Corporate Financing and Claims Overview

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Questions and Answers

How would you classify a financial instrument that provides its holder with a claim on a company's assets, junior only to senior debt holders, and offers a variable rate of return tied to the company's performance?

  • Common Equity
  • Subordinated Debt (correct)
  • Preferred Equity
  • Senior Secured Debt

In a situation where a company faces liquidation, what is the correct order of claim precedence among the following parties?

  • Debtholders, then Shareholders (correct)
  • Shareholders, then Debtholders
  • Preferred Shareholders, then Debtholders, then Common Shareholders
  • Shareholders and Debtholders pari passu

What is the MOST accurate distinction between debt and equity regarding control rights in a corporation?

  • Both debtholders and shareholders share equal control rights in proportion to their investment.
  • Shareholders possess primary control rights through voting, while debtholders have control rights only upon liquidation or bankruptcy. (correct)
  • Control rights are determined randomly at the discretion of the board of directors.
  • Debtholders possess full control rights, while shareholders have no control unless specified in the debt contract.

What is the primary implication of shareholders having a 'residual claim' on a corporation's cash flow?

<p>Shareholders receive dividends and assets only after all debtholders and other creditors have been paid. (D)</p> Signup and view all the answers

How would you classify a security that has characteristics of both debt and equity, potentially offering fixed interest payments along with the possibility of equity appreciation?

<p>Convertible Bond (B)</p> Signup and view all the answers

Flashcards

Equity

A financial contract giving stockholders ownership and rights like voting and dividends.

Debt

A financial contract entitling lenders to fixed cash payoffs for a set period.

Cash flow rights

Rights concerning payment priority for debtholders and shareholders.

Control rights

Rights that determine who has control over a corporation's decisions.

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Perpetual claim

A claim without a fixed term, as held by shareholders.

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Study Notes

Corporate Financing Claims

  • Corporations use future cash flow claims to secure current financing.
  • These claims fall into two main categories: equity-like and debt-like securities.

Equity

  • Definition: A financial contract granting perpetual ownership to a stockholder.
  • Rights: Voting rights in shareholder meetings, dividend payouts, and a share of liquidation proceeds.

Debt

  • Definition: A financial contract obligating the corporation to specific cash payments over a certain period.
  • Fixed payouts: The payments and maturity dates are predetermined.

Equity vs. Debt: Key Differences

Cash Flow Rights

  • Debtholders: Have priority in repayment. Repayments and maturity dates are predefined.
  • Shareholders: Have a residual claim (receive dividends after debtholders are paid). Their liability is limited. Payouts are not predetermined and their claim is perpetual.

Control Rights

  • Debtholders: Have no control over the company unless it's liquidated, in which case they gain control of assets to satisfy debt claims.
  • Shareholders: Have full management control through the board of directors.

Valuation of Claims

  • The value of equity and debt reflects investor assessments of underlying cash flows.
  • The combined value of a company's debt and equity equals the total company value.
  • Debtholders receive fixed payments.
  • Shareholders receive varying payments.

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