1. Chapter 22 Corporate Control and Governance Lawrence J. Gitman Jeff Madura Introduction to Finance

2. 22-1 Copyright © 2001 Addison-Wesley Describe the relationship between managers and investors, and explain the potential conflict in goals. Explain how a firm’s board of directors can control the managers of the firm. Explain how investors in the firm’s stock can control the managers of the firm. Explain how the market for corporate control can ensure that managers of firms serve their firm’s respective shareholders. Learning Goals

3. 22-2 Copyright © 2001 Addison-Wesley Describe the relationship between managers and creditors. Describe the relationship between mutual fund management and investors. Learning Goals

4. 22-3 Copyright © 2001 Addison-Wesley Relationship Between a Firm’s Managers and Its Investors Managers serve as agents for the firm’s owners or shareholders and make decisions that are supposed to maximize the value of the firm’s stock price. Managerial investment and financing decisions affect the performance of the firm, which affects the dividend payments. These decisions also affect stock price and therefore the size of capital gains realized.

5. 22-4 Copyright © 2001 Addison-Wesley Figure 22.1 Relationship Between a Firm’s Managers and Its Investors

6. 22-5 Copyright © 2001 Addison-Wesley Relationship Between a Firm’s Managers and Its Investors Ownership versus Control  The separation between ownership and control introduces conflicts, which lead to agency problems.  This encourages shareholders to monitor the firm’s managers.  However, because the ownership of a typical corporation is spread across many shareholders, most are unwilling to monitor management because they would receive only a small proportion of any benefit.

7. 22-6 Copyright © 2001 Addison-Wesley Relationship Between a Firm’s Managers and Its Investors Asymmetric Information  A problem called “asymmetric information” occurs because a firm’s managers have information about the firm that is not available to shareholders.  This further complicates any attempt by shareholders to monitor the firm.  Although firms are required to inform investors by providing financial statements, some firms use accounting procedures that mislead investors.

8. 22-7 Copyright © 2001 Addison-Wesley Relationship Between a Firm’s Managers and Its Investors Asymmetric Information  Unfortunately, it is very difficult or impossible for shareholders to determine whether a particular management decision will enhance their wealth.  Thus, shareholders commonly use stock price performance as an initial indicator.

9. 22-8 Copyright © 2001 Addison-Wesley Control by the Board of Directors Shareholders elect the board of directors, which oversees the key management decisions of a firm. Inside directors are those members of a board of directors who are also employed by the firm while outside directors are not. Outside directors may be employed or retired from high-level managerial positions at other firms. A typical term for a director is 3 years.

10. 22-9 Copyright © 2001 Addison-Wesley Control by the Board of Directors Duties of the Board  Appoints high-level managers of the firm including Chief Executive Officer (CEO).  Monitors high-level managers.  Fires high-level managers.  Attend board meetings (usually between 5 and 10 per year).

11. 22-10 Copyright © 2001 Addison-Wesley Control by the Board of Directors Compensation for Board Members  Commonly receive between $15,000 and $25,000 annually for serving on boards of relatively small publicly-traded firms.  In 1998, the mean level of compensation for outside directors of the 200 largest firms was about $112,000.  The relatively high compensation levels was partially attributable to the strong stock price performance of many of the firms.

12. 22-11 Copyright © 2001 Addison-Wesley Control by the Board of Directors Impact of Outside Directors  In general, outside directors are expected to be more effective than inside directors at enacting changes that improve the firm’s stock price.  Their independence gives them the flexibility to serve in the best interests of shareholders, even if their actions do not serve in the interests of the firm’s managers.

13. 22-12 Copyright © 2001 Addison-Wesley Control by the Board of Directors Impact of Outside Directors  Impact of outside director as Board Chair  Impact of stock ownership by board members  Impact of the size of the board

14. 22-13 Copyright © 2001 Addison-Wesley Control by the Board of Directors How the Board Aligns Manger and Investor Interests  Three common methods are usually implemented by a firm’s board of directors to align the interests of managers and investors: Reducing free cash flow Forcing stock ownership by high-level managers Aligning compensation and stock price performance

15. 22-14 Copyright © 2001 Addison-Wesley Table 22.1 Aligning Compensation and Stock-Price Performance

16. 22-15 Copyright © 2001 Addison-Wesley Control by Investors Investors’ Characteristics that Affect Their Degree of Control  Number of shareholders  Proportion of institutional ownership

17. 22-16 Copyright © 2001 Addison-Wesley Control by Investors Shareholder Activism  Communication with the firm  Proxy contest  Shareholder lawsuits or other actions

18. 22-17 Copyright © 2001 Addison-Wesley Market for Corporate Control To the extent that managers do not act in the best interest of shareholders, the stock price of the firm will be less than what it would have been if the managers focused on maximizing shareholder wealth. However, an underperforming firm is subject to the “market for corporate control,” because it is subject to takeover by another firm.

19. 22-18 Copyright © 2001 Addison-Wesley Market for Corporate Control Barriers to Corporate Control  Anti-takeover amendments  Poison pills  Golden parachutes

20. 22-19 Copyright © 2001 Addison-Wesley Market for Corporate Control Barriers to Corporate Control Figure 22.2

21. 22-20 Copyright © 2001 Addison-Wesley Monitoring and Control by Creditors Like shareholders, creditors must monitor a firm’s management. However, creditors are more concerned with the firm’s ability to repay its debt than with stock price. Creditors must monitor managers so that they do not make decisions that benefit themselves or shareholders at creditors’ expense. Creditors commonly include restrictive protective covenants in loan or bond indentures to safeguard themselves against adverse managerial actions.

22. 22-21 Copyright © 2001 Addison-Wesley Conflict Between Managers and Mutual Fund Investors Just as a firm’s managers may be tempted act in ways that benefit themselves at shareholders expense, mutual fund managers may be tempted as well. Two examples of situations where investors do not act in shareholders best interests include: (a) managing tax liabilities for shareholders, and (b) managerial expenses charged to shareholders. In addition, the boards of directors at mutual funds are relatively weak; thus, the agency problem in the mutual fund industry is typically more pronounced.

23. Chapter 22 End of Chapter Lawrence J. Gitman Jeff Madura Introduction to Finance