Corporate Governance Topic 1 Reading:

Chapter 29 (Berk & DeMarzo) FINM7402 Coordinator & Lecturer: Dr Hasibul Chowdhury Email: [email protected] Tutors:

Minh Le Email: [email protected] Timothy Estreich

Email: [email protected] Jon Aster Email: [email protected]

Course Staff • Berk, J., and DeMarzo, P. (2023). Corporate

Finance. [Global edition], 6th Edition, Pearson

Publishing. Textbook Lecture / Seminar • Theory development seasoned with practical applications. • Prepare with required and recommended readings (see course profile and

Blackboard). Tutorial • Discuss solutions to tutorial questions as needed. • Additional practical applications. • Participation will assist in preparation for exams • Solutions will be made available after the tutorials Course structure Mid-semester exam (30%) • Mid-semester exam • 90 minutes, 10 minutes perusal • MCQs, Problem solving and short answer • Topics covered: Topics 1 to 4 (including tutorials) Individual

assignment (20%) • Case study using data from real company • Submission by the due date via Blackboard.

Final exam (50%) • Centrally administered during exam block • 120 minutes, 10 minutes perusal • Short answer, short discussion, and problem-solving questions • Topics covered: Topic 1 – Topic 10 (including tutorials) Assessment Capital Budgeting Cost of Capital

Capital Structure Capital Structure – MM Theory Debt, Taxes & Financial Distress Payout Policy Risk Management Financial Options Real Options Special Topics Corporate Governance Mergers & Acquisitions Raising New Capital Course objective and teaching plan Tips to succeed in FINM7402 • Read the course outline carefully. • Review the lecture note before each lecture. • Attempt tutorial questions before the tutorial. • Study relevant chapter/s related to each topic. • See your tutor promptly if you’re having difficulties. • To succeed, there is no alternative to HARD WORK. • The course is progressive (don’t fall behind). CRICOS code 00025B • Define corporate finance and understand its main aspects. • Discuss information theory including adverse selection and moral hazard. • Define corporate governance and the principal-agent model. • Discuss strategies to mitigate moral hazard: monitoring and compensation. • Discuss regulations in the context of corporate governance. Topic 1: Learning Objectives 8 Part A Corporate Finance: The Basics • Broadly speaking, any decision that a business makes has financial implications, and affects

the finances of a business is a corporate finance decision.

Corporate finance: What is it? Corporate Finance: The Basics First principles & the Big Picture Corporate Finance: The Basics • Maximizing the value of the business (firm).

As a result of this singular objective,

we can…

- Choose the right investment decision rule to use amongst a menu of such rules (NPV,

IRR, payback …)

- Determine the right mix of debt and equity for a specific business - Examine the right amount of cash should be returned to the owners of a business and the

right amount to hold back as a cash balance.

• This certitude does come at a cost. To the extent that you accept the objective of maximizing

firm value, everything in corporate finance makes complete sense.

If you don’t, nothing will.

Corporate finance is focused on… Corporate Finance: The Basics • Every business, small or large,

public or private, Australian or Emerging market,

has to make

investment, financing and dividend decisions.

• The objective in corporate finance for all these businesses remains the same:

maximizing the

value.

• While the constraints and challenges that firms face can vary dramatically across firms, the first

principles do not change.

- A public traded firm, with its greater access to capital markets and more diversified investor base,

may have much lower costs of debt and equity than a private business, but they both should look for

the financing mix that minimizes their costs of capital.

- A firm in an emerging market may face greater uncertainty,

when accessing new investments, than a

firm in a developed market,

but both should invest only if they believe they can generate higher

returns on their investments than they face as their respective hurdle rates.

