Course learning outcomes
● Agency conflicts ➔ using international corporate governance
● Control and ownership
● Managers
● Payout decision
● IPOs (initial public offering)
● Debtholder’s conflicts
● Socially responsible investment, corporate social responsibility (SRI, CSR)
● Behavioral biases
Introduction
After 2007-08 financial crisis, people lost their confidence in capitalism.
In 2007 financial crisis only in US 9 million people lost their jobs and 10 million their homes.
Look at the world in 2018, the richest 28 people owned the same wealth as the 3.8 billion
poorest citizens in the world.
No need to mention the environmental catastrophes and global warming. We humans create a
cost of $4.7 trillion every year due to environmental damages.
Does traditional Financial Management fail?
1. Can corporations create profit for investors as well as value for society?
2. Are the participants of corporations bound by a common purpose and long run goal?
3. Do leaders inspire and engage their workforce?
4. Do investors involve active monitoring and engagement?
What do managers care in traditional financial management?
Manager (Agent) ➔ goal: maximize the value of the business (firm)
● Investment decision
○ Invest in assets that earn a return greater than the minimum acceptable hurdle
rate
● Financing decision
○ Find the right kind of debt for your firm and the right mix of debt and equity to
fund your operations
● Payout decision
○ If you cannot find a lucrative investment that satisfies you minimum acceptable
rate, then distribute the cash to the owners
What is value?
What is the objective of a firm?
➔ I don’t know, it´s subjective
What was the secret of Apple Co.?
➔ Steve Jobs and his friends have followed a radically different approach to business: creating
both value for society and profit for investors.
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,Case: Turing
Case: Merck ➔ grow the pie
Grow the pie - Alex Edman
“A company thus serves not only investors, but also colleagues, customers, suppliers, the
environment, communities, and the government. Together these other constituencies are known
as enterprise’s stakeholders who collectively enjoy value.”
Pie mentality
● Ignoring the pie is costly
○ More pressure on regulators
○ If we only focus on shareholder maximization, the trust on capitalism may decay
● Trade-off is there
○ Same people may be out as a result of creative destruction
○ Pareto improvements ➔ when the pie grows, it is always possible to find a way of
compensating those slices that would otherwise fall (Coarse Theorem)
● Externalities ➔ the consequence that enterprises exert on society, but don’t feedback
into their earnings
In financial management we will not ignore the human element. Our assumptions will be that
people are normal (sometimes irrational).
Ch 1 Defining corporate governance and key
theoretical models
Corporate governance will help us minimize conflicts.
Shareholder ➔ residual claimants
Stakeholders ➔ customers, employees, people, etc.
Who is the owner of the firm? (share- or stakeholders)
No universal agreement on the goal of corporation.
It depends on several factors such as: culture electoral system, legal tradition, governments’
political orientation and so on.
Types of conflicts
● Shareholders vs. managers
● Shareholders vs. debtholders
● Shareholders vs. non-financial shareholders
● Large shareholders vs. minor shareholders
2
,Corporate governance system is the combination of mechanisms which ensure that the
management runs the firm for the benefit of one or several stakeholders (shareholders,
creditors, suppliers, clients, employees).
Principal-agent problem
Moral hazard ➔ once a contract is signed, it may be that the interest of the agent is to behave
badly or less responsibly.
Agency problem arises when an agent acts on behalf of a principal ➔ may not be in the best
interest of the principal
● Insufficient effort
● Extravagant investment
● Entrenchment
● Self-dealing
● Lack of transparency
● Accounting manipulations
How to mitigate the principal-agent problem ➔ Complete contracts
● What the managers must do in each future contingency of the world
● What the distribution of profits will be in each contingency
Asymmetric information ➔ moral hazard
The principal cannot keep track of the agent’s actions at all times.
