CTP Exam Quiz 09

Security measures
When a firm permits their information to be externally accessed via the internet, they should take measures to regulate that access and protect the information from unauthorized access. A firewall is a specific software program that acts as a filter for all incoming data. The incoming data must be approved before entering the firm’s computer system. Approval is based on the firm’s specific criteria. To prevent ‘eavesdropping’ of a firm’s communications, an encrypted protocol such as TLS (Transport Layer Security) or its predecessor SSL (secure socket layer) can be used. With this protocol, only one end of the communication is authenticated.

Security measures
To prevent ‘eavesdropping’ of a firm’s communications, an encrypted protocol such as TLS (Transport Layer Security) or its predecessor SSL (secure socket layer) can be used. With this protocol, only one end of the communication is authenticated. When it is necessary that both parties to the communication be authenticated, a Public Key Infrastructure (PKI) can be used. With PKI, there is a public key (i.e. PIN and password) and private key (i.e. a PIN, a password, and/or digital signature). The public key can be used by anyone to send data, messages, etc. The private key is required to access the information. Only authorized persons are allowed access to the private key.

Electronic networks
There are several ways a firm can communicate electronically. They can use the internet, an intranet, and/or an extranet. All of these networks can use any of the internet protocols like HTTP (Hypertext Transfer Protocol) and FTP (File Transfer Protocol). The main disadvantage to the internet is that it is accessible by the general public and firms typically do not want their internal processes available for such scrutiny. An intranet is only accessible by computers within the firm. Intranets are advantageous due to their inherent privacy and ease of securing.

Electronic networks
Since everyone within the firm has access to the same information, intranets help facilitate better communications and collaboration within a firm. Better communication improves worker productivity. An extranet is an expanded version of an intranet that permits access by trading partners. Extranets are advantageous because their trading partners can readily communicate financial information.
However, an extranet is mapped on the internet and is more exposed to unauthorized access. It is considered a virtual private network (VPN).

Raising capital
When a firm wants to raise capital it can be either through issuing debt or issuing equity and either of these methods can be private issue or public issue. Public issues of debt or equity are highly regulated because the general public is the market, and are generally expensive. Private issues are for a limited number of private entities like a trust company or other large institutional investor. Private issues can be more tailored to suit the investors, but are not as regulated or expensive.

Raising capital
Regardless of the method of raising capital, the firm’s treasury still needs to ensure that any terms of the issue are complied with. This includes ensuring that dividend and/or interest payments are made promptly, financial statements are complete and submitted, and that the raised capital is being allocated appropriately. The treasury also will need to communicate with bankers, investors including investment bankers, regulatory agencies to some degree, and auditors.

Issuing debt
Certain circumstances make issuing debt a profitable method of raising capital. For example, if a firm is profitable, has ample assets, and has a regular cash flow, then the inherent risk of issuing debt is low and the return on the debt can be substantial. Generally, the debt is profitable if it is to be used for something that will generate funds to repay the debt. Debt is more desirable than issuing equity because the interest payments are tax deductible and the payments are fixed.

Issuing debt
Debt is often preferred by certain investors since government issued debt, like municipal bonds, are generally tax free. Debt can be issued in short intermediate or long terms. The longer the time to maturity the higher the yield and so the more the borrower has to pay in the long run. Still, many firms rely on long term bonds to raise the bulk of their capital needs.

Bonds
When a firm chooses to raise capital through issuing debt, the debt instrument is called a bond. It is an agreement that states the borrower will repay the principal to the lender at a set time and may or may not include interest payments, depending on the kind of bond it is. There are many different kinds of bonds including mortgage bonds, unsecured bonds, callable bonds, convertible bonds, government bonds, industrial revenue bonds, zero coupon bonds, high yield bonds, and special purpose bonds that can be issued for very specific and/or one time project.

Bonds
Secured bonds are secured by the asset that is being financed such as with mortgage bonds. Unsecured bonds are also known as debentures and are based on the sound business reputation of the issuer. The other kinds of bonds have differing conditions imposed on them and may or may not be secured by the underlying asset. The government bonds for example could be based on the anticipated tax revenue or tied directly to the revenues associated with the financed asset.

Asset securitization
There are certain kinds of debt that were not considered liquid enough to be considered a good investment. However, asset securitization has made these kinds of debt highly liquid and marketable and has become more common in recent years. Residential mortgages are a good example of asset securitization. The GSEs (Government Sponsored Entities) like GNMA, FNMA and others consolidate their mortgages into marketable securities that pay a set amount to the investor.