Corporate finance is universal Corporate Finance: The Basics CRICOS code 00025B • In August 2019, the Business Roundtable (a nonprofit lobbyist association consisting of about 181

CEOs of major global corporations) released its new stakeholder model (or stakeholder capitalism)

of the revised purpose of the corporation, stating explicitly that businesses exist to serve multiple

stakeholders—including customers, employees, communities, the environment, and suppliers—in

addition to shareholders. • This new stakeholder model could have a substantial impact on corporate incentive designs, metrics,

and other governance areas as corporations continue or begin to operationalize this stakeholder model

into their long-term strategies. The stakeholder model and ESG Source: Full Scope Insights (FSI) Corporate Finance: The Basics CRICOS code 00025B • The “Stakeholder Value Creation Chain” below is a model developed by Pay Governance to illustrate the

intersection of ESG strategy, the stakeholder model, and the creation of firm value. Source: Harvard law School Forum on Corporate Governance, 2020 The stakeholder model and ESG (cont’d) Corporate Finance: The Basics Types of firms –U.S. % of Firms % of Revenue Corporate Finance: The Basics Shareholders (Principal): Owners • Appointed by the shareholders Board of Directors

• Appointed by the Board • Executes the operations Management (CEO, CFO, Executives) –

Agent/Control Corporation: Ownership vs Control Corporate Finance: The Basics The classical objective function 18 STOCKHOLDERS Maximize stockholder

wealth Hire & fire managers - Board - Annual Meeting BONDHOLDERS/ LENDERS Lend Money Protect bondholder Interests FINANCIAL MARKETS SOCIETYManagers Reveal information honestly and on time Markets are efficient and assess effect on value No Social Costs All costs can be traced to firm Corporate Finance: The Basics What can go wrong? 19 STOCKHOLDERS Managers put their interests above stockholders Have little control over managers BONDHOLDERS Lend Money Bondholders can get ripped off FINANCIAL MARKETS SOCIETYManagers Delay bad news or

provide

misleading information Markets make mistakes and can over react Significant Social Costs Some costs cannot be traced to firm Corporate Finance: The Basics Part B Information Theory Consider the perfect information condition: • Agents are constantly informed, without delay, of the changing market conditions • Agents also know perfectly all the characteristics of the goods: No hidden defects, etc. In reality: • It takes time to gather information (about goods, jobs, opportunities). • Gathering Information has opportunity costs. • Information is intrinsically valuable If an agent has private information, does he share it with other agents? Information Theory: investigates how markets operate in the presence of imperfect information. Information theory: Perfect information Information theory • Special Cases of Information Theory: • The “Market for Lemons” • Adverse Selection • Moral Hazard • Core Model: The Principal-Agent Problem Information theory topics Information theory • Akerlof 1970: “The Market for Lemons: Quality, Uncertainty and the Market Mechanism” • Akerlof investigates the effect of asymmetric information on the market equilibrium, based on the

example of the used cars market. • Assumptions: • Used cars can either be of a good quality (“plums”), or they can be faulty (“lemons”). • The seller knows the level of quality of his own car • Potential buyers do not know the level of quality and cannot observe it ⇒ asymmetric

information • How does this affect the market outcome? The “market for lemons” Information theory The “market for lemons” • The buyer cannot observe the quality of a particular car. • When meeting a car owner, he will only be prepared to offer a price which corresponds to the

“average” quality of the cars on the market. • He does not have any information which would allow to tailor his offer for a particular car. • The owner of a lemon: • Has no interest in revealing the information he has about the (low) quality of his car • If he does so, he will receive a lower offer (by improving the information available to the buyer) • By keeping the information for himself, he can expect a price higher than the value of the car ⇒

market power Information theory The “market for lemons” • The owner of a plum: • Has no interest of selling his car at the average price offered by the buyers (he knows that the

car is really worth more than the average offer) • Crucial aspect: He cannot improve the information of the buyer by revealing the quality of the

car ! • This is because the real information (my car is a plum) is “drowned” by the noise made by the

owners of lemons !!

