Lecture 1 + tutorial

Created Date @February 5, 2025

Tags Lecture

Valuation is central to most of what we do in financial analysis

Two types of valuation tasks:

project valuation: the value of an investment project

enterprise valuation: the value of a stand-alone business

Why business valuation?

As a company owner or investor, you may need a current and reliable valuation
for:

Financing

Selling or buying shares

Acquisition by another company

Harvesting (e.g., through an IPO)

—> the importance of valuation boils down to assessing the ability of the business
to generate cash flows from the point of sale, as well as assessing the risk levels
associated with these cash flows.

valuation for financing

entrepreneur and outside investors need to agree on the value of the

company, which will determine the percentage of the ownership that they get
at each round of the investment process.

Valuation is the next important step after initial screening and business plan
evaluation

Lecture 1 + tutorial 1
 for financing, equity valuation is key

acquisitions

IPO and entrepreneurial exit

IPO - initial public offering

valuation is key within the context of IPOs

traditionally, companies seek to time their IPO as to get public at their

highest valuation.

buying/selling shares once company gets listed.

Fundamental analysis:

valuation to understand the intrinsic (fundamental) value of a share

is the share overpriced, priced at ‘par’ or underpriced, based on the

fundamentals?

Should we buy, sell, or hold the share?

How to deal with valuation

valuation is an art - not a science

several methods - none are wrong

minimum bid

maximum bid

Some myths about valuation

Lecture 1 + tutorial 2
 business strategy

key questions: sustainability and competetive advantage

1. does the firm have a competitive advantage?

2. how durable is this competitive advantage? (long term growth prospects..)

3. What protection does the firm have from competitors? (patents, licenses,
established market share, economies of scale…)

Porter suggests two major competitive strategies:

low-cost strategy

the firm seeks to be the low-cost producer, and hence the cost leader in
the industry

cost advantages vary by industry and might include economies of scale,

proprietary technology, or preferential access to raw materials.

differentiation strategy

Lecture 1 + tutorial 3
 Firm positions itself as unique in the industry in an area that is important to
buyers

A company can attempt to differentiate itself based on its distribution

system or some unique marketing approach.

Strategies within the sector (competitive strategies):

defensive strategy involves positioning the firm so that its capabilities provide
the best means to deflect the effect of competitive forces in the industry

offensive strategy involves using the company’s strength to affect the

competitive industry forces, thus improving the firm’s relative industry
position.

Growth & Risk

Overview of business-related factors

Lecture 1 + tutorial 4
 What is finance?

finance is the study of financial decision making

financial decision making is concerned with resource usage to meet targets

for productive decision making (i.e., Wealth Maximization (creating more

value) or Social Impact)

Define the parameters of the decision

recognize the risks of financial decisions

The business cycle

Lecture 1 + tutorial 5
 Two branches of accounting

Financial accounting

performed for the owners, and other external stakeholders such as tax
authorities and banks.

used to show them how much profit has been made and what the business
is worth

Management accounting

performed for/by managers of the business (generally internal

stakeholders only)

used to help managers make decisions - plan future activities and enables
them to control the business.

Key Financial Statements

Lecture 1 + tutorial 6
 Balance Sheet

shows resources (assets) of the firm and how it has financed these resources.

Indicates current and fixed assets available at a point in time.

Lecture 1 + tutorial 7
 Income statement

contains information on the profitability of the firm during some period, in

contrast to the balance sheet at a fixed point in time.

indicates the flow of sales, expenses and earnings during the period

Sales - expenses = profit

Cash Flow Statement

a cash flow statements shows the actual movements of cash in a business

cash inflows expected from cash receipts such as capital, loans and revenue
(positive cash flows)

cash outflows expected from cash payments made on purchases of inventory

and other expenditures (negative cash flows)

—> timing of cash flows is important because business transactions can be for
immediate cash or on credit

Three types of CFS:

cash flows from operating activities: the sources and uses of cash that arise
from the normal operations of a firm.

Lecture 1 + tutorial 8
 cash flows from investing activities: change in gross plant and equipment plus
the change in the investment account

cash flows from financing activities: financing sources minus financing uses

Profit vs. cash

Revenue and expenses recognition

cash accounting

record income when cash is received

record an expense when cash is paid

accrual accounting

record income when it is earned regardless of when cash transactions

occur

record an expense when it is incurred, regardless of when cash

transactions occur

The analysis of the business

financial statements are the lens on the business

—> F/S translate economic factors and strategy into accounting numbers, like
assets, sales, margins, CFs and earnings…

Financial statement analysis focuses the lens

—> organizes the financial statement in a way that highlights these features in a
business.

Financial statement analysis

Financial statement analysis allows the company managers and prospective

investors to assess the overall ‘health’ of the company, by identifying its
strenghts and weaknesses.

Lecture 1 + tutorial 9
 Financial Ratio Analysis allows to gauge a firm’s ability to raise funds on
reasonable terms and to deploy them productively. It facilitates to identify
areas of strengths and weaknesses, where ratios between different periods can
be compared, or a comparison against an ‘industry standard’ can be made.
Vertical analysis (aka common size analysis) is based on the comparison of
entities to a common reference point in the same statement, e.g. expression of
each figure on the income statement as a percentage of total sales, each
figure on the balance sheet as a percentage of total assets.
Horizontal analysis (aka trend analysis) compares the ratios across two or
more periods or looks at the expression of current results relative to some base
period.

Financial Ratio Analysis

—> various shareholder ratios, e.g. P/E ratio; B/M, dividend yield

Overview of valuation techniques

market/book value of assets: can be relevant for businesses that are ‘asset
rich’ (net asset valuation)

Lecture 1 + tutorial 10
 Cash flow based value: value of the business as the present value of projected
cash flows

Valuation using comparables (market value financial ratios), such as P/E (price
to earnings) ratio, P/B (price to book) and other ratios of comparable public
companies.

Forward - looking and static valuation methods

Asset based valuation is a ‘static’ method, since it derives value from the BS
data measured in the moment (’picture’).

Valuation using comparables (multiples) is also a static method

Forecasting financial performance involves forecasting of variables (a ‘film’)

—> these involve CFs and dividend forecasting methods

Some terminology

enterprise value = market value of equity + value of (net) debt

market value (of equity) = Market Cap(italization)

Book value (of equity) = balance sheet

market capitalization (market value of equity) = number of shares * share

price

Lecture 1 + tutorial 11
 book value of equity: balance sheet net value

Valuation methods: net asset value models

became popular in the 1930th when companies could be bought for under
their Net Asset Value

What asset values should we use in valuation?

monetary items (current assets) —> book values

non-monetary items:

1. replacement cost - going concern

2. realizable values - assumes break up basis (e.g., bankruptcy)

—> replacement cost is typically higher than realisable value

questions on slide???

Lecture 1 + tutorial 12
 Some remarks on ROCE:

will be affected by accounting depreciation policies

needs to be compared very carefully, across time and across companies

Lecture 1 + tutorial 13
Lecture 1 + tutorial 14
 Liquidity:

The ability to pay debts as they fall due

importance of cash flow

liquidity vs profitability

‘working capital’ management

Working capital

Working capital = current assets - current liabilities

current assets: inventory, receivables and cash

current liabilities: accounts payable and bank overdrafts

Lecture 1 + tutorial 15
 Current ratio:

current ratio = current assets / current liabilities

What is a good ratio?

Should it be 2:1 ? (often considered as a ‘good’ ratio - but depends on the

industry and the business strategy

Low ratio could indicate liquidity problems or efficiency!!

Quick ratio:

consider only those current assets that can be turned into cash ‘quickly’

also known as ‘acid test’ ratio

quick ratio = (current assets - inventory) / current liabilities

should it be 1:1?

Financial gearing - solvency

indicates the proportion of a company’s finance that comes from external

providers

seen as a key indicator of risk

gearing ratio = debt / capital employed (%)

debt-to-equity ratio = debt / equity (%)

how much debt?

above 50% debt/equity is a warning sign. Above 100% is high

Ratios used can be seen on slide!

Lecture 1 + tutorial 16
 Lecture 2 + tutorial
Created Date @February 11, 2025

Tags Lecture

What is the time value of money?

The time value of money is the concept that money available now is worth more
than the same amount in the future.

opportunity costs: money invested today could earn returns (investing now)

Risk and uncertainty: future payments may not be as valuable due to potential
risks

Inflation reduces the value of money over time.

Rule: it is only possible to compare or combine values at the same point in time.
To compare 1,000 today and 1,000 in one year, we need to move cash flows to the
same point in time.

moving cash flows forward in time

moving cash flows backward in time

Moving Cash Flows Forward in time

Suppose we have 1,000 today and we wish to determine the equivalent amount in
one year’s time. If the current market interest rate is 10% we can use that rate as
an ‘exchange rate’ to move the cash flow forward in time

Lecture 2 + tutorial 1
 In general, if the market interest rate for the year is r, then we multiply by the
interest rate factor, (1+r), to move the cash flow (CF) from the beginning to the end
of the year

The process of moving a value or cash flow forward in time is known as

compounding.

Rule: to move a cash flow forward in time, you must compound it.
We can apply this rule repeatedly. Suppose we want to know how much the 1,000
is worth in two years time. If the interest rate for year 2 is also 10%.

Lecture 2 + tutorial 2
 In the second year we earn interest on our original 1,000, plus we earn interest on
the interest we received in the first year.

This effect of earning ‘interest on interest’ is known as compound interest.

In general to take a cash flow CF toward n periods into the future, we must
compound it by the n intervening interest rate factors.

If the interest rate r is constant, then the future value (FV) of a cash flow is:

Lecture 2 + tutorial 3
 Moving cash flows back in time

Suppose you would like to compute the value today of 1,000 you anticipate
receiving in one year. If the current market interest rate is 10%

To move the cash flow backward in time, we divide it by the interest rate factor,
(1+r), where r is the interest rate

This process of moving a value or cash flow backward in time is known as

discounting.

Rule: to move a cash flow back in time, we must discount it

Lecture 2 + tutorial 4
 In general to move a cash flow CF backwards n periods, we must discount it by
the n intervening interest rate factors. If the interest rate r is constant then the
present value (PV) of a cash flow is:

Three rules of time travel:

Rule 1: only values at the same point in time can be compared or combined

Rule 2: to move a cash flow forward in time, you must compound it

Rule 3: to move a cash flow backward in time, you must discount it.

Simple perpetuities

Say you get a 1,000 each year.

Perpetuities formula:

1. The stream of cash flow payments continues indefinitely. Po is the (finite)

present value of these future cashflows.

2. We assume that all cash flows are of the same magnitude.

Lecture 2 + tutorial 5
 Perpetuities with growth (dividend)

g is growth rate, i.e. CF0 grow at the same rate of growth forever.
—> at a certain point in time you can’t predict the growth rate (so forever might
give it a bit more uncertainty).

Discount rate

Discount rate: interest rate used to compute present value of future cash flows

the discount rate used should be consistent with both the riskiness and the
type of cash flow being discounted.

the riskier the cash flow (i.e., the higher the likelihood that the cash flow may
not occur, or that the amount of the cash flow is uncertain), the higher the
discount rate should be. This is because investors demand a higher return to
compensate for the increased risk associated with those cash flows.

Equity cash flows versus firm cash flows: if the cash flows being discounted
are cash flows to equity, the appropriate discount rate is a cost of equity. If the
cash flows are cash flows to the firm, the appropriate discount rate is the cost
of capital.

Risk definition

Risk is usually defined in terms of the variance of actual returns around an

expected return

Lecture 2 + tutorial 6
 Risk and return

a typical way to structure the discount rate

Discount rate = risk-free rate + risk premium

—> start with a risk-free rate (such as the rate of return on government bonds,
which are considered virtually risk-free)

—> then add a risk premium to account for the specific risk associated with the
cash flow or investment.

Matching cash flows and discount rates (step 2 is focus this week)

Lecture 2 + tutorial 7
 Cost of equity

the cost of equity should be higher for riskier investments and lower for safer
investments

while risk is usually defined in terms of the variance of actual returns around
an expected return, risk and return models in finance assume that the risk that
should be rewarded (and thus built into the discount rate) in valuation should
be the risk perceived by the marginal investor in the investment

Most risk and return models in finance also assume that the marginal investor
is well diversified, hence only risk that cannot be diversified matters.

Systematic Risk and Individual Risk

While the notion that the cost of equity should be higher for riskier investments
and lower for safer investments is intuitive, what risk should be built into the cost
of equity is the question.

