Course: Corporate governance and financial stakeholders
Objective: Role that different financial stakeholders play in the governance of a company and different issues affecting the
relationship between managers, equity holders and debt holders.
1. CG as a solution to principle agency problems between the company’s managers and financial stakeholders.
2. Different types of financial stakeholders and their implications for the governance of the company
3. Relationship changes during bankruptcy
Session 3: Valuation
Measuring shareholder wealth
Session 4: Corporate Governance and Financial Stakeholders
Agency view of corporate governance. CG as solution to principle-agency problems between managers and
financial stakeholders
Session 5: Concentrated Debt Ownership by Banks in Project Finance
Banks as financial stakeholders (creditors) with concentrated debt ownership. PF a special type of
incorporation in which banks are the dominant financial stakeholders
Session 7: The Government as Financial Stakeholder & Privatization
Government as a financial stakeholder and privatization of state owned enterprises
Session 9: Engagement by Institutional Equity Investors
Institutional investors as equity holders and the Impact of their engagement
Session 10: Common Ownership by Institutional Equity Investors
Common ownership effects on firms and economy
Session 11: Stakeholder Dynamics during Bankruptcy
Changes in relationship between financial stakeholders during bankruptcy
Session 13: Institutional Equity Investors in Practice
Engagement practices of institutional investors and proxy voting on ESG issues
Be able to interpret and explain tables of regression results of the papers!
Each column show results of a single regression, therefore top row is
dependent variable with different specifications.
4/5 main open questions on main topics with subquestions
Introduction to paper will be giving to interpret tables
Definitions will be asked
Interpret every table in papers before exam.
1
,Session 3: Valuation Monmouth Inc.
3.1 How can you calculate a company’s weighted cost of capital?
Weighted Average of Cost of Capital = specific combination of cost of debt and equity capital according to the company’s capital
structure.
WACC is:
Firm’s cost of capital = the promised expected return offered to equity and debt investors in exchange for the capital they
provide.
Discount rate = used to discount future cash flows of the company (DCF-valuation) to value the PV of the company.
Opportunity cost of capital = expected return on alternative investment with the same duration and risk
Required expected return = investors are value maximizers and requires the same return they could get on a alternative
investment with the same duration and risk. Lower return wouldn’t be accepted; a higher return would be outbid.
WACC is not:
Supply cost of capital = would not be the appropriate discount rate to compare with alternative investments.
1. WACC = D/V * kd * (1−t) + E/V * ke
D = Market value of debt
E = Market value of equity
V = D + E = Enterprise Value
Both require market value, not book value because we need the current cost and not the historical cost.
Kd = cost of debt = expected return on a traded fixed-rate straight bond of an equal credit quality and same term
Ke = cost of equity = expected return on equity investment
Ke and Kd both include the risk-free rate; Ke is generally higher than Kd because equity is riskier than debt.
T = corporate tax rate
Cost of debt has different ways to calculate it:
1. Risk-free rate + default spread (Debt rating approach):
Credit spread for the company’s credit rating over long-term risk-free rate. We can take the average rate on corporate bond
with the same credit rating.
2. Weighted average of yield to maturity for all the company’s debt
Cost of equity is calculated with CAPM. If the equity beta is not available (not publicly traded) we use equity beta from
comparable firms. Delever them, take the average and relever it with target capital ratio. There are 2 formulas to do this.
βu = E/V*βe and βu = βe /(1+(1−t)*D/E)
WACC is after tax because of interest shield of debt and future cash flows to be discounted are unlevered. WACC has to consider
possible future changes in capital structure. This can be done with unlevering the Beta and relever it with the predicted future
capital structure or target ratio. The term of the risk-free rate should be consistent with the term of the cash flows or asset.
3.2 What is the CAPM and how can it be used to calculate the company’s cost of equity?
How does a company’s cost of equity change when the company changes its leverage?
Capital Asset Pricing Model (CAPM) is a risk and return model which states that the expected return consists of the risk free rate
(time value) and the systematic risk Beta * equity market risk premium which is expected return of the market portfolio (index)
above the risk free rate. Beta is the only asset specific component. Only systematic risk is rewarded because the rest can be
diversified away.
