2.1. Governance and management Flashcards
Corporate governance
the framework by which the relationships among the management, board of directors, controlling shareholders, minority shareholders and other stakeholders are balanced
Financial economics
deals with the way suppliers of finance assure themselves of getting a return on their investment
Societal definition of corporate governance
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
Scope of corporate governance
Firm’s evolution in the beginning
the entrepreneur is the owner, director and manager
Firm’s evolution later on
several conditions change the scenario:
- company growth
- need for a more professionalised mgmt
=> progressive separation between ownership and control
Ownership vs. Control
- 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
Public limited company vs. Private limited company
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
Causes of the rise of public comapnies
- greater effectiveness and transparency of financial markets
- development of managerial schools
Agency relationship
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
2 consequences of the principal-agent relationship
- if both principal and agaent are utility maximisers, the agent will act in his/her interest rather than in the interest of the principal
- the principal is forced to arrange safeguard mechanisms (contracts, controls, incentives…) to protect her investment, which are often extremely costly
Ways to minimise the agency costs
- Monitoring
- Bonding cost
- Residual loss
Monitoring cost
- audits, writing compensation contracts
- having a board of directors
- financial statements
Bonding cost
- Provide accurate info to shareholders
- The agent may commit to contractual obligations that limit or restrict the agent’s activity
Residual loss
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
Sources of agency conflict
- Moral hazard
- Earning retentions
- Time horizon
- Risk aversion
Moral hazard
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
Earning retentions
investment in projects instead of redistributing the benefits
- CEOs benefit from size
- Raises the cost of replacing
- Over diversification
Time horizon
- Shareholders -> long term horizon
- Manager -> shorter horizon
Risk aversion
- 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
Structure of governance mechanisms
Board of directors
Governance
Role is to direct the company
Protect the company’s interests and the shareholders’ assets and ensure a return on their investment.
Governance vs. Management
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