Asset securitization
Essentially, the investor becomes the mortgage lender. In the case of mortgage debt, the security is considered a mortgage backed security (MBS). These securities are very liquid because many pension funds, foreign governments, and other institutional investors invest in MBS. Inventory and Accounts receivable are other examples of assets that can be securitized.

Off balance sheet financing
When a firm already has a high level of debt, yet still finds it necessary to raise capital, it can use a form of classifying that is considered ‘off balance sheet’ financing. For example, in operating leases an asset is leased and not technically financed. The lessee is only required to include the lease payment on the balance sheet, not the entire debt that would have been incurred to acquire the asset.

Off balance sheet financing
When a firm already has a high level of debt, yet still finds it necessary to raise capital, it can use a form of classifying that is considered ‘off balance sheet’ financing. For example, in operating leases an asset is leased and not technically financed. The lessee is only required to include the lease payment on the balance sheet, not the entire debt that would have been incurred to acquire the asset. Firms also use off balance sheet financing when added debt might violate any current debt terms. Off balance sheet financing is subject to numerous GAAP (Generally Accepted Accounting Principles) rules that specify when a lease should be capitalized and not expensed.

Bond Indentures and Covenants
When a firm does issue debt equity in the form of a bond, it becomes subject to a variety of contractual conditions, restrictions, and obligations imposed by the bondholders. The conditions include the confirmation that the firm is a legal entity, that it is in compliance with federal regulations such as the Employee Retirement Income and Security Act (ERISA), that the bondholder will not be held liable for environmental violations, and that the bond issue is authorized.

Bond Indentures and Covenants
The restrictions generally prohibit the firm from engaging in activity that will increase risk of default, such as issuing more debt, and the obligations generally include the requirement that the firm maintain specified financial ratios and make regular financial reports. Collectively these legal contracts are known as bond Indentures and Covenants. They are designed to protect the bondholder’s interests as opposed to the equity holder’s interest.

Off balance sheet financing
When a firm already has a high level of debt, yet still finds it necessary to raise capital, it can use a form of classifying that is considered ‘off balance sheet’ financing. For example, in operating leases an asset is leased and not technically financed. The lessee is only required to include the lease payment on the balance sheet, not the entire debt that would have been incurred to acquire the asset. Firms also use off balance sheet financing when added debt might violate any current debt terms. Off balance sheet financing is subject to numerous GAAP (Generally Accepted Accounting Principles) rules that specify when a lease should be capitalized and not expensed.

Bond Indentures and Covenants
When a firm does issue debt equity in the form of a bond, it becomes subject to a variety of contractual conditions, restrictions, and obligations imposed by the bondholders. The conditions include the confirmation that the firm is a legal entity, that it is in compliance with federal regulations such as the Employee Retirement Income and Security Act (ERISA), that the bondholder will not be held liable for environmental violations, and that the bond issue is authorized. The restrictions generally prohibit the firm from engaging in activity that will increase risk of default, such as issuing more debt, and the obligations generally include the requirement that the firm maintain specified financial ratios and make regular financial reports. Collectively these legal contracts are known as bond Indentures and Covenants. They are designed to protect the bondholder’s interests as opposed to the equity holder’s interest.

Rights of bond holders
A bond is a debt agreement that requires, among other things, a firm to pay interest to the bondholder until the bond maturity at which time the face value of the bond is repaid in entirety. Generally, the bondholders have the right to demand that their bonds be repaid immediately (even if this causes the firm to go into default) if the firm fails to conform to the specified indentures and contracts. Since bondholders have seniority over equity holders, the bond holders are the first to receive payment in the event that the firm does ultimately file for bankruptcy. However, there is usually a cure period when the firm is granted time to make the necessary corrections regarding late payments or other violations without immediate recourse by the bondholders.

Rights of bond holders
A bond is a debt agreement that requires, among other things, a firm to pay interest to the bondholder until the bond maturity at which time the face value of the bond is repaid in entirety. Generally, the bondholders have the right to demand that their bonds be repaid immediately (even if this causes the firm to go into default) if the firm fails to conform to the specified indentures and contracts. Since bondholders have seniority over equity holders, the bond holders are the first to receive payment in the event that the firm does ultimately file for bankruptcy. However, there is usually a cure period when the firm is granted time to make the necessary corrections regarding late payments or other violations without immediate recourse by the bondholders.

