What is Corporate Governance

Question 1

What is corporate governance?

Answer 1

Corporate governance refers to the system by which companies are directed and controlled. It involves frameworks, mechanisms, and processes ensuring accountability, fairness, and transparency between stakeholders, primarily shareholders and management.

Question 2

What is the goal of corporate governance?

Answer 2

To align the interests of stakeholders and maximize organizational value while minimizing conflicts.

Question 3

What is the principal-agent problem?

Answer 3

A conflict arising when agents (managers) act in their own interest instead of the principal’s (shareholders).a

Question 4

What causes the principal-agent problem?

Answer 4

Moral hazard (agents act irresponsibly after the contracts are signed) and asymmetric information (agents have more knowledge than principals).

Question 5

Why is the principal-agent problem significant?

Answer 5

It leads to inefficiencies, such as reduced effort, self-serving behaviors, or financial losses.

Question 6

What is moral hazard?

Answer 6

When agents take risks or prioritize personal benefits because principals bear the consequences.

Question 7

Give examples of moral hazard in governance.

Answer 7

Insufficient effort, extravagant spending, self-dealing, or manipulating accounting records.

Question 8

What is asymmetric information?

Answer 8

When agents have more information than principals, making oversight difficult and costly.

Question 9

Why is asymmetric information important in governance?

Answer 9

It enables moral hazard, as principals cannot monitor agents effectively at all times.

Question 10

What are complete contracts?

Answer 10

Contracts that specify all future actions and profit distributions alongside them to eliminate agency conflicts.

Question 11

What is Jensen & Meckling’s contribution?

Answer 11

They introduced agency costs and explained conflicts from the separation of ownership and control.

Question 12

What are the components of agency costs?

Answer 12

Monitoring costs: oversights expenses like audits.
Bonding costs: agent’s efforts to show loyalty (buying shares).
Residual loss: value from suboptimal agent decisions.

Question 13

What are perquisites (perks)?

Answer 13

Non-essential benefits for managers are shareholder’s expense, e.g. jets or nepotistic hires.

Question 14

How do perks affect shareholder value?

Answer 14

Excessive perks reduce stock prices and long-term firm performance (Yermack, 2006).

Question 15

What is empire building?

Answer 15

Managers prioritize firm growth over profitability for power, status or higher compensation.

Question 16

How does empire building harm shareholders?

Answer 16

Leads to wasteful investments in project with negative NPV, reducing shareholder value.

Question 17

What is Jensen’s Free Cash Flow Hypothesis?

Answer 17

Free cash flow should only be invested in projects with positive NPV or returned to shareholders.

Question 18

How can majority shareholders exploit minority shareholders?

Answer 18

Through tunneling, transfer pricing, nepotism, or infighting.

Question 19

What is tunneling?

Answer 19

Diverting resources to entities controlled by majority shareholders, harming minority shareholders.

Question 20

What is transfer pricing?

Answer 20

Overcharging for goods/services from related parties, transferring value to majority-controlled entities.

Question 21

What is nepotism in governance?

Answer 21

Appointing family members to top roles, often leading to poor management and entrenchment.

Question 22

What is shareholder infighting?

Answer 22

Disputes between controlling shareholders, common in family businesses (Puma vs. Adidas)

Question 23

What governance issue is highlighted by Puma vs. Adidas?

Answer 23

Family shareholder conflicts; the Dassler brothers’ feud split their company into two rivals.

Question 24

What did Williamson (1984) contribute?

Answer 24

Highlighted the impracticality of complete contracts and the need for alternative governance mechanisms.

Question 25

What did Yermack (2006) demonstrate?

Answer 25

Executive perks, like personal jet use, reduce shareholder value and firm performance.

Question 26

How can agency problems be mitigated?

Answer 26

Through monitoring (audits, reports), incentive alignment (stock options), and regulatory oversight.

Question 27

Why are governance mechanisms costly?

Answer 27

Monitoring and compliance require significant resources, contributing to agency costs.

Question 28

Why is corporate governance essential?

Answer 28

It ensures accountability, aligns stakeholder interests, and protect shareholder value.

Question 29

What are key challenges in corporate governance?

Answer 29

Balancing diverse interests, reducing information asymmetry, and minimizing agency costs.