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

The scenario describes a decline in governance quality for the investee company, which implies higher risk for investors and lenders. This risk change should influence how valuation is performed.
Option 1: 'the future cash flows from the company's operating activities' If governance worsens, future cash flows could be more volatile or uncertain, but the act of recognizing that risk typically alters the discounting mechanism rather than directly inflating or deflating cash flow projections themselves. Valuation adjustments due to governance risk are usually captured by discounting at a higher rate, not by systematically increasing cash flow forecasts without justification.
Option 2: 'the company's equity value' In theory, equity value is what you derive from discounting cash flows or applying multiples, but simply stating to increase equity value ignores the mechanism by which risk adjustments are made. A governance deterioration would more plausibly affect the discount rate used, rather than automatically pushing up equity value without changing the underlying cash flows or growth assumptions appropriately.
Option 3: 'the discount rates in the valuation model used to value the company' This is the mechanism that directly reflects increased governance risk: higher perceived risk leads to higher required return, which translates into higher discount rates in the model. By raising discount rates, the present value of expected future cash flows decreases to reflect greater risk, aligning with prudent valuation practice when governance is deteriorating.
Overall, the prudent response to worsening governance is to adjust the risk assessment embedded in the valuation by increasing the discount rate, rather than altering cash flows or equity value in isolation without justification. Consequently, the most appropriate adjustment is to the discount rates in the valuation model used to value the company.

FINA3401.13791.202610 Practice Ch. 7 Quiz

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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