Chapter 2: Questions

Question 1

PQ2.1: Describe the risks associated with investing in debentures issued by large companies quoted on the stock exchange

Answer 1

A debenture is generally regarded as a low-risk investment because:
* it is secured against some or all of the assets of the business
* in the event of default, a receiver may be appointed to intercept income from the secured asset or to take possession of it to sell it in order to meet the payment
* trustees act on behalf of debenture holders and oversee their rights as set out in a loan agreement.
The main risks for the debenture holder are:
* falling profitability of the company (making coupon payments more difficult) and falling asset values
* falling real values of the fixed nominal coupon payments as a result of inflation
* relatively low marketability (compared with government bonds) because of relatively small issues and relatively infrequent trading
* a capital loss arising from a fall in the price of the debenture in the market resulting from a rise in interest rates.

Question 2

PQ2.2.1: Describe the characteristics of ordinary shares:

Answer 2

• Ordinary shares are the lowest ranking form of finance issued by companies. If the company were wound up, ordinary shareholders would be the last to receive any
  proceeds arising from the sale of the company’s assets.
• Owners of ordinary shares are part-owners of the company.
• Ordinary shareholders usually get voting rights in proportion to the number of shares held.
• Ordinary shares offer investors high potential returns for high risk, particularly the risk of capital losses. The expected overall future return on ordinary shares is generally higher than for most other classes of investments to compensate for the greater risk of default, and for the variability of returns.
• The profit after interest and tax have been paid is available for distribution to the ordinary shareholders, but the company might not pay it all to the shareholders. The cash paid out each year is called the dividend; the remaining profit (if any) is retained in the business.
• Dividends are not a legal obligation of the company but are paid after loan stock holders and preference shareholders and only at the discretion of the directors.
• Dividends usually increase with inflation and the real growth in a company’s earnings.
• The marketability of ordinary shares varies according to the size of the company but is generally good due to the large number of shares issued.

Question 3

PQ2.2.2: Describe the characteristics of Eurobonds

Answer 3

• A Eurobond is a form of unsecured medium or long-term borrowing. Eurobonds are issued by large companies, governments and supra-national organisations in the Euromarket.
• They are issued in many currencies.
• They are outside the tax and legal jurisdiction of any country. Eurobonds are bearer bonds; there is no central register of ownership.
• The bonds pay regular interest payments (usually once a year) and a final capital repayment usually at par.
• The risk is generally lower than that of other unsecured loan stock since the issuers tend to be large, stable organisations.
• Marketability tends to be higher than other loan stock because issues tend to be quite large.
• The return depends upon the issuer (and hence risk) and issue size (and hence marketability).
• They often have novel features due to the absence of government regulations.

Question 4

PQ2.2.2: Describe the characteristics of convertible bonds

Answer 4

• Convertible bonds are unsecured loan stocks that can be converted into ordinary shares of the issuing company.
• Convertible bonds combine the lower risk of loan stock with the potential for large capital gains of an ordinary share.
• The date of conversion might be a single date or, at the option of the holder, one of a series of specified dates.
• If the holder chooses not to convert, the convertible might remain as unsecured loan stock or it might be redeemed at the conversion date.
• They have a stated annual interest payment, usually paid in two instalments.
• The interest paid is generally lower than that on conventional loan stock because of the value of the option to convert.
• The characteristics become more like those of the security into which it is likely to convert, as the date of conversion approaches.

Question 5

PQ2.3: Explain why a small business should take care in managing its overdraft:

Answer 5

• A company’s bank can demand immediate repayment of an overdraft with no notice. If the bank is concerned that the overdraft is being used incorrectly or is at risk of not being repaid, then the bank may withdraw the facility, leaving the company without a means of settling its bills and damaging its relations with other creditors.
• If the company exceeds its overdraft limit the bank may penalise it financially. The company’s credit rating may suffer if the overdraft is abused, which would damage the company’s ability to obtain credit in future.
• Overdrafts are expensive. If an overdraft is used instead of a more suitable (ie cheaper) method of funding, the interest charges and fees may adversely affect the company’s profits.

