principle.
3. C: Debt not currently pang interest 4. D: Debt in default.
· Why don't bond prices change when bond ratings change?
The bond ratings are based on publicly available information and therefore may not provide information that the market did not have before the change.
· Are the costs of bond issues related to their ratings?
Investment –grade issues have much lower direct costs than non-investment grade issues.
20.5 · Create an idea of an unusual bond and analyze its features.
The text provides an example of an unusual bond; income bonds are a hybrid between debt and equity. For the firm interest is tax deductible, but the payment depends on income rather than being fixed. This feature makes it riskier than normal bonds, and although the tax deductibility may make them appear cheaper, the market prices them according to risk as well.
20.6 · What are the differences between private and public bond issues? 1. Direct private placement of long-term debt does not require SEC registration. 2. Direct placement is more likely to have more restrictive covenants. 3. Distribution costs are lower for private bonds.
4. It is easier to renegotiate a private placement because there are fewer investors.
· A private placement is more likely to have restrictive covenants than is a public issue. Why? It is arranged between a firm and a few financial institutions, such as banks or insurance companies, that are very much interested in avoiding the transfer of wealth from them to stockholders. It is easier for a few financial institutions to renegotiate restrictive covenants if circumstances change.
CONCEPT QUESTIONS – CHAPTER 21
21.1 · What are some reasons that assets like automobiles would be leased with operating leases, whereas machines or real estate would be leased with financial leases?
1. Operating leases have a cancellation option that protects the lessee from technological obsolescence in the case of equipment.
2. The service provided by the lessor in an operating lease eliminates the problem of retraining employees to service the new equipment or the problem of repairs in the case of a person leasing a car.
· What are the differences between an operating lease and a financial lease? 1. Operating leases are not fully amortized.
2. In an operating lease the lessor maintains and insures the leased asset. With financial leases the lessee must do both himself. 3. Operating leases have a cancellation option.
21.2 · Define capital lease.
Capital leases meet at least one of the following: 1. Transfer of ownership by the end of the lease term. 2. Bargain purchase price option.
3. Lease term at least 75 percent of asset’s economic life. 4. PV (lease payments) at least 90 percent of asset’s fair value.
· Define operating lease.
“Operating lease” is a general term applied to leases which are typically not fully amortized, are maintained by the lessor, and have a cancellation option.
21.3· What are the IRS guidelines for treating a lease contract as a lease for tax purposes?
Very generally, the guidelines are set up to identify lease contracts which are purely a tax dodge.
21.5 · How should one discount a riskless cash flow? At the after-tax riskless interest rate.
21.9 · Summarize the good and bad arguments for leasing. Good Arguments:
a. Leasing reduces taxes because firms are in different tax bracket. b. Leasing reduces uncertainty by eliminating the residual value risk.
c. Leasing lowers transactions costs by reducing the changes of ownership of an asset over its useful life. Bad Arguments:
a. Leasing improves accounting income and the balance sheet if leases are kept off the books. b. Leasing provides 100% financing, but secured equipment loans require an initial down payment.
c. There are special reasons like government appropriations for acquisitions and circumventing bureaucratic firms. CONCEPT QUESTIONS - CHAPTER 22
22.2 · What is a call option?
A call option is a contract that gives the owner the right to buy an asset at a fixed price within a certain time period.
· How is a call option's price related to the underlng stock price at the expiration date? If the stock is \linearly related. If it's \
22.3 · What is a put option?
A put option is a contract that gives the owner the right to sell an asset at a fixed price within a certain time period.
· How is a put option related to the underlng stock price at expiration date?
If the stock is \linearly related. If it's \
22.6 · What is a put-call parity?
The theorem says that because a call's payoff is the same as payoffs from a combination of bung a put, bung the underlng stock and borrowing at the risk-free rate, the call and the combination should be equally priced.
22.7 · List the factors that determine the value of options? 1. Exercise price 2. Maturity
3. Price of the underlng asset 4. Variability of the underlng asset 5. Interest rate
· Why does a stock's variability affect the value of options written on it?
The more variable the stock the higher the possibility that it will go over the exercise price in the case of a call or under the exercise price in the case of a put. The variability increases the changes of the stocks price extremes.
