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Summary AFM book Corporate Finance Berk & DeMarzo - Advanced Financial Management - VU

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Summary of the book Corporate Finance of Berk & DeMarzo Summary of the recommended material in Lecture 1 t/m 10. Chapter 2, 3, 11, and 12 are missing out, because for me it was assumed as general knowledge. Sometimes there are soms hidden Dutch words involved

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  • 29, 10, 14 t/m 18, 23, 24 ,26, 27, 6
  • October 18, 2024
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  • 2024/2025
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Advanced Financial Management 2024-2025
Vrije Universiteit Amsterdam
Lecture 1

Chapter 29

29.1
Corporate governance: system of controls, regulations, incentives for fraud prevention
• To mitigate conflict of interest
o Incentives à owning stock and compensation that is sensitive to performance
o Punishments à firing a manager for poor performance or fraud

Conflict of interest between managers and investors à due to separation of ownership and control

29.2
Monitoring the firm’s managers is costly and no shareholder will have an incentive to do so à one will bear the full cost of monitoring,
while all shareholders benefit from it
• Shareholders elect a board of directors

Types of directors:
• Inside directors: employees, former employees, family members (of employees)
• Gray directors: not directly connected to the firm, but have existing or potential business relationship
• Outside or independent directors: all other directors
o Are most likely to make decisions solely in the interest of shareholders

It’s hard to explain the relationship between an independent board and firm performance
• Hypothesizes about boards with majority of outside directors that are better in monitoring managers:
o Board with majority of outside directors is more likely to fire CEO for poor performance
o Fewer value-destroying acquisitions + act in shareholders’ interest if targeted in acquisition

A captured board: its monitoring duties have been compromised by connections or perceived loyalties to management

Research à smaller boards are associated with greater firm value and performance

Other monitors:
• Security analysts à independent valuations of the firm à make buy and sell recommendations to clients
o Uncover irregularities
• Lenders à are creditors
o Loans and lines of credit contain early warning signs à requirement of certain quick ratio or profitability level
o Minimizing risk
• SEC à protecting investing public against fraud and stock price manipulation
• Employees of the firm à detect fraud à however, less incentive to report it

29.3
Compensating performance by:
• Bonuses
• Stock and option grants

Increasing pay-for-performance comes with managers taking more risk

Back-dating: process of selecting a stock option's grant date retroactively such that it falls on a day when the stock price was at its
lowest
• It suggests that some executive stock option compensation may not have been earned as the result of good future
performance of the firm

29.4
Shareholder’s expressions for displeasure, by direct action:
• Shareholder voice
o Submit a resolution at the annual meeting à to vote
o Organize ‘no’ votes à refuse to vote to approve a nominee for the board
• Shareholder approval
o Shareholders must approve many actions taken by the board
o ‘say on pay’ vote = nonbinding vote to (dis)approve of the compensation plan for senior executives
• Proxy contests
o Most extreme form of direct action
o Contest between nominees of management and current board vs. completely di]erent nominees of dissident
shareholders

1

,Advanced Financial Management 2024-2025
Vrije Universiteit Amsterdam
• Activist funds
o Hedge funds that invest in undervalued companies à quickly accumulating a stake in the company and use this to
influence other shareholders to put pressure on management à to change strategy

Management entrenchment: a situation where the management uses their position that only benefit themselves and not the company

29.5
Insider trading: happens when a person makes a trade based on privileged information

29.6
Dual class shares: one class has superior voting rights over the other class

Tunneling: process of trying to move profits up the pyramid à away from companies in which it has few cash flow rights and towards
firms in which it has more cash flow rights

29.7
Good governance = value enhancing

Lecture 2

Chapter 2
Net working capital = current assets – current liabilities
• Capital required in short term to run business

Chapter 3, 7 and 8

Lecture 3

Chapter 10

10.2
Probability distribution: probability (pR) that each possible return (R) will occur
Expected or mean return: weighted average of possible returns à weight = probability
• 𝐸[𝑅] = ∑ 𝑝𝑟 • 𝑅
• E = ‘balancing point’ of distribution
Variance: expected squared deviation from mean
• Var(R) = 0 when return is risk-free and never deviates from its mean
• Measure how ‘spread out’ distribution of return is
Standard deviation: square root of variance
• Volatility: definition of SD in finance

