Corporate Finance

Lecture 1
Introduction to Corporate
Governance

BME
Fall 2020
 Robert Somogyi
BME, Department of Finance

somogyi@finance.bme.hu
 Schedule
Week 1 Introduction to corporate governance

Week 2 Capital investment decisions I: Present and future value calculations

Week 3 Capital investment decisions II: Investment decision criteria

Week 4 Capital investment decisions III: What if analyses

Week 5 Capital investment decisions IV: Real options and decision trees

Week 6 BREAK

Week 7 Numerical exercises

Week 8 MID-TERM TEST I

Week 9 Business and Financial Risk: Breakeven analysis, operating and financial leverage

Week 10 Dividend Policy

Week 11 Long-term Financial Policy: Cost of capital

Week 12 Mergers and acquisitions

Week 13 Numerical exercises

Week 14 MID-TERM TEST II

Week 15 RETAKE-TEST
 Online teaching
• Live on Tuesdays starting from 14:15 (Central
European Time)
• MS Teams
• ”Corporate finance BMEGT35M411” group
– Team code: ypyqnku
• Recordings will be available later
• Attendance is optional
• Questions can be asked in the Forum in the Moodle
system
 Recommended literature

• Brealey, R. - Myers, C.S. - Allen, F.: Principles of

Corporate Finance, McGraw-Hill, 2008.

• Bodie - Kane - Marcus: Investments (10th

edition), McGraw-Hill, 2014.

• (Lecture slides are sufficient.)

 Moodle
• Slides and recordings will be available after each lecture in
the Moodle system (probably starting later this week):
https://edu.gtk.bme.hu/
For your first login, you have to find your eduID and
corresponding password using the blue link below:
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Our departmental Facebook

page regularly features news
articles from the financial
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Hungarian):

https://www.facebook.com/BMEPenzugyekTanszek
 Assessment methods
• Two mid-term tests, probably in the Moodle
system
• First on the 8th week, second on the 14th week
• 50 points each, total of 100 points = 100%
• These cannot be re-taken seperately for any
reason
• One re-take exam free of charge including the full
body of the course on the 15th week
• There is no way of getting additional points in this
course
 Grades
Grade● [ECTS equivalent] Points
jeles (5) ● Excellent [A] Over 90%

jeles (5) ● Very Good [B] 80 – 90%

jó (4) ● Good [C] 70 – 80%

közepes (3) ● Satisfactory [D] 60 – 70%

elégséges (2) ● Pass [E] 40 – 60%

elégtelen (1) ● Fail [F] 0 - 40%

Lower limits are included in each range

 Overview of Lecture 1: Introduction to
Corporate Governance
• What is corporate governance?
• Stakeholder groups
• Conflicts of interests between stakeholders
• Stakeholder management practices
• Environmental and social considerations
 Definitions of corporate governance
• 1. “the system by which companies are directed and
controlled.” (Cadbury report, 1991)

• 2. “Corporate governance includes a set of relationships

between a company’s management, its board, its
shareholders, and other stakeholders.” (OECD, 1999, 2015)

• 3. „ the system of internal controls and procedures by which

individual companies are managed. It provides a framework
that defines the rights, roles and responsibilities of various
groups . . . within an organization.” (CFA Institute, 2009)
 Importance of corporate governance

• Poor corporate governance carries significant risks:

– Weak control systems: Accounting scandals,
Bankruptcies (Enron)
– Inefficient decision making: e.g. managers’ insufficient
or excessive risk-taking due to bad compensation
scheme
– Legal and reputational risks: e.g. Volkswagen’s recent
emission scandal (dieselgate) resulting in fines + loss in
reputation
 Stakeholder groups
1. Shareholders
2. Creditors
3. Managers
4. Other employees
5. Board of directors
6. Customers
7. Suppliers
8. Regulators
 Stakeholder groups

1. Shareholders
– Own shares of stock: voting rights and right to receive
dividends
– Interested in corporate profitability: increased company
value translates into higher share price
– Represented by board of directors: little direct
involvement in corporate activities
– Controlling vs minority shareholders: difference in
power to influence company elections and resolutions
 Stakeholder groups

