Corporate Finance E-Book

Michelle R. Clayman

• Herausgeber: John Wiley & Sons
• Kategorie: Fachliteratur
• Serie: The CFA Institute Series
• Sprache: Englisch

Seitenzahl: 968

Veröffentlichungsjahr: 2012

Beschreibung

The book that fills the practitioner need for a distillation of the most important tools and concepts of corporate finance In today's competitive business environment, companies must find innovative ways to enable rapid and sustainable growth not just to survive, but to thrive. Corporate Finance: A Practical Approach is designed to help financial analysts, executives, and investors achieve this goal with a practice-oriented distillation of the most important tools and concepts of corporate finance. Updated for a post-financial crisis environment, the Second Edition provides coverage of the most important issues surrounding modern corporate finance for the new global economy: * Preserves the hallmark conciseness of the first edition while offering expanded coverage of key topics including dividend policy, share repurchases, and capital structure * Current, real-world examples are integrated throughout the book to provide the reader with a concrete understanding of critical business growth concepts * Explanations and examples are rigorous and global, but make minimal use of mathematics * Each chapter presents learning objectives which highlight key material, helping the reader glean the most effective business advice possible * Written by the experts at CFA Institute, the world's largest association of professional investment managers Created for current and aspiring financial professionals and investors alike, Corporate Finance focuses on the knowledge, skills, and abilities necessary to succeed in today's global corporate world.

Leseprobe

CONTENTS

Foreword

Acknowledgments

About the CFA Institute Investment Series

Chapter 1: Corporate Governance

Learning Outcomes

1. Introduction

2. Corporate Governance: Objectives and Guiding Principles

3. Forms of Business and Conflicts of Interest

4. Specific Sources of Conflict: Agency Relationships

5. Corporate Governance Evaluation

6. Environmental, Social, and Governance Factors

7. Valuation Implications of Corporate Governance

8. Summary

Problems

Chapter 2: Capital Budgeting

Learning Outcomes

1. Introduction

2. The Capital Budgeting Process

3. Basic Principles of Capital Budgeting

4. Investment Decision Criteria

5. Cash Flow Projections

6. More on Cash Flow Projections

7. Project Analysis and Evaluation

8. Other Income Measures and Valuation Models

9. Summary

Problems

Chapter 3: Cost of Capital

Learning Outcomes

1. Introduction

2. Cost of Capital

3. Costs of the Different Sources of Capital

4. Topics in Cost of Capital Estimation

5. Summary

Problems

Chapter 4: Measures of Leverage

Learning Outcomes

1. Introduction

2. Leverage

3. Business Risk and Financial Risk

4. Summary

Problems

Chapter 5: Capital Structure

Learning Outcomes

1. Introduction

2. The Capital Structure Decision

3. Practical Issues in Capital Structure Policy

4. Summary

Problems

Chapter 6: Dividends and Share Repurchases: Basics

Learning Outcomes

1. Introduction

2. Dividends: Forms

3. Dividends: Payment Chronology

4. Share Repurchases

5. Concluding Remarks

6. Summary

Problems

Chapter 7: Dividends and Share Repurchases: Analysis

Learning Outcomes

1. Introduction

2. Dividend Policy and Company Value: Theory

3. Factors Affecting Dividend Policy

4. Payout Policies

5. Analysis of Dividend Safety

6. Summary

Problems

Chapter 8: Working Capital Management

Learning Outcomes

1. Introduction

2. Managing and Measuring Liquidity

3. Managing the Cash Position

4. Investing Short-Term Funds

5. Managing Accounts Receivable

6. Managing Inventory

7. Managing Accounts Payable

8. Managing Short-Term Financing

9. Summary

Problems

Chapter 9: Financial Statement Analysis

Learning Outcomes

1. Introduction

2. Common-Size Analysis

3. Financial Ratio Analysis

4. Pro Forma Analysis

5. Summary

Problems

Chapter 10: Mergers and Acquisitions

Learning Outcomes

1. Introduction

2. Mergers and Acquisitions: Definitions and Classifications

3. Motives for Merger

4. Transaction Characteristics

5. Takeovers

6. Regulation

7. Merger Analysis

8. Who Benefits from Mergers?

9. Corporate Restructuring

10. Summary

Problems

Glossary

References

About the Authors

About the CFA Program

Index

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® 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.

Copyright © 2012 by CFA Institute. All rights reserved.

