be designed to encourage certain patterns of consumer expenditure or to raise revenues for particular categories of government expenditure.
Different countries may tax imported goods in different ways, and special taxes may be imposed for certain industries based on emissions or physical size.
28
explain how you can use Loan capital (Debt) to raise funds long term
A company issues loan capital to raise money from investors. In return, the company will
pay the investor a stream of interest payments plus an eventual return of capital. The
amounts of interest and capital payments to be made will be specified at outset.
29
This contrasts with shares, where dividends are paid at the discretion of
the company’s directors.
30
Long-term loan capital instruments are often referred to as
‘bonds’ or ‘corporate bonds’, and
short-term instruments as ‘bills’.
31
Issues of loan capital may be listed on a
stock exchange
32
Holders of loan capital are ______of the company and, unlike shareholders, they do not
have_________.
Holders of loan capital are creditors of the company and, unlike shareholders, they do not
have voting rights
33
Holders of loan capital receive specified ‘interest’ payments which are a _______to the company, not a distribution of
_______. On a winding-up they would rank equally with, or in some cases above, other ________.
They receive specified ‘interest’ payments which are a cost to the company, not a distribution of
profits. On a winding-up they would rank equally with, or in some cases above, other creditors.
34
explain the Features of loan capital
It is conventional to refer to loan capital in units of £100 nominal.
The nominal amount of a loan is often referred to as its ‘par value’.
It is usual to express the interest payments as a proportion of the par value.
For example, a holder of £100 nominal of a 10% debenture will receive £10 interest per
annum. The loan coupon payments are normally made every six months so this
debenture would pay £5 every six months per £100 nominal held.
It is normal to issue loan capital at a price close to, or just below, par.
Unlike shares, there is no legal restriction on the issue price relative to par. So, £98, £99,
£100, £101 etc are all possible issue prices per £100 nominal.
Almost all loan capital is redeemed at par.
The market price of £100 nominal of loan capital need not be £100.
Most loan capital is redeemable on a set date, often after 10 to 20 years
35
Question
What is the total amount of cash you would receive if you purchased £200 nominal of a 6% bond
redeeming on 31 December 20XX+10, and purchased on 1 January 20XX?
Solution
In each of the years 20XX to 20XX+10 inclusive, you would receive 6% of £200 = £12. This would
normally be paid in two semi-annual payments of £6 for 11 years. This amounts to £132. At the
maturity of the bond you would get £200 back in addition to the final coupon payment we have
included above. Total cash received = £332.
Since bonds are tradable, the price of a bond varies with supply and demand for the bonds. One
of the main influences on the price of a bond is the interest rate in the economy. There is an
inverse relationship between interest rates and the price of a bond.
36
Question
Suppose interest rates or returns available on long-term investments rise in the economy. Explain
what would happen to the price of a fixed coupon long-term bond that offers a fixed interest rate
of (say) 3% pa.
Solution
If the returns available on other investments rise, the 3% pa interest rate available on the fixed
coupon bond will look poor relative to other investments, and investors will sell the bond, causing
the price to fall. As the price falls, the 3% starts to look higher as a proportion of the falling bond
price. Also, investors will then be able to buy the bond at a greater discount to par, meaning that
they will receive a bigger capital gain if they hold it until maturity. Eventually the bond price
reaches a level where the combination of these two factors makes the attractiveness of the bond
equivalent to that of other investments.
37
The rights of bondholders
The rights of holders of loan capital will be set out in a_____________ drawn up when the
loan is issued. In most cases, a trustee is appointed to act on behalf of the loan
stockholders.
loan agreement. The trustee is normally a corporate body such as a bank or insurance
company.
38
The legal documentation setting out the obligations of the issuing company to
the loan stockholders is known as
the Trust Deed.
39
Suggest issues that the Trust Deed of a bond issued by a company might cover
Solution
Typical issues covered in a Trust Deed include:
description of any assets of the company that might be set aside to cover the particular
loan in the event that the company winds up
details of exactly how the assets should be used to repay the bondholders in the event of
a winding-up and how surplus cash should be treated
the rights of the company to issue further bonds that rank above or alongside this
particular issue
covenants that describe how much the company’s profit must remain above the amount
of the interest payments on the bond. This is a form of protection for bondholders to
ensure that their interest payments are easily met by the company in future.
arrangements for changing the trustees
a description of circumstances under which bondholders must be consulted, eg if
covenants are breached or about to be breached
40
Debentures are loans that are secured on
some or all of the assets of a company.
