4. Corporate Governance 3

Question 1

What are investment banks’ roles in IPOs?

Answer 1

They play a similar role for the IPO of shares as they do for underwriting the issue of corporate bonds.
- Help prepare the prospectus
- Conduct a ‘road show’ to promote shares to investors
- Advertise IPO and make it attractive to their cusomters through sales force
- Book building: Obtaining indiciations of willingness to purchase at different prices, before the final offer price is decided. Book building greatly reduces risk because it ensures that the IPO is not priced too high and doesn’t fail to attract investors.

Question 2

In what scenarios can it be very difficult to establish appropriate IPO prices?

Answer 2

For example, Twitter share price is way lower now than IPO price because:
- IPO done before company had finished maturing. They were still expanding and making major changes.
- Not yet produced a stable flow of profits
- Number of shares issued was small relative to potential demand

Question 3

What are some of the challenges of corporate governance faced by public companies?

Answer 3

• Increased separation of ownership and control (can be limited by only publicly issuing a minority of shares).
• Shareholders are very dispersed (many shareholders with small ownership, low attendance rate for annual general meetings so low active involvement from shareholders).
• Excessive remuneration packages paid to senior managers (small relative to earnings so shareholders don’t really care).
• Failure to prevent over-expansion. Often too much money is paid in acquistions, reducing benefits of acquisitions.
• Pressure to focus too much on the short-term. Pressure to set and achieve quarterly earnings targets, and focus little on long-term development. Quarterly earnings growth results in higher share valuations and increased bonuses to senior management.

Question 4

What problems are caused by the pressure on managers of public companies to achieve quarterly earnings target?

Answer 4

• Firms with variable earnings can suffer major share price falls when e.g. an order is delayed. This in turn makes it difficult for them to raise external funds for investment.
• Difficult to develop new products or services for which revenues are initially relatively low.
• Firsm spend too little money on measures with a long-term return (e.g. safety measures or R&D).

Question 5

What are three mechanisms of corporate governance that ATTEMPT to ensure that firms behave in the interests of their shareholders?

Answer 5

1) Through law and regulation that governs the actions of management and shareholders (e.g., shareholders’ control over management through shareholder voting and the AGM).
2) Through public equity markets, which reward companies and their management with higher share prices when they seem to be doing well.
3) Possibility of takeovers (this is the strongest discipline on management)

Question 6

What is the market for corporate control?

Answer 6

The possibility of a takeover of the company, in which the management will lose their jobs.
The market for corporate control is the role of equity markets in facilitating corporate takeovers. It’s a critical component of a free market that helps to improve the efficiency of public companies. The theory is that stockholders can remove inefficient managers by accepting takeover bids that are induced by poor performance. The market for corporate control is an important part of the managerial labour market, where alternative teams compete for the rights to manage corporate resources.

Question 7

Define two types of takeover

Answer 7

Merger: Where two companies are combined into a new company, with new shares being issued in exchange for the shares of the old company.

Acquisition: When the shares of one company (the target) are acquired by another company (the acquirer), in exchange either for cash or for newly issued shares in the combined company.
An acquisition must be agreed by the shareholders of the target company, but does not need to be by the management.