CTP Exam Quiz 10

Preferred stock
When a firm chooses to raise capital by issuing equity shares, it can choose to make the shares either common stock or preferred stock. Preferred stock holders have priority payment claims over common stock holders in the event the issuer is forced to liquidate assets. Also preferred stock holders have a fixed dividend which also has priority over common stock dividend payments, if there even are any. However this can be a disadvantage if the issuer’s shares appreciate in value to such a point that the common stock dividend is greater than the preferred stock fixed payment and the preferred stock agreement has no provision to compensate for this change. Also, preferred stock holders, like bond holders, have no voting rights and are subordinate to bondholder’s claims on assets in the event of bankruptcy. Firms benefit from preferred stock because costs are locked in and, unlike with bond payments, there is no default risk if the firm misses a payment.

Stock and bond valuation
When analysts rate securities (common stock) they use a variety of formulas that involve calculating the kind of return that is required to make the security a worthwhile investment. The analysis uses the cash flow for a given period and the opportunity cost to derive the current value of the asset. The cash flow of the security can be difficult to calculate, however, because it can be hard to predict what the dividend payments will be for a given period since they are determined periodically and not fixed. Also, capital gains from the appreciation of the security are unpredictable as well, yet could be substantial enough to earn a higher rating. In contrast, bonds are easier to rate because they have fixed coupon rates and a fixed term to maturity. The bond valuations are more certain than stock valuation.

Going public
When a private firm wants to ‘go public’ by issuing stock to the public it is known as an Initial Public Offering (IPO). However there is the risk that the stock will not sell well and the anticipated capital will not be raised. An investment banker can provide underwriting services that include efforts to get the best price for the new issues or they can agree to buy the new issues and resell them on the secondary market. If the investment banker opts to a full underwriting agreement then they earn a premium for their risk, generally the difference between what they paid the issuer for the stock and what they sold it for minus any underwriting expenses. Some of the public offering duties include preparing the issue for submission to the SEC.

Cost of capital
The cost of capital includes the cost of debt and/or the cost of equity. It is the rate of return that would be required to make an investment comparable to the rate of return from alternative investments (i.e. the opportunity costs). The cost of debt can be calculated by multiplying the interest paid on the debt by the difference of 1 and the firm’s marginal tax rate (i x (1-tax rate). This is the after tax cost because interest payments on debt is tax deductible.

Initial Public Offering process
There are numerous reasons why firms choose to go public such as to raise capital for expansion, to acquire other companies, or to divide itself into smaller subsidiaries. When a private firm decides to go public and sell its shares to the public, this is considered an Initial Public Offering (IPO). The services of underwriters are required. These are investment bankers who will essentially guarantee that the initial sale of shares will be accomplished either because they buy the shares outright for resale or because they can arrange for other investors who will buy the shares. After SEC approval of the IPO, the shares are listed on an exchange where they are traded in the secondary market.

Theories of capital structure
The capital structure of a firm is the mix of its capital sources including equity issues (i.e. stock issues and retained earnings) and long term and some short term debt issues. Several theories attempt to explain how a firm chooses a particular capital structure. One theory involves ‘trade off’ models. An example of trade off would be when a firm seeking to raise capital opts for debt because the tax benefits of debt balance out the increased risk of bankruptcy due to excessive debt. The pecking order theory of capital structure suggests that a firm does not plan their capital structure, but acts according to market and financial conditions.

Capital structure risk
When a firm decides to raise capital, it establishes its capital structure, which is a mix of capital sources. Before it can make a decision about the capital source, it must assess its business risk which includes its operating leverage risk and its financial leverage risk. Generally, firms with high gross margin per sale but few sales have a high operating leverage. Firms with high volume of sales but low gross margin per sale have low operating leverage. The higher the operating leverage the greater the risk. Financial leverage attempts to increase the return of equity using more debt.

Capital structure risk
When a firm decides to raise capital, it establishes its capital structure, which is a mix of capital sources. Before it can make a decision about the capital source, it must assess its business risk which includes its operating leverage risk and its financial leverage risk. Generally, firms with high gross margin per sale but few sales have a high operating leverage. Firms with high volume of sales but low gross margin per sale have low operating leverage. The higher the operating leverage the greater the risk. Financial leverage attempts to increase the return of equity using more debt.

Setting dividend policy
A firm makes the decision as to when and in what amounts their stock dividends will be distributed. However, if the firm also has long term debt, that debt most likely has covenants that restrict the amount of dividends . The higher the dividend amount and/or the more frequent the disbursements the less retained earnings a firm will have to expand its asset base and possibly impede its ability to pay its obligations. This would conflict with bondholder’s interest. Setting the dividend policy involves estimating the long term company profits and rate of profit growth and then calculating its future need for capital.

