The Rise of Corporate Governance

Over the last few years Corporate Governance became a very important consideration for any business around the world. After corporate scandals such as Enron and Worldcom in the USA and Independent Insurance Co in the UK, investors and governments demanded better corporate governance practices by the businesses.

Various measures were taken by governments to prevent further corporate scandals. For example, US introduced the Sarbanes-Oxley Act 2002, to comply with which placed a significant financial burden on businesses.

Ehlers and Lazenby define corporate governance in the narrow sense as the formal system of accountability of the board of directors to shareholders and in the broad sense as an informal and formal relationship between the corporate sector and its stakeholders and the impact of the corporate sector on society.

To succeed in contemporary environment, companies need to have reputation of having a strong corporate governance. Triple bottom line principle (“people, planet, profit” or “the three pillars”) became prominent. It refers to the principle according to which enterprises measured by and must report on it’s economic, social and environmental performances. This is in contrast with the past when only reporting on economic performances (single bottom line) were required.

Corporate governance is beneficial to the firm in many respects. What is most important is that it increases long-term performance on the enterprise-wide basis. Therefore, it increases shareholder’s wealth, which is the main objective of the business.

Proper corporate governance also benefits society and country as a whole. For example, if country’s businesses are known for maintaining proper corporate governance, foreign capital will flow into the country as foreign investors will be interested in investing in the country’s businesses.

Within the country, resources also will be used more efficiently due to good corporate governance. In such environment investors will be investing into companies with biggest potential to deliver value to customers and inefficient management will be replaced in underperforming businesses.

Further, society and communities will benefit in various ways. For example, enterprises with proper corporate governance comply with laws and regulations, such as requirements with respect to pollution. Overall, good corporate governance benefits all stakeholders of the enterprise and is a prerequisite for success of any business.

 

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Finding the Market Price Ratio of Exchange

When the acquiring company knows the ratio of exchange, it can be used to find the market price ratio of exchange. The market price rate of exchange is found as follows:

(MP of acquiring company * ratio of exchange)/ MP of the target company

Where: MP refers to the market price per share.

The market price ratio of exchange indicates how much of market price per share of the acquiring firm is exchanged for every $1.00 of the market price per share of the target company.

It is normal for the market price ratio of exchange to be above 1. This is an indication that the acquiring company pays a premium above the market price to acquire a target company.

Test yourself:

ABC (acquiring company) is acquiring BCD (target company) with the use of a stock swap transaction. ABC’s market price is $60 and BCD’s market price is $55. However, during merger negotiations, ABC agreed to a 1.5 ratio of exchange where it valued BCD’s shares at $90.

Find the market price per share in the ABC/BCD merger.

Solution:

(60*1.5)/55=1.6

This means that ABC gives $1.6 of its market price in exchange for every dollar of the BCD’s market price.

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Purchase versus Lease Decision

When deciding on whether to purchase or lease an asset, a firm should compare after-tax cash outflows associated with each option. The option with the lowest present value of after-tax cash outflows should be selected.

To make a decision between purchase and lease alternatives, we need to do the following:

  • Determine after-tax cash outflows for lease alternatives.
  • Determine after-tax cash outflows for purchase alternatives.
  • When completing steps 1 and 2,  the purchase option at the end of the lease should be incorporated into analysis in step 1 and sale of purchased asset at the end of the term (equivalent to the lease term) should be incorporated in analysis in step 2. This will ensure that we compare assets of equal lives.
  • Find the present value of the cash outflows under lease and purchase. The after-tax cost of debt should be used as a discount rate. One can use a financial calculator to find present value of the mixed stream of outflows or find the present value of the annuity.
  • Select an option with the lowest present value.

It is also important to remember that financial manager must always attempt to find options with the lowest cost of capital to ensure maximization of the owners’ wealth.

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Agency problem and agency costs

Agency costs refer to costs which arise due to an agency problem. Agency problem, which is also called principal–agent problem or agency dilemma, occurs when an agent acts on behalf of the principal. The problem arises because agents’ interests and priorities may be different from that of the principal.

Agency costs are costs that a principal incurs to decrease or eliminate the agency problem by providing agent with incentive to act in the best interests of the principal as well as by monitoring the agent’s actions to ensure the agent is acting honestly and in the best interests of the principal.

