ch02sm - Chapter 2 Financing Decisions(Introduction and...

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Chapter 2 Financing Decisions (Introduction and Equity Decisions) Answers to End-of-Chapter Assignments Questions Q1. Debt Versus Equity Securities. What are the primary characteristics that distinguish debt from equity securities? Answer. The text discusses the following four ways that debt and equity securities are distinguished: rights in corporate dissolution, voting rights, nature of period cash flows paid in interest (debt) and dividends (equity), and nature of final payment. Debt securities have superior claims to equity securities--holders of debt securities must be paid before holders of equity securities. Also, debt securities may be secured by claims against specific assets. Holders of common stock generally have voting rights, while holders of debt securities do not have voting rights. Periodic interest payments on debt securities are contractual obligations that must be paid, while dividend declarations are at the discretion of a company’s board of directors. The final amount received by holders of debt securities is contractually stipulated; the final amount received by a shareholder depends on the market price (if the stock is sold) or the amount that remains after satisfying claims of creditors (if the company is liquidated). Q2. Hybrid Securities. What is a hybrid security? What are the four hybrid securities identified in the text, and what makes them hybrid? Answer. A hybrid security is one that has some characteristics of both debt and equity. The four securities discussed in the text are preferred stock, convertible preferred stock, convertible debt, and bonds issued with detachable warrants. Preferred stock has a stipulated annual cash payment (like debt), but it is designated an equity security and like equity has no contractual amount due at a certain future date. Like debt, preferred stock has preference in liquidation over common stockholders. Convertible preferred stock has an additional equity feature, an embedded option that allows it to be converted into common stock. Convertible debt has all the normal debt characteristics, but it also has an embedded option that allows it to be converted into common stock. Bonds issued with detachable warrants are classified as a hybrid because debt and equity securities are issued together as a package. However, the debt and equity securities are separable after issuance. Q3. Optimal Capital Structure. What is the definition of optimal capital structure? Answer. As defined in the text, optimal capital structure is the “mix of debt, preferred stock, and common equity that minimizes the weighted cost to the firm of its employed capital ” (Moyer, McGuigan, and Kretlow, CONTEMPORARY FINANCIAL MANAGEMENT, 8th Edition 2001 (Cincinnati, Ohio: South-Western College Publishing). Alternatively, optimal capital structure is the debt to equity ratio or debt to value ratio at which the value of the firm is maximized. Q4.
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This note was uploaded on 03/31/2008 for the course FINA 33012 taught by Professor Bennett during the Spring '08 term at Kent State.

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ch02sm - Chapter 2 Financing Decisions(Introduction and...

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