Understanding Finance Theory and Practice - Debt

Flashcards covering the basics of debt financing, bonds, and leasing.

What are the two main instruments of debt financing?

Bank loans and Bonds

Why is debt cheaper than equity?

Interest payments are tax deductible, debt is less risky than equity, interest payments are legally protected, and debtholders rank higher than shareholders in liquidation.

What is the primary difference between debt and equity financing?

Debt financing involves borrowing money, while equity financing involves selling a portion of equity in the company.

How do banks securitize long-term bank loans?

Banks parcel up debts as securities and sell them on a market.

What are the main features of bonds?

A nominal value, a coupon (interest rate), a maturity date, and a market price.

Define 'irredeemable bonds'.

Bonds for which the principal is never repaid.

What does a bond rating indicate?

The investment risk associated with the bond, based on the issuing company's expected financial performance.

What is the formula for the valuation of irredeemable bonds?

V0 = I / r (V0 = market value, I = annual interest, r = required rate of return)

What are convertible bonds?

Debt securities that can be converted into ordinary shares of the company at the option of the holder.

Define 'conversion ratio'.

The number of ordinary shares obtained from one convertible bond.

Define 'conversion value'.

The market value of ordinary shares into which one bond may be converted; equal to the conversion ratio multiplied by the market price of the share.

Define 'conversion premium'.

The difference between the price of a convertible bond and its conversion value.

Define 'rights premium'.

The difference between the value of the convertible bond and its value as straight debt.

What are the attractions of convertible bonds for companies?

If directors believe that the current share price is depressed, fixed-interest payments for financial planning, lower interest rate compared to straight bonds, and self-liquidating nature.

What are the attractions of convertible bonds for investors?

Lower-risk investment in the short-term with potential for greater returns in the longer-term, opportunity to financially participate in the growth of the company, and ability to evaluate company performance before converting.

What is the formula for calculating the conversion value of convertible bonds?

CV = P0(1 + g)^n * R (CV = conversion value, P0 = current share price, g = expected growth rate, n = time to conversion, R = number of ordinary shares)

Define 'leasing'.

A form of short- to medium-term financing, where an operating lease is designed for short-term use of an asset.

Who is the 'lessor' and the 'lessee' in a lease agreement?

Lessor is the provider of the lease (owns the asset), while the lessee is the user of the leased asset (hires the asset).

What are the key differences between an operating lease and a finance lease?

Operating Lease: short-term, rental-focused, costs expensed on income statement. Finance Lease: long-term, ownership-like, asset and liability recorded on balance sheet.