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Principles of Finance

2.3 Role of the Board of Directors

Principles of Finance2.3 Role of the Board of Directors

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Table of contents
  1. Preface
  2. 1 Introduction to Finance
    1. Why It Matters
    2. 1.1 What Is Finance?
    3. 1.2 The Role of Finance in an Organization
    4. 1.3 Importance of Data and Technology
    5. 1.4 Careers in Finance
    6. 1.5 Markets and Participants
    7. 1.6 Microeconomic and Macroeconomic Matters
    8. 1.7 Financial Instruments
    9. 1.8 Concepts of Time and Value
    10. Summary
    11. Key Terms
    12. Multiple Choice
    13. Review Questions
    14. Video Activity
  3. 2 Corporate Structure and Governance
    1. Why It Matters
    2. 2.1 Business Structures
    3. 2.2 Relationship between Shareholders and Company Management
    4. 2.3 Role of the Board of Directors
    5. 2.4 Agency Issues: Shareholders and Corporate Boards
    6. 2.5 Interacting with Investors, Intermediaries, and Other Market Participants
    7. 2.6 Companies in Domestic and Global Markets
    8. Summary
    9. Key Terms
    10. CFA Institute
    11. Multiple Choice
    12. Review Questions
    13. Video Activity
  4. 3 Economic Foundations: Money and Rates
    1. Why It Matters
    2. 3.1 Microeconomics
    3. 3.2 Macroeconomics
    4. 3.3 Business Cycles and Economic Activity
    5. 3.4 Interest Rates
    6. 3.5 Foreign Exchange Rates
    7. 3.6 Sources and Characteristics of Economic Data
    8. Summary
    9. Key Terms
    10. CFA Institute
    11. Multiple Choice
    12. Review Questions
    13. Problems
    14. Video Activity
  5. 4 Accrual Accounting Process
    1. Why It Matters
    2. 4.1 Cash versus Accrual Accounting
    3. 4.2 Economic Basis for Accrual Accounting
    4. 4.3 How Does a Company Recognize a Sale and an Expense?
    5. 4.4 When Should a Company Capitalize or Expense an Item?
    6. 4.5 What Is “Profit” versus “Loss” for the Company?
    7. Summary
    8. Key Terms
    9. Multiple Choice
    10. Review Questions
    11. Problems
    12. Video Activity
  6. 5 Financial Statements
    1. Why It Matters
    2. 5.1 The Income Statement
    3. 5.2 The Balance Sheet
    4. 5.3 The Relationship between the Balance Sheet and the Income Statement
    5. 5.4 The Statement of Owner’s Equity
    6. 5.5 The Statement of Cash Flows
    7. 5.6 Operating Cash Flow and Free Cash Flow to the Firm (FCFF)
    8. 5.7 Common-Size Statements
    9. 5.8 Reporting Financial Activity
    10. Summary
    11. Key Terms
    12. CFA Institute
    13. Multiple Choice
    14. Review Questions
    15. Problems
    16. Video Activity
  7. 6 Measures of Financial Health
    1. Why It Matters
    2. 6.1 Ratios: Condensing Information into Smaller Pieces
    3. 6.2 Operating Efficiency Ratios
    4. 6.3 Liquidity Ratios
    5. 6.4 Solvency Ratios
    6. 6.5 Market Value Ratios
    7. 6.6 Profitability Ratios and the DuPont Method
    8. Summary
    9. Key Terms
    10. CFA Institute
    11. Multiple Choice
    12. Review Questions
    13. Problems
    14. Video Activity
  8. 7 Time Value of Money I: Single Payment Value
    1. Why It Matters
    2. 7.1 Now versus Later Concepts
    3. 7.2 Time Value of Money (TVM) Basics
    4. 7.3 Methods for Solving Time Value of Money Problems
    5. 7.4 Applications of TVM in Finance
    6. Summary
    7. Key Terms
    8. CFA Institute
    9. Multiple Choice
    10. Review Questions
    11. Problems
    12. Video Activity
  9. 8 Time Value of Money II: Equal Multiple Payments
    1. Why It Matters
    2. 8.1 Perpetuities
    3. 8.2 Annuities
    4. 8.3 Loan Amortization
    5. 8.4 Stated versus Effective Rates
    6. 8.5 Equal Payments with a Financial Calculator and Excel
    7. Summary
    8. Key Terms
    9. CFA Institute
    10. Multiple Choice
    11. Problems
    12. Video Activity
  10. 9 Time Value of Money III: Unequal Multiple Payment Values
    1. Why It Matters
    2. 9.1 Timing of Cash Flows
    3. 9.2 Unequal Payments Using a Financial Calculator or Microsoft Excel
    4. Summary
    5. Key Terms
    6. CFA Institute
    7. Multiple Choice
    8. Review Questions
    9. Problems
    10. Video Activity
  11. 10 Bonds and Bond Valuation
    1. Why It Matters
    2. 10.1 Characteristics of Bonds
    3. 10.2 Bond Valuation
    4. 10.3 Using the Yield Curve
    5. 10.4 Risks of Interest Rates and Default
    6. 10.5 Using Spreadsheets to Solve Bond Problems
