Chapter 2

1. 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 • Underwritten offering • 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 • Firm commitment contract • 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 • Negotiation contract • 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 • 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 • 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 )