Module 1 - Basic Goal of The Firm-Introduction Lecture Note
Module 1 - Basic Goal of The Firm-Introduction Lecture Note
Lecture 1
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Lecture 1
1- What is the primary goal of the firm? How is this goal related to the
societal goals and considerations? Is this goal consistent with the basic
goals of micro economics?
2- What is “AGENCY” conflict?
What are some of the common agency conflicts that occur between
stockholders and managers?
Between stockholders and creditors?
Could agency situations exist in any other situations? In discussing this
point, please consider government employees, including elected
officials.
3- How do agency conflicts affect the value of the firm? What can be done to
mitigate the effects of potential conflicts?
Most of the key concepts of corporate governance are provide the framework of
reference in the strategic management of the firm.
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The purpose of management of a firm is to make decisions and take actions to
maximize the value of a firm’s stock.. In this respect, executive management’s
basic overriding goal is thus to create value for stockholders.
As a result stockholders get to elect the directors, who then hire the managing
executives.
The directors have little choice but to operate like this, because stockholders will
remove them if they fail in their fiduciary duty.
Some years ago, stockholders were passive. They simply voted with their feet:
that is, sold their stock if they thought a particular firm’s management was not
performing well. Today, ownership is increasingly concentrated in the hands of
institutional investors such as pension funds and mutual funds, and their holdings
are so large, they would depress the stock prices if they simply dumped it.
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FIGURE 1: THE CORPORATE GOVERNANCE SYSTEM
The Principal-Agent Relationship
These efforts help to make business operations more efficient, and thus
increases its competitiveness.
In order to maximize stock prices, managers must offer goods and services
that consumers desire – otherwise known as being more ‘competitive’ – and
they must price those goods and services as low as possible, and low prices
require efficient, low cost operations.
The quest for stock price maximization also leads to innovation, new products
and services, and improved productivity.
Consumers benefit as a result of management’s efforts and so do the
employees, because efficient, profitable firms are able to offer more stable
higher paying jobs, advancement opportunities, and generally better working
conditions.
Stockholding public also benefits, as increasingly through pension retirement
plans or direct individual investments in companies, many adult working
people are participants as investors in the economic activities. These people
are interested in the successful operations of the firms, hence higher stock
prices will help most citizens.
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Also, through the “wealth effect” higher stock prices lead to increased
spending and to lower “cost of capital” to firms. Both of these effects stimulate
the economy, producing more and better jobs, and most importantly,
economic growth.
IV- AGENCY RELATIONSHIPS: PRINCIPAL – AGENT PROBLEM
The potential agency problem arises whenever the manager of a company owns
less than 100 percent of the stock of the firm.
If the firm is a proprietorship managed by its owner, then the owner- manager will
presumably operate so as to maximize his own welfare, with welfare measured in
the form of increased personal wealth, more leisure, or perquisites.
If the owner- manager incorporates his company and then sells some of the
stock to outsiders, a potential conflict of interest will immediately arise.
With the outside shareholders having ownership of some of the stock of the firm,
owner-manager has less of an incentive to work too hard to increase his wealth,
as some of that wealth will have to go to the new stockholders.
In essence, the fact that the owner-manager will no longer have the possibility to
enjoy all of the benefits of full ownership of the firm through the wealth created by
his efforts, nor bear all the costs of perquisites will increase the likelihood that he
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will have more incentive to take actions at the management of the firm that are
not necessarily in the best interests of all the shareholders.
The above case represents the conflict of interest that lies at the heart of the
Agency problem. In this case, the shareholders will need to monitor the actions of
the managers so as to align the interests of the managers with their own interests
in the firm.
It has been argued that when their share in the ownership of the firm is less than
100 percent, the primary goal of many managers will become that of
maximization of the size of their firms, rather than seeking active ways to
maximize the wealth of their shareholders.
For instance, by creating large rapidly growing firms, managers seek to:
(1) Increase their job security to prevent the likelihood of hostile takeovers;
(2) Increase their own power, status and salaries;
(3) Create more opportunities for their lower and mid-level managers (crony
capitalism)
In order to ensure that the interests of the managers are aligned with that of the
shareholders, some agency costs must be borne by the firm.
