Questions and Answers
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?
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?
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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?
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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?
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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?
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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?
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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'?
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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?
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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?
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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?
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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?
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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?
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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?
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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?
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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?
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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?
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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?
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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?
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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?
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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?
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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?
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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?
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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.
