Volume 2 - Corporate Issuers

Question 1

Organizational Forms, Corporate
Issuer Features, and Ownership

Answer 1

• compare the organizational forms of businesses
• describe key features of corporate issuers
• compare publicly and privately owned corporate issuers

Question 2

Sole trader / Proprietorship : No separate legal identity.
Owner operated and has unlimited liability
Financed by Partners (so the growth depends on them) and tax as personnal income (pass-trought)

Question 3

General Partnership: No separate legal identity. Partners operated and they have unlimited liability
Financed by Partners (so the growth depends on them) and tax as personnal income (pass-trought)

Question 4

Limited Partnership: No separate legal identity
General Partner Operated (GP) GP has unlimited liability.
However, the LP’s have limited liabilty
Financed by Partners (so the growth depends on them) and tax as personnal income (pass-trought)

Question 5

Limited liability company (Private company) : Separate legal entity
Board management operated
Owners (shareholders) have limited liability
Profits taxed as personnal income (pass-trought)
Unbounded acces to capital, unlimited business potential but, there may be legal limits on number of owners (require a vote for transfer of ownership)

Question 6

Public Limited Company (Corporation): Separate legal entity
Board management operated
Owners (shareholders) have limited liability
Profits taxed at corporate level (dividends taxed as personnal income)
No restrictions on ownership / transfer
They can be privately owned or publicly owned

Question 7

Act in the best interest of ShareHolders and, indirectly, all StakeHolders

Question 8

Economic balance sheet : Adds other intangible / hard to quantify assets & liabilities ( Humain capital, customer relationship, etc)

Economic Income Statement: Return in Excess of owners required return on equity (Economic profit = Required Return on Equity - Return on Equity)

Answer 8

Financial balance and income statement: Assets, liabilities, equity, income after duties… etc

Question 9

Shareholders may suffer double taxation: Coporate tax on profits + personnal tax on dividends.

Answer 9

Some jurisdictions offer relief:
- Personal Tax Credit on dividend income
- Low / zero corporate tax rates on earnings paid out as dividends

Double taxation to the extent that they tax shareholders on the dividend income they have received from a company’s after-tax profits.

Question 10

Public (listed) company: shares listed on a stock exchange

• Liquidity –> Secondary Market for shares
• Prices Transparency (Value = Market cap = Shares * Price)
• Extensive Disclosure and reporting requiremenrs (Regulations, Disclosures, etc)

Question 11

Private (unlisted) company:
- No ready market for shares, sale requires buyer, company agree

• No price transparency (Valuation required a model)
• Fewer disclosure and reporting requirements

Question 12

How Shares are issued:

Private companies Going Public:
Private Placements : Accredited investors risk/ terms outlined in private placement memorandom

• Iinitial Public Offering (IPO): Company raises capital from public
• Direct listing : No new shares (no capital raised)
• SPAC (Special Purpose Acquisition Company) : Shell company raises capital via IPO then make an acquisition
• Via acquisition (By a larger company)
• Secondary Offerings (Secondaries: Company raises capital from public (Another round of raising capital) !! Not the same as secondary market (Issued shares already trade between participants)

Question 13

Public Going Private:
All shares are acquired and then delisted

Question 14

The three main types of organizations in a market economy are government entities, non-for-profit non-governmental organizations (non-profits), and for-profit businesses, also known as companies.

Question 15

The key areas of focus when comparing different organizational forms of businesses are:

Legal identity: The legal relationship between the business and its owner(s)

Operational control: The relationship between the owner(s) and the managers who operate the business

Business liability: The liability exposure of individual owners with respect to activities undertaken by the business

Taxation: The treatment of business profits/losses for tax purposes

External financing: The ability to raise debt and new equity to fund operations

Question 16

In a partnership: Partners are personally responsible for covering any of the firm’s liabilities, including any portion that other partners are unable to pay.

Question 17

Limited Liability Partnerships
Many countries with common law traditions, such as Canada, India, and the United Kingdom, allow some businesses to operate as limited liability partnerships (LLPs) with only limited partners and no general partner. All partners are have limited liability and managerial responsibilities. In practice, partners agree to appoint one or more managing partners to perform the operational role that would be filled by a GP in a limited partnership structure.

Question 18

Like sole proprietorships, all forms of partnerships are pass-through businesses meaning that the entity itself is not taxed but profits (or losses) are treated as the partners’ personal income for tax purposes. All net income generated by the firm is deemed to be passed through and taxed, regardless of whether it is has been distributed or retained and reinvested by the partnership.

Question 19

Limited Companies
A limited company is like a limited partnership in the sense that the ownership and management role are separated. However, under this type of structure, the business is owned by shareholders (not partners), who all enjoy the protection of limited liability. Shareholders elect representatives to serve on the company’s board of directors, which is responsible for appointing professional managers to senior executive roles such as CEO and CFO. Shares in a limited company are more easily transferrable than partnership interests.

Question 20

Private Limited Companies
A private limited company, or limited liability company (LLC), is a pass-through business that does not pay tax on the income that it generates. Instead, the firm’s profits are taxed as the personal incomes of its individual owners (i.e., shareholders). LLCs are subject to legal restrictions on the number of owners and votes are required to approve transfer ownership interests, which limits the company’s ability to grow.

Question 21

Public Limited Companies
Unlike private limited companies, public limited companies (better known as corporations) face no limitations on the number of owners they can have and their shareholders are free to transfer their ownership interest as they wish (more acces to capital) .

Answer 21

The major disadvantage of this organizational form is that a public limited company’s income is taxed twice — once at the corporate level, and again at the individual owner level for any profits that are distributed to shareholders. This second level of taxation can be avoided to the extent that profits are retained by the corporation and reinvested to expand its operations.

Question 22

Public limited companies or corporations are described as corporate issuers because the external financing that they require to grow their operations is obtained by issuing debt and equity securities in capital markets.

Question 23

Recall that, in a limited partnership structure, the general partner has risk unlimited exposure. However, it is possible to designate a publicly traded limited liability corporation as an LLP’s general partner. This arrangement is popular because it allows the fund to raise capital from investors while limiting their liability. While the corporation has unlimited liability in its capacity as general partner, it cannot lose more than the value of its investment. An additional benefit is that, by owning a significant (although not necessarily a majority) stake in the GP, a company’s founders can effectively control a partnership while limiting their liability.

Question 24

Unlike partners in a partnership structure, corporate investors are rarely experts in the operations of the companies that they own. Potential capital providers for corporate equity issuers include individuals, institutions, family offices, governments, and other corporations.

Question 25

free float: shares that are actively traded on a public exchange.

Question 26

Trading private company shares is significantly more challenging because investors must seek out counterparties directly and they do not benefit from price transparency.

