1242018 Strayer University Bookshelf Acp Financial Theory Practic ✓ Solved
12/4/2018 Strayer University Bookshelf: ACP Financial Theory & Practice 1/ PRINTED BY: [email protected] . Printing is for personal, private use only. No part of this book may be reproduced or transmitted without publisher's prior permission. Violators will be prosecuted. A restricted voting rights provision automatically deprives a shareholder of voting rights if he or she owns more than a speciied amount of stock.
Interlocking boards of directors occur when the CEO of Company A sits on the board of Company B and B’s CEO sits on A’s board. A stock option provides for the purchase of a share of stock at a ixed price, called the exercise price, no matter what the actual price of the stock is. Stock options have an expiration date, after which they cannot be exercised. An Employee Stock Ownership Plan (ESOP) is a plan that facilitates employees’ ownership of stock in the company for which they work. Questions (13-1) Deine each of the following terms: a.
Agent; principal; agency relationship b. Agency cost c. Basic types of agency conlicts d. Managerial entrenchment; nonpecuniary beneits e. Greenmail; poison pills; restricted voting rights f.
Stock option; ESOP (13-2) What is the possible agency conlict between inside owner/managers and outside shareholders? (13-3) What are some possible agency conlicts between borrowers and lenders? (13-4) What are some actions an entrenched management might take that would harm shareholders? (13-5) How is it possible for an employee stock option to be valuable even if the irm’s stock price fails to meet shareholders’ expectations? 12/4/2018 Strayer University Bookshelf: ACP Financial Theory & Practice 2/4 Mini Case Suppose you decide (as did Steve Jobs and Mark Zuckerberg) 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 and then to buy a yacht and take off for the South Paciic 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 irst begin operations, assuming you are the only employee and only your money is invested in the business, would any agency conlicts exist? Explain your answer. 12/4/2018 Strayer University Bookshelf: ACP Financial Theory & Practice 3/ PRINTED BY: [email protected] . Printing is for personal, private use only. No part of this book may be reproduced or transmitted without publisher's prior permission.
Violators will be prosecuted. b. If you expanded and hired additional people to help you, might that give rise to agency problems? 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 conlict might occur? d. Suppose your company raises funds from outside lenders.
What type of agency costs might occur? How might lenders mitigate the agency costs? 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 irm’s value. f.
What is corporate governance? List ive corporate governance provisions that are internal to a irm and are under its control. g. What characteristics of the board of directors usually lead to effective corporate governance? h. List three provisions in the corporate charter that affect takeovers. i. Briely describe the use of stock options in a compensation plan.
What are some potential problems with stock options as a form of compensation? j. What is block ownership? How does it affect corporate governance? k. Briely explain how regulatory agencies and legal systems affect corporate governance. 12/4/2018 Strayer University Bookshelf: ACP Financial Theory & Practice 4/ PRINTED BY: [email protected] .
Printing is for personal, private use only. No part of this book may be reproduced or transmitted without publisher's prior permission. Violators will be prosecuted.
Paper for above instructions
Agency Relationships and Financial Theory in Corporate GovernanceUnderstanding Agency Relationships
At the core of corporate finance and governance lies the concept of the agency relationship. An agency relationship exists when one party, known as the principal, delegates authority to another party, called the agent, to act on their behalf. In a corporate setting, shareholders (principals) employ managers (agents) to run the company. The essence of this relationship is trust; shareholders expect managers to make decisions that align with their best interests (Jensen & Meckling, 1976).
When starting the business and funding it solely with personal capital, agency conflicts are minimal because the owner-manager has full control and interest in the company's success. However, as the business expands and employees are hired, agency issues may arise as employees may not be as motivated to act in the owners' best interests, leading to potential inefficiencies and misalignments in objectives (Fama & Jensen, 1983).
Agency Conflicts in Expanding Companies
When additional staff members are hired, the relationship between the owner-manager and employees becomes one of agency whereby the manager (the agent) is expected to act in the best interests of the owner (the principal). Agency problems emerge here due to differing goals; while the owner desires profit maximization and efficiency, employees may prioritize job security and work-life balance (Bebchuk & Fried, 2004). Thus, performance incentives or monitoring mechanisms are essential to align these incentives and mitigate potential agency costs.
If the owner-manager sells stock to outside investors but retains control of the company, conflicts may arise between the goals of these outside shareholders and the owner-manager. Outside investors typically seek dividends and stock appreciation, while the owner-manager may focus on long-term growth, personal benefits, or operating operational autonomy without perspective consideration of shareholder interests (Shleifer & Vishny, 1997). This divergence can lead to agency problems, particularly if the owner's interests are not aligned with those of the shareholders.
When acquiring funds from outside lenders, agency costs may differ, as lenders are primarily concerned with repayment rather than growth. The issue can arise if the manager takes undue risks that could jeopardize loan repayment—such as investing in high-risk projects without considering the financial implications for the lenders. Lenders can mitigate these agency costs through various mechanisms, such as requiring collateral, imposing covenants, or conducting thorough due diligence before providing funds (Myers, 2001).
Managerial Entrenchment and Value Destruction
If the company succeeds and the founder no longer possesses controlling stock, managerial entrenchment may result in several detrimental behaviors that can harm the firm’s value. Managerial entrenchment occurs when management seeks to maintain their position irrespective of shareholder interests. Potential actions include:
1. Excessive Perks: Managers may prioritize personal benefits over firm profitability, indulging in luxuries financed by company resources (Bebchuk & Fried, 2004).
