Question

Give an example of each:

- off-balance sheet financing

- primary advantages and disadvantages of issuing preferred stock

- economic benefits that mergers can provide, as well as their potential for reducing competition

-the pros and cons of ERM

Answer 1

Off-balance sheet financing: It means that a company does not include a libaility on its balance sheet. It is usually done to maintain large capital expenditure without impacting leverage ratios like debt:equity.

An example: Instead of directly purchasing an asset (let's say some heavy machinery) a company creates a special purpose vehicle (SPV) which purchases the asset and then leases it to the original company who records it on their books as an operating lease. Real life examples include use of SPVs by Enron to hide debt.

Primary advantages and disadvantages of issuing preferred stock

Example of advantage: Preferred stock don't carry voting rights in comparison to common stock. Hence even with raising funds through issuing stock, the ownership of company and decision making power of common stock holders is not diluted.

Example of disadvantage: Compared to debt, it is a costly source of finance as the preference dividend is paid after deducting tax from profits, hence there is no tax-benefit on such shares.

Economic benefits that mergers can provide, as well as their potential for reducing competition

One of the benefits of mergers is achieving greater economies of scale, by reducing average costs at higher output by combining resources and technology. This could lead to lower costs for consumers. Example, a larger company could negotiate better prices for procuring raw material.

Mergers also include competitors combing to decrease competition in the market and allowing the combined large firm to hold benefits like greater pricing power and sometimes even monopolistic control in the market. For example, AB InBev's acquisition of SABMiller led to significantly less competition in the alcoholic beverages market.

The pros and cons of ERM

Pros: It helps in being aware and hence minimizing the risks for a business.It can also lead to better strategic decision making as both down-side and up-side of key risks are evaluated.

Cons: It requires a lot of resources including time and money, and estimation of risk is often very complex.