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Copyright © 2010 Pearson Prentice Hall. All rights reserved.

Chapter 2

Financial Goals and Corporate Governance

Copyright © 2010 Pearson Prentice Hall. All rights reserved.2-2

Who Owns the Business?

• Most companies are created by entrepreneurs who are either individuals or a small set of partners.

• In either case they may be the members of a family.

• Over time, however, some firms may choose to go public via an initial public offering or IPO.


Exhibit 2.1 Who Owns the Business?

[Insert Exhibit 2.1]


Separation of Ownership from Management

• The change in ownership from 100% privately held toward an increased share of publicly traded shares brings along with it the probability that a firm may be managed by hired professionals and not the owners.

• This raises the possibility that ownership and management may not be perfectly aligned in their business and financial objectives, the so called agency problem.


The Goal of Management

• Maximization of shareholders’ wealth is the dominant goal of management in the Anglo-American world.

• In the rest of the world, this perspective still holds true (although to a lesser extent in some countries).

• In Anglo-American markets, this goal is realistic; in many other countries it is not.


The Goal of Management

• There are basic differences in corporate and investor philosophies globally.

• In this context, the universal truths of finance become culturally determined norms.


Shareholder Wealth Maximization

• In a Shareholder Wealth Maximization model (SWM), a firm should strive to maximize the return to shareholders, as measured by the sum of capital gains and dividends, for a given level of risk.

• Alternatively, the firm should minimize the level of risk to shareholders for a given rate of return.



• The SWM model assumes as a universal truth that the stock market is efficient.

• An equity share price is always correct because it captures all the expectations of return and risk as perceived by investors, quickly incorporating new information into the share price.

• Share prices are, in turn, the best allocators of capital in the macro economy.



• The SWM model also treats its definition of risk as a universal truth.

• Risk is defined as the added risk that a firm’s shares bring to a diversified portfolio.

• Therefore the unsystematic, or operational risk, should not be of concern to investors (unless bankruptcy becomes a concern) because it can be diversified.

• Systematic, or market, risk cannot however be eliminated.



• Agency theory is the study of how shareholders can motivate management to accept the prescriptions of the SWM model.

• Liberal use of stock options should encourage management to think more like shareholders.

• If management deviates too extensively from SWM objectives, the board of directors should replace them.

• If the board of directors is too weak (or not at “arms-length”) the discipline of the capital markets could effect the same outcome through a takeover.

• This outcome is made more possible in Anglo-American markets due to the one-share one-vote rule.



• Long-term value maximization can conflict with short-term value maximization as a result of compensation systems focused on quarterly or near-term results.

• Short-term actions taken by management that are destructive over the long-term have been labeled impatient capitalism.

• This point of debate is often referred to a firm’s investment horizon (how long it takes for a firm’s actions, investments and operations to result in earnings).



• In contrast to impatient capitalism is patient capitalism.

• This focuses on long-term SWM.• Many investors, such as Warren Buffet, have focused on mainstream firms that grow slowly and steadily, rather than latching on to high-growth but risky sectors.


Stakeholder Capitalism Model

• In the non-Anglo-American markets, controlling shareholders also strive to maximize long-term returns to equity.

• However, they are more constrained by other powerful stakeholders.

• In particular, labor unions are more powerful than in the Anglo-American markets.

• In addition, Governments interfere more in the marketplace to protect important stakeholder groups, such as local communities, the environment and employment.



• The SCM model does not assume that equity markets are either efficient or inefficient.

• The inefficiency does not really matter, because the firm’s financial goals are not exclusively shareholder-oriented, because they are constrained by the other stake-holders.

• The SCM model assumes that long-term “loyal” shareholders – those typically with controlling interests – should influence corporate strategy, rather than the transient portfolio investor.



• The SCM model assumes that total risk – i.e. operating and financial risk – does count.

• It is a specific corporate objective to generate growing earnings and dividends over the long run with as much certainty as possible.

• In this case, risk is measured more by product market variability than by short-term variation in earnings and share price.


Operational Goals for MNEs

• The MNE must determine for itself proper balance between three common operational financial objectives:– maximization of consolidated after-tax income;– minimization of the firm’s effective global tax burden;

– correct positioning of the firm’s income, cash flows, and available funds as to country and currency.

• These goals are frequently incompatible, in that the pursuit of one may result in a less-desirable outcome in regard to another.