These agency costs occur due to the moral hazard problems inherent in such
situations, where managers take actions that are more in line with their own self
interests. Moral hazard problems exist because agents (managers) take
unobservable actions that can not always be closely monitored by the principals
(shareholders). This creates a certain degree of hazards, leading to potentially
risky situations for shareholders.
Agency costs include all costs that must be borne by shareholders to encourage
managers to maximize firms stock price, rather than act in their own self interest.
Agency costs may include:
(1) Expenditures to monitor managerial actions such as audit costs;
(2) Expenditures to structure the organization in a way that will limit
undesirable manager behavior—such as appointing outside independent
directors to sit on the board of directors
(3) Opportunity costs which are incurred when shareholder imposed
restrictions such as requirements for stockholder votes on certain issues
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limit the ability of managers to take timely actions that would enhance
shareholder wealth.
There are some specific mechanisms to motivate managers to act in the best
interests of the shareholders:
A- Managerial Remuneration:
EVA is superior of the ROE and EPS measures because it measures the
true profitability of the firm leading to value creation.
EVA is calculated by subtracting annual cost of all the capital a firm uses
from after tax operating profits.
B- Shareholder Activism:
Institutional capital has more interest in the companies they own stock in,
because of the implications of selling large chunks of securities from low
performing companies. The markets react negatively when large sums of
stock must be traded in the markets in a hurry. Rather than selling the
stock and moving on, many institutional prefer to work together with the
management of the company to work a solution to performance problems.
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The most fundamental change that the shareholder activism are trying to
bring about is the more independent board of directors.
All too often, in the past managers (agents) had control of the directors,
functioning mostly like a rubber stamp board, that had diminished the
accountability of the management. This is why institutional investors are
pressing for independent boards.
C- Threat of Firing
Creditors have a claim on the firms earning stream for payment of interest and
principal on the debt, and they have a claim on the assets of the firm in the case
of a bankruptcy.
Creditors lend funds to the firm based on their assessment of the firm’s risk,
which is in turn based on the (1) riskiness of the firms existing assets; (2)
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expectations of the riskiness of future asset additions; (3) the existing capital
structure; (4) expectations concerning the future capital structure (debt versus
equity financing) decisions. These are the primary determinants of the riskiness
of a firm’s cash flows, hence the safety of its debt.
Suppose the firm sells some safe assets and invest the proceeds in a large new
project which is far riskier that the firm’s old assets. This will add new riskiness to
the form, and hence will cause the investors and creditors to increase their
required rates of return on their investments in the firm to increase. The cost of
debt will increase, therefore this will cause the value of the outstanding debt to
fall.
If the risky project is successful, shareholders stand to gain value on the equity
they own, hence will maximize their wealth. However, due to the increased
riskiness of the assets, the value of the debt has declined, given that the debt is
paid back at a fixed rate (at the old lower risk rate).
On the other hand, if the venture is not successful, the debt holders stand to lose,
and share the losses with the equity holders.
This dilemma causes the conflict of interest. Using leverage is proper only if the
investment will result in increased cash flow and thus lead to increased value for
all.
The question is, can and should the shareholders through their managers/agents
try to expropriate wealth from the creditors? The answer will generally be, no.
This will get into unethical business practices and ought not be allowed.
This type of behavior will jeopardize the firms chances of continued access to
finance at reasonable terms. The next time the firm needs financing from
creditors, they may either be denied new financing or will be charged higher
interest (cost of capital). This is one of the reason why in emerging markets cost
of capital is too high due to perceived higher risks of doing business.
Creditors belong to the class of interested parties that fall under the group of
“stakeholders” of the firm. It follows that for management, it is best to act in a
balanced way responsible and accountable, fair and transparently towards the
best interests of two classes of security holders: Shareholders and creditors.
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Stock price maximization goal requires fair, and equitable treatment of all parties,
with responsibility, accountability and transparency. Managerial decisions
basically affect the way in which the economic positions of the stakeholders.
If the decision is made to reorganize the question arises as to who will receive
what asset from the reorganized firm. Management gets to make the initial move,
because typically managers choose to try to reorganize so as to preserve their
jobs. In order to avoid any loss of additional value, the firm must be reorganized
so that all creditors and the residual shareholders will receive the highest
possible value that is available in the distressed firm.
Corporate governance, thus, deals with the ways in which suppliers of finance to
a firm can assure themselves of receiving a fair rate of return on their investment.
