ISBR ADVANCED CAPITAL MANAGEMENT FAQ

1. What is Agency Problem?

High tension model of corporate governance, which involved collecting money from private investors to
run business, led to limited liability, wherein downside is limited and upside is unlimited. When
American market became institutionalized, it led to complete separation between owner ship and
management, which led to agency problem.
2. What is the objective of a corporation?
Objective of corporation is share holder wealth maximization
3. How share holder wealth maximization is practically determined?
Share holders wealth is defined as share price.
4. Why marginal cost of debt is costlier?
Marginal cost of debt is costlier due to agency cost and Bankruptcy cost.
5. What is agency cost of debt?
In mid 1980s against matured firms which did not return back cash to share holders, Leveraged Buy out
were initiated, this led to these firms being saddled with huge amount of low quality debt, which led to
rating down grade, this action led to transfer of wealth from debt to equity share holders, Equity share
holders incorporated covenants in debt agreement to protect themselves against such actions, these
covenants led to monitoring cost, this was called as agency cost.
6. What are covenants?
Covenants are conditions incorporated by lender in the loan agreement, certain covenants calls for
positive actions like maintaining interest coverage ratio, credit rating, allowing lender to nominate board
members they are called as positive covenants.
Certain covenants puts restrictions like declaration of dividend beyond threshold limit, restriction on
further borrowings, restriction of M& A transactions, they are called as negative covenants.
Even though popular meaning of default is nonpayment of debt, loan agreement specify breach of
covenants as default which entitles the lender to immediately recall the loan.
7. What is debt theory suggested by Modigliani & Miller?
MM1 theory says that the weighted average cost of capital will not change due to debt equity mix.
MMI assumed no taxes but MM2 says that the firm value will increase to the extent of tax relief on debt.
Thus Modigliani and miller only talked about tax benefit of debt but ignored bankruptcy cost.
8. What is Merton Miller equilibrium?
In Modigliani and Miller equation it is assumed that debt and equity will be treated equally for tax
purpose in the hands of investor thus MMII equation is
V
L
= V
U
+B*T
Empirically it was noticed that many countries treat debt and equity income differently for tax purpose
in the hands of investor
Thus Merton Miller Equilibrium is
V
L
= V
U +
B*( 1- (1-t
c
)(1-t
ps
)/(1-t
pd
)
T
c
= Corporate Tax
T
pd =
Personal Tax Debt
T
PS
= Personal Tax equity.
9. What is static trade off theory?
In static trade off theory as against Modigliani and Miller theory which assumes no transaction cost,
bankruptcy cost is traded off against tax benefits on debt to get optimum capital structure, in static
trade off theory only direct cost of bankruptcy like rating down grade , cost of liquidation and increase
in equity share holders expectations are taken into considerations.
10. What is dynamic trade off theory?
In dynamic trade off theory indirect cost of bankruptcy like costs imposed by supplier, employees and
customer in the event of bankruptcy is taken into consideration.
In the event of bankruptcy being perceived suppliers demand advance payment or LC and impose cost
on firm, customers desert the company because of fear regarding non availability of after sales services
and spares, good employees leave the company imposing cost and even sale of asset to infuse cost do
not fetch good price due to distress element. All this affect EBIT.
11. What is underinvestment problem of debt overhang?
If there is excessive debt in firms capital structure, managers of the firm refuse to accept good projects
with positive NPV since all benefits will go to debt holders, they will be willing to accept only high risk
projects in such firms since in the event of excessive gain the equity owner being residual owner can
keep the gain, while in the event of loss due to limited liability they can leave the firm to debt holders
and walk away.
12. Trace the history of Corporate Governance?
Corporate Governance was suggested as antidote for agency problem between share holders and
Management. It originated in UK in early nineties after a series of scams after middle eighties.
Cadbury committee gave its report its recommendations included
a. separation of office of Chairman and Managing Director
b. Independent Directors
c. Committee of independent Directors for various critical issues like nomination, compensation , audit
Next committee Greenbury committee concentrated on CEO remuneration
d. Hampel committee wanted corporate governance to be followed in spirit than in letter, it also
expressed concerns about internal control.
e. Turnbull committee went into details about internal controls
Since all these forms part of corporate governance code in UK it is called as combined code.
13. What are the recommendations of Cadbury committee about Board?
Cadbury Committee recommended board to be of appropriate size. Neither two small and function like
country club board, nor too big and become unwieldy.
It wanted the position of Chairman and CEO to be separated.
It placed much emphasis on independent Directors; it wanted 2/3 of Directors to be independent if
Chairman and CEO post is held by the same person. I/3 of Board to be independent if Chairman and CEO
post are separated.
It wanted proper balance between executive and non executive directors.
It talked about nomination committee, compensation committee and audit committee consisting of
independent directors to nominate directors, fix their compensation, to attend to any concerns
expressed by auditors.
14. What are the main recommendations of Sarbene & Oxley committee?
Sarbene & Oxley committee was appointed post Enron in US. Unlike the self regulatory approach of UK,
US relied on legal approach and Congress passed Sarbene & Oxley act in 2002. The main areas are
a. Auditors are prohibited from doing any other service
b. CEO, CFO should sign financial statement and they will be criminally liable for any deliberate mis
representation
c. Auditors are criminally liable for any deliberate misrepresentation in financial statement.
d. CEO & CFO should certify the effectiveness of internal control system.
e. Whistle blowers were protected
f. Public Company accounting overseeing board will oversee the audit of listed companies instead of
AICPA which is an association of accountants.
Thus Sarbene and Oxley act focused on accounting and Audit. It main concern was in removing
information asymmetry between share holder and Management.
15. What is various forms of share holder activism?
In past in US shareholder activism depended on Rich individual share holders like Kerkorian and Carl
Icnah , For example in nineties, Chrysler was forced to return excess cash back to share holders to the
active role played by Kirk Kerkorian but of late institutional share holders like pension funds and hedge
funds are active and successfully removed takeover defense clauses like staggered board and poison pill
from many target company, Proxy advisers advise individual share holders on voting on various
resolutions.
16. What is equity valuation as call option?
Equity resembles a call option on assets of the Company since it has unlimited upside and limited
downside, here the debt holders are option writers.
17. What is information asymmetry and problem of Lemon?
Unlike the assumption of perfect information in Finance, in real life there is an information asymmetry
between the managers and share holders, so share holders feel that the managers can make them do
adverse selection in the form of worthless shares thus holding a lemon. To avoid this share holders
instead of relying on published information, focus on signals, if a company repeatedly approach market
with equity issue the share holders take it as a signal that the share prices are overvalued and arbitrarily
reduce the price, even tax payment if high is taken as signal for genuineness of profits and share holders
raise the price, bonus issue is taken as signal for ability to pay higher dividends in future and the price is
raised. In Mergers issue of consideration in the form of shares is taken as signal for over valuation of
shares. Thus the market instead of functioning rational that is cash flow discounted at cost of capital to
arrive at value of shares mostly relies on signals. Problem of Lemon is when information asymmetry
prevails bad items replacing good items and adverse selection becomes highly probable, people go by
warranties and reputation when confronted by information asymmetry.
18. What is Pecking order theory?
Pecking order theory suggest that due to inherent conflict between managers and share holders in
selection of mode of finance, share holders rather than discounting expected cash flow due to
information asymmetry look for signals. Managers knowing this desperately try to avoid giving signals.
Retained earnings is preferred source of finance for managers since it do not give signals, while if equity
is overvalued considerably they prefer equity as next source of finance, if equity is properly valued they
use debt, thus instead of determining capital structure based on risk and return they are based on
signals.
19. What is free cash flow of Firm?
Free cash flow of firm is available to both equity and debt holders.
EBIT- TAX = NOPLAT (Net operating profit less adjusted tax) + depreciation = cash flow
Cash flow - investment in fixed assets - investment in working capital = Free cash flow of Firm.