-“That’s what they all say” • So his best option is to exit the market. • As a result the average quality of cars on the market decreases. Information theory The “market for lemons” • Another crucial aspect : • What happens if the buyers realise that the good cars are exiting the market ? • Or if they anticipate this will happen (game theory aspect) • They reduce their average offer in line with the reduction in average quality • Following this reasoning, more owners of plums leave the market • In the end, the market disappears ! • In theory, a “market for lemons” cannot exist for long Information theory Adverse selection • What is “adverse selection” ? • An asymmetric-information problem that occurs when the quality of the good is unobservable

by one of the parties before the transaction / contract occurs • Example: • The “market for lemons” already mentioned • More critically: the insurance market • The sub-prime mortgage crisis. Information theory Adverse selection • Car insurance market example • Imagine you want to get insurance for a new car... • But you’ve been stopped once already for drunk driving, and you’ve had a speeding ticket. • What will happen if you reveal this information to your insurer? • Similar problems with medical insurance • Companies only want to insure healthy people! • Which is why health insurance is often public Information theory • Avoidance mechanisms: • The problem is the asymmetric information prior to the transaction,

• Most methods rely on revealing this information • 2nd hand cars: Servicing history, MOT, etc. • Labour market: Interviews and trial periods • Insurance market: Insurance history, questionnaires, etc.

• Health insurance: health checks, age limit, etc. Adverse selection Information theory Moral hazard • What is “Moral hazard”? • An asymmetric-information problem that occurs when the behaviour of one party is

unobservable by the other party after a contract is agreed • The terms the contract were agreed on change once the contract is signed • Examples: • The insurance market (again!) • The labour market (shirking) Information theory Moral hazard • Car insurance example: • You get third-party insurance for your car (legal minimum insurance) • You’re late for an appointment, you park your car. On your way, you can’t remember if you

removed the car-radio/tom-tom, etc. • What do you do ? • How does your decision change if you have comprehensive insurance ? • Your level of risk changes with the level of insurance!

Information theory Moral hazard • Labour market example: • You are hired by a private firm, your contract is fixed-term and your pay is result-based. • A big deadline is close: Do you work Saturdays? • You are hired to become a civil servant. Your career track is guaranteed, you can’t be fired

and your pay and pension are inflation protected. • Do you still turn up to work on Saturdays? • Your level of effort changes with the characteristics of your contract! Information theory Moral hazard • Avoidance mechanisms: • The problem is the asymmetric information on behaviour after the transaction • Most mechanisms involve monitoring behaviour or incentives/disincentives. • Car insurance: excess fees, bonus-malus systems • Labour market: annual monitoring reports, results-based incentives (stock-options,

bonuses) Information theory Information theory: The principal-agent problem • Most of these aspects of asymmetric information can be grouped into the “principal-agent

problem” • An agency

problem is a situation where a person (the principal) hires another person

(the agent) to carry out a task in his name. P A Performs Hires Information theory Information theory: The principal-agent problem The Principal-Agent problem arises whenever information asymmetry exists between principals

(owners of capital) and their agents (workers). • Agent may know more information about their work/goods/opportunities but can’t credibly

communicate it to the principal. (Asymmetric Information) • Principal expects work to be done in a way that maximizes his own interests, but the agent

might privately benefit by not doing so.

(Moral Hazard) Agency Theory was pioneered by Jensen and Meckling (1976), where they define a firm as a set

of contracts between principals and agents. Information theory The principal-agent problem • This framework can be used to identify and deal with the information asymmetries in the

design of contracts: • What information revealing-mechanisms can be used to minimise the asymmetry? • What is the optimal intensity of monitoring (which is costly to the principal)? • What is the optimal intensity of incentives (which are costly and can lead to rent-seeking

behaviour)? Information theory Agency theory: Moral hazard example Think of a stock as an ownership contract between principals (stockholders) and agents (the

