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Questions and Answers
What is a primary reason corporations issue fixed-income securities?
What is a primary reason corporations issue fixed-income securities?
Which of the following fixed-income instruments is typically used by governments to cover budget deficits?
Which of the following fixed-income instruments is typically used by governments to cover budget deficits?
How do companies typically decide which method to use for raising money when expenses exceed revenue?
How do companies typically decide which method to use for raising money when expenses exceed revenue?
What is a feature common to fixed-income securities such as bonds and debentures?
What is a feature common to fixed-income securities such as bonds and debentures?
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What is one advantage of using financial leverage for companies?
What is one advantage of using financial leverage for companies?
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Which of the following reflects a characteristic of money market instruments?
Which of the following reflects a characteristic of money market instruments?
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What is a primary characteristic of bonds as fixed-income securities?
What is a primary characteristic of bonds as fixed-income securities?
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Why might a corporation choose to issue bonds instead of using available cash for a purchase?
Why might a corporation choose to issue bonds instead of using available cash for a purchase?
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What motivates a government to issue fixed-income securities over tax increases?
What motivates a government to issue fixed-income securities over tax increases?
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Which of the following is NOT a common alternative for companies to raise cash besides issuing fixed-income securities?
Which of the following is NOT a common alternative for companies to raise cash besides issuing fixed-income securities?
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In the context of financial leverage, what signifies a successful use of borrowed funds?
In the context of financial leverage, what signifies a successful use of borrowed funds?
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How can issuing fixed-income securities be beneficial in terms of financial leverage?
How can issuing fixed-income securities be beneficial in terms of financial leverage?
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What is the borrowing cost incurred by a company that issues $1 million in bonds at 10% interest?
What is the borrowing cost incurred by a company that issues $1 million in bonds at 10% interest?
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Why would a company opt to issue bonds for 'general corporate purposes'?
Why would a company opt to issue bonds for 'general corporate purposes'?
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Which of the following best describes the relationship between fixed-income securities and market conditions?
Which of the following best describes the relationship between fixed-income securities and market conditions?
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What typically constitutes an advantage of using financial leverage for a company?
What typically constitutes an advantage of using financial leverage for a company?
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What type of investor is most likely to benefit from the fixed-income feature of bonds?
What type of investor is most likely to benefit from the fixed-income feature of bonds?
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Which of the following represents a common misconception about bonds as fixed-income securities?
Which of the following represents a common misconception about bonds as fixed-income securities?
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What is a primary advantage of forced conversion for the issuing company?
What is a primary advantage of forced conversion for the issuing company?
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How does the price of convertible bonds relate to their forced conversion levels?
How does the price of convertible bonds relate to their forced conversion levels?
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What is one tax implication for bondholders when converting bonds to equity?
What is one tax implication for bondholders when converting bonds to equity?
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In what way does forced conversion impact the financial leverage of a company?
In what way does forced conversion impact the financial leverage of a company?
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What action must bondholders take if a forced conversion clause is enacted?
What action must bondholders take if a forced conversion clause is enacted?
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What is a key characteristic of convertible bonds compared to regular bonds?
What is a key characteristic of convertible bonds compared to regular bonds?
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What impact does the conversion privilege have on the attractiveness of a bond?
What impact does the conversion privilege have on the attractiveness of a bond?
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What is a primary characteristic of extendible bonds?
What is a primary characteristic of extendible bonds?
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How does the conversion price of most convertible bonds change over time?
How does the conversion price of most convertible bonds change over time?
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Which of the following statements about retractable bonds is true?
Which of the following statements about retractable bonds is true?
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What is a potential advantage for a company issuing convertible securities?
What is a potential advantage for a company issuing convertible securities?
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What happens if a holder does not take action during the election period for an extendible bond?
What happens if a holder does not take action during the election period for an extendible bond?
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Which statement accurately describes the tax implications for investors holding convertible bonds?
Which statement accurately describes the tax implications for investors holding convertible bonds?
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How does the maturity period for extendible bonds typically compare to retractable bonds?
How does the maturity period for extendible bonds typically compare to retractable bonds?
