F3: Sources of long-term funds

Answer: A. A rights issue offers new shares to existing shareholders in proportion to their current holding (e.g. 1 new share for every 4 held), typically at a discount to the market price, to encourage take-up and compensate for dilution risk. A scrip dividend offers new shares instead of a cash dividend, not a capital-raising exercise aimed at all shareholders proportionally for cash. A share buyback returns cash to shareholders by repurchasing shares, the opposite of raising new capital. A bonus issue capitalises reserves into additional free shares for existing shareholders and raises no new cash at all, unlike a rights issue.

Answer: B. TERP is calculated by taking the total value of the shares held before the issue plus the cash raised from the new shares, divided by the total number of shares after the issue. For a 1-for-4 issue: 4 existing shares at $3.00 = $12.00, plus 1 new share at $2.00 = $2.00, giving a total value of $14.00 across 5 shares, so TERP = $14.00 / 5 = $2.80. $2.50 would result from averaging the two prices directly (($3.00+$2.00)/2) rather than weighting by the number of shares at each price. $3.00 is simply the pre-issue cum-rights price, ignoring the dilutive effect of issuing shares below market price. $2.00 is just the rights issue price itself, not the blended theoretical price of the enlarged share capital.

Answer: C. The value of a right per new share is the difference between TERP and the subscription price: $2.80 - $2.00 = $0.80. Because 4 existing shares are needed to earn the right to buy 1 new share, this $0.80 of value is spread over 4 existing shares, giving a value per existing share of $0.80 / 4 = $0.20. $0.80 is the value of the right per new share, not per existing share held — a common point of confusion. $1.00 does not correspond to any correct step in the calculation. $0.60 would result from an incorrect subtraction ($2.80 minus $2.20) rather than using the actual $2.00 issue price.

Answer: D. The standard TERP calculation assumes the funds raised earn the same rate of return as the company's existing operations. A yield-adjusted TERP instead reflects the reality that new funds may be invested at a different (often lower) expected return; if the new investment underperforms existing assets, the blended future return — and therefore the theoretical share price — will be lower than the simple TERP calculation suggests. It is not always higher; the direction of the adjustment depends on whether the new funds are expected to earn more or less than the existing return, and here a lower return implies a downward adjustment. It does not ignore the issue price, since that price is still what determines the cash raised and the resulting number of new shares. The two measures are only identical in the special case where the new funds are expected to earn exactly the same return as existing assets, which is not assumed as a general rule.

Answer: A. Underwriting transfers the risk of an undersubscribed issue from the company to the underwriter: if shareholders and the market do not take up all the new shares on offer, the underwriter is contractually obliged to purchase the shortfall, guaranteeing the company receives the finance it needs, in return for an underwriting fee. It does not remove the need to set a subscription price — the price is still fixed in advance and is central to the underwriting agreement. Shareholders are never legally obliged to take up rights; they can let them lapse or sell them in the market, which is precisely the risk underwriting is designed to cover. Underwriting does not convert the transaction into a bonus issue, which involves no cash subscription at all and is an entirely different mechanism.

Answer: B. A placing involves shares being sold directly to a limited number of institutional investors identified by the sponsoring broker, which is faster and cheaper than a full public offer because it avoids the marketing and administrative costs of soliciting the wider public. A public offer for subscription invites applications from the general public at a fixed price, which is a broader and more expensive process than a placing. An introduction is used when a company already has a sufficiently wide spread of shareholders (e.g. following a demerger) and simply obtains a listing without raising any new capital or selling shares. A rights issue is a method of raising further capital from a company's existing shareholders after it is already listed, not a method of obtaining an initial listing.

Answer: C. An IPO is the process through which a previously private company offers its shares for sale to the public for the first time and becomes listed on a stock exchange, widening its shareholder base and typically raising significant new capital. Issuing new shares only to existing shareholders describes a rights issue, which applies to an already-listed company, not a first-time public sale. A company buying back all its shares to go private describes a 'take-private' or delisting transaction, the reverse of an IPO. Merging with an already-listed company to obtain a listing indirectly describes a reverse takeover, a distinct alternative route to listing, not an IPO itself.