41
Debentures if the company fails to make payments what happens
the stockholders have actions available to them if the company fails to make payments.
- These actions include appointing a receiver to intercept income from secured assets, or taking possession of the secured asset to sell it in order to meet the debt.
42
There are how many types of debenture:
two; mortgage debenture (fixed charge) and floating charge debenture.
43
explain A mortgage debenture
has specific secured assets mentioned in the legal documentation, and the company can sell or make major alterations to the secured asset only with the permission of the mortgage debenture holders
44
explain A floating charge debenture
allows the company to change the secured assets in the normal course of business, but the trustee must give permission and ensure that the assets are equally satisfactory from the debenture holders’ viewpoint.
45
Debenture holders can apply to the courts to convert a_______ to a________ when a company fails to make payments.
Debenture holders can apply to the courts to convert a floating charge to a fixed charge when a company fails to make payments.
46
Debentures and loan stocks are used to raise
large amounts of funds, have a fixed redemption date and carry a fixed rate of interest.
47
Debentures are more secure than
ordinary or preference shares in the same company, but there is still an element of risk.
47
Debentures tax characteristics
Debenture interest is tax deductible and deducted from pre-tax profits.
Interest payments must be made irrespective of the company’s profitability or cashflow position, and failure to adhere to agreed terms may place the continuation of the company at risk.
48
Explain element of risk on debentures
Risk comes from default and from the asset over which the fixed charge has been placed being insufficient to cover the loan.
Debentures trade at yields above government securities but may not be readily marketable.
49
The marketability of debentures is usually ________than that of government bonds.
worse
50
marketability of debenture stocks
There are bigger spreads between buying and selling prices and lower volumes traded.
Marketability is highest just after a new issue.
51
Debenture stocks are considered more risky than government bonds because
the security ultimately depends on the company’s continuing profitability and the market value of the charged assets, which cannot be guaranteed for the full outstanding term of the debenture.
52
Unsecured loan stocks
Description
With unsecured loan stock there is no specific security for the loan. If the company
defaults, the loan stockholders’ only remedy is to sue the company.
53
Unsecured loan stocks
Description
With unsecured loan stock there is no specific security for the loan. If the company
defaults, the loan stockholders’ only remedy is to sue the company.
54
Question
Suggest a reason why companies don’t always issue unsecured loan stocks rather than
debentures.
Solution
Debentures are secured upon the assets of a company. This security means that the company can
offer a lower rate of coupon (ie interest) to investors. The company will therefore find it cheaper
to borrow using debentures than using unsecured loan stock.
Sometimes a company’s credit rating may be so poor that issuing a bond that does not have a
security attached may be impossible.
55
Rank Debenture holders; unsecured loan stockholders
Debenture holders have a prior claim to the assets of the company on which there is a charge, and unsecured loan stockholders rank after debenture holders. Other creditors rank equally with unsecured loan stockholders.
56
If the company is liquidated, high-ranking claimants such as debenture holders may get __________, while low-ranking claimants
all their capital returned, while low-ranking claimants like shareholders may get nothing. A proportionate payment will be made if the total money available is insufficient.
57
Gross redemption yields on unsecured loan stock are ______than debentures to compensate for ________
Gross redemption yields on unsecured loan stock are higher than debentures to compensate for poorer marketability and greater risk.
58
The marketability of unsecured loan stock is
worse than that of government bonds, and the standing of the issuer and the size of the issue determine marketability.
59
Unsecured loan stocks are ________secure than debentures, and unsecured loan stockholders are even more _________on the company's continuing profitability to meet the required payments.
Unsecured loan stocks are less secure than debentures, and unsecured loan stockholders are even more dependent on the company's continuing profitability to meet the required payments.
60
How is unsecured loan stock in a company is more secure than shares in the same company.
Unsecured loan stock payments are a legal obligation on the company, and unsecured loan stockholders are entitled to be repaid fully in the event of a winding-up before shareholders can receive anything. Therefore, unsecured loan stock in a company is more secure than shares in the same company.
61
Subordinated debt:
In the event of default, the holder of subordinated debt ranks
below the firm's general creditors (but ahead of preference shareholders and ordinary shareholders).
62
The subordinated lender holds a junior debt and is paid
after all senior debt holders are satisfied.
63
he rating of subordinated debt reflects
the lower level of security and, consequently, the terms on which it is issued.
