MKT 450 Strategic Management Mishari Alnahedh

LECTURE 4: CORPORATE GOVERNANCE

Organization Structure and Management Systems Mishari Alnahedh Learning Objectives Define corporate governance and explain why it is used to monitor and control managers’ strategic decisions. Explain how ownership came to be separated from managerial control in the modern corporation.

Corporate Governance Agency Problems Agency Problems Mishari Alnahedh Corporate Governance Corporate governance represents the relationship among stakeholders that is used to determine and control the strategic direction and performance of organizations. Agency Problems An agency relationship exists when one or more persons (the principal or principals) hire another person or persons (the agent or agents) as decision-making specialists to perform a service. Examples: - Shareholders (P) and CEO (A) - Manager (P) and subordinates (A)

Agency Problems Mishari Alnahedh “A very widespread economic situation is that of the relation between principal and agent. Even in ordinary and legal discourse, the principal-agent relation would be significant in scope and economic magnitude. But economic theory in recent years has recognized that analogous interactions are almost universal in the economy, at least as one significant component of almost all transactions” (Kenneth Arrow)

Risk Bearing Specialist Managerial Decision-Making Specialist Agency Theory Mishari Alnahedh An agency relationship exists when: Agency Relationship Risk Bearing Specialist (Principal) Managerial Decision-Making Specialist (Agent) Shareholders (Principals) Firm Owners Hire Managers (Agents) Decision Makers which creates

Agency Costs Applications Agency Problems Mishari Alnahedh Agency Costs Agency costs are the sum of incentive costs, monitoring costs, enforcement costs, and individual financial losses incurred by principals, because it is impossible to use governance mechanisms to guarantee total compliance by the agent. Applications Executive compensation Incentives in organizations Contracts with service providers

What is the problem of the separation of ownership from control? Separation of Ownership from Management Control Mishari Alnahedh What is the problem of the separation of ownership from control? How did ownership come to be separated from managerial control in the modern corporation? Do we have any justification for assuming that those in control of a modern corporation will also choose to operate it in the interests of the stockholders?

The Basic Tasks of Organization Mishari Alnahedh Achieving high levels of productivity requires SPECIALIZATION Specialization by individuals necessitates COORDINATION For coordination to be effective requires COOPERATION But goals of employees = goals of owners THE AGENCY PROBLEM ORGANIZATIONAL CHALLENGE: design structure & systems that: Permit specialization Facilitate coordination by grouping individuals & link groups with systems of communication, decision making, & control Deploy incentives to align individual & firm goals

Agency Theory Overview – Eisenhardt (1989) Mishari Alnahedh Key idea Principal-agent relationships should reflect efficient organization of information and risk-bearing costs Unit of analysis Contract between principal and agent Human assumptions Self-interest Bounded rationality Risk aversion Organizational assumptions Partial goal conflict among participants Efficiency as the effectiveness criterion Information asymmetry between principal and agent Information assumption Information as a purchasable commodity Contracting problems Agency (moral hazard and adverse selection) Risk sharing Problem domain Relationships in which the principal and agent have partly differing goals and risk preferences (e.g., compensation, regulation, leadership, impression management, whistle-blowing, vertical integration, transfer pricing)

Institutions of Capitalism Mishari Alnahedh What are the “institutions of capitalism” which lessen the problem of the separation of ownership from control? Takeovers (the market for corporate control) Recruitment of executives from outside the firm Monitoring by boards of directors Executive compensation heavily weighted toward stock options Monitoring by institutional investors Debt (minimize free cash flow) e.g., LBOs Separate chairperson and CEO Internal control of multidivisional as a “miniature capital market”