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P18.5 Coase Theorem. According to the Coase Theorem, resource allocation will be efficient
so long as transaction costs remain low and property rights can be freely assigned and
exchanged.
A. Does the Coase Theorem imply that government has little if any role to play in the
market economy? Explain.
B. According to the Coase Theorem, are efficient and equitable economic outcomes
assured? Explain.
P18.5 SOLUTION
P18.6 Decision Authority. At the end of World War II, goods production and services
provision were each responsible for roughly one-half of economic activity and total
employment in the United States. Today, the provision of services is responsible for
roughly two-thirds of employment and three-quarters of total employment.
A. Can you explain the decline of centralized decision authority and the emergence of the
“flat” organization style, as a natural result of these trends in aggregate economic
activity and employment?
B. Is the emerging use of personal computers as Internet-centered communications devices
likely to favor flat organization? Why or why not?
Organization Structure and Corporate Governance 579
P18.6 SOLUTION
B. At the moment, the answer to this question is not clear, and open to debate. The
emerging use of personal computers as Internet-centered communications devices is
P18.7 Sarbanes-Oxley Act. The Sarbanes-Oxley Act, named for sponsors Sen. Paul Sarbanes,
D-Md., and Rep. Michael Oxley, R-Ohio, is the most sweeping law affecting
corporations since the 1930s. It is having a dramatic effect on the costs companies pay
for independent audits of the financial numbers reported to the outside world. In many
cases, companies now pay double historical auditing costs to get auditors to attest that
all corporate internal controls have been checked and given their seal of approval. This
is a big change for companies that have long accepted internal controls that are less
than perfect, and for good reason. A company could eliminate padded travel expenses if
it wanted to hire a small army in accounting to verify every taxicab receipt. However,
such detailed oversight would often cost much more than direct savings. Critics of
traditional failures in corporate governance point out that internal control has an
importance beyond that of simply catching the occasional fraud. By going through the
effort of complying with Sarbanes-Oxley, many companies are unearthing operating
inefficiencies.
A. Critics of Sarbanes-Oxley contend that the act results in excessive compliance
costs. Explain why risk-adverse corporate management may be overstating such
costs.
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B. Supporters of Sarbanes-Oxley argue that the act will produce significant net
benefits as corporations improve both the transparency and accuracy of financial
reporting. Describe some of the improvements in management efficiency that
might be spurred by corporate compliance with Sarbanes-Oxley.
P18.7 SOLUTION
A. Companies are spending a lot of money to comply, but several analysts contend that
high Sarbanes-Oxley compliance costs result from bad compliance advice, not because
B. It is quite possible that corporate compliance with Sarbanes-Oxley will lead to real
improvements in managerial efficiency. For example, it has long been common for
multinational companies to use many different accounting systems at various units
P18.8 Information Asymmetry Problem. Shareholders face a daunting information
asymmetry problem when it comes to measuring the performance of the CEO. As head
of the corporation, the CEO is in charge of the firm’s management information system.
Accounting methods always leave room for managerial interpretation, and this
flexibility can and has been used to understate expenses and inflate reported earnings.
When CEO compensation is tied to various accounting performance targets, it is a bit
Organization Structure and Corporate Governance 581
like asking students to fill out their own final grade report. At a minimum, shareholders
should not be surprised when accounting data places firm and managerial performance
in a favorable light. Shareholders must take steps to guard against significant
manipulation of accounting standards and/or accounting bias that results in a
meaningful distortion of accounting performance.
A. What pitfalls are faced by independent auditors and boards of directors in their
efforts to maintain the firm’s accounting statements as independent and unbiased
indicators of firm and managerial performance?
B. What corporate governance mechanisms might be used to guard against the
manipulation of the firm’s accounting statements?
P18.8 SOLUTION
A. Of course, the fact that accounting standards leave substantial room for interpretation
B. The most obvious and simplest corporate governance mechanisms used to guard against
manipulation of the firm’s accounting statements are corporate practices that insure
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P18.9 Executive Stock Options. Warren Buffett, chairman and CEO of Berkshire Hathaway,
Inc., is an outspoken critic of executive-stock option plans, at least as they are commonly
employed. In a typical stock-option plan, top executives are given the right to buy
company stock at the current price for a period of up to 10 years in length. Such options
have obvious economic value given the 10 %+ long-run rate of return on common
stocks. Nevertheless, the costs of executive stock-option-based compensation are
typically not reflected in the company’s income statement.
A. Explain how the failure to include stock-option based compensation costs in the
firm’s income statement could lead to a type of information asymmetry problem.
B. How could the potential for such a problem be avoided? In other words, how
would you design an effective executive stock-option-based compensation plan?
P18.9 SOLUTION
A. The failure to include stock-option based compensation costs in the firm’s income
B. When Berkshire acquires an option-issuing company, Buffett institutes a cash
P18.10 Institutional Stock Ownership. During the amazing bull market of the 1990s, an
investment strategy of simply mimicking the Standard & Poor’s 500 Index became
popular. The S&P 500 is a value-weighted market index of 500 common stocks thought
to measure overall movement in the aggregate stock market. Under this investment
strategy, the amount invested in each stock is proportionate to each component’s share
of the total market valuation of all 500 companies. If the largest component,
ExxonMobil, accounts for roughly3.4 % of the index, and the second largest component,
GE, accounts for roughly 2.8 %, index followers simply invest 3.4 % of their portfolio in
Organization Structure and Corporate Governance 583
ExxonMobil, 2.8 % in GE, and so on.
