CFA Level 3 - Equity Investments Session 12 - Reading 28

CFA Level 3 - Equity Investments Session 12 - Reading 28 (Notes, Practice Questions, Sample Questions) 1. Which of the following statements regarding corporate governance is least accurate? A)Recent financial scandals have focused mostly on managers’ insufficient effort. (Explanation — Recent scandals have focused mostly on self-dealing (e.g., plush office decorations) rather than less obvious management deficiencies (e.g., insufficient effort) because it is much more visible and easier to prove.) B)European laws have helped managers avoid takeovers. C)Moral hazard problems occur because the owners of the firm often have a distant relationship with the firm’s management. 2. Which of the following statements regarding inadequacies in corporate governance is least accurate? A)Stock prices often drop when investments are announced. B)Shareholders are often ignorant of managerial compensation details. C)If managers were paid using stock-based compensation, the level of executive pay could be reduced. (Explanation — The level of managerial compensation has grown beyond what many consider reasonable. However, this growth is partly due to performance-based compensation. The higher the performance, the greater the payoff from stock and stock option compensation. Stock prices often drop when investments are announced because managers often misuse funds in value wasting projects) 3. Which of the following statements regarding corporate governance is least accurate? A)Managers use accounting manipulations to their benefit. B)The cross holding of shares in Asia has enabled managers to more effectively thwart takeovers. C)Shareholders would prefer managers reject hostile takeovers. (Explanation — Managers may engage in entrenchment strategies to keep their jobs. As an example, managers may resist hostile takeovers that would result in the loss of their job, even when the takeover would benefit shareholders. Most hostile takeovers benefit shareholders because a higher price is received for their stock in the takeover) 4. Which of the following statements regarding management compensation is most accurate? A)Both bonuses and stock-based compensation largely reward a manager’s short-term efforts. B)Bonuses largely reward a manager’s long-term efforts whereas stock-based compensation reflects more of the manager’s short-term efforts. C)Bonuses largely reward a manager’s short-term efforts whereas stock-based compensation reflects more of the manager’s long-term efforts (Explanation — Bonuses and stock-based compensation complement one another in the executive compensation package. They both serve different purposes. Bonuses, based on accounting figures, largely reward a manager’s short-term efforts whereas stock-based compensation reflects more of the manager’s long-term efforts) 5. If a manager is confident in her abilities, then: A)implicit incentives such as the manager losing her job act as a complement for explicit incentives, such as stock options. B)implicit incentives such as the manager losing her job act as a substitute for explicit incentives, such as stock options. (Explanation — Stock options are explicit incentives. An example of an implicit incentive would be the manager losing her job. If a manager is confident in her abilities, then she would be willing to accept a higher probability of being fired for increased compensation. In this case, a strong implicit incentive would be accompanied by an attractive compensation package and the two types of incentives would be measured as substitutes) C)implicit incentives such as stock options act as a substitute for explicit incentives, such as the manager losing her job 6.1 The board of directors of Worldwide Graphics has hired Bloom and Moore Consultants to investigate the corporate governance of Worldwide Graphics (WG). There have been some complaints from shareholders that the executives at WG have not been managing the firm in the best interest of the shareholders. The board of directors has requested an assessment of the managers’ incentive structure and an assessment of the decisions of the executives over the past few years. The board of directors specifically ask for Bloom and Moore to look for possible cases where WG executives are not acting in the best interests of WG shareholders. Furthermore, labor groups and the community where WG has its headquarters have been pressuring WG management to address the welfare of employees and the community. In essence, they want WG to maximize the welfare of all stakeholders and not just shareholders.When given a job such as this, the consultants Fred Bloom and Steven Moore typically assess the board of directors and their incentive structure too. Bloom and Moore have found that poor corporate governance often starts with problems in the board of directors. Among their findings, Bloom and Moore find that only a small minority of the WG board members are WG executives, and the majority of all the board members serve on the boards of several other companies. Bloom feels that the members being on other boards is a good thing because it means the board members have a lot of experience. Bloom and Moore also find that the board members receive a flat fee and do not get stock options. Moore feels this fee structure is good because it increases the board members’ objectivity. One of the accusations made by the shareholders is that WG executives have not been taking adequate risk. In essence, the shareholders have complained that the managers have been avoiding projects with higher risk and higher return because high risk projects have a higher probability of negative outcomes, which jeopardize the jobs of the managers. In examining the activities of WG managers, Bloom and Moore find that there had been a great deal of expansion and, in the past year, even an acquisition by WG of another firm. Bloom and Moore discuss if such expansion is incongruous with the accusation of WG managers not taking risk. Bloom and Moore find that the executives of WG have been given stock options as part of their compensation, but the board members