Lecture 4

Question 1

Balance sheet of a firm

Answer 1

Snapshot of the financial assets and liabilities of a firm on the reporting date

Corporate finance studies how a firm finances its investment and business activities

Question 2

typically a firm finances in one of the following ways

Answer 2

Investment from shareholders

Borrowing from creditors

Using short term resources from suppliers and employees

Question 3

Equity

Answer 3

A financing tool (normally in forms of common shares, ownership)

Has residual claim (low priority) on the firms free cash flow

Has no fixed maturity and rate of return (soft budget contraint)

Shareholders can vot on company strategies and hiring and firing of management

Question 4

Debt

Answer 4

A financing tool (normally in the forms of bank loans, bonds and commercial papers)

Is a contractual priority claim on the firms cash flows than equity

Has a fixed maturity date and predetermined interest rate

Has tax deductibility on interest payments

Creditors have no voting rights over the firms strategies

Has different senioriteis:
senior debt , subordinate and junior

Question 5

Conflicts of interest arise in several ways:

Answer 5

1) disagree on investemnt projects and risk taking
Creditors prefer safe projects while shareholders prefer risky projects

2) Disagree on project finance
When financing new projects, shareholders prefer to issue new debts, while creditors are concerned about their seniority in the debt claims

3) Disagree on dividend polity
Shareholders prefer higher dividend while creditors want to be paid first

Question 6

how many types of shareholders are there

Answer 6

Small individual investors:

dispersed, small stake and high turnover

Large shareholders/institutional shareholders:

Banks (acquire ownership via proxy voting - delegated by other shareholders to attend voting on their behalf)

Private equity

Assets managers:
pension funds, insurance companies, mutual funds and hedge funds

Question 7

What are the control/voting rights (shareholders and corporate governance)

Answer 7

To vote on major investment decision

To appoint board of directors and CEO and executive compensation

To vote in case of liquidation of the companys assets

To vote on auditor ratification

Question 8

is there any value in voting rights

Answer 8

Empirical studies show that shares with voting rights are traded at a premium to normal shares 45-100% on slide

Question 9

shareholders incentive to actively control:

Answer 9

Small investors:
lack of expertise

Costly: many legislations require shareholders to attend voting personally

Hard to coordinate with dispersed ownership

Free riding problem

Concentraded investors/institutional investors:

Have the incentive and the capacity (experise and manpower) to collect information and control

Have bargaining power to influencem anagement

Institutional investors can easily sell their shares if they are unhappy with the management, leaving the problem unsolvd

Selling may not work if having too much staek or invested in index

But it also depends on the degree of legal protection in a country

Question 10

INstitutional investors have stewardship role towards their clients

Answer 10

Responsible allocation, management and oversight of capital to create long-term value for clients, leading to substainable benefits for the economy, the environment and society

Legal and ethical obligations towards investors

Active ownership via voting and engagement

Question 11

How institutional investors invest:
no engagement with management

Answer 11

Passive investing: track index

Negative screening: avoid firms, industries with poor financial/ESG performance

Positive screening: seeking best performers and include those in the portfolio

Question 12

How institutional investors invest:
Engaging management

Answer 12

Corporate governance issues (CEO, board seats, divestment etc.)
Environemtnal and social issues on the rise

Ways to influence:
Collaborate with other institutional investors

private negotiations with management on ESG, corporate governance issues (most frequent, effective and not observable)

Threat to divest

Question 13

Most institutional investors rely on proxy advisory firms:

key functions

Answer 13

Research on corporate governance and executive compensation

Publish guidelines on shareholder voting

Question 14

Proxy advisory firms:
Challenges

Answer 14

Market dominance (top two counts for 97%)
Conflict of interest (proxy firms also work with issuer and investors)

Untraparent guidelines

Question 15

shareholder activism

Answer 15

A shareholder activist is a shareholder who uses his or her equity stake to bring change withing the company

Question 16

Key plays (shareholder activism):
pension funds

Answer 16

Mutual funds are regulated investement funds offered to the public and availbale for daily trading

Question 17

Key plays (shareholder activism)
hedge funds

Answer 17

Pooled investemnt funds for accredited investors that make extensive use of risky investment strategies like short selling, leverage and derivatives to achieve high returns

Question 18

Shareholder activism
Motivation

Answer 18

Financial performance: reduce cost divestment, strategic M&A, divident policy

Governance quality: board composition, compensation, provisions etc.

