Corporate Governance

Question 1

What is the idea behind the seperation of ownership and control and what is its consequence?

Answer 1

Shareholders: limit their role of providing equity to the firm
Managers: run the firm on a day-to-day basis on behalf of the shareholders
–> Matching individuals who own capital (principals) with individuals who know what to do with it (agents)

Principal-Agency Model: interest of the two groups may not necessarily coincide
–> Shareholders want value of shares be high
–> Managers: may have other interests

Question 2

Potential and real conflicts of interests from the agent?

Answer 2

Potential: difficult to assess if they hurt or benefit the shareholders
–> Managerial shirking (e.g. playing golf)
–> Managerial consumption of prerequisites (e.g. jet)

Real:
–> Manager desire to stay in power
–> Managerial risk aversion (tied up wealth in company)
–> FCF and empire building

Question 3

What is Corporate Governance and what are its benefits?

Answer 3

= Set of institutional and market mechanisms that induce self-interested managers to maximize the value of the residual CFs of the firm on behalf of the shareholders and thereby restrict their exprapiation through job consumption, lack of effort, overstaffing, etc.

Good corporate governance leads to
- high stock price multiples
- lower cost of capital as it reduces shareholders monitoring and auditing costs

Question 4

What are examples of Mechanisms of Corporate Governance?

Answer 4

• Legitimate threat of firing by the board of directors which monitors and disciplines the managers
• Alignment of incentives between managers and shareholders by stock-based compensation
• Contractual obligations for bond managers to behave in shareholde’s best interest