    7. Summary
    8. Key Terms
    9. CFA Institute
    10. Multiple Choice
    11. Review Questions
    12. Problems
    13. Video Activity
  12. 11 Stocks and Stock Valuation
    1. Why It Matters
    2. 11.1 Multiple Approaches to Stock Valuation
    3. 11.2 Dividend Discount Models (DDMs)
    4. 11.3 Discounted Cash Flow (DCF) Model
    5. 11.4 Preferred Stock
    6. 11.5 Efficient Markets
    7. Summary
    8. Key Terms
    9. CFA Institute
    10. Multiple Choice
    11. Review Questions
    12. Problems
    13. Video Activity
  13. 12 Historical Performance of US Markets
    1. Why It Matters
    2. 12.1 Overview of US Financial Markets
    3. 12.2 Historical Picture of Inflation
    4. 12.3 Historical Picture of Returns to Bonds
    5. 12.4 Historical Picture of Returns to Stocks
    6. Summary
    7. Key Terms
    8. Multiple Choice
    9. Review Questions
    10. Video Activity
  14. 13 Statistical Analysis in Finance
    1. Why It Matters
    2. 13.1 Measures of Center
    3. 13.2 Measures of Spread
    4. 13.3 Measures of Position
    5. 13.4 Statistical Distributions
    6. 13.5 Probability Distributions
    7. 13.6 Data Visualization and Graphical Displays
    8. 13.7 The R Statistical Analysis Tool
    9. Summary
    10. Key Terms
    11. CFA Institute
    12. Multiple Choice
    13. Review Questions
    14. Problems
    15. Video Activity
  15. 14 Regression Analysis in Finance
    1. Why It Matters
    2. 14.1 Correlation Analysis
    3. 14.2 Linear Regression Analysis
    4. 14.3 Best-Fit Linear Model
    5. 14.4 Regression Applications in Finance
    6. 14.5 Predictions and Prediction Intervals
    7. 14.6 Use of R Statistical Analysis Tool for Regression Analysis
    8. Summary
    9. Key Terms
    10. Multiple Choice
    11. Review Questions
    12. Problems
    13. Video Activity
  16. 15 How to Think about Investing
    1. Why It Matters
    2. 15.1 Risk and Return to an Individual Asset
    3. 15.2 Risk and Return to Multiple Assets
    4. 15.3 The Capital Asset Pricing Model (CAPM)
    5. 15.4 Applications in Performance Measurement
    6. 15.5 Using Excel to Make Investment Decisions
    7. Summary
    8. Key Terms
    9. CFA Institute
    10. Multiple Choice
    11. Review Questions
    12. Problems
    13. Video Activity
  17. 16 How Companies Think about Investing
    1. Why It Matters
    2. 16.1 Payback Period Method
    3. 16.2 Net Present Value (NPV) Method
    4. 16.3 Internal Rate of Return (IRR) Method
    5. 16.4 Alternative Methods
    6. 16.5 Choosing between Projects
    7. 16.6 Using Excel to Make Company Investment Decisions
    8. Summary
    9. Key Terms
    10. CFA Institute
    11. Multiple Choice
    12. Review Questions
    13. Problems
    14. Video Activity
  18. 17 How Firms Raise Capital
    1. Why It Matters
    2. 17.1 The Concept of Capital Structure
    3. 17.2 The Costs of Debt and Equity Capital
    4. 17.3 Calculating the Weighted Average Cost of Capital
    5. 17.4 Capital Structure Choices
    6. 17.5 Optimal Capital Structure
    7. 17.6 Alternative Sources of Funds
    8. Summary
    9. Key Terms
    10. CFA Institute
    11. Multiple Choice
    12. Review Questions
    13. Problems
    14. Video Activity
  19. 18 Financial Forecasting
    1. Why It Matters
    2. 18.1 The Importance of Forecasting
    3. 18.2 Forecasting Sales
    4. 18.3 Pro Forma Financials
    5. 18.4 Generating the Complete Forecast
    6. 18.5 Forecasting Cash Flow and Assessing the Value of Growth
    7. 18.6 Using Excel to Create the Long-Term Forecast
    8. Summary
    9. Key Terms
    10. Multiple Choice
    11. Review Questions
    12. Problems
    13. Video Activity
  20. 19 The Importance of Trade Credit and Working Capital in Planning
    1. Why It Matters
    2. 19.1 What Is Working Capital?
    3. 19.2 What Is Trade Credit?
    4. 19.3 Cash Management
    5. 19.4 Receivables Management
    6. 19.5 Inventory Management
    7. 19.6 Using Excel to Create the Short-Term Plan
    8. Summary
    9. Key Terms
    10. Multiple Choice
    11. Review Questions
    12. Video Activity
  21. 20 Risk Management and the Financial Manager
    1. Why It Matters
    2. 20.1 The Importance of Risk Management
    3. 20.2 Commodity Price Risk
    4. 20.3 Exchange Rates and Risk
    5. 20.4 Interest Rate Risk
    6. Summary
    7. Key Terms
    8. CFA Institute
    9. Multiple Choice
    10. Review Questions
    11. Problems
    12. Video Activity
  22. Index

