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STUDY SESSION 10
CORPORATE FINANCE (1)
Readings:
•  Introduction to Corporate Governance and Other
0 ESG Considerations
•  Capital Budgeting
•  Cost of Capital

All rights reserved

INTRODUCTION TO
CORPORATE GOVERNANCE
AND OTHER
ESG CONSIDERATIONS

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CORPORATE GOVERNANCE OVERVIEW

Corporate governance refers to the internal controls and procedures by which a
company is managed
•  Provides a framework that defines the rights, roles and responsibilities of various
groups
•  Minimizes and manages conflicts of interest between the different groups

•  Shareholder theory: Maximizing shareholder returns is the most important task
of the company’s managers

•  Stakeholder theory: Also considers the interests of customers, suppliers,

employees, and other groups who have an interest in the company

COMPANY STAKEHOLDERS
•  Shareholders
•  The most junior class of capital providers → if the company goes insolvent,
shareholders only receive a pay out (if any) after all creditors’ claims have
been paid
•  Elect the board of directors and vote for specified resolutions
•  Controlling shareholders: Control the election of board of directors and
influence outcomes of company resolutions
•  Non-controlling / Minority shareholders: Have little control in voting matters

•  Creditors
•  Lend funds to the company, e.g., bondholders and banks
•  Do not have voting rights
•  Can be protected by issuing covenants → restrict the company’s activities
•  Repaid in the form of interest and principal → no further payments are
received

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COMPANY STAKEHOLDERS cont.

•  Managers and Employees
•  Senior managers usually receive a combination of salary, bonus, and equity-
based pay → have an interest in the company performing well
•  Employees are mostly concerned with fair pay and career development
•  Most adversely affected group if the company gets into difficulty

•  Board of Directors
•  Implement strategic direction of firm, protect interests of shareholders, and
monitor the performance of the company and managers

•  Customers
•  Apart from enjoying a company’s product or service, customers may require a
product guarantee or after-sales service

COMPANY STAKEHOLDERS cont.

•  Suppliers
•  Want the company to have sufficient funds and cash flow so that they can be
paid

•  Governments/Regulators
•  Protect the interest of the public
•  Ensure companies comply with laws
•  Receive taxation from companies!

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PRINCIPAL-AGENT RELATIONSHIP
Principal-agent relationship: Arises when a principal (the company) hires an agent
(the manager) to perform a certain task or service
•  The agent must act in the best interests of the principal → there are conflicts of
interest when this does not happen, e.g.:
•  Managers may want to unreasonably increase their remuneration at the
expense of shareholders
•  Managers may take low risk decisions to protect their positions, but
shareholders with diversified portfolios may prefer higher risk to generate a
higher return
•  Information asymmetry: Managers have more info than shareholders
•  If the board is influenced by insiders, this can be detrimental to shareholders
•  The board favours influential shareholders

OTHER CONFLICTS OF INTEREST

Controlling and Minority shareholders
•  Controlling shareholders often outweigh the view of minority shareholders
•  Related-party transactions: Can occur when controlling shareholders have an
interest in a transaction between the company and a third party
•  Multiple-class (or dual-class) share structures: One voting class (often the
founders) has superior voting powers

Shareholders and Creditors

•  Shareholders → prefer higher risk to be taken to generate higher returns and a
higher share price
•  Creditors → prefer lower risk to be taken as are only concerned about receiving
interest and the return of principal
•  Creditors get concerned when the company issues new debt to a level where
default risk increases
•  Large dividend payments favour shareholders, and can be detrimental to
creditors

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OTHER CONFLICTS OF INTEREST cont.