Diversification reduces or eliminates (in the limit case) firm-specific risk.

Portfolio theory

Lecture 2 + tutorial 8
 The effect of increasing portfolio size
Key message: diversification results in risk reduction without reduction in return.

Risk (some other notes)

unsystematic (individual risk) refers to the country, industry or company risk

inherent in an asset. It can be diversified away.

systematic risk refers to the portion of an individual asset’s total variance

attributable to the variability of a market benchmark. It cannot be diversified
away.

The required rate of return is the minimum rate of return on investor requires
on an investment, including the pure rate of interest rate and all other risk
premiums to compensate the investor for taking the investment risk.

Cost of equity (only holds when you are diversifying)

The cost of equity refers to two separate concepts, depending on the party
involved

If you are the company, the cost of equity is the return that the company must
offer its equity investors (shareholders) to compensate them for the risk of

Lecture 2 + tutorial 9
 investing in the business.

If you are the investors, the cost of equity is the expected rate of return on
your investment in the company’s equity. It is the return that investors
requires, given the risk they take by investing in the company’s stock.

We use a model that has been in use the longest and is still the standard for
most practitioners to estimate the cost of equity known as the Capital Asset
Pricing Model (CAPM) developed by William F. Sharpe in 1960s.

CAPM Sharpe (1964) formula

The Capital Asset Pricing Model (CAPM) is a foundational model in finance that
describes the relationship between systematic risk and expected return for cases
(e.g., equity).

The CAPM indicates what should be the expected or required rates of return on
risky assets (e.g., equity)

Risk-Free Rate

On a risk-free asset, the actual return is equal to the expected return. Therefore,
there is no variance around the expected return.

Lecture 2 + tutorial 10
 In practice, the risk-free rate is typically represented by government securities.
The right risk-free rate to use in valuing a company in US dollars would be:

A three-month Treasury bill rate

A ten-year Treasury bond rate

A thirty-year Treasury bond rate

Others

Time horizon matters: thus, the riskfree rates in valuation will depend upon when
the cash flow is expected to occur and will vary across time.

Currencies matter: a risk free rate is currency-specific and can be very different
for different currencies.
Not all government securities are riskfree: some governments face default risk
and the rates on bonds issued by them will not be riskfree.

The Market Portfolio and E(Rm)

Theoretically, the market portfolio should include all US and non-US stocks
and bonds, real estate, coins, stamps, art, … and other marketable risky assets
from around the world.

Lecture 2 + tutorial 11
 Most people use the Standard & Poor’s 500 Composite Index as the proxy due
to

it contains large proportion of the total market value of US stocks.

it is a value weighted index.

Using a different proxy for the market portfolio will lead to a different beta
value

depending on company’s location.

It assumes the future is the same as the past.

The ubiquitous historical risk premium

The historical premium is the premium that stocks have historically earned over
riskless securities.
While the users of the historical risk premiums act as if it is a fact (rather than an
estimate), it is sensitive to:

how far back you go in history

Whether you use [Link] rates or [Link] rates

M arket risk premium = E (Rm ) − RF ​

Understanding Beta

Changes in the value of market portfolio represent systematic shocks to the

economy.

We can then measure the systematic risk of a security by calculating the

sensitivity of the security’s return to the market portfolio, known as the beta of
the security.

Lecture 2 + tutorial 12
 The number of observations and time interval used in the calculation of beta
vary widely, causing beta to vary.

There is no correct interval for analysis

5 year is a good benchmark

The meaning of beta (additional notes)

beta measures the degree and type of correlation between R_m and the
returns generated by a financial instruments.

Beta > 1

Aggressive shares. These shares have bigger movements than the market.
Rise more in a bull market and fall more in a bear market.

Beta < 1

Defensive shares. These shares experience smaller movements than the

market.

Beta = 1

Neutral shares. These shares carry the same risk as the market.

CAPM formula interpretation (summary)

According to CAPM, only the systematic risk (beta) matters.

Lecture 2 + tutorial 13
 QUESTION = D

The security market line (SML)

The CAPM model contends that the systematic risk-return relationship is positive
(the higher the risk the higher the return) and linear.

Identifying undervalued & overvalued assets

in equilibrium, all assets and all portfolios of assets should be plot on the SML

Any security with an estimated return that plots above the SML is underpriced.

Any security with an estimated return that plots below the SML is overpriced.

Lecture 2 + tutorial 14
 see slide 51-53 for example on stocks overvalue or undervalue

Stability of beta

betas for individual stocks are not stable

High-beta portfolios tent to decline over time toward 1, whereas low-beta

portfolios tend to increase over time toward 1

Trading volumes of shares may affect the beta stability.

Portfolio betas are reasonably stable

The larger the portfolio of stocks and longer the period, the more stable the
beta of the portfolios.

Cost of debt:

Similar to the concept of cost of equity, the cost of debt can be understood
from both the company’s perspective and the debt investors’ perspective

From the company’s perspective, the cost of debt is the effective rate it pays
on its borrowed funds. It represents the cost of financing that comes from
taking on debt.

Lecture 2 + tutorial 15
 From a debt investor’s perspective, the cost of debt is the yield or interest rate
they earn from lending money to a company.

Cost of debt estimation approaches

The cost of debt is the rate at which you can borrow at currently, it will reflect not
only your default risk but also the level of interest rates in the market.
The two most widely used approaches to estimating cost of debt are:

1. looking up the yield to maturity on a straight bond outstanding from the firm.
The liquidation of this approach is that very few firms have long-term straight
bonds that are liquid and widely traded.

2. Looking up the rating for the firm and estimating a default spread based on the
rating. While this approach is more robust, different bonds from the same firm
can have different ratings. You have to use a median rating for the firm.

—> Our attention is on the second method. The underlying idea is that investors
will receive higher returns (spread) as compensation when a firm’s credit rating is
low, indicating higher default risk.

How to do this?

Step 1: determine the company’s credit rating

the credit rating is provided by agencies such as Standard & Poor’s,

Moody’s, or Fitch.

typically range from: Investment grade (AAA-BBB) and junk-grade (BB-

CCC)

—> when in trouble (either because you have not ratings or multiple ratings
for a firm), estimate a synthetic rating for your firm and the cost of debt
based upon that rating.

Step 2: find the yield spread for the credit rating

Yield spread or credit spread is the difference between the company’s

bond yield and the risk-free rate (e.g., treasury bond yield)

Lecture 2 + tutorial 16
 Look up the typical yield spread associated with the company’s credit
rating

Step 3: use the risk-free rate

The risk-free rate is typically the yield on long-term government bonds

(e.g., US treasury bonds)

For example, if the yield on a 10-year treasury bond is 3% this is the

baseline return with no credit risk.

Step 4: calculate the cost of debt

the cost of debt is the sum of the risk-free rate, and the yield spread (from
rating):

Cost of debt = Risk-free rate + Yield spread

Cost of Capital for business - weighted average cost of capital (WACC)

Three step procedure to calculate WACC:

1. Evaluate the firm’s capital structure and determine the relative importance of
each component in the mix (i.e., capital structure weights).

2. Estimate the opportunity cost (i.e., cost of capital) of each of the sources of
financing and adjust it for the effects of taxes where appropriate.

3. Calculate the firm’s WACC by computing a weighted average of the estimated

after-tax costs of capital sources used by the firm.

WACC:

Lecture 2 + tutorial 17
 Use market weights, not book weights

Market value vs. book value: the market value of equity and debt reflects the
price that investors are willing to pay for the company’s securities today.

investor perspective

investors’ decisions are based on market value because that’s what they care
about when making investment decisions. If an investor buys equity or debt in
the market, they are effectively buying at the market value, not at the historical
book value.

consistency with the cost of capital

the cost of equity is determined based on the market price of the company’s
shares (e.g., CAPM)

The cost of debt is determined based on the interest rates investors demand
for lending to the company, which again is driven by the market conditions
(such as credit ratings, interest rates, and other risk factors).

Lecture 2 + tutorial 18
 Taxes and WACC (T in the formula)

the interest payments on this debt are deducted from income before tax is
calculated.

interest on debt is tax-deductible

Therefore, the effective cost to the company is reduced by the amount of this
tax saving.

Lecture 2 + tutorial 19
 Lecture 3 + tutorial
Created Date @February 25, 2025

Tags Lecture

Reading for this week: CH2, ‘’orecasting cash flows’, ch 6 ‘forecasting financial
performance’ + repetition of FCF computation from ch4

Capitalization approaches

very useful technique that takes the time - value of money and risk into
account and allows to establish a valuation of early stage and growth
companies.

major variables (cash flows, dividends, earnings, sales, gross profit margin)
can be projected into the future (e.g., a 5 years period) and discounted at a
firm’s capitalization rate (for the project do 3 years).

The valuation forecast horizon is usually divided into two parts: the ‘planning
period’ and the ‘implicit period’ (i.e. a ‘terminal value’ after the planning
period).

Variables that are difficult to estimate are: the capitalization rate (WACC) and
the revenue growth rate (g).

Discounted cash flow valuation (DCF)

the idea behind DCF valuation is simple:

The value of an investment is determined by the magnitude and the timing of

the cash flows it is expected to generate.

The DCF approach provides a basis for assessing the value of these cash
flows.

It is considered a cornerstone of financial analysis.

Lecture 3 + tutorial 1
 Forecasting cash flows
DCF for firm valuation steps:

Cash flow to the firm (FCFF)

cash flow to the firm should be the cash produced by a firm during a particular
period of time that can be distributed to the firm’s creditors (principal and
interest payments) and stakeholders (dividends and share repurchases)

We call it Free cash flow to the firm (FCFF).

‘free’ does not mean ‘free of cost’. It refers to the fact that the cash flow under
discussion is available - not needed for any particular purpose.

How to calculate FCFF

accounting income is not the same as cash flow because it is calculated using
the accrual basis of accounting.

Therefore, accounting income in Income statement cannot directely used to

calculate free cash flow to the firm (FCFF)

Lecture 3 + tutorial 2
 However, the income statement provides a good starting point. Necessary
adjustments should be made to align it with cash flow calculations.

FCFF calculation:

Step 1: we start with earnings before interest and expense (EBIT). Then we
calculate after-tax EBIT. Unlike income statements, we do not deduct interest
expense before calculating tax liability

because FCFF represents cash flow available for both creditors (interest and
principal) and shareholders.

—> where to find it? income statement.

Step 2: Depreciation and amortization. We add this back because they do not
involve actual cash outflows.

Lecture 3 + tutorial 3
 —> where to find it? Income statement.
Step 3: capital expenditures: any expenditures the firm has planned for the period
to cover the cost of acquiring new capital equipment. Capital expenditures are
deducted because they represent a cash outflow.

—> where to find it? Cash flow statement investing activities.

Step 4: Net working capital (NWC)

NWC = current assets - current liabilities = cash + inventory + receivables -

payables

it represents the short-term liquidity of the business, or the capital needed to

operate on a daily basis. Firms may need:

maintain a minimum cash balance to meet unexpected expenditures;

inventories of raw materials and finished product to accommodate

production uncertainties and demand fluctuations.

changes in net working capital: NWCt - NWCt-1

increase in NWC: it means the firm has more money tied up in current assets
(e.g., higher inventory or receivables) or has paid off more current liabilities
(e.g., reduced payables). This reduces the cash available for other purposes,
so it’s a cash outflow.

Decrease in NWC: it means the firm has freed up cash, either by reducing
current assets (e.g., collecting receivables) or increasing current liabilities
(e.g., delaying payables). This is a cash inflow.

—> where to find it? Balance sheet.

Step 5: FCFF at period t is calculated as:

FCFF(t)= EBIT * (1-tax rate) + DAt - CAPEX(t) - change NWC(t)

DCF implementation

Lecture 3 + tutorial 4
 FCFF Forecasting

The valuation forecast horizon is usually divided into two parts:

Planning period: the period when we make explicit and detailed forecasts (3-
10 years typically). The length of planning period is 5 years here.

Implicit period: we estimate the value of the remaining FCFF beyond the
planning period by including an one-time cash flow called the terminal value
(TV).

The application of the DCF model to the estimation of enterprise value today
(V0) is:

V0 = PV (planning period FCFF) + PV (terminal value).

FCFF in planning period

Lecture 3 + tutorial 5
 Terminal Value

we assume that FCFF grows at a constant growth rate g after planning period
(Gordon growth model).

