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Financial Goals and Corporate Governance


Chapter 2 Financial Goals and Corporate Governance Corporate Governance Reform 3. Companies can not make loans to corporate directors 4. Companies must test their ... – PowerPoint PPT presentation

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Title: Financial Goals and Corporate Governance

Chapter 2
  • Financial Goals and Corporate Governance

The Goals of Chapter 2
  • Introduce different types of ownership of firms
  • Discuss the goal of management, and introduce the
    Shareholder Wealth Maximization Model (SWM) and
    the Stakeholder Capitalism Model (SCM)
  • Introduce the goals and structures of corporate
  • Compare different corporate governance regimes
  • Discuss the failure of corporate governance and
    the reform of corporate governance in the U.S.

Who Owns the Business?
Who Owns the Business?
  • Most companies are created by entrepreneurs who
    are either individuals or a small set of partners
  • Usually, founders are often the members of a
  • Most business begin their lives as 100 privately
    held, often by a family
  • Over time, however, some firms may choose to go
    public via an initial public offering (IPO)
  • Typically, only a relatively small percentage of
    the company shares is sold to the public in IPO
    (A to B in Exhibit 2.1)
  • Scenario 1 Sell more and more equity shares to
    investing public and become totally public traded
    firm (B to C or D in Exhibit 2.1)
  • Scenario 2 The private owners may choose to
    retain a major share, and the private owners can
    decide to have explicit control or not

Exhibit 2.1 Who Owns the Business?
Insert Exhibit 2.1
  • ? The other impact of IPO is that firm becomes
    subject to many of the increased legal,
    regulatory, and reporting requirement in most
  • ? In late 2005, a very large private firm, Koch
    Industries (U.S.), purchased all outstanding
    shares of Georgia-Pacific (U.S.), a very large
    publicly traded forest products company, and took
    Georgia-Pacific private
  • Georgia-Pacific is one of the world's leading
    manufacturers and distributors of tissue, pulp,
    paper, packaging, and related chemicals

Who Owns the Business?
  • In the U.S. and U.K., most corporations in stock
    markets are characterized by widespread ownership
    of shares
  • In the rest of world, ownership of corporations
    is usually characterized by controlling
  • Typical controlling shareholders are as follows
  • Government (e.g., privatized utilities)
  • Institutions (such as banks in Germany)
  • Family (such as in France and Asia)
  • France has the highest number of family
    businesses (about 65 of the CAC 40 firms are
    family owned)

Who Owns the Business?
  • Consortiums (??) (such as keiretsus in Japan and
    chaebols in South Korea)
  • A consortium is a huge enterprise including
    banks, industry companies, suppliers, and
    manufacturers as component firms
  • Usually, the cross-shareholding strategy is
    adopted by the management to maintain the control
    power for the whole enterprise

Goal of Management
The Goal of Management
  • Maximization of shareholders wealth is the
    dominant goal of management in the Anglo-American
    world, which usually includes the U.S., the U.K.,
    Canada, Australia, and New Zealand
  • In Anglo-American markets, this goal is
    realistic in many other countries it is not
    because these exists some difference in corporate
    and investor philosophies
  • In this section, two kinds of models are
    introduced, the Shareholder Wealth Maximization
    Model (SWM) and the Stakeholder Capitalism Model

Shareholder Wealth Maximization
  • In the 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
  • In other words, the firm should minimize the
    level of risk to shareholders for a given rate of
  • The SWM model assumes that the stock market is
    efficient such that the performance of managers
    can be reflected from the movement of stock
    prices quickly
  • That is, an equity share price is always correct
    because it incorporates new information quickly
    and thus reflects all the expectations of return
    and risk as perceived by investors

Shareholder Wealth Maximization
  • Risk is defined as the added risk that a firms
    shares bring into a diversified portfolio
  • Therefore the unsystematic should not be of
    concern to investors because it can be
  • Investors care about only systematic risk, which
    cannot be eliminated through diversification
  • The change in ownership from 100 privately held
    toward an increased share of publicly traded
    shares brings another impact 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

