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What are the two main types of long-term debt instruments?
What are the two main types of long-term debt instruments?
Which of the following describes the main advantage of debt financing?
Which of the following describes the main advantage of debt financing?
What is the primary disadvantage associated with debt financing?
What is the primary disadvantage associated with debt financing?
Which of the following is NOT a characteristic of a term loan?
Which of the following is NOT a characteristic of a term loan?
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What is the key characteristic of a fixed interest rate on a long-term debt instrument?
What is the key characteristic of a fixed interest rate on a long-term debt instrument?
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What determines the maturity date of a debt instrument?
What determines the maturity date of a debt instrument?
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What is the benefit of debt financing over equity financing in terms of management control?
What is the benefit of debt financing over equity financing in terms of management control?
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What is the par value of a bond typically set at?
What is the par value of a bond typically set at?
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Why is the cost of capital crucial for a firm?
Why is the cost of capital crucial for a firm?
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What is the difference between a term loan and a bond?
What is the difference between a term loan and a bond?
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What is the challenge when determining a firm's overall cost of capital?
What is the challenge when determining a firm's overall cost of capital?
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How should a firm manage the overall cost of capital effectively?
How should a firm manage the overall cost of capital effectively?
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What is the yield to maturity (YTM) of a bond?
What is the yield to maturity (YTM) of a bond?
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What is the purpose of a call provision in a bond?
What is the purpose of a call provision in a bond?
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What is the role of bond ratings?
What is the role of bond ratings?
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How is the coupon interest payment calculated?
How is the coupon interest payment calculated?
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What is the present value of a bond with a par value of $1,000, a coupon rate of 12%, a maturity of 10 years, and a required rate of return of 12%?
What is the present value of a bond with a par value of $1,000, a coupon rate of 12%, a maturity of 10 years, and a required rate of return of 12%?
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A bond with a par value of $1,000 and a coupon rate of 14% is trading at a discount. What can we conclude about the required rate of return on this bond?
A bond with a par value of $1,000 and a coupon rate of 14% is trading at a discount. What can we conclude about the required rate of return on this bond?
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A bond with a par value of $1,000 and a coupon rate of 14% is trading at a premium. What can we conclude about the required rate of return on this bond?
A bond with a par value of $1,000 and a coupon rate of 14% is trading at a premium. What can we conclude about the required rate of return on this bond?
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What is the yield-to-maturity on a bond with a par value of $1,000, a coupon rate of 14%, a maturity of 10 years, and a current market price of $1,000?
What is the yield-to-maturity on a bond with a par value of $1,000, a coupon rate of 14%, a maturity of 10 years, and a current market price of $1,000?
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A bond with a par value of $1,000 and a coupon rate of 8% is trading at a discount. What is the relationship between the yield-to-maturity and the coupon rate?
A bond with a par value of $1,000 and a coupon rate of 8% is trading at a discount. What is the relationship between the yield-to-maturity and the coupon rate?
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What is the after-tax cost of debt for Suk Kedirik Berhad?
What is the after-tax cost of debt for Suk Kedirik Berhad?
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What is the cost of preferred stock for Suk Kedirik Berhad?
What is the cost of preferred stock for Suk Kedirik Berhad?
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What is the cost of equity for Suk Kedirik Berhad?
What is the cost of equity for Suk Kedirik Berhad?
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Given the information provided, which source of financing would you recommend for Suk Kedirik Berhad?
Given the information provided, which source of financing would you recommend for Suk Kedirik Berhad?
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What is the weighted average cost of capital (WACC) for Suk Kedirik Berhad if the firm would like to maintain its current capital structure?
What is the weighted average cost of capital (WACC) for Suk Kedirik Berhad if the firm would like to maintain its current capital structure?
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What is the first step in calculating the Weighted Average Cost of Capital (WACC)?
What is the first step in calculating the Weighted Average Cost of Capital (WACC)?
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What is the coupon rate of the bond under the Dynamic Corporation's financing alternatives?
