Session 1 - Norman - Financial theory of the firm

Question 1

Give a definition of a corporation

Answer 1

Corporations are social constructions and human institutions. A firm need a legal status. Jensen defines public corporations as the nexus for a complex set of voluntary contracts among stakeholders. The rights are determined by law, the corporation’s charter and the contracts with the individual

Question 2

Explain the agency problem in the hearth of corporate governance

Answer 2

1. Ownership is widely dispersed among uninformed, largely indifferent shareholders
2. Control is in the hands of a professional management clique able to amass corporate power to consolidate its own interest

Question 3

Give the 5 essential features of the modern corporation

Answer 3

1. legal personality : shareholders/managers have no right on to any of the firm’s assets
2. Limited liability : shifting downside risk from shareholders to creditors
3. Delegated management : shareholders assign Board of director (BoD) to monitor management
4. Transferable shares : owners of corporation shares can transfer them
5. Investor ownership : The right to control and to receive the firm’s earnings

Question 4

Give the 4 ethical questions that arise from corporation structure

Answer 4

1. What is the ultimate purpose or justification of corporate law and of the corporation
2. Whose interests should the corporation serve, what is the role of management and to whom do managers owe fiduciary duties
3. Why should shareholders enjoy such a privileged position
4. What duties should firms have to those adversely affected

Question 5

To justify governance rights, 2 sets of principles are committed to :

Answer 5

1. Respect for autonomy and freedom of choice

2. Promoting human well-being (or value)

Question 6

Corporate law is a standard-form contract. Give the 2 assumptions this statement is based on

Answer 6

1. All of the contracting is really free and voluntary

2. Nobody will voluntary enter a contract that does not make them better off

Question 7

Give the main ethical issue about corporate law

Answer 7

The law has created an entity that is guaranteed to throw off as many costs and risks onto others as it can. It is clearly not the case that all contracts are fair, just supportive of human dignity, or consistent with the interests of society.

Question 8

What is the ethical issue about non-shareholding stakeholders ?

Answer 8

They are left to depend on contracts and governance regulation (mechanism outside corporate law), both very imperfect to protect their interests

Question 9

What is the objective of a corporation ?

Answer 9

• It is to maximise profits, or at least produce a satisfactory level of profit
• OR, it is to manage these contractual relationships
• BUT, any firm is entitled to set almost any objective for itself, including forgoing profit

Question 10

Why do shareholders have right to all the profits ?

Answer 10

From a contractual theory of the firm, nothing is special about shareholders, not even ownership. They just form another group of stakeholders but this does not imply that all other stakeholders should get what a shareholder gets : Control and Ownership

Question 11

Under what condition do stakeholder groups freely contract to coordinate their joint production in one form of co-operative rather than another ? And why has the investor co-owned co-operative come to dominate most sectors

Answer 11

There are great governance costs and burdens in controlling a firm. Investor having unity of interests, have the lowest cost. The group with the lowest governance costs, the combined ownership and transactional costs, controls the firm and has the right to its residual earnings. Shareholders control therefore, is usually in the best interest of other stakeholders.