Corporate Governance and the Time Value of Money

Vocabulary flashcards covering key definitions and relationships in Corporate Governance and Time Value of Money from Lecture 2.

Corporate Governance

The system concerning the control and direction of a company, which addresses control challenges such as asymmetric information and agency problems.

Asymmetric Information

An information imbalance occurring between corporate insiders (such as management) and outsiders (such as investors and stakeholders).

Agency Problem

Aka Principal-Agent Problem, it occurs when managers (agents) act in their own interests (such as empire building or boosting short-term earnings) rather than maximizing long-term value for stakeholders (principals).

Why does the Agency Problem happen?

Arises due to the separation of ownership and control. Aggravated by asymmetric information.

Empire Building

A corporate behaviour where managers aggressively expand the size, budget, staff, or asset scope of a company (often through unneeded mergers or overinvestment ) primarily for their own interests rather than to maximise shareholder value

Managing Agency Problems

1) Corporate Governance Codes

2) Internal Controls and Decision-Making Processes

3) Compensation plans

4) Activist Shareholders

5) Information

6) Threat of Takeover

Corporate Governance Codes

Regulations and business practices historically designed to protect shareholders and other investors, but some are being updated to include other stakeholders (E.g. Netherlands and UK).

How do Legal Requirements support Corporate Governance?

They give protection from insider trading and fiduciary duty.

Fiduciary Duty

The strict legal obligation of directors/executives to act in the best interest of the owners.

Insider Trading Laws

Protections designed to maintain market fairness and transparency for all investors.

What is main purpose of Board of Directors in Corporate Governance?

Acts as the internal oversight body elected by shareholders to represent their interests.

Responsible for key decisions that prevent executive self-interest, such as:

1) Approving shareholder payouts

2) Issuing new securities

3) Setting and approving executive compensation packages

Why is Board Independence critical to effective governance?

It prevents conflicts of interest between company mangers and shareholders.

It ensures that the board can objectively supervise managers without fear of losing their jobs or financial perks.

The 3 Tests for Board Independence

1) Majority Outside Directors

2) Independent Chairman (is board of chair separate from CEO)

3) Independent Committees (audit and compensation committees)

Internal Control and Decision-Making Processes

Financial guardrails and strict decision-making processes so one manager doesn’t exploit the company’s financials

Internal Control and Decision-Making Processes

Financial guardrails and strict decision-making processes so one manager doesn’t exploit the company’s financials

Activist Shareholders

Large institutional investors who buy significant share to force their way onto the board and demand strategic changes

What is Information in terms of Managing Agency Problems

Transparent financial disclosure, monitoring by equity analysts —> this makes it less likely for managers to hide poor financial decisions

Threat of Takeover

If share price becomes depressed enough

Does Corporate Governance work?

Corporate scandals happen in every country, despite corporate governance codes and efforts to address agency problems.

Book Value of Equity

Calculated from a company’s balance sheet.

The difference between a company’s total assets and total liabilities

Market Capitalisation/ Market Value

The value of the company according to the stock market.

Calculated as the price of share * number of shares

Financial Statements

Financial Statements present a summary of business activities in economic terms. Analysts must use their own knowledge of the business/industry/strategy to interpret the financial information presented.

Limitations of Accounting Data

They’re based on the past.

The fundamental value-creating processes within the firm are not identified and measured.

They’re frequently based on guess, estimates and judgements and can be subject to manipulation —> but the same can be said about market values

Market-to-Book Ratio (M/B) aka P/B

The ratio of the market’s valuation of a firm to its accounting (book) value.

Price-Earnings Ratio (P/E)

The ratio of a firm's price per share to its earnings per share as reported in its accounts.

Interest Rate

The 'exchange rate' between earlier money and later money, representing the time value of money or the opportunity cost of money.

Future Value (FV) formula

$$FV = PV(1 + r)^t$$

Present Value (PV)

The current value of future cash flows, calculated by discounting using the formula $PV = \frac{FV}{(1 + r)^t}$.

Compounding

The process of accumulating interest over multiple periods to calculate the Future Value of an initial investment.

Discounting

The process of calculating the Present Value of future cash flows by adjusting for the time value of money.

Compounding and Discounting Relationship

The reciprocal processes where Compounding transitions a Present Value forward into a Future Value, while Discounting translates a Future Value back into a Present Value.

Future Value Curves across Interest Rates

Graph showing that for an initial investment of $100$, higher interest rates $r$ cause the Future Value to grow exponentially faster over an increasing number of years.