Customers and Shareholders
•  Excessive pricing may benefit shareholders, but hurt customers

Customers and Suppliers

•  Generous credit terms to customers may benefit customers, but suppliers may
not be paid timeously

Shareholders and Governments/Regulators

•  Applying accounting standards that reduce tax benefit shareholders, but reduce
govt. income
•  Bank shareholders may prefer lower equity capital, and regulators higher capital

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STAKEHOLDER MANAGEMENT
Stakeholder management relates to the management of relationships between
the company and different stakeholder groups → the company needs to
understand the interests of the stakeholders

•  Legal infrastructure: Defines the laws stakeholders must follow, and legal
recourse if a party’s rights are violated

•  Contractual infrastructure: Contracts between the company and stakeholders →

outline the rights and responsibilities of both parties

•  Organizational infrastructure: Relates to the internal systems and governance

procedures the company has in place to manage stakeholder relationships

•  Governmental infrastructure: Relates to regulations imposed on companies by

regulators

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MECHANISMS OF STAKEHOLDER MANAGEMENT

Annual General Meeting (AGM)
•  Audited financial statements are presented
•  Present a summary of the performance of the company
•  Shareholders elect directors, approve financial statements, appoint external
auditor, vote on board remuneration → ordinary resolutions → require simple
majority (50%)

Extraordinary General Meeting (EGM)
•  Held when significant resolutions are proposed that require shareholder
approval
•  Often relate to material corporate proposals, e.g., mergers and acquisitions,
sales of significant assets, amendments to company bylaws → special
resolutions → require supermajority, e.g., 66.7% or 75%

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MECHANISMS OF STAKEHOLDER MANAGEMENT cont.

Proxy voting: Where someone has been given authority to vote on somebody
else’s behalf

Cumulative voting: Shareholders can accumulate their votes and vote all their
shares for one candidate → increases chances that minority shareholders are
represented
Example: 3 board positions are up for vote, 6 candidates for the positions,
shareholder owns 100 shares:
Cumulative voting: Shareholder can give maximum of 300 votes to one candidate
(votes = shares × seats = 100 × 3 = 300)
Majority / Straight voting: Shareholder can give maximum of 100 votes to each of
3 candidates

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COMPOSITION OF BOARD OF DIRECTORS

One-tier structure:
On a
•  Executive (internal) directors → usually members of senior
management single
board
•  Non-executive (external) directors → not involved in day-to-day
operations, but provide oversight role
•  Independent director: Type of non-exec director that does not have a material
relationship with the company regarding employment, ownership, or
remuneration

Two-tier structure:
•  Supervisory board → non-executive (external) directors → led by chairperson Sep-
•  Management board → executive (internal) directors → led by CEO arate

Board elections:
•  Board members usually elected at the same meeting, and for a certain term (e.g.,
3 years)
•  But can have staggered board elections → directors usually divided into
3 classes → classes are elected separately → one class elected every year

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RESPONSIBILITIES OF BOARD OF DIRECTORS

Directors have a duty of care and loyalty to all stakeholders → must act in the
interests of stakeholders
•  Provide strategic direction for the company → delegate implementation to
senior management
•  Implement systems to establish if company goals are being met
•  Evaluate management’s performance, determine senior executive remuneration
•  Appoint and terminate senior managers
•  Succession planning for important executives
•  Ensure effectiveness of audit and control systems
•  Review financial statements for fairness and accuracy
•  Oversee reports by internal audit, the audit committee, and the external auditors
•  Ensure compliance with all laws, regulations, and ethical standards
•  Ensure an enterprise risk management system → risks must be identified,
mitigated, assessed, and managed
•  Review proposals for large corporate transactions, e.g., M&A, changes in
capital structure

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BOARD OF DIRECTORS COMMITTEES

•  Audit committee
•  Oversee the audit and control systems and ensure they are effective
•  Supervise the internal audit function and internal controls
•  Recommend external auditor and remuneration

•  Governance committee
•  Implement sound corporate governance practices and company’s code of
ethics
•  Ensure compliance with laws and regulations

•  Remuneration / Compensation committee

•  Develop and propose remuneration policies for the directors and important
executives
•  Draw up contracts of managers and directors
•  Set performance criteria and evaluate the performance of managers
•  Can implement employee benefit plans

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BOARD OF DIRECTORS COMMITTEES cont.