If you are at time t = 5, the cash flow stream from t = 6 is a growing perpetuity.
Therefore, the present value of from t = 6 to infinity is:

—> we discount the terminal value to get the present value today.

Lecture 3 + tutorial 6
 Examples can be seen on the slide!

Conservative and optimistic cash flows

biases exist because of managerial incentives and overconfidence

conservatism in the forecast: may result if a cash flow forecast will serve as
future targets that will influence future bonuses.

optimism in the forecast: may result if the manager gets a bonus for identifying
a promising investment opportunity that the firm initiates.

‘hoped-for’ vs. ‘expected’ cash flows.

If all goes as planned, these are the cash flows that we expect to achieve’.

Some notes on the assumptions about the growth rate

it is logical to assume that beta is higher during the higher growth stage and
becomes close to 1 (or lower) in the steady state.

Lecture 3 + tutorial 7
 Since no firm in the long term, can grow faster than the economy in which it
operates (can be the global economy), a stable growth rate cannot be greater
than the growth rate in the economy.

This stable growth rate cannot be greater than the discount rate, because the
risk-free rate that is embedded in the discount rate will also be built on the
same factors - real growth in the economy and the expected inflation rate.

Context of application of DCF valuation approach

—> this approach is easiest to use for businesses, whose cashflows are currently
positive and can be forecasted with some reliability, and where a proxy for risk
that can be used to obtain discount rates is available.

—> this valuation technique is very sensitive to the assumptions related to

perpetual growth rate and the discount rate and thus, the assumptions made can
strongly affect the obtained business value.

The importance of terminal value estimation

Consider the situation where FCFF is expected to grow at a rate of 12% per year
for a period of five years, followed by a 2% growth there after. If the cost of
capital for the firm is 10%.

Lecture 3 + tutorial 8
 The importance of terminal value estimation
Consider the situation where FCFF is expected to grow at a rate of 2% per year
forever. If the cost of capital for the firm is 10%.

Lecture 3 + tutorial 9
 From Firm value to Equity value

So far, we use DCF to estimate the total value of the firm to all investors-both
equity and debt holders, i.e., enterprise value.

From Firm value to equity value

DCF for firm value and equity values: summary

Lecture 3 + tutorial 10
 Dividend Discount Model (DDM)

Lecture 3 + tutorial 11
 Lecture 4 + tutorial
Created Date @March 3, 2025

Tags Lecture

Overview of valuation techniques (RECAP)

Market/book value of assets: can be relevant for businesses that are ‘asset
rich’ (net asset valuation)

cash flow based value: value of the business as the present value of projected
cash flows

Other capitalization approaches: other major variables besides cash flows

(dividends, income, sales) can be capitalized).

Valuation using comparables (market value financial ratios), such as P/E (price
to earnings) ratio, P/B (price to book) and other ratios of comparable public
companies.

Relative valuation

alternative to discounted cash flow approach

widely used by practitioners due to the ease of interpretation and calculation

Value estimate is the product of two inputs:

Firm financial characteristics (sales)

Estimated price multiple (multiplier)

Value can be determined by comparing assets and companies based on

relative ratios

relevant variables include earnings, cash flow, book value, sales or dividends.

Relative valuation ratios include e.g., price/earnings; price/cash flow;

price/book value, price/sales, or dividend yields.

Lecture 4 + tutorial 1
 The most popular relative valuation technique is based on price to earnings
multiplier.

Relative valuation - some other comments

—> some ratios will be removed (not all are needed for the exam)

Higher multiples imply greater expected growth prospects - more investor

optimism.

most applicable for comparison between similar type firms

P/E - most commonly assessed multiple (there is also a ‘forward’ looking

version of it).

P/EBITDA (EBITDA multiple) - suitable for valuation of stable, mature

businesses.

P/B - most useful with firms with fixed assets and illiquid assets

P/S - useful for e.g., intercountry comparisons within industry.

P/CF - less prone to manipulation than EPS and EBITDA.

++ other sector specific multiples (e.g. value/subscriber, value/website visitor,

value / customer).

Key points

identification of appropriate comparables is paramount

The initial estimate must be tailored to the investment’s specific attributes

The specific metric used as the basis for the valuation can vary from one
application to another.

P/E ratio

equity analysts tend to focus their attention on estimating the earnings of the
firms they evaluate, and then use the price - to earnings (P/E) ratio to evaluate
the price of common stock.

Lecture 4 + tutorial 2
 Earnings power is the chief driver of investment value. Earnings per Share
(EPS) is a chief focus of analysts and investors.

A business value can be approximated via multiplication of a business annual

earnings by the average P/E ratio obtained by considering similar
industries/businesses.

P/E ratio analysis has a long history, and was already discussed as a common
stock valuation method by Benjamin Graham& David Dodd back in 1943.

P/E Ratio: This values the stock based on expected annual earnings.

Price/Earnings Ratio = Earnings Multiplier.

Formula = current market price (p) / earnings per share (EPS)

—> share price can be seen as a ‘multiple’ of earnings.

—> the size of the ‘multiple’ reflects expectations of future growth.

—> companies with high P/E ratio (publicly traded) are often perceived as growth
companies, i.e., the investors are willing to pay a higher price for these stocks in
the anticipation of future growth and high earnings.

--→ for project only p/e ratio for competitors for valuation.

P/E Ratio for equity valuation

1. If we want to estimate the fair price of equity being valued (e.g., non-public
company)

2. or we want to evaluate, whether the share is under/overvalued relative to the

comparable company (group of companies).

We assume here that the comparison firms are themselves efficiently priced.

We use the P/E metric obtained from comparable firm/s to value the target
firm’s equity (price) in the following manner:

Lecture 4 + tutorial 3
 Application of the P/E ratio

Example from book: valuing company

Lecture 4 + tutorial 4
 Refining the valuation estimate

If we closely scrutinize the market comparables, are they really simlar to

ExxonMobil’s chemical division?

Does size matter?

The revenues of ExxonMobil’s chemical division make it the 3rd largest

chemical company in the world.

If firm size is an important determinant of P/E rations, then the appropriate

comparison group would consist of the very largest firms from the industry.

Refining the valuation estimate

Lecture 4 + tutorial 5
 The P/E Ratio Model

Since the P/E ratio is a function of the long-run growth prospects, we expect the
ratio to vary across industries. The picture above demonstrates that investors
believed that software will be the fastest growing sector of the economy for years
to come.

Drawbacks to the P/E Ratio

Lecture 4 + tutorial 6
 EPS can be negative. The P/E ratio does not make economic sense with a
negative denominator.

the components of earnings that are on-going or recurrent are most important
for this method.

Earnings often have volatile, transient components, making application of

this method difficult.

Management can ‘manage earnings’ and distort earnings per share.

Distortions can affect the comparability of P/E ratios across companies.

Other major issues

There are two major problems with usage of the earnings multiplier approach in
valuation.

1. the risk of the company is not incorporated into the analysis.

2. It is implicitly assumed that the expected growth rate in earnings in each of the
companies is equal.

EBITDA Multiple
Popular approach used by business professionals to estimate a firm’s enterprise
value.
Uses EBITDA (earnings before interest, taxes, depreciation and amortization).

Analysts generally view EBITDA as a crude measure of a firm’s cash flow, and
thus view EBITDA multiples as roughly analogous to the cash flow multiples.

Enterprise value (RECAP)

Enterprise value of a firm is defined as the sum of the values of the firm’s interest-
bearing debt and its equity minus the firm’s cash balance on the date of the
valuation.

Market value of equity = enterprise value - debt + cash.

Lecture 4 + tutorial 7
 Airgas example: enterprise value vs. firm value

The airgas EBITDA Multiple:

Example from textbook: valuing a privately held firm

Lecture 4 + tutorial 8
 Example: valuing a privately held firm

EBITDA vs. Free Cash Flow

EBITDA is not always a good estimate of free cash flow.

Lecture 4 + tutorial 9
 EBITDA vs. Free Cash Flow
Why use EBITDA Multiples rather than free cash flow multiples?

Advantage: EBITDA provides a good measure of the before-tax cash flows

that are generated by the firm’s existing assets.

if we assume that the firm will not be paying taxes and will not be investing
and growing and it will not experience any changes in working capital; FCF
will be equal to EBITDA.

Disadvantage: EBITDA measures only the earnings of the firm’s assets already
in place, it ignores the value of the firm’s new investments.

Why not use a FCF multiple? Too volatile, since it reflects discretionary
expenditures for capital investments and working capital that can change
dramatically from year to year.

EBTIDA Multiple: key points

EBITDA multiples provide a good valuation tool for businesses in which most
of the value comes from a firm’s existing assets.

Lecture 4 + tutorial 10
 We see EBITDA multiples being used primarily for the valuation of stable,
mature businesses.

EBITDA multiples are much less useful for evaluating businesses whose
values come mainly from future growth opportunities.

Effects of risk and growth on EBITDA Multiples

To reflect differences in risk characteristics and growth opportunities, EBITDA
multiples should be adjusted for:

variations in operating leverage; differences in profit margins

differences between fixed and variable operating costs.

Firms that incur higher levels of fixed operating costs, but lower variable
costs will experience more volatile swings in profits as their sales rise and
fall over the business cycle.

Differences in expected growth rates.

Normalising EBITDA
Any given year’s EBITDA may be influenced by idiosyncratic effects that need to
be accounted for when using the EBITDA valuation model
nonrecurring special events:

onetime transaction with a customer, which contributed to EBITDA but is not

likely to be repeated in future years - make a downward adjustment to EBITDA

Extraordinary write-offs- make an upward adjustment.

Possible nonrecurring items:

Lecture 4 + tutorial 11
 Practical issues with normalizing EBITDA

Determining nonrecurring items are difficult:

Requiring judgment, there is no ‘bright-line’ separating recurring from

nonrecurring income

What management says is nonrecurring may not be

Management’s labeling of large losses as nonrecurring is affected by timing

and other factors.

Adjust/allocate nonrecurring losses over past years.

Although a given event may be nonrecurring, on average, some such events

may occur every few years.

Other valuation ratios that are often used by analysts

Price sales/Ratio

Sales is subject to less manipulation than other financial data

This ratio varies dramatically by industry

Relative comparisons using P/S ratio should be between firms in similar

industries

Lecture 4 + tutorial 12
 The formula: Price / Sales per share.

Many early stage firms do not have earnings, which leads to a

meaningless P/E ratio

The ratio of stock price to sales per share is sometimes employed in

valuation of these firms.

Price/Book ratio

price-to-book ratio is defined as price per share divided by book value of

equity per share

This ratio may vary across industries and companies with different growth
prospects.

Furthermore, international comparative analysis should accommodate the

variations in accounting standards across countries.

Price to book ratio

the formula = P / BV

Low P/BV companies are so called ‘value’ companies.

P = the stock price

BV = the end of year book value of the stock.

The main strengths of relative value are:

They are commonly used, easy to calculate and are well understood

The cost of equity does not need to be estimated

The growth rate of dividends does not need to be estimated

Some of the ratios do not require positive earnings.

the main weaknesses of relative value:

Lecture 4 + tutorial 13
 Need to identify a comparable peer group of companies

Could give misleading answers if the market valuation is at extremes

most important according to teacher

(mostly) backward looking

Some Key points

investment (companies) that look very similar on the surface can generate
cashflows with very different risks and growth rates and should thus sell for
different multiples

—> operating and financial leverage is an important determinant of value, as well

as liquidity and market cap
—> valuation using market comparables requires the same diligence and care as
discounted cash flow analysis.

Examples on slide / exercises

Summary:

We discussed the application of market-based multiples, based on

comparable firms for valuing the target company or investment.

Popular with practitioners in various investment settings (acquisition, private

equity investment, determining fair value of publicly listed company, IPO, etc.).

We discussed various examples with the two most popular earnings multiples
(P/E and EBITDA) and reviewed other comparables used by analysts and
investors.

This method has several advantages (no need for explicit estimates of neither
the investment’s future cash flows nor the discount rate).

It also allows to make direct use of observed market pricing information.

Lecture 4 + tutorial 14
 Lecture 5
Created Date @March 11, 2025

Tags Lecture

How was it possible that so many scandals, frauds, and collapses had
occurred?

What might be done to prevent them happening again, and restore

confidence?

The answers are all linked to corporate governance?

So what is corporate governance?

How can it improve corporate accountability?

Types of business

Sole proprietorship

An unincorporated business that has just one owner who pays personal
income tax on profits earned from the business.

can hire employees, but there is just one owner who runs the business

Small but most common.

unlimited personal liability to any of the debt.