Esg practices: labor rights, environmental impacts

Question 19

Shareholder activism: approach

Answer 19

Acquire 10% shares or less to gain a board seat of a company

Shareholder engagement - private dialogues

Shareholder proposals (to be voted at annual general meeting)

Vote no campaign

Proxy contest

Question 20

Shareholder proposals

Answer 20

SEC shareholder proposal rule 14a-8 allowed shareholders to file proposals (proxy) to be voted at annual general meeting

Proposals may be filed after private negotiations failed

More ESG proposals are being voted on

Proposals getting majority voting results are not binding for the management

Question 21

Proxy voting

Answer 21

During the proxy seasons (april-june) public companies hold general annual meetings:

Management prepare proxy statement, providing voting guidelines for shareholders before annual meetings

Shareholders, activist file proxy proposals on corporate governance, ESG, and other issues before meeting

Historically most shareholder proposals were not passed, or not implemented after passing

In recent years, the number of ESG proposals increase significantly and are often supported by shareholders

Question 22

Shareholder activism example

Answer 22

Activist investor christopher hohn, founder of childrens investment fund, targeted abm amro in 2007 that lead to the sale of the bank

Question 23

Annual proxy statements of companies before annual general meetings dislcosure about:

Answer 23

Executive compensation

Nomination of board of directors

Ratification of auditors

(Proposals from management and shareholders, voting procedures and voting guidelines for shareholders)

Question 24

Proxy fight

Answer 24

A dissident shareholder fights against management adn tries to persuade the other shareholders

Its a costly undertaking because:

Free-riding probblem: dissident shareholder incurs huge costs launching proxy fight while other shareholders benefit from the success of the proxy fight.

Incumbent management more likely to get votes

Incumbent management can use company funds to promote themselves

Question 25

Disadvantage of equity only financing

Answer 25

Moral hazard problem: Equity is soft budget contraint on the management and therefore invites moral hazard problems

2) dispersed ownership and free riding problem:

Due to risk aversion of investors, no one would want to hold a substancial part of the ownership

Legal framework protecting investor invest –> dispersed ownsership

Free-riding problem increases as small investors rely on the big shareholders to monitor management

Question 26

Bank loans

Answer 26

Relationship banking

Syndication of loans

Question 27

Corporate bond

Answer 27

Publicly traded bond

Private placement

Question 28

Employee financing

Answer 28

Pension liabilities

Wages payable

Question 29

Supplier financing

Answer 29

Accounts payable

Question 30

Why should creditors care about corporate governance quality

Answer 30

Quality of corporate governance affects the financial well being of creditors

Question 31

How could creditors affect governance quality

Loan covenant:

Answer 31

Restrict asset sale without creditors permission

Require interest coverage ratio (EBIT/total interest expense)

ESG performance becomes increasingly important

Question 32

How could creditors affect governance quality

Regular credit monitor:

Answer 32

Financial performance

Collateral management

Question 33

Financing tools - hybrids

Answer 33

Share some characteristics with equity and some with debt

E.g.
Convertible bond: Bond that can be converted into a predetermined number of shares

Preferred shares: A share that has fixed dividend ad no control over management

Option linked bonds: a bond in which cash flow is linked to a price index.

Question 34

The following factors affect firms choice between equity and debt, between short-term and long-term debt

Answer 34

Firm size (larger firms are more leveraged)

Tangibility (the more collaterals a firm could offer, the more debt it could issue)

Growth rate (higher growth cannot be collateralized, therefore lower leverage, venture capital are better financiers)

Profitability (the more profitable, the more internal financing via retained earnings)

Volatility (the more volatile the earnings, the less likely to use loan)

Legal framework (in weaker legal frameworks, firms are less likely to obtain long term debts)

Question 35

Damages of debt overhang

Answer 35

Forego new investment opportunities

Loss in human capital and know-how

Increased risk for bankruptcy and cause financial instability, (i.e. 2008 financial crisis, sovereign debt crisis…)

Question 36

Case credit swiss

Answer 36

Following Silicon Valley Bank’s collapse, Credit Swiss also suffered in valuation
* The Swiss regulator brokered UBS’s acquisition of Credit Swiss to rescue and stabilize the
market.
* On 19 March 2023, the Swiss regulator approved the rescue plan that wipes out Credit
Swiss’ $17 billion Additional Tier 1 bond (AT1 bond)
* AT1 bonds are contingent convertible securities
* It can be converted into equity if a bank’s capital ratio falls below some level
* In such contingency, the bondholders of AT1 bond can lose their principal entirely.
* Credit Swiss’ shareholders have not lost suffered…?