Ch12

Creating Shared value

A concept that involves creating economic value for shareholders while also creating social value by addressing society's needs and challenges. Managers need to reestablish the important relationship between superior firm performance and society progress. Will gain and sustain competitive advantage and reshape capitalism and its relationship to society.

Adverse Selection

Agency Theory Occurs when information asymmetry increases the likelihood of selecting inferior alternatives. Principal agent relationships, adverse selection describes a situation in which an agent misrepresents his or her ability to do the job. Common during the recruiting process. Creates an incentive for opportunistic employees to free ride on the efforts of others

Moral Hazard

Agency Theory Situation in which information asymmetry increases the incentive of one party to take undue risks of shirk other responsibilities because the costs accrue to the other party. Costs of default are rolled over to society. Knowing that there is a high probability of being bailed out (too big to fail) increases moral hazard. Any profits remain private while losses become public. Principal agent relationship - difficult of the principal to ascertain whether the agent has really put forth a best effort. Agent is able to do the work but may decide not to do so. To overcome, firms put several governance mechanisms in place.

Information Asymmetry

Agents are generally better informed than the principals. Breed on the job consumption, perquisites, and excessive compensation.

Business Ethics

Agreed upon code of conduct in business, based on societal norms Lay the foundation and provide training for behavior that is consistent with the principles, norms, and standards of business practice that have been agreed upon by society. Differ to some degree in different cultures around the globe. Fairness, honesty, and reciprocity are universal norms, many of these have been codified into law. Staying within the law is a minimum acceptable standard. Can be legal, but ethicaly questionable

Inside Directors

Board of Directors Generally part of the company's senior management team, chief financial officer (CFO) and chief operating officer (COO). Appointed by shareholders to provide the board with necessary info pertaining to the company's internal workings and performance. Tend to align with the management and the CEO rather than shareholders

Outside Directors

Board of Directors Not employees of the firm. Frequently are senior executives from other firms or full time professionals who are appointed to a board and who serve on several boards simultaneously. More likely to watch out for the interests of shareholders.

Board Independence

Critical to effectively fulfilling a board's governance responsibilities. Board members are directly responsible to shareholders, they have an incentive to ensure that shareholders' interests are pursued. If not, they can experience a loss in reputation or can be removed outright.

CEO pay and firm performance

Executive Compensation 2/3 of CEO pay is linked to firm performance. Pay and performance is a positive relationship, but the link is weak at best.

Stock Options

Executive Compensation Based on agency theory and gives the recipient the right, but not obligation, to buy a company's stock at a predetermined price sometime in the future. If the company's share price rises above the negotiated strike price, the executive stands to reap significant gains.

Absolute size of pay package

Executive Compensation Ratio of CEO to average employee in US is 300 to 1

Other Governance Mechanisms

Executive Compensation Market for Corporate Control Financial statement auditors, government regulators, and industry analysts

Ecomagination

GE's strategic initiative to provide cleaner and more efficient sources of energy, provide abundant sources of clean water anywhere in the world and reduce emissions. Solve the trade off between increasing value creation and lowering costs. Create value for society by reducing emissions and lowering energy consumption.

CEO/Chairperson Duality

Holding both the role of CEO and chairperson of the board, declining somewhat in recent years.

Public Stock Companies

Important institutional arrangement in modern, free market economies. It provides goods and services as well as employment, pays taxes, and increases the standard of living. Implicit contract based on trust between society and the public stock company. Society grants the right to incorporation, but in turn, expects companies to be good citizens by adding value to society. Limited liability for investors Transferability of investor ownership Legal personality Separation of legal ownership and management controls Major contributor to value creation since its inception Contributed to some black swan events

Separation of legal ownership and management controls

In publicly traded companies the stockholders (principals represented by the board of directors) are the legal owners of the company and they delegate decision making authority to professional managers (the agents)

Ficuiary Responsibility

Legal duty to act solely in another party's interests - toward shareholders because of the trust placed in him or her. Prior to shareholders' meeting the board slate of nominees, although they can directly nominate director candidates. large institutional investors support their favored candidates through proxy votes.

