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Subject 6. Valuation implications of corporate governance

Weak corporate governance systems give rise to various kinds of risks which may compromise the value of investments in the company.

  • Accounting risk: A company's financial statement recognition and related disclosures may be incomplete, misleading, or materially misstated.
  • Asset risk: A company's assets may be misappropriated by managers or directors.
  • Liability risk: Management may enter into excessive obligations (i.e., off-balance-sheet obligations), committed to on behalf of shareholders, that effectively destroy the value of shareholders' equity.
  • Strategic policy risk: Managers may enter into transactions that "benefit" the company in the short-term but may not be in the best long-term interest of shareholders.

Evidence indicates that companies with sound corporate governance systems show higher profitability and investment performance measures relative to those with weaker structures.

Practice Question 1

Which of the following statements is the LEAST ACCURATE with respect to the risks to the valuation of an investment that a weak corporate governance system poses?

A. Strategic policy risk: the possibility that management may undertake certain empire building transactions that would ensure their job security at the expense of shareholder interests.
B. Market risk: the possibility that the firms inherent risk may drift upwards.
C. Asset risk: the possibility that the firms' assets are misappropriated by managers or directors.
D. Accounting risk: the possibility that company's financial statements are misleading.

Correct Answer: B

Business is risky in nature. Some of the most successful companies today had to allow their inherent risk to increase in the pursuit of higher returns. Thus, the business risk inherent in a company is the answer least related to the issue of a weak corporate governance system.

Study notes from a previous year's CFA exam:

6. Valuation implications of corporate governance