CORPORATE FINANCE ffirs 13 January 2012; 9:6:55

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4 CFA Institute is the premier association for investment professionals around the world, with over 101,000 members in 134 countries. Since 1963 the organization has developed and administered the renowned Chartered Financial Analyst s Program. With a rich history of leading the investment profession, CFA Institute has set the highest standards in ethics, education, and professional excellence within the global investment community, and is the foremost authority on investment profession conduct and practice. Each book in the CFA Institute Investment Series is geared toward industry practitioners along with graduate-level finance students and covers the most important topics in the industry. The authors of these cutting-edge books are themselves industry professionals and academics and bring their wealth of knowledge and expertise to this series.

5 CORPORATE FINANCE A Practical Approach Second Edition Michelle R. Clayman, CFA Martin S. Fridson, CFA George H. Troughton, CFA John Wiley & Sons, Inc.

6 Copyright r 2012 by CFA Institute. All rights reserved. Published by John Wiley & Sons, Inc., Hoboken, New Jersey Published simultaneously in Canada No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning, or otherwise, except as permitted under Section 107 or 108 of the 1976 United States Copyright Act, without either the prior written permission of the Publisher, or authorization through payment of the appropriate per-copy fee to the Copyright Clearance Center, Inc., 222 Rosewood Drive, Danvers, MA 01923, (978) , fax (978) , or on the web at com. Requests to the Publisher for permission should be addressed to the Permissions Department, John Wiley & Sons, Inc., 111 River Street, Hoboken, NJ 07030, (201) , fax (201) , or online at Limit of Liability/Disclaimer of Warranty: While the publisher and author have used their best efforts in preparing this book, they make no representations or warranties with respect to the accuracy or completeness of the contents of this book and specifically disclaim any implied warranties of merchantability or fitness for a particular purpose. No warranty may be created or extended by sales representatives or written sales materials. The advice and strategies contained herein may not be suitable for your situation. You should consult with a professional where appropriate. Neither the publisher nor author shall be liable for any loss of profit or any other commercial damages, including but not limited to special, incidental, consequential, or other damages. For general information on our other products and services or for technical support, please contact our Customer Care Department within the United States at (800) , outside the United States at (317) or fax (317) Wiley also publishes its books in a variety of electronic formats. Some content that appears in print may not be available in electronic formats. For more information about Wiley products, visit our web site at Library of Congress Cataloging-in-Publication Data: Corporate finance : a practical approach / [edited by] Michelle R. Clayman, Martin S. Fridson, George H. Troughton. 2nd ed. p. cm. (CFA Institute investment series ; 42) Includes index. ISBN (cloth); ISBN (ebk); ISBN (ebk); ISBN (ebk) 1. Corporations Finance. I. Clayman, Michelle R. II. Fridson, Martin S. III. Troughton, George H. HG4026.C dc Printed in the United States of America

7 CONTENTS Foreword Acknowledgments About the CFA Institute Investment Series xi xv xvii CHAPTER 1 Corporate Governance 1 Learning Outcomes 1 1. Introduction 1 2. Corporate Governance: Objectives and Guiding Principles 2 3. Forms of Business and Conflicts of Interest Sole Proprietorships Partnerships Corporations 5 4. Specific Sources of Conflict: Agency Relationships Manager Shareholder Conflicts Director Shareholder Conflicts Corporate Governance Evaluation The Board of Directors Examples of Codes of Corporate Governance Environmental, Social, and Governance Factors Valuation Implications of Corporate Governance Summary 40 Problems 42 CHAPTER 2 Capital Budgeting 47 Learning Outcomes Introduction The Capital Budgeting Process Basic Principles of Capital Budgeting Investment Decision Criteria Net Present Value Internal Rate of Return Payback Period Discounted Payback Period Average Accounting Rate of Return Profitability Index NPV Profile 59 v

8 vi Contents 4.8. Ranking Conflicts between NPV and IRR The Multiple IRR Problem and the No IRR Problem Popularity and Usage of the Capital Budgeting Methods Cash Flow Projections Table Format with Cash Flows Collected by Year Table Format with Cash Flows Collected by Type Equation Format for Organizing Cash Flows More on Cash Flow Projections Straight-Line and Accelerated Depreciation Methods Cash Flows for a Replacement Project Spreadsheet Modeling Effects of Inflation on Capital Budgeting Analysis Project Analysis and Evaluation Mutually Exclusive Projects with Unequal Lives Capital Rationing Risk Analysis of Capital Investments Standalone Methods Risk Analysis of Capital Investments Market Risk Methods Real Options Common Capital Budgeting Pitfalls Other Income Measures and Valuation Models The Basic Capital Budgeting Model Economic and Accounting Income Economic Profit, Residual Income, and Claims Valuation Summary 110 Problems 113 CHAPTER 3 Cost of Capital 127 Learning Outcomes Introduction Cost of Capital Taxes and the Cost of Capital Weights of the Weighted Average Applying the Cost of Capital to Capital Budgeting and Security Valuation Costs of the Different Sources of Capital Cost of Debt Cost of Preferred Stock Cost of Common Equity Topics in Cost of Capital Estimation Estimating Beta and Determining a Project Beta Country Risk Marginal Cost of Capital Schedule Flotation Costs What Do CFOs Do? Summary 160 Problems 163