Question 27

Companies issue a private placement memorandum (PPM), which is a legal document that specifies the terms of the offering. Private placements are not registered with any regulatory authority and therefore may only be marketed to accredited investors. These are individuals and institutions with the resources and sophistication to accept the increased risk that comes with investing in opportunities that are subject to less regulatory oversight and lower disclosure requirements.

Question 28

The US Securities and Exchange Commission (SEC) requires public firms to file information in its publicly accessible EDGAR (Electronic Data Gathering, Analysis, and Retrieval) system on a regular schedule. Similar reporting requirements exist for companies that are listed in the European Union.

Answer 28

Private companies are subject to certain reporting requirements, but these disclosures are not made available to the general public. These companies may make selective disclosures to potential investors and lenders in order to reduce their cost of accessing new sources of capital.

Question 29

Direct listing (DL): A DL is executed without the services of an underwriter because no new capital is raised. Rather, the company’s shares become listed on an exchange, where they can be sold by existing shareholders. This is a faster, less costly alternative to an IPO

Question 30

Acquisition: A private company that is acquired by a larger competitor can become part of a combined entity that is publicly traded. Alternatively, a special purpose acquisition company (SPAC) can be created for the specific purpose of acquiring a private company to take it public. SPACs are created by raising funds in an IPO with the intention of finding an acquisition target. The proceeds of the IPO must be placed in a trust account and the SPAC has a finite time period (e.g., 18 months) to complete the acquisition of a private company or return the funds to investors.

Question 31

Just as young companies “go public” through IPOs, it is not uncommon for an established public company to be taken private through “go-private” transactions, such as a leveraged buyout (LBO) led by outside investors.

Question 32

Governments often invest in companies in strategically important industries (e.g., natural resources, power generation) to pursue their national interests. A government may sell some of its shares over time as ownership is transferred to the private sector. It is also common for non-profit entities to be long-term investors. In some cases, a foundation will own the majority of the shares issued by its founding company. Such an arrangement prevents the company from being acquired by a competitor.

Question 33

Investors and Other Stakeholders

Answer 33

• compare the organizational forms of businesses
• describe key features of corporate issuers
• compare publicly and privately owned corporate issuers

Question 34

Debtholders (Lenders) :

• Provide capital with a finite maturity
• Issuers obligated to make interest and principal payments on set dates
• Debtholders have no decisioin-making power within the Corp.
  -Interest is paid before distributions to equity / investors
  (Priority claim)

Answer 34

Lower Risk for investor, Cheaper for issuer and also tax deductible

DEBT INCREASES RISK for Equity Investors

Question 35

Equity Investors:

-Provide permanent Capital
-Issuers do not commit to future dividends or repayments
-Equity holders have VOTING RiIGHTS for key decisions
-Cash distribution are at the DISCRETION of the board
-Equity investos own what is left after all payments are made (Residual claim)

Answer 35

Higher Risk for investor, Costlier for issuer

Question 36

Financial leverage by using debt (Debt financing) can give a higher ROE but also higher RISK

Question 37

The firm has one set of CF that will be split between capital providers with differing risk and return profile. –> Potential conflict

Answer 37

Shareholders - Maxime the residual cash flows : unlimited upside

Bondholders - Maximize likelihood of timely payments : limited upside

Question 38

Stakeholders depend on the company and the company depends on them. (Any party with a vested interest in the company)

Answer 38

Stakeholders may compromise or enhance a company’s ability to maximize shareholder value

Question 39

Shareholder theory of governance:

• Stakeholders only considered to the extent that they affect shareholder value
• Corporate governance should consider all stakeholders interests

-ESG should be an explicit objective of the board

Question 40

Stakeholders are divided in 2 groups

Private Debtholders :
-Often hold debt to maturity
-Direct acces to management and non-public info
-Critical lenders may have influence
-Wide variation in risk appetite
May engage in distressed investing

Answer 40

Public debtholder (bondholders):
-Tradeable securities
-Reliance on public info and financial statements
-Little to no influence (may have if restructuring debt)

Question 41

Primary stakeholders groups:
1- Managers
2-Employees
3-Customers
4-Suppliers
5-Gouv

Question 42

Why is ESG growing in importance ?

Answer 42

Due to:
1- Financial impact of ESG factors has risen Ex: Disasters

2- Interest in E, S has grown (Particularly amongst the young)

3-Increased ESG regulation

Question 43

Analyst should consider ESG by using sensitivity / Scenario analysis (What if)

Answer 43

Make assumptions concerning plausibles scenarios related to ESG and their consequences on the firm.

Question 44

Because equity securities do not mature and companies are under no obligation to return any principal of an equity owner’s investment, equity is a more permanent source of capital compared to debt, which must be rolled over as it matures. Equity ownership confers voting rights, which can be used to elect directors and vote on important matters at annual shareholder meetings.

Question 45

Distributions made to shareholders must come from funds that remain after obligations to lenders have been met. Because of their higher priority, lenders are typically willing to provide capital at a lower cost compared to equity investors. The risk of providing debt capital is also reduced by the stream of contractually obligated cash flows that are received.

Question 46

In practice, when a company does file for bankruptcy protection, bondholders are often willing to accept renegotiated terms that include equity ownership in a reorganized firm that emerges from the process. Existing shareholders may find that their positions have been effectively wiped out by the resulting dilution of the company’s equity.

Question 47

Risk/Return:

Upside potential: Unlimited for equity, limited to contractual payments for debt

Maximum loss: Both debtholders and equity owners cannot lose more than the value of their investment

Investment risk: Higher for equity compared to debt, which has a higher priority claim

Investment interest: Lenders seek only timely repayment, while equity investors want to maximize the value of net assets

Question 48

The differences in the nature of debt and equity create a potential conflict of interest. Specifically, bondholders have an interest in stable operations that generate steady cash flows. Unlike equity owners, lenders do not benefit from any excess returns. By contrast, equity owners are positioned to benefit from the company taking risks that are expected to be rewarded.

Answer 48

To protect their interests, lenders typically require covenants that either require the company to take certain actions or prohibit it from taking others. If a company takes on more leverage, lenders will increase the cost of debt to appropriately reflect the new level of financial risk.

Question 49

According to the shareholder theory of governance, a company’s primary obligation is to maximize shareholder value. Relationships with any other groups are only considered to the extent that they impact a company’s ability to pursue this objective.

Question 50

According to stakeholder theory, shareholders are just one of the stakeholder groups that should be considered.

Question 51

Some private lenders are willing to provide equity capital as well, which gives them more of a growth focus. They may be willing to convert their loans into equity positions if the company defaults on its obligations. Others are more conservative, placing more emphasis on the valuations of assets that have been pledged as collateral.

