CONCEPT QUESTIONS - CHAPTER 14

14.1 List the three ways financin !ecisi"ns can create #a$%e. 1. Fool investors 2. Reduce costs or increase subsidies 3. Create a new security 14.& H"w !" y"% !efine an efficient 'ar(et) It is a market where current prices reflect all available information. Na'e the three f"%n!ati"ns "f 'ar(et efficiency) Rationality, independent deviations from rationality and arbitra e

14.* H"w w"%$! y"% !escri+e the three f"r's "f the efficient-'ar(et hy,"theses) 1. !eak"form #$% postulates that prices reflect all information contained in the past history of prices. 2. &emistron form #$% says that prices not only reflect the history of prices but all publicly available information. 3. &tron form #$% contends that prices reflect all available information, public and private 'or (inside(). -hat c"%$! 'a(e 'ar(ets inefficient) 1. *ar e costs of ac+uirin and skillfully utili,in information 2. -he e.istence of private information 3. *ar e transactions costs

."es 'ar(et efficiency 'ean y"% can thr"w !arts at a /inancia$ P"st $istin "f T"r"nt" St"c( E0chan e st"c(s t" ,ic( a ,"rtf"$i") /o. 0ll it says is that, on avera e, a portfolio mana er will not be able to achieve e.cess returns on a risk"ad1usted basis. -hat !"es it 'ean t" say the ,rice y"% ,ay f"r a st"c( is fair) It means that the stock has been priced takin into account all publicly available information. 14.4 -hat c"nc$%si"ns a+"%t 'ar(et efficiency can +e !rawn fr"' a#ai$a+$e e#i!ence) #vidence supports the weak form and semi stron form, but not the stron form, efficient market hypothesis. 14.1 -hat are three i',$icati"ns "f the efficient-'ar(et hy,"thesis f"r c"r,"rate finance) 1. -he prices of stocks and bonds cannot be affected by the company2s choice of accountin method. 2. Financial mana ers cannot time issues of stocks and bonds.
0nswers to Concept 3uestions 0"1

3. 0 firm can sell as many stocks and bonds as it wants without depressin prices.

CONCEPT QUESTIONS - CHAPTER 12

12.1 -hat is a c"',any3s +""( #a$%e) It is the sum of the common shares, capital surplus and accumulated retained earnin s. -hat ri hts !" st"c(h"$!ers ha#e) 1. 4otin ri hts for board members 2. 5ro.y ri hts 3. 0sset 5articipation in case of li+uidation 6. 4otin ri hts for mer ers and ac+uisitions 7. 5reemptive ri hts to new shares issued. -hat is a ,r"0y) It is the rant of authority by a shareholder to someone else to vote his or her shares. -hy !" fir's iss%e n"n#"tin shares) H"w are they #a$%e!) $ana ement of a firm can raise e+uity capital by issuin non"votin or limited" votin stock while maintainin control. $arket prices of 8.&. stocks with superior votin ri hts were found to be about 7 percent hi her than the prices of otherwise identical stocks.

12.& -hat is c"r,"rate !e+t) .escri+e its enera$ feat%res. Corporate debt is a security issued by corporations as a result of borrowin money and represents somethin that must be repaid. Its main features are9 1. It does not represent ownership interest in the firm. 2. 5ayment of interest on debt is ta. deductible because it is considered a cost of doin business. 3. 8npaid debt is a liability of the firm. -hy is it s"'eti'es !iffic%$t t" te$$ whether a ,artic%$ar sec%rity is !e+t "r e4%ity) :ecause it has characteristics that are particular to both. Companies are very adept at creatin hybrid securities that are considered debt by CCR0 but have e+uity features such as bein repaid in common shares. 12.* -hat are ,referre! shares) 5referred stock is a security that has preference over common stock in the payment of dividends and in the distribution of assets in the case of li+uidation.

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0nswers to Concept 3uestions

 -hy are ,referre! shares ar %a+$y '"re $i(e !e+t than e4%ity) 5referred stock is similar to both debt and common e+uity. 5referred shareholders receive a stated dividend only, and if the corporation is li+uidated, preferred stockholders et a stated value. %owever, unpaid preferred dividends are not debts of a company and preferred dividends not a ta. deductible business e.pense. -hy is it attracti#e f"r fir's that are n"t ,ayin ta0es t" iss%e ,referre! shares) &uch low"ta. companies can make little use of the ta. deduction on interest. %owever, they can issue preferred shares and en1oy lower financial costs since preferred dividends are si nificantly lower than interest payments.

-hat are three reas"ns5 %nre$ate! t" ta0es5 why ,referre! shares are iss%e!) 1. :ecause of the way utility rates are determined in re ulatory environments, re ulated public utilities can pass the ta. disadvanta e of issuin preferred stock on to their customers. 2. &ince preferred shareholders often cannot vote, preferreds may be a means of raisin e+uity without surrenderin control. 3. Firms issuin preferred stock can avoid the threat of bankruptcy that e.ists with debt financin . 12.2 -hat is the financia$ a,) -he financial ap is the difference between total spendin and internal financin . -hat are the 'a6"r s"%rces "f c"r,"rate financin ) -hat tren!s ha#e e'er e! in recent years) 1. Internal financin 2. #.ternal financin 'new lon "term borrowin , and e+uity) ;ebt<e+uity ratios of Canadian industrial corporations have remained relatively stable in contrast with increased reliance on debt financin in the 8.&. in the 1=>?s. %owever, in recent years, with the cheap interest rates on debt financin , the debt levels of companies has increased. In addition to fi.ed assets, these financin sources will likely be used for investment in affiliates or ac+uisitions. -he increasin pace of lobali,ation of markets and international competition will force companies to become lar er and more international.

CONCEPT QUESTIONS - CHAPTER 17

17.1 -hat is the ,ie '"!e$ "f ca,ita$ str%ct%re) It is a model in which the value of the firm is pictured as a pie cut into debt and e+uity slices.
0nswers to Concept 3uestions 0"3

17.& -hy sh"%$! financia$ 'ana ers ch""se the ca,ita$ str%ct%re that 'a0i'i8es the #a$%e "f the fir'. :ecause this capital structure also ma.imi,es the value of e+uity. 17.* .escri+e financia$ $e#era e. It is the e.tent to which a company relies on debt in its capital structure. -hat is $e#ere! e4%ity) -he e+uity of a firm that has debt in its capital structure. H"w can a shareh"$!er "f Trans Can %n!" the c"',any3s financia$ $e#era e) :y sellin shares of -rans Can and buyin bonds or investin the proceeds in another company2s debt. 17.4 -hy !"es the e0,ecte! ret%rn "n e4%ity rise with fir' $e#era e) :ecause debtholders must be paid first, the cash flows to the shareholders become more variable, increasin the risk for the shareholders. -hat is the e0act re$ati"nshi, +etween the e0,ecte! ret%rn "n e4%ity an! fir' $e#era e) Rs @ ro A 'ro B r:) ':<&)

H"w are 'ar(et-#a$%e +a$ance sheets set %,) -hey are set up the same way as historical accountin balance sheets with assets on the left side and liabilities on the ri ht side. %owever, instead of valuin assets in terms of historical values, market values are used. 17.2 -hat 'a(es a $e#ere! fir' '"re #a$%a+$e than an "therwise-i!entica$ %n$e#ere! fir') Interest payments are ta. deductible and dividend payments are not. -herefore, there is a ta. benefit with interest which can be retained by the shareholders. -hat is 99 Pr","siti"n I %n!er c"r,"rate ta0es) 4* @ 48 A -C: -hat 99 Pr","siti"n II %n!er c"r,"rate ta0es) rs @ ro A ':<&)'1"-c)'ro B r:)

CONCEPT QUESTIONS - CHAPTER 1:

1:.1 -hat !"es ris(-ne%tra$ity 'ean) Investors are indifferent to the presence of risk. Can "ne ha#e +an(r%,tcy ris( with"%t +an(r%,tcy c"sts)
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Ces. !hen a firm takes on debt, the risk of bankruptcy is always present but bankruptcy cost may not be. -hy !" we say that st"c(h"$!ers +ear +an(r%,tcy c"sts) :ecause in the presence of bankruptcy costs, bondholders would pay less for any debt issued. -his then will reduce the value of potential future dividends. 1:.& -hat is the 'ain !irect c"st "f financia$ !istress) *e al and administrative costs of li+uidation or reor ani,ation. -hat are the in!irect c"sts "f financia$ !istress) -hose that arise because of an impaired ability to conduct business B such as loss of reputation, loss of customers, low employee morale, etc. -h" ,ays the c"sts "f se$fish strate iesD 8ltimately, the stockholders. 1:.* H"w can c"#enants an! !e+t c"ns"$i!ati"n re!%ce !e+t a ency c"sts) Covenants can increase the value of the firm which is favoured by shareholders as well as protectin bondholders. -hey offer the lowest"cost solution to the shareholder"bondholder conflict. 1:.4 List a$$ the c$ai's t" the fir'3s assets. 5ayments to stockholders and bondholders, payments to the overnment, payments to lawyers, and payments to any and all other claimants to the cash flows of the firm. .escri+e 'ar(ete! c$ai's an! n"n'ar(ete! c$ai's. $arketed claims are claims that can be sold or bou ht in capital markets. /onmarketed claims are claims that cannot be sold in capital markets. H"w can a fir' 'a0i'i8e the #a$%e "f its 'ar(ete! c$ai's) :y minimi,in the value of nonmarketed claims such as ta.es. 1:.2 ." 'ana ers ha#e an incenti#e t" f""$ in#est"rs +y iss%in a!!iti"na$ !e+t) $an ers may be able to fool investors to think that the firm is more valuable by increasin the level of debt. 0ccordin to this theory, investors would then push up the price of the shares. %owever, since there are costs to this e.tra debt in the form of interest payments, the investors will +uicly see throu h this and the share may actually fall below what it would have been if the debt was never issued in the first place. Is there a c"st t" iss%in a!!iti"na$ !e+t)
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0nswers to Concept 3uestions

Ces, there is a cost in that the share price may fall below where the price should have been if the debt had never been issued. -hat e',irica$ e#i!ence s% ests that 'ana ers si na$ inf"r'ati"n thr"% h !e+t $e#e$s) -he empirical evidence concernin e.chan e offers supports the theory that an increase in levera e is viewed as a positive si nal for the firm, and the share price increases. 1:.7 -hat are a ency c"sts) Costs that arise from conflicts of interest between mana ers, bondholders and stockholders. -hy are shir(in an! ,er4%isites c"nsi!ere! an a ency c"st "f e4%ity) :ecause mana ers will act in their own best interests rather than those of shareholders. H"w !" a ency c"sts "f e4%ity affect the fir'3s !e+t-e4%ity rati") -he optimal debt"e+uity ratio is hi her in a world with a ency costs than in a world without such costs. -hat is the /ree Cash /$"w Hy,"thesis) !e mi ht e.pect to see more wasteful activity in a firm capable of eneratin lar e cash flows. 1:.: -hat is the ,ec(in -"r!er the"ry) -his theory states that when a firm seeks new capital it faces 2timin 2 issues of new stock. -he company will choose its form of financin oin throu h a specific order of courses startin with the cheapest ' internal) to the most e.pensive. -hat are the ,r"+$e's "f iss%in e4%ity acc"r!in t" this the"ry) -he theory implies that only overvalued firms have an incentive to issue e+uity and iven market reactions to a stock issue, virtually no firm will issue e+uity. -he model results in firms bein financed virtually entirely by debt. $oderatin the pure theory, we would predict that debt should be issued before e+uity. -hat is financia$ s$ac() If a firm e.pects to fund a profitable pro1ect in the future it will start to accumulate a cash reservoir today, thus avoidin the need to o to the capital markets. 1:.1 H"w !" r"wth ",,"rt%nities !ecrease the a!#anta e "f !e+t financin ) Erowth implies si nificant e+uity financin , even in a world with low bankruptcy costs. -o eliminate the potential increasin ta. liability resultin from rowin

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0nswers to Concept 3uestions

#:I-, the firm would want to issue enou h debt so that interest e+uals #:I-. 0ny further increase in debt would, however, lower the value of the firm in a world with bankruptcy costs. 1:.; H"w !" ,ers"na$ ta0es chan e the c"nc$%si"ns "f the 9"!i $iani-9i$$er '"!e$ a+"%t ca,ita$ str%ct%re) *et -s and -: be personal ta. rate on e+uity distributions and ordinary income, respectively. !hen -s G -: , the ain from levera e is reduced when -s @ -: , the $$ with corporate ta. result is unchan ed. 1:.1< List the e',irica$ re %$arities we "+ser#e f"r c"r,"rate ca,ita$ str%ct%re) 1. $ost corporations have low debt ratios. 2. Chan es in financial levera e affect firm value. 3. -here are differences in the capital structure of different industries. -hat are the fact"rs t" c"nsi!er in esta+$ishin a !e+t-e4%ity rati") 1. -a.es 2. Financial distress costs 3. 5eckin order and financial slack.

CONCEPT QUESTIONS - CHAPTER 11

11.1 H"w is the AP= 'eth"! a,,$ie!) 054 is e+ual to the /54 of the pro1ect 'i.e. the value of the pro1ect for an unlevered firm) plus the /54 of financin side effects. -hat a!!iti"na$ inf"r'ati"n +ey"n! NP= !"es "ne nee! t" ca$c%$ate A>P=) /54 of financin side effects '/54F). 11.& H"w is the /TE 9eth"! a,,$ie!) F-# calls for the discountin of the cash flows of a pro1ect to the e+uity holder at the cost of e+uity capital. -hat inf"r'ati"n is nee!e! t" ca$c%$ate /TE) *evered cash flow and the cost of e+uity capital. 11.* H"w is the -ACC 'eth"! a,,$ie!) !0CC calls for the discountin of unlevered cash flows of a pro1ect '8CF) at the wei hted avera e cost of capital, !0CC. 11.4 -hat is the 'ain !ifference +etween AP= an! -ACC) !0CC is based upon a tar et debt rate and 054 is based upon the level of debt.

0nswers to Concept 3uestions

0"H

 -hat is the 'ain !ifference +etween the /TE a,,r"ach an! the tw" "ther a,,r"aches) F-# uses levered cash flow and other methods use unlevered cash flow. -hen sh"%$! the AP= 'eth"! +e %se!) !hen the level of debt is known in each future period. -hen sh"%$! the /TE an! -ACC a,,r"aches +e %se!) !hen the tar et debt ratio is known.

11.2 -hat a!6%st'ents are re4%ire! in ca,ita$ +%! etin f"r ,r"6ects with +eta !ifferences fr"' the fir'?s) It re+uires ad1ustments on the discount rate to properly match the discount rate with the risk of the pro1ect. 11.7 H"w !" f$"tati"n c"sts an! s%+si!i8e! financin affect AP=) Flotation costs reduce the 054, but subsidi,ed financin enhances it substantiallyI the overall effect is enhancin . 11.: H"w is +eta a!6%ste! f"r $e#era e an! c"r,"rate ta0es) *evera e and corporate ta.es increase beta.

