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Corporate Restructuring and Governance > 2. Corporate Governance Problem > Flashcards

2. Corporate Governance Problem Flashcards

1
Q

Learning Objectives

A
  • Explain shareholder value maximisation
  • Explain the conditions for the CG problem
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2
Q

CG: Framework

A
  • Hart 1995
  • CG issues are present arise in organisation whenever two condition are present: There is an agency problem, contracts are incomplete.
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3
Q

CG Framework: Agency Problem

A
  • Agent employed by the principal.
  • Moral hazard problem - agent might not act in the principal’s interests.
  • Agent’s actions are hidden or unobservable.
  • Separation of ownership and control - shareholder (principals) employ senior managers (agents) to use firm’s resources to achieve shareholders objectives.
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4
Q

What is the shareholders objective?

A
  • Maximise their wealth by maximising the value of the firm.
  • Maximising the present value of the profit stream maximises the value of the firm.
  • Shareholder Value maximisation rests on the notion that those providing equity capital seek to maximise the return on their investment.
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5
Q

CG Framework: Why does the agency problem matter?

A
  • No agency problem, no CG problem. Everyone working for a firm can be instructed (contracted) to maximise profit.
  • With complete contracts specifying all parties’ obligations in all future states, there is no role for governance structure.
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6
Q

CG Framework: Agency Problem Matters - Literature

A
  • Hart 1995
  • “Agency problems alone do not provide a rationale for corporate governance”
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7
Q

CG Framework: Incomplete Contracts

A
  • Transaction costs explain why contracts are incomplete.
  • Incomplete contracts means there is no contractual solution to the agency problem.
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8
Q

CG Framework: Incomplete Contracts - What do transaction costs include?

A
  • Identifying all possible outcomes and specifying each party’s actions in each outcome.
  • Each party’s costs of negotiating what they will do in each outcome.
  • Writing contracts so they can be enforced by a third party.
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9
Q

CG Framework: Why does CG matter?

A
  • If there are agency problems and contracts are incomplete, CG matters.
  • CG is concerned with the design of mechanisms and processes that align the objectives of senior managers with those of shareholders.
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10
Q

Governance Structure Matters: Learning Objs

A
  • Owner-Manager v Shareholder and Owner-Manager
  • Jensen and Meckling 1976 model to show impact of governance structure on manager behaviour.
  • Show agency costs are created when an owner-manager owning 100% of a firm sells a share of ownership to an outside equity holder.
  • Gov’t structure is synonymous with ownership structure.
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11
Q

Manager Shareholder Conflict and Firm Value - What do we assume?

A
  • Suppose owner-manager owns 100% of the firm
  • Owner manager faces constraint VmFm
  • Vm = Maximum firm value when no benefits consumed.
  • Fm = Maximum value of benefits that can be extracted from the firm an consumed by owner-manager.
  • Owner-managers utility maximised at point C.
  • V* is value of firm
  • F* is the amount of benefits consumed.
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12
Q

Manager-Shareholder Conflict and Firm value - Alpha Share

A
  • Suppose owner-manager sells 1-alpha share in the firm to an outside equity holder, retaining alpha.
  • Cost to owner-manager of consuming benefits is alpha£1.
  • Owner-Mgr trade-off between firm value and consuming benefits is constraint v1 p1.
  • Owner-manager maximises utility at point A.
  • V0 is value of the firm, F0 benefits are consumed.
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13
Q

Manager-Shareholder Conflict and Firm Value: Rational Outside Shareholder

A
  • ROS will not pay (1-a)V* they know they bear some cost of owner manager consuming benefits.
  • Outside shareholder revises firm value down below v8 so let V2P2 represent owner manager’s constraint.
  • Owner-managers utility maximised at point B
  • V’ value of firm, F’ benefits are consumed
  • Owner managers bears loss in value of firm from V* to V’
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13
Q

Agency Costs in Manager Shareholder Conflict and Firm Value Firm

A
  • Difference V* to V’ are agency costs.
  • Outside shareholder rational, loss in firm value entirely borne by owner-manager.
  • If a contract could be designed at 0 cost, owner-manager to consume F* benefits, shareholder have to pay 1-aV*
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14
Q

Monitoring to reduce agent costs: LOs

A
  • Jensen and Meckling 1976 model to show the effect of monitoring on agency costs
  • Provide theoretical rational for use of CG systems.
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15
Q

Monitoring to Reduce Agency Costs: Overview

A
  • Resources are spent to reduce mgr’s consumption of non-pecuniary benefits.
    E.g. Board of Directors (Monitoring) and exec compensation
  • Analysis applies to any CG mechanism that reduces manager’s consumption of benefits,
16
Q

Monitoring to Reduce Agency Costs: Firm Value and Elements

A
  • Assume positive monitoring, firm value given by
  • V = Vm - M - F(M,a)
  • Vm = Maximum value of the firm when no benefits are consumed.
  • M = Monitoring costs incurred by shareholders
  • F(M,a) = Benefits consumed by owner-manager given monitoring and manager’s ownership a
  • ACE depicts locus of firm value for various M and a given a
  • ACE is u-shaped as minoring reduces F at a decreasing rate.
  • Monitoring reduces consumption of benefits F” and increases value of firm to V”
  • Distance D-C measures optimal monitoring costs.
17
Q

What are Agency Costs based on this model?

A
  • Some point the MC of monitoring exceeds MB, so managers and shareholders are not perfectly aligned. TF residual loss.
  • Costs of monitoring and or applying any CG system are an agency cost.
18
Q

Residual Loss Definition

A
  • ## Cost to the outside shareholder of any activity by the manager that is not in shareholders interests.
19
Q

Agency Cost Definition Formula

A
  • Sum of expenditures on systems designed to align managers and shareholders interests + residual loss.
20
Q

Further Issues with Corporate Governance Problem: LOs

A
  • Explain criticisms of the agency perspective
  • Explain advantages of PLC ownership structure
21
Q

Criticisms of the Agency Perspective

A
  • Myopic Market Perspective
  • Stakeholder Perspective
22
Q

Criticisms of the Agency Perspective - Myopic Market Perspective Definition

A
  • Focus on short-term share value will not benefit the firm or long-term investors because it encourages underinvestment in long-term projects.
23
Q

Criticisms of the Agency Perspective - Stakeholder Perspective

A
  • 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.
24
Q

Advantages of PLCs

A
  • Fama and Jensen 1983
  • Issuing shares allows residual risk to be spread. E.g. risk of fluctuating profits is spread across individual shareholders.
  • Individuals spread their risk by holding portfolio of shares.
  • 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.

Corporate Restructuring and Governance (8 decks)

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