Chapter 2
Financial Goals and
Corporate
Governance
The Goals of Chapter 2
• Introduce different types of ownership of firms
• Discuss the goal of management, and introduce the
Shareholder Wealth Maximization Model (SWM) and
the Stakeholder Capitalism Model (SCM)
• Introduce the goals and structures of corporate
governance
• Compare different corporate governance regimes
• Discuss the failure of corporate governance and the
reform of corporate governance in the U.S.
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Who Owns the Business?
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Who Owns the Business?
• Most companies are created by entrepreneurs who are
either individuals or a small set of partners
– Usually, founders are often the members of a family
– Most business begin their lives as 100% privately held, often
by a family
• Over time, however, some firms may choose to go
public via an initial public offering (IPO)
– Typically, only a relatively small percentage of the company
shares is sold to the public in IPO (A to B in Exhibit 2.1)
– Scenario 1: Sell more and more equity shares to investing
public and become totally public traded firm (B to C or D in
Exhibit 2.1)
– Scenario 2: The private owners may choose to retain a major
share, and the private owners can decide to have explicit
control or not
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Exhibit 2.1 Who Owns the Business?
[Insert Exhibit 2.1]
※ The other impact of IPO is that firm becomes subject to many of the increased legal,
regulatory, and reporting requirement in most countries
※ In late 2005, a very large private firm, Koch Industries (U.S.), purchased all
outstanding shares of Georgia-Pacific (U.S.), a very large publicly traded forest
products company, and took Georgia-Pacific private
• Georgia-Pacific is one of the world's leading manufacturers and distributors of tissue, pulp,
paper, packaging, and related chemicals
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Who Owns the Business?
• In the U.S. and U.K., most corporations in stock
markets are characterized by widespread ownership
of shares
• In the rest of world, ownership of corporations is
usually characterized by controlling shareholders
• Typical controlling shareholders are as follows:
– Government (e.g., privatized utilities)
– Institutions (such as banks in Germany)
– Family (such as in France and Asia)
• France has the highest number of family businesses (about
65% of the CAC 40 firms are family owned)
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Who Owns the Business?
– Consortiums (財團) (such as keiretsus in Japan and
chaebols in South Korea)
• A consortium is a huge enterprise including banks, industry
companies, suppliers, and manufacturers as component firms
• Usually, the cross-shareholding strategy is adopted by the
management to maintain the control power for the whole
enterprise
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Goal of Management
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The Goal of Management
• Maximization of shareholders’ wealth is the
dominant goal of management in the AngloAmerican world, which usually includes the U.S.,
the U.K., Canada, Australia, and New Zealand
• In Anglo-American markets, this goal is realistic; in
many other countries it is not because these exists
some difference in corporate and investor
philosophies
• In this section, two kinds of models are introduced,
the Shareholder Wealth Maximization Model
(SWM) and the Stakeholder Capitalism Model
(SCM)
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Shareholder Wealth Maximization
• In the 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
– In other words, the firm should minimize the level of risk
to shareholders for a given rate of return
• The SWM model assumes that the stock market is
efficient such that the performance of managers can
be reflected from the movement of stock prices
quickly
– That is, an equity share price is always correct because it
incorporates new information quickly and thus reflects all
the expectations of return and risk as perceived by
investors
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Shareholder Wealth Maximization
• Risk is defined as the added risk that a firm’s shares
bring into a diversified portfolio
– Therefore the unsystematic should not be of concern to
investors because it can be diversified
– Investors care about only systematic risk, which cannot be
eliminated through diversification
• The change in ownership from 100% privately held
toward an increased share of publicly traded shares
brings another impact 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
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Shareholder Wealth Maximization
• Agency problems: Conflicts of interest between
managers and stockholders
– Empire building, avoid good but risky projects, or
overconsume luxuries
– Possible solutions:
• Compensation plans (bonus linked with the performance of the
stock or executive stock options)
• Penalty for underperformance (the board of directors can
replace the manager)
• Specialist monitoring (analysts, fund managers, banks)
• Discipline of the capital market (takeovers by other firms)
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Shareholder Wealth Maximization
• Long-term vs. short-term value maximization
– Long-term value maximization can conflict with short-term
value maximization as a result of compensation systems
focused on near-term results
– The other reason for seeking short-term value maximization
for public firms is the requirement of periodical earning report
(quarterly in the U.S.)
– Short-term actions taken by management that are destructive
over the long-term have been labeled impatient capitalism
– In contrast to impatient capitalism is patient capitalism, which
focuses on long-term SWM
– Note that the long-term or short-term is a relative notion
compared with a firm’s investment horizon (how long it takes
for a firm’s actions, investments, and operations to result in
earnings)
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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
– For example, labor unions are more powerful than in France
and South Korea, banks have significant influence on firms’
decision in Germany, etc.
