Chapter 13
Corporate Governance
ANSWERS TO END-OF-CHAPTER QUESTIONS
13-1 a. An agency relationship arises whenever one or more individuals, the principals, hire
b. Agency costs include all costs borne by shareholders to encourage managers to
maximize a firm’s stock price rather than act in their own self-interests. The three
c. An agency problem arises whenever a manager of a firm owns less than 100 percent
of the firm’s common stock, creating a potential conflict of interest called an agency
In addition to conflicts between stockholders and managers, there can also be
conflicts between stockholders (through managers) and creditors. Creditors have a
d. Managerial entrenchment occurs when a company has such a weak board of directors
and has such strong anti-takeover provisions in its corporate charter that senior
Mini Case: 13 – 1
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website, in whole or in part.
e. Targeted share repurchases, also known as greenmail, occur when a company buys
back stock from a potential acquiror at a higher than fair-market price. In return, the
potential acquiror agrees not to attempt to take over the company. Shareholder rights
f. A stock option allows its owner to purchase a share of stock at a fixed price, called
the strike price, no matter what the actual price of the stock is. Stock options always
13-2 Owner/managers benefit from higher wealth due to ownership, but they also benefit from
the perks they consume, such as lavish offices, vacations, golf club memberships, etc. If
13-3 After the loan is originated, borrowers might make decisions that are harmful to the
lender. For example, borrowers might invest in risky projects. From the borrower’s point
13-4 Entrenched managers consume too many perquisites, such as lavish offices, excessive
13-5 Stock options in compensation plans usually are issued with a strike price equal to the
Mini Case: 13 – 2
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website, in whole or in part.
MINI CASE
Suppose you decide (like Steve Jobs and Mark Zuckerberg did) to start a company. Your
product is a software platform that integrates a wide range of media devices, including
laptop computers, desktop computers, digital video recorders, and cell phones. Your initial
market is the student body at your university. Once you have established your company
and set up procedures for operating it, you plan to expand to other colleges in the area,
and eventually to go nationwide. At some point, hopefully sooner rather than later, you
plan to go public with an IPO, then to buy a yacht and take off for the South Pacific to
indulge in your passion for underwater photography. With these issues in mind, you need
to answer for yourself, and potential investors, the following questions.
a. What is an agency relationship? When you first begin operations, assuming you
are the only employee and only your money is invested in the business, would
any agency conflicts exist? Explain your answer.
Answer: An agency relationship arises whenever one or more individuals, called principals,
No agency problem would exist. A potential agency problem arises whenever the
manager of a firm owns less than 100 percent of the firm’s common stock, or the firm
b. If you expanded, and hired additional people to help you, might that give rise to
agency problems?
Answer: By expanding the business and hiring additional employees, this might give rise to
Mini Case: 13 – 3
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website, in whole or in part.
c. Suppose you need additional capital to expand and you sell some stock to outside
investors. If you maintain enough stock to control the company, what type of
agency conflict might occur?
Answer: As the owner/manager you benefit from your increased wealth due to the company,
but you also benefit from perquisites, such as more leisure, luxurious offices,
d. Suppose your company raises funds from outside lenders. What type of agency
costs might occur? How might lenders mitigate the agency costs?
Answer: An agency conflict occurs between the borrow and the lender because the borrower
makes decisions after the loan is made that affect the lender’s welfare. For example,
e. Suppose your company is very successful and you cash out most of your stock
and turn the company over to an elected board of directors. Neither you nor any
other stockholders own a controlling interest (this is the situation at most public
companies). List six potential managerial behaviors that can harm a firm’s
value.
Answer: Managers might:
1. Expend too little time and effort.
2. Consume too many nonpecuniary benefits.
3. Avoid difficult decisions (e.g., close plant) out of loyalty to friends in company.
Mini Case: 13 – 4
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website, in whole or in part.
f. The managers at KFS have heard that corporate governance can affect
shareholder value. What is corporate governance? List five corporate
governance provisions that are internal to a firm and are under its control.
Answer: Corporate governance is the set of laws, rules, and procedures that influence a
company’s operations and the decisions made by its managers.
g. What characteristics of the board of directors usually lead to effective corporate
governance?
Answer: (1) The CEO is not also the chairman of the board and does not have undue influence
over the nominating committee; (2) the board has a majority of true outsiders who
.
h. List three provisions in the corporate charter that affect takeovers.
i. Briefly describe the use of stock options in a compensation plan. What are some
potential problems with stock options as a form of compensation?
Answer: Gives owner of option the right to buy a share of the company’s stock at a specified
Manager can underperform market or peer group, yet still reap rewards from options
Mini Case: 13 – 5
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website, in whole or in part.
j. What is block ownership? How does it affect corporate governance?
Answer: Block ownership occurs when an outside investor owns large amount (i.e., block) of
k. Briefly explain how regulatory agencies and legal systems affect corporate
governance.
Answer: Companies in countries with strong protection for investors tend to have better access
Mini Case: 13 – 6
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website, in whole or in part.