Corporate Issuers (8%) Flashcards
1
Q
Key Attributes of Organizational Forms:
Legal Identity
A
Whether the business is a separate legal entity from its owners.
2
Q
Key Attributes of Organizational Forms:
Owner-Manager Relationship
A
The relationship between the business owners and those who manage the business.
3
Q
Key Attributes of Organizational Forms:
Owner Liability
A
The extent to which owners are personally liable for the business’s actions and debts.
4
Q
Key Attributes of Organizational Forms:
Taxation
A
How business profits and losses are treated for tax purposes.
5
Q
Key Attributes of Organizational Forms:
Access to Financing
A
The ability to raise capital for expansion and distribute risks.
6
Q
Sole Trader or Proprietorship:
Description
A
A single owner provides capital, retains full control, and is responsible for all risks and returns.
7
Q
Sole Trader or Proprietorship:
Legal Identity
A
No separate legal identity
8
Q
Sole Trader or Proprietorship:
Liability
A
Full Personal Liability
9
Q
Sole Trader or Proprietorship:
Taxation
A
Business Profits Taxed as Personal Income
10
Q
General Partnership:
Description
A
Two or more owners (general partners) share resources, risks, and returns.
11
Q
General Partnership:
Legal Identity
A
No separate legal identity.
12
Q
General Partnership:
Liability
A
Partners have unlimited personal liability.
13
Q
General Partnership:
Taxation
A
Profits taxed as personal income.
14
Q
Limited Partnership:
Description
A
At least one general partner (with unlimited liability) and one or more limited partners (with liability limited to their investment).
15
Q
Limited Partnership:
Legal Identity
A
Partial separate legal identity.
16
Q
Limited Partnership:
Liability
A
General partners have unlimited liability;
limited partners have liability limited to their investment.
17
Q
Limited Partnership:
Taxation
A
Profits taxed as personal income.
18
Q
Limited Liability Partnership (LLP):
Description
A
Composed entirely of partners with limited liability.
19
Q
Limited Liability Partnership (LLP):
Legal Identity
A
Separate legal identity.
20
Q
Limited Liability Partnership (LLP):
Liability
A
All partners have limited liability.
21
Q
Limited Liability Partnership (LLP):
Taxation
A
Profits taxed as personal income.
22
Q
Limited Liability Partnership (LLP):
Applicability
A
Often restricted to professional services firms.
Example: Law firms, accounting firms, and architecture firms.
23
Q
Limited Companies:
Private Limited Company:
Description
A
Combines limited liability, improved transferability of ownership, and separation of ownership and management.
24
Q
Limited Companies:
Private Limited Company:
Legal Identity
A
Separate legal identity.
25
Limited Companies:
Private Limited Company:
Liability
Owners (shareholders) have limited liability.
26
Limited Companies:
Private Limited Company:
Taxation
Profits taxed at both the corporate and personal levels.
(Double Taxation)
27
Limited Companies:
Private Limited Company:
Access to Financing
Better access to financing compared to partnerships.
28
Limited Companies:
Private Limited Company:
Examples
LLCs or S corporations in the United States
29
Limited Companies:
Public Limited Company (Corporation):
Description
Suitable for companies seeking to go public, with no restrictions on the number of owners or ownership transferability.
30
Limited Companies:
Public Limited Company (Corporation):
Legal Identity
Separate legal identity
31
Limited Companies:
Public Limited Company (Corporation):
Liability
Shareholders have limited liability.
32
Limited Companies:
Public Limited Company (Corporation):
Taxation
Profits taxed at both the corporate and personal levels.
(Double Taxation)
33
Limited Companies:
Public Limited Company (Corporation):
Access to Financing
Greatest access to financing.
34
Limited Companies:
Public Limited Company (Corporation):
Examples
Large multinational companies like Apple, Toyota, and Siemens.
35
True or False: Partnerships are typically taxed at the entity level rather than at the individual partner level.
True
False
False.
Partnerships are typically pass-through entities, meaning that business income earned by the partnership is passed through to the partners according to the terms of partnership agreement, and each partner is taxed at the personal level.
36
If a company owner expects to have a significant need for financing, which of the following organizational forms is the least appropriate choice?
A. Corporate
B. Partnership
C. Sole proprietorship
C is correct. A sole proprietorship is limited in financing to the owner’s funds and by the amount the owner can borrow personally. A partnership expands access to financing by adding owners, spreading risk, and adding borrowing capacity. The corporate form provides for the broadest access to financing because there are no limits to the number of shareholders and, with limited liability, shareholders are relatively more comfortable with the company borrowing.
37
Organizational Form
A legal and tax classification of a business, specific to a jurisdiction, that determines the organization’s legal identity, owner–manager relationship, owner liability, taxation, and access to financing.
38
________________ liability is a benefit to the corporate organizational form, but the form does face a possible disadvantage because of ________________ taxation of distributed business income.
Limited liability is a benefit to the corporate organizational form, but the form does face a possible disadvantage because of double taxation of distributed business income.
39
Identify two features that distinguish a general partnership from a limited partnership.
Owner–manager relationship: The management of a general partnership is typically shared by the general partners, while in a limited partnership, the general partner often exercises most managerial responsibilities.
Owner liability of business debts and obligations: In a general partnership, the partners are personally legally liable for business debt and actions undertaken by the company.
In a limited partnership, only the general partner faces personal liability; limited partners’ liability is limited to their investment in the partnership.
40
Corporations:
Owner-Manager Separation
Corporations typically have a separation between ownership and management.
Shareholders own the corporation but are largely removed from its day-to-day operations.
Instead, they elect a board of directors that appoints executive management to run the company.
This separation allows the corporation to access financing from a larger pool of potential investors who do not need to be involved in management.
41
Corporations:
Owner/Shareholder Liability
Shareholders in a corporation have limited liability. This means that the maximum amount they can lose is what they have invested in the company; they are not responsible for the corporation's debts unless they have specifically guaranteed them
42
Corporations:
External Financing
Corporations can access external financing more easily than other business forms due to the separation of ownership and management. Financing can be raised through:
Equity: By selling shares to investors or reinvesting profits.
Debt: Through loans, bonds, and leases.
43
Corporations:
Taxation
Corporations are taxed on their profits, and shareholders may pay additional taxes on dividends, leading to double taxation.
44
Corporate Issuers
Limited companies or corporations that seek financing in financial markets by, for example, issuing debt or equity securities.
45
Explain why the separation of ownership from management allows for corporate issuers to have greater access to capital.
By separating ownership from management responsibilities, corporations can attract a broad range of owners, especially individuals and institutions, who do not want to be involved in management but would like to participate as investors.
46
Limited liability of shareholders refers to the fact that the ________________ amount shareholders may lose on their investment is the ________________ paid to buy the shares.
Limited liability of shareholders refers to the fact that the maximum amount shareholders may lose on their investment is the price paid to buy the shares.
47
In which of the following situations does the double taxation of the corporate organizational form matter the least?
A.The company expects to pay all its after-tax income as a dividend to shareholders each year.
B.The company’s shareholders reside in a tax jurisdiction with a high tax rate on dividend income.
C.The company is expecting to reinvest all its after-tax profits each year into growth of the business.
C is correct. Reinvestment of all profits implies that the company pays no dividend to shareholders, and thus, no double taxation occurs.
