Suggested Solution

Test-9

Question.1
(i) D Short-term loans are subject to a loan agreement giving the bank security and a definite repayment
schedule. This lowers the risk from their perspective, hence the interest rate charged is lower.

(ii) A Ordinary shares are most risky from the debt holder's perspective – the company can decide whether
and how much of a dividend to pay.
Preference shares are next most risky – dividends are only payable if profit is available to pay
dividends from.
Trade payables are next because they have to be paid before shareholders but are typically
unsecured.
Finally, banks with fixed and floating charges face least risk.

(iii) D Zero coupon bonds are issued at a discount to their redemption value and do not pay any interest.

(iv) D Retained Earning

Question.2
(a) 12%
(b) $12

Question.3
Discount factor
Years 10% Present valu
$ $
1-3 Interest 12 2.487 29.84
3 Redemption 120 0.751 90.12
Premium ______
Value of debt 119.96

Question.4
(a)
Venture capital is normally provided to a private by a specialized investment institution. Management has to give a
proper business plan. Venture capital will demand an exit route for its investment.

Business angels are wealthy individuals who purchase equity shares. They don’t participate in business management.

(b)
Feature Bank loans Loan stock
Flexibility Terms are flexible Terms are fixed
Confidentiality Only bank will require Customer will have to fulfil the publicity requirements that
information an issue of loan stock on the financial markets would need
Speed Quick to arrange Slower to arrange due to the need to fulfil the requirements
of a public issue
Costs Low cost High issuance costs
Restrictions Security (collateral) and Much less restrictive
covenants are required
Financial Detailed financial No such submissions required
information information is required
 Suggested Solution
Test-9

(c)
Irredeemable:
It will never be repaid. Debt holder will only receive interest income.
Redeemable:
Redeemable debt will be repaid and cancelled

(d)
Feature Ordinary shares Preference shares

Dividend rate Variable – as per profit Fixed e.g. 7% per annum

Dividend Paid only if there are spare funds after the Receives the dividend before ordinary
distribution payment of a preference dividend shareholders (therefore lower risk)

Liquidation The last to be repaid in a liquidation Repaid before (in preference to) the ordinary
shareholders
Voting rights Normally receive the right to vote on Typically receive no right to vote on company
major decisions. decisions.

Redemption Their investments are not normally Their investments are normally redeemable.
redeemable.

(e)
Direct investments: Indirect investment:
 Often required to fund the whole project.  Opportunity to invest with other investors in parts.
 Normally illiquid.  More liquid.
 Holding period is normally long term.  Holding period is normally medium term.