20. What is Free cash flow of equity?
PAT+ Depreciation+ non cash expenses- non cash income investment in fixed assets investment in
working capital repayment of borrowings+ additional borrowings = free cash flow of equity.
21. What is the consequence of violation of efficient market theory assumptions?
Efficient market theory talks about innumerable number of sellers and buyers , everybody is a price
taker and nobody is a price maker, all investors are rational, no taxes , no transaction cost, perfect
information.
Consequence of efficient market data are past data cannot be used to predict future called as weak
form of market efficiency, semi strong form of market efficiency states that published information
cannot be used to make superior returns.
Violations of each of the assumptions
Innumerable number of traded securities and innumerable number of buyers and sellers: If the market
lacks in depth or breadth then few people can control the pricing, thus market prices are unreliable
indicators of value. In such market practices like circular trading, artificial pricing bear hammering takes
place. Even though BSE has the highest number of shares listed in the world, it lacks in depth, that is
very few shares sell on day to day basis, thus illiquidity problem is a major problem.
All investors are rational: When investors are irrational like companies not rational and delay the
release of bad information to the last trading day like Friday, thus consistently prices are low on last
trading days.
Crowd behavior like program trading led to market crash in 1987 called as black Wednesday.
If no taxes are violated then if taxes are there investors prefer company to take debt due to tax
advantage of deductibility of interest for tax purpose.
In December month generally share price dip due to investors actually booking losses to claim tax
benefits.
Due to investor tendency to over react earnings surprises can be used to make excess returns.
No transaction cost: In practice agency, bankruptcy cost is there, agency cost leads to preference for
existing shareholders for debt than equity and bankruptcy cost prevents use of excessive debt to take
advantage of tax benefits.
Perfect information: In real life there is information asymmetry, so investors rely on signaling than
rational information to determine the price of share.
Equity has cost like agency, information asymmetry. Which leads to bonding, review and commitment
cost as well as regulatory cost?

22. What is the relationship for debt equity ratio?
There is a difference between accounting and financial balance sheet , in accounting balance sheet
asset are valued based on historical cost, while in financial balance sheet the expectations of the
investors determines value of assets. For example a growth company like Apple will have enormous
franchise value represented by market capitalization, in such companies equity should be preferred
means of finance.
When the company is small and growth oriented then issue of shares involves huge flotation cost and
retained earnings is preferred source of finance. Thus debt equity ratio will be low.
A matured company where the growth has been peaked out the share holder expects the company to
take debt and return their money. Here debt equity ratio will be high
Generally buy backs are done for doing leveraged capital restructuring that is borrowing money to repay
retained earnings. Here debt equity ratio will increase.
For intangible assets like R&D better to finance using equity than debt with fixed interest debt since the
results of the activity are uncertain. Here debt equity ratio will decrease.