A. Explain how the stock market’s ability to discipline the managers of
underperforming firms could be reduced if all investors simply purchased index
funds that mimicked the S&P 500.
B. Explain how institutional investors, even those with index funds, actually
discipline the managers of underperforming firms in practice.
P18.10 SOLUTION
A. The market value of the firm is the discounted net present value of all future profits
B. In practice, institutional investors, even those with Index funds, actually do discipline
584 Chapter 18
CASE STUDY FOR CHAPTER 19
Do Boards of Directors Make Good Corporate Watchdogs?
Is the large publicly traded corporation in eclipse? Some say yes. Harvard financial economist
Michael Jensen, for example, argues that the experience of the past 2 decades indicates that
corporate internal control systems have failed to deal effectively with economic changes, especially
slow growth and the requirement for exit from declining industries. In some parts of the economy,
new and smaller organizations are emerging to take the place of giant corporations. Although
Of course, given recent experience it is quite valid to express concern with respect to the
adaptive capability of some large corporations. Still, pronouncements concerning the “death” of
the modern corporation may be premature. The corporate form has endured because it is a useful
and effective means for gathering and deploying economic resources. Questions about corporate
effectiveness are ultimately questions about what is referred to as “corporate governance.”
Corporate governance is the system of controls that helps the corporation effectively manage,
administer, and direct economic resources.
Problems in corporate governance exist to the extent that unresolved material conflicts
endure between the self-seeking goals of (agent) managers and the value-maximization goal of
(principal) stockholders. “Agency costs” incurred by stockholders are reflected in expenses for
Hiring the right chief executive officer is widely viewed as a board of director’s most difficult
task. However, firing a deficient CEO can be even more important because board negligence can
leave a company permanently impaired. Dismissing an underperforming CEO is tough because it
Organization Structure and Corporate Governance 585
boards sometime have no alternative but to seek new leadership.
Nowhere has the management turnstile been spinning faster that at high-tech giant Hewlett–
Packard. When Hewlett-Packard merged with Compaq Computer in 2003, one of the many
arguments for the deal was that the combination would benefit from a deeper pool of top managerial
talent. However, top management from Compaq didn’t last long on H-P CEO Carly Fiorina’s team.
Michael Capellas, who had been CEO of Compaq, quickly left H-P to try and salvage bankrupt
Within a year after leaving H-P, both Capellas and Clarke were working hard to overcome a
history of accounting fraud at new and troubled employers. Capellas faced the herculean task of
successfully dealing with creditors and customers to bring MCI out of bankruptcy, and Clarke was
named chief operating officer of embattled software giant Computer Associates, which was being
investigated by the Securities and Exchange Commission for cooking the books. Computer
Associates CEO Sanjay Kumar stepped down under pressure in, 2004. As the Computer Associates
board began its search for a new CEO, shareholder activists called for an outsider to come in and
clean up the mess.
A. Does incompetence by top management and corporate boards of directors invalidate the
value-maximization theory of the firm?
B. Many shareholder groups prefer to split the chairman and CEO posts, and install an
outsider as chairman of the board of directors. From the shareholder viewpoint, discuss
some of the advantages and disadvantages of an “outside” chairman.
C. Shareholders often want change when corporate performance is poor, top executive pay is
excessive, and/or management is unresponsive. However, removing corporate directors by
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D. In addition to casting their vote in annual proxy contests, shareholders “vote with their feet”
when they sell the stock of poorly performing companies. How is this likely to influence
inferior performance by top management and the board of directors?
CASE STUDY SOLUTION
the subsequent 1992 board revolt, could have been averted had competitive pressures been
allowed to force GM to cut costs and improve product development. In retrospect, it is
apparent that sheltering GM from foreign competition during the early-1980s allowed the
company to maintain excessive overhead, pay extravagant wages and benefits to blue-collar
workers, and delay needed investment in new plant and equipment. As a result, GM’s stock–
price performance was sub-par and shareholders suffered.
B. Warren E. Buffett, Chairman and CEO of Berkshire Hathaway, Inc., is an outspoken
Organization Structure and Corporate Governance 587
C. Despite the fact that shareholders are generally offered only one slate of candidates in proxy
contests, and they can vote no only by withholding votes from would-be board members, the
current shareholder voting process is far from ineffectual.
Until recently, activist shareholders haven’t focused much attention on replacing
ineffectual top management and members of the board of directors. Instead, activists usually
A number of innovations might be proposed to improve the shareholder referendum
process. For example, it might be worth seriously considering proposals to allow outside
shareholders to nominate a fixed percentage of outside board members, say 50% or more.
D. Shareholders “vote with their feet” by selling the stocks of poorly performing companies
more often than they express their dissatisfaction by casting votes against management in