64
he rating of subordinated debt reflects
the lower level of security and, consequently, the terms on which it is issued.
65
whats a Eurobond
Eurobond is a bond issued in the "Euro" market, which gives borrowers access to international investors.
66
Eurobonds give borrowers access to
the investors of another country, and companies throughout the world raise money by issuing Eurobonds.
67
Eurobonds are redeemed ______ on a set date with fixed coupon payments during the term of the Eurobond. However, coupon payments on Eurobonds are usually made _________rather than _________.
Eurobonds are redeemed at par on a set date with fixed coupon payments during the term of the Eurobond. However, coupon payments on Eurobonds are usually made annually rather than six-monthly.
68
Eurobonds secured true or false
Almost all Eurobonds are unsecured, and Eurobond investors rank equally with other unsecured creditors if a company is wound up.
69
Eurobonds are "bearer form" documents, which means that
they can be transferred from one owner to another by delivery.
70
Eurobond issues can be made in what currency
Eurobond issues can be made in almost any currency including the euro
71
Governments can also issue ________
Governments can also issue Eurobonds
72
floating-rate notes (FRNs)
floating-rate notes (FRNs) are medium-term debt securities issued in the Euro market whose interest payments "float" with short-term interest rates, possibly with a stipulated minimum rate.
73
The type of Eurobond often issued with a minimum interest rate below which the coupons will not fall, known as an interest-rate floor.
floating-rate notes (FRNs)
74
FRNs are a popular choice for borrowers when interest rates are high because
they are not fixed and therefore allow for more flexibility.
75
Investors, on the other hand, must consider the risk of inflation wiping out the return they receive from their investment, and may demand
a higher interest rate from a fixed-interest stock as a premium to cover the risk they are taking.
76
What opportunity do Eurobonds present
They represent a convenient method of raising large amounts of foreign currency
denominated funds without having to enter overseas financial markets. It may be possible
to raise funds at a lower rate of interest than is available on domestic currency funds, but
there may be associated exchange rate risks if the funds raised are converted for use in
domestic projects.
77
Eurobonds marketability is
Marketability
Marketability is better than debentures and unsecured loan stocks, but not usually as good as
government bonds.
78
Return on eurobonds
Gross redemption yields depend upon
the issuer (and hence risk) and issue size (and hence
marketability). Inflation will affect the real return achieved.
79
Shareholders are owners of the business and receive dividends made from a company’s profits at the
discretion of the directors.
80
Dividends can be paid net of tax with an attaching tax credit for the recipient, known as .
franked investment income
81
Holders of ordinary shares are entitled to whatever profit is left over after
other providers of finance have received their interest payments, making ordinary shares the lowest ranking form of finance issued by companies.
82
Ordinary shares are almost always irredeemable, meaning
there is no fixed date for the company to repay the share capital.
83
All shares have a_____or ______ value, and the issued share capital cannot be greater than the authorised share capital.
'par' or 'nominal'
84
Ordinary shares give
an equal right to share in residual profits, give one vote per share, give an equal share to any assets left over following a winding-up after all other creditors have been paid, are fully paid, and give various other minor rights.
85
The low ranking of ordinary shares in terms of payment of dividends and on winding up makes them
a more risky investment than other types of capital from the investors’ point of view.
86
Ordinary shareholders have the right to
attend and speak at company meetings, vote to appoint directors, and vote to reduce dividends, among other rights
87
A friend says: ‘Ordinary shares are the most risky form of investment so a prudent investor should
avoid investing in them.’
Comment briefly on this statement.
Solution
It is true that ordinary shares are potentially risky in that the return from them may be very
volatile (and uncertain). However, an investor would expect, on average, to gain a higher return
from shares than from other investments, to compensate for the higher level of risk.
In the long term, dividends and share prices should increase in line with inflation and real
economic growth. Therefore shares are a suitable investment for an investor requiring a return
linked to inflation.
Also, holding a diversified portfolio of shares will help to reduce risk
88
Suggest why some companies might have some non-voting shares.
Solution
Non-voting shares may arise when a family-controlled company needs to raise more cash, but
does not want the loss of control (and potential take-over) that comes with it. They therefore
issue non-voting shares for the general public, and retain the voting shares themselves.
89
Considering ordinary shares, the expected return on the investment will be influenced by two
things:
how much income yield (or ‘dividend yield’ for equities) an investor expects to receive
how much capital growth an investor expects to obtain from holding the share over a
certain period.
