Chapter 4

Financial Goals
and Corporate
Governance
 Learning Objectives

• Examine the different ownership structures for

businesses globally and how this impacts the
separation between ownership and management—
the agency problem
• Explore the different goals of management—
stockholder wealth maximization versus
stakeholder capitalism
• Analyze how financial management differs between
the public traded and the privately held firm
• Evaluate the multitude of goals, structures, and
trends in corporate governance globally

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 Who Owns the Business?

• In global business today the ownership and

control of organizations varies dramatically
across countries and cultures.
• To understand how and why those
businesses operate, one must first
understand the many different ownership
structures.

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 Types of Ownership

• A public enterprise is a business owned by a

government
• A private enterprise is owned by a private
company or individual
• A business owned by a private party is
privately held.
– Becomes a publicly traded company if the owners
sell a portion of their ownership in the business
in the capital markets
• See Exhibit 4.1 for an overview of these
ownership distinctions
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 Exhibit 4.1 Business Ownership

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 Types of Ownership

• Any business can “go public” by listing a

portion of its ownership in the public
marketplace via an initial public offering.
• Conversely, some publicly traded firms go
private when a single investor or group buys
outstanding shares and ceases to trade.
• Family-controlled firms may prove to be
more profitable.

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 Separation of Ownership from
Management
• SOEs and widely held publicly traded
companies typically separate management
and ownership.
• This raises the possibility that ownership
and management may not be perfectly
aligned in their business and financial
objectives, the so-called agency problem.

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 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.

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 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.

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 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.

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 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.

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 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
firm’s 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.

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 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 restricted stock 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
“arms-length”) 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.

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 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
firm’s investment horizon (how long it takes
for a firm’s actions, investments and
operations to result in earnings).
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 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.

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 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.

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 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
firm’s 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.

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 Stakeholder Capitalism Model

• The objective of the privately held firm is to

maximize current and sustainable income.
• Exhibit 4.2 shows distinctions between
state-owned, publicly traded, and privately
held firms.

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 Exhibit 4.2 Public Versus Private
Ownership

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 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.

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 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 firm’s effective global tax burden;
– correct positioning of the firm’s 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.

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 Public/Private Hybrids

• Many firms are publicly traded but are still

heavily influenced or even controlled by
families.
• Exhibit 4.3 illustrates how family businesses
on average out-perform indexes of public
companies in the United States France,
Germany, and Western Europe.

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 Exhibit 4.3 The Superior
Performance of Family

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 Publicly Traded Versus Privately
Held: The Global Shift
• Exhibit 4.4 illustrates how the number of
U.S. publicly listed firms peaked in 1996 at
8,783. Today around 5,000 listings.
• The number of publicly listed firms world
wide peaked in 2008.
• U.S. listings as a % of worldwide listings of
publicly traded firms dropped from 33.3% in
1996 to 11% at year-end 2010.

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 Exhibit 4.4 Global Equity Share
Listings

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 Possible Causes in the Decline of
Publicly Traded Shares
• Sarbanes-Oxley has added reporting
requirements
• The growth of private equity markets
• The growth of Electronic Communication
Networks (ECNs) helped reduce transaction
costs, but also made it less profitable for
brokerage houses to research smaller firms.
Thus trading volume on smaller firms fell off
and some ceased trading at all.

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 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.

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 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
corporation’s equity.

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 Corporate Governance

• The most widely accepted statement of good

corporate governance practices has been
established by the OECD:
– Shareholder rights. Shareholders are the owners of
the firm, and their interests should take precedence
over other stakeholders.
– Board responsibilities. The board of the company is
recognized as the individual entity with final full legal
responsibility for the firm, including proper oversight of
management.
– Equitable treatment of shareholders. Equitable
treatment is specifically targeted toward domestic
versus foreign residents as shareholders, as well as
majority and minority interests.

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 Corporate Governance, cont.

– Stakeholder rights. Governance practices

should formally acknowledge the interests of
other stakeholders—employees, creditors,
community, and government.
– Transparency and disclosure. Public and
equitable reporting of firm operating and
financial results and parameters should be done
in a timely manner, and available to all interests
equitably.

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 Structure of Corporate
Governance
• The modern corporation’s actions and behaviors are
directed and controlled by both internal forces and
external forces (Exhibit 4.5).
• 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 company’s
future.
• The external forces include equity markets in which
the shares are traded, the analysts who critique the
company’s investment prospects and external
regulators, among others.

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 Exhibit 4.5 The Structure of Corporate
Governance

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 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
corporation’s strategic and operational
direction.

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 Structure of Corporate
Governance
• Equity markets should reflect the market’s constant
evaluation of the promise and performance of the
company.
• Debt markets should reflect the company’s 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 company’s investment
value with accuracy.

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 Comparative Corporate
Governance
• The need for a corporate governance process arise
from the separation of ownership from
management and from varying stakeholder views.
• Corporate governance regimes may be classified by
the evolution of business ownership over time (see
Exhibit 4.6).
• Exchange rate regimes are a function of:
– the financial market development;
– the degree of separation between management and
ownership;
– the concept of disclosure and transparency; and
– the historical development of the legal system.

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 Exhibit 4.6 Comparative Corporate
Governance Regimes

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 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.

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 Good Governance and Corporate
Reputation
• Good governance SHOULD matter.
• Exhibit 4.7 describes a set of governance
policies and practices

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 Exhibit 4.7 The Growing Consensus
on Good Corporate Governance

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 Corporate Governance Reform
• Within the U.S. and U.K., the main corporate
governance problem is the one treated by agency
theory: with widespread share ownership, how can
a firm align management’s 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.

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 The Sarbanes-Oxley Act

• This act was passed by the U.S. 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 U.S. situation, but
some terms do conflict with practices in other countries.

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 Corporate Governance Reform

• Poor performance of management usually

requires changes in management,
ownership, or both.
• Exhibit 4.8 illustrates some of the
alternative paths available to shareholders
when they are dissatisfied with firm
performance.

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 Exhibit 4.8 Potential Responses to
Shareholder Dissatisfaction

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 Corporate Responsibility and
Sustainability
• The purpose of the corporation is to
certainly create profits and value for its
stakeholders, but the responsibility of the
corporation is to do so in a way that inflicts
no costs on the environment and society
• Sustainability is often described as a goal,
while responsibility is an obligation of the
corporation.
– The obligation is to pursue profit, social
development, and the environment—but to do so
along sustainable principles.

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