Level 1 - Study Session 10 - Corporate Finance (1)

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Contents


Introduction to Corporate Governance and other ESG Considerations (Reading 31)[edit]

Describe corporate governance (LOS 31.a)[edit]

  • Corporate Governance: Internal controls and procedures by which a company is management
    • Framework for rights and roles of various groups in an organization
    • Minimizes conflicting interests between insiders and external shareowners
  • Shareholder Theory: Primary focus of corporate governance is interests of shareholders
  • Stakeholder Theory: Primary focus of corporate governance is all groups that have interest in firm (employees, suppliers, customers, etc.)

Describe a company’s stakeholder groups and compare interests of stakeholder groups (LOS 31.b)[edit]

  • Shareholders: Voting rights and claim to net assets of corporation after liabilities are settled
  • Board of Directors:
    • Protect interest of the shareholders
    • Hire/fire/decide on compensation of firm’s senior managers
    • Set strategic direction and monitor financial/other performance of firm’s activities
    • One Tier: Executives and non-executives on same level; two tier = non-executives above
  • Senior Managers: Interests are to get paid and get continued employment; typically get bonuses tied to firm performance so they can care about that too
  • Employees: Interest in firm success because of rate of pay, career advancement, training, working conditions
  • Creditors: Owners of outstanding bonds/loans; interest in receiving their payments (protected by covenants)
  • Suppliers: Interest in relationship with firm, their trade profitability, and growth/stability of firm
    • Short term creditors - care about solvency and ongoing financial strength

Describe principal–agent and other relationships in corporate governance and the conflicts that may arise in these relationships (LOS 31.d)[edit]

  • Principal-Agent Conflict: When an agent is hired to act in the interest of the principal, but their interests don’t always coincide
    • Eg. Insurance salesman wants to maximize commissions by selling policies to as many people as possible (even if they are bad risks) - insurance company may lose money on these policies
  • Conflicts of Interest Between Shareholders and Managers/Directors
    • Managers favor management interest (risks depend on firm) - which can be at the expense of shareholder interests (risks diversified through stock portfolio)
    • Information Asymmetry: Managers have better information about the firm than do shareholders; impaired in ability to evaluate if managers are acting in shareholder interests
  • Conflicts of Interest Between Groups of Shareholders
    • Single/group of shareholder(s) may hold majority votes and act against interests of minority shareholders
    • Related Party Transactions: Agreements/transactions that benefit entities (shareholders) in which they have a financial interest, to the detriment of minority shareholders
  • Conflicts of Interest Between Creditors and Shareholders
    • Shareholders may prefer more risk than creditors (who have limited upside from good results)
      • Eg. additional debt issuance (increases default risk), more equity dividends
  • Conflicts of Interest Between Shareholders and Other Stakeholders
    • Company may increase prices to the detriment of customers; may also pay less in taxes

Describe stakeholder management (LOS 31.e)[edit]

Describe mechanisms to manage stakeholder relationships and mitigate associated risks (LOS 31.f)[edit]

  • Stakeholder Management: Company relations with stakeholders based on having a good understanding of interests and maintaining effective communication with stakeholders - based on four types of infrastructures:
    • Legal Infrastructure: Laws/legal recourse stakeholders have
    • Contractual Infrastructure: Contracts that dictate rights/responsibilities of company/stakeholders
    • Organizational Infrastructure: Corporate governance procedures about stakeholder relationships
    • Governmental Infrastructure: Regulations
  • Shareholder Management: Defined by standard practices
    • Annual General Meeting: Management shows audited financial statement, talks about company performance and significant actions over the period, and Q&A
      • Any shareholder can attend and vote, or send a proxy
    • Ordinary Resolution: Approval of auditor/election of directors, usually require a simple majority vote
    • Special Resolution: Mergers/takeovers, bylaw amendment, usually require a supermajority vote (⅔ or ¾)
      • Can be addressed at extraordinary general meetings (called when vote is required)
    • When electing board members, companies can use regular majority voting, or cumulative voting (# of shares * # of board positions being elected; can cast all your votes for 1 person if you want)

