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Corporate Finance - FI502

Tentative learning plan…

Topic 2: Capital Topic 3: Capital

Topic 1: Corporate Topic 4: Market of
Budgeting & Firm Structure & Payout
Governance Corporate Control
Valuation Policy
• Corporate • Valuing stocks and • Modigiliani & Miller • Basics of Mergers
Governance & bonds, capital proposition I & II, and Acquisitions
Agency Problem budgeting process Optimal Capital • M&A types and
• Board Monitoring and valuation with Structure theories, motives
• Regulations leverage and payout policies • Major steps in
acquisitions
Study material to consult…
• Textbook: “Corporate Finance” by Berk & DeMarzo (2014)
• Ebook available through library sources
• May find a cheap second-hand edition through Amazon
• Generally a recent edition of any book with ‘corporate
finance’, title will serve the purpose

• Lecture slides just serve as a guide to what you need to

learn. However, for a better understanding and decent grades,
you are expected to engage in wider reading – at least of the
textbook

• Lecture slides and other related material are available through

moodle as per the new school policy
 Method of assessment*

Quiz Project Final Exam

• Individual • Group (Report • Written Exam**

• Worth 20% & • Worth 50%
Presentation)**
• Worth 30%

* As per RSB policy you will not receive the grades for your coursework
before the exam
**Details on project will be provided on moodle and discussed in class
Session: • Helicopter view of Corporate Finance
Corporate • Corporate Governance, Agency Costs & Board
Monitoring
Governance • Compensation Policies
• Managing Agency Conflict
• Regulation
• Corporate Governance Around the World
Session Outline: • The Trade-Off of Corporate Governance
Maximising firm value

… The Purpose of Corporate Finance

What • It is about maximizing firm value

Corporate • Any decisions made by firms that

Finance is… have financial implications falls

under the ambit of Corporate
Finance. Therefore, every action
taken by a firm has a corporate
financial aspect, irrespective of
what functional area claims
responsibility for it.

• In nutshell, everything that a

business does fits under the rubric
of corporate finance.
Corporate
finance
decisions
 ❑Practical: as a single objective leads to
clearer decision rules
❑Should lead to survival in a competitive
world
Why value ❑Counters the tendency of managers to
maximization… pursue goals for their own benefit
❑Shareholders own the firm so should get
the value
❑It is better for society [???]
potential gains & pitfalls for society

Benefits:
❖Scarce economic resources are used in the best manner
❖Profitable companies are more likely to survive, so safer employment
❖Focus on R&D tend to enhance firm value, so more innovations in society

Costs:
❖May entice unethical behavior (but regulation should prevent that)
❖May encourage value-destroying short-termism if misinterpreted or investors are impatient
❖May turn cruel for some stakeholders and resulting in a displeasure
 ethical Concerns
In 2015, Wells Fargo was ordered to
pay $185 million to settle charges
that employees had fraudulently
signed customers up for deposit and
credit card accounts to hit sales
targets and receive bonuses. Wells
Fargo employees opened deposit
and credit card accounts without
consent from consumers and
transfer funds from the consumers'
legitimate accounts temporarily into
the new, unauthorized accounts.
Employees even went as far as
secretly creating PINs, false email,
and phone addresses for
unauthorized deposit accounts. The
scandal also cost CEO John Stumpf
his job.
 Corporate Governance and Agency Costs
• The system of controls, regulations, and incentives designed to
minimize agency costs between managers and investors and
prevent corporate fraud
• The role of the corporate governance system is to mitigate the conflict of
interest that results from the separation of ownership and control without
unduly burdening managers with the risk of the firm.
• In the United States, the board of directors has a clear fiduciary
duty to protect the interests of the shareholders.
• Most other countries give some weight to the interests of other
stakeholders in the firm, such as the employees.
Types of Directors

• Inside Directors
• Members of a BOD who are employees, former
employees, or family members of employees
• Gray Directors
• Members of a board of directors who are not as
directly connected to the firm as insiders are, but
who have existing or potential business
relationships with the firm
• Outside (Independent) Directors
• Any member of a board of directors other than an
inside or gray director
Board Independence

• On a board composed of insider, gray, and independent directors, the role of the
independent director is really that of a watchdog.
• However, because independent directors’ personal wealth is likely to be less
sensitive to performance than that of insider and gray directors, they have less
incentive to closely monitor the firm.
• Captured Board
• Describes a board of directors whose monitoring duties have been compromised
by connections or perceived loyalties to management
Board Size and Performance

• Researchers have found that smaller boards produce surprisingly robust

result that are associated with greater firm value and performance.
• The likely explanation for this phenomenon comes from the psychology
and sociology research, which finds that smaller groups make better
decisions than larger groups.
Other Monitors

• Includes security analysts, lenders, the SEC, and employees

• Securities analysts produce independent valuations of the firms they
cover so that they can make buy and sell recommendations to clients.
• Lenders carefully monitor firms to which they are exposed as creditors.
• Employees of the firm are most likely to detect outright fraud because
of their inside knowledge.
• The SEC protects the investing public against fraud and stock price
manipulation.
 • Compensation policies of firms include
grants of stock or stock options to

Compensation Policies executives.

• This ties managerial wealth to the
wealth of shareholders, thus a way to
value maximization.
• 1990s witnessed a substantial increase
in management compensation but
with some negative consequences.
• For example, often options are
granted “at the money,” meaning
that the exercise price is equal to
the current stock price.
• Managers therefore have an
incentive to manipulate the
release of financial forecasts so
that bad news comes out before
options are granted (to drive the
exercise price down) and good
news comes out after options
are granted.
 Compensation Policies (contd.)