9 Contents vii CHAPTER 4 Measures of Leverage 171 Learning Outcomes Introduction Leverage Business Risk and Financial Risk Business Risk and Its Components Sales Risk Operating Risk Financial Risk Total Leverage Breakeven Points and Operating Breakeven Points The Risks of Creditors and Owners Summary 194 Problems 194 CHAPTER 5 Capital Structure 199 Learning Outcomes Introduction The Capital Structure Decision Proposition I without Taxes: Capital Structure Irrelevance Proposition II without Taxes: Higher Financial Leverage Raises the Cost of Equity Taxes, the Cost of Capital, and the Value of the Company Costs of Financial Distress Agency Costs Costs of Asymmetric Information The Optimal Capital Structure According to the Static Trade-Off Theory Practical Issues in Capital Structure Policy Debt Ratings Evaluating Capital Structure Policy Leverage in an International Setting Summary 222 Problems 223 CHAPTER 6 Dividends and Share Repurchases: Basics 229 Learning Outcomes Introduction Dividends: Forms Regular Cash Dividends Extra or Special (Irregular) Dividends Liquidating Dividends 234

10 viii Contents 2.4. Stock Dividends Stock Splits Dividends: Payment Chronology Declaration Date Ex-Dividend Date Holder-of-Record Date Payment Date Interval between Key Dates in the Dividend Payment Chronology Share Repurchases Share Repurchase Methods Financial Statement Effects of Repurchases Valuation Equivalence of Cash Dividends and Share Repurchases: The Baseline Concluding Remarks Summary 251 Problems 252 CHAPTER 7 Dividends and Share Repurchases: Analysis 257 Learning Outcomes Introduction Dividend Policy and Company Value: Theory Dividend Policy Does Not Matter Dividend Policy Matters: The Bird-in-the-Hand Argument Dividend Policy Matters: The Tax Argument Other Theoretical Issues Dividend Theory: Summary Factors Affecting Dividend Policy Investment Opportunities The Expected Volatility of Future Earnings Financial Flexibility Tax Considerations Flotation Costs Contractual and Legal Restrictions Factors Affecting Dividend Policy: Summary Payout Policies Types of Dividend Policies The Dividend versus Share Repurchase Decision Global Trends in Payout Policy Analysis of Dividend Safety Summary 297 Problems 298 CHAPTER 8 Working Capital Management 303 Learning Outcomes Introduction 304

11 Contents ix 2. Managing and Measuring Liquidity Defining Liquidity Management Measuring Liquidity Managing the Cash Position Forecasting Short-Term Cash Flows Monitoring Cash Uses and Levels Investing Short-Term Funds Short-Term Investment Instruments Strategies Evaluating Short-Term Funds Management Managing Accounts Receivable Key Elements of the Trade Credit Granting Process Managing Customers Receipts Evaluating Accounts Receivable Management Managing Inventory Approaches to Managing Levels of Inventory Inventory Costs Evaluating Inventory Management Managing Accounts Payable The Economics of Taking a Trade Discount Managing Cash Disbursements Evaluating Accounts Payable Management Managing Short-Term Financing Sources of Short-Term Financing Short-Term Borrowing Approaches Asset-Based Loans Computing the Costs of Borrowing Summary 343 Problems 344 CHAPTER 9 Financial Statement Analysis 347 Learning Outcomes Introduction Common-Size Analysis Vertical Common-Size Analysis Horizontal Common-Size Analysis Financial Ratio Analysis Activity Ratios Liquidity Analysis Solvency Analysis Profitability Analysis Other Ratios Effective Use of Ratio Analysis Pro Forma Analysis Estimating the Sales-Driven Relations Estimating the Fixed Burdens 396

12 x Contents 4.3. Forecasting Revenues Constructing Pro Forma Statements Summary 401 Problems 402 CHAPTER 10 Mergers and Acquisitions 407 Learning Outcomes Introduction Mergers and Acquisitions: Definitions and Classifications Motives for Merger Synergy Growth Increasing Market Power Acquiring Unique Capabilities and Resources Diversification Bootstrapping Earnings Managers Personal Incentives Tax Considerations Unlocking Hidden Value Cross-Border Motivations Transaction Characteristics Form of Acquisition Method of Payment Mind-Set of Target Management Takeovers Pre-Offer Takeover Defense Mechanisms Post-Offer Takeover Defense Mechanisms Regulation Antitrust Securities Laws Merger Analysis Target Company Valuation Bid Evaluation Who Benefits from Mergers? Corporate Restructuring Summary 452 Problems 454 Glossary 463 References 475 About the Authors 481 About the CFA Program 487 Index 489