Question 52

Board of Directors: While the optimal board composition will vary depending on an individual company’s circumstances, best practices dictate that at least one-third of directors should be independent (i.e., without a material relationship with respect to ownership, employment, or remuneration). Some countries have adopted corporate governance codes with standards and requirements designed to achieve greater diversity of backgrounds, experience, and expertise on corporate boards.

Answer 52

A one-tier board structure, which is commonly used in the US and UK, has a single board of directors, composed of both executive (internal) and non-executive (external) members. In Continental Europe, it is more common for companies to use a two-tier board structure with a supervisory board that oversees a management board made up of internal directors.

Question 53

Environmental Factors: Climate change and carbon emissions, air/water pollution, biodiversity, deforestation, energy efficiency, waste management, water scarcity

Social Factors: Customer satisfaction, product responsibility, data security/privacy, diversity, occupational health and safety, treatment of employees, community relations, charitable activities, human rights, labor standards

Governance Factors: Board independence/diversity, audit committee structure, bribery/corruption, executive compensation, shareholder rights, lobbying/political contributions, whistleblower schemes

Question 54

Corporate Governance: Conflicts,
Mechanisms, Risks, and Benefits

Answer 54

• describe the principal-agent relationship and conflicts that may arise
  between stakeholder groups

-describe corporate governance and mechanisms to manage
stakeholder relationships and mitigate associated risks

-describe potential risks of poor corporate governance and stakeholder management and benefits of effective corporate
governance and stakeholder management

Question 55

Principal-agent : One party hires another to perform a task or service, can be present with or without a contract

Answer 55

Conflicts arise when interest diverge –> Agency costs

Question 56

The agent :
- Is expected to act in the principal’s best interest
- Posses more info than the principal (asymetry)

Question 57

Agency Costs can be :
- Direct : ex. Monitoring
- Indirect : ex. Foregone Profits

Answer 57

As information asymetry increases, return demanded by shareholders and lenders, increases

Question 58

Shareholder v Directors Management:
- Information Asymetry

-Principal tool to align interest : Compensation

-Interest may still diverge due to:
Insufficient effort, Inappropirate risk appetite, Empire Building (Compensation based on size –> Too many acquisitions), Entrenchment (Play it safe) & Self dealing (Exploit firm’s ressources ex. Private Jet)

Question 59

Controlling v Minority Shareholders:

-Dipsered ownership: Many shareholder, none with control

-Concentraded ownership: Individual shareholder or group who can control

Answer 59

Possible Conflicts:

1- CS want to seek diversification and MS already hold a portfolio and focus on max. Value

2- CS want long term investment and MS are seeking quick gains

Question 60

Coporate Reporting and Transparency: External stakeholders rely on corporate reporting for information on performance and position

Question 61

Shareholders Mechanism to manage the relationship:

Shareholder meetings:
- Annual general meeting (AGM): Discuss board elections, auditor, etc

• Extrardinary general meetings (EGM): Called when resoltuions requiring shareholder approval or if a minimum number (%) of shareholders request.
• Shareholder activism: Investor strategies to compel a company to act in a desired manner
• Shareholder litigation: Activists may pursue “shareholder derivative lawsuits”

-Corporate Takeovers: Proxy contest / Fights (Tender offers or Hostile takeover)

Answer 61

Anti-Takeover Measures: Preservation of employement should incentivize board to max s/h wealth :

Staggered board elections

Poison Pill : s/h rights plan. One s/h pruchasing a given % of shares triggers right to buy more shares at a discount

Question 62

Creditor Mechanism to manage the relationship:

• Bond indenture : Describes the structure of the bond, the obligations of the company, the rights of the bondholders ( Require certain actions, prohibit certains actions and require cassets to be pledged)
• Creditor Commities : Established when a company files for bankruptcy (in some countries)

Question 63

Board mechanism:

• Audit commitee

-Nominating / Governance Commitee

• Compensation Commitee

Question 64

Employee mechanism:

-Labor Laws

-Unions

-Employee stock ownership plans

Question 65

Customer and supplier mechanism:
- Contracts
-Social media

Question 66

Gov mechanism:
-Laws and regulations

-Corporate governance codes

Question 67

In a corporate setting, corporate governance systems are designed and implemented to create a system of checks and balances that appropriately manage the conflicting interests in relationships between a company’s various stakeholders.

Question 68

Shareholders are at an information asymmetry disadvantage in their agency relationships with both managers and directors. These agents have better information about material matters (e.g., investment opportunities, corporate strategy), which makes it more difficult for shareholders to manage and evaluate managerial performance. This disadvantage tends to be even more pronounced for companies with more complex product or service offerings, as well as when companies have fewer institutional owners or relatively low free floats due to insiders having large, closely-held positions.

Question 69

Equity owners who hold enough shares to determine the outcome of shareholder votes, board elections, etc. are called controlling shareholders. This may be a single individual or entity, such as a company’s founder or another company or even a government. But control could also be held by a group (e.g., a family), even if none of the members of that group hold a majority position on their own. Equity owners who are not in a position to influence corporate activities are known as minority shareholders.

Question 70

Dispersed ownership is defined by many minority shareholders, none of whom is in a position to exert control individually. In a concentrated ownership scenario, a single shareholder is able to control the outcome of votes, or at least exert significant influence. A concentrated majority shareholder owns more than 50% of a company’s shares. Concentrated minority ownership is possible if, for example, 40% of a company’s shares are owned by a single shareholder and no other owner’s position is greater than 10%.

Question 71

Dual-class share structures grant disproportionately large voting power to one class of shareholders. Founders can use this structure to retain control over a company even as their economic interest is diluted. CFA Institute advocates against multi-class share structures that leave shareholders fully exposed to the consequences of decisions in which they have little or no say.

Question 72

Transparency is critical to reducing the asymmetrical information advantage that agents enjoy relative to their principals.

Question 73

High-quality, timely reporting benefits all of a company’s stakeholders, but particularly its capital providers. Regulatory filings help equity investors assess the performance of a company and its managers, cast informed votes on company matters, and make investment decisions. Creditors also use this mechanism to protect their interests by requiring borrowers to provide periodic updates on their financial condition. Bondholders often hire financial institutions to act as trustees and monitor whether a corporate issuer is in compliance with the terms of its bond contract.

Question 74

Occasionally, an extraordinary general meeting (EGM) may be called by either the company or its shareholders to hold a vote on matters that require shareholder approval (e.g., merger proposals, amendments to corporate bylaws). Companies are required to hold an extraordinary meeting if the proportion of shareholders requesting one exceeds a specified threshold.