do not receive cash bonuses based upon the net income of WG. Bloom says that stock options help in aligning the interests of executives with shareholders, and bonuses based upon income would only be a substitute and not a compliment to stock options. Moore says that stock options and bonuses based upon income are more complements than substitutes. They also discuss if giving stock options to board members as compensation help motivate the board to monitor and direct the WG executives to act on behalf of the shareholders. Bloom and Moore also recommend that WG use more debt in its financing. They both recognize that firms with higher total debt ratios seem to be managed better and in a fashion that has the shareholder interests in mind. Bloom says that a higher debt ratio leads to managers having less cash to siphon off to provide the executives with perks. Moore says that recent changes in the law, as a result of recent corporate scandals, have allowed debt-holders to form voting blocks to influence the board decisions. There has been an outcry for WG executives to try to maximize the welfare of parties other than WG shareholders, e.g., employees and the community. In responding to this outcry, Bloom and Moore should: A)point out that such pursuits are illegal given the fiduciary responsibility that WG executives have for WG shareholders. B)recommend that WG employ the Cadbury metric to pursue this goal. C)point out that no adequate, widely-used metric for pursuing such a goal exists. (Explanation — The only correct answer is that there is no widely-used and adequate metric for pursuing the goal of maximizing the welfare of multifarious stakeholders. It is legal, but there is no such thing as a Cadbury metric.) 6.2 In their discussion concerning whether stock options and bonuses based upon income are substitutes or complements: A)Bloom is correct and Moore is incorrect. B)Bloom is incorrect and Moore is correct. (Explanation — It is true that stock options and bonuses are not substitutes because their values are based upon two different variables. The value of options is based upon market data, and the value of a bonus is based upon accounting income.) C)Bloom and Moore could both be correct. It depends upon the circumstances. 6.3 There are only a minority of executive directors on WG‘s board of directors, and most of the members are also members of other boards. With respect to the effectiveness of the board, the fact that there is only a minority of executives on the board is: A)positive for board effectiveness, and the members being on other boards is positive for board effectiveness. B)positive for board effectiveness, but the members being on other boards is negative for board effectiveness. (Explanation — Fewer executives on the board is usually seen as a positive thing for shareholders. One way WG executives could make the board less effective, however, is to see to it that the board members are on several other boards so that they are overcommitted and cannot perform well on the board of WG.) C)negative for board effectiveness, but the members being on other boards is positive for board effectiveness. 6.4 Bloom and Moore investigate whether AG executives have been avoiding risks and the effect of the executives expanding and making acquisitions. A)These actions are both moral hazard problems, but they are mutually exclusive. B)Avoiding risks is a moral hazard problem, but making acquisitions is not a moral hazard problem. C)These actions are both moral hazard problems, and they can occur together. (Explanation — Managers avoiding risk is a moral hazard problem in that the managers avoid profitable ventures that have a good chance of increasing the value of the firm, but the venture could lead to the managers losing their job if the venture fails. Making acquisitions or “empire building” can be a problem. The acquisitions can be low risk and low return projects and congruous with the other case where the managers are not acting on behalf of the shareholders.) 6.5 Bloom and Moore discuss whether to give the board of directors stock options as part of their compensation. Giving stock options to the board of directors: A)has not proven effective at all in increasing the board’s incentives to act on behalf of shareholders. B)can increase the board’s incentives to act on behalf of shareholders, but its effectiveness is limited. (Explanation — Providing directors with stock options rather than fixed fees goes in the right direction, but it has its limitations for the same reason that managers’ stock options have limitations. In particular, if the managers go for a risky strategy that reduces investor value but raises the value of their stock options, directors may have little incentive to oppose the move if they themselves are endowed with stock options.) C)can be effective, but it is usually too costly to implement. 6.6 In the discussion concerning why firms with a higher debt ratio may be run better and more in the interest of shareholders: A)Bloom is correct and Moore is incorrect. (Explanation — Bloom is correct in that debt imposes a discipline and natural restriction on the use of the cash flow. Moore is wrong because there has not been any legislation concerning allowing debt-holders to form voting blocks.) B)both Bloom and Moore are correct. C)Bloom is incorrect and Moore is correct. 7. Which of the following statements regarding stock options as management compensation is most accurate? A)When a stock option is out of the money, the manager has an incentive to take greater risk. When it is in the money, its incentive effect is similar to that of stock compensation. (Explanation — When stock options are out of the money, managers have an incentive to take greater risks. The reason is that the option is worthless when the firm’s stock price is less than the option exercise price. If the option is currently in the money, a stock option is similar to stock in terms of its incentive effect. The only difference is that the option will provide lower compensation (the stock price minus the exercise price) relative to an outright payment of stock) B)When a stock option is out of the money, the manager has an incentive to take greater risk and its incentive effect is similar to that of stock compensation. C)When a stock option is in the money, the manager has an incentive to take greater risk and its incentive effect is similar to that of stock compensation. 