Chapter 14 - An Overview of Corporate Financing

CHAPTER 14
An Overview of Corporate Financing

Answers to Problem Sets

1. a. False. Net equity issues have been negative, meaning that share
repurchases have been larger than share issues.

b. True

c. True
 
Est. Time: 01 – 05

2. a. 80 votes

b. 10 X 80 = 800 votes.
 
Est. Time: 01 – 05

3. a. Subordinated

b. Floating rate

c. Convertible

d. Warrant

e. Common stock; preferred stock

 
Est. Time: 01 – 05

4. a. False. About half of all common stock is held by financial institutions,

such as mutual funds, pension funds, and insurance companies.

b. True

c. False. An investor can buy and sell units of a partnership.

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Chapter 14 - An Overview of Corporate Financing

Est. Time: 01 – 05

5. One would expect that the voting shares have a higher price because they
have an added benefit/responsibility that has value.

Est. Time: 01 – 05

6. a.
Gross Profits $ 760,000
Interest on Debt 100,000
Earnings before Taxes (EBT) $ 660,000
Tax (at 35%) 231,000
Funds Available to Common Shareholders $ 429,000
b.
Gross Profits (EBT) $ 760,000
Tax (at 35%) 266,000
Net Income $ 494,000
Preferred Dividend (8% on $1 million) 80,000
Funds Available to Common Shareholders $ 414,000

Est. Time: 06 – 10

7. a. Less valuable. The option to repay provides value to the borrower.

b. More valuable. If the company’s share price rises, the bondholder

can exchange the bond for shares. If the share price goes down, the
bondholder is under no obligation to convert the bond to shares,
thereby protecting the investment.

c. More valuable. The collateral provides extra protection for the

lender.

d. Less valuable. Subordinated debt is only paid after senior debt is

paid. The lender therefore has more risk.

Est. Time: 01 – 05

8. Answers will differ.

Using the timeline prepared by the New Fed

(www.ny.frb.org/research/global_economy/Crisis_Timeline.pdf), some key events of
the financial crisis include:

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Chapter 14 - An Overview of Corporate Financing

June 2007: Bear Stearns pledges $3.2 billion to aid one of its ailing hedge funds.
Sept. 2007: Northern Rock receives emergency funding from the Bank of England.
Oct. 2007: Citigroup begins a string of writedowns based on mortgage losses.
Dec. 2007: Fed establishes Term Auction Facility lines.
Jan. 2008: Ratings agencies threaten to downgrade Ambac and MBIA (major
bond issuers).
Feb. 2008: Economic stimulus package is signed into law.
Mar. 2008: JPMorgan purchases Bear Stearns with support from the Fed.
Mar. 2008: SEC proposes ban on naked short selling.
July 2008: FDIC takes over IndyMac Bank.
Sept. 2008: Lehman is forced into bankruptcy.
B of A purchases Merrill Lynch.
10 banks create $70 billion liquidity fund.
AIG debt is downgraded.
RMC money market fund “breaks the buck.”
Treasury bailout plan is voted down in the House.
Oct. 2008: 9 large banks agree to capital injection from Treasury.
Revised bailout plan passes in House.
Consumer confidence hits lowest point on record.
Dec. 2008: NBER announces recession began in Dec 2007.
Treasury injects $5 billion in GMAC.
Feb 2009: Treasury announces Capital Assistance Program.
Fed expands Term Auction Facility lines.
May 2009: Fed releases results of bank stress tests.

Est. Time: 16 – 20

9. Answers will differ. Some purported causes of the financial crisis include:

 Long periods of very low interest rates leading to easy credit conditions
 High leverage ratios
 The bursting of the U.S. housing market bubble
 High rates of default on subprime mortgages
 Massive losses on investments in mortgage-backed securities
 Opaque derivative markets and amplified losses through credit default swaps
 High rates of unemployment and job losses

Est. Time: 16 – 20

10. a. For majority voting, you must own or otherwise control the votes of a
simple majority of the shares outstanding, i.e., one-half of the shares
outstanding plus one. Here, with 200,000 shares outstanding, you
must control the votes of 100,001 shares.

b. With cumulative voting, the directors are elected in order of the total
number of votes each receives. With 200,000 shares outstanding

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Chapter 14 - An Overview of Corporate Financing

and five directors to be elected, there will be a total of 1,000,000

votes cast. To ensure you can elect at least one director, you must
ensure that someone else can elect at most four directors. That is,
you must have enough votes so that, even if the others split their
votes evenly among five other candidates, the number of votes
your candidate gets would be higher by one.
Let x be the number of votes controlled by you, so that others control
(1,000,000 - x) votes. To elect one director:
1,000,000  x
x   1
5
Solving, we find x = 166,666.8 votes, or 33,333.4 shares. Because
there are no fractional shares, we need 33,334 shares.

Est. Time: 11 – 15

11. Holderness defines “diffuse ownership” as the absence of investors holding

large blocks of stock. A “block” is defined as a holding of at least 5% of
outstanding shares. He finds that block holdings are frequent for U.S.
companies, as in other countries. But block ownership is not the only
indication of how ownership is structured. For example, diversified business
groups are more common in other countries than in the U.S. Also family
control of business groups is more common outside the U.S. See the article
by La Porta, et al., and also Chapter 33.

Est. Time: 11 – 15

12. One could write a book on this topic – as Reinhart and Rogoff did. Here are
some points to start. First, unlike earlier banking crises, the crisis of 2007-
2009 was triggered by securitization and the over-expansion of the subprime
mortgage market in the U.S. Second, the recent crisis was not confined to
one country. It propagated from the U.S. through most of Europe.

Est. Time: 11 – 15

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in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.