Published by John Wiley & Sons, Inc., Hoboken, New Jersey

Published simultaneously in Canada

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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 978-1-118-10537-5 (cloth); ISBN 978-1-118-21729-0 (ebk);ISBN 978-1-118-21730-6 (ebk); ISBN 978-1-118-21731-3 (ebk)

1. Corporations—Finance. I. Clayman, Michelle R. II. Fridson, Martin S. III. Troughton, George H.

HG4026.C67 2012

658.15—dc23

2011039258

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 2008. 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 real-world 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.

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 short-term borrowing versus cash disbursements and other accounts payable strategies.

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

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.

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 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 once-staid 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 practitioner-important 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 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.

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 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 governance-related 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. 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.

EXHIBIT 1-1 Comparison of Characteristics of Business Forms

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.

3.2. 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.

3.3. 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 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 well-being 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.

4.1. 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 net income (the earnings remaining after the payment of dividends) is reinvested in the company. We normally term this reinvested income retained earnings. Second, the firm can issue stock to obtain the capital, either through an initial public offering (IPO) if the firm is currently privately owned, or through a seasoned equity offering (SEO) if the firm already has shares outstanding. By whatever means the firm obtains equity capital, shareholders entrust management to use the funds efficiently and effectively to generate profits and maximize investors’ wealth.

However, although the manager is responsible for advancing the shareholder’s best interests, this may not happen. For example, management may use funds to try to expand the size of the business to increase their job security, power, and salaries without consideration of the shareholders’ interests. In addition, managers may also grant themselves numerous and expensive perquisites, which are treated as ordinary business expenses. Managers enjoy these benefits, and shareholders bear the costs. This is a serious agency problem and, unfortunately, there are a number of recent real-world examples of their occurrence in corporations.

Managers also may make other business decisions, such as investing in highly risky ventures, that benefit themselves but that may not serve the company’s investors well. For example, managers who hold substantial amounts of executive stock options will receive large benefits if risky ventures pay off, but will not suffer losses if the ventures fail. By contrast, managers whose wealth is closely tied to the company and who are therefore not well diversified may choose to not invest in projects with a positive expected net present value because of excessive risk aversion. The checks and balances in effective corporate governance systems are designed to reduce the probability of such practices.

The cases of Enron (bankruptcy filing: 2001, in the United States) and Tyco (resignation of CEO: 2002, in the United States) make clear that in the absence of the checks and balances of strong and effective corporate governance systems, investors and others cannot necessarily rely upon managers to serve as stewards of the resources entrusted to them. Example 1-1, dealing with Enron, illustrates the problems that can ensue from a lack of commitment to a corporate governance system. Example 1-2, dealing with Tyco, illustrates a case in which there were inadequate checks and balances to the power of a CEO.

EXAMPLE 1-1 Corporate Governance Failure (1)

Enron was one of the world’s largest energy, commodities, and services companies. However, it is better known today as a classic example of how the conflicts of interest between shareholders and managers can harm even major corporations and their shareholders. Enron executives, with the approval of members of the board of directors, overrode provisions in Enron’s code of ethics and corporate governance system that forbade any practices involving self-dealing by executives. Specifically, Enron’s chief financial officer set up off-shore partnerships in which he served as general partner. As an Enron executive, he was able to make deals with these partnerships on behalf of Enron. As a general partner of the partnerships, he received the enormous fees that the deals generated.4

The partnerships served other useful purposes. For example, they made it possible to hide billions of dollars in Enron debt off of the company’s balance sheet, and generated artificial profits for Enron. Thus, disclosure of the company’s rapidly deteriorating financial condition was delayed, preventing investors and creditors from obtaining information critical to the valuation and riskiness of their securities. At the same time, Enron executives were selling their own stock in the company.

These egregious breaches of good governance harmed both Enron’s outside shareholders and their creditors. The bonds were becoming riskier but the creditors were not informed of the deteriorating prospects. The exorbitant fees the executives paid themselves came out of the shareholders’ earnings, earnings that were already overstated by the artificial profits. Investors did not receive full information about the problems in the company until well after the collapse and the company’s bankruptcy filing, by which time their stock had lost essentially all of its value.

Most, if not all, of the core attributes of good governance were violated by Enron’s managers, but especially the responsibility to deal fairly with all stakeholders, including investors and creditors, and to provide full transparency of all material information on a timely basis.

EXAMPLE 1-2 Corporate Governance Failure (2)

Tyco provides another well-known example of a corporate governance failure. The CEO of Tyco used corporate funds to buy home decorating items, including a $17,000 traveling toilette box, a $445 pincushion, and a $15,000 umbrella stand. He also borrowed money from the company’s employee loan program to buy $270 million-worth of yachts, art, jewelry, and vacation estates. Then, in his capacity as CEO, he forgave the loan. All told, the CEO may have looted the firm, and thereby its shareholders, of over $600 million.5

It is instructive that in court proceedings in the Tyco case, the CEO and his representatives have not argued that he did not do these things, but rather that it was not illegal for him to do so. Tyco is a striking example of excessive perquisite consumption by a CEO.

