CFA – 10 & 11.

Corporate Finance

Corporate Governance
- Shareholder theory – most important to maximise shareholder returns; minimise
conflicts between insiders and shareholders
- Stakeholder theory – beyond interests of only its shareholders
o Stakeholder theory does not mean all stakeholders should have the right to
participate in the governance. Indeed, only shareholders have such right
- Shareholders
o Shareholders maintain control over the company through their power to elect the
board of directors and vote for resolutions
o Shareholder activism – compelling the company to act, to improve shareholder
value
 Cumulative voting allows minority shareholders to accumulate and vote
 Cross-shareholdings prevent shareholder activism because the cross-held
companies implicitly support each other
o Dual-class structure – to separate voting control from economic ownership –
company insiders carry superior voting rights to others
- Board of directors
o Shareholder-director relationship – principal-agent relationship
o Executive (internal) directors – employees of the company
o Non-executive (external) directors – not employees of the company
o One-tier structure – a single board of directors composed of executive and non-
executive directors
o Two-tier structure – two separate boards
 Supervisory board – primarily composed of non-executive directors, overseeing
management board
 Management (executive) board – composed of executive directors
o CEO duality – CEO also serves as the board’s chairperson, decreasing shareholder
protection
o Duty of care – act on a fully-informed basis, in good faith, with due diligence and
care
o Duty of loyalty – act in the interests of company and shareholders
- Stakeholder management frameworks
o General meetings
 Ordinary resolutions – simple majority of votes, such as election of directors
 Special resolutions – supermajority of votes
 Proxy voting – allow shareholders to authorise another individual to vote on
their behalf – most common
o Audit function
 Internal audits – independent internal audit function
 Audit committee to recommend external auditors
o Remuneration policies
 Primary goal – aligning interests of managers with those of shareholders
 Incentive plans
 Say on pay – shareholders to vote on executive remuneration
- ESG considerations
 o Environmental and social factors have been adopted in investment analysis more
slowly than governance factors
o ESG implementation approaches
 Sustainable investing
 Responsible investing
 Thematic investing – focus investments within a specific theme
 Impact investing – ESG along with measurable financial returns
 Negative screening (most common) – exclude investments in certain sectors
 Positive screening/best-in-class

Capital Budgeting
- Assumptions
o Cash flows based on opportunity costs
o After-tax cash flows
o Ignore intangible costs and benefits, which should result in cash flows at some other
times
o Ignore financing costs (e.g. interest costs), which are reflected in required rate of
return
- Investment decision criteria
o Net Present Value (NPV)
 Projects with positive NPVs theoretically increase shareholder value, value of
the company and value of its stock
o Internal required rate of return (IRR)
 For nonconventional cash flows (cash flows that change signs more than once
during the project’s life), there may be multiple IRR or no IRR
o Payback period
 Years required to recover investment (ignore time value of money)
 Ignore cash flows after payback period is reached
o Discounted payback period
 Years required for cumulative discounted cash flows to recover investment
o Profitability index

 Invest if PI > 1, do not invest if PI < 1

- NPV profile

o Crossover rate – the rate at which two projects have the same NPV
Cost of Capital
- Rate of return required by suppliers of capital – bondholders and shareholders

- After-tax cost of debt is generally lower than both cost of equity

- Marginal tax rate, but not average tax rate
- Target capital structure – proportion of capital source
o Forecasted market value, but not current market value
o Without target capital structure, we either use company’s current capital structure
(use market value, but not book value), or average of competitors’ capital structures
- Cost of debt
o Yield to maturity (YTM) – annual return
- Cost of preferred stock

- Cost of common equity

o Capital Asset Pricing Model (CAPM) (most popular)
 Use equity beta – measure of financial risk, but not asset beta – business risk
 Pure-play method
 1st step – un-lever equity beta to get asset beta of comparable company

 2nd step – lever asset beta to get equity beta of project

Higher debt-to-equity ratio of project will increase equity beta, while asset
beta does not change
 (Developing country) country risk premium upon equity risk premium of
developed country
 Country risk premium
= sovereign yield spread*(S.D. of equity market relative to bond market)
o Dividend Discount Model
o Bond yield plus risk premium

- Maybe required to calculate the cost of capital for the new project solely, or the cost of
capital of the whole company after the project
- WACC and Capital budgeting
 o When more and more capital is raised
 Increasing marginal cost of capital
 Decreasing marginal return of investment (investment opportunity schedule)
o Optimal capital budget

Leverage
- Business risk
o Business risk = sales risk + operating risk
o Sales risk – uncertainty about price and quantity
o Operating risk – use of both variable and fixed operating costs
 Degree of operating leverage

(Contribution margin/operating income)

- Financial risk – use of debt financing (fixed financing cost)

o Degree of financial leverage

(Operating income/profit before tax)

- Total leverage
o Degree of total leverage
DTL = DOL*DFL = (contribution margin/profit before tax)

- Break-even point

- Operating break-even point

Working Capital Management

- Liquidity
 o Operating cycle = days of inventory + days of receivables
o Net operating cycle (cash conversion cycle) = days of inventory + days of
receivables – days of payables
- Accounts receivables management
o Credit terms
 1/10 net 30 = 1% discount if paid within 10 days, or pay full in 30 days