Describe functions and responsibilities of a company’s board of directors and its committees (LOS 31.g)[edit]

  • Board Structure
    • Can have any # of directors on a board with different areas of expertise
    • Independent Directors: Non-executive members with no relationship to company
      • Lead Independent Director can call a meeting of just independent directors
    • Two-Tier Board: Supervisory board (non-executive) and management board (executive)
    • On one-tier boards, separation of CEO and chairman in the US has become more common
    • Staggered Board: Elections for some board positions are held each year (less common; usually board members are elected at the same meeting and keep the position for multiple years)
  • Board Responsibilities
    • Senior management selection/pay
    • Strategic direction for company
    • Approving capital structure changes, big acquisitions, and large CAPEX
    • Reviewing company performance making corrective steps
    • Continuity planning (of senior staff)
    • Internal controls/risk management
    • Quality of firm’s financial reporting, internal audits, and oversight of external auditors
  • Board Committees
    • Audit Committee: Oversight of financial reporting/internal controls/internal and external auditors
    • Governance Committee: Oversight of corp. governance code/code of ethics/conflicts of interest/compliance with laws and regulations
    • Nominations Committee: Proposing and finding new board members for election
    • Risk Committee: Oversight of risk policy and management
    • Investment Committee: Oversight on large acquisitions/sales or disposals of assets/performance of acquisitions

Describe market and non-market factors that can affect stakeholder relationships and corporate governance (LOS 31.h)[edit]

  • Activist Shareholders: Try to exert their will to make changes that increase shareholder value
    • Shareholder lawsuits, getting on the board, votes, raising issues to public
    • Proxy Fight: Try to get proxies of other shareholders to vote in favor of their proposals
    • Tender Offer: Try to buy a specific number of public shares to take over company
    • Hostile Takeover: Can act as an influencer on management/boards to do what shareholders are saying
      • Can cause corporate governance issues when management proposes and board approves anti-takeover measures
  • Non Market Factors
    • Firms in countries with a common law system (judge ruling becomes law) are better protected than in a civil law system (judges are bound to rule based on specifically enacted law)
    • With advances in communications, shareholders can voice their concerns better which as increased concern about managers’ professional reputations - results in policies more consistent with interests of shareholders
    • Mutual funds must now have policies to vote their proxies in the best interest of their investors (after 2003 SEC mandate)

Identify potential risks of poor corporate governance and stakeholder management and identify benefits from effective corporate governance and stakeholder management (LOS 31.i)[edit]

  • Risks of weak corporate governance
    • Internal controls and board oversight are weak, leading some stakeholders to benefit over others (eg. accounting fraud)
    • Unmonitored managers may pursue their own benefit over the company’s
    • Legal and reputational risks due to poor compliance (violating stakeholder rights or not complying with government regulation)
  • Benefits of effective corporate governance
    • Management/board member incentives align their interests with those of shareholders
    • Effective control and oversight of audits and management by board
    • Avoid legal and regulatory risk

Describe factors relevant to the analysis of corporate governance and stakeholder management (LOS 31.j)[edit]

