Phase I: Corporate Governance Analysis (11 marks)

Objective: Assess the companys corporate governance structure and examine the relationships between different stakeholders in the business (stockholders, society, bondholders, and financial markets).

Key Steps

1. Examine whether there is a separation between the management of a business and its owners. If so, assess how much power owners have in monitoring management and influencing decisions.

2. If the firm has borrowed money, either form banks or in the form of bonds, evaluate the potential for conflicts of interest between the equity investors and lenders and how it is managed.

3. If the firm is publicly traded, examine how markets get information about the firm and investor reactions and assessments of the stock.

4. Evaluate the companys standing as a corporate citizen, by looking at its reputation (good or bad) in society.

Framework for Analysis: This section helps you to complete Part I of the project. 1.

Shareholder Concerns

a. Voting Structure (0.5 mark): If it is a publicly traded firm, look at whether the firm has multiple classes of shares and if so, whether they have different voting rights. If the government is an investor, check to see whether it has veto powers (golden shares) over key decisions.

b. Ownership structure (1.5 marks): Start by looking at proportions of the outstanding stock held by institutions, insiders and individuals. This data is generally available in public sources, in most countries.

How many stockholders does the company have?

What percent of the stock is held by institutional investors?

Does the company have listings in foreign markets?

(If you can, estimate the percent of the stock held by non-domestic investors) Who are the insiders in this company? (Besides the managers and directors, anyone with more than 5% is treated as an insider)

What role do the insiders play in running the company?

What percent of the stock is held by insiders in the company?

What percent of the stock is held by employees overall? (Include the holdings by employee pension plans)

Have insiders been buying or selling stock in this company in the most recent year?

c. Top shareholders (1.5 mark): Look at the top ten to twenty holders of the companys shares. In addition to checking to see how many are institutions, look for the presence of founders and activist investors on the list. (You are trying to see if these stockholders will be willing to stand and contest management, if they feel that their value is being put at risk.)

d. CEO and top management (1.5 mark): Look at the background of the CEO and examine how he or she got to the position. In particular, check for tenure (how long he or she been CE)), whether the CEO came up through the ranks or from another organization, his/her age and connections to the ownership of the company. If you can, ask the same questions about the rest of the top management team.

Who is the CEO of the company?

How long has he or she been CEO?

If it is a family run company, is the CEO part of the family? If not, what career path did the CEO take to get to the top? (Did he or she come from within the organization or from outside?)

How much did the CEO make last year?

What form did the compensation take? (Break down by salary, bonus and option components)

How much stock and options in the company does the CEO own?

e. Board of Directors (1.5 mark): evaluate whether there is evidence that the board is willing to stand up to management

Who is on the board of directors of the company?

How long have they served as directors?

How many of the directors are insider directors? (i.e. employees or managers of the company)

How many of the directors have other connections to the firm (as suppliers, clients, customers..)?

How many of the directors are CEOs of other companies?

Do any of the directors have large stockholdings or represent those who do?

f. Compensation Structure (1 mark): Find out how much the CEO/top managers were paid in recent periods and in what form (cash, restricted stock, options) and how these payments relate to company performance over the same periods (both in terms of accounting profits and stock prices).

2. Bondholder Concerns

a. Debt type (0.5 mark): If your firm borrows money, examine whether it borrows from banks or by issuing bonds. With either one, follow through and find more details on the borrowing.

b. Debt covenants (0.5 mark): Check to see if there are covenants or restrictions imposed by the lenders. You may be able to find this information in the annual report or filings with the regulatory agencies.

c. Default risk measures (0.5 mark): If your company has been rated by a ratings agency (S&P, Moodys, Fitch), find out the bond rating and the ratings agencys views of the company.

3. Financial Markets

a. Trading and Liquidity (0.5 mark): If it is a publicly traded company, examine the portion of the shares that is available for trading (free float) and how much trading there is in the company (by looking at trading volume, relative to market value). If you can, get measures of liquidity costs from the market including bid-ask spreads.

b. Analyst following (0.5 mark): If it is a publicly traded company, see if you can find a listing of the sell-side analysts who follow the company and what they think about the stock. Many services provide information on both metrics, with a breakdown of buy, sell and hold recommendations from analysts following a company.

4. Society and other Stakeholders

a. Employee satisfaction (0.5 mark): Look for hard data on employee satisfaction such as employee turnover and compensation numbers for your company, relative to its peer group. Also, look for qualitative assessments of the company as an employer, generally from news stories about the issue.

b. Society (1 mark): In general, it is tough to get a measure of how a company stands with society, unless your company is at one of the extremes. In addition to looking for news stories that mention your company is a social context, you can try to see if the company makes the lists of socially responsible corporations that are published by some external entities (environmental, labour and political) but recognize that they may be no consensus, since these groups have different agendas.