Effective corporate governance attempts to bridge the gap resulting from conflict
of interest that may occur between the principals (shareholders) and the agents
(managers) in the firm.
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CORPORATE GOVERNANCE is thus the set of internal and external
mechanisms that allow the shareholders to assure themselves of a rate of return
(positive of negative) on their investment by maintaining a balanced approach for
the treatment of all parties. (Figure 2)
It appears that the main weakness is in the effective enforcement of the enacted
new legal frameworks due mainly to the lack of capacity. The following
arguments can be made in favor of achieving further improvements in corporate
governance:
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What are the OECD Principles of Corporate Governance?
Corporate governance is only part of the larger economic context in which firms
operate, which includes the macroeconomic policies and the degree of
competition in product and factor markets.
The corporate governance framework also depends on the legal, regulatory and
institutional environment. In addition factors such as business ethics and
corporate awareness of the environmental and social interests of the
communities in which it operates can also have an impact on the reputation and
the long term success of the firm.
The Principles are intended to assist OECD and non-OECD governments in their
efforts to evaluate and improve the legal, institutional and regulatory framework
for corporate governance in their countries, and to provide guidance and
suggestions for stock exchanges, investors, corporations, and other parties that
have a role in the process of developing good corporate governance.
The Principles focus on publicly traded companies, both financial and non-
financial. However, to the extent they are deemed applicable, they might also be
a useful tool to improve corporate governance in non-traded companies, for
example, privately held and stateowned enterprises.
The Principles represent a common basis that OECD member countries consider
essential for the development of good governance practices. They are intended
to be concise, understandable and accessible to the international community.
They are not intended to substitute for government, semi-government or private
sector initiatives to develop more detailed “best practice” in corporate
governance.
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OECD Principles of Corporate Governance.2004. www.oecd.org
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(2) The rights of the shareholders.
These include the set of rights including secure ownership of their shares; the
right to a full disclosure of information; voting rights; participation decisions on
sale or modification of corporate assets, including mergers and new issues.
This framework for principles of corporate governance seeks the ethical and
transparent operations of enterprises and their management. The areas most
central to good corporate governance center upon:
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focus on governance problems that result from the separation of ownership and
control. However, this is not simply an issue of the relationship between
shareholders and management, although that is indeed the central element.
In some jurisdictions, governance issues also arise from the power of certain
controlling shareholders over minority shareholders. In other countries,
employees have important legal rights irrespective of their ownership rights.
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management, the board, the employees, the government, the debt holders of
the firm, the suppliers, the customers and clients, other financial institutions,
etc.
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FIGURE 2: INTERNAL AND EXTERNAL MECHANISMS OF CORPORATE
GOVERNANCE
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EXHIBIT 1 - The Twelve Key Standards for Sound Financial Systems
The 12 standard areas highlighted here have been designated by the Financial Stability Forum as
key for sound financial systems and deserving of priority implementation depending on country
circumstances. While the key standards vary in terms of their degree of international
endorsement, they are broadly accepted as representing minimum requirements for good
practice. Some of the key standards are relevant for more than one policy area, e.g. sections of
the Code of Good Practices on Transparency in Monetary and Financial Policies have relevance
for aspects of payment and settlement as well as financial regulation and supervision.
http://www.fsforum.org/compendium/key_standards_for_sound_financial_system.htm l
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EXHIBIT 2: Insider versus Outsider Models of Corporate Governance
The Dutch-German model looks to balance a profit impulse with broader goals to
form a socially responsible capitalism. Beyond the interests of shareholders, the
structure seeks to represent the interests of workers, creditors and the state as a
whole. The structure has also been described as designed to “rise above the
fray” of short-term capitalism to give a better view of longer-term goals and
benefits3.
In the United States and the U. K., most companies have broad diversified
shareholdings.4 Because no particular shareholder has the insider knowledge or
power to fully protect its rights, the board is responsible for representing and
defending the collective interests of the shareholders.
Company and security laws are designed to aid the market in limiting any
temptation the managers may have to use the company for their own interests.
The market acts as a Darwinian selection – rewarding successful companies and
punishing failures. Good companies can raise more equity and hire better
managers.
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Sweden, for example has a liquid equity market with many foreign investors but investment companies still
play an important role in corporate affairs. In addition, 46% of the largest companies is held by a single
entity. Japanese firms (especially the largest ones) tend to be a part of keiretsu, a system on interlocking
ownership. In France, many of the largest firms are held by AXA-UP or Societe Generale. D. Brean and C.
