Homework Set #5: Chapter 12
Due Week 10 and worth 100 points
Directions: Answer the following questions on a separate document. Explain how you reached the answer or show your work if a mathematical calculation is needed, or both. Submit your assignment using the assignment link above.
In your own words, complete the Mini-Case on Page 562 of your textbook.
Suppose you decide (as did Steve Jobs and Mark Zuckerberg) 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 and 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.
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. An agency relationship is when someone hires another person(s) to perform a service for them and gives decision-making authority to the hired person. An example would be someone opening a small restaurant or bakery and hiring someone to handle all the management tasks and decisions. If I am the only employee and am only using my money to invest in the business, then there is no agency conflict because there is no other party involved. Agency conflicts typically arise when there are two or more parties involved.
If you expanded and hired additional people to help you, might that give rise to agency problems? If I decide to expand and hire additional people to help, then agency problems might arise. The more people there are involved in a matter, the greater the likelihood for conflicts to arise.
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? If I maintain enough stock to control the company, agency conflict between inside owner/managers and outside owners might occur. Obviously, decisions would be made to continue increasing the value of the company as it would increase the owner’s welfare, but the issue of perks could cause a conflict of interest. Perks may be nice for the owner and help to make their life better, but the same perks do nothing to increase the welfare of the outside investors.
Suppose your company raises funds from outside lenders. What type of agency costs might occur? How might lenders mitigate the agency costs? If the company raises funds from outside lenders conflicts between stockholders and creditors may occur. Two types of agency costs that might occur are asset switching and increased leverage. Asset switching is when safe assets are sold and invested in a large and riskier project, where the stockholders win, and the creditors lose. Increased leverage occurs when a company borrows funds and then issues additional debt to repurchase outstanding stock which increases the firm’s financial leverage. Two ways that lenders might mitigate these costs are to charge a higher rate in order to protect themselves against increased risk or by writing debt covenants that detail what actions borrowers can and cannot take.
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. (1) Managers might not expand the time and effort required to maximize firm value. In other words, they are too busy participating in external activities or partaking in nonproductive activities that the corporate tasks are not being focused on. (2) Managers might use corporate resources on activities that benefit themselves rather than shareholders. Purchasing perks for themselves and indulging in a lavish lifestyle. (3) Mangers might avoid making difficult but value-enhancing decisions that harm friends in the company. They will be less likely to make a decision that will benefit the whole company if it will adversely affect a friend or favorite worker within the company. (4) Managers might take on too much risk or they might not take on enough risk. (5) If a company is generating positive free cash flow, a manger might “stockpile” it in the form of marketable securities instead of returning FCF to investors. Extra cash on hand reduces risk while also leading to higher compensations. (6) Mangers might not release all the information that investors desire.
What is corporate governance? List five corporate governance provisions that are internal to a firm and are under its control. Corporate governance is the set of laws, rules, and procedures that influence the company’s operations and the decisions its managers make. (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.
What characteristics of the board of directors usually lead to effective corporate governance? The characteristics of the board of directors that usually leads to effective corporate governance are: the CEO is not also the chairman of the board, the board has a majority of true outsiders who bring some type of business expertise to the board and are not too busy with other activities, the board is not too large, and board members are compensated appropriately.
List three provisions in the corporate charter that affect takeovers. Three provisions in the corporate charter that affect takeovers are banning targeted share repurchases where stock is repurchased only from a hostile bidder, no shareholder rights provision or poison pill disallowing shareholders of targeted firms to buy specified numbers of shares in the company at very low prices if an outside firm acquires a certain percentage of the firm’s stock, and restricted voting rights provision which cancels the voting rights of any shareholder who owns more than a specified amount of the firm’s stock.
Briefly describe the use of stock options in a compensation plan. What are some potential problems with stock options as a form of compensation? In theory, the use of stock options in a compensation plan is to align managerial interest with that of shareholders, so managers will do what they can in order to maximize the firm’s value. Executives can still get monumental additional money from stock options, even though the firm did not perform as well as shareholders expected. Another problem is that some executives would illegally falsify financial statements in order to drive up the stock prices right before exercising their own stock options.
What is block ownership? How does it affect corporate governance? Block ownership is when institutional investors own large portions or percentages of stock in one company. It affects corporate governance as the institutions can monitor management more effectively and are better able to influence changes to board in order to facilitate an improvement in performance for firms that have been underperforming. In this sense, board members are less tolerant of managers who are not operating with the best interest of the shareholders.
Briefly explain how regulatory agencies and legal systems affect corporate governance. Regulatory agencies affect corporate governance by forcing companies to operate at a higher standard. While the fines and penalties may be small, the damage to a firm’s reputation can lead to a large reduction in the firm’s intrinsic value. Regarding legal systems, studies have shown that firms located in countries with strong legal protection for investors have stronger corporate governance and that this is reflected in better access to financial markets, a lower cost of equity, increases in market liquidity, and less nonsystematic volatility in stock returns.
Brigham & Ehrhardt. (2017). Financial Management: Theory and Practice (15th ed). Boston, MA: Cengage