Lecture 2 -The Corporate Governance Problem

What is a Public Limited Company (PLC)?

A company that issues freely tradable shares, usually traded on a stock exchange.

What advantages of PLCs do Fama and Jensen (1983) identify?

Risk diversification, separation and specialisation of ownership and control, efficient delegation of decisions, and access to professional managerial expertise.

What is idiosyncratic risk?

Firm-specific risk that investors can reduce by holding diversified portfolios of shares.

What are Hart’s (1995) two necessary conditions for a corporate governance problem?

An agency problem and incomplete contracts. Both conditions must be present.

Define the agency relationship in a PLC.

Shareholders are principals who delegate decision-making to senior managers, the agents, who control the firm’s resources.

What is moral hazard in corporate governance?

Managers may take actions that are hidden or difficult for shareholders to observe, allowing them to pursue personal interests.

What is the assumed objective of shareholders in the lecture?

Maximise shareholder wealth by maximising firm value, linked to the present value of the firm’s future profit stream.

Why do agency problems alone not justify corporate governance according to Hart (1995)?

If complete enforceable contracts could specify all future obligations, agency conflicts could be resolved contractually without a separate governance structure.

What are incomplete contracts?

Contracts that cannot specify all parties’ obligations, actions and payoffs in every possible future state.

Why are contracts incomplete?

Transaction costs arise from identifying future states, negotiating obligations and drafting contracts that third parties can enforce.

What is corporate governance designed to achieve?

To align senior managers’ objectives with those of shareholders through governance mechanisms and processes.

What does α represent in Jensen and Meckling’s (1976) ownership model?

The fraction of the firm retained by the owner-manager after selling outside equity. Outside shareholders own 1 − α.

What happens when an owner-manager owns 100% of the firm?

The manager bears the full reduction in firm value caused by consuming personal benefits. Utility is maximised at point C, with firm value V* and benefits F*.

How does selling outside equity change managerial incentives?

The manager bears only α of the financial cost of each £1 of benefits consumed, encouraging greater consumption of personal benefits.

A manager retains 40% of the firm. What is their personal equity cost of consuming £1 in benefits?

40p, because α × £1 = 0.40 × £1.

What occurs at point A in the Jensen and Meckling model?

Following the sale of outside equity, the manager initially maximises utility at firm value V₀ and benefit consumption F₀, before accounting for investors’ price adjustments.

Why do rational outside shareholders reduce the price they pay?

They anticipate that reduced managerial ownership will increase consumption of personal benefits and reduce firm value.

What occurs at point B in the ownership model?

The final equilibrium after investors adjust their valuation. Firm value is V′, benefits consumed are F′, and the original owner-manager bears the reduction in value.

How does the lecture measure agency costs from selling outside equity?

Agency costs = V* − V′, the reduction in firm value relative to the original full-ownership equilibrium.

Why might monitoring reduce agency costs?

It restricts managerial consumption of non-pecuniary benefits and helps align managers’ behaviour with shareholders’ interests.

What corporate governance mechanisms are mentioned as examples?

Board monitoring and executive compensation, both intended to reduce managerial opportunism.

State the monitoring model.

V = Vm − M − F(M, α), where Vm is maximum firm value, M is monitoring expenditure and F(M, α) is managerial benefits consumed.

Why does monitoring involve a trade-off?

Monitoring costs resources but reduces managerial benefit consumption. Firm value improves only when the benefits from reduced opportunism outweigh monitoring costs.

What is the optimal level of monitoring?

The point where the marginal benefit of additional monitoring equals its marginal cost.

Why does monitoring not eliminate all agency costs?

Monitoring becomes progressively less effective, so beyond a point its marginal cost exceeds its marginal benefit. Some residual loss remains.

What is residual loss?

The remaining reduction in firm value resulting from managerial actions that are not in shareholders’ interests.

What are total agency costs in the lecture’s monitoring framework?

Monitoring costs plus residual loss. Expenditure on governance mechanisms is itself an agency cost.

What is the myopic market criticism of agency theory?

Excessive focus on short-term share value may encourage managers to underinvest in long-term projects, harming the firm and long-term investors.

What is the stakeholder criticism of the agency perspective?

An excessive focus on shareholder primacy neglects the interests of employees, buyers, sellers and society.

What criticisms does the lecture raise against stakeholder theory?

It can be aspirational, may justify managerial wastefulness and lacks objective measures of organisational success.