Corporate Governance

• Although the governance structure of any company – domestic, international, or multinational – is fundamental to its very existence, this subject has become a lightning rod for political and business debate in the past few years.

• Spectacular failures in corporate governance have raised issues about the very ethics and culture of the conduct of business.



• The single overriding objective of corporate governance is the optimization over time of the returns to shareholders.

• In order to achieve this goal, good governance practices should focus the attention of the board of directors of the corporation by developing and implementing a strategy that ensures corporate growth and improvement in the value of the corporation’s equity.



• The most widely accepted statement of good corporate governance practices are established by the OECD:– The corporate governance framework should protect shareholders rights.

– The corporate governance framework should ensure the equitable treatment of all shareholders.

– Stakeholders should be involved in corporate governance.

– Disclosure and transparency is critical.– The board of directors should be monitored and held accountable for what guidance it gives.


Structure of Corporate Governance

• The modern corporation’s actions and behaviors are directed and controlled by both internal forces and external forces.

• The internal forces, the officers of the corporation and the board of directors are those directly responsible for determining both the strategic direction and the execution of the company’s future.

• The external forces include equity markets in which the shares are traded, the analysts who critique the company’s investment prospects and external regulators, among others.


Exhibit 2.2 The Structure of Corporate Governance



• The board of directors is the legal body that is accountable for the governance of the corporation.

• The senior officers of the corporation are the creators and directors of the corporation’s strategic and operational direction.



• Equity markets should reflect the market’s constant evaluation of the promise and performance of the company.

• Debt markets should reflect the company’s ability to repay its debt in a timely and efficient manner.

• Auditors and legal advisors are responsible for providing an external professional opinion as to the fairness, legality and accuracy of corporate financial statements.

• Regulators work to ensure, among other things, that a regular and orderly disclosure process of corporate performance is conducted so that investors may evaluate a company’s investment value with accuracy


Exhibit 2.3 Comparative Corporate Governance Regimes


Failures in Corporate Governance

• Failures in corporate governance have become increasingly visible in recent years.

• In each case, prestigious auditing firms missed the violations or minimized them, presumably because of lucrative consulting relationships or other conflicts of interest.

• In addition, security analysts urged investors to buy the shares of firms they knew to be highly risky (or even close to bankruptcy).

• Top executives themselves were responsible for mismanagement and still received overly generous compensation while destroying their firms.


Corporate Governance Reform

Within the United States and the United Kingdom, the main corporate governance problem is the one treated by agency theory: with widespread share ownership, how can a firm align management’s interest with that of the shareholders?Because individual shareholders do not have the resources or the power to monitor management, the U.S. and U.K. markets rely on regulators to assist in the agency theory monitoring task.Outside the U.S. and U.K., large, controlling shareholders are in the majority – these entities are able to monitor management in some ways better than the regulators can.


The Sarbanes-Oxley Act• This act was passed by the US Congress, and

signed by President George W. Bush during 2002 and has three major requirements:– CEOs of publicly traded companies must vouch for the

veracity of published financial statements;– corporate boards must have audit committees drawn

from independent directors;– companies can no longer make loans to corporate

directors, and– Companies must test their internal financial

controls against fraud

• Penalties have been spelled out for various levels of failure.

• Most of its terms are appropriate for the US situation, but some terms do conflict with practices in other countries.


Additional Corporate Governance Issues

• Board structure and compensation issues

• Transparency, accounting and auditing

• Minority shareholder rights


Mini-Case Questions: Governance Failure at Enron

• Which parts of the corporate governance system, internal and external, do you believe failed Enron the most?

• How do you think each of the individual stakeholders and components of the corporate governance system should have either prevented the problems at Enron or acted to resolve the problems before they reached crisis proportions?

• If all publicly traded firms in the United States are operating within the same basic corporate governance system as Enron, why would some people believe this was an isolated incident, and not an example of many failures to come?

Copyright © 2010 Pearson Prentice Hall. All rights reserved.

Chapter 2

Additional Chapter Exhibits


Exhibit 2.4 Country Governance Rankings 2008


Exhibit 2.5 The Premium Paid for Voting Shares: Accounting Standards


Exhibit 2.6 The Premium Paid for Voting Shares: Law Enforcement


Exhibit 2.7 U.S. Director Independence 2008


Exhibit 2.8 Potential Responses to Shareholder Dissatisfaction


Exhibit 1 Enron’s Actual Operating Income