Corporate Issuers (8%)

Question 1

Key Attributes of Organizational Forms:

Legal Identity

Answer 1

Whether the business is a separate legal entity from its owners.

Question 2

Key Attributes of Organizational Forms:

Owner-Manager Relationship

Answer 2

The relationship between the business owners and those who manage the business.

Question 3

Key Attributes of Organizational Forms:

Owner Liability

Answer 3

The extent to which owners are personally liable for the business’s actions and debts.

Question 4

Key Attributes of Organizational Forms:

Taxation

Answer 4

How business profits and losses are treated for tax purposes.

Question 5

Key Attributes of Organizational Forms:

Access to Financing

Answer 5

The ability to raise capital for expansion and distribute risks.

Question 6

Sole Trader or Proprietorship:
Description

Answer 6

A single owner provides capital, retains full control, and is responsible for all risks and returns.

Question 7

Sole Trader or Proprietorship:
Legal Identity

Answer 7

No separate legal identity

Question 8

Sole Trader or Proprietorship:
Liability

Answer 8

Full Personal Liability

Question 9

Sole Trader or Proprietorship:
Taxation

Answer 9

Business Profits Taxed as Personal Income

Question 10

General Partnership:
Description

Answer 10

Two or more owners (general partners) share resources, risks, and returns.

Question 11

General Partnership:
Legal Identity

Answer 11

No separate legal identity.

Question 12

General Partnership:
Liability

Answer 12

Partners have unlimited personal liability.

Question 13

General Partnership:
Taxation

Answer 13

Profits taxed as personal income.

Question 14

Limited Partnership:
Description

Answer 14

At least one general partner (with unlimited liability) and one or more limited partners (with liability limited to their investment).

Question 15

Limited Partnership:
Legal Identity

Answer 15

Partial separate legal identity.

Question 16

Limited Partnership:
Liability

Answer 16

General partners have unlimited liability;
limited partners have liability limited to their investment.

Question 17

Limited Partnership:
Taxation

Answer 17

Profits taxed as personal income.

Question 18

Limited Liability Partnership (LLP):
Description

Answer 18

Composed entirely of partners with limited liability.

Question 19

Limited Liability Partnership (LLP):
Legal Identity

Answer 19

Separate legal identity.

Question 20

Limited Liability Partnership (LLP):
Liability

Answer 20

All partners have limited liability.

Question 21

Limited Liability Partnership (LLP):
Taxation

Answer 21

Profits taxed as personal income.

Question 22

Limited Liability Partnership (LLP):
Applicability

Answer 22

Often restricted to professional services firms.

Example: Law firms, accounting firms, and architecture firms.

Question 23

Limited Companies:
Private Limited Company:
Description

Answer 23

Combines limited liability, improved transferability of ownership, and separation of ownership and management.

Question 24

Limited Companies:
Private Limited Company:
Legal Identity

Answer 24

Separate legal identity.

Question 25

Limited Companies:
Private Limited Company:
Liability

Answer 25

Owners (shareholders) have limited liability.

Question 26

Limited Companies:
Private Limited Company:
Taxation

Answer 26

Profits taxed at both the corporate and personal levels.

(Double Taxation)

Question 27

Limited Companies:
Private Limited Company:
Access to Financing

Answer 27

Better access to financing compared to partnerships.

Question 28

Limited Companies:
Private Limited Company:
Examples

Answer 28

LLCs or S corporations in the United States

Question 29

Limited Companies:
Public Limited Company (Corporation):

Description

Answer 29

Suitable for companies seeking to go public, with no restrictions on the number of owners or ownership transferability.

Question 30

Limited Companies:
Public Limited Company (Corporation):

Legal Identity

Answer 30

Separate legal identity

Question 31

Limited Companies:
Public Limited Company (Corporation):

Liability

Answer 31

Shareholders have limited liability.

Question 32

Limited Companies:
Public Limited Company (Corporation):

Taxation

Answer 32

Profits taxed at both the corporate and personal levels.

(Double Taxation)

Question 33

Limited Companies:
Public Limited Company (Corporation):

Access to Financing

Answer 33

Greatest access to financing.

Question 34

Limited Companies:
Public Limited Company (Corporation):

Examples

Answer 34

Large multinational companies like Apple, Toyota, and Siemens.