E(r)=rf + βe * (E(rm)−rf ) = rf +β (EMRP)
The Security Market Line (SML) is the graphical representation of CAPM. E(r) = ke
A company’s cost of equity increases as the leverage increases, as the risk for the equity holders increases they require a higher
expected return, the risk premium increases because the equity beta increases. . Cost of debt goes up because as you increase
leverage, you increase risk and creditors demand higher default premium.
WACC should go down because as the percentage of your capital structure that is debt increases, the percentage of your capital
structure that is equity decreases. Since the cost of equity is greater than the cost of debt, even if both costs increase, you
lowering the percentage of equity will lower the highest cost of capital, therefore lowering the WACC. This happens until the
optimal degree of leverage is reached. After this point additional costs of financial distress exceed the benefits of additional tax
shield. And the WACC will start to rise!
2
, 3.3 How can you calculate free cash flows?
Free Cash Flow to Firm (FCFF) = cash available to firm (debt and equity holders) after necessary investments.
EBIT*(1-t) = EBIAT or NOPAT
+ adjustments for noncash charges (add noncash expenses subtract noncash revenue)
- changes in working capital (subtract increase i.e. cash outflow, add decrease i.e. cash inflow)
- Capital expenditures (investments in noncurrent assets)
= unlevered free cash flow (UFCF) or free cash flow to firm (FCFF)
3.4 How can you value a company with the WACC method?
Project the future unlevered FCFs.
WACC is used as discount rate to calculate the present value of future unlevered free cash flow. Terminal value = value of all
cash flows after forecasting period, calculated with perpetual growth method.
This PV is enterprise value. Subtract net debt to get equity value. Equity value divided by shares outstanding gives a share price.
Session 4: Corporate Governance and Financial Stakeholders
4.1 What are the main mechanisms of corporate governance?
Corporate governance = set of systems by which a corporation is directed and controlled. It tries to align the interests of all
stakeholders of the firm to mitigate conflicts of interest. It is also influenced by and impacts all stakeholders.
Governance gets particularly challenging with large corporations with dispersed shareholders, because the owners (providers of
capital) are not involved in the management and have to hire an agent. This inevitably results in agency costs (theory of agency
costs, 3 kinds). CG practices trade of between costs (conflict of interest, monitoring) and benefits (professional management) of
agents. Agency costs can never be completely eliminated because of asymmetric information (managers as insiders know things
owners do not).
CG varies over time, country, ownership structure, and firm size and type.
Primary reason of existence of CG: it tries to solve 2 essential types of conflict: Owner-Manager and Intra-Shareholder conflicts.
Some mechanisms solve both conflicts others solve one and make the other worse.
Solve both: independent auditors, disclosure requirements from laws
Worse: election of board of directors because controlling shareholders will gain more influence over the managers but at the
expense of noncontrolling shareholders
Importance and prevalence of two types of conflicts vary:
The relative importance of both conflicts depend on how dispersed a corporate ownership structure (country) is and passive
ownership by in institutional investors, e.g. index funds, mutual funds, pension funds and insurance companies.
Country: Common law vs Civil law countries.
Common: US/UK have ownership structures that are fully dispersed, no single shareholders has control
Civil: Europe, Asia, Latin America have ownership structures that are not fully dispersed, one or small number of controlling
shareholders
As a result, owner-manager more often in common law and intra-shareholder more often in civil law. There are exceptions, such
as Google, Facebook
Ownership structure: passive ownership by large institutional investors such as index funds, pension funds, mutual funds and
insurance companies
Growth of institutionals can mitigate owner-manager (more incentive to monitor and can assemble controlling interest,
however they are managed by managers themselves and can be quite passive ownership (no engagement).
Growth of institutional investors will not completely solve owner-manager conflict because they are managed by managers
themselves and are mostly passive owners, e.g. not voting. The growth of institutional investors initiates a change in CG.
Enron as example of CG failure, managers acting in their own best interest and shareholders not accurately informed by
managers through manipulation of financial statements.
(Sarbanes-Oxley Act (SOX) to protect investors and improve corporate governance. CEO and CFO have to sign off on financial
statements.)