90
define the
dividend yield
(dividend per share/
market price per share)
we can see that the higher the price paid, the lower the
dividend yield from the investment (the dividend paid by a company does not alter when the
market price of the share changes).
91
define the
dividend yield
(dividend per share/
market price per share)
we can see that the higher the price paid, the lower the
dividend yield from the investment (the dividend paid by a company does not alter when the
market price of the share changes).
92
Risk can often be thought of in two components:
the uncertainty and volatility of the future income stream
the uncertainty of capital return in the event of a winding-up
93
Suggest why some companies might have some non-voting shares.
Solution
Non-voting shares may arise when a family-controlled company needs to raise more cash, but
does not want the loss of control (and potential take-over) that comes with it. They therefore
issue non-voting shares for the general public, and retain the voting shares themselves.
94
Preference shares are less common than
ordinary shares and have investment characteristics similar to unsecured loan stocks.
95
Preference shares offer
They offer a fixed stream of investment income in the form of a fixed dividend, which is usually expressed as a fixed percentage of the par value.
96
Preference shares do not usually carry
voting rights.
97
Preference shareholders have a preferential right to either .
dividends, or return of capital, or both, compared to ordinary shareholders
98
Dividends on preference shares must be paid before any dividends can be paid________, and preference shareholders have the _________to vote if the rights attaching to their shares are being varied.
Dividends on preference shares must be paid before any dividends can be paid to ordinary shareholders, and preference shareholders have the right to vote if the rights attaching to their shares are being varied.
99
Compare a preference share to an unsecured loan stock.
Solution
Both have a fixed coupon, expressed as a percentage of the nominal amount.
Preference shares can be redeemable but are normally irredeemable. Loan stocks can be
irredeemable, but are normally redeemable.
Preference shares normally carry the right to vote if dividends have not been paid. Loan stock
holders only have the right to wind up the company and try to recover their losses. On wind up, a
loan stockholder will rank above a preference shareholder.
The tax treatment is different (both for the issuing company and for the investor).
100
Preference share dividends (except for participating shares) are________ a set amount which is almost always paid
limited
101
Preference shares may also be non-cumulative,______,______,____and ____.
redeemable, participating, convertible, stepped, or pay variable dividends.
102
The risk of preference shareholders not getting their dividends is
greater than the risk of loan stockholders not being paid, but less than the risk of ordinary shareholders not being paid.
103
Preference shares offer a relatively predictable _________, but __________about the return of capital in the event of a winding-up.
Preference shares offer a relatively predictable future income stream, but uncertainty about the return of capital in the event of a winding-up.
104
The expected return on preference shares is likely to be less than on ordinary shares because
the risk of holding preference shares is less.
105
Marketability of preference shares is similar to
loan capital marketability.
106
Preference shares offer the investor a lower risk than ordinary shares and therefore a
lower expected rate of return, but a higher expected return than that received on loan stock (ignoring any tax differences).
107
Question
GHI plc issues £500,000 of convertible loan stock. Holders will have the option to convert each
£100 of stock into 80 ordinary shares in 6 months’ time. The current share price is 86p, and the
loan stock is trading at par.
Calculate the current conversion premium per share
Solution
First we need to find the effective conversion price. This is the price an investor pays for a share
by buying it via the convertible, rather than on the cash market. The stock is trading at par and so
£100 of stock costs £100.
Effective conversion price = 10,000
80
p
= 125p.
The conversion premium is the effective conversion price minus the current share price. So here
the conversion premium per share = 125 – 86 = 39p
108
There are many types of finance that lie between
debt and equity finance.
109
what are Convertibles
Convertibles are unsecured loan stocks or preference shares that convert into ordinary shares of the issuing company. Convertible preference shares are preference shares that allow the holder to convert into ordinary shares at a later date.
110
Convertible unsecured loan stocks are unsecured loan stocks that allow
the holder to convert into ordinary shares of the company at a later date.
111
Conversion Dates and Terms:
Conversion dates and terms are specified at the time of issue. There will be a specified number of ordinary shares for each convertible. The date of conversion might be a single date or, at the option of the holder, one of a series of specified dates.
112
Conversion Premium:
The conversion premium is the difference between the cost of obtaining one ordinary share by purchasing the required number of convertible securities and converting it with the market price of the share.
113
Investment Characteristics Prior to Conversion: The characteristics of a convertible loan stock in the period prior to conversion are a cross between those of fixed-interest stock and ordinary shares. As the likely date of conversion (or not) gets nearer, it becomes clearer whether the convertible will stay as loan stock or become ordinary shares.