CEO). • Stockholders want the CEO’s actions to optimize stockholder returns, but they can’t perfectly

monitor CEO actions. Examples of potential “perks”: • He might use the company jet for private travel purposes. • Select vendors that provide gifts/travel/discounts to the CEO. • Hire employees for personal reasons, instead of qualifications. • Play golf on company time. • Many other possible examples… How might stockholders ensure that CEO’s don’t privately profit at the stockholders’ expense? Information theory Agency theory: Moral hazard resolution Possible Resolutions: • CEO Monitoring: principals hire auditors to certify accounts (required by law) • Incentivize the CEO by rewarding good management: bonuses and stock options But even this has potential problems: • The CEO can try to “cook the books” to hide his self-interested actions... • The hiring of auditors produces another agency problem: auditors can be self interested and

lie as well!! Information theory Part C Corporate Governance • Corporate Governance  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. • Implements two alternative strategies to mitigate moral hazard:

 Monitoring: usually imposed by controls and regulations  Incentives/Compensation: set by contract to reward desirable outcomes Corporate governance and agency costs Corporate governance Types of Directors: • Inside Directors  Members of a board of directors 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 grey director. Monitoring: Board of Directors Corporate governance CEOs pick directors: A 1992 survey by Korn/Ferry revealed that 74% of companies relied on

recommendations from the CEO to come up with new directors and only 16% used an

outside search firm. While that number has changed in recent years, CEOs still determine

who sits on their boards. While more companies have outsiders involved in picking directors

now, CEOs exercise significant influence over the process. Directors don’t have big equity stakes: Directors often hold only token stakes in their

companies. Most directors in companies today still receive more compensation as directors

than they gain from their stockholdings. While share ownership is up among directors today,

they usually get these shares from the firm (rather than buy them). And some directors are CEOs of other firms: Many directors are themselves CEOs of other

firms. Worse still, there are cases where CEOs sit on each other’s boards. The CEO often hand-picks directors…

Corporate governance • On a board composed of insider, grey, 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 independence Corporate governance The Calpers tests for independent boards Calpers, the California Employees Pension fund, suggested three tests of an independent

board: • Are a majority of the directors outside directors (for example, not employees of the firm, not

ex-managers, etc)? • Is the chairman of the board independent of the company (and not the CEO of the company)? • Are the compensation and audit committees composed entirely of outsiders? Board independence Corporate governance • 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 Board size and performance Corporate governance Includes security analysts, lenders, the S E C, Institutional Investors 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 S E C (ASIC) protects the investing public against fraud and stock price manipulation. Other monitors Corporate governance CRICOS code 00025B • Institutional investors are financial institutions that accept funds from third parties for investment in their

own name but on such parties’ behalf.

• Some widely known types of institutional investors are- pension funds, mutual funds, hedge funds,

endowments, banks, insurance companies, venture capital funds, and REITs (Real Estate

Investment Trusts). • They are considered sophisticated investors who are knowledgeable and, therefore, less likely to make

uninformed decision-making and investments. • The institutional investors’ activism as shareholders is thought to improve corporate governance

because the monitoring of financial markets benefits all shareholders. • Unlike in the case of private equity and hedge funds, most institutional investors are not remunerated on

the basis of the performance of portfolio companies, but on the basis of the volume of assets under

management. • Incentives for churning of assets and strong conflicts of interest add to those factors and create a

challenging context for the notion of institutional shareholder engagement and their promotion of better

governance practices. Institutional investors and their types Corporate governance CRICOS code 00025B Source: Federal Reserve Statistical Release Data: Flow of Funds Data United States. Note: Exchange-Traded Funds are first listed on December 7, 2001. Equity ownership has evolved… Corporate governance CRICOS code 00025B • Institutional investors are very important for keeping shareholder value high by reducing agency conflict and promoting

good governance.

• Institutional investors influence corporate governance in a significant way through their voting rights. By voting in favour

of certain proposals or candidates, institutional investors can promote good corporate governance practices and hold

the board and management to account. • Institutional investors engage in dialogue with company management and board members to influence corporate

governance practices related to corporate accountability framework, board compensation, sustainability initiatives,

corporate ethics and performance standards.