3
Objective: Role that different financial stakeholders play in the governance of a company and different issues affecting the
relationship between managers, equity holders and debt holders.
1. CG as a solution to principle agency problems between the company’s managers and financial stakeholders.
2. Different types of financial stakeholders and their implications for the governance of the company
3. Relationship changes during bankruptcy
Session 3: Valuation
Measuring shareholder wealth
Session 4: Corporate Governance and Financial Stakeholders
Agency view of corporate governance. CG as solution to principle-agency problems between managers and
financial stakeholders
Session 5: Concentrated Debt Ownership by Banks in Project Finance
Banks as financial stakeholders (creditors) with concentrated debt ownership. PF a special type of
incorporation in which banks are the dominant financial stakeholders
Session 7: The Government as Financial Stakeholder & Privatization
Government as a financial stakeholder and privatization of state owned enterprises
Session 9: Engagement by Institutional Equity Investors
Institutional investors as equity holders and the Impact of their engagement
Session 10: Common Ownership by Institutional Equity Investors
Common ownership effects on firms and economy
Session 11: Stakeholder Dynamics during Bankruptcy
Changes in relationship between financial stakeholders during bankruptcy
Session 13: Institutional Equity Investors in Practice
Engagement practices of institutional investors and proxy voting on ESG issues
Be able to interpret and explain tables of regression results of the papers!
Each column show results of a single regression, therefore top row is
dependent variable with different specifications.
4/5 main open questions on main topics with subquestions
Introduction to paper will be giving to interpret tables
Definitions will be asked
Interpret every table in papers before exam.
1
,Session 3: Valuation Monmouth Inc.
3.1 How can you calculate a company’s weighted cost of capital?
Weighted Average of Cost of Capital = specific combination of cost of debt and equity capital according to the company’s capital
structure.
WACC is:
Firm’s cost of capital = the promised expected return offered to equity and debt investors in exchange for the capital they
provide.
Discount rate = used to discount future cash flows of the company (DCF-valuation) to value the PV of the company.
Opportunity cost of capital = expected return on alternative investment with the same duration and risk
Required expected return = investors are value maximizers and requires the same return they could get on a alternative
investment with the same duration and risk. Lower return wouldn’t be accepted; a higher return would be outbid.
WACC is not:
Supply cost of capital = would not be the appropriate discount rate to compare with alternative investments.
1. WACC = D/V * kd * (1−t) + E/V * ke
D = Market value of debt
E = Market value of equity
V = D + E = Enterprise Value
Both require market value, not book value because we need the current cost and not the historical cost.
Kd = cost of debt = expected return on a traded fixed-rate straight bond of an equal credit quality and same term
Ke = cost of equity = expected return on equity investment
Ke and Kd both include the risk-free rate; Ke is generally higher than Kd because equity is riskier than debt.
T = corporate tax rate
Cost of debt has different ways to calculate it:
1. Risk-free rate + default spread (Debt rating approach):
Credit spread for the company’s credit rating over long-term risk-free rate. We can take the average rate on corporate bond
with the same credit rating.
2. Weighted average of yield to maturity for all the company’s debt
Cost of equity is calculated with CAPM. If the equity beta is not available (not publicly traded) we use equity beta from
comparable firms. Delever them, take the average and relever it with target capital ratio. There are 2 formulas to do this.
βu = E/V*βe and βu = βe /(1+(1−t)*D/E)
WACC is after tax because of interest shield of debt and future cash flows to be discounted are unlevered. WACC has to consider
possible future changes in capital structure. This can be done with unlevering the Beta and relever it with the predicted future
capital structure or target ratio. The term of the risk-free rate should be consistent with the term of the cash flows or asset.
3.2 What is the CAPM and how can it be used to calculate the company’s cost of equity?
How does a company’s cost of equity change when the company changes its leverage?
Capital Asset Pricing Model (CAPM) is a risk and return model which states that the expected return consists of the risk free rate
(time value) and the systematic risk Beta * equity market risk premium which is expected return of the market portfolio (index)
above the risk free rate. Beta is the only asset specific component. Only systematic risk is rewarded because the rest can be
diversified away.