Shareholder Wealth Maximization
  • Agency problems Conflicts of interest between
    managers and stockholders
  • Empire building, avoid good but risky projects,
    or overconsume luxuries
  • Possible solutions
  • Compensation plans (bonus linked with the
    performance of the stock or executive stock
  • Penalty for underperformance (the board of
    directors can replace the manager)
  • Specialist monitoring (analysts, fund managers,
  • Discipline of the capital market (takeovers by
    other firms)

Shareholder Wealth Maximization
  • Long-term vs. short-term value maximization
  • Long-term value maximization can conflict with
    short-term value maximization as a result of
    compensation systems focused on near-term results
  • The other reason for seeking short-term value
    maximization for public firms is the requirement
    of periodical earning report (quarterly in the
  • Short-term actions taken by management that are
    destructive over the long-term have been labeled
    impatient capitalism
  • In contrast to impatient capitalism is patient
    capitalism, which focuses on long-term SWM
  • Note that the long-term or short-term is a
    relative notion compared with a firms investment
    horizon (how long it takes for a firms actions,
    investments, and operations to result in earnings)

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
  • For example, labor unions are more powerful than
    in France and South Korea, banks have significant
    influence on firms decision in Germany, etc.
  • In addition, governments interfere more in the
    market place to protect important stakeholder
    groups, such as local communities, the
    environment, and the employment
  • 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 due to the constraints
    imposed by other stakeholders

Stakeholder Capitalism Model
  • The SCM model assumes that long-term loyal
    shareholderstypically controlling
    shareholdersshould influence corporate strategy,
    rather than the transient (short-term) portfolio
  • The SCM model assumes that total risk, which is
    reflected from both the operating and financial
    risks, 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

  • The SWM could nurture some short-run oriented and
    impatient capital, but SCM can avoid this flaw
  • In the SCM, trying to meet the desires of
    multiple stakeholders leaves management without a
    clear goal
  • The SWM gets increasing focus in recent years
  • As more non-Anglo-American countries try to
    privatize their industries, focusing on the
    shareholder wealth seems a better strategy to
    attract international capital
  • Many shareholder-based MNEs are increasingly
    dominating their industry

Operational Objectives for MNEs
  • The MNE must determine for itself proper balance
    between three common operational financial
  • Maximization of consolidated after-tax income
    (primary goal)
  • Minimization of the firms effective global tax
  • Correct positioning of the firms income, cash
    flows, and available funds as to country and
  • Consolidated income is the total amount of the
    incomes of all subsidiaries in different local
    currencies expressed in the currency of the
    parent company
  • These objectives are frequently incompatible, in
    that the pursuit of one may result in a
    less-desirable outcome in regard to another
  • E.g., the first objective focuses on the current
    earnings, but the third objective focuses on
    generating sustainable cash flows in the future

Goals and Structures of Corporate Governance
Failures in Corporate Governance
  • For any company the corporate governance is
    fundamental to its existence
  • Moreover, many studies have continued to show the
    linkages between good governance (at both country
    and corporate level) and the lower cost of
    capital and higher corporate profitability
  • Spectacular failures in corporate governance
    again highlighted the importance of the corporate
    governance, e.g., the accounting scandals and
    questionable ethics in Enron and WorldCom
  • Enron (2001) (referring to the Mini-case in Ch 2)
  • Enron was one of the world's leading electricity,
    natural gas, communications and pulp and paper
    companies, with claimed revenues of nearly 101
    billion in 2000
  • Using special purpose entities to hide debt in
    its own books

