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Concepts
Corporate Governance

Description
Corporate Governance and ESG - Introduction
Definition:
- System of internal controls and procedures by which individual companies are managed
- Provide a framework that defines the rights, roles and responsibilities of various group within an organisation
- Is an arrangement of checks, balannces and incentives a company needs, to minimise and manage conflicts of interests between insiders and external shareholders
Shareholder theory:
Primary focus on the interests of shareholders - maximise market value of firm's common equity
Corporate governance focuses on managers - owners conflict
Stakeholder theory:
Consider conflict among groups that have interest in the firm's activities and performance (shareholders, employees, suppliers, customers)

Stakeholder groups and interests Sharehoders

1
...
BOD
Responsibility:
- protect the interest of shareholders
- Hire, fire and set the compensation of firm's senior managers
- Set strategic direction of the firm
- Monitor the financial performance and other aspect of the firm's ongoing activities

Stakeholder groups and interests Senior managers

3
...
Employees
Interest:
- pay rate, opportunities for career advancement, training and working conditions
- Sustainability and success of the firm

Stakeholder groups and interests Creditors

5
...
Directors

Shareholders = Principal ; Director = agent
Reasons for conflict:
- Risk of directors (more dependent on firm performance) ≠ Risk of shareholders (hold a diersified portfolio)
- Directors favor self-iinterest at the expense of shareholders
- Directors favor a group of shareholders at the expense of another
- Information asymmertry: Directors have more and better information about the functioning of the firm and its trategic direction than shareholders

Conflict of interest: Group of
shareholders

A single shareholder / group of shareholders might hold a majority of votes and act against the interest of the minority shareholders
...
g
...

shareholders

- Shareholders prefer more business risk than creditors, since creditors have limited upside from good results compared to shareholders
- Shareholders could act against the interest of creditors by issuing new debt / paying greater dividend →↑ default risk faced by creditors

Conflict of interest: Shareholders
vs
...
Legal infrastructure: Identify relevant laws and legal recourse of stakeholders whien their rights are violated
2
...
Organisational infrastructure: Company's corporate governance procedures, including internal systems and practices that address how to manage stakeholders relationships
4
...
g
...
)

Board structure

One-tier board: Single BOD, with both internal directors (EDs) and external directors (NEDs)
Two-tier board: Includes supervisory board (NEDs only) and management board (EDs only)
...
Audit committee
- Oversight of the FR function and implementation of accounting policies
- Effectiveness of the company's IS and internal audit function
- Recommending external auditor and its compensation
- Proposing remedies based on their review of internal and external audits
2
...
Nomination committee
- Proposed candidates for board election
- Manage the search process
- Align board composition with corporate governance policies
4
...
Risk committee
- Inform appropriate risk policy and risk tolerance of the organisation
- oversee risk management process of the organisation
6
...
Communication and engagement with shareholders to support management in the negative events
2
...
Threat of hostile takeover (management pursue policies more in allignment with the interest of shareholders) and existence of anti-hostile takeover provisions (↑issues of corporate
governance and conflicts of interest)
4
...
Proxy fight a group of shareholders may seek proxies to vote in favor of their proposals and policies

Risks of poor corporate governance Risks of porr corporate governance
Benefits of effective corporate governance
/ Benefits of effective corporate
- Some stakeholders could gain advantage, at the costs of others (e
...
: accounting fraud, poor - Align managers' interest with shareholders' interest → ↑ opera onal efficiency
governance
recordkeeping)
- Avoid legal and regulatory risks
- Manager may choose lowe-than-optima risk →lower company's value
- Better operating results
- Managers might have incentive that causes them to pursue their own interest, rather than - ↓ risk of debt default and bankruptcy → ↓ cost of debt financing
the company's benefit
- Better performance, ↑ company value
- Legal risks: stakeholders lawsuits
- Reputation risks: failure to comply with Government's regulations
- Failure to manage creditors' rights →debt default and bankruptcy
Factors relevant to analysis of
1
...
Composition of board
Consideratons on whether directors:
- are ED, NED or independent directors
- involve in RPTs with the company
- have diversified of expertise that suits the company's strategy and challenges
- have served for too long and may become too close to the company's management
3
...
Composition of shareholders
Affiliate company holds a significant portion of shares → able to dictate company's policy and direc on, hinder change by protec ng from poten al hos le takeovers and ac vist shareholders
5
...
Management of LT risks
Failure to manage stakeholder issues / Failure to manage other LT risks to company's sustainability → bad consequences for shareholders