If the owner dies, the business stops.

Partnership

A formal arrangement by two or more parties to manage and operate a

business and share its profits.

owned and run by more than one person

All partners are liable for the firm’s debt.

Corporation

Lecture 5 1
 A legal entity that is separate and distinct from its owners.

Corporation and its typical features

A corporation is a legal entity that is separate and distinct from its owners,
established under the laws of a state or country.
You have the shareholders who are the owners of the corporate with limited
liability and the ownership.
Then you also have the management who run the daily management. CEO, CFO,
and others. They control the business.
—> Separation of ownership and control
Next to the shareholders you have the board who are elected by the shareholders.
The board can hire/fire CEO. They monitor and supervise the managers.

Summary of its typical features:

Separation of ownership and control

legal rights and responsibilities (legal person): can sue or be sued, enter into
contracts, and are held accountable for their actions under the law

Limited liability

Perpetual existence

Lecture 5 2
 Ownership through shares: shareholders are the owners.

Agency theory

Separation of ownership and control —> managers are hired by shareholders.

Principal: anyone who hires someone else to do a certain job at their expense

Agent: a person hired to do a certain job in exchange for an agreed

compensation.

If they have the same interests, everything is fine, but if they have self-interest
and this is not aligned (conflicts of interest), there is a problem —> agent acting in
his own interest on the principal’s expense —> agency problem.

Agency theory in the corporate setting

Shareholders-manager problem

Shareholders (principals) employ managers (agents) to run the firm in the best
interest of the shareholders.

However, some managers act wrongly and embezzle shareholder funds. E.g,

Insufficient effort: not searching for new opportunities, etc.

Extravagant investments: pet project and empire building.

Entrenchment strategies: take actions that hurt shareholders to keep or

secure their position

Lecture 5 3
 Invest in a declining history or old-fashioned technology that they are
good at running

manipulate performance measures

Self-dealing: increase private benefits from running the firm

outright expropriation of minority shareholder value

excessive salaries and consumption of perquisites, e.g., private jet.

information asymmetry theory

There is also the problem of information asymmetry whereby the principal and
the agent have access to different levels of information

in practice, this means that the principal is at a disadvantage because the

agent will have more information

Information asymmetry theory deals with the study of decisions in

transactions where one party has more or better information than the other

Two types of information problems:

Type 1: Adverse selection

Adverse selection is a situation in which one party in a transaction has more or
better
information than the other, leading to an inefficient market outcome.

How to identify peaches and lemons? If you don’t know if it’s a peach or
lemon, there is information asymmetry.

Type 2: moral hazard

A situation where an economic actor has an incentive to increase its exposure to

risk because it does not bear the full costs of that risk.

How to distinguish two types of information asymmetry?

Lecture 5 4
 Contract theory

Suppose that the manager and investors sign a contract that specifies how the
manager will use the funds and also how the investment returns will be
divided between the manager and investors.

If the two sides can write a complete contract that specifies exactly what the
manager will do under each of all possible future contingencies, there will be
no room for any conflicts of interest or managerial discretion. —> under a
complete contract, there will be no agency problem.

However, it is practically impossible to foresee all future contingencies and

write a complete contract —> incomplete contracts.

Lecture 5 5
 What is corporate governance?

Corporate governance deals with the ways in which suppliers of finance to

corporations assure themselves of getting a return on their investment
(Shleifer and Vishny, 1997)

How shareholders in a managerial-controlled public firm will minimize their

agency costs.

Corporate governance refers to the laws, regulation, institutions and corporate

practices that protect shareholders and other investors (brealey, myers,
marcus, 2019).

Friedman doctrine

The primary responsibilities of a corporation is to its owners (shareholders)

Businesses should focus on profit maximization

Ethical and legal boundaries must be maintained

Rejects the idea of corporate social responsibility (CSR) beyond profit-making.

not the responsibility of the corporate CSR, the government and public
should do this.

Friedman criticisms

May encourage short-termism over sustainable growth

Ethical concerns: profit maximization may lead to negative externalities

(pollution, exploitation)

Ignores broader stakeholder interests (employees, community, environment).

Stakeholder theory

Stakeholder theory takes account of the interests of a wider group of

constituents rather than that of shareholders

The term ‘stakeholder’ can encompass any individual or group on which the
activities of the company have an impact.

Lecture 5 6
 What is corporate governance?

OECD: corporate governance refers to a set of relationships between a

company’s board, its shareholders and other stakeholders.

Criticisms to stakeholder theory

Lack of clear prioritization: not providing a clear framework for prioritizing the
interests of different stakeholders when they conflict

Difficulty in implementation: often criticized for being too idealistic and difficult
to implement in practice.

Undermining shareholder value: undermining the primary purpose of a

business, which is to generate profits for shareholders

Measurement challenges: lacking clear metrics for measuring success.

measuring sustainability is hard or diversity, etc.

Lack of legal enforcement: not legally binding in most jurisdictions

What corporate governance is not?

not about management as such, but about the control and direction of
managers

Not just codes or regulation (very important mechanisms) but also about
internal and external mechanisms and introducing a corporate culture with
integrity and ethical behaviour.

Not a faith/belief, but a field of practice and study.

Why corporate governance?

Encourage transparency and accountability by putting in place a system of

internal controls.

Lecture 5 7
 Ensure good decision making: good management, good investments; create
checks and balances and prevent abuse of power.

Diminish corporate failures and scandals.

Crucial for corporate performance, economic efficiency and social welfare.

How does governance work

Corporate governance mechanisms are the instruments used to motivate and

monitor managers.

Motivate to align their own interests with those of other stakeholders.

Monitor them to work properly, not to pursue their own interests.

Major corporate governance mechanisms:

internal (firm-oriented)

Ownership structure, board structure, compensation structure.

External (market-oriented)

capital market/analysts, auditors, takeover market, debt market/creditors,

product market competition, labour market, law and regulation, …

Informal mechanisms: codes, social norms, reputation, and trusts.

Cross-countries differences.

Lecture 5 8
 Lecture 6
Created Date @March 15, 2025

Tags Lecture

Ownership structure and Article 1

Shareholders and their rights

Shareholders, also known as stockholders, are individuals, companies, or

institutions that own at least one share of a company’s stock.

Complex corporate structures: multiple layers of ownership, such as

subsidiaries, holding companies, or shell companies, to obscure the true
ownership.

Shareholders are entitled to control and economic rights

Control rights: elect board members; vote on matters of corporate policy

Economic rights: receive dividend; trade shares

—> dividends and capital gains (differences between purchase and sell
prices) are two sources of profits for shareholders

Different types of shares

Voting shares and non-voting shares

Google GOOGL (class A with voting rights) and GOOG (class C without
voting rights)

Snap class A without voting power

Dual-class shares

Google Class A (GOOGL)

Lecture 6 1
 Google Class B: non-listed, non-traded shares held by founders and
insiders. These confer 10x voting power of Class A shares.

Priority structure of the main claims

Preferred (preference) shares

Usually do not give shareholders voting rights

Provide a fixed dividend

In a liquidation, preferred shareholders’ claims on residual assets would

typically rank ahead of common shareholders but behind bondholders and
secured creditors.

Common (ordinary) shares

How do shareholders exercise corporate governance?

Hirschman (1970): voice and exit framework

Voice: dissatisfaction directly to management

Exit: selling the shareholding

Voice channel

Some examples of monitoring, intervening, or governing through voice:

Direct confrontation: public criticism of management or launching a proxy fight

Behind-the-scenes ‘jawboning’: advising management on strategy

Researching how to vote on a shareholder proposal or proxy fight launched by

others.

Lecture 6 2
 A hypothetical corporation

Market value: 100 million

Total shareholders: 1,000 with equal stakes

Individual ownership stake: 100,000,000/1,000 = 100,000

Cost of governance improvement initiative: 1 million

Expected increase in company value 5% —> market value to 105 million

Individual action: benefit 5% x 100,000 = 5,000. Cost: 1,000,000. Net benefit =

-995,000

Collective action: benefit = 5,000. Cost = 1,000,000/1,000 = 1,000. Net benefit =

4,000

No single shareholder has an incentive to act independently

Collaboration leads to a positive net benefit for each shareholder

Without collaboration, governance improvements fail, and the company

remains undervalued.

Voice channel and free-rider problem

Shareholders may choose not to monitor at all because of their small interests
in the corporation

Minor shareholders may profit from the monitoring activities of others —> free-
rider problem

A large shareholder internalises more of the benefits of monitoring

This theory predicts that a structure with only one large shareholder is
optimal.

Exit channel

Even if a shareholder cannot exercise voice, she can still govern through exit.

Shareholders ‘vote with their feet’ —> exit

Lecture 6 3
 So called ‘Wall Street Walk’ or ‘Walk Street Rule’

Exit channel

Managers can choose to shirk or work;

Shareholder informed about the firm’s fundamental can observe whether

managers work hard to improve fundamentals;

Shareholders can sell their shares and drive down the stock price;

It punishes the manager ex post and thus induces him to maximize value
ex ante.

Blockholder governs more by the threat of exit rather than actual exit.

Factors affecting the strength of exit

A single shareholder will strategically limit her order to hide her private
information

In contrast, multiple shareholders trade aggressively

Such trading impounds more information into the manager’s action.

As with the voice channel, the effectiveness of exit also depends on the
number of shareholders, N, but in the opposite direction —> more
shareholders, more effective of exit.

Ownership structure

Is defined as the way a firm is owned by different entities.

Who are the owners? how much do the own?

WHO identity/composition: helps us to know the investors’ incentives and

objectives to exercise power/monitor managers in the firm.
HOW MUCH size/concentration/distribution: helps us to know the investors’
power position in the firm.

Ownership identity on corporate governance

Lecture 6 4
 Ownership can have different effects when shares are held by different types of
shareholders —> different incentives and objectives

Families

They are often controlling shareholders and participate in management

Potential conflict of interests between them an other shareholders?

Insider vs. outsider

Insider: e.g., officers, directors, and those that hold more than 10% of any
class of a company’s securities,

Outsider

Individuals vs. Institutional investor

Individual/retail investors

Institutional investors: manage capital on behalf of other people.

Ownership (relative) size on corporate governance

Dispersed ownership structure

Monitoring may not be optimal (free-riding)

Agency issues between managers and shareholders.

Concentrated ownership structure

Stronger incentive / larger ability to monitor

Larger private benefits of control; risk of wealth expropriation

Article 1
Blockholders background

A blockholder refers to an individual or organisation which owns a substantial

amount of a company’s shares or debt.

Lecture 6 5
 There is not set number of shares to make somebody a blockholder, although
the SEC does require any 5% or larger equity owner to file paperwork stating
as much

Edmans and Holderness (2017) survey paper provides some descriptive

statistics about blockholders’ ownership in a random sample of US public
corporations

hand-collected from 375 randomly selected public corporations between

1995 and 2015

no type of firm is excluded

Blockholders are ubiquitous. Virtually every corporation has them

Motivation

Blockholders are important to study

Ubiquitous

Important to the corporate governance because of their large ownership

Research gaps

The theoretical literature on corporate governance provides conflicting

predictions on whether a single large blockholder or a dispersed set of
smaller blockholders is better for firm value.

Most studies have been conducted solely for Western Europe and Asia.

Only focus on the role of the largest blockholder or analyzed total

blockholder ownership without considering its distribution.

Blockholder presence:

Lecture 6 6
 No present in firm B, but present in firm A.

Blockholder dispersion

Both firms have blockholders and the total ownership of blockholder are same
(100%), but the levels of blockholder ownership dispersion are significantly
different.

Research question: the relation between blockholder presence and blockholder

dispersion and firm value for US companies.

Lecture 6 7
 Theories: Effect of blockholder presence

Positive effect: free-rider problem when shareholders only own a small fraction of
shares. A large blockholder internalises more of the benefits of monitoring —> a
structure with one large blockholder is optimal.

Negative effect: agency problem is not just between all shareholders and
managers but maybe a more relevant one is between controlling shareholders and
smaller shareholders.

Theories: Effect of blockholder dispersion

Positive effect: exit channel predicts that the more dispersed of blockholders, the
more effective of exit channel
Negative effect: A second (or third, etc.) blockholder can be good for firm value if
she monitors the first block holder. Incentive to monitor and the ability to
challenge expropriation decisions by the first blockholder require the second
blockholder to be sufficiently large.

— Methodology
Data sources —> is this relevant?