Failures in Corporate Governance
  • WorldCom (2002)
  • The U.S.s second largest long distance phone
    company (after ATT)
  • Classifying expenses as investments
  • Failures in corporate governance have become
    increasingly visible in recent years
  • In each case, prestigious auditing firms, such as
    Arthur Andersen, missed the accounting principle,
    possibly because of profitable consulting
    business with their client, that causes conflicts
    of interest with their original auditing business
  • The most strange is that top executives
    themselves should be responsible for
    mismanagement, but they still received overly
    generous compensation while destroying their

Goals of Corporate Governance
  • The most widely accepted statement of good
    corporate governance practices are established by
    the OECD (Organization for Economic Cooperation
    and Development) (?????????)
  • Protect shareholders rights
  • Ensure the equitable treatment of all
    shareholders, especially for minority and foreign
  • Recognize the right of stakeholders, and involve
    stakeholders in corporate governance
  • Ensure that timely disclosure is made
    transparently on all matters regarding the
  • Transparency is defined as the degree to which an
    investor can discern the true activities and
    value drivers of a company from the disclosures
  • Ensure the effective monitoring of management by
    the board and the boards accountability to the
    company and the shareholders

Structure of Corporate Governance
  • The overview of various parties and their
    responsibilities associated with the corporate

Different Corporate Governance Regimes
Comparative Corporate Governance Regimes
  • The origins of the need for corporate governance
  • The separation of ownership from management
  • The significance of the roles of various
    stakeholders in different cultures
  • ? Firms facing different conditions of the above
    two factors will adopt different corporate
    governance regimes as follows

Comparative Corporate Governance Regimes
  • The preferred regimes are a function of at least
    four major factors as follows
  • 1. Financial market development
  • The market that grows slowly (the emerging
    markets), or have industrialized rapidly by
    utilizing neighboring capital market (West
    Europe), might not form large public equity
    market systems
  • Thus, their ownership shares are highly
    concentrated such that major shareholders have
    enough power to monitor or affect the management,
    so few disciplined processes of governance are
  • 2. Separation between management and ownership
  • In some countries, the ownership and the
    management is integrated, so the agency problem
    issues is not important
  • In some countries, the ownership is widely
    dispersed and separated from management, aligning
    the goal of management and stockholders is much
    more difficult

Comparative Corporate Governance Regimes
  • 3. Disclosure and transparency
  • The disclosure regarding the operation and
    financial conditions and the transparency for the
    decision-making process vary across countries
  • Due to the degree of ownership that is public,
    the degree to which government protects
    stakeholders rights versus ownership rights, and
    the extent to which family-based and
    government-affiliated business remains central to
    the culture, the degrees of required disclosure
    and transparency are different
  • 4. Historical development of the legal system
  • Investor protection is better in countries in
    which English common law is the basis of the
    legal system (in the U.S. and U.K.), compared to
    the codified civil law that is typical in France
    and Germany
  • In countries with weak investor protection,
    controlling shareholder ownership is often a
    substitute for a lack of legal protection
  • That is, the controlling shareholder can decide
    the direction of the firm or he is the management
    of the firm. In order to protect his interest,
    the controlling shareholder should maintain a
    well corporate governance and exploit his asset
    in the best way

Family Ownership and Corporate Governance
  • Although market-based regimes seem to be the
    mainstream of corporate governance, family-based
    regimes are more common than market-based regimes
  • In a study of 5,232 corporations in Western
    Europe in 2002, family-controlled (wildly-held)
    firms represented 44 (37) of the sample
  • Opposed to popular belief, family-owned firms in
    some highly developed economies typically
    outperform publicly owned firms
  • In SP 500, family firms outperform nonfamily
    firms, and a CEO from the family also perform
    better than those with outside-CEOs
  • In Norway, based on a 120-firm sample,
    founding-family-controlled firms are with higher
    value than non-founding-family-controlled firms,
    regardless of firm age, board independence, and
    number of share classes

Good Corporate Governance does Matter
  • A McKinsey study in 2002 surveyed more than 200
    institutional investors as to the value they
    place on good governance