The role of complete transparency in sound corporate governance, including understandable and accurate financial statements, cannot be overestimated. Without full information, investors and other stakeholders are unable to evaluate the company’s financial position and riskiness, whether the condition is improving or deteriorating, and whether insiders are aggrandizing themselves, or making poor business decisions, to the detriment of long-term investors.

Two additional cases illustrate how false, misleading, or incomplete corporate disclosure may harm investors and other stakeholders.

EXAMPLE 1-3 Corporate Governance Failure (3)

The Italian firm, Parmalat, was one of the world’s largest dairy foods suppliers. The founders and top executives of Parmalat were accused of fictitiously reporting the existence of a $4.9 billion bank account so that the company’s enormous liabilities would appear less daunting.6 By hiding the true financial condition of the firm, the executives were able to continue borrowing. The fraud perpetrated by Parmalat’s largest shareholders and executives hurt Parmalat’s creditors as well as the shareholders. Parmalat eventually defaulted on a $185 million bond payment in November 2003 and the company collapsed shortly thereafter.

EXAMPLE 1-4 Corporate Governance Failure (4)

During the late 1990s, Adelphia, the fifth-largest provider of cable entertainment in the United States, and the company’s founders embarked on an aggressive acquisition campaign to increase the size of the company. During this time, the size of Adelphia’s debt more than tripled from $3.5 billion to $12.6 billion. However, the founders also arranged a $2.3 billion personal loan, which Adelphia guaranteed, but this arrangement was not fully disclosed to Adelphia’s other stakeholders.7 In addition, it is alleged that fictitious transactions were recorded to boost accounting profits.8 These actions by Adelphia’s owners were harmful to all of Adelphia’s nonfounder stakeholders, including investors and creditors. The company collapsed in bankruptcy in 2002.

The severity of the agency problems of the companies discussed in Examples 1-1 through 1-4 does not represent the norm, although the potential for serious conflicts of interest between shareholders and managers is inherent in the modern corporation. Strong corporate governance systems provide mechanisms for monitoring managers’ activities, rewarding good performance and disciplining those in a position of responsibility for the company to make sure they act in the interests of the company’s stakeholders.

4.2. Director–Shareholder Conflicts

Corporate governance systems rely on a system of checks and balances between the managers and investors in which the board of directors plays a critical role. The purpose of boards of directors in modern corporations is to provide an intermediary between managers and the owners, the shareholders. Members of the board of directors serve as agents for the owners, the shareholders, a mechanism designed to represent the investors and to ensure that their interests are being well served. This intermediary generally is responsible for monitoring the activities of managers, approving strategies and policies, and making certain that these serve investors’ interests. The board is also responsible for approving mergers and acquisitions, approving audit contracts and reviewing the audit and financial statements, setting managers’ compensation including any incentive or performance awards, and disciplining or replacing poorly performing managers.

The conflict between directors and shareholders arises when directors come to identify with the managers’ interests rather than those of the shareholders. This can occur when the board is not independent, for example, or when the members of the board have business or personal relationships with the managers that bias their judgment or compromise their duties to the shareholders. If members of the board have consulting agreements with the company, serve as major lenders to the firm, are members of the manager’s family, or are from the circle of close friends, their objectivity may be called into question. Many corporations have been found to have inter-linked boards. For example, one or more senior managers from one firm may serve as directors in the companies of their own board members, frequently on compensation committees. Another ever-present problem is the frequently overly generous compensation paid to directors for their services. Excessive compensation may incline directors to accommodate the wishes of management rather than attend to the concerns of investors.

All of the examples cited in this section involve compliant or less than independent board members. In Section 5, we formulate the most important points to check in evaluating a company’s corporate governance system.

5. CORPORATE GOVERNANCE EVALUATION

An essential component of the analysis of a company and its risk is a review of the quality of its corporate governance system. This evaluation requires an assessment of issues relating to the board of directors, managers, and shareholders. Ultimately, the long-term performance of a company is dependent upon the quality of managers’ decisions and their commitment to applying sound management practice. However, as one group concerned with the issues observes, “by analyzing the state of corporate governance for a given company, an analyst or shareholder may ascertain whether the company is governed in a manner that produces better management practices, promotes higher returns on shareholder capital, or if there is a governance and/or management problem which may impair company performance.”9

In the following sections we provide a set of guidelines for evaluating the quality of corporate governance in a company. We reiterate that there is no single system of governance that is appropriate for all companies in all industries worldwide. However, this core set of global best practices is being applied in financial markets in Europe, Asia, and North America. They represent a standard by which corporate practices may be evaluated.

