4. Corporate Governance Flashcards
What are some of the challenges associated with external financing (equity and debt) faced by investors (capital market frictions)?
- ADVERSE SELECTION: investors demand higher returns due to not being fully aware of the risks or potential returns (asymmetric information). This results in low-risk borrowers being less likely to use capital markets for financing (due to the dilution of their interests) while riskier borrowers are more likely to, resulting in a worse selection for investors and investors demanding even higher returns to compensate.
- MORAL HAZARD: Company may take bigger risks than investors expect, knowing that these outside investors are carrying the costs of failure. This is an especially great problem for debt finance because those investors do not share in any ‘upside’ (get a bigger return from the business doing well).
- INADEQUATE MANAGEMENT. Often a problem when companies grow rapidly and someone who is good at running a small business may not do a good job with a large business. A manager that has been successful in the past may not cope well with a change in the market (e.g. new technology). Especially a common problem in family-owned firms.
- SELF-SERVING MANAGEMENT: Management looking after themselves rather than invesors. Agency cost of equity. Principle-Agent problem. Only an issue in companies owned by outsiders.
- CORRUPT MANAGEMENT and stealing from the company.
- NON-CONTRACTUAL HUMAN CAPITAL: Senior members in company key to growth that have partial ownership of company become less motivated when external equity financing is sourced (due to share dilution).
What are the problems and benefits associated with direct or family ownership?
It helps overcome problems of asymmetric information, self-serving management, moral hazard (at least equity-related) and transaction costs (reduced costs of raising capital if only relying on internal and debt financing). Also there can be an increased focus on long-term growth in private, particularly family owned firms, as there is less pressure for quarterly gains.
But direct ownership is a handicap for businesses that require substantial outside funds (they could use debt finance but this can be costly and excessively risky). Also as businesses become larger they must increasingly rely on professional salaried managers, so owners are less involved in decision making. Because of these limits to family ownership, many larger businesses are owned by outside shareholders.
INADEQUATE MANAGEMENT is often a problem when companies grow rapidly and someone who is good at running a small business may not do a good job with a large business. A manager that has been successful in the past may not cope well with a change in the market (e.g. new technology). Especially a common problem in family-owned firms.
What are the disadvantages of equity financing to a company?
- There is a separation between ownership (the shareholders) and control (the managers).
- Asymmetric information between investors/owners and management. Increased trading/transaction costs/cost of capital (cost of equity capital).
- Self-serving management
- Corrupt management
- Key members of board (with share ownership) become less motivated due to share dilution
How does the ratio of market capitalisation to GDP in high income countries compare to that of lower income countries? Why is this?
The ratio of market capitalisation to GDP tends to be much greater in high income countries than in low. One reason for this is that government owned and privately owned companies (non-listed companies (many of which are family owned)) are relatively more important in lower income countries. One reason for this is that the public equity and bond investment market (number of investors) is smaller in low-income countries.
What are some examples of ownership arrangements?
- Privately owned by outside investors such as private equity funds
- Privately owned by insiders (family)
- Sole proprietorship
- Partnership
- Co-operative or mutual (owned by employees or customers)
- Owned by a charitable foundation (e.g., IKEA)
- Publically owned
What is limited liability and what is its purpose?
Limited liability: An arrangement where shareholders’ financial obligation to a company is limited to only what they have paid for their shares. If the company owes money, creditors cannot ask shareholders for repayment beyond the nominal value of their shares.
What is the purpose of limited liability?
Limited liability is an arrangement that has been developed to reduce capital market frictions created by the separation of ownership and control that exists in companies owned by outside shareholders.
- It protects outside shareholders from risks that they cannot fully control (e.g. management driving company into bankruptcy).
- It reduces the costs of capital for companies seeking financing from capital markets (as it encourages people to invest in the company).
How are creditors and customers of limited companies protected?
By strict legal rules such as those on money paid to shareholders. A company cannot legally pay out money to shareholders which it has not earned from activities. This prevents shareholders using limited liability as a means to defraud lenders. Without this restriction a company could borrow money, pay it out to shareholders and then go bankrupt, making money at the expense of creditors without actually having any earnings.
In many countries such as the UK it is also illegal for a company to continue trading when it is insolvent (liabilities > assets + potential future earnings).
Covenants.
Must provide financial performance information to relevant government body (e.g. Companies house) which creditors can access to determine financial health of company (and detailed public financial statements if the company is public).
What is the purpose of strict reporting requirements?
To protect all stakeholders (including creditors, customers, suppliers, and shareholders).
By preventing fraudulent behaviour by the managers, to get accurate information about the financial state of the company, and to prevent excessive payouts to shareholders.
What is an annual general meeting?
An annual general meeting (AGM) is a yearly gathering between the shareholders of a company and its board of directors. For example,
- To discuss and decide dividend rate
- To elect or replace board of directors and management
