Chapter
Introduction to Finance
22
Corporate Control
and Governance
Lawrence J. Gitman
Jeff Madura
Learning Goals
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.
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Learning Goals
Describe the relationship between managers
and creditors.
Describe the relationship between mutual fund
management and investors.
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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.
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Relationship Between a Firm’s
Managers and Its Investors
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Figure 22.1
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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.
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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.
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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.
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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.
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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).
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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.
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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.
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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
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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
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Aligning Compensation
and Stock-Price Performance
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Table 22.1
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Control by Investors
 Investors’ Characteristics that Affect
Their Degree of Control
 Number of shareholders
 Proportion of institutional ownership
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Control by Investors
 Shareholder Activism
 Communication with the firm
 Proxy contest
 Shareholder lawsuits or other actions
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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.
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Market for Corporate Control
 Barriers to Corporate Control
 Anti-takeover amendments
 Poison pills
 Golden parachutes
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Market for Corporate Control
 Barriers to Corporate Control
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Figure 22.2
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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.
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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.
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Chapter
Introduction to Finance
22
End of Chapter
Lawrence J. Gitman
Jeff Madura