MLI28C060 - Corporate Finance Seminar 8

Question 1. Describe the key features of Agency Theory in terms of how it views the firm. Adopts a focus on shareholder value maximisation 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 Goal: efficient arrangement (lowest agency costs) of agent- principal relationships

Incentive alignment: Executive Compensation Incentive alignment: Executive Compensation – use of salary, bonuses, and long-term incentives to align managers’ interests with shareholders’ interests (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 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

Market for Corporate Control Market for Corporate Control – the purchase of a firm that is underperforming relative to industry rivals in order to improve its strategic competitiveness – A key assumption is liquid (active) stock market Managerial Labour Market Managerial Labour Market – Assumes active market for executives – i.e. ability to hire new executive talent External Governance Mechanisms

Question 2. Describe the key features of Stakeholder Theory in terms of how it views the firm Stakeholder theory views the firm in terms of its social embeddedness within wider society

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

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

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

Market Stakeholder Map

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

Nonmarket Stakeholder Map

Question 3. What is the difference between unitary and dual board structures? Unitary structure boards: – Single board with roles separated between Executive and Nonexecutive – CEO separated from Chairperson – Primarily based on Anglo-American shareholder value system (i.e. based on Agency theory) Dual-tier boards: – Two board tiers (a) supervisory and (b) management “board” comprised of management – CEO/Chairperson (often called President) sits on supervisory board and heads up lower subordinate management board – Common board structure in Continental Europe – Loosely based on Stakeholder perspective

Question 4. What are the agency theory views on board structure? Traditional agency view is board is separated with roles defined as Executive and Nonexecutive Executives run the company on day-to-day basis Nonexecutives are in charge of monitoring and surveillance on behalf of shareholders Roles of CEO and Chairperson separated