2. Corporate Governance Problem Flashcards
Learning Objectives
- Explain shareholder value maximisation
- Explain the conditions for the CG problem
CG: Framework
- Hart 1995
- CG issues are present arise in organisation whenever two condition are present: There is an agency problem, contracts are incomplete.
CG Framework: Agency Problem
- 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.
What is the shareholders objective?
- 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.
CG Framework: Why does the agency problem matter?
- 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.
CG Framework: Agency Problem Matters - Literature
- Hart 1995
- “Agency problems alone do not provide a rationale for corporate governance”
CG Framework: Incomplete Contracts
- Transaction costs explain why contracts are incomplete.
- Incomplete contracts means there is no contractual solution to the agency problem.
CG Framework: Incomplete Contracts - What do transaction costs include?
- 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.
CG Framework: Why does CG matter?
- 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.
Governance Structure Matters: Learning Objs
- 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.
Manager Shareholder Conflict and Firm Value - What do we assume?
- 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.
Manager-Shareholder Conflict and Firm value - Alpha Share
- 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.
Manager-Shareholder Conflict and Firm Value: Rational Outside Shareholder
- 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’
Agency Costs in Manager Shareholder Conflict and Firm Value Firm
- 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*
Monitoring to reduce agent costs: LOs
- Jensen and Meckling 1976 model to show the effect of monitoring on agency costs
- Provide theoretical rational for use of CG systems.
Monitoring to Reduce Agency Costs: Overview
- 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,
Monitoring to Reduce Agency Costs: Firm Value and Elements
- 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.
What are Agency Costs based on this model?
- 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.
Residual Loss Definition
- ## Cost to the outside shareholder of any activity by the manager that is not in shareholders interests.
Agency Cost Definition Formula
- Sum of expenditures on systems designed to align managers and shareholders interests + residual loss.
Further Issues with Corporate Governance Problem: LOs
- Explain criticisms of the agency perspective
- Explain advantages of PLC ownership structure
Criticisms of the Agency Perspective
- Myopic Market Perspective
- Stakeholder Perspective
Criticisms of the Agency Perspective - Myopic Market Perspective Definition
- Focus on short-term share value will not benefit the firm or long-term investors because it encourages underinvestment in long-term projects.
Criticisms of the Agency Perspective - 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.
Advantages of PLCs
- 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.