Shared Value Creation Framework

Managers maintain a dual focus on shareholder value creation and value creation for society. Defined by economic and societal needs. Externalities such as pollution, wasted energy, and costly accidents actually create internal costs, lost in reputation if not directly on the bottom line. 1) Expand the customer base to bring nonconsumers 2) Expand traditional internal value chains to include more nontraditional partners (nongovernmental organizations, NGOs) 33) Focus on creation new regional clusters

Leveraged Buyout (LBO)

Market for Corporate Control Single investor or group of investors buys with the help of borrowed money (leveraged against in the company's assets, outstanding shares of a publicly traded company in order to take it private. LBO changes the ownership structure of a company from public to private. Expectation is often that the private owners will restructure the company and eventually take it public again through an initial public offering.

Poison Pill

Market for Corporate Control Defensive provisions that kick in should a buyer reach a certain level of share ownership without top management approval. Become rare because they retard an effective function of equity markets.

Corporate Governance

Mechanisms to direct and control an enterprise in order to ensure that it pursues its strategic goals successfully and legally. Checks and balances and asking the tough questions at the right time. Attempts to address the principal agent problem which can occur any time an agent performs activities on behalf of a principal. Can arise whenever a principal delegates decision making and control over resources to agents with the expectation that they will act in the principal's best interest.

Financial statement auditors, government regulators, and industry analysts

Other Governance Mechanisms External governance All public companies must file a number of financial statements with SEC, a federal regulatory agency whose task it is to oversee stock trading and enforce federal securities. follow GAAP and be audited by CPAs

Market for Corporate Control

Other Governance Mechanisms Important external corporate governance mechanism. Consists of activist investors who seek to gain control of an underperforming corporation by buying shares of its stock in the open market. Corporate managers strive to protect shareholder value by delivering strong share price performance or putting in place poison pills. Shares fall to a low enough value, the become the target of hostile takeover.

Executive Compensation

Other Governance Mechanisms Internal Board of directors determines executive compensation packages. The board frequently grants stock options. 2 Issues: Absolute size of pay package CEO pay and firm performance

Agency Theory

Principal agent problem is a core part of agency theory. Views the firm as nexus of legal contracts. Corporations are viewed merely as a set of legal contracts between different parties. Conflicts may arise are to be addressed in the legal realm. Everyday application in employment contracts The firm needs to design work, tasks, incentives, and employment contracts and other mechanisms in ways that minimize opportunism by agents. Adverse Selection Moral Hazard

Shared Value Creation Framework

Provides guidance to managers about how to reconcile the economic imperative of gaining and sustaining competitive advantage with corporate social responsibility. Helps managers create a larger pie that benefits both shareholders and other stakeholders. Must understand role of public stock company

Board of Directors

Shareholders of public stock companies appoint board of directors. The centerpiece of corporate governance in such companies. Shareholder's interests are not uniform. Long term viability and profitable growth should allow consistent dividend payments and result in stock appreciation over time. Hedge funds often to profit from short tern movements of stock prices. More proactive investors and demand changes in a firm's strategy.

Shareholder Capitalism

Shareholders the providers of the necessary risk capital and the legal owners of public companies have the most legitimate claim on profits

Codes of Conduct

Standard codified in law, go above and beyond the law in detailing how the organization expects an employee to behave and to represent the company in business dealings. allow an organization to overcome moral hazards and adverse selections. When facing ethical dilemma, acceptable norms of professional behavior Feel comfortable explaining and defending the decision in public

Legal personality

The law regards a non living entity such as a for profit firm as similar to a person with legal rights and obligations. Allows a firm's continuation beyond the founder or founder's family

Limited liability for investors

The shareholders who provide the risk capital are liable only to the capital specifically invested, and not for other investments they may have made or for their personal wealth. Limited liability encourages investments by the wider public and entrepreneurial risk taking

Stakeholder theory

These strategic actions will lead to a larger pie of revenues and profits that can be distributed among a company's stakeholders.

Transferability of investor ownership

Through trading of shares of stock on exchanges like New York Stock Exchange and NASDAQ or exchanges in other countries. Each share represents only a minute fraction of ownership in a company, thus easing transferability