Question 35

True or False: Partnerships are typically taxed at the entity level rather than at the individual partner level.

True
False

Answer 35

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.

Question 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

Answer 36

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.

Question 37

Organizational Form

Answer 37

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.

Question 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.

Answer 38

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.

Question 39

Identify two features that distinguish a general partnership from a limited partnership.

Answer 39

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.

Question 40

Corporations:
Owner-Manager Separation

Answer 40

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.

Question 41

Corporations:
Owner/Shareholder Liability

Answer 41

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

Question 42

Corporations:
External Financing

Answer 42

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.

Question 43

Corporations:
Taxation

Answer 43

Corporations are taxed on their profits, and shareholders may pay additional taxes on dividends, leading to double taxation.

Question 44

Corporate Issuers

Answer 44

Limited companies or corporations that seek financing in financial markets by, for example, issuing debt or equity securities.

Question 45

Explain why the separation of ownership from management allows for corporate issuers to have greater access to capital.

Answer 45

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.

Question 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.

Answer 46

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.

Question 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.

Answer 47

C is correct. Reinvestment of all profits implies that the company pays no dividend to shareholders, and thus, no double taxation occurs.

Question 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.

Answer 48

C is correct. A corporation is a legally separate entity from its owners.

Question 49

Publicly Owned Companies:

Exchange Listing

Answer 49

Shares are listed and traded on an exchange, providing liquidity and price transparency. Investors can easily buy or sell shares on the exchange.

Question 49

Privately Owned Companies:

Exchange Listing

Answer 49

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.

Question 50

Publicly Owned Companies:

Share Ownership and Transfer

Answer 50

Ownership can be transferred easily between investors through the exchange.

Question 51

Privately Owned Companies:

Share Ownership and Transfer

Answer 51

Ownership transfer is more restricted and often requires negotiation between the buyer and seller. The company may also refuse the transfer of ownership.

Question 52

Publicly Owned Companies:

Share Issuance and Financing

Answer 52

Can issue new shares that trade in the secondary market. Have access to a large pool of potential investors.

Question 53

Privately Owned Companies:

Share Issuance and Financing

Answer 53

Finance through private placements from fewer investors, who usually have longer holding periods.

Question 54

Publicly Owned Companies:

Public Companies

Answer 54

Must register with regulatory authorities and comply with strict reporting and disclosure requirements, including filing audited financial statements regularly.

Question 55

Publicly Owned Companies:

Private Companies

Answer 55

Generally subject to fewer regulatory disclosures and compliance requirements.

Question 56

Going Public:
Initial Public Offering

Answer 56

New shares are issued, capital is raised, and shares begin trading on an exchange.

Question 57

Going Public:
Direct Listing

Answer 57

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.

Question 58

Going Public:
Special Purpose Acquisition Company (SPAC)

Answer 58

A private company is acquired by a publicly listed SPAC, becoming a public company.

Question 59

Going Private

Answer 59

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.

Question 60

exchange

Answer 60

A rules-based, open access market venue where financial instruments are traded, with price and volume transparency accessible by issuers, investors, and their intermediaries.

Question 61

Free Float

Answer 61

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.

Question 62

Private Placement

Answer 62

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.

Question 63

accredited investors

Answer 63

Investors that meet certain minimum regulatory net worth or other requirements in order to invest in certain types of alternative assets.

Question 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

Answer 64

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.

Question 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

Answer 65

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.

Question 66

Describe two benefits of being a public company and two reasons that an issuer may instead prefer to be private company.

Answer 66

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.

Question 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

Answer 67

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.

Question 68

residual claim

Answer 68

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

Question 69

Financial leverage

Answer 69

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.

Question 70

Dilution

Answer 70

An increase in the number of shares outstanding from share issuance that decreases the percentage of shares owned by existing shareholders.

Question 71

Corporate equity and debt holders share the same investor perspective with respect to:

A. maximum loss.
B. investment risk.
C. return potential.

Answer 71

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.

Question 72

True or False:
Debtholders, unlike equity holders, have symmetric potential downside losses and upside gains.

True.
False.

Answer 72

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.

Question 73

Conflicts of Interest:
Shareholders vs. Bondholders

Answer 73

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.

