L14 - Corporate Financing Flashcards Preview

19ECB004 - Introduction to Financial Economics > L14 - Corporate Financing > Flashcards

Flashcards in L14 - Corporate Financing Deck (30)
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1
Q

What do Corporation invest in?

A

Corporations invest in long-term assets (e.g., property, plant, equipment, machinery) and in net working capital (current assets minus current liabilities).

So how do companies finances their investments?

  • Internal Funds –> Profits, Depreciations - (non-cash expenses)
  • External Funds –> New equity, Borrowing

Firms tend to prefer to use their own money to finance their investments, after then they prefer to raise finances external using debt (their preferences change depending on the economics situation)

2
Q

Why is internal funding more convenient than external?

A

Internal funding (retained earnings + depreciation) makes up more than 2/3 of corporate financing in Germany, Japan, UK.

internal funding is more convenient than external — Why?

  • avoids the costs of issuing new securities or negotiating debt;
  • shareholders happy if retained profits finance +NPV projects(they forego dividends but the stock has a greater market value).

When managers are too averse to external funding (and risk) they tend to rely too much on internal funds (losing risky but

+NPV projects).

3
Q

How do you measure a firms reliance on Debt vs. New Equity?

A

measured using the debt ratio –> the proportion of debt relative to the firm value

Debt ratio = value of debt/ value of debt + value of shares

value of debt = current liabilities + long-term liabilities

The ratio varies from company to industry but you don’t want a debt ratio more than 1 –> it means you are financing a lot of investments by borrowing and thus owe lots of money to multiple creditors

Debt Ratio can be measured by either :

  • Book value: tells us how much capital the firm has raised from shareholders in the past (accounting value)
  • Market value: measures the value that shareholders place on those shares today.
4
Q

How does the measurement of new equity and debt affect their value?

A

the market value of equity is often much larger than the book value of equity –> market has more current information and thus tends to price them higher than the book value does

the market debt ratio is often much lower than the book debt ratio

5
Q

What is new equity in terms of common stock?

A
  • A corporation is owned by its common stockholders.
  • Corporations can raise new cash by issuing new stock.
  • Stocks (or shares) held by investors are called issued and outstanding;
  • Stocks/shares that are bought back from investors are called issued but not outstanding.
6
Q

What is the difference between stocks and shares?

A

Shares refers to the ownership certificates of a particular company;

Stocks refers to the ownership certificates of any company, i.e. to the overall ownership in one or more companies.

7
Q

Who holds the most of common stocks?

A
8
Q

What are residual cash flow rights?

A
  • Shareholders have residual cash flow rights
  • the privileged rights go to lenders of the firm e.g. banks, bank holders - this is why a company prefers internal sources of finance so they don’t have to may all their profit to lenders first before their shareholders
  • Shareholders have residual (but ultimate) control rights over the firm’s affairs (e.g.: investment decisions, recruitment policy, decided to merge, etc.)
  • In widely held corporations, common stockholders control is limited or restricted to the individual entitlement to vote (owning few shares =} little impact on the outcome).
  • Cash flow and control rights are limited (or extinguished) in case the firm goes into bankruptcy
9
Q

What is the Voting procedure in a company?

A
  • Stockholders exercise their control rights by voting.
  • Many decisions require a simple majority vote to be approved.
  • Some decisions require a supermajority, e.g. 75% of those eligible to vote. (e.g. mergers)
10
Q

What are the different classes of shares?

A
  • Usually companies have one class of common stock and each share has one vote.
  • Occasionally, however, a firm may have two classes of stock outstanding, which differ in their right to vote.

Example: When Facebook made its first issue of common stock, the founders were reluctant to give up control of the company.

Therefore, the company created two classes of shares. The A shares, which were sold to the public, had 1 vote each, while the B shares, which were owned by the founders, had 10 votes each. Both classes of shares had the same cash-flow rights, but they had different control rights.

11
Q

Why do you have to pay a premium for stocks with superior voting power?

A

Greater control rights grant larger private benefits!

  • Prevent challenge to his/her management position
  • extra bargaining power in an acquisition secure a business advantage
  • toss out bad management or force management to adopt policies that enhance shareholder value (these can also benefit all shareholders) –> help deal with the principal-agent problem
12
Q

What is the preferred stock?

A
  • The dividend rate on preferred stocks is fixed at the time of their issue –> like debt
  • They give priority over common stock when receiving dividends. –> paid before common stockholders but still after debt
  • Common stockholders do not receive dividends unless preferred stockholders receive theirs.
  • They do not give ownership right… unless the company fails to pay the preferred dividend.
  • In that case, preferred stockholders gain some voting rights.

.

13
Q

What is Debt Financing?

A
  • When companies borrow money, they promise to make regular interest payments and to repay the principal.
  • However, this liability is limited.
  • Debt has the unique feature of allowing the borrowers (i.e., stockholders) to walk away from their obligation to pay (i.e., default) in exchange for the assets of the company.
  • They are willing to do so if Value of Assets < Value of Debt
  • this is not straightforward → bankruptcy process
14
Q

What is Default risk?

