Subject 1: What is corporate governance?

Question 1

What is the principal-agent problem in corporate governance?

Answer 1

It arises when an agent (management) may not act in the best interest of the principal (shareholders), often due to conflicting incentives.

Question 2

What role does asymmetric information play in the principal-agent problem?

Answer 2

It allows agents to have more information than principals, making it challenging to monitor and ensure alignment with shareholders’ interests.

Question 3

Define moral hazard in the context of corporate governance.

Answer 3

Moral hazard is when an agent takes actions that benefit themselves at the expense of the principal, particularly after signing a contract.

Question 4

What are agency costs?

Answer 4

Agency costs are expenses incurred to align management’s actions with shareholders’ interests, including monitoring, bonding, and residual losses.

Question 5

What is the purpose of monitoring costs in corporate governance?

Answer 5

Monitoring costs are incurred by shareholders to observe and regulate management’s behavior to ensure they act in shareholders’ interests.

Question 6

Explain bonding costs in the context of agency problems.

Answer 6

Bonding costs are expenses agents bear to signal their alignment with shareholders, like purchasing company shares.

Question 7

What are residual losses?

Answer 7

Residual losses occur when an agent makes decisions that do not maximize the firm’s value, despite oversight efforts.

Question 8

What is the perquisite problem in agency theory?

Answer 8

It refers to managers using company resources for personal gain, which reduces shareholder value.

Question 9

Give examples of perquisites in corporate governance.

Answer 9

Examples include spending on corporate jets, luxury offices, and hiring family members for high-paying roles.

Question 10

What does empire building refer to in corporate governance?

Answer 10

Empire building occurs when management prioritizes company growth over shareholder returns, often through negative-value investments.

Question 11

How does empire building negatively impact shareholders?

Answer 11

It leads to investments in projects with negative NPV, diverting resources away from profitable opportunities.

Question 12

Why are complete contracts impractical in corporate governance?

Answer 12

They are too complex and unpredictable to account for all future contingencies, making them difficult to enforce.

Question 13

What is expropriation of minority shareholders?

Answer 13

It is when large shareholders take action that benefit themselves at the expense of minority shareholders.

Question 14

Describe tunneling as it relates to minority shareholder expropriation.

Answer 14

Tunneling involves transferring assets or profits from one company to another owned by the same major shareholders, often at unfair prices.

Question 15

What is transfer pricing in the context of corporate governance?

Answer 15

Transfer pricing occurs when services or goods are overcharged between companies owned by large shareholders, costing minority shareholders.

Question 16

What is nepotism in corporate governance?

Answer 16

Nepotism is the practice of hiring family members for key roles, often leading to inefficient management.

Question 17

What impact can infighting among major shareholders have on a company?

Answer 17

Infighting can divert focus from corporate goals, destabilizing the company and reducing shareholder value.

Question 18

How did the rivalry between Puma and Adidas demonstrate shareholder infighting?

Answer 18

The Dassler brothers’ split led to long-standing competition between their companies, showing how family conflicts can affect business.

Question 19

Why is moral hazard more likely when contracts are incomplete?

Answer 19

Incomplete contracts make it hard to specify every action managers should take, increasing risk of self-serving behaviour.

Question 20

How does separating ownership and control contribute to agency problems?

Answer 20

When owners are not directly managing the firm, conflicts of interest arise, as managers may not share owners’ priorities.

Question 21

What is the free cash flow problem?

Answer 21

The free cash flow problem occurs when management uses excess cash for unnecessary growth instead of returning it to shareholders.

Question 22

Why might managers be incentivized to grow a company unnecessarily?

Answer 22

Company growth can increase managers’ power, social status and compensation, often at the expense of shareholder value.

Question 23

How can agency costs be minimized?

Answer 23

Agency costs can be minimized through monitoring, proper incentives, and partial ownership stakes for managers.

Question 24

What did Jense (1986) argue about free cash flow?

Answer 24

Jensen argued that free cash flow is problematic if left to managers, as they may misuse it for non-value-adding projects.

Question 25

What is the impact of CEO perks on shareholder value?

Answer 25

Studies show that disclosure of CEO perks, like personal jet use, can lead to a decrease in stock price and underperformance.

Question 26

What is performance-based compensation, and how does it help mitigate agency problems?

Answer 26

Performance-based compensation ties a manager’s pay to specific company goals, aligning their interests with shareholders’ by incentivizing actions that increase shareholder value.

Question 27

What are some common monitoring mechanisms used to manage agency problems?

Answer 27

Mechanisms include regular audits, performance reviews, board oversight, and compliance checks to ensure managers act in shareholders’ best interests.

Question 28

How does asymmetric information affect the principal-agent problem?

Answer 28

Asymmetric information creates an imbalance, where agents often have more knowledge about operations than principals, making it difficult for principals to monitor and evaluate management decisions effectively.

Question 29

Give an example of tunneling as a form of minority shareholder expropriation.

Answer 29

Tunneling may occur when a controlling shareholder sells assets from one company to another they control at deflated prices, transferring value away from minority shareholders to benefit themselves.

Question 30

How does transfer pricing disadvantage minority shareholders?

Answer 30

In transfer pricing, related companies charge inflated prices for services, shifting profits to entities where majority shareholders have greater control, leaving minority shareholders with reduced profits.

Question 31

How does Jensen & Meckling’s (1976) study contribute to corporate governance understanding?

Answer 31

Jensen & Meckling introduced the principal-agent theory, explaining the challenges and costs associated with separating ownership and control, which are central to modern corporate governance practices.

Question 32

What are bonding costs, and why are they important?

Answer 32

Bonding costs are incurred by agents to prove their commitment to shareholders’ interests, such as purchasing shares.

Question 33

How does infighting among large shareholders impact a company’s performance?

Answer 33

Infighting, as seen in the Puma vs. Adidas rivalry, can distract from strategic goals, reduce decision-making efficiency, and cause instability, ultimately harming shareholder value and company performance.

Question 34

Describe a scenario that illustrates moral hazard in corporate governance.

Answer 34

An example of moral hazard is when a manager, after securing a long-term contract, reduces their efforts or pursues personal benefits since they are no longer at immediate risk of job loss.

Question 35

What did Yermack (2006) find regarding CEO perks and shareholder value?

Answer 35

Yermack’s study revealed that when CEO perks, such as personal jet use, were disclosed, it led to a decline in stock prices and long-term underperformance, as shareholder perceived these perks as misaligned with value creation.