•  Nomination committee
•  Search for candidates who are suitable and qualified to be directors

•  Risk committee
•  Determine the risk policy, profile, and appetite
•  Responsible for enterprise risk management → risks must be identified,
mitigated, assessed, and managed

•  Investment committee
•  Analyse proposed investment opportunities, e.g., M&A, large projects,
expansions, divestures
•  Monitor the performance of investments
•  Establish and revise the investment strategy and policies

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FACTORS AFFECTING STAKEHOLDER RELATIONSHIPS & CORPORATE GOVERNANCE

Market Factors
•  Shareholder engagement
•  More frequent engagement and contact with shareholders (other than just at AGM)
has been beneficial → shareholders are more inclined to support companies who
provide more frequent communication against negative comments and reports

•  Shareholder activism
•  Relates to strategies used by shareholders to make the company act in a certain
manner → motivation is to increase shareholder value (often initiated by hedge funds)
•  Initiate proxy battles, propose shareholder resolutions, publicly raise awareness on
contentious issues, and pursue shareholder derivative lawsuits

•  Competition and Takeovers

•  Proxy contest (proxy fight): Shareholders are encouraged to vote for a group who are
looking to gain a controlling position on the board
•  Tender offer: Shareholders sell their shares to the group wanting to take control
•  Hostile takeover: A group tries to acquire a company without management’s consent
•  Anti-takeover measures: Staggered boards and shareholder rights plans (poison pills)

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FACTORS AFFECTING STAKEHOLDER RELATIONSHIPS & CORPORATE GOVERNANCE

Non-market Factors
•  Legal environment
•  Common law systems → laws are created from statutes enacted by the
legislature and by judges through judicial opinions
•  Civil law systems → laws are created through statutes → judge’s role is
limited to apply the statutes
•  Common law systems provide better protection to shareholders →
shareholders can appeal to a judge to rule against management

•  The media
•  Media coverage of a company can sway public opinion
•  Media coverage can encourage regulators to adopt corporate governance
measures
•  Social media has made it easier for stakeholders to be heard

•  Corporate Governance Industry

•  The corporate governance industry provides ratings and recommendations on
companies’ corporate governance practices and proxy voting

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RISKS OF POOR CORPORATE GOVERNANCE AND STAKEHOLDER MANAGEMENT

•  Weak Control Systems
•  E.g.: Poor audit procedures or board oversight
•  Can benefit one stakeholder group, to the detriment of others

•  Ineffective decision making

•  If managers have more info than the board or shareholders → can make
decision to suit their interests, e.g., take less risk than shareholders want
•  Excessive executive pay
•  Related-party transactions

•  Legal, Regulatory, and Reputational Risks

•  Violating laws or regulations may trigger investigations by govt. or regulators
•  Contract breaches may result in lawsuits from stakeholders
•  Conflicts of interest can cause reputational damage

•  Default and Bankruptcy risks

•  Poor corporate governance can have an adverse affect on the
company’s financial position → can lead to risk of default on debt

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BENEFITS OF EFFECTIVE CORPORATE GOVERNANCE AND STAKEHOLDER MANAGEMENT

•  Operational Efficiency
•  Clear delegation of responsibilities
•  When corporate decisions are effectively monitored and controlled → reduces
risks

•  Improved control
•  Good governance assists to identify and manage risks at an early stage
•  Effective audit systems improve control
•  Having systems that monitor policy compliance, and violation reporting
procedures → reduce regulatory and legal risks
•  Procedures to deal with conflicts of interests and related-party transactions
promotes fairness

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BENEFITS OF EFFECTIVE CORPORATE GOVERNANCE AND STAKEHOLDER MANAGEMENT

•  Better Operating and Financial Performance

•  Good governance:
•  Diminishes costs that result from weak control systems, such as costs of
poor investments, legal costs
•  Results in improved decision-making
•  Appropriate remuneration policies result in better operating performance and
corporate value

•  Lower Default Risk and Cost of Debt

•  Better governance → lower risk and improved credit rating
•  Default risk can be reduced by:
•  Well functioning audit systems
•  Better transparency
•  Information asymmetry control between the company and
providers of capital

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ANALYST CONSIDERATIONS IN CORPORATE GOVERNANCE AND

STAKEHOLDER MANAGEMENT

•  Economic Ownership and Voting Control

•  Usual situation → one vote for each share
•  Dual-class structure: One voting class (often the founders) has superior voting
powers

•  Board of Directors Representation

•  Does the experience and skills of the board suit the company’s needs and
strategy?
•  Are directors involved in related-party transactions?
•  Long service history is good for stability, but can impact adversely on diversity

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ANALYST CONSIDERATIONS IN CORPORATE GOVERNANCE AND

STAKEHOLDER MANAGEMENT cont.