Clientele Effect and dividend policy
Dividend policy should consider the financial status of the potential investor. Lower tax bracket investors prefer regular and high dividends. Higher tax bracket investors prefer no or low dividends and instead prefer to benefit from the stock appreciation. This is the Clientele Effect and can influence the firm’s dividend policy. Because news of a dividend reduction implies negative earnings, firms try to keep dividend disbursements stable. Debt covenants usually prohibit dividend payments from exceeding retained earnings.

Dividend disbursement dates
When determining dividend policy, the firm should consider the timing of disbursement. Also, any disbursement involves at least four important dates. These are the declaration date, the ex-dividend date, the holder-of- record date, and the payment date. The declaration date is when the dividend is officially announced by the board of directors. The ex-dividend date is four days prior to the holder-of- record date so that the brokers can send their list of eligible stockholders to the firm.

Kinds of dividends
When establishing a dividend policy, the firm can consider other options besides the most common cash dividend. With stock dividends, the firm can opt to use stock to pay the dividend instead of cash. This does not increase the amount of equity issued because it just reduces the pre share of the stock. This is also true of stock splits. Both stock splits and dividends increase the firm’s record keeping. Liquidating dividends can be used when a firm knows it will be going out of business and it liquidates its remaining capital to pay dividends.

SEC and stock repurchase
When a firm chooses a stock repurchase plan, it must comply with SEC guidelines and then submit a full disclosure to the SEC and ultimately to its stockholders. Once the shares are repurchased, they are retired and have no dividend rights or voting rights. However, if they are sold again in a stock option or warrant program, they will again have the specified rights. The SEC permits a firm to make a tender offer to repurchase 5% or less of its outstanding shares on the open market without having to submit disclosure forms.

International treasury management
In addition to the usual treasury management responsibilities, international treasury management includes consideration for the tax laws, the business laws, the political climate, the business customs, and the payment systems of the countries in which their firm does business. For example, though the Chinese government is stable, it can still impose strict reinvestment and currency laws on firms that effectively prohibit money transfers out of the country and/or conversion to a different currency. It can also require that a firm be partly or wholly owned by Chinese citizens. It should also be remembered that the Foreign Corrupt Practices Act prohibits U.S. firms from engaging in unethical (by U.S. standards) business practices, even if it is the norm in a particular country. A tax professional should be consulted about a country’s tax laws prior to doing business there.

Forex market
Forex (FX) is an unregulated, OTC (over the counter), and now mostly electronic foreign exchange market for currencies that is always open for trade. The daily trading value for Forex transactions exceeds $1.9 trillion. Anyone can trade in the Forex market but usually only central banks, investment banks, and very large multinational companies actually do. Forex trades typically have very high values and so brokers are usually affiliated with a central bank. In the U.S., Forex brokers are authorized and regulated by the National Futures Association (NFA). Currencies are priced in pairs like USD/EUR. The first of the pair is considered the base currency, and in this case, is the U.S. dollar.

Foreign exchange risk
When a firm makes an investment that requires payment in a foreign currency then their currency has to be converted to the foreign currency for the duration of the investment. Foreign exchange risk is the chance that the exchange rate will change in an adverse way before the currency can be converted back to the original. A firm can hedge against this risk by using forward rates for the currency. A forward rate is the price agreed on for a currency to be paid for and delivered at a future date, usually within a year.

Foreign exchange risk
When a firm makes an investment that requires payment in a foreign currency then their currency has to be converted to the foreign currency for the duration of the investment. Foreign exchange risk is the chance that the exchange rate will change in an adverse way before the currency can be converted back to the original. A firm can hedge against this risk by using forward rates for the currency. A forward rate is the price agreed on for a currency to be paid for and delivered at a future date, usually within a year.

CLS Bank
The CLS (Continuous Linked Settlement) Bank provides same day settlement of international transactions involving foreign currencies. It simplifies settlement by assuming risk associated with the legal restrictions, differing time zones, and differing local financial procedures that exist in various countries. It does this by linking the Real Time Gross Settlement (RTGS) systems of settlement banks and other institutions. It is structured according to the Edge Act requirements (section 25 of the Federal Reserve Act) for international banking activities. Its main office is in New York and is supervised by the Federal Reserve. It holds currency for each country represented by its member’s, provided the currency is eligible.

Non-check payment
A giro represents a direct fund transfer from one account to another. It acts just like a debit card. In most European countries, the use of giros is far more prevalent than the use of checks. Compared to checks, giros are considered a more secure method of receiving payment for goods and services including utilities. Customers can make payments via the mail, by phone, or the internet using a bank giro transfer. From the buyer’s position, giros have the disadvantage of not having ‘float’ available.
Smart cards are most common in Europe, particularly in France.

Differences in banking practices
In the U.S., the Federal Reserve processes most of the payments via ACH and/or Fedwire. It also controls the money supply, according to the Treasury Department’s goals, using a variety of financial tools including the issuance of government debt in the form of Treasury bills. Most banking systems outside of the U.S. have far fewer banks and rely on a few large clearing banks to process payments within the country, and several large banks to issue government debt. Also, outside the U.S., banks can pay interest on corporate demand deposit accounts and can even hold corporate equity stock.

