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Knowledge objective
Understand corporate governance ...
as a system of ownership and stakeholder interests as an agency problem in terms of TMT incentives in relation to value creation in terms of markets for corporate control in relation to international
Agency Theory
Basic Terms
Organizations:
people hired by the owners to run the firm (managers and workers)
Agency
Goal:
Costs: costs associated with monitoring agent behavior and enforcing contracts
efficient arrangement (lowest agency costs) of agent-principal relationships.
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Agency Relationship:
Owners and Managers
Shareholders (Principals)
Firm owners
Decision makers
Managers (Agents)
A specialist in risk-bearing (the principal) pays compensation to A specialist in managerial decisionmaking specialist (the agent)
Agency Relationship
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Principal-Agent Theory
The heart of principal-agent theory is the trade-off between (a) the cost of measuring behavior and (b) the cost of measuring outcomes and transferring risk to the agent. Information is asymmetrically distributed between principals and agents
(Eisenhardt, 1989)
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Examples Problem of Product Diversification Increased size, and the relationship of size to managerial compensation Reduction of managerial employment risk Use of Free Cash Flows Managers prefer to invest these funds in additional product diversification (see above). Shareholders prefer the funds as dividends so they control how the funds 7 are invested.
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Governance Mechanisms
Executive Compensation
Stock ownership (long-term incentive compensation) managers more susceptible to market changes which are partially beyond their control Incentive systems do not guarantee that managers make the right decisions, but do increase the likelihood that managers will do the things for which they are rewarded
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Risk
Diversification
Related Linked
Unrelated Businesses
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Debtholders often limit dividend payments (covenants) Why? If the firm pays all excess cash to shareholders, there may not be enough left for debtholders. Dividends are a means that shareholders can use to expropriate wealth from debtholders.
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External Control
External control mechanisms: SEC, External auditors; Bondholders and lenders (banks); Financial analysts and credit rating agencies; Mergers and acquisitions; Institutional investors- pension funds, mutual funds; Stock prices; Labor markets.
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Governance Mechanisms
Ownership Large block shareholders have a Concentration strong incentive to monitor
management closely Their large stakes make it worth their while to spend time, effort and expense to monitor closely They may also obtain Board seats which enhances their ability to monitor effectively (although financial institutions are legally forbidden from directly holding board seats)
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Governance Mechanisms
Boards of Directors
Insiders
Related Outsiders
Individuals not involved with day-to-day operations, but who have a relationship with the company
Outsiders
Individuals who are independent of the firms day-to-day operations and other relationships 18
Governance Mechanisms
Boards of Directors Recommendations for more effective Board Governance: Increase diversity of board members backgrounds Strengthen internal management and accounting control systems Establish formal processes for evaluation of the boards performance
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Governance Mechanisms
Executive Compensation Salary, bonuses, long term incentive compensation Executive decisions are complex and non-routine Many factors intervene making it difficult to establish how managerial decisions are directly responsible for outcomes
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Governance Mechanisms
Market for Corporate Control Firms face the risk of takeover when they are operated inefficiently Many firms begin to operate more efficiently as a result of the threat of takeover, even though the actual incidence of hostile takeovers is relatively small Changes in regulations have made hostile takeovers difficult Acts as an important source of discipline over managerial incompetence and waste
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Germany
Medium to large firms have a two-tiered board
vorstand monitors and controls managerial decisions aufsichtsrat selects the Vorstand employees, union members and shareholders appoint members to the Aufsichtsrat
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Japan
Obligation, family and consensus are important factors Banks (especially main bank) are highly influential with firms managers Keiretsus are strongly interrelated groups of firms tied together by cross-shareholdings
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Japan
Other characteristics:
powerful government intervention close relationships between firms and government sectors passive and stable shareholders who exert little control virtual absence of external market for corporate control
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