13 FOREWORD I am honored to introduce this second edition of Corporate Finance: A Practical Approach, which promises to be an important and comprehensive discourse on corporate financial management. The significant additions in this edition and revisions to the first edition build on the topic areas introduced in Furthermore, they bring much-needed practical dimensions to the complex and dynamic aspects of corporate finance. Certainly, the global financial landscape has changed dramatically since the release of the first edition of this work. The economic drama and financial carnage injected into the marketplace starting in late 2007 have penetrated the very core of financial thought and practice and have challenged long-standing economic beliefs and relationships. The effects on corporate governance, capital structure, and budgeting caused by this extreme market volatility and economic upheaval have moved corporate treasurers and chief financial officers to the front lines in their companies continuing pursuits of profitability and financial security. Only those institutions that can quickly adapt their financial management and corporate structure to this new normal will survive well into the future. The chapters in this edition have been revised to take into consideration some of the profound changes that have affected this new global financial setting. Yet, it is refreshing to note that no matter what economic environment exists in the future, sound, traditional financial management practices will always be essential to the long-term success of any entity. The authors of these chapters are leading industry practitioners and recognized academic thought leaders. Their unique perspectives and thorough understanding of their respective topic areas are invaluable in providing readers with a factual exposition of the subject matter. In addition, their commonsense approach of highlighting important learning outcomes and incorporating practical problem-solving tools gives readers techniques they can apply in realworld financial settings. Like the original text, this edition is assembled from readings used in the CFA Program curriculum. The CFA Program is a comprehensive, self-directed, distance learning program administered by CFA Institute. Since the early 1960s, the attainment of the CFA designation has been viewed as a significant achievement in the realm of finance and investment management. Those who enter the CFA Program sit for three consecutive and rigorous examinations that cover a broad range of important financial topics, including accounting, quantitative methods, equity and fixed-income analysis, portfolio management, and ethics. Most who enter this program already possess a strong record of achievement in the financial industry, as well as advanced business degrees, but welcome the additional focus and comprehensive curriculum of this designation program. I am fortunate to have earned the CFA charter and am proud to serve on the Board of Governors of CFA Institute. xi

14 xii Foreword WHY THIS TEXT IS IMPORTANT Competing in the global financial arena has been a far more daunting challenge during this decade than in earlier periods. The scarcity of credit and risk capital following the global financial challenges of the past few years, along with the evolution of emerging economies as formidable players on the world financial stage, demands that businesses operate at utmost efficiency. Optimal financial management and peak operating effectiveness are prerequisites not only for success but also for survival. And in order to successfully commit risk capital, companies must incorporate disciplined, systematic capital-budgeting techniques so as to allocate capital to only those projects with optimal returns. Furthermore, companies must be able to understand the life spans of projects, effectively anticipate cash flow needs, and accurately forecast lean periods in their liquidity to avoid potentially devastating shocks to their financial and market health. Also critical in this new financial environment is the ability to properly analyze the effects of inflation, disinflation, foreign currency shocks, and regulatory risk on existing projects, as well as the ability to recognize capital-budgeting biases and errors. This book offers comprehensive insights into avoiding these common pitfalls. In particular, the chapter on capital budgeting is instrumental in instilling in the reader the discipline to anticipate extraneous influences on capital planning. Another critical section of the book concerns forecasting and evaluating the weighted average cost of capital that an entity faces. Recent as well as long-term financial history has taught everyone the importance of properly analyzing this crucial financial component. The degree of assumed leverage, tax benefits and implications of using debt over other forms of capitalization, the cost of debt versus common and preferred equity, and the impact of changes in debt ratings all are essential areas of knowledge for company leaders. The ability to use the cost of capital as an effective discipline in organizational budgeting is yet another key component of continued financial stability. In addition to the tools and techniques for measuring the cost of capital, the appropriate use of financial leverage is an important topic in this text. Clearly, increased leverage heightens the level of earnings volatility and, ultimately, the cost of equity and the overall risk attached to any company. Properly understanding the prudent use of financial leverage as an earnings-enhancement vehicle is essential. Furthermore, examining the degree of operating leverage and the impact of cost structure on production is a vital component of measuring and evaluating the operating efficiency of any organization. And last but not least, an incredibly large part of ultimately determining the financial competitiveness of a company is successfully anticipating and accounting for the effect of taxes. A key element of attracting investors and maintaining adequate sources of capital is fully understanding how an entity manages its own equity in the context of dividends and share repurchases. In addition, I cannot overstate the advantages of having a technical grasp of the effects on financial statements of altering dividend policy or engaging in share buybacks or secondary offerings, nor can I overemphasize the commensurate impacts on a company s effective cost of capital and overall financial flexibility. In this environment of heightened investor focus on liquidity and financial health, effective working capital management is a necessity. The text walks the reader through the important steps in successfully monitoring an optimal cash balance, contains a primer on short-term investment instruments, and delves into accounts receivable and inventory management. It also examines the benefits of shortterm borrowing versus cash disbursements and other accounts payable strategies.

