ADVANCED

FINANCIAL
MANAGEMENT
Chapter 1: Corporate
Governance

CORPORATE GOVERANCE
UNDERSTANDING THE GOAL OF CORPORATE
FINANCE (CF) :
CF is about managing the financial resources of
the firm to create value for shareholders
(maximizing the shareholders wealth).
What about the rest of stakeholders?
CF is also about people creating value for people
People create value, not the assets. So you pay
people for creating value for you.

CORPORATE GOVERNANCE
UNDERSTANDING THE GOAL OF CORPORATE FINANCE:

From the stockholders point of view, what is a good

financial management decision?

Stockholders hold the stock of the firm because they seek

to increase their wealth, then : good decisions increase the
price of the stock, and poor decisions decrease the price of
the stock.

It follows that the financial manager (CFO) acts in the

shareholders best interests by making decisions that
increase the value of the stock.

The goal of corporate finance is to maximize the

price of the stock as this maximize the shareholders
wealth.

CORPORATE GOVERNANCE
UNDERSTANDING THE GOAL OF CORPORATE FINANCE:

Thats why CFOs focus on stock price maximization when making

decisions.

Stock prices are observable and can be used to judge the

performance of a publicly traded firm.

But, unlike earnings or sales, which are updated once every

quarter or once every year, stock prices are updated constantly in
the market to reflect new information (good or bad) coming out
about the firm.

Thus, managers receive instantaneous feedback from

shareholders on every action that they take.

A good illustration is the response of markets to a firm announcing

that it plans to acquire another firm or lunching a new product or
opening new locations.

CORPORATE GOVERNANCE
UNDERSTANDING THE GOAL OF CORPORATE FINANCE:

Note that the goal of maximizing stock prices (shareholder

s wealth) is observable only for firms that are publicly
traded (firms listed in stock exchanges) as prices are
observed in the market.

For private firms (not publicly traded) the goal of

maximizing the firm should be estimated value based on
observable financial indicators.

CORPORATE GOVERNANCE
AGENCY PROBLEM AND CONFLICTS OF INTERESTS

An agent is someone who is given the authority to act on

behalf of another, referred to as the principal.

Shareholders are the principals, because they are the owners

of the firm.

Board of directors, CEO, and Senior Managers are agents of

the shareholders, as they make decisions on behalf of
shareholders.

Potential conflicts of interests arise as a result of the

separation of management and ownership.

Conflict of Interest: A situation that has the potential to

damage the impartiality/neutrality/independence of a person
because of the possibility of a clash between theperson'sselfinterestandothers interest.

CORPORATE GOVERNANCE
AGENCY PROBLEM AND CONFLICT OF INTERESTS

Because of conflicts of interests between managers and owners,

managers may make decisions that are not in line with the goal of
maximization of shareholder wealth (don't always do what's in the best
interest of the shareholders).
As a result of conflicts of interests Board of Directors, CEO, and Senior
Managers, not only might they benefit themselves in terms of salary and other
benefits, but they might also avoid projects with huge potential returns. Why is
this so? Because if the project doesn't turn out, they may lose their jobs.
The agency problem will persist unless an incentive structure is set up that
aligns the interests of managers and shareholders. In other words, what's
good for shareholders must also be good for managers. If that is not the
case, managers will make decisions in their best interests rather than
maximizing shareholder wealth.

CORPORATE
GOVERNANCE
KEY TERMS TO APPROACH CORPORATE
GOVERNANCE

Assymetric Information
Adverse Selection
Moral Hazard
Agency Theory
Managerial Opportunism
Earnings Manangement

CORPORATE GOVERNANCE
DEFINITION:
Corporate governance is the system of principles,
policies, procedures and defined responsabilities set
up and used by stakeholders to overcome or
managing conflicts of interests among them.
Is this sufficient to prevent and managing conflicts of
interests?
What about global accounting scandals like Enron or World
Com?

CORPORATE GOVERNANCE
ISSUES ABOUT USING MARKET STOCK PRICES AS INDICATOR OF
SHAREHOLDERS WEALTH
ARE MARKETS PRICES THE TRUE VALUE OF THE FIRM?
Managers are compensated based on stock price performance.
Managers argue there is no guarantee that market prices are the
true value of the firm as markets might overreact to bad news of the
firm or underreact (not assimilating information) to good news.
Remember that market prices are based on information from the
firm and analysts or investors following the firm.
Regulation enforces firms to disclose relevant information (financial or
non-financial) concerning firms. Information must be disclosed promptly,
fully and truthfully to investors. Are managers tempted to
manipulate information?

CORPORATE GOVERNANCE
ISSUES ABOUT USING MARKET STOCK PRICES AS
INDICATOR OF SHAREHOLDERS WEALTH
ARGUMENTS AGAINST STOCK PRICES AS INDICATOR OF
SHAREHOLDERS WEALTH
Stock markets do not always REASONABLY and
rationally assess the effects of new information on
prices and they become volatile. Bubbles are proof
enough that emotions overcome reason.
Sometimes overreaction is explained by reported
earnings that are much higher or lower than
expected, and then stock prices jump too much on good
news and drop too much on bad news.