Environmental and social
considerations in investment
analysis

ESG integration / ESG investing: making investment decisions with the use of environmental, social and governance factors
Considered issues: harm to the environment, risk of loss due to environment accidents, changing in demographics of workforce changing in work preference

ESG integration method

1
...
g
...
Positive screening: identify companies with best practices across environmental sustainability, employee right and safety, and overall governance practices
3
...
Thematic investing: investing based on single goal (e
...
: development of alternative energy sources; clean water resoruces)

Concepts

Description

Capital budgeting process

Capital budgeting
Definition: process of identifying and evaluating capital projects, with CF over more than 1 year
4 steps:
Step 1 - Generate investment ideas
Step 2 - Analyse project ideas : Accept / Reject project based on expected future CF
Step 3 - Create firm-wide capitak budgeting : Prioritise projects according to the timing of project's CF, available resource and overall strategic plan
Step 4 - Monitor decisions and conduct post-audit ; compare actual result with projected result, identify systematic errors in the forecasting process and improve company operations

Categories of capital budgeting
projects

1
...
Replacement projects for cost reduction : whether obsolete equipment but still in use should be replaced - Fairly detailed analysis is required
3
...
New product / market development - Detailed analysis is required, due to large amount of uncertainty involved
5
...
Other projects

Basic principles of capital budgeting 1
...

- Relevant CF in consideration is incremental CF (change in CF if the project is undertaken)
- Sunk cost should not be included in the analysis
- Take into account externalities (effect of the project on other firms / exisitng product lines)
2
...
Timing of the CF
4
...
Financial costs are reflected in the project's requirement rate of return
Independent vs
...
Capital
rationing

Unlimited fund: could undertake all projetes with expected return > COC
Capital rationing: prioritise expenditure with goal of achieving the maximum increase in shareholders' wealth, given its available capital

Net present value (NPV)

𝑃𝑟𝑒𝑠𝑒𝑛𝑡 𝑣𝑎𝑙𝑢𝑒 = 𝐹𝑢𝑡𝑢𝑟𝑒 𝑣𝑎𝑙𝑢𝑒 × (1 + 𝑟)
𝑃𝑟𝑒𝑠𝑒𝑛𝑡 𝑣𝑎𝑙𝑢𝑒 = 𝑃 ×

1 − (1 + 𝑟)
𝑟

In which:
P = Periodic payment
r = rate per period
n = number of periods
Internal rate of return (IRR)

Definition: the rate at which PV of cash inflow = PV of cash outflow
IRR > Required rate of return → Accept
IRR < Required rate of return → Reject

Payback period

Number of years it takes to recover the initial cost of investment
Benefits:
- Good measure for project liquidity
Drawback:
- Does not take into account time value of money
- Does not take into account CF beyond payback period (salvage value, terminal value)
- Does not measure profitability

Discounted payback period

Use PV of CF to calculate number of years it takes to recover the initial cost of investment
Benefits:
- Good measure for project liquidity
Drawback:
- Does not take into account CF beyond payback period (salvage value, terminal value)
- Does not measure profitability

