CFA Level 2 - Corporate Finance Session 9 - Reading 31

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CFA Level 2 - Corporate Finance, Session 9 - Reading 31

(Practice Questions, Sample Questions)

1. Which of the following best describes the importance of a corporate governance system? A strong corporate governance system:

A)maximizes shareholder value.
B)gives the firm the ability to attract and fairly compensate qualified managers to ensure that assets of the company are used efficiently and productively.
C)is essential for companies to operate efficiently, while the lack of an effective corporate governance system can threaten the very existence of a firm.

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(Explanation): (C) A strong corporate governance system is essential for companies and financial markets to operate efficiently, while the lack of strong corporate governance system represents a major operational risk that can threaten the very existence of a firm. A strong corporate governance system cannot in itself maximize shareholder value, but studies have shown that the lack of effective system certainly reduces shareholder value.

2. Corporate governance is defined as:

A)the system of principles, policies, procedures, and clearly defined responsibilities and accountabilities used by stakeholders to overcome conflicts of interest inherent in the corporate form.

B)the system in a corporate structure that insures fairness and equitable treatment in all dealings between managers, directors, and shareholders.
C)a system designed to insure that a corporation’s business is conducted in an ethical, fair, and professional manner

(Explanation): (A) McEnally and Kim define corporate governance as “the system of principles, polices, procedures, and clearly defined responsibilities and accountabilities used by stakeholders to overcome conflicts of interest in the corporate form.”

3. Chen Michiba is an Executive Vice President with the Sakai Corporation. Michiba is concerned that Sakai does not have an effective corporate governance system in place and drafts a memo to the company’s senior management team detailing a potential structure for an improved system. Michiba starts his memo by listing the two key objectives of corporate governance:
Objective 1:
Establish clear lines of responsibility and a system of accountability and performance measurement in all phases of a company’s operations.
Objective 2:
Ensure that all legal and regulatory requirements are met and complied with fully and in a timely fashion.

Michiba is:

A)correct with respect to Objective 1, but incorrect with respect to Objective 2.
B)incorrect with respect to both Objectives.
C)correct with respect to both Objectives

(Explanation): (B) Although Michiba lists two admirable goals and actions that should be performed by a firm’s board of directors, neither item is one of the two key objectives of a corporate governance system. The two key objectives of a corporate governance system: (1) Eliminate or reduce conflicts of interest (particularly those between managers and shareholders), and (2) Ensure that the assets of a company are used efficiently and productively and in the best interests of its investors and other stakeholders.

4. Which of the following statements regarding effective corporate governance systems is least accurate?

A)The primary responsibilities of a corporate board of directors are to institute corporate values and establish long-term strategic objectives that are in the best interests of shareholders.
B)A comprehensive list of corporate governance best practices can be applied effectively to any corporation worldwide to strengthen the company’s corporate governance structure.
C)A corporate governance system must be continuously monitored because of changes in management and the board of directors

(Explanation): (B) Corporate governance systems will differ according to the legal environment, culture, and industry in which a firm operates, so a list of best practices cannot simply be applied to all firms worldwide with any expectation that the corporate governance structure will be strengthened. There are, however, a number of common characteristics that all sound corporate governance structures share

5. Which of the following statements regarding effective corporate governance systems is least accurate?

6. Most corporate governance systems focus on the elimination or reduction of any potential conflicts that may arise between management and:

A)directors.
B)shareholders.
C)employees

(Explanation): (B) There is potential for many conflicts of interest to arise in a corporation, but most corporate governance systems focus on those between management and shareholders

7. A principal-agent problem may exist between:

A)shareholders and directors.
B)managers and directors.
C)regulators and directors

(Explanation): (A) An agency relationship exists when an individual (the agent) acts on behalf of another individual (the principal). Such a relationship creates the potential for a principal-agent problem where the agent may act for his own well being rather than that of a principal. The key test of whether a principal-agent problem may exist is if one party is responsible for acting in the best interest of the other. Of the answer choices given, directors are responsible for acting in the best interests of shareholders

8. All of the following are responsibilities of the board of directors for a corporation EXCEPT:

A)ensure new board members are adequately trained to perform board functions.
B)make disclosures regarding company operations, risk, and financial position that are accurate and transparent.
C)ensure that management has supplied the board with sufficient information to be fully informed and make appropriate decisions

(Explanation): (B) Actually making disclosures about company operations is the responsibility of management. It is the responsibility of the board to make sure management is acting in the best interests of shareholders, which may entail appointing/serving on the audit committee to review those disclosures. Both remaining choices listed are all board responsibilities