Answer: D. Cumulative preference shares carry a fixed dividend rate; if the company cannot pay the dividend in a given year, it accumulates as an arrear that must be paid, along with the current year's dividend, before any dividend can be paid to ordinary shareholders. Being irredeemable, there is no obligation to repay the capital, making this a hybrid instrument between debt and equity. Unlike debt interest, preference dividends are a distribution of profit and are not tax-deductible, which increases their effective cost to the company relative to debt. Preference shareholders typically have limited or no voting rights except in specific circumstances (such as when their dividend is in arrears), unlike ordinary shareholders. Preference shares rank above ordinary shares (though below debt) on liquidation, not below them.

Answer: A. The value of irredeemable debt is the present value of a perpetuity of interest payments, calculated as annual interest divided by the required rate of return: $6.00 / 0.08 = $75.00 per $100 nominal. Because the required return (8%) now exceeds the fixed coupon rate (6%), the loan notes trade at a discount to their nominal value, which is why $100.00 (simply the nominal/par value) is incorrect. $48.00 would result from multiplying interest by the required return instead of dividing by it (6 x 0.08 = 0.48, misapplied). $133.33 reverses the relationship implied by the coupon and required return, effectively treating the notes as if the coupon rate were higher than the required return.

Answer: B. The value of redeemable debt is the present value of the interest annuity plus the present value of the redemption amount, both discounted at the investors' required return. PV of the interest annuity = $7 x 2.531 (3-year annuity factor at 9%) = $17.72. PV of the redemption value = $100 x 0.772 (year-3 discount factor at 9%) = $77.22. Total value = $17.72 + $77.22 = $94.94. As the required return (9%) exceeds the coupon rate (7%), the notes trade below par, which is why $100.00 is incorrect. $77.22 only captures the present value of the redemption amount and omits the coupon stream entirely. $17.72 only captures the present value of the interest annuity and omits the redemption amount entirely.

Answer: C. The conversion value of a convertible bond is what the bond would be worth if converted into shares today, calculated as the number of shares receivable multiplied by the current share price: 20 shares x $4.50 = $90.00. $4.50 is simply the share price on its own and ignores the number of shares receivable on conversion. $20.00 is simply the conversion ratio (number of shares) and ignores the share price entirely. $100.00 is simply the bond's nominal value, ignoring the conversion terms entirely.

Answer: D. The conversion premium is the amount by which the market price of a convertible bond exceeds its current conversion value, reflecting the value investors place on the bond's downside protection (its floor value as a straight bond, since it continues to pay interest and can be redeemed even if the share price falls) combined with the upside potential of converting into shares later if the share price rises. It is not a pricing anomaly to be arbitraged away — it is a rational reflection of the option value embedded in the convertible instrument. It has no direct relationship to the redemption value at maturity, which is a separate, fixed figure. It is also unrelated to the coupon rate expressed in dollars, which is simply the periodic interest payment.

Answer: A. Because a warrant gives the holder a separately tradeable right to buy shares at a fixed price in future — potentially valuable if the share price rises — investors are willing to accept a lower coupon rate on the accompanying bond in exchange for this added upside, reducing the company's immediate cost of debt finance. Unlike a convertible bond, warrants are detachable and do not convert the bond itself; the bond remains a separate debt instrument that must still be repaid at maturity regardless of whether the warrant is exercised, so the redemption obligation is not eliminated. Bondholders are never obliged to convert, since holding a warrant is a right, not an obligation — the term 'convert' does not even strictly apply, as the warrant and bond are distinct instruments. The premise that warrants alone are always more valuable than the underlying bond is not correct or relevant to why they are typically issued attached to bonds rather than alone.

Answer: B. A zero coupon (deep discount) bond pays no periodic interest; the investor's entire return comes from the difference between the discounted issue price and the full redemption value paid at maturity. This is attractive to the issuer because it avoids regular cash interest payments, which can help manage cash flow, though the full redemption amount must still be found at maturity. A convertible bond is a different instrument tied to a conversion option into shares and does not by itself remove the redemption obligation. A eurobond is defined by being issued in a currency other than that of the country where it is issued, which is a different characteristic unrelated to the coupon structure described. An irredeemable bond pays interest indefinitely with no redemption at all, which is the opposite structure to the discount-then-redemption pattern described here.