Question 75

Hedge funds tend to be among the most prominent activist investors because they have the flexibility to invest in illiquid and/or distressed securities and general partners are incentivized to benefit from a turnaround in a company’s fortunes. Institutional investors that are subject to greater regulation are more limited in their ability to conduct activist campaigns, although some mutual funds use their influence to achieve positive corporate actions.

Question 76

Shareholder litigation: Activist investors have also pursued their objectives through legal channels by filing derivative lawsuits claiming that managers and directors have failed to act for the benefit of shareholders. However, the ability to file derivatives lawsuits is severely restricted in some jurisdictions and outright banned in others.

Question 77

Corporate Takeovers
There are several means that can be used to gain control of a company:

• A proxy contest is a campaign to persuade shareholders to vote to replace the current board of directors.
• A tender offer involves shareholders selling interests directly to a group seeking to take control.
• A hostile takeover is an effort to execute a takeover without management’s consent.

Answer 77

poison pills : that increase the cost of a potential acquisition.

Question 78

Bond Indenture:
An indenture is a legal contract that describes the structure of a bond, obligations of the issuer, and rights of the bondholders. Covenants are included in the bond indenture to protect the interests of lenders by either restricting the borrower’s activities or requiring certain actions.

Question 79

Creditor Committees:
If a company is struggling to meet its debt obligations but has not yet filed for bankruptcy protection, credit committees may be formed on an ad-hoc basis to discuss the possibility of restructuring the company’s debts.

Question 80

Audit comitee: best practice dictates that all members be independent directors. Additionally, at least one committee member should have expertise in accounting and financial reporting.

Question 81

Remuneration comittee: Committee: members typically design executive compensation plans to align the interests of managers with those of shareholders. For top executives, much of their total compensation is variable and determined by metrics such as the company’s stock price. To the extent possible, long-term value creation is incentivized and decisions based on short-term profits are discouraged.

Answer 81

Some jurisdictions have adopted say-on-pay provisions that allow shareholders to express their views on a company’s remuneration packages, which can limit the committee’s ability to grant compensation that is perceived to be excessive or inadequate. As with the audit and governance committees, best practices dictate that all directors on this committee be independent.

Question 82

Other Committees

Risk Committee: The risk committee helps directors determine the company’s risk policy, profile, and appetite. Members of this committee oversee the establishment of enterprise risk management plans and monitor their implementation to ensure that a company’s activities remain consistent with its appetite for risk.

Investment Committee: The investment committee reviews material investment opportunities (e.g., major capital projects, expansion into new markets) that are being considered by management. This committee establishes a company’s investment strategy and policies.

Question 83

Employment Contracts ->
Employee stock ownership plans (ESOPs) may be used to attract and retain talented employees.

Question 84

Corporate Governance Codes :
A company’s corporate governance practices should be consistent with relevant legal and regulatory standards. Some jurisdictions require companies to publicly disclose deviations from voluntary corporate governance standards.

Answer 84

In the United States, there is no national level corporate governance code or law, but the SEC enforces various national securities laws that include corporate governance provisions, such as a requirement that boards include a majority of independent directors.

Question 85

Weak Control Systems, Ineffective Decision Making:
Weak control systems can benefit one stakeholder group at the expense of others. For example, an ineffective board can protect management and harm shareholders’ interests. Such flaws can ultimately have a negative impact on a company’s performance and valuation.

Question 86

Scrutiny and Control:
Solid corporate governance practices allow risks to be identified earlier when they are easier to manage. A properly functioning audit committee plays an essential role in effectively controlling managers and directors. Adopting best practices can help companies avoid both the explicit costs associated with additional regulatory scrutiny and legal challenges, as well as the hidden costs that can be incurred due to, for example, preferential treatment of related parties.

Question 87

Operating performance:
Directors of companies that have committed to good corporate governance will find it easier to define the firm’s risk profile, determine its optimal strategy, and monitor managerial decisions.

Question 88

Legal, Regulatory, and Reputational Risks and Benefits:
Failure to properly manage stakeholder interests can result in reputational damage, lawsuits, or investigations by regulators. These risks are particularly significant for publicly traded companies, which are subject to higher levels of scrutiny than private companies (the other way applies –> Conversely)

Question 89

Empirical evidence indicates that adopting best corporate governance practices reduces the perceived riskiness of a company’s stock, improves valuations, and correlates with stronger performance during a market crisis.

Question 90

Analyzing Corporate Governance
Key questions that investors and analysts should seek to answer when evaluating a company’s corporate governance :

Answer 90

Ownership and voting structure: Are voting rights proportionate to economic exposure? Does one class of shareholders have a disproportionate influence over the results of votes?

Board of Directors: How does the company’s board rate in terms of director independence, diversity, expertise, etc.?

Compensation: Are executive compensation packages structured to align the interests of managers with those of shareholders?

Investors: What are the backgrounds and track records of the company’s major shareholders?

Shareholder rights: How does the company compare to its peers with respect to protecting the interests of its shareholders?

Long-term risk assessment: Are the company’s leaders identifying and adequately addressing long-term risks related to factors such as sustainability, human capital, and transparency?

Question 91

Working Capital and Liquidity

Answer 91

• explain the cash conversion cycle and compare issuers’ cash conversion cycles
• explain liquidity and compare issuers’ liquidity levels
• describe issuers’ objectives and compare methods for managing
  working capital and liquidity

Question 92

Working capital (basic) = Current assets - Current liabilities

An adjusted net working capital measure excludes cash and marketable securities from current assets and any interest-bearing debt from current liabilities.

Answer 92

Net Working Capital = (Current assets, Cash, Marketables securities) - (Current liabilities, Short-term debt, Current Debt)

Current Debt –> Ammount of long term debt payable in the next year

Question 93

Operating Cycle:

Collection –>(Cash) –>Purchase–>(Raw materials)—>Production—>(Finished goods)–>Sales—>(Customer credit)–> COLLECTION

Answer 93

Companies that produce physical goods go through a typical operating cycle:

• Raw materials are purchased from suppliers.
• The company converts raw materials into finished goods, which are held as inventory while waiting to be sold.
• Finished goods are sold to customers.
• The funds earned from selling inventory are used to purchase more raw materials.

Question 94

If the cash conversion cycle is short = the better. Cash is freed to be used elsewhere

Question 95

Discount Standard payment terms 30 days, 2% discount for payment within 10 days.

Standard notation: 2/10 NET 30

Answer 95

Calculate the EAR of pyaing early (that is equal to borrowing money). If the firm dosn’t have the cash avaible –> Borrow if the rate is < that the EAR of the discount

Question 96

Lower Working capital = More efficient operations

Working Capital to sales Ratio allows comparison accros firms of different sizes

Answer 96

Working capital levels and cash conversion cycle are + correlated

Question 97

Issuer : Liquidity = Ability to meet short term liabilities

If short term liabilities > Cash

Issuers requires other sources of liquidity

Question 98

Secondary sources of liquidity (Can signal deterioration of financial health):

-Suspending or reducing dividend payments to shareholders.

