Chapter 10
Corporate Governance
ANSWERS TO BEGINNING-OF–CHAPTER QUESTIONS
10-1 An agent is someone who does some work on behalf of someone else, the principal. In
the case of a company that is run by a manager for the owner, then the owner is the
principal and the manager is the agent. Principal–agent, or agency, conflicts arise when
the agent’s incentives, whether they be in the form of salary structure or other incentives,
10-2 In a company, an agency conflict arises when the manager is paid a fixed salary and the
amount of effort isn’t monitored. The manager has an incentive to shirk or not work very
10-3 Stock options are a good form of compensation because when the stock does well, the
options become more valuable and pay the manager more. This aligns the manager’s
incentives for pay with the owner’s; when the company is more valuable, both the owner
and the manager are better off. However, the payoff to stock options isn’t the same as the
10-4 We often think of corporate managers as being focused on just one thing—shareholder
wealth maximization. However, in truth managers are people, and many of them no
more concentrate single–mindedly on wealth maximization than all students do on grade
maximization. And, if a manager does not inherently focus on wealth maximization, then
consistent with wealth maximization.
a. Entrenched managers are ones who have a firm control over the firm’s board of
directors and who cannot easily be replaced if they are ineffective or simply not
interested in maximizing shareholder wealth. Entrenchment can obviously exist if the
CEO and the other executives have a majority of the stock, but it can also exist
through other means. Years ago, before the increase in institutional ownership of
stock, managers controlled the proxy mechanism, and the thousands of small
stockholders “voted with their feet” instead of voting incompetent managers out of
office. So, in the past, management entrenchment and the inefficiencies it brings on
b. Hostile takeovers have also reduced entrenchment. The concentration of ownership
in institutional hands, and the development of the junk bond market for financing
takeovers, has made hostile takeovers easier, and that has led to the replacement of
many ineffective management teams.
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c. Incentive compensation plans, such as those that pay managers (and even lower–
level employees) in part with stock and options, and where the size of the awards are
d. Greenmail is like blackmail, and it refers to a situation where a firm’s management
buys the stock of a person or company that is threatening a takeover at price higher
than the fair market price of the firm’s stock. Managements sometimes “pay
e. Poison pills refer to any action that a management might take to ward off a takeover.
Originally, companies did things like build into debt contracts terms that would
greatly increase the interest rate the firm was required to pay in the event of a
takeover, hence they really were poison pills. Now, though, clever lawyers have
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f. A strong board of directors is one that is not controlled by the chairman of the
board, that has competent independent (outside) directors, and that is willing to
replace an ineffective management team. Some characteristics of a strong board are
(1) outside directors as opposed to employees of the firm, (2) directors who do not
have ties to the firm, such as one of its lawyers or other suppliers who get fees from
g. The vesting period refers to how soon options really belong to an employee. For
example, an employee might be given options to buy 5,000 shares of stock, but only
if he or she remains with the company for 3 years after the option was granted.
h. An ESOP is an Employee Stock Ownership Plan. ESOPs provide significant tax
10-5 Politicians and the investing public seem to cycle between wanting regulation to protect
against fraudulent or dangerous corporate behavior and being upset about the costs of this
regulation. The outrage in response to the fraudulent behavior of Enron, WorldCom and
other companies during the early 2000s led to the passage of the Sarbanes Oxley bill,
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transparent and honest. That attitude changed, however, by the mid–2000s as the real
estate price bubble that was to become the Global Financial Crisis took hold. Home
prices were increasing, financial services companies were making tons of money by
issuing shady loans to unqualified buyers and then colluding with the ratings agencies to
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ANSWERS TO END-OF-CHAPTER QUESTIONS
10-1 a. An agency relationship arises whenever one or more individuals, the principals, hire
another individual, the agent, to perform some service and then delegate decision-
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
conflict. The fact that the manager will neither gain all the benefits of the wealth
created by his or her efforts nor bear all of the costs of perquisite consumption will
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
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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
10-2 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
10-3 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
10-4 Entrenched managers consume too many perquisites, such as lavish offices, excessive
10-5 Stock options in compensation plans usually are issued with a strike price equal to the
current stock price. As long as the stock price increases, the option will become valuable,
even if the stock price doesn’t increase as much as investors expect.
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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,
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
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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.
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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
governance?
Answer: (1) The CEO is not also the chairman of the board and does not have undue influence
.
h. List three provisions in the corporate charter that affect takeovers.
Answer: These include targeted share repurchases (i.e., greenmail), shareholder rights
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
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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
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