15 Foreword xiii Finally, the critical steps in a merger and acquisition strategy are defined and analyzed. This segment of the text highlights the effects of the successful use of these approaches on firm competitiveness, scale, and market power and addresses the potential pitfalls of integration and cost management. Finally, this section examines the impact of taxes and regulatory challenges on a potentially successful business combination tactic, as well as discussing when an acquisition posture makes sense. WHAT HAS CHANGED SINCE THE FIRST EDITION This second edition provides the reader with comprehensive updates on all topics, especially where new techniques or technologies have emerged, and gears the learning outcomes, descriptions, and end-of-chapter exercises to the new economic realities of this decade. The sections on dividend policy, share repurchases, and capital structure have also been revised and reconstructed. These chapters contain significantly new content as well as updated exercises. No book can provide a practitioner or student with a no-fail recipe for comprehensive success in financial management, and most entities have discovered that challenges and impacts generally appear from unexpected sources and directions. The authors have tried to create a substantial taxonomy of corporate financial topics with real-world, commonsense applications as well as rigorous problems and exercises that allow readers to test their comprehension of the subjects covered. This book will become an important resource for a wide array of individuals. Some may ask whether the intricacies of capital budgeting, corporate liquidity, and dividend policy are of interest to a cross section of practitioners, but as many have discovered over the past five years, ignoring the key building blocks of an optimal corporate financial structure and a lean, competitive, and well-capitalized organization can be perilous. Today s corporate landscape, with all its volatility and high barriers to entry, requires that most members of a corporate entity be well schooled in the fundamentals of financial management. Organizations today must deal with formidable foreign competition, an older workforce, and significant capital investments in order to achieve critical scale. A sound understanding of the capital management techniques needed to maintain competitiveness and innovation is a necessity. Students will use this book either as a resource to gain a broad understanding of corporate financial practice or as a useful reference tool for quickly comprehending specific areas of the financial domain. The long-term performance of all organizations is based on sound decision making by their constituents, whose decisions have wide-ranging implications for the future soundness of their companies. I hope this book will prove to be a valuable resource for present and future members of these organizations. Matthew Scanlan, CFA President and CEO Renaissance Institutional Management LLC CFA Institute Board of Governors

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17 ACKNOWLEDGMENTS We would like to thank the many individuals who played important roles in producing this book. The standards and orientation of the second edition are a continuation of those set for the first edition. Robert R. Johnson, CFA, former senior managing director of CFA Institute, supported the creation of custom curriculum readings in this area and their revision. Dennis W. McLeavey, CFA, initiated the project during his term as head of Curriculum Development. Christopher B. Wiese, CFA, oversaw final organization, writing, and editing of the first edition for the CFA curriculum. First edition manuscript reviewers were Jean-Francois Bureau, CFA, Sean D. Carr, Rosita P. Chang, CFA, Jacques R. Gagné, CFA, Gene C. Lai, Asjeet S. Lamba, CFA, Piman Limpaphayom, CFA, and Zhiyi Song, CFA. Chapter authors Pamela P. Drake, CFA, and John D. Stowe, CFA, provided notable assistance at critical junctures. We thank all of the above for their excellent and detailed work. For this second edition, Gregory Noronha, CFA, was added to the author lineup. Second edition manuscript reviewers were Evan Ashcraft, CFA, David K. Chan, CFA, Lee Dunham, CFA, Philip Fanara, CFA, Usman Hayat, CFA, William Jacobson, CFA, Frank Laatsch, CFA, Murli Rajan, CFA, Knut Reinertz, CFA, Sanjiv Sabherwal, Sandeep Singh, CFA, Frank Smudde, CFA, and Peter Stimes, CFA. Jerald E. Pinto, CFA, director, Curriculum Projects, had primary responsibility for the delivery of the revised chapters. xv

