FINC 349 LECTURE 11

Practice flashcards covering foundational concepts, fixed-income vs. equity, key fixed-income characteristics, mortgage types, loan repayment structures, capital structure, capitalized interest, credit quality, leverage, and LBOs.

What foundational concepts are reviewed in the early weeks of fixed-income and mortgages?

Time value of money (TVM), pricing loans/bonds/notes, and understanding principal vs. interest.

What is the primary difference between fixed-income (debt) and equity from a payment perspective?

Fixed-income involves contractual payments (interest + principal), while equity is a residual claim, paid after debt.

How does risk generally correlate with required return for senior debt, junior debt, and equity?

Senior, collateralized debt has less risk than junior debt, which has less risk than equity, leading to lower required returns in that order.

What are coupon payments in fixed-income?

Periodic cash payments to investors, representing the interest or 'reward' for lending.

What is the significance of 'seniority' in fixed-income debt?

Senior debt has priority over subordinated debt in payoff during default or bankruptcy, and is often secured by collateral.

Who has priority during default or bankruptcy: debt holders or equity holders?

Debt holders have priority over equity holders.

What is a mortgage defined as in the context of these notes?

A loan secured by real property (residential or commercial) as collateral.

For a semiannual payment schedule, how do you calculate the number of periods and the periodic rate?

Number of periods = years × 2; Periodic rate = annual rate / 2.

Describe the repayment structure of a 'bullet' loan.

Borrowers pay interest each period and repay all principal in one lump sum ('bullet') at the end of the loan term.

In a level principal repayment structure, how do principal, interest, and total payments change over time?

Equal principal is repaid each period, while interest declines as the principal balance decreases, causing total payments to decline over time.

What characterizes a 'Level Debt Service' (Annuity) repayment structure?

The total payment remains constant each period, with the interest portion falling and the principal portion rising over the loan term.

What does 'capital structure' refer to in finance?

The mix of debt and equity used to finance a firm's assets, residing on the right side of the balance sheet.

What is the difference between external and internal financing?

External financing is from outside the firm (debt, new equity issuance), while internal financing uses retained earnings (from net income).

What is 'capitalized interest'?

Interest that is not paid currently but is added to the principal balance of a loan.

What are the consequences of capitalized interest?

Principal grows, and the borrower ends up paying interest on interest in later periods due to the higher opening balance.

What happens if a borrower underpays or is late on interest payments, leading to a technical default?

Penalties are assessed and often capitalized (added to the principal).

How does a borrower's credit quality typically affect the down payment required for a mortgage?

Better credit usually results in a lower down payment requirement because lenders have more confidence in the borrower's ability to repay.

What is 'leverage' in finance?

Using debt to acquire assets, which is powerful when the returns on the acquired assets exceed the cost of debt (considering the tax shield).

What is a Leveraged Buyout (LBO), and when does it work best?

An LBO is a type of merger and acquisition (M&A) mostly financed by debt, working best when the target company has large, predictable, and stable free cash flows to service the high fixed debt obligations.

How does the tax deductibility of interest affect the cost of debt?

It lowers the after-tax cost of debt, which in turn lowers the Weighted Average Cost of Capital (WACC) up to a certain point.