Investment Characteristics Prior to Conversion: The characteristics of a convertible loan stock in the period prior to conversion are a cross between those of fixed-interest stock and ordinary shares. As the likely date of conversion (or not) gets nearer, it becomes clearer whether the convertible will stay as loan stock or become ordinary shares.
114
Advantages: Convertible stocks have several advantages over ordinary share capital and ordinary unsecured loan stocks, both from the issuer’s and from the investor’s point of view.
They are popular in the US as a form of finance for new companies. Investors have the security of a fixed return in the short term and the possibility of long-term capital gain if they convert to ordinary shares in the future.
115
Convertible stocks are a popular hybrid form of finance, as they offer advantages to both
the issuer and the investor.
116
(Convertible stocks)The terms of conversion are specified at the time of issue, and the conversion premium is the difference between
the effective conversion price and the current share price.
117
As the likely date of conversion (or not) gets nearer, it becomes clearer whether the convertible will stay as loan stock or
become ordinary shares.
118
This hypothetical scenario of winding up a company demonstrates the order in which creditors and shareholders are paid from the company's assets. The process begins with the payment
of hire purchase companies and mortgage debenture holders, followed by floating-charge debenture holders, employees, other creditors, preference shareholders, and finally, ordinary shareholders.
119
The winding-up process is initiated when the company is unable to pay its debts and a court order is made to sell off its assets to repay the creditors. In this scenario, the
unsecured loan stock holders sue the company after it fails to pay the interest on their loan, leading to the court order for winding up.
120
WInding up; The first to receive payment are the
hire purchase company, which repossesses its machinery, and the mortgage debenture holders, who receive payment from the sale of assets charged to them. However, if the assets are almost worthless due to the decline of the widget industry, this may not provide much comfort to the mortgage debenture holders.
121
(winding up)The next to be paid are the
floating-charge debenture holders, who have first claim to the remaining assets. They are followed by employees, who receive any arrears in their wages. Other creditors, such as the bank and trade suppliers, and unsecured loan stock holders are paid next.
122
(winding up)The next to be paid are the
floating-charge debenture holders, who have first claim to the remaining assets. They are followed by employees, who receive any arrears in their wages. Other creditors, such as the bank and trade suppliers, and unsecured loan stock holders are paid next.
123
(winding up) If there is anything left after all the above claims have been satisfied, preference shareholders
receive payment. Finally, ordinary shareholders receive any remaining funds, which may be zero, depending on the amount of debt owed and the value of the company's assets.
124
This scenario highlights the importance of understanding the different types of creditors and shareholders and their priority in the event of winding up a company. It also emphasizes the need for companies to manage their debts and financial obligations carefully to avoid insolvency and potential legal action
This scenario highlights the importance of understanding the different types of creditors and shareholders and their priority in the event of winding up a company. It also emphasizes the need for companies to manage their debts and financial obligations carefully to avoid insolvency and potential legal action
125
Describe:
(i) par value and market value of shares
(ii) authorised and issued share capital
(iii) preference shares and ordinary shares
(iv) loan capital and ordinary share capital
(v) fixed and floating charges
(vi) debentures and unsecured loan stocks
(vii) Eurobonds and traditional forms of UK loan capital.
(i) Par value and market value
The par value of a share has little significance other than the restriction that shares cannot be
issued for less than their par value. A company’s share capital is found by multiplying the par
value of its shares by the number of shares in issue.
The market value of a share is what it would actually sell for in the open market. It usually bears
no relation whatever to the par value of the share. The market value can change from minute to
minute as trading takes place. The par value, however, is fixed and cannot normally be changed.
(ii) Authorised and issued share capital
The authorised share capital of a company is expressed as a nominal value, ie x shares of y par
value. The value stated is the maximum amount that the directors can issue without the approval
of the shareholders of the company.
The issued share capital is the nominal amount that has actually been issued. It cannot be greater
than the authorised share capital.
(iii) Preference and ordinary shares
Preference shares normally pay a fixed dividend. Ordinary share dividends vary depending on the
level of profits made by the company.
Preference dividends must be paid before an ordinary dividend can be paid. There is no similar
obligation for companies to pay ordinary dividends.
Ordinary shares will (normally) carry the right to vote. Preference shares do not normally have
this right, unless either:
a preference dividend is not paid, or
the company is proposing to alter the rights attaching to preference shares.