Usually the agent has more information
Separation of ownership and control
Jensen & Meckling (1976) ➔ principal-agent problem
Firm grows ➔ sell (1-α)% of the shares
Owner-manager Agent
● No conflict of interest ● She has only α% of the shares
● Maximum incentive to work harder ● Conflict of interest starts
● Additional revenue will always be ● Less incentive to work harder
accrued by her ● If she works harder, the fruits will go
to shareholders
Principal Agent
● Has the required funds ● She knows how to run the firm
● Not qualified to run the firm ● But lack of funds to finance its
operations
What if the manager runs the company in her interest rather than the principal? ➔ agency cost
1. Monitoring
● It consists of the principal observing the agent and keeping a record of the
agent’s behavior
● Also intervening in various ways to constraint the agent’s behavior and to avoid
unwanted actions
3
, 2. Bonding cost
● The costs incurred by the agent in order to signal credibly to the principal that she
will act in the interest of the principal
● Ex. buy shares
3. Residual loss
● Incurred by the principal
● Agent may not make the decision to maximize the value of the firm
Agency problems
● perquisites/ fringe benefits
○ Consumption by the management
● Empire building/ Free Cash Flow problem
○ The management pursuing growth rather than shareholder maximization
Perquisites
● Consumption by the management
○ Accrue to the managers
○ Born to the shareholder
● Ex. CEO mansions, corporate jets, giving the job to family members
Empire building
● The management pursuing growth rather than shareholder maximization
● Management should invest only in projects with NPV>0
● NPV<0 ➔ destroys shareholder value
Why does a manager enjoy increasing size of the firm?
● Power and social status
● Managerial compensation grows with the company size
Managerial entrenchment
● Shielding themselves against hostile takeovers
● Family firms and suboptimal human capital allocations
● Quite like managerial shirking ➔ managerial risk aversion
Firm value = Debt + Equity
Debt has seniority on firm assets. But limited claim up to value of
debt.
Equity holder gets the leftover on firm assets unlimited gain.
● Highly debt financed firm may gamble other people’s money
● If they fail, the cost is borne to the debtholder but if they are
successful, there will be a massive pay-off for the
shareholders
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, There is an optimal mix of debt and equity
which minimizes the sum of the agency costs
of debt and equity ➔ optimal capital
structure.
Usually there are 2 different types of shareholders
● Controlling shareholders
● Minority shareholders
It is about expropriation of minority shareholders
● Tunneling ➔ large shareholders transferring the firm’s assets or profits into his own
pockets
● Transfer pricing ➔ overcharging the firm for services or assets provided
● Nepotism ➔ large family shareholders appointing family members to top management
positions rather than the most suitable candidates on the job market
● Infighting ➔ likely to deflect management time as well as other firm resources
Related-party transaction ➔ tunneling, transfer pricing.
Ownership pyramids ➔ more tempted to engage in related-party transactions
Alternative forms of organization and ownership
Stock ownership Mutual organization
● Traditional stock exchange ● Building society or bank ➔ can be
corporations savers and borrowers
● P&A problem is low ● P&A problem is severe
● $1=1 vote ● 1 person=1 vote
● Stock price as performance measure ● Not listed in stock market
● High conflict of interest between ● Low degree of conflict, because
stakeholders and owners owners are the stakeholders
● Stock market has disciplinary function ● Lower market discipline
➔ lots of monitoring ● Members can withdraw their money
● Members can sell their stock, just a any time ➔ pure loss in fund
replacement
What is ownership? ➔ cash flow rights
Cash flow rights give the holder a pro rata right to the firm’s earnings. In case of liquidation,
cash flow rights give the owner a pro rata right to the firm’s assets (after stakeholder claims
have been met).
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,Control is defined as control right ➔ stems from voting rights.
Voting rights give the holder the right to make certain decisions about the firm and/or vote in
favor of members of the company’s board of directors.
What are the other channels of ownership?
● Founder ➔ may have right to appoint specific number of board members, as long as the
founder keeps a particular percentage of the assets
● Golden share ➔ another channel, sometimes held by government, which enables the
government to block the takeover of a firm by a foreign investor
● Management’s de facto control ➔ management can control firm de facto in the absence
of a large shareholder
Ch 2 Corporate control across the world
● Ownership structure?