Question 74

Interest payments to debtholders are:

A. residual payments.
B. at the discretion of the board.
C. deductible for corporate income tax purposes.

Answer 74

C is correct. Interest payments on debt are tax deductible for the firm.

Question 75

All of the following are characteristics of debt except:

A. limited liability.
B. unlimited return.
C. priority in payment.

Answer 75

B is correct. Shareholders, not debtholders, have the potential for unlimited return.

Question 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.

Answer 76

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.

Question 77

Which of the following groups has a residual claim on an issuer’s cash flows?

A. Employees
B. Debtholders
C. Shareholders

Answer 77

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.

Question 78

Stakeholders

Answer 78

Any party with an interest, financial or non-financial, in an entity or its actions.

Question 79

Shareholder Theory

Answer 79

Focus: Maximizing shareholder value.

Responsibility:
-Directors and managers primarily serve shareholders.

Impact on other stakeholders: Considered only if it affects shareholder value.

Question 80

Stakeholder Theory

Answer 80

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.

Question 81

Conflicts of Interest among Lenders and Shareholders

Answer 81

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.

Question 82

Inside Directors

Answer 82

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.

Question 83

Independent Directors

Answer 83

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.

Question 84

supervisory board

Answer 84

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.

Question 85

Staggered Board

Answer 85

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.

Question 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

Answer 86

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.

Question 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.

Answer 87

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.

Question 88

Negative Externalities

Answer 88

A cost to a third party because of the production or consumption of a good or service.

Question 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.

Answer 89

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.

Question 90

Material

Answer 90

(materiality) Refers to information that is decision-useful for a reasonable investor.

Question 91

ESG: Physical Risks

Answer 91

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.

Question 92

ESG: Transition Risks

Answer 92

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.

Question 93

Transition Risk: Stranded Assets

Answer 93

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.

Question 94

Historically, analysts have best been able to evaluate a company’s:

A. social practices.

B. governance practices.

C. environmental practices.

Answer 94

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.

Question 95

Historically, environmental and social issues have been treated as ______________. However, they are increasingly being recognized as _________________.

(negative externalities, internalized costs).

Answer 95

Historically, environmental and social issues have been treated as negative externalities. However, they are increasingly being recognized as internalized costs.

Question 96

Stranded assets best represent _____________.
(physical risk, transition risk)

Answer 96

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.

Question 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.

Answer 97

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.

Question 98

Principal-Agent Relationship

Answer 98

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.

Question 99

Fill in the blank for each with: (1) principal or (2) agent.

shareholders (________) elect directors (_______), who then hire managers (______) to maximize shareholder value.

Answer 99

shareholders (principals) elect directors (agents), who then hire managers (agents) to maximize shareholder value.

Question 100

Common Divergences Between Manager and Shareholder Interests:

Insufficient Effort

Answer 100

Managers may not invest adequately in projects, manage costs effectively, or make tough decisions due to personal interests or external commitments.

Question 101

Common Divergences Between Manager and Shareholder Interests:

Inappropriate Risk Appetite

Answer 101

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.

Question 102

Common Divergences Between Manager and Shareholder Interests:

Empire Building

Answer 102

Managers may pursue growth for its own sake to increase their compensation and status, even if it doesn’t add shareholder value.

Question 103

Common Divergences Between Manager and Shareholder Interests:

Entrenchment

Answer 103

Managers may take actions to secure their positions rather than acting in the best interests of shareholders.

Question 104

Common Divergences Between Manager and Shareholder Interests:

Self-Dealing

Answer 104

Managers might exploit company resources for personal benefits, which can reduce overall firm value.

Question 105

Dual-Class Share Structures

Answer 105

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.

Question 106

agency costs

Answer 106

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.

Question 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.

Answer 107

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.

Question 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

Answer 108

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.

Question 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

Answer 109

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.

Question 110

A ________________ corporate ownership structure involves many shareholders, none of whom can exercise control over the corporation.

Answer 110

dispersed

Question 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

Answer 111

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.

Question 112

Discuss the potential conflicts between controlling shareholders and minority shareholders in a dual-class structure.

Answer 112

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.

Question 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.

Answer 113

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.

Question 114

Mechanisms to Protect Shareholder Interests:

Shareholder Activism

Answer 114

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.

Question 115

Mechanisms to Protect Shareholder Interests:

Shareholder Litigation

Answer 115

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.