– In addition, governments interfere more in the market place
to protect important stakeholder groups, such as local
communities, the environment, and the 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 due
to the constraints imposed by other stakeholders
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Stakeholder Capitalism Model
• The SCM model assumes that long-term “loyal”
shareholders–typically controlling shareholders–
should influence corporate strategy, rather than the
transient (short-term) portfolio investor
• The SCM model assumes that total risk, which is
reflected from both the operating and financial risks,
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
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SWM vs. SCM
• The SWM could nurture some short-run oriented
and impatient capital, but SCM can avoid this flaw
• In the SCM, trying to meet the desires of multiple
stakeholders leaves management without a clear
goal
• The SWM gets increasing focus in recent years
– As more non-Anglo-American countries try to privatize
their industries, focusing on the shareholder wealth seems
a better strategy to attract international capital
– Many shareholder-based MNEs are increasingly
dominating their industry
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Operational Objectives for MNEs
• The MNE must determine for itself proper balance
between three common operational financial objectives:
– Maximization of consolidated after-tax income (primary goal)
– 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
• Consolidated income is the total amount of the incomes
of all subsidiaries in different local currencies expressed
in the currency of the parent company
• These objectives are frequently incompatible, in that the
pursuit of one may result in a less-desirable outcome in
regard to another
– E.g., the first objective focuses on the current earnings, but the
third objective focuses on generating sustainable cash flows in
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the future
Goals and Structures of
Corporate Governance
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Failures in Corporate Governance
• For any company the corporate governance is
fundamental to its existence
– Moreover, many studies have continued to show the
linkages between good governance (at both country and
corporate level) and the lower cost of capital and higher
corporate profitability
• Spectacular failures in corporate governance again
highlighted the importance of the corporate
governance, e.g., the accounting scandals and
questionable ethics in Enron and WorldCom
– Enron (2001) (referring to the Mini-case in Ch 2)
• Enron was one of the world's leading electricity, natural gas,
communications and pulp and paper companies, with claimed
revenues of nearly $101 billion in 2000
• Using special purpose entities to hide debt in its own books
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Failures in Corporate Governance
– WorldCom (2002)
• The U.S.’s second largest long distance phone company (after
AT&T)
• Classifying expenses as investments
• Failures in corporate governance have become
increasingly visible in recent years
• In each case, prestigious auditing firms, such as
Arthur Andersen, missed the accounting principle,
possibly because of profitable consulting business
with their client, that causes conflicts of interest with
their original auditing business
• The most strange is that top executives themselves
should be responsible for mismanagement, but they
still received overly generous compensation while
destroying their firms
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Goals of Corporate Governance
• The most widely accepted statement of good corporate
governance practices are established by the OECD
(Organization for Economic Cooperation and
Development) (經濟合作暨發展組織):
– Protect shareholders’ rights
– Ensure the equitable treatment of all shareholders,
especially for minority and foreign shareholders
– Recognize the right of stakeholders, and involve stakeholders
in corporate governance
– Ensure that timely disclosure is made transparently on all
matters regarding the corporation
• Transparency is defined as the degree to which an investor can discern
the true activities and value drivers of a company from the disclosures
– Ensure the effective monitoring of management by the
board and the board’s accountability to the company and the
shareholders
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Structure of Corporate Governance
• The overview of various parties and their responsibilities
associated with the corporate governance
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Different Corporate
Governance Regimes
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Comparative Corporate Governance
Regimes
• The origins of the need for corporate governance
– The separation of ownership from management
– The significance of the roles of various stakeholders in different
cultures
※ Firms facing different conditions of the above two factors will
adopt different corporate governance regimes as follows
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Comparative Corporate Governance
Regimes
• The preferred regimes are a function of at least four
major factors as follows
1. Financial market development
• The market that grows slowly (the emerging markets), or have
industrialized rapidly by utilizing neighboring capital market
(West Europe), might not form large public equity market
systems
• Thus, their ownership shares are highly concentrated such that
major shareholders have enough power to monitor or affect the
management, so few disciplined processes of governance are
developed
2. Separation between management and ownership
• In some countries, the ownership and the management is
integrated, so the agency problem issues is not important
• In some countries, the ownership is widely dispersed and
separated from management, aligning the goal of management
and stockholders is much more difficult
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Comparative Corporate Governance
Regimes
3. Disclosure and transparency
• The disclosure regarding the operation and financial conditions and
the transparency for the decision-making process vary across
countries
• Due to the degree of ownership that is public, the degree to which
government protects stakeholders’ rights versus ownership rights,
and the extent to which family-based and government-affiliated
business remains central to the culture, the degrees of required
disclosure and transparency are different
4. Historical development of the legal system
• Investor protection is better in countries in which English common
law is the basis of the legal system (in the U.S. and U.K.), compared