(iv) Loan capital and share capital
Holders of loan capital are creditors of the company. They receive interest payments which are a
cost to the company, not a distribution of profits. Loan capital is redeemable, often after 10 to 20
years. The interest payments and redemption terms are fixed at the outset of the loan. Loan
capital may be secured on the assets of the company. These assets may be sold in the event of
default.
Holders of share capital are members of the company, ie they own the company. They receive
dividends which are variable, and which are paid out of the profits of the company. Shares are
not usually redeemable. Share capital is not secured on the assets of the company, although the
shareholders do have a right to the residual value of the company on a winding-up – but only
after all the creditors have been paid.Page 34 CB1-04: Long-term finance
© IFE: 2019 Examinations The Actuarial Education Company
(v) Fixed and floating charges
A fixed charge means that the loan is secured against specific named assets. If the company
defaults on interest or capital payments, the assets can be sold and the proceeds used to
reimburse the lenders.
A floating charge means that the loan is secured on the general assets or a class of assets of the
company. No specific assets are named in the trust deed. The company can sell or alter its assets,
as long as the replacement assets are satisfactory for the lenders (ie of a sufficient value to cover
the amount of the loan). If the company defaults, a floating charge will ‘crystallise’ and the assets
must be sold to repay the lenders.
(vi) Debentures and unsecured loan stock
A debenture is a loan to a company which is secured on the assets of the company. It may be
secured by a fixed charge or a floating charge. If the company defaults on its payments, the
assets covered by the charge will be sold and the proceeds used to reimburse the debenture
holders. The rights of the debenture holders will be set out in a Trust Deed, which is overseen by
a trustee.
An unsecured loan stock will not be secured on any of the company’s assets. It may be governed
by a Trust Deed. If the company defaults, the only remedy available to the loan stockholders is to
sue the company.
(vii) Eurobonds and traditional loan capital
Eurobonds are issued outside the legal and tax jurisdiction of the country in whose currency they
are denominated. They are traded on the international markets. They may have fixed or variable
rates of interest. If the interest paid is variable, the issue is known as a ‘floating-rate note’.
Eurobonds are bearer documents. They are normally unsecured. Coupons are normally payable
annually, without deduction of tax.
Traditional UK loan capital is issued in the UK and may be traded on the London Stock Exchange.
Fixed interest rates are the norm (although a very small number of issues with variable interest
rates have been made). The issuing company will keep a register of loan holders. Traditional UK
loan capital is often secured on the issuing company’s assets. Coupon payments are typically
made twice a year.
126
Explain whether each statement is true or false:
(i) Government bonds are more marketable than debenture stock.
(ii) Eurobonds are more marketable than ordinary shares.
(iii) Debentures provide a higher return than unsecured loan stock.
(iv) Convertible loan stock generally provides a lower income yield than a conventional loan
stock.
(v) Ordinary shares generally provide a higher income yield than convertible preference
shares.
(vi) Warrants are a form of loan stock.
(vii) Executive share options are a form of warrant.
(viii) Eurobonds are less risky than debentures.
(i) True. Marketability of debentures is lower than the marketability of government bonds
because the debenture issues are smaller. Trading in a particular debenture can be
infrequent.
(ii) False. Ordinary shares are the most common form of company finance and are the most
marketable. Eurobonds are usually more marketable than other forms of debt finance
because they are issued in larger amounts and are actively marketed by banks.
(iii) False. Debentures provide a lower expected return because they are the more secure
form of company finance. Holders of unsecured loan stock take a greater risk and thus
require a greater reward.CB1-04: Long-term finance Page 35
The Actuarial Education Company © IFE: 2019 Examinations
(iv) True. Convertible loan stock generally provides a lower income than conventional loan
stock because convertibles offer the prospect of dividend growth in the future. Investors
are attracted by the prospect of dividend growth in the future and are thus willing to
accept lower income in the short term.
(v) False. Convertible preference shares generally provide a higher income than ordinary
shares because convertibles do not at present offer the benefit of dividend growth. An
ordinary shareholder is willing to accept a lower initial income in return for dividend
growth, whereas the holder of a convertible does not benefit from dividend growth at
present and would require a higher income.
(vi) False. Warrants are not a form of loan stock. They are call options written by a company
on its own stock. They are often issued in conjunction with a fixed-interest bond to make
the bond more attractive to investors.