23. Why companies refuse to return cash?
Companies may not return back cash
Because of investment needs, due to managerialism managers may invest in unrelated business to
reduce business risk, due to hubris, If dividends are taxed adversely compared to retained earnings then
for tax arbitrage money will not be retained.
24. Do you agree with capital structure indifference and dividend indifference theories propounded by
Modigliani & Miller?
Capital structure and dividend theory of Modigliani and miller goes with several assumptions that
rational investor, all investors are risk averse, only limited source of finance , no taxes etc, if these
assumptions are violated the irrelevance assumption will go away.
But a company gains value by three methods, investment decisions, financing decisions and dividend
policy, if the company is capable of doing very good projects as in the case of Apple, then what ever
mistakes it makes in capital structure or dividend policy will be ignored by shareholder. To that extent
we can treat this theory true.
25. What is contingent value of equity?
Since equity has limited downside and unlimited upside it can be valued as a call option, where equity
holder is call buyer and debt giver call writer. You can use binomial or black schools model.
26. What is Leland Pyle model on information asymmetry?
In an atmosphere where the people who propose the project has more information than the people
who finance it, adverse selection becomes clear possibility so cost of financing increases. Because of
increase in cost of financing lemon problem arises that is only bad projects are available for financing,
while good projects are not available due to high cost of capital.
To avoid these three methods can be used, signaling, screening warranty, reputation.
Signaling is done as per Leyland Pyle model by promoters holding more equity in the project.
Screening is done by appointing high quality investment bankers and auditors and high quality
institutional investor
Reputation can be established by high quality board and management
To assure debt holders they wont be expropriated for the benefit of equity holders conversion options
and detachable warrants are issued.
High quality board and high quality audit no more gains trust of share holders after Enron, Satyam
episode.
27. What is constituency theory of dividend?
A company attracts investor as per its dividend policy. Dividend policies are sticky and once increased it
cannot be revised downwards. For example British Petroleum declared high dividend and attracted
investors who expected high dividend, but when it got good projects to invest because of stickiness of
dividends it was forced to borrow and declare dividend and it was a very bad policy.
After deregulation Lucent technology was spun off as separate company by AT&T which was a matured
telecom company whose shareholders expected high dividends, but being a young research company it
needed the earnings for further investment, but to satisfy the shareholders it borrowed and paid
dividends which proved to be disastrous.
Thus companies should choose their dividend policy appropriately to attract right type of share holders.
28. What is signaling theory on dividend?
Since dividends are sticks any increase in dividend or number of shares by way of bonus issue is taken by
market as signal that company will pay excess dividend so it has some insider information that it will get
excess free cash flow in future.
To avoid such signaling companies resorts to buyback to return excess cash. But such signaling is not
taken when Managers own lot of shares due to ESOP and the buyback is taken as part of managerialism.


29. What is expectation theory on dividend?
Expectation theory on dividend states that dividend will increase the value of the shares only if it is more
than the expectation, thus dividend is sticky downwards, now days more companies resort to buyback
not to create any expectation on dividends.
30. What is regret theory of dividend?
If dividend is declared share price should fall equal to the value of dividend, thus Modigliani and Miller
framed dividend irrelevance theory. But shares have higher value of regret since the value may go up in
future, while cash has least amount of regret. That is why people prefer dividends to retained earnings
and dividend raises share price.

31. What is radical theory of dividend?
Radical theory of dividend says if there is tax arbitrage exist between dividends and capital gains, people
take advantage of the same. Thus in India where dividends are taxed at 15% while long term capital
gains is exempt from tax, bonus shares are preferred to dividends.
32. What is the conclusion of Walter and Gordon models?
Subject to assumptions like rational investor, no taxes, retained earning being the only source of
finance, investor expectation and productivity of retained earnings will remain same
These theories state that if productivity of retained earnings is higher than investor expectations share
price will be more if more earnings are retained, if productivity of retained earnings is less than investor
expectations then price will raise by distributing more of earnings.
But in real life, book earnings can be easily manipulated, the amount the investor will allow the
management to retain will depend on his trust.
For example Berkshire Hathaway never paid dividends from its inception, still it has high share price,
this is a rare exception to general rule.

32. What are two methods by which Beta can be estimated?
Beta can be estimated by two methods regression and build up. In regression method the stock price is
regressed against market index. In build up method Beta of assets of comparable companies are
ascertained.

E
=
A
(1+D/E(1-t))
Where D = Debt, E= Equity t= tax
33. What is meant by leveraged equity?
As debt goes beyond a level cost of equity will increase steeply
For example E
=

A
( 1+D/E(1-T)
If D/E ratio becomes 9 and tax 30% equity beta will increase from 1 to 7.3 steeply raising equity cost,
this is due to bankruptcy cost.