48
Corporate issuers are characterized by all of the following except:
A. Corporate income is taxed at both the corporate and personal levels.
B.Owners do not need to be involved in management of the company.
C.The owners of the corporation are not legally distinct from the corporation.
C is correct. A corporation is a legally separate entity from its owners.
49
Publicly Owned Companies:
Exchange Listing
Shares are listed and traded on an exchange, providing liquidity and price transparency. Investors can easily buy or sell shares on the exchange.
49
Privately Owned Companies:
Exchange Listing
Shares are not listed on an exchange, making ownership transfer more difficult and less transparent. Shareholders must find a willing buyer, and the company may restrict ownership transfers.
50
Publicly Owned Companies:
Share Ownership and Transfer
Ownership can be transferred easily between investors through the exchange.
51
Privately Owned Companies:
Share Ownership and Transfer
Ownership transfer is more restricted and often requires negotiation between the buyer and seller. The company may also refuse the transfer of ownership.
52
Publicly Owned Companies:
Share Issuance and Financing
Can issue new shares that trade in the secondary market. Have access to a large pool of potential investors.
53
Privately Owned Companies:
Share Issuance and Financing
Finance through private placements from fewer investors, who usually have longer holding periods.
54
Publicly Owned Companies:
Public Companies
Must register with regulatory authorities and comply with strict reporting and disclosure requirements, including filing audited financial statements regularly.
55
Publicly Owned Companies:
Private Companies
Generally subject to fewer regulatory disclosures and compliance requirements.
56
Going Public:
Initial Public Offering
New shares are issued, capital is raised, and shares begin trading on an exchange.
57
Going Public:
Direct Listing
Existing shares are listed on an exchange without issuing new shares or raising capital.
A direct listing does not involve an underwriter and no new shares are issued, so no capital is raised. Instead, the company simply lists existing shares on an exchange at a price determined by the market, and shares become available to the public as they are sold by existing shareholders.
58
Going Public:
Special Purpose Acquisition Company (SPAC)
A private company is acquired by a publicly listed SPAC, becoming a public company.
59
Going Private
Public companies may decide to go private through a process where investors acquire all publicly traded shares, delisting the company from the exchange. This often involves using debt to finance the acquisition, with the goal of restructuring or making changes to increase the company's value.
60
exchange
A rules-based, open access market venue where financial instruments are traded, with price and volume transparency accessible by issuers, investors, and their intermediaries.
61
Free Float
The portion of a listed company’s equity securities that are not held by insiders, strategic investors, sponsors, founders, and so on, that are more freely available for trading.
62
Private Placement
A sale of debt or equity securities to a small group of investors on an unregulated basis. The terms of the offering are negotiated by the issuer and investors.
63
accredited investors
Investors that meet certain minimum regulatory net worth or other requirements in order to invest in certain types of alternative assets.
64
A corporate issuer has the following attributes:
(1) It has no need for new equity financing,
(2) its debt needs are well satisfied through its existing credit facility with a bank, and
(3) it has a majority owner that exercises management control of the company.
Is this corporate issuer more likely public or private?
A. Public
B. Private
B is correct. The lack of need for new equity capital implies less reason to have exchange-listed stock, as does the ability to operate the business with the current debt capacity available under its existing credit facility. The majority owner exercising management control could possibly imply either public or private status, although combined with the first two attributes, it is doubtful that such a company would be public.
65
Which of the following does not reflect a primary difference between an initial public offering (IPO) and a direct listing?
A. Whether or not employees own shares in the private company
B.Whether or not new capital is raised
C.Whether or not an underwriter is used
A is correct. A company with employee shareholders can go public with either an IPO or a direct listing; employee shareownership does not differ by the choice of transaction.
66
Describe two benefits of being a public company and two reasons that an issuer may instead prefer to be private company.
Benefits of public status:
(1) Public listing allows the company to access capital from a broader range of investors, thus making larger capital raises more feasible.
(2) Public listing allows for price transparency for investors and ease of trading because of stock exchange listing. This may be especially beneficial if employees own significant stock, because listing creates a market for these shares.
Benefits of private status:
(1) Fewer disclosure requirements, thus reducing compliance costs and perhaps conferring competitive advantages because information can be kept private.
(2) Fewer stakeholders, thus allowing for improved access to communication channels.
67
A public company acquires a private company. Is the acquired company public or private after the acquisition? Explain the rationale for your choice.
A. Public
B. Private
A is correct. Even though the acquired company will not have its own shares, the shareholders of the acquirer own the formerly private company, though the percentage of assets of the combined company attributable to the acquired company may be small. The acquirer’s board of directors and management now operate the newly acquired company.
68
residual claim
equity is a residual claim against company cash flows—whatever is left after expenses, investments, and debt payments. Cash distributions to equity investors are at the discretion of the board of directors
69
Financial leverage
The use of debt in the capital structure. Measured using ratios such as operating income to operating income less interest expense, total assets to total equity, or debt to equity.
70
Dilution
An increase in the number of shares outstanding from share issuance that decreases the percentage of shares owned by existing shareholders.
71
Corporate equity and debt holders share the same investor perspective with respect to:
A. maximum loss.
B. investment risk.
C. return potential.
A is correct. For both equity and debt holders, their initial investment represents their maximum possible loss. The return potential is theoretically unlimited for equity holders, while it is capped for debtholders. Equity holders are exposed to a higher level of investment risk, as they hold a residual claim on the firm’s cash flows that is lower in priority to the debtholders’ claim.
72
True or False:
Debtholders, unlike equity holders, have symmetric potential downside losses and upside gains.
True.
False.
B is correct; the statement is false. Both debtholders and equity holders have asymmetric potential payoffs. For debtholders, potential upside gains are limited to interest and principal repayments, regardless of how high the value of the firm rises. In contrast, if the value of the firm falls below the value of its debt, debtholders can lose up to their initial investment.
73
Conflicts of Interest:
Shareholders vs. Bondholders
Shareholders seek to maximize residual cash flows and are willing to take greater risks for higher potential returns.
They prefer the use of debt financing to avoid dilution.
In contrast, bondholders prefer less risky projects and financial stability to ensure timely repayment.
This creates potential conflicts, as shareholders benefit from higher leverage and risk, while bondholders do not.
74
Interest payments to debtholders are:
A. residual payments.
B. at the discretion of the board.
C. deductible for corporate income tax purposes.
C is correct. Interest payments on debt are tax deductible for the firm.
75
All of the following are characteristics of debt except:
A. limited liability.
B. unlimited return.
C. priority in payment.
B is correct. Shareholders, not debtholders, have the potential for unlimited return.
76
All else being equal, a jurisdiction increasing its corporate income tax rate would most likely lead to ____________________ (lower/higher/the same) use of debt financing by issuers.
Higher. An increase in the corporate income tax rate would likely result in a higher mix of debt. Interest payments on debt are tax deductible, so an increase in the tax rate would reduce the after-tax cost of debt financing, all else being equal, thus making debt financing relatively more attractive than equity financing.
77
Which of the following groups has a residual claim on an issuer’s cash flows?
A. Employees
B. Debtholders
C. Shareholders
C is correct. Shareholders are residual claimants to a firm’s cash flows and receive discretionary distributions after priority claims (e.g., employee compensation, supplier payments, interest expenses, and taxes) are met.
78
Stakeholders
Any party with an interest, financial or non-financial, in an entity or its actions.
