Unit 5: Corporate Finance

Corporate Governance

What is Corporate Governance?

 Corporate governance refers to the firm’s internal controls

and the procedures by which the firm is managed
 Defines rights and responsibilities of management,
the board, and shareholders
 Good corporate governance ensures that
shareholder interests are protected
Factors Affecting Corporate Governance

 Board of directors—independent directors, qualifications

of directors, terms, committee structure
 Management—code of ethics, board oversight,
compensation, alignment of interests
 Shareholder rights—voting rights (e.g., cumulative), proxy
voting, actions requiring shareholder approval

26
What Makes a Good Board

 Acts in the best interest of shareholders

 Independent majority
 Sometimes meets without managers present
 Ability to hire outside consultants with specialized knowledge
(e.g., risk management, technology, legal)
 Annual terms give shareholders more control than longer,
possibly staggered, terms
 Negative factors: CEO (or past CEO) is chair, members are
closely related to customers or suppliers
Independent Board Members

 Board members who do not have material relationships with

management or significant shareholders

 No compensation from firm for other than board service

(e.g., no consulting or finder’s fees)

 Works to protect shareholders’ long-term interest

What Makes a Good Board Member

 Qualifications and experience

 Can they make informed decisions?
 Do they understand the business?
 Are they ethical?
 Have they had legal or regulatory problems?
 Have they had other board experience?
 Do they attend meetings?
Board Committees

 Audit: Ensures quality of financial reporting

 Proper procedures (e.g., GAAP)
 Controls auditors
 Compensation: Sets executive compensation
 Links compensation to LT performance
 Need independence from management
 Nominations: Nominates/recruits new members
Code of Ethics

 Strong code of ethics needed

 Policies should prevent personal use of corporate
assets
 Board members should not serve as
consultants
 Board members should not receive finder’s fees for M&A
or sales opportunities
Provisions of a Code of Ethics

 Congruent with local laws

 Prohibit advantages to firm insiders
 Conditions for waivers (and frequency of use)
 Require timely information to board
 Periodic audits/reviews of code

Weak code allows related-party transactions

and personal use of company assets
Shareholders and Proxy Voting Rules

Easy proxy voting = better shareholder rights

Negatives:
 Limits on proxy voting
 Meetings timed inconveniently
 Require attendance
 Allows “share blocking”
 Cumulative voting with large minority
shareholder group (e.g., founding family)
Shareholder Sponsored Action

Greater ability to influence board = greater

shareholder protection

 Board nominations
 Resolutions/proposals
 Issues:
 When can they be made?
 Can board member be removed?
 Simple majority vs. supermajority
Different Classes of Stocks

 Classes separate voting rights and economic value

 Potential acquirers may only deal with one class of
stockholders

 Generally, separation of voting rights works to the impairment

of at least one set of shareholders

 Different classes lead to trouble raising equity capital

Takeover Defense and Sharevalue

Takeover defenses reduce shareholder value

 Golden parachutes
 Poison pills
 Greenmail
Is shareholder approval required to implement? Past acquisition
interest?
Government intervention in acquisition likely?
Corporate Governance - Problem

Which of the following characteristics of a board is least

supportive of shareowner protection?
A.Firm suppliers, customers, and consultants are not
represented on the board.
B. The board chairman is the ex-CEO of the firm.
C.The board often meets without firm management present.
 Measures of Leverage Definitions

• Leverage: Refers to the effect of fixed elements in cost

structure
Two types:
• Operating leverage: Fixed op. expenses
• Financial leverage: Fixed financing costs
• Business risk: Variability in EBIT
– Affected by operating leverage
• Financial risk: Variability of EPS from fixed interest
costs of debt financing
 Degree of Operating Leverage (DOL)

% change in EBIT
Definition/Interpretation: DOL 
% change in sales

sales  TVC
Calculation: DOL 
sales  TVC  fixed

When fixed costs are zero, DOL = 1, there is no

operating leverage: %∆ EBIT = %∆ sales
1
 Degreeof Operating Leverage (DOL)

Example: A firm produced 5,000 units last year. Its fixed

costs were $70,000, its selling price was $75, and its
variable unit cost was $50. What was the firm’s DOL at 5,000
units?

Sales  TVC Q(P  VUnit )

DOL  
Sales  TVC  Fixed Q(P  VUnit )  Fixed

5,000(75  50)
  2.27
5,000(75  50)  70,000

1
Degree of Financial Leverage (DFL)

% change in EPS
Definition/Interpretation: DFL 
% change in EBIT

EBIT
Calculation: DFL 
EBIT  interest

When fixed financing costs are zero, DFL = 1, there

is no financial leverage: %∆ EPS = %∆ EBIT
 Degree of Financial Leverage (DFL)

Example: A firm has EBIT of $55,000 and interest expense of

$20,000. If EBIT increases by 3%, what will be the effect on
earnings per share?

