Define

Corporate Governance

Corporate Governance is the set of internal  controls, processes, and procedures by which firms are managed. 

It defines the appropriate rights, roles, and responsibilities of management, the board of directors, and shareholders within an organization. 

The firm's checks and balances.

True/False

The majority of board and committee members should be independent (not management), and the board should meet regularly without management present.

True/False

It is not necessary for board membrsto have the experience and knowledge to advise management and review its acitivities.

FALSE

Board members should have the experience and knowledge necessary to advise management and review its activities

True/False

The board should have the resources it needs to act independently, with the exception ---they are not allowed to hire outside consultants without the approval from management

False

The board should have the resources it needs to act independently, including the ability to hire outside consultants without approval from management

True/False

An independent board member is not required to work to protect the long-term interests of shareholders

False

An independent board member must work to protect the long-term interests of shareholders

True/False

Board members should have the skills and experience required to make informed decisions about the firm's future

1.  THe products or services the firm produces

2.  Financial operations, accounting, and auditing

3.  Legal issues

4.  Strategies and planning

5.  The firm's business and financial risks

Members who serve on the board for a long time (more than 10 years) may become too closely aligned with management to be considered independent so No they should not serve more than 10 years.

True/False

Having a code of ethics cna be a mitigating factor with regulators if a breach occurs

1.  Comply with corporate governance standards of the company's home country and stock exchange

2.  Prohibit the company from giving advantages to company insiders that are not available to shareholders

3.  Discourage payments to board members of consultancy fees or finder's fees for acquisition targets

4.  Designate a person responsible for corporate governance

A company with a weak code of ethics may allow practices such as transactions with parties related to management or personal use of company assets by management or board members

Such practices benefit company insiders rather than shareholders

(w_d)(k_d)(1-t)+(w_ps)(k_ps)+(w_ce)(k_ce)

cost of debt, preferred stock, and equity with their respective weights

1. target weights (best)

2. market value weights

3. industry averages (worst)

*never estimate weights based on book values (balance sheet accounts)

marginal cost of capital--the cost of capital for the next additional dollar of capital

the marginal cost of capital increases as a firm's WACC changes as more capital is raised (EX: issuing more equity raises the WACC and MCC)

MCC slopes upwards on a graph of CC and new capital raised--as new capital raised increases, the MCC increases

investment opportunity schedule--on the same graph, we can substitute IRR for CC on the y-axis. Funding our very best project will require low capital raised, and result in a high IRR. As we take on more capital and fund less productive projects, the IRR curve slopes downwards. This is called the Investment Opporunity Schedule.

Where MCC = IOS on a graph is the optimal capital budget. For example, if we move to the right, the MCC will be greater than our IRR, which results in negative value. We will continue to raise capital up to this point

-WACC should be used for projects that reflect the normal risk of operations--normal firm projects

-for projects with greater than normal risk, a discount rate greater than WACC should be used

-for projecst with a lower than normal risk, a rate lower than WACC should be used

D_ps/P

preferred dividends/market price of preferred

1. CAPM: Rf + β(Er - Rf)

2. Dividend Discount: D₁/P₀ + g

    g= ROE*(1-payout ratio)

3. Bond Yield + Risk Premium: yield + premium

*used to derive the beta for a given project

-we use the equity betas of companies that are purely engaged in operations that are similar to our new project

-we have to delever the comparable firm's equity beta, and re-lever it according to our own capital structure

Unlever (comparable): β_asset=β_equity [1/1+((1-t)*D/E)]

Relever (subject): β_project=β_asset*[1+(1-t)*D/E)]

*used to estimate increased risk in cost of equity in developing countries--the CRP is added to the market risk premium in the CAPM

CRP= sovereign yield spread*(annualized stdev of equity index of developing country/annualized stdev of severeign bond market in terms of the developed market currency)

-shows the WACC for different amounts of financing

-graph looks like a series of steps sloping upwards

*WACC increases as more capital is taken on--debt and equity become more risky and more expensive

Break points: occur any time one of the components (D or E) of the company's WACC changes

Break points = amount of capital at which the component's cost of capital changes

                        weight of the component in capital structure

-fees charged by investment bankers when a company raises external equity capital (2%-7%)

*appropriate way to account for flotation costs is to add these cash outflows the initial outlay of a project--this will help calculate the correct NPV

*these are one-time cash outflows that only are significant at the inception of the project--should not affect the cost of equity perpetually