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19 ABOUT THE CFA INSTITUTE INVESTMENT SERIES CFA Institute is pleased to provide you with the CFA Institute Investment Series, which covers major areas in the field of investments. We provide this best-in-class series for the same reason we have been chartering investment professionals for more than 45 years: to lead the investment profession globally by setting the highest standards of ethics, education, and professional excellence. The books in the CFA Institute Investment Series contain practical, globally relevant material. They are intended both for those contemplating entry into the extremely competitive field of investment management as well as for those seeking a means of keeping their knowledge fresh and up to date. This series was designed to be user friendly and highly relevant. We hope you find this series helpful in your efforts to grow your investment knowledge, whether you are a relatively new entrant or an experienced veteran ethically bound to keep up to date in the ever-changing market environment. As a long-term, committed participant in the investment profession and a not-for-profit global membership association, CFA Institute is pleased to provide you with this opportunity. THE TEXTS One of the most prominent texts over the years in the investment management industry has been Maginn and Tuttle s Managing Investment Portfolios: A Dynamic Process. The third edition updates key concepts from the 1990 second edition. Some of the more experienced members of our community own the prior two editions and will add the third edition to their libraries. Not only does this seminal work take the concepts from the other readings and put them in a portfolio context, but it also updates the concepts of alternative investments, performance presentation standards, portfolio execution, and, very importantly, individual investor portfolio management. Focusing attention away from institutional portfolios and toward the individual investor makes this edition an important and timely work. Quantitative Investment Analysis focuses on some key tools that are needed by today s professional investor. In addition to classic time value of money, discounted cash flow applications, and probability material, there are two aspects that can be of value over traditional thinking. The first involves the chapters dealing with correlation and regression that ultimately figure into the formation of hypotheses for purposes of testing. This gets to a critical skill that challenges many professionals: the ability to distinguish useful information from the overwhelming quantity of available data. For most investment researchers and managers, their xvii

20 xviii About the CFA Institute Investment Series analysis is not solely the result of newly created data and tests that they perform. Rather, they synthesize and analyze primary research done by others. Without a rigorous manner by which to explore research, you cannot understand good research or have a basis on which to evaluate less rigorous research. Second, the last chapter of Quantitative Investment Analysis covers portfolio concepts and takes the reader beyond the traditional capital asset pricing model (CAPM) type of tools and into the more practical world of multifactor models and arbitrage pricing theory. Fixed Income Analysis has been at the forefront of new concepts in recent years, and this particular text offers some of the most recent material for the seasoned professional who is not a fixed-income specialist. The application of option and derivative technology to the oncestaid province of fixed income has helped contribute to an explosion of thought in this area. Professionals have been challenged to stay up to speed with credit derivatives, swaptions, collateralized mortgage securities, mortgage-backed securities, and other vehicles, and this explosion of products has strained the world s financial markets and tested central banks to provide sufficient oversight. Armed with a thorough grasp of the new exposures, the professional investor is much better able to anticipate and understand the challenges our central bankers and markets face. International Financial Statement Analysis is designed to address the ever-increasing need for investment professionals and students to think about financial statement analysis from a global perspective. The text is a practically oriented introduction to financial statement analysis that is distinguished by its combination of a true international orientation, a structured presentation style, and abundant illustrations and tools covering concepts as they are introduced in the text. The authors cover this discipline comprehensively and with an eye to ensuring the reader s success at all levels in the complex world of financial statement analysis. Equity Asset Valuation is a particularly cogent and important resource for anyone involved in estimating the value of securities and understanding security pricing. A well-informed professional knows that the common forms of equity valuation dividend discount modeling, free cash flow modeling, price/earnings modeling, and residual income modeling can all be reconciled with one another under certain assumptions. With a deep understanding of the underlying assumptions, the professional investor can better understand what other investors assume when calculating their valuation estimates. This text has a global orientation, including emerging markets. The second edition provides new coverage of private company valuation and expanded coverage of required rate of return estimation. Investments: Principles of Portfolio and Equity Analysis provides an accessible yet rigorous introduction to portfolio and equity analysis. Portfolio planning and portfolio management are presented within a context of up-to-date, global coverage of security markets, trading, and market-related concepts and products. The essentials of equity analysis and valuation are explained in detail and profusely illustrated. The book includes coverage of practitionerimportant but often neglected topics, such as industry analysis. Throughout, the focus is on the practical application of key concepts with examples drawn from both emerging and developed markets. Each chapter affords the reader many opportunities to self-check his or her understanding of topics. In contrast to other texts, the chapters are collaborations of respected senior investment practitioners and leading business school teachers from around the globe. By virtue of its well-rounded, expert, and global perspectives, the book should be of interest to anyone who is looking for an introduction to portfolio and equity analysis. The New Wealth Management: The Financial Advisor s Guide to Managing and Investing Client Assets is an updated version of Harold Evensky s mainstay reference guide for wealth

