Question 1

Solara Media is a publicly traded digital-content company founded by its current chief executive officer. Solara has two share classes. Public investors primarily own Class A shares, while the founder owns all Class B shares. Both classes have equal economic rights per share, but the Class B shares carry substantially more votes. The founder can elect a majority of directors despite holding less than one-quarter of the company's total economic interest.

Several institutional shareholders have expressed concern that the board includes five current or former Solara executives among its eight directors. The founder also serves as board chair and controls the agenda for director nominations. Solara has met all debt obligations, and its loan agreements contain conventional restrictions on additional borrowing and distributions.

Management proposes leasing a production studio for ten years from a private company wholly owned by the founder's sibling. Management states that the location is strategically important, but it has not obtained an independent assessment of the lease rate. The founder argues that the full board should approve the lease because the company's external auditor has confirmed that the founder's relationship to the lessor will be disclosed in the notes to the financial statements. Several outside shareholders request a review process that addresses both the pricing and the conflict of interest before the company signs the agreement.

Solara also has excess cash and is considering the open-market share repurchase summarized in Exhibit 1. Assume the company can repurchase shares immediately at the current market price, the repurchased shares are retired, annual earnings otherwise remain unchanged, and the transaction has no signaling, tax, or transaction-cost effects. The founder has stated that no Class B shares will be sold. Management expects the repurchase to be supplied entirely by Class A shareholders.

An analyst reviewing the proposal notes that the repurchase reduces interest income but also reduces the number of shares outstanding. The analyst also considers how the repurchase would affect the founder's voting power, given that each outstanding Class A share continues to have one vote and each outstanding Class B share continues to have ten votes.

Accepted Answer

***Solara’s main governance risk is that the founder’s voting control exceeds the founder’s economic interest.***
- The founder owns all Class B shares and can elect a majority of directors despite holding less than one-quarter of the economic interest, creating a **controlling–minority shareholder conflict**, not a customer–supplier dispute.
- Five of eight directors are current or former executives, and the founder chairs the board and controls nominations; these features weaken independent oversight.

***The lease requires independent review, while the repurchase’s voting effect depends on which shares are retired.***
- An **independent board committee** should review the sibling-owned lessor’s conflict and the lease price before approval; disclosure in audited financial statements does not establish that the price is fair.
- Exhibit 1 shows that USD 30 million ÷ USD 15 retires 2 million Class A shares, leaving the founder with 20 million of 26 million votes, or **76.9%**; retiring both classes pro rata instead leaves voting percentages unchanged.

**Traps in this case**

*Treating disclosure or management approval as conflict review*
- Neither the auditor’s confirmation of disclosure nor management’s approval substitutes for independent scrutiny of the unassessed lease rate.

*Confusing creditor protections with weak shareholder governance*
- Solara has met its debt obligations, and its customary borrowing and distribution restrictions do not indicate creditor–shareholder risk shifting or weak board independence.

*Assuming every repurchase increases the founder’s voting percentage*
- That percentage rises when only Class A shares are retired, but **remains unchanged** when Class A and Class B shares are retired proportionately. [Practice more Corporate Finance (Level I) questions on Oncourse]

Question 2

Northstar Packaging is evaluating an automated packaging line with a four-year operating life. The equipment will be installed in a warehouse owned by Northstar. The warehouse is currently unused, but an unrelated logistics company has offered to lease it for four years at the annual amount shown in Exhibit 1. The lease payments would be received at each year-end and taxed at Northstar's 25% corporate tax rate. Northstar paid for a feasibility study last year, and the study has no alternative use.

The equipment and installation costs will be depreciated straight-line to a zero book value over four years. Revenue and cash operating costs are expected to occur evenly during each year but are modeled as year-end cash flows. Initial net working capital is invested at time 0 and fully recovered at the end of year 4. The forecast salvage amount in Exhibit 1 is already stated after tax. Northstar's capital-allocation committee requires analysts to include all incremental opportunity costs, exclude sunk costs, and discount the project at 10%.