34. How to determine the terms of issue of debt?
For example for accompany like Boeing whose project life cycle is long , long term debt is preferred to
short term debt.
Cash flow from operations should be matching cash outflow from debt
Currency of inflow should match currency of outflow. For example in the case of Indonesian taxi
company safeset currency of revenue was rupiah while currency of liability was $, in 1997 when
rupaiah steeply depreciated against $ the company went bankrupt.
For companies with market power to pass on price increase floating interest rate is preferred to fixed
rate.
For companies which have high contingency value conversion options and warrants to be given with
debt.
If information asymmetry is high and legal system is weak then institutional borrowing is preferred to
market borrowings.
If legal system is weak short term borrowings will dominate long term borrowings.
If proper floating rate bench mark is not available, fixed rate borrowing with call and put options are
resorted to.


35. What are various stages of sickness what are the remedies against the same?
Incipient stage, at this stage if the sickness is detected then it is easily curable.
Ratio analysis is used extensively to detect incipient sickness.
Beaver Model: It uses 30 ratios to detect sickness
Wilcox Model: It goes with liquidation value of firm to detect sickness
Blum Marc model: It uses 12 ratios with cash flow to debt model being the most important ratio
Altmans Z score model: It goes with multivariate analysis
Z = 1.2X1 + 1.4X2 +3.3X3 + .6X4 + X5
X1 = Sales/ Total assets X2 = Retained Earnings/ Total Assets X3 = EBIT/ Total assets X4= Market value
of equity/ book value of debt X5 = Working capital/ Total assets
If the Z value is less than 1.89 then the company is sick, if it is between 1.89 to 2.89 it is in grey area, if it
is > 2.89 it is a healthy company.
LC Gupta model uses 56 ratios to predict sickness; Argenti scorecard is a non financial model to predict
sickness.
If sickness reaches advanced stage external and internal reconstruction to be used, while if the sickness
reaches terminal stage then the company should be wound up.

36. Describe DuPont chart?
DuPont chart explains the composition of ROE
Profit/ Sales * sales/total assets * total assets/ equity = return on equity
ROE is the only measure where book value of equity is used rather than market value.
If book value turns negative this poses problem (Especially in turnaround situations)
This ratio can be used to find out the reasons for change in ROE.

37. What are the information asymmetry and agency problems involved in public issue?
Due to information asymmetry price of equity cannot be estimated accurately.
Thus merchant bankers are employed to find proper price of equity.
But in practice merchant bankers suffer conflict of interest and try to over value issue to gain the
business.
The error in estimation follows normal distribution with half estimates are over estimates and other half
are under estimates.
If a discriminatory price auction that is French auction is followed this will lead to winners curse, thus
the bidders will never state their real estimates and try to under bid.
Thus non discriminatory price auction or Dutch auction is followed.
Here again QIBs who are supposed to protect investor interest are affected by conflict of interest and
help the management to maintain high price so that they can get allotment and en-cash it immediately
after the initial spurt after listing.
To avoid this recently SEBI introduced the concept of anchor investor, which can get allotment up to
30% of QIB quota with compulsory locks in period of 30 days after listing.
38. What is divisional cost of capital?
Some times within the same companies different divisions operate , each one has different cost of
capital, if average cost of capital is taken for evaluating all the projects of the company, this will result in
high cost division being subsidized by low cost division. Thus divisional cost of capital should be
determined to ascertain cutoff rate for various projects.
39. What is sustainable growth rate?
Sustainable growth rate is long term growth rate based only on reinvestment of earning
Sustainable growth rate = retained earnings* Return on equity
40 What are nonvoting shares?
Shares which are having excess dividend but do not have voting rights are called as nonvoting shares. If
the capital of company has excessive nonvoting shares, then governance becomes suspect.
For example in Companies like Apple and Google promoters own Part B share which has 10 times the
voting rights of Part A shares , thus with 20% of their money being invested they can control 80% voting
rights.
41. What are shares with disproportionate voting rights?
Shares which carry low or no dividends but disproportionate voting rights are called as shares with
disproportionate voting rights. In India public companies are prohibited from issuing shares with
disproportionate voting rights.
42. What is pyramiding?
Pyramiding is complex capital structure with complicated cross holding, which makes it difficult to
ascertain true ownership of the company. Companies with such complex capital structure may have
poor governance.
Most of Indian Family managed companies follow this capital structure.
43. What are the various ways in which debt is structured?
In international financial market debt preceded equity, so when equity was issued stable dividends were
promised to make it look like debt.
Today debt is structured like equity , where in return varies with the return on project, for example
Disney issued debt whose return varied based on gate collections thus looking more like equity.
Insurance companies issue catastrophe bond whose return depends on whether a particular
catastrophe strikes or not.
44. What is securitization?
Securitization is a derivative in which value of securities depends on the underlying assets.
45. What is ABS, MBS?
ABS is asset based securitization, while MBS is mortgage based securitization. In Asset based
securitization the underlying is credit card, education loan or other unsecured receivables, while in
mortgage based securitization Properties act as securities.
46. What are two types of Mortgage based securitization?
RMBS: Residential Mortgage based securitization, where the security is a residential property
CMBS: Commercial Mortgage based securitization where security is commercial property
Unlike in the case of Residential Mortgage based securitization personal recourse cannot be had in
commercial mortgage based securitization.

