Comparative Corporate Governance and Financial Goals

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Chapter 1
Comparative Corporate Governance and Financial Goals
 End-of-Chapter Questions
1.Corporate goals: shareholder wealth maximization. Explain the assumptions and objectives of the shareholder wealth maximization pmodel. Answer:The Anglo-American markets have a philosophy that a firm’s objective should follow the shareholder wealth maximization (SWM) model. More specifically, the 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 risk to shareholders for a given rate of return.

The SWM model assumes as a universal truth that the stock market is efficient. This means that the share price is always correct because it captures all the expectations of return and risk as perceived by investors. It quickly incorporates new information into the share price. Share prices, in turn, are deemed the best allocators of capital in the macro economy.

The SWM model also treats its definition of risk as a universal truth. Risk is defined as the added risk that the firm’s shares bring to a diversified portfolio. The total operational risk of the firm can be eliminated through portfolio diversification by the investors. Therefore, this unsystematic risk, the risk of the individual security, should not be a prime concern for management unless it increases the prospect of bankruptcy. Systematic risk, the risk of the market in general, cannot be eliminated. This reflects risk that the share price will be a function of the stock market.

2.Corporate goals: stakeholder capitalism. Explain the assumptions and objectives of the stakeholder capitalism model. Answer:In the non-Anglo-American markets, controlling shareholders also strive to maximize long term returns to equity. However, they are more constrained by powerful other stakeholders. In particular, labor unions are more powerful than in the Anglo-American markets. Governments interfere more in the marketplace to protect important stakeholder groups, such as local communities, the environment and employment. Banks and other financial institutions are more important creditors than securities markets. This model has been labeled the stakeholder capitalism model (SCM).

Market efficiency. The SCM model does not assume that equity markets are either efficient or inefficient. It does not really matter because the firm’s financial goals are not exclusively shareholder-oriented since they are constrained by the other stakeholders. In any case, the SCM model assumes that long-term “loyal” shareholders, typically controlling shareholders, should influence corporate strategy rather than the transient portfolio investor.

Risk. The SCM model assumes that total risk, that is, operating and financial risk, does count. It is a specific-corporate objective to generate growing earnings and dividends over the long run with as much certainty as possible, given the firm’s mission statement and goals. Risk is measured more by product market variability than by short term variation in earnings and share price.

Single versus multiple goals. Although the SCM model typically avoids a flaw of the SWM model, namely impatient capital that is short-run oriented, it has its own flaw. Trying to meet the desires of multiple stakeholders leaves management without a clear signal about the tradeoffs. Instead, management tries to influence the tradeoffs through written and oral disclosures and complex compensation systems.

The score card. In contrast to the SCM model, the SWM model requires a single goal of value maximization with a well-defined score card. 3.Corporate governance. Define the following terms.
(a)Corporate governance.
Answer:The relationship among stakeholders used to determine and control the strategic direction and performance of an organization is termed corporate governance. The corporate governance of the organization is therefore the way in...
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