Phase II: Risk and Return (14 marks)

Objective Estimate the risk parameters for your company and use these parameters to

estimate costs of equity and capital for the firm.

Key Steps

1. Looking at the stock price history of your company, evaluate both its riskiness and its performance as an investment, relative to the market and after adjusting for risk.

2. Develop a measure of equity risk in the company and compute a cost of equity for it. If the company is in multiple businesses and regions, estimate the cost of equity for each.

3. Develop or find a measure of default risk in the company and compute a cost of debt for it.

4. Based on the mix of debt and equity used by the company, estimate an overall cost of capital for the company. If it is in individual businesses and regions, estimate the cost of capital for each.

Framework for Analysis

1. Estimating Risk free rate and Equity Risk Premium (4 marks)

a. Choose a currency to do your analysis in and estimate a risk-free rate in that currency. If there is a Aaa rated entity issuing long term bonds in the currency, you can use the interest rate on those bonds as your risk-free rate. If not, you will have to subtract out the default spread for the entity from the interest rate on the entitys bonds to get to a risk-free rate.

b. Based on the geographical risk exposure of your company, estimate an equity risk premium for the company. You should be able to find at least a revenue breakdown by region, in your companys financial reports, and sometimes asset and income breakdowns. You can find equity risk premiums for individual countries, as well as regions, on http://www.damodaran.com (under updated data).

2. Estimating relative risk (5 marks)

a. Run a regression of returns on your firms stock against returns on a market index, preferably using monthly data and 5 years of observations. Use the regression to evaluate your companys performance on a risk adjusted basis during the period of the regression and its riskiness, relative to the market, and break down the risk into firm specific and market components. To run the regression, you will need to get data on past returns for your stock and for a market index.

• What is the intercept of the regression? What does it tell you about the performance of this company's stock during the period of the regression?
• What is the slope of the regression?
  • What does it tell you about the risk of the stock?
  • How precise is this estimate of risk? (Provide a range for the estimate.)
• What portion of this firm's risk can be attributed to market factors? What portion to firm-specific factors? Why is this important?
• How much of the risk for this firm is due to business factors? How much of it is due to financial leverage?

b. Based on your companys business mix, estimate a bottom up beta for your companys operating businesses. You should be able to find the breakdown by business in your companys financial filings, though the details are richer in some than others. To get the beta for each business, you will need to find other publicly traded companies that operate primarily in that business, average their betas and correct for financial leverage and cash holdings.

• Break down your firm by business components, and estimate a business beta for each component
• Attach reasonable weights to each component and estimate an unlevered beta for the business.
• Using the current leverage of the company, estimate a levered beta for each component.

c. Estimate the market value of debt outstanding in the company (see below), compute a market debt to equity ratio for the entire company, and use that ratio to compute a levered beta for the company. If you can allocate the debt across the different businesses, compute the debt to equity ratio and levered beta for each business. (If not, use the companys debt to equity ratio for all of the businesses).

d. Use the levered betas, in conjunction with the risk-free rate and equity risk premium, to compute costs of equity for each business and for the overall company.

3. Estimating Default Risk and Cost of Debt (2 marks)

a. If your company is rated, find the bond rating and estimate a default spread based on the rating. Add the default spread to the risk-free rate to estimate a pre-tax cost of debt.

b. Estimate a synthetic rating for your company, based upon financial ratios. If the company has an actual rating, compare the synthetic rating to the actual rating and explain the reasons for differences. If your company does not have an actual rating, use the synthetic rating to estimate a default spread for the companys debt and a pre-tax cost of debt based on that spread.

c. Estimate the marginal tax rate for your company, based on the country of incorporation and use that tax rate to compute an after-tax cost of debt for the company and its divisions (if they have their own costs of debt)

4. Estimating Cost of Capital (3 marks)

a. Compute the market value of all of the companys equity.

b. Compute the market value of the companys interest-bearing debt, using the interest expenses and weighted maturity of the debt, if need be. Compute the present value of lease and other contractual commitments that your company has contractually obligated itself to pay. Add the two values to estimate the market value of debt (which you will need to use for the levered beta computation in the earlier section)

c. Compute a debt to capital ratio, using the market values, and a cost of capital based on this ratio for both the company and its individual business units.

Proper referencing in text and bibliography (1 mark)

Overall neatness of the report (1 mark)

Executive Summary (1 mark)

Oral presentation for Phase I and II (2 marks)