47. What is CDO?
CDO is collateralized debt obligation, in which underlying is either a loan or a pool of loan, or bond or
portfolio of bonds. If loan is underlying it is called as CLO else it is called, if bond is underlying it is called
as CBO.
48. What is a pass through or pay through certificate?
Pass through certificate is whatever amount collected from investor is passed onto to the investor, while
pay through certificate is where the sponsor bears the risk.
49. What is SPV?
SPV is a special Purpose vehicle.
50. What are the ways in which the CDO can be credit enhanced?
By structuring the CDO in the various tranches with high rating, mezzanine rating and equity rating.
By retaining some excess cash and not allowing everything to pass through called as
overcollateralization.
Waterfall model, under which unless higher level tranches are paid lower level tranches will not be paid.
51. What is balance sheet CDO?
The underlying loan or portfolio of loan is removed from the balance sheet of sponsor and sold to SPV,
but the sponsor buys equity tranche to instill confidence.

52. What is synthetic CDO?
Synthetic CDOs are CDO s in which loan risks are taken through CDS without actual transfer of loan and
proceeds obtained by credit Linked notes are invested in treasury security.
52. What is CDO squared?
When one CDO is an underlying for other CDO it is called as CDO squared.
53. What is complicated capital structure?
Fixed interest debt against call and put option, floating rate with cap floor and collar, loan with pre
payment option, pyramiding, ESOP, Convertible debt.
54. What is junk bond?
Junk bond is a unrated bond given at very high rate of interest. These instruments were introduced in US
by Drexel & Burnham through Bond trader Milliken to facilitate hostile takeover.
55. What is diffused capital structure?
Diffused capital structure leads to shirking behavior by share holders, leading to agency problem. Such a
structure is for firms with low residual risks measured by
2
=
2

M
2
+
2
where e
2
is residual risk, or
measured in terms of standard deviation of share price or accounting earning. Agency problem can be
tackled by loading firm with debt. For example a company like L&T has diffused capital structure in India.
56. What is promoter holding?
Promoter holding high percentage of shares is a good thing provided he acquired the same through cash
payments, but if promoters holding is through sweat equity, due to high swap ratio with a private firm in
merger owned by promoter, buy back of shares where no cash is involved then such high share holding
do not mean much, a low promoter holding will only encourage high rent seeking behavior in the form
of perquisites from the firm. If the promoters are more than one the relationship between them
determines the future. Firms with high residual risks needs concentrated equity ownership.
But a promoter may own single digit in a company with diffused structure, here his intention is to seek
high perquisites from the company and milk the excess cash of the company for group investments, he
do not have much incentives to monitor the company . This type of behavior can be controlled by
allowing hostile takeover.
57. What are shares with disproportionate voting rights?
In many American companies Part A shares are entitled to high dividends but usually 1/10 th voting
rights of Part B shares.
Part B shares carry 1 voting right fewer rights to dividends.
In these types of companies a person can control 80% voting rights by holding 10% shares of type
B.These types of companies will not have much capital governance.
58. What about high share holding by an activist shareholder?
If share holders like Carl Icahn or Kirk Kerkorian are one among top share holders, they can effectively
challenge the policies of the company through proxy hunting. But share holders found out that these
share holders usually take care of their interest than that of minority share holders.
Now a days shareholders look for holding by institutions like Berkshire Hathaway as a means of
monitoring the firm.
59. What about institutional share holders?
Institutional share holders like hedge fund and pension funds play activist role in US in enforcing
corporate governance.
In India where institutional shareholders depend upon management for information in an atmosphere
where information asymmetry is high and a chances of being punished being low for trading on insider
information as well as for privately placing shares at low price, the institutional investor go along with
existing management.
But high FII holding gives comfort to investors of good governance practice, but this involves risk if the
FIIs want to leave the country then when they exit it will leave to huge price fluctuations.
60. what about major shares held by group companies?
If major shares are held by group companies then excess cash will go for investment in group companies
and not to share holders leading to complex pyramiding structure.
61. What are problems in companies with significant employee share holdings?
In such companies there will be conflict of interest between employee welfare and share holder wealth.
62. What is APV?
APV (Adjusted Present Value) uses different discount rates to different benefits like tax benefits, subsidy
based on risk. It is a practical demonstration of dynamic trade off theory where present value of tax
benefit on debt and bankruptcy cost is matched.
63. What is classical contract?
Classical contract is based on legal contract, in which the behavior of manager is regulated by contract
in terms of law. But these contracts suffer from the problem of bounded rationality, where by human
beings cannot for see all future problems and regulate the same.
64. What is revised contract?
Revised contract is based on psychological contract, where bonding cost and monitoring cost and
commitment cost. to be incurred as agency cost to achieve goal congruence.
65. What is bonding cost?
ESOPs are used as instrument of bonding between managers and firms. By bonding goal conflict is
converted to goal congruence.
66. What is monitoring cost?
Appointment of Independent Board and Auditors to monitor performance and appointment of external
regulating agencies to regulate performance.
67. What are the legal methods adopted for ensuring corporate governance?
Shareholders are allowed to vote electronically to ensure larger participation. In Sarbene and Oxley act
in US legal threats are used to avoid conflict of interest.
68. How to ensure commitment of Managers?
ESOP only ensures short term commitment, whereby many a times Managers pursue short term
objectives like profit maximization at the expense of long term goals like R&D and new product
development. Training and new skill development, advertisement and brand development. To prevent
such behavior firms like GE ensure long term commitment like awarding performance share provided
the CEO is able to outperform index like S&P 500 over a period of 20 years.
69. How Auditors independence is maintained In US?
In US audit firms are few and have large size, they are formed as Limited Liability Partnership firms and
cannot take more than 10% of its revenue from single client. If Auditor knowingly signs any false
accounts he is subject to huge criminal consequences, apart from this Audit firm cannot do any other
business. Thus by using law conflict of interest is stamped out.
70. What is conflict of interest?
In Finance conflict of interest plays a major role. For example a financial analyst who is attached
to investment banker gives a sell recommendation to a share whose public issue his employer is
handling will lead to his employer losing business. In US conflict of interest are tried to be curbed by
building Chinese wall between the various divisions, but in practice it is not very successful.
69. What is compliance cost?
Compliance cost is incurred to monitor agency cost created by equity, sometimes these cost becomes
very high, there by firm feels whether it is worthwhile to stay listed at least during downturn period.
Alternate mechanisms like private equity are available for firms to seek fund and to avoid short term
pressure of stock markets.

