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«1. Corporate Performance_ 3 2. Corporate Governance 15 3. Mergers and Acquisitions 29 4. Key Formulas _ 51 © 2014 Allen Resources, Inc. All rights ...»

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1. Corporate Performance_________________________________ 3

2. Corporate Governance ________________________________ 15

3. Mergers and Acquisitions______________________________ 29

4. Key Formulas _______________________________________ 51

© 2014 Allen Resources, Inc. All rights reserved.

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Any use of these materials without the express written consent of the publisher is a violation of federal and/or international copyright laws.

9-1 Corporate Governance

2. Corporate Governance Learning Objectives This summary includes a review and an analysis of the principles set forth by CFA Institute.

Upon review of this summary, you should be able to:

Explain corporate governance and its importance

Describe the objectives of effective corporate governance systems

Explain the primary attributes of an effective corporate governance system...............pg. 17 Understand whether a company’s corporate governance system has the core attributes of an effective system

Understand the similarities and differences between the three main business forms..pg. 17 Know the potential conflicts of interest inherent in each business form

Know the similarities and differences of agency relationships between managers and shareholders and between directors and shareholders and discuss potential conflicts

Know the responsibilities of the board of directors

Define and explain what board attributes and investor or analyst must assess...........pg. 21 Describe effective corporate governance practices as these relate to the attributes of the board of directors

Understand the strengths and weaknesses of a firm’s corporate governance practice

List the elements of a firm’s statement of corporate governance policies that should be assessed by investors and analysts

Detail the implications of environmental, social, and governance risk for valuing firms

9-15 ©2014 Allen Resources, Inc.

Study Session 9 Overview This reading defines corporate governance and explains the importance of an effective corporate governance system to investment analysts. This reading also discusses the agency conflicts that can arise between managers and shareholders and between the board of directors and shareholders, and considers the implications of corporate governance on firm valuation.

Corporate Governance and Its Importance Learning Objective: Explain corporate governance and its importance.

The corporate form of business dominates because of:

1. ease and efficiency in raising capital.

2. ability to obtain resources.

3. producing products and services.

In a small business where there is a single owner/manager, by definition, the firm makes value maximizing decisions; the manager has only him or herself to please, not a large body of shareholders. In a larger corporation, the owners are not necessarily the same individuals who operate the firm’s assets. In large corporations, stockholders are diverse, usually holding only a very small percentage of the firm’s equity. Professionals manage the company and they may not have a substantial ownership stake in the firm. In this situation, there may be conflicts between owners and managers. This is not the only possible agency conflict; other combinations of stakeholders (any parties with an interest in the firm) may also experience conflicts. Potential agency problems could arise between a manager and an employee, a stockholder and a bondholder, a manager and a supplier, a stockholder and government, a manager and a community, or a director and a shareholder. Corporate governance is a set of principles, policies, and procedures that outline responsibilities which make managers accountable to stakeholders, and minimize conflicts of interest within the corporation.

Failure of a corporate governance system could have serious negative consequences for the firm.

The business press has been filled recently with corporate misdeeds resulting in executives receiving substantial jail time, and bankruptcy filings for some of the firms involved. The scandals of the early 2000s have led to increased regulation, for example, the Sarbanes-Oxley Act, which spells out many responsibilities of managers and boards.

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Objectives of Corporate Governance Systems Learning Objective: Describe the objectives of effective corporate governance systems.

Learning Objective: Explain the primary attributes of an effective corporate governance system.

Learning Objective: Understand whether a company’s corporate governance system has the core attributes of an effective system.

The objectives of an effective corporate governance system are:

1. reduce or eliminate conflicts, in particular, manager-shareholder conflicts.

2. make sure that the firm’s assets are used effectively in the best interest of its shareholders and other stakeholders.

While corporate governance systems differ, depending on the needs of the firm and local

government regulations, an effective system should:

• define the rights of shareholders and other stakeholders.

• explain what responsibilities managers and directors have toward shareholders.

• explain how managers and directors will be accountable for their performances.

• treat managers, shareholders, and directors fairly.

• be transparent and accurate concerning operations, risk, financial statements, and managerial performance.

Investors need to examine a firm’s corporate governance system for the above attributes and evaluate its effectiveness.

The Three Business Forms Learning Objective: Understand the similarities and differences between the three main business forms.

Business can be organized as sole proprietorships, partnerships, or corporations. A sole proprietorship is a business owned and operated by a single individual. In a partnership two or more individuals reach an agreement to own and operate a business and divide its profits. A partnership may be a general partnership in which all partners are owner/operators of the business, or a limited partnership (typically organized for real estate or oil and gas exploration business) in which general partner(s) manage the company and limited partners contribute capital. A corporation is a legal entity created by a state and is separate from its owners and managers.

–  –  –

Easy transferability - ownership typically is in Double taxation - firm earnings are taxed at the form of shares of stock which can be sold if the corporate level and then again at the the original owner no longer wishes to keep an personal level as dividends or realized capital ownership interest. gains.

Limited liability - owners can only lose the It’s harder for owners to monitor the actions amount invested in the firm in the event of of managers, particularly in a large bankruptcy. Creditors cannot seize their corporation with many shareholders.

personal assets.

