1. Corporate Finance MLI28C060 Lecture 9 Thursday 22 October 2015

2. Corporate governance II: Agency versus Stakeholder views of firm structure Structure: - Agency theory and its view of firm structure - Stakeholder theory and its view of firm structure - How firms are structured and the relationship between executive management and investors Reading: Fama, E. F. (1980). Agency problems and the theory of the firm. Journal of Political Economy, 88 (2), 288-307 Jensen, M. C., & Meckling, W. H. (1976). Theory of the Firm: Managerial Behaviour, Agency Costs and ownership Structure. Journal of Financial Economics, 3, 305-360

3. Agency theory and its view of firm structure

4. Basic Questions Who owns the business? Do the owners manage the business themselves? Most companies start as 100% family owned and move toward being 100% publicly traded Sometimes publicly traded firms return to being privately held Family controlled firms often out-perform publicly traded firms Moving from family to public firms brings agency issues

5. Figure 1. Who Owns the Business?

6. What is the Goal of Management? As Trident becomes more deeply committed to multinational operations, a new constraint develops – one that springs from divergent worldwide opinions and practices as to just what the firms’ overall goal should be: – Shareholder Wealth Maximization – As characterized by Anglo-American markets – Stakeholder Capitalism Model – As characterized by Continental European and Japanese markets

7. The Goal of Management Shareholder Wealth Maximization – A firm should strive to maximize the return to shareholders (those individuals owning equity shares in the firm) – This view defines risk in a very strict financial sense – Risk is defined as the added risk a firm’s shares bring to a diversified portfolio (a fully diversified portfolio represents systematic risk) – The added firm-specific risk is known as unsystematic risk

8. Agency Theory Basic Terms Organizations: series of contractual relationships between agents and principals Goal: efficient arrangement (lowest agency costs) of agent-principal relationships. Principals: owners (shareholders) of a firm Agents: people hired by the owners to run the firm (managers and workers) Agency Costs: costs associated with monitoring agent behavior and enforcing contracts

9. A specialist in risk-bearing (the principal) pays compensation toA specialist in risk-bearing (the principal) pays compensation to A specialist in managerial decision- making specialist (the agent)A specialist in managerial decision- making specialist (the agent) Agency Relationship: Owners and Managers AgencyRelationship Managers(Agents) Shareholders(Principals) Decision makersDecision makers Firm ownersFirm owners

10. Principal-Agent Theory The heart of principal-agent theory is the trade-off between (a) the cost of measuring behavior and (b) the cost of measuring outcomes and transferring risk to the agent. Information is asymmetrically distributed between principals and agents

11. Agency Theory: Conflicts Principals engage in monitoring behavior to assess the activities and decisions of managers But … dispersed shareholding makes it difficult and inefficient to monitor management’s behavior Boards of Directors have a fiduciary duty to shareholders to monitor top management However, Boards of Directors are often accused of being lax in performing this function

12. Agency Theory Problem Problem: cost of measuring behavior Problem: cost of measuring behavior – the desires or goals of principal and agent conflict and it is difficult or expensive for the principal to verify that the agent has behaved appropriately – the desires or goals of the principal and agent conflict and it is difficult or expensive for the principal to verify that the agent has behaved appropriately Solution: Measure outcomes, transfer risk to the agent Solution: Measure outcomes, transfer risk to the agent – principals create incentive-based performance contracts – principals monitor contract performance (e.g., BOD) (e.g., BOD) – Markey supply of managerial know-how (CEOs) mitigate the agency problem

13. Corporate Governance Mechanisms Executive Compensation – use of salary, bonuses, and long-term incentives to align managers’ interests with shareholders’ interests Monitoring by top-level managers Monitoring by top-level managers – they may obtain Board seats (not in financial institutions) – they may elect Board representatives Internal Governance Mechanisms

14. Governance Mechanisms Executive Compensation – one example of internal mechanism (long-term incentive compensation)  Stock ownership (long-term incentive compensation) » managers more susceptible to market changes which are partially beyond their control » managers more susceptible to market changes which are partially beyond their control  Incentive systems do not guarantee that managers make the “right” decisions, but do increase the likelihood that managers will do the things for which they are rewarded