● Legal traditions?
● How do conflicts change?
● Shareholder and credit holder rights?
● Banking systems?
In UK/US / Outsider system
● A very different ownership structure from the rest of the world
● The firms are widely held
● Institutional shareholders are the main type of owners
● The main conflict ➔ manager vs. shareholder
● More developed stock market
● More hostile takeovers
In continental Europe / Insider system
● Ownership concentration is there
● Family firms widespread ➔ better monitoring
● Main conflict ➔ minority vs. majority shareholders
● Bank control is important, as a result of proxy right
Outsider system ➔ badly performing managers are punished by the outsiders (minority
shareholders) due to high investor protection rights.
Insider system ➔ badly performing managers are punished by the insiders (majority/large
shareholders)
What about ownership structure in the Netherlands?
In the Netherlands institutional shareholders are the main type.
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,Initial Public Offering (IPO)= the firm’s obtaining a listing on a stock exchange and offering its
shares to the general public for the very first time
● Primary shares ➔ issued by the company to increase equity capital
● Secondary shares ➔ the founder/owner sells their shares directly
Firms usually issue primary and secondary shares at the same time.
Evolution of control after the IPO
UK vs. Germany
How does the percentage of equity held by the initial shareholder change over time?
● There is a rapid separation of ownership and control in UK firms after IPO
● In German IPOs, a sizeable degree of control remains with the initial shareholders a long
time after the IPO
How to define corporate control?
The regulations differ across countries
● Blocking minority ➔ 25%
○ Ex. takeover, liquidation, M&A may require supermajority. In this case, the power
of blocking minority appears
● Simple majority ➔ 50%
○ Decisions on daily operations, investments, but not changing the destiny of the
firm
● Supermajority ➔ 75%
○ Big strategic decisions
Controlling minority in Europe is much more widespread than UK and US ➔ takeover is not
easy in Europe, much more difficult than UK and US.
US & UK Continental Western Europe
● Most firms are widely held ● Majority of votes is held by one
● 3 largest shareholders vote for less shareholder or group of shareholders
than 30% ● Most firms have 1 shareholder with
● Conflict ➔ shareholder and blocking minority
management, typical P&A ● Conflict ➔ minority and large
shareholders
Corporate control in Asia
Except Japan and Taiwan, family ownership plays a very important role in Asia.
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, Japan
● Keiretsus ➔ a group of industrial companies with close ties to a single bank which acts
as the principal lender to the group
● Banks
○ The banks usually have ownership of group companies (usually cross holdings
between the group companies)
○ Banks are widely held and these banks have the ownership of the group
companies
● After 1997 Asian financial crisis
○ CG practices have started to change in Japan. The cross holdings have started
to diminish
Korea
● Chaebols ➔ a group of industrial companies controlled by a family firm
● Cross holdings
○ Korea is also dominated by cross holdings
○ But the new cross holdings have been forbidden in Korea since 2014
Chaebols
● The benefit is creating cheap and quick financing when needed
● With cross holdings firms can shield from outside disciplinary actions such as takeovers
After ‘97 crisis, these chaebol’s channeled funds from member firms with few investment
opportunities to those with many such options.
This may suggest the existence of efficient internal capital markets within such business
groups.
Such markets work well for business groups that are in the form of ownership pyramids rather
than horizontal structures.
China
● State Owned Companies (SOEs) have complex control and ownership structures ➔
average 32% government, 4% foreign investors
● Since 80s, managers of SOE have power of decision making
● Decision making power has transferred from government to firm level
● 1990 Shenzhen Stock Exchange founded
● 1991 Shanghai Stock Exchange founded
● 5 types of shareholders
○ Central government
○ Legal persons (institutional founders)
○ Employees
○ Domestic institutions
○ Foreign investors (B and H) shares
■ H shares issued in Hong Kong stock exchange (have more stringent
regulations)
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