79
Shareholder Theory
Focus: Maximizing shareholder value.
Responsibility:
-Directors and managers primarily serve shareholders.
Impact on other stakeholders: Considered only if it affects shareholder value.
80
Stakeholder Theory
Focus: Considering the interests of all stakeholders.
Challenges:
- Balancing multiple objectives.
- Defining and measuring non-shareholder objectives.
- Competing globally if competitors do not face similar constraints.
- Direct costs of adhering to higher ESG standards.
81
Conflicts of Interest among Lenders and Shareholders
Shareholders: Prefer higher risk for potential higher returns, favor leveraging debt to avoid dilution.
Bondholders: Prefer lower risk and stable cash flows, use contractual restrictions to protect their interests.
82
Inside Directors
Members of a corporation’s board of directors who are not independent. Typically, inside directors are employees or founders (and their family) of the company.
83
Independent Directors
Members of a corporation’s board of directors who do not have an employment or familial relationship with the company, nor do they have a relationship that would impair their independence such as an economic interest in a vendor or competitor of the company.
84
supervisory board
In some jurisdictions, a corporation’s board of directors is formally composed of a supervisory board and a management board. The supervisory board appoints and oversees the management board and often includes representatives of employees and other non-shareholder stakeholders.
85
Staggered Board
A structure of board elections in which only part of the board is elected simultaneously—for example, only one-third of the board may be up for election each year, so the board can be replaced over three years, not in one year if all seats were elected annually. This structure fosters greater continuity of board members but is an obstacle for shareholders seeking to effect change.
86
Which of the following board structures would most limit shareholders’ ability to effect a major change in the management of a firm?
A. Majority inside, staggered
B.Majority independent, staggered
C.Majority independent, non-staggered
A is correct. A board with a majority of inside directors could more easily resist outside change than one with a majority of directors who were independent of management.
Also, a staggered board would allow only a portion of the directors to be voted out each year, so it would take several years to replace a majority of directors.
87
Compared with public debtholders (e.g., bondholders), private debtholders (e.g., banks, lessors):
A. have less influence over company management.
B.have access to non-public information about the company.
C.are less likely to consent to changes in the debt contract.
B is correct. Private debtholders, including banks and other direct lenders, typically have direct access to management and non-public information, which lowers information asymmetry.
88
Negative Externalities
A cost to a third party because of the production or consumption of a good or service.
89
ESG considerations are increasingly relevant for which of the following reasons (select up to three options)?
A.Many in the new generation of investors are demanding that investment strategies incorporate ESG factors.
B.ESG issues are having more material impacts on companies’ valuations.
C.Environmental and social issues are being treated as negative externalities.
A is correct. A growing number among the new generation of investors increasingly demand that their inherited wealth or pension contributions be managed using investment strategies that systematically consider material ESG risks, as well as negative environmental and societal impacts, of their portfolio investments.
90
Material
(materiality) Refers to information that is decision-useful for a reasonable investor.
91
ESG: Physical Risks
Economic and financial losses from the increase in the severity and frequency of extreme weather due to climate change—for example, the loss of coastal real estate from a storm.
92
ESG: Transition Risks
Economic and financial losses from the transition to a lower-carbon economy in response to climate change—for example, the abandonment of an oil well that is no longer economical.
93
Transition Risk: Stranded Assets
A resource that is no longer economically valuable owing to changes in demand, regulations, or availability of substitutes—for example, a newly discovered oil well that will not be brought into production.
94
Historically, analysts have best been able to evaluate a company’s:
A. social practices.
B. governance practices.
C. environmental practices.
B is correct. Corporate governance factors are well understood and quantifiable by analysts, including the consequences of poor corporate governance. In contrast, the inclusion of environmental and social factors in investment decision-making has evolved more slowly. The results of evaluating the effects of environmental and social factors on firm performance are often less clear.
95
Historically, environmental and social issues have been treated as ______________. However, they are increasingly being recognized as _________________.
(negative externalities, internalized costs).
Historically, environmental and social issues have been treated as negative externalities. However, they are increasingly being recognized as internalized costs.
96
Stranded assets best represent _____________.
(physical risk, transition risk)
Stranded assets best represent transition risk.
Transition risks are losses related to the transition to a lower-carbon economy. An oil well may become a stranded asset due to government regulations or changes in consumer preferences that affect the price of oil or otherwise impair an issuer’s ability to fully realize the asset value. Physical risks include damage to property stemming from extreme weather, which is expected to increase in both frequency and severity due to climate change.
97
A company’s effectiveness in managing long-term risks and sustainability is best classified as a:
A. social factor.
B. governance factor.
C. environmental factor.
B is correct. Corporate governance and stakeholder management address issues that include a company’s effectiveness in managing long-term risks and sustainability. Management effectiveness can be assessed through an evaluation of the company’s financial and non-financial performance over the long run, along with a comparison against industry peers to isolate controllable variables.
98
Principal-Agent Relationship
A principal-agent relationship (or agency relationship) is established when one party (the principal) hires another party (the agent) to perform a task or service.
The agent is expected to act in the principal’s best interest, which involves trust and expectations of loyalty and diligence.
99
Fill in the blank for each with: (1) principal or (2) agent.
shareholders (________) elect directors (_______), who then hire managers (______) to maximize shareholder value.
shareholders (principals) elect directors (agents), who then hire managers (agents) to maximize shareholder value.
100
Common Divergences Between Manager and Shareholder Interests:
Insufficient Effort
Managers may not invest adequately in projects, manage costs effectively, or make tough decisions due to personal interests or external commitments.
101
Common Divergences Between Manager and Shareholder Interests:
Inappropriate Risk Appetite
Managers may either take excessive risks (due to compensation structures like stock options) or be overly risk-averse (due to lack of incentives), which may not align with shareholders’ interests.
102
Common Divergences Between Manager and Shareholder Interests:
Empire Building
Managers may pursue growth for its own sake to increase their compensation and status, even if it doesn't add shareholder value.
103
Common Divergences Between Manager and Shareholder Interests:
Entrenchment
Managers may take actions to secure their positions rather than acting in the best interests of shareholders.
104
Common Divergences Between Manager and Shareholder Interests:
Self-Dealing
Managers might exploit company resources for personal benefits, which can reduce overall firm value.
105
Dual-Class Share Structures
Dual-class share structures grant different voting rights to different classes of shares, allowing insiders or founders to maintain control despite owning a smaller percentage of shares. This can lead to conflicts as controlling shareholders might pursue personal interests over the majority's will.
106
agency costs
Direct and indirect costs borne by the principal in a principal-agent relationship owing primarily to information asymmetries.
Agency costs include the costs of monitoring and assessing the agent as well as missed opportunities.
107
A controlling shareholder of Stillcreek Corporation owns 55% of Stillcreek’s shares, and the remaining shares are spread among a large group of shareholders. In this situation, conflicts of interest are most likely to arise between:
A. shareholders and bondholders.
B.the controlling shareholder and managers.
C.the controlling shareholder and minority shareholders.
C is correct. In this ownership structure, the controlling shareholder’s power is likely more influential than that of minority shareholders. Thus, the controlling shareholder may be able to exploit its position to the detriment of the interests of the remaining shareholders. A and B are incorrect, because the ownership structure in and of itself is unlikely to create material conflicts between shareholders and bondholders or shareholders and managers.