CONCEPT QUESTIONS - CHAPTER 1;

1;.& .escri+e the ,r"ce!%re "f a !i#i!en! ,ay'ent. 1. ;ividends are declared9 -he board of directors passes a resolution to pay dividends. 2. ;ate of record9 5reparation of the list of shareholders entitled to dividends. 3. #.";ividend date9 0 date before the date of record when the brokera e firm entitles stockholders to receive the dividend if they buy before this date. 6. ;ate of payment9 ;ividend checks are sent to stockholders. -hy sh"%$! the ,rice "f a st"c( chan e when it "es e0-!i#i!en!) :ecause in essence the firm is reducin its value by the amount paid out in cash for the dividend. 1;.* H"w can an in#est"r 'a(e h"'e'a!e !i#i!en!s) :y sellin shares of the stock. Are !i#i!en!s irre$e#ant) If we consider a perfect capital market, dividend policy, and therefore the timin of dividend payout, should be irrelevant. -hat ass%',ti"ns are nee!e! t" sh"w that !i#i!en! ,"$icy is irre$e#ant)
0"> 0nswers to Concept 3uestions

1. 5erfect markets e.ist. 2. Investors have homo eneous e.pectations 3. -he investment policy and borrowin policy of the firm is fi.ed. 1;.4 In a ,erfect ca,ita$ 'ar(et5 are re,%rchases ,referre! t" !i#i!en!s) In a perfect capital market, the firm is indifferent between a dividend and a repurchase. If the repurchase is financed with cash, the total value to the shareholder is the same under dividend payment strate y as under the repurchase strate y. -hat are fi#e reas"ns f"r ,referrin re,%rchases t" !i#i!en!s in the rea$ w"r$!) 1. Fle.ibility " -he firm is not committed to repurchasin shares each year, as it is with dividends. 2. #.ecutive compensation B Firms with si nificant stock option plans will repurchase shares to maintain their float of shares within a desirable ran e. 3. Jffset dilution" Firms will repurchase shares to offset other sources of dilution, other than 1ust stock options. 6. Repurchase investment B If mana ers believe that their share is undervalued in the market, they will repurchase shares. 7. -a.es B Repurchases attract a lower rate of ta. than dividends for the shareholders.

1;.2 List f"%r a$ternati#es t" ,ayin !i#i!en!s with e0cess cash. 1. Invest in capital pro1ects 2. 5urchase other companies 3. 5urchase financial assets 6. Repurchase shares of the company In!icate a ,r"+$e' with each "f these a$ternati#es 1. Invest in capital pro1ects " if the firm has already taken all the positive /54 pro1ects available, then it will end up investin in ne ative /54 pro1ects that will reduce firm value. 2. 5urchase other companies B 5remiums are re+uired to be paid on ac+uisitions, and there are si nificant up front costs for an ac+uisition. 3. 5urchase financial assets B -he result of this depends on the personal ta. rates, and will only be beneficial to the firm when personal ta. rates are hi her than corporate rates on dividends. 6. Repurchase shares of the company B !e showed earlier that there are 7 potential reasons why a repurchase may be better than the payment of dividends for the firm.

1;.7 -hat are the ta0 +enefits "f $"w !i#i!en!s)

0nswers to Concept 3uestions

0"=

:ecause the ta. rate on dividends at the personal level is hi her than the effective rate on capital ains, shareholders demand hi her e.pected returns on hi h" dividend stocks than on low"dividend stocks. E0,$ain the re$ati"nshi, +etween a st"c(?s !i#i!en! yie$! an! its ,reta0 ret%rn. -he e.pected preta. return on a security with a hi h dividend yield is reater than the e.pected preta. return on an otherwise identical security with a low dividend yield. 1;.: -hat are the rea$ w"r$! fact"rs fa#"rin a hi h-!i#i!en! ,"$icy) 1. ;esire for current income 2. Resolution of uncertainty 3. :rokera e and other transaction costs 6. Fear of consumption out of principal 1;.1 H"w !"es the 'ar(et react t" %ne0,ecte! !i#i!en! chan es) -hat !"es this te$$ %s a+"%t the !i#i!en!s) A+"%t !i#i!en! ,"$icy) -he market reacts to une.pected dividend chan es. Cou find with some consistency that stock prises rise when the current dividend is une.pected increased, and they enerally fall when the dividend is une.pected dcreased. -his illustrates the fact that dividends are important. :ut, many authors have pointed out that this observation does not really tell us much about dividend policy -hat is a !i#i!en! c$iente$e) Eroups of investors attracted to different payouts are called clienteles. A$$ thin s c"nsi!ere!5 w"%$! y"% e0,ect a ris(y fir' with si nificant5 +%t hi h$y %ncertain r"wth ,r"s,ects t" ha#e a $"w "r hi h !i#i!en! ,ay"%t) *ow dividend payout.

CONCEPT QUESTIONS - CHAPTER &<

&<.& -hat are the +asic ,r"ce!%res in se$$in a new iss%e) 1. Jbtain approval of the :oard of ;irectors. 2. File a preliminary prospectus with the J&C. 3. ;istribute prospectus to potential investors. 6. ;etermine offer price once the final prospectus is approved. 7. 5lace tombstone advertisements. -hat is a ,re$i'inary ,r"s,ects) 0 document filed with the J&C containin information relevant to the offerin . -hat is the POP syste' an! 9@.S an! what a!#anta es !"es it "ffer)

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0nswers to Concept 3uestions

-he 5rompt Jfferin 5rospectus '5J5), introduced by the J&C in 1=>3, is a streamlined reportin and re istration system for lar e companies that issue securities re ularly. :ecause the J&C has an e.tensive file of information on these companies, only a short prospectus is re+uired when securities are issued. In the early 1==?s, securities re ulators in Canada and the &#C in the 8.&. introduced a $ulti"Kurisdictional ;isclosure &ystem '$K;&). 8nder $K;&, lar e issuers in the two countries are allowed to issue securities in both countries under disclosure documents satisfactory to re ulators in the home country. &<.* S%,,"se that a st"c(+r"(er ca$$s y"% %, "%t "f the +$%e an! "ffers t" se$$ Aa$$ the shares y"% wantB "f a new iss%e. ." y"% thin( the iss%e wi$$ +e '"re "r $ess %n!er,rice! than a#era e) It will probably be less underpriced because otherwise it would have been oversold and there would be no need for the broker to try to sell it to you. -hat fact"rs !eter'ine the !e ree "f %n!er,ricin ) &maller, more speculative issues must be si nificantly underpriced, on avera e, to attract investors. -o counteract the winnerLs curse and to attract the avera e investor, underwriters underprice issues.

&<.2 -hat are the !ifferent c"sts ass"ciate! with sec%rity "fferin s) 1. &pread9 -he difference between the offerin price and what the underwriter pays the issuin company. 2. Jther direct e.penses9 Filin fees, le al fees and ta.es. 3. Indirect e.penses9 $ana ement time spent analy,in the issuance. 6. 0bnormal returns9 -he drop in the current stock price by 1M to 2M in a seasoned new issue of stock. 7. 8nderpricin 9 &ettin the offerin price below the correct value in an initial new issue of stock. F. Jverallotment 'Ereen shoe) option9 -he underwriter2s ri ht to buy additional shares at the offer price to cover overallotments. -hat $ess"ns !" we $earn fr"' st%!yin iss%e c"sts) 1. -here are substantial financial economies of scale. 2. -he cost associated with underpricin can be substantial and can e.ceed the direct costs. 3. -he issue costs are hi her for initial offerin s than for seasoned ones. &<.7 H"w !"es a ri hts "fferin w"r() In a ri hts offerin , each shareholder is issued an option to buy a specified number of shares from the firm at a specified price within a certain time frame. -hese ri hts are often traded on securities e.chan es or over the counter. -hat 4%esti"ns '%st financia$ 'ana e'ent answer in a ri hts "fferin s) 1. !hat price should e.istin shareholders pay for a share of new stockD 2. %ow many ri hts will be re+uired to purchase one share of stockD
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0nswers to Concept 3uestions

3. !hat effect will the ri hts offerin have on the price of the e.istin stockD H"w is the #a$%e "f a ri ht !eter'ine!) 4alue of one ri ht @ Ri hts"on stock price " e."ri hts stock price @ '#."ri hts price " &ubscription price) < 'ri hts per share) @ 'Ri hts"on price " &ubscription price) < 'ri hts per share A1) -hen !"es a ri hts "fferin affect the #a$%e "f a c"',any?s shares) 0 ri hts offerin affects the value of a companyLs shares on the day when the shares trade e. ri hts. ."es a ri hts "ffer ca%se a share ,rice !ecrease) H"w are e0istin shareh"$!ers affecte! +y a ri hts "ffer) -he price should drop by the value of the ri ht. &hareholders cannot lose or ain from e.ercisin or sellin ri hts.

