Corporation and Governance

Question 1

What is a corporation?

Answer 1

• Legal entity
• Owned by shareholders
• Can make contracts
• Carry on a business
• Borrow or lend money
• Pay taxes but can’t vote

Private company

• Shares are not publicly traded

Limited liability

• No responsibility for corporation’ debt
  E.g. Case of Lehman brothers in 2008

Public company

• Own the corporation
• Can’t manage & control it
• Can sell their shares to new investors via stock market without disrupting the operations of the business

Question 2

Corporate Governance

What is it broadly?
What is it concerned with?
What is the difference between internal and external stakeholders

Answer 2

Broadly, corporate governance is the way in which organisations are directed, administered and controlled.

It is concerned with the relationship between internal and external stakeholders, with essentially:

         - Internal stakeholders are managers and directors
         - External stakeholders are the shareholders.

Question 3

Investment and Financing Decisions

What are they related to?
What do they involve?
What decisions are made?
What do they both include?

Answer 3

Investment decision:

• Is related to the purchase of real assets
• Involves in managing assets already in place
• Decides when to shut down and dispose of real assets when they are no longer profitable
• Manages and control risks of investments

Financing decision

• Is related to the sale of financial assets and securities
• Whether to raise money from new and existing owners by selling more shares of stock (equity) or to borrow (debt)
• The choice between debt and equity is called capital structure decision
• Includes the meeting its obligations to banks, bondholders, and stockholders that have contributed financing in the past. Example: repay debts when they become due. If not, it ends up insolvent and bankrupt!

Question 4

Key financial goal of a corporation (7)

Answer 4

• Make the most profit
• Pay the highest dividend
• Be the best employer
• Be the most environmentally friendly
• Be the cheapest
• Be the biggest
• Have the best product

Question 5

Key financial goal of a corporation (4,2)

Answer 5

• Traditionally, the main goal of organisations (public) was the maximise shareholder wealth.
• This means capital and revenue returns need to be as high as possible: Capital = share price and Revenue = dividends
• To transform that wealth into the most desirable time pattern of consumption
• To manage risk characteristics of that consumption plan

However profit maximisation might not be a well-defined objective, for at least two reasons:

• A corporation might be able to increase current profit by cutting back on outlays for maintenance or staff training (which have long term added value)
• Company may increase future profits by cutting this year’s dividend and investing the freed-up cash in the firm. Might not be in shareholders interest if company earns only a modest return on money.

Question 6

Agency problem

What are they?
When do they arise?

Answer 6

Conflicts between shareholders’ and managers’ objectives

Agency problems arise when agents (managers) work for principals (shareholders or owners) – A separation of ownership and control

Question 7

Agency problem

Three important features that contribute to the existence of the agency problem within public limited companies:

Answer 7

1. Divergence of ownership and control
2. Interest conflicts between managers (agents) and shareholders (principals).
3. Asymmetry of information exists between agents and principals

Question 8

Example of Exam Questions

Define the term ‘corporate governance’
What are the key differences between investment and financing decisions of a corporation? Examples?
What is the main financial goal of a corporation? Explain.
Explain agency problem. Are there any ways to minimise the agency cost in corporate governance?

Answer 8

answer