Chapter 2

Financial Goals and Corporate Governance

Copyright 2010 Pearson Prentice Hall. All rights reserved.

Who Owns the Business?

Most companies are created by entrepreneurs who are either individuals or a small set of partners. In either case they may be the members of a family. Over time, however, some firms may choose to go public via an initial public offering or IPO.

Copyright 2010 Pearson Prentice Hall. All rights reserved.

2-2

Exhibit 2.1 Who Owns the Business?

[Insert Exhibit 2.1]

Copyright 2010 Pearson Prentice Hall. All rights reserved.

2-3

Separation of Ownership from Management The change in ownership from 100% privately held toward an increased share of publicly traded shares brings along with it the probability that a firm may be managed by hired professionals and not the owners. This raises the possibility that ownership and management may not be perfectly aligned in their business and financial objectives, the so called agency problem.
2-4

Copyright 2010 Pearson Prentice Hall. All rights reserved.

The Goal of Management

Maximization of shareholders wealth is the dominant goal of management in the Anglo-American world. In the rest of the world, this perspective still holds true (although to a lesser extent in some countries). In Anglo-American markets, this goal is realistic; in many other countries it is not.

Copyright 2010 Pearson Prentice Hall. All rights reserved.

2-5

The Goal of Management

There are basic differences in corporate and investor philosophies globally. In this context, the universal truths of finance become culturally determined norms.

Copyright 2010 Pearson Prentice Hall. All rights reserved.

2-6

Shareholder Wealth Maximization

In a Shareholder Wealth Maximization model (SWM), a firm should strive to maximize the return to shareholders, as measured by the sum of capital gains and dividends, for a given level of risk. Alternatively, the firm should minimize the level of risk to shareholders for a given rate of return.

Copyright 2010 Pearson Prentice Hall. All rights reserved.

2-7

Shareholder Wealth Maximization

The SWM model assumes as a universal truth that the stock market is efficient. An equity share price is always correct because it captures all the expectations of return and risk as perceived by investors, quickly incorporating new information into the share price. Share prices are, in turn, the best allocators of capital in the macro economy.
Copyright 2010 Pearson Prentice Hall. All rights reserved.

2-8

Shareholder Wealth Maximization

The SWM model also treats its definition of risk as a universal truth. Risk is defined as the added risk that a firms shares bring to a diversified portfolio. Therefore the unsystematic, or operational risk, should not be of concern to investors (unless bankruptcy becomes a concern) because it can be diversified. Systematic, or market, risk cannot however be eliminated.

Copyright 2010 Pearson Prentice Hall. All rights reserved.

2-9

Shareholder Wealth Maximization

Agency theory is the study of how shareholders can motivate management to accept the prescriptions of the SWM model. Liberal use of stock options should encourage management to think more like shareholders. If management deviates too extensively from SWM objectives, the board of directors should replace them. If the board of directors is too weak (or not at armslength) the discipline of the capital markets could effect the same outcome through a takeover. This outcome is made more possible in Anglo-American markets due to the one-share one-vote rule.

Copyright 2010 Pearson Prentice Hall. All rights reserved.

2-10

Shareholder Wealth Maximization

Long-term value maximization can conflict with short-term value maximization as a result of compensation systems focused on quarterly or near-term results. Short-term actions taken by management that are destructive over the long-term have been labeled impatient capitalism. This point of debate is often referred to a firms investment horizon (how long it takes for a firms actions, investments and operations to result in earnings).

Copyright 2010 Pearson Prentice Hall. All rights reserved.

2-11

Shareholder Wealth Maximization

In contrast to impatient capitalism is patient capitalism. This focuses on long-term SWM. Many investors, such as Warren Buffet, have focused on mainstream firms that grow slowly and steadily, rather than latching on to high-growth but risky sectors.

Copyright 2010 Pearson Prentice Hall. All rights reserved.

2-12

Stakeholder Capitalism Model

In the non-Anglo-American markets, controlling shareholders also strive to maximize long-term returns to equity. However, they are more constrained by other powerful stakeholders. In particular, labor unions are more powerful than in the Anglo-American markets. In addition, Governments interfere more in the marketplace to protect important stakeholder groups, such as local communities, the environment and employment.
Copyright 2010 Pearson Prentice Hall. All rights reserved.

2-13

Stakeholder Capitalism Model

The SCM model does not assume that equity markets are either efficient or inefficient. The inefficiency does not really matter, because the firms financial goals are not exclusively shareholder-oriented, because they are constrained by the other stake-holders. The SCM model assumes that long-term loyal shareholders those typically with controlling interests should influence corporate strategy, rather than the transient portfolio investor.

Copyright 2010 Pearson Prentice Hall. All rights reserved.

2-14

Stakeholder Capitalism Model

The SCM model assumes that total risk i.e. operating and financial risk does count. It is a specific corporate objective to generate growing earnings and dividends over the long run with as much certainty as possible. In this case, risk is measured more by product market variability than by short-term variation in earnings and share price.

Copyright 2010 Pearson Prentice Hall. All rights reserved.

2-15

Operational Goals for MNEs

The MNE must determine for itself proper balance between three common operational financial objectives:
maximization of consolidated after-tax income; minimization of the firms effective global tax burden; correct positioning of the firms income, cash flows, and available funds as to country and currency.

These goals are frequently incompatible, in that the pursuit of one may result in a less-desirable outcome in regard to another.

Copyright 2010 Pearson Prentice Hall. All rights reserved.

2-16

Corporate Governance
Although the governance structure of any company domestic, international, or multinational is fundamental to its very existence, this subject has become a lightning rod for political and business debate in the past few years. Spectacular failures in corporate governance have raised issues about the very ethics and culture of the conduct of business.
Copyright 2010 Pearson Prentice Hall. All rights reserved.