2. Creditors:
– Bondholders or banks: lenders and providers of debt
financing, in exchange receive interest payments
– No voting power: as opposed to shareholders
– Payments pre-determined: contractual agreement
– Interested in company’s stability: conflict of interest
with shareholders who might have a higher risk
tolerance
 Stakeholder groups

3. Managers and employees:

– Managers: compensated through salary, bonuses,
equity-based compensation
– Lower-level employees: ‘fair’ salary, working conditions,
access to promotions, trainings, safe and healthy work
environment
– Interested in company’s viability: benefit from good
performance, suffer from poor performance (lay-offs)
 Stakeholder groups
4. Board of directors:
– Elected by shareholders to protect their interests,
provide strategic direction, monitor company
performance
– One-tier structure: single board of directors with
excecutive (internal) and non-excecutive (external)
directors
– Two-tier structure: supervisory board (with excecutive
directs) + management board (with non-excecutive
directors). The former could challange the latter.
 Stakeholder groups
4. Board of directors (cont’d):
– No single optimal structure: number of directors should
vary with company size, experience and qualifications of
members, it can evolve in time.
– CEO duality: when CEO is also chairman of the board.
Less and less common in one-tier systems, not permitted
in two-tier systems.
– Committees: BoD can establish them to focus on specific
functions, e.g. audit committee, compensation
committee, nomination committee etc.
 Stakeholder groups
4. Board of directors (cont’d):

– Responsibilities: duty of care (act on a fully informed

basis) + duty of loyalty (act in the interest of the
company and its shareholders)
– Focus on strategic direction: delegate daily acitivities to
management
– Oversees audit reports: from internal audits, the audit
committee, external audits, proposes follow-up action
 Stakeholder groups

https://techcrunch.com/2019/08/22/oracle-directors-give-blessing-to-
shareholder-lawsuit-against-larry-ellison-and-safra-catz/?guccounter=1 20
 Stakeholder groups
5. Customers:

– Satisfy their needs

– Meet safety standards

– Typically less interested in company’s performance:

except for long-term customers (e.g. MS PowerPoint and
switching cost of learning another software)
 Stakeholder groups
6. Suppliers:

– Interested in getting paid, on time

– Long-term relationship: benefitting both parties

– Interested in company’s stability: like creditors

 Stakeholder groups
7. Goverment and regulators:

– Protect the interest of the general public: safety

standards, competition authorities etc.

– Protect country’s economic interests: collect taxes, levy

import duties
Conflicts of interest among stakeholders
About Volkswagen’s dieselgate scandal:

http://www.euronews.com/2015/09/28/europe-s-
carmakers-tricking-drivers-on-fuel-efficiency-new-
report-claims
(0 - 0:59)

According to the video, which stakeholders’ interests are in

conflict in the car industry?

What solution is put forward by the expert?

Conflicts of interest among stakeholders

https://edition.cnn.com/2018/10/16/business/volkswagen-audi-
diesel-fine/index.html 25
 Conflicts of interest among stakeholders
1. Shareholders vs managers:

– Delegation: shareholders delegate most decisions to

managers
– Different risk tolerance: managers are more risk-averse
– Information asymmetry : managers are better informed
about the decision problems than shareholders
– Principal-agent problem: due to info asymmetry,
shareholders (the principal) cannot fully control whether the
managers (the agents) act in their best interest. E.g. is the
poor performance due to bad management or due to a
downturn in the economy?
 Conflicts of interest among stakeholders
2. Controlling vs minority shareholders:

– Minority outweighed by controlling shareholders: both

in election of directors and in specific resolutions
– Takeover transactions: An extreme example: Qtel paid a
48% premium per share for a consortium of controlling
shareholders of Wataniya in 2007 compared to minority
shareholders during a takeover
– Related-party transactions: controlling shareholder can
force company to deal with another firm it owns even if
detrimental to firm
 Conflicts of interest among stakeholders
3. Shareholders vs creditors:

– Shareholders seek growth: accept riskier projects in

exchange for higher expected returns
– Creditors seek stability: Pre-arranged contracts, gain
independent of company performance, fear default in
case of excessive risks
– Level of borrowing: higher level of borrowing increases
default risk, so it is detrimental to creditors whereas it
could be profitable for shareholders
 Conflicts of interest among stakeholders
4. Shareholders vs customers:
– Price: opposed interests
– Safety features

5. Shareholders vs regulators:
– Taxes: opposed interests
– Equity capital requirements: e.g. for banks regulators
want relatively high levels to avoid crises
 Stakeholder management
Importance:
– Balance interests of different stakeholders
– Limit conflicts

Mechanisms:
– Differ by country and jurisdiction
– With some common elements, such as the existence of
general meetings, auditing, policies on manager
compensation and on related-party transactions, etc.
 Stakeholder management
General meetings:
– Shareholders exercise their right to vote on major
corporate matters and elect board of directors
– Annual general meeting following the end of the fiscal
year, overview of internal audit and company
performance, addressing shareholder questions
– Extraordinary general meetings called to vote on
significant resolutions, such as modification of bylaws,
mergers and acquisitions, sale of large assets, etc.
 Stakeholder management
Audit function:
– The set of systems, controls and policies in place to
examine the firm’s operation and financial records, in
order to mitigate fraud
– Internal audits: conducted by independent internal
department
– External audits: conducted typically annually by an
external audit firm, usually recommended by the audit
committee
– Board of directors review audits before they are
presented to shareholders at the annual general meeting
 Stakeholder management
Compensation policies:
– Aliging the interest of managers and shareholders:
incentive plan including a variable component based on
stock price
– Risk of ‘short-termism’: managers maximize short-run
stock price instead of company performance leading to
long-run stock price
– Long-term incentive plans: e.g. restricting sale of stocks
until retirement OR delay compensation partially until
some performance targets are met
– Say on pay: shareholders vote on excecutive
compensation plans
 Stakeholder management
Policies on related-party transactions:
– Increasingly common practice
– Avoid conflicts of interest: conducted by independent
internal department
– Directors and managers are required to disclose any
direct or indirect, actual or potential conflict of interest
when dealing with a related-party
– Voting excluding the director holding the conflicting
interest
 ESG
ESG = environmental and social governance

– Lack of definitive terminology: several commonly used terms co-

exist: ‘sustainable investing’ and ‘responsible investing’ and ‘ESG
investing’ and ‘socially responsible investing’
– Environmental and social factors evolved more slowly than other
corporate governance factors
– Recent environmental disasters and social controversies speeded
up the use of ESG: e.g. BP oil spill in the Gulf of Mexico in 2010;
Walmart’s 2011 loss of a class action suit due to wage
discrimination and Volkswagen’s 2015 ‘dieselgate’ scandal
– Good ESG can reduce a firm’s cost (e.g. by reducing turnover)
and/or mitigate the risk of litigation and improve its reputation
 ESG

https://www.economist.com/briefing/2019/08/22/big-business-is-
beginning-to-accept-broader-social-responsibilities 36
 ESG factors
– Environmental factors: natural resource management,
pollution prevention, water conservation, energy
efficiency etc.
– Social factors: management of human capital, human
rights and welfare concerns, worker training, employee
diversity etc. Minimizing social risks can reduce
operating costs as well (e.g. lower turnover, reduced
reputational risks)
– Industry dependent: e.g. emissions, water usage and
pollution crucial for a mining company, less important
for a bank
 ESG

https://www.bbc.com/news/business-48999338 38
 ESG implementation
– Negative screening: most widespread approach,
excludes certain sectors from investment (e.g. fossil fuel
extraction or weapons’ trade)
– Positive screening (best-in-class): finding the best
companies in each sector through some ESG scoring
method
– Thematic investing: investment in a specific sector e.g.
startups dealing with climate change
– Impact investing: targets specific environmental or
social goal, e.g. buying green bonds to advance low-
carbon initiatives
 Summary of Lecture 1: Introduction to
Corporate Governance
• Companies should consider all of their stakeholders,
not just their shareholders, when planning and
implementing their strategy
• Conflicts of interests between different stakeholder
groups arise naturally
• Adopting good corporate governance practices is
important to mitigate these conflicts
• Environmental and social considerations play an
increasingly important role in investments
Next time: present and future value of
money