(vii) True. Executive share options are options to buy the company’s shares. They are issued
to senior management as part of an incentive package.
(viii) False. Debentures are secured on some or all of the assets of the company. Eurobonds
are a form of unsecured loan stock and rank after debentures in a wind-up.
127
Which of the following statements concerning Eurobonds is false?
Answer = D
The term ‘Euro’ is misleading (although the oldest, and still the main, markets are in Europe). The
other statements are all correct.
128
Consider the following definition:
‘The lender’s security is a specified asset which the borrower cannot dispose of (without the
lender’s permission). The lender can repossess upon default or appoint a receiver to intercept
income (eg rent).’
This is a definition of a:
Answer = C
Debentures can be either fixed-charge (or mortgage) debentures or floating-charge debentures.
Fixed-charge debentures are secured against a particular asset
129
Which of the following is correct?
A Interest payments are always greater than dividend payments.
B Interest is paid out of pre-tax profit and dividends are paid out of post-tax profit.
C Interest is paid on debentures and dividends are paid on unsecured loan stock.
D Interest is taxable but dividends are not. [2
Answer = B
Interest is paid on loan stock, whereas dividends are paid on equity. Interest could be greater than,
equal to or less than dividend payments (though the overall return to equity is expected to be
greater than the return to debt because equity is riskier for the investor). Interest payments are
treated as an expense for the company and are therefore paid out of pre-tax profit. Dividends are
paid out of post-tax profit. Both interest and dividends are taxable, though in some countries
governments give at least some credit to the recipient for the tax that has already been paid by
the company
130
Which of the following ranks lowest if a company is wound up?
A Eurobonds
B mortgage debentures
C floating-charge debentures
D preference shares [2
Answer = D
Loan stock holders (Options A, B and C) are always paid before preference shareholders
131
A highly risk-averse investor should NOT invest in ordinary shares because:
A ordinary shares offer a low expected return relative to other securities.
B ordinary shareholders have the last entitlement in the event of a winding-up of the
company.
C they offer a low initial yield.
D shareholders have pre-emptive rights. [2
Answer = B
A is false, and C and D are wrong because these should not prevent a risk-averse investor from
investing in ordinary shares.
132
Under a floating charge:
A the company may not, in the usual course of business, realise assets which are subject to
the charge.
B a default by the company will make the charge crystallise into a fixed charge.
C specific assets are available to meet investors’ claims if the company defaults on interest
or capital payments.
D security is provided in the event that the borrower defaults on the final capital payment,
but not in the event of default on the interest payments.
Answer = B
A and C would be true for a fixed charge
133
Which of the following will NOT dilute the value of the equity in a business?
A warrants
B Eurobonds
C convertible loan stock
D executive stock options [2
Answer = B
Eurobonds do not have any effect on the number of shares issued. The other three could all
cause an increase in the number of shares and therefore a dilution of the value of the equity in
the business.
134
A convertible bond gives the right to purchase 70 ordinary shares per £100 nominal. The market
prices of the convertible bond and ordinary shares are £120 and 90 pence respectively. The
conversion premium per share is:
A 81p
B 125p
C 129p
D 171p [2
Answer = A
The conversion premium is the extra amount that an investor pays for a share by buying it as a
convertible, compared with the cost of buying the share directly.
In this case, the calculation is: 120 / 0.90
70
= 81p.
135
Explain why ordinary shares are popular amongst both issuers and investors. [5
Ordinary shares are attractive to issuers because:
they are the lowest ranking form of finance issued by companies. Dividends are not a
legal obligation of the company and are paid only at the discretion of the
directors [1]
income yields are usually low because of the expected future capital gain. Ordinary
shares therefore have lower servicing costs compared to debt in the early years after
issued. [1]
Ordinary shares are attractive to investors because:
they are expected to provide a high rate of return. Dividends and capital values are
expected to grow over time. Due to their residual nature, the level of dividends and the
capital value will be more volatile than most other forms of investment. As a
consequence of this risk, the return can be expected to be high. [1]
profits are likely to grow due to inflation and therefore shares are likely to offer
protection from inflation with a high real rate of return. [1]
they are often highly marketable because issues of ordinary shares tend to be large and of
a standard type. Buying and selling of ordinary shares by investors takes place relatively
frequently. [1]
[Total 5]
136
Loan stock can be issued in many forms. Describe the generic characteristics of loan stock.