-Delaying or reducing capital expenditures, which helps meet short-term obligations but can lead to underperformance over the long-term.

-Issuing new equity, which raises cash but dilutes the positions of existing shareholders.

-Renegotiating the terms of contracts such as short-term and long-term debt, rental and lease agreements, and contracts with customers and suppliers.

-Selling assets that can be liquidated relatively quickly without damaging the company’s long-term value.

-Filing for bankruptcy protection and continuing to operate while the company is reorganized and debt obligations are renegotiated.

Answer 98

Primary:
- Cash and Marketable securities
- Borrowing (banks,bondholders,supplier credit)
- Cash flow from business (can take time) -> Primary source of liquidity

Question 99

While maximizing firm value –> by reducing Working Capital: It is important to maintain readt acces to funds necessary for day-to-day operations and obligations (Minimize excess liquidity)

Answer 99

1- Determine optimal working capital level in relation to revenue

2- Forecast future working capital levels based on revenue forecats –> (Permanent Current Assets that are relative constant levels of inventory, recibables,etc) & (Seasonal Inventory, Staffing requirements)

Question 100

Effect on liauidity

Drag: Lagging cash flows (takes more time). A drag on liquidity is a lag on cash inflows resulting in a shortage of available funds. It occurs when funds are unavailable because assets are not being efficiently converted into cash.

Pull : Accelerated cash flows (Early payements). A pull on liquidity occurs when disbursements are made before cash can be generated from sales.

Answer 100

Drags:
Uncollectable receivables
Obsolete inventory
Tight credit (i.e., lenders are less willing to lend or charging higher interest rates).

Pulls:
Making payments early
Reduced credit limits from suppliers (i.e., suppliers tightening their credit terms)
Limits on short-term lines of credit from banks
Low liquidity positions

Question 101

Liquidity refers to the ability to generate the cash required to meet short-term obligations. The more liquid an asset is, the lower its liquidity cost, which is the discount to market value that must be accepted to quickly convert it into cash. A company carrying $100 of inventory may only be able to receive $90 if it has to be sold immediately (i.e., a 10% liquidity cost).

Question 102

All else equal, a company reduces its cash conversion cycle in the following ways:

Increase DPO: A company can seek to obtain longer payment terms from its suppliers, but whether this can be achieved depends on the power dynamics of the relationship. A supplier of critical inputs that sells to many other companies is unlikely to offer more generous payment terms. A company is more likely to be successful if it commits to purchasing higher volumes from a particular supplier.

Reduce DOH: Discontinue products with niche demand. Use data analytics to improve demand forecasts and adjust stock levels accordingly. Switch to “just in time” inventory management with smaller, more frequent deliveries from suppliers.

Reduce DSO: Charge fees for late payments. Tighten credit standards. Require up-front deposits. Accelerate installment payments. Contract with third-party collection agencies. Offer a price reduction for cash settlement within a discount period.

Question 103

Permanent current assets represent the base levels of cash, inventory, and receivables needed to maintain routine operations at any point throughout the year. Variable current assets are the incremental increases above the base levels to meet additional needs during periods of peak production and sales.

Question 104

Conservative Approach to Working Capital Management:

A conservative approach is characterized by relatively large positions for current account items to minimize the risk of disruptions and increase the ability to respond to uncertainty. This approach relies on long-term debt and equity to fund all permanent (and some variable) current assets.

Answer 104

Pros:
Relying on long-term sources of capital reduces rollover risk
Greater certainty over financing costs and cash flows
Lower risk of inventory shortages
Greater flexibility to adapt to adverse market conditions

Cons:
Higher borrowing costs (if the yield curve is upward-sloping)
Higher cost of equity and shareholder dilution
Less flexibility to borrow on an as-needed basis
Issuing long-term debt and equity requires longer lead times
Long-term debt typically imposes more covenants
Increased risk of inventory obsolescence

Question 105

Companies will tend to prefer a conservative approach if they:

Are in the early-stage of their development with limited access to short-term borrowing facilities;
Are more established with higher margins and greater ability to pass the higher borrowing costs onto their customers;
Expect interest rates to either remain stable or rise;
Have a preference for cash flow stability and want to avoid rollover risk, particularly during periods of market turmoil.

Question 106

Aggressive Approach to Working Capital Management:
An aggressive approach to working capital management maintains relatively low levels of cash, inventory, etc., and relies on short-term funding sources to finance all variable (and some permanent) current assets.
risk of running out of inventory or cash –> anticipate cash flow needs with a high degree of precision.

Answer 106

Pros:
Lower financing costs under a normal upward-sloping yield curve
Greater flexibility to borrow only as needed
Short-term borrowing imposes fewer covenants and involves less rigorous credit analysis
Ability to reduce borrowing costs by refinancing on short notice if interest rates fall

Cons:
Risk of having to refinance at higher short-term rates
Potential difficulty rolling over short-term debt during periods of market turmoil
Possible need to rely on relatively expensive trade credit or sell receivables to raise cash if short-term debt cannot be rolled over
Sales may suffer if customer credit terms are tightened to reduce the cash conversion cycle

Question 107

Firms will tend to prefer an aggressive approach if they:

Are seeking a cost advantage relative to their competitors in a low-margin industry;
Are able to predict their future sales volumes and cash needs more accurately;
Expect interest rates to fall;
Want to shorten their cash conversion cycle;
Have inventories that can be liquidated quickly.

Question 108

Moderate Approach to Working Capital Management:
Companies may seek to strike a balance between these two extremes by taking a moderate approach characterized by funding permanent working capital requirements with long-term debt and equity and relying on short-term resources to fund variable working capital needs. Because of this balance, it is known as a “matched” approach

Answer 108

A company is likely to prefer this approach if it is able to predict its base current asset requirements reasonably accurately but has greater uncertainty about its variable needs.

Question 109

Major objectives when formulating a short-term borrowing strategy include:

Maintaining diversified sources of credit that are sufficient to meet ongoing cash needs. A firm should not be dependent on a single lender.

Ensuring sufficient capacity to meet variable cash needs that change due to seasonal demand or planned expansion.

Borrowing at cost-effective rates with terms that do not unduly impair the company’s operations and anticipate changing market conditions.

Determining an overall borrowing rate that accounts for both explicit funding costs as well as implicit costs (e.g., trade credit).