Specialization - a corporation can have many employees, each expert in a specific area of the business, but not expert in all aspects of operations and financing.

Legal entity - the corporation is a separate entity. It can enter into contracts, sue or be sued, purchase land and assets, borrow money, etc.

Greater ability to raise capital and grow the firm While there are more sole proprietorships than any other business form, revenue from corporations accounts for 90% of total revenues among U.S. businesses.

Conflicts of Interest Learning Objective: Know the potential conflicts of interest inherent in each business form.

A sole proprietorship will have no conflicts between managers and shareholders. The manager is the sole owner and will make decisions that benefit him/her. A sole proprietorship could experience other conflicts of interest; for example, between creditors and the sole proprietor. A partnership could experience conflicts among the owners and operators, with the potential for conflict rising as partners are added. A corporation has the most potential for conflict. Managers who may not even own shares in the corporation make the day-to-day operating decisions for the firm, which may or may not be in the best interest of shareholders. It is harder for shareholders, particularly those who own only a small percentage of the firm, to monitor the actions of managers and ensure that the managers are acting in the shareholders’ best interest.

–  –  –

The Principal-Agent Relationship Learning Objective: Know the similarities and differences of agency relationships between managers and shareholders and between directors and shareholders and discuss potential conflicts.

The objective of the firm is maximizing shareholder wealth. The firm accomplishes this by maximizing stock price, which is achieved by accepting all possible positive net present value projects. Managers may have personal goals other than shareholder wealth maximization. An agency relationship occurs when the principals (shareholders) hire agents (managers) to operate the firm. Agency theory addresses the conflicts of interest that can arise when agents have decision-making power and perform services for the principals. In particular, agency theory addresses agency costs or agency problems resulting from these conflicts of interest. Corporate governance is primarily concerned with manager/shareholder and director/shareholder agency conflicts.

Manager/Shareholder Agency Conflict

Possible manager/shareholders conflicts include:

• excessive perquisite consumption. The manager may want a corporate jet or an office stocked with works of art, which benefit the manager but not necessarily the shareholders.

• decisions which benefit the manager at the expense of the shareholder. For example, finance theory states that non-diversifiable risk, not total risk, is relevant. In other words, the market will only compensate an investor for taking on non-diversifiable risk, as measured by beta. While it is bad news for an investor if a firm he owns stock in declares bankruptcy, it is not disastrous news if he has a diversified portfolio. A manager is more concerned with total risk, which includes both non-diversifiable risk and firm-specific, or diversifiable, risk. It is disastrous for a manager if his firm declares bankruptcy since there is an extremely reduced job market for former CEOs of bankrupt firms. As another example, the manager may prefer to head a large, rapidly growing firm. The larger the firm, the more difficult a hostile takeover of the firm (and the possible loss of employment accompanying a takeover). Generally, there is more status and salary for a CEO of a large firm versus a small business. On the other hand, managers compensated heavily with stock options might take on very risky ventures (risk increases the value of options) that could benefit managers more than shareholders.

• fraud. In recent years, major corporate scandals have rocked the financial markets. In World Com’s case, managers falsified the firm’s accounting statements, making the company look more profitable than it was. In his plea agreement, convicted Enron Chief Financial Officer, Andrew Fastow, stated that Enron’s financial statements were designed to materially mislead investors. An effective corporate governance system must be transparent, with accurate financial statements.

–  –  –

Director/Shareholder Agency Conflicts Learning Objective: Know the responsibilities of the board of directors.

The firm’s board of directors is elected by shareholders. One of its functions is to monitor management and ensure that managers are acting in the shareholders’ best interests. Boards typically make major corporate decisions, such as hiring the chief executive officer and other top managers and setting their salaries, approving mergers and other major capital expenditures, and declaring dividends. A firm can have outside or independent directors, directors who are not employed by the firm (although they may own stock in the firm), and inside directors, directors who are also employees, usually top management such as the chief executive officer or chief financial officer. Outside directors may be more objective, for example, willing to make difficult decisions, such as firing an underperforming executive. They are not involved with the day-today operations of the firm. Inside directors have the advantage of knowing more about the firm.

Conflicts between directors and shareholders can occur when the board relinquishes its monitoring and control function and is no longer independent of management. This can occur when board members have close, personal relationships with management, if they have consulting contracts that depend on the firm’s goodwill, or if they simply ignore their responsibilities to shareholders because of lack of time or desire.

Assessing the Effectiveness of Corporate Governance Learning Objective: Define and explain what board attributes and investor or analyst must assess.

The board of directors should:

• be independent of firm managers.

• be objective.

• have no relationships, business or personal, which could compromise board independence.

• have the expertise and resources to competently perform its duties. For example, board members should be able to hire outside consultants when needed as part of their decisionmaking and to aid in their monitoring of managers.

An analyst should look closely at the firm’s corporate governance practices and at the composition and actions of the board of directors to determine whether the directors are providing appropriate oversight.

Learning Objective: Describe effective corporate governance practices as these relate to the attributes of the board of directors.

Most financial markets require information about corporate governance to be disclosed, generally as part of its regular filings. In the U.S., corporate filings with the Securities and Exchange Commission are easily available to investors.

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