71. What is the difference between corporate finance and project finance?
In project finance the project is managed by separate SPV and the lender has only recourse to project
cash flow, but in corporate finance the project is managed as a division of company and lender not only
has recourse to project but also corporate cash flow as well as to the assets of the company.
72. What is venture capital?
The existing method of financing through stock exchange is applicable only for well established firm, but
to finance new ideas they are totally inadequate since they do not have any track record. To finance
such ideas in US there is venture capital which is used to finance start up and where entry is restricted to
high net worth persons since the risk and return are very high.
Of late the seed or start up stage is financed by angel investor, who himself was an entrepreneur who
successfully promoted a new venture not only gives money but also shares his knowledge with budding
entrepreneur.
Once the venture is successful first and second stage finance are done by venture capital firm.
Mezzanine stage finance before public issue is done by private equity.
72. What are various internal structures adopted by organization for projects?
A divisional structure is adopted where the returns or tax benefits exceed the risk; separate company
structure is adopted if the risk outweighs benefits, if risk is too high it is shared in the form of joint
venture.
73. What is networked system of corporate governance?
In networked system cross holding is used to finance companies, where major share holder manages
company thereby agency cost is not there and much importance is not given to stock exchange
74. . What is stake holders wealth maximization?
Stake holders wealth maximization is the object of networked system of corporate governance; here
the stake holders are customer, suppliers, employees, society, and government. In long run there is not
much difference between share holder and stake holder wealth maximization as it is not possible to
maximize wealth of shareholders by exploiting other stake holders.
75. How stake holders wealth is maximized?
Customers wealth is maximized through TQM, employee wealth is maximized through HRM, Supplier
wealth is maximized through SCM, Government can be satisfied by paying proper taxes and acting as
good corporate citizen by obeying law, society can be satisfied by environmental compliance, corporate
social responsibilities. Investors are satisfied through quality financial reporting.
76. What is triple bottom line reporting?
Triple bottom line reporting not only reports financial performance, but also environmental
performance and corporate social responsibilities.
77. What is quality financial reporting?
Apart from high quality financial reporting using high quality accounting standards, financial reporting is
used as a form of periodic dialogue with share holders in the form of high quality disclosures in foot
notes like
1. Customer wise revenue
2. Product wise revenue
3. Region wise revenue
4. Customer churn
5. Employee churn
6. Order book outstanding
7. Ageing analysis of products
8. Trend analysis
9. Risk analysis
10. Internal control review
11. Detailed discussions on contingent liabilities
12. Competitor analysis
13. Strategy review
14. Share holding pattern
But in Indian situation the foot notes gives only information needed by government and tax authorities
like CIF Value of imports, FOB Value of exports , quantitative details of material consumed, quantitative
details of finished products, foreign exchange earning earnings and out go, making annual reports
opaque and contributing to information asymmetry.
78. When debt is placed privately and traded publically?
When flexibility is desired but interference in management can be tolerated institutional debt is
preferred.
When flexibility not desired but interference in management will not be tolerated debt can be raised
from public.
79. When equity is placed privately and traded publically?
Equity is placed privately if the firm is bothered about change of control but wants quick realization of
money and avoid maze of regulations.
Equity is placed publically when firm dont mind flotation cost, compliance cost and delay in realization
of funds, but dont want the control to change.
80. What are various stages of control?
26% negative control, power to block important decisions
51 % positive control power to run company
75% absolute control all important decisions other than decisions oppressing minority can be taken
100% absolute power.
81. What is right issue?
It is right of preemption given by law, any public company two years after incorporation or one year
after first issue can issue shares only to existing shareholders in the same proportion in which they hold
shares, this is done to prevent majority share holders from expropriating the wealth of minority share
holders, usually right shares are issued at discount as loyalty bonus.
82. What is bonus issue?
Reserves are capitalized and further shares are issued as bonus shares, they act as signals as well as tax
arbitrage.
But in India share premium amount which is collected from share holders can be used to make bonus
issue, thus

