5. Bonds vs Equity, Leverage

Question 1

When a company raises finance it has two broad choices – to raise money by

Answer 1

• Borrowing - bonds, bank loands
• Selling more equity

Question 2

what is leverage

Answer 2

the proportion of debt finance compared to equity finance in the company
- leverage increases when debt proportion rises
- leverage decreases when equity proportion rises

Question 3

what is the consequence of larger leverage

Answer 3

The larger the leverage, the more the gain to the shareholders is magnified.

Question 5

what are the 2 things that have an impact on how much borrowing companies have:

Answer 5

• How much lenders are willing to lend (risk), and how much they interest they charge for that lending. (higher risk = higher interest rate - borrowing expensive)
• The fact that, if the company does not perform well, a larger proportion of borrowing will have the opposite effect on the equity value
  
  • If it does badly → debt repayments crush profits and shareholders lose more. (come last)

Question 6

What happens to risk, simplistically, as a company borrows more?

Answer 6

more a company borrows, the greater the risks

Question 7

Why can the proportion of debt not go beyond a certain level?

Answer 7

presents too large a risk for the lenders to be willing to lend.

Question 8

What happens to a company’s credit rating assessment as the proportion of debt increases and what is the impact?

Answer 8

FALLS
- make the borrowing more expensive (higher interest), perhaps prohibitively so.