The treasurer is also reviewing working-capital policy. Northstar currently purchases inputs throughout the year and generally pays suppliers on day 40. The company has sufficient capacity under a revolving-credit facility to finance early supplier payments, but the treasurer is concerned that drawing on the facility will increase reported short-term borrowings. She instructs an analyst to compare the explicit bank rate with the implicit annualized cost of not taking the supplier discount.

Northstar's current financing policy uses long-term debt for permanent working capital and short-term credit for seasonal requirements. A proposed conservative policy would use long-term debt for both permanent and seasonal working-capital requirements. The chief financial officer expects the conservative policy to create periods of surplus cash but believes it may protect the company against disruptions in short-term credit markets. No commitment fees, compensating balances, or transaction costs apply to the revolver, and all stated rates may be compared on a simple annualized basis.

Accepted Answer

***The packaging decision turns on incremental after-tax cash flows, including the warehouse’s forgone rent but excluding the sunk feasibility study.***
- Exhibit 1 gives annual operating cash flow before the warehouse cost of **USD 2.05 million**: $(4.20-2.00-1.60)\times0.75+1.60$, with depreciation of $(6.00+0.40)/4=1.60$ million.
- Forgone rent reduces that cash flow by $0.30\times0.75=0.225$ million annually; NPV is $-6.90+1.825(3.1699)+1.10/(1.10)^4\approx$ **−USD 0.36 million**, including working-capital recovery and after-tax salvage in year 4.

***The working-capital decisions turn on the cash conversion cycle, the supplier discount’s implicit cost, and refinancing risk.***
- Exhibit 2 gives a current cash conversion cycle of **39 days**: $46+31-38$.
- Forgoing the 2/10, net 40 discount costs $(0.02/0.98)(365/30)\approx$ **24.83%** annually, so using the **9%** revolver to pay on day 10 is preferable.

**Traps in this case**

*Omitting or mistaxing the warehouse opportunity cost*
- The unused warehouse could earn taxable rent, so omitting it produces an NPV near **USD 0.35 million**, while subtracting the full pretax rent understates project cash flow.

*Confusing payment terms with the cash conversion cycle*
- The **38-day** payables figure determines the current cash conversion cycle; the supplier’s day-40 deadline determines the **30-day** financing interval between discount and net-payment dates.

*Assuming conservative funding lowers financing costs*
- Funding seasonal needs with long-term debt can create surplus cash and **lower refinancing risk**, but it does not establish a lower overall financing cost or increase seasonal short-term borrowing. [Practice more Corporate Finance (Level I) questions on Oncourse]

Question 3

Meridian Distribution operates a wholesale distribution platform that purchases consumer products from manufacturers and resells them to independent retailers. Its business model requires substantial investment in inventory and trade receivables. Following a decline in demand, Meridian's board asks management to improve liquidity, reduce leverage, and concentrate resources on the company's core distribution network.

The treasurer proposes tighter inventory controls and automated customer credit monitoring. The expected changes in operating-cycle measures are presented in Exhibit 1. Management does not expect the proposal to affect supplier payment terms, sales volume, or gross margins. The board evaluates the proposal using the cash conversion cycle and expects that a shorter cycle will reduce the amount of external financing required for operations.

Meridian's debt agreements do not prohibit exchanges of debt for equity. A group of creditors has offered to exchange USD 80 million of outstanding debt for newly issued common shares. The exchange would occur at fair market value and would not involve a cash payment. EBIT is expected to remain unchanged immediately after the transaction, but the interest expense associated with the exchanged debt would be eliminated. The board wants to understand the directional effects on financial leverage and interest coverage rather than any accounting gain or loss on extinguishment.

Meridian also owns a non-core logistics software segment that licenses route-planning software under multiyear subscriptions. The segment has stable renewal rates and is expected to generate the cash flows shown in Exhibit 2. A strategic acquirer has made an all-cash offer for the segment. As an alternative, Meridian could complete a tax-free spin-off by distributing the segment's shares pro rata to Meridian shareholders. Transaction costs and taxes may be ignored for both alternatives.

