Corp. Flashcards
Q: What are the key features that differentiate organizational forms?
A: Key features include:
Legal separation from owners
Owner involvement in operations
Liability (limited or unlimited)
Tax treatment of profits/losses
Access to capital
Q: What is a sole proprietorship?
A: A business owned and operated by an individual, where the owner has unlimited liability and profits are taxed as personal income.
Q: How does a general partnership differ from a limited partnership?
A:
General Partnership: All partners have unlimited liability and share profits.
Limited Partnership: General partners manage the business with unlimited liability, while limited partners have liability limited to their investment and typically do not manage the business.
Q: What distinguishes a corporation from other business structures?
A: A corporation is a separate legal entity with limited liability for shareholders, access to capital markets, and a separation between ownership and management.
Q: What is double taxation, and how does it impact corporate shareholders?
A: Corporations pay taxes on profits, and shareholders are taxed again on dividends received. The effective tax rate depends on how much profit is distributed as dividends.
Q: What are the key differences between public and private corporations?
A:
Public Corporations: Shares trade on exchanges, subject to regulations and financial disclosures.
Private Corporations: Shares are not publicly traded, have fewer regulatory requirements, and raise capital through private placements.
Q: What is the key difference in claim priority between debtholders and equity holders?
A: Debtholders have a legal, contractual claim to interest and principal payments, while equity holders have a residual claim to net assets after all obligations are met.
Q: Why is debt considered a less costly form of capital than equity?
A: Debt is less risky than equity because debtholders receive fixed payments and have priority in case of liquidation, leading to lower required returns.
Q: How does leverage impact return on equity (ROE)?
A: Increased leverage can raise ROE if the return on assets exceeds the cost of debt, but it also increases financial risk.
Q: What happens to equity and debt values when a company’s value changes?
A: Equity value fluctuates with the company’s value, while debt value remains fixed unless the company is worth less than its debt.
Q: What is the main difference between shareholder theory and stakeholder theory in corporate governance?
A: Shareholder theory prioritizes maximizing shareholder value, while stakeholder theory considers the interests of multiple groups, including employees, lenders, and regulators.
Q: Why do investors consider environmental, social, and governance (ESG) factors?
A: ESG factors impact financial performance through regulatory risks, reputation effects, and operational efficiency, affecting both equity and debt investors.
Q: What is a principal-agent conflict?
A: A conflict that arises when an agent, hired to act in the principal’s interest, pursues their own interests instead, leading to potential misalignment.
Q: What are agency costs?
A: Costs incurred due to principal-agent conflicts, including direct costs like monitoring agents and indirect costs like lost business opportunities.
Q: How can conflicts of interest arise between shareholders and managers?
A: Managers may take lower risks than shareholders prefer, engage in empire-building, or entrench themselves rather than maximizing shareholder value.
Q: What mechanisms help mitigate conflicts between shareholders and managers?
A: Corporate governance mechanisms like independent board oversight, executive compensation structures, shareholder activism, and proxy voting.
Q: What are the risks of poor corporate governance?
A: Accounting fraud, weak oversight, regulatory violations, reputational damage, and misaligned management incentives leading to lower firm value.
Q: What are the benefits of effective corporate governance?
A: Improved operational efficiency, reduced legal risks, better financial performance, and stronger alignment between management and shareholder interests.
Question: What does the Cash Conversion Cycle (CCC) measure?
Answer: The CCC measures how efficiently a company converts its investments in inventory and other resources into cash inflows from sales. It represents the time taken to turn investments into cash.
Question: How can a company reduce its Cash Conversion Cycle (CCC)?
Answer:
Reduce inventory levels (risk: supply chain disruptions).
Accelerate receivables collection (risk: lost sales).
Extend payables period (risk: supplier relationship issues).
Question: What can increase a company’s liquidity risk?
Answer:
Drags on Liquidity: Excess inventory, slow receivables collection.
Pulls on Liquidity: Faster supplier payments, reduced credit availability.
Seasonality & Business Cycles: Can cause fluctuations in CCC an
Q: What are the four types of capital investments?
A: The four types are:
Going concern projects – Maintain business operations or reduce costs.
Regulatory/compliance projects – Required by government or insurers, often safety/environmental-related.
Expansion projects – Grow the business by entering new markets or launching new products.
Other projects – Investments outside existing business lines, often high-risk and similar to startups.
Q: What are the four steps in the capital allocation process?
A:
Idea Generation – Identify project opportunities from internal and external sources.
Analyzing Project Proposals – Forecast cash flows and determine expected profitability.
Creating the Capital Budget – Prioritize projects based on strategic fit and available resources.