Kobrak, Corporate Governance in the Twenty-First Century, 2003 G8 Pre-Summit Conference Governing
Globalization: G8, Public and Corporate Governance (2003) (available at
www.g8.utoronto.ca/conferences/2003/insead/insead_papers/brean_kobrak_paper ).
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In the United States, for example, 62% of companies have no shareholder holding more than 15% of the
company’s shares. In Germany, by contrast, 89% of listed companies have at least one shareholder with
more than 15% of the company’s shares.
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Underperforming companies are susceptible to takeover in the market for capital
control. This reliance on market forces means that regulation is aimed at
increased information and transparency aimed at making the market operate in
as efficient a manner as possible.
The “outsider” model in the United States has been developed gradually since
the 1930s. U.S. banks used to hold large blocks of shares and had their
representatives sit on boards just as the German banks do today.
Economic growth after the Second World War led to widespread equity
investment by smaller shareholders without the intermediation of banks.
As a result of these forces, the United States and the U.K. have consistently
aimed to increase the amount of disclosure, its quality and veracity and the time
it takes to get the information to the market.
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This is not to say that U.S. companies are left free from considering the social implications of their actions.
To the contrary, they must comply with a host of welfare, environmental and labor laws. Rather, the decision
has been made not to weave such considerations into the legal fabric of corporate and securities regulation.
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EXHIBIT 3: What Is a Family Business?
It is also a complex, dual system consisting of the family and the business; family
members involved in the business are part of a task system (the business) and
part of a family system.
These two systems overlap. This is where conflict may occur because each
system has its own rules, roles and requirements. For example, the family
system is an emotional one, stressing relationships and rewarding loyalty with
love and with care. Entry into this system is by birth, and membership is
permanent.
Conflicts arise when roles assumed in one system intrude on roles in the other,
when communication patterns used in one system are used in the other or when
there are conflicts of interest between the two systems. For example, a conflict
may arise between parent and child, between siblings or between a husband and
wife when roles assumed in the business system carry over to the family system.
The boss and employee roles a husband and wife might assume at work most
likely will not be appropriate as at-home roles. Alternatively, a role assumed in
the family may not work well in the business. For instance, offspring who are the
peace makers at home may find themselves mediating management conflicts
between family members whether or not they have the desire or qualifications to
do so.
A special case of role carryover may occur when an individual is continually cast
in a particular role. This happens primarily to children. Everyone grows up with a
label: the good one, the black sheep, the smart one. While a person may outgrow
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a label, the family often perceives that person as still carrying the attribute. This
perception may affect the way that person operates in the business.
Family communication patterns don't always affect the business, but when they
do it can be very embarrassing. Often you say things to family members in a way
you would never speak to other employees or managers. This problem is
compounded when your communication is misread by the family member. Often
parents are surprised by a son's or daughter's negative reaction to a business
directive or performance evaluation. This reaction is probably because the
individual perceived the instructions or evaluation as orders or criticism from Dad
or Mom, not from the boss.
System overlap is apparent when conflicts of interest arise between the family
and the business. Some families put personal concerns before business
concerns instead of trying to achieve a balance between the two. It is important
to understand that the family's strong emotional attachments and overriding
sense of loyalty to each other create unique management situations. For
example, solving a family problem, such as giving an unemployable or
incompetent relative a position in the firm, ignores the company's personnel
needs but meets the needs of family loyalty.
Another example of conflict of interest occurs when business owners feel that
giving children equal salaries is fair. Siblings who have more responsibility but
receive the same pay as those with less responsibility usually resent it. In cases
of sibling rivalry, it isn't unusual for one sibling to withhold information from
another or try to engage in power plays, i.e., behaviors that can be detrimental to
the firm.
The list below contains the issues that most family businesses face:
Participation -- who can participate in the family business and under what
circumstances.
Leadership and ownership -- how to prepare the next generation to
assume responsibility for the business.
Letting go -- how to help the entrepreneur let go of the family business.
Liquidity and estate taxes.
Attracting and retaining nonfamily executives.
Compensation of family members -- equality versus merit.
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Successors -- who chooses and how to choose among multiple
successors.
Strengthening family harmony.
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References
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