Blockholder defintion:

Blockholders: shareholdings owning > 5% of a company’s stock.

—> because of SEC who requires such owners to file their ownership stake.

Blockholder presence measures

Total block fraction: the % of blockholders ownership in a firm

Block: a dummy for the presence of at least one blockholder

Blockholder dispersion measures

Lecture 6 8
 #Blocks: the number of blockholders in a firm

Herfindahl index:

Where Si represents the ownership of blockholder i

But what is the intuition of Herfindahl index?

A lower value of Herfindahl index implies a higher dispersion —> see slide 49
for example.

Assume each blockholder in a firms owns an equal share. The relationship

between the Herfindahl index and the number of blockholders can be illustrated
as follows:

Lecture 6 9
 Firm value measures:

Tobin’s Q: market value / book value

Larger Tobin’s Q implies higher valuation

Q Ratio: a valuation method that divides the market value of a company by the
replacement value of the firm’s assets.

Control variables

Control variables / controls: a set of independent variables which are not

interest to the study’s objectives, but are controlled because they could
influence the dependent variable

For this study, control variables include

Firm size

leverage

Lecture 6 10
 capital intensity

capital expenditure

GIM (corporate governance index)

beta

Methodology

regression analysis

correlation but not causality!!

— results
Main results:

significantly negative coefficients on block and total block fraction

block presence and size are negatively related to Tobin’s Q.

A lower value of Herfindahl implies a higher dispersion

Significantly positive coefficients of Herfindahl

More dispersed blockholder base is negatively correlated with Tobin’s Q

The results are robust when using alternative dispersion measure #Blocks.

— Conclusion

For a large sample of US firms, this paper examines the relation between
blockholder presence and blockholder dispersion and firm value as measured
by Tobin’s Q.

Main findings

A consistently negative correlation between firm value and blockholder

dispersion

Lecture 6 11
 A consistently negative correlation between firm value and the presence
and total ownership stake of block holders.

Summary of this lecture:

Explain corporate governance theories, mechanisms and the cross-country

differences ;

Understand the shareholders and ownership structure : who / how much

do owners own

Explain the effect of ownership structure on corporate governance : pros /

cons of concentrated / dispersed ownership structure ; different types of
owners

Evaluate scientific research on the functioning of corporate governance

mechanisms and
their impact on firm value / performance.

Analyze the relationship between blockholder and firm value : How to

empirically analyze an
important empirical question

Lecture 6 12
 Lecture 7
Created Date @March 18, 2025

Tags Lecture

Ownership structure
Institutional investors have lots of influence.

Recap of last meeting

Shareholders and their rights

Voice and exit framework

Ownership structure is defined as the way a firm is owned by different entities

Who are the owners? How much do they own?

WHO (identity/composition)

helps us to know the investors’ invenctives and objectives to exercise

power/monitor managers in the firm

Family

insiders and outsiders

Retail and institutional investor (our focus today)

HOW MUCH (size/concentration/distribution)

helps us to know the investors’ power position in the firm

Free-rider problem

Expropriation of controlling shareholders

Lecture 7 1
 Agency problem between managers and small ownership shareholders

Institutional investors

An institutional investor is an entity that manages capital on behalf of clients

Most often includes banks, insurance companies, pension funds, mutual

funds, and venture capital, etc.

They can invest in many different securities: stock market, equity (in which we are
mainly interested), more.

on slide a pic can be seen where you can see that in the US of the institutional
ownership, more and more has been owned by foreign investors (from 1.6% in
1950 to 16.4% in 2020) and less by the household sector (from 92.8% in 1950 to
38.3 % in 2020) (=retail??). Also the mutual fund is owning more and more from
(1.6% in 1950 to 20.8% in 2020).

Mutual funds

a mutual fund is a professionally managed investment vehicle

Lecture 7 2
 Venture capital funds for example

types of mutual funds by asset classes

Equity funds

invest primarily in stocks

Aim for capital growth over the long term

Suitable for investors with a higher risk tolerance

higher returns but also higher risks.

examples: fidelity small cap discovery fund

Bond funds

Focus on fixed-income securities like bonds

Provide regular income with lower risk compared to equity funds

Suitable for conservative investors

examples: fidelity inflation-protected bond fund

Balanced funds

Lecture 7 3
 combine stocks and bonds for moderate risk

Offer a balance between growth and income

suitable for investors seeking a mix of stability and growth.

Example: vanguard wellington fund

Types of mutual funds by management style

Active funds

actively managed funds aim to outperform a specific benchmark index

Fund managers make regular buy and sell decisions based on market
research

buy the undervalued funds and sell the overvalued ones

Typically involve higher management fees and operating expenses due to

active trading

Passive funds

Passive funds replicate the performance of a specific index (e.g., S&P

500)

These funds follow a buy-and-hold strategy with minimal trading activity

They have lower management fees and expense ratios compared to active
funds

Examples: vanguard 500 index fund and fidelity U.S. bond index fund.

Benefits of investing in mutual funds

Diversification: invest in a variety of assets to reduce risk

Professional management: handled by experienced fund managers

Ability to participate in investments that may be available only to larger

investors

Lecture 7 4
 Institutional ownership on corporate governance

Given the size of their shareholdings, the power of the institutional investors
cannot be doubted

The institutional investors’ potential to exert significant influence on

companies has clear implications for corporate governance

Hirschman (1970): ‘exit and voice’ framework)

voice: dissatisfaction directly to management

Exit: selling the shareholding

Voice channel

Institutional investors can actively govern portfolio firms by exercising

shareholder voice.

They can approach managers through a number of informal, ‘behind the

scenes’, channels to make suggestions and express approval or disapproval

Effective use of voice requires that institutional investors be able to make

formal proposals to corporate executives and have the ability to let other
shareholders vote on such proposals

proxy proposals

Legal obligations

Legal obligations of institutional investors to govern.

Thus, mutual funds and their investment advisers are obliged to use
shareholder voice, that is, to vote their proxies in a manner that is deemed
beneficial to the value of the funds.

Expansion of the obligations of mutual funds and their advisors with respect to
the transparent and unconflicted use of shareholder voice.

Public disclose of proxy voting policies

The reporting of votes actually cast either publicly or to clients

Lecture 7 5
 The establishment of policies to manage conflicts of interest
—> mutual funds and their advisors often had business ties with portfolio
firms, which may have led them to vote their proxies in a manner that
favored portfolio firms and their managers (who could otherwise withhold
business) rather than their own fund shareholders.

Article 2
3.1: Background and introduction

in 2017, US listed companies were the world’s largest recipients of cross-

border equity investments with an outstanding amount of USD 4 trillion

Continental Europe has an outstanding amount of USD 3.9 trillion of foreign

ownership.

Motivation:

Institutional holdings have been increasing globally, but we know little about
their influence on corporations worldwide

Institutional investors potentially influence firms internationally to adopt better

governance practices, by influencing the management and using voting rights
(’voice’) their decisions to buy or threaten to sell their shares (’voting with their
feet’).

Research question: the relation between stock-level institutional holdings and

corporate governance in 23 countries during the period 2003-2008 both in and
out of the US.

3.2: theory —> discussed in the data part.

3.3: Data and methodology

Data source and sample

Firm-level governance data: RiskMetrics 2004-2008

Institutional ownership data: FactSet/LionShares

Lecture 7 6
 Professional money managers such as mutual funds, pension funds, bank
trusts, and insurance companies

2004-2007 (one-year lagged) Why? —> economic crisis

Firm characteristics data: Datastream/Worldscope

Final sample

Governance index by country and by year

41 firm-level governance attributes

A composite governance measure GOV41 (as a percentage)

Highest in 2008 is Canada (72.8F)

it means that on average, Canadian firms meet the minimum acceptable

criteria for 72.8% of the 41 governance attributes.

For every country except New Zealand, the average governance index has
increased, Thus, over the sample period we see that the corporate
governance has improved around the world.

Sweden, The Netherlands, and Switzerland improve the most.

Institutional ownership by country and by year

See pic on slide but you can basically see that for everyone this has increased and
for some countries more: US, Canada and Greece.
IO_TOTAL = sumo f all institutions ownership / total market capitalization.

Domestic and foreign institutional investors

Gillan and Starks (2003) highlight the special role that institutional investors, in
particular foreign institutional investors, play in prompting change in corporate
governance practices worldwide.

Foreign institutions are often credited with taking a more active stance, while
domestic institutions that have business relations with local corporations may
feel compelled to be loyal to management.

Legal Family and shareholder protection: two legal systems

Lecture 7 7
 Common Law

a body of unwritten laws based on legal precedents established by the

courts.

US, UK and Commonwealth countries

Civil Law

A body of written laws with core principles codified into a referable system

Common in mainland Europe (France, Germany, Norway) and Eastern Asia

(China, Japan).

—> LLSV (1998) paper about this (compares the shareholder and creditor rights
between common law and civil countries). Key findings: common law countries
generally have stronger shareholder protection than civil law countries.

Pic on slide where you can see that in countries with civil law also more
institutions with its origin in such countries are active.

Methodology

Regression method

Dependent variable: firm level governance index GOV41 at time t

Independent variable or interest: IO_TOTAL at time t-1

Control variables: firm characteristics related to dependent variable, e.g.,

size

3.4: Main results

A significantly positive relation between institutional ownership and corporate

governance

A significantly positive relation between foreign institutional ownership and

corporate governance

A positive association between firm-level governance and “governance at

home”of institutional ownership ⇒ institutions seem to “export” good
governance across countries.

Lecture 7 8
 3.5 Conclusion

This paper examines whether institutional investors affect corporate

governance by analyzing portfolio holdings of institutions in companies from
23 countries during the period 2003-2008.

Key findings

Firm-level governance is positively associated with international

institutional investment

Summary
Explain corporate governance theories, mechanisms and the cross-country
differences ;

Know different types of institutional investors : bank / pension funds /

mutual funds/ VCs

Explain institutional investors’ impact on corporate governance : “voice”

and “exit”

Evaluate scientific research on the functioning of corporate governance

mechanisms and their impact on firm value / performance.

Evaluate and analyze institutional investors effect on global corporate

governance quality

Lecture 7 9
 Lecture 8
Created Date @March 19, 2025

Tags Lecture

Board and board structure

You have independent directors, who have no link with the company. They are
possibly better in assessing the company and monitoring it.
Board and board responsibilities

the board is a governing body elected by shareholders to represent the

interests of shareholders.

The board is expected to provide both advisory and oversight functions

strategic oversight: approving major decisions, such as mergers,

acquisitions, and business strategies

Hiring and evaluating leadership: selecting, compensating, and, if

necessary, replacing the CEO and other top executives.

risk management: ensuring the company has processes to identify,

evaluate, and manage risks effectively.

compliance: ensuring adherence to laws, regulations, and ethical

standards.

financial oversight: approving financial statements, budgets, and

dividends, and ensuring robust audit and reporting processes.

The responsibilities of directors are separate and distinct from those of

management. The board is not an extension of management.

The operations of the board

Lecture 8 1
 boards typically meet several times a year (quarterly), with additional meetings
as needed.

formal gatherings where directors discuss the company’s strategic

direction, review management’s performance, and make key decisions.

Decisions are made collectively, often through voting.

—> each director has one vote, and decisions typically require a majority to
pass, unless the company’s bylaws or charter specify a higher threshold.

A chairman presides over meetings of the board of directors. The chairman is

responsible for setting the agenda, scheduling meetings, and coordinating
actions of board committees.

CEO-chairman duality: Apple, Steve Jobs. Amazon, Jeff Bezos. Meta,

Mark Zuckerberg.

Required by Sarbanes-Oxley (SOC) Act (2002), independent directors meet at

least once a year in executive session, in which executive directors are not
present.

Board committees

Board can form committees to deal with their many tasks in a more efficient
manner. Common committees include

audit committee

remuneration / compensation committee

Nominating committee

Boards are free to establish additional committees beyond those required by

listing exchanges.

Although the board may delegate various activities to these committees, it is

the board as a whole that remains ultimately responsible.

Audit committee

Lecture 8 2
 It is responsible for oversight of the financial reporting process, selection of
the independent auditor, and receipt of audit results both internal and external.

Under SOX, the audit committee must have at least three independent
directors, all of whom are financially literate

The chair also must be a financial expert.

