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
another individual, the agent, to perform some service and then delegate decision-
making authority to that agent. Primary agency relationships exist between (1)
stockholders and managers, and (2) between debtholders and stockholders.
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
increase the incentive to take actions that are not in the best interests of the nonmanager
shareholders.
In addition to conflicts between stockholders and managers, there can also be
conflicts between stockholders (through managers) and creditors. Creditors have a
claim on part of the firm’s earnings stream for payment of interest and principal on
debt, and they have a claim on the firm’s assets in the event of bankruptcy. However,
stockholders have control (through managers) of decisions that affect the riskiness of
the firm.
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
provisions, also known as poison pills, allow existing shareholders in a company to
purchase additional shares of stock at a lower than market value if a potential acquiror
purchases a controlling stake in the company. A restricted voting rights provision
automatically deprives a shareholder of voting rights if the shareholder owns more than
a specified amount of stock.
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
the owner/manager is the only manager, then the owner/manager bears full cost of the
perks. But if the owner/manager only owns part of the company, the owner/manager reaps
all the benefits of the perks but the cost is shared by the outside shareholders. Potential
investors know this might happen, so they pay less for a minority interest in a company.
13-4 Entrenched managers consume too many perquisites, such as lavish offices, excessive
staffs, country club memberships, and corporate jets. They also invest in projects or
acquisitions that make the firm larger, even if they don’t make the firm more valuable.
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, (1)
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
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, executive
assistants, expense accounts, limousines, corporate jets, and a generous retirement plan.
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.
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
.
h. List three provisions in the corporate charter that affect takeovers.
Answer: These include targeted share repurchases (i.e., greenmail), shareholder rights
provisions (i.e., poison pills), and restricted voting rights plans.
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
price (called the strike price) even if the actual stock price is higher. Usually can’t
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