La Bourse / Volume I / Nº I.03 / Quiz, reflection, essays

A woman and a man seated together in a white gazebo, both writing in notebooks, daylight off the lake behind them. — Plate I.03 · Quiz, reflection, essaysTwo Hands, One Page.An instrument is the moment a conviction acquires a second person. Until somebody else has signed it, it is still only an opinion with a spreadsheet.

ASSESSMENT · Chapter I.03 — The First Instrument

Three instruments: a ten-point quiz, eight reflection questions, five essay prompts. The quiz checks comprehension rather than recall. The reflections are private and first-person. The essays are arguable from more than one side.

THE QUIZ — ten points

Four on recall.

1. Name the five answers that turn a document into an instrument.

Counterparty, principal, term, price, trigger. One mark for the five, one for observing that failed proposals almost always answer principal, term and price while omitting the counterparty who can be telephoned and the fact that turns the number on — which are the two that make a page enforceable.

2. Under IFRS 15 and ASC 606, how does a customer prepayment for goods appear in the accounts, and what is the single most useful consequence?

As a contract liability — deferred revenue — recognised as revenue as delivery occurs. It is not financial indebtedness, so it does not consume covenant headroom, and the discount reduces the transaction price rather than appearing as a finance cost. Credit any answer that also names the honest consequence: it does move working-capital ratios and the CFO should hear that from you first.

3. State the shortfall clause in the chapter's instrument, in one sentence.

Any undelivered balance is refunded in cash at list price, plus a stated make-good of 15 percent of the prepayment, within thirty days.

4. In the regeneration covenant, what happens when the stock metric comes back exactly flat, and why?

The tranche releases. The covenant gates against depletion, not for performance. A covenant that demands improvement every period is a ratchet, and a ratchet ends the relationship in year three — the same mechanism that kills gainshare schemes.

Four on application.

5. Your treasurer says: "A 3 percent discount for paying a year up front is worse than our 4 percent deposit rate. Decline it." What has been missed?

The money is not outstanding for a year. With even delivery the average balance is half the prepayment, so the annualised yield is 2d/(1 − d) — 6.19 percent on a 3 percent discount, comfortably ahead of 4 percent. The stronger answer adds the qualification: if the delivery profile is lumpy rather than even, the average balance is higher and the yield lower, so the actual profile must be computed before quoting.

6. A colleague proposes prepaying a supplier for a product that supplier has never made before, on the grounds that the arithmetic works. Diagnose it.

The arithmetic on the spread does work, and it is not the binding constraint. The exposure on failure to deliver is the relationship, and a new product has no reliability history to price. Prepay the proven line and let the cash fund the new activity behind it. Credit any answer naming the shortfall clause as the term that caps the exposure, and noting that a clause does not manufacture a delivery record.

7. You are asked to pick the first counterparty. Your largest customer is 40 percent of revenue and has a strong balance sheet. Why might you choose somebody else?

Because the negotiation will be run by a procurement function whose incentives are to capture the whole surplus, which will push the discount outside your window; and because concentration risk means your funding and your revenue would then fail together. Choose by tenure and order consistency, and set a stated cap on the share of working capital any one counterparty may fund.

8. Why is the shortfall clause written before the discount is negotiated?

Because the clause is what allows the counterparty's risk committee to say yes. A discount agreed before the protection is settled will have to be given a second time when the protection is added — you will pay twice for one concession.

Two that require the arithmetic to be done.

9. A buyer prepays £150,000 for a year of even deliveries at a 4 percent discount. The buyer earns 5 percent on cash; the seller's WACC is 11 percent. Does each side gain, and by how much? Show your working.