108
Which of the following stakeholders are most likely to demand higher returns and risk premiums when faced with greater information asymmetry due to the greater potential conflicts of interest?
A. Directors and managers
B. Suppliers and customers
C. Shareholders and lenders
C is correct. Greater information asymmetry increases risk for shareholders and lenders, who will seek to be compensated for taking that risk with a lower share price or multiple and a higher yield on debt investments.
109
An analyst is examining the governance of several companies in her coverage area and learns that one of the CEOs is highly involved in political and charitable activities. These activities may result in which one of the following misalignments of interests between management and shareholders?
A. Self-dealing
B. Entrenchment
C. Insufficient effort
C is correct.
The CEO’s outside activities could result in insufficient effort. Managers may allocate too little time to their role because they are committed to political or charitable activities, personal investments, or serving as directors or managers of other companies.
110
A ________________ corporate ownership structure involves many shareholders, none of whom can exercise control over the corporation.
dispersed
111
A company’s management team, whose compensation includes significant stock grants and options, is pursuing a large debt-financed acquisition.
The management team discusses how this acquisition may not align with the interests of all stakeholders, and it is proposed that they increase equity financing for the acquisition.
Increasing equity financing for the transaction would increase support by which stakeholder?
A. Debtholders
B. Management
C. Shareholders
A is correct. Debtholders with a fixed claim tend to be risk averse and prefer that the corporation take actions to ensure sufficient cash flow to meet its debt obligations. For this reason, debtholders tend to prefer that a company raise more equity as opposed to increasing debt to a level that may increase default risk.
112
Discuss the potential conflicts between controlling shareholders and minority shareholders in a dual-class structure.
A dual-class structure allows stakeholders to effectively control the company by virtue of their ownership of a share class with superior voting rights. While it is possible for minority shareholders to change voting rights in their favor, it can be difficult and expensive to do so.
113
A construction firm has the opportunity to invest in a high-risk, high-reward capital infrastructure project. Which of the following could be a reason why the company decides not to pursue the project?
A. The compensation of managers is closely tied to the size of the company’s business.
B. Management receives excessive all-cash compensation.
C. Management has recently received a generous options reward in the company’s shares.
B is correct. When compensation—particularly if it is excessive—is entirely in cash, the risk tolerance of managers may be too low, as they are inclined to protect their cash compensation. Additionally, there may be little upside for them if the project performs well.
114
Mechanisms to Protect Shareholder Interests:
Shareholder Activism
Shareholder activism involves strategies to compel a company to act in a desired manner, often to increase shareholder value. Activists use tactics such as initiating proxy fights, proposing shareholder resolutions, and publicizing issues of contention.
115
Mechanisms to Protect Shareholder Interests:
Shareholder Litigation
Shareholder derivative lawsuits are legal proceedings initiated against the board of directors, management, and/or controlling shareholders by a shareholder acting on behalf of the company. These lawsuits address failures to act in the company’s best interest.
116
Mechanisms to Protect Shareholder Interests:
Corporate Takeovers
Changes in corporate control via takeovers can be pursued through proxy contests, tender offers, and hostile takeovers. Anti-takeover measures, such as staggered board elections and shareholder rights plans (poison pills), can reduce the likelihood of unwanted takeovers but may also have negative implications for corporate governance practices.
117
Protecting Creditor Interests:
Bond Indenture
A bond indenture is a legal contract that describes the structure of a bond, the obligations of the company, and the rights of the bondholders. It includes terms and conditions requiring the company to meet specific requirements or prohibiting certain actions.
118
Protecting Creditor Interests:
Creditor Committees
Official creditor committees represent bondholders during bankruptcy proceedings and protect bondholder interests in restructuring or liquidation. Ad hoc committees may form to approach the company with potential options to restructure bonds when a company struggles to meet its obligations.
119
Which of the following is typically used to represent creditors’ interests?
A. Ad hoc committee
B. Poison pill
C. Tender offer
A is correct. An ad hoc committee is a group of creditors who approach an issuer in financial distress with options for debt restructuring.
120
A primary responsibility of a board’s audit committee does not include:
A. oversight of accounting policies.
B. adoption of proper corporate governance.
C.recommending remuneration for the external auditor.
B is correct. The adoption of proper corporate governance is the responsibility of a corporation’s governance committee.
121
Mechanisms to Protect Shareholder Interests:
Compensation, or remuneration, committee
The compensation, or remuneration, committee develops and proposes remuneration policies for the directors and key executives, which often includes setting performance criteria and evaluating manager performance.
122
Mechanisms to Protect Shareholder Interests:
Governance Committee
This committee appraises director and manager candidates and oversees the board election process. It sets nomination procedures and policies, including board directorship criteria, the search for and identification of qualified candidates for board directorships, and the election process by shareholders.
The committee also oversees the establishment and enforcement of corporate policies, including:
a corporate governance code;
the charter of the board and its committees;
a code of ethics; and
a policy on conflicts of interest, among others.
123
Mechanisms to Protect Shareholder Interests:
Audit Committee
should be composed solely of independent board members and include at least one director with accounting or financial management expertise.
The audit committee monitors the issuer’s financial reporting process, including the proper selection and implementation of accounting policies according to accounting standards and regulations in order to ensure the integrity of the financial statements. It supervises the internal audit function and ensures its independence and competence
The audit committee is also responsible for recommending the appointment of an independent external auditor and proposing its remuneration.
124
Creditor Committees:
Ad Hoc Committee
A small group of lenders or bondholders who negotiate with an issuer on debt restructuring and refinancing before the issuer submits a final proposal to the wider group of all lenders and bondholders.
125
Mechanisms to Protect Shareholder Interests:
Corporate Takeover: Proxy Contest
When a shareholder or group of shareholders campaigns for certain matters they have submitted to a shareholder vote, often a slate of directors who oppose the incumbent board and management. The incumbent board and management simultaneously campaign for their side.
126
Mechanisms to Protect Shareholder Interests:
Corporate Takeover: Tender Offer
A solicitation by a current or prospective shareholder to other shareholders to acquire a substantial percentage, including 100%, of shares at a specified price. This action is usually undertaken by a potential acquirer whose bid was rejected by the issuer’s board of directors, prompting the potential acquirer to appeal directly to shareholders.
127
Mechanisms to Protect Shareholder Interests:
Corporate Takeover: Hostile Offer
When a potential acquirer seeks to acquire a company (the target) against the wishes of the target’s board of directors. Typically, a tender offer is used to carry out the hostile takeover, against which a board might use a poison pill in its defense.
128
Which of the following best describes shareholder activists? Shareholder activists:
A. help stabilize a company’s strategic direction.
B. have little effect on the company’s long-term investors.
C. are unlikely to alter the composition of a company’s shareholder base.
A is correct. Shareholder activists often narrow a company’s strategic direction to focus on the few things that the company has historically done well, often shedding assets and closing divisions in the process.
129
Proxy Voting
A form of casting a ballot in an election in which a voter authorizes a representative to vote on their behalf according to instructions. In corporate elections, proxy ballots are cast by shareholders that direct a representative, typically the corporate secretary, to enter their votes as instructed.
130
Mechanisms to Protect Shareholder Interests:
Extraordinary general meetings (EGMs)
Meetings besides an AGM of the corporate board and shareholders, typically held to deliberate and vote on urgent matters. Corporate charters and bylaws specify who can call an EGM and under what conditions.
