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Chapter 4

Financial Goals
and Corporate
Governance

Learning Objectives
Examine the different ownership structures for
businesses globally and how this impacts the
separation between ownership and management
the agency problem
Explore the different goals of management
stockholder wealth maximization versus stakeholder
capitalism
Analyze how financial management differs between
the public traded and the privately held firm
Evaluate the multitude of goals, structures, and
trends in corporate governance globally

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Who Owns the Business?


In global business today the ownership and
control of organizations varies dramatically
across countries and cultures.
To understand how and why those
businesses operate, one must first
understand the many different ownership
structures.

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Types of Ownership
A public enterprise is a business owned by a
government
A private enterprise is owned by a private
company or individual
A business owned by a private party is
privately held.
Becomes a publicly traded company if the owners
sell a portion of their ownership in the business
in the capital markets

See Exhibit 4.1 for an overview of these


ownership distinctions
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Exhibit 4.1 Business Ownership

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Types of Ownership
Any business can go public by listing a
portion of its ownership in the public
marketplace via an initial public offering.
Conversely, some publicly traded firms go
private when a single investor or group buys
outstanding shares and ceases to trade.
Family-controlled firms may prove to be
more profitable.

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Separation of Ownership from


Management
SOEs and widely held publicly traded
companies typically separate management
and ownership.
This raises the possibility that ownership and
management may not be perfectly aligned in
their business and financial objectives, the
so-called agency problem.

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The Goal of Management


Maximization of shareholders wealth is the
dominant goal of management in the AngloAmerican 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.

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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.

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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.

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Shareholder Wealth
Maximization
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.

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Shareholder Wealth
Maximization
The SWM model also treats its definition of
risk as a universal truth.
Risk is defined as the added risk that a
firms 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.

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Shareholder Wealth Maximization


Agency theory is the study of how shareholders
can motivate management to accept the
prescriptions of the SWM model.
Liberal use of restricted stock 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 AngloAmerican markets due to the one-share one-vote
rule.
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Shareholder Wealth
Maximization
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
firms investment horizon (how long it takes
for a firms actions, investments and
operations to result in earnings).
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Shareholder Wealth
Maximization
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.

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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.

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Stakeholder Capitalism Model


The SCM model does not assume that equity
markets are either efficient or inefficient.
The inefficiency does not really matter, because the
firms 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.

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Stakeholder Capitalism Model


The objective of the privately held firm is to
maximize current and sustainable income.
Exhibit 4.2 shows distinctions between
state-owned, publicly traded, and privately
held firms.

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Exhibit 4.2 Public Versus Private


Ownership

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Stakeholder Capitalism Model


The SCM model assumes that total riski.e.,
operating and financial riskdoes 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 shortterm variation in earnings and share price.

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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 firms effective global tax burden;
correct positioning of the firms 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.

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Public/Private Hybrids
Many firms are publicly traded but are still
heavily influenced or even controlled by
families.
Exhibit 4.3 illustrates how family businesses
on average out-perform indexes of public
companies in the United States France,
Germany, and Western Europe.

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Exhibit 4.3 The Superior


Performance of Family

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Publicly Traded Versus Privately


Held: The Global Shift
Exhibit 4.4 illustrates how the number of
U.S. publicly listed firms peaked in 1996 at
8,783. Today around 5,000 listings.
The number of publicly listed firms world
wide peaked in 2008.
U.S. listings as a % of worldwide listings of
publicly traded firms dropped from 33.3% in
1996 to 11% at year-end 2010.

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Exhibit 4.4 Global Equity Share


Listings

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Possible Causes in the Decline of


Publicly Traded Shares
Sarbanes-Oxley has added reporting
requirements
The growth of private equity markets
The growth of Electronic Communication
Networks (ECNs) helped reduce transaction
costs, but also made it less profitable for
brokerage houses to research smaller firms.
Thus trading volume on smaller firms fell off
and some ceased trading at all.

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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.

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Corporate Governance
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
corporations equity.

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Corporate Governance
The most widely accepted statement of good
corporate governance practices has been
established by the OECD:
Shareholder rights. Shareholders are the owners of
the firm, and their interests should take precedence
over other stakeholders.
Board responsibilities. The board of the company is
recognized as the individual entity with final full legal
responsibility for the firm, including proper oversight of
management.
Equitable treatment of shareholders. Equitable
treatment is specifically targeted toward domestic
versus foreign residents as shareholders, as well as
majority and minority interests.
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Corporate Governance, cont.


Stakeholder rights. Governance practices
should formally acknowledge the interests of
other stakeholdersemployees, creditors,
community, and government.
Transparency and disclosure. Public and
equitable reporting of firm operating and financial
results and parameters should be done in a
timely manner, and available to all interests
equitably.

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Structure of Corporate
Governance
The modern corporations actions and behaviors are
directed and controlled by both internal forces and
external forces (Exhibit 4.5).
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 companys
future.
The external forces include equity markets in which
the shares are traded, the analysts who critique the
companys investment prospects and external
regulators, among others.
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Exhibit 4.5 The Structure of Corporate


Governance

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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
corporations strategic and operational
direction.

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Structure of Corporate
Governance
Equity markets should reflect the markets constant
evaluation of the promise and performance of the
company.
Debt markets should reflect the companys 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 companys investment
value with accuracy.
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Comparative Corporate
Governance
The need for a corporate governance process arise
from the separation of ownership from
management and from varying stakeholder views.
Corporate governance regimes may be classified by
the evolution of business ownership over time (see
Exhibit 4.6).
Exchange rate regimes are a function of:
the financial market development;
the degree of separation between management and
ownership;
the concept of disclosure and transparency; and
the historical development of the legal system.

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Exhibit 4.6 Comparative Corporate


Governance Regimes

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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.

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Good Governance and Corporate


Reputation
Good governance SHOULD matter.
Exhibit 4.7 describes a set of governance
policies and practices

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Exhibit 4.7 The Growing Consensus


on Good Corporate Governance

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Corporate Governance Reform


Within the U.S. and U.K., the main corporate
governance problem is the one treated by agency
theory: with widespread share ownership, how can
a firm align managements 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 majoritythese entities are
able to monitor management in some ways better
than the regulators can.

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The Sarbanes-Oxley Act


This act was passed by the U.S. 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 U.S. situation, but
some terms do conflict with practices in other countries.
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Corporate Governance Reform


Poor performance of management usually
requires changes in management,
ownership, or both.
Exhibit 4.8 illustrates some of the
alternative paths available to shareholders
when they are dissatisfied with firm
performance.

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Exhibit 4.8 Potential Responses to


Shareholder Dissatisfaction

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Corporate Responsibility and


Sustainability
The purpose of the corporation is to
certainly create profits and value for its
stakeholders, but the responsibility of the
corporation is to do so in a way that inflicts
no costs on the environment and society
Sustainability is often described as a goal,
while responsibility is an obligation of the
corporation.
The obligation is to pursue profit, social
development, and the environmentbut to do so
along sustainable principles.
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