List value 150,000 / 0.96 = £156,250, so goods received for nothing are £6,250. Average capital outstanding is 150,000 / 2 = £75,000, so the buyer's yield is 6,250 / 75,000 = 8.33% — which is 2d/(1 − d). Buyer: 6,250 − (75,000 × 5%) = 6,250 − 3,750 = +£2,500 a year. Seller: (75,000 × 11%) − 6,250 = 8,250 − 6,250 = +£2,000 a year. Both gain; the sum, £4,500, is 75,000 × (11% − 5%) — the spread on the average balance. Full marks require the average-balance step. An answer that compares 4 percent with 5 percent and concludes the buyer loses has made exactly the error the chapter is about.

10. Same parties. Documentation will cost £6,000. What is the smallest prepayment worth writing, and what changes that answer?

The surplus accrues at half the spread on the principal: (11% − 5%) / 2 = 3% of P. So P > 6,000 / 0.03 = £200,000. At £150,000 the deal earns £4,500 a year against £6,000 of paper and does not pay for itself in year one. What changes it: reusing the template. At £1,000 of marginal documentation the floor falls to £33,333, which is why the second instrument is where the economics live — and why a catalogue of structures is a product rather than a textbook device.

REFLECTION — eight questions, for one person and a pen

These are not for a room. Write the answers by hand if you can; the slowness is the point.

Which trading relationship in your working life has lasted longest, and what have you never asked of it? Write the thing you have not asked.

When did you last decline an offer because you compared the wrong two numbers? What would you need to have asked to catch it?

Where in your own life is somebody else's creditworthiness sitting unused — a guarantee, a reputation, a standing arrangement — and what would it take to let it cross?

What do you deliver so reliably that you would happily be paid for a year of it in advance? Be honest about how you know.

Recall an agreement that outlasted the enthusiasm of everybody who made it. What was written into it that did the holding?

What is the sentence in a contract you have signed that you did not fully understand, and what stopped you asking?

Think of a time you asked for something and discovered the other party was glad to be asked. What did you believe beforehand that turned out not to be true?

If you had to end the next ninety days with one signature — yours and one other person's — whose would you want, and what would the page say?

ESSAY PROMPTS — five

Each is arguable from more than one side. Each requires at least one source the chapter cites and at least one it does not.

1. Who should own the surplus? The chapter shows that the gain from a prepaid offtake is the spread between two costs of capital, and that the discount merely divides it. Argue either that this surplus should be split by bargaining like any other commercial term, or that in supply chains with severe power asymmetry it should be set by standard — as Fairtrade's pre-finance requirement effectively does. Use the Fairtrade Trader Standard, and one source on buyer power or supply-chain bargaining that the chapter does not cite.

2. Relational contract or enforceable instrument? Ian Macneil argued that real commercial exchange is governed by relationship rather than by the written document. This chapter argues the opposite direction — that writing the relationship down is what makes it survive its authors. Take a position, and address the strongest version of the case against you: that formalising a long relationship can degrade the very flexibility that made it valuable. Use Macneil, and one empirical study of contracting behaviour the chapter does not cite.

3. The financing was the innovation. The solar power purchase agreement changed the adoption curve of a technology that itself did not change. Argue whether financial structure or technical advance has been the binding constraint on regenerative transitions generally — and name one case where the opposite of your thesis is clearly true. Use Shah, and one source on technology diffusion or learning curves that the chapter does not cite.

4. Does the customer make a good creditor? The chapter recommends that the first counterparty be a customer rather than a lender, and shows that this requires fewer permissions. Argue the counter-case: that mixing the commercial and the credit relationship gives a buyer leverage it did not previously hold, and that a bank's indifference is a feature. Use Hirschman on exit and voice, and one source on trade credit or supply-chain finance that the chapter does not cite.

5. The covenant that releases on flat. Ostrom's contribution was a set of principles specifying when commons arrangements collapse. This chapter offers a contractual analogue: a covenant that gates against depletion rather than demanding improvement. Argue whether a flat-releases covenant is a realistic design that survives contact with counterparties, or an insufficient one that permits a stock to be held at a degraded level indefinitely. Use Ostrom, and one source on sustainability-linked finance or outcome-based contracting that the chapter does not cite.