Monitoring & Post-Audit – Compare actual vs. projected results and refine forecasting methods.
Q: What is Internal Rate of Return (IRR), and how is it used in investment decisions?
A: IRR is the discount rate that makes the NPV of a project equal to zero.
If IRR > required rate of return, accept the project.
If IRR < required rate of return, reject the project.
Advantages:
✔ Measures profitability as a percentage.
✔ Indicates margin of safety before a project becomes unprofitable.
Disadvantages:
✖ Assumes reinvestment at IRR, which may be unrealistic.
✖ Can produce multiple IRRs if cash flow patterns are unconventional.
Q: What are the key differences between NPV and IRR?
A:
NPV: Measures total value added to the firm. Preferred for decision-making.
IRR: Measures return percentage but can be misleading due to reinvestment assumptions and multiple IRRs.
NPV is generally the superior method because it directly reflects changes in shareholder value.
Which of the following is most likely a going concern project?
A)
Opening a retail outlet in a new region.
B)
Acquiring and merging with a supplier to secure a source for a key component.
C)
Purchasing a new model of a factory machine that will decrease unit production costs.
Explanation
Going concern projects are those to maintain the business or to increase the efficiency of existing operations. The other two projects are business growth investments that increase the size of the company. (Module 24.1, LOS 24.a)
In the capital allocation process, a post-audit is used to:
A)
improve cash flow forecasts and stimulate management to improve operations and bring results into line with forecasts.
Correct Answer
B)
improve cash flow forecasts and eliminate potentially profitable but risky projects.
Incorrect Answer
C)
stimulate management to improve operations, bring results into line with forecasts, and eliminate potentially profitable but risky projects.
Explanation
A post-audit identifies what went right and what went wrong. It is used to improve forecasting and operations. (Module 24.1, LOS 24.b)
What should capital allocation decisions be based on?
Back:
✅ After-tax cash flows, not accounting income.
💡 Key Points:
Accounting income includes accruals and ignores cash timing.
Firm value is based on cash flows firms keep, not those paid in taxes.
Depreciation & amortization create tax savings and should be included.
Front:
📌 Which cash flows should be considered in capital budgeting?
Back:
✅ Incremental cash flows only
💡 Key Points:
Ignore sunk costs (e.g., past consulting fees).
Consider cannibalization (when a new product reduces existing sales).
Positive externalities (new projects boosting other products) should be included.
Front:
📌 Why is the timing of cash flows important?
Back:
✅ The time value of money
💡 Key Points:
Money received earlier is worth more than money received later.
Future cash flows should be discounted to reflect their present value.
Front:
📌 What are common cognitive errors in capital budgeting?
Back:
❌ Poor forecasting (e.g., ignoring competitor responses).
❌ Not considering the cost of internal funds (should match cost of equity).
❌ Incorrectly accounting for inflation (nominal vs. real analysis mismatch).
Front:
📌 What are behavioral biases that affect capital allocation?
Back:
❌ Pet projects may receive biased projections.
❌ Anchoring to past budgets prevents proper allocation.
❌ Focusing on EPS/ROE may lead to rejecting profitable long-term projects.
❌ Failing to generate alternative ideas can cause missed opportunities.
Front:
📌 What are types of real options in capital investments?
Back:
✅ Timing options: Delay investment for better info.
✅ Abandonment options: Exit if future cash flows are negative.
✅ Expansion options: Scale up investment if profitable.
✅ Flexibility options: Adjust pricing or production methods.
✅ Fundamental options: Value depends on external factors (e.g., commodity prices).
Front:
📌 What factors affect a company’s capital structure?
Back:
✅ Internal Factors:
Revenue stability & growth 📈
Predictability of cash flows 💰
Business risk (e.g., demand volatility) ⚠️
Asset liquidity & collateral availability 🏦
✅ External Factors:
Market & business cycle conditions 📊
Regulation & industry norms 📜
Cost & availability of debt financing 💵
Front:
📌 How does a company’s business model affect its ability to take on debt?
Back:
✅ Companies with stable & recurring revenues can take on more debt.
Noncyclical industries (e.g., utilities) support higher debt than cyclical industries.
Low fixed costs (low operating leverage) → Higher debt capacity.
Subscription models (Netflix) > Pay-per-use models (movie theaters) in debt capacity.
More tangible assets = Easier to use as collateral for loans.
Front:
📌 How does a company’s life cycle stage impact its capital structure?
Back:
✅ Start-up Stage: High risk, low assets → Mostly equity financing.
✅ Growth Stage: Rising revenue → Conservative use of debt (secured by assets).