•  Remuneration and Company Performance

•  Executive pay is made up of base salary, short-term bonus, and equity (e.g.,
share options) → the following must be analysed:
•  Alignment with shareholders: Pay plans consisting of cash only pay, and no
equity, can result in a misalignment between executives and shareholders
•  Variation in pay: If pay is performance based and there is low variation over
many years → performance targets may be too easy
•  Is the pay excessive compared to competitors?
•  Does the pay plan include a strategic target? E.g.: If there is a reward for
concluding a certain sale, does the sale align with the company’s strategy
and objectives?
•  A pay plan based on a prior period in the life cycle of the company (e.g.,
growth phase), may no longer be relevant

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ANALYST CONSIDERATIONS IN CORPORATE GOVERNANCE AND

STAKEHOLDER MANAGEMENT cont.

•  Investors in the Company

•  Cross-shareholdings and large affiliated shareholders → can protect the
company from outside shareholders pressures
•  Activist shareholders → covered!

•  Strength of Shareholders’ Rights

•  Governance codes indicate the strength of shareholders’ rights → we need to
analyse whether the rights are strong, weak, or average

•  Managing Long-term Risks

•  We need to analsye how a company manages environmental risks and human
capital, and how it treats stakeholders
•  Examine:
•  Correlation between stakeholder relations and the share price
•  Fines, penalties, and number of investigations

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ESG CONSIDERATIONS
ESG Terminology
•  Environmental, Social, and Governance (ESG) factors are increasingly being
considered in investment analysis → referred to as ESG investing → also referred
to as sustainable investing (SI) and responsible investing (RI)
•  Socially responsible investing (SRI) → a related term that has many meanings

ESG Growth
•  ESG growth has been spurred by the concept of “universal owners” → long-term
investors such as pension funds → some encourage companies to reduce ESG-
related costs

Remember Fiduciary Duty from Ethics:

•  A fiduciary must act solely in the interest of investors and beneficiaries → so
accepting lower returns or taking higher risk in a pension plan to promote ESG
factors would violate fiduciary duty and is prohibited by ERISA….but → the US
Department of Labor (DOL) ruled that certain ESG-related investment practices
do not violate ERISA or fiduciary duty

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ESG IMPLEMENTATION APPROACHES

•  Negative screening: Exclude certain sectors or companies based on specific ESG
criteria → sector weightings comparable to a relative benchmark index are not
maintained

•  Positive screening and relative/best-in-class screening

•  Positive screening: Invest in sectors and companies with good ESG practices
•  Relative/best-in-class screening: Invest in companies with the best ESG
practices relative to competitors → does not exclude any industries →
maintains sector weightings comparable to a relative benchmark index

•  Full integration: Including of ESG factors into traditional financial analysis of

stocks, e.g., how ESG affect cash flow and the discount rate/cost of capital are
considered

•  Overlay/portfolio tilt: Changing the ESG characteristics of a portfolio to a desired

level by implementing certain investment strategies or products

•  Risk factor/risk premium investing: Including ESG factors when

analysing systematic risks

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ESG IMPLEMENTATION APPROACHES cont.

•  Thematic investment: Investing in themes or assets that relate to ESG factors,
e.g., clean energy and green technology

•  Engagement/active ownership: Direct contact with companies by influential

shareholders to persuade companies to engage in good ESG practices → often
implemented by investment vehicles and direct transactions, e.g., venture capital
•  Green finance: Goal is to achieve economic growth and simultaneously reduce
pollution and improve efficiency when using natural resources → the most
common investment vehicle used are green bonds → proceeds go to
environmentally friendly projects

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