Question 110

Factors influencing short-term borrowing for a firm:

-Size
-Creditworthiness
-Legal Considerations
-Regulatory considerations
-Underlying assets

Question 111

Capital Investments and Capital Allocation

Answer 111

• describe types of capital investments
• describe the capital allocation process, calculate net present value
  (NPV), internal rate of return (IRR), and return on invested capital (ROIC), and contrast their use in capital allocation
• describe principles of capital allocation and common capital allocation pitfalls
• describe types of real options relevant to capital investments

Question 112

Cpaitla investments: Invest. with one year or longer –> Create long-term assets on the balance sheet

Question 113

Regulatory compliance project: Not discretionary, required to meet rules and standards. Typically increase expenses, do not make revenue.

Answer 113

Expensive regulatory costs

Question 114

Going concern project (maintenance capital expenditures) : Continue the compan’ys current operations, maintain existing business size

ex: Asset remplacement, IT hardware, software maintance, etc

Answer 114

Risk: Low –> easy to evaluate

Funding: Match term of new finance with lifespan of new assets

Question 115

Analysts can use a company’s reported depreciation expense as a proxy for its annual capital budget for going concern projects. However, this is only an approximation and its usefulness depends on the level of disclosure regarding estimated useful lives for various asset classes. This method of estimation is likely to be more accurate for relatively short-lived assets.

Question 116

Expansion of Existing business project: Increase in scale –> Increase in size of operatiuons (ex: R & D)
Increase in scope –> Extend to adjacent products (ex: computer hardware –> Video games dev.)

Answer 116

Risk: Higher than maintance, compliance (greater uncertainity, longer, more capital)

Funding: Firms in early phase - Equity
More established firms have more acces to debt (Lower perceived risk)

Question 117

New lines of business project: New line = Complettely outside / minimally related to current business

ex: Acquisition of a firm in a different industry, capital invest. to explore new tech.

Answer 117

Risk: Higherst risk projects (Inforeseen challenges of unfamiliar business, Overpayment (acquisition))

Question 118

Capital Allocation is the process used by firm’s management and board to make capital invest. and return decision

Answer 118

Objective: Earn risk-ajusted returns > Investors could earn on similar risk (opportunity cost) –> Best alternative foregone

Question 119

Steps of capital allocation:

1- Idea Generation: This can originate from within the company or from outside the company.

2- Investment Analysis: Collect information to forecast the investment’s expected cash flows and profitability.

3- Planning and Prioritization: Select and prioritize profitable investment opportunities that together best fit the company’s strategy.

4- Monitoring and Post-Investment Review: Compare actual results to forecasted results to (i) monitor forecasts and analysis that underlie the capital allocation process, (ii) improve business operations, and (iii) plan for the future. This part of the process can be complicated due to challenges in accurately measuring expected and actual results.

Question 120

The NPV and IRR are used by management to asses individual invest.

The Return on Invested Capital (ROIC) is used as a aggregate measure for analyst

Answer 120

Choose an investment depending on the highest NPV not IRR

Question 121

Capital Allocation Pitfalls

Cognitive Errors:
- Internal forecasting errors (ex:Including sunk costs in a project’s valuation,
Incorrectly estimating a project’s overhead costs, Using a discount rate that does not accurately reflect a project’s true risk)

• Ignoring costs of internal financing (thinking it has 0% required return)
• Inconsistent treatment of inflation. Projected cash flows should be discounted at the matching rate (nominal or real). Nominal cash flows should be discounted at a nominal discount rate, and real cash flows should be discounted at a real discount rate. Inflation does not affect all revenues and costs uniformly. Certain costs may rise faster or more slowly than revenues.

  Behavorial Errors:

• Inertia –> Tendency to reuse their most recent capital budget with only minor adjustments (do it like last year).
• Basing decisions on earnings metrics. Relatively low capital spending compared to its peers may indicate that a company is focused on short-term profits rather than investing in long-term sustainable growth opportunities. However, this may also indicate that a company is (wisely) limiting its investments due to a lack of profitable opportunities.
• Pet project
• Failing to consider alternatives

Answer 121

Principals: Use after-tax cash flows
Consider impact of tax benefits on cash flows
Use incremental CF (ignore sink costs), ‘examine broadly’ –> Impact on other areas of business. cost savings
Time value of money : consider impact on NPV and IRR of a change in timings

Question 122

Real Options
- Timing option: Option to delay the investment

• Sizing option: Option to expand, grow, or abandon
• Flexibility option: Option to alter operations, such as changing prices or substituting inputs
• Fundamental option: Option to alter decisions based on future beyond the firm’s control events (e.g., drill based on price of oil, continue R&D depending on initial results)

Question 123

Analyzing Projects with Real Options

• Use the discounted cash flow (DCF) analysis without considering real options
• Adjust the stand-alone DCF analysis by including the present value of the expected costs and benefits options

Project NPV = NPV (based on DCF alone) - Cost of options + Value of options

• Use option pricing models
• Use decision trees

Question 124

Return on invested capital (ROIC), also known as return on capital employed (ROCE), measures a company’s profitability relative to the amount of capital that has been invested by lenders and equity owners. ROIC reflects the effectiveness of a company’s management in converting capital into profits, regardless of what type of capital is used (e.g., debt, equity).

Answer 124

Advantages:
- It is calculated using easily-accessible data (unlike NPV and IRR).

-ROIC allows outside analysts to assess a company’s ability to create value from capital budgeting decisions at an aggregate level rather than at the level of individual projects.

• Investors can compare ROIC to the rate of return that they require as compensation. Companies create value for investors by generating an ROIC in excess of their cost of capital. However, it is important to use a blended cost of capital rather than a required return on debt or equity in isolation.

Drawbacks:
Accounting based figure and not cash based like NPV or IRR
Backward looking (can be volatile and difficult to indetify trends)
It is an aggregate measure that can mask differences in profitability among various capital projects.
Calculation of operating profit, invested capital is open to interpretation

Question 125

The NPV of an investment uses the opportunity cost of capital to discount the cash flows.

Question 126

The capital allocation process is based on the following key principles:

After-tax cash flows: Decisions are based on cash flows, not accounting concepts. Adjustments must be made for non-cash items, such as depreciation. Additionally, because taxes are a cash expense, analysis is done on an after-tax basis.

Incremental cash flows: Measure incremental cash flows, which reflect the cash flows realized from a particular decision net of what they would have been without that decision. For example, the value of a project to replace a machine is based on the differences in expected cash flows if a new machine is purchased and the cash flows if the company continues to use the existing machine. Decisions to accept or reject a project should be based on current and future cash flows, meaning that sunk costs (cash flows that have occurred) must be ignored.

Timing of cash flows: The evaluation of a project can be significantly influenced by the projected timing of its cash flows. For example, a project’s value will change if a cash flow is received in Year 5 rather than Year 3.

