Corporate Financing: Equity and Debt Securities
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Questions and Answers

A corporation is facing financial distress and is being liquidated. How are the proceeds from the liquidation typically distributed, considering the differences in cash flow rights between debtholders and shareholders?

  • A government-appointed trustee decides the distribution of proceeds, disregarding the original claims.
  • Shareholders and debtholders receive proceeds simultaneously, proportional to their initial investment.
  • Debtholders receive the proceeds first, up to the amount of their outstanding debt, due to their payment priority. (correct)
  • Shareholders receive the proceeds first, as they have complete control over the firm until liquidation.

    • A company is considering issuing either debt or equity to finance a new project. What key factor should the company consider when deciding between debt and equity financing, given the differences in control rights?

  • The immediate cash flow needs, as debt provides a lump sum while equity requires ongoing dividend payments.
  • The tax implications, as interest payments on debt are tax-deductible while dividend payments are not.
  • The degree to which the company wants to retain control, as issuing equity dilutes ownership and control. (correct)
  • The current market interest rates, as higher rates make debt financing unattractive regardless of control implications.

    • Company XYZ is performing exceptionally well and has generated significant profits. Considering the cash flow rights of shareholders, what action can the company take?

  • Reinvest all profits into the company, without paying dividends, to maximize future growth and shareholder value.
  • Allocate the profits to pay off all outstanding debts immediately, regardless of the debt's maturity schedule.
  • Distribute a substantial portion of the profits as dividends to shareholders, at the discretion of the board of directors. (correct)
  • Use the profits to buy back company stock, increasing earnings per share but reducing overall equity.

    • How would a significant increase in a company's debt-to-equity ratio likely impact the perceived risk and required return for both debtholders and shareholders?

    <p>Increase the risk for both debtholders and shareholders, as the company becomes more financially leveraged and vulnerable to economic downturns. (A)</p> Signup and view all the answers

    A technology startup is seeking funding but is hesitant to issue equity due to concerns about diluting control. Which alternative financing structure could allow the founders to retain significant control while still raising capital?

    <p>Offering preferred stock with limited voting rights and a fixed dividend, balancing capital raising with control retention. (A)</p> Signup and view all the answers

    Flashcards

    Equity

    A financial contract granting stockholders ownership, voting rights, and dividends.

    Debt

    A financial contract that entitles lenders to fixed cash payoffs from a corporation.

    Cash Flow Rights

    Rights determining how cash flows are distributed to stakeholders.

    Control Rights

    The ability to influence management decisions within a corporation.

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    Residual Claim

    Shareholders' rights to remaining cash flows after debts are paid.

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    Study Notes

    Corporate Financing Claims

    • Corporations use future cash flow claims to secure current financing.
    • These claims are broadly categorized as equity-like and debt-like securities.

    Equity Securities

    • Represents perpetual ownership in a corporation, granting voting rights in shareholder meetings and dividend/liquidation proceeds.

    Debt Securities

    • A financial agreement obligating a corporation to pay a predetermined set of cash flows over a specified period to the lender.

    Equity vs. Debt Differences

    Cash Flow Rights

    • Debt: Priority repayment, fixed payments with predefined maturity.
    • Equity: Residual claim on cash flow, receives dividends (after debt) and has limited liability. Payoffs are not predetermined and claims are perpetual.

    Control Rights

    • Debt: No control rights unless the company is liquidated; then, creditors can seize assets to recoup the debt.
    • Equity: Complete control over the corporation; the board of directors, ultimately accountable to the equity holders.

    Valuation of Equity and Debt

    • The value of issued equity and debt reflects investor assessments of the underlying cash flow claims.
    • The combined value of a firm's debt and equity equates to the firm's total valuation.

    Payment Structures

    • Debt Payments: Fixed amounts.
    • Equity Payments: Variable (depending on the corporation's performance).

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    Description

    Overview of corporate financing methods, focusing on equity and debt securities. It highlights cash flow and control rights. Debt securities are prioritized for repayment with fixed payments and predefined maturity, while equity has residual claim.

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