U.K. payment clearing systems
In the U.K. the Automated Payment and Clearing System (APACS) is a payments trade association that is comprised of 31 members who process 97 % of the transaction volume. The primary purpose of the APACS is to manage the clearing and settlement of transactions using the three main clearing companies; the Clearing House Automated Payment System (CHAPS), Bankers Automated Clearing Service (Bacs), and the Cheque and Credit Clearing Company. Bacs is a non-profit organization of 13 banks and building firms that processes up to 84 million daily payments. It is the oldest of the clearing companies and most wages payments are paid through it.

TARGET
The Trans-European Automated Real Time Gross Settlement Express Transfer System (TARGET) is operated by the European System of Central Banks (ESCB) for immediate large value payments of euros. It is a decentralized system that links the central banks’ payment systems of participating European countries. The monetary policy of a member country that is implemented through their central bank is settled through TARGET. The Clearing House Automated Payment System (CHAPS), which is based in London, facilitates cross border payment settlement with TARGET.

MNC
A multinational corporation (MNC) is a firm that has branches, subsidiaries, or assets in other countries besides its own. They are usually American, European, or Japanese and most often have a centralized control structure of management. To minimize costs of numerous fund transfers, the centralized treasury department of many MNCs provides in-house banking services to their subsidiaries. The centralized treasury then has fewer transactions to implement through their financial institution. Another cost saving measure used by MNCs that takes advantage of economies of scale is to use a shared service center (SSC).

Sweeping, pooling, and netting
In the U.S. when subsidiaries or branches of a firm transfer funds to a central account to maximize profits, it is called cash concentration. In other countries, this kind of funds transfer is called ‘sweeping’. If the country permits banks to charge interest on deficits and pay interest on surpluses, the funds transfer is called ‘pooling’. If funds from one subsidiary account is used to eliminate the deficit in another subsidiary account within the same bank, but no funds are actually transferred, it is called ‘notional pooling’. Netting is used by firms in the U.S. and in most of the world to reduce the number of intra-company funds transfers. It calculates mutual financial obligations to derive the net value of funds that should be transferred.

Sweeping, pooling, and netting
In the U.S. when subsidiaries or branches of a firm transfer funds to a central account to maximize profits, it is called cash concentration. In other countries, this kind of funds transfer is called ‘sweeping’. If the country permits banks to charge interest on deficits and pay interest on surpluses, the funds transfer is called ‘pooling’. If funds from one subsidiary account is used to eliminate the deficit in another subsidiary account within the same bank, but no funds are actually transferred, it is called ‘notional pooling’. Netting is used by firms in the U.S. and in most of the world to reduce the number of intra-company funds transfers. It calculates mutual financial obligations to derive the net value of funds that should be transferred.

Currency repatriation
Currency repatriation is the process of converting a currency back into the holder’s original currency. The currency can be transferred electronically or physically and usually means the funds are transferred out of the target country. To minimize currency exchange risk and to secure profits MNCs (multi-national corporation) have to repatriate their currency frequently. Repatriation through dividends is the most convenient.

Taxes imposed on MNCs
The tax liability of a multi-national corporation (MNC) is more complex than for purely domestic corporations. U.S. tax law requires firms to include income from all sources in and out of the U.S. when determining their taxes owed. Outside the U.S. an MNC is liable for certain taxes imposed on foreign corporations. For example the asset tax is a tax imposed on assets held in the host country regardless if there are any profits generated by the asset. A value added tax (VAT) is a sales tax imposed at every stage of production when the product at that stage is sold.

Financial risk management
For financial risk management to be effective, a firm must first assess their attitude towards risk. The treasury manager can provide financial information that will help with this assessment. They should identify all sources of exposure to risk, such as interest rate and foreign exchange rates, and measure the degree of that exposure. Finally, a strategy to minimize the risk should be developed, applied, and monitored. A balance sheet that matches the exposed assets with the exposed liabilities can help determine exposure to interest rate changes. Currency hedges can help minimize foreign exchange risk.

Risk management measurements
A risk profile measures how sensitive a firm is to changes in interest rates, commodity prices, and/ or foreign exchange rates. The firm’s treasury is a primary source for financial information that will indicate the previous levels of sensitivity. A risk profile then uses this information to calculate the probability that one of these changes will occur, and if so, if that would significantly impact the firm. One technique used to determine this probability is the value-at-risk measure. It uses statistical data of prices and volatility to measure risk. Financial institutions and securities firms use value-at-risk measures to determine which elements should be hedged and when.

Risk management
Risk management minimizes the uncertainty associated with investments. When risk management is effective, a firm’s underlying assets can increase in value. This makes the firm more desirable to investors which can lead to greater access to credit. Hedging is one strategy that can help minimize risk. To a lesser degree, speculation and arbitrage can also help manage financial risk, though they are more for experienced traders rather than for a firm’s treasury.