What is the coupon rate of the bond under the Dynamic Corporation's financing alternatives?
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Which financing alternative has the least flotation cost expressed as a percentage of the par value?
Which financing alternative has the least flotation cost expressed as a percentage of the par value?
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If Dynamic Corporation issues common stock, what is the expected dividend for the next year?
If Dynamic Corporation issues common stock, what is the expected dividend for the next year?
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What method can be used to determine the cost of preferred stock?
What method can be used to determine the cost of preferred stock?
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Which component of WACC considers the tax advantage derived from debt financing?
Which component of WACC considers the tax advantage derived from debt financing?
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What is the total amount of capital in the current capital structure of Suk Berhad?
What is the total amount of capital in the current capital structure of Suk Berhad?
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In the presented illustration, what is the corporate tax rate applied to the bond interest?
In the presented illustration, what is the corporate tax rate applied to the bond interest?
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What is the cost of equity capital if the risk-free rate is 6.1%, the expected market risk premium is 8.6%, and the company's equity beta is 0.58?
What is the cost of equity capital if the risk-free rate is 6.1%, the expected market risk premium is 8.6%, and the company's equity beta is 0.58?
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In the context of cost of capital, what will happen to the share price if the rate of return on investment is lower than the cost of capital?
In the context of cost of capital, what will happen to the share price if the rate of return on investment is lower than the cost of capital?
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What is the weighted average cost of capital based on?
What is the weighted average cost of capital based on?
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How is the cost of common stock for Royan Industries calculated given a share price of RM50, a growth rate of 6%, and a dividend yield of 4%?
How is the cost of common stock for Royan Industries calculated given a share price of RM50, a growth rate of 6%, and a dividend yield of 4%?
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What does the systematic risk of an asset, represented by beta (β), measure?
What does the systematic risk of an asset, represented by beta (β), measure?
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Which of the following does not affect the determination of the weighted average cost of capital?
Which of the following does not affect the determination of the weighted average cost of capital?
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What would be a reason for a firm to raise external funds through common stock?
What would be a reason for a firm to raise external funds through common stock?
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Which factor is NOT a determinant in assessing a firm's cost of capital?
Which factor is NOT a determinant in assessing a firm's cost of capital?
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Study Notes
Chapter 8: Long Term Financing
- This chapter covers various methods of long-term financing, including bonds, preferred shares, and common stock.
- The content includes types of bonds, characteristics of financial instruments, advantages and disadvantages of these instruments, and cost of financing.
- The objective is for learners to determine a firm's cost of debt, equity capital, overall cost of capital, identify pitfalls of overall cost of capital and how to manage them.
- Capital is essential for a firm to operate, and firms need various financing sources (debt to equity) especially when large capital expenditures are involved.
Chapter Content
- Types: Bonds, Preferred Shares and Common Stock.
- Characteristics of Bonds, Preferred Shares and Stock.
- Advantages and disadvantages of these instruments.
- Cost of Financing.
Chapter Objective
- Know how to determine a firm's cost of debt.
- Know how to determine a firm's cost of equity capital.
- Know how to determine a firm's overall cost of capital.
- Understand pitfalls of overall cost of capital and how to manage them.
Introduction
- Capital is a necessary element of production for a firm.
- Firms need to secure proper financing (from debt to equity) to support operations, especially during large capital expenditures.
- The cost of capital is the minimum rate of return needed by investors to satisfy their required rate of return on the firm's investments.
Debt
- Debt creates a fixed obligation that must be serviced regardless of financial conditions.
- Debt is a source of financing for capital investments.
- Long-term debt instruments can be convertible or non-convertible. Convertible bonds allow holders to exchange the debt for a specific number of common shares, while non-convertible bonds do not.
Features of Long-Term Debts
- Fixed interest rate: fixed obligations that need servicing when due
- Fixed maturity date: the date set for final payment, fixed at issuance
Preference of Debt Financing over Equity Financing
- Management control: Debt holders do not participate in company management decisions.
