a) What is an agency relationship? When you first begin operations, assuming you are the only employee and only your money is invested in the business, would any agency conflicts exist? Explain your answer. An agency relationship is a fiduciary and consensual relationship where a person (the principal) appoints another (the agent) to act on his behalf when dealing with third parties. In agency relationships, the principal is liable for any actions of the agent while acting in his capacity. Examples include a principal-agent relationship, an employer and employee relationship etc. An agency conflict refers to a situation where there is a conflict of interest between the agent and the principal. In the situation where I am the only investor and employee, there would be no agency conflict since only one party is involved.
b) If you expanded, and hired additional people to help you, might that give rise to agency problems? Hiring more employees would give rise to an agency relationship. The employee will be the agent who is controlled by the employer and whose actions and omissions that occur in the scope of employment the employer is liable. By the virtue that an agency relationship exists, agency problems are bound to arise due to conflicts between employees and me (the employer).
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c) Suppose you need additional capital to expand and you sell some stock to outside investors. If you maintain enough stock to control the company, what type of agency conflict might occur? Issuing stock would separate the management from the stockholders. Therefore, the possible types of agency conflicts would be between me (management) and the stockholders and between employer and employees.
d) Suppose your company raises funds from outside lenders. What type of agency costs might occur? How might lenders mitigate the agency costs? The agency costs that might occur in this scenario will be between the lenders and the management and between the lenders and the stockholders. The agency costs could be as a result of demand of high dividends by stockholders hence putting the lenders at risk of delayed payments or engagement in high risks investments by the management which puts the lenders at risk of losing their money or taking up of more debt by the management which could make the business bankrupt. To mitigate the agency costs, the lenders could enter into contract agreements with the management that restricts the amount of debt they can take and that restricts the payment of dividends to stockholders before debt is paid.
e) Suppose your company is very successful and you cash out most of your stock and turn the company over to an elected board of directors. Neither you nor any other stockholders own a controlling interest (this is the situation at most public companies). List six potential managerial behaviors that can harm a firm’s value.
The 6 potential managerial behaviors that can harm the firm’s value:
Managers might settle for satisfactory returns rather than returns that maximize the shareholder’s value. In so doing, the management would not utilize the resources efficiently to provide the maximum return.
Managers might settle for short-term profits rather than long-term growth of the firm. They may make investments that provide profits in the short-term but are not sustainable and do not promote future growth and sustainability for the firm.
Managers might take higher risks than is acceptable by the stockholders and therefore put the stockholder’s investment at risk.
Managers might consume too many benefits in kind which will in turn hike the company’s expenses.
When the company has a positive free cash flow, managers might stockpile it in the form of a marketable security instead of paying it out to stockholders.
Managers might alter the financial statements to project good performance to stockholders when that is not the reality.
f) The managers at KFS have heard that corporate governance can affect shareholder value. What is corporate governance? List five corporate governance provisions that are internal to a firm and are under its control.
Corporate governance is a system of rules, processes and practices that control and direct corporations. It basically aims to create a balance of interest among the various stakeholders in a corporation e.g. suppliers, shareholders, management, customers, employees etc. The corporate governance provisions under a firm’s control include:
Having a board of directors that monitors and reviews the performance of the management.
Putting in place a fair and structured compensation plan.
Charter provisions and by-laws that prevent any hostile takeover
Putting in place controls and monitoring the accounting systems of the firm.
Choosing of an optimal capital structure for the firm
g) What characteristics of the board of directors usually lead to effective corporate governance?
- The board should be comprised of more non-executive directors and independent directors than executive directors.
- The board should be comprised of individuals with who have different areas of expertise for diversity.
- The roles of the CEO and the chairman of the board should be distinct and vested on different people.
- The board should not be too big in size to ensure effectiveness in decision making.
h) List three provisions in the corporate charter that affect takeovers.
- Targeted share repurchase i
-Restricted voting rights
- Shareholder rights provisions i.e. poison pill
i) Briefly describe the use of stock options in a compensation plan. What are some potential problems with stock options as a form of compensation?
Stock options are compensation plans used by companies which give employees the right to purchase the stock of a company at a discount within a specified period of time. The main purpose of stock options is to inspire high levels of commitment and establish a long term relationship with employees. However, stock options could be misused by the management to manipulate financial statements so as to increase the share price. They could also lead to dilution in ownership of shares.
j) What is block ownership? How does it affect corporate governance?
Block ownership describes a situation where an outside investor owns a large amount of the company’s shares enough to influence the company’s decision using voting rights. Block investors influence corporate governance by monitoring the company’s management since they often have control over management and taking an active role when necessary which in turn leads to good corporate governance.
k) Briefly explain how regulatory agencies and legal systems affect corporate governance.
Regulatory agencies and legal systems in a country affect the laws governing a company which directly affects its corporate governance. In addition, a nation that has put in place legal systems and regulatory agencies to govern companies will tend to have strong corporate governance because the interests of investors are sought to be protected.
