Chapter 1 Flashcards
What is a corporation?
Lawyers: is a legal business structure that established the business as being a separate entity from the owners
Economics: a bundle of contract
General: mechanism that allows different parties to contribute capital, expertise and labour for mutual benefit
Types of Corporation
- sole proprietorship
- Partnership
- Corporations
Essential characteristics of a public corporation?
- limited liability for investors
- transferability of investor ownership
- through trading - legal personality (has legal rights)
- separation of legal ownership and management control
Difference between ownership and management?
Ownership: people who own the business
management: people who take care of day-to-day activities and management operations
Issues with Separation and Ownership Control
- growing business–> need more skilled workers, and maximize returns more effectively
- need to seek outside capital
- the shareholders act as an agent and the director appoint officers
- top management are not willing to bear responsibility for their decision unless they own stock
What is a principle?
they are the ones who hire the C-suit and decide
- monitoring
the agent
they are the people in the c-suit and are reviewed by the board of directors
- performs the duties
princple-agent problem
- information asymmetry
- conflict of interest
- lack of trust
- different objectives
- agency cost
- adverse selection: inferior alternatives being selected
- Moral hazard
- Free Cash Flow
what is agency cost?
The value the company losses due to misalignment of interest and dissonance
monitoring all activities of agents is really costly. therefore full monitoring is not optimal
What is the moral hazard?
- the incentive of one party increased, as a result, leads to taking unnecessary risks
Free Cash Flow importance
- the cash remaining after operations is invested in projects with a positive NPV
managers–> over diversify
shareholders–> distribution on dividends
Product Diversification (example of agency problem)
Benefit for managers
- increase firm size
- increase portfolio diversification reduces employment risk, job loss, and loss of competition and managerial reputation
- managers are less vulnerable to the reduction of demand with a single product
Building Empire (Agency Problem Example)
- impoverish stockholders is to overpay and takeover
- mergers do not work due to profit being relative to peer groups and mergers are reversed within a few years
- acquiring firms managers are not as thrilled as the stockholders as firm prices tend to decline after takeover announcements
EXAMPLES OF ACQUISITION
- HP bought autonomy 60% more than what it was valued –> misstep
- Refusing to sell: Microsoft tried to buy yahoo but refused because Yahoo overestimated what they were worth
- Ultra sonic: CEO disappearing
Examples of agency cost
- consuming excessive perks
- managers with fixed salaries do not put in extra effort
- hiring friends
- taking no risks or chances to avoid being fired
- taking excessive risk to earn large bonuses
- having a short-run horizon due to managers retiring
- managing earnings and self-dealing
Evidence of self-interested behaviour
Bankruptcy: linked to fraud and several agency problems
Financial restatements
Class action lawsuits
Violating foreign corrupt practices
Massaging earings
Fraud Examiners Red Flags
- living beyond one’s means (ceo)
- financial difficulties
- usually close association with vendors
- control issues and lack of willingness to share duties
- a wheeler-dealer attitude
- family problems
- addiction and irritability
Prevention of Stealing
Legislation: legal structure (common vs civil law)
Financial structure (market vs bank(
both have shown to be important in protecting investor rights
- functioning legal system and allowing for lawsuits
- accounting laws, conflict of interest laws, and reporting and regulations
Issues with the going through the legal system
- the cost of legal requirements outweighs the benefit
- laws can have unintended consequences
- you can not legislate corporate governance, it supplements the legal framework
Corporate Governance
corporate governance prevents expropriation of outside investors (controlling and minority shareholders, debt holders, etc.)
History of Corporate Governnace
- started in the UK1992 with Cadbury report
- this was a result of several high profile companies failing
Cadbury Report
titled financial aspects of coporae governance
- sets out recommendation on the arrangement of company boards and accounting system to lessen failures
- adopted by the European union, us and the world bank
Main reco of Cadbury report
- wider use of independent directors
- audit committee
- separation of chairman and CEO
- loyal to the code of best practices
- protect shareholders rights
-recognize the rights of stakeholders - timely and accurate disclosure
- responsibility of the board of directors
Accountability
- managers accountable to a board of directors
- board of directors are accountable to shareholders
Fairness
- protect shareholders’ rights
-treat shareholders equitably - provide effective redress for violation
Transparency
- timely, and accurate disclosure
financial performance, ownership, and current situation of the company
Independence
independent directors and advisers free from the influence of others
Importance of Corporate Governance
- better access to external finance
- lower capital cost
- improved company performance
- higher firm valuation and share performance
- reduced risk of corporate crisis
- higher valuation of human capital in companies
- avoidance of costly litigation through adherence to laws
- promote efficient use of scacre resources
- trust in inventors
- positive link to economic development and performance
- international recognition
Some best practices
- independent audit committee
- penalties for misrepresentation
- shareholders approve executive pay
- pay a premium for well-governed
Higher premium: weaker legal protection
lower premium: countries w stronger protection
negative of poor governance
- reduced shareholder value
- job reduction
- reputation damage
- reduce morale
- anger for users and lawmakers