&<.: -hat are the !ifferent s"%rces "f #ent%re-ca,ita$ financin ) 5rivate partnerships and corporations, lar e industrial or financial corporation, and wealthy families and individuals. -hat are the !ifferent sta es f"r c"',anies see(in #ent%re ca,ita$ financin ) &eed money, start"up, and then first throu h fourth round financin as the company ets off the round. -hat is the ,ri#ate e4%ity 'ar(et) -he private e+uity market involves the issuance of securities to a small number of private investors or certain +ualified institutional investors. CONCEPT QUESTIONS - CHAPTER &1 &1.& ." +earer +"n!s ha#e any a!#anta e) -hy 'i ht 9r. CI Li(e t" Dee, 9y Affairs Pri#ateC ,refer t" h"$! +earer +"n!s) -hey have the advanta e of secrecy. -hat a!#anta es an! what !isa!#anta es !" +"n!h"$!ers !eri#e fr"' ,r"#isi"ns "f sin(in f%n!s) -hey provide additional security as an early warnin system if sinkin fund payments are not made. :ut if interest rates are hi h, the company will buy the bonds from the market, and if rates are low, it will use the lottery, e.ercisin an option that makes sinkin fund bonds less attractive to bondholders.

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0nswers to Concept 3uestions

 -hat is a ca$$ ,r"#isi"n) -hat is the !ifference +etween the ca$$ ,rice an! the state! ,rice) It is an option that allows the company after a certain number of years to repurchase the bonds at the call price. -his option will only be e.ercised if interest rates drop. -he difference between the call price and the stated price is the call premium. &1.* -hat are the a!#anta es t" a fir' "f ha#in a ca$$ ,r"#isi"n) If interest rates o down and the market bond prices are hi her than the call price, the firm can e.ercise its call option and buy the bonds at less than the market price. -hat are the !isa!#anta es t" +"n!h"$!ers "f ha#in a ca$$ ,r"#isi"n) If the firm decides to e.ercise its option, bondholders will have to sell their bonds to the firm at less than the market price. -hy !"es a Cana!a ,$%s ca$$ effecti#e$y 'a(e ca$$in !e+t %nattracti#e) In the event of a call, the issuin firm must provide a call premium that would compensate investors for the difference in interest between the ori inal bond and the new debt issued to replace it.

&1.4 List an! !escri+e the !ifferent +"n! ratin c$asses. 1. Investment rade N000<0aa to :::<:aa9 e.tremely stron to ade+uate capacity to pay interest and principal. 2. &peculative ::<:a to CC<Ca9 sli htly to e.tremely speculative capacity to pay interest and principle. 3. C9 ;ebt not currently payin interest 6. ;9 ;ebt in default. -hy !"n3t +"n! ,rices chan e when +"n! ratin s chan e) -he bond ratin s are based on publicly available information and therefore may not provide information that the market did not have before the chan e. Are the c"sts "f +"n! iss%es re$ate! t" their ratin s) Investment B rade issues have much lower direct costs than non"investment rade issues. &1.2 -hy 'i ht a 8er"-c"%,"n +"n! +e attracti#e t" in#est"rs) Oero"coupon bonds offer investors two principal advanta es9 '1) enerally, no dan er of a call and '2) a uarantee of a PtrueQ yield, irrespective of what happens to interest rates. H"w 'i ht a ,%t feat%re affect a +"n!?s c"%,"n) H"w a+"%t a c"n#erti+i$ity feat%re) -hy)
0nswers to Concept 3uestions 0"13

0 put feature may reduce the level of coupon re+uired because the protection of the floor price increases the e.pected value of the bond. &imilarly, convertibility allows the holder to profit if the issuerLs stock price rises, therefore the re+uired coupon would be less. -hat is the attracti"n "f a f$"atin -rate) -he coupon payments are ad1ustable as the market interest rates fluctuate.

&1.7 -hat are the !ifferences +etween ,ri#ate an! ,%+$ic +"n! iss%es) 1. ;irect private placement of lon "term debt does not re+uire &#C re istration. 2. ;irect placement is more likely to have more restrictive covenants. 3. ;istribution costs are lower for private bonds. 6. It is easier to rene otiate a private placement because there are fewer investors. A ,ri#ate ,$ace'ent is '"re $i(e$y t" ha#e restricti#e c"#enants than is a ,%+$ic iss%e. -hy) It is arran ed between a firm and a few financial institutions, such as banks or insurance companies, that are very much interested in avoidin the transfer of wealth from them to stockholders. It is easier for a few financial institutions to rene otiate restrictive covenants if circumstances chan e. &1.: -hat are the feat%res "f syn!icate! +an( $"ans) 0 syndicated loan is a loan made by a roup of banks. Jne bank, called the lead bank, ne otiates with the borrower and draws up a loan a reement. -he lead bank typically retains a share of the loan, and is responsible for collectin interest and principal from the borrower and for dispersin payments to the various participants.

CONCEPT QUESTIONS E CHAPTER &&

&&.1 -hat are the !ifferences +etween an ",eratin $ease an! a financia$ $ease) 1. Jperatin leases have a cancellation option. 2. In an operatin lease, the lessor maintains and insures the leased asset. !ith financial leases the lessee must do both himself. 3. Jperatin leases are not fully amorti,ed. -hat is a sa$e an! $ease-+ac( a ree'ent) 0 sale and lease"back occurs when a company sells an asset it owns to another firm and immediately leases it back. H"w !"es a $e#era e! $ease w"r()

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0nswers to Concept 3uestions

0 levera ed lease is a three"sided arran ement amon the lessee, the lessor, and the lenders. -he lessee uses the assets and makes periodic lease payments. -he lessor purchases the assets, delivers them to the lessee, and collects the lease payment. -he lessor puts up no more than 6? to 7? percent of the purchase price. -he lenders supply the remainder and receive interest payments from the lessor. &&.& .efine the ter's ca,ita$ $ease an! ",eratin $ease. Capital leases meet at least one of the followin 9 1. -ransfer of ownership by the end of the lease term. 2. :ar ain purchase price option. 3. *ease term at least H7 percent of assetLs economic life. 6. 54 'lease payments) at least =? percent of assetLs fair value. PJperatin leaseQ is a eneral term applied to leases which are typically not fully amorti,ed, are maintained by the lessor, and have a cancellation option. H"w are ca,ita$ $eases re,"rte! in a fir'?s financia$ state'ents) If the lease is a capital 'financial) lease, then the present value of the lease appears as both an asset and a liability on the lesseeLs balance sheet. &&.* -hy is Cana!a Re#en%e A ency c"ncerne! a+"%t $easin ) #ssentially, the CR0 re+uires that a lease be primarily for business purposes and not merely for ta. avoidance. In particular, CR0 is on the lookout for leases that are really conditional sales a reements in dis uise. -hat are s"'e stan!ar!s CRA %ses in e#a$%atin a $ease) -he lease will be disallowed if9 1. -he lessee automatically ac+uires title to the property after payment of a specified amount in the form of rentalsI or 2. -he lessee is re+uired to buy the property from the lessorI or 3. -he lessee has the ri ht to ac+uire the property for less than the fair market value. &&.4 -hat are the cash f$"w c"nse4%ences "f $easin instea! "f +%yin ) 1. 0 cost is the after"ta. lease payment. 2. For one CC0 ta. shield. 3. 0 benefit is the purchase price. E0,$ain why the F1254<< in Ta+$e &&.* has a ,"siti#e si n. :ecause we are lookin at leasin relative to buyin , -ransCanada saves R17,6?? in year ?. &&.2 H"w sh"%$! "ne !isc"%nt a ris($ess cash f$"w) 0t the after"ta. riskless interest rate.
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&&.; S%''ari8e the ""! an! +a! ar %'ents f"r $easin . Eood 0r uments9 a. *easin reduces ta.es because firms are in different ta. bracket. b. *easin reduces uncertainty by eliminatin the residual value risk. c. *easin lowers transactions costs by reducin the chan es of ownership of an asset over its useful life. :ad 0r uments9 a. *easin improves accountin income and the balance sheet if leases are kept off the books. b. *easin provides 1??M financin , but secured e+uipment loans re+uire an initial down payment. c. -here are special reasons like overnment appropriations for ac+uisitions and circumventin bureaucratic firms.

