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Complete Test Bank Corporate Finance 12th Edition Ross Questions & Answers with rationales (Chapter 1-31)
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Test Bank for Corporate Finance 12th Edition Ross / All Chapter 1 - 31 Updated 2023
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TEST BANK FOR CORPORATE FINANCE 11TH EDITION BY STEPHEN ROSS, RANDOLPH WESTERFIELD, JEFFREY JAFFE, BRADFORD JORDAN
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CourseHero Chapter 1, 2, 6, 7, 11 notesJanuary 16, 2021 4:36 PM
CHAPTER 1 – The Capital Market
Financial markets drive economic growth by transforming savings into investments. The
three components of wealth transfer are: financial instruments, financial markets, and
financial intermediaries.
Suppliers and Users of Investment Capital
Capital can be used through:
1. Direct Investment (Land, buildings, human capital)
2. Indirect Investment (Financial Assets like stocks and bonds, wealth-generating assets)
Capital is mobile, scarce, and sensitive
It comes from retail and institutional investors and goes towards corporations and
government. Foreign investments play a large role, and there are two main kinds of bonds:
foreign bonds and Eurobonds – denominated in some currency and sold in other countries.
Investment Objectives:
1. Safety
2. Income
3. Growth
One security cannot maximize two or more of these objectives, so they are mutually
exclusive. If you want to maximize safety, you must sacrifice income or growth. Short-term
bonds to preferred to common stocks range from safest to most risky, and from steady
income with limited growth to variable income with highest growth.
For governments, a lower yield signals a steadier economy. They offer T-bills, marketable
bonds, and Canada Savings Bonds.
Financial instruments are formal docs that set out rights and obligations of the parties
involved.
Debt instrument represent a legal obligation to repay borrowed funds at a specific time, such
as bank loans, commercial paper, T-bills, bonds, debenture, etc.
Equity instruments represent part-ownership of a company, such as common and preferred
shares.
Investment Funds are companies that manage investments for clients, like mutual funds.
Derivative Products derive their value from the price of another asset like a stock, stock
index, commodity price, etc. They’re suited for hedging or speculative purposes.
Other Investment Products include income trusts, exchange-traded funds, etc.
Primary Markets – involve the sale of securities to the market by the issuer (capital
formation). Secondary markets involve the sale of previously issued securities (no funds go
to the issuer).
Chapter 2 – The Canadian Securities Industry
Financial INTERMEDIARIES facilitate the transfer of capital from suppliers to users. There
are different types, such as banks and trust companies that accept deposits from capital
suppliers and lend to capital users. Investment funds and insurance companies collect
money and invest in securities.
Primary Markets –new issue market where investment dealers act as principals or agents.
Underwriting or financing – the purchase of new securities from the issuer on a given date at
a specified price, which is then sold to others. ID’s serve as principals, and their
TEXTBOOK NOTES Page 1
,a specified price, which is then sold to others. ID’s serve as principals, and their
compensation is the spread b/w the purchase and resale price. They assume the risk of the
security not selling, but often form underwriting syndicates to decrease risk and increase
marketability of the shares.
IDs can also be agents who market the new securities on a best efforts basis. They receive
commission, but it is the issuer that assumes the risk. This is typical for smaller speculative
companies or private placements for large companies with good credit ratings.
Secondary Markets – facilitate the transfer of existing securities among investors. IDs can
also act as principals by trading securities from their own inventory and when they trade for
their own account. They assume the majority of the risk. ID’s are brokers/agents when they
execute transactions for customers and charge them commissions. There is no min. for
commissions, so many discount brokerage firms with a do-it-yourself attitude has developed
over the years.
Agency Transaction – clients instructing their IDs to get the best possible price (market
order), and once it goes through on the exchange’s ticker, the details of the trade go to the
buyer and seller. The firms phone their clients to confirm the transaction and mail written info
to them.
Afterwards, they must settle the transaction and hand over the money. They must provide
funds by the settlement date (usually 3 days after the trade).
Chartered BANKS
Banks gather funds through savings deposits or certificates of deposit, and transfers them to
users in form of loans. They make the spread between what they charge for loans and what
they pay for deposits, as well as service fees.
