Chapter 4

Public Corporation

Jointly owned by a multitude of shareholders Protected with limited liability Efficient risk sharing mechanism Capacity to raise large amounts of capital at low cost Often separates ownership and management A key weakness is the conflict of interest between managers and shareholders

4-1

INTERNATIONAL FINANCE

Chapter 4

Shareholders and Managers

Shareholders allocate decision-making authority to the managers Most shareholders are either not qualified to make complex b i k l business d i i decisions or d not do t have the time to devote to making the numerous decisions that are necessary A complete contract that specifies exactly what a manager should do under all future contingencies is not possible

4-2

The Agency Problem

Having the short-term control of the firm’s assets, managers might be tempted to act in their own short-term best interest instead of the shareholder’s long-term best interest

Outright stealing is one example Consumption of lavish perquisites is another Simply retaining too much of “cash flow” is another

4-3

Free Cash Flow

A firm’s funds in excess of what is needed for undertaking all profitable projects Managerial incentives:

Provides measure of independence from markets Size of company often related to compensation Social and political power related to size of firm

Corporate Governance

Economic, legal, and institutional framework in which corporate control and cash flow rights are distributed among shareholders, managers and other stakeholders of the company Central problem: How to protect outside investors from controlling insiders

4-4 4-5

Problem: More free cash flow usually means higher likelihood of misuse

1

Corporate Governance Issues

In principle, shareholders elect a board of directors, who in turn hire and fire the managers who actually run the company In reality, management-friendly insiders often dominate the board of directors, with relatively few outside directors who can...