55,000
DFL   1.57
55,000  20,000

EPS will increase by 3% × 1.57 = 4.71%

 Degree of Total Leverage (DTL)

% change in EPS
Definition/Interpretation: DTL 
% change in sales

DTL  DOL  DFL

Q(P – V)
DTL=
Q(P – V) – fixed – interest Two sources of
leverage; multiplicative
sales – TVC
=
sales – TVC – fixed – interest
 Degree of Total Leverage (DTL)

Example: What is the DTL of a firm that had sales last year of
$375,000, total variable costs of $250,000, fixed costs of $70,000,
and interest expense of $20,000?

sales – TVC
DTL =
sales – TVC – fixed – interest

375,000 – 250,000
= = 3.57
375,000 – 250,000 – 70,000 – 20,000

DOL  DFL = DTL; 2.27 1.57 = 3.57

 Degree of Total Leverage

• Three rules of leverage:

1. High fixed costs = high operating leverage

2. High debt ratio = high financial leverage
3. High fixed costs + high debt ratio = high total leverage
Leverage - Problem

Polsen, Inc. has fixed operating costs of $1.5 million, fixed

financing costs of $1.0 million, sells their output at $700 per
unit, and has variable costs of $200 per unit. At an output of
5,000 units, a decrease in sales of 1% can be expected to
decrease operating earnings by:
A. 1.0%.
B. 2.5%.
C. 3.5%.
Breakeven Quantity of Sales

Breakeven quantity is the level of sales at which a

firm’s net income is zero

Total Fixed Costs

QBE =
Price Var. Cost per unit

Example: If P = $85; V = $60; FC = $500,000;

What is the firm’s breakeven quantity of sales?

QBE = 500,000 / (85 – 60) = 20,000 units

 Net Income at Various Sales Levels

Example: Assume the following for a firm:

P = $85; VC = $60; FC = $500,000; Int = $20,000;
Q = 25,000 units, no taxes

What is the firm’s net income?

NI = Q (P – V) – Fixed Costs – Interest

= 25,000 (85 – 60) – 500,000 – 20,000

= $105,000
Operating Breakeven Quantity of Sales

Operating breakeven quantity is the level of sales that

just covers a firm’s fixed operating costs

Fixed Operating Costs

Q obe =
Price - Var. Cost per unit

Example: If P = $85, V = $60, fixed operating costs =

$300,000, what is the firm’s operating breakeven quantity of
sales?

QOBE = 300,000 / (85 – 60) = 12,000 units

Unit 6: Equity Investments
Market Indexes

A security market index represents the performance of an asset

class, security market, or segment of a market.

The performance of the market or segment over a period of

time is represented by the percentage change in (i.e., the return
on) the value of the index.
Market Indexes

A price index uses only the prices of the constituent

securities in the return calculation. The rate of return is called
a price return.

A total return index uses both the price of and the income
from the index securities in the return calculation.
 Market Indexes

Decisions that index providers must make when constructing and

managing indexes include:

• The target market the index will measure.

• Which securities from the target market to include.

• The appropriate weighting method.

• How frequently to rebalance the index to its target weights.

• How frequently to re-examine the selection and weighting of

securities.

26
 Market Indexes

A price-weighted index is the arithmetic mean of the prices of

the index securities. The divisor, which is initially equal to the
number of securities in the index, must be adjusted for stock
splits and changes in the composition of the index over time.

An equal-weighted index assigns the same weight to each of

its constituent securities.

Equal-weighted index = (1 + average percentage change in index stocks) × initial index value
Market Indexes

A market capitalization-weighted index gives each constituent

security a weight equal to its proportion of the total market
value of all securities in the index.

Market capitalization can be adjusted for a security’s market

float or free float to reflect the fact that not all outstanding
shares are available for purchase.

A fundamental-weighted index uses weights that are

independent of security prices, such as company earnings,
revenue, assets, or cash flow.
Market Indexes

Market capitalization can be adjusted for a security’s market

float or free float to reflect the fact that not all outstanding
shares are available for purchase.

A fundamental-weighted index uses weights that are

independent of security prices, such as company earnings,
revenue, assets, or cash flow.
Market Indexes

Index providers periodically rebalance the weights of the constituent

securities.

This is most important for equal-weighted indexes.

