I recently had an Ibanking interview and I was wondering what the best/correct answer would be to the following 1) A company is going to build a mine, why would the company finance debt as oppose to equity or vice versa? 2) Why would a company issue convertible debt? What is the benefit? I think that they would pay a lower interest rate, but not sure 3) what effect would re-capitalizing debt for equity (buy back shares and issue debt) have on the P/E ratio?
Those are pretty straightforward. CFAI curriculum covers them all
iteracom Wrote: ------------------------------------------------------- > Those are pretty straightforward. CFAI curriculum > covers them all answer?
- could be due to capital structure reasons. in addition, there is a pecking order in terms of raising capital. issuing equity is usually last on the list. 2) convertible debt gives the bond holder an option which has value. because of this, they could issue debt at a cheaper cost, in terms of interest costs…However, they will potentially be dilutive to the equity holders. 3) not sure at this point.
Jay5150 Wrote: ------------------------------------------------------- > 1) could be due to capital structure reasons. in > addition, there is a pecking order in terms of > raising capital. issuing equity is usually last on > the list. > > 2) convertible debt gives the bond holder an > option which has value. because of this, they > could issue debt at a cheaper cost, in terms of > interest costs…However, they will potentially > be dilutive to the equity holders. > > 3) not sure at this point. 1) agreed, raising equity is last resort 2) again, probably couldnt raise straight debt 3) E - doesn’t change, P - might or might not change, depending on market perception, usually it will go up, as equity purchase is a positive sign. In general issuing debt is the best source of financing possible.
Oh Johnny Boi you got a long way to go
For question 3) shouldn’t we assume that P will remain the same and that E will go down because of the interest expense from the debt? So the P/E ratio should go up?
wake2000 Wrote: ------------------------------------------------------- > Oh Johnny Boi you got a long way to go I already have my CFA, its just been a while since I was dealing with certain aspects of the material. Its in my brain somewhere
Jonnyboi Wrote: ------------------------------------------------------- > wake2000 Wrote: > -------------------------------------------------- > ----- > > Oh Johnny Boi you got a long way to go > > > I already have my CFA, its just been a while since > I was dealing with certain aspects of the > material. Its in my brain somewhere Dang boi, for being a charterholder you struggled with some gimmies. How long ago did you go through the program?
Jonnyboi Wrote: ------------------------------------------------------- > wake2000 Wrote: > -------------------------------------------------- > ----- > > Oh Johnny Boi you got a long way to go > > > I already have my CFA, its just been a while since > I was dealing with certain aspects of the > material. Its in my brain somewhere thats awesome
Jonnyboi Wrote: ------------------------------------------------------- > > > I already have my CFA, its just been a while since > I was dealing with certain aspects of the > material. Its in my brain somewhere If you honestly have the CFA charter, not knowing the answers to these basic questions is sad.
comp_sci_kid Wrote: ------------------------------------------------------- > 3) E - doesn’t change, P - might or might not > change, depending on market perception, usually it > will go up, as equity purchase is a positive sign. > > No, you are totally wrong about the “E”. If the firm buys back shares, of course E will change. E stands for “earnings PER SHARE” in case you didn’t know. It doesn’t stand for “All of earnings”. oh god. So, if the firm buys shares back, shares outstanding drops, so the E = “earnings PER SHARE” will increase, which will DROP your P/E multiple. Which is attractive for investors. — Now from here, you can speculate what the market will do now that the PE looks cheaper. Yes investors may be tempted to buy more, which will raise the PE. Very unlikely investors will sell, so the PE will not go down.
oh boy, embarassing you are absolutely right for some reason i thought of e as total earnings
wow that was saaad
and whats P in the numerator of the ratio? common equity PER SHARE? i just canceled out your PER SHARE dude
greengrape Wrote: ------------------------------------------------------- > No, you are totally wrong about the “E”. > I like my E with some sissurp.
Remember that they’re not purchasing shares with cash; they’re purchasing shares with debt. Total earnings will go down, because some of those earnings are now going to be used to pay interest on the new debt that was used to purchase back shares. Shares outstanding will go down. In general, the debt is going to carry an interest rate that is lower than the required return on equity (because it’s more senior in the capital structure), so it’s going to reduce the weighted average cost of capital and therefore raise the total enterprise value. As long as the interest rate is < required return on common equity, the final share price should go up, to reflect an increase in the earnings per share in the future (since a smaller % rate is paid to the debtholders, that leaves more for the remaining equity holders). Thus total earnings will go down, but earnings per share will go up. SO, the P/E ratio ought to go up, PROVIDED that the market thinks that the additional debt is sustainable. If it’s not sustainable, then the market will shun the stock and the price will go down. However, if the debt is not sustainable, that would probably be reflected in the interest rate on the debt. In the real world, people have to make some guesses, so there is probably a grey area at some point where it is hard to tell what will happen to the price and the P/E. So it really boils down to whether the interest on the debt is < the long term earnings yield (which is the inverse of the PE ratio).
exellent explanation bchad. in any case the fact that the number of shares change affects both the numerator and denominator of the ratio. P/E may very well be defined as common equity divided by total earnings. focusing exclusively on the fact that the shares outstanding get reduced won’t get you to the right answer
Jonnyboi Wrote: ------------------------------------------------------- > I already have my CFA, its just been a while since > I was dealing with certain aspects of the > material. Its in my brain somewhere I’d be willing to put alot of money down that Jonnyboi is NOT A CHARTERHOLDER…lol…that’s just obvious Almost seems like a waste of an Ibanking interview… I wish I could have taken it instead
bchadwick Wrote: ------------------------------------------------------- > Remember that they’re not purchasing shares with > cash; they’re purchasing shares with debt. > > Total earnings will go down, because some of those > earnings are now going to be used to pay interest > on the new debt that was used to purchase back > shares. Shares outstanding will go down. > > In general, the debt is going to carry an interest > rate that is lower than the required return on > equity (because it’s more senior in the capital > structure), so it’s going to reduce the weighted > average cost of capital and therefore raise the > total enterprise value. As long as the interest > rate is < required return on common equity, the > final share price should go up, to reflect an > increase in the earnings per share in the future > (since a smaller % rate is paid to the > debtholders, that leaves more for the remaining > equity holders). Thus total earnings will go > down, but earnings per share will go up. > > SO, the P/E ratio ought to go up, PROVIDED that > the market thinks that the additional debt is > sustainable. If it’s not sustainable, then the > market will shun the stock and the price will go > down. However, if the debt is not sustainable, > that would probably be reflected in the interest > rate on the debt. In the real world, people have > to make some guesses, so there is probably a grey > area at some point where it is hard to tell what > will happen to the price and the P/E. > > So it really boils down to whether the interest on > the debt is < the long term earnings yield (which > is the inverse of the PE ratio). Great explanation, thanks chad!