Concept Checks

7.1: It is debt.
The fact that the payments are fixed and tax-deductible make it debt. The fact that the holders of the security have to wait for other debt holders makes it more like unsecured debt.

7.2: The venture capitalist who is invested only in software businesses
The fact that this venture capitalist is not diversified will result in him demanding a return for all of the risk in the sector, including some of the risk that is diversifiable.

7.3: The venture capitalist with a higher required rate of return
The only way to earn the higher return is to get a disproportionate share of the ownership.

7.4: False.
The warrant prices are high because they should be high. It is only if the market is over estimating the variance that warrant issues will be justified.

7.5: False
There might still be scenarios (such as project financing, where the firm might want to convey propreitary information to the lender) where bank debt is superior.

7.6: No
The short term rates are lower than long term rates because of differences in expected inflation and a liquidity premium (for risk). Neither is a sign of inefficiency and neither can be exploited to lower the cost of borrowing.

7.7: False
The convertible bond yields are lower because they include a valuable option (the conversion option). Unless this option is mispriced, convertible bonds are not cheaper than equity.

7.8: No
Preferred stock shares as many characteristics with debt (no voting power, fixed payments) as it does with equity. It is closest to non-tax deductible debt.

7.9: 8%
There is no tax benefit from interest expenses because of the net operating loss carry forward. Next year it will drop to 4.8%.

7.10: Conservatively financed, publicly traded firms with a wide and diverse stock holding
Private firm owners invest their own money. Public companies with activist stockholders have another mechanism for maintaining discipline.

7.11: Airplane manufacturer, High-tech company, Grocery store
Airplane manufacturers have large implicit bankruptcy costs, because their contracts with buyers tend to be very long term. High-tech firms have a high variance in operating income, leading to a higher probability of default. Grocery stores have low variance in income and low bankruptcy costs.

7.12: No.
The risk that they will not get these cash flows, even if they hold until maturity, has increased and they are not being compensated for this risk.

7.13: Microsoft's management
It has a much better track record of managing your money, and has the potential to earn higher returns with that money.

7.14: In much more financial trouble than the average firm
Why else would they be scraping the bottom of the barrel and issuing convertible preferred (the least preferred option)