Management intends to use any cash received from a segment sale to repay debt. A spin-off would create an independently financed public company, but Meridian itself would receive no cash from the share distribution. The board evaluates the sale offer by comparing it with the segment's standalone value under a constant-growth model.

Accepted Answer

***Meridian can shorten its operating cycle and reduce leverage without selling the software segment.***
- Exhibit 1 gives a current cash conversion cycle of **52 + 43 − 38 = 57 days**; reducing inventory days by 4 and receivable days by 6, with payables unchanged, shortens it by **10 days**.
- Current interest coverage is **USD 72 million ÷ USD 24 million = 3.0x**; exchanging USD 80 million of debt for equity reduces debt from USD 300 million to USD 220 million and increases coverage because EBIT stays constant while interest expense falls.

***The sale raises cash for Meridian, but its offer is below the segment’s standalone value.***
- The cash offer would provide **USD 150 million** for debt repayment; distributing shares in a spin-off would provide Meridian **no cash**.
- Exhibit 2 values the segment at **USD 18 million ÷ (10% − 2%) = USD 225 million**, so the constant-growth comparison favors rejecting the USD 150 million offer.

**Traps in this case**

*Treating lower inventory and receivable days as a longer cash cycle*
- Both decreases shorten the cycle, while unchanged supplier payment terms leave days payables outstanding at **38 days**.

*Treating the debt-for-equity exchange as cash financing or a source of higher interest expense*
- Creditors receive newly issued shares rather than cash, and eliminating the exchanged debt’s interest expense improves coverage.

*Treating a spin-off as sale proceeds or the USD 150 million offer as fair value*
- Meridian receives cash only from the sale, and the offer is **USD 75 million below** the segment’s USD 225 million constant-growth value. [Practice more Corporate Finance (Level I) questions on Oncourse]

Question 4

Two founders form a general partnership without a limited-liability election. One partner signs an authorised supplier contract, and the partnership defaults. The supplier may most likely pursue:

Accepted Answer

Both partners' personal assets. ***Both partners' personal assets***
- In a **general partnership**, both founders ordinarily have unlimited personal liability for authorised partnership obligations.
- Because the supplier contract was authorised and the partnership defaulted, the supplier may pursue either partner’s personal assets, subject to applicable legal procedures.

*Only the partner who signed the contract*
- The signing partner acted for the **partnership**, not solely on their own behalf, when entering the authorised supplier contract.
- The other general partner can also be personally liable for the partnership’s unpaid obligation.

*Only the partnership's business assets*
- Business assets are not the supplier’s only potential source of recovery because the founders made **no limited-liability election**.
- Limiting recovery to entity assets would treat this general partnership like a limited-liability entity. [Practice more Corporate Finance (Level I) questions on Oncourse]

Question 5

An analyst assessing a publicly traded corporation should most likely conclude that:

Accepted Answer

Ownership and control are typically separated, with professional managers directing daily operations on behalf of shareholders. ***Ownership and control are typically separated, with professional managers directing daily operations on behalf of shareholders***
- In a publicly traded corporation, shareholders typically hold dispersed ownership interests while **professional managers** direct daily operations.
- The board of directors oversees management on shareholders’ behalf, creating a separation between **ownership and control**.

*Shareholders directly own corporate assets*
- The **corporation** is a separate legal entity that owns its assets.
- Shareholders own shares in the corporation, not a direct interest in each corporate asset.

*Shareholders may bind the corporation contractually*
- Holding shares alone gives a shareholder no **authority to contract** on the corporation’s behalf.
- Authorized corporate representatives, rather than shareholders acting solely as owners, enter contracts that bind the corporation. [Practice more Corporate Finance (Level I) questions on Oncourse]

Corporate Finance (Level I) Questions

Topics

Organizational Forms, Corporate Issuer Features, and Ownership

Investors and Other Stakeholders

Corporate Governance: Conflicts, Mechanisms, Risks, and Benefits

Working Capital and Liquidity

Capital Investments and Capital Allocation

Capital Structure

Business Models

About Corporate Finance (Level I) Questions