8. Suppose shareholders wish that the board directors undertook more risk. Which of the following would most likely achieve that goal? A)The directors were paid with stock and their liability insurance was paid for. B)The directors were paid with stock options and their liability insurance was their responsibility. C)The directors were paid with stock options and their liability insurance was paid for (Explanation — If board directors were paid in stock options, they would be encouraged to take more risk. If their liability insurance were paid for, then they would also have an incentive to take greater risk because they would not have to face the potential consequences of their decisions) 9. Which of the following statements regarding management compensation is most accurate? A)Stock-based compensation and bonuses are substitutes whereas explicit and implicit incentives are most often complements. B)Stock-based compensation and bonuses are complements whereas explicit and implicit incentives are most often complements. C)Stock-based compensation and bonuses are complements whereas explicit and implicit incentives are most often substitutes. (Explanation — Bonuses and stock-based compensation are complements because bonuses reflect the manager’s short-term success whereas stock-based compensation more reflects the manager’s longer-term successes. Implicit incentives are usually substitutes for explicit incentives because the stronger the implicit incentive, the lower the need is for explicit incentives) 10. In which of the following situations is the board of directors most likely to become more effective? A)The firm’s earnings have been increasing and the stock price has been consistently increasing. B)The economy is in a recession and the firm’s stock price has been consistently declining. C)The firm has sustained several quarters of losses and the firm’s stock price has been consistently declining. (Explanation — If the firm’s earnings have been consistently decreasing, the firm is likely nearing crisis. Boards become more active during periods of crisis or when the stock price declines. It is at these times when the personal relationship between managers and directors deteriorates and that boards find themselves in the public limelight) 11. Which of the following would enable a Board of Directors to act in the best long-term interest of the shareholders? A)A majority of the Board of Directors is comprised of independent members and the Chairman of the Board is also a former Chief Executive Officer of the firm. B)A majority of the Board of Directors is comprised of independent members and the Board meets regularly outside the presence of management. (Explanation — The Chairman of the Board, who is also the CEO or former CEO, may impair the Board members from expressing opinions contrary to management. Also, when Board members’ interests are closely aligned with a firm supplier, customer, pension advisor, etc., independence may be impaired) C)There are Board members who are closely aligned with a firm supplier and the Board meets regularly outside the presence of management 12. Which of the following prescriptions would least likely improve board of director effectiveness? A)The board should have an independent chairman. B)Directors should be subject to maximum equity positions. (Explanation — Directors should be required to hold a minimum amount of equity, not limited to a maximum of how much equity they can hold) C)Self-evaluations of boards should be performed 13. In which of the following situations would an active investor be the least effective monitor of management? The active investor holds a: A)small block of liquid stock. (Explanation — If the active investor holds a small block of stock, then they do not have as strong an incentive to monitor management as they would if they held more shares and hence had more at stake. If the stock were liquid, they would also be less likely to be an effective monitor of management because they can easily sell their shares if management misbehaves. If instead the stock was illiquid, the active investor would likely place pressure on management to change because they could not cash out as easily) B)large block of illiquid stock. C)small block of illiquid stock. 14. Which of the following refers to the situation where an active investor does not own the majority of the firm’s shares but persuades other shareholders of her position? A)The active investor has real control. (Explanation — An active investor must have control to effectuate change. To have control, the shareholder must have either a majority of the firm’s shares (formal control) or be able to persuade other minority shareholders of her position (real control)) B)The active investor has contingent control. C)The active investor has formal control. 15. Which of the following is least likely to limit active investor effectiveness? A)Active investors are strictly monitored as to their performance. (Explanation — Active investors may not be effective monitors of management because active investors themselves are often unmonitored. Institutional (active) investors rarely face the same pressure that they apply to corporations. Their compensation is usually based on assets managed instead of performance, they are not subject to proxy fights, and they do not carry debt) B)Managers may become too focused on short-term performance. C)Active investors may liquidate their shares. 