10.3
Realized return: this return actually occurs over a particular time period
• Rt+1 = ( ( Divt+1 + Pt+1 ) / Pt ) – 1 = ( Divt+1 / Pt ) + ( ( Pt+1 – Pt ) / Pt )
• Rt+1 = dividend yield + capital gain rate

Empirical distribution: probability distribution using historical data

Average annual return: average of realized returns

Estimating cost of capital for investment à determine expected return of investors to compensate investment risk
• Possible to look at:
o Distribution of past returns and future returns are the same? à look at return that investors expected in the past on
similar investments + assume that they will require the same in the future
1. You do not know what investors expected in the past à only observe actual returns that were realized back
then
• If we believe that investors are neither overly optimistic nor pessimistic, the average realized return should match
investors’ expected return à use the security’s historical average return to estimate its expected return
2. Average return is just an estimate of the true expected return + is subject to estimation error à this error can
be large, given the volatility of stock returns

Standard error: standard deviation of estimated value of the mean of the actual distribution around its true value = standard deviation
of average return
• Provides indication of how far the same average might deviate form expected return


2

, Advanced Financial Management 2024-2025
Vrije Universiteit Amsterdam
95% confidence interval = historical average return +/- 2•standard error
• Average return in the past is not a reliable estimate of a security’s expected return

10.4
Excess return: returns achieved above and beyond the return that investor wanted
Investments with higher volatility should have a higher risk premium à and higher returns

10.5
Common risk: risk that is perfectly correlated with the gebeurtenis à example that an earthquake occurs
Independent risk: risks that share no correlation à example of theft
Diversification: averaging out of independent risks in a large portfolio à reducing risks

Theft (100,000 homes) Earthquake (100,000 homes)
1% chance that home will be robbed 1% chance that home will be damaged by earthquake
+/- 1,000 theft claims per year OR 0 claims
OR 100,000 claims
Number of claims is predictable, so almost no risk Number of claims is very risky, because 1% chance on
having to pay ALL homes
Independent risk Common risk

10.6
Stock prices and dividends fluctuate due to news:
1. Firm-specific news: good/bad news about company itself
2. Market-wide news: news about the economy as a whole à a]ects all stocks

Firm-specific = idiosyncratic = unique = diversifiable risk: risk is unrelated across stocks + fluctuations of stock’s return that are due
to firm-specific news are independent
• Possible to diversify by combining many stocks in a large portfolio à amount of good and bad news will be relatively constant
o Risk eliminating
Systematic = undiversifiable = market risk: all stocks are a]ected simultaneously by the news + fluctuations of stock’s return that are
due to market-wide news are common risks
• Not possible to diversify

The risk premium for diversifiable risk is zero, so investors are not compensated for holding firm-specific risk
• Implies that risk premium of a stock is not a]ected by its diversifiable, firm-specific risk
• Diversifiable risk of stocks is not compensated with additional risk premium, because investors could then buy stocks, earn
additional premium and simultaneously diversify and eliminate the risk
o Otherwise investors could earn additional premium without taking extra risk

The risk premium of a security is determined by its systematic risk and does not depend on its diversifiable risk
• Implies that a stock’s volatility is not especially useful in determining the risk premium that investors will earn
o Stock’s volatility = measure of total risk = systematic risk + diversifiable risk

10.7
Investor cares about its systematic risk à cannot be eliminated by diversification à compensation by earning higher return

Measure systematic risk of a stock à how sensitive is the stock to systematic shocks that a]ect the economy as a whole
• Look at the average change in its return for each 1% change in the return of a portfolio that fluctuates solely due to systematic
risk
o Find a portfolio that contains only systematic risk = eSicient portfolio
§ No way to reduce the risk of this portfolio without lowering its expected return
§ A natural candidate is the market portfolio = portfolio of all stocks and securities traded in the capital
markets à often index portfolio

The beta of a security is the expected % change in its return given a 1% change in the return of the market portfolio

Beta measures sensitivity of a security to market-wide risk factors
• Stocks à related to sensitivity of underlying revenues and cash flows to general economic conditions
• Average beta of a stock in the market = 1
o Average stock price moves about 1% for each 1% move in the overall market
• Stocks in cyclical industries (revenues and profits vary greatly over the business cycle) are more sensitive to systematic risk
have betas above 1
o Tech companies
• Stocks in non-cyclical industries are more sensitive to systematic risk have betas below 1
o Drug and food companies, household products

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