Chapter 3.

Corporate Finance, Creating Shareholder Value and Corporate Governance

List of Terms

1. CFO - Company officer responsible for managing a corporation’s finance

function. The CFO primarily oversees a corporation’s working capital decision,
the capital budgeting decision and the capital structure decision.
2. Controller - Corporation officer who handles and monitors a corporation’s
accounting and audit activities. The Financial Controller oversees tax accounting,
cost (internal) accounting, financial (external) accounting as well as the data
collecting/processing systems.
3. Treasurer - Company officer responsible for managing a corporation’s finance
function. Smaller companies tend to use the term treasurer, while larger
companies typically use the term chief financial officer to represent the officer
responsible for the finance function.
4. Capital Budgeting - The process of managing a corporation’s investment
decisions.
5. Capital Structure - The mixture of financing (debt and equity) a corporation uses
to finance its operations.
6. Working Capital - The short-term assets and liabilities of a corporation
7. Shareholder value - Return that investors receive for their capital. This return is realized
through dividend disbursements, stock buy-backs, and capital gains on stock price
increases.
8. Corporate governance - Interaction between shareholders and management intended to
assure that management uses invested capital to maximize shareholder value.
9. Sole proprietorship - A form of business organization. A sole proprietorship is a
business owned by one person.
10. Partnership - A company formed by two or more individuals and can be either a general
partnership or a limited partnership. In a general partnership, each partner is liable for the
debts of the partnership and shares in the profits and losses of the firm. Limited
partnership limit the liability to the amount of cash contributed by each partner.
11. Corporation - A form of business organization. The main characteristics of this form of
business organization include limited liability, corporate taxes in addition to personal
income taxes for its owners. Corporate ownership is easily transferable.
12. Limited / unlimited liability. - In a business with limited liability, owners are only liable
for the amount of cash contributed by each investor. In a business with unlimited
liability, owners are liable for an amount greater than their investment in the company.
13. Dividends - A method of providing return to the shareholders when part of free cash
flows generated by the company is distributed to the shareholders.
14. Stock buy-back - A method of providing return to the shareholders through buying back
corporate stock.
15. Capital gains - A method of providing return to the shareholders when corporate share
price increases.
16. Free cash flow - Cash flow available for distribution to shareholders after paying all
corporate taxes.
17. Return on equity - Net income divided by equity. This ratio measures how efficiently
firm utilizes shareholder’s investment dollars.
18. Stock options - A right – but not an obligation – to buy a stock from the company at a
fixed price during a specified time period.
19. Acquisition - When one company purchases a majority interest in the acquired.
20. Divestiture - The partial or full disposal of an investment or asset through
sale, exchange, closure or bankruptcy. Divestiture can be done slowly and systematically over a
long period of time, or in large lots over a short time period.
21. Agency problem - A conflict of interest arising between creditors, shareholders and
management because of differing goals
22. Stock split - the increase in the number of outstanding shares of stock while making no
change in shareholder’s equity.
23. Corporate raider - A company that attempts to acquire another company against the
wishes and efforts of management of the target company. Corporate raiders launched
many hostile takeover attempts of poorly performing companies in the 1980s.
24. Hostile takeover - A takeover attempt that is strongly resisted by the target firm.
25. Junk bond - A riskier bond that is considered non investment grade by a major
rating agency
26. Voting rights - Shareholder’s right to vote on the shareholder meeting.
27. Shark repellant - Defense mechanism against unwanted takeovers when the board of
directors is staggered so that one-fourth of the board members are elected each year and
serve a four-year term.
28. White Knight - Defense mechanism against unwanted takeovers when the target
company finds a friendly merger candidate.
29. Pac-Man defense - Defense mechanism against unwanted takeovers when the target
company employs a counter-takeover bid for the raider.
30. Greenmail - Defense mechanism against unwanted takeovers when the target company
purchases the acquirer’s shares at a premium over the market price.
31. Golden parachute - Defense mechanism against unwanted takeovers when the target
company provides compensation to top-level executives in the event of a change of
corporate control.
32. Self-tender offer - Defense mechanism against unwanted takeovers when the target
company agrees to purchase some of the current outstanding shares from its shareholders,
usually at a price above what the acquiring company is offering.
33. Poison pill - Defense mechanism against unwanted takeovers when the target company
gives current shareholders the right to purchase shares of the company at a bargain price,
contingent on another firm acquiring control.
34. Crown jewels - Defense mechanism against unwanted takeovers when the target
company sells off its major assets.
35. Proxy solicitations - An attempt to gain control of a firm by soliciting a sufficient
amount of votes to replace the existing management.
36. Mutual fund - The most common type of investment company which holds large
investment portfolio of assets that is divided up into small “shares” and sold to investors.
37. Insider trading – When investing parties use information not readily available to the
public when making trading decisions.
38. Institutional investors - Includes commercial banks, investment banks, insurance
companies, mutual funds, corporations, governments, and any other large pool of assets
that invest in financial markets.
39. Shareholder activism - Active involvement of shareholders in corporate governance
through influencing management decisions.
Chapter 3. Corporate Finance, Creating Shareholder Value and Corporate
Governance