Reconstitution refers to changing the securities that are included in an
index.

This is necessary when securities mature or when they no longer have

the required characteristics to be included.

Indexes are used for the following purposes:

• Reflection of market sentiment.
• Benchmark of manager performance.
• Measure of market return.
• Measure of beta and excess return.
• Model portfolio for index funds.
 Market Indexes

• Broad market equity indexes represent the majority of stocks in a market.

• Multi-market equity indexes contain the indexes of several countries.

Multi-market equity indexes with fundamental weighting use market
capitalization weighting for the securities within a country’s market but
then weight the countries within the global index by a fundamental factor.

• Sector indexes measure the returns for a sector (e.g., health care) and
are useful because some sectors do better than others in certain
business cycle phases. These indexes are used to evaluate portfolio
managers and as models for sector investment funds.

• Style indexes measure the returns to market capitalization and value or

growth strategies.

• Stocks tend to migrate among classifications, which causes style indexes

to have higher constituent turnover than broad market indexes.
Fixed Income Indexes

Fixed-income indexes can be classified by issuer, collateral, coupon, maturity,

credit risk (e.g., investment grade versus high-yield), and inflation protection.

They can be delineated as:

• broad market
• sector, style
• other specialized indexes.

Indexes exist for various sectors, regions, and levels of development.

The fixed-income security universe is much broader than the equity universe,
and fixed-income indexes have higher turnover. Index providers must depend on
dealers for fixed-income security prices, and the securities are often illiquid.

Fixed-income security indexes vary widely in their numbers of constituent

securities and can be difficult and expensive to replicate.
 Alternative Assets Indexes

Indexes have been developed to represent markets for alternative

assets such as:
• Commodities
• Real estate
• Hedge funds.

Issues in creating commodity indexes include the weighting method

(different indexes can have vastly different commodity weights and
resulting risk and return) and the fact that commodity indexes are
based on the performance of commodity futures contracts, not the
actual commodities, which can result in different performance for a
commodity index versus the actual commodity.
 Alternative Assets Indexes

Real estate indexes include appraisal indexes, repeat property sales

indexes, and indexes of real estate investment trusts.

Because hedge funds report their performance to index providers

voluntarily, the performance of different hedge fund indexes can vary
substantially and index returns have an upward bias.
 Market Indexes from Commercial Providers

Security market indexes available from commercial providers represent a

variety of asset classes and reflect target markets that can be classified by:

• Geographic location, such as country, regional, or global indexes.

• Sector or industry, such as indexes of energy producers.
• Level of economic development, such as emerging market indexes.
• Fundamental factors, such as indexes of value stocks or growth stocks.
 Industry Analysis Objectives

Industry Analysis allows us to answer the following questions:

• How can we select Peer Groups?

• Which are the key factors that need to be taken into
account?
• Which are the advantages that companies have when they
belong to strategically well positioned industries?
Industry Analysis Uses

Understand the business model and its environment

Only by understanding its environment we can identify:

• Growth Opportunities
• Competitive Dynamics
• Risks
• Adequate level of debt and repayment capaci
 Industry Analysis Uses

Spot investment opportunities

A top down analysis allows us to identify if the perspectives in

the sector are
• Positive
• Negative
• Neutral

In that manner we can identify if they are incorpated in the current

prices

The Industry factor influences total return of a portfolio at least as

much as the country factor.
 Industry Analysis Uses

Industry analysis allows us to determine the relevant discount rate

required for evaluating equity investments

Effective
Industry Name Number of firms Beta D/E Ratio Tax rate Unlevered beta
Advertising 47 1.44 85.08% 4.13% 0.88
Aerospace/Defense 77 1.23 24.28% 8.54% 1.04
Air Transport 18 1.44 103.43% 18.47% 0.81
Apparel 51 1.06 41.77% 11.11% 0.80
Auto & Truck 13 1.10 164.93% 5.93% 0.49
Auto Parts 46 1.21 50.86% 7.25% 0.88
Bank (Money Center) 7 1.00 177.75% 19.36% 0.43
Banks (Regional) 611 0.57 62.92% 17.46% 0.39
Beverage (Alcoholic) 21 1.13 31.28% 6.62% 0.91
Beverage (Soft) 34 1.22 19.24% 4.00% 1.07
Broadcasting 27 1.21 98.45% 13.31% 0.70
Brokerage & Investment Banking 39 1.46 268.39% 12.83% 0.48
Building Materials 42 1.23 32.07% 16.26% 0.99
Business & Consumer Services 165 1.07 30.31% 8.32% 0.87
Cable TV 14 1.11 60.17% 14.55% 0.77
 How to Identify Similar Companies?