CONCEPT QUESTIONS - CHAPTER &*

&*.& -hat is a ca$$ ",ti"n) 0 call option is a contract that ives the owner the ri ht to buy an asset at a fi.ed price within a certain time period. H"w is a ca$$ ",ti"n3s ,rice re$ate! t" the %n!er$yin st"c( ,rice at the e0,irati"n !ate) If the stock is (in the money( 'above the strikin price), stock price and option price are linearly related. If it2s (out of the money(, the call option is worthless. &*.* -hat is a ,%t ",ti"n) 0 put option is a contract that ives the owner the ri ht to sell an asset at a fi.ed price within a certain time period. H"w is a ,%t ",ti"n re$ate! t" the %n!er$yin st"c( ,rice at e0,irati"n !ate) If the stock is (in the money( 'below the strikin price), stock price and option price are linearly related. If it2s (out of the money(, the put option is worthless. &*.7 -hat is a ,%t-ca$$ ,arity) -he theorem says that because a call2s payoff is the same as payoffs from a combination of buyin a put, buyin the underlyin stock and borrowin at the risk"free rate, the call and the combination should be e+ually priced. &*.: List the fact"rs that !eter'ine the #a$%e "f ",ti"ns) 1. #.ercise price 2. $aturity 3. 5rice of the underlyin asset 6. 4ariability of the underlyin asset 7. Interest rate

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0nswers to Concept 3uestions

 -hy !"es a st"c(3s #aria+i$ity affect the #a$%e "f ",ti"ns written "n it) -he more variable the stock price, the hi her the possibility that the price will o over the e.ercise price in the case of a call or under the e.ercise price in the case of a put. -he variability increases the chan es of the stocks price e.tremes. &*.1 H"w !"es the tw"-state ",ti"n '"!e$ w"r() It uses the fact that buyin call can be made e+uivalent to buyin the stock and borrowin to determine option value. -hat is the f"r'%$a f"r the G$ac(-Sch"$es ",ti"n-,ricin '"!e$) C @ & . /'d1) " #e"rt d/'d2) !here d1 @ Sln'&<#) A 'rf A '1<2)2)tT < '2t)1<2 d2 @ d1 " '2t)1<2 &*.; H"w can the fir' +e e0,resse! in ter's "f ca$$ ",ti"ns) :ondholders own the firm and have written a call to stockholders with an e.ercise price e+ual to the promised interest payment. H"w can the fir' +e e0,resse! in ter's "f ,%t ",ti"ns) &tockholders own the firm and have purchased a put option from the bondholders with an e.ercise price e+ual to the promised interest payment. H"w !"es ,%t-ca$$ ,arity re$ate these tw" e0,ressi"ns) 0 call option2s payoff is the same as the payoff from a combination of buyin a put, buyin the underlyin stock and borrowin at the risk"free rate. Conse+uently, puts and calls can always be stated in terms of the other. -hy are "#ern'ent $"an %arantees n"t free) -hy !" s%ch %arantees "ften enc"%ra e fir's t" increase their ris() 0 overnment loan uarantee converts a risky bond into a riskless bond. !ith option pricin , this obli ation has a cost e+ual to the value of a put. &olvency, because of the overnment uarantee, is a stron er possibility but never a certainty. &ince the put option allows a risky firm to borrow at subsidi,ed rates, it is an asset to the shareholders. -he more volatile the firm, the reater the value to the shareholders. H"w can ",ti"ns +e %se! t" e0,$ain strate ies $i(e se$ectin hi h-ris( ,r"6ects an! 'i$(in the fir') &electin hi h"risk pro1ects is e.plained as follows. &tock is a call option on the firm. 0 rise in the volatility of the firm due to selectin hi h"risk pro1ects, increases the value of the call option, i.e., the stock. $ilkin the firm is e.plained by thinkin in terms of a put option. -he put option represents the ability of the
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&*.1<

0nswers to Concept 3uestions

shareholders to sell the firm to the bondholders in e.chan e for the bondholdersL promised payment. -he value of the put increases as the value of the firm falls, e. ., when a dividend is paid out in anticipation of financial distress. &*.11 &*.1& H"w can a c"ntin ent #a$%e ri hts ,$an assist in a 'er er) It can be used to accommodate a seller who would otherwise be reluctant. -hy are the hi!!en ",ti"ns in ,r"6ects #a$%a+$e) #ven the best laid plans of men and mice often o astray. -he option to adapt plans to new circumstances is a valuable asset.

CONCEPT QUESTIONS - CHAPTER &4

&4.1 -hy !" c"',anies iss%e ",ti"ns t" e0ec%ti#es if they c"st the c"',any '"re than they are w"rth t" the e0ec%ti#e) -hy n"t 6%st i#e cash an! s,$it the !ifference) -"%$!n?t that 'a(e +"th the c"',any an! e0ec%ti#e +etter "ff) Jne of the purposes to ive stock options to e.ecutives 'instead of cash) is to tie the performance of the firmLs share price with the compensation of the e.ecutives. In this way, the e.ecutive has an incentive to increase shareholder value, and act in the best interests of the shareholders. &4.& -hat are the tw" ",ti"ns that 'any +%sinesses ha#e) $ost businesses have the option to abandon under bad conditions and the option to e.pand under ood conditions. -hy !"es a strict NP= ca$c%$ati"n ty,ica$$y %n!erstate the #a$%e "f a fir' "r a ,r"6ect) 4irtually all pro1ects have embedded options, which are i nored in /54 calculations and likely lead to undervaluation.

CONCEPT QUESTIONS - CHAPTER &2

&2.& -hat is the (ey !ifference +etween a warrant an! a tra!e! ca$$ ",ti"ns) !hen a warrant is e.ercised, the number of shares increases. 0lso, the warrant is an option sold by the firm. !hen an options is e.ercised, it is the seller of the option that must ive up their shares in the company. -hy !"es !i$%ti"n "cc%r when warrants are e0ercise!) :ecause additional shares of stock are issued and sold to warrant holders at a below market price. H"w can the fir' h%rt warrant h"$!ers)

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0nswers to Concept 3uestions

-he firm can hurt warrant holders by takin any action that reduces the value of the stock. 0 typical e.ample would be the payment of abnormally hi h dividends. &2.* H"w can the G$ac(-Sch"$es '"!e$ +e %se! t" #a$%e warrants) First, calculate the value of an identical call. -he warrant price is the call price multiplied by U<'U A Uw). &2.4 -hat are the c"n#ersi"n rati"5 the c"n#ersi"n ,rice5 an! the c"n#ersi"n ,re'i%') -he conversion ratio is the number of shares received for each debenture. -he conversion price is e+uivalent to the price which the holders of convertible bonds pay for each share of common stock they receive. -he conversion premium is the e.cess of the conversion price over the common stock price. &2.2 -hat three e$e'ents 'a(e %, the #a$%e "f a c"n#erti+$e +"n!. Convertible bond value @ Ereater of 'strai ht bond value and conversion value) plus option value. .escri+e the ,ay"ff str%ct%re "f c"n#erti+$e +"n!s) It is the value of the firm if the value of the firm is less than total face value. It is the face value if the total face value is less that the value of the firm but reater than its conversion value. It is the conversion value if the value of the firm and the conversion value are reater than total face value.

