Week 8 Flashcards
What are the major sources of long-term finance? How can they differ?
The major sources of long-term finance are equity, or debt from the external capital market, or retained profits from the internal capital market.
The differences between these come in the form of cost, tax, security and restrictive requirements, and maturity terms and cash flow requirements.
What is the main source of finance?
The main source of finance is from internally generated cash flows, this has increased over time.
When must cash flow requirements be met with debt or equity?
If a company’s cash flow requirements are higher than the internal cash flow (net income + depreciation - dividends), they must be met with long-term debt and equity.
What are some of the major differences between debt and equity as a source of financing?
Equity creates an ownership interest, debt holders do not have ownership costs. Dividends are not a cost of doing business and hence are not tax deductible, stockholders have no legal recourse if not paid. Common stockholders vote for the board of directors and other issues.
Creditors have legal recourse if interest or principal payments are missed, potentially leading to bankruptcy and financial distress.
What does having ordinary shares mean for an investor?
Ordinary shares give a residual claim to earnings and assets after other assets, as compensation, they expect a return greater than lending, equity has no maturity date, but can be brought back through a share repurchase. Shareholders have voting rights proportional to their holdings.
What are the pros of using equity financing?
Equity pros:
access to additional capital base, increased liquidity of capital, provides an alternative resource to cash, enhances corporate image, increases market exposure and operational and incentive independence, the obligation for dividends is discretionary, it is also a perpetual source of finance (doesn’t have to be paid off).
What are the cons of using equity financing?
Equity cons:
Increases information disclosure requirements, more stringent legal and corporate governance responsibilities, highest-cost source of finance for firms, transaction costs of issuing shares, issuing more shares to new shareholders can dilute existing shareholders’ ownership and control. Most importantly, the returns to shareholders can be subject to double taxation (business income and shareholder) unless there are franking credits.
What does using debt financing mean for a company?
Corporate long-term debt financing is a contractual claim on the firm, the company must make scheduled interest payments and/or principal repayment, defaulting on these payments can result in the sale of the assets securing the debt or actions to wind-up the company and recover debt owed, interest payments are tax deductible and most debt securities have a set maturity date.
What is the difference between registered and bearer form bonds?
Bonds can be registered in which case the firm keeps record of initial ownership and any changes in ownership, in the bearer form the holder of the security is the owner.
What forms of security are there for bonds?
Bond security can come in the form of collateral (financial securities or any asset pledged on a debt), mortgage securities (secured by real property), debentures (unsecured bonds), or notes (unsecured debt with an original maturity less than 10 years
What is the seniority of a bond?
The seniority of a bond is a ranking of bonds, more senior bond holders will get paid first in the event of liquidation.
What do the terms of a debt agreement include?
The terms of a debt agreement include: the amount of debt and the security provided over the debt, the interest rate and repayment arrangements, the existence of any call provisions, and any protective covenants attached to the debt (rules about what the company can do while holding the debt).
Has debt or equity financing grown more of late? Why?
Debt finance use has grown over time, as a result of increasing attractiveness to investors: low interest rate environment, availability of credit ratings for evaluating and pricing corporate debt, the psychological effect of equity market crashes, an alternative to government debt securities, and the attractive features of corporate bonds, and higher returns relative to government bonds.
What does a call provision of a bond give? How can they tell if this is a good idea? What will it mean for purchasers of these?
A call provision gives corporate bond issuers the option to repurchase all or part of the debt at or after certain specified dates at a specified call price, this should be done by using NPV analysis (comparing the cost of calling the debt against the interest savings from calling and/or re-issuing debt). As the call provision is valuable to the firm the callable bonds have higher coupon rates and promised yields.
What is the promised return of a bond equation?
The promised return is (the face value – the market value)/market value.
What does a put provision of a bond give? How can they tell when to do this and what is the cost?
A put provision gives debt-holders the option to sell the debt to the company when certain exercise conditions are met (at face value), this is useful to bond holders, meaning these bonds provide a lower coupon rate and promised yields. A bond holder should do this when interest rates go up (when bond value is lower than face value).
What does a convertibility provision do? Who is favored and when will it be used?
Convertibility provisions allow debt to be converted into equity securities of the issuing firm at a set conversion ratio by bond holders. These favor bond holders and as such are normally issued with a lower coupon rate. If the value of the ordinary shares is greater than the value of the bond they will convert to shares.
What does it mean when a bond has floating or reset coupon rates?
Floating or reset coupon rates adjust in line with movements in underlying market interest rates, they reduce the interest rate risk associated with debt securities.