• By Products and Services

• Consumer electronics
• Gold mining
• Heavy machinery
• Pharmaceuticals

We need to consider the activity that generates most of the

company´s revenue

• This kind of classifications include:

• GICS (Global Industry Classification Standard)
• RGS (Russell Global Sectors)
 How to Identify Similar Companies?

• For its sensitivity to the business cycle

Cyclicals: Earnings are strongly correlated with the business cycle

This correlation can be caused by:

1. High correlation of the company demand and the business
cycle
Restaurants
Tourism
Tecnology
Construction
Luxury goods

2. High fixed costs (high operating leverage)

 How to Identify Similar Companies?

• For its sensitivity to the business cycle

Non Cyclicals (Defensive) Earnings are not correlated with the

business cycle:

Healthcare
Food
Utilities

• For behaving similarly (statistically)

When the companies have behaved similarly in the past

 Commercial Classification Systems

• GICS (Global Industry Classification Standard):

Developed by MSCI and S&P, suppliers of global indexes (1999)
• Sectors (11)
• Industry groups (24)
• Industries (68)
• Sub Industries (157)
• RGS (Russel Global Sectors)
• Sectors (9)
• Sub sectors(33)
• Industries (157)
• ICB (Industry Classification Benchmark)
• Developed by Dow Jones y FTSE
• 10 Industries
• 19 supersectors
• 41 sectors
• 114 subsectors
Commercial Classification Systems

Representative Sector
• Basic Materials
• Discretional consumption
• Consumer Staple
• Energy
• Financial Services
• Healthcare
• Industrial
• Real Estate
• Technology
• Telecom
• Utilities
 Government Classification Systems

International Standard Industrial Classification of All Economic

Activities (ISIC)
Adopted by UnitedNations in 1948

Statistical Classification of Economic Activities in the European

Community (NACE)
Known as the European ISIC

Australian and New Zealand Standard Industrial Classification

(ANZSIC)

North American Industry Classification System (NAICS)

Developed for Canadá, EEUU y México
 Strenghts and Weaknesses of Current Classifications

Government:
• U.S. Laws forbid the Census Boreau to share information related to company
activities: NAICS codes areunknown

• Are only updated each 5 years

• Do not differentiate by:

• Company Size
• For profit or non-for profit
• Public or private (trade or not in the stock market)

Commercial:
• Distinguish by company size

• Include only for profit companies and that are public

Construction of Peer Groups

• Neither government nor commercial classifications can be

used directly as peer groups
• Group of peers are involved in similar business activities that
are influenced by closely related factors
• Peer comparison helps to understand the performance of the
company and to value by comparables
• Peer group construction is a subjective process:
• Start from commercial classification systems.
• Search for competitors in the company´s annual report
• Look for more competitors in competitor´s annual reports
• Review specialized publications
• Confirm that each comparable company receives a significant
portion of its income and operating profit from the same
business as the target company
Construction of Peer Groups

• Refine the peer group by asking:

• What proportion of sales and operating profit is derived from

business activities similar to that of the target company?
• Does the alleged peer company face a demand environment
similar to that of the target company?
• Does the company in question have a finance company as a
subsidiary?
If this is the case, it is necessary to make adjustments so that
the operations are comparable.
Unit 7: Fixed Income
Asset Backed Securities

Securitization:

Process by which financial assets:

• Mortgages
• Accounts receivable
• Automobile loans

Are purchased by an entity that then issues securities

supported by the cash flows from those financial assets.

.
Asset Backed Securities

Benefits:

• Reduces intermediation costs (lower funding costs for

borrowers and higher risk-adjusted returns for investors).

• Investors’ claim to the loans is stronger than it is with only a

general claim against the bank’s overall assets.

• Securitized loans are actively traded, which increases the

liquidity of the bank’s assets compared to holding the loans.

• Banks are able to lend more than if they could only fund
loans with bank assets. When a loan portfolio is securitized,
the bank receives the proceeds, which can then be used to
make more loans.
Asset Backed Securities

Benefits:

• Securitization has led to financial innovation that allows

investors to invest in securities that better match their
preferred risk, maturity, and return characteristics.

• The investor can gain exposure to long-term mortgages

without having the specialized resources and expertise
necessary to provide loan origination and loan servicing
functions.

• Securitization provides diversification and risk reduction

compared to purchasing individual loans (whole loans).

.
 Asset Backed Securities: Example

• Fred Motor Company sells most of its cars on retail sales

installment contracts.