9. Sunil Reddy is an analyst for Worldwide Financial Services. Reddy thinks that Worldwide’s procedures for analyzing companies for inclusion in client portfolios would be more robust if it included a review of the company’s board of directors. Reddy prepares a list of five items concerning the board of directors that analysts should assess:
Item 1: Frequency of separate sessions for independent directors.
Item 2: Use of independent legal counsel as opposed to company in-house counsel.
Item 3: Composition of the nominating committee.
Item 4: Composition of the compensation committee.
Item 5: Whether the board has staggered or annual elections.

Which of the items on Reddy’s list are attributes of a board of directors that are important for an analyst to assess?

A)Items 1, 3, and 5 only.
B)All five items.
C)Items 2, 3, and 4 only.

(Explanation): (B) All five of the items on Reddy’s list are important factors that an analyst should review when assessing a board of directors.
10. Ashley Jones is considering joining the board of directors of Dusseau Investment Management (DIM). Before joining the board, Jones wants to make sure she fully understands what her responsibilities would be as a board member. Kenley Walker, administrative assistant to DIM’s CEO prepares a memo to Jones detailing responsibilities of board members.
Responsibility 1: Establish corporate values and governance structures to ensure that business is conducted in an ethical, fair, and professional manner.
Responsibility 2: Determine which proxy issues that have received a majority of shareholder votes should be addressed or ignored.
Responsibility 3: Hire the company’s chief executive officer (CEO), and determine the CEO’s compensation package.

Which of the responsibilities listed by Walker are CORRECT?

A)Responsibility 1 only.
B)Responsibilities 1 and 3 only.
C)Responsibilities 1, 2, and 3

(Explanation): (B) Directors should always address all proxy issues that have received a majority of shareholder votes. Responsibilities of directors include hiring the firm’s CEO and determining the CEO’s compensation, and establishing corporate values and governance structures to ensure that business is conducted in an ethical, fair, and professional manner.

11. Which of the following statements concerning the audit committee of the board of directors is least accurate? The audit committee:

A)should directly oversee the internal audit staff of the company.
B)should not have any dialogue with management in order to ensure that the committee’s actions are independent of management activities.
C)should consist entirely of independent board members

(Explanation): (B) The audit committee should have full access to and the cooperation of management in order to perform their duties

12. Which of the following is most consistent with corporate governance best practice?

A)Any related-party transactions must be approved in advance by the board of directors.
B)Elections are staggered with at least 3 directors up for reelection to the board each year.
C)Half of the board members are independent

(Explanation): (A) Any insider or related-party transactions, such as making a personal loan to a company CEO should be approved in advance by the board of directors. Note that for purposes of the exam, global best practice calls for 75% of board members to be independent, board members do not serve on more than 2-3 boards total, and that all directors are elected annually

13. Which of the following is least consistent with corporate governance best practice?

A)Board members conduct a self-assessment on an annual basis.
B)The CEO and Chairman of the board are separate positions held by separate individuals.
C)Directors have access to in-house legal counsel whenever necessary to assess the company’s compliance with regulatory requirements

(Explanation): (C) Directors should have access to independent, not in-house legal counsel for any questions related to the company’s compliance with regulatory requirements. Both remaining statements are all considered corporate governance best practices

14. Mike Ransom was recently elected to the board of directors for Tedeschi Chemical Corporation (TCC). Ransom knows that as a board member, he is responsible for serving on at least one board committee. In an effort to understand the board committee structure, he asks Kelly Williams, who has served on the board for 7 years, to describe the structure and practices of various committees to him. Williams makes the following statements:
Statement 1: The audit committee consists of four independent members, one of which has a background in accounting and auditing.
Statement 2: The audit committee has an annual meeting with auditors and management to assess any issues which may arise in the audit process.
Statement 3: TCC’s internal auditors report directly to the audit committee.
Which of Williams’s statements about TCC’s committee structure are consistent with corporate governance best practice?