Question 116

Mechanisms to Protect Shareholder Interests:

Corporate Takeovers

Answer 116

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.

Question 117

Protecting Creditor Interests:
Bond Indenture

Answer 117

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.

Question 118

Protecting Creditor Interests:
Creditor Committees

Answer 118

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.

Question 119

Which of the following is typically used to represent creditors’ interests?

A. Ad hoc committee
B. Poison pill
C. Tender offer

Answer 119

A is correct. An ad hoc committee is a group of creditors who approach an issuer in financial distress with options for debt restructuring.

Question 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.

Answer 120

B is correct. The adoption of proper corporate governance is the responsibility of a corporation’s governance committee.

Question 121

Mechanisms to Protect Shareholder Interests:

Compensation, or remuneration, committee

Answer 121

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.

Question 122

Mechanisms to Protect Shareholder Interests:

Governance Committee

Answer 122

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.

Question 123

Mechanisms to Protect Shareholder Interests:

Audit Committee

Answer 123

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.

Question 124

Creditor Committees:
Ad Hoc Committee

Answer 124

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.

Question 125

Mechanisms to Protect Shareholder Interests:

Corporate Takeover: Proxy Contest

Answer 125

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.

Question 126

Mechanisms to Protect Shareholder Interests:

Corporate Takeover: Tender Offer

Answer 126

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.

Question 127

Mechanisms to Protect Shareholder Interests:

Corporate Takeover: Hostile Offer

Answer 127

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.

Question 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.

Answer 128

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.

Question 129

Proxy Voting

Answer 129

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.

Question 130

Mechanisms to Protect Shareholder Interests:

Extraordinary general meetings (EGMs)

Answer 130

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

Question 131

Mechanisms to Protect Shareholder Interests:

Annual general meeting (AGM)

Answer 131

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

Question 132

Weak Corporate Governance:

Operational Risks:

Fraud and Mismanagement

Answer 132

Without adequate controls, stakeholders can be exploited for personal gain by management, leading to significant operational risks and failures.

Question 133

Strong Corporate Governance:

Operational Benefits:

Improved Decision-Making and Accountability

Answer 133

Strong governance practices ensure proper scrutiny and control at all levels, aligning managerial decisions with shareholder interests and improving operational results.

Question 134

Weak Corporate Governance:

Legal, Regulatory, and Reputational Risks:

Non-Compliance and Legal Issues

Answer 134

Weak compliance with regulatory requirements or poor reporting practices can expose companies to investigations, lawsuits, and significant reputational damage.

Question 135

Strong Corporate Governance:

Legal, Regulatory, and Reputational Benefits:

Reputation and Long-Term Relationships

Answer 135

Effective governance helps build and maintain a positive reputation, attracting talent, securing capital, and enhancing customer and supplier relationships.

Question 136

Weak Corporate Governance:

Financial Risks:

Increased Default Risk

Answer 136

Poor governance can affect a company’s financial stability, increasing the risk of default and impacting all stakeholders.

Question 137

Strong Corporate Governance:

Financial Benefits:

Lower Cost of Capital

Answer 137

Good governance reduces the perceived risk for investors and creditors, lowering the required return on capital and enhancing the firm’s valuation.

Question 138

Corporate Governance:

Key Considerations for Analysis:

Ownership & Voting Structure

Answer 138

What is the company’s ownership and voting structure?

Question 139

Corporate Governance:

Key Considerations for Analysis:

Board Composition

Answer 139

Do board members’ skills and experience match the current and future needs of the company?

Question 140

Corporate Governance:

Key Considerations for Analysis:

Management Compensation

Answer 140

How closely does the management team’s compensation and incentive structure align with factors expected to drive overall company results?

Question 141

Corporate Governance:

Key Considerations for Analysis:

Significant Investors

Answer 141

Who are the significant investors in the company?

Question 142

Corporate Governance:

Key Considerations for Analysis:

Shareholder Rights

Answer 142

How strong are company shareholder rights versus its peers?

Question 143

Corporate Governance:

Key Considerations for Analysis:

Risk Management and Sustainability

Answer 143

How effective is the company in managing long-term risks and sustainability?

Question 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.

Answer 144

C is correct. A benefit of an effective corporate governance structure is to enable adequate scrutiny and control over operations.