Question 127

Capital Structure

Answer 127

• calculate and interpret the weighted-average cost of capital for a company
• explain factors affecting capital structure and the weighted-average cost of capital
• explain the Modigliani–Miller propositions regarding capital structure
• describe optimal and target capital structures

Question 128

The issuer’s required rate of retunr is derived from its investirs required rates of returns (cost of capital)

Answer 128

The cost of capital is the rate of return that is required as compensation by suppliers of capital. It can also be thought of as an opportunity cost. A company may raise capital in various forms, such as debt, equity, and hybrid instruments (e.g., preferred stock, convertible debt).

Question 129

WACC = (Cost of debt * Weighting of debt) + (Cost of equity* Weighting of equity)

Answer 129

• If interest is tax deductible, cost of debt = rd (1-t)
• Dividends distributions are not deductible

Question 130

WACC weightings are based on either:

1- Market values : Investors opportunity costs are based on market values

2- Target values : Less common, targets typically based on book values

Other sources of finance ex: Preferred stock, non- controlling interest (SHOULD be included in the WACC)

Answer 130

If the WACC target is unknown, as is often the case for outside analysts, it is appropriate to use the market value-weighted proportions of debt and equity in the company’s current capital structure. If an issuer uses other sources of capital, such as preferred shares, the after-tax cost of these components should be included in WACC.

Question 131

Two ways to maximize NPV:
1- Maximize Return
2- Minimize Required Return (WACC)

Answer 131

Objectives for management in capital struture decisions:

1- Minimize WACC
2- Match liquidity / time horizon with that of capital investments

Question 132

Key internal factors that influence a company’s capital structure decisions include:

Business model characteristics
Stage in corporate life cycle
Cash flows and profitability
Asset types and ownership

Answer 132

External, or top-down, factors affecting capital structure choices include:

Capital markets and economic conditions
Regulatory constraints
Industry factors

Question 133

Business model: Capital Intense (ex: Utilities, transportation, real estate)

Require high level of capital
– Low asset turnover, high CAPEX to sales, High Wcapital to sales

As owners of many assets that can be pledged as collateral, capital-intensive businesses have greater capacity to borrow.

Answer 133

• Capital needs can be reduced by franchising / contracting
• Assets often leased - Cheaper implicit rate than borrowing (leased asset acts as collateral)

Question 134

Regulated industries (ex. banks, utilities):

Gov. / regulator may dictate the capital structure

Question 135

Capital Light (ex Tech, services):

• Low Capital needs (high fixed assets turnover, low CAPEX to sales)
• Operate networks for others (ex. Uber, Airbnb)
• Upfront payments / commissions —> Negative cash conversion cycle (no need to finance working capital)
• Employee compensation primarly stock, reduced need for cash
• If profitable early, minimal need for external financing until large expansion

Question 136

Debt investors required rate return = Risk free + Spread

Spread: Compensation for issuer-specific risks

Answer 136

Macroeconomic, country-specific facotrs can increase Rf and Spread

Increase in recession risk -> Increase in spreads –> increase rd

Industry factors are significant

Sales risks : lower risk –> Lower costs financing

Profitability risks : Stability of profit margins is affected by a company,s mix of fixed and variable costs ( Higher Operating leverage = Higher Fixed costs = Higher Risk)

Question 137

Financial Leverage and Interest Coverage

Like operating leverage, financial leverage increases the riskiness of a company’s profits by creating fixed obligations that must be met regardless of sales. Companies with higher debt burdens are less capable of supporting additional debt.

Answer 137

Interest coverage ratio = Interest coverage = Operating Profit (EBT) / Interest payments

Question 138

A company’s ability to increase the proportion of debt in its capital structure will be influenced by the types of assets that it can offer as collateral to back its obligations. All else equal, companies are better positioned to support more debt to the extent that their assets are more tangible, fungible, and liquid.

Answer 138

• Tangible assets are identifiable and physical. Intangible assets (e.g., goodwill) have no physical form. Accounting standards may not permit companies to carry internally generated intangible assets (e.g., patents) on their balance sheets.
• Fungible assets can be interchanged with others that have the same features. For example, money is fungible because one USD 100 bill can be exchanged for another USD 100 bill or ten USD 10 bills.
• Liquid assets can be quickly converted into cash at (or very close to) their market value.

Question 139

Modigliani and Miller (1958): Under certain asusmptions a company’s choice of capital structure is irrelevant in determining its value.

Extremely restrictive

Answer 139

The 5 key assumptions:
1- Homogenous expectations : Investors agree on futur CF invst. will generate

2- Perfect Capital Markets : No transactions costs, no taxes, no bankruptcy costs, everyone has the same information

3- Risk-free Rate exist : And everybody can borrow and lend at this rate

4- No Agency Costs : Managers always act to maximize shareholder wealth (no conflict of interest)

5- Independent Decision : Financing and investment decisions are independent of each other

Question 140

MM proposition 1 (without taxes) : Capital structure irrelevance

If the assumptions hold, the present value of the firm’s cash flows remains the same regardless of the capital structure.

1. The value of the levered company (VL) is equal to the value of the unlevered company (Vu)
2. The value of a company is determined solely by its expected future CFs ( not debt / equity mix)
3. The WACC is unaffected by capital structure –> Risk increases, cost equity increases, but debt offsets

Answer 140

1. If not true –> The overvalued firm will be sold, undervalued bought to make arbritage profits and drive prices back to equality
2. If shareholders desire leverage they can achieve it themselves by borrowing or lending

Question 141

The explicit direct costs of financial distress include the legal and administrative cash expenses associated with bankruptcy. The implicit indirect costs include foregone investment opportunities, reputational risk, impaired ability to conduct business, and costs stemming from conflicts of interest between managers and debtholders (also known as agency costs).

Answer 141

The costs of financial distress tend to be lower for companies with marketable tangible assets that can be sold relatively quickly in the event of a bankruptcy (e.g., airlines). Companies without marketable tangible assets (e.g., tech and pharmaceutical companies) tend to incur greater costs due to financial distress.

Question 142

MM proposition 2 (without taxes) : Higher financial leverage raises cost of equity

• As cheaper debt is added to the capital structure, financial risk increases and the cost of equity increases
• Lower-cost debt capital is perfectly offset by the increase in the cost of equity

Question 143

MM proposition 1 (with taxes) : The value of a levered company is greateer than that of an unlevered company

( VL = Vu + tD)

t: tax rate
D: Value of debt

Answer 143

Inteerest saves cash –> Tax deductible

The cost of equity, is a linear function of the debt-to-equity ratio

re = r0 + D/E (r0 - rd)

r0 : WACC of 100% equity firm
rd : Debt required return

Question 144

MM proposition 2 (with taxes) : The WACC decreases as more debt is introduced

Question 145

MM made it clear that the primary driver of firm value are Cash Flows

Question 146

Optimal level of debt (D*) maximize firm value, minimize WACC

Finding D* requires estimations of :
- Value of tax shield
- PV costs of financial distress

Answer 146

Taking now into account financial distress.

