Week 8 - Corporate governance

Question 1

What is corporate governance?

Answer 1

The way a company is structured and the structure of decision making

aligns management incentives with owners

Question 2

What is the principle-agent problem?

Answer 2

Conflicts of interest between management and ownership

agents = management
Principle = ownership

Question 3

Describe sole proprietors and their importance of corporate governance

Answer 3

unlimited liability
limited financing options

low importance of corporate governance as ownership and management normally the same person

Question 4

Describe Partnerships and their importance of corporate governance

Answer 4

unlimited liability

higher levels of corporate governance is needed due to freeloader partners and same liability

Question 5

Describe Companies and their importance of corporate governance

Answer 5

own legal entity
limited liability for ownership

corporate governance is very important due to separation of ownership and management

Question 6

Describe “consortia of firms” and their importance of corporate governance

Answer 6

group of firms formed for risky projects

• spread risk across firms

corporate governance is important due to high risk and multiple stakeholders

Question 7

Describe cooperatives and their importance of corporate governance

Answer 7

entities normally owned by consumers

corporate governance is important due to separation of ownership

Question 8

Describe public companies and their importance of corporate governance

Answer 8

state-owned company
- not profit motivated

corporate governance is important due to public ownership

Question 9

what is information asymmetry and what issues does it cause?

Answer 9

The misalignment of information between ownership and management

causes:
1. Adverse selection

2. Moral Hazard

Question 10

What is adverse selection?

Answer 10

Adverse selection

• When bad results occur as bad products or services are likely to be chosen

Example:
Paying the average price for a used car
- The better quality cars are likely priced higher

Question 11

What is Moral hazard?

Answer 11

Moral Hazard
- two parties enter into a contract where one party ensures economic protection for the other party. The other party then makes a hidden action that harms the protecting party

Example:
financial institutions being bailed out by the government
- Banks then take on excessive risk

Question 12

What are the methods of corporate governance improvement?

Answer 12

1. Executive pay
2. Internal and external mechanisms
3. regulatory bodies

Question 13

What is “executive pay” and the associated theories?

Answer 13

Executive pay is a corporate governance method of high compensation for executives

Tournament wage theory
- By disproportionately paying executives, other works try harder to try land the high paying jobs

Efficiency wage theory
- Paying workers above the market wage makes the opportunity cost of being fired too high
=> increases retention rate and lowers retraining costs

Question 14

What are the ASX principles of corporate governance

Answer 14

1. solid foundation for management and oversight
2. Structure the board to add value
3. Promote ethical and responsible decision making
4. Safeguard integrity of financial reporting
5. Timely and balanced disclosures
6. Respect the rights of shareholders
7. Recognise and manage risks
8. Fair and responsible remuneration

Question 15

What are internal mechanisms of corporate governance?

Answer 15

Board of directors
non-executive independent board members
public board meetings

Question 16

What are external mechanisms of corporate governance?

Answer 16

Take over threats
Bankruptcy
auditors
relationship investing