Reading 33: Corporate Governance－LOS e corporate

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CFA Institute Area 8-11, 13: Asset Valuation
Session 10: Equity Portfolio Management
Reading 33: Corporate Governance
LOS e: Critique the effectiveness of debt as a corporate governance mechanism.

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Which of the following statements regarding debt and its effect on corporate health via corporate governance mechanisms is most accurate?

A) In some situations it can be beneficial; in others it can be a detriment.

B) Debt is unambiguously beneficial.

C) Debt is unambiguously detrimental.

D) Debt is neutral with respect to corporate governance.

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Answer and Explanation

In some situations debt can be beneficial; in others debt can be a detriment. It is beneficial when it motivates management to not waste cash. With the pressure to make periodic interest and principal payments, management does not have the luxury of spending cash on frivolous projects and perks. If the firm has no cash after paying the debtholders, it is detrimental because it prevents the firm from investing in valuable projects. The illiquidity may be due to circumstances beyond managements control.

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Which of the following statements regarding bankruptcy as a mechanism for enforcing good corporate governance is most accurate?

A) Bankruptcy costs are comparatively minor but bankruptcy does not discipline management to the extent expected.

B) Bankruptcy costs are substantial but bankruptcy does not discipline management to the extent expected.

C) Bankruptcy costs are comparatively minor and bankruptcy provides strong discipline against poor management.

D) Bankruptcy costs are substantial and bankruptcy provides strong discipline against poor management.

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Answer and Explanation

Bankruptcy costs are substantial and include both direct and indirect costs. Bankruptcy does not actually discipline management to the extent expected. Managers are often able to retain their positions during a firms bankruptcy.

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A firm would like to issue new securities to fund a new project. The firms managers have been paid predominantly with equity-based compensation and now hold most of the firms stock. If the firm wants to motivate their managers to work harder, which of the following securities should be issued?

A) Debt.

B) Common stock.

C) Shelf registered preferred stock.

D) Shelf registered common stock.

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Answer and Explanation

In terms of providing the strongest incentive for managers, the firm should issue debt. If the project is profitable and the firm has issued debt, the managers/owners wont have to share their residual claim on profits with other common stock holders. By issuing debt, the manager/owners can more clearly see the end result of their efforts, and this will motivate them to perform better.

Additionally, debt provides an incentive effect relative to preferred stock because the firm will have a legally binding obligation to make payments on the debt and management will not be able to waste cash on extravagant projects and perks.

In terms of providing the strongest incentive for managers, the firm should issue debt. If the project is profitable and the firm has issued debt, the managers/owners wont have to share their residual claim on profits with other common stock holders. By issuing debt, the manager/owners can more clearly see the end result of their efforts, and this will motivate them to perform better.

Additionally, debt provides an incentive effect relative to preferred stock because the firm will have a legally binding obligation to make payments on the debt and management will not be able to waste cash on extravagant projects and perks.