In the context of an organization

In the context of an organization, agency costs refer to the costs of eliminating or decreasing the agency problem which arises due to management (agent) acting on behalf of shareholders (principal).

Agency problem, in the context of an organization, refers to the tendency of management to pursue its own needs as a first priority, which may be at the expense of the needs of the shareholders.

Agency costs include costs which arise due to maintenance of corporate governance structure of the organization. The goal is to give the management incentive to treat the needs of shareholders as a priority as well as ensuring honest dealings of management and monitoring management’s performance.

A typical example of agency costs occurs when rewards of management are tied to shareholders’ wealth maximization or performance of the company.

As an example, to tie rewards of management to the shareholders’ wealth maximization management may be given portion of shares of the company. Therefore, management becomes shareholders as well and their needs and interests become more aligned with other shareholders.

Alternatively, management is given stock options which will allow purchasing stock at the market price set at the time when stock options are granted at some point in the future. This gives management an incentive to be interested in shareholders’ wealth maximization since management will be able to benefit from it personally by buying appreciated shares at some point in the future at the price set at the time stock options were granted (at the lower price).

To tie rewards of management to the performance of the company, management may be evaluated based on their ability to achieve certain measures such as EPS. Performance shares or cash bonus may be given to reward management for meeting specific performance measures.

The other ways which help to decrease the agency problem in organisations is the pressure that shareholders place on the management and negative implications which will materialize if management cannot meet shareholders’ expectations.

Another factor that helps to decrease the agency problem in organisations is the threat of takeover by an individual, group or company which believes that company could be managed better. It serves as impetus for management to work harder in meeting shareholders’ needs.

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Stock splits and reverse stock splits

Organizations undertake stock splits when it is perceived within the firm that shares of the company are traded at a too high price and this may slow down trading activity. If a stock split is undertaken, the market value of shares can slightly increase. Such increase tends to be maintained as long as dividends after the split also increase.

If a firm undertakes a 2 for 1 split than 2 new shares will be given in exchange for every 1 old share. The stock split does not affect the organizational capital structure.

Organizations can also do reverse stock splits when firm wants to increase the share price. Increase in share price may help to enhance trading of a shares activity. This occurs because unsophisticated investors tend to equate low priced stocks to low quality investments.

If firm undertakes a 1 for 2 split, one new share will be exchanged for 2 old shares.

Establishing a dividend policy

Dividend policy refers to the policy which is used as a guide when a firm makes dividend decisions. It assists the board of directors in establishing how much should be paid to shareholders in dividends.

Dividend policy should be established in such a way that it provides for adequate financing for the firm. Dividend policy must also be aligned with the main objective of the firm which is to maximize shareholders’ wealth.

Investors tend to prefer stable increasing dividends as opposed to fluctuating dividends.

Factors which affect dividend policy

There are number of external and internal factors which affect dividend policy.

External factors which affect dividend policy

Contractual constraints – refer to restrictive provisions in a loan agreement and may include dollar or percentage of earnings limit on dividends and an inability to make dividend payments until certain levels of earnings is reached.

Legal constraints – this type of constraints depends on the location of the firm. Usually, due to legal constraints, firms are not able to pay out any dividends if the firm has any overdue liabilities or if it is bankrupt.

Firm also cannot pay any part of par value of common stock. Sometimes, in addition to the inability to pay any part of par value of common stock, firm also may not pay any part of paid-in capital in excess of par.

Market reactions – a firm needs to consider how markets will react to its dividend decisions. For example, if dividends are not paid or decreasing then markets will see it as a negative signal and the stock price will likely to drop. This will decrease shareholders’ wealth. If dividends are paid out consistently or even increasing in amounts, this can be seen as a positive signal by the market participants and stock price will likely to increase. This will increase shareholders’ wealth.

Shareholders generally prefer fixed or increasing dividends. This decreases uncertainty and investors are likely to use lower rate at which earnings will be discounted. This will lead to an appreciation of share and an increase in shareholders’ wealth.

Current and expected state of the economy – If state of the economy is uncertain or heading downward than it may be wise for management to pay smaller or no dividends to prepare a safety reserve for the company which can help to deal with future negative economic conditions.

However, if the economy is growing very fast then the firm may have more acceptable investments to take advantage of. It can be best not to distribute dividends but rather use these funds for investments.