Question 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.

Answer 145

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.

Question 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.

Answer 146

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.

Question 147

Operating Cycle

Answer 147

The length of time between a company’s acquisition of goods or raw materials and the collection of cash from sales to customers.

Question 148

days payable outstanding (DPO)

Answer 148

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).

Question 149

days of inventory on hand (DOH)

Answer 149

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).

Question 150

days sales outstanding (DSO)

Answer 150

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).

Question 151

cash conversion cycle

Answer 151

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.

Question 152

Primary Liquidity Sources:
Cash + Securities

Answer 152

Immediate cash available in bank accounts or as currency or securities that can be quickly sold without significant loss of value.

Question 153

Primary Liquidity Sources:
Borrowings

Answer 153

Obtaining cash from banks, bondholders, or trade credit from suppliers. This creates an obligation that must be repaid.

Question 154

Primary Liquidity Sources:
Cash Flow from Operations

Answer 154

Cash generated from business activities. This is a substantial long-term source of liquidity for profitable firms.

Question 155

Cash Flow from Operations

Answer 155

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.

Question 156

Secondary Liquidity Sources

Answer 156

Suspending or Reducing Dividends

Delaying or Reducing Capital Expenditures

Issuing Equity

Renegotiating Contract Terms

Selling Assets

Filing for Bankruptcy Protection and Reorganization

Question 157

Drag on Liquidity

Answer 157

An action or event that reduces available funds or delays cash inflows.

Uncollected Receivables
Obsolete Inventory
Borrowing Constraints

Question 158

Pull on Liquidity

Answer 158

An action or event that accelerates cash outflows.

Making Payments Early
Reduced Credit Limits
Limits on Short-Term Lines of Credit
Low Liquidity Positions

Question 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

Answer 159

C is correct. The increase in credit limits is not a pull on liquidity but is in fact the opposite: it provides liquidity.

Question 160

Current Ratio

Answer 160

The broadest measure of liquidity.

A measure of liquidity that is the ratio of current assets to current liabilities.

Question 161

Quick Ratio

Answer 161

The quick ratio is a ratio of short-term assets to short-term liabilities that excludes inventory

Question 162

Cash Ratio

Answer 162

A measure of liquidity that is the ratio of cash and marketable securities to current liabilities.

Question 163

Implications of Quick Ratio > 1

Answer 163

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.

Question 164

Implications of Cash Ratio > 1

Answer 164

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.

Question 165

Drag or Pull on Liquidity:

Lender Reducing Line of Credit

Answer 165

Pull

Question 166

Identify the Current Liabilities:
Cash
Marketable Securities
A/R
Inventory
Prepaid Expenses
A/P
Accrued Expenses
S.T. Debt

Answer 166

Current Liabilities =
A/P
+ Accrued Expenses
+ S.T. Debt

Question 167

Identify the Current Assets:
Cash
Marketable Securities
A/R
Inventory
Prepaid Expenses
A/P
Accrued Expenses
S.T. Debt

Answer 167

Current Assets =
Cash +
Marketable Securities +
A/R +
Inventory +
Prepaid Expenses

Question 168

Capital Investments

Answer 168

An expenditure for an asset or resource with a useful life of more than one year.

Question 169

Depreciation

Answer 169

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.

Question 170

Amortization

Answer 170

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.

Question 171

Maintenance CAPEX

Answer 171

Investments in assets to keep them in operation or increase their efficiency without extending their useful lives.

Question 172

Match Funding

Answer 172

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.

Question 173

Net Present Value (NPV)

Answer 173

NPV is the present value of expected future cash inflows minus the investment costs.

Question 174

internal rate of return (IRR)

Answer 174

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).

Question 175

Decision Rules for Investing:
NPV Decision Rule

Answer 175

If NPV >= 0: Invest
If NPV <0 : Do not invest

Question 176

internal rate of return (IRR)

Answer 176

The internal rate of return (IRR) is the discount rate that makes the net present value of an investment equal to zero.

Question 177

Decision Rules for Investing:
IRR Decision Rule

Answer 177

IRR >= r .: Invest
IRR < r .: Do not invest

Question 178

Hurdle Rate

Answer 178

Also called “preferred return.” The minimum rate of return on investment that a fund must reach before a GP receives carried interest.

