2.1. Governance and management

Question 1

Corporate governance

Answer 1

the framework by which the relationships among the management, board of directors, controlling shareholders, minority shareholders and other stakeholders are balanced

Question 2

Financial economics

Answer 2

deals with the way suppliers of finance assure themselves of getting a return on their investment

Question 3

Societal definition of corporate governance

Answer 3

the whole set of legal, cultural and institutional arrangements that determine what public corporations can do, who controls them, how that control is exercised and how the risks and return from the activities

Question 4

Scope of corporate governance

Answer 4

Question 5

Firm’s evolution in the beginning

Answer 5

the entrepreneur is the owner, director and manager

Question 6

Firm’s evolution later on

Answer 6

several conditions change the scenario:

• company growth
• need for a more professionalised mgmt

=> progressive separation between ownership and control

Question 7

Ownership vs. Control

Answer 7

• Owners are shareholders who invests capital into a limited company, does not manage it or control it
• Directors are people who control the business and take directions from owners
• Once a year, an AGM (Annual General Meeting) is held to discuss the business’ objectives

Question 8

Public limited company vs. Private limited company

Answer 8

Public

• offers shares to general public
• many shareholders
• limited liability
• scrutinised by securities regulatory authorities

Private

• does not offer shares to general public
• limited number of members
• limited liability
• less document filing requirements

Question 9

Causes of the rise of public comapnies

Answer 9

• greater effectiveness and transparency of financial markets
• development of managerial schools

Question 10

Agency relationship

Answer 10

contract according to which the principal delegates an agent to fulfil a task which implies a power, for the agent itself, to take decisions in name of the principal

Principal: shareholders

Agent: managers

Question 11

2 consequences of the principal-agent relationship

Answer 11

1. if both principal and agaent are utility maximisers, the agent will act in his/her interest rather than in the interest of the principal
2. the principal is forced to arrange safeguard mechanisms (contracts, controls, incentives…) to protect her investment, which are often extremely costly

Question 12

Ways to minimise the agency costs

Answer 12

• Monitoring
• Bonding cost
• Residual loss

Question 13

Monitoring cost

Answer 13

• audits, writing compensation contracts
• having a board of directors
• financial statements

Question 14

Bonding cost

Answer 14

• Provide accurate info to shareholders
• The agent may commit to contractual obligations that limit or restrict the agent’s activity

Question 15

Residual loss

Answer 15

Arise from the conflict of interests:

The actions that would promote self interest of the principal differ from those that would promote the self-interest of the agent, despite monitoring and bonding activities

Question 16

Sources of agency conflict

Answer 16

• Moral hazard
• Earning retentions
• Time horizon
• Risk aversion

Question 17

Moral hazard

Answer 17

the risk that a party to a transaction has not entered into the contract in good faith, has provided misleading information about its assets, liabilities or credit capacity, or has an incentive to take unusual risks in a desperate attempt to earn a profit before the contract settles

manager does not invest in positive NPV project (net present value) because:

• higher personal utility from alternative use of money: incidental payment benefits,…
• manager could invest in assets that best suit his/her skills: increase his/her own value and cost of substitution
• lack of managerial effort

Question 18

Earning retentions

Answer 18

investment in projects instead of redistributing the benefits

• CEOs benefit from size
• Raises the cost of replacing
• Over diversification

Question 19

Time horizon

Answer 19

• Shareholders -> long term horizon
• Manager -> shorter horizon

Question 20

Risk aversion

Answer 20

• Shareholders can diversify their portfolio (invest in different industries)
• Managers, salary and human capital tied to the results of the company
  
  • Investment and financing (equity over debt) policies that minimise the risk
  • is influenced by compensation scheme

Question 21

Structure of governance mechanisms

Answer 21

Question 22

Board of directors

Answer 22

Governance

Role is to direct the company

Protect the company’s interests and the shareholders’ assets and ensure a return on their investment.

Question 23

Governance vs. Management

Answer 23

Governance:

• Strategy formulation
• Policymaking
• monitor management
• hire, evaluate, incentivize, and replace the top managers, to make sure that the financial reports are appropriate and accurate
• to oversee the overall strategy and direction
• to manage risk
• to set the tone at the top
• to ensure the integrity of the company’s operations and employees

Manager:

• Accountability
• Supervising executive activities