Changes in government policies and state of the industry must also be taken into account.

Internal factors which affect dividend policy

Financing needs of the firm – Mature firms usually have better access to external financing. Therefore, they are more likely to pay out a large portion of earnings in dividends. If a company is young and rapidly growing than it will likely be unable to pay a large portion of earnings in dividends as it will require retained earnings to finance acceptable projects and its access to external financing is likely to be limited.

Preference of the shareholders – a firm should consider the needs and interests of the majority of its shareholders when making dividend decisions. For example, if shareholders will be able to earn higher returns by investing individually then what firm can earn by reinvesting funds than a higher dividend payment should be considered.

If the firm will have to issue more stock to be able to pay out dividends than it may be in the best interest of the current stakeholders not to issue dividends to avoid potential dilution of ownership. Dilution of ownership occurs because after issuing of additional stock, retained earnings will have to be distributed over a larger amount of the shareholders. This leads to dilution of earnings for existing shareholders. This also leads to dilution of control.

Firms also need to consider the wealth level of the majority of its shareholders. If the majority of shareholders are lower income earners than they likely will need dividend income and will prefer payment of dividends. However, if the majority of shareholders are high income earners then they will likely to prefer appreciation of share as it will defer tax payment even if the tax applicable on dividends and capital gains is the same, as in US after 2003 Tax Act.

Interestingly, in an efficient market, preferences of the shareholders should be met by price mechanism. If dividend payments are lower than required by many investors than those investors will sell their shares. Share prices will drop and this will raise an investors’ expected return. Higher expected return will increase the weighted marginal cost of capital and intersection between IOS and WMCC schedules will occur at a lower optimal capital budget point. Due to higher WMCC, fewer of the projects will be acceptable and more of the retained earnings can be paid out as dividends. Therefore the owners’ preferences are satisfied by price mechanism.

Stability of earnings – If earnings of the company are not stable from period to period than it is wise to follow conservative payments of dividends.

Earnings requirement – this constraint is imposed by the firm. It consists of a firm not being able to pay out in dividends more than the sum of the current and the most recent past retained earnings. However, the firm still can pay out dividends even if it incurred losses in the current financial period.

One of the reasons firms may want to pay dividends in years when the firm incurred a loss is to send positive signal to the market indicating that the loss is only a temporary phenomenon and that the company has its operations under control. Otherwise, shareholders may start selling shares which will decrease price of the shares and even further decrease wealth of the owners of the company (shareholders).

Lack of adequate cash and cash equivalents – occurs when firm do not have adequate cash and cash equivalents, such as marketable securities, to make dividend payments. Borrowing with intention to use funds to pay out dividends is usually not welcomed by lenders because the use of funds is not aligned with activity that would help firm to pay back debt to the lender. Borrowing to pay dividends is also usually not a wise business decision.

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Factors favouring higher and lower dividends

Higher dividends

There are factors that make higher dividends beneficial. For example, higher dividends tend to decrease an agency’s costs. This occurs because the more dividends management needs to pay out, the more external financing the firm will require. External financing increases the scrutiny that management actions have to undergo and, therefore, decreases the agency problem and agency costs.

It is also suggested that for investors to sell current stock to obtain income equivalent to dividends is not the same psychologically as receiving dividends. It is harder psychologically to sell stock to obtain income than to use dividends to obtain income. Therefore, it is argued, that these two actions cannot be viewed as substitutes, as proposed by the dividend irrelevance theory. The above point suggests that shareholders who need income that comes from dividends are psychologically more comfortable with receiving dividends than with selling part of their shares.

Another argument for the benefits of higher dividends refers to the fact that $1 of dividends received now cannot be seen as equivalent to $1 of future dividends or stock appreciation to be received at some point in the future.

Investors will prefer $1 to be received now to $1 to be received in the future. The only way they will be indifferent is if the amount to be received in the future will be adjusted to account for the time value of money.

Time value of money refers to the fact that investors will prefer $1 today to $1 tomorrow. For example, if an investor can receive $100 today or a certain amount 1 year from now, the only way the investor will be indifferent is if the amount 1 year from now is larger by an equivalent to investor’s required return.

In other words, future dividends or share appreciation must bring benefit of $1 plus additional return based on the required return of the investor. Only in such case investor will be indifferent. If investor’s required return is 9% per year than the investor will be indifferent if $100 is received today or $109 received in 1 year from now.