to the codified civil law that is typical in France and Germany
• In countries with weak investor protection, controlling shareholder
ownership is often a substitute for a lack of legal protection
– That is, the controlling shareholder can decide the direction of the firm
or he is the management of the firm. In order to protect his interest, the
controlling shareholder should maintain a well corporate governance
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and exploit his asset in the best way
Family Ownership and Corporate
Governance
• Although market-based regimes seem to be the
mainstream of corporate governance, family-based
regimes are more common than market-based regimes
– In a study of 5,232 corporations in Western Europe in 2002,
family-controlled (wildly-held) firms represented 44% (37%)
of the sample
• Opposed to popular belief, family-owned firms in
some highly developed economies typically
outperform publicly owned firms
– In S&P 500, family firms outperform nonfamily firms, and a
CEO from the family also perform better than those with
outside-CEOs
– In Norway, based on a 120-firm sample, founding-familycontrolled firms are with higher value than non-foundingfamily-controlled firms, regardless of firm age, board
independence, and number of share classes
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Good Corporate Governance does
Matter
• A McKinsey study in 2002 surveyed more than 200
institutional investors as to the value they place on good
governance
※ Generally speaking, for countries with less development of the corporate governance,
institutional investors would like to pay more premium for the shares of corporations
with good corporate governance
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Good Corporate Governance does
Matter
• Exhibit 2.5 compares the premiums that shareholders are
willing to pay for the voting right in selected markets with
different ratings of accounting standard
※ The idea to examine the premium paid for voting shares is that if the country is
perceived to have good corporate governance, investors would not need to obtain
voting rights to try to protect their investment
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Good Corporate Governance does
Matter
• Exhibit 2.6 compares the premiums that shareholders are
willing to pay for the voting right in selected markets with
different ratings of law enforcement
※ Generally speaking, for countries with better accounting standard and law
enforcement, the premium paid for voting shares over non-voting shares decreases
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Corporate Governance
Reform
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Corporate Governance Reform
• Within the U.S. and U.K., the main corporate
governance problem centers around the agency problem:
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 monitoring task
• Outside the U.S. and U.K., controlling shareholders are
usually in the majority–these entities are able to monitor
management in some ways better than the regulators can
• After the failure of corporate governance of Enron and
WorldCom, some regulatory reform of corporate
governance started in 2002 in the U.S.
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Corporate Governance Reform
• The Sarbanes-Oxley Act was passed by the U.S.
Congress, and signed by President George W. Bush
during 2002 and has four major requirements:
1. CEOs of publicly traded companies must vouch for the
veracity of published financial statements
• This provision tried to instill a sense of responsibility and
accountability in senior management
• Many companies requires business unit managers and directors
at lower levels to sign their financial statements as well
2. Corporate boards must have audit committees drawn from
independent directors
• In Germany, however, supervisory board must include employee
representatives, but according to the U.S. law, employees are not
independent
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Corporate Governance Reform
3. Companies can not make loans to corporate directors
4. Companies must test their internal financial controls against
fraud
• In order to meeting the new regulations, firms spends too much
on modifying internal controls to combat fraud, rather than
operating the firm
• The cost is disproportionately high especially for smaller firms
• Thus, more smaller firms choose to stay private or to sell out to
larger firms instead of going the initial public offering (IPO)
route because it costs too much to comply the law for public
firms
• In summary, most of the terms in Sarbanes-Oxley Act
are appropriate for the U.S. situation, but some terms
do conflict with practices in other countries
– As a consequence, this act hinders many foreign companies to
list their shares on the exchanges in the U.S.
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Corporate Governance Reform
• Possible reforms for board structure and compensation
issues (learned from European standards)
– CEOs cannot be the chairman of the board
• More than 80% of the companies in the Fortune 500, the CEO
is also the chairman of the board
– Adopt two-tiered structure in Germany
• Supervisory board (mostly outside, non-executive directors and
typically large, e.g., Siemens has 18 members)
• Management board (predominantly inside, executive directors
and smaller, e.g., Siemens has 8 members)
– Change the compensation schemes to replace stock options
with restricted stock shares
• If the performance of stock is poor, the management with stock
options will not feel any real loss since they just loss some
potential future benefit
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Corporate Governance Reform
• Restricted stock to the management cannot be sold publicly
until after a specified period of time
• For poor stock performance, the recipient (the management)
has actually lost money
• The remaining problems of the accounting process
– The U.S. system is characterized as strictly rule based, rather
than conceptually based, as is common in Western Europe
• There are constantly more clever accountants find ways to
follow the rule, yet not meet the underlying purpose for which
the rule were intended, e.g., using SPE in the Enron case
– Another debate of the accounting process is the roles of the
accounting firm and the companies itself
• Is it logical for the current practice that companies pay
accounting firms to investigate whether their reporting
practices consistent with generally accepted accounting
principles (GAAPs)?
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Actions of Minority Shareholders
• Minority shareholder rights
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