Financing Decisions (Introduction and Equity Decisions)
Answers to End-of-Chapter Assignments
Debt Versus Equity Securities.
What are the primary characteristics that distinguish debt
from equity securities?
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).
What is a hybrid security?
What are the four hybrid securities
identified in the text, and what makes them hybrid?
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.
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
an additional equity feature, an embedded option that allows it to be converted into
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
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
Optimal Capital Structure.
What is the definition of optimal capital structure?
As defined in the text, optimal capital structure is the “mix of debt, preferred
stock, and common equity that
to the firm
” (Moyer, McGuigan, and Kretlow, CONTEMPORARY FINANCIAL
MANAGEMENT, 8th Edition 2001 (Cincinnati, Ohio:
Alternatively, optimal capital structure is the debt to equity ratio or debt to
value ratio at which the value of the firm is maximized.