Question 179

Return on invested capital:
Definition

Answer 179

a profitability measure for the total capital that management has invested

Question 180

Return on invested capital:
Motivation for using

Answer 180

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,

Question 181

ROIC vs. Investors’ Require Rate of Return

Answer 181

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.

Question 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

Answer 181

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.

Question 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.

Answer 182

B is correct. IRR is the required rate of return that makes an investment’s NPV equal to zero.

Question 183

Behavioral Biases in Capital Allocation:
Inertia

Answer 183

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.

Question 184

Behavioral Biases in Capital Allocation:

Basing Investment Decisions on Accounting Measures, such as EPS:

Answer 184

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.

Question 185

Behavioral Biases in Capital Allocation:

Pet Project Bias

Answer 185

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.

Question 186

Behavioral Biases in Capital Allocation:

Failure to Consider Investment Alternatives or Alternative Scenarios

Answer 186

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.

Question 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.

Answer 187

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.

Question 188

Explain why some managers might reject projects that significantly increase shareholder value (i.e., have a high NPV).

Answer 188

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.

Question 189

Capex: Real Options

Answer 189

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

Question 190

Capex:
Timing Option

Answer 190

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.

Question 191

Capex:
Sizing Option

Answer 191

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.

Question 192

Capex:
Sizing Option:
Abandonment Option

Answer 192

The option to terminate an investment at some future time if the financial results are disappointing.

Question 193

Capex:
Sizing Option:
Growth Option

Answer 193

The option to make additional investments in a project at some future time if the financial results are strong. Also called an expansion option.

Question 194

Capex:
Flexibility Option

Answer 194

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.

Question 195

Capex:
Flexibility Option:
Price-Setting Option

Answer 195

The option to adjust prices when demand or supply varies from what is forecast.

Question 196

Capex:
Flexibility Option:
Production-Flexibility Option

Answer 196

The option to alter production when demand varies from what is forecast.

Question 197

Capex:
Fundamental Option

Answer 197

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.

Question 198

Capex:
Investment analysis without considering options

Answer 198

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.

Question 199

Capex:
Calculation of NPV with real options

Answer 199

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.

Question 200

Capex:
Decision trees and option pricing models:

Answer 200

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.

Question 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.

Answer 201

B is correct. An abandonment option is a type of real option, which allows a company to abandon the investment after it is undertaken.

Question 202

cost of capital

Answer 202

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).

Question 203

weighted-average cost of capital

Answer 203

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.

Question 204

cost of debt

Answer 204

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.

Question 205

cost of equity

Answer 205

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.

Question 206

capital structure

Answer 206

The mix of debt and equity that a company uses to finance its business; a company’s specific mix of long-term financing.

Question 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

Answer 207

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.

Question 208

Factors Affecting Capital Structure:

Business Model:

Capital-Intensive Business

Answer 208

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.

Question 209

Factors Affecting Capital Structure:

Business Model:

Capital-Light Business

Answer 209

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.

Question 210

Factors Affecting Capital Structure:

Corporate Life Cycle:

Startup

Answer 210

High business risk, negative free cash flow, limited debt availability. Financing primarily through equity, including from founders, employees, and venture capitalists.

Question 211

Factors Affecting Capital Structure:

Corporate Life Cycle:

Growth

Answer 211

Rising revenue, negative but improving free cash flow, moderate business risk. Financing mix of equity and increasing amounts of secured debt.

Question 212

Factors Affecting Capital Structure:

Corporate Life Cycle:

Mature

Answer 212

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.

Question 213

Determinants of the Costs of Debt and Equity:

Top-Down Factors:

Economic Conditions

Answer 213

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.

Question 214

Determinants of the Costs of Debt and Equity:

Top-Down Factors:

Industry Conditions

Answer 214

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.

Question 215

Determinants of the Costs of Debt and Equity:

Issuer-Specific Factors:

Sales Risks

Answer 215

Stability and predictability of revenue streams. Companies with stable, growing revenues can secure financing at lower costs.

Question 216

Determinants of the Costs of Debt and Equity:

Issuer-Specific Factors:

Profitability Risks

Answer 216

Operating leverage, or the proportion of fixed to variable costs, influences profit stability. High operating leverage means greater profit variability with changes in revenue.