A)Statement 3 only.
B)Statements 2 and 3 only.
C)Statements 1, 2, and 3

(Explanation): (A) Statement 3 is a best practice – the internal audit staff of the firm should report directly to the audit committee. The other statements are not consistent with best practices. On the audit committee, two or more members should have relevant financial experience. The audit committee should have at least an annual meeting with auditors, but management should NOT be present

15. McCool and Company is a consulting firm that provides research reports on corporate governance at large corporations and whether corporate governance systems are consistent with global best practices. McCool recently completed an evaluation of ARC Industries and listed the following observations:
2 of the 10 directors for ARC Industries are former employees and 4 of the 10 have large personal stock holdings in the company.
The Chief Executive Officer for ARC has regular meetings with the Chairman of the Board.
Each board member is up for reelection to the board on an annual basis.
The nominating committee consists of 3 independent directors and the CEO of ARC Industries.
The compensation committee consists of 5 independent directors.
ARC has a requirement that all board members serving on the audit committee must be independent and must have a background in finance or accounting.

McCool and Company gives each company they evaluate a score based on how many of the following four items are consistent with global best practice:

Item 1: Board Independence.
Item 2: How the board is elected.
Item 3: Makeup of the nominating committee.
Item 4: Makeup of the audit committee.

Based on the observations of ARC Industries, what was ARC’s most likely score on the McCool report?
A) 25%
B) 50%
C) 75%

(Explanation): (C) Based on the observations, ARC Industries is in accordance with global corporate governance best practices with respect to 3 of the 4 items, resulting in a score of 75%.
With respect to Board independence, global best practice states that 75% of the directors should be independent. McCool observes that 2 of the 10 directors are former employees, but assuming no other conflicts, this would still result in 80% of the board being independent. Note that personal stock holdings among board members should be encouraged as it puts the board members in the same position as investors and can help align board member and investor interests.
Global corporate governance best practice supports annual elections of each board member rather than staggered elections – based on the observations, ARC is consistent with this practice.
The nominating committee should be made up entirely of independent directors. Having the company CEO on this committee means that ARC is not consistent with corporate governance best practice with respect to this item.
The audit committee should be made up entirely of independent directors and at least two members of the committee should have relevant accounting or auditing experience. It appears from the observations that ARC received a positive score for their requirements for serving on the audit committee

16. Kathryn Rutherford recently joined the Board of Directors for Orvis Asset Management Company (Orvis) and will participate in its annual Board of Directors meeting. Rutherford is an Executive Vice President with Signature Bank, and knows Orvis’ finances well, serving as a commercial lender to Orvis for the last five years. Besides Rutherford, OAMC’s board consists of the following seven members:
Dane Corser, CFO for Orvis who also serves on the board for Spencer Pharmaceuticals
Tricia DeLucia, a granddaughter of Orvis’ founder, Michael Orvis
Wendy Kepling, a former Executive Vice President with Orvis
Troy Montgomery, the retired CEO of Forner Capital Management, another asset management firm
Mike Shute, President of Spencer Pharmaceuticals
Robert Stuart, an attorney with Bricker and Palmer, Orvis’ outside counsel
Jason Winterfeld, Chairman and CEO of Orvis
Orvis is a publicly traded firm that specializes in managing equity portfolios for both institutional and individual clients. The firm’s investment philosophy is to focus on companies with a history of not changing their dividend payments in order to achieve stable returns. The firm’s marketing approach focuses on tax-exempt pension funds and endowments as well as individuals who depend on dividend payments to meet living expenses. Historically, Orvis has been a successful manager, but recently performance has declined relative to the firm’s benchmark. The primary focus at this board meeting is defining the long-term strategic objectives for the company and making sure the assets of the company, specifically its proprietary investment process, are being used in the best interests of the firm’s shareholders.

Winterfeld states that Item 1 on the Board’s agenda is to discuss the impact of dividends on shareholder value. Kepling begins the discussion by questioning whether Orvis’ investment process should focus on dividends at all. Kepling states, “According to work by Modigliani and Miller, dividends are irrelevant. If an investor holds a non-dividend paying stock, but wants the benefits of a dividend, all they have to do is sell a portion of the stock to get the cash flow they want. Whether the individual receives a cash dividend or sells a portion of their stock, the combination of the investment in the firm and the cash in hand is the same.” Montgomery replies, “I disagree with the theory that dividends are irrelevant. According to work by Gordon and Lintner, dividend payments matter because they are less risky than capital gains. Since investors perceive dividends as being less risky, a firm that starts paying a dividend is likely to see an increase in their P/E ratio.”

Kepling is also aware that Modigliani and Miller have done a great deal of work regarding capital structure theory. She asks Corser if Modigiani and Miller’s theory on capital structure has any implications for the percentage of debt and equity that Orvis has in its capital structure. Corser replies with two statements:

(1) Since Orvis has to pay taxes on its earnings, according to Modigliani and Miller, the optimal capital structure would be 100% debt.

