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.

b. Agency costs include all costs borne by shareholders to encourage managers to

maximize a firm’s stock price rather than act in their own self-interests. The three
major categories of agency costs are (1) expenditures to monitor managerial actions,
such as audit costs; (2) expenditures to structure the organization in a way that will
limit undesirable managerial behavior, such as appointing outside investors to the
board of directors; and (3) opportunity costs which are incurred when shareholder-
imposed restrictions, such as requirements for stockholder votes on certain issues,
limit the ability of managers to take timely actions that would enhance shareholder
wealth.

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.

d. Managerial entrenchment occurs when a company has such a weak board of directors
and has such strong anti-takeover provisions in its corporate charter that senior
managers feel there is very little chance that they will be removed. Non-pecuniary
benefits are perks that are not actual cash payments, such as lavish offices,
memberships at country clubs, corporate jets, and excessively large staffs.

Mini Case: 13 - 1
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website, in whole or in part.
 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.

f. A stock option allows its owner to purchase a share of stock at a fixed price, called
the strike price, no matter what the actual price of the stock is. Stock options always
have an expiration date, after which they cannot be exercised. A restricted stock
grant allows an employee to buy shares of stock at a large discount from the current
stock price, but the employee is restricted from selling the stock for a specified
number of years. An Employee Stock Ownership Plan, often called an ESOP, is a
type of retirement plan in which employees own stock in the company.

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.

13-3 After the loan is originated, borrowers might make decisions that are harmful to the
lender. For example, borrowers might invest in risky projects. From the borrower’s point
of view, risky project are like options. If the project pays off big, most of the benefits
accrue to the borrowers (the creditors just get the principal back). If the project fails by a
little or by a lot, the borrower doesn’t get anything. So borrowers have an incentive to
take on riskier projects. Borrowers also might take on additional debt. Lenders anticipate
this, and charge a higher interest rate.

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.

13-5 Stock options in compensation plans usually are issued with a strike price equal to the
current stock price. As long as the stock price increases, the option will become valuable,
even if the stock price doesn’t increase as much as investors expect.

Mini Case: 13 - 2
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website, in whole or in part.
 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) hires another individual or organization, called an agent, to perform some service
and (2) then delegates decision-making authority to that agent.
No agency problem would exist. A potential agency problem arises whenever the
manager of a firm owns less than 100 percent of the firm’s common stock, or the firm
borrows. Since you are the only employee and only your money is invested in the
business, you own 100 percent of the firm. As a single proprietor presumably you
will operate the business so as to maximize your own welfare, with welfare measured
in the form of increased personal wealth, more leisure, or perquisites.

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
agency problems. An agency relationship could exist between you and your
employees if you, the principal, hired the employees to perform some service and
delegated some decision-making authority to them.

Mini Case: 13 - 3
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website, in whole or in part.
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. However, if the owner/manager incorporates the business and then
sells some of the stock to outsiders, a potential conflict of interest immediately arises.
Notice that the value of the perquisites still accrues to the owner/manager, but the
cost of the perquisites is now partially born by the outsiders. This might even induce
the owner/manager to increase consumption of perquisite.

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,
the borrower could invest in risky projects or take on additional debt. Anticipating
such behavior, creditors might charge a higher than normal interest rate to
compensate for the possible risk. This high interest rate is an agency cost. Creditors
can protect themselves by (1) having the loan secured and (2) placing restrictive
covenants in debt agreements.

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.
3. Avoid difficult decisions (e.g., close plant) out of loyalty to friends in company.
4. Reject risky positive NPV projects to avoid looking bad if project fails; take on
risky negative NPV projects to try and hit a home run.
5. Avoid returning capital to investors by making excess investments in marketable
securities or by paying too much for acquisitions.
6. Massage information releases or manage earnings to avoid revealing bad news.

Mini Case: 13 - 4
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website, in whole or in part.
 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.

The provisions under a firm’s control are: (1) monitoring and discipline by the board
of directors; (2) charter provisions and bylaws that affect the likelihood of hostile
takeovers; (3) compensation plans; (4) capital structure choices; and (5) accounting
control systems.

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
over the nominating committee; (2) the board has a majority of true outsiders who
bring some type of business expertise to the board (and he board is not an interlocked
board); (3) the board is not too large; and (4) board members are compensated
appropriately (not too high, and some compensation is linked to company’s
performance).
.
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
exercise the option for several years (called the vesting period). Can’t exercise the
option after a certain number of years (called the expiration, or maturity, date).

Manager can underperform market or peer group, yet still reap rewards from options
as long as the stock price increases to above the exercise cost. Options sometimes
encourage managers to falsify financial statements or take excessive risks.

Mini Case: 13 - 5
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website, in whole or in part.
 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
company’s shares. Large institutional investors, such as CalPERS or TIAA-CREF,
often own large blocks. Blockholders often monitor managers and take active role,
leading to better corporate governance.

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
to financial markets, a lower cost of equity, increased in market liquidity, and less
noise in stock prices.

Mini Case: 13 - 6
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website, in whole or in part.
 Mini Case: 13 - 7
© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible
website, in whole or in part.