Answer: C. A eurobond is a bond issued in a currency other than that of the country in which it is issued or sold — here, a dollar-denominated bond sold outside the US. Eurobonds are typically unsecured, are subject to lighter regulation than domestic issues, and can offer access to international pools of capital, sometimes at a lower cost. A domestic bond, by contrast, is issued in the issuer's home market and currency, which does not match the cross-currency, cross-border nature described. A convertible bond is defined by its conversion option into equity, an entirely different characteristic unrelated to currency or market of issue. A preference share is an equity-type instrument, not a debt instrument, and the description here is clearly of a bond.

Answer: D. A negative covenant restricts the company from taking certain actions without lender consent — here, prohibiting further secured borrowing, which would otherwise dilute the existing lender's security position. A positive covenant, by contrast, requires the company to actively do something, such as maintaining insurance or providing regular financial information, which is not what is described here. A financial covenant based on a profitability ratio (e.g. a minimum interest cover or maximum gearing ratio) is a different, numerically-defined type of restriction, not the qualitative restriction on further borrowing described. A conversion clause is a feature of convertible debt allowing conversion into equity, which is unrelated to a covenant restricting further borrowing.

Answer: A. A bilateral bank loan is typically quicker and cheaper to arrange than a public bond issue, since it avoids the extensive prospectus, credit-rating, underwriting and marketing costs required to sell debt securities to the wider investing public, making it particularly attractive for smaller companies without the scale to justify a public issue. It is not the case that bank loans are always cheaper in interest rate terms — the rate depends on the company's specific credit risk and negotiating position, and large, highly-rated companies can often borrow more cheaply in the bond markets. Bank loans commonly do include covenants, often more restrictive ones than a bond issue, since the bank is the sole lender and can negotiate detailed terms directly. Bank loans are frequently secured on company assets, exactly like many bonds; the presence or absence of security is not a distinguishing feature between the two forms of finance in general.

Answer: B. The core comparison between a finance lease and a loan to purchase is financial: the implicit interest rate embedded in the lease payments should be compared to the loan's interest rate, alongside how each option affects the company's balance sheet gearing, cash flow timing and covenant headroom, since a finance lease creates a lease liability similar in substance to debt. It is not true that lessors never require security — the leased asset itself typically serves as security, since the lessor retains legal title until/unless ownership transfers. There is no general rule that leasing is always cheaper; the better option depends on the specific rates and terms negotiated in each case. A finance lease is not treated as a simple rental expense — under current accounting standards it is recognised as an asset and a corresponding lease liability on the statement of financial position, in substance similar to a loan-funded purchase, not excluded from financing analysis.

Answer: C. Sale and leaseback releases the capital value tied up in an owned asset as an immediate cash lump sum, providing a source of finance, while the company continues to use the asset operationally under a lease — effectively substituting ownership for a financing arrangement. It does not remove future payment obligations; the company now pays lease rentals over the lease term, replacing ownership costs with financing costs. It reduces, rather than increases, the company's recognised ownership of fixed assets, since the property is sold and no longer owned. It has no bearing on, and does not eliminate, the need for capital investment in the business's other assets, which remains a separate consideration.

Answer: D. Venture capital firms specialise in providing equity finance to higher-risk, high-growth companies that lack the track record or assets needed to access conventional debt or public capital markets, typically in exchange for a shareholding, board representation, and an active role in strategic decision-making, with an expectation of an eventual exit (e.g. sale or IPO) to realise their return. A public bond issue requires an established credit profile and disclosure history that an early-stage, unproven company is unlikely to have, and bond investors are not generally suited to bearing this level of risk. Marketing preference shares to retail investors is unusual for an unproven early-stage business and does not match how such finance is typically sourced. A conventional secured bank loan specifically requires security and a track record to assess creditworthiness, which is precisely what this company lacks.

