CF-E5

FIN 6301, Corporate Finance 1

Course Learning Outcomes for Unit V Upon completion of this unit, students should be able to:

3. Apply the valuation principle. 3.1 Discuss key factors that affect a firm’s external financing requirements. 3.2 Describe the basic types of agency conflicts.

Course/Unit Learning Outcomes

Learning Activity

3.1

Unit Lesson Chapter 12, pp. 499-526 Chapter 13, pp. 537-555 Unit V Essay

3.2

Unit Lesson Chapter 12, pp. 499-526 Chapter 13, pp. 537-555 Unit V Essay

Required Unit Resources Chapter 12: Corporate Valuation and Financial Planning, pp. 499–526 Chapter 13: Corporate Governance, pp. 537–555

Unit Lesson

Corporate Governance Corporate governance pertains to the system of rules and practices that serve as the basis for the direction and control of a firm. The essential function of corporate governance is to balance the interests of the main stakeholders of a company. Governance provides a framework that enables leaders to attain the goals and objectives of a company, encompassing all aspects of management in terms of action plans, internal control, performance assessment, and corporate disclosure. Corporate governance plays an important role in the long-term success of a company, with the general recognition that a well-governed company is associated with better commercial success (The Institute of Chartered Accountants in England and Wales [ICAEW], n.d.). The board of directors of a company plays a pivotal role in corporate governance. These directors are either elected by shareholders or appointed by other board members, and they represent the shareholders of the company. The board is responsible for making important decisions such as the appointment of corporate officers, executive compensation, and policies for dividends. Extending their responsibilities beyond the financial realm, the board of directors can also sometimes be involved in social or environmental projects. The composition of boards is made up of both inside (i.e., major shareholders, founders, and executives) and independent members (i.e., those who do not have ties with the inside members but are considered experts in the field of management and direction in large companies). Independent members are considered an integral part of the board because they dilute the concentration of power and ensure that the interest of shareholders with the insiders are aligned.

UNIT V STUDY GUIDE

Corporate Valuation and Governance

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Good and Bad Governance Good corporate governance can positively affect the financial performance of corporations. Characteristics of good corporate governance include being transparent with rules and control, being environmentally aware and responsible, and practicing ethical behaviors and sound corporate governance practices. Good corporate governance has wider impact on other sectors because of the focus on being transparent and accountable with the corporate practices. On the other hand, bad corporate governance can negatively affect the financial performance of corporations by casting doubts on the reliability, integrity, and obligation to shareholders. Examples of bad corporate governance include tolerance for illegal or unethical activities, publishing of spurious or noncompliant financial results because of lack of cooperation with auditors, bad executive compensation packages, and poorly structured boards that make the ousting of ineffective incumbents difficult. The Sarbanes-Oxley Act was introduced in the United States in 2002 to combat fraudulent corporate activities in order to protect investors. Also called the Corporate Responsibility Act of 2002, the legislation was responsible for mandating stringent reforms that were intended to improve the financial disclosures of corporations in order to prevent accounting frauds. The reforms made through the act involved four sweeping areas:

1. corporate responsibility, 2. increased criminal punishment, 3. accounting regulation, and 4. new protections (Sarbanes-Oxley Act of 2002, 2018).

The passage of the Sarbanes-Oxley Act has shown positive effects in modern corporate governance, specifically in encouraging financial transparency that discourages fraudulent activities. In a study conducted by Gomulya and Boeker (2016), the researchers found that the enactment of the Sarbanes-Oxley Act altered the governance dynamics through the creation of greater expectations for sounder corporate governance. For instance, Gomulya and Boeker (2016) found that directors are more likely to reduce their support for chief executive officers (CEOs) after financial misconduct, leading to the replacement of that CEO. In another study conducted by Funchal and Monte-Mor (2016), the researchers found that the Sarbanes-Oxley Act led to economic gains based on access to the credit market, a significant increase in total debt, and a reduction of the cost of debt. Consider the following real-life example of Enron that precipitated the creation and the passage of the Sarbanes-Oxley Act in 2002 (Brigham & Ehrhardt, 2020). Founded in 1985, Enron had been regarded as one of the most innovative companies during that time. In 2000, the company began to crumble when CEO Jeffrey Skilling hid financial losses from their trading business and other operations using mark-to-market accounting wherein the value of security is measured based on current market value instead of actual book value. This mark-to-market strategy allowed Enron to hide losses and make the company appear to be more profitable than it really was. To address the mounting liabilities of the company, Chief Financial Officer (CFO) Andrew Fastow deliberately made the company appear to be financially sound even though they were already losing money. As evidenced by the decisions of the corporate leaders, they engaged in various fraudulent activities that eventually led to the fall of Enron.

