Question

1. Explain the meaning of mezzanine finance, describing the circumstances in which it is most commonly used.

Answer 1

Mezzanine financing refers to the combination of debt and equity financing which gives a right to the lender to convert the debt to an equity interest in the Company after a default takes place, and in most cases, after venture capital firms and other senior leaders are compensated.

The instrument has warrants embedded in it which help in increasing the value of subordinated debt and provide incresaed flexibility when dealing with bond holders.

This type of financing is most preferred by companies that are cash flow positive to fund: further growth via expansion projects, acquisitions, leveraged buyouts etc.

When mezzanine debt is used with senior debt, then less amount of equity is required in the business. Since equity is an expensive form of capital, hence this helps in reducing the cost of capital of the company. This in turn maximises the value of the Firm and the return on equity.

Also, it is preferred by lenders who are particularly risk averse about their investments. Since they can convert the debt into equity later, this provides them with an assurance and flexibility.

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