1. Equity and Debt Financing Strategies
Chapter 2
Equity and Debt Financing Strategies

2. A. Enlarge Cash Pie Maximization of shareholders’ equity value
Maximization of cash flow pie
Marketing the rights of the future cash flows generated by its current and prospective projects

3. (A)Tax factors in financing
Uneven tax treatment of various components of financial cost
Debt vs. Equity financing
Personal taxes vs. Corporate taxes
Zero-coupon bond
Supply side: Low cost
Demand side: meet future commitments

4. (B)Financial innovations
Appeals to a special niche in the market
Low cost
Repackage mortgage into complex derivative securities

5. ( C )Increasing liquidity
Investors are willing to accept lower returns on more liquid assets
Approaches to increase liquidity
Going public
Standardizing their claims
Underwriting new public issues
Buying insurance for a bond issue
Listed on organized exchanges

6. (D)Reducing transaction costs
Reduce transaction costs
increase new proceeds
Approaches to reduce transaction costs
Use of investment bankers to underwrite new issues
Shelf registration
Extendible notes
Secured debt
leasing

7. (E)Bridging the credibility gap (reduce the costs of information asymmetries)
Management overprice issues vs. market response
High risk asset issues Large gap
Large discount Low net proceeds
S.Myers’ pecking order theory
R/E
Debt and convertibles
Common stock

8. (F)Managing financial conflicts
Three sources of conflicts related to financial policy
Separation of ownership and control
Stockholder-Manager Conflicts
Separation of stockholders and bondholders
Stockholders-Bondholders Conflicts
Separation of investors and non-investors
Non-investors Stakeholder Conflicts

9. (F)Managing financial conflicts
Stockholder-Manager Conflicts
Agency costs
Free cash flow paid out to shareholders cash-flow in excess of that required to undertake all economically sound investments
Managers have a greater incentive to shirk their responsibilities as their equity interest falls
Incentive approach

10. (F)Managing financial conflicts
Stockholders-Bondholders Conflicts
Bondholders have prior but fixed claims
Stockholder have limit liability for unlimited claims on remaining assets i.e. put option
Stockholders Bondholders
Risky project Rating downgrade
Transfer assets Bond covenants

11. (F)Managing financial conflicts
Non-investor stakeholder Conflicts
Implicit commitment of service and parts, durability to customers
Safe work environment or lifetime employment to employees
Advertising to distributors

12. B. Venture Capital (A)The special features of ventures
Its large appetite for cash
Growth options
Increasing the profitability of existing product lines
Expanding into profitable new products or markets
Difficult to establish its value
Expected future cash flows

13. (B)Financing ventures
Bank loans
Advantages
Face-to-face negotiation
Flexibility
Less information asymmetry
Provision of continuous access to funds
Disadvantages
Bank debt is still debt
Increase the probability of financial distress
Growth options make poor collateral

14. (B)Financing ventures
Private placements
Private place securities
Difficult to sell prior to maturity
Restrictive covenants
Convertible securities
Convertible bonds or preferred stock
Fixed income
Conversion feature

15. (B)Financing ventures
Venture Capitalists
Private equity, closer relationship, more control, high rate of return
Strict contract: modest salaries for managers

16. ( C )VC Contracting Risk-return analysis of venture
The future cash-flows are unknown
(both in amount and timing)
The appropriate discount rate is unknown
Any two parties analyzing the same deal will disagree about the future cash-flow, or the appropriate discount rate to apply, or both.

17. ( C )VC Contracting Deal-making --- venture capital contract
Allocating cash-flows
Determined by initial investment, required rate of return
Allocating risks
Required rate of return usually is higher than the true expected return on the venture capital portfolio

18. ( C )VC Contracting The value of the option to abandon
The option to re-value a project
The option to increase capital committed

19. C. IPO (Initial public offering)
(A)Rights v.s Underwritten Offerings
Rights offerings
Each stockholder receives options (warrants) to buy the newly issued securities
One right is issued for each share held
Must be registered with the SEC
Inexpensive (underwritten offering expenses are from 3 to 30 times higher than the costs of right-offering)
Unpopular ( 20%, why? Underwritten offering provide monitoring companies and guarantees to investors)

20. (A)Rights v.s Underwritten Offerings
Underwriting syndicate is a synthetic put, leading underwriter
Typical underwriting process
Laddering
Investment bankers’ contributions
Handle most of the paperwork details
Marketing
Take risk to both of its capital and reputation

21. (B) Best efforts vs. Firm commitment contracts
Best effort contract
The underwriter acts only as a marketing agent for the firm
The underwriter does not agree to purchase the issue at a pre-determined price
The issuer gets the net proceeds, but without any guarantee of the final amount from the investment banker
To investor
Call option : price restriction in oversubscribe
Put option : under-subscribed

22. (B) Best efforts vs. Firm commitment contracts
The underwriter agree to purchase the whole issue
The underwriter resale the issue to the public at a specific price
The prohibition against raising prices for an oversubscribed issue means that the company gives a free call option to potential stockholders