Question 6

PQ2.4.1: Describe the characteristics of certificates of deposit as an investment

Answer 6

• A certificate of deposit is a certificate issued by a bank stating that some money has been deposited with it for a fixed term.
• Interest and the principal is payable on maturity.
• The interest can be fixed at the outset or it can vary over the term of the deposit.
• Certificates can be bought and sold during the term.
• The risk and marketability and hence the return will depend on the issuing bank

Question 7

PQ2.4.2: Describe the characteristics of commercial property as an investment

Answer 7

• Commercial property includes land and buildings in the form of offices, shops, and factories.
• Investment in property incurs high transactions costs of buying and selling, eg estate agent fees or surveyor fees.
• There may be renovation costs as well as ongoing maintenance costs.
• The return from investing in property comes from rental income and from the potential capital gain on sale.
• Rental terms are specified in lease agreements and are reviewed at specific intervals, typically every three to five years.
• Property is a ‘real’ investment with rents and capital values expected to increase in line with inflation in the long term.
• Rental income is not guaranteed, as there may be times when the property is empty.
• Capital values are not guaranteed either, as property prices can fluctuate over time.
• This makes commercial property a high-risk investment.
• The large unit sizes involved mean that property is less divisible and hence a less flexible investment than, say, equities.
• Each property is unique and so can be difficult to value.
• Valuation requires an experienced surveyor and can be expensive.
• Property investments can be difficult to sell.
• It is easier to obtain finance for investment in property than for other investments since property is immobile.

Question 8

PQ2.4.3: Describe the characteristics of government bills as an investment

Answer 8

• Government bills (known as Treasury bills in the UK and the US) are issued by governments to fund their short-term spending requirements.
• They are issued at a discount and redeemed at par with no coupon.
• The return is typically quoted as a simple rate of discount for the term of the bill.
• They are highly secure and highly marketable.
• The return is consequently low and is regarded as the risk-free return for short-term investment within an economy

Question 9

PQ2.4.4: Describe the characteristics of index-linked government bonds as an investment

Answer 9

• Government bonds are issued by governments to fund their long-term spending plans.
• In return for the purchase price of the bond, an investor receives a series of regular interest payments, known as coupons, and a redemption payment at maturity.
• In the case of index-linked bonds, the coupons and the redemption payments received are linked to an inflation index between the date of issue of the bond and the date of the payment.
• For administrative reasons, there may be a time lag in the inflation index used to calculate the payment amounts.
• Since the cashflows are linked to an inflation index, index-linked bonds are (almost) risk-free relative to inflation.
• As they are issued by governments, they are considered to be a secure investment.
• They are usually quite marketable, as they are desired by those investors seeking inflation protection.
• Due to the high security and good marketability, index-linked bonds offer a relatively low expected real rate of return.

Question 10

PQ2.5: A company listed on the stock market is not performing in a satisfactory manner. Explain how market forces might discipline the managers of this company.

Answer 10

• The goal of the managers is assumed to be the maximisation of shareholder wealth. However, managers of companies often have different objectives that may be based on their own personal goals rather than those of the shareholders.
• Ultimately, if shareholders’ preferences are not being taken into account by the managers of the company, shareholders will discipline the managers via the Board of Directors or sell the shares causing the share price to fall. Managers can be disciplined by a fall in salary or perks or indeed by losing their job.
• If the share price falls, this will leave the company open to attack by predators, and the management may be removed as part of the takeover.
• The presence of the capital markets’ continuous assessment therefore stimulates efficiency and provides incentives to business managers to improve their performance.
• Shareholders can bring market forces to bear on the managers by rewarding them in relation to the share price performance or through performance-related pay and bonuses. This can be achieved by awarding shares or share options to the managers – the managers will then be incentivised to maximise the value of the shares by behaving in accordance with the shareholders’ preferences