Bondholders are creditors of the company. They have no voting rights. [1]
In most cases a trustee is appointed to look after the interests of the bondholders. The Trust
Deed sets out the obligations of the company to the bondholders, for example, bondholders may
acquire voting rights in certain circumstances. [1]
A bond gives the holder the right to an annual coupon (usually paid in two instalments) and the
redemption of the nominal value after a certain fixed amount of time. [1]CB1-04: Long-term finance Page 37
The Actuarial Education Company © IFE: 2019 Examinations
The coupon is usually a fixed proportion of the nominal value. For example, a 5% debenture will
pay £5 interest per annum for each £100 of stock. [1]
The market price of the bond varies with the demand for and the supply of the bond. One of the
main influences on the price of a bond is the interest rate being offered elsewhere. If interest
rates rise, the price of bonds tends to fall. [1]
Most stocks are issued close to par and thus there is rarely much in the way of capital gain
expected. Therefore they usually provide a higher level of initial income yield than equities. [1]
However, the overall return on a bond is likely to be slightly less than from an equity issued by the
same borrower due to the greater security of loan stock. [1]
Marketability of corporate bonds tends to be lower than the marketability of the equivalent
equity and lower than Government bonds, which are extremely marketable. [1]
[Maximum 5]
137
Describe the investment characteristics of convertible loan stock. [5
Convertible bonds are issues of loan capital, which give the holder the option to convert into
equity. The dates and terms of conversion will be fixed at the outset. [1]
The investment characteristics of convertible bonds may be similar to conventional bonds or to
ordinary shares or a combination of both. [1]
It depends on whether or not conversion is likely. If conversion is almost certain, a convertible is
effectively the same as the underlying share with a different income stream in the period before
conversion. If conversion is unlikely, the convertible is very similar to a normal fixed-interest
bond. [1]
In all cases the option to convert will have some positive value. [1]
This uncertainty/option value can be measured by the conversion premium. This is the price paid
for an ordinary share by buying a convertible (ie the effective conversion price per share) less the
market price of an ordinary share. [1]
The ‘effective conversion price per share’ is given by:
price of convertible number of shares it converts into [1]
[Maximum 5]
138
An investor purchases a convertible loan stock convertible to one ordinary share at any time up to
31 December 20XX. List the possible courses of action open to the investor, and state
circumstances in which each might be appropriate. [5
Convert now
This could be appropriate if the value to the investor (after tax) of the dividend is bigger than the
loan stock coupon. [1]
Convert later
If interest income is bigger, the investor could wait until the dividend grows to exceed it. He or
she might even wait a bit longer than that if dividends were thought to be volatile. [1]Page 38 CB1-04: Long-term finance
© IFE: 2019 Examinations The Actuarial Education Company
Convert at last possible date
The investor might do this if the interest income remained higher than the dividend throughout
the whole life of the loan stock. This would be the correct course of action if the share price was
higher than the remaining value of the loan stock. [1]
Sell
The investor might do this if he or she wanted the money and the market value of the convertible
loan stock was bigger than the market value of the shares it converted to (which it should be). [1]
Hold to redemption
Do this if none of the situations described above apply. [1]
[Total
139
Explain the reasons why a company might choose to issue a Eurobond rather than issue ordinary
shares in order to raise capital.
Eurobonds are unsecured loans and therefore their owners do not vote, whereas issuing ordinary
shares may result in the control of the company being diluted if the existing shareholders do not
buy all of the shares. [1]
Eurobonds rank ahead of ordinary shares in the event of a wind up, and therefore are less risky.
This means that over the long term they should offer a lower return and be cheaper for the
company to service. [1]
Eurobonds are easy to issue in a variety of currencies, whereas shares are normally only issued in
the domestic currency. [1]
Eurobonds are cheaper and easier to service because they:
are bearer and do not require a register of owners to be maintained [1]
do not entitle owners to be invited to annual general meetings [1]
Eurobonds can be issued on a floating rate basis, which may mean that the interest reduces if
short-term interest rates reduce. [1]
Eurobonds mature on some future date, and no longer need to be maintained, whereas equity
shares once issued are normally irredeemable. [1]
[Maximu
140
A company that obtains a quotation on a stock exchange means that the
price of its securities will be included on the exchange’s official list.
141
A company that obtains a quotation on a stock exchange means that the price of its securities will be included on the exchange’s official list. Such quoted securities are called
listed securities.
142
The minimum requirements for a ‘full’ listing on the Stock Exchange’s main market are
more onerous than for an AIM quotation
