An analyst noticed that an investee company's governance was worsening. To account for this, the analyst is most likely to increase:

Question

BlackTom AI · Accepted Answer

In assessing how governance deterioration affects valuation, the key idea is that governance risk translates into higher uncertainty and risk premium. 
Option 1: 'the company's equity value' — If governance is worsening, future risk is higher, but this does not directly justify increasing the equity value; in fact, poorer governance would typically reduce value due to discounting and risk adjustments, not raise it. 
Option 2: 'the future cash flows from the company's operating activities' — While governance issues can affect cash flow realizations, the standard adjustment when governance risk rises is not to directly bump cash flows upward; governance risk more commonly feeds into the discount rate or required return rather than inflating cash flow estimates themselves. 
Option 3: 'the discount rates in the valuation model used to value the company' — This is the core mechanism: higher governance risk increases the appropriate discount rate (cost of capital) used to discount future cash flows, reflecting greater risk, which lowers present value. 
Thus, among the options, the mechanism that aligns with adjusting for governance deterioration is increasing the discount rates in the valuation model, since it captures the higher required return due to elevated risk.

FINA3401.13791.202610 Chapter 7 Quiz Valuation & Integration

An analyst noticed that an investee company's governance was worsening. To account for this, the analyst is most likely to increase:

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