&2.7 -hat is wr"n with the si',$e #iew that it is chea,er t" iss%e a +"n! with a warrant "r a c"n#erti+$e feat%re +eca%se the re4%ire! c"%,"n is $"wer than "n strai ht !e+t) In an efficient capital market the difference between the market value of a convertible bond and the value of strai ht bond is the fair price investors pay for the call option that the convertible or the warrant provides. -hat is wr"n with the /ree L%nch st"ry) -his story compares convertible financin to strai ht debt when the price falls and to common stock when price rises. -hat is wr"n with the AE0,ensi#e L%nchB st"ry) -his story compares convertible financin to strai ht debt when the price rises and to common stock when price falls.

&2.: -hy !" fir's iss%e c"n#erti+$e +"n!s an! +"n!s with warrants) 1. -o match cash flows, that is, they issue securities whose cash flows match those of the firm. 2. -o bypass assessin the risk of the company 'risk syner y). -he risk of company start"ups is hard to evaluate.
0nswers to Concept 3uestions 0"1=

3. -o reduce a ency costs associated with raisin money by providin a packa e that reduces bondholder"stockholder conflicts. &2.1 -hy wi$$ c"n#erti+$e +"n!s n"t +e #"$%ntari$y c"n#erte! t" st"c( +ef"re e0,irati"n) :ecause the holder of the convertible has the option to wait and perhaps do better than what is implied by current stock prices. -hen sh"%$! fir's f"rce c"n#ersi"n "f c"n#erti+$es) -hy) -heoretically conversion should be forced as soon as the conversion value reaches the call price because other conversion policies will reduce shareholder value. If conversion is forced when conversion values are above the call price, bondholders will be allowed to e.chan e less valuable bonds for more valuable common stock. In the opposite situation, shareholders are ivin bondholders the e.cess value.

CONCEPT QUESTIONS E CHAPTER &7

&7.1 -hat is a f"rwar! c"ntract) 0n a reement to trade at a set price in the future. Hi#e e0a',$es "f f"rwar! c"ntracts in y"%r $ife. 0 forward contract is formed when you contract an artisan to construct a ban1o and a ree to pay him R1,2?? on delivery. &7.& -hat is a f%t%res c"ntract) Futures contracts are like forward contracts e.cept that9 1. -hey are traded on or ani,ed e.chan es. 2. -hey let the seller choose when to make delivery on any day durin the delivery month. 3. -hey are marked to market daily. H"w is a f%t%res c"ntract re$ate! t" a f"rwar! c"ntract) In both contracts, it is the obli ation of both the buyer and seller to settle the contract at the future date. -hy !" e0chan es re4%ire f%t%res c"ntracts t" +e 'ar(e! t" the 'ar(et) :ecause there is no accumulation of loss, the mark to the market convention reduces the risk of default. &7.* .efine sh"rt an! $"n he! es. 0 short futures hed e involves sellin a futures contract. 0 lon futures hed e involves buyin a futures contract. Un!er what circ%'stances is each "f the tw" he! es %se!)

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0nswers to Concept 3uestions

&hort hed es are used when you will be makin delivery at a future date and wish to minimi,e the risk of a drop in price. *on hed es are used when you must purchase at a future date and wish to minimi,e the risk of a rise in price. &7.4 H"w are f"rwar! c"ntracts "n +"n!s ,rice!) -he same as any other cash flow stream B as the sum of discounted cash flows9
5 FJR!.CJ/-@ '1 A r1)St@1 'It<'1Art)t A 50R<'1 A r-)-T

-hat are the !ifferences +etween f"rwar! c"ntracts "n +"n!s an! f%t%res c"ntracts "n +"n!s) Futures contracts on bonds have the followin characteristics9 1. -hey are traded on or ani,ed e.chan es. 2. -he seller can make delivery on any day durin the month. 3. -hey are marked to market daily. Hi#e e0a',$es "f he! in with f%t%res c"ntracts "n +"n!s. Cour partnership has 1ust leased commercial space in a downtown hotel to a department store chain. -he lessee has a reed to pay R1 million per year for > years. Cou can hed e the risk of a rise in inflation 'and hence a fall in the value of the lease contract) over this period by formin a short hed e in the -"bond futures market. &7.2 -hat is !%rati"n) -he wei hted avera e maturity of a cash flow stream in present value terms. H"w is the c"nce,t "f !%rati"n %se! t" re!%ce interest rate ris() :y matchin the duration of financial assets and liabilities, a chan e in interest rates has the same impact on the value of the assets and liabilities. &7.7 Sh"w that a c%rrency swa, is e4%i#a$ent t" a series "f f"rwar! c"ntracts. 0ssume the swap is for five year at a fi.ed term of 1?? million V for R7? million each year. -his is e+uivalent to a series of forward contracts. In year one, for e.ample, it is e+uivalent to a one"year forward contract of 1?? million V at 2 V <R.

CONCEPT QUESTIONS E CHAPTER &:

&:.& -hat is the !ifference +etween net w"r(in ca,ita$ an! cash) /et workin capital includes not only cash, but also other current assets minus current liabilities. -i$$ net w"r(in ca,ita$ a$ways increase when cash increases) /o. -here are transactions such as collection of accounts receivable that increase cash but leave net workin capital unchan ed. 0ny transaction that will increase
0nswers to Concept 3uestions 0"21

cash but produce a correspondin decrease in another current asset account or an increase in a current liability will have the same effect. List the ,"tentia$ %ses "f cash. 1. 0c+uisition of capital 2. 0c+uisition of marketable securities 3. 0c+uisition of workin capital 6. 5ayment of dividends 7. Retirement of debt F. 5ayment for labor, mana ement and services rendered List the ,"tentia$ s"%rces "f cash. 1. &ale of services or merchandise 2. Collection of accounts receivable 3. Issuance of debt or stock 6. &ale of marketable securities 7. &ale of fi.ed assets F. &hort"term bank loans H. Increased accrued e.penses, wa es, or ta.es. &:.* -hat !"es it 'ean t" say that a fir' has an in#ent"ry-t%rn"#er rati" "f 4) It means that on avera e the inventory is kept on hand for '3F7 days per year<6 times per year) @ =1.27 days. .escri+e ",eratin cyc$e an! cash cyc$e. -hat are the !ifferences +etween the') -he operatin cycle is the period of time from the ac+uisition of raw material until the collection of cash from sales. It includes conversion of raw materials into finished oods, inventories, sales and collection of accounts receivable. -he cash cycle is the period of time from the cash payment for raw materials to the collection of cash. -he difference between the two is the accounts payable sta e, the time between the ac+uisition of raw materials and the cash payment for them. &:.4 -hat (ee,s the rea$ w"r$! fr"' +ein an i!ea$ "ne where net w"r(in ca,ita$ c"%$! a$ways +e 8er") 0 lon "term rise in sales level will result in a permanent investment in current assets. In addition, any day"to"day and month"to"month fluctuation in the level of sales will produce a non,ero /!C. -hat c"nsi!erati"ns !eter'ine the ",ti'a$ c"',r"'ise +etween f$e0i+$e an! restricti#e net-w"r(in -ca,ita$ ,"$icies) 1. Cash reserves9 %ow much cash does mana ement wantD 2. $atchin of asset and liability maturity 'maturity hed in ) 3. -erm structure9 -he difference between short"term and lon "term interest rates
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&:.2 H"w w"%$! y"% c"n!%ct a sensiti#ity ana$ysis f"r /%n T"ys? net cash +a$ance) :y determinin the net cash balance under different scenario assumptions B chan in factors that will affects net cash balance and fi urin out the result. -hat c"%$! y"% $earn fr"' s%ch an ana$ysis) It will ive you an idea of what the ran e of net cash balances will be under the different scenarios and how sensitive the net cash balance is to each of the factors that affect it. &:.7 -hat are the tw" +asic f"r's "f sh"rt-ter' financin ) 8nsecured bank borrowin and secured bank borrowin . .escri+e tw" ty,es "f sec%re! $"ans. 1. 0ccounts receivable financin . In this type of borrowin , accounts receivable are either assi ned or factored. In the latter case receivables are actually sold at a discount. 2. -rust receipt. -his is one of the three types of inventory loans in which the borrower holds the inventory in PtrustQ for the lender.

