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    End of Chapter Exercises - Answers: Chapter 2: Markets and Players

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    Yvonne
    This document contains answers to questions about markets and players. It defines debt and equity, describes the differences between debtholders and equityholders, classifies preferred stock, explains what an IPO is and how it takes place, defines a Eurobond, lists the main types of bonds issued by governments and firms, discusses sources of finance for startups, and describes risks for private equity firms undertaking leveraged buyouts.

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    End of Chapter Exercises - Answers: Chapter 2: Markets and Players

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    Yvonne
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    This document contains answers to questions about markets and players. It defines debt and equity, describes the differences between debtholders and equityholders, classifies preferred stock, explains what an IPO is and how it takes place, defines a Eurobond, lists the main types of bonds issued by governments and firms, discusses sources of finance for startups, and describes risks for private equity firms undertaking leveraged buyouts.

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    This document contains answers to questions about markets and players. It defines debt and equity, describes the differences between debtholders and equityholders, classifies preferred stock, explains what an IPO is and how it takes place, defines a Eurobond, lists the main types of bonds issued by governments and firms, discusses sources of finance for startups, and describes risks for private equity firms undertaking leveraged buyouts.

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    © All Rights Reserved
    Download as PDF, TXT or read online from Scribd
    Download as pdf or txt
    21 views2 pages

    End of Chapter Exercises - Answers: Chapter 2: Markets and Players

    Uploaded by

    Yvonne
    This document contains answers to questions about markets and players. It defines debt and equity, describes the differences between debtholders and equityholders, classifies preferred stock, explains what an IPO is and how it takes place, defines a Eurobond, lists the main types of bonds issued by governments and firms, discusses sources of finance for startups, and describes risks for private equity firms undertaking leveraged buyouts.

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    1

    END OF CHAPTER EXERCISES - ANSWERS

    Chapter 2 : Markets and Players

    Q1 What constitutes “debt” and “equity” ?

    A1
    Broadly speaking debt consists of bank loans and corporate bonds issued by the company.
    Preferred stock has attributes of both debt and equity but is usually classified as debt.

    Q2 How do the rights of debtholders differ from the rights of equityholders?

    A2
    Debtholders (i.e. bondholders and suppliers of bank loans) have prior claims on the firm’s
    cash flow. They are legally entitled to receive periodic payments (i.e. coupon or interest
    payments) and the repayment of their principal. Debtholders do not receive any additional
    payments when the company does exceptionally well. Debtholders can force the company
    into liquidation if it fails to pay its periodic coupon/interest payments.

    Equityholders have a security (a share certificate) which entitles the holder to receive
    dividends as ratified at the AGM of the company. Shares do not have a redemption date – so
    the company has not agreed to pay back the principal at a specific time in the future. After
    paying taxes and interest payments on debt (and any repayments of debt principal), a
    company’s earnings “belong to” the shareholders. Equityholders are ‘last in the food chain’
    and only receive dividends after all debtholders have been paid.

    Earnings which accrue to equityholders may either be distributed in dividends or retained by


    the firm to finance projects with expected NPVs which are positive (which will then lead to
    higher dividends in the future). The equity holders can vote on the future of the company
    (e.g. at the AGM or “extraordinary” meetings) and can vote on the composition of the board of
    directors. Debtholders cannot vote but they nevertheless have “influence” – particularly when
    the company cannot pay all its debt interest payments.

    Q3 Is preferred stock equity or debt?

    A3
    It is a “mixture” of both. The holders of preferred stock are paid after all the bondholders and
    before the equityholders. The holders of preferred stock may receive no cash payments in a
    particular year - but even than they cannot put the firm into liquidation.

    Q4 What is an IPO? How does it take place?

    A4
    This is an initial sale of shares to the general public, in order to raise finance for the firm’s
    future activities. The IPO will (usually) be organised by a large investment bank who will act
    as underwriter of the issue. The bank will attempt to “build a book” of customers which will
    show how many shares investors might wish to purchase at various prices. On the basis of
    its estimate of demand for the new shares (at different prices), the bank will finally set a single
    offer price for the shares. The underwriter will buy any shares not taken up by the public, so
    the firm is guaranteed to receive the issue price times the amount of shares issued.

    © K. Cuthbertson and D. Nitzsche (2008) ‘Investments’, J. Wiley, 2nd edition


    2

    Q5 What is a Eurobond (or international bond)?

    A5
    Eurobonds are bonds denominated in a currency which is different from the currency of the
    country in which the bonds are issued. For example, a French firm issuing US-dollar
    denominated bonds in Singapore or a French firm raising US-dollars in London are both
    Eurobond issues.

    Q6 What are the main types of bond issued by governments and firms?

    A6
    Governments usually issue conventional long dated bonds with fixed nominal coupons.
    Some governments also issue index linked bonds which pay a guaranteed yield (usually
    about 3%) above whatever the rate of inflation turns out to be in future years.

    Companies issue long term fixed coupon corporate bonds as well as bonds with floating rate
    coupons linked to LIBOR (these are Floating rate notes, FRNs). Some corporate bonds are
    callable bonds (i.e. can be re-purchased at par if the issuer wishes, at specific future times)
    and others might be convertible into shares (at the option of the holder), at some future date.

    Q7 If you start a ‘high-tech’ firm, what are the initial likely sources of finance and how
    would this change as the firm becomes successful?

    A7
    Your ‘own savings’ or re-mortgaging your house might be an initial source. Also, funds from
    ‘Business Angels’ or a secured bank loan might be used. Venture capitalists provide equity
    finance would be a likely source when bringing the product to market. Early stage financing
    might include issues of convertible bonds, since these give bondholders the opportunity to
    convert their bonds in stocks, at a later date. Eventually, the firm might raise funds on the
    secondary market (e.g. AIM in the UK or NASDAQ in the USA), before finally obtaining a full
    listing and going public.

    Q8 What are the possible risky for a private equity firm undertaking a leveraged buyout
    (LBO) ?

    A8
    A leveraged buyout usually involves raising most of the finance for a takeover by issuing
    bonds or taking out bank loans. These funds are used to purchase the shares of the target
    company. Risk comes from the high level of (coupon) interest payments on the bonds and
    debt interest payments on bank loans. If profits temporarily fall this may trigger insolvency
    proceedings or result in a lower credit rating for the firm, which makes it more expensive to
    issue further debt should this be required.

    © K. Cuthbertson and D. Nitzsche (2008) ‘Investments’, J. Wiley, 2nd edition

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