Audit committee duties (NO NEED TO MEMORIZE)

Overseeing the financial reporting and disclosure process

Monitoring the choice of accounting policies and principles

Overseeing the hiring, performance, and independence of the external auditor

Overseeing regulatory compliance, ethics, and whistleblower hotlines

Monitoring internal control processes

Overseeing the performance of the internal audit function

Discussing risk-management policies and practices with management

Compensation committee duties (NO NEED TO MEMORIZE)

Setting the compensation of the CEO

Setting and reviewing performance-related goals for the CEO

Determining appropriate compensation structure for the CEO, given these

performance expectations

Monitoring CEO performance relative to targets

Setting or advising the CEO on other officers compensation

Advising the CEO on and overseeing compensation of non-executive

employees

Setting board compensation

Hiring consultants to assist in the compensation process, as appropriate

Lecture 8 3
 Nominating Committee

identifying, evaluating, and nominating new directors when board seats need
to be filled.

The nominating committee is also typically in charge of leading the CEO

succession-planning process.

Nominating committee duties (NO NEED TO MEMORIZE)

Identifying qualified individuals to serve on the board

Selecting nominees to be put before a shareholder vote at the annual meeting

Hiring consultants to assist in the director recruitment process, as appropriate

Determining governance standards for the corporation

Managing the board evaluation process

Managing the CEO evaluation process

Board duties

Fiduciary duty: act in the best interest of the shareholders

duty of care: acting in good faith, with reasonable care, making well-
informed decisions, being prepared for meetings, and exercising sound
judgment.

duty of loyalty: prioritize the firm’s interest above personal or external

interests.

duty of confidentiality: maintain sensitive information about the firm.

they know many competitive information.

Board directors van violate their fiduciary duty in several ways

Conflict of interests

insider trading

failure to monitor management

Lecture 8 4
 Board structure

board structure is defined as the way that the board of directors is formed by
different persons.

It is characterized by:

size

composition

type

Board type:

one-tier vs. two-tier

two-tier: board of management and the supervisory board.

Board size:

small board, large board. In general the more assets the more directors.

Increasing the number of directors has both costs and benefits

Pros:

capacity for monitoring and advising increases with board size

pool more information and allow for greater diversity of backgrounds

and viewpoints

Cons

coordination (free-rider problem) and communication problems

increase.

The need to find more directors may lower their quality.

studies document mostly negative correlations between board size and firm
performance.

Lecture 8 5
 Composition:

Proportion of inside versus outside directors in a board.

inside director: a board member who is an employee, officer, or direct

stakeholder in the company

outside director:

—> independent director: no material relationship with the firm

—> affiliated direct: some material link to the firm, e.g., formal
employee, family member, or financial relationship.

Diversity in terms of gender, ethnicity, education, and experience can bring

different perspectives to deal with issues.

Independent directors - stock exchange requirements:

According to the NASDAQ: Independent Director means a person other than

an Executive Officer or employee of the Company or any other individual
having a relationship which, in the opinion of the Company’s board of
directors, would interfere with the exercise of independent judgment in
carrying out the responsibilities of a director.

According NYSE: No director qualifies as “independent” unless the board of

directors affirmatively determines that the director has no material relationship
with the listed company (either directly or as a partner, shareholder or officer
of an organization that has a relationship with the company).

Definition - NO NEED TO MEMORIZE

What defines the independent director ?

Not an employee (in the past or present)

No business relationship

Has not received remuneration from the firm

Does not participate in stock option schemes etc.

No close family ties

Lecture 8 6
 Do not represent a significant shareholder

Has not served on the board for too many years

Can independent directors do a good job/monitor well?

YES:

Not or less subject to potential conflicts of interest that reduce monitoring

capacity

Care about their reputation because they also serve in other firms or large
organizations.

Posse technical expertise both in management and decision-making

NO:

They may not have a significant financial interest in the firm, and therefore
may have little to gain personally from improvements in firm performance.

Information gap: be less informed about the company than insiders

They may not have enough time to devote into company affairs.

They may owe their positions to management, who proposed them as

directors in the first place.

Article 3
2.1: background and introduction
Motivation and research question:

The dominant view of independent directors is that they are beneficial to

shareholder value

an abundance of international guidelines for corporate governance

Direct empirical evidence on the value of independent directors is scant.

Lecture 8 7
 Research question: the value of independent directors on shareholder value.
Specifically, examining the stock price reaction to the sudden deaths of
corporate directors.

2.2.: Data and methodology

Event study: a statistical method to examine the impact of an event (e.g., M&A
announcement) on the stock return of a firm.
normal return: returns when the analyzed even would not have taken place. They
are estimated according to certain theoretical models.
Abnormal return (AR) at time t

AR = real stock return at t - normal return at t

Cumulative abnormal return (CAR) at time window (t0,t1)

CAR(t0,t1) = sum or ARs between relative day t0 and t1

Event study - interpretation

Negative events (e.g.) sudden death of independent directors:

Lower CARs —> Investors value more to the negative events.

Higher CARs —> Investors value less to the negative events

Positive events (e.g.) better-than-expected earnings announcement.

Lower CARs —> Investors value less to the positive events.

Higher CARs —> Investors value more to the positive events.

Data source and sample

Search keywords (e.g., director, death) in newspapers for firms listed on

Amex, Nasdaq and NYSE between 1994-2007

Sample: 772 deaths and 229 sudden deaths of directors holding 279
directorships

Lecture 8 8
 one person cal hold multiple directorships (interlocking directors)

Sudden death definition: rely on the medical literature.

Sample of sudden death directors

Inside directors: current employees of the firm

Gray directors: retired employees of the firm, relatives of the CEO, or persons
with conflicts of interest or related to the firm’s business.

Independent directors: not current or former employees and who do not have
dealings with the firm.

you can see from SOX act 2002 more independent directors.

2.4: main results

Stock price reaction to the death of independent directors

Stock prices drop significantly following the death of independent directors.

Effect of degree of independence

negative CAR —> on average independent directors are valued by investors

But the degree of independence of directors may be different among a group

of independent directors.

Directors with short tenure are considered more independent

Directors appointed by CEOs are considered less independent.

Whether the degree of independence of directors is a determinant of their

contribution to shareholder value?

—> how to test?

CAR = alfa + beta * degree of independent directors + gamme * controls + epsilon

Table 5:

Lecture 8 9
 longer tenure (less independence) —> higher CAR in negative events —> less
reaction from investors —> less valued by investors
Appoined by CEO (less independence) —> higher CAR in negative events —> less
reactions from investors —> less valued by investors.

Effect of degree of independence

So far we find that the degree of independence could affect investors’

reaction to the death of directors

It is natural to expect that board composition structure could also affect

investors’ reaction to the death of directors.

Outsider ratio definition

independent (outsider) directors ratio is about the amount of independent

directors compared to insider directors. So when this is high lost of
independent directors are there compared to insider directors.

When the outsider ratio is high the sudden death of an independent director
may not cause severe problems compared to situations with lower outsider
ratios.

Again - Table 5
More outsiders (lower marginal effect) —> higher CAR in negative effects —> less
reaction from investors —> less valued by investors.

Majority change definition

When the sudden death directors holds the swing vote (so let’s say 3
independent directors vs. 2 insider directors) then his sudden death is called a
majority change.

Again - table 5

Lecture 8 10
 Majority change (higher marginal effect) —> lower CAR in negative events —> more
reaction from investors —> more valued by investors

2.4: conclusion

this paper investigates the contributions of independent directors to

shareholder value

The methodology is the event study testing stock price reactions to sudden
deaths in the US

key findings:

following director death stock prices drop by 0.85% on average

the degree of independence on board structure determine the marginal

value of independent directors.

Summary:

Explain corporate governance theories, mechanisms and the cross-country

differences ;

Know boards’ roles, duties, and committees : monitor and adviser /

fiduciary / audit ; compensation ; nomination committee

Explain board structure : type / size / composition

Evaluate scientific research on the functioning of corporate governance

mechanisms and their impact on firm value / performance.

Understand and implement event study : normal returns / AR /CAR

Evaluate and analyze the value of independent directors to firms

Lecture 8 11
 Lecture 9
Created Date @March 25, 2025

Tags Lecture

Board diversity in the U.S.

Bogan et al. 2021:

They investigate the trends and drivers of racial and gender diversity on U.S.
corporate boards.

Sample: roughly 3,100 firms per year listed on the NYSE or Nasdaq
headquartered and incorporated in the U.S. à 2012-2021

Minority: any race that is not Caucasian/White

URM: underrepresented minorities

Black/African American

Hispanic/Latin American

Native American/Alaskan Native

Native Hawaiian/Other Pacific Islander

NURM: non-underrepresented minorities

Asian excluding Indian/South Asian

Indian/South Asian

Middle-Eastern / North African

Other

Board diversity initiatives in the U.S.

over past two decades, policymakers around the world require more female
representation and minority groups on corporate boards of directors.

Lecture 9 1
 Israel passed the first board gender quota in 1999: one female board director
for publicly traded companies.

More and more EU countries passed recently

In North America, board diversity quotas are less pervasive

Only the state of California requires quotas on public boards

NYSE Board Advisory Council

Nasdaq new rules on board diversity

The murder of George Floyd incident and BLM movement.

can have some effects to the board diversity. After the event of George
Floyd, the representation of black people in the boardroom increased.

California Bill
2019 feb: Assembly Bill No. 979 was first read
2020 sep: Assembly Bill No. 979 was signed into law by Governor Gavin Newsom.
All firms with their principal executive office in the state of California, listed on a
major stock exchange.
2021 dec: at least one director from an underrepresented community

2022 dec: 5 to 8 board members: at least two. more than 9 at least three diverse
directors. Otherwise: monetary penalties.

NYSE board advisory council

May 2019: NYSE establised the NYSE Board Advisory Council

The goal is to increase both racial and gender diversity by introducing

candidates with diverse background to NYSE-listed firms

The initiative would help to increase transparency of the board hiring process,
as well as reduce costs and effort for the firms in search of directors to hire

Council members are leaders of well-known corporations to employ their

connections to identify diverse board candidates.

Lecture 9 2
 Voluntary for NYSE-listed firms

Not voluntary:
Nasdaq rules

On December 1, 2020, the Nasdaq filed a proposal and was approved by SEC
on August 6, 2021

Nasdaq-listed firms would have to include at least one “diverse” director on

their boards within two years after the SEC approval date, and two “diverse”
directors within four or five years, depending on market tier

Diversity : gender, ethnicity, and gender identity

Comply or disclose rules

The murder of George Floyd

the effect of the murder of George Floyd on minority appointments is very

significant. If we look within minority group

The effect of the murder is mainly concentrated on the URM group. But if we look
within the URM group. The effect of the murder of George Floyd is mainly

Lecture 9 3
 concentrated on the Black group.

Fraction of female directors over year

Has increased

Gender quota in Europe

nov, 2012: proposal of directive by European Commission

nov, 2022: formally adopted by the European Parliament

dec, 2022: entered into force

Apply to listed companies

Non-executive directors > 40% OR All director positions > 33%

dec, 2024: transposition deadline member states are required to transpose the
directive into national law by this date

jun, 2026: compliance deadline

Some academic study shows that firms’ values have lowered due to these new
laws and more women on the directors’ board due to the fact that the quota led to
younger and less experienced boards. This is partly due to the fact that women
have always had fewer opportunities so it’s hard to find qualified ones. It does not
say female directors are harmful to the firm’s performance. They should get more
opportunities. This study was published in 2012 and based on data from 2008.
After this paper, more research has been done and all studies based on data from
2001-2011 show negative changes while the one research from 2011-2016 positive
effects. And even more recent research (2020/2019) shows mixed results or no
changes in firm value.

Benefit of gender diverse boards — Agency theory

Lecture 9 4
 Cost of gender diverse boards

Too much board monitoring can also decrease shareholder value

breakdown in communication between managers and directors

Unnecessary over-monitoring in well-governed firms can be detrimental to the

firm value

The more dissimilar directors are, the more they could disagree and the more
conflict there could be on the board.

The benefit of gender diverse boards — resource dependence theory

Lecture 9 5
 When an organization appoints an individual to a board, it expects the individual
will come to support the organization, will concern himself with its problems, will
invariably present it to others, and will try to aid the organization.

Token status theory

Critical mass theory (kristie, 2011)

The magic seems to occur when three or more women serve on a board together.
We find that having three or more women on a board can create a critical mass
where women are no longer seen as outsiders and are able to influence the
content and process of board discussions more substantially.
Kramer et al. (2007)

One - token (or even solo)

Two - presence
Three and more - voice

Article 4
2.1 background and introduction

Lecture 9 6
 Motivation and research question:

Would things have been different if more women were running the
corporations in the U.S. and around the world?