✅ Mature Stage: Stable cash flows → Can support more debt, including unsecured debt.
Front:
📌 How do macroeconomic factors influence the cost of capital?
Back:
✅ Top-down factors affecting WACC:
Inflation 📈 → Increases interest rates & cost of debt.
GDP growth 📊 → Impacts investor risk appetite.
Monetary policy 💰 → Central bank rates affect corporate borrowing costs.
Exchange rates 🌍 → Can impact multinational firms’ cost of capital.
Credit spreads 📉 → Higher spreads = higher debt costs.
A company is most likely to be financed only by equity during its:
A)
start-up stage.
B)
growth stage.
C)
mature stage.
Explanation
During the start-up stage, a firm is unlikely to have positive earnings and cash flows or significant assets that can be pledged as debt collateral, so firms in this stage are typically financed by equity only. (Module 25.1, LOS 25.b)
What is the weighted-average cost of capital (WACC)?
Back:
WACC is the blended cost of a company’s debt and equity, reflecting the return required by investors and lenders.
Why is the cost of debt typically lower than the cost of equity?
Back:
Debt holders have priority claims over equity holders, and interest expenses on debt are often tax-deductible.
What are the key factors that affect a company’s capital structure?
Back:
Factors include revenue stability, cash flow predictability, business risk, asset liquidity, and debt financing costs.
How does industry type influence a company’s capital structure?
Back:
Noncyclical industries with stable revenues can take on more debt, while cyclical industries with volatile earnings tend to rely more on equity.
What role do tangible assets play in debt financing?
Back:
Tangible assets serve as collateral, making debt financing easier and reducing borrowing costs.
How do start-up companies typically finance their operations?
Back:
Start-ups rely mostly on equity due to high business risk, lack of collateral, and uncertain cash flows.
How do business cycles impact the cost of capital?
Back:
During downturns, credit spreads widen, making debt more expensive, while in strong economies, borrowing costs decrease.
What are some macroeconomic factors that influence a company’s cost of capital?
Back:
Inflation, GDP growth, monetary policy, and exchange rates all affect interest rates and credit spreads.
A company’s optimal capital structure:
A)
maximizes firm value and minimizes the weighted-average cost of capital.
B)
minimizes the interest rate on debt and maximizes expected earnings per share.
C)
maximizes expected earnings per share and maximizes the price per share of common stock.
Explanation
The optimal capital structure minimizes the firm’s WACC and maximizes the firm’s value (stock price). (Module 25.2, LOS 25.c)
Which of the following statements regarding Modigliani and Miller’s Proposition II with no taxes is most accurate?
A)
A firm’s cost of debt financing increases as a firm’s financial leverage increases.
B)
A firm’s weighted-average cost of capital is not affected by its choice of capital structure.
C)
A firm’s cost of equity financing increases as the proportion equity in a firm’s capital structure is increased.
Explanation
MM’s Proposition II (with no taxes) states that capital structure is irrelevant because the decrease in a firm’s WACC from additional debt financing is just offset by the increase in WACC from a decrease in equity financing. The cost of debt is held constant, and the cost of equity financing increases as the proportion of debt in the capital structure is increased. (Module 25.2, LOS 25.c)
What is a business model?
Back:
A business model explains how a firm provides a product or service, finds customers, delivers the product or service, and makes a profit.
What are the key components of a business model?
Back:
A business model answers five key questions:
Who? Identifies potential customers.
What? Defines the product or service and its differentiation.
How? Describes key assets and suppliers.
Where? Explains sales channels and delivery methods.
How much? Determines pricing strategy.
What are some common pricing strategies?
Back:
Price takers: Commodity producers (e.g., oil).
Price makers: Companies with differentiated products (e.g., patented drugs).
Price discrimination: Different pricing for different customers (e.g., tiered or dynamic pricing).
Bundling: Selling complementary products together.
Freemium: Basic service is free, with paid premium features.
What are common business model variations?
Back:
B2B (Business-to-Business): Selling to companies.
B2C (Business-to-Consumer): Selling directly to consumers.
Subscription: Recurring revenue model (e.g., Netflix).
Licensing & Franchising: Using a brand or product for a fee (e.g., biotech licensing a drug).
Hidden Revenue: Free products supported by ads (e.g., Google Search).
What is the value chain in a business model?
Back:
A firm’s value chain refers to how it creates value through its operations, including:
Inbound logistics
Operations
Outbound logistics
Marketing
Sales & service
What are network effects and crowdsourcing?
Back:
Network effects: A business becomes more valuable as more users join (e.g., eBay, Facebook).
Crowdsourcing: Users contribute to the business (e.g., Wikipedia, Waze).
