2. Corporate Governance Problem

Question 1

Learning Objectives

Answer 1

• Explain shareholder value maximisation
• Explain the conditions for the CG problem

Question 2

CG: Framework

Answer 2

• Hart 1995
• CG issues are present arise in organisation whenever two condition are present: There is an agency problem, contracts are incomplete.

Question 3

CG Framework: Agency Problem

Answer 3

• Agent employed by the principal.
• Moral hazard problem - agent might not act in the principal’s interests.
• Agent’s actions are hidden or unobservable.
• Separation of ownership and control - shareholder (principals) employ senior managers (agents) to use firm’s resources to achieve shareholders objectives.

Question 4

What is the shareholders objective?

Answer 4

• Maximise their wealth by maximising the value of the firm.
• Maximising the present value of the profit stream maximises the value of the firm.
• Shareholder Value maximisation rests on the notion that those providing equity capital seek to maximise the return on their investment.

Question 5

CG Framework: Why does the agency problem matter?

Answer 5

• No agency problem, no CG problem. Everyone working for a firm can be instructed (contracted) to maximise profit.
• With complete contracts specifying all parties’ obligations in all future states, there is no role for governance structure.

Question 6

CG Framework: Agency Problem Matters - Literature

Answer 6

• Hart 1995
• “Agency problems alone do not provide a rationale for corporate governance”

Question 7

CG Framework: Incomplete Contracts

Answer 7

• Transaction costs explain why contracts are incomplete.
• Incomplete contracts means there is no contractual solution to the agency problem.

Question 8

CG Framework: Incomplete Contracts - What do transaction costs include?

Answer 8

• Identifying all possible outcomes and specifying each party’s actions in each outcome.
• Each party’s costs of negotiating what they will do in each outcome.
• Writing contracts so they can be enforced by a third party.

Question 9

CG Framework: Why does CG matter?

Answer 9

• If there are agency problems and contracts are incomplete, CG matters.
• CG is concerned with the design of mechanisms and processes that align the objectives of senior managers with those of shareholders.

Question 10

Governance Structure Matters: Learning Objs

Answer 10

• Owner-Manager v Shareholder and Owner-Manager
• Jensen and Meckling 1976 model to show impact of governance structure on manager behaviour.
• Show agency costs are created when an owner-manager owning 100% of a firm sells a share of ownership to an outside equity holder.
• Gov’t structure is synonymous with ownership structure.

Question 11

Manager Shareholder Conflict and Firm Value - What do we assume?

Answer 11

• Suppose owner-manager owns 100% of the firm
• Owner manager faces constraint VmFm
• Vm = Maximum firm value when no benefits consumed.
• Fm = Maximum value of benefits that can be extracted from the firm an consumed by owner-manager.
• Owner-managers utility maximised at point C.
• V* is value of firm
• F* is the amount of benefits consumed.

Question 12

Manager-Shareholder Conflict and Firm value - Alpha Share

Answer 12

• Suppose owner-manager sells 1-alpha share in the firm to an outside equity holder, retaining alpha.
• Cost to owner-manager of consuming benefits is alpha£1.
• Owner-Mgr trade-off between firm value and consuming benefits is constraint v1 p1.
• Owner-manager maximises utility at point A.
• V0 is value of the firm, F0 benefits are consumed.

Question 13

Manager-Shareholder Conflict and Firm Value: Rational Outside Shareholder

Answer 13

• ROS will not pay (1-a)V* they know they bear some cost of owner manager consuming benefits.
• Outside shareholder revises firm value down below v8 so let V2P2 represent owner manager’s constraint.
• Owner-managers utility maximised at point B
• V’ value of firm, F’ benefits are consumed
• Owner managers bears loss in value of firm from V* to V’

Question 13

Agency Costs in Manager Shareholder Conflict and Firm Value Firm

Answer 13

• Difference V* to V’ are agency costs.
• Outside shareholder rational, loss in firm value entirely borne by owner-manager.
• If a contract could be designed at 0 cost, owner-manager to consume F* benefits, shareholder have to pay 1-aV*

Question 14

Monitoring to reduce agent costs: LOs

Answer 14

• Jensen and Meckling 1976 model to show the effect of monitoring on agency costs
• Provide theoretical rational for use of CG systems.

Question 15

Monitoring to Reduce Agency Costs: Overview

Answer 15

• Resources are spent to reduce mgr’s consumption of non-pecuniary benefits.
  E.g. Board of Directors (Monitoring) and exec compensation
• Analysis applies to any CG mechanism that reduces manager’s consumption of benefits,

Question 16

Monitoring to Reduce Agency Costs: Firm Value and Elements

Answer 16

• Assume positive monitoring, firm value given by
• V = Vm - M - F(M,a)
• Vm = Maximum value of the firm when no benefits are consumed.
• M = Monitoring costs incurred by shareholders
• F(M,a) = Benefits consumed by owner-manager given monitoring and manager’s ownership a
• ACE depicts locus of firm value for various M and a given a
• ACE is u-shaped as minoring reduces F at a decreasing rate.
• Monitoring reduces consumption of benefits F” and increases value of firm to V”
• Distance D-C measures optimal monitoring costs.

Question 17

What are Agency Costs based on this model?

Answer 17

• Some point the MC of monitoring exceeds MB, so managers and shareholders are not perfectly aligned. TF residual loss.
• Costs of monitoring and or applying any CG system are an agency cost.

Question 18

Residual Loss Definition

Answer 18

• ## Cost to the outside shareholder of any activity by the manager that is not in shareholders interests.

Question 19

Agency Cost Definition Formula

Answer 19

• Sum of expenditures on systems designed to align managers and shareholders interests + residual loss.

Question 20

Further Issues with Corporate Governance Problem: LOs

Answer 20

• Explain criticisms of the agency perspective
• Explain advantages of PLC ownership structure

Question 21

Criticisms of the Agency Perspective

Answer 21

• Myopic Market Perspective
• Stakeholder Perspective

Question 22

Criticisms of the Agency Perspective - Myopic Market Perspective Definition

Answer 22

• Focus on short-term share value will not benefit the firm or long-term investors because it encourages underinvestment in long-term projects.

Question 23

Criticisms of the Agency Perspective - Stakeholder Perspective

Answer 23

• Too much focus on shareholder primacy and shareholder value maximisation.
• Firms should widen objectives to serve the interests of employees, buyers, sellers, and the wider community.

Question 24

Advantages of PLCs

Answer 24

- Fama and Jensen 1983 - Issuing shares allows residual risk to be spread. E.g. risk of fluctuating profits is spread across individual shareholders. - Individuals spread their risk by holding portfolio of shares. - Separation of ownership and control allows managers and equity holders to specialise. - Efficient to delegate decision control when there are many shareholders. - Shareholders can hire experts in decision-making.