sending misleading signals.
83. What is Syndicated, club loan?
They are loans given by foreign banks, if the loan amount is heavy it is arranged by lead bank by publicly
inviting subscription from other banks, but if it is small it is done through private placement hence called
as syndicated loan.
84. What is Foreign Bond?
Foreign bonds are borrowings by foreigner in a country in its currency by issuing bonds, important
bonds are
Yankee Bond : USA
Bull Dog bond : UK
Samurai Bond: Public issue in Japan
Shibosai Bond: Private placement in Japan
Foreign bonds are generally used for long term borrowings.
85. What are Euro Bonds?
Euro Bonds are borrowing in a countrys currency outside the country by issuing bonds. They are used
for medium term borrowings.
86. What is a depository receipt?
Depository receipts are issued by foreign banks whose underlings are shares of another country. ADR
American depository receipt, GDR Global depository receipts.
87. What is the difference between ADR/GDR?
ADRs are listed is American stock exchanges like NYSE, AMEX, NASDAQ where listing norms are far more
stringent , while GDRs are listed in London and Luxemburg where listing norms are far more relaxed.
88. What are various forms of business risk?
Various forms of business risks are high breakeven point, low margin of safety, high concentration risk,
high foreign currency risk, high technology risk, high competition etc
89. What is various forms of Financial risks?
High financial leverage ( high amount of other peoples money), high operating leverage( high fixed cost)
90. What is general rule for capital structure?
High business risk should be offset by low financial risk and vice versa.

91. What are the means by which information asymmetry in debt market can be countered?
Credit Rating, covenants, conversion options, warrants for purchasing equity shares at particular price
attached to debt, debenture trustees, sinking fund
92. What tools are available to Board to discipline Managers and many a time why they are not
effective?
1. Board has monitoring and bonding tools
2. In monitoring the board sets strategy, risk levels to be taken to achieve strategy, monitoring actual
performance against strategy
3. Managers pay is based on performance which can be set by board
4. Appointment and removal of senior personnel done by board
5. In practice promoters who are the executive directors manage the board
6. There is substantial information asymmetry between promoter and non promoter directors
7. Non executive Directors duties are not clear
8. In reality promoter director appoints and removes non executive directors
9. Auditors are appointed by promoters, who are the major shareholders.
93. What are tracking shares?
Tracking shares are issued to track the performance of a division within the company
94. What is delisting of shares?
Listing is an agreement between the company and exchange to trade the shares of the company in the
exchange. This agreement is subject to terms and conditions
There are two types of delisting, compulsory, and voluntary
In compulsory delisting the exchange suspends trading of shares of the company for non compliance
with terms of listing agreement
But since this harms minority share holders more than managers, the exchange transfers this to T group
and reports trading of these shares under Z group.
In voluntary delisting the company itself wants to delist its share from exchange
Since NSE & BSE has emerged as national exchange, many companies want to delist the shares from
regional exchanges to avoid paying listing fees and other cost, this is permitted
But if the company wants to go private it can do it only through reverse book building route as per SEBI.
95. What is qualified institutional placement?
Companies which are listed in national stock exchange can go for qualified institutional placement
All securities other than warrant for equity can be placed by way of qualified institutional placement
Securities should be allotted only to QIB
Minimum 10% should be issued to mutual funds
Not more than 50% should be allotted to single QIB
Minimum price should be average of six months closing price or average of two weeks closing price in an
exchange where higher highest number of shares of the company is traded
There should be minimum 2 investors for placement up to 250 crores and five investors for placements
above 250 crores
This is resorted to by companies in a dull market.

96. Explain various Greeks of the option?
Delta: relation between value of option and value of underlying
Gamma: Rate of change in value of the option, compared to rate of change in value of underlying
Theta: As the time of expiry decrease option value decrease, theta is time decay
Vega/ lamda/ kappa: relationship between volatility of underlying and value of option. Higher the
volatility higher the value, lower the volatility lower the value
Rho : relationship between interest rate in value of option, higher the interest rate higher the value of
call and lower the value of put and vice versa
97. Explain what is dynamic hedging or delta hedging?
If call option on a underlying not available, find out the delta of the option and buy delta equivalent of
underlying. It is like buying call option on the underlying. This is called as delta hedging. But delta
changes frequently, so it has to be rebalanced, it is called as dynamic hedging. How frequently delta
should be balanced depends on gamma.
98. What is flotation cost?
Cost of intermediaries like underwriters, Auditors, Lawyers, registration charges, cost of compliance, and
cost of marketing are all called as flotation cost; they make issue of equity very costly. E intermediaries
are used to bring down flotation cost
99. What is bridge loan?
When a company goes for public issue, it will take 3 or four months for it to receive proceeds. To avoid
this delaying the projects for reputed company, bank will give loan for interim period and offset them
against proceeds of public issue. This is called as bridge loan.
100. What are the indicators for quality trading in stock?
1. Screen based trading 2. Regulator 3. T+2 deliveries in cash market 4. Cash market and derivatives are
separated 5. Large number of players 6. Large volume of stock 7. No player can influence market 8. Very
low transaction cost 9. High liquidity 10. Clearing house as counter party 11. Securities held in
dematerialized form 12. Absence of insider trading
101. What is insider trading?
Insider trading means trading done by insider like directors, auditors, senior management personnel,
their friends and relatives based on unpublished price sensitive information
It is a criminal offence in US , where SEC has done several prosecutions like Milliken, Boesky and
recently Rajaratnam and Rajat Gupta
In India it is still civil offence and maximum penalty is 3 times the profits made or 25 crores whichever is
higher
In India there is no prosecution for insider trading and this practice is rampant
SEBI has been recently given more powers like tapping telephone conducting search and seizure against
market intermediaries
One hopes that SEBI will bring down this menace which makes Indian market inefficient