The empirical evidence in the extant literature is inconclusive and most of the
studies focus on firms in the U.S. and a few other developed countries

Mixed evidence

Corporate governance in China is significantly weaker than that in the U.S.

and other developed countries

Research question: Do women directors improve firm performance in China?

2.2: Theory and hypotheses

Hypothesis 1: Agency Theory and Resource dependence theory

Gender-diverse boards have beneficial effects on firm performance

Hypothesis 2: token status theory and critical mass theory

If women directors have impacts on corporate decisions and firm

performance, those impacts should be more pronounced when the critical
mass is reached, i.e, at least three female directors.

2.3: Data and methodology

Data sources and samples:

Initial sample:

All lasted firms in Shanghai and Shenzhen Stock Exchanges for the period
1999-2011

Exclude the financial and public utility firms from our sample. Firm-years
with negative equity or negative sales are also excluded

Financial and board composition data: Chinese Securities Market and

Accounting Research (CSMAR) organisation

Lecture 9 7
 The final sample consists of 16,964 firm-year observations and over 2,000
firms.

Regression model:

Firm performance measures:

Return on sales (ROS) = net income/sales

Return on assets (ROA)= net income / assets

Board gender diversity measures:

%_women: the percentage of women directors on the board

D_1Woman: A dummy variable equals one if the board has one female director
and 0 otherwise

From 52.2% in 1999 to 66.3% in 2011

D_2Women: A dummy variable equals one if the board has two female
directors and 0 otherwise

From 21.3% in 1999 to 29.2% in 2011

D_3Women: A dummy variable equals one if the board has at least three
female director and 0 otherwise

Hovering around 8.6% à attaining a critical mass on a board is not easy.

Lecture 9 8
 It seems that the gender diversity increases sharply, however, the absolute
change is low: only 3%.
Fixed effects:

Why do we need fixed effects?

To reduce possible bias due to unmeasured, unchanging variables that may be

correlated with the variable of interest.
Correlation vs. causality

We are interested in the casual effect of board gender diversity on firm

performance

But even if we find a positive relationship between board gender diversity and
firm performance, we cannot say that board gender diversity casually
influence firm performance

2.4: Main results

Percent of women directors and firm performance

Estimated coefficients on %_Women are positive and significant

à female directors have a significant and positive impact on firm performance

The number of women on board and firm performance

The results confirm the critical mass theory which argues that absolute
number of women directors matter for firm performance

Lecture 9 9
 One is a token, two is a presence, and three is a voice

Does women directors’ effect on firm performance vary by ownership?

The listed firms in China have unique ownership structures

State owners

Are charged with political and social, as well as economic goals

Less incentive to maximize firm value and monitor managerial activities

Legal person owners

Are usually charged with profit goals

Stronger incentive to maximize firm value and monitor managerial

activities

Run baseline regression analysis for state owners and legal person ownership
subsample separately

%_Women only has a significant impact on both ROS and ROA for the legal
person subsample.

2.5: Conclusion

This paper examines the effect of board gender diversity on firm performance
in China’s listed firms from 1999 to 2011

Key findings

A positive and significant relation between board gender diversity and firm
performance

Boards with three or more female directors have a stronger impact on firm
performance

The impact of female directors on firm performance is significant in legal

person-controlled firms but insignificant in state-controlled firms

Summary (incl. previous lecture):

Lecture 9 10
 Explain corporate governance theories, mechanisms and the cross-country
differences ;

Know boards’ roles, duties, and committees : monitor and adviser / fiduciary /
audit ;compensation ; nomination committee

Explain board structure : size / composition

Understand the current status of boards diversity issue : limited diversity

Understand and explain theories on gender diversity : agency theory /

resource dependence theory / token status theory / critical mass theory

Evaluate scientific research on the functioning of corporate governance

mechanisms and their impact on firm value / performance.

Understand and implement event study : normal returns / AR /CAR

Evaluate and analyze the value of independent directors to firms

Evaluate and analyze the effect of board gender diversity to firm performance

Lecture 9 11
 Lecture 10
Created Date @March 26, 2025

Tags Lecture

Compensation
Executive compensation level in the U.S. has risen exponentially since 1980. This
is for the 50 largest U.S. firms. For CEOs in the S&P 500, since the 2000s, this has
stagnated a bit. And before this compensation mainly existed from just salary &
bonuses, but since the 1950s, more and more of the compensation has partly
turned into options and LTIP & Stock. From the 2000s one less than 50% of the
compensation exists from salary, and in 2014 can be seen that only 13% is salary,
23% is bonus & LTIP, 16% is options, and 44% is stock. Stock as compensation
has gotten popular since 2004.
Looking at just top CEO compensation, for example, with Elon Musk, he doesn’t
even receive a salary but just gets everything from option awards, same for Tim
Cook.

Restricted stock

Restricted stock is stock of a company that is not fully transferable (from the
stock-issuing company to the person receiving the stock award) until certain
conditions (restrictions) have been met. Upon satisfaction of those conditions,
the stock is no longer restricted and becomes transferable to the person
holding the award.

Restricted stock units (RSU) is a popular type of restricted stock incentive

scheme. Two structures:

Time-based RSU

Performance-based RSU

Lecture 10 1
 Restricted stock units - Apple and Cook example:

Equity awards with time-based vesting align the interests of our named executive
officers with the interests of our shareholders by promoting the stability and
retention of a high-performing executive team over the longer term. - Apple 2023

The Compensation Committee chose ... performance-based RSUs ... aligns the
interests of our named executive officers with the interests of our shareholders in
creating long-term value. Performance-based RSUs are a substantial, at-risk

Lecture 10 2
 component of our named executive officers’ compensation tied to Apple’s long-
term performance.

Stock options definition

Stock options represent a right but not obligation to buy (or sell) shares of a
stock at a particular price (exercise price) by some future date (expiration
date)

Two types of options according to the right:

Call option: right to buy

Put option: right to sell

Two types of options according to the exercise time:

European option: an option that may only be exercised on expiry

American option: an option that may be exercised on any trading day on or

before expiration.

Option example:

Lecture 10 3
 Black-Scholes-Merton model
—> can be used to calculate the value of an option

Stock options- Tesla and Musk example

Further, each of the requirements underlying the performance milestones was

selected to be very difficult to achieve. If any options have not vested by the end
of the term of the option award, they will be forfeited and Mr. Musk will not realize
the value of such options - Tesla 2019

Restricted stocks v.s. stock options:

restricted stocks stock option

Shares must be purchased via exercising

Shares are granted
options

Value is the difference between the exercise

Value is the fair market value of a stock
price and market value of underlying stock

Upon vesting, no action is required of Employee must take action to exercise option
employees; share are typically deposited and decide on next steps (whether to hold or

Lecture 10 4
 into a brokerage account for them sell).

More risky because value may be zero if

Less risky because employee ultimately
market price is equal to or less than the
receives stock with fair market value.
exercise price.

Others (’Stealth’ compensation)

Severance pay

Golden handshakes: awarded to retiring or fired CEOs

Golden parachutes: awarded to CEOs who lose their jobs their firms are
acquired

Pensions: since 2006, U.S. public firms are required to disclose both the
present value of executives’ accumulated pension benefits and their year-to-
year change.

Perks: goods and services provided to the executive

Corporate jets

Club memberships

Personal security

Compensation theories:
Agency theory - optimal contracting

Lecture 10 5
 First-best contract Second-best contract

First-best contract is to compensate the Firm performance is verifiable and explicitly

manager based on his effort. observable

Shareholders exert time and effort to

Second-best contract is based on the (noisy)
monitor the manager and collect such
performance
information

Manager’s effort is non-verifiable and

difficult to observe

Theoretical predictions:

A first-best contract outperforms a second-best contract as it eliminates

uncertainty from random noise, allowing for better manager incentives.

The use of explicit performance-based contracts is less likely when there are
shareholders actively monitoring the managers.

Managerial power theory - rent seeking

Lecture 10 6
 Optimal contracting theory

Executive pay is decided directly by shareholders, or by their well-

incentivized or monitored representatives (directors)

Managerial power theory

Both the level and structure of pay are decided by the executives
themselves (in conjunction with a complicit board.

Theoretical predictions:

Executive pay will be higher and less sensitive to performance in firms in

which managers have relatively more power.

Two aspects of executive compensation:

Good aspects:

Achieve a better alignment of mutual interests and a closer link between

pay and company performance

Positive pay-performance relationship

An attractive employment condition to attract, motivate and retain

executives

Lecture 10 7
 Bad aspects:

Managers can influence their own pay

Pay-performance relationship is non-existing or even negative

Managers may be inclined to raise company risk.

Article 5
— A comparison of CEO pay-performance sensitivity in privately held and public
firms

2.1: background and introduction

Motivation and research question:

CEO contract design plays a number of important roles, including acting as a

sorting mechanism, and providing incentives for effort and the retention of
human capital

Large private firms play such an important role in the economy

lack of information on CEO pay

This paper conducts one of the first large-sample studies of CEO contract
design in large privately-held U.S. firms.

2.2: Theory and hypothese development

Shareholder monitoring hypothesis

Optimal contracting theory of Holmstörm (1979) predicts that the use of

explicit performance-based contracts is less likely when there are
shareholders actively monitoring the managers.

Which types of firms can better monitor the manager? Private or public firms?

Large outside shareholders are active monitoring shareholders (Shleifer and

Vishny (1986))

Lecture 10 8
 The shareholder monitoring hypothesis:

CEO pay-performance sensitivity is weaker in privately-held firms than in

public firms.

Managerial power theory - rent seeking

It predicts that executive pay will be higher and less sensitive to performance
in firms in which managers have relatively more power

which types of firms have more powerful managers who could influence their
own compensation? Private or public firms?

It is public firms because of the dispersed ownership

CEO power hypothesis

Lecture 10 9
 CEO power hypothesis:

CEO pay-performance is sensitivity is stronger in privately-held firms than in

public firms

2.3: Data and methodology

Sample

Initial sample: U.S. privately-held and public firms with available information on
firm financials and CEO compensation in Capital IQ from 1999 to 2011.

Public firms: firms traded in NYSE, AMEX, or NASDAQ

Private firms

Remove firm-year observations associated with going public and going private
transactions

Final sample

Public firms: 45,730 firm-year observations representing 5863 unique

firms

Private firms: 7168 firm-year observations representing 2492 unique firms

Lecture 10 10
 CEO pay

CEO total pay (Totalpay) in a given year as the sum of

Salaries (salary)

bonuses (Bonus)

the grant date value of restricted stock awards (stock)

grant-date Black-Scholes value of granted options (Options)

Other pay (Otherpay)

Natural logarithm rather than the absolute raw level

ln(Totalpay)

Why logarithm transformation?

Reduce skewness of variables (e.g., income, population size, or sales)

—> making the data closer to a normal distribution, which is an assumption for
linear regression and statistical tests.

What can be seen in the summary statistics?

Public firms’ CEOs earn higher total compensation

Public and private firms have different compensation structures.

Ownership is more concentrated in privately-held firms.

Methodology

Regression analysis

When the dependent variable or independent variable is in the natural

logarithm form, the magnitude interpretation of estimated coefficients is very
different from the case when (in)dependent variables are in the raw value. (not
be covered in the exam!)

Focus on the sign of estimated coefficients (positive or negative)

Lecture 10 11
 2.4: Main results
Baseline results

Estimated coefficients on private are negative and significant at 1% level

—> Private firms have lower CEO compensation

Estimated coefficients on ROA are positive and significant at 1% level.

—> CEO pay is largely responsive to performance in both groups of firms.

Baseline results - interaction terms

If we want to investigate whether the relationship between independent variable

ROA and dependent variable Ln(totalpay) is different in the private and public
firms groups, we can run the following regression model including an interaction
term:

To see for which company the ROA is more sensitive for two companies we fill this
formula in. With firm A: private = 1 and for firm B: private = 0. Then with the data
from the results this can be calculated:

Private firm A: Ln(totalpay) = 13.896 + 0.19 ROA

Public firm B: Ln(totalpay) = 14.225 + 1.099 ROA

Lecture 10 12
 Here can be seen that for firm B the totalpay is much more sensitive to changes in
performance (ROA) compared to firm A.
—> Consistent with the shareholder monitoring hypothesis (H1)

public firms have stronger pay-performance sensitivity.