15. Corporate Governance Mechanisms Market for Corporate Control – the purchase of a firm that is underperforming relative to industry rivals in order to improve its strategic competitiveness External Governance Mechanisms

16. Shareholder Wealth Maximization Agency Theory – the study of how shareholders (SH) can motivate management to act in SH best interests Long-term versus short-term value maximization – Impatient capitalism focuses on the short-term sometimes at the expense of long-term value – Exacerbated by improper management incentives from SH

17. Figure 1: The Structure of Corporate Governance

18. The Structure of Corporate Governance The Board of Directors – The legal body accountable for the governance of the corporation Officers and Management – Creators and directors of the firm’s strategic and operational direction Equity Markets – Reflect the market’s constant evaluation of the promise and performance of the company

19. The Structure of Corporate Governance Debt Markets – Provide funding and are interested in the financial health of the firm Auditors and Legal Advisors – Provide an external professional opinion as to the fairness, legality, and accuracy of financial statements Regulators – Require a regular and orderly disclosure process of corporate performance

20. Figure 2. Potential Responses to Shareholder Dissatisfaction

21. Stakeholder theory and its view of firm structure

22. Business and Society: An Interactive System

23. Introduction – The Stakeholder Theory of the Firm Two critical questions: 1.What is the purpose of the modern corporation? 2.To whom, or what, should the firm be responsible? Traditional view: “Ownership Theory of the Firm” – Firm is the property of its owners – Purpose is to maximize returns to shareholders – Shareholders’ interests are paramount and take precedence over all others

24. Contrasting view: “Stakeholder Theory of the Firm” – Argues the corporation serves a broader purpose, to create value for society – Must make profit for owners to survive, however, creates other kinds of value too – Corporations have multiple obligations, all “stakeholder” groups must be taken into account Introduction – The Stakeholder Theory of the Firm

25. The Stakeholder Concept A stakeholder refers to persons or groups that affect, or are affected by, an organization’s decisions, policies, and operations A stake is an interest in – or claim to – a business enterprise Businesses are embedded in networks that involve many groups with such a stake

26. The Stakeholder Concept A Tip for Understanding Term stakeholder is NOT the same as stockholder Words sound similar BUT are not the same Stockholders are one of several kinds of stakeholders

27. Market and Nonmarket Stakeholders Stakeholder groups can be divided in to two categories: 1.Market stakeholders 2.Nonmarket stakeholders Market stakeholders are those that engage in economic transactions with the company as it carries out its primary purpose of providing society with goods and services Sometimes referred to as primary stakeholders

28. Stakeholder “Maps” Drawing “maps” of stakeholder systems, with the business firm in the center, is one way to visualize the relationship between the firm and its stakeholders Each relationship is based on a unique transaction or two-way exchange

29. Market Stakeholder Map

30. Nonmarket Stakeholders Nonmarket stakeholders are people or groups who—although they do not engage in direct economic exchange with the firm—are affected by or can affect its actions – Sometimes called secondary stakeholders

31. Nonmarket Stakeholder Map

32. Issues: Market and Nonmarket Stakeholders Should government be a nonmarket or market stakeholder? – Normally governments do not have direct exchange with businesses, but in some industries there is such an exchange Should the natural environment be a nonmarket stakeholder? – Not a social group, generally considered to be represented by activist groups Should managers be classified as stakeholders? – Addressed in Exhibit 1.A on next slide

33. Stakeholder Capitalism Model A view that all a corporations stakeholders (employees, management, suppliers, local community, local/national government and creditors) need to be considered in addition to the equity holders The goal is to earn as much as possible in the long run, but to retain enough to increase the corporate wealth for the benefit of all The definition of corporate wealth is much broader than just financial wealth, it includes technical, market and human resources as well Doesn’t make an issue of market efficiency because long-term loyal SH should be more influential than transient SH

34. Stakeholder Capitalism Model Risk – Total risk, both operating and financial risk, is important Single versus Multiple Goals – Avoids the problem of impatient capital but fails to give clear expectations about tradeoffs among different groups of stakeholders The Score Card – Firms worldwide are moving more toward the SWM model

35. How firms are structured and the relationship between executive management and investors