Special elections of board members, usually proposed by shareholders
Amendments to bylaws or articles of association
Mergers and acquisitions, takeovers, and asset sales
Capital increases
Voluntary firm liquidation
131
Mechanisms to Protect Shareholder Interests:
Annual general meeting (AGM)
A yearly meeting of the corporate board of directors and shareholders, typically held in person and digitally, during which votes on directors, compensation plans, shareholder resolutions, and any other matters properly brought forward at the meeting are held. Issuer management may also make presentations and hold events.
Board member elections
Appointment of independent auditor
Approval of annual financial statements, dividends, and director and auditor compensation
Approval of equity-based compensation plans
“Say on pay” non-binding votes on compensation plans
132
Weak Corporate Governance:
Operational Risks:
Fraud and Mismanagement
Without adequate controls, stakeholders can be exploited for personal gain by management, leading to significant operational risks and failures.
133
Strong Corporate Governance:
Operational Benefits:
Improved Decision-Making and Accountability
Strong governance practices ensure proper scrutiny and control at all levels, aligning managerial decisions with shareholder interests and improving operational results.
134
Weak Corporate Governance:
Legal, Regulatory, and Reputational Risks:
Non-Compliance and Legal Issues
Weak compliance with regulatory requirements or poor reporting practices can expose companies to investigations, lawsuits, and significant reputational damage.
135
Strong Corporate Governance:
Legal, Regulatory, and Reputational Benefits:
Reputation and Long-Term Relationships
Effective governance helps build and maintain a positive reputation, attracting talent, securing capital, and enhancing customer and supplier relationships.
136
Weak Corporate Governance:
Financial Risks:
Increased Default Risk
Poor governance can affect a company's financial stability, increasing the risk of default and impacting all stakeholders.
137
Strong Corporate Governance:
Financial Benefits:
Lower Cost of Capital
Good governance reduces the perceived risk for investors and creditors, lowering the required return on capital and enhancing the firm’s valuation.
138
Corporate Governance:
Key Considerations for Analysis:
Ownership & Voting Structure
What is the company's ownership and voting structure?
139
Corporate Governance:
Key Considerations for Analysis:
Board Composition
Do board members' skills and experience match the current and future needs of the company?
140
Corporate Governance:
Key Considerations for Analysis:
Management Compensation
How closely does the management team’s compensation and incentive structure align with factors expected to drive overall company results?
141
Corporate Governance:
Key Considerations for Analysis:
Significant Investors
Who are the significant investors in the company?
142
Corporate Governance:
Key Considerations for Analysis:
Shareholder Rights
How strong are company shareholder rights versus its peers?
143
Corporate Governance:
Key Considerations for Analysis:
Risk Management and Sustainability
How effective is the company in managing long-term risks and sustainability?
144
Which of the following is not a benefit of an effective corporate governance structure?
A. Operating performance can be improved.
B. A corporation’s cost of debt can be reduced.
C. Corporate decisions and activities require less control.
C is correct. A benefit of an effective corporate governance structure is to enable adequate scrutiny and control over operations.
145
An investment analyst would likely be most concerned about an executive compensation plan that:
A. varies each year.
B. is consistent with the compensation plans of a company’s competitors.
C. is cash-based only, without an equity component.
C is correct. If an executive remuneration plan offers cash only, the interests of management and investors (and other stakeholders) may be misaligned. An equity-based compensation plan is commonly used to align management interests with those of shareholders.
146
Benefits of effective corporate governance include all of the following except:
A. avoidance of fraud.
B. higher investor confidence.
C. reduced cost of equity.
A is correct. Effective corporate governance allows for the mitigation, not the avoidance, of risk factors such as fraud, or at least their identification and control at early stages.
147
Operating Cycle
The length of time between a company’s acquisition of goods or raw materials and the collection of cash from sales to customers.
148
days payable outstanding (DPO)
The average number of days it takes a company to pay its suppliers. It is calculated as either the ending or average balance of accounts payable divided by (cost of goods sold/days in the period).
149
days of inventory on hand (DOH)
The average number of days it would take to sell the amount of inventory on hand. It is calculated as either the ending or average balance of inventories divided by (cost of goods sold/days in the period).
150
days sales outstanding (DSO)
The average number of days it takes for a company to receive payment from customers who purchase goods or services on credit. It is calculated as either the ending or average balance of accounts receivable divided by (revenues/days in the period).
151
cash conversion cycle
The amount of time between an issuer paying its suppliers in cash and receiving cash from its customers.
The cash conversion cycle is the number of days it takes a company to convert an inventory investment into cash receipts from customers.
152
Primary Liquidity Sources:
Cash + Securities
Immediate cash available in bank accounts or as currency or securities that can be quickly sold without significant loss of value.
153
Primary Liquidity Sources:
Borrowings
Obtaining cash from banks, bondholders, or trade credit from suppliers. This creates an obligation that must be repaid.
154
Primary Liquidity Sources:
Cash Flow from Operations
Cash generated from business activities. This is a substantial long-term source of liquidity for profitable firms.
155
Cash Flow from Operations
A cash profit measure over a period for an issuer’s primary business activities. It includes cash from customers as well as interest and dividends received from financial investments, less cash paid to employees and suppliers as well as taxes paid to governments and interest paid to lenders.
156
Secondary Liquidity Sources
Suspending or Reducing Dividends
Delaying or Reducing Capital Expenditures
Issuing Equity
Renegotiating Contract Terms
Selling Assets
Filing for Bankruptcy Protection and Reorganization
157
Drag on Liquidity
An action or event that reduces available funds or delays cash inflows.
Uncollected Receivables
Obsolete Inventory
Borrowing Constraints
158
Pull on Liquidity
An action or event that accelerates cash outflows.
Making Payments Early
Reduced Credit Limits
Limits on Short-Term Lines of Credit
Low Liquidity Positions
159
Keown Corporation is experiencing liquidity challenges. As an analyst, you note three recent trends related to Keown’s working capital:
1. An increase in average days sales outstanding is a drag on liquidity.
2. An increase in days of inventory on hand is a drag on liquidity.
3. An increase in credit limits by lenders is a pull on liquidity.
Which trend does not contribute to the firm’s liquidity challenges?
A. The change in average days sales outstanding
B.The change in days of inventory on hand
C.The change in credit limits
C is correct. The increase in credit limits is not a pull on liquidity but is in fact the opposite: it provides liquidity.
160
Current Ratio
The broadest measure of liquidity.
A measure of liquidity that is the ratio of current assets to current liabilities.
161
Quick Ratio
The quick ratio is a ratio of short-term assets to short-term liabilities that excludes inventory
162
Cash Ratio
A measure of liquidity that is the ratio of cash and marketable securities to current liabilities.
163
Implications of Quick Ratio > 1
A firm able to meet its short-term obligations without liquidating inventory would therefore have a quick ratio greater than one.
However, this scenario would require the firm to collect all receivables without delays or customer delinquencies.
164
Implications of Cash Ratio > 1
A cash ratio equal to or greater than one indicates that a firm could satisfy all its short-term obligations without having to wait to sell inventory or collect receivables.
