SM_Ch2-2.docx

Fundamentals of Corporate Finance Second European Edition

Solutions Manual Chapter 2 Basic 8. Partnerships [LO1] Why are professional firms, such as accountants and lawyers, more likely to have a partnership form rather than a sole ownership or limited company structure? Answer: Professional firms are more likely to choose a partnership corporate form because it allows partners to maintain their sole proprietorship business model but draw from the economies of scale that come from combining business operations. That is, partners can keep and grow their own clients and have the benefit of paying for a share of admin resources, overheads and assets. 9. Macro Governance [LO3] Why do you think corporate behaviour in bank-based financial systems would be different from that in market-based financial systems? How do you think other differences in the macro environment can affect corporate objectives? Answer: Corporate behaviour in bank-based financial systems would be different from market-based financial systems because of the nature of financing between the two financial systems. In a bank based financial system, companies will strive to meet the requirements set out by their chief financiers, which are banks. Banks, as a major source of funding, will influence corporate risk taking behaviour and encourage longer investment horizons. On the other hand, corporations in market based environment must satisfy the needs of the investing public, who naturally focus on share price performance. 10. Corporate Governance Principles [LO3] In your opinion what is the most important issue in corporate governance? Explain your answer. Answer: Many issues are important in running a firm and your answer depends on the type of firm you are discussing. Moreover, your role in a company would make you feel one issue is more important than any other. For example, if you are a minority shareholder, you would be concerned with how the majority or controlling shareholders engage with management and whether they are able to abuse their power. If you are an international investor, then country-level corporate governance would be more important. 11. Corporate Governance [LO1] Explain why the corporate governance of a sole proprietorship should be different from that of a partnership, which in turn should be different from that of a limited corporation.

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Fundamentals of Corporate Finance Second European Edition

Answer: In a sole proprietorship there is no real need for formal governance structures since all business activities are concentrated on one individual. That is, the stakeholders, the shareholders, and the managers are all one individual. In a partnership, semi-formal corporate governance structures are present, such as a Partnership Agreement or Partnership Deed. These are designed to ensure that each partner carries out his or her duties as expected. A limited corporation is a separate legal entity that is different from a sole proprietorship and partnership. 12. Corporate Governance across the World [LO3] Why is there no single code of corporate governance applied to all the countries of the world? Would emerging-market firms have different issues to consider? Answer: While a corporation’s goal remains the same (maximization of share value), different institutional, economic, legal, financial, and cultural characteristics means that the corporate governance environment will vary across countries. Similarly, corporate governance codes for emerging market firms should consider the real issues in each country such as poor quality of law enforcement and limited ability to obtain independent directors. Thus, corporate governance structures that are borrowed from developed markets such as the US, UK, Japan, Germany and others must be adjusted in a manner that suits the environment in emerging markets..

13. Sole Proprietorship [LO1] Sole proprietorship is the most common type of business throughout the world. Why do you think this is the case? What are the benefits of sole proprietorships over other forms of business? Answer: Sole proprietorships are the most common types of business throughout the world because they are the simplest to set up. In many countries, you do not need to complete any forms or registration to begin running a sole proprietorship. 14. Stakeholders [LO2] Discuss what is meant by a stakeholder. In what ways are stakeholders represented in two-tier board structures? How does this differ from companies with a unitary board structure? Use real examples to illustrate your answer. Answer: A stakeholder is any party which has an interest in the operations of the company, either directly or indirectly. Examples include shareholders, employees, creditors, customers, suppliers, normal citizens, etc. In a two tier board system, the board structure is divided into two parts consisting of the supervisory and executive board. The supervisory board is composed of outside shareholders and other stakeholders, such as employee groups (trade unions) and banks (capital providers). A good example of a supervisory board is DaimlerChrysler AG, which was comprised of 20 members - half of which were elected by shareholders at the Annual Meeting. The other half comprises members elected by the company’s employees who work in Germany (Annual report, 2008). The supervisory board can hire or fire any member of the executive board. The latter is composed of executive directors who direct the day-to-day © McGraw-Hill Education 2014

Fundamentals of Corporate Finance Second European Edition

operations of the firm. In a unitary board, the executive and nonexecutive directors sit on the same board and it is very rare for stakeholders such as employees to be represented.

Intermediate 15. Agency Problems [LO2] Who owns a corporation? Describe the process whereby the owners control the firm’s management. What is the main reason why an agency relationship exists in the corporate form of organization? In this context, what kinds of problem can arise? Answer: In the corporate form of ownership, the shareholders are the owners of the firm. The shareholders elect the directors of the corporation, who in turn appoint the firm’s management. This separation of ownership from control in the corporate form of organization is what causes agency problems to exist. Management may act in its own or someone else’s best interests, rather than those of the shareholders. If such events occur, they may contradict the goal of maximizing the share price of the equity of the firm. 16. Board Committees [LO2] Explain why you think public listed companies have board subcommittees like the remuneration committee, audit committee and risk management committee? Why could this responsibility not simply be left to the board of directors? Explain. Answer: In large complex corporations, the sheer range of tasks and responsibilities can be exceptionally large. The board of directors or executive board should be seen as the apex of a corporation’s management structure. If other tasks are required by the board that draw on specialized skills or experiences, or if an activity (such as audit or remuneration) must be handled independently to ensure accountability, then sub-committees will be formed. 17. Corporate Governance [LO3] Is it possible to improve one aspect of corporate governance in a firm but weaken another at the same time? Use an illustration to explain your answer. Answer: Yes, it is possible to improve one aspect of a corporate governance principle and weaken another. For example, if you improve the rights of shareholders, it may weaken the rights of other stakeholders such as employees and communities. Many examples can be given here and lecturers should encourage students to come up with their own solutions. 18. Government Ownership [LO3] In recent years, governments have taken control of banks through buying their shares. What impact does this have on the lending culture of these © McGraw-Hill Education 2014