21 About the CFA Institute Investment Series xix managers. Harold Evensky, Stephen Horan, and Thomas Robinson have updated the core text of the 1997 first edition and added an abundance of new material to fully reflect today s investment challenges. The text provides authoritative coverage across the full spectrum of wealth management and serves as a comprehensive guide for financial advisors. The book expertly blends investment theory and real-world applications and is written in the same thorough but highly accessible style as the first edition. Corporate Finance: A Practical Approach is a solid foundation for those looking to achieve lasting business growth. In today s competitive business environment, companies must find innovative ways to enable rapid and sustainable growth. This text equips readers with the foundational knowledge and tools for making smart business decisions and formulating strategies to maximize company value. It covers everything from managing relationships between stakeholders to evaluating merger and acquisition bids, as well as the companies behind them. The second edition of the book preserves the hallmark conciseness of the first edition while expanding coverage of dividend policy, share repurchases, and capital structure. Through extensive use of real-world examples, readers will gain critical perspective into interpreting corporate financial data, evaluating projects, and allocating funds in ways that increase corporate value. Readers will gain insights into the tools and strategies used in modern corporate financial management.

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23 CHAPTER 1 CORPORATE GOVERNANCE Rebecca T. McEnally, CFA New Bern, North Carolina, U.S.A. Kenneth Kim Buffalo, New York, U.S.A. LEARNING OUTCOMES After completing this chapter, you will be able to do the following: Explain corporate governance, describe the objectives and core attributes of an effective corporate governance system, and evaluate whether a company s corporate governance has those attributes. Compare major business forms and describe the conflicts of interest associated with each. Explain conflicts that arise in agency relationships, including manager-shareholder conflicts and director-shareholder conflicts. Describe responsibilities of the board of directors and explain qualifications and core competencies that an investment analyst should look for in the board of directors. Explain effective corporate governance practice as it relates to the board of directors, and evaluate the strengths and weaknesses of a company s corporate governance practice. Describe elements of a company s statement of corporate governance policies that investment analysts should assess. Explain the valuation implications of corporate governance. 1. INTRODUCTION The modern corporation is a very efficient and effective means of raising capital, obtaining needed resources, and generating products and services. These and other advantages have caused the corporate form of business to become the dominant one in many countries. The corporate form, in contrast to other business forms, frequently involves the separation of ownership and control of the assets of the business. The ownership of the modern, public corporation is typically diffuse; it has many owners, most with proportionally small stakes in 1

24 2 Corporate Finance the company, who are distant from, and often play no role in, corporate decisions. Professional managers control and deploy the assets of the corporation. This separation of ownership (shareholders) and control (managers) may result in a number of conflicts of interest between managers and shareholders. Conflicts of interest can also arise that affect creditors as well as other stakeholders such as employees and suppliers. In order to remove or at least minimize such conflicts of interest, corporate governance structures have been developed and implemented in corporations. Specifically, corporate governance is the system of principles, policies, procedures, and clearly defined responsibilities and accountabilities used by stakeholders to overcome the conflicts of interest inherent in the corporate form. The failure of a company to establish an effective system of corporate governance represents a major operational risk to the company and its investors. 1 Corporate governance deficiencies may even imperil the continued existence of a company. Consequently, to understand the risks inherent in an investment in a company, it is essential to understand the quality of the company s corporate governance practices. It is also necessary to continually monitor a company s practices, because changes in management, the composition of its board of directors, the company s competitive and market conditions, or mergers and acquisitions, can affect them in important ways. A series of major corporate collapses in North America, Europe, and Asia, nearly all of which involved the failure or direct override by managers of corporate governance systems, have made it clear that strong corporate governance structures are essential to the efficient and effective functioning of companies and the financial markets in which they operate. Investors lost great amounts of money in the failed companies. The collapses weakened the trust and confidence essential to the efficient functioning of financial markets worldwide. Legislators and regulators responded to the erosion of trust by introducing strong new regulatory frameworks. These measures are intended to restore the faith of investors in companies and the markets, and, very importantly, to help prevent future collapses. Nevertheless, the new regulations did not address all outstanding corporate governance problems and were not uniform across capital markets. Thus, we may expect corporate governancerelated laws and regulations to further evolve. The chapter is organized as follows: Section 2 presents the objectives of corporate governance systems and the key attributes of effective ones. Section 3 addresses forms of business and conflicts of interest, and Section 4 discusses two major sources of governance problems. In Section 5 we discuss standards and principles of corporate governance, providing three representative sets of principles from current practice. Section 6 addresses environmental, social, and governance factors. Section 7 touches on the valuation implications of the quality of corporate governance, and Section 8 summarizes the chapter. 2. CORPORATE GOVERNANCE: OBJECTIVES AND GUIDING PRINCIPLES The modern corporation is subject to a variety of conflicts of interest. This fact leads to the following two major objectives of corporate governance: 1 An operational risk is the risk of loss from failures in a company s systems and procedures or from external events.