Learning Outcomes

By the end of this section, you will be able to:

  • Describe the oversight functions performed by boards.
  • Define an independent board member.
  • Compare arguments for and against having independent board members.
  • Describe ways boards can become diverse.

Functions of a Board of Directors

A board of directors is a group of people who are elected to represent shareholders, and these directors are then ultimately responsible for running the company. Every public company is legally required to install a board of directors. Nonprofit organizations and many private companies often establish a board of directors as well, even if they are not legally required to do so.

The board is responsible for protecting shareholders’ interests, establishing management policies, overseeing the corporation or organization, and making decisions about important issues. The board of directors acts as a fiduciary for shareholders. The board is also tasked with a number of other responsibilities, including setting company goals, creating dividend and stock option policies, hiring and firing chief executive officers (CEOs), and ensuring that the company has the resources it needs to perform well.

Basic Structure of a Board of Directors

The bylaws of a company or organization determine the structure, responsibilities, and powers given to a board of directors. The bylaws also determine how many board members there are, how the members are elected, and how frequently the board members meet.

The board must represent shareholder and management interests, so it is best for the board to include both internal and external members. Usually, there is an internal director and an external director. The internal director is a member of the board who is involved with the daily workings of the company and manages the interests of shareholders, officers, and employees. The external director represents the interests of those who function outside of the company. The CEO often serves as the chairman of the company’s board of directors.

