LOS g: Discuss the valuation implications of corporate governance.

Q1. Entering into a merger that would provide benefits for management, but ultimately would destroy shareholder value is an example of:

A)   liability risk.

B)   strategic policy risk.

C)   asset risk.

Q2. Studies support the conclusion that companies with effective corporate governance systems have been shown to have higher measures of profitability and generate higher returns than companies with weak corporate governance systems. Which of the following is the most critical activity that an analyst can engage in to assess the strength of a corporate governance system at a firm?

A)   Note whether financial transactions between a company and its senior management are approved by the board of directors.

B)   Evaluate the quality and quantity of financial information provided to investors.

C)   Determine whether a corporate code of ethics and statement of governance policies is easily accessible for investors and stakeholders.

Q3. Dan Berger, an analyst for Romulus Capital Management Inc. (RCMI), is talking with a colleague, Amy Woods, about the benefits of including corporate governance assessments in the firm’s valuation models. Berger makes the following statements:

Statement 1:        Although the results are inconclusive in emerging markets, companies in developed countries that have strong corporate governance systems have provided shareholders with higher returns than companies with weak governance system.

Statement 2:        A weak corporate governance system can cause a company to go bankrupt.

In regard to Berger’s statements, Woods should:

A)   agree with both Statements.

B)   disagree with Statement 1, but agree with Statement 2.

C)   agree with Statement 1, but disagree with Statement 2.

Q4. Which of the following is NOT a risk arising from having an ineffective corporate governance system?

A)   Management may use company assets for personal or inappropriate purposes.

B)   Management may enter into off-balance sheet obligations that reduce the value of a company.

C)   An otherwise profitable company may not have cash on hand to pay its bondholders.

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Q1. Entering into a merger that would provide benefits for management, but ultimately would destroy shareholder value is an example of:

A)   liability risk.

B)   strategic policy risk.

C)   asset risk.

Correct answer is B)

Strategic policy risk is the risk that managers may enter into transactions or incur other business risks that would not be in the best long-term interests of shareholders, but would result in large payoffs for managers or directors.

Q2. Studies support the conclusion that companies with effective corporate governance systems have been shown to have higher measures of profitability and generate higher returns than companies with weak corporate governance systems. Which of the following is the most critical activity that an analyst can engage in to assess the strength of a corporate governance system at a firm?

A)   Note whether financial transactions between a company and its senior management are approved by the board of directors.

B)   Evaluate the quality and quantity of financial information provided to investors.

C)   Determine whether a corporate code of ethics and statement of governance policies is easily accessible for investors and stakeholders.

Correct answer is B)

Over the last few years, most of the major corporate scandals (i.e. Enron, Worldcom) have involved attempts to hide or falsify financial information provided to investors. Since investors rely on information provided by management to make investment decisions, having misinformation can result in the mispricing of securities, misallocation of capital, and ultimately a lack of confidence that can reduce the efficiency and effectiveness of financial markets. As a result, one of the most critical roles an analyst can play in the corporate governance process is to evaluate the quantity (more is better) and quality of financial data that companies provide.

Q3. Dan Berger, an analyst for Romulus Capital Management Inc. (RCMI), is talking with a colleague, Amy Woods, about the benefits of including corporate governance assessments in the firm’s valuation models. Berger makes the following statements:

Statement 1:        Although the results are inconclusive in emerging markets, companies in developed countries that have strong corporate governance systems have provided shareholders with higher returns than companies with weak governance system.

Statement 2:        A weak corporate governance system can cause a company to go bankrupt.

In regard to Berger’s statements, Woods should:

A)   agree with both Statements.

B)   disagree with Statement 1, but agree with Statement 2.

C)   agree with Statement 1, but disagree with Statement 2.

Correct answer is B)

Woods should disagree with Statement 1. Companies with strong corporate governance systems have been shown to have higher profitability and generate higher returns than companies with weaker corporate governance systems in both developing and emerging markets. Statement 2 is correct – in extreme cases, the lack of an effective corporate governance system could lead to a company’s bankruptcy such as the case of Enron in 2001.

Q4. Which of the following is NOT a risk arising from having an ineffective corporate governance system?

A)   Management may use company assets for personal or inappropriate purposes.

B)   Management may enter into off-balance sheet obligations that reduce the value of a company.

C)   An otherwise profitable company may not have cash on hand to pay its bondholders.

Correct answer is C)

A profitable company having inadequate cash to pay its bondholders is an example of liquidity risk and would be a result of poor financial management rather than poor corporate governance. The primary risks of an ineffective corporate governance system include financial disclosure risk, asset risk, liability risk, and strategic policy risk.