Financial Management

Off-balance-sheet financing

Why do many companies find off-balance-sheet financing attractive? How might a company’s investors bondholders and stockholders react?

Off-balance-sheet is attractive to many companies because it permits them to publish financial statements which present the firm as stronger than it really is. Leaving the debt off the right-hand side of the balance sheet lowers the firm’s reported financial leverage. Omitting the proceeds from the financing from the left-hand side of the balance sheet increases reported profitability measures based on assets such as return on assets and basic earning power. Investors who are unaware of the off-balance-sheet financing have no basis for reacting to it. However, to the extent that a company’s investors learn of its off-balance-sheet financing activities¾from the footnotes to the firm’s financial statements, from analysts, or from the financial press¾they will react on one of several ways. First, they will recast the firm’s financial statements to include the missing financing in order to better understand the company’s financial health. If they believe the company still to be strong, and especially if they think that the company has successfully used the off-balance-sheet financing to lower its funding costs, they will most likely approve of it and accord the company a higher market value. On the other hand, if they discover that the company is not as strong as they believed, they will likely consider themselves the victims of misrepresentation and lower the company’s market value.

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Identify four benefits of a lease to the lessee and two benefits to the lessor

Four benefits to the lessee are:

(1) tax savings from the ability to deduct all lease expenses and/or the ability to transfer tax deductions to a lessor who can obtain more value from them and pass on the savings,
(2) cost savings from the lessor’s expertise and economies of scale,
(3) the ability to transfer the risk of the asset’s obsolescence to the lessor, and
(4) the flexibility of 100% financing without many of the formalities of a comparable bank loan.

Two benefits to the lessor are:

(1) the ability to make a profitable “loan” to the lessee, and
(2) a superior position should the lessee default on its lease payments since the lessor owns the leased asset.

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Technical default and financial default

What is the difference between technical default and financial default? Which is more critical to bondholders?

Default means not performing according to a loan agreement. Financial default refers to the failure to pay interest and/or principal when due. Technical default refers to the failure to adhere to other terms of the agreement, such as providing information, maintaining insurance on collateral, keeping financial ratios within specific boundaries, etc. Since bondholders lend money to companies primarily to earn interest (and retrieve their principal), financial default is by far the more critical.

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Bond concepts

a. Indenture the formal agreement between lender and buyer specifying the terms of the loan and the relationship of the parties.

b. Trustee a third party who represents the interests of the lender(s) to the borrower.

c. Mortgage a legal agreement between borrower and lender, distinct from but accompanying the loan agreement, which specifies the loan collateral.

d. Debenture a bond without collateral.

e. Sinking fund an account set up by the borrower into which the borrower regularly deposits money to repay the loan.

f. Serial bond a bond carrying a serial number which permits it to be specifically identified and (possibly) retired prior to its maturity date.

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What is a junk bond?

Why were junk bonds so popular in the 1980s? Why are they less popular today?

A junk bond is a bond which is rated below investment grade on its date of issue. Junk bonds became popular in the early 1980s primarily through the efforts of Michael Milken at the investment banking firm of Drexel, Burnham, Lambert. Milken argued successfully that the interest rate on these bonds was greater than the rate appropriate for their risk of default which made them a very attractive investment. Investors flocked to junk bonds for their high yields, providing a considerable amount of funds to new and high-risk ventures. The 1980s was a period of economic growth¾there were few defaults on junk bonds throughout most of the decade which supported Milken’s assertions. However, the recession and Milken’s highly publicized legal troubles in the late 1980s burst the junk bond bubble. Fewer junk bonds are issued today, and those that are outstanding are evaluated much more realistically.

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Foreign bond, Eurobond, and multi-currency bond

Distinguish between a foreign bond, Eurobond, and multi-currency bond. What are the advantages and disadvantages of each to both lender and borrower.

These three types of international bonds differ either in their mix of currencies or in the difference between their currency and the currency of the country in which they are initially sold. For borrowers, they share the advantage of attracting financing from sources that might not otherwise have been available, broadening the demand for the companies’ securities and lowering their costs of capital. They also provide opportunities for companies to raise funds and schedule repayments in currencies that best hedge their anticipated future cash flows, reducing their risks. For lenders, these bonds offer opportunities to invest in companies in their domestic currencies. There are few if any disadvantages. More specifically:

(1) A foreign bond is a bond issued by a foreign borrower in the currency of the country of issue (for example, the Swiss pharmaceutical company Bayer issuing a U.S. dollar denominated bond in the United States).

(2) A Eurobond is a bond denominated in a currency other than that of the country of issue (for example, Proctor & Gamble issuing a U.S. dollar denominated bond in Germany). Eurobonds also have the advantages of limited regulation and recordkeeping and no tax withholding requirements, which further lower the interest rate required by investors.

(3) A multi-currency bond is a bond denominated in more than one currency (for example, Toyota issuing a bond promising interest payments in yen and the repayment of principal in U.S. dollars).

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What is a floating rate note?

A floating rate note (FRN) is an intermediate- or long-term bond with a floating interest rate. FRNs are issued in the Eurocurrency markets (where they originated) and in most other major capital markets worldwide. FRNs provide an alternative to traditional bonds with their fixed interest rates, reallocating the risks of interest rate movements between the parties.

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In what way can owners’ equity been seen as

a. An accounting measure? Owners’ equity represents the amount of a company’s assets not offset by liabilities, hence owned by the firm’s investors. Mathematically, owners’ equity equals assets minus liabilities.

b. A legal concept? Owners’ equity represents the legal ownership of the business, the investment of those with the authority to hire (or be) the firm’s management and set company policy.

c. An investment concept? Owners’ equity identifies that some people have contributed money to the firm and represents one measure of the value of the money they have invested.

d. A value claim concept? Owners’ equity indicates that there is a person or group of people who have the last claim to the income produced by the company and to any residual value should the firm dissolve.

e. A risk concept? Owners’ equity represents a class of contributors to the company who bear a relatively high amount of risk in return for potentially high returns.

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Distinguish among the following common stock concepts

a. Authorized shares the total number of shares a company can issue as approved by the government.

b. Issued shares the total number of shares sold to investors at any time in the past.

c. Outstanding shares the number of shares currently in the hands of investors.

d. Treasury shares the number of issued shares not currently in the hands of investors having been repurchased by the company and “held in the company’s treasury.”

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Common stock concepts

a. Par value the maximum capital contribution required from investors for each share.

b. Book value the accounting value for each share; total owners’ equity divided by the number of shares outstanding.

c. Market value the price of each share in the financial marketplace reflecting investors forecasts of future cash flows the company will produce.

d. Liquidation value the value investors would receive for each share if the company were dissolved and its assets sold.

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