A corporate board room with approximately ten chairs placed around a long table.
Figure 2.2 Corporate Boardroom (credit: “495 Express Lanes Board Room” by Fairfax County Chamber of Commerce/flickr, CC BY 2.0)

International Structure of a Board of Directors

The structure of a board of directors varies more outside of the United States. In Asia and the European Union, there are commonly executive and supervisory boards. The executive board is made up of company insiders who are elected by employees and shareholders. In most cases, the executive board is headed by the company CEO or a managing officer. The supervisory board oversees daily business operations and acts much like a typical US board of directors. The chair of the board varies, but the board is always led by someone other than the prominent executive officer.

Oversight: Corporate Governance

Corporate governance is a discipline that focuses on how a company conducts its business and the various controls that are implemented to ensure proper procedures and ethical behavior.

Although many companies and managers do operate with a fair and honest philosophy, others will try to exploit the temporary benefits of actions that fall outside ethical behavior. Companies do not always adhere to laws. You may have seen or read news stories about false reporting of earnings, failure to reveal financial information, or payments of large bonuses to top executives shortly after a company files for bankruptcy.

In one infamous example, the insurance giant AIG paid for a lavish trip to California for top employees of the company immediately after declaring that the company was insolvent. It asked for and received financial support from the US government in the bailout of 2008.2

At other times, a company may cross the line between legal and illegal and violate the law in order to increase profits. Because of the potential for human self-interest and greed, governments have enacted laws and regulations that require specific actions of a company or restrict its activities in an effort to ensure fair competition and ethical behavior.

Often, Congress enacts laws and regulations in response to major economic or other highly visible events. Following the great market crash of 1929, the US government created a new set of rules and regulations governing the issuing and trading of securities, the Securities Act of 1933 and the Securities Exchange Act of 1934. The government also created the Securities and Exchange Commission (SEC) to oversee these laws and regulations.

The new laws required that firms make available specific financial information to current owners and prospective owners and that the SEC approve the initial sale of securities to the public. More recently, following a series of major ethical lapses at some firms, the US government enacted new legislation in 2002. One of the most sweeping acts is the Sarbanes-Oxley Act (SOX), which requires, among other things, the following:

  • That the CEO and chief financial officer (CFO) must attest to the fairness and accuracy of the company’s financial reporting
  • That the company implements and maintains an effective structure of internal controls responsible for the reporting of financial results
  • That the company and an external public accounting firm confirm the effectiveness of the controls over the most recent fiscal year

In addition, SOX created the Public Company Accounting Oversight Board, outlining the prohibited activities of auditors. It also set a requirement that the SEC issue new rulings that establish compliance with the act.

Board of Directors Oversight and Corporate Governance

Because of the widely publicized control breakdowns at Wells Fargo Bank and recent regulatory actions, boards of directors of public companies and financial institutions have been directed to improve oversight and corporate governance. Boards are evolving from focusing primarily on the needs of top key individuals to considering broader aspects of ethics, values, and corporate culture. Boards now oversee the monitoring systems being put in place and may take on direct responsibilities related to senior management.

The Role of the Audit Committee

A strong independent audit committee (AC) is an important part of the corporate governance efforts of any firm. The AC is formed by the board of directors as a separately chartered subcommittee of the board of directors. It reports regularly to the BOD and assists the board by assuming responsibilities for critical corporate financial matters, such as reviewing audit plans and findings, approving external public accountants, and coordinating the efforts of both internal and external financial reviews and audits. The audit committee provides expertise in all financial and accounting matters for a company, and it is therefore a critical part of a company’s corporate governance efforts.

Some important functions of the audit committee include

  • confirming the accuracy of the firm’s financial reporting;
  • verifying that systems of internal control and risk management are operating effectively;
  • ensuring compliance with legal and regulatory requirements;
  • verifying the qualifications, independence, and performance of the external public auditing firm; and
  • coordinating the activities and performance of the internal audit function.