Calling a bond, a sinking fund, and defeasance of debt
When a firm chooses to raise capital by issuing debt (i.e. bonds), it will be subject to several indentures and covenants. However, it can also include in the debt agreement provisions that could provide an opportunity to reduce the total debt. For example, to account for the possibility of more favorable interest rates for refinancing purposes, the firm could include the right to call in the bonds for early redemption. A sinking fund provision states that the firm will regularly repurchase some portion of the total issued bonds.

Calling a bond, a sinking fund, and defeasance of debt
A sinking fund provision states that the firm will regularly repurchase some portion of the total issued bonds. Alternatively a sinking fund can require that the firm keep a trust fund that will pay all bond obligations at their maturity. A sinking fund basically minimizes risk of default. A defeasance of debt is similar to a sinking fund in that they both essentially minimize the debt. However, a defeasance of debt removes the debt from the balance sheet because the bond issuer sets aside funds that will offset the cost of the bonds. This will void the debt.

Secured and unsecured loans
Debt can either be secured or unsecured. If the debt is secured by collateral (i.e. an asset, inventory, other securities etc.) then the lender usually imposes a lien on the collateral. A lien is a legal right to use the collateral to satisfy the debt in lieu of payment, if needed. According to the Uniform Commercial Code (UCC), the lender should register their lien with the state (or states) in which the borrower operates. The lien then becomes part of the public record and states publicly that the assets in question have already been pledged as collateral for a debt.

Secured and unsecured loans
It is common practice for a lender to verify the collateral does not already have an existing lien imposed by doing a lien search. Unsecured loans do not rely on collateral. Instead they are based on the borrower’s good credit history and/or have other conditions like a guarantee of principal imposed. Some third party or a parent company guarantees that the principal will be repaid.

Range of guarantees
A guarantee of principal guarantees that the principal will be repaid to the lender in the event the borrower defaults. Generally, lenders that give unsecured loans require a guarantee by some third party known as the ‘guarantee party’ and it is usually the parent company acting on behalf of a subsidiary. There are several arrangements that involve the guarantee party. They can agree to assume the entire loan, or only funds for a specific project. They can agree to assume the loan only if and when the borrower actually is in default.

Range of guarantees
There are several arrangements that involve the guarantee party. They can agree to assume the entire loan, or only funds for a specific project. They can agree to assume the loan only if and when the borrower actually is in default. They can agree to just provide a ‘comfort letter’ that assures the lender of certain actions or conditions. Or they can offer just a performance guarantee that states they will do their best to persuade the borrower to perform their obligations. Each of these guarantees might have a
special name depending on the lender’s legal counsel.

Paid in capital
When a firm chooses to raise capital by issuing equity (i.e. stocks) it is granting ownership to the purchasers. This is in contrast to issuing debt (i.e. bonds) which grants no ownership rights. When a firm buys back their stock, it is considered treasury stock and has no ownership rights. When a firm issues stock initially, it has an original, or par, value. If an investor buys the stock at par value, that amount times the number of shares bought is the ‘paid in capital’ amount.

Paid in capital
If an investor buys the stock at par value, that amount times the number of shares bought is the ‘paid in capital’ amount. However, if the investor buys the stock at some amount above par value, then the amount that an investor pays for a share minus its par value is multiplied by the number shares an investor has purchased to derive the amount of the ‘additional paid in capital’. These amounts are shown on the company’s balance sheet. There can be different levels of stock that a firm issues with varying degrees of rights or payments.

Convertible bonds and warrants
A convertible bond is one that can be converted into the issuer’s equity stock. Time and price conditions are imposed on convertible stock, but they are desirable to the investor because they offer an option to reap benefits when the firm’s stock price is rising. The issuer benefits because the bond debt is being repaid with stocks without new equity being issued. Also, the issuing of additional stock can be misinterpreted in a negative way.

Convertible bonds and warrants
Also, the issuing of additional stock can be misinterpreted in a negative way. However, the issuing of convertible bonds has no such negative connotation. Of course, if the stock price increases substantially, the firm might end up paying more in dividends on the shares than they would have paid in interest on the debt. An alternative to convertibles is warrants which are basically options that the issuer grants along with the bond to convert bonds to stocks. It is often referred to as a ‘sweetener’ to a bond.