2. Risk Aversion: Avoiding risk can lead to missed growth opportunities; entrenched managers may opt for safe investments at the expense of innovation (Berger, 1997).
3. Underspending on R&D: Entrenched management might not invest in necessary research and development initiatives needed for long-term competitiveness (D’Aurizio, 2020).
4. Poor Decisions: Managers may make decisions that perpetuate their power rather than maximizing shareholder value, including rejecting mergers or acquisitions that could make them redundant (Jensen, 1983).
5. Misleading Financial Reporting: To protect their status, managers may present overly optimistic forecasts or engage in accounting practices that mask underperformance (Healy & Wahlen, 1999).
6. Resistance to Shareholder Initiatives: Entrenched management may resist shareholder campaigns for changes in governance, especially if it threatens their power (Macey & O'Hara, 2003).
Corporate Governance and Its Provisions
Corporate governance refers to the structures and processes through which corporations are directed and controlled, which includes the relationships among the stakeholders involved (OECD, 2004). Good corporate governance ensures that the interests of shareholders are protected and that managerial actions align with shareholder value maximization.
Numerous provisions for internal governance exist within firms:
1. Board of Directors: An effective board provides oversight and ensures that management acts in the best interests of the shareholders.
2. Performance-Based Compensation: Aligning managerial compensation with company performance can mitigate agency conflicts (Murphy, 1999).
3. Formal Reporting Mechanisms: Regular, detailed reports on company performance can improve transparency and help shareholders make informed decisions (Bushman & Smith, 2001).
4. Shareholder Rights: Clear definitions of shareholders' rights facilitate checks and balances between management and ownership (Coffee, 1991).
5. Audit Committees: Independent committees can enhance oversight of financial reporting processes and prevent managerial misconduct (Beasley, 1996).
Effective Governance Characteristics
An effective board of directors typically exhibits several key characteristics that support strong corporate governance, including:
- Independence: Independent directors can provide objective oversight.
- Diversity: A diverse board can present a range of perspectives and improved decision-making (Carter et al., 2003).
- Relevant Experience: Directors with industry-specific knowledge or managerial experience can enhance governance quality (Raheja, 2005).
- Commitment: Active participation in board meetings and an understanding of their responsibilities contribute positively to governance (Krause et al., 2014).
- Accountability: Mechanisms for holding board members accountable for their decisions foster responsibility (Adams & Ferreira, 2007).
Takeover Provisions and Stock Options
Provisions in the corporate charter can significantly impact takeovers, including:
1. Poison Pill Strategies: Rights issues that dilute shares to deter hostile takeovers (Weisbach, 1988).
2. Staggered Board Terms: Prevents rapid changes in board composition, making hostile takeovers difficult.
3. Supermajority Voting Requirements: Requiring a high percentage of shareholder votes to approve a takeover bid can deter unwanted offers (Zhang, 2012).
Regarding stock options, they are often employed as part of compensation plans to align the interests of managers with those of shareholders, permitting employees to purchase company stock at a fixed price. However, they bear potential downfalls, such as:
- Short-Term Focus: Managers might prioritize boosting stock prices in the short term rather than sustainable growth (Kumar & Kalyanaraman, 2008).
- Dilution of Current Shareholder Value: Issuing too many options may dilute the ownership stake of existing shareholders (Hall & Murphy, 2003).
Conclusion
Effective corporate governance is paramount in ensuring that the interests of various stakeholders are aligned within the agency relationships at play in a company. Mechanisms set in place facilitate checks and balances and help overcome potential agency conflicts that can arise as a business grows. Understanding these concepts and their implications allows both existing and potential investors to navigate the complexities of corporate governance.
References
1. Adams, R. B., & Ferreira, D. (2007). A theory of friendly boards. Journal of Finance, 62(1), 217-250.
2. Beasley, M. S. (1996). An empirical analysis of the relation between board of director composition and financial statement fraud. The Accounting Review, 71(4), 443-465.
3. Bebchuk, L., & Fried, J. (2004). Pay without performance: The unfulfilled promise of executive compensation. Harvard University Press.
4. Berger, P. G. (1997). The role of corporate governance in risk management: Evidence from the S&P 500. Journal of Risk and Insurance, 64(2), 156-167.
5. Bushman, R. M., & Smith, A. J. (2001). Financial accounting information and corporate governance. Journal of Accounting and Economics, 32(1), 237-333.
6. Carter, D. A., Simkins, B. J., & Simpson, W. G. (2003). Corporate governance, board diversity, and firm value. The Financial Review, 38(1), 33-53.
7. Coffee, J. C. (1991). Liquidity versus control: The institutional investor as a perceived threat. Yale Law Journal, 91(6), 1367-1400.
8. D’Aurizio, L. (2020). Corporate governance, risk, and performance: Evidence from R&D intensive manufacturing firms. Journal of Business Research, 115, 225-233.
9. Fama, E. F., & Jensen, M. C. (1983). Separation of ownership and control. Journal of Law and Economics, 26(2), 301-325.
10. Hall, B. J., & Murphy, K. J. (2003). The trouble with stock options. Journal of Economic Perspectives, 17(3), 49-70.
This text provides an in-depth understanding of agency relationships, the conflicts that can arise within, and mechanisms of corporate governance—a foundational aspect of financial theory and practice.