(2) If bankruptcy costs are included in Modigliani and Miller’s capital structure theory, the value of a firm will be maximized when a firm’s cost of debt is minimized.

Which of the following questions about board independence is most accurate?

A)Montgomery qualifies as an independent director, but Stuart does not.
B)Stuart qualifies as an independent director, but Kepling does not.
C)Shute qualifies as an independent director, but DeLucia does not

(Explanation): (A) Montgomery may have prior ties to the asset management business, but there appears to be no prior relationship with Orvis. Stuart, as an attorney with Orvis’ outside counsel, cannot be classified as independent due to his firm’s relationship with Orvis.
DeLucia, as a family member, and Kepling as a former employee cannot be classified as independent. Also, due to interlocking directorships, Shute cannot be classified as an independent director (Corser serves on the board for Spencer Pharmaceuticals, where Shute is the President and Shute serves on the board for Orvis, where Corser is the CFO).

17. Jason Winterfeld is the Chairman of the Board of Directors at Orvis, as well as the firm’s CEO. Which of the following best describes Winterfeld’s position according to corporate governance best practices? Having the CEO also serve as Chairman of the Board is:

A)not in the best interest of shareholders because the Chairman/CEO could influence the culture of the board room and diminish the role of independent board members.
B)in the best interest of shareholders because the CEO has the knowledge and experience to provide information to the board about company strategy and operations.
C)not in the best interest of shareholders because only an independent Chairman insures the proper functioning of the Board.

(Explanation): (A) Corporate governance experts believe that having a CEO also serve in the role of Chairman of the Board can negatively influence boardroom culture and diminish the role of independent board members. It is for this reason that corporate governance best practice supports having the Chairman and CEO as separate positions. Note that while the CEO does have the knowledge and experience to provide information to the board about company strategy and operations, if management is doing their job, it will provide the board with all necessary information, while it is the board’s responsibility to see that they get the information. Having the CEO as a knowledge base is not a valid justification for the dual role

18. Given that Orvis does not meet the global corporate governance best practice that 75 percent of directors are independent, which of the following would be the best recommendation for a more effective system of corporate governance?

A)Reduce the potential for conflicts of interest between principals and agents of the firm.
B)Determine board member responsibilities and how the board will be held accountable.
C)Create long-term strategic objectives for the company that are consistent with shareholders’ best interests

(Explanation): (A) Since one of the two primary objectives of corporate governance is to eliminate or reduce conflicts of interest in a firm, and Orvis obviously has many potential conflicts of interest on their board, reducing the potential conflicts of interest between principals and agents of the firm is the best answer. In a corporation, principal-agent relationships exist between shareholders and management, and directors and shareholders. A principal agent problem occurs when managers or directors (the agent) act in their own best interests rather than those of the owners of the firm (the shareholders/principals). Both remaining answer choices are all good things, but do not get to the core principals of corporate governance which are reducing or eliminating conflicts of interest, and using company assets productively and in the best interests of shareholders

19. Which of the following statements best reflects Orvis’ investment philosophy and marketing approach? Orvis’ investment philosophy is:

A)not consistent with a stable dividend policy, and the marketing approach depends on the clientele effect.
B)not consistent with a stable dividend policy, and the marketing approach depends on the signaling effect.
C)consistent with a stable dividend policy, and the marketing approach depends on the clientele effect

(Explanation): (A) Orvis’ investment philosophy is to focus on companies with a history of not changing their dividend payments, which is NOT consistent with a stable dividend policy. A stable dividend policy aligns the company’s dividend with the firm’s long-term growth rate to achieve stability in the rate of increase for the dividend each year. If the company never changed their dividend payments, the value of the dividend would decline over time as a result of inflation. The marketing approach seems to depend on the clientele effect which refers to the varying preference for dividends among different groups of investors. Tax considerations, institutional investor requirements, and individual investor preferences to spend dividends only and not dip into principal are all rationales for the clientele effect

20. With regard to their statements about dividend theories:

A)Kepling is correct; Montgomery is correct.
B)Kepling is correct; Montgomery is incorrect.
C)Kepling is incorrect; Montgomery is correct