CONCEPT QUESTIONS E CHAPTER &1

&1.1 -hat is the transacti"ns '"ti#e5 an! h"w !"es it $ea! fir's t" h"$! cash) It is the necessity to hold cash for disbursements to pay wa es, trade debts, ta.es and dividends. 0 firm that does not have cash for these transactions will not be able to meet its obli ations. :ecause cash inflows and outflows are seldom synchroni,ed, firms need cash balances to serve as a buffer. -hat is the c"st t" fir's "f h"$!in e0cess cash) -he cost of holdin cash is the interest income that the firm could have received from investin in -reasury bills and other marketable securities. &1.& -hat is a tar et cash +a$ance) It is a firmLs desired level of cash holdin s to satisfy the transactions and compensatin balance needs. -hat are the stren ths an! wea(nesses "f the Ga%'"$ '"!e$ an! the 9i$$erOrr '"!e$) -he :aumol model is a very simple and strai htforward model with sensible conclusions, but it assumes a constant disbursement rate, lack of cash receipts durin the pro1ected period, and makes no allowance for Psafety stock.Q It also assumes discrete, certain cash flows. -he $iller"Jrr model improves the understandin of the problem by determinin the relationships amon the different variables, but it ne lects other factors that affect the tar et cash balance.
0nswers to Concept 3uestions 0"23

&1.* .escri+e c"$$ecti"n an! !is+%rse'ent f$"at. Collection float is the time that elapses from the moment the customer mails the payment until cash is received. ;isbursement float is the time that elapses from the moment a company mails a check and the time cash is withdrawn from the companyLs bank account. -hat are $"c(+"0es) C"ncentrati"n +an(s) Ier"-+a$ance acc"%nts) *ockbo.es are postal bo.es strate ically located in such a way that the mailin time from customers to the bo. is minimi,ed. -he firmLs bank has direct access to the bo.es, and thus in"house handlin is eliminated and collection float is reduced. Concentration banks are re ional banks in which the company has accounts and to which it sends e.cess cash at the end of the day. In this fashion che+ues obtained from nearby customers can be collected daily. Oero"balance accounts are used to avoid carryin e.tra balances in each disbursement account. Funds transferred in 1ust cover che+ues presented that day. H"w !" c"',%ter an! c"''%nicati"ns techn"$" ies ai! in cash 'ana e'ent +y $ar e c"r,"rati"ns) /ew technolo ies focus on reducin float virtually to ,ero by replacin che+ues with electronic funds transfer. #.amples used in Canada include pre"authori,ed payments, point"of"sales transfers and electronic trade payables. -he bank where the firm has its accounts. &1.4 -hy !" fir's fin! the'se$#es with i!$e cash) -o finance seasonal or cyclical activities 'transactions motive), to finance planned e.penditures 'investment motive), and to provide for unanticipated contin encies 'precautionary motive). -hat are s"'e ty,es "f '"ney 'ar(et sec%rities) 1. -reasury bills and notes 2. Federal a ency securities 3. $unicipal securities 6. Commercial paper 7. Certificates of deposit F. Repurchase a reements H. #urodollar certificates of deposit >. :ankersL acceptances

CONCEPT QUESTIONS - CHAPTER &;

&;.1 -hat c"nsi!erati"ns enter int" the !eter'inati"n "f the ter's "f sa$e) 1. 5robability of non"payment 2. &i,e of the account 3. 5erishability of oods
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6. Industry standards and competition 7. &tandard speed of collection F. 5rice of the oods E0,$ain the !esi n "f c"''"n cre!it instr%'ents. -he most common credit instrument is the invoice, which is sent with the shipment of oods and which the customer si ns as evidence that the oods have been received. 5romissory notes may be re+uired for lar e orders where the firm anticipates collection problems. 0 commercial draft is written by the sellin firm specifyin the amount and date of payment. -he draft is sent to the customerLs bank with the shippin invoices, where it is si ned by the customer, before the invoices are turned over. 0 bankerLs acceptance is a written a reement by the bank to pay for the oods and collect the money from the customer. 0 conditional sales contract is an arran ement where the firm retains le al ownership until the customer has completed payment.

&;.& List the fact"rs that inf$%ence the !ecisi"n t" rant cre!it. 1. -he delayed revenues from rantin credit 2. -he immediate cost of rantin credit 3. -he probability of non"payment 6. -he appropriate re+uired rate of return for delayed cash flows. &;.* -hat are the a!#anta es "f cre!it ins%rance) -he advanta es of credit insurance is that it ives e.porters support to provide services to overseas customers who they mi ht otherwise have been reluctant to sell to. In addition, the e.porter will find obtainin bank financin is easier. &;.4 -hat is cre!it ana$ysis) It is the process of tryin to determine the probability that a customer will default. It involves9 a. atherin relevant information, and b. determinin creditworthiness -hat are the fi#e Cs "f cre!it) Character, capacity, capital, collateral, conditions. -hat are cre!it sc"rin '"!e$s an! h"w are they %se!) Credit scorin models are elaborate statistical methods of calculatin a numerical ratin for a customer based on information collected and then rantin or refusin credit based on the result. Computeri,ed scorin models employ a statistical techni+ue called multiple discriminant analysis '$;0).

&;.2 -hat t""$s can a 'ana er %se t" ana$y8e a c"$$ecti"n ,"$icy) 0vera e collection period, the a in schedule, and the payments pattern.
0nswers to Concept 3uestions 0"27

&;.7 -hat ser#ices !" fact"rs ,r"#i!e) -he factor checks the credit of new customers, authori,es credit, handles collection and bookkeepin . In addition factorin provides insurance a ainst bad debts.

CONCEPT QUESTIONS - CHAPTER *<

*<.1 -hat is a 'er er) H"w !"es a 'er er !iffer fr"' "ther f"r's "f ac4%isiti"n) 0 mer er is the absorption of one firm by another, where the ac+uirin firm retains its identity and the ac+uired firm ceases to e.ist. It differs from other forms of ac+uisition in that no new firm is created, and there is no need of buyin the individual assets of the ac+uired firm or its stock. -hat is a ta(e"#er) It is the transference of control of a firm from one roup of shareholders to another by means of a ma1ority vote of the board of directors. *<.& -hat fact"rs inf$%ence the ch"ice +etween a ta0a+$e an! a ta0-free ac4%isiti"n) -here are two factors to consider when comparin a ta."free ac+uisition and a ta.able ac+uisition9 -he capital ains effect, and the write"up effect. -hat is the write-%, effect in a ta0a+$e ac4%isiti"n) In a ta.able ac+uisition, the assets of the sellin firm are revalued or Pwritten upQ from their historical book value to their estimated current market value.

*<.* -hat is the r"$e "f ""!wi$$ in ,%rchase acc"%ntin f"r 'er ers. Eoodwill is the e.cess of the purchase price over the sum of all the identifiable assets and liabilities and identifiable intan ible assets. *<.2 -hat are s"%rces "f ,"ssi+$e syner y in ac4%isiti"ns) 1. Revenue enhancement9 marketin ains, strate ic benefits, and market power. 2. Cost reduction9 economies of scale, economies of vertical inte ration, complementary resources, and elimination of inefficient mana ement. 3. *ower ta.es9 uses of ta. losses use of unused debt capacity, use of surplus funds, and ability to write up the value of depreciable assets. 6. *ower cost of capital9 cost of issuin securities is sub1ect to economies of scale. *<.: H"w is the !istri+%ti"n "f 'er er ains c"',$icate! if "ne "f the fir's has !e+t "%tstan!in )

0"2F

0nswers to Concept 3uestions

-here e.ists a coinsurance effect which reduces bankruptcy risk after the mer er, makes bondholders ain, and the shareholders lose. *<.1 -hy can a 'er er create the a,,earance "f earnin s r"wth) If a hi h price"earnin s ratio company ac+uires a low price"earnin s company, the market mi ht assume that the price"earnin s ratio does not chan e. -hy is !i#ersificati"n enera$$y a ,""r '"ti#e f"r a 'er er) &hareholders can diversify more easily than corporations by simply purchasin common stock in different corporations.