- Cost of funds: Interest paid to debt holders is tax deductible.
Types of Debt
- Term Loans: can be obtained quickly, flexible, low issuance costs, more than 5 years maturity, from banks, insurance companies, or pension funds. Interest rates can be fixed or variable.
- Bonds: long-term promissory notes issued by governments or businesses. Obligates the issuer to make periodic interest payments and principal payment to the bondholder.
Bond Characteristics/ Features
- Par Value: The face value of the bond, usually RM1,000.
- Coupon/Interest Rate: The percentage of par value paid to bondholders. Usually paid annually or semi-annually.
- Yield to Maturity (YTM): The rate a bondholder earns if bought, held, and interest is reinvested until maturity.
- Call Provision: Gives the issuing firm the right to call in the bond before maturity.
- Bond Ratings: Qualitative guide to default probability.
- Bond Maturities: The date the par value is repaid. Maturities typically range from 5 to 40 years.
Bond Categories
- Issued with convertible e Bonds
- Bonds with stock purchase warrants
- Zero Coupon Bonds
- Subordinated Debentures
- Index Bonds
- Income Bonds
Secured Bonds
- Convertible Bonds: Exchangeable for shares of common stock.
- Bonds with Stock Purchase Warrants: Similar to convertible bonds, allow holders to buy stock at a predetermined price.
- Indexed Bonds: Interest rates linked to a price index.
- Zero Coupon Bonds: Sold at a deep discount, no interest or principal payments until maturity.
- Debentures: Long-term claims not secured by company assets. The bondholders receive payment after senior creditors are settled.
- Subordinated Debentures: Junior debt, claims settled after senior creditors.
- Income Bonds: Pay interest only when the firm earns enough profit
Bond Valuation
- Present Value Equation: Calculation of present value of bond.
Illustration (Example of bond valuation calculation)
- Example of calculating bond value from TM Afic Inc.
Exercise
- KUAT Public Utilities examples.
- TM Afiq example of preferred stock valuation.
- Royan Industries examples of preferred stock and common stock costs
Common Equity
- Ownership of the firm.
- Ownership proportion depends on the number of common shares held versus total outstanding common shares.
- Common stockholders are the real owners
Cost of Equity
- Return required by equity investors for the risk associated with cash flows.
- Major methods:
- Dividend growth model
- SML (Security Market Line) or CAPM (Capital Asset Pricing Model)
The Dividend Growth Model Approach
- Formula for calculating cost of equity using a dividend growth model.
Dividend Growth Model Example
- Calculation of the cost of equity when given dividend, growth rate, and current price.
The SML Approach
- Method for calculating cost of equity, using risk-free rate, market risk premium, and systematic risk (beta) of assets.
SML Example
- Calculation of the cost of equity capital with risk-free rate, market risk premium, and beta provided
Cost of Equity Example
- Calculation approach using SML and DGM when given relevant financial information.
- Examples using given information to calculate cost of equity
- Calculate the cost of equity for different situations.
Cost of Capital
- Crucial to evaluating projects before investment.
- Correlated with the share price of the firm. Higher rate of return projects lead to higher share prices
The Weighted Average Cost of Capital (WACC)
- Computation of cost of capital by considering the proportion of total capital structure.
- Function of individual cost of capital and percentage of funds provided by debt, preferred stock and common stock.
Illustration (Example of WACC calculation)
- Calculation of WACC when considering different financing options.
Exercise (example)
- Dynamic Corporation financing options, calculating costs and choosing the best alternative.
- Suk Berhad capital structure, calculating costs, and recommend financing structure
References
- List of references used in the chapter with authors and the source
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Description
Test your knowledge on long-term debt instruments and the nuances of debt financing. This quiz covers key concepts such as term loans, bonds, and the overall cost of capital. Challenge yourself with questions on the advantages and disadvantages of debt financing.