Fundamentals of Corporate Finance Second European Edition

banks? Is this consistent with shareholder maximization? Use an example to illustrate your answer. Answer: Governments have different objectives to shareholders. Whereas shareholders wish to maximize the value of their own investment, governments are more concerned with maximizing social welfare. This can sometimes contradict that of shareholders. For example, several governments purchased the shares of financially stricken banks in 2008. Shortly afterwards, they put pressure on the banks to lend to smaller companies and give mortgages, even though the banks themselves felt that the lending decisions were not value maximizing. Challenge 19. Agency Problems [LO2] Suppose you own equity in a company. The current share price is £25. Another company has just announced that it wants to buy your company, and will pay £35 per share to acquire all the outstanding shares. Your company’s management immediately begins fighting off this hostile bid. Is management acting in the shareholders’ best interests? Why or why not? Answer: Clearly the bidder thinks that the £35 is money well spent and that your firm has untapped value that the market does not appreciate. Managers have many agendas, including job safety. However, it is also possible that they do not believe that the bidding company will be good for the company over the longer term. Chapter 22 on Mergers and Acquisitions covers a very similar situation when Ryanair submitted a higher bid for Aer Lingus. In the end, the bid was unsuccessful because the major shareholders did not believe that the takeover was good for the company. 20. Agency Problems and Corporate Ownership [LO3] Corporate ownership varies around the world. Historically, individuals have owned the majority of shares in public corporations in the United States. In Germany and Japan, however, banks and other large financial institutions own most of the equity in public corporations. Do you think agency problems are likely to be more or less severe in Germany and Japan than in the United States? Why? In recent years, large financial institutions such as mutual funds and pension funds have been becoming the dominant owners of shares in the United Kingdom, and these institutions are becoming more active in corporate affairs. What are the implications of this trend for agency problems and corporate control? Answer: We would expect agency problems to be less severe in countries with a relatively small percentage of individual ownership. Fewer individual owners should reduce the number of diverse opinions concerning corporate goals. The high percentage of institutional ownership might lead to a higher degree of agreement © McGraw-Hill Education 2014

Fundamentals of Corporate Finance Second European Edition

between owners and managers on decisions concerning risky projects. In addition, institutions may be better able to implement effective monitoring mechanisms on managers than can individual owners, based on the institutions’ deeper resources and experiences with their own management. The increase in institutional ownership of equity in the United Kingdom and the growing activism of these large shareholder groups may lead to a reduction in agency problems for U.K. corporations and a more efficient market for corporate control. 21. Executive Compensation [LO2] Critics have charged that compensation to top managers in the banking sector is simply too high and should be cut back. Look at the financial accounts of some banks in your region and determine the total pay of their chief executive officers. Are such amounts excessive? In answering, it might be helpful to recognize that superstar athletes such as Cristiano Ronaldo and Lionel Messi, top entertainers such as Tom Cruise and Kate Winslet, as well as many others at the top of their respective fields earn at least as much, if not a great deal more. Answer: How much is too much? Who is worth more, Cristiano Ronaldo or Lionel Messi? The simplest answer is that there is a market for executives just as there is for all types of labour. Executive compensation is the price that clears the market. The same is true for athletes and performers. 22. Corporate Governance around the World [LO3] In the Middle East, many companies have a Sharia Supervisory Board to which the board of directors report. Evaluate the merits of such a governance structure and argue whether this approach to governance could be extended to other areas where the supervisory board guides on ethical, social or environmental matters. Answer: Supervisory boards, like the Sharia board, can be of use when the objectives of a firm are tied to social, environmental or ethical issues. The purpose of such a board is to guide executives in making the correct decisions with respect to the company’s remit. An example of a supervisory board that may work in a separate area is that of football teams. In this situation, the supervisory board would consist of fan representatives and they would guide the executive board on football decisions. Other areas include firms with where public oversight is required, such as the banking sector. 23. Institutional Shareholders [LO2] Regulators have developed a number of new policies with respect to institutional shareholder involvement in the running of firms. Review the reasons why regulators would prefer more or less involvement of institutions in the running of corporations. In addition, discuss the proposals that have been put forward by regulators in your own country, and whether these are likely to be effective.

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Fundamentals of Corporate Finance Second European Edition

Answer: Institutional shareholders are increasingly becoming instrumental in demanding good corporate governance in companies in which they invest, (e.g. NAPF in UK and CalPERS in US). The main reason why institutions are important in corporate governance is because they are normally the largest shareholders in the firm. As representatives of their investee base, they should take the role of owners in monitoring firms. With respect to country specific regulations, the student should review their own country’s corporate governance code and take a view on the effectiveness of the code. 24. Codes of Corporate Governance [LO3] Download a set of country codes from the European Corporate Governance Institute website (www.ecgi.org) and identify any differences and similarities between your chosen country and the US codes. What are the main differences between your chosen country and the US’s governance codes? Answer: The student would be expected to carry out this research themselves.

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