Answer: A. A management buyout occurs when a company's existing management team raises finance — typically a combination of their own equity, private equity investment and significant debt (often described as a leveraged buyout when debt-heavy) — to purchase the business or division they currently manage from its parent or owners. A rights issue is a method of raising further equity capital from existing shareholders of an already-listed or established company, unrelated to an ownership-change transaction like this. A scrip dividend is a form of dividend distribution paid in shares rather than cash, unrelated to an acquisition. An initial public offering is the process of a private company first selling shares to the public, which is the opposite direction of transaction to a buyout that typically takes a business out of a group structure (and sometimes private).

Answer: B. Sukuk are Sharia-compliant financial certificates that are economically similar to bonds, but instead of paying interest, investors receive a return derived from an underlying asset — for example rental income from a leased asset or a share of profits from a specific venture — structured to avoid riba (interest). A conventional zero coupon bond does not comply with Sharia law simply because it lacks periodic coupons; its return is still effectively interest embedded in the discount, so it is not automatically compliant. A standard interest-bearing bank overdraft is not compliant, since interest is charged, contrary to the premise. Ordinary shares are generally acceptable in principle under Islamic finance (subject to screening of the underlying business activities for compliance), so it is incorrect to say they cannot be issued at all under any Islamic finance interpretation.

Answer: C. Murabaha is structured as a cost-plus sale (the bank buys the asset and resells it to the client at a disclosed, pre-agreed mark-up, paid in instalments) specifically because Sharia law prohibits earning a return through interest on a loan (riba); a mark-up on a genuine trade of an asset is a permissible way for the financier to earn a return instead. It is not designed to avoid regulatory oversight — Islamic finance institutions are typically regulated in the same way as conventional ones, often with an additional Sharia supervisory board. There is no general rule that murabaha is always cheaper than conventional lending; its cost depends on the negotiated mark-up, which can be comparable to conventional interest rates in commercial terms. The company remains obliged to pay the agreed instalments over time, just as it would under a loan, so payment obligations are not eliminated.

Answer: D. Crowdfunding raises finance by inviting many individuals to contribute relatively small amounts via an online platform, in exchange for equity (equity crowdfunding), debt (peer-to-peer lending), or non-financial rewards, and has become an accessible alternative source of finance particularly for smaller and earlier-stage businesses. A eurobond issue involves large-scale institutional debt finance in international capital markets, a completely different scale and structure from crowdfunding. A rights issue is a capital-raising method open only to the existing shareholders of an already-established or listed company, not the general public via an online platform. Venture capital involves a small number of specialist professional investors taking often-substantial equity stakes with active involvement, unlike the many small, typically passive contributors seen in crowdfunding.

Answer: A. Debt is generally more attractive than equity when a company has stable, predictable cash flows to service fixed interest and principal obligations, since interest is typically tax-deductible (reducing its effective cost) and debt does not dilute the ownership or control of existing shareholders, unlike issuing new equity. Wanting to avoid fixed payment obligations altogether would actually favour equity, since equity carries no contractual obligation to make payments, in contrast to debt's fixed interest and repayment commitments. Existing shareholders wanting further dilution would support an equity issue, not point towards debt, since debt does not dilute ownership at all. Highly volatile cash flows and low existing borrowing capacity are risk factors that would argue against taking on further debt, since the company may struggle to meet fixed obligations in a downturn — this scenario points towards equity, not debt, being the more prudent choice.

Answer: A. The company first calculates the gross proceeds from the issue (5,000,000 shares x $2.00 = $10,000,000), then deducts the issue costs (3% x $10,000,000 = $300,000) to arrive at the net proceeds actually available to the company: $10,000,000 - $300,000 = $9,700,000. $10,000,000 is the gross proceeds figure before any issue costs are deducted, and overstates what the company actually receives. $9,400,000 would result from incorrectly deducting 6% rather than the correct 3% issue cost rate. $300,000 is simply the issue cost itself, not the net amount received by the company after deducting that cost from the gross proceeds.