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What happens if a holder does not notify the trustee of their decision to retract a bond?
What happens if a holder does not notify the trustee of their decision to retract a bond?
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What is generally the rationale for companies to issue extendible and retractable bonds?
What is generally the rationale for companies to issue extendible and retractable bonds?
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Why might investors prefer convertible securities during a company's growth phase?
Why might investors prefer convertible securities during a company's growth phase?
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What is an essential factor that could affect the tax implications of extendible and retractable bonds for investors?
What is an essential factor that could affect the tax implications of extendible and retractable bonds for investors?
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How can issuing convertible bonds indirectly help a company raise equity capital?
How can issuing convertible bonds indirectly help a company raise equity capital?
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Which option is true regarding the interest rates of extendible bonds compared to their initial rates?
Which option is true regarding the interest rates of extendible bonds compared to their initial rates?
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In the context of convertible bonds, what does the term 'conversion privilege' refer to?
In the context of convertible bonds, what does the term 'conversion privilege' refer to?
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What is a common misconception regarding the redemption of retractable bonds?
What is a common misconception regarding the redemption of retractable bonds?
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What does 'no adjustment for interest or dividends' imply for certain convertible debentures?
What does 'no adjustment for interest or dividends' imply for certain convertible debentures?
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For corporations, how do extendible bonds support financial growth strategies?
For corporations, how do extendible bonds support financial growth strategies?
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Which critical factor must investors consider when deciding whether to extend or retract their bonds?
Which critical factor must investors consider when deciding whether to extend or retract their bonds?
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What typically differentiates the election period for extendible bonds from retractable bonds?
What typically differentiates the election period for extendible bonds from retractable bonds?
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Study Notes
Financial Leverage
- Financial leverage utilizes borrowed funds to enhance potential returns on investments.
- Example: A company borrows $1 million at 10% interest to extend production capacity, expecting after-tax profits of over $100,000 annually.
- Expected returns must exceed borrowing costs for successful financial leverage.
Fixed-Income Securities Overview
- Commonly equated with bonds, fixed-income securities include various types such as debentures, money market instruments, and preferred shares.
- Bonds are long-term debt securities secured by physical assets like buildings or machinery.
- Issuers can customize terms of fixed-income securities to meet financing needs and lender expectations.
Rationale for Issuing Fixed-Income Securities
- Corporations and governments issue these securities to fund operations and manage deficits when expenses exceed revenues.
- Governments predominantly use tax revenues, while companies can also sell assets, borrow from banks, or issue equity.
- Companies lean towards the cheapest financing method available.
- Common reasons for issuing fixed-income securities:
- Financing operations or growth.
- Taking advantage of financial leverage.
Extendible and Retractable Bonds
- Extendible bonds allow investors to convert short-term debt (around five years) into longer-term bonds (up to ten years) at slightly higher interest rates.
- Example: GHI International Inc.'s extendible bonds can shift maturity from July 26, 2025, to July 26, 2030.
- Retractable bonds let investors redeem long-term debt (at least ten years) early, typically five years before maturity.
- Example: JKL Inc. offers retractable bonds due June 30, 2030, callable at par on June 30, 2025.
Convertible Bonds and Debentures
- Convertible securities combine bond features with the option to exchange for common shares, locking in a conversion price.
- These bonds provide fixed interest and repayment dates while allowing capital appreciation through conversion into equity.
- Convertible bonds make investments more attractive and can reduce borrowing costs.
Characteristics of Convertible Bonds
- Conversion prices typically increase over time, encouraging early conversions.
- Convertible bonds can be converted into stock at any time until expiration, though certain issuances may not adjust for interest or dividends.
- Forced conversions benefit issuing companies by relieving interest payment obligations and facilitating new debt financing.
- Example: RFC Inc. offers convertible bonds redeemable at $1,000, convertible into shares at a price of $22.71, with a forced conversion clause affecting shareholder decisions.
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Description
This quiz explores the concept of financial leverage through a case study of a corporation purchasing a paper bags company using bond issuance. Test your understanding of how companies can leverage debt to finance acquisitions and the implications for cash flow and borrowing costs.