*<.; In an efficient 'ar(et with n" ta0 effects5 sh"%$! an ac4%irin fir' %se cash "r st"c() It would not matter because the /54 of the ac+uisition will be ,ero, and so the ac+uired firm2s shareholders obtain nothin but the value of the stock. If they use cash, the value of the ac+uired firm2s stockholders is the same as the value of the ori inal firm. *<.; -hat can a fir' !" t" 'a(e a ta(e"#er $ess $i(e$yD 1. If an individual or roup owns 71 percent of company stock, called a control block, hostile takeovers are virtually impossible. 2. It can chan e the corporate charter by re+uirin a hi her percenta e of share approval for a mer er or sta erin the election of board members. 3. It can en a e in standstill a reements ' reenmail). 6. It can make an e.clusionary self"tender 7. It can provide olden parachutes to top e.ecutives F. It can sell ma1or assets, i.e., the (crown 1ewels(. H. It can use (poison pills(. >. It can o"private, with the purchase of publicly owned stock by a private roup, often e.istin mana ement. =. It can seek a white kni ht. *<.1< -hat !"es the e#i!ence say a+"%t the +enefits "f 'er ers an! ac4%isiti"ns) It says that they usually benefit the shareholders of the ac+uired firm but do not si nificantly affect the shareholders of the ac+uirin firm. In terms of the new entity, a monopoly power can be created.

CONCEPT QUESTIONS - CHAPTER *1

*1.1 .escri+e financia$ !istress) It is a situation where operatin cash flows at a firm are not sufficient to satisfy current obli ations and the firm is forced to take corrective action.
0nswers to Concept 3uestions 0"2H

 -hat are st"c( +ase! ins"$#ency an! f$"w +ase! ins"$#ency) &tock based insolvency occurs when a firm has ne ative net worth. Flow based insolvency occurs when a firm has a short fall in cash flow. *1.& -hy !"esn3t financia$ !istress a$ways ca%se fir's t" !ie) Financial restructurin may make a firm worth more (alive than dead(. -hat is a +enefit "f financia$ !istress) It can serve as an early warnin system or (wake up call. *1.* -hat is +an(r%,tcy) :ankruptcy is a le al proceedin for li+uidatin or reor ani,in a business. -hat is the !ifference +etween $i4%i!ati"n an! re"r ani8ati"n) *i+uidation occurs when the assets of a firm are sold and, after payment of the bankruptcy administration costs, the proceeds are distributed amon the creditors. Reor ani,ation is the restructurin of the firm with some provision for repayment of creditors. -hat is the C"',anies? Cre!it"rs Arran e'ent Act) -he CC00 is federal le islation allowin for the reor ani,ation and continuation of insolvent businesses. *1.4 -hat are tw" ways a fir' can restr%ct%re its finances) 5rivate workouts and formal bankruptcy. -hy !" fir's %se f"r'a$ +an(r%,tcy) #+uity holdouts 5rivate workouts may be more e.pensive because of comple. capital structure or conflicts of interest. -hat is a ,re,ac(a e! +an(r%,tcy) 0 situation where the firm and most of all creditors a ree to a private reor ani,ation before bankruptcy takes place. 0fter the private a reement, the firm files for formal bankruptcy. -hat is the 'ain +enefit "f ,re,ac(a e! +an(r%,tcyD It forces holdouts to accept in bankruptcy reor ani,ation. *1.2 -as OJK?s ins"$#ency st"c(-+ase! "r f$"w-+ase!) Flow"based9 JWC could not service its debt because of a lack of cash flow. -hat are s"'e "f the c"sts "f the OJK +an(r%,tcy) 1. ;irect costs of restructurin " le al fees. 2. Indirect costs of restructurin " loss of key employee and ood name.
0"2> 0nswers to Concept 3uestions

3. Costs of complicated financial structure.

CONCEPT QUESTIONS - CHAPTER *&

*&.& -hat are the three (in!s "f f"rei n e0chan e transacti"ns) &pot, forward, and swap *&.* -hat is the $aw "f "ne ,rice) -hat is ,%rchasin -,"wer ,arity) -he law of one price is the simplest version of 555. It states that a commodity will cost the same re ardless of what currency is used to purchase it. 555 says that different currencies represent different purchasin powers, and the e.chan e rate ad1usts to keep the purchasin power constant. -hat is the re$ati"nshi, +etween inf$ati"n an! e0chan e-rate '"#e'ents) -his relationship is called (relative purchasin power parity( and states that the rate of inflation in one country relative to the inflation rate in another country determines the rate of chan e of the e.chan e rate of the currencies of the two countries. *&.4 -hat is the interest-rate-,arity the"re') It is a theorem that implies that if interest rates are hi her in one country than another, the latter country2s currency will sell at a premium in the forward market. In this way money earns the same re ardless of what currency it is invested in. -hy is the f"rwar! rate re$ate! t" the e0,ecte! f%t%re s,"t rate) -he tradin in forward rates is based on what traders e.pect the spot rate to be in the future. If the e.pectation for the spot rate is RX<;$ in three months, disre ardin risk aversion, the three month forward rate should also be RX<;$. H"w can "ne "ffset f"rei n e0chan e ris( thr"% h a transacti"n in the f"rwar! 'ar(ets) -hrou h the purchase or sale of a forward contract in a position offsettin that of the firm2s liability or promised payment. H"w can fir's he! e %sin c%rrency swa,s "r c%rrency ",ti"ns) In a currency swap, where each borrower raises funds in different currencies and then swap liabilities, the funds in the desired currency are obtained at a lower rate than for direct borrowin . -he basic idea behind hed in with options is to take an options position opposite to the cash position. *&.2 -hat ,r"+$e's !" internati"na$ ,r"6ects ,"se f"r the %se "f net ,resent #a$%e techni4%es) 1. Forei n e.chan e conversion. !hat e.chan e rate should one use, the company2s pro1ection or the market2s.
0nswers to Concept 3uestions 0"2=

2. Repatriation of funds. &ome countries place restrictions on remittance of funds to the investin country. 3. -he appropriate discount rate may be lower than the domestic rate if the firm can diversify in ways that its shareholders cannot. Forei n political risk may raise the re+uired return in some cases. H"w is internati"na$ ca,ita$ +%! etin affecte! +y r"win in#est"r interest in internati"na$ !i#ersificati"n) Firms can benefit from a lower cost of capital for international pro1ects which provide diversification services for the firmsL shareholders. %owever, as investors diversify lobally, the cost of capital advanta e to firms will likely decline. In addition, the increased political risks may offset the ains from international diversification. *&.7 -hat are the three ways fir's can finance f"rei n ,r"6ects) 1. Raise cash in the home county and e.port it to finance the forei n pro1ect. 2. Raise cash by borrowin in the forei n country where the pro1ect is located. 3. :orrow in a third country where the cost of debt is lowest. -hat s"%rces "f financin are a#ai$a+$e) Canadian banks, #urobanks, and international bond $arkets. *&.: -hat iss%es arise when re,"rtin f"rei n ",erati"ns) 1. !hat e.chan e rate should you use if the e.chan e rate has chan ed durin the periodD 2. %ow do you handle unreali,ed accountin ains or losses from forei n currencyD

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0nswers to Concept 3uestions