165
Drag or Pull on Liquidity:
Lender Reducing Line of Credit
Pull
166
Identify the Current Liabilities:
Cash
Marketable Securities
A/R
Inventory
Prepaid Expenses
A/P
Accrued Expenses
S.T. Debt
Current Liabilities =
A/P
+ Accrued Expenses
+ S.T. Debt
167
Identify the Current Assets:
Cash
Marketable Securities
A/R
Inventory
Prepaid Expenses
A/P
Accrued Expenses
S.T. Debt
Current Assets =
Cash +
Marketable Securities +
A/R +
Inventory +
Prepaid Expenses
168
Capital Investments
An expenditure for an asset or resource with a useful life of more than one year.
169
Depreciation
The process of systematically allocating the cost of long-lived (tangible) assets to the periods during which the assets are expected to provide economic benefits.
170
Amortization
The process of allocating the cost of intangible long-term assets having a finite useful life to accounting periods; the allocation of the amount of a bond premium or discount to the periods remaining until bond maturity.
171
Maintenance CAPEX
Investments in assets to keep them in operation or increase their efficiency without extending their useful lives.
172
Match Funding
Financing an asset with a source, such as a loan or bond, that is aligned with certain attributes of the asset, such as duration and the respective streams of income and financing costs.
173
Net Present Value (NPV)
NPV is the present value of expected future cash inflows minus the investment costs.
174
internal rate of return (IRR)
The discount rate that makes net present value equal 0; the discount rate that makes the present value of an investment’s costs (outflows) equal to the present value of the investment’s benefits (inflows).
175
Decision Rules for Investing:
NPV Decision Rule
If NPV >= 0: Invest
If NPV <0 : Do not invest
176
internal rate of return (IRR)
The internal rate of return (IRR) is the discount rate that makes the net present value of an investment equal to zero.
177
Decision Rules for Investing:
IRR Decision Rule
IRR >= r .: Invest
IRR < r .: Do not invest
178
Hurdle Rate
Also called “preferred return.” The minimum rate of return on investment that a fund must reach before a GP receives carried interest.
179
Return on invested capital:
Definition
a profitability measure for the total capital that management has invested
180
Return on invested capital:
Motivation for using
Independent investment analysts do not have the necessary information to calculate or audit management’s calculations of project NPVs or IRRs. Analysts of listed companies have consolidated financial statements and, sometimes, segment-level information, all of which are highly aggregated and include cash flows associated with many projects. Return on invested capital, also known as return on capital employed (ROCE), is a profitability measure for the total capital that management has invested,
181
ROIC vs. Investors' Require Rate of Return
ROIC can be compared to investors’ required rate of return. If an issuer’s ROIC is greater than the investors’ required rate of return over time, the issuer is creating value for investors.
Conversely, if the ROIC is below the required rate of return, it is an indicator that investors would have been better off investing elsewhere; the issuer should take actions to improve turnover or profit margins, dispose of investments in underperforming areas, return capital, or seek alternative areas of investment with greater returns.
181
Which step in the capital allocation process most likely involves the calculation of NPV and IRR?
IA. dea generation
B. Investment analysis
C. Planning and prioritization
B is correct. The investment analysis step involves forecasting the amount, timing, duration, and volatility of an investment’s expected cash flows and subsequently using NPV and IRR to determine whether the investment will be a wise use of capital.
182
Which of the following relationships is true?
A. If IRR > Required rate of return, then NPV < 0.
B. If IRR = Required rate of return, then NPV = 0.
C.Required rate of return = Risk-free rate.
B is correct. IRR is the required rate of return that makes an investment’s NPV equal to zero.
183
Behavioral Biases in Capital Allocation:
Inertia
A tendency to anchor capital investment budgets to prior-year amounts can result in static or rising investments despite falling returns. This bias can be identified by examining year-over-year capital investment levels and their returns.
184
Behavioral Biases in Capital Allocation:
Basing Investment Decisions on Accounting Measures, such as EPS:
Managers may prioritize short-term accounting measures over long-term value creation. This can lead to underinvestment in high NPV projects or overemphasis on cost-cutting and share buybacks. Analysts should examine management compensation and capital spending trends relative to peers.
185
Behavioral Biases in Capital Allocation:
Pet Project Bias
Preferential treatment of certain projects, often due to executive favoritism, can result in investments based on overly optimistic projections. Analysts should evaluate corporate governance structures and watch for signs of capital misallocation.
186
Behavioral Biases in Capital Allocation:
Failure to Consider Investment Alternatives or Alternative Scenarios
Not considering viable alternatives or different outcomes can result in missed opportunities or unpreparedness for adverse scenarios. Firms should conduct breakeven, scenario, and simulation analyses to evaluate different possibilities.
187
True or false: Investment projects funded using internally generated funds (e.g., cash flow from operations) should be evaluated using a lower required rate of return as compared to projects funded using debt or share issuance.
False.
Ignoring the cost of internal financing is a common cognitive error. Internally generated capital, such as cash flow from operations, is equity financing because it could be returned to equity investors as a dividend or share repurchase. While internally generated capital is not raised from equity investors by issuing shares, it is withheld from them, therefore incurring their opportunity cost.
188
Explain why some managers might reject projects that significantly increase shareholder value (i.e., have a high NPV).
Managers may have an incentive to increase accounting profitability measures, such as earnings per share, net income, or return on equity.
Many capital investments, even those with high NPVs, can reduce rather than increase these measures in the near term, while cost cutting and share buybacks, in contrast, may have a positive effect on such measures.
If this incentive is strong enough, management may forgo high-NPV projects in favor of actions that increase near-term earnings per share.
189
Capex: Real Options
A right, but not an obligation, for management to make a decision with respect to a capital investment that alters future cash flows from the original forecasted scenario.
real options provide companies with flexibility with regard to future decision
190
Capex:
Timing Option
Timing option:
Instead of investing now, the company can choose to delay its investing decision. In doing so, companies forgo near-term returns and hope to obtain improved information for the NPV of projects selected. Investments may be sequenced over time, so that investing in a project creates the option to make future investments.
191
Capex:
Sizing Option
An abandonment option allows a company to abandon the investment after it is undertaken if the financial results are disappointing. At some future date, if the cash flow from abandoning an investment exceeds the present value of the cash flows from continuing the investment, the company should exercise the abandonment option. Conversely, if the company can make additional investments when future financial results are strong, the company has a growth option, or expansion option.
192
Capex:
Sizing Option:
Abandonment Option
The option to terminate an investment at some future time if the financial results are disappointing.
193
Capex:
Sizing Option:
Growth Option
The option to make additional investments in a project at some future time if the financial results are strong. Also called an expansion option.
194
Capex:
Flexibility Option
Companies may also benefit from operational flexibility other than abandonment or expansion once an investment is complete. For example, suppose a firm finds that demand for a product or service exceeds capacity. Management may be able to exercise a price-setting option.
By increasing prices, the company could benefit from the excess demand, which it cannot do by increasing production. Alternatively, a firm may consider production flexibility options to alter production when demand differs from its forecast. For example, a firm may add overtime or extra shifts to increase production for a given capacity.
195
Capex:
Flexibility Option:
Price-Setting Option
The option to adjust prices when demand or supply varies from what is forecast.
196
Capex:
Flexibility Option:
Production-Flexibility Option
The option to alter production when demand varies from what is forecast.