(Explanation): (A) Kepling is correct. According to Modigliani and Miller’s dividend irrelevance theory, a stock holder can effectively create their own dividend policy by buying or selling a firm’s stock to get the combination of cash flow and ownership they want to receive. Note that Modigliani and Miller’s theory only holds in a perfect world with no taxes or brokerage costs. Montgomery is also correct. According to Gordon and Lintner’s “bird-in-the-hand theory,” a dollar of dividends is less risky than a dollar of capital gains. Since dividends are less risky, a company that pays dividends will cause its cost of equity to decrease. Since the cost of equity declines, the required return for the investor will also decline, which will result in a higher P/E ratio

21. With regard to Corser’s statements about Modigliani and Miller’s theory on capital structure, Kepling should:

A)agree with both Statements 1 and 2.
B)disagree with Statement 1, but agree with Statement 2.
C)agree with Statement 1, but disagree with Statement 2

(Explanation): (C) Modgliani and Miller’s work on capital structure theory concludes that in a world with no taxes and no bankruptcy costs, capital structure is irrelevant. However, in a subsequent study, they updated their work to include the effect of taxes. Since corporations can deduct interest payments when determining taxable income, the stockholders will benefit from the use of debt. According to their theory, the optimal capital structure in a world with taxes is 100% debt – Statement 1 is correct. However, if bankruptcy costs are factored into their results, debt is useful initially for its tax savings to lower the cost of capital, but only up to the point where it increases risk and the cost of debt and equity starts to rise. In a world with taxes and bankruptcy costs, the optimal capital structure is the one that minimizes the weighted average cost of overall capital - not simply the cost of debt

22. Jon Fisher is a junior analyst for Folker Capital Management. Jim Russell, Director of Research has asked Fisher to prepare a list of items that may be included in a company’s statement of governance practices that would help assess company governance policies concerning the operation of the board of directors. Fisher’s list includes the following items:
Item 1: Board and committee self-assessment reports.
Item 2: Statement of the responsibilities directors have to review and oversee management.
Item 3: Reports of findings in directors’ oversight and review of management.
Item 4: Statement detailing how directors are trained before they join the board.

Which items should analysts include in order to understand a company’s corporate governance practices as they relate to the board of directors?

A)All 4 items should be included.
B)Item 1 only.
C)Items 1 and 3 only.

(Explanation): (A) All of the items on the list are elements of a company’s statement of corporate governance policies that should be assessed by investors and analysts

23. Which of the following would be the most effective means for a manufacturing firm to communicate its corporate governance policies to shareholders?

A)Include a statement on the company website that the company is committed to global corporate governance best practices.
B)Adopt a statement of governance policies that is provided by the North American Association of Manufacturers.
C)Provide access to internal management performance assessment reports

(Explanation): (C) Management performance assessments as well as reports of director’s oversight and review of management are an important element of a statement of governance policies that investors and analysts should assess. Note that a statement of governance practices should be company specific (not a boilerplate statement) and that it should be detailed – simply telling investors that the company is committed to best practices is insufficient

24. John Zehetmeier, an analyst for Folker Capital Management is helping his colleague, Chris Augustine, understand elements of a company’s statement of governance policies that would be helpful in analyzing a company. Zehetmeier makes the following statements:
Statement 1: A corporate code of ethics that conveys the values, responsibilities, and ethical conduct of an organization should be included in a statement of governance policies.
Statement 2: A statement of director oversight responsibilities would be the best place to find information about nomination and compensation award polices.
Augustine should:

A)agree with Statement 1, but disagree with Statement 2.
B)agree with both of Zehetmaier’s statements.
C)disagree with both of Zehetmeier’s statements

(Explanation): (B) Augustine should agree with both statements. A corporate code of ethics should articulate the values, responsibilities, and ethical conduct of an organization and should be included in a statement of governance policies. Also, a statement of director’s oversight, monitoring, and review responsibilities should include information regarding internal controls, risk management, accounting disclosure, compliance, nominations, and compensation awards

25. 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)An otherwise profitable company may not have cash on hand to pay its bondholders.
C)Management may enter into off-balance sheet obligations that reduce the value of a company

(Explanation): (B) 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

26. 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)disagree with Statement 1, but agree with Statement 2.
B)agree with both Statements.
C)agree with Statement 1, but disagree with Statement 2

(Explanation): (A) 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 developed 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

27. 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)Determine whether a corporate code of ethics and statement of governance policies is easily accessible for investors and stakeholders.
C)Evaluate the quality and quantity of financial information provided to investors

(Explanation): (C) 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

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

A)liability risk.
B)asset risk.
C)strategic policy risk

(Explanation): (C) 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