The optimal amount of debt in a company’s capital structure will be less than 100% when financial distress costs are assumed because, at some point, the incremental impact of these costs will outweigh any additional benefits from further borrowing (Debtors will expect more return from a company that has more financial leverage).

Question 147

There are several reasons why managers often use book values instead of market value when determining a target capital structure.

Fluctuations in market values can be significant, but they rarely impact the appropriate borrowing level. Indeed, a rapid increase in a company’s share price may indicate that there is an opportunity to raise relatively low-cost equity capital.

Managers are primarily concerned about the capital that has been invested by the company, not the value of capital that has been invested in the company.

Since lenders, investors, and rating agencies emphasize the book values in their calculations, management takes this into account in their capital structure policies to ensure their ability to borrow easily and at a low cost.

Question 148

To estimate a company’s WACC without knowing its target capital structure, analysts can use the following methods:

1- Assume that the company will maintain its current capital structure (based on market values).

2- Infer target weights that a company is moving toward based on recent changes in its capital structure or statements from managers.

3- Take an average of the capital structures of industry peers. This may be a simple arithmetic average or a weighted average that is skewed toward the capital structures of larger peers.

Question 149

For their part, managers are aware that they are being scrutinized and they give careful consideration to the signals that their actions will send to investors. According to the pecking order theory, managers rank sources of capital in the following order (they want to use the least information content first) :

1- Internally generated funds (i.e., retained earnings)
2- New debt issues
3- New equity issues

Answer 149

An implication of the pecking order theory is that managers would buy back their company’s shares if they believed the shares were trading below their intrinsic value. Therefore, investors are skeptical about new equity issues, interpreting them as a signal that managers believe their stock is overvalued.

Question 150

Debt signaling is consistent with the pecking order theory. This is the idea that, by issuing new debt, managers are conveying their confidence in their company’s ability to meet the obligations in the bond indenture.

Question 151

According to agency theory, companies can reduce these costs by issuing debt instead of equity. Jensen’s free cash flow hypothesis states that taking on more financial leverage disciplines managers by leaving them with less cash to use unwisely.

Question 152

Business Models

Answer 152

describe key features of business models

describe various types of business models

Question 153

Business model:
No precise generally acepted definition
We do have elements

Answer 153

Value proposition (Who, what,where, how much)

Value chain (How is the firm organized, What are its competitive advantages)

Question 154

Value proposition :

• The Customers and the Market (“Who”) :
  Companies can target customers based on geography, market segments, or customer segments.
• Product or Service Offering (“What” and Often “Why”) : A company’s value proposition should be able to define the products and/or services that it is offering, as well as how these are different than those being offered by its competitors and how they meet the needs of its target consumers.
• Channels (“Where”) : The two key components of a channel strategy are making sales to customers (sales/marketing) and delivering the product or service to customers (distribution/logistics).
• Pricing (“How Much”) : A firm’s pricing strategy should be consistent with its business model. For example, the manufacturer of a highly differentiated product is positioned to have some pricing power and charge a premium relative to its competitors.

Question 155

Advances in e-commerce have allowed for the development of new channel strategies. An omnichannel strategy involves both digital and physical channels. For example, the “click and collect” model allows customers to purchase items online and either pick them up at a physical store or have them delivered to their homes.

Question 156

Price discrimination occurs when different customers are charged different prices for the same product or service. Examples include:

Tiered pricing discriminates among groups of customers, such as by charging lower per-unit prices to high volume buyers.

Dynamic pricing fluctuates based on timing, such as lower off-peak pricing during periods of low demand and higher “surge” or “congestion” pricing.

Value-based pricing sets prices based on the perceived value of a product or service to the consumer. For example, the price of a pharmaceutical drug may be set based on the savings it is expected to deliver in terms of fewer hospitalizations.

Auction/reverse auction models are used to determine prices for different customers based on a competitive bidding process. Advances in technology have made it easier for companies to use both dynamic pricing and auction-based pricing schemes.

Question 157

Alternatives to Ownership

Subscription pricing

Leasing allows an individual or business to pay for the use of an asset that continues to be owned by another entity with lower costs of capital and maintenance.

Licensing arrangements permit the use of an intangible asset in exchange for royalty payments.

Franchising agreements grant a franchisor the exclusive right to distribute a company’s products and/or services within a specified area.

Fractionalization divides a single large asset that consumers would not use entirely into smaller units that suit their needs. Examples include sub-letting office units, sharing server capacity, and timesharing of vacation properties and private jets.

Question 158

Pricing for Rapid Growth

Penetration pricing is used to quickly establish market share with the intention of charging higher prices after consumer acceptance and scale have been achieved.

Freemium pricing offers a basic level of functionality at no cost in the expectation that users will be willing to pay for premium features or content.

A hidden revenue business model is based on providing a service at no cost while generating revenues that are not provided by users. The most common example of this model is providing free media content and generating revenue from advertisers for access to the audience.

Question 159

A supply chain includes all of the steps and processes involved in the physical transformation of a product up to the point that it is purchased by the end consumer.

Question 160

Pricing for Multiple Products

Firms that sell multiple or complex products may prefer the following pricing strategies:

Bundling encourages customers to purchase multiple products or services by charging a lower price than they would pay to purchase each individually. This strategy is most useful when the products or services are complementary and have high incremental margins and marketing costs (e.g., television and internet service).

Razors-and-blades pricing entices customers with a low price for a piece of equipment that requires ongoing purchases of high-margin consumables. Printers and ink cartridges are another notable use of this strategy.

With add-on pricing, customers add extra products or services to their orders, either at the time of purchase or after initial product use. For example, apps may require users to make in-app purchases in order to access additional features. However, this pricing strategy can cause reputational damage if customers feel that the company has taken advantage of a “captive” dynamic.

Question 161

Network effects represent the value that is derived from incremental increases in users, rather than internally generated by firms. This concept applies to new technologies such as messaging services, social media platforms, and payment processing systems. An example from before the digital era is credit cards

Answer 161

Crowdsourcing relies on users to generate a product or service, typically voluntarily and often with little or no oversight. For example, the Waze app aggregates input on traffic conditions from users.

Question 162

A specific concern among investors of energy companies is the existence of “stranded assets,” which are carbon-intensive assets at risk of no longer being economically viable because of changes in regulation or investor sentiment.