The role of the audit committee has significantly expanded over the years, and it has become exceedingly important with the enactment of the Sarbanes-Oxley Act. Due to this increase in importance and recognition, several boards have shifted some of the audit committee’s responsibilities to separately chartered committees in order to create a balance of duties and ensure that those duties are effectively focused on and efficiently executed. Some of these additional committees have been known to include a compensation committee, a disclosure committee, and a governance committee, and they all have related objectives that need to be documented within the charter of each of the individual committees. It is important for the different committees to have close working relationships so that the audit committee can help each one fulfill its responsibilities to senior management, the greater board of directors, shareholders, and other stakeholders.

The audit committee performs an internal audit to review the organization’s corporate governance process and to communicate any recommendations for changes. The audit committee will usually follow up and monitor the process put in place to implement any changes or necessary improvements. As with any other corporate function, the audit committee’s role is greatly affected by the legal, institutional, financial, cultural, and political circumstances that impact the company.

Importance of Improving Oversight and Governance

It is crucial to today’s corporate environment that firms do not lose sight of achieving and maintaining strong and efficient oversight and governance. This is true despite the litany of other important items on the busy agendas of most boards.

Keeping a focus on the critical ethics of management, as well as the traditional focus on the importance of ethics to the overall organization, is not only timely in this day and age but also sound business practice. The importance of establishing a comprehensive system of checks and balances cannot be overemphasized. Beginning with the chief executive officer, these checks and balances need to progress through senior management, and they ultimately include the board of directors itself. Similar checks and balances need to then filter down though the rest of the entire firm. By taking the appropriate steps to improve corporate oversight and governance, overall business risk can be mitigated and future operational problems reduced. Additionally, such steps can lead to the positive effects of achieving sustainable operational and financial benefits for a company and its shareholders.

The Importance of Independence in Boards of Directors

An independent board of directors is composed of individuals who have no material interest in the company other than their directorship. They maintain their independence by only accepting compensation from the company for their BOD services. They also have their own information sources, instead of relying on information provided by senior management of the company. It is considered a corporate governance best practice to have independent members serve on boards of directors for both publicly and privately held companies.

In most cases, board members have no affiliation with activities or organizations that could result in conflicts of interest. An example of this might be a scenario in which a board is considering the formation of a partnership or alliance with an organization that is directly associated with one of its board members. In such an instance, a director might be excused from participating in that decision process, particularly if it is clear that it would lead to potential conflict.

A board with a majority of independent directors can bring expertise and objectivity, which

  • helps assure ownership that the company is being run legally, ethically, and in the best interest of shareholders;
  • allows for both independence and objectivity regarding senior managerial representatives and limits situations in which a key decision maker might have a vested interest or an “ax to grind”; and
  • enables board members to advance discussions with no hidden agendas for self-advancement or other self-profiting motives.

The Importance of Diversity in Boards of Directors

As mentioned earlier, diversity can be an important quality for any board of directors. Increasingly over recent years, corporate management has begun to appreciate the value of diversity in boards of directors. This has resulted in a significant increase in the total number of women and people of color in boardrooms in the United States. However, many business observers believe that corporate governance practices have a long way to go in this respect. Increasing representation has now grown to become a high priority for most businesses and organizations around the world.

Board members face many challenges in making decisions effectively and efficiently as possible. Because of such challenges, the potential objective of diversifying the boardroom competes with other worthy topics and objectives such as improving cybersecurity, advancing customer service, identifying and reducing risk, improving community relations, and positioning strategically within an industry. This has left corporate governance experts and researchers in a situation where they find themselves “playing catch-up” to adequately diversify.

Footnotes

  • 2Scott Vogel. “You Paid for It: AIG’s Retreat Destination, Up Close.” Washington Post. October 9, 2008. http://voices.washingtonpost.com/travellog/2008/10/disaster_tourism_comes_to_cali.html
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