Question

Which of the following is true of the underwriting of IPOs performed by investment banks?

	a.	The investment bank is prohibited from profiting from the underwriting.
	b.	The investment bank is not responsible for reselling the purchased shares in the market.
	c.	The investment bank commits to buy stock from the issuing company at a fixed price.
	d.	The investment bank resells the underwritten stock in the market at a discounted price.

Stockholders have preemptive rights because:

	a.	are written into the companies rules of operation (its charter, articles, or bylaws).
	b.	preemptive rights prevent disproportional  ownership.
	c.	are required by law.
	d.	preemptive rights come with every stock purchase.

Which of the following is a reason why lenders insist on bond indentures?

	a.	To ensure that bond-issuing companies prefer debt financing to equity financing
	b.	To ensure that lenders of rights are comparable to the rights of stockholders
	c.	To make the bonds easy to sell in secondary markets
	d.	To ensure that bond-issuing companies do not accept risky projects

Bond ratings assess the:

	a.	liquidity risk of companies that issue bonds.
	b.	maturity risk of individual bonds.
	c.	the overall risk (DR+LR+MR) of companies that issue bonds.
	d.	default risk of individual bonds.

Which class of investors do not have claims on the income and assets of the firm prior to preferred shareholders?

	a.	Bondholders
	b.	Common shareholders
	c.	Creditors
	d.	Lenders such as banks

Answer 1

Ans.1. Underwriting is the process whereby an investment bank (underwriter) assists a Company float an IPO in the market providing services like market research, promotions, fixing price and finally selling the shares in the market. Mostly, the underwriters guarantee a certain number of shares sold in the IPO, and any unsold shares out of the underwritten shares are bought by the underwriter (who can later sell them in the market).

Out of the four statements given, option C. is true : The investment bank commits to buy a certain number of shares (underwritten shares) at a defined price from the issuing company. The sale of shares in public is now underwriter’s area of concern.

Option A is incorrect as an underwriter profits from the difference between the price at which he buys from the issuing company and the price at which he sells to the public. Option B is incorrect because the investment bank sells the shares bought by them from issuing company, to the general public to make a profit. Option D is incorrect because the underwriter resells the underwritten stock at a premium (to earn profit) and not at a discount.

Ans.2. A pre emptive right given to a stockholder gives the right to him/her to buy shares in proportion to his existing ownership in any new issue of shares by his Company, so that his share in ownership does not dilute. Pre emptive rights are usually defined by the Company’s Articles, and any Company not wishing to grant this right may exclude it in the Articles.

So, option A is correct. Option C and D are not correct as per explanation above. Option B is incorrect because pre emptive right gives option but does not oblige the shareholder to buy so it does not guarantee same proportion.

Ans.3. A bond indenture is a legal document between a bond issuer and bondholder specifying the terms of the bond, such as amount, interest payable, etc. Since the number of bondholders are huge and widespread, the bondholders are generally represented by a Trustee such as a Bank, so that if the bond issuer defaults, the Trustee can enforce the indenture against bond issuer on behalf of bondholders.

Option A is incorrect since a bond indenture is not the reason for a Company to chose debt over equity as a means of financing, Option B is incorrect since the rights of equity shareholders and bondholders are not equal. Bondholders are given higher priority in paying off debts in case of liquidation and shareholders come later. Option D is also incorrect since an indenture does not guide the Company in what kinds of projects it choses.

Option C is correct, since the bond indenture being a legal document instills faith and makes it easy to sell bonds in the secondary market.

Ans.4. Bond ratings assess the overall risk of the Company issuing bond : default risk, liquidity risk and maturity risk. Therefore, option C. is correct.

Ans.5. In respect of claims to the income and assets of a Company at the time of liquidation, lenders, creditors, bondholders are given first priority, then come preferred shareholders and last in the priority are common shareholders.

Therefore, correct answer is option B.