Corporate Governance

1
Corporate Governance
2
Directors Duties

• Fiduciary duty
• Corporate profit and shareholder gain
• Lawfully ethical philanthropic
• Duty of loyalty and duty of fair dealing
• Director or senior exec may not take advantage of
  a corporate opportunity
• Duty of care
• Ordinary, prudent person
• Duty to be informed may rely on experts

3
Duty of Care example

• Smith v. Van Gorkom
• No advance notice that meeting was to consider
  sale of company
• Board agreed to sell after 2 hours
• Board had no information as to valuation, other
  potential buyers
• Chairman rammed through sale with few questions
  involvement

4
Directors Duties

• Duty not to entrench
• If corporation is not performing well, changes
  should be made in management
• Duty of Supervision
• An element of duty of care
• Internal controls ethical standards
• Regular meetings rigorous discussion of
  performance

5
Management Changes

• Dennis Denis (95 JFE)
• Management Turnover
• Forced
• Normal retirement for example
• Forced Operating Income/Assets decreases in 3
  years prior increases following
• Normal Little difference prior small
  improvement afterward

5
6
Dennis Dennis, cont.

• Forced resignations are rare
• 68 preceded by active monitoring by large S/H,
  B/H or potential acquirers
• 56 are the target of some form of control
  activity
• Boards not so effective in isolation
• Modern Trend Outside Directors
• Sarbanes - Oxley

6
7
Hostile Takeovers

• An effective (but not necessarily efficient) way
  to remove bad management
• Target management is removed in a majority of the
  cases shortly after a successful takeover

7
8
Sarbanes Oxley (SOX)

• Overhaul of incentives and independence in audit
  process
• Limit other consulting fees
• Rotate partners every five yrs
• Stiffening penalties for false information
• CEO and CFO must personally sign
• Validate internal financial control processes

9
International Governance

• English Common Law court precedents
• French Civil Law codification of laws
• Even if laws are codified they may not be
  enforced
• S/H protection significantly higher in English
  Common Law countries

10
International Governance

• Understand S/H will price protect themselves
• Will discount the price they are willing to pay
  for shares
• Lack of S/H protection
• Lack of transparency
• Discounted share price ? higher cost of capital

11
International Governance

• Ownership significantly more concentrated in
  foreign countries
• Nature of agency problem changes
• Mgmt v. S/H ?
• Large S/H v. Minority S/H
• (Minority S/H is S/H with small ownership)
• Families/small groups own majority

12
International Governance

• Premiums paid for voting v. non-voting shares
  significantly higher in foreign countries (e.g.,
  Italy, Mexico) than in U.S.
• Indicates control is more valuable i.e.,
  majority S/H can extract more value from minority
  S/H
• In US laws are generally more protective of
  minority S/H rights premium small for voting
  shares

13
International Governance

• Firms less willing to go public
• Investors price protect against majority
  extraction/lack of transparency
• Discounted price would be dilutive to majority S/H

14
Example Pre-acquisition assumptions

• Assume the following projected FCFs on a
  stand-alone basis for the target.
• Long-run growth after 2013 is 4
• The firm currently has 100 million in 8 debt
  O/S. Capital structure is 1/3 Debt and 2/3
  equity
• Tax rate 40

15
Calculation of Re

• Beta 1.38
• Rf 5.0 (20 yr T-Bond)
• Market Risk Premium 5.5 (Ibbotson)
• Re Rf B(Rm Rf)
• Re 5 1.38(5.5)
• Re 12.6

16
Calculation of WACC

• WACC Re E/(DE) Rd(1-t)D/(DE)
• WACC 12.6 x 2/3 8 x (1-40) x 1/3
• WACC 8.4 1.6
• WACC 10

17
Target Cash Flows Before Acquisition (Millions)
18
Target Cash Flows Before Acquisition (Millions)
19
Pro-Forma Balance Sheet and Income Statement
20
Post Acquisition Assumptions(Should specifically
identify)

• Transition Costs 40 million in first year,
  declining by 10 million per year
• Severance pay
• Disruption Learning curve Cultural change
• Additional Capital Spending 10 million first
  year then 5 million thereafter
• Depreciation 5 million more/yr
• Change in NWC 18 in 2011 8 in 2012 and 9 in
  2013

21
Post Acquisition Assumptions(Should specifically
identify)

• Sales 60 higher in years 2010-2013 and afterward
• After tax operating margin 13.33
• Long-run growth increased to 5
• Capital Structure constant
• Beta unchanged

22
Acquisition Effect on EBIT
23
Target Cash Flows After Acquisition (Millions)
24
Target Cash Flows After Acquisition (Millions)
25
Reasonableness Implied Market Multiples

• Firm Value/EBITDA 512/70 7.31
• (note the above is a firm value)
• P/E 412/25.2 16.3
• (note the above is an equity value)
• Compare these to similar company multiples

26
Synergy

• Equity Firm
• Post Acquisition Value 412 512
• Pre-Acquisition Value 363 463
• Total Synergy 49 49

27
Net Present Value

• Assume Acquirer offers a 10 premium on Equity
  Value
• Offers 400 for equity
• Total synergy 49
• Synergy to target S/H 37 (400 363)
• NPV 12

28
Alternatively Change in FCF

• Assuming Existing Estimated FCF stream of target
  is fairly
• valued ? we can Examine the Change in FCF as a
• (2008 CF Premium paid to target see previous
  slide)
• Capital Budgeting Project

29
Projecting Combined I/S B/S

• Why?
• Financing Needs consolidated
• Benchmark
• Impact on Financial ratios
• Short-run v. Long-run effect
• Negative short-run
• Positive long-run

30
Target Goodwill Calculation

• Assume Pre-acquisition value is appraised value
  with
• Difference reflected in Net Fixed Assets

31
Goodwill

• Goodwill is the difference between the purchase
  price and the appraised value of the assets at
  time of acquisition
• Ex 500 463 37
• Amortization of goodwill is not deductible for
  tax purposes

32
Combined Balance Sheet at Acquisition

• Assuming Purchase Assets for 500 100 cash 400
  debt