Corporate Governance Understanding

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Independence of the board and good corporate governance

The inextricable link highlighted in the National article is the independence of the board of directors. Outside directors, sometimes called non-management directors, may be executives be executives of other firms but are not employees of the board’s corporation. Analysts who favor a high proportion of outside directors’ state that outside directors are less biased and more likely to evaluate management’s performance objectively than are inside directors. This is the main reason why the New York Stock Exchange requires that all companies listed on the exchange have an audit committee composed of independent, outside members (Ryan & Wiggins 2004, 497-524).

Legal, financial or future merger and acquisition advice

Without independence of the board, especially in a situation where the CEO is free to nominate directors, the CEO might select only board members who, in the CEO’s opinion, will not disturb the company’s policies and functioning. Consequently, CEO-friendly, passive boards are likely to result. Directors selected by the board often feel that they should go along with any proposal made by the CEO, which may not always be in the best interest of the shareholders.

Due to agency conflicts, management is likely to act in ways that will protect its interests, for example by awarding itself huge bonuses that may not necessarily reflect the performance levels. An independent board is more likely to make advice on merger and acquisition strategies as top management will be mostly concerned with increasing shareholder value, rather than in enriching or protecting top management positions.

2010 UK Corporate Governance Code

As per the 2010 UK Corporate Governance Code, the audit committee should be made up of only independent non-executive directors, excluding the chairman (Webster 2010, pp. 8-15). The audit committee acts as an extension of the board and, consequently, may have almost unrestricted authority in certain areas. The audit, reimbursement, and recommendation board are usually composed of only outside sovereign directors.

Chairman and CEO

Arguments for the same person holding both the Chairman of the Board and CEO positions contend that that outside directors are less effective than are inside directors because the outsiders are less likely to have the necessary interest, availability, or competency. Directors may at times serve on so many boards that they spread their time and interest too thin to actively fulfill their responsibilities.

Arguments could also point out that the term outsider is too simplistic, in that some outsiders are not truly objective and should be considered more as insiders than as outsiders. For example, there can be affiliated directors who, though not really employed by the corporation, handle the legal or insurance work of the company or are important suppliers, thus dependent on the current management for a key part of their business. These outsiders face a conflict of interest and are therefore not likely to be objective.

On the other hand, the combined chair of the board and CEO position is increasingly being criticized because of the potential conflict of interest. The CEO is supposed to focus on strategy, planning, external relations, and responsibility to the board.

The Chairperson’s responsibility is to ensure that the board and its committees perform their functions as stated in the board’s charter. Further, the chairperson schedules board meetings and presides over the annual shareholders’ meetings. Critics of combining the two offices in one person ask how the board can properly oversee top management if the chairman is also top management. For this reason, the Chairman and CEO positions are separated by lay in some countries such as Germany, the Netherlands and Finland (Boone et al. 2007, 66-101).

The Chairman of the Board and the CEO positions should be split for effective corporate governance. Shareholders of a company may find it difficult to curb the powers of the CEO, especially where the CEO is also the Chairman of the Board. The bigger the corporation, the more active is its board of directors, meaning that it will be in a better position to assume its role of monitoring and evaluating the performance of top management, as well as determining the overall business strategy. Although research does not clearly indicate either a definite positive or a negative effect of combined positions on corporate performance, the stock market does respond negatively to announcements of CEOs also assuming the Chairman position (Harris & Helfat 2008, 901-904).

Tesco share price

Tesco’s share price declined in value by 5.6 pence in the two day period between March 14 and March 15, 2011.

Lowest price

From the provided information, it can be seen that Tesco’s share price hit a 52 week low of 368.40 pence, to 15 March 2011, which is actually 17.75 pence lower than Tuesday’s closing price.

Dividend yield

The dividend yield for Tesco, as at 15 March 2011, is 3.5 per cent. Harris & Helfat (2008, 901-904) notes “the dividend yield is the dividends per share divided by the market value per share, and measures the shareholders’ return in relation to the market value of the share.” The information on the market value per share is not generally available from the financial statements; it has to be collected from external sources, such as stock exchanges. In the case of Tesco, dividend yield on 15 March 2011 will be calculated using the recorded price on the said day, that is, 386.15 pence. The dividend yield will therefore be given as (13.53/386.15)*100% = 3.5%

Ex-dividend

Payments made in cash to the stockholders are termed as dividends. These are typically declared by the board of directors and are paid to the current stock holders of record at a a=date specified by the board, known as the date of record. Those stockholders who are to receive dividends are identified by use of an ex-dividend date. Because of the time required to record the transfer of ownership of common stock, major stock exchanges specify an ex-dividend date that is 2 business days before day that is recorded.

Shareholders buying shares before an ex-dividend date are permitted to obtain the dividend in question; while those purchasing on or after the ex-dividend date are not entitled to the dividend. For example, a dividend may be declared on May 30 with a date of record of June 30. In this case, June 28 would become the ex-dividend date. In Tesco’s situation, the share last went ex-dividend (xd) on October 13, as illustrated by the tables of information.

Market capitalization

Market capitalization is the “aggregate market values of a security, equal to the market price per share of the company, increased by the total outstanding shares of the firm” (Vance, 63). Tesco’s market capitalization stands at £31,522m as at 14 March 2011.

Key elements

Key information for WACC

The overall cost of capital is the “weighted average of the cost of shareholder’s capital and the cost of borrowing.” Boone et al. (2007, 66-101) notes “the four key elements used in the calculation of the weighted average cost of capital include: the cost of equity, the cost of debt, the market value of the company’s common shares, and the market value of the company’s debt.”

Kuoni is considering undertaking an investment which will deliver NOPAT of €5,000 for an investment cost of €40,000, on the basis if a WACC of 8.5%.

The ROIC (Return on Invested Capital) is used to measure the company’s performance in utilizing capital in profitable investments (Vance 2002, pp. 43-67). The ROIC is calculated by NOPAT by the capital invested, given as €5000/€40000 * 100% = 12.5%

The capital charge is the monetary cost of using investing capital, and is arrived at by multiplying the invested capital by the Weighted Average Cost Of Capital (WACC), that is Invested capital (*) WACC. Kuoni can calculate its Capital Charge as 8.5% * €40000 = €3,400.

The economic profit illustrates the returns that a company should make in order to satisfy the providers of the invested capital. The economic profit is calculated by deducting the capital charge form the Net Operating Profits after Taxes (NOPAT), which is equal to NOPAT – Capital Charge. The economic profit for Kuoni can therefore be calculated as €5000 – €3400 = €1600.

Kuoni can therefore proceed with the considered investment project as it has a positive economic profit. The positive economic profit implies that Kuoni, after servicing the cost of capital, will be able to increase the company’s value by €1,600 through undertaking the project.

Works Cited

Boone, Adams et al. “The determinants of corporate board size and composition: An empirical analysis.” Journal of Financial Economics, 85, 2007: p. 66-101. Print.

Harris, Duncan & Helfat, Carnuy. “CEO duality, succession, capabilities and agency theory: commentary and research agenda.” Strategic Management Journal, September 1998: pp. 901-904. Print.

Ryan, Harold and Wiggins, Richard. “Who is in whose pocket: Director compensation, board independence and barriers to effective monitoring.” Journal of Financial Economics, 73 2004: p. 497-524. Print.

Vance, David E. Financial analysis and decision making: tools and techniques to solve financial problems and make effective business decisions. New York: McGraw-Hill Professional, 2002. Print.

Webster, Martin. The UK Corporate Governance Code. London: LexisNexis, 2010. Print.

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