1. What are the alternative roles of the CFO?

The CFO oversees all financing activities of the firm. In the traditional role, the
CFO managed the controller and treasury functions. Today, the responsibilities
and importance of the CFO in creating shareholder value has expanded greatly.
The CFO plays the role of a corporate strategist, measures and manages the risk
position of the firm and acts as an internal investment banker for growth and
acquisition activity.
2. What are the primary activities of a controller versus a treasurer?
The controller is the head accountant of the firm and is responsible for
maintaining the company’s books and financial statements. The treasurer is in
charge of managing the company’s cash, which includes managing the firm’s day-
to-day cash inflows and outflows.
3. Discuss the differences between ‘Corporate Cops’ and ‘Business Advocates’.
In the past, the finance department was viewed as the corporate cop whose
primary purpose was overseeing company spending and getting the books closed
on a timely basis. Today they act as business advocates who are assigned to, and
very much a part of, individual business units. They share key financial
information to assist in decision-making.
4. What are the three primary areas of strategic corporate finance?
Capital budgeting involves investment in fixed assets. Capital structure entails
choosing to issue either debt o equity instruments to finance investments, and
working capital management is related to the use and financing of short-term
assets and liabilities.
5. What are the advantages and disadvantages of the alternative legal forms of
business?
There are three types of companies: (1) sole proprietorships, (2) partnerships, and (3)
corporations. Limited liability of shareholders, the ease of transferring ownership, and the
ability to raise capital are the main advantages of corporations. The disadvantages include
double taxation of income and agency problems. Partnerships are not taxable, yet
individuals are subject to unlimited liability, and the transfer of ownership is difficult.
6. What are the main difference between partnerships and corporations?
A Partnership is a company formed by two or more individuals and can be either a
general partnership or a limited partnership. In a general partnership, each partner is
liable for the debts of the partnership and shares in the profits and losses of the firm. A
corporation is a form of business organization. The main characteristics of this form of
business organization include limited liability, corporate taxes in addition to personal
income taxes for its owners. Corporate ownership is easily transferable.
7. What is meant by creating shareholder value and why is it the appropriate business
goal?
Creating shareholder value refers to providing shareholders with maximum return on
their investments. It is the appropriate goal because it is a measure that encompasses and
reflects all other considered factors - sales, employers, products, profits, etc.
8. What are the avenues for shareholder value creation?
The avenues for shareholders value creation involve (1) allocating capital to investments
offering the highest returns and minimizing the amount of capital needed to meet the
 company’s objectives (capital management), (2) minimizing the cost of capital (financial
management, including debt/equity management, use of financial innovation and
strategic risk management), and (3) enhancing performance by applying appropriate
ownership structures.
9. Why may the interests of the shareholders and other stakeholders differ? Give some
examples.
Shareholders are suppliers of capital to corporations and they expect to receive highest
possible return on their investments. Management can allocate corporate resources to
investments that benefit management and not shareholders: private jets for management
and other unnecessary business expenses. The community expects a corporation to be
“socially responsible” and contribute to social interests. Some examples include
donations to philanthropic and other nonprofit organizations.
10. What three reasons does Roberto Guizuetta of Coca-Cola give to support the goal of
maximizing shareholder value?
First, companies are created to meet economic needs of society. The need to create
shareholder value is demanded by the capitalist economic system. Second, if a company
creates shareholder value, it is a healthy company. Only healthy companies can
contribute to society. Third, focusing on creating value in the long term serves interests of
all stakeholders. The company will only maximize shareholder value in the long term if it
promotes social well being necessary for a healthy business environment.
11. What does corporate governance mean? Is good corporate governance related to
value creation? Why?
Corporate governance involves the rules and procedures that prescribe how stockholders
insure that managers act to increase shareholder value. Good governance definitely
enhances shareholder value.
12. What role does the Board of Directors serve?
The Board of Directors are a group of individuals who are elected by stockholders to
establish corporate management policies and make decisions on major company issues,
such as dividend policies.