A

Default risk: a term used to describe the likelihood that a firm will walk away from its obligation, voluntarily or involuntarily.

Bond ratings are issued on debt instruments to help investors assess the default risk of a firm.

15
Q

What is a Debt Claim?

A
  • The claim a lender has on a business
  • Debt claim on cash flows is limited (to the interest and principal) =} no residual cash flow rights (contrary to equity).
  • Debt offers no control rights (unless the firm defaults).
  • As lenders are not owners → no voting power
16
Q

How can debt be seen as a tax subsidy?

A

a subsidy helps you give some sort of competitive advantage e.g. makes the costs of your goods cheaper, makes exporting cheaper so you can compete in international markets, to help a subsidy an infant industry so they can thrive

  • debt is a subsidy as it reduces the amount of taxable income as interest is paid out to lenders before tax
  • interest is paid of pre-tax income
  • dividends are paid on after-tax income

As with equity, financial institutions hold the vast majority of corporate debt (in the form of bonds)

17
Q

What is Secured Debt?

A

debt that has first claim on specific collateral in event of default?

18
Q

What is Senior and Subordinated debt?

A

•Senior debt: debt a company must repay 1st if goes out of business.

Subordinated debt: debt that may be repaid in bankruptcy only after senior debt is repaid

19
Q

What are the different bond classifications?

A
  • Investment grade: bonds rated Baa or above by Moody’s or BBB or above by S&P.
  • Junk Bond: bonds with a rating below Baa or BBB.
20
Q

What are Callable Bonds?

A

•Callable bond: bonds that may be repurchased by the firm before maturity at a specified call price. (this is a premium to cover the interest payments lost by the lender)

  • If the company performs well, you may be able to make a capital gain by owning shares rather than bonds
21
Q

What are the Convertible bonds?

A

A convertible bond is a fixed-income debt security that yields interest payments, but can be converted into a predetermined number of common stock or equity shares. The conversion from the bond to stock can be done at certain times during the bond’s life and is usually at the discretion of the bondholder.

22
Q

How does a financial decide between short-term (bank loan) or long term (bonds) debt?

A

It depends on the time-horizon of the project to be financed:

  • finance a temporary increase in inventories → take out a short-term bank loan.
  • cash needed to pay for expansion of plant, new building, new machinery,… → issue long-term bonds
23
Q

Should interest rates be fixed or floating when a company takes debt on?

A

•Normally bank loans carry floating rates (e.g.: LIBOR+1p.p.)

  • LIBOR: interest rate at which major international banks lend to each other –> in 2022 this will no longer be used, London banks are starting to use the Sterling Over Night Index Average (SONIA)
  • Bonds carry fixed payments (the coupons).
  • depends on the current outlook on interest rates and uncertainty in the economy
24
Q

Should a company borrow in domestic or foreign currency?

A
  • It depends on whether the company has overseas operations or not.
  • If it needs to spend foreign currency, it makes sense to borrow foreign currency
  • also if this is done there is no need to worry about how fluctuations in the exchange rate will affect the companies purchasing power when paying in the domestic currency
25
Q

What promises should be made to the lender?

A
  • It depends on the lenders’ concerns about the risk associated with the loan (i.e., probability of default).
  • Lenders may demand that their debt is senior (→ safer).
  • Firms may set aside some of its assets (collateral) for the protection of particular creditors.
  • if the firm defaults on the loan, the bank can seize the collateral and use it to help pay off the debt.
26
Q

Should a company issue straight or convertible bonds?

A
  • •Convertible bonds give its owner the option to exchange the bond for a predetermined number of shares.
  • There is no obligation for the bondholders to convert;
  • It depends on expectations about the firm’s share price:
    • expect an increase → can convert bonds with profit
      • expect a decrease → there is no obligation to convert
27
Q

How are corporations and investors linked?

A

Flow of savings to corporations’ investments

The savings may flow through financial markets or financial intermediaries

28
Q

What are Financial Markets?

A
  • •Markets where financial assets (stocks, bonds, etc.) are:
    • issued by corporations (‘primary issues’ → primary market)
    • traded by investors (‘secondary transactions’ → secondary market)
  • → Regularly traded on organized stock exchanges (New York, London, Hong Kong…)
  • •In other cases, there is no organized (or regular) exchange → over-the-counter (OTC) markets.
29
Q

What are Financial Intermediaries?

A

•Financial intermediaries are organizations that:

  • raise money/savings from investors
  • provide financing for individuals, companies and other organizations.
30
Q

What is the role of financial markets and intermediaries?

A

Besides channelling savings to real investment:

  • Payment Mechanism: allow individuals to make and receive payments quickly and safely over long distances.
  • Borrowing and Lending: allocate savings towards those who can best use them. (maturity transformation?)
  • Pooling Risk: allow individuals to share risk –> diversification
  • Information: about the ‘real’ value of securities and commodities (how much they worth) and allow estimation of rates of return that investors can expect on their savings.