• Institutional investors have a role in controlling the environmental and social fabric. Investors have the power to divest

from companies that engage in unethical or unsustainable practices. By withdrawing their investments, they can send a

clear message about their intolerance for poor governance practices. • Institutional investors who are unsatisfied with the performance or management of a firm may either sell their shares

(“exit”) or interact with the companies in which they have invested (“voice”) (McCahery, Sautner, & Starks, 2016). • Institutional investors’ participation with their investee businesses, known colloquially as “shareholder or investor

activism,” may take several forms, including consultations, voting, shareholder resolutions and recommendations,

priority lists, and governance rating systems (Mallin, 2016). Role of institutional investors in corporate governance Corporate governance CRICOS code 00025B • Institutional ownership of US public firms rose from 32% to 73% of the overall market from 1980 to

2017, and the 100 largest institutions now own more than 50% of all equity. This shift in ownership has

the potential to substantially affect the corporate governance of public firms (Lewellen & Lewellen, 2022

JF). • Institutions have traditionally been viewed as passive owners, raising concerns that their growth will

weaken governance and exacerbate agency problems (Bebchuk, Cohen, and Hirst (2017)).

• However, recent studies provide evidence that larger institutions often exercise “voice” through proxy

voting and behind-the-scenes engagement with management (Carleton, Nelson, and Weis-bach (1998),

Appel, Gormley, and Keim (2016), McCahery, Sautner, and Starks(2016)). Roles of institutional investors: Empirical evidence Corporate governance CRICOS code 00025B • Institutional investors influence various corporate policies, including CEO pay, investment, takeovers,

board structure, and output prices (Aggarwal et al. (2011), Aghion, VanReenen, and Zingales (2013),

Fich, Harford, and Tran (2015), He and Huang(2017), Azar, Schmalz, and Tecu (2018), Azar, Raina, and

Schmalz (2019), Koch, Panayides, and Thomas (2021), Lewellen and Lowry (2021)).

• Recently Lewellen and Lewellen (2022 JF) show that the institutions become active shareholders to

monitor the firm, engage managers, and vote on shareholder proposals in order to earn financial

incentives i.e., annual management fees. They find that in 2017, the average institution gains an extra

$129,000 in annual management fees if a stockholding increases 1% in value, considering both the

direct effect on assets undermanagement and the indirect effect on subsequent fund flows. Roles of institutional investors: Empirical evidence

(cont’d) Corporate governance Stock and Options • Managers’ pay can be linked to the performance of a firm in many ways.  Many companies have adopted compensation policies that include grants of stock or stock

options to executives. ▪ These grants give managers a direct incentive to increase the stock price, which ties

managerial wealth to the wealth of shareholders. Compensation policies Corporate governance Source: Execucomp CEO Compensation Corporate governance • The use of stock and option grants in the 1990s has lead to a substantial increase in

management compensation. - However, this has had 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. Pay and performance sensitivity Corporate governance • Recent research has found evidence suggesting that many executives have

engaged in backdating their option grants. Backdating • The practice of choosing the grant date of a stock option retroactively, so that

the date of the grant would 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. Pay and performance sensitivity Corporate governance The Sarbanes-Oxley Act (S O X) • The overall intent of S O X was to improve the accuracy of information given to both boards and to

shareholders. - S O X attempted to achieve this goal in three ways: 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. The Cadbury Commission • Following the collapse of some large public companies, the U.K. government commissioned Sir Adrian Cadbury to form a committee

to develop a code of best practices in corporate governance. The Dodd-Frank Act

• Dodd-Frank act (2010) added several new regulations designed to strengthen corporate governance, including:

- Independent Compensation Committees - Nominating Directors - Vote on Executive Pay and Golden Parachutes - Claw back Provisions - Pay Disclosure Regulation Corporate governance • Corporate governance is a system of checks and balances that trades off

costs and benefits. • 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. The tradeoff of corporate governance Corporate governance CRICOS code 00025B • Define corporate finance and understand its main aspects. • Discuss information theory including adverse selection and moral hazard. • Define corporate governance and the principal-agent model. • Discuss strategies to mitigate moral hazard: monitoring and compensation. • Discuss regulations in the context of corporate governance. Topic 1: Learning Objectives 58 51作业君版权所有