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Fundamentals of Corporate Finance, 3e (Berk/DeMarzo/Harford)
Chapter 26 Corporate Governance
26.1 Corporate Governance and Agency Costs
1) Which of the following statements is FALSE?
A) The conlict of interest between managers and investors derives from the separation of
ownership and control in a corporation.
B) Any discussion of corporate structure—the system of controls, regulations, and
incentives designed to prevent fraud—is a story of conlicts of interest and attempts to
minimize them.
C) Once control and ownership are separated a conlict of interest arises between the
owners and the people in control of a corporation.
D) The separation of ownership and control is perhaps the most important reason for the
success of the corporate organizational form. Because any investor can hold an ownership
stake in a corporation, investors are able to diversify and thus, with no costs, reduce their
risk exposures.
AACSB Objective: Relective Thinking Skills
Author: JN
Question Status: Previous Edition
2) Which of the following statements is FALSE?
A) The incentives come from owning stock in the company and from compensation that is
sensitive to performance.
B) The role of the corporate governance system is to mitigate the conlict of interest that
results from the combination of ownership and control without unduly burdening managers
with the risk of the irm.
C) Punishment comes when a board ires a manager for poor performance or fraud, or
when, upon failure of the board to act, shareholders or raiders launch control contests to
replace the board and management.
D) The corporate governance system attempts to align interests by providing incentives for
taking the right action and punishments for taking the wrong action.
AACSB Objective: Relective Thinking Skills
Author: JN
Question Status: Previous Edition
1
3) Which of the following is an example of an agency problem?
A) managers not working as diligently if they are not the sole owner of the business
B) the board of directors iring an incompetent manager
C) the manager owning a great deal of stock in the company
D) a corporate raider attempting to purchase the company
AACSB Objective: Analytic Skills
Author: JP
Question Status: Previous Edition
4) What is corporate governance?
AACSB Objective: Relective Thinking Skills
Author: JN
Question Status: Previous Edition
26.2 Monitoring by the Board of Directors and Others
1) Directors who are employees, former employees, or family members of employees are
called ________.
A) managing directors
B) independent directors
C) inside directors
D) gray directors
AACSB Objective: Analytic Skills
Author: JN
Question Status: Previous Edition
2) Directors who are not as directly connected to the irm but who have existing or
potential business relationships with the irm are called ________.
A) gray directors
B) independent directors
C) advising directors
D) inside directors
AACSB Objective: Analytic Skills
Author: JN
Question Status: Previous Edition
3) Directors who are not employees, former employees, or family members of employees
and who do not have existing or potential business relationships with the irm are called
________.
A) monitoring directors
B) independent directors
C) gray directors
2
D) inside directors
AACSB Objective: Analytic Skills
Author: JN
Question Status: Previous Edition
4) Which of the following statements is FALSE?
A) The shareholders as a group elect a board of directors to monitor managers. The
directors themselves, however, have the same conlict of interest–monitoring is costly and
in many cases directors do not get signiicantly greater beneits than other shareholders
from monitoring the managers closely.
B) In principle, the board of directors hires the executive team, sets its compensation,
approves major investments and acquisitions, and dismisses executives if necessary.
C) In the United States, the board of directors has a clear iduciary duty to protect the
interests of both the owners of the irm (the shareholders) and the interests of other
stakeholders in the irm (such as the employees).
D) When the ownership of a corporation is widely held, no one shareholder has an incentive
to bear the cost of monitoring, because she bears the full cost of monitoring but the beneit
is divided among all shareholders.
AACSB Objective: Analytic Skills
Author: JN
Question Status: Previous Edition
5) Tammy is a member of the Board of Directors of Moon Corporation. Her husband is the
manager of a large division. What type of director is Tammy?
A) inside director
B) outside director
C) gray director
D) resident director
AACSB Objective: Relective Thinking Skills
Author: JP
Question Status: Previous Edition
6) Which of the following statements is FALSE?
A) Researchers have hypothesized that boards with a majority of outside directors are
better monitors of managerial efort and actions.
B) Studies have found that irms with independent boards make fewer value-creating
acquisitions but are more likely to act in shareholders' interests if targeted in an
acquisition.
C) One early study showed that a board was more likely to ire the irm's CEO for poor
performance if the board had a majority of outside directors.
D) Although the irm's stock price increases on the announcement of its addition of an
independent board member, the increased irm value appears to come from the potential
for the board to make better decisions on acquisitions and CEO turnover rather than from
improvements in the irm's operating performance.
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AACSB Objective: Analytic Skills
Author: JN
Question Status: Previous Edition
7) Which of the following statements is FALSE?
A) A board is said to be classiied when its monitoring duties have been compromised by
connections or perceived loyalties to management.
B) Even the most active independent directors spend only one or two days per month on
irm business, and many independent directors sit on multiple boards, further dividing their
attention.
C) On a board composed of insider, gray, and independent directors, the role of the
independent director is really that of a watchdog.
D) Because independent directors' personal wealth is likely to be less sensitive to
performance than that of insider and gray directors, they have less incentive to closely
monitor the irm.
AACSB Objective: Analytic Skills
Author: JN
Question Status: Previous Edition
4
8) Which of the following statements is FALSE?
A) When the CEO is also chairman of the board, the nominating letter ofering a seat to a
new director comes from her. This process merely serves to reinforce the sense that the
outside directors owe their positions to the CEO and work for the CEO rather than for the
shareholders.
B) Over time, most of the independent directors will have been nominated by the CEO.
Even though they have no business ties to the irm, they are still likely to be friends or at
least acquaintances of the CEO.