The information and corporate disclosure available in a specific jurisdiction will vary widely. However, most large financial markets and, increasingly, smaller ones require a substantial amount of information be provided about companies’ governance structures and practices. In addition, a few regulatory jurisdictions will require a subset of the criteria we shall give as part of registration, exchange listing, or other requirements.

The analyst should begin by carefully reviewing the requirements in effect for the company. Information is generally available in the company’s required filings with regulators. For example, in the United States, such information is provided in the 10-K report, the annual report, and the Proxy Statement (SEC Form DEF 14A). All of these are filed with the U.S. Securities and Exchange Commission (U.S. SEC), are available on the U.S. SEC website, usually are available on the company’s website, and are provided by the company to current investors as well as on request. In Europe, the company’s annual report provides some information. However, in an increasing number of EU countries, companies are required to provide a report on corporate governance. This report typically will provide information on board activities and decisions, whether the company has abided by its relevant national code, and explain why it departed from the code, if it has. In addition, the announcement of the company’s annual general meeting should disclose the issues on the agenda that are subject to shareholder vote. The specific sources of information will differ by jurisdiction and company.

5.1. The Board of Directors

Boards of directors are a critical part of the system of checks and balances that lie at the heart of corporate governance systems. Board members, both individually and as a group, have the responsibility to:

Establish corporate values and governance structures for the company to ensure that the business is conducted in an ethical, competent, fair, and professional manner.Ensure that all legal and regulatory requirements are met and complied with fully and in a timely fashion.Establish long-term strategic objectives for the company with a goal of ensuring that the best interests of shareholders come first and that the company’s obligations to others are met in a timely and complete manner.Establish clear lines of responsibility and a strong system of accountability and performance measurement in all phases of a company’s operations.Hire the chief executive officer, determine the compensation package, and periodically evaluate the officer’s performance.Ensure that management has supplied the board with sufficient information for it to be fully informed and prepared to make the decisions that are its responsibility, and to be able to adequately monitor and oversee the company’s management.Meet frequently enough to adequately perform its duties, and meet in extraordinary session as required by events.Acquire adequate training so that members are able to adequately perform their duties.

Depending upon the nature of the company and the industries within which the company operates, these responsibilities will vary; however, these general obligations are common to all companies.

In summarizing the duties and needs of boards of directors, The Corporate Governance of Listed Companies: A Manual for Investors10 states:

Board members owe a duty to make decisions based on what ultimately is best for the long-term interests of shareowners. In order to do this effectively, board members need a combination of three things: independence, experience and resources.

First, a board should be composed of at least a majority of independent board members with the autonomy to act independently from management. Board members should bring with them a commitment to take an unbiased approach in making decisions that will benefit the company and long-term shareowners, rather than simply voting with management. Second, board members who have appropriate experience and expertise relevant to the Company’s business are best able to evaluate what is in the best interests of shareowners. Depending on the nature of the business, this may require specialized expertise by at least some board members. Third, there need to be internal mechanisms to support the independent work of the board, including the authority to hire outside consultants without management’s intervention or approval. This mechanism alone provides the board with the ability to obtain expert help in specialized areas, to circumvent potential areas of conflict with management, and to preserve the integrity of the board’s independent oversight function. [Emphasis added]

In the following sections we detail the attributes of the board that an investor or investment analyst must assess.

5.1.1. Board Composition and Independence

The board of directors of a corporation is established for the primary purpose of serving the best interests of the outside shareholders in the company. Other stakeholders including employees, creditors, and suppliers are usually in a more powerful position to oversee their interests in the company than are shareholders. The millions of outside investors cannot, individually or collectively, monitor, oversee, and approve management’s strategies and policies, performance, and compensation and consumption of perquisites.

The objectives of the board are to see that company assets are used in the best long-term interests of shareholders and that management strategies, plans, policies, and practices are designed to achieve this objective. In a recent amendment to the Investment Company Act of 1940 rules, the U.S. SEC argues that a board must be “an independent force in [company] affairs rather than a passive affiliate of management. Its independent directors must bring to the boardroom a high degree of rigor and skeptical objectivity to the evaluation of [company] managements and its plans and proposals, particularly when evaluating conflicts of interest.”11

Similarly, the Corporate Governance Handbook12 observes:

Board independence is essential to a sound governance structure. Without independence there can be little accountability. In the words of Professor Jeffrey Sonnenfeld of Yale University, “The highest performing companies have extremely contentious boards that regard dissent as an obligation and that treat no subject as undiscussable.”

