CFA Level I · CFA Level I Exam

Corporate Governance: Conflicts, Mechanisms, Risks, and Benefits: formula sheet

Full chapter guide

Key formulas

Definition of corporate governance: Corporate governance = system of controls, policies and procedures to direct and control a company and balance stakeholder interests; Use this wording for definition questions.
Shareholder theory: Objective = maximize shareholder wealth; Other stakeholders are protected through contracts and law.
Stakeholder theory: Objective = balance the interests of all stakeholder groups; Rests on the idea that long-term value depends on all groups.
Agency relationship: Principal (shareholder) → hires → Agent (manager); The conflict arises when the agent's interests differ from the principal's.
Residual claim: Shareholders have a residual claim, paid only after creditors and other contractual claims are satisfied; This is why shareholders and creditors differ on risk.
Agency relationship: Principal (delegates) → Agent (acts on principal's behalf); Conflict arises when the agent's interests differ from the principal's. Shareholders are principals to managers and directors.
Agency costs: Agency costs = monitoring costs + bonding costs + residual loss; Agency costs are commonly described in these three parts (Jensen and Meckling). This is a framework to recall, not a curriculum formula or a calculation. Residual loss is the value still lost after monitoring and bonding.
Shareholder vs manager: Shareholders: maximise long-run value | Managers: pay, perks, job security, growth for its own sake; Typical examples are overpaying for acquisitions, excessive perks and short-term bonus targeting.
Controlling vs minority: Control or voting power ≠ proportional economic ownership; Dual-class shares, pyramids and cross-holdings can give control with little capital. Related-party transactions are the classic risk.
Shareholder vs creditor: Shareholders: upside with limited liability | Creditors: fixed claim, downside exposure; Value shifts to shareholders through higher risk, large dividends or extra debt that ranks equally or ahead.
Duty of care: Directors act with the diligence and prudence a reasonable person would use; Applies to decisions, oversight and being informed.
Duty of loyalty: Directors place the company and shareholders ahead of personal interest; Breached by self-dealing or undisclosed conflicts.
Audit committee: Financial reporting, internal control, internal audit, external auditor; Should be independent with financial expertise.
Remuneration committee: Executive pay design aligned with long-term performance; Independent members guard against self-serving pay.
Nomination committee: Director selection, board composition, succession planning; Independence prevents CEO from picking friendly directors.
Governance committee: Governance policies, board evaluation and practices; Sometimes combined with nomination.
Risk committee: Risk appetite, risk limits, risk management framework; Common in financial firms but relevant to any company.
Investment committee (optional): Review of major investments and capital allocation; Used by some firms with frequent large capital decisions; a matter of company practice, not a rule.
Infrastructure layers: Legal + Contractual + Organizational + Governmental; Classify any example by who creates it: the law and courts, a contract, the firm itself, or a public body such as a regulator. Transparency supports these layers.
Majority (statutory) voting: Votes per share = 1 for each open seat, voted seat by seat; Each seat is voted on separately, so a holder with a majority of shares can win every seat.
Cumulative voting: Total votes = shares owned × number of seats up for election; You may place all votes on one candidate. This helps minority holders. Example: 1,000 shares and 5 seats give 5,000 votes.
Proxy voting: Shareholder → appoints proxy → proxy votes at the meeting; Lets shareholders who cannot attend still vote, often on management's recommended items unless instructed.
Value link (intuition): Firm value = PV of expected cash flows, discounted at the required return; Good governance can raise expected cash flows and lower the required return, so value rises. This is a concept, not a numeric formula to memorize.
Benefit chain: Better governance → lower agency costs and risk → lower cost of capital → higher valuation; Use this chain to reason through the effect in a question.
Perpetuity valuation check: V = CF ÷ r; Use it to test direction: if r falls and CF is unchanged, V rises.

Quick revision

Corporate governance is the system of controls, incentives and rules that directs and oversees a company.
Stakeholders include shareholders, creditors, managers, employees, directors, customers, suppliers and governments.
Principal-agent conflict: managers (agents) may act in their own interest instead of the shareholders' (principals).
Other conflicts exist between controlling and minority shareholders, and between shareholders and creditors.
The board of directors oversees management and represents shareholder interests.
Independent directors help reduce conflicts because they have no ties that compromise judgment.
Key board committees include audit, remuneration (compensation) and nomination.
Weak governance raises risks such as poor oversight, weak controls and unreliable reporting.
Effective governance can lower risk, support trust and improve decision making.
ESG factors are part of governance analysis and feed into investment decisions.
In scenario questions, first name the conflict or weakness, then pick the mechanism or risk that matches.
There are no calculations here, so read carefully and answer every question since wrong answers are not penalised.

Common mistakes

Saying the board represents managers. Fix: The board is typically elected by shareholders to oversee managers and represent shareholders' interests. In some jurisdictions, such as two-tier systems with employee representation, other stakeholders also have seats.
Confusing shareholder theory with stakeholder theory. Fix: Shareholder theory has one objective, maximizing shareholder wealth. Stakeholder theory balances several groups.
Treating every conflict as shareholders vs managers. Fix: Always identify the two parties first. A related-party deal by a founder points to controlling vs minority, not management.
Saying creditors are harmed when shareholders choose safer projects. Fix: Remember the shareholder-creditor conflict runs toward higher risk, big payouts and extra debt. Safer choices favour creditors.
Assigning executive pay-setting to the nomination committee Fix: Nomination picks directors; remuneration sets pay.
Thinking the audit committee performs the audit Fix: It oversees the external auditor, internal audit and controls; it does not audit itself.
Treating a bond covenant as legal infrastructure. Fix: A covenant is an agreement between issuer and lender, so it is contractual infrastructure. Legal infrastructure is the law itself.
Mixing up majority and cumulative voting. Fix: Cumulative voting lets you concentrate votes on one candidate and helps minorities. Majority voting treats each seat separately and favours the larger holder.
Treating every related-party transaction as improper. Fix: Related-party deals are a risk flag, not proof of abuse. The concern is terms that are not arm's length, not independently approved, or not disclosed.
Assuming high executive pay is itself the governance weakness. Fix: Focus on design. Weak governance is pay that is not linked to long-term performance or that rewards short-term metrics and excess risk.

Exam tips

Learn the one-line interest of each stakeholder group, such as shareholders, creditors, managers, employees, customers, suppliers and government.
Know the definition of corporate governance and the shareholder versus stakeholder models well enough to spot a wrong paraphrase.
When a stem describes a manager acting for personal gain, think agency problem. When it describes two groups with opposing claims, think stakeholder conflict.
With three options and no penalty for wrong answers, eliminate the option that gives a group the wrong goal, then choose between the other two. Never leave a question blank.
Name the two parties before you read the options. Wrong options usually pair the right action with the wrong parties.
Link keywords to conflicts: bonus or perks to manager, board ties to director, related-party to controlling holder, dividend or risk to creditor.
Direction matters. Shareholder-creditor conflicts involve more risk or payouts, not less.
Questions on remedies reward specific matches: covenants for creditors, independent directors for oversight, aligned pay for managers, minority protections for minority holders.