Corporate Governance Problem

Question 1

What does the “Agency problem” mean in terms of Corporate Governance?

*remembering that “Agents” are senior executives who manage the firm on the behalf of the shareholders for that firm (owners).

Answer 1

Whether Senior Executives of a Firm will serve shareholder interests or their own.

Question 2

What is the single objective for shareholders of a company?

and how do senior executives get in the way of this?

Answer 2

Sole interest to maximise shareholder value.

SE’s get in the way by potentially using the firms resources to benefit themselves and not maximise this shareholder value.

Question 3

What are the two points that Adam Smith states in the Wealth of Nations (1776), in terms of CG?

Answer 3

1) Managers are not expected to be as vigilant in their stewardship of the firm if they have no ownership interest

2) Negligence and profusion prevail in the management of the joint stock firm

Question 4

What is Corporate Governance?

Answer 4

Corporate governance is the formal system of accountability of senior management to firms’ shareholders

via
- Executive compensation
- Board of directors

Question 5

Explain shareholder value maximisation

Answer 5

Shareholder value maximisation is a notion that those providing equity capital seek to maximise the return on their investment.

Shareholders want to maximise their wealth by maximising the value of the firm hence employing competent SE’s.

Question 6

Why will there always be a CG problem between agents and shareholders in terms of contracts?

Answer 6

It’s very hard to have a contractual solution to the agency problem as Complete contracts would need to anticipate and detail every possible future scenario, decision, and outcome, which is practically unattainable.

Hence, there is always an element of incomplete contracts which is one of the conditions for a CG problem, according to Hart 1995

Question 7

What conditions does Hart, 1995 say are the conditions for the CG problem?

State & explain them.

Answer 7

1) The Agency problem: Agents might not act in owners interest is a Moral Hazard.

2) Incomplete contracts: Incomplete contracts means there is not a contractual solution to the agency problem. This can be explained through transaction costs.

Question 8

What are transaction costs, with examples?

Answer 8

Transactions costs are costs that are incurred when there are incomplete contracts between shareholders and management.

1) identifying all possible outcomes and specifying each party’s actions in each outcome
2) each party’s costs of negotiating what they will do in each outcome
3) writing contracts so they can be enforced by a third party

Question 9

What Model is used to show the impact of governance structure on manager behaviour?

Answer 9

Jensen and Meckling (1976)

More on Paper

Question 10

What type of costs are created when an owner-manager (100%) sells a share to an outside equity holder?

Answer 10

Agency costs.

Question 11

What is the Agency costs formula?

Answer 11

AC = sum of expenditures on systems designed to align managers’ and shareholders’ interests + “residual loss”

where Residual loss is the cost to the outside shareholder of any activity by the manager that is not in shareholder’s interests

Question 12

What are agency costs?

Answer 12

Any type of costs that is used for monitoring and or applying any corporate governance system.

Question 13

State & Explain two perspectives that critiques the agency perspective

Answer 13

• Stakeholder perspective – Too much focus on shareholder primacy and shareholder value maximisation. Firms should widen objectives to serve the interests of employees, buyers, sellers, and the wider community
• Myopic market perspective – focus on short-term share value will not benefit the firm or long-term investors because it encourages underinvestment in long-term projects

Question 14

Explain advantages of PLC ownership structure according to (Fama and Jensen, 1983)

Answer 14

• Separation of ownership and control allows managers and equity holders to specialise
• Efficient to delegate decision control when there are many shareholders
• Shareholders can hire experts in decision-making
• Individuals spread their risk by holding a portfolio of shares

Question 15

Explain the theoretical rationale for the use of corporate governance systems (in terms of Agency theory)

Answer 15

Agency Theory rationale; there will be potential conflicts of interest between managers and shareholders due to separated ownership and control meaning there needs to be some monitoring mechanisms in place to keep agency costs down.

Through BOD, Exec Compensation and Perf. Metrics it allows BOD to continually oversee and evaluate managerial actions.

This ensures managers act in the best interest of shareholders, minimising opportunism and maximising shareholder value.

Thus Effective monitoring reduces the likelihood of managerial actions that harm shareholders, promoting ethical and efficient corporate operations.

Question 16

Explain the Stewardship Theory rationale for the use of CG systems

in terms of Idea and rationale

Answer 16

Idea: Assumes that managers are inherently responsible stewards who act in the best interests of shareholders.

Rationale: While assuming positive managerial behavior, it recognizes the need for monitoring mechanisms to ensure accountability and to align managerial actions with shareholder interests.

Question 17

Explain the Resource Dependency Theory rationale for the use of CG systems

in terms of Idea and rationale

Answer 17

Idea: Emphasises the interdependence of organisations and the need to manage external dependencies.

Rationale: Corporate governance mechanisms are seen as tools for managing relationships with external stakeholders, ensuring a stable and reliable supply of essential resources.

e.g. forming strategic alliances or diversifying strategies decided at board level to manage external dependencies effectively.