  • Company Ownership and Voting Structure
    • Dual Class Structure: One class of shares comes with more votes (eg. to keep control in the family)
      • Important to consider what their interests are
      • Normal company shares typically trade at a discount to comparable single class structured companies
  • Composition of Company’s Board
    • Analysts should look at whether directors:
      • Are executive, non-executive, or independent
      • Involved in related party transactions
      • Have diversity of expertise to suit company strategy
      • Have served for many years and become too close to management
      • Basically look at conflicts of interest + enough expertise
  • Management Incentives and Remuneration
    • Analysts should be concerned if:
      • Short term (cash) bonuses have more incentives than long term (stock) bonuses
      • Performance incentives are fairly stable over time - targets easy to achieve?
      • Higher remuneration than comparable companies in industry
      • Incentives not aligned with company strategy
  • Composition of Shareholders
    • If too significant a portion of shares are controlled by an affiliated company/institution, they can exert too much influence on company’s policies and direction
      • If they vote with management/support board members too much, they can hinder change from potential hostile takeovers and activist shareholders
  • Relative Strength of Shareholders’ Rights
    • Weak shareholder rights reduce increases in returns from being acquired/change in strategy
      • Eg. anti-takeover provisions, staggered boards (make it harder to vote someone new in), super voting shares all restrict rights of shareholders to see change
  • Management of Long-Term Risks
    • Failure to manage risks of stakeholder conflicts or other sustainability risks is bad mmk

Describe environmental and social considerations in investment analysis (LOS 31.k)[edit]

  • ESG Integration/Investing: Use of environmental, social, and governance factors in making investment decisions
    • Also called sustainable/responsible/socially responsible investing

Describe how environmental, social, and governance factors may be used in investment analysis (LOS 31.l)[edit]

  • Negative Screening: Certain companies or sectors are excluded from portfolios
  • Positive Screening: Identify companies with best practices across environmental sustainability, employee/human rights, and governance practices
  • Impact Investing: Investing to promote a specific social/environmental goal
  • Thematic Investing: Investing based on a single goal, such as the development of alternative energy or clean water sources

Capital Budgeting (Reading 32)[edit]

Describe the capital budgeting process and distinguish among the various categories of capital projects (LOS 32.a)[edit]

  • Capital Budgeting Process: Identifying and evaluating capital projects where CFs are received over a period longer than one year
    • Steps: Idea generation, analyzing project proposals, creating firm-wide capital budget, monitoring/post-audit
  • Capital Budget Categories:
    • Replacement projects to maintain business: don’t require much detailed analysis
    • Replacement projects for cost reduction: detailed analysis
    • Expansion projects: detailed analysis
    • New product/market development: detailed analysis
    • Mandatory projects (eg. government/insurance company regulated): accompany new projects
    • Other projects: may need detailed analysis or be tough to analyze

Describe the basic principles of capital budgeting (LOS 32.b)[edit]

  • Five principles of capital budgeting:
  1. Decisions are based on incremental cash flows
    1. Sunk costs are not included (eg. consulting costs for research)
    2. Externalities are included
      1. Cannibalization: Taking market share from other product
  2. Cash flows are based on opportunity costs (included)
  3. Timing of cash flows is important (time value of money)
  4. Cash flows are analyzed on after-tax basis
  5. Financing costs are reflected in required rate of return

Explain how the evaluation and selection of capital projects is affected by mutually exclusive projects, project sequencing, and capital rationing (LOS 32.c)[edit]

  • Independent Projects: Evaluated separately
  • Mutually Exclusive Projects: Only one can be chosen
  • Project Sequencing: One project follows another; if first project doesn’t work then firm won’t invest in second
  • Unlimited Funds vs. Capital Rationing
    • If a firm has unlimited funds, then it will take all projects that exceed cost of capital
    • If it has constraints, then they must pick and choose to maximize shareholder value

Calculate and interpret net present value (NPV), internal rate of return (IRR), payback period, discounted payback period, and profitability index (PI) of a single capital project (LOS 32.d)[edit]

  • NPV: Use calculator
    • DECISION RULE: Accept projects with positive NPV and reject with negative
  • IRR: Discount rate that makes PV of expected inflows = initial cost of project / makes NPV 0
    • DECISION RULE: Accept if IRR > required rate of return, otherwise reject
    • Return on each dollar invested - if outlay and inflows increase by the same proportion, IRR stays the same
  • Payback Period: # of years it takes to recover initial investment
    • = Full Years Until Recovery + (Unrecovered Cost at Beg. of Last Year / Cash Flow)
    • Measure of liquidity (shorter payback = better) but does not take PROFITABILITY or TVM into account
  • Discounted Payback Period: Same as payback period but uses discounted cash flows
  • Profitability Index: Present value of project’s FUTURE cash flows divided by initial cash outlay
    • PI = (PV of Future Cash Flows) / = 1 + NPV /
    • DECISION RULE: If PI > 1, accept

