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Appendix 3• Suggested answers to review questions

Factors that affect the value of convertible loan notes include:

lthe prevailing interest rates;

lthe perceived riskiness of the loan notes;

lthe rate of conversion (that is, how many shares per £100 of loan notes);

lthe anticipated value of the shares at the date of conversion; and

lvolatility of the share price.

8.6 A business that wishes to buy a particular non-current asset, and to use borrowed

funds to do so, can borrow the cash from a bank, by issuing loan notes (say), and buy

the asset. It then pays interest on the loan and at the end of the loan period repays

the loan. It may be the case that the loan will be repaid piecemeal.

In the case of leasing, the business arranges for a financier (for example, a bank)

to buy the asset outright. The business then leases the asset from the financier for the

duration of that asset’s useful life. Each year the business pays the financier an equal

leasing fee. From the financier’s point of view, this fee must be sufficient to com-

pensate for the cash tied up in the asset (interest) and to repay the loan. Thus a lease

of this type closely resembles a loan that is repaid piecemeal over the period of the

loan. If the latter is a source of finance, which undoubtedly it is, then the former

must also be a source of finance.

9.1 Members of the LSE, and most other of the world’s stock markets, act as:

lagentsfor their clients who wish to buy securities through the LSE; and

lmarket makers, who buy and sell securities of particular types, much as any other

trader does.

9.2 No. Shareholders can sell the shares as they wish. If a potential buyer can be

identified, the shares can be transacted privately between the parties. The problem

lies in finding a buyer. Since the LSE is the location where buyers and sellers, includ-

ing LSE members in their market-making role, congregate (electronically, if not

physically), this is a convenient place to sell the shares.

9.3 Price efficiency means that security prices always rationally reflect all information

relevant to their value.

9.4 Yes. If the market reflects all information (public and private), it clearly reflects all

public information.

9.5 Yes. Given the amount of research that is undertaken into individual businesses and

their economic environment, by intelligent and skilled analysts, and that the results

of the research feed into decisions to buy and sell securities, we should expect that,

through the pressures of buyers and sellers, prices would rationally reflect all

known, relevant information. The financial rewards to investors for getting the price

right are such that the pressure and incentive to do so are enormous.

9.6 Not necessarily, but wherever there is a significant amount of valid research into the

securities, and there is an orderly and fair market, we should expect price efficiency

to exist, at least to some extent.

10.1The discounted value of all future cash flows that will be generated by the asset.

10.2The approach (unless the loan notes would only generate returns for the next one or

two years) would have to be to deduce the ‘internal rate of return’ of the loan notes

by trial and error.

Chapter 9

Chapter 10

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