1.4 The Agency Problem of Corporation

The separation of ownership and control rights is an important symbol of modern companies，leading to achieving the corporate goal of being bigger，stronger，and longer.However，the separation of two rights can also bring about principal-agent problems.This agency problem arises from the agency relationship that exists in a corporation where stockholders（ principals） hire managers（ agents） to run the company.The interest of agents is not always aligned with principals.For instance，the owners.goal is to pursue the maximization of shareholder wealth，while the managers.goal is to maximize personal compensation（including the equivalent use of monetary and non monetary income for on-the-job consumption）.As such，the managers may harm the owners.goals in order to achieve their own goals.The typical form is called the owner-manager conflict，including moral risk and adverse selection.Therefore，in order to minimize the agency problem，the owners must provide effective incentives and constraints to the managers.

Corporate governance is the way to minimize the agency problem.It refers to a mechanism of supervision and balance between owners and managers，which is to reasonably allocate the rights and responsibilities between the two through a system arrangement，in order to achieve the company's goal of maximizing shareholder wealth.Corporate governance includes internal and external mechanisms.The internal mechanisms of corporate governance include decision-making mechanism，supervision mechanism，and incentive mechanism，while the external mechanisms include legal environment，capital market，product market，managers market and corporate control market.

1.4.1 Internal Mechanisms of Corporate Governance

1.Decision-Making Mechanism（决策机制）

The board of directors is the decision-making body for corporate governance.On the one hand，the board of directors is responsible to all shareholders and exercises its power within the authorized scope of the shareholders.meeting；On the other hand，the board of directors entrusts specific affairs to the executing agency，forming a second layer of commission agency relationship.Therefore，the quality of the board of directors is directly related to the success of corporate governance，while the composition of directors is directly related to the efficiency and effectiveness of the board of directors.Independence is a necessary condition for the efficient functioning of the board of directors.To ensure the independence of the board of directors，it is necessary to be independent of both major shareholders and the management team，such as establishing independent directors.

2.Supervision Mechanism（监督机制）

In order to avoid the board of directors representing the interests of owners from pursuing their own interests and damaging the interests of the company，shareholders，creditors，and employees，it is necessary to restrict and supervise the board of directors through certain institutional arrangements.At the same time，for the agency relationship between the board of directors and the management，it is also necessary for the board of directors to supervise the managers they hire，in order to avoid managers from pursuing their own interests and harming the company's interests.Therefore，the supervision mechanism is the institutional design by which the owners effectively review and control the management's decision-making behavior，including internal and external supervision mechanisms.Internal supervision mechanisms refer to shareholder meetings and supervisory board，while external supervision mechanisms refer to media and intermediary agencies.

3.Incentive Mechanism（激励机制）

Incentives can be used to align the interests of management and shareholders.The incentives need to be structured carefully to make sure that they achieve their intended goal.The core of motivating managers is to transform their pursuit of maximizing personal utility into the pursuit of company's goal.In the process of modern company operation，the incentive for managers is mainly reflected in equity incentives.Equity incentive is a form of economic rights granted to managers by acquiring company's equity.By doing so，they can participate in corporate decision-making，share profits，and take risks as shareholders，thus diligently and responsibly serving the long-term development of the company.

1.4.2 External Mechanisms of Corporate Governance

1.Legal Environment（法律环境）

To achieve good corporate governance，there must be a legal system to protect investors.If a country has a high level of investor property protection，investors are willing to invest in stocks and bonds，and the capital market will be highly developed.The high degree of investor property protection can avoid conflicts of interest between investors and managers，ensuring that the majority of the company's cash flow is repaid to investors in the form of dividends and stock repurchases.

2.Capital Market（资本市场）

Good corporate governance cannot be achieved without effective capital markets.An effective capital market can quickly provide signals to all shareholders about the company's operating conditions，thereby transmitting bad behavior by the management to the stock price.For instance，managers.opportunistic behavior can cause a decline in the stock price.If the company's stock price is lower than that of its competitors，shareholders can choose to sell the company's stock，raise inquiries at shareholders.meetings，or directly take over the control of the company.Under the pressure of such a supervisory mechanism，the board of directors and management can only fulfill their responsibilities to ensure the realization of shareholders.interests.

3.Product Market（产品市场）

In a competitive and customer-oriented industrial environment，if a company's products or services are popular with customers，its market share will increase.If the company's products or services cannot occupy a certain market share，shareholders will pay attention to the company's business management status.Although the appointment and removal of managers are determined by the board of directors，shareholders can use their rights to influence the board of directors and encourage them to punish incompetent managers.

4.Managers Market（经理人市场）

In an effective managers market，information about managers.business acumen and sense of responsibility is publicly known.Irresponsible or incompetent managers may find it difficult to get satisfactory jobs after being fired，and can only receive low positions and low salaries.Diligent and capable managers will receive high positions and superior compensation.The loss of status and personal income after business failure，as well as the competition for control of the company in the capital market，can serve as a warning to managers who attempt to slack off or pursue excessive compensation.

5.Corporate Control（公司控制）

Due to the free transfer of company stocks through the securities market，hostile acquirers may choose companies with poor performance or insufficient potential growth capabilities to acquire their stocks，thereby achieving control over the company.The corporate control market forces managers to fully utilize their operational abilities，otherwise their personal interests may be affected，as managers of merged companies are often replaced or downgraded.Thus，the threat of a takeover may result in better management.

Burkart et al.（2003） demonstrate that in the United States and United Kingdom，some of the largest publicly listed firms，such as Wal-Mart Stores and Ford Motor，are family controlled.In effect，except for the United States and United Kingdom，the concentrated ownership structure rather than diffused ownership，is found to be the prominent characteristic of large publicly traded companies around the rest of the world，such as Western Europe，South and East Asia，Latin America，the Middle East，and Africa.In particular，ownership and control rights over the company are often maintained in the hand of a group of individuals who are usually combined through family.Even in the United States，where ownership is dispersed at its highest，founders or families are found to exercise a substantive extent of control over most of public corporations.Publicly traded family firms accounted for 34% of China's listed companies，while the Small and Medium Enterprises board（SME） in the Shenzhen Stock Exchange（SZSE） was almost entirely constituted by family firms at the end of 2018.

For those listed firms above，is the owner-manager conflict considered as