CG & Valuation

Question 1

How should CG influence Valuation?

Answer 1

− Better corporate governance should be associated with lower agency costs, i.e., fewer investment distortions,
less perk consumption and shirking etc.
− As a consequence, one can expect less capital and free cash flow are diverted by self-serving managers, i.e.,
FCF to equity should be higher
− Due to disclosure requirements etc., investors should realize this and, hence, be willing to pay more for well-governed companies leading to higher asset prices
− Numerator in the Tobin’s q formula should react to news about corporate governance (while the denominator
should remain unchanged) leading to changes in Q
→ Well-governed firms should be associated with higher values of Tobin’s Q

Question 2

What are many studies only able to show?

Answer 2

correlations between variables (e.g., y = firm value and x = governance
quality)

Question 3

What do correlations suggest?

Answer 3

that it is likely that there is a positive relation between two variables, but they do not (per
se) provide causal evidence (i.e., x determines y)

Question 4

What are govenrnance studies in academia and, particularly, in practice, plagued by?

Answer 4

numerous statistical concerns
which make drawing valid inferences very difficult

Question 5

How to Measure Corporate Governance?

Answer 5

− Instead of looking at a single control mechanism, broad corporate governance indexes are constructed

Question 6

What is Construction? (from how to measure Corporate Governance)

Answer 6

A value of one is assigned to each governance attribute that a firm has in place, and zero
otherwise

Question 7

On what principle are the codes of many countries in Europe based on?

Answer 7

comply-or-explain principle

Question 8

Explain the comply-or-explain principle

Answer 8

− Acknowledges that “one size may not fit all” and that
flexibility is required
− Yet, if a recommendation is important but many firms do not
comply with it, it may become mandatory

Question 9

On what does the comply-or-explain principle rely on and why?

Answer 9

Relies on the functioning of self-regulation, since
a) those that should be regulated are members of the commission
b) authorizes executive and supervisory board to diverge

Question 10

Through what is the comply-or-explain principle enforced?

Answer 10

through market pressure and valuation

Question 11

Explain Drobetz et al. (2004)

Answer 11

Construct a German corporate governance rating as a proxy for firm-level governance:
− To qualify for an inclusion into the rating, each practice and attitude
i. must refer to a governance element that is not (yet) legally required
ii. needs to be considered as international market practice from an investor’s perspective

Question 12

What are the relations between corporate governance and firm value?

Answer 12

− Document a strong positive relation between the quality of
firm-level corporate governance and firm value
− Valuation measures: (i) Tobin’s Q and the (ii) market-tobook ratio

Question 13

Explain Gompers et al. (2003)
- Proxy fights

Answer 13

Construct a “Governance Index”: Proxy for the balance of power between managers and shareholders

− Proxy fights and hostile takeovers were rare, and investor activism was in its infancy
− The rise of the junk bond market in the 1980s disturbed this equilibrium by enabling hostile-takeover offers

many states passed anti-takeover laws giving firms defenses against hostile bids:

By 1990 there was considerable variation across firms in the strength of shareholder rights

Question 14

Explain Gompers et al. (2003)
- the index construction

Answer 14

The index construction is straightforward:
− For every firm one point is added for every provision that reduces shareholder rights
− Governance Index (“G”) is just the sum of points for the existence of each provision

Provisions can be divided into 5 main groups

Question 15

What are the 5 main groups that Provisions can be divided into?

Answer 15

− Tactics for delaying hostile bidders (Delay) - Classified Board
− Voting rights (Voting) - Unequal Voting
− Director/officer protection (Protection) - Golden Parachute
− Other takeover defenses (Other) - Posion Pill
− State laws (State) - Fair Price Law

Question 16

Which two extreme portfolios pays the Gompers et al (2003)

Answer 16

“Dictatorship Portfolio”

“Democracy Portfolio”

Question 17

Explain the “Dictatorship Portfolio”

Answer 17

− Firms in the highest decile of the index
− having the “highest management power”
− or the “weakest shareholder rights”