2-17

Corporate Governance
The single overriding objective of corporate governance is the optimization over time of the returns to shareholders. In order to achieve this goal, good governance practices should focus the attention of the board of directors of the corporation by developing and implementing a strategy that ensures corporate growth and improvement in the value of the corporations equity.
Copyright 2010 Pearson Prentice Hall. All rights reserved.

2-18

Corporate Governance
The most widely accepted statement of good corporate governance practices are established by the OECD:
The corporate governance framework should protect shareholders rights. The corporate governance framework should ensure the equitable treatment of all shareholders. Stakeholders should be involved in corporate governance. Disclosure and transparency is critical. The board of directors should be monitored and held accountable for what guidance it gives.

Copyright 2010 Pearson Prentice Hall. All rights reserved.

2-19

Structure of Corporate Governance

The modern corporations actions and behaviors are directed and controlled by both internal forces and external forces. The internal forces, the officers of the corporation and the board of directors are those directly responsible for determining both the strategic direction and the execution of the companys future. The external forces include equity markets in which the shares are traded, the analysts who critique the companys investment prospects and external regulators, among others.

Copyright 2010 Pearson Prentice Hall. All rights reserved.

2-20

Exhibit 2.2 The Structure of Corporate Governance

Copyright 2010 Pearson Prentice Hall. All rights reserved.

2-21

Structure of Corporate Governance

The board of directors is the legal body that is accountable for the governance of the corporation. The senior officers of the corporation are the creators and directors of the corporations strategic and operational direction.

Copyright 2010 Pearson Prentice Hall. All rights reserved.

2-22

Structure of Corporate Governance

Equity markets should reflect the markets constant evaluation of the promise and performance of the company. Debt markets should reflect the companys ability to repay its debt in a timely and efficient manner. Auditors and legal advisors are responsible for providing an external professional opinion as to the fairness, legality and accuracy of corporate financial statements. Regulators work to ensure, among other things, that a regular and orderly disclosure process of corporate performance is conducted so that investors may evaluate a companys investment value with accuracy

Copyright 2010 Pearson Prentice Hall. All rights reserved.

2-23

Exhibit 2.3 Comparative Corporate Governance Regimes

Copyright 2010 Pearson Prentice Hall. All rights reserved.

2-24

Failures in Corporate Governance

Failures in corporate governance have become increasingly visible in recent years. In each case, prestigious auditing firms missed the violations or minimized them, presumably because of lucrative consulting relationships or other conflicts of interest. In addition, security analysts urged investors to buy the shares of firms they knew to be highly risky (or even close to bankruptcy). Top executives themselves were responsible for mismanagement and still received overly generous compensation while destroying their firms.

Copyright 2010 Pearson Prentice Hall. All rights reserved.

2-25

Corporate Governance Reform

Within the United States and the United Kingdom, the main corporate governance problem is the one treated by agency theory: with widespread share ownership, how can a firm align managements interest with that of the shareholders? Because individual shareholders do not have the resources or the power to monitor management, the U.S. and U.K. markets rely on regulators to assist in the agency theory monitoring task. Outside the U.S. and U.K., large, controlling shareholders are in the majority these entities are able to monitor management in some ways better than the regulators can.

Copyright 2010 Pearson Prentice Hall. All rights reserved.

2-26

The Sarbanes-Oxley Act

This act was passed by the US Congress, and signed by President George W. Bush during 2002 and has three major requirements:

CEOs of publicly traded companies must vouch for the veracity of published financial statements; corporate boards must have audit committees drawn from independent directors; companies can no longer make loans to corporate directors, and Companies must test their internal financial controls against fraud

Penalties have been spelled out for various levels of failure. Most of its terms are appropriate for the US situation, but some terms do conflict with practices in other countries.

Copyright 2010 Pearson Prentice Hall. All rights reserved.

2-27

Additional Corporate Governance Issues

Board structure and compensation issues Transparency, accounting and auditing Minority shareholder rights

Copyright 2010 Pearson Prentice Hall. All rights reserved.

2-28

Mini-Case Questions: Governance Failure at Enron

Which parts of the corporate governance system, internal and external, do you believe failed Enron the most? How do you think each of the individual stakeholders and components of the corporate governance system should have either prevented the problems at Enron or acted to resolve the problems before they reached crisis proportions? If all publicly traded firms in the United States are operating within the same basic corporate governance system as Enron, why would some people believe this was an isolated incident, and not an example of many failures to come?

Copyright 2010 Pearson Prentice Hall. All rights reserved.

2-29

Chapter 2

Additional Chapter Exhibits

Copyright 2010 Pearson Prentice Hall. All rights reserved.

Exhibit 2.4 Country Governance Rankings 2008

Copyright 2010 Pearson Prentice Hall. All rights reserved.

2-31

Exhibit 2.5 The Premium Paid for Voting Shares: Accounting Standards

Copyright 2010 Pearson Prentice Hall. All rights reserved.

2-32

Exhibit 2.6 The Premium Paid for Voting Shares: Law Enforcement

Copyright 2010 Pearson Prentice Hall. All rights reserved.

2-33

Exhibit 2.7 U.S. Director Independence 2008

Copyright 2010 Pearson Prentice Hall. All rights reserved.

2-34

Exhibit 2.8 Potential Responses to Shareholder Dissatisfaction

Copyright 2010 Pearson Prentice Hall. All rights reserved.

2-35

Exhibit 1 Enrons Actual Operating Income

Copyright 2010 Pearson Prentice Hall. All rights reserved.

2-36