Chapter 13: Corporate Governance Mini Case Book Title: Finan
Chapter 13: Corporate Governance Mini Case Book Title: Financial Management: Theory and Practice
Suppose you decide (as did Steve Jobs and Mark Zuckerberg) to start a company. Your product is a software platform that integrates a wide range of media devices, including laptop computers, desktop computers, digital video recorders, and cell phones. Your initial market is the student body at your university. Once you have established your company and set up procedures for operating it, you plan to expand to other colleges in the area and eventually to go nationwide.
At some point, hopefully sooner rather than later, you plan to go public with an IPO and then to buy a yacht and take off for the South Pacific to indulge in your passion for underwater photography. With these issues in mind, you need to answer for yourself, and potential investors, the following questions:
Paper For Above instruction
a. What is an agency relationship? When you first begin operations, assuming you are the only employee and only your money is invested in the business, would any agency conflicts exist? Explain your answer.
An agency relationship occurs when one party (the principal) delegates decision-making authority to another party (the agent) to act on their behalf. In a business context, this typically involves shareholders (principals) employing managers (agents) to run the company. The relationship introduces potential conflicts of interest because the agent's goals may not align perfectly with those of the principal. When starting a business where you are the sole employee and owner, an agency relationship is minimal or nonexistent because you serve as both principal and agent. Since there are no external investors or separate management tiers, potential agency conflicts are unlikely at this initial stage.
b. If you expanded and hired additional people to help you, might that give rise to agency problems?
Yes, hiring additional employees can lead to agency problems. As the company grows, managers and employees act as agents for the owners or shareholders, and their interests may diverge from those of the owners. Managers might pursue personal benefits, job security, or other agendas that are not aligned with maximizing shareholder value. This divergence can result in agency costs, such as efforts to monitor employee actions or align interests through incentives.
c. Suppose you need additional capital to expand, and you sell some stock to outside investors. If you maintain enough stock to control the company, what type of agency conflict might occur?
This scenario can lead to conflicts between minority shareholders and the majority (controlling) shareholders. While you may retain control, minority investors may prefer the company to pursue strategies that maximize overall firm value, which might not align with the controlling shareholders' personal interests—such as prioritizing short-term gains or diverting resources for personal benefits. These conflicts can result in agency problems where controlling shareholders’ actions do not necessarily benefit minority shareholders.
d. Suppose your company raises funds from outside lenders. What type of agency costs might occur? How might lenders mitigate the agency costs?
When external lenders provide funding, agency costs arise from the risk that managers may undertake actions that are risky or detrimental to debt repayment, such as excessive risk-taking or asset substitution. Lenders face the problem of moral hazard, where managers may not act in the best interest of debt holders. To mitigate agency costs, lenders impose covenants—restrictions on certain activities—and require collateral to secure the loans. These measures align managers’ actions with lenders’ interests and reduce the likelihood of adverse activities that threaten repayment.
e. Suppose your company is very successful, and you cash out most of your stock and turn the company over to an elected board of directors. Neither you nor any other stockholders own a controlling interest (this is the situation at most public companies). List six potential managerial behaviors that can harm a firm’s value.
- Engaging in empire-building by expanding the firm beyond its efficient size.
- Paying excessive managerial compensation to inflate personal wealth.
- Favoring short-term stock price increases over long-term strategy.
- Self-dealing and related-party transactions that benefit managers at the expense of shareholders.
- Neglecting risk management, leading to vulnerability to financial or operational shocks.
- Lack of transparency and inadequate disclosure, obscuring true company performance and decisions.
f. What is corporate governance? List five corporate governance provisions that are internal to a firm and under its control.
Corporate governance refers to the system of rules, practices, and processes by which a company is directed and controlled. It aims to align the interests of management with those of shareholders and ensure accountability, transparency, and fairness in corporate decision-making. Internal provisions include:
- Establishment of an independent board of directors to oversee management.
- Implementation of executive compensation policies linked to firm performance.
- Internal audits and financial reporting controls to ensure accuracy and transparency.
- Codes of ethics and conduct guiding managerial behavior.
- Shareholder voting procedures and rights embedded in the company's bylaws and charter.
g. What characteristics of the board of directors usually lead to effective corporate governance?
An effective board typically exhibits characteristics such as independence from management, diverse expertise relevant to the firm's operations, experience in corporate governance, accountability through rigorous oversight, and a willingness to challenge management decisions. An independent board reduces conflicts of interest and enhances objective decision-making, while diverse experience broadens strategic perspectives. Moreover, having a formal process for evaluating management performance and enforcing accountability is crucial for effective governance.
h. List three provisions in the corporate charter that affect takeovers.
- Anti-takeover amendments that restrict or prohibit certain types of acquisitions.
- Poison pills, such as shareholder rights plans, which make hostile takeovers more difficult or costly.
- Staggered board provisions, where only a portion of directors are elected each year, delaying potential takeovers.
i. Briefly describe the use of stock options in a compensation plan. What are some potential problems with stock options as a form of compensation?
Stock options give management or employees the right to purchase company stock at a predetermined price, usually below market value, incentivizing them to increase the firm's stock price to profit. However, problems include the risk of encouraging excessive risk-taking, potential for manipulation of financial results to boost stock prices, and dilution of existing shareholders' equity. Additionally, stock options can incentivize short-term performance at the expense of long-term company health.
j. What is block ownership? How does it affect corporate governance?
Block ownership refers to large shareholders holding substantial portions of a company's stock, usually above 5%. Such ownership can influence corporate governance by enabling these shareholders to sway board decisions, influence strategic direction, or oppose management initiatives. While block ownership can bring stability and aligned interests, it can also lead to conflicts of interest or entrenchment if blocks use their voting power to suppress takeover bids or enforce personal agendas.
k. Briefly explain how regulatory agencies and legal systems affect corporate governance.
Regulatory agencies establish rules and frameworks—such as securities laws, stock exchange requirements, and corporate disclosure standards—that promote transparency, fairness, and accountability. Legal systems enforce laws related to fiduciary duties, shareholder rights, and anti-fraud measures, holding directors and officers accountable for misconduct. These mechanisms deter opportunistic behavior, protect minority shareholders, and enhance overall confidence in the corporate governance system.
References
Journal of Corporate Finance, 14(3), 257-273. Corporate governance: Principles, policies, and practices. Oxford University Press. Journal of Law and Economics, 26(2), 301-325. Journal of Applied Corporate Finance, 19(3), 89-103. Journal of Applied Corporate Finance, 14(3), 8-21. The Anatomy of Corporate Law: A Comparative and Functional Approach. Oxford University Press. The Journal of Finance, 52(2), 737-783. Corporate Governance: Principles, Policies, and Practices. Oxford University Press. Journal of Financial Economics, 20(1-3), 431-460. Annual Review of Financial Economics, 7, 161-185.