Lower dividends

Transactions costs often make lower dividends more beneficial for stockholders and for the firm. It is more beneficial for a stock holder to have lower dividends if an investor intends to reinvest dividends in stock. This occurs because there are transactions costs that investor have to incur to buy stock such as brokerage fees.

The firm will benefit from paying lower dividends in the case where external financing is required. This is because external financing results in costs such as flotation costs. If firm just uses retained earnings available instead of paying out dividends then the costs of external financing will be avoided or decreased.

Tax that investors have to pay on capital gains is generally lower than tax that they have to pay on dividends (this, however, may differ depending on location of investors and is no longer applicable to US investors as a result of the 2003 Tax Act).

Moreover, tax on capital gains must only be paid in the future, when the gain will be realized. The tax on dividends must be paid when payment of dividends occurs. Therefore, from this perspective, it is generally more beneficial to reinvest earnings compared to paying it out as dividends to the shareholders.

Also, if investors want to reinvest dividends by buying more stock, investors still lose money by paying taxes on dividends. Therefore, an argument made by dividend irrelevance theory suggesting that investors can reinvest dividends by buying more stock and therefore obtaining the same result as by funds being reinvested is irrelevant as soon as assumptions of a perfect world (which includes the assumption that there are no taxes) is no longer hold.

 

Residual theory of dividends

Residual theory of dividends purports that dividends must only be distributed after firm undertakes all acceptable investments. To determine whether any retained earnings are left to be distributed to shareholders, the three steps described below are undertaken.

Step 1 – The optimal level of capital expenditures is determined by finding the intersection between the investment opportunities schedule and the weighted marginal cost of capital schedule.

Step 2 – Taking into account the optimal capital structure proportions, the amount of financing that must come from equity is determined.

Step 3 – Retained earnings are used to cover necessary expenditures in proportion to a company’s capital structure equity percentage. If retained earnings do not cover the portion that must come from equity then new stock is issued.

The dividends are only distributed if retained earnings were enough to cover the equity portion of the investment (the second portion of investment is covered by debt) and only if there are any funds left in the retained earnings after investment expenditure is covered.

The residual theory of dividends also implies that if companies do not have investments with internal rate of returns (IRR) higher than weighted marginal cost of capital (WMCC) or Net present value (NPV) higher than zero than all retained earnings should be distributed as dividends.

Test yourself:

ABC Company has a capital structure of 35% of debt and 65% of equity. ABC’s retained earnings in this financial period are $2,000,000. The new investment required, which were determined by the intersection of IOS and WMCC, is $2,400,000. Determine if ABC will be able to distribute any dividends.

Solution:

The funds required to cover new investment is $2,400,000. The amount that must come from equity is $2,400,000*.65=$1,560,000. The rest of the amount, which is $840,000 (2,400,000-1,560,000) will come from debt. The ABC Company has $2,000,000 of retained earnings. Since only $1,560,000 is required to cover portion of funds that must come from equity, $440,000 (=$2,000,000-$1,560,000) is left in the retained earnings and can be distributed to shareholders as dividends.

Test yourself:

BCD Company has a capital structure of 35% of debt and 65% of equity. BCD’s retained earnings in this financial period are $1,000,000. The new investment required, which were determined by the intersection of IOS and WMCC, is $2,400,000. Determine if BCD Company will be able to distribute any dividends in this financial period.

Solution:

The funds required to cover new investment is $2,400,000. The amount that must come from equity is $2,400,000*.65=$1,560,000. The rest of the amount, which is $840,000 (2,400,000-1,560,000), will come from debt. The firm has $1,000,000 in retained earnings. The additional common stock needs to be issued to the amount of $560,000 to obtain enough funds that must come from equity. Since retained earnings were completely used to cover the expenditures associated with investment, there can be no dividends that BCD Company can distribute to shareholders during this financial period.

From the above two examples it is evident how under the residual theory of dividends, dividends are only distributed if there is any money left in the retained earnings after all acceptable investments are undertaken.

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Weighted Marginal Cost of Capital (WMCC) and Investment Opportunities Schedule

By finding all break points, we can construct the weighted marginal cost of capital – WMCC – schedule. (WMCC) schedules show the relationship between the level of total new financing and a company’s weighted average cost of capital.