Profitability index

𝑃𝑟𝑜𝑓𝑖𝑡𝑎𝑏𝑖𝑙𝑖𝑡𝑦 𝑖𝑛𝑑𝑒𝑥 𝑃𝐼 =
PI > 1 → accept
PI < 1 → reject

𝑃𝑉 𝑜𝑓 𝑓𝑢𝑡𝑢𝑟𝑒 𝐶𝐹
𝑁𝑃𝑉
= 1+
𝐶𝑎𝑠ℎ 𝑜𝑢𝑡𝑓𝑙𝑜𝑤 𝑎𝑡 𝑦𝑒𝑎𝑟 0
𝐶𝐹

NPV profile

Definition: a graph that shows a project's NPV at different discount rate
Crossover rate: rate at which NPV of 2 projects intersect (due to difference in timing of CF)

Advantages / Disadvantages of NPV Advantages of NPV: Direct measure expected increase in firm's value
and IRR
Disadvantages of NPV: does not include any consideraton of the size of the project
Advantages of IRR: measure profitability as % → provide informa on on the margin of safety (how much the profitability could fall before the project becomes uneconomic)
Disadvantages of IRR: (1) Possibilty of conflict with NPV; and (2) possibility of multiple IRR / No IRR
Conflict project ranking between IRR and NPV (Project A's NPV is higher, while project B's IRR is higher)
Reason:
- due to difference in CF timing
- due to difference in project size
Multiple IRR / No IRR: Due to unconventional CF ( -, +, +, +, -, + )

Relations between NPV and value
of share price

Positive NPV project → propor onate increase in company's stock price

Concepts

Description
Cost of Capital

Calculating a company's Weighted
Cost of capital

How Marginal cost of capital and
investment opportunity schedule
are used t determined optimal
capital budget

Applying marginal COC
indetermining project's NPV
Calculating cost of debt (Kd)

Calculate cost of preferred stock
(Kps)

𝑊𝐴𝐶𝐶 = 𝑤 × 𝑘 × 1 − 𝑡 + 𝑤 × 𝑘
+ 𝑤 × 𝑘
In which:
𝑤 = % 𝑜𝑓 𝑑𝑒𝑏𝑡 𝑖𝑛 𝑡ℎ𝑒 𝑐𝑎𝑝𝑖𝑡𝑎𝑙 𝑠𝑡𝑟𝑢𝑐𝑡𝑢𝑟𝑒
𝑘 = 𝑐𝑜𝑠𝑡 𝑜𝑓 𝑖𝑠𝑠𝑢𝑖𝑛𝑔 𝑛𝑒𝑤 𝑑𝑒𝑏𝑡
𝑤 = % 𝑜𝑓 𝑝𝑟𝑒𝑓𝑒𝑟𝑟𝑒𝑑 𝑠ℎ𝑎𝑟𝑒𝑠 𝑖𝑛 𝑡ℎ𝑒 𝑐𝑎𝑝𝑖𝑡𝑎𝑙 𝑠𝑡𝑟𝑢𝑐𝑡𝑢𝑟𝑒
𝑘 = 𝑐𝑜𝑠𝑡 𝑜𝑓 𝑝𝑟𝑒𝑓𝑒𝑟𝑟𝑒𝑑 𝑠ℎ𝑎𝑟𝑒𝑠
𝑤 = % 𝑜𝑓 𝑐𝑜𝑚𝑚𝑜𝑛 𝑒𝑞𝑢𝑖𝑡𝑦 𝑖𝑛 𝑡ℎ𝑒 𝑐𝑎𝑝𝑖𝑡𝑎𝑙 𝑠𝑡𝑟𝑢𝑐𝑡𝑢𝑟𝑒
𝑘 = 𝑐𝑜𝑠𝑡 𝑜𝑓 𝑐𝑜𝑚𝑚𝑜𝑛 𝑒𝑞𝑢𝑖𝑡𝑦
𝑡 = 𝑡𝑎𝑥 𝑟𝑎𝑡𝑒
Firm's debt structure (% of debt, preferred shares and common equity) should be based on target capital structure
If no target capital strucuture → use current capital structure / industry average capital structure
↑ capital raised → ↑ cost of raising addi onal capital → upward sloping marginal cost of capital curve
Downward sloping investment opprtunity schedule
Marginal cost of capital curve intersects investment opportunity schedule curve → op mal capital budget
Firm should undertake all projects with IRR (Investment Opportunity schedule) > cost of fund (Marginal cost of capital)
Marginal COC (WACC for additional fund) should be used in determining project's NPV
Project's risk level might be different from firm's risk level → Discount rate should be adjusted upward for higher-risk projects, and downward for lower-risk projects
- Yield to marturity approach: assume before-tax cost of debt is the market interest rate (YTM) on new debt (not the coupon rate on exsiting debt)
- Debt rating approach (if YTM is not available): based on market yield for debt with same rating and same maturity as the firm's exisiting debt