23. ( C ) Negotiation contract vs. Competitive Bid
Higher total flotation costs
Lower variance of issue cost
Managers’ favorite
Stable
Valuable proprietary information
Effectiveness in monitoring

24. ( C ) Negotiation Contract vs. Competitive Bid
Competitive bid contract
Lower total flotation costs
Higher variance of issue cost
Issuers bear all of the price risk
No third party is certifying for investors the value of the shares

25. (D)Shelf vs. Traditional Registration
The issuing firm, its investment banker, its auditing firm and its law firm all participate in filing the required registration statement with the SEC
The offering can only proceed when the registration statement becomes effective

26. (D)Shelf vs. Traditional Registration
Shelf registration
A recent development
It allows companies to register their securities, “put them on the shelf” and then issue the securities whenever they choose
After the securities are registered, management can offer and sell them for up two years on a continuous basis

27. (E)Under-pricing

28. (E)Under-pricing Information asymmetry
Uninformed investors would earn systematically below normal returns. Recognizing their disadvantaged position in this bidding process, uninformed investors will response by bidding for IPO only if the offer price is lower than the after-market price
The greater price uncertainty is, the greater is the under-pricing

29. (E)Under-pricing Other explanations
Regulations require underwriters to set the offering price below the expected value
Underwriters collude to exploit inexperienced issuers and to favor investors
Under-priced new issues “leave a good taste” with investors so that future underwriting from the same issuer can be sold at attractive prices.

30. (E)Under-pricing
“Firm commitment” underwriting spreads do not cover all of the risks, so that the underwriter under-prices new issues to compensate
The issuing corporation and underwriter perceive that under-pricing constitutes a form of insurance against legal suit

31. D. International cross-listing
(a)Types
. Direct share listing
. Depository receipt(DR)
Negotiable certificate that represent a foreign company’s publicly traded equity or debt.

32. E. Enlarge cash pie --- International cross-listing
(b) Participants
. Listing company
. Investment bank
. Custodian bank
. Exchange

33. E. Enlarge cash pie --- international cross-listing
(c) Why do firms cross-list?
. Market segmentation
. Investor recognition
. Liquidity
. Commitment to reveal information

34. E. Debt Financing (A) Bank loan
Bank loans may provide a possible solution to the problem of “information asymmetry” that attends all public securities offerings
Banks have better information to price their loans
Cost of borrowing vs. Cost of securities offering (Long-term relationship)

35. Corporate Policy
Inside debt-holders are in a better position to monitor the firm after the debt is issued
Restrictive covenants
Easy to renegotiate
Easy to evaluate and monitor issuer though deposit accounts

36. Corporate Policy
There may be an advantage to maintaining confidence about the firm’s investment opportunities
Develop a new product
Develop a new market strategy
Avoid the costly and time-consuming process of registering issues with the SEC
Small borrowing

37. Corporate Policy
Positive market response to announcements of bank loans
Provide a credible “seal of approval” to equity investors and other claimants of the firm

38. (B). Convertibles --- Corporate Policy
Rationale for the use of convertibles: the relative insensitivity of their value to the risk of the issue company
Easier for bond issuer and purchaser to agree on the value of bond
It protests the bondholder against the adverse consequences of management policy that increase the risk of the company

39. (C) Junk Bond --- Corporate Policy
Optimal debt capacity
The firm’s tax-paying status
larger tax shields, less debt capacity
Risk of the firm’s assets
bankruptcy cost
Composition of its assets
assets in place
The ideal junk bond issuer is a firm that can take full advantage of the interest rate shields, that does not have a potential for severe bankruptcy costs.and that has a total market value that is largely attribute to assets in place

40. Corporate Policy Financial synergies of junk bond
The reintegration of financial and industrial resources and interests
---Investment banks
The reintegration of ownership and control
---Competition
Increased capital access for smaller companies
---Size and term flexibility and spread

41. Corporate Policy The democratization of capital
---Managers and employees
Increased industrial competitiveness
---Financing high-growth, innovative companies that are smaller and higher operating risk, e.g. communications, semiconductors
---Restructuring ownership and strategy of low growth companies through LBO and re-capitalization, e.g. textile
---Recovering equity through workouts and turnarounds of distressed companies e.g. mining

42. (D). LYON --- Financial Synergies
LYON is a variant of the convertible that value is relatively insensitive to the risk of the issuing firm
Company risk value of bond
Reduce disagreement (information asymmetry) between management and potential investors
Increase cash pie
e.g. Smaller, high-growth companies with volatile earning

43. Financial Synergies
LYON is a zero-coupon, fixed-income component with an equity call option
Zero-coupon and convertible features reduce transaction cost
increase cash pie

44. Financial Synergies
LYON gives investors the right to put the notes back to the company
Put back to companies reduce the exposure of investor’s principal to a drop in the issuer’s principal to a drop in the issuer’s credit standing
Put option accounted for a large portion of the value of LYON

45. Financial Synergies
LYON satisfies the objective of portfolio insurance to institutional investors
Provide upside potential while limiting downside risk
underlying stock price value of LYON
underlying stock price protected by put
(or interest rate )