Answer: B. Pre-emption rights require that new shares issued for cash are offered first to existing shareholders in proportion to their current holdings (typically via a rights issue), protecting them from having their percentage ownership and voting influence diluted without being given a fair first opportunity to subscribe and maintain their proportionate stake; shareholders can waive this right in some circumstances (e.g. for smaller share placings, subject to shareholder approval limits). Underwriting rights relate to a separate arrangement guaranteeing take-up of an issue, not the priority right of first refusal for existing shareholders. Covenant rights are protections written into loan agreements restricting a borrower's actions, unrelated to equity issuance priority. Conversion rights are a specific feature of convertible bonds allowing conversion into equity, unrelated to the pre-emption protection given to existing shareholders on a new cash issue.

Answer: C. Subordinated (mezzanine) debt ranks below senior secured debt but above ordinary equity in a company's capital structure and on liquidation, and because lenders accept this lower-priority, higher-risk position, they demand a higher interest rate than senior lenders, often combined with additional upside such as an equity conversion option or attached warrants — a hybrid instrument bridging the gap between straight debt and equity. Senior secured debt is, by definition, the instrument that ranks above subordinated debt, not the one described in the scenario, which explicitly ranks below senior debt. Preference shares are an equity-type instrument, not senior debt, in essentially all jurisdictions, and typically rank below all debt (including subordinated debt) on liquidation. A eurobond is defined purely by its currency of denomination relative to the country of issue, an entirely different characteristic from ranking or subordination.

Answer: D. A credit rating is an independent assessment of a company's ability to meet its debt obligations; a higher rating (e.g. investment grade) signals lower default risk, allowing the company to access debt markets at a lower interest rate, since investors require less compensation for a lower perceived risk of non-payment, whereas a lower rating typically results in a higher cost of borrowing to compensate lenders for the greater risk. It is not correct that the rating has no bearing on pricing — it is one of the most direct and observable influences on the interest margin a bond or loan will carry. The relationship is the opposite of what this option claims: a lower rating (higher risk) results in a higher, not lower, cost of debt, since lenders demand greater compensation for bearing more risk. Credit ratings are highly relevant to debt investors specifically, as they directly assess default risk on debt instruments, not merely a matter for equity investors.

Answer: A. A negative pledge clause prevents the company from granting security to other lenders in the future without extending equivalent protection to the existing bondholders, safeguarding them from being effectively pushed down the priority ranking (structurally subordinated) by new secured debt that would otherwise have a prior claim on the company's assets. A sinking fund clause is a different type of protective provision, requiring the company to accumulate funds over time (or make scheduled repurchases) to reduce the risk of a large repayment burden at maturity, which is unrelated to the ranking-protection function described. A call provision gives the issuer, not the bondholder, the right to redeem the bond early, which is a different feature entirely, focused on the issuer's flexibility rather than protecting the bondholder's ranking. A poison pill is a corporate governance defence mechanism used by target companies against hostile takeovers, entirely unrelated to bond covenant protection.

Answer: B. Government grants are typically non-repayable, do not carry interest, and do not dilute existing shareholders, making them an attractive source of partial project funding when a company's plans align with government objectives (such as regional development or job creation) — but they are usually conditional, and the company will need to meet specified criteria (e.g. minimum job creation, investment thresholds, or time limits) or risk clawback of the grant. It is not the case that grants must be repaid with interest — that description applies to loans, not grants, which is the whole point of this type of finance. Grants involve no share issuance at all, so they do not dilute ownership in the way an equity issue would. Grants are not universally available with no conditions; they are typically targeted at specific regions, industries, or types of project meeting defined policy objectives, and companies must usually apply and qualify.

Answer: C. A green bond is economically similar to a conventional bond in terms of its coupon and repayment structure, but the proceeds are contractually restricted (ring-fenced) to funding specific environmentally beneficial projects, and issuers are typically expected to report on and sometimes have independently verified how the proceeds are used, which can broaden the investor base to those with sustainability mandates and, in some markets, achieve a modestly lower cost of funding (a 'greenium'). It is not a convertible bond — a green bond's defining feature is the restricted use of proceeds, not any equity conversion mechanism, which is an entirely separate and unrelated feature. There is no basis for assuming environmental projects generate no return, and green bonds are not defined by having a zero coupon; they can carry a normal coupon structure like any other bond. Eurobonds are defined by being issued in a currency other than that of the issuing location and can be issued by companies as well as governments, an unrelated characteristic to the green/sustainable use-of-proceeds feature described.