13. What is the agency problem?
Shareholders are the principals (contributors of capital) and management is the agent
(authority over the use of capital). Management might not be acting in the best interests
of shareholders. This conflict of interest between management and shareholders is called
the agency problem.
14. What control mechanisms are built into the corporate organization to protect
shareholders?
Internal control mechanisms include: 1) the board of directors, appointed by shareholders
to represent their interests, 2) audited financial statements, 3) managerial compensation
linked to the value of common stock, and 4) managerial stock ownership interest.
External control mechanisms include: 1) the managerial control market, 2) the market for
corporate control, and 3) shareholder activism.
15. What is different between corporate governance in the 1980s and the 1990s?
The main characteristics of corporate governance in the 1980s included diffusion of stock
ownership, unfair corporate voting procedures in electing board members and
management, and a low degree of managerial stock ownership. In the 1990s institutional
investors were becoming more active in corporate governance issues, management
compensation systems were reviewed and included management stock ownership and
stock options to managers. Institutional activism rekindled the internal monitoring
process by the board of directors.
16. Who were the corporate raiders and what did they do?
 A corporate raider is a company that attempts to acquire another company against the
wishes and efforts of management of the target company. Corporate raiders launched
many hostile takeover attempts of poorly performing companies in the 1980s.
17. How did hostile takeovers in the 1980s better align the interests of shareholders and
corporate managers?
The agency problem has declined as the threat of hostile takeovers has forced
management to focus on maximizing shareholder value.
18. Since the hostile takeovers in the 1980s, what has been the main mechanism of
improved corporate governance?
First, the shareholdings of institutional investors increased, giving them greater power to
oversee management’s decisions. Management took on more stock option plans in which
their pay was tied with performance. Finally, the Board of Directors became more
proactive.
19. Why did dividends decline in popularity in the 1990s? What did corporations do
with the retained earnings?
Dividends declined in popularity because shareholders preferred that corporations
reinvest these earnings to get further capital gains in their stock by management investing
into profitable business projects and investments.
20. How does the US corporate governance system differ from those around the world
(from class)?
U.S. corporate governance model includes minority shareholders and board of directors.
Japan-Germany Dedicated capital model includes large equity holders, which never sell
their shares. In the rest of the world corporate governance model usually includes
majority equity owners, which oversee management.
21. Who are the institutional investors and what roles do they play in corporate
governance?
Institutional investors include commercial banks, investment banks, insurance
companies, mutual funds, corporations, governments, and any other large pool of assets
that invest in financial markets. Institutional investors, through the concentration of large
blocks of shares, influence management of corporations by reducing the principal-agent
problem.
22. What were the main causes of the corporate malfeasance in the late 1990s and early
2000s?
In the 1990s, the shareholdings of institutional investors increased; therefore financial
institutions owned a larger percentage of a company’s shares. The media and investors
closely monitored corporations. The SEC relaxed the proxy solicitation rules, which
reduced the costs of coordinating challenges against underperforming management
teams, and gave investors more power. Also, changes were made in reporting
requirements as mandated by the SEC. In the early 2000s, accounting scams at Enron
and WorldCom prompted legislative hearings.
23. Who is the CII and what recommendations has it made to insure effective corporate
governance?
The Council of Institutional Investors (CII) is a group of institutional investors who often
act together to bring about corporate governance. It’s recommendations include: 1)
annual elections of the board of directors, 2) at least two-thirds of directors should be
from outside the corporation, 3) availability to shareholders of adequate information
regarding director backgrounds, 4) all members of oversight committees should be
independent directs, and 5) a majority vote from common shareholders should be
required to pass any major corporate decision.
24. How do companies perform after being placed on CII’s focus list?
When a company is placed on the CII's focus list this indicates that institutional investors
can become more involved in the corporate governance issues or consider selling their
shares. Managers are induced to improve the company’s performance. After being placed
on CII’s focus list companies show better profit and stock performance as compared to
their industry and S&P 500 averages.