Question 217

Determinants of the Costs of Debt and Equity:

Issuer-Specific Factors:

Financial Leverage

Answer 217

Existing debt levels affect the ability to take on more debt. Higher indebtedness increases financial risk, raising the cost of additional debt.

Question 218

Determinants of the Costs of Debt and Equity:

Issuer-Specific Factors:

Collateral and Asset Type

Answer 218

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.

Question 219

MM Proposition I: Capital Structure Irrelevance (Without Taxes):

Key Idea

Answer 219

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.

Question 220

MM Proposition II: Cost of Equity and Financial Leverage (Without Taxes):

Key Idea

Answer 220

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.

Question 221

MM Proposition I: Capital Structure With Taxes:

Key Idea

Answer 221

When corporate taxes are considered, the value of a levered firm increases because interest payments on debt are tax-deductible, creating a tax shield.

Question 222

MM Proposition II: Cost of Equity and Financial Leverage (With Taxes):

Key Idea

Answer 222

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.

Question 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.

Answer 223

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).

Question 224

True or False:
What is clear from MM is that the primary driver of firm value is capital structure.

A. True
B. False

Answer 224

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.

Question 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.

Answer 225

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.

Question 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%.

Answer 226

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%.

Question 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

Answer 227

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.

Question 228

Optimal Capital Structure

Answer 228

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.

Question 229

Why might a company’s “Target Capital Structure” differ from the “Optimal Capital Structure” ?

Answer 229

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

Question 230

asymmetric information

Answer 230

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.

Question 231

Pecking-Order Theory

Answer 231

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.

Question 232

Free Cash Flow Hypothesis

Answer 232

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.

Question 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

Answer 233

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.

Question 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

Answer 234

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.

Question 235

Business Model

Answer 235

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.

Question 236

Channels

Answer 236

Venues where a company markets and/or delivers its products and services.

Question 237

Omnichannel

Answer 237

Refers to a company selling its products or services in multiple channels, such as in store and online.

Question 238

Price Discrimination

Answer 238

A pricing approach that charges different prices to different customers based on their willingness to pay.

Question 239

Commodity Producer

Answer 239

A firm that makes and/or sells commodities.

Question 240

Differentiated Products

Answer 240

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.

Question 241

Pricing Power

Answer 241

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.

Question 242

Tiered Pricing

Answer 242

A pricing approach that charges different prices to different buyers, commonly based on volume purchased.

Ex: Costco

Question 243

Dynamic Pricing

Answer 243

A pricing approach that charges different prices at different times. Specific examples include off-peak pricing, “surge” pricing, and “congestion” pricing.

Ex: Uber

Question 244

Value-based pricing

Answer 244

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

Question 245

Auction/reverse auction models

Answer 245

Pricing models that establish prices through bidding (by sellers in the case of reverse auctions).

Question 246

Bundling

Answer 246

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.

Question 247

Razor, razorblade pricing

Answer 247

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.

Question 248

Add-on pricing

Answer 248

A pricing approach based on high-margin optional features, customizations, and additional content.

Question 249

penetration pricing

Answer 249

A discount pricing approach used when a firm willingly sacrifices margins in order to build scale and market share.

Question 250

freemium business model

Answer 250

A pricing approach that allows customers a certain level of usage or functionality at no charge. Those who wish to use more must pay.

Question 251

hidden revenue business model

Answer 251

Business models that provide services to users at no charge and generate revenues elsewhere.

Question 252

Franchising

Answer 252

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.

Question 253

Value Proposition

Answer 253

The product or service attributes valued by a firm’s target customer that lead those customers to prefer that firm’s offering.

Question 254

Value Chain

Answer 254

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

Question 255

Supply Chain

Answer 255

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.

Question 256

Unit Economics

Answer 256

The expression of revenues and costs on a per-unit basis.

Question 257

Contract Manufacturers

Answer 257

Companies that make products for other companies that meet specific terms and specifications.

Question 258

Value Added Resellers

Answer 258

Businesses that distribute a product and also handle more complex aspects of product installation, customization, service, or support.

Question 259

Network Effects

Answer 259

A business model that increases in value to its users as the number of users increases, for example communication and payment networks.

Question 260

Crowdsourcing

Answer 260

A business model that enables users to contribute directly to a product, service, or online content.