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Chapter 10 - Chapter 10 Corporate Governance Corporate...

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Chapter 10 Corporate Governance Corporate governance is the set of mechanisms used to manage the relationship among stakeholders and to determine and control the strategic direction and performance of organizations. At its core, corporate governance is concerned with identifying ways to ensure that strategic decisions are made effectively. Corporate governance has been emphasized in recent years because, as the Opening Case illustrates, corporate governance mechanisms increasingly affect all stakeholders and the firm's future. Effective corporate governance is also of interest to nations. Governments want firms operating within their countries to grow and provide employment, wealth, and satisfaction. This raises standards of living and enhances social cohesion. Three internal governance mechanisms examined here are (1) ownership concentration, as represented by types of shareholders and their different incentives to monitor managers, (2) the board of directors, and (3) executive compensation. The external governance mechanism is the market for corporate control. SEPARATION OF OWNERSHIP AND MANAGERIAL CONTROL The growth of the large, modern public corporation is based primarily on the efficient separation of ownership and managerial control. Shareholders make investments by purchasing stock (representing ownership), which entitles them to a share of the firm’s residual income (or profits) that remain after all expenses have been paid. The right to share in residual income also means that shareholders also must accept the risk that no residual profits will remain if the firm’s expenses exceed its income. Shareholders can manage investment risk by investing in a diversified portfolio of firms. In small firms, managers and owners are often one in the same—less separation of ownership and control. As family-controlled firms grow, the owners generally do not have sufficient capital or managerial skills to grow the business and seek other sources of capital and skills to support this expansion. Agency Relationships While the efficient separation of ownership and control enables specialization both by owners and managers, it also results in some potential costs (and risks) for owners by creating an agency relationship. An agency relationship exists when one party (the principal[s]) delegates decision making to another party (the agent[s]) in return for compensation as a decision-making specialist who performs a service. This relationship can be broader than just owners and managers—e.g., consultants and clients or insured and insurer. The potential for conflicts of interests between owners and managers is created by the delegation of the responsibilities of decision making to managers. Therefore, managers may take actions that are not in the best interests of owners by selecting strategic alternatives that serve managerial interests rather than shareholder or owner interests.
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