? Generally speaking, for countries with less
development of the corporate governance,
institutional investors would like to pay more
premium for the shares of corporations with good
corporate governance
Good Corporate Governance does Matter
  • Exhibit 2.5 compares the premiums that
    shareholders are willing to pay for the voting
    right in selected markets with different ratings
    of accounting standard

? The idea to examine the premium paid for voting
shares is that if the country is perceived to
have good corporate governance, investors would
not need to obtain voting rights to try to
protect their investment
Good Corporate Governance does Matter
  • Exhibit 2.6 compares the premiums that
    shareholders are willing to pay for the voting
    right in selected markets with different ratings
    of law enforcement

? Generally speaking, for countries with better
accounting standard and law enforcement, the
premium paid for voting shares over non-voting
shares decreases
Corporate Governance Reform
Corporate Governance Reform
  • Within the U.S. and U.K., the main corporate
    governance problem centers around the agency
    problem 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 monitoring task
  • Outside the U.S. and U.K., controlling
    shareholders are usually in the majoritythese
    entities are able to monitor management in some
    ways better than the regulators can
  • After the failure of corporate governance of
    Enron and WorldCom, some regulatory reform of
    corporate governance started in 2002 in the U.S.

Corporate Governance Reform
  • The Sarbanes-Oxley Act was passed by the U.S.
    Congress, and signed by President George W. Bush
    during 2002 and has four major requirements
  • 1. CEOs of publicly traded companies must vouch
    for the veracity of published financial
  • This provision tried to instill a sense of
    responsibility and accountability in senior
  • Many companies requires business unit managers
    and directors at lower levels to sign their
    financial statements as well
  • 2. Corporate boards must have audit committees
    drawn from independent directors
  • In Germany, however, supervisory board must
    include employee representatives, but according
    to the U.S. law, employees are not independent

Corporate Governance Reform
  • 3. Companies can not make loans to corporate
  • 4. Companies must test their internal financial
    controls against fraud
  • In order to meeting the new regulations, firms
    spends too much on modifying internal controls to
    combat fraud, rather than operating the firm
  • The cost is disproportionately high especially
    for smaller firms
  • Thus, more smaller firms choose to stay private
    or to sell out to larger firms instead of going
    the initial public offering (IPO) route because
    it costs too much to comply the law for public
  • In summary, most of the terms in Sarbanes-Oxley
    Act are appropriate for the U.S. situation, but
    some terms do conflict with practices in other
  • As a consequence, this act hinders many foreign
    companies to list their shares on the exchanges
    in the U.S.

Corporate Governance Reform
  • Possible reforms for board structure and
    compensation issues (learned from European
  • CEOs cannot be the chairman of the board
  • More than 80 of the companies in the Fortune
    500, the CEO is also the chairman of the board
  • Adopt two-tiered structure in Germany
  • Supervisory board (mostly outside, non-executive
    directors and typically large, e.g., Siemens has
    18 members)
  • Management board (predominantly inside, executive
    directors and smaller, e.g., Siemens has 8
  • Change the compensation schemes to replace stock
    options with restricted stock shares
  • If the performance of stock is poor, the
    management with stock options will not feel any
    real loss since they just loss some potential
    future benefit

Corporate Governance Reform
  • Restricted stock to the management cannot be sold
    publicly until after a specified period of time
  • For poor stock performance, the recipient (the
    management) has actually lost money
  • The remaining problems of the accounting process
  • The U.S. system is characterized as strictly rule
    based, rather than conceptually based, as is
    common in Western Europe
  • There are constantly more clever accountants find
    ways to follow the rule, yet not meet the
    underlying purpose for which the rule were
    intended, e.g., using SPE in the Enron case
  • Another debate of the accounting process is the
    roles of the accounting firm and the companies
  • Is it logical for the current practice that
    companies pay accounting firms to investigate
    whether their reporting practices consistent with
    generally accepted accounting principles (GAAPs)?

Actions of Minority Shareholders
  • Minority shareholder rights
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