Explain the NPV profile, compare the NPV and IRR methods when evaluating independent and mutually exclusive projects, and describe the problems associated with each of the evaluation methods (LOS 32.e)[edit]

  • NPV Profile: Graph that shows a project’s NPV (y-axis) for different discount rates (x-axis)
    • X-intercepts are IRR (where NPV = 0)
    • Crossover Rate: Where 2 NPVs intersect
      • To calculate from cash flows, subtract 1 project’s CFs from the other and get IRR
  • Advantages and Disadvantages of NPV and IRR
    • NPV
      • Advantages: Direct measure of expected increase in value of the firm
      • Weakness: Does not take into consideration the size of a project (eg. NPV of $100 great for $100 cost but bad for $1mm cost)
    • IRR
      • Advantages: Measures profitability as a percentage (% above required rate of return - shows how much return can fall before negative NPV)
      • Weakness: Mutually exclusive project ranking different than NPV
        • Can have multiple IRRs or no IRR (unconventional cash flow patterns)
    • When IRR and NPV rule conflict in mutually exclusive projects, use NPV rule

Contrast the NPV decision rule to the IRR decision rule and identify problems associated with the IRR rule; (LOS 32.f)[edit]

Describe expected relations among an investment’s NPV, company value, and share price (LOS 32.g)[edit]

  • A positive NPV project should proportionately increase company’s stock price
    • Find market cap of company and add NPV; divide by # of shares outstanding to find increase
    • This is theoretical since a stock price is more of a function of expectations

Cost of Capital (Reading 33)[edit]

Calculate and interpret the weighted average cost of capital (WACC) of a company (LOS 33.a)[edit]

Describe how taxes affect the cost of capital from different capital sources (LOS 33.b)[edit]

  • Weighted Average Cost of Capital: Discount rate for capital budgeting/DCF analysis
  • )
  • Cost of debt is taken after taxes because interest paid is tax deductible

Describe the use of target capital structure in estimating WACC and how target capital structure weights may be determined (LOS 33.c)[edit]

  • Use target capital structure for the firm
  • If unavailable, use current capital structure based on current market value
    • Take into account trends (eg. reducing debt by x% each year, make that change)
  • Can also use industry average capital structure (from a sample)


Explain how the marginal cost of capital and the investment opportunity schedule are used to determine the optimal capital budget (LOS 33.d)[edit]

  • As more capital is raised, the cost of raising additional capital rises = increases WACC
    • Forms upward sloping marginal cost of capital curve
  • Firms will undertake projects with highest IRRs first, and lower IRRs later
    • Form downward sloping investment opportunity schedule
  • Optimal Capital Budget: Intersection of MCC and IOS curves
    • Firms should accept all projects with IRR > MCC; to the right of the optimal capital budget, MCC > IRR so they shouldn’t accept them as they erode value created by firm

Explain the marginal cost of capital’s role in determining the net present value of a project (LOS 33.e)[edit]

  • Not all projects carry the same risk
  • WACC is the appropriate discount rate for projects with ~ same risk as firm’s existing projects, since component costs of capital used to calculate WACC are based on existing level of risk
  • If project risk > average firm risk, use higher WACC and vice versa
  • WACC also assumes the current capital structure will remain during the life of the project

Calculate and interpret the cost of debt capital using the yield-to-maturity approach and the debt-rating approach (LOS 33.f)[edit]

