Corporate Finance
MLI28C060
Lecture 9
Thursday 22 October 2015
Corporate governance II: Agency versus Stakeholder
views of firm structure
Structure:
- Agency theory and its view of firm structure
- Stakeholder theory and its view of firm structure
- How firms are structured and the relationship between executive
management and investors
Reading:
Fama, E. F. (1980). Agency problems and the theory of the firm. Journal of
Political Economy, 88 (2), 288-307
Jensen, M. C., & Meckling, W. H. (1976). Theory of the Firm: Managerial
Behaviour, Agency Costs and ownership Structure. Journal of Financial
Economics, 3, 305-360
Agency theory and its view of firm structure
Basic Questions
• Who owns the business?
• Do the owners manage the business themselves?
• Most companies start as 100% family owned and
move toward being 100% publicly traded
• Sometimes publicly traded firms return to being
privately held
• Family controlled firms often out-perform publicly
traded firms
• Moving from family to public firms brings agency
issues
Figure 1. Who Owns the Business?
What is the Goal of Management?
• As Trident becomes more deeply committed to
multinational operations, a new constraint develops
– one that springs from divergent worldwide
opinions and practices as to just what the firms’
overall goal should be:
– Shareholder Wealth Maximization – As characterized by
Anglo-American markets
– Stakeholder Capitalism Model – As characterized by
Continental European and Japanese markets
The Goal of Management
• Shareholder Wealth Maximization
– A firm should strive to maximize the return to shareholders
(those individuals owning equity shares in the firm)
– This view defines risk in a very strict financial sense
– Risk is defined as the added risk a firm’s shares bring to a
diversified portfolio (a fully diversified portfolio represents
systematic risk)
– The added firm-specific risk is known as unsystematic risk
Agency Theory
Basic Terms
Organizations:
series of contractual
between agents and principals
relationships
Principals: owners (shareholders) of a firm
Agents:
people hired by the owners to run the firm
(managers and workers)
Agency
Costs: costs associated with monitoring agent
behavior and enforcing contracts
Goal:
efficient arrangement (lowest agency costs) of
agent-principal relationships.
Agency Relationship:
Owners and Managers
Shareholders
(Principals)
• Firm owners
• Decision makers
Managers
(Agents)
• A specialist in risk-bearing (the
principal) pays compensation to
• A specialist in managerial decisionmaking specialist (the agent)
Agency
Relationship
Principal-Agent Theory
The heart of principal-agent theory is the trade-off
between
(a) the cost of measuring behavior and
(b) the cost of measuring outcomes and transferring
risk to the agent.
Information is asymmetrically distributed between
principals and agents
Agency Theory: Conflicts
• Principals engage in monitoring behavior to assess the
activities and decisions of managers
But … dispersed shareholding makes it difficult and
inefficient to monitor management’s behavior
• Boards of Directors have a fiduciary duty to shareholders
to monitor top management
However, Boards of Directors are often accused of being
lax in performing this function
Agency Theory Problem
• Problem: cost of measuring behavior
– the desires or goals of the principal and agent conflict
and it is difficult or expensive for the principal to verify
that the agent has behaved appropriately
• Solution: Measure outcomes, transfer risk to the agent
– principals create incentive-based performance
contracts
– principals monitor contract performance
(e.g., BOD)
– Markey supply of managerial know-how (CEOs)
mitigate the agency problem
Corporate Governance Mechanisms
Internal Governance Mechanisms
Executive Compensation
– use of salary, bonuses, and long-term incentives to
align managers’ interests with shareholders’ interests
• Monitoring by top-level managers
– they may obtain Board seats (not in financial
institutions)
– they may elect Board representatives
Governance Mechanisms
Executive Compensation
– one example of internal mechanism
 Stock ownership (long-term incentive
compensation)
» managers more susceptible to market changes
which are partially beyond their control
 Incentive systems do not guarantee that managers
make the “right” decisions, but do increase the
likelihood that managers will do the things for
which they are rewarded
Corporate Governance Mechanisms
External Governance Mechanisms
Market for Corporate Control
– the purchase of a firm that is
underperforming relative to industry rivals in
order to improve its strategic competitiveness
Shareholder Wealth Maximization
• Agency Theory – the study of how shareholders (SH)
can motivate management to act in SH best interests
• Long-term versus short-term value maximization
– Impatient capitalism focuses on the short-term sometimes
at the expense of long-term value
– Exacerbated by improper management incentives from SH
Figure 1: The Structure of Corporate
Governance
The Structure of Corporate Governance
• The Board of Directors
– The legal body accountable for the governance of the
corporation
• Officers and Management
– Creators and directors of the firm’s strategic and
operational direction
• Equity Markets
– Reflect the market’s constant evaluation of the promise
and performance of the company
The Structure of Corporate Governance
• Debt Markets
– Provide funding and are interested in the financial health
of the firm
• Auditors and Legal Advisors
– Provide an external professional opinion as to the fairness,
legality, and accuracy of financial statements
• Regulators
– Require a regular and orderly disclosure process of
corporate performance
Figure 2. Potential Responses to Shareholder
Dissatisfaction
Stakeholder theory and its view of firm structure
Business and Society: An Interactive System
Introduction – The Stakeholder Theory of the Firm
• Two critical questions:
1. What is the purpose of the modern corporation?
2. To whom, or what, should the firm be responsible?
• Traditional view: “Ownership Theory of the
Firm”
– Firm is the property of its owners
– Purpose is to maximize returns to shareholders
– Shareholders’ interests are paramount and take
precedence over all others
Introduction – The Stakeholder Theory of the Firm
• Contrasting view: “Stakeholder Theory of the
Firm”
– Argues the corporation serves a broader purpose, to
create value for society
– Must make profit for owners to survive, however,
creates other kinds of value too
– Corporations have multiple obligations, all
“stakeholder” groups must be taken into account
The Stakeholder Concept
• A stakeholder refers to persons or groups that
affect, or are affected by, an organization’s
decisions, policies, and operations
• A stake is an interest in – or claim to – a
business enterprise
• Businesses are embedded in networks that
involve many groups with such a stake
The Stakeholder Concept A Tip for Understanding
• Term stakeholder is NOT the same as
stockholder
• Words sound similar BUT are not the same
• Stockholders are one of several kinds of
stakeholders
Market and Nonmarket Stakeholders
Stakeholder groups can be divided in to two
categories:
1. Market stakeholders
2. Nonmarket stakeholders
Market stakeholders are those that engage in
economic transactions with the company as it
carries out its primary purpose of providing
society with goods and services
Sometimes referred to as primary stakeholders
Stakeholder “Maps”
• Drawing “maps” of stakeholder systems, with
the business firm in the center, is one way to
visualize the relationship between the firm and
its stakeholders
• Each relationship is based on a unique
transaction or two-way exchange
Market Stakeholder Map
Nonmarket Stakeholders
• Nonmarket stakeholders are people or
groups who—although they do not engage in
direct economic exchange with the firm—are
affected by or can affect its actions
– Sometimes called secondary stakeholders
Nonmarket Stakeholder Map
Issues: Market and Nonmarket Stakeholders
• Should government be a nonmarket or market
stakeholder?
– Normally governments do not have direct exchange
with businesses, but in some industries there is such
an exchange
• Should the natural environment be a nonmarket
stakeholder?
– Not a social group, generally considered to be
represented by activist groups
• Should managers be classified as stakeholders?
– Addressed in Exhibit 1.A on next slide
Stakeholder Capitalism Model
• A view that all a corporations stakeholders (employees,
management, suppliers, local community, local/national
government and creditors) need to be considered in addition
to the equity holders
• The goal is to earn as much as possible in the long run, but to
retain enough to increase the corporate wealth for the benefit
of all
• The definition of corporate wealth is much broader than just
financial wealth, it includes technical, market and human
resources as well
• Doesn’t make an issue of market efficiency because long-term
loyal SH should be more influential than transient SH
Stakeholder Capitalism Model
• Risk – Total risk, both operating and financial
risk, is important
• Single versus Multiple Goals – Avoids the
problem of impatient capital but fails to give
clear expectations about tradeoffs among
different groups of stakeholders
• The Score Card – Firms worldwide are moving
more toward the SWM model
How firms are structured and the relationship
between executive management and investors