Schedule I Banks: Widely held, with no investor holding more than 20% and foreign
ownership more than 25%. The Big Six banks in Canada account for over 83% of bank
assets: RBC, CIBC, BMO, Scotiabank, TD, and National.
It’s important that they keep a large reserve of liquid assets, but it’s not a legal requirement.
Usually it is 13.5%.
Schedule II Banks: incorporated and operate in Canada, but are subsidiaries of foreign
banks.
They can accept deposits, and there was only 24 in 2007.
Schedule III Banks: Branches of foreign banks that can accept deposits and provide loans –
not subsidiaries but branches.
Banks with equity over $5 billion must have maximum 20% control for any individual or
group. Medium banks with $1-5 billion can have a single owner hold up to 65%, if the
remaining are traded publicly. Small banks don’t matter.
Recently, banks moved into the securities business and can offer trust, insurance, and
investment counselling/portfolio management services to clients.
“Chinese Walls” – controls to restrict the flow of info b/w various bank business segments.
OTHER INTERMEDIARIES
Trust and Mortgage Companies – although they offer similar services of banks, they are
distinct because they are the only type of corporation in Canada permitted to act as trustees
in charge of corporate or individual financial assets.
Credit Unions and Caisses Populaires – cooperative, member-owned businesses that
provide basic financial services to members. Has a prudent portfolio approach.
Life Insurance Companies – May act as trustees for funds they get from policyholders. Since
most arelong-term, they invest in mortgage and long-term bonds. Also required to have a
prudent portfolio approach, and can own trust companies through subs. Demutualization has
occurred, meaning policyholders are being replaced by shareholders.
Property and Casualty Insurance Companies – Similar, but smaller than life insurance
companies, and liquidity a primary investment objective.
Investment Funds – can be a corp or a trust. They sell shares to the public and invest
proceeds in portfolios of securities. Closed-end funds issue shares at the start-up, and open-
end funds (mutual funds) issue and redeem shares on a continuous basis. 95% of funds
invested are these.
Savings Banks – take deposits but do not offer lending services – 100% guaranteed
TEXTBOOK NOTES Page 2
,Savings Banks – take deposits but do not offer lending services – 100% guaranteed
deposits.
Pension Plans – Pension contributions are made to a trustee who manages it (trust or
insurance co.) They buy government and corporate debt, as well as investment-grade
common shares to protect against inflation. Cannot invest more than 20% of assets in
foreign securities.
Sales Finance and Consumer Loan Companies – direct cash loans to consumers and buy
instalment sales contracts from retailers and dealers at a discount
Business Development Bank of Canada –federal agency whose mandate is to provide fixed-
term financing to small businesses.
CHAPTER 6: Fixed Income Securities: Features and Types
A fixed income security provides a known income stream to the holder and has a known
maturity date. A traditional type pays interim interest or dividends, such as bonds,
debentures, mortgages, swaps, and preferred shares. For discounted fixed income
securities, the return is the increase in principal value, which is like income, not capital gains.
They include strip (0 coupon) bonds and T-Bills.
Bonds are debt instruments that are secured by real assets and are often called mortgage
bonds. A Bond trust indenture is a legal contract.
Term to Maturity – the remaining life of the bond. Medium Length Bonds – 3-10 years.
Liquid bonds have significant trading volumes. Negotiable bonds are in deliverable form, and
marketable bonds are those for which there is a ready market.
Bond Features
Interest is generally paid semi-annually.
Floating Rate Bonds – have adjustable coupons that are tied to short-term interest rates.
They offer protection in times of interest volatility and act like secure money market
securities.
Callable/Redeemable Bonds – give the issuer the option to “call” or repurchase outstanding
bonds at predetermined call prices (premiums) at specific times. Usually the issuer has to
give a 30 day notice. Redemption price is based on a scale, and gets lower as time to
maturity declines. Most corporate bonds have a Canada yield call attached, which permit the
issuer to call the issue at a price based on the yield of a Government bond with the same
maturity and yield spread (premium).