E(r)=rf + βe * (E(rm)−rf ) = rf +β (EMRP)
The Security Market Line (SML) is the graphical representation of CAPM. E(r) = ke
A company’s cost of equity increases as the leverage increases, as the risk for the equity holders increases they require a higher
expected return, the risk premium increases because the equity beta increases. . Cost of debt goes up because as you increase
leverage, you increase risk and creditors demand higher default premium.
WACC should go down because as the percentage of your capital structure that is debt increases, the percentage of your capital
structure that is equity decreases. Since the cost of equity is greater than the cost of debt, even if both costs increase, you
lowering the percentage of equity will lower the highest cost of capital, therefore lowering the WACC. This happens until the
optimal degree of leverage is reached. After this point additional costs of financial distress exceed the benefits of additional tax
shield. And the WACC will start to rise!
2
, 3.3 How can you calculate free cash flows?
Free Cash Flow to Firm (FCFF) = cash available to firm (debt and equity holders) after necessary investments.
EBIT*(1-t) = EBIAT or NOPAT
+ adjustments for noncash charges (add noncash expenses subtract noncash revenue)
- changes in working capital (subtract increase i.e. cash outflow, add decrease i.e. cash inflow)
- Capital expenditures (investments in noncurrent assets)
= unlevered free cash flow (UFCF) or free cash flow to firm (FCFF)
3.4 How can you value a company with the WACC method?
Project the future unlevered FCFs.
WACC is used as discount rate to calculate the present value of future unlevered free cash flow. Terminal value = value of all
cash flows after forecasting period, calculated with perpetual growth method.
This PV is enterprise value. Subtract net debt to get equity value. Equity value divided by shares outstanding gives a share price.
Session 4: Corporate Governance and Financial Stakeholders
4.1 What are the main mechanisms of corporate governance?
Corporate governance = set of systems by which a corporation is directed and controlled. It tries to align the interests of all
stakeholders of the firm to mitigate conflicts of interest. It is also influenced by and impacts all stakeholders.
Governance gets particularly challenging with large corporations with dispersed shareholders, because the owners (providers of
capital) are not involved in the management and have to hire an agent. This inevitably results in agency costs (theory of agency
costs, 3 kinds). CG practices trade of between costs (conflict of interest, monitoring) and benefits (professional management) of
agents. Agency costs can never be completely eliminated because of asymmetric information (managers as insiders know things
owners do not).
CG varies over time, country, ownership structure, and firm size and type.
Primary reason of existence of CG: it tries to solve 2 essential types of conflict: Owner-Manager and Intra-Shareholder conflicts.
Some mechanisms solve both conflicts others solve one and make the other worse.
Solve both: independent auditors, disclosure requirements from laws
Worse: election of board of directors because controlling shareholders will gain more influence over the managers but at the
expense of noncontrolling shareholders
Importance and prevalence of two types of conflicts vary:
The relative importance of both conflicts depend on how dispersed a corporate ownership structure (country) is and passive
ownership by in institutional investors, e.g. index funds, mutual funds, pension funds and insurance companies.
Country: Common law vs Civil law countries.
Common: US/UK have ownership structures that are fully dispersed, no single shareholders has control
Civil: Europe, Asia, Latin America have ownership structures that are not fully dispersed, one or small number of controlling
shareholders
As a result, owner-manager more often in common law and intra-shareholder more often in civil law. There are exceptions, such
as Google, Facebook
Ownership structure: passive ownership by large institutional investors such as index funds, pension funds, mutual funds and
insurance companies
Growth of institutionals can mitigate owner-manager (more incentive to monitor and can assemble controlling interest,
however they are managed by managers themselves and can be quite passive ownership (no engagement).
Growth of institutional investors will not completely solve owner-manager conflict because they are managed by managers
themselves and are mostly passive owners, e.g. not voting. The growth of institutional investors initiates a change in CG.
Enron as example of CG failure, managers acting in their own best interest and shareholders not accurately informed by
managers through manipulation of financial statements.
(Sarbanes-Oxley Act (SOX) to protect investors and improve corporate governance. CEO and CFO have to sign off on financial
statements.)
3