197
Capex:
Fundamental Option
Fundamental option: The entire value of an investment may depend on factors outside the firm’s control, such as the price of a commodity. For example, the value of an oil well or refinery investment is contingent on the price of oil. The value of a gold mine is contingent on the price of gold. If oil prices were low, a company likely would not choose to drill a well. If oil prices were high, it would go ahead and drill. Many R&D (research and development) projects are also very similar to such options.
198
Capex:
Investment analysis without considering options
If the NPV is positive without considering real options and the project involves real options that could increase its net present value, then the NPV represents a minimum return and the firm should make the investment.
199
Capex:
Calculation of NPV with real options
Under this approach, the firm calculates a project’s NPV based on expected cash flows and then subtracts the incremental cost of the real option and adds its associated value, as shown in Equation 4:
Project NPV = NPV (without options) – Option cost + Option value.
200
Capex:
Decision trees and option pricing models:
Either approach may be used by firms seeking to assess the value of a capital investment that involves future sequential decisions and alternative outcomes for a given investment. These models often assign a probability and expected timing to future outcomes, which are used to calculate the project’s NPV.
201
Which of the following statements about real options is true?
A. Using option pricing models estimates an option’s value with the highest accuracy.
B. Real options allow companies to abandon an investment project if its profitability is poor.
C. Real options would allow a refinery to hedge future prices of crude oil needed for production.
B is correct. An abandonment option is a type of real option, which allows a company to abandon the investment after it is undertaken.
202
cost of capital
The cost of financing for a company; the rate of return that suppliers of capital require as compensation for their contribution of capital (also called opportunity cost of funds).
203
weighted-average cost of capital
weighted-average cost of capital (WACC) blends its costs of debt and equity to obtain a single cost of capital. The WACC, after adjusting for any project-specific risks, is what issuers use as r in NPV analysis and as the hurdle rate for IRR analysis.
204
cost of debt
The required return on debt financing for a company, such as when it issues a bond, takes out a bank loan, or leases an asset through a finance lease.
205
cost of equity
The return required by equity investors to compensate for both the time value of money and the risk. Also referred to as the required rate of return on common stock or the required return on equity.
206
capital structure
The mix of debt and equity that a company uses to finance its business; a company’s specific mix of long-term financing.
207
True or False:
Since the cost of debt and equity are controlled by the firm, managers can lower the cost of capital for the firm by reduce reducing the cost of debt and equity used in their capital allocation process.
A. True
B. False
B is correct. This statement is false because the costs of debt and equity are not selected by management but are determined in financial markets by investors, though they are influenced by management’s actions.
208
Factors Affecting Capital Structure:
Business Model:
Capital-Intensive Business
Require substantial assets (e.g., utilities, transportation, real estate, certain types of manufacturing, natural resource production).
These businesses exhibit low asset turnover, high capital expenditures relative to sales, and high net working capital to sales ratios.
209
Factors Affecting Capital Structure:
Business Model:
Capital-Light Business
Require fewer assets (e.g., technology firms, service businesses). They may operate networks (like Uber or Airbnb) without owning significant assets themselves, have short or negative cash conversion cycles, and often compensate employees with stock.
210
Factors Affecting Capital Structure:
Corporate Life Cycle:
Startup
High business risk, negative free cash flow, limited debt availability. Financing primarily through equity, including from founders, employees, and venture capitalists.
211
Factors Affecting Capital Structure:
Corporate Life Cycle:
Growth
Rising revenue, negative but improving free cash flow, moderate business risk. Financing mix of equity and increasing amounts of secured debt.
212
Factors Affecting Capital Structure:
Corporate Life Cycle:
Mature
Stable revenue and positive free cash flow, low business risk. High availability of unsecured debt and greater use of debt financing to maintain an investment-grade credit rating.
213
Determinants of the Costs of Debt and Equity:
Top-Down Factors:
Economic Conditions
Affect both debt and equity markets. Interest rates on sovereign debt influence the base rates, with higher rates demanding higher spreads for riskier debt. Macroeconomic factors like inflation, growth, and monetary policy significantly impact these rates.
214
Determinants of the Costs of Debt and Equity:
Top-Down Factors:
Industry Conditions
Specific industry risks can affect the cost of capital. For example, higher oil prices may reduce credit spreads for oil producers but increase them for airlines.
215
Determinants of the Costs of Debt and Equity:
Issuer-Specific Factors:
Sales Risks
Stability and predictability of revenue streams. Companies with stable, growing revenues can secure financing at lower costs.
216
Determinants of the Costs of Debt and Equity:
Issuer-Specific Factors:
Profitability Risks
Operating leverage, or the proportion of fixed to variable costs, influences profit stability. High operating leverage means greater profit variability with changes in revenue.
217
Determinants of the Costs of Debt and Equity:
Issuer-Specific Factors:
Financial Leverage
Existing debt levels affect the ability to take on more debt. Higher indebtedness increases financial risk, raising the cost of additional debt.
218
Determinants of the Costs of Debt and Equity:
Issuer-Specific Factors:
Collateral and Asset Type
The quality and type of assets used as collateral can affect the cost of debt. Secure, fungible assets like real estate generally offer lower-cost financing compared to specialized or low-value assets.
219
MM Proposition I: Capital Structure Irrelevance (Without Taxes):
Key Idea
In a world without taxes, transaction costs, or financial distress costs, the value of a company is unaffected by its capital structure. This means that changing the mix of debt and equity does not change the firm's value.
220
MM Proposition II: Cost of Equity and Financial Leverage (Without Taxes):
Key Idea
While debt is cheaper than equity due to the priority claim of debtholders, increasing financial leverage (using more debt) raises the firm's cost of equity. This increase exactly offsets the benefit of lower-cost debt, leaving the WACC unchanged.
221
MM Proposition I: Capital Structure With Taxes:
Key Idea
When corporate taxes are considered, the value of a levered firm increases because interest payments on debt are tax-deductible, creating a tax shield.
222
MM Proposition II: Cost of Equity and Financial Leverage (With Taxes):
Key Idea
With taxes, the cost of equity still increases with leverage, but the presence of the tax shield means that the WACC decreases as more debt is used, leading to a higher firm value.
223
The view that debt financing is highly advantageous and the optimal capital structure is 100% debt is consistent with:
A. MM without taxes.
B. MM with taxes and financial distress costs.
C. MM with taxes and no financial distress cost.
C is correct.
MM with taxes and no distress cost leads to the conclusion that the optimal capital structure is 100% debt. This is because tax law favors debt financing over equity financing since the interest expense on debt financing is tax deductible. Ignoring financial distress costs, the value of the company increases with increasing levels of debt. The value of the levered firm (VL) is greater than that of the unlevered one (VU) by the amount equal to the tax rate multiplied by the level of debt (tD).
224
True or False:
What is clear from MM is that the primary driver of firm value is capital structure.
A. True
B. False
B is correct. This statement is false since it is future cash flows that are the primary driver of value. Under a set of restrictive assumptions, MM’s conclusion of capital structure irrelevance is obtained. Relaxing these assumptions, MM showed that capital structure does impact value, but it has only a modest impact compared to future cash flows.
225
MM Proposition II without taxes differs from MM Proposition I without taxes since it concludes that:
A. WACC is unaffected by capital structure.
B. the value of the levered firm is equal to that of the unlevered firm.
C. higher leverage raises the cost of equity, which exactly offsets the lower cost of debt.
C is correct.