Sinking Fund Provisions – Require the issuer to rebuy a certain amt of debt per year; it helps
them avoid having to come up with the entire face value of the issue at maturity. To
bondholders, this repurchase isn’t always favourable, and there is often no premium.
Purchase Fund Provisions – they require the repurchase of a certain amount of debt only if
that debt can be bought at or below a given price. These are advantageous to debt holders.
Retractable Bonds – allows the holder to sell the bonds back to the issuer at predetermined
prices at specified times. Extendible Bonds allow them to extend the maturity, and since
both these types are advantageous to the holder, they pay more for those bonds.
Convertible Bonds – may be converted into common shares at predetermined prices. This is
afforded to the investor to make the issue more saleable and reduce the interest rate
offered. Most of these are callable, and prices increase over time.
When the conversion price is well below the market price, convertibles trade like debentures.
A premium appears as market price approaches conversion price. When market price
exceeds the conversion, it is said to “sell of the stock”.
Protective Covenants – clauses in the trust indenture that restrict actions of the issuer, which
can be negative or positive. Common examples include:
Prohibition of a Prior Lien – prohibits the issue of securities that would rank senior to the first
mortgage bond payments. Debentures include negative pledge provisions, which preclude
TEXTBOOK NOTES Page 3
, mortgage bond payments. Debentures include negative pledge provisions, which preclude
the issue of additional bonds that are secured by company properties unless they
receive similar collateral.
Closed End Mortgages – prohibits the issue of new bonds based on the same
assets/collateral from original bonds.
Open End Mortages – include general provisions limiting the issue of new bonds to provide
a proper margin of safety.
Sinking Fund Clause – require the issuer to maintain a certain working capital and/or restrict
dividend payments so that repayments of debt are easier.
Covenants often prohibit companies from entering into sale and leaseback arrangements,
selling assets by sale or merger, and disposing/issuing debt or shares of a subsidiary.
Government of Canada securities
Marketable Bonds – Have a specified interest payments and are transferable. Non-Callable.
Treasury Bills – short-term government obligations that are sold at a discount from face
value.
Quite large, but now they come in shares of $1000 with a min. of $100,000 per purchase.
Canada Savings Bonds – can be cashed out by the owner at their full par value and interest
at any bank in Canada. Not transferable, and sold in registered form to provide protection
against loss. Corporations are not allowed to buy these (only individuals, estates, and
trusts). The rate of return is allowed to vary in order to avoid cash-out rushes. They can pay
REGULAR INTEREST, or COMPOUND INTEREST
Include: Canada Premium Bonds – can only be redeemed once a year, and provide a higher
rate than CSBs.
Canada RSP and RIF Options – permit Canadians to hold CSBs in government RRSP w/o a
self- plan.
Canada Investment Bonds – offered through investment dealers and has a fixed rate until
maturity. They offer higher rates than CSBs or CPBs.
Through the provincial government, Direct bonds are issued directly by the government,
while Guaranteed Bonds are issued in the name of a crown corporation and guaranteed by
the prov. Govt
Municipal gov’t issue instalment debentures or serial bonds to raise money.
Corporate Bonds
Mortgage bonds – secured by real property such as land or buildings. First MB are called
Senior Securities because they have the first claim to assets.
Collateral trust bonds – secured by a pledge of other financial assets like shares, bonds, and
T- bills.
Equipment trust certificate – secured by equipment, which are leased until the loan is over.
Corporate debentures – similar to bonds but unsecured, or by a general floating charge over
the company’s leftover assets.
Subordinated debentres/corporate notes – unsecured promises to pay interst and principal.
Secured loans or collateral trust notes are secured by the assets purchased with the loan,
such as cars. Secured term notes are traded in the money market.
BONDS must be:
1. Domestic
2. Foreign – issued in a country other than the issuer’s (A CAD company issueing bonds in the
US in US dollars). Foreign-pay bonds are those whose payments are made in a foreign
currency.
3. Eurobonds – issued in a country other than the issuer’s, but in the issuer’s currency (a CAD
company issuing bonds in GERMANY in U.S. or CAD dollars).
TEXTBOOK NOTES Page 4
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