Question 18

Explain the “Democracy Portfolio”

Answer 18

− Firms in the lowest decile of the index
− described as having the “lowest management power”
− or the “strongest shareholder rights”

Question 19

Explain the Gompers et al. (2003) investment strategy

Answer 19

Gompers et al. (2003) build portfolios of well (Democracies) and poorly governed firms (Dictatorships) and calculate monthly portfolio returns over their sample period

An investment strategy that
− bought firms in the lowest decile of the index (strongest rights)
− sold firms in the highest decile of the index (weakest rights)
would have earned abnormal returns of 8.5 percent per year during the sample period

Question 20

What are the outcomes of Gompers et al. (2003) investment strategy?

Answer 20

− Market participants in 1990s were not able to forecast accurately the significance of governance for the
expected future performance of firms
− Hence, prices in the 1990s had not yet precisely priced the expected effects of the differences between wellgoverned and poorly governed firms on future profitability
→ Trading on the basis of such differences is profitable

Question 21

Explain Bebchuk et al. (2009)

Answer 21

Investigate the relative importance of the twenty-four provisions followed by the Investor Responsibility Research
Center (IRRC) and included in the GIM governance index

→Which provisions, among the many provisions that firms have, are the ones that play a key role in the link
between corporate governance and firm value?

Question 22

What are the provisions garnering significant shareholder opposition (Bebchuk et al. (2009)?

Answer 22

− Voting decisions on shareholders‘ resolutions
− Which of the 24 IRRC provisions were opposed by a nontrivial number of resolutions that often passed?
→4 types of precatory resolutions – targeting 6 IRRC provisions – stood out

Question 23

What are the four types of precatory resolutions, and six IRRC provisions are targeted (Bebchuk et al. 2009)?

Answer 23

1. Resolutions against classified boards, which passed in 91% of the votes on them during 2003–2004
2. Resolutions against poison pills, which passed in 72% of the votes on them during 2003–2004
3. Resolutions against golden parachutes, which passed in 62% of the votes on them during 2003–2004
4. Resolutions against supermajority provisions, which simultaneously targeted, supermajority merger
   requirements, limits on charter amendments

Question 24

What are the main findings (Bebchuk et al. 2009)?

Answer 24

The 6 provisions included in the E index fully drive the findings documented by prior research that the IRRC
provisions in the aggregate are correlated with Tobin’s Q

Bebchuk et al. (2009) contribute to understanding GIM’s results concerning the association between governance
& abnormal returns

→Bebchuk et al (2013) show that there is a disappearing association between governance and returns during
the period of 2000–2008

Question 25

Explain Bebchuk et al. (2013)

Answer 25

In 1990, investors might not yet have had sufficient experience to be able to forecast the expected difference in
performance between well-governed and poorly governed firms
→Market prices in the 1990s had not yet precisely priced the expected effects of the differences
Over time, a sufficient number of market participants have learned to appreciate the significance of these
differences
→Trading on the basis of these governance indices should not be expected to yield abnormal profits

Question 26

Through what were proxies identified for the attention to governance (Bebchuk et al. 2013)?

Answer 26

− the media
− institutional investors
− academic researchers
And finally construct an aggregate

Question 27

What’s the empirical finding (Bebchuk et al. 2013)?

Answer 27

(Long-run) Abnormal returns decreased to zero as the attention paid to corporate governance heightened

Question 28

What will good governance cease to be associated with at the end of the learning period and why? (Bebchuk et al 2013)

Answer 28

abnormal returns after the end of the learning period simply because the improved performance associated with good governance will become factored into market prices

Question 29

What is better governance positively related to (according to Bhagat & Bolton 2008)?

Answer 29

contemporaneous and
future operating performance, but not correlated with stock price performance

Question 30

Conclusions

Answer 30

− Corporate Governance quality difficult to condense into single number
− Causal and significant relationship between governance and firm value
− Investors only gradually learned about the importance of governance
− In efficient markets, this implies that investors cannot earn positive abnormal returns by holding portfolios of
well-governed firms