1.  Follow proper accounting/auditing procedures

2.  Appoint external auditor --free from mgmt influence

3.  Resolve conflicts between auditor & mgmt--favors shareholders

4.  Approve/reject non-audit engagments with external auditor

5.  No restrictions on communication with firm's internal auditors

6.  Control the AUDIT BUDGET

1.  Determine executive compensation is linked to firm's long-term profitability

2. Provide shareholders with details @ executive compensation in public docs

3.  Require firm and board to seek shareholder approval for share-based compensation plans

1.  Review the performance, independence, and skills of existing board members

2.  Create nomination procedures & policies

3.  Prepare a succession plan for senior mgmt

True/False

Confidential voting and remote proxy voting promote the interests of shareholders

True/False

Shareholders should determine whether a firm permits investors to nominate board member and propose initiatives to be discussed at the annual meeting.

False

INVESTORS should determine whether a firm permits SHAREHOLDERS to nominate board member and propose initiatives to be discussed at the annual meeting and whether the firm regards shareholders proposals as binding or advisory

1. Estimate the relation between changes in sales and the changes in sales driven income statement and balance sheet items
2. Estimate future tax rate, interest rates on debt, lease payments etc..
3. Forecast sales
4. estimate fixed operating and financial costs
5. integrate these estimates into pro forma financial statements

Sources of cash it uses in its normal day-to-day operations. 

Primary sources include:

- cash balances      

- short-term funding

The cash balances result from collecting revenues from sales, collecting cash from receivables, and generating cash from other short-term investments.

Liquidating short-term or long-lived assets, negotiating debt agreements, or filing for bankruptcy and reorganizing the company.

Using secondary sources of liquidity in a business is Highly LIKELY to change the company's normal operations, because:

1. you are changing company's financial structure and operations significantly.

2. It may also indicate that its financial position is deteriorating.

A Drag on Liquidity delays or reduces cash inflows, or increases borrowing costs.

Ex) Uncollected receivables and bad debts, obsolete inventory (which takes longer to sell), and tight short-term  credit due to economic conditions.

Accelerated cash outflows.

Ex) paying vendors sooner than is optimal and changes in credit terms that require repayments of outstanding balances.

Just think of Cash being pulled out of the firm. It is a PULL on Liquidity.

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Best-known measure of liquidity.

Measures company's ability to pay short-term liabilities.

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or

(cash + short-term marketable securities + receivables)/

current liabilities

Accounts receivable Liquidity

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Average Collection Period= [image]

or

= 365/Receivables Turnover 

or

= Average receivables / Average day's Credit Sales

It is desirable to have a ratio close to the industry average. A ratio too high may indicate the customers are too slow in paying their bills.

A ratio too low may indicate that the firm's credit policy is too rigorous, which might hamper sales.

Inv Turnover = COGS / Avg. Inventory

*** makes sure to use COGS in numerator and not sales. People tend to automatically put in sales  when they see turnover ***

= 365/inventory turnover

= average inventory / average day's COGS

Once again, you want to have a ratio close to the industry norm. DO not think more is better.

= purchases / average trade payables.

=365/ Payables turnover Ratio

= Average Payables/ average day's purchases

The operating cycle, is the average number of days that it takes to turn raw materials into cash proceeds from sales:

Operating cycle = days of inventory + days of receivables.

Cash Conversion Cycle

Net Operating Cycle

Length of time it takes to turn the firm's cash investment in inventory back into cash, in the form of collections from the sales of inventory.

Cycle= (Avg. days of Receivable) + (avg. days inventory) + (avg. days of payables)

Inventory Conversion Period + Receivables Conversion Period - Payables Conversion Period

High cash conversion cycles are bad. Conversion cycles that is too

high shows that the company has an excessive amount of investment in working capital.

The purpose of short-term securities are to  manage a firm's daily cash position to make sure there is sufficient liquidity, but in hopes to avoid excessive cash balances because of the interest foregone by not investing in cash in short-term securities to earn interest.

Here are a few short-term securities:

- U.S. Treasury Bills. - Bank Certificates of Deposits. - Time Deposits. - repurchase agreements. - Commercial paper. - Money market mutual funds. - Adjustable-rate preferred stock.

What is the discount-basis yield (Bank Discount Yield or BDY)?

BDY = (face value - price)/face value * (360/days)

or 

BDY = % discount * (360/days)

= [(face value - price)/PRICE] * [360/days]

= Holding period return * [360/days]

remember, Holding Period Return (HPR) is the percentage of face value (what you will get) minus the price you paid over the price you paid.

= [(face value - price)/price] * [365 / days to maturity]

= HPR * [365/days]