  • YTM Approach: Use current market interest rate (YTM) on new (marginal) debt that can be issued by the firm, not coupon rate of existing debt (even if they give you both)
  • Debt-Rating Approach: Take the debt rating of the firm and the average maturity to find yield using a yield curve
    • Also called matrix pricing
    • Take covenants/seniority/other characteristics into account

Calculate and interpret the cost of noncallable, nonconvertible preferred stock (LOS 33.g)[edit]

  • Cost of Preferred Stock
  • D = preferred dividends and P = preferred share price

Calculate and interpret the cost of equity capital using the capital asset pricing model approach, the dividend discount model approach, and the bond-yieldplus risk-premium approach (LOS 33.h)[edit]

  • CAPM
      • Where Rf = risk free rate, B is beta, and Rm is expected return on the market
    • Rf should be yield on default risk-free debt (T-notes) with maturity = useful life of project
  • Dividend Discount Model: Use when dividends are expected to grow at a constant rate
      • Where D1 = next dividend, P0 = stock price, and g = sustainable growth rate
      • If given dividend for this year, multiply by growth rate to get D1!!!!
    • Difficulty lies in estimating growth rate
  • Bond Yield Plus Risk Premium: Ad hoc approach to estimate required rate of return (risk premium is usually 3-5%)
    • = bond yield + risk premium

Calculate and interpret the beta and cost of capital for a project (LOS 33.i)[edit]

  • Pure Play Method: A project’s beta can be calculated by getting the beta of a publicly traded firm engaged purely in a business similar to, and with a risk similar to, the project under consideration
    • Since beta is a function of capital structure as well, it must be unlevered then relevered
    • = unlevered beta of company, D/E = debt to equity
  • Issues with estimating beta of comparable/any company’s equity:
    • Uses historical data, and beta is sensitive to length of time and frequency of data
    • Affected by which index is chosen
    • Betas revert to 1 over time and may need to be adjusted accordingly
    • Estimates of small-cap firm may need upward adjustment of risk inherent in small firms

Describe uses of country risk premiums in estimating the cost of equity (LOS 33.j)[edit]

  • Country Risk Premium: Additional risk when using CAPM for developing countries
    • Sovereign Yield Spread: Difference in yields between developing country’s government bonds and Treasury bonds of a similar maturity
    • CRP = Sovereign Yield Spread x [Annualized Std Dev of Equity Index of Developing Country / Annualized Std Dev of Sovereign Bond Market in Terms of Developed Market Currency)

Describe the marginal cost of capital schedule, explain why it may be upward sloping with respect to additional capital, and calculate and interpret its break-points (LOS 33.k)[edit]

  • Marginal Cost of Capital: Cost of last new dollar of capital a firm raises
    • Costs more to raise more debt due to financial risk
    • Costs more to raise more capital due to flotation costs
  • Marginal Cost of Capital Schedule: Shows WACC for different amounts of financing and how WACC rises at different break points
    • Break Points: When cost of one component of WACC changes
      • Amount of Capital when Cost of Capital Changes / Weight of Component
  • To calculate the marginal cost of capital schedule:
    • Calculate breakpoints for each change in cost of component
    • Calculate WACC for each break point, using weight of component
      • Eg. 60% equity and 40% debt, divide the total break point capital into 60/40
    • Graph with WACC on Y axis and Capital Raised on X Axis

Explain and demonstrate the correct treatment of flotation costs (LOS 33.l)[edit]

  • Flotation Costs: Fees charged by investment bankers when company raises external equity capital (usually around 2-7% of total equity capital raised)
    • Incorrect Method: Incorporating the flotation costs directly into the cost of capital (eg. reducing share price by flotation cost in dividend growth model)
      • This is wrong because this increases total WACC and flotation costs will be a factor for the duration of the project
      • Overstates NPV for project
    • Correct Method: Adjust initial project cost by dollar amount of flotation cost
      • Calculate WACC and find out how much of the project is funded by equity
      • Multiply $ amount of equity by flotation costs and increase initial outflow by that much
      • Can be tax deductible so be careful