MM Proposition II without taxes differs from MM Proposition I without taxes in that the cost of equity will rise with leverage and completely offset the lower cost of debt. Debt has a lower cost relative to equity because debtholders have a priority claim on the cash flow of the firm. So, one would expect WACC to decline with more debt. MM Proposition II without taxes argues that the cost of equity is a linear function of the debt-to-equity ratio. The addition of more low-cost debt to the capital structure will increase the debt-to-equity ratio and raise the cost of equity, offsetting the lower debt cost. As a result, the firm’s WACC is unchanged.
226
Company Y has an unlevered WACC of 10%. It has a cost of debt equal to 5.5% and a debt-to-equity ratio of 0.75. The corporate tax rate is 25%.
The cost of equity for Company Y will be 13.37% if it pays no corporate taxes and 12.53% if it pays corporate taxes.
The cost of equity is a linear function of its debt-to-equity ratio and without taxes is calculated as follows:
re=r0+(r0−rd)DE
= 10% + (10% – 5.5%)(0.75) = 13.37%.
The cost of equity with taxes is calculated as
re=r0+(r0−rd)(1−t)DE
= 10% + (10% – 5.5%)(1 – 0.25)(0.75) = 12.53%.
227
If Company Y is an all-equity-financed firm, its cost of equity will be ________ its WACC.
A. greater than
B. equal to
C. lower than
B is correct. Since Company Y is an unlevered firm and has no debt in its capital structure, the cost of equity will be the same as WACC. Since the weighting of debt is zero, the WACC formula is simply
WACC = Weighting of equity × Cost of equity.
228
Optimal Capital Structure
The optimal capital structure is the mix of debt and equity that minimizes a company's WACC and maximizes its value. It represents the point where the benefits of debt, such as tax shields, are balanced against the costs, such as financial distress and bankruptcy costs.
229
Why might a company's "Target Capital Structure" differ from the "Optimal Capital Structure" ?
Managers establish a target capital structure based on the trade-off theory, market conditions, and firm-specific factors. The target structure may differ from the optimal structure due to:
A. Short-term financing opportunities
B. Market value fluctuations
C. Transaction costs
230
asymmetric information
Also known as information asymmetry; the differential of information between corporate insiders and outsiders regarding the company’s performance and prospects. Managers typically have more information about the company’s performance and prospects than owners and creditors.
231
Pecking-Order Theory
The theory that managers consider how their actions might be interpreted by outsiders and thereby order their preferences for various forms of corporate financing. Forms of financing that are least visible to outsiders (e.g., internally generated funds) are most preferable to managers, and those that are most visible (e.g., equity issuance) are least preferable.
232
Free Cash Flow Hypothesis
The hypothesis that higher debt levels discipline managers by forcing them to make fixed debt service payments and by reducing the company’s free cash flow.
233
True or False:
Under the pecking order theory, the firm has no optimal capital structure and a firm’s capital structure reflects its historic need for external financing.
A. True
B. False
A is correct.
The pecking order theory is based on asymmetric information held by investors and issuers and the idea that managers consider what their actions may signal to investors. The signaling model suggests a hierarchy in methods in financing the firm. Internal funds are used first, then debt is used, and finally, reluctantly, firms use equity. There is no optimal capital structure, and a firm’s capital structure reflects its historic need for external financing.
234
True or False:
The target capital structure should be estimated using the market value of equity and debt in calculating WACC.
A. True
B. False
B is correct.
Target capital structure is often estimated using book values because market values can fluctuate significantly and are unlikely to impact borrowing capacity. Issuers will often aim for a certain credit rating, such as investment grade, which is strongly influenced by the issuer’s (book value) level of indebtedness relative to cash flows.
235
Business Model
A concise description of how a business works and makes revenues and profits, including its customers, products or services, channels for reaching customers, and pricing.
236
Channels
Venues where a company markets and/or delivers its products and services.
237
Omnichannel
Refers to a company selling its products or services in multiple channels, such as in store and online.
238
Price Discrimination
A pricing approach that charges different prices to different customers based on their willingness to pay.
239
Commodity Producer
A firm that makes and/or sells commodities.
240
Differentiated Products
A product or service from a firm that is distinguishable or distinct from those of competing firms. It is customers who determine and value whether a product is differentiated.
241
Pricing Power
The ability of a firm to set prices for its products or services without materially losing volume share. Generally this means that the product or service is not a commodity because the firm is not a price taker.
242
Tiered Pricing
A pricing approach that charges different prices to different buyers, commonly based on volume purchased.
Ex: Costco
243
Dynamic Pricing
A pricing approach that charges different prices at different times. Specific examples include off-peak pricing, “surge” pricing, and “congestion” pricing.
Ex: Uber
244
Value-based pricing
Setting prices based on the value received by the customer, which often involves estimating opportunity cost. This approach is commonly attempted in pharmaceuticals, where, for example, the price of a new drug that reduces the risk of stroke by 33% would reflect the savings from avoided hospitalization and death. Such an approach leads to different prices for different drugs since drugs vary in effectiveness and the type of disease they treat, and the prices of hospitalizations, physician services, and so on, that may be avoided from their use also vary by country.
Ex: Pharma Drugs
245
Auction/reverse auction models
Pricing models that establish prices through bidding (by sellers in the case of reverse auctions).
246
Bundling
refers to combining multiple products or services so that customers are incentivized or required to buy them together. Bundling can be effective, particularly for products that are complementary and that have high incremental profit margins and high marketing costs relative to the cost of the product itself.
247
Razor, razorblade pricing
combines a low price on an initial purchase of equipment (e.g., razor, printer, gaming console, diagnostic equipment) with high-margin prices on repeat-purchase consumables associated with the equipment (razorblades, printer ink, games, reagents). Often, companies design the equipment to work only with their proprietary consumables. Other companies selling generic consumables can render this pricing model unprofitable.
248
Add-on pricing
A pricing approach based on high-margin optional features, customizations, and additional content.
249
penetration pricing
A discount pricing approach used when a firm willingly sacrifices margins in order to build scale and market share.
250
freemium business model
A pricing approach that allows customers a certain level of usage or functionality at no charge. Those who wish to use more must pay.
251
hidden revenue business model
Business models that provide services to users at no charge and generate revenues elsewhere.
252
Franchising
A situation where an owner of an asset and associated intellectual property divests the asset and licenses intellectual property to a third-party operator (franchisee) in exchange for royalties. Franchisees operate under the constraints of a franchise agreement.
253
Value Proposition
The product or service attributes valued by a firm’s target customer that lead those customers to prefer that firm’s offering.
254
Value Chain
The systems and processes in a firm that create value for its customers.
The value chain includes only those functions performed by a single firm, including functions that are valued by customers but may not involve physical transformation or handling the product. Note that a firm’s value chain is different from its supply chain
255
Supply Chain
The sequence of processes involved in the creation and delivery of a physical product to the end customer, both within and external to a firm, regardless of whether those steps are performed by a single firm.
256
Unit Economics
The expression of revenues and costs on a per-unit basis.
257
Contract Manufacturers
Companies that make products for other companies that meet specific terms and specifications.
258
Value Added Resellers
Businesses that distribute a product and also handle more complex aspects of product installation, customization, service, or support.
259
Network Effects
A business model that increases in value to its users as the number of users increases, for example communication and payment networks.
260
Crowdsourcing
A business model that enables users to contribute directly to a product, service, or online content.