CORPORATE GOVERNANCE
ISSUES ABOUT USING MARKET STOCK PRICES AS INDICATOR OF
SHAREHOLDERS WEALTH
WHAT TO DO? CHOOSING ANOTHER INDICATOR FOR
SHAREHOLDERS WEALTH

If we put aside stock price maximization as indicator to measure the goal

corporate finance we must replace it with another one to measure
the contribution of managers decisions to shareholders wealth.
Note that new indicator is to be clear and unambiguous to evaluate
success and failure from managers decisions.

Are Market Share or Profit Maximization good indicators for

shareholders wealth?

CORPORATE GOVERNANCE
ISSUES ABOUT USING MARKET STOCK PRICES AS INDICATOR
OF SHAREHOLDERS WEALTH
MAXIMIZE MARKET SHARE:

Market share is observable and measurable.

Decision Rule: Investments decisions are based on their contribution
to market share: Investments that increase market share are better
than investments that increase it less

Do market share really create value? Be aware that investments

with a higher market share are not always the higher-return
investments, and firms that focus on increasing market share can be
worse off as a result.

CORPORATE GOVERNANCE
ISSUES ABOUT USING MARKET STOCK PRICES AS INDICATOR OF
SHAREHOLDERS WEALTH
PROFIT MAXIMIZATION

Profits are observable and measurable. Do higher profits translate into

higher value for shareholders in the long run?
Emphasis on current profitability may result in short-term decisions that
maximize profits at the expense of long-term profits and value.
Managers might be tempted to influence the preparation of accounting
information to increase current profits (accounting distortions = creative
accounting = aggressive accounting = earnings management = cooking the
books).
For measuring managers performance profit maximization goal is to be
restated in terms of return (such as return on equity or excess returns over a
cost of capital).

CORPORATE GOVERNANCE
CONFLICT RESOLUTION : REDUCING AGENCY PROBLEMS
Conflicts of interests among stockholders, managers, and debtholders lie at
the heart of the problems with maximization of shareholders wealth.
Reducing these conflicts is an objective in Corporate Governance.

REDUCING AGENCY PROBLEMS BETWEEN STOCKHOLDERS AND

MANAGERS

Key: Making managers think and behave like stockholders. How?

Compensate managers with stocks in the firms they manage. If this is done,
the benefits from higher stock prices are the same for stockholder and
managers, and managers will do their best to maximize stock prices.

CORPORATE GOVERNANCE
REDUCING AGENCY PROBLEMS BETWEEN STOCKHOLDERS AND
MANAGERS
WHAT TO DO AS SHAREHOLDER TO AVOID SURPRISES?

Improve corporate governance. Monitoring, Controlling and Reporting are key

activities to prevent surprises
Increase levels of transparency. Too often, managers hold back critical
information to investors
Pay attention to the market reaction and look for explanations. If the market
reaction is not consistent with expectations, i.e., the stock price goes down when
markets receive good news find out possible explanations. Is the information
incomplete and/or not convincing?, Is the decision destroying and not creating value?.
Focus first and foremost on long term value. Always link managers decisions
with value creation and tie rewards to long-term value.

CORPORATE GOVERNANCE
REDUCING AGENCY PROBLEMS BETWEEN DEBTHOLDERS AND
SHAREHOLDERS
Debtholders are paid as agreed in a contract (interest and principal) irrespective
of the size of the cash flows or profits generated by the investments of the firm.
Debtholders do not receive more or less if the investments succeed or fail.
But, for the debtholders to be paid the firm must makes enough cash flows meet its
debt obligations.
Debtholders bear a significant portion of the risk investments fail, as they will
not be paid. As a result, debtholders tend to view decisions that increase risk much
more negatively than stockholders.
Equity holders (shareholders) are entitle to receive the cash flows that are left
over after paying debtholders.
Equity holders have the right of declaring the firm bankruptcy if the firm does
not make enough cash flow meet its debt obligations

CORPORATE GOVERNANCE
Reducing Agency Problems between Stockholders and Managers
Debtholders set up COVENANTS (restrictions) preventing the firm from
taking any action that hurts them. Covenants protect debtholders
from risky decisions made by the Board of Directors, CEO,
managers or shareholders .
Examples of Covenants:
Restrict the firms investment policy. When a business is faced with the
question of whether to invest in a risky project, with high expected returns,
stockholders may be tempted to take it, based on the potential profits and
cash flows available to them. Debtholders will be exposed to downside risk to
the investments. Putting restrictions on where firms can invest and
how much risk they can take on in their new investments, provide
lenders with the power to reject investments that are not in their
best interests.

CORPORATE GOVERNANCE
Reducing Agency Problems between Stockholders and Managers
Examples of Covenants:
Restrict dividend policy. Dividend payments (and stock
buybacks) reduce the cash available to the firm to meet debt
payments and increase the likelihood of default. Can debt be used
to pay dividends?. Many debt agreements restrict dividend policy
by tying dividend payments to earnings.
Restrict additional leverage. Additional debt increases the
likelihood that the company will be unable to make debt payments.
Firms are required to get the consent of existing lenders before
borrowing more funds. This is done to protect the interests of
existing lenders.