CHAPTER 4 CORPORATE GOVERNANCE AROUND THE WORLD
SUGGESTED ANSWERS TO END-OF-CHAPTERQUESTIONS AND PROBLEMS
Questions
1. The majority of major corporations are franchised as public corporations. Discuss the key
strength and weakness of the ‘public corporation’. When do you think the public corporation
as an organizational form is unsuitable?
Answer: The key strength of the public corporation lies in that it allows for efficient risk sharing
among investors. As a result, the public corporation may raise a large sum of capital at a
relatively low cost. The main weakness of the public corporation stems from the conflicts of
2. The public corporation is owned by multitude of shareholders but managed by professional
managers. Managers can take self-interested actions at the expense of shareholders.
Discuss the conditions under which the so-called agency problem arises.
Answer: The agency problem arises when managers have control rights but insignificant cash
3. Following corporate scandals and failures in the U.S. and abroad, there is a growing
demand for corporate governance reform. What should be the key objectives of
corporate governance reform? What kind of obstacles can there be thwarting reform
efforts?
Answer: The key objectives of corporate governance reform should be to strengthen
shareholder rights and protect shareholders from expropriation by corporate insiders, whether
4. Studies show that the legal protection of shareholder rights varies a great deal across
countries. Discuss the possible reasons why the English common law tradition
provides the strongest and the French civil law tradition the weakest protection of
investors.
Answer: In civil law countries, the state historically has played an active role in regulating
economic activities and has been less protective of property rights. In England, control of the
5. Explain ‘the wedge’ between the control and cash flow rights and discuss its implications for
corporate governance.
Answer: When there is a separation of ownership and control, managers have control rights with
insignificant cash flow rights, whereas shareholders have cash flow rights but no control rights.
6. Discuss different ways that dominant investors use to establish and maintain the control of
the company with relatively small investments.
Answer: Dominant investors may use: (i) shares with superior voting rights, (ii) pyramidal
7. The Cadbury Code of the Best Practice adopted in the United Kingdom led to a successful
reform of corporate governance in the country. Explain the key requirements of the Code
and discuss how it may have contributed to the success of reform.
Answer: The Code requires that chairman of the board and CEO be held by two different
individuals, and that there should be at least three outside board members. The recommended
8. Many companies grant stocks or stock options to the managers. Discuss the benefits
and possible costs of using this kind of incentive compensation scheme.
Answer: Stock options can be useful for aligning the interest of managers with that of
shareholders and reduce the wedge between managerial control rights and cash flow rights. But
9. It has been shown that foreign companies listed in the U.S. stock exchanges are valued
more than those from the same countries that are not listed in the U.S. Explain the reasons
why U.S.-listed foreign firms are valued more than those which are not. Also explain why not
every foreign firm wants to list stocks in the United States.
Answer: Foreign companies domiciled in countries with weak investor protection can bond
themselves credibly to better investor protection by listing their stocks in U.S. exchanges that
10. Explain “free cash flows.” Why do managers like to retain free cash flows instead of
distributing it to shareholders? Discuss what mechanisms may be used to solve this
problem?
Answer: Free cash flow represents a firm’s internally generated fund in excess of the amount
needed to undertake all profitable investment projects. Managers may want to keep free cash
Minicase. Parmalat: Europe’s Enron
Discussion points.
1. How was it possible for Parmalat managers to “cook the books” and hide it for so long?
2. Investigate and discuss the role that international banks and auditors might have played
in Parmalat’s collapse.
3. Study and discuss Italy’s corporate governance regime and its role in the failure of
Parmalat.
Suggested Answers:
1. Parmalat was able to cook the books mainly due to the fact that Italy has a low level of
2. Apparently, international banks and auditors failed to do the due diligence, perhaps
3. Italy has a weak corporate governance regime that does not provide a strong protection of
outside shareholders. The majority of public firms are dominated by large controlling