16. Which of the following statements regarding bankruptcy as a mechanism for enforcing good corporate governance is most accurate? A)Bankruptcy costs are substantial but bankruptcy does not discipline management to the extent expected. (Explanation — Bankruptcy costs are substantial and include both direct and indirect costs. Bankruptcy does not actually discipline management to the extent expected. Managers are often able to retain their positions during a firm’s bankruptcy) B)Bankruptcy costs are comparatively minor but bankruptcy does not discipline management to the extent expected. C)Bankruptcy costs are substantial and bankruptcy provides strong discipline against poor management 17. A firm would like to issue new securities to fund a new project. The firm’s managers have been paid predominantly with equity-based compensation and now hold most of the firm’s stock. If the firm wants to motivate their managers to work harder, which of the following securities should be issued? A)Shelf registered preferred stock. B)Debt. (Explanation — In terms of providing the strongest incentive for managers, the firm should issue debt. If the project is profitable and the firm has issued debt, the managers/owners won’t have to share their residual claim on profits with other common stock holders. By issuing debt, the manager/owners can more clearly see the end result of their efforts, and this will motivate them to perform better. Additionally, debt provides an incentive effect relative to preferred stock because the firm will have a legally binding obligation to make payments on the debt and management will not be able to waste cash on extravagant projects and perks) C)Common stock. 18. Which of the following statements regarding debt and its effect on corporate health via corporate governance mechanisms is most accurate? A)Debt is unambiguously beneficial. B)In some situations it can be beneficial; in others it can be a detriment. (Explanation — In some situations debt can be beneficial; in others debt can be a detriment. It is beneficial when it motivates management to not waste cash. With the pressure to make periodic interest and principal payments, management does not have the luxury of spending cash on frivolous projects and perks. If the firm has no cash after paying the debtholders, it is detrimental because it prevents the firm from investing in valuable projects) C)Debt is unambiguously detrimental 19. Which of the following is NOT representative of a firm in a stakeholder society? A)Employees are treated fairly and given extra benefits such as child care and extra family time off which makes them feel more secure and part of a community. B)Because the firm is viewed favorably by the community it is extended tax breaks and favorable terms by creditors and suppliers. C)Managers of the firm are under greater control by the stakeholders (Explanation — In a stakeholder society the social responsibilities of the corporation are to treat the employees fairly with respect to salaries, job security, training, child care, exercise facilities, family time off, etc. This results in the firm being viewed favorably by the community thus creditors offer better financing terms and suppliers offer better pricing and credit terms. By attempting to protect the best interests of all stakeholders the managers are left largely unmonitored thus there is less control of the management under a stakeholder society. In a stockholder society management is under greater control and scrutiny by the stockholders to perform well to maintain a high stock price) 20. Which of the following statements regarding advantages and disadvantages in a stakeholder society is least accurate? A)Profits are sacrificed in the short term for increased shareholder wealth in the long-run. B)Stockholders and creditors may be hesitant to invest fearing that gains must be shared with other stakeholders. C)Taxes are distributed more equitably under a stakeholder society than a shareholder society. (Explanation — There is no evidence that taxes are redistributed more equitably under a stakeholder society where management and the board of directors redistribute taxes to the stakeholders versus a shareholder society where elected officials redistribute taxes) 21. According to the Cadbury Report concerning the best practices in maintaining a board of directors, the pay of executive directors should be: A)unrelated to the profits of the company. B)merit based only. C)subject to the recommendations of a committee that is made up wholly or mainly of non-executive directors (Explanation — The Cadbury Report (3.3) only says that the pay should be subject to the recommendations of a committee that is made up wholly or mainly of non-executive directors) 22. The Cadbury Report for best practice in maintaining an effective board of directors makes a recommendation concerning non-executive directors. It specifies that there should be: A)a majority of non-executive directors, and no specific number is mentioned. B)no more than five, but no fewer than three. C)a sufficient number so that their views carry weight in the board’s decisions, but no specific number is mentioned. (Explanation — The Cadbury Report (1.3) specifies that the board should include non-executive directors in a sufficient number for their views to carry weight in the board’s decisions, but no specific number is mentioned) 23. A board of directors should have a company secretary, who is responsible for ensuring that the board procedures are followed and that there is compliance with the applicable rules and regulations. With respect to having access to the secretary and/or removing the secretary, the Cadbury Report specifies that: A)all directors should have access to the advice and services of the company secretary, and removal of the company secretary should be a matter for the board as a whole. (Explanation — With respect to having access to the secretary and removing the secretary, the Cadbury Report (1.6) specifies that all directors should have access to the advice and services of the company secretary, and removal of the company secretary should be a matter for the board as a whole) B)only the chairman of the board should have access to the advice and services of the company secretary, and removal of the company secretary should be a matter for the board as a whole. C)all directors should have access to the advice and services of the company secretary, and removal of the company secretary should be a matter of the chairman of the board only.