25 Chapter 1 Corporate Governance 3 1. To eliminate or mitigate conflicts of interest, particularly those between managers and shareholders. 2. To ensure that the assets of the company are used efficiently and productively and in the best interests of its investors and other stakeholders. How then can a company go about achieving those objectives? The first point is that it should have a set of principles and procedures sufficiently comprehensive to be called a corporate governance system. No single system of effective corporate governance applies to all firms in all industries worldwide. Different industries and economic systems, legal and regulatory environments, and cultural differences may affect the characteristics of an effective corporate governance system for a particular company. However, there are certain characteristics that are common to all sound corporate governance structures. The core attributes of an effective corporate governance system are: Delineation of the rights of shareholders and other core stakeholders. Clearly defined manager and director governance responsibilities to stakeholders. Identifiable and measurable accountabilities for the performance of the responsibilities. Fairness and equitable treatment in all dealings between managers, directors, and shareholders. Complete transparency and accuracy in disclosures regarding operations, performance, risk, and financial position. These core attributes form the foundation for systems of good governance, as well as for the individual principles embodied in such systems. Investors and analysts should determine whether companies in which they may be interested have these core attributes. 3. FORMS OF BUSINESS AND CONFLICTS OF INTEREST The goal of for-profit businesses in any society is simple and straightforward: to maximize their owners wealth. This can be achieved through strategies that result in long-term growth in sales and profits. However, pursuing wealth maximization involves taking risks. A business itself is risky for a variety of reasons. For example, there may be demand uncertainty for its products and/or services, economic uncertainty, and competitive pressures. Financial risk is present when a business must use debt to finance operations. Thus, continued access to sufficient capital is an important consideration and risk for businesses. These risks, and the inherent conflicts of interests in businesses, increase the need for strong corporate governance. A firm s ability to obtain capital and to control risk is perhaps most influenced by the manner in which it is organized. Three of the predominant forms of business globally are the sole proprietorship, the partnership, and the corporation. Hybrids of these three primary business forms also exist, but we do not discuss them here because they are simply combinations of the three main business forms. With regard to the three primary business forms, each has different advantages and disadvantages. We will discuss each of them, the conflicts of interest that can arise in each, and the relative need for strong corporate governance associated with each form. However, a summary of the characteristics is provided in Exhibit 1-1.

26 4 Corporate Finance EXHIBIT 1-1 Comparison of Characteristics of Business Forms Characteristic Sole Proprietorship Partnership Corporation Ownership Sole owner Multiple owners Unlimited ownership Legal requirements and regulation Legal distinction between owner and business Few; entity easily formed Few; entity easily formed Numerous legal requirements None None Legal separation between owners and business Liability Unlimited Unlimited but shared among partners Limited Ability to raise capital Very limited Limited Nearly unlimited Transferability of ownership Owner expertise in business Nontransferable (except by sale of entire business) Nontransferable Easily transferable Essential Essential Unnecessary 3.1. Sole Proprietorships The sole proprietorship is a business owned and operated by a single person. The owner of the local cleaner, restaurant, beauty salon, or fruit stand is typically a sole proprietor. Generally, there are few, if any, legal formalities involved in establishing a sole proprietorship and they are relatively easy to start. In many jurisdictions, there are few, if any, legal distinctions between the sole proprietor and the business. For example, tax liabilities and related filing requirements for sole proprietorships are frequently set at the level of the sole proprietor. Legitimate business expenses are simply deducted from the sole proprietor s taxable income. Sole proprietorships are the most numerous form of business worldwide, representing, for example, approximately 70 percent of all businesses in the United States, by number. 2 However, because they are usually small-scale operations, they represent the smallest amount of market capitalization in many markets. Indeed, the difficulties of the sole proprietor in raising large amounts of capital, coupled with unlimited liability and lack of transferability of ownership, are serious impediments to the growth of a sole proprietorship. From the point of view of corporate governance, the sole proprietorship presents fewer risks than the corporation because the manager and the owner are one and the same. Indeed, the major corporate governance risks are those faced by creditors and suppliers of goods and services to the business. These stakeholders are in a position to be able to demand the types and quality of information that they need to evaluate risks before lending money to the business or providing goods and services to it. In addition, because they typically maintain direct, recurring business relations with the companies, they are better able to monitor the condition and risks of the business, and to control their own exposure to risk. Consequently, we will not consider sole proprietorships further in this chapter. 2 Megginson (1997), 40.