Thereafter, we can construct the investment opportunities schedule (IOS), which is a graph where the business’s investment opportunities are ranked based on their returns and financing required, arranged from the highest returns and all the way to the lowest returns. It is the decreasing function of the level of total financing.

If we combine the weighted marginal cost of capital (WMCC) schedule and investment opportunities schedule (IOS), we can use it to make investment decisions. The rule is to invest in projects up to the point on the graph where marginal return from investment equals its WMCC (where IOS=WMCC).

All projects on the left of the point where IOS=WMCC will maximize shareholders wealth and all points on the right of the point where IOS=WMCC will decrease shareholders’ wealth.

It is important to note that the majority of firms stop investing before the marginal return from investment equals its weighted marginal cost of capital (WMCC). Therefore, the majority of businesses prefer a capital rationing position (the position below the optimal investment budget, which is also called the optimal capital budget).

Test yourself


ABC Company has to make an investment of $1,000,000. The long-term debt weight in the capital structure is 35%. ABC has $700,000 of retained earnings but 50% of it must be paid to common stock shareholders in the form of dividends. Preferred stock is currently not used as a source of finance by ABC.

What are the weights that ABC will have for each source of capital?

SOLUTION:

Firstly, we need to find out how much of retained earnings ABC has left after payment of dividends to shareholders: $700,000*0.5=$350,000.

Therefore, the weight of retained earnings is 35% ($350,000 out of $1,000,000).

$1,000,000-$350,000 (35%, funds available from long-term debt source) – $350,000 (35%, funds available from retained earnings) = $300,000 (30%)

Therefore, the weights are as follows:

Long-term debt – 40%

Retained earnings – 35%

Common stock – 30%

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Using CAPM (Capital Asset Pricing Model)

In addition to Gordon Model, another way to find the cost of common stock is by using Capital Asset Pricing Model (CAPM). CAPM allows us to ascertain the relationship between required return and non-diversifiable risk, which is measured by the beta coefficient (b).

Beta coefficient (b) refers to the index that measures non-diversifiable risk (risk which a company cannot eliminate through diversification). It indicates how an asset’s return will react to the changes in the market return, which in turn shows the return on a portfolio of all securities in the market.

Capital Asset Pricing Model (CAPM) is simple, as long as you know the formula and have the information necessary for the formula. The formula is as follows:

rs= Rf+(b*(rm-Rf))

Where:

rs – required return (return on a portfolio or a security)

Rf – risk free rate (e.g. rate on the U.S. Treasury bill)

b – beta coefficient

rm – market return

EXAMPLE:

If Rf (risk free rate) is 5%, beta is 2 and market return (rm) is 12%, the rs (required return or cost of common stock) can be found as follows:

Rs=5%+(2*(12%-5%)

Rs=19%

Test yourself

Assuming we know that beta (company’s market risk coefficient) is 2, market return is 13%, risk free rate of return is 7%, current dividend is $4 and dividend growth over the past 5 years is 5% and the same growth is expected in the future. With CAPM, find the price of the ordinary share.

SOLUTION:

First, using CAPM, we find rs:

rs= Rf+(b*(rm-Rf))

rs=7+(2*(13-7))

rs=19%

Next, we use the Gordon model (P0=D1/(rs-g)) to find the price of the ordinary share:

Po=(4*(1+.05))/(.19-.05)

Po=4.2/0.14

Po=$30

Test yourself:

ABC’s financial manager prepared the following information. The dividend which were paid in the current year was $5. The growth of dividends over the last 5 years were 7% and the same growth of dividends is expected to be in the future. Risk free rate is 8%, market rate is 14% and beta coefficient is 2.

Required: What is the market price of ABC’s ordinary shares?

Solution:

Firstly we need to find required return (rs) with the help of the capital asset pricing model (CAPM).

rs= Rf+(b*(rm-Rf))

rs=8+(2*(14-8))

rs=20

Next, we need to use Gordon model:

Po=D1/(rs-g)

Po=5*(1+0.07)/(0.20-0.07)

Po=5.35/0.13

Po=41.15

The price of the ABC’s ordinary share is $41.15. Note that we determined D1 (dividend within the next period) by taking known D0 (last dividend) and multiplying it by (1+ growth rate).

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