Corporate Valuation: What Is the Worth of a Company? Corporate valuation answers the main question of how much a company is worth. In order to determine the value of a corporation, standard ratios, tools, and methods used by financial analysts are utilized to determine the worth of corporations. Knowledge regarding corporate valuation is particularly important when it comes to evaluating mergers, acquisition, market instability, and the level of a company’s financial stress. There are many reasons why engaging in corporate valuation would be beneficial for a company. Corporate valuation can be useful in knowing the true value of a company. It can also make a company appear more attractive to investors by giving them self-assurance that their money is in good hands, and it can be used as a metric for growth for the complete business operations of a company. Corporate valuation can lead to information about the company’s weaknesses, which is often necessary for growth. It can also be useful in getting ready for worst-case scenarios, especially during times of unexpected disasters. Finally, corporate

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valuation can be useful in preparing for the future. Knowledge about a company’s true value is necessary if one decides to sell it in the future. If corporate valuation has already been established, the selling process can be streamlined significantly.

Methods of Corporate Valuation The common method for corporate valuation is the asset-based method wherein the book value of a company’s equity is calculated by determining the value of the assets minus the debt. Equity is the most important factor to be calculated. Equity refers to the possessions of a company’s assets if it was to stop its operation. Other factors, such as cash and working capital, and intangible factors, such as brand name and reputation, are included in this method of corporate valuation. Intangible assets, such as goodwill or brand loyalty, are considered of value, but they cannot be measured quantitatively. Most accountants prefer the traditional balance sheet method when conducting corporate valuation, which is a quick way of determining if a company has more cash than its current market value. In order to perform a traditional balance sheet method, accountants examine the cash, equivalents, and short-term investments of a company. Then, the sum is divided by the outstanding shares in order to determine the available cash. Acquiring a company through cash allows for a quickly funded strategic transaction. The alternative method for corporate valuation is comparing the company’s current working capital with its market capitalization. Working capital refers to what remains when the current liabilities are subtracted from the company’s current assets. Working capital is the funds that can be easily accessed to conduct the day-to- day operations of a company. This knowledge is particularly important during trade and investment transactions. Shareholder’s equity is an accounting tool that determines the liquid assets of a company such as cash, property, and retained earnings. Shareholder’s equity measures the liquidation potential of a company if all tangible assets were sold. Shareholder’s equity can be useful for accountants in determining the value of a corporation by establishing the book value—the official value of the accounting ledger. Free cash flow is another method of valuing what a corporation is worth, which is one of the most common measurement tools used in the field for both public and private banking corporations. Cash flow pertains to all of the money passing through a company minus all of the fixed expenses during a specific course of time. Cash flow can be summarized as the earnings of a company before interest, taxes, amortization, and depreciation. The focus of cash flow is on the business operations and not profits or secondary costs. Consider the following example/scenario to demonstrate why corporate valuation is necessary in a merger. The companies HyperLoop and MacroLoop are going to merge as single company. Corporate valuation will be performed in order to determine how much each company is worth. This corporate valuation may be based on different methods of assessment such as the asset-based method (i.e., assets minus debt) or the comparison of the company’s current working capital with its market capitalization. The determination of which method to use in the corporate valuation of each company may depend on the leaders of each company. The economic valuation of a company is used to establish the fair market value of the organization. This can be especially beneficial during a merger, when establishing partnership ownership, or when dissolving or restricting the organization. Once valuation of each company has been made, the leaders of each company are more informed as to what the appropriate terms of the merger should be and can make well-informed strategic decisions.

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References Brigham, E. F., & Ehrhardt, M. C. (2020). Financial management: Theory and practice (16th ed.). Cengage

Learning. https://bookshelf.vitalsource.com/#/books/9781337909730 Funchal, B., & Monte-Mor, D. S. (2016, September). Corporate governance and credit access in Brazil: The

Sarbanes-Oxley Act as a natural experiment. Corporate Governance: An International Review, 24(5), 528–547. https://onlinelibrary.wiley.com/doi/abs/10.1111/corg.12151

Gomulya, D., & Boeker, W. (2016, September). Reassessing board member allegiance: CEO replacement

following financial misconduct. Strategic Management Journal, 37(9), 1898–1918. The Institute of Chartered Accountants in England and Wales. (n.d.). What is corporate governance?

https://www.icaew.com/technical/corporate-governance/overview/does-corporate-governance-matter Sarbanes-Oxley Act of 2002, 15 U.S.C. § 7201 (2018).

Key factors affecting a firm’s external financing requirement