Chapter 1 - Introduction to Corporate Governance

Question 1

What are corporations - Lawyer definition?

Answer 1

A corporation is a legal business structure that establishes the business as being a separate entity from the owners.

Question 2

What are corporations - Economist definition

Answer 2

A corporation is a bundle of contracts

Question 3

What is a corporation?

Answer 3

A mechanism established to allow different parties to contribute capital, expertise, and labour for their mutual benefits.

Question 4

What are types of corporations

Answer 4

1. Sole proprietorship
2. Partnership
3. Corporations - Public vs private

Question 5

What are essential characteristics of public corporations?

Answer 5

1. Limited liability for investors
2. Transferability of investor ownership - Through the trading of shares of stock exchange
3. Legal personality - Has legal rights and obligations
4. Separation of legal ownership and management control

Question 6

Historically, how were firms managed?

Answer 6

Founder owners and descendants

Question 7

What does it mean when a small firms manager owns large share of the stock?

Answer 7

Implies there is little separation between ownership and management control.

Question 8

What are issues that small firms may face?

Answer 8

1. As they grow, they may not have access to all needed skills to manage the growing firm and maximize its returns, so may need outsiders to improve management.
2. May need to seek outside capital (whereby the give up some ownership control)

Question 9

Why do we have a separation of ownership and control?

Answer 9

The thousands, or more, investors who own public corporations could not collectively make the daily decisions needed to operate a business. Therefore it has led to:
1. The shareholders elect directors to act as agents in supervising the firm
2. The directors appoint officers (or executives) to actually run the firm on a day to day basis.

Question 10

Why do problems arise in corporations?

Answer 10

The agents (top management) are not willing to bear responsibility for their decisions unless they own a substantial amount of stock in the corporation.

Question 11

What are the two parts of family firms?

Answer 11

1. 100% owned and managed by founders and their families.
2. No separation between ownership and management control.

Question 12

What are the two parts of small firms?

Answer 12

1. Managers may still own large shareholdings
2. Minimal separation between ownership and management control.

Question 13

What are two parts of large firms / growth oriented firms?

Answer 13

1. Needs outside talent / capital
2. Wide separation between ownership and management control.

Question 14

What is the reason Adam Smith and Milton Friedman presents as to why we need corporate governance?

Answer 14

The directors of such companies, however, being the managers rather of other peoples money than of their own, it cannot well be expected that they should watch over it with the same anxious vigilance with which the partners in a private copartners frequently watch over their own.

No one spends others peoples money as carefully as they spend their own.

Question 15

What is the principal agent problem?

Answer 15

There is a conflict of interest between principal and agent, there is a lack of trust on the good faith of agents.

Question 16

Why does the principal agent problem exist?

Answer 16

They have different objectives:
Shareholders - Want to increase the value of the firm.
Managers - Own utility (Nice offices, luxury cars, empire building), thus they want to avoid unpopular decisions

Question 17

What are agency costs? Is it good or bad, explain. What are explicit agency costs?

Answer 17

Any cost to the company that does not benefit shareholders. Monitoring the activities of agents is costly, hence full monitoring is not optimal. The value forgone due to imperfect optimal monitoring.

Question 18

What does the term empire building imply?

Answer 18

Building the sphere of your influence.

Question 19

What does information asymmetry cause? Who is more informed in the principal agent relationship?

Answer 19

Adverse selection and moral hazards. The agent is better informed.

Question 20

What does adverse selection increase?

Answer 20

The likelihood of selecting inferior alternatives.

Question 21

What do moral hazards increase? Who takes on the costs?

Answer 21

the incentive of one party to take undue risk or shirk other responsibilities. The other party who did not partake in the undue risk.

Question 22

What are the two types of agency costs?

Answer 22

Direct - Corporate expenditure and monitoring expenditure
Indirect - Lost Opportunities

Question 23

What are corporate expenditures?

Answer 23

Benefit the management but costs the shareholders.

Question 24

What are monitoring expenditure?

Answer 24

Incurred to monitor and incentivize managers.

Question 25

What are lost opportunity costs?

Answer 25

Management inaction to protect their jobs.

Question 26

What is a firms free cash flow?

Answer 26

Resources remaining after the firm has invested in all projects that have positive net present values within its current businesses.

Question 27

How does FCF lead to agency problems?

Answer 27

1. Managerial inclination to over diversify can be acted upon.
2. Shareholders would prefer distribution as dividends, so they can control how the cash is invested

Question 28

What are the two manager benefits from product diversification that shareholders do not like?

Answer 28

1. Increase in firm size
2. Firm portfolio diversification can reduce top executives employment risk (job loss, loss of compensation, and loss of managerial reputation)

Question 29

How does diversification reduce risks to the agents?

Answer 29

They are less vulnerable to the reduction in demand associated associated with a single or limited number of product lines or businesses.

Question 30

T or F - Emphasis on corporate size and diversification does not necessarily bode well for shareholders

Answer 30

True.

Question 31

What is the quickest and most decisive way to impoverish stakeholders?

Answer 31

Overpay on a takeover.

Question 32

What are pieces of evidence that mergers do not work

Answer 32

1. The profitability of merged firms relative to their peer groups do not increase significantly after mergers.
2. A large number of mergers are revised within a few years, which is a clear admission that the acquisition did not work,

Question 33

What is the impact of acquisitions on the bidding firm?

Answer 33

Stock prices decline on the takeover announcement a significant portion of the time.

Question 34

What are the impacts of refusing to sell?

Answer 34

Managers recommend rejecting takeover offers - even when it provides significant upside to the shareholders.

Managers could say that takeover substantially undervalues the company’s brand and worldwide assets.

Question 35

What are the four agency problems?

Answer 35

1. Diversification.
2. Refusal to sell.
3. Building Empires
4. Free Cash Flow