• Backdating
• The practice of choosing the grant date of a stock option retroactively
• Doing so would make the date of the grant coincide with a date when
the stock price was lower than its price at the time the grant was
actually awarded
• By backdating the option in this way, the executive receives a stock
option that is already in-the-money.
 • Evidence support the notion that
greater managerial ownership is
Managing associated with fewer value-
reducing actions by managers.
Agency • But while increasing
managerial ownership may
Conflict reduce perquisite
consumption, it also makes
managers harder to fire.
 Direct Action by Shareholders

Shareholder Voice: Any shareholder can submit a resolution that is put to a vote at the
annual meeting.
• Recently, unhappy shareholders have started to refuse to vote to approve the slate of nominees for the board.

Shareholder Approval: Shareholders must approve many major actions taken by the board.

• For example, target shareholders must approve

merger agreements.

Proxy Contests: Disgruntled shareholders can hold a proxy contest and introduce a rival slate
of directors for election to the board (happens in M&A)
 Figure:Proxy Contest Outcomes

Source: FactSet SharkWatch

Management entrenchment & Take over threat

Large investors have

become increasingly One motivation for a
interested in measuring takeover can be to replace
the balance of power poorly performing
between shareholders and management.
managers in a firm.

The Investor Responsibility

Research Center (IRRC) has Many of the provisions An active takeover market
collected information on listed in the IRRC index is part of the system
24 different characteristics concern protection from through which the threat
that can entrench takeovers. of dismissal is maintained
managers.
Regulations
• The Sarbanes-Oxley Act (SOX): To improve the accuracy of information given to both boards and to
shareholders, mainly through
1. By overhauling incentives and independence in the auditing process
2. By stiffening penalties for providing false information
3. By forcing companies to validate their internal financial control processes
• Cadbury Commission: to develop a code of best practices in corporate governance (UK)
• Dodd-Frank Act: to strengthen corporate governance in the aftermath of 2008 financial crisis through
• Independent Compensation Committees
• Nominating Directors
• Vote on Executive Pay and Golden Parachutes
• Clawback Provisions
• Pay Disclosure
 Insider Trading

• Occurs when a person makes a

trade based on privileged
information.
• Examples: knowledge of an upcoming
merger announcement, earnings release, or
change in payout policy.
• Penalties: jail time, fines, and civil
penalties.
Financial times article on insider trading:
• Insider trading: friends with benefits https://on.ft.com/2G1z1mc
• Trio of investment bankers charged with insider trading https://on.ft.com/2RIOI4w
• CME to pay $3.5m over leak of secret trade data https://on.ft.com/3iQLlEp
 • Protection of Shareholder Rights
Corporate • The degree to which investors are
Governance protected against expropriation of
company funds by managers and even
Around the the degree to which their rights are
World enforced vary widely across countries
and legal regimes.
 • Much of the focus in the United States is on the
agency conflict between shareholders and
managers.
• In many other countries, the central conflict is
between what are called “controlling
shareholders” and “minority shareholders.”
Controlling
• In these firms, there is usually little conflict
Owners and between the controlling family and the
management (it is often made up of
Pyramids family members).
• Instead, the conflict arises between the minority
shareholders (those without the controlling
block) and the controlling shareholders.
Controlling Owners and Pyramids
• Dual Class Shares and the Value of Control
• Dual Class Shares
• One class of a firm’s shares with superior voting rights over the others
• A way for families to gain control over firms (Class A and B shares)
• Pyramid Structure
• A way for an investor to control a corporation without owning 50% of the equity
• the investor first creates a company in which he has a controlling interest
• This company then owns a controlling interest in another company.
• investor controls both companies but may own as little as 25% of the second
company.
Figure: Pesenti Family Pyramid, 1995
Controlling Owners and Pyramids
• Tunneling: A conflict of interest that arises when a shareholder who has a
controlling interest in multiple firms moves profits (and hence dividends) away
from companies in which he has relatively less cash flow toward firms in which
he has relatively more cash flow rights (“up the pyramid”)
• Stakeholder Model: The explicit consideration most countries (other than the
United States) give to other stakeholders besides equity holders, in particular,
rank-and-file employees
• Cross-holdings: one firm having an equity position (long or short) in another
company
• Not very common in US but in rest of the world (e.g. Keiretsu in Japan,
Chaebol in Korea)
• Example: Microsoft purchasing $150mil of nonvoting preferred stock of Apple
in 1997 later converted into equity
Table: Employee Participation in Corporate Governance in
OECD Countries
Source: Based on Mandated Works Employee Appointed Constitutional Employee No Explicit
Organization for Economic Councils
Austria
Board Members
Austria
Protections
France
Requirements
Australia
Cooperation and Belgium Czech Republic Iceland Canada

Development, Survey of Denmark Denmark Italy Chile

Finland Estonia Norway Ireland
Corporate Governance France France blank Israel

Developments in O E C D Germany Germany blank Japan

Greece Hungary blank Mexico
Countries (2004) and O E C Hungary Luxembourg blank New Zealand

D Corporate Governance Korea Netherlands blank Poland

Factbook 2017. Netherlands

Portugal
Norway
Slovak Republic
blank
blank
Switzerland
Turkey
Slovenia Slovenia blank United Kingdom
Spain Sweden blank United States
The Tradeoff of • Corporate governance is a system of
checks and balances that trades off costs
Corporate and benefits.
Governance
• This trade-off is very complicated. No
one structure works for all firms.
• Good governance is value enhancing
and is something investors in the firm
should strive for.