2.5: Conclusions

This paper studies CEO contract design employing a unique dataset on a

privately-held and public firm CEO annual compensation

Key findings:

CEOs in public firms are paid 30% more than CEOs in comparable private
firms.

Both private and public firm CEO pays are positively and significantly
related to firm accounting performance

Pay-performance link is much weaker in privately-held firms.

Summary:

Explain corporate governance theories, mechanisms and the cross-country

differences ;

Know and understand different types of executive compensation

components : salary / bonus / restricted stocks / stock options / others

Understand and explain theories on executive compensation : optimal

contracting theory / rent seeking

Evaluate scientific research on the functioning of corporate governance

mechanisms and
their impact on firm value / performance.

Evaluate and analyze CEO pay-performance sensitivity in private and

public firms

Lecture 10 13
 Lecture 11
Created Date @April 1, 2025

Tags Lecture

Compensation

1. Perks introduction
Perks:

perquisites / perks: goods and services provided to the executive

Corporate jets

Club memberships

Personal security

They were largely hidden from shareholders until the SEC increased its
disclosure requirements in 2006

Perks are labeled as ‘stealth’ compensation that may allow executives to

extract rents surreptitiously

Duality of perks:

Bad aspects

value-destructive nature of perquisite consumption

not transparent

Good aspects

Perks are not solely perks

They also provide substantial operational benefits, e.g., nicer office space,
club membership, security guard, and corporate jets.

Lecture 11 1
 Corporate jets as a Perk

Corporate jet is a perfect example of the dual features of perk consumption

highly visible and widely recognized for its perquisite properties

a means to increase efficiency as well

Availability of detailed corporate jet flight data enable use to disentangle use
of corporate jets that are more likely driven by:

operational needs

perquisite consumption

For example with Musk he uses it to move from Tesla, to SpaceX to Twitter (X)
efficiently (operational needs) but at the same time he also uses it to go to the
Qartar World Cup (perquisite consumption).
—> Twitter accounts tracking them down have been blocked.

Article 6: Are all perks solely perks?

Evidence from corporate jets.
2.1: Background and introduction
Motivation and research question

The duality of many perk-enabling assets, calls to abolish such forms of

executive perquisite consumption must be viewed with some caution

The extent to which decreases in such assets will enhance shareholder value
is intrinsically related to the operational benefits the assets provide

This paper takes advantage of a setting in which rich data to isolate the
operational benefits of one particularly salient perk-enabling asset-corporate
jets.

Lecture 11 2
 2.2: Data and methodology
Sample:

Company jet flights: Wall Street Journal (WSJ) Jet Tracker database between
2007 and 2010

Flight details such as company name, tail number, and departure and
arrival information

Determine the top arrival location for each jet and assume that this is the
home base of the jet.

Manually collect the locations of all operating units of sample firms

(subsidiaries, divisions, and plants, etc.)

Data on firm governance and on CEO characteristics.

Three types of flights:

Internal flights: subsidiaries, division, plants unit

External flights: other than resorts or internal company locations

Resort flights: Las Vegas, Scottsdale, West Palm Beach

For time savings they first looked at flight time provided on a website (real-time
flight time by the corporate jet) and on google maps for the ‘regular’ flight time.
What could be seen is that private jets are faster.

—> these estimates of time savings are lower bounds, and almost certainly grossly
underestimate the total time saved.

Methodology

We are interested in the casual effect of internal flights on firm performance

but even if we find a positive relationship between internal flights and firm
performance we cannot say that internal flights casually influence firm
performance

Lecture 11 3
 This is the scenario we want: more internal flights can causally increase the firm
performance:

Reverse causality: firms may increase the number of internal flights when the
company is doing well:

Higher performance —> financial constraints would be less binding —> more
money to travel —> more flights

They may feel a more pressing need to visit distant company locations as a
way of diagnosing problems

This scenario is also different from what you would expect: a third variable that
simultaneously increases the number of internal flights and causes better firm
performance. However, the number of internal flights is nothing to do with the
firm’s performance.

observable variable example: firm size

unobservable variable example: leadership style

Lecture 11 4
 This scenario is also called ‘spurious (fake) correlation’: the number of internal
flights and firm performance are associated but not causally related due to
coincidence:

it is very difficult to build the causal relationship in corporate governance

literature and other finance / economy literature

Economists have developed some methods and try to argue the causality

These methods are out of scope for this course; not be covered in the
exam.

Let’s just focus on correlation

How does this paper deal with this issue?

Instrumental variable (IV) strategy (NOT IN EXAM!)

2.3: Main results

Flights and firm value

Lecture 11 5
 Just focus on the 2nd stage regressions and treat them as the normal
regressions

The coefficient on internal flights is positive in both regressions, and

significant at the 5% level in the ROA regression

provide some support for our prediction that internal flights provide net
efficiency gains and thus increase firm value.

Flights and firm value - effect of information environment

Hypothesis: internal flights are more valuable among companies in which the
costs of transmitting information remotely are greater.

measures:

business diversity: negative Herfindahl of segment sales [-1, 0]. The

larger, the more diverse.

Internal info asymmetry: higher numbers representing greater information

asymmetry

Business diversity measure example:

Lecture 11 6
 So the Herfindahl of segment sales goes from 0 (most diverse business) and to 1
(least diverse business)

Business diversity = -1 * Herfindahl segment sales

So then -1 is least diverse business and 0 is the most diverse business.

We are interested in the estimated coefficient of log (# Int flights) because it

measures the effect of internal flights on firms’ performance.

For Firm A with least diverse business, the effect of internal flights is negative,
while the effect of internal flights is positive to firm value for firm B with most

Lecture 11 7
 diverse business.

= consistent with hypothesis

Second hypothesis - effect of governance quality

Hypothesis: internal flights will be lower among poorly governed firms

Governance quality measures

dual class: one of the most extreme governance structures in its ability to
protect managers’ private benefits of control. If dual class = 1, it means
lower corporate governance quality

governance index: a summary measure of CEO entrenchment. The higher,

the lower the governance.

Firm A, Dual class = 1, and firm B’s dual class = 0

We are interested in the estimated coefficient of log (# Int flights) because it

measures the effect of internal flights on firm’s performance.

Lecture 11 8
 We can clearly see that the estimated coefficients on log(#Intflights) are
completely different between Firm A and Firm B. For Firm A with lower
governance quality, the effect of internal flights is negative, while the effect of
internal flights is positive to firm value for Firm B with better governance
quality

= consistent with hypothesis

2.4: conclusion

many corporate assets that enable forms of perquisite consumption also

provide operational benefits, e.g., corporate jets.

Key findings

Business-related flights increase firm performance

Channels: benefit of information gathering and monitoring

Summary

Explain corporate governance theories, mechanisms and the cross-country

differences ;

Know and understand different types of executive compensation

components : salary / bonus / restricted stocks / stock options / others

Lecture 11 9
 Understand and explain theories on executive compensation : optimal
contracting theory / rent seeking

Know and understand a particular type of compensation–perks : dual

features

Evaluate scientific research on the functioning of corporate governance

mechanisms and their impact on firm value / performance.

Evaluate and analyze CEO pay-performance sensitivity in private and

public firms

Evaluate and analyze the effect of perks on firm performance

Lecture 11 10
 Lecture 12
Created Date @April 2, 2025

Tags Lecture

International Corporate Governance

Example on slides about Tesla and Elon Musk. They set up a Giga factory in
Germany, and it was a bit hard due to environmental concerns and also Tesla not
wanting to follow all German / European laws about stuff such as council. Part of
this they could get out of, but not everything. In Shanghai, it took them about 0,5
year while in Germany, it took more than 2 years.

Government endorsement in Shanghai

Governance systems are not uniform across countries.

Lecture 12 1
 1. Factors influencing corporate governance system

Corporate governance differences across countries:

Governance systems are not uniform across countries

They are shaped by a variety of factors that are inherent to the business
environment:

Financial system

Protections afforded by legal system

Enforcement of regulations

Societal and cultural values

Differences in these factors impact the prevalence of agency problems and

the control mechanisms needed to prevent them.

Factor 1: financial system

= a set of institutions, such as banks, insurance companies, and stock

exchanges that permit the exchange of funds

Lecture 12 2
 Market-based system:

The capital market (stocks and bonds) is the major source of finance

The role of bank is transactional: each loan is evaluated based on ‘hard’

criteria

Banks’ influence is not prevalent in the same way and does not infiltrate the
corporate governance structure.

Bank-based system:

Banks are the main source of finance.

The role of the bank is relational: firms build up a long-term relationship with
banks

Banks play a key role in the funding of companies and so may exercise some
control via the board structure.

Financial structure = country’s bank credit / the sum of non-financial sector debt
and stock market capitalization

Capital market:

A capital market is a market in which long-term debt (over a year) or equity-

backed securities are bought and sold

types of capital market

—> primary market and secondary market

—> equity market bond market

Efficient capital markets can ‘discipline’ corporations:

stock prices decline

cost of capital (equity or debt) increases

risk of bankruptcy or being taken over increases

Regulatory and disclosure requirements.

Lecture 12 3
 Factor 2: legal tradition

A country’s legal system has important implications on the rights afforded to

business owners:

Protection of property against expropriation

Predictability of how claims will be resolved

Enforceability of contracts

A strong legal system mitigates agency problems because self-interested

managers know illegal actions will be punished

Two legal systems

Common law

A body of unwritten laws based on legal precedents established by the

courts

US, UK, and commonwealth countries

Civil law

A body of written lwas with core principles codified into a referable system

Common in mainland Europe (France, Germany, Norway) and Eastern Asia

(China, Japan)

LLSV (1998)

A seminal paper in finance and law literature

compare the shareholder and creditor righst between common law and
civil countries

Shareholder’s rights, e.g.:

one share one vote

proxy by mail

Oppressed minority

Lecture 12 4
 Mandatory dividend

Compare average shareholder protection scores across countries with

different legal origins.

Lecture 12 5
 You have English common law: US, UK, Australia, India and few more
You have French civil law: France, NL, Spain, Italy, Brazil, and more there

You have German civil law: Germany, China, Japan

Lecture 12 6
 Scandinavian Civil law: Norway, Sweden, Denmark

Based on these figures, the rank of legal origin that provides shareholder
protection:

1. English common law

2. German and Scandinavian civil law

3. French civil law

Factor 3: Enforcement of regulations

Even if the legal system is strong, officials must be willing to enforce

regulations in a fair and consistent manner

Regulatory enforcement signals that management is being monitored, which

contributes to investor confidence that their interests will be protected.

Factor 4: Societal and cultural values

Culture: a set of common ideas, beliefs and values that are shared by the
members of a group of individuals

Hofdstede’s cultural dimensions theroy

Lecture 12 7
 Managerial behaviour is influenced by the society in which the company
operates

For example, individualism countries (e.g., US) may have higher protection to
minor shareholders since those rights support the importance of individual
shareholders in dealing with managers or dominant shareholders.

High power distance countries (e.g., China, Japan, Russia) often reflect
centralized control, with strong family or state ownership. Low power distance
countries (e.g., Sweden, Netherlands, Canada) emphasizes independence,
accountability, and shareholder rights.

US corporate governance
What we discussed so far mostly focus on the U.S. corporate governance system.

Shareholders and ownership structure

Board and board structure

Lecture 12 8
 Compensation

Legal system

Capital Market

—-

You see the CEO in the board of directors: Tim Cook, Elon Musk, Satya Nadella

Market governance system

Shareholder value (and rights) prevail

Lecture 12 9
 Common law system: better investor protection

Highly dispersed ownership; institutional investors dominate, much more

proactive

One-tier board system: CEO is almost always a member of the board; no

mandatory employee representation; strong managerial power

Large executive compensation packages, especially equity-based incentives.

Germany corporate governance

BMW board. Susanna Klatten and Stefan Quandt are brother and sister.

Lecture 12 10
 remains pretty stable.

Lecture 12 11
 Stakeholder governance: high priority is given to stakeholders (compared to
the US).

Bank-oriented system: banks can have exceptional power if several roles (as
lenders, advisors, owners, board members, trustees) are exercised
simultaneously.

German employs a civil law system; mediocre minority protection, yet the
quality of enforcement is high.

Share ownership is medium concentrated; significant cross-holdings;

blockholders are rarely challenged; takeover activity is very limited.

Mandatory two-tier boards (dual), co-operation

Co-determination principle: compulsory employee representation on the

board, up to half of the seats.

Lecture 12 12