Answer: D. While the underlying required rate of return that shareholders expect on retained earnings is conceptually the same as their required return on newly invested equity capital (an opportunity cost, since shareholders could otherwise have received the earnings as a dividend and invested it themselves), using retained earnings avoids the practical issue costs of a new share issue (underwriting, legal and advisory fees) and avoids the negative signalling effect a new issue can have on the share price, making it the practically cheaper and generally preferred source under pecking order theory. Retained earnings do not have a zero required return — shareholders still have an opportunity cost of foregone dividends and expect the retained funds to be invested to earn at least their required rate of return. New equity issues do typically incur real issue costs, so it is incorrect to claim they are identical in cost to retained earnings on this basis. Retained earnings can be used to fund any value-creating use, including new investment projects, not solely debt repayment.

Answer: A. A syndicated loan allows a group of banks to jointly fund a single large loan facility, coordinated by a lead bank (or arranger), spreading the funding requirement and credit risk across multiple lenders — this is a common solution when a loan is too large or too risky for one bank to provide alone. A eurobond is a debt security typically sold to a broad base of institutional bond market investors, not a bank-syndicated loan arrangement, and is not restricted to retail investors. A rights issue is a method of raising new equity capital from existing shareholders, an entirely different type of financing (and different provider base) from a syndicated bank loan. A scrip dividend concerns how a company distributes a dividend in shares rather than cash, unrelated to raising new debt finance.

Answer: B. Offshore (eurocurrency) markets are typically subject to lighter regulatory and disclosure requirements than many domestic markets, which can reduce the cost, time and complexity of raising finance, while also giving access to a broader, more international pool of investors who may accept different terms or pricing than the domestic market alone — this combination of speed, potentially lower cost, and wider investor access is the main attraction. It is the opposite of what is generally true to say offshore markets are always more heavily regulated; lighter regulation is typically cited as one of their defining features relative to many domestic markets. Borrowing offshore does not automatically eliminate foreign exchange risk — if the offshore borrowing is in a currency different from the company's functional/reporting currency, FX exposure is created, not removed, and would need to be separately managed. Domestic markets are not devoid of institutional investors; most established domestic bond and loan markets have substantial institutional investor participation, so this is a false generalisation.

Answer: C. Conventional theory ranks the cost of capital broadly in line with the risk borne by each type of provider: senior secured debt is generally the cheapest, since lenders have the strongest security and priority claim; subordinated/mezzanine debt costs more, reflecting its lower priority; preference shares cost more still, since dividends are discretionary and not tax-deductible, though they still rank ahead of ordinary shares on liquidation; and ordinary equity is generally the most expensive, since ordinary shareholders bear the residual risk and rank last. Reversing this ordering (equity cheapest, debt most expensive) directly contradicts the risk-return relationship underpinning the cost of capital, since it would mean the riskiest capital provider demands the lowest return, which is inconsistent with financial theory. It is not correct that all sources cost the same — the whole basis of capital structure decisions is that different sources have materially different costs, reflecting their different risk profiles. Preference shares are not generally the cheapest source; they typically cost more than any form of debt because dividends are discretionary and non-tax-deductible, even though they are usually cheaper than ordinary equity.

Answer: D. Issue costs are a genuine cash cost of raising finance through a particular route; they reduce the net proceeds actually available for investment (or mean a larger gross amount must be raised to achieve the required net funding), and this practical cost should be weighed alongside the ongoing cost of capital (interest, dividend expectations) of each financing option when choosing between them — a full comparison needs to consider both the upfront raising cost and the ongoing cost of the capital raised. It would be poor financial management to ignore a real cash cost simply because it is one-off rather than recurring; one-off costs still affect the net funds available and the overall cost-effectiveness of a financing route. Higher issue costs on their own do not make an option automatically cheaper — quite the opposite, higher one-off costs work against, not for, the option that bears them, so this reasoning is reversed. MM's theorem is a simplified model based on perfect-market assumptions with no issue costs; in the real world, financing choice clearly does have practical cost implications, which is precisely why issue costs must be considered rather than dismissed by an idealised theory.