102. What are firm specific variable and policy variable in multiple regression model?
Altman Z score
Z= 1.2 X1+ 1.4X2+3.3X3+.6X4+X5
X1= Working capital/ total assets, X2 = Retained Earning/ Total Asset, X3= EBIT/ Total assets, X4= Book
value of debt/ market value of equity X5= Sales/ total assets
All variables here are firm specific
While in Arbitrage pricing model of Roll and Ross
Difference between interest rates of short term and long term treasury instruments
Difference in interest rate between highest rate corporate bond and long term treasury instrument
Inflation rate
Industrial growth rate
Determines investors expectations on long term equity return
Here all variables are policy variables.
103. What is franchise and secular value of PE?
Secular value of PE = 1/ Ke
Franchise value = Franchise Factor * growth factor
Franchise Factor = 1/Ke - 1/ ROE
Growth factor = g/ Ke- g
Where g is sustainable growth rate.


102. What are various psychological factors influence stock price?
Crowd behavior: People subordinate their thinking to crowd thinking
Halo effect: Certain shares are held in great esteem based on past performance and people wont let it
go even if the current trend indicates otherwise
Anchoring: People think their purchase price as value and refuse to sell and cut loss even though there
are clear indications they over paid for the stock
Regret: Loss aversion forces people to minimize loss by selling when price decline
Immediate gains: It forces people to sell when the market is raising instead of holding the stock
Heuristics: People rely on their instinct rather than detailed analysis, when they trade in stock
Saturation: Repeated issues make people to avoid security due to familiarity
Expectation: Expectation determine stock price than actual performance

103. What is group think?
People when they come together try to trade favours than to do their job. This makes the job of finding
independent Directors very hard; eminence in ones profession is no guarantee for effectiveness as
Directors.
104. What is Moral Hazard?
Deviant behavior should be punished, but if such behavior is bailed out as it happened in the recent
subprime crisis, it will encourage others to imitate this behavior. Recent amendment to company law
has substantially increased liability of Auditors and independent directors to enforce this.
105. What is Morale Hazard?
People are not in a position to realize other mans loss, unless it hurts him, to counter this SEBI has given
various provisions like promoters should take a stake in issue with lock in period and merchant bankers
should take stake in issue.
106. What are various safeguards given by SEBI in favor of small investors in public issues?
Green shoe options, IPO rating, reservations for small investors, basis of price to be disclosed, safety net,
appointment of compliance officer.
107. What is utility theory?
Unlike the earlier assumptions that all investors are risk averse, utility theory states that different
investors have different risk appetite, thus small investors finance only tried and tested issues, thus
track record is prescribed for public issue as entry barriers, but others can approach angel investor,
venture capitalist and private equity depending on their risk appetite

108. What is complex capital structure?
Capital structure which has instruments which are hybrid like Convertible debenture, partially
convertible debentures, cumulative convertible debentures, debentures with warrant attached, equity
with entitled rate of return. Overhanging equity like ESOP.
109. Name few committees for corporate governance in India?
Kumara Mangalam Birla committee, Naresh Chandra Committee, Narayana Murthy Committee, JJ Irani
Committee.
110. Name methods for valuation of shares?
Two stage growth model, three stage growth model both are cash flow based model. Leading P/E,
Trailing P/E, Price to sales, Market to book, Price to EBDITA, PE/G ratio or fools ratio.
111. What is built up method of valuation?
When a company has more than one division, if each division is valued and they are added up they give
the value total value. This assumes that value of one business will not affect other business. But in many
cases it is not so. A fully separated or partially separated business is more valuable than combined
business.
112. What is control premium?
Shares are valued based on dividend declared, since an investor cannot decide dividend, but if an person
wants to purchase controlling interest in a firm then premium for control to be added to value arrived
or, alternatively free cash flow based valuation of firm to be decided to find the value of controlling
interest.
113. What is perpetual or horizon value?
Perpetual or horizon value assumes indefinite life for firm, which was true in 1920s, but this assumption
should be suitably modified for firms which function in extremely competitive atmosphere today.
114. What is liquidity discount?
Unlisted shares and thinly traded shares are subject to discount due to liquidity.
115. What is green shoe option?
Green shoe option allows firms to over issue shares by 10 to 15%,. Use promoters holding to stabilize
market by selling the shares immediately after listing and buying them back when their value decline.