C) Researchers have found the surprisingly robust result that larger boards are associated
with greater irm value and performance.
D) The CEO can be expected to stack the board with directors who are less likely to
challenge her.
AACSB Objective: Analytic Skills
Author: JN
Question Status: Previous Edition
9) Which of the following statements is FALSE?
A) In addition to the evidence that board independence matters for major activities such as
iring CEOs and making corporate acquisitions, researchers have found a strong
connection between board structure and irm performance.
B) Theoretical and empirical research support the notion that the longer a CEO has served,
especially when that person is also chairman of the board, the more likely the board is to
become captured.
C) Most irms that have just gone public either as young companies or as older irms
returning to public status after a leveraged buyout (LBO) choose to start with smaller
boards.
D) Boards tend to grow over time as members are added for various reasons. For example,
boards are often expanded by one or two seats after an acquisition to accommodate the
target CEO and perhaps one other target director.
AACSB Objective: Relective Thinking Skills
Author: JN
Question Status: Previous Edition
5
10) What is the diference between inside, gray, and outside directors?
AACSB Objective: Analytic Skills
Author: JN
Question Status: Previous Edition
26.3 Compensation Policies
1) Which of the following statements is FALSE?
A) Increasing the pay-for-performance sensitivity comes with the added beneit of reducing
managers' risk.
B) Stock and option grants give managers a direct incentive to increase the stock price to
make their stock or options as valuable as possible.
C) By tying compensation to performance, the shareholders efectively give the manager an
ownership stake in the irm.
D) During the 1990s, most companies adopted compensation policies that more directly
gave managers an ownership stake by including grants of stock or stock options to
executives.
AACSB Objective: Analytic Skills
Author: JN
Question Status: Previous Edition
6
2) Which of the following statements is FALSE?
A) The substantial use of stock and option grants in the 1990s greatly increased managers'
pay-for-performance sensitivity.
B) The optimal level of sensitivity of managers' compensation to the performance of their
irms depends on the managers' level of risk aversion, which is hard to measure.
C) While decreasing managers' risk exposure, increasing the sensitivity of managerial pay
and wealth to irm performance does have some negative efects.
D) In the absence of monitoring, the other way the conlict of interest between managers
and owners can be mitigated is by closely aligning their interests through the managers'
compensation policy.
AACSB Objective: Analytic Skills
Author: JN
Question Status: Previous Edition
7
3) Billy, the CEO of Movin On Up Company, was granted stock options with an exercise
price of $62.04 per share. The following are the week-ending stock prices that occurred
during the quarter:
Date Stock Price
7-Sep-05 56.82
13-Sep-05 57.24
20-Sep-05 60.51
27-Sep-05 57.23
4-Oct-05 60.14
11-Oct-05 60.42
18-Oct-05 61.5
25-Oct-05 59.84
1-Nov-05 60.02
8-Nov-05 60.14
15-Nov-05 61.52
22-Nov-05 61.67
29-Nov-05 63.94
6-Dec-05 62.39
13-Dec-05 62.04
20-Dec-05 64
27-Dec-05 65.52
What is the most likely date on which the stock options were awarded?
A) 13-Sep-05
B) 11-Oct-05
C) 13-Dec-05
D) not enough information to answer the question
AACSB Objective: Analytic Skills
Author: JP
Question Status: Previous Edition
8
4) Billy, the CEO of Movin On Up Company, was granted stock options with an exercise
price of $55.00 per share. The following are the week-ending stock prices that occurred
during the quarter:
Date Stock Price
7-Sep-05 56.82
13-Sep-05 57.24
20-Sep-05 60.51
27-Sep-05 57.23
4-Oct-05 60.14
11-Oct-05 60.42
18-Oct-05 61.5
25-Oct-05 59.84
1-Nov-05 60.02
8-Nov-05 60.14
15-Nov-05 61.52
22-Nov-05 61.67
29-Nov-05 63.94
6-Dec-05 62.39
13-Dec-05 62.04
20-Dec-05 64
27-Dec-05 65.52
If Movin On Up engaged in the practice of backdating, which of the following is the most
likely exercise price for Billy's options?
A) $65.52
B) $67.50
C) $65.00
D) $56.82
AACSB Objective: Analytic Skills
Author: JP
Question Status: Previous Edition
9
5) Which of the following statements is FALSE?
A) Backdating refers to the practice of choosing the grant date of a stock option
retroactively, so that the date of the grant would coincide with a date when the stock price
was at its low for the quarter or for the year.
B) Unless it is reported in a timely manner to the IRS and to shareholders, and relected in
the irm's inancial statements, backdating is illegal.
C) The use of backdating suggests that some executive stock option compensation may not
truly have been earned as the result of good future performance of the irm.
D) By backdating the option, the executive receives a stock option that is already out-of-
the-money, with a strike price equal to the higher price on the supposed grant date.
AACSB Objective: Analytic Skills
Author: JN
Question Status: Previous Edition
6) Which of the following statements is FALSE?
A) New SEC rules require irms to report option grants within two days of the grant date,
which may help prevent further abuses.
B) Studies have found evidence that the practice of timing the release of information to
maximize the value of CEO stock options is widespread.
C) Managers have an incentive to manipulate the release of inancial forecasts so that good
news comes out before options are granted and bad news is delayed until after the options
are granted.
D) The factor contributing most to the climb in CEO total compensation for the 1990s was
the sharp increase in the value of stock and options granted each year.
AACSB Objective: Analytic Skills
Author: JN
Question Status: Previous Edition
10
