Chapter 14-16 Testable Questions

Briefly describe 3 (of 5 listed in your text) methods of repaying bonds.

•Simplest method - single sum payment at maturity •Serial payments - paid off in installments over life of issue •Sinking-fund provision - semiannual or annual contributions made into fund by trustee •Conversion - converting debt to common stock •Call feature - retire or force in debt issue before maturity

Why is secondary trading in the security markets important?

Because buyers of new securities also have a place to sell them rapidly at fair, competitive prices, the secondary market provides liquidity, thus enhancing the corporation's ability to raise funds.

What are bond ratings based on? How does the bond rating affect the interest rate paid by a corporation on its bonds?

Bonds receive ratings based on the corporation's ability to make interest payments, its consistency of performance, its size, its debt-equity ratio, its working capital position, and a number of other factors. The higher the rating on a bond, the lower the interest payment that will be required to satisfy the bondholder.

Discuss how an underwriting syndicate decreases risk for each underwriter and at the same time facilitates the distribution process.

By forming a syndicate of many underwriters rather than just one, the overall risk is diffused and the capabilities for widespread distribution are enhanced. A syndicate may be formed from as few as two or as many as 50 investment banking houses.

Discuss the reason for the differences between underwriting spreads for stocks and bonds.

Common stocks often carry a larger underwriting spread than bonds because the market reaction to stocks is more uncertain.

What are three forms of corporate securities discussed in the chapter? In terms of the number of transactions in the markets, which is seen the most and which the least and why?

Corporate bonds, preferred stock, and common stock are the three forms of corporate securities discussed in the chapter. As bonds come due and are paid off, the corporation normally replaces this debt with new bonds. Thus corporate bond issuances have traditionally made up the majority of external financing transactions. Preferred stock is the least used, because the dividend is not tax deductible to the corporation, as is bond interest.

What are electronic communication networks (ECNs)?

ECNs are electronic trading systems that automatically match buy and sell orders at specific prices via computers. They are now part of the operations of the two major markets (at one time they competed with them).

What is the purpose of market stabilization activities during the distribution process?

Market stabilization activities are managed in an attempt to ensure that the market price will not fall below a desired level during the distribution process. Syndicate members committed to purchasing the stock at a given price could be in trouble if there is a rapid decline in the price of the stock.

How would you define "efficient security markets"?

Markets are efficient when: prices adjust rapidly to new information; there is a continuous market, in which each successive trade is made at a price close the the previous price; and the market can absorb large dollar amounts of securities without destabilizing the price.

Discuss the benefits accruing to a company that is traded in the public securities markets.

The benefits of having a publicly traded security are: •Greater ability to raise capital. •Increased liquidity for existing stockholders. •Ease in estate planning for existing stockholders.

What is the difference between a bond agreement and a bond indenture?

The bond agreement covers a limited number of items, whereas the bond indenture is a supplement that often contains over 100 pages of complicated legal wording and specifies every minute detail concerning the bond issue. The bond indenture covers such topics as pledged collateral, methods of repayment, restrictions on the corporation, and procedures for initiating claims against the corporation.

List 3 disadvantages of debt.

The disadvantages are: •Interest and principal payment obligations are set by contract and must be paid regardless of firm's economic position. •Bond indenture agreements may place burdensome restrictions on the firm. •Debt, utilized beyond a given point, may put the company at risk of financial distress and depress common stock values.

What are the disadvantages to being public?

The disadvantages of being public are: •The president must be a public relations representative to the investment community. •Tremendous pressure is put on the firm for short-term performance. •The initial cost of going public can be very expensive for a small firm. •There are high reporting compliance costs.

In addition to U.S. corporations, what government groups compete for funds in the U.S. capital markets? With regard to this competition, what is the role of the capital markets?

The federal government, government agencies, and state and local governments all compete or a limited supply of financial capital. The capital markets serve as a way of allocating the available capital to the most efficient user.

In what way is an investment banker a risk taker?

The investment banker is a risk taker (underwriter) in that the investment banking house agrees to buy the securities from the corporation and resell them to other security dealers and the public at an agreed-upon price. If they can't sell the securities at the initial offering price, they suffer a loss.

List 3 advantages of debt.

The primary advantages of debt are: •Interest payments are tax deductible. •The financial obligation is clearly specified and of a fixed nature. •In an inflationary economy, debt may be paid back with cheaper dollars (the dollars have less purchasing power than when received) •The use of debt, up to a prudent point, may lower the cost of capital to the firm.

If a firm were to go into bankruptcy, what would be the general order of claims? That is, sort the following:

The priority of claims would be: senior secured debt, junior secured debt, senior debenture, subordinated debenture, preferred stock, common stock

How does a leveraged buyout work? What does the debt structure of the firm normally look like after a leveraged buyout? What might be done to reduce the debt?

The use of a leveraged buy-out implies that either management or some other investor group wants to take the company private. After the repurchase, the company exits with substantial debt and heavy interest expense. To reduce the debt load, assets may be sold off. Also, returns from asset sales may be redeployed into higher return areas.

The efficient market hypothesis is interpreted in a weak form, a semistrong form, and a strong form. How can we differentiate its various forms?

The weak form of efficient markets simply states that past price information is unrelated to future prices and that since no trends are predictable, investors cannot take advantage of them. The semistrong form states that prices reflect all public information. The strong form states that all information, both public and private, is reflected in the stock prices.

What is a key tax characteristic associated with state and local (municipal) securities? Give an example, not from your text.

They are tax exempt, meaning the interstate paid is normally exempt from federal income taxes and from state income taxes in the state of issue. If the state of Nebraska issues a bond that is bought by someone living in the state of Nebraska, the interest is not taxable by Nebraska. However, if someone living in NE buys a bond issued by Iowa, the interest will be taxed by NE.