𝐷
𝑃
In which:
𝐷 = 𝑝𝑟𝑒𝑓𝑒𝑟𝑟𝑒𝑑 𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑𝑠
𝑃 = 𝑚𝑎𝑟𝑘𝑒𝑡 𝑝𝑟𝑖𝑐𝑒 𝑜𝑓 𝑝𝑟𝑒𝑓𝑒𝑟𝑟𝑒𝑑 𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑𝑠
𝑘

=

Calculating cost of common equity 1
...
Dividend discount model approach: Dividends are expected to grow at constant rate

𝐷
𝐷
→ 𝑘 =𝑔+
𝑘 −𝑔
𝑃
In which:
𝐷 = 𝑛𝑒𝑥𝑡 𝑦𝑒𝑎𝑟 𝑠 𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑
𝑔 = 𝑔𝑟𝑜𝑤𝑡ℎ 𝑟𝑎𝑡𝑒
𝑃 =

Where:
𝑔 = 𝑟𝑒𝑡𝑒𝑛𝑡𝑖𝑜𝑛 𝑟𝑎𝑡𝑒 × 𝑅𝑂𝐸 = 1 − 𝑝𝑎𝑦𝑜𝑢𝑡 𝑟𝑎𝑡𝑖𝑜 × 𝑅𝑂𝐸
3
...
3 types if cash dividends:
- Regular dividends: pay out a proportion of profits on consistent schedule
...
This is the first date that a share trades without ("ex") the dividend
...
(2 days after Ex-dividend date)
Payment date: when payment is electronically transferred to shareholder accounts

Share repurchase method

Share repurchase: buy back shares of its own common stock
...
Buy in the open market: repurchase in the open market at the prevailing market price → give flexibility to choose the ming of the transac on
2
...
Repurchase by direct negotiation: negotiate directly with a large shareholder to by back a block of shares, @ price > current market price, to:
- keep a large block of shares from coming into the market and reducing stock price
- repurchase from a potential acquirer after an unsuccessful takeover attempt

Effect of share repurchase on EPS
when financed by cash / debt

Repurchase by cash → ↓ interest income and earnings
Repurchase by debt
After tax cost of debt < share yield → ↑ EPS
After tax cost of debt > share yield → ↓ EPS
After tax cost of debt = share yield → no effect on EPS

Effect of share repurchase on Book Repurchase price < current BVPS → ↑ BVPS
value per share (BVPS)
Repurchase price > current BVPS → ↓ BVPS
Repurchase price = current BVPS→ no effect on BVPS
Effect of cash dividends and share Same amount of cash dividends and share repurchase have same impact on shareholders' wealth
repurchase on shareholders' wealth

Concepts
Primary / Secondary source of
liquidity

Description
Working Capital Management
Primary source of liquidity: Source of cash used in normal operation, including:
- Cash balance from selling goods / services ; collecting receivables ; generating cash from other sources (ST investments)
- ST funding : trade credit from vendors ; line of credit from banks
- Effective CF management of collection and payment
Secondary source of liquidity: from liquidating ST or LT assets; negotiating debt agreement; filing for bankcruptcy; and reorganisng the company
**Secondary source of liquidity changes the financial structure and operation of firm significanty, and might indicate problem in financial position

Factors that affect Liquidation
position

Drags on liquidity: delay or reduce cash inflows, or increase borrowing costs (e
...
: uncollected receivables and bad debts, obsolete inventory)
Pulls

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