27 Chapter 1 Corporate Governance Partnerships A partnership, which is composed of more than one owner/manager, is similar to a sole proprietorship. For the most part, partnerships share many of the same advantages and disadvantages as the sole proprietorship. Two obvious advantages of a partnership over a sole proprietorship are the pooling together of financial capital of the partners and the sharing of business risk among them. However, even these advantages may not be as important as the pooling together of service-oriented expertise and skill, especially for larger partnerships. Some very large international partnerships operate in such fields as real estate, law, investment banking, architecture, engineering, advertising, and accounting. Note also that larger partnerships may enjoy competitive and economy-of-scale benefits over sole proprietorships. Partners typically overcome conflicts of interest internally by engaging in partnership contracts specifying the rights and responsibilities of each partner. Conflicts of interest with those entities outside the partnership are similar to those for the sole proprietorship and are dealt with in the same way. Hence, we will not consider these conflicts further in this chapter Corporations Corporations represent less than 20 percent of all businesses in the United States but generate approximately 90 percent of the country s business revenue. 3 The percentage is lower elsewhere, but growing. The corporation is a legal entity, and has rights similar to those of a person. For example, a corporation is permitted to enter into contracts. The chief officers of the corporation, the executives or top managers, act as agents for the firm and are legally entitled to authorize corporate activities and to enter into contracts on behalf of the business. There are several important and striking advantages of the corporate form of business. First, corporations can raise very large amounts of capital by issuing either stocks or bonds to the investing public. A corporation can grant ownership stakes, common stock, to individual investors in exchange for cash or other assets. Similarly, it can borrow money, for example, bonds or other debt from individual or institutional investors, in exchange for interest payments and a promise to pay back the principal of the loan. Shareholders are the owners of the corporation, and any profits that the corporation generates accrue to the shareholders. A second advantage is that corporate owners need not be experts in the industry or management of the business, unlike the owners of sole proprietorships and partnerships where business expertise is essential to success. Any individual with sufficient money can own stock. This has benefits to both the business and the owners. The business can seek capital from millions of investors, not only in domestic markets but worldwide. Among the most important advantages of the corporate form is that stock ownership is easily transferable. Transferability of shares allows corporations to have unlimited life. A final and extremely important advantage is that shareholders have limited liability. That is, they can lose only the money they have invested, nothing more. The corporate form of business has a number of disadvantages, however. For example, because many corporations have thousands or even millions of nonmanager owners, they are subject to more regulation than are partnerships or sole proprietorships. While regulation serves to protect shareholders, it can also be costly to shareholders as well. For example, the corporation must hire accountants and lawyers to deal with accounting and other legal 3 Megginson (1997).

28 6 Corporate Finance documents to comply with regulations. Perhaps the most significant disadvantage with the corporation (and the one most critical to corporate governance) is the difficulty that shareholders have in monitoring management and the firm s operations. As a sole proprietor of a small business, the owner will be able to directly oversee such day-to-day business concerns as inventory levels, product quality, expenses, and employees. However, it is impossible for a shareholder of a large corporation such as General Motors or International Business Machines to monitor business activities and personnel, and to exert any control rights over the firm. In fact, a shareholder of a large firm may not even feel like an owner in the usual sense, especially because corporations are owned by so many other shareholders, and because most owners of a large public corporation hold only a relatively small stake in it. Agency relationships arise when someone, an agent, acts on behalf of another person, the principal. In a corporation, managers are the agents who act on behalf of the owners, the shareholders. If a corporation has in place a diligent management team that works in the best interests of its shareholders and other stakeholders, then the problem of passive shareholders and bondholders becomes a nonissue. In real life, unfortunately, management may not always work in the stakeholders best interests. Managers may be tempted to see to their own wellbeing and wealth at the expense of their shareholders and others to whom they owe a fiduciary duty. This is known as an agency problem, or the principal agent problem. The money of shareholders, the principals, is used and managed by agents, the managers, who promise that the firm will pursue wealth-maximizing business activities. However, there are potential problems with these relationships, which we will discuss next. 4. SPECIFIC SOURCES OF CONFLICT: AGENCY RELATIONSHIPS Conflicts among the various constituencies in corporations have the potential to cause problems in the relationships among managers, directors, shareholders, creditors, employees, and suppliers. However, we will concentrate here on the relationships between (1) managers and shareholders, and (2) directors and shareholders. These two relationships are the primary focus of most systems of corporate governance. However, to the extent that strong corporate governance structures are in place and effective in companies, the agency conflicts among other stakeholders are mitigated as well. For example, managers are responsible for maximizing the wealth of the shareholders and minimizing waste (including excessive compensation and perquisite consumption). To the extent that managers do so, the interests of employees and suppliers are more likely to be met because the probability increases that sufficient funds will be available for payment of salaries and benefits, as well as for goods and services. In this section, we will describe these agency relationships, discuss the problems inherent in each, and will illustrate these agency problems with real-world examples. An understanding of the nature of the conflicts in each relationship is essential to a full understanding of the importance of the provisions in codes of corporate governance Manager Shareholder Conflicts From the point of view of investors, the manager shareholder relationship is the most critical one. It is important to recognize that firms and their managers, the shareholders agents, obtain operating and investing capital from the shareholders, the owners, in two ways. First, although shareholders have a 100 percent claim on the firm s net income, the undistributed