By Dwi Joko Pramudito WA Song Young Kang Jay B Barney, Chapter 12

 Agency Cost  Organizational Structure  Management Control System  Compensation Policies

Agency Cost  The cost of actions taken to reduce agency problems and the cost of unresolved agency problems  Source of Agency Costs:  Managerial Perquisites  Managerial Risk Aversion

Agency Costs  Monitoring, Bonding and Residual Agency Costs  Monitoring mechanisms are institutional devices through which a firm’s equity holder can observe, measure, evaluate and control managerial behavior  Bonding mechanisms are investments or policies that manager adopt to reassure outside equity holders that they will behave in ways consistent with equity holders’ interests when making decision

Organizational Structure

Major Component of the M- Form Structure ComponentActivity Board of DirectorsEvaluate the firm’s decision making to ensure that it is consistent with the interest of equity holders (monitoring) Institutional InvestorEvaluate the firm’s decision making to ensure that it is consistent with the interest of major institutional equity investors (monitoring)

Major Component of the M- Form Structure ComponentActivity Senior ExecutiveFormulates corporate strategies consistent with equity holders’ interest (bonding) and assures strategy implementation (monitoring) Strategy Formulation: Decides which businesses the firm should operates in Decides how the firm should compete in those business Specifies economies of scope around which the diversified firm will operate Strategy Implementation Encourages cooperation across division to exploit economies of scope Evaluates performance of divisions Allocates capital across division Corporate StaffProvides information to the senior executive about internal and external environment for strategy formulation and implementation (monitoring and bonding)

Major Component of the M- Form Structure ComponentActivity Division General Managers Formulates divisional strategies consistent with corporate strategies (bonding) and assures strategy implementation (bonding) Strategy Formulation: Decide how the division will compete in its business, given the corporate strategy Strategy Implementation Coordinates the decision and actions of functional managers reporting to the division general manager to implement strategy Compete for corporate capital Cooperates with other divisions to exploit corporate economies of scope Shared Activity Managers Supports the operations of multiple divisions (bonding)

Management Control Systems  Management controls fall into two categories:  Financial or output control Focus on the financial and other results of manager’s strategic and other decision  Strategic or process control focus on the quality of the strategic decision process in which a manager has engaged

Evaluating Divisional Performance  Measuring divisional performance with accounting numbers  Setting account performance standards  Establishing budgets  Limits of accounting measures of divisional performance  Managerial discretion  Short term bias  Agency problem

Evaluating Divisional Performance  Measuring divisional economic performance:  EVA (economic value added)  EVA = adjusted accounting earning – (WACC x total capital employed by division)

Allocating Corporate Capital  Zero-Based Capital Budgeting  List all capital allocation requests from divisions in a firm, rank them from “most important” to “least important” and then fund all the projects a firm can afford  Cross-Divisional Capital Allocation  Firms bring their division general managers (with their staffs) together with the senior executive (with corporate staffs) and the shared activity managers, to decide collectively how capital should be allocated

Transferring Intermediate Product Alternative Transfer Pricing Schemes Exchange Autonomy Buying and selling division general managers are free to negotiate transfer price without corporate involvement Transfer price is set equal to the selling division’s price to external customer Mandated Full Cost Transfer price is set equal to the selling division’s actual cost of production Transfer price is set equal to the selling division’s standard costs Mandated Market Based Transfer price is set equal to the market price in the selling division’s market Dual Pricing Transfer price for the buying division is set equal to the selling division’s actual or standard cost Transfer price for the selling divisions is set equal to the price to external customers or to the market price in the selling division’s market

Compensation Policies  A firm’s compensation policies constitute a final set of monitoring and bonding mechanism for implementing a diversification strategy  A study showed that if a substantial percentage of a CEO’s compensation came in the form of stock and stock options in the firm, changes in compensation would be closely linked with changes in the firm’s performance