22.8 · How does the two-state option model work?
It uses the fact that bung call can be made equivalent to bung the stock and borrowing to determine option value.
· What is the formula for the Black-Scholes option-pricing model? C=SoN(d1) - Ee-rftdN(d2)
Where d1 = [ln(S/E) + d(rf + (1/2)s2)t] / (s2t)1/2
d2 = d1 - (s2t)1/2
22.9 · How can the firm be expressed in terms of call options?
Bondholders own the firm and have written a call to stockholders with an exercise price equal to the promised interest payment.
· How can the firm be expressed in terms of put options?
Stockholders own the firm and have purchased a put option from the bondholders with an exercise price equal to the promised interest payment.
· How does put-call parity relate these two expressions?
A call option's payoff is the same as the payoff from a combination of bung a put, bung the underlng stock and borrowing at the risk-free rate. Consequently, puts and calls can always be stated in terms of the other.
22.12 · Why are the hidden options in projects valuable?
Even the best laid plans of men and mice often go astray. The option to adapt plans to new circumstances is a valuable asset.
CONCEPT QUESTIONS - CHAPTER 23
23.1 · Why do companies issue options to executives of they cost the company more than they are worth to the executive? Why not just give cash and split the difference? Wouldn’t that make both the company and executive better off?
One of the purposes to give stock options to CEOs (instead of cash) is to bond the performance of the firm’s stock with the compensation of the CEO. In this way, the CEO has an incentive to increase shareholder value.
23.2h What are the two options that many businesses have?
Most businesses have the option to abandon under bad conditions and the option to expand under good conditions.
h Why does a strict NPV calculation typically understate the value of a firm or a project?
Virtually all projects have embedded options, which are ignored in NPV calculations and likely leads to undervaluation.
CONCEPT QUESTIONS - CHAPTER 24
24.2 · What is the key difference between a warrant and a traded call options?
When a warrant is exercised, the number of shares increases. Also, the Warrant is an option sold by the firm.
· Why does dilution occur when warrants are exercised?
Because additional shares of stock are sold to warrant holders at a below market price.
· How can the firm hurt warrant holders?
The firm can hurt warrant holders by taking any action that reduces the value of the stock. A typical example would be the payment of abnormally high dividends.
24.4 · What are the conversion ratio, the conversion price, and the conversion premium? The conversion ratio is the number of shares received for each debenture. The conversion
price is equivalent to the price which the holders of convertible bonds pay for each share of common stock they receive. The conversion premium is the excess of the conversion price over the common stock price.
24.5 · What three elements make up the value of a convertible bond.
Convertible bond value = Greater of (straight bond value and conversion value) plus option value.
· Describe the payoff structure of convertible bonds?
It is the value of the firm if the value of the firm is less than total face value. It is the face value if the total face value is less that the value of the firm but greater than its conversion value. It is the conversion value if the value of the firm and the conversion value are greater than total face value.
24.6 · What is wrong with the simple view that it is cheaper to issue a bond with a warrant or a convertible feature because the required coupon is lower?
In an efficient capital market the difference between the market value of a convertible bond and the value of straight bond is the fair price investors pay for the call option that the convertible or the warrant provides.
· What is wrong with the Free Lunch story?
This story compares convertible financing to straight debt when the price falls and to common stock when price rises.
24.7 · Why do firms issue convertible bonds?
1. To match cash flows, that is, they issue securities whose cash flows match those of the firm. 2. To bypass assessing the risk of the company (risk synergy). The risk of company start-ups is hard to evaluate.
3. To reduce agency costs associated with raising money by providing a package that reduces bondholder-stockholder conflicts.
24.8 · Why will convertible bonds not be voluntarily converted to stock before expiration? Because the holder of the convertible has the option to wait and perhaps do better than what is implied by current stock prices.
· When should firms force conversion of convertibles? Why?
Theoretically conversion should be forced as soon as the conversion value reaches the call price because other conversion policies will reduce shareholder value. If conversion is forced when conversion values are above the call price, bondholders will be allowed to exchange less valuable bonds for more valuable common stock. In the opposite situation, shareholders are giving bondholders the excess value.
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