Clearly, for members who are appointed to the board to be in a position to best perform their fiduciary responsibilities to shareholders, at a minimum a majority of the members must be independent of management. However, global best practice now recommends that at least three-quarters of the board members should be independent.

Some experts in corporate governance have argued that all members of the board should be independent, eliminating the possibility of any senior executives serving on the board. Those who hold this position argue that the presence of managers in board deliberations may work to the detriment of the best interests of investors and other shareholders by intimidating the board or otherwise limiting debate and full discussion of important matters. Others argue that with appropriate additional safeguards, such potential problems can be overcome to the benefit of all stakeholders.

Independence is difficult to evaluate. Factors that often indicate a lack of independence include:

Former employment with the company, including founders, executives, or other employees.Business relationships, for example, prior or current service as outside counsel, auditors, or consultants, or business interests involving contractual commitments and obligations.Personal relationships, whether familial, friendship, or other affiliations.Interlocking directorships, a director of another company whose independence might be impaired by the relationship with the other board or company, particularly if the director serves on interlocking compensation committees.Ongoing banking or other creditor relationships.

Information on the business and other relationships of board members as well as nominees for the board may be obtained from regulatory filings in most jurisdictions. For example, in the United States, such information is required to be provided in the Proxy Statement, SEC Form DEF 14A, sent to shareholders and filed with the SEC prior to shareholder meetings.

5.1.2. Independent Chairman of the Board

Many, if not most, corporate boards now permit a senior executive of a corporation to serve as the chairman of the board of directors. However, corporate governance experts do not regard such an arrangement to be in the best interests of the shareholders of the company. As the U.S. SEC observes,

This practice may contribute to the [company’s] ability to dominate the actions of the board of directors. The chairman of a . . . board can largely control the board’s agenda, which may include matters not welcomed by the [company’s management] . . . Perhaps more important, the chairman of the board can have a substantial influence on the . . . boardroom’s culture. The boardroom culture can foster (or suppress) the type of meaningful dialogue between . . . management and independent directors that is critical for healthy . . . governance. It can support (or diminish) the role of the independent directors in the continuous, active engagement of . . . management necessary for them to fulfill their duties. A boardroom culture conducive to decisions favoring the long-term interest of . . . shareholders may be more likely to prevail when the chairman does not have the conflicts of interest inherent in his role as an executive of the [company]. Moreover, a . . . board may be more effective when negotiating with the [company] over matters such as the [compensation] if it were not at the same time led by an executive of the [company] with whom it is negotiating.13

Not all market participants agree with this view. Many corporate managers argue that it is essential for efficient and effective board functioning that the chairman be the senior executive in the company. They base their arguments on the proposition that only such an executive has the knowledge and experience necessary to provide needed information to the board on questions on strategy, policy, and the operational functioning of the company. Critics of this position counter that it is incumbent upon corporate management to provide all such necessary information to the board. Indeed, many argue that this obligation is the sole reason that one or more corporate managers serve as members of the board.

Whether the company has separate positions for the chief executive and chairman of the board can be determined readily from regulatory filings of the company. If the positions are not separate, an investor may doubt that the board is operating efficiently and effectively in its monitoring and oversight of corporate operations, and that decisions made are necessarily in the best interests of investors and other stakeholders.

Tradition and practice in many countries prescribes a so-called “unitary” board system, a single board of directors. However, some countries, notably Germany, have developed a formal system whose intent is to overcome such difficulties as lack of independence of board members and lack of independence of the chairman of the board from company management. The latter approach requires a tiered hierarchy of boards, a management board responsible for overseeing management’s strategy, planning, and similar functions, and an independent supervisory board charged with monitoring and reviewing decisions of the management board, and making decisions in which conflicts of interest in the management board may impair their independence, for example, in determining managerial compensation.

Clearly, independence of the chairman of the board does not guarantee that the board will function properly. However, independence should be regarded as a necessary condition, even if it is not a sufficient one.

5.1.3. Qualifications of Directors

In addition to independence, directors need to bring sufficient skill and experience to the position to ensure that they will be able to fulfill their fiduciary responsibilities to investors and other stakeholders. Information on directors’ prior business experience and other biographical material, including current and past business affiliations, can generally be found in regulatory filings.

Boards of directors require a variety of skills and experience in order to function properly. These skills will vary by industry although such core skills as knowledge of finance, accounting, and legal matters are required by all boards. Evaluation of the members should include an assessment of whether needed skills are available among the board members. Among the qualifications and core competencies that an investor should look for in the board as a group, and in individual members or candidates for the board, are:

Independence (see factors to consider in Section 5.1.1 above).