• Cars become collateral until the loan is paid

• Loans have maturities between 48 and 60 months (various interest

rates).

• Fred is also the servicer of the loans:

• collects payments
• sends out delinquency notices
• repossesses and disposes of the cars if customers don´t pay
 Asset Backed Securities: Example

• Fred has 50,000 auto for $1 billion total

• would like to remove from its balance sheet
• use the proceeds to make more auto loans.

• An SPE (Special Purpose Entity) is created.

• Also called Trust or Issuer
• Different legal entity from the issuer

• SPE sells ABS (Asset Backed Securities) to investors

• Fred´s Balance Sheet is now smaller and can now lend more
money to sell new cars

• In this case, the seller and the servicer are the same entity (Fred
Motor Company), but that is not always the case.
Asset Backed Securities: Example
 Asset Backed Securities: Tranches

• Principal and interestpay ments on the original loans allocated to:

• Pay servicing fees to the servicer
• Principal and interest payments to the owners of the ABS.

• There may be several or tranches, of ABS issued by the trust

• Different priority claims to the cash flows
• Different specifications of the payments to be received if the
cash flows from the loans are not sufficient to pay all the cash
flows. (time tranching)

• Waterfall structure:
• Each class of ABS (tranche) is paid sequentially, from the cash
flows from the underlying loan portfolio.
 Asset Backed Securities: Credit Trenching

• Different tranches have different exposures

• Senior tranches: lower risk and lower yields
• Subordinated Tranches: higher risk and higher yields

Example

Senior Tranche $300,000,000 absorbs remaining losses

Subordinated Tranche A $80,000,000 absorbs next $80 MM in losses
Subordinated Tranche B $30,000,000 absorbs first $30 MM in losses
Total $410,000,000
 Asset Backed Securities: Time Trenching

• First tranche receives all principal repayments from the underlying

assets up to the principal value of the tranche.

• Second tranche would then receive all principal repayments from

the underlying assets until the principal value of this tranche is paid
off.

• Other tranches with sequential claims to remaining principal

repayments.

• Both credit tranching and time tranching are included in the same
structure
 Typical Residential Mortgage Loans

• Residential mortgage loan: loan for which the collateral that

underlies the loan is residential real estate

Key Characteristics
• Maturity
• Interest rate
• Amortization of Capital
• Prepayment Provisions
• Foreclosure
 Agency RMBS

• Residential mortgage-backed securities (RMBS) can be

• Agency issues issued by

• Government National Mortgage Association (GNMA or
Ginnie Mae)
• backed by the full faith and credit of the U.S.
government.
• Federal National Mortgage Association (Fannie Mae)
• Federal Home Loan Mortgage Corporation (Freddie Mac)
• Both Fannie and Freddie are NOT backed by the full
faith and credit of the U.S. government.
Agency RMBS

Agency RMBS are mortgage pass-through securities.

Non-Agency RMBS

RMBS not issued by GNMA, Fannie Mae, or Freddie Mac

are not guaranteed by the government

• Credit quality depends on:

• Quality of the issuer
• Characteristics of the loans:
• LTV ratios
• Credit enhancements
• Credit tranching
• Shifting interest mechanism
Commercial Mortgage Backed Securities

Commercial mortgage-backed securities (CMBS)

• Apartments (multi-family).
• Warehouses (industrial use property).
• Shopping centers.
• Office buildings.
• Health care facilities.
• Senior housing.
• Hotel/resort properties.

CMBS are nonrecourse loans: lender can only look to the

collateral as repayment cash flows from the property are
insufficient.

In contrast, residential mortgage lender with recourse can go

back to the borrower to collect any excess of the loan
amount above the net proceeds from selling the property.
Commercial Mortgage Backed Securities

Being non-recourse, CMBS analyses focuses on risk of the

property, not of the borrower:

• Debt-to-service-coverage ratio (DSC)

• Loan to Value Ratio (LTV)

Other Asset Backed Securities

Other Asset Backed Securities include:

• Auto Loan ABS

• 36 to 72 months

• Credit Card ABS

• 36 to 72 months

• CDO Collateralized Debt Obligations

• Collateralized by pool of obligations
• Issued by SPE

• CLO Collateralized loan obligations

• Collateralized by portfolio of bank loans
Other Asset Backed Securities

• Structured CDOs:
• Backed by ABS, RMBS, other CDOs and CMBS

• Synthetic CDOs:
• Collateral is a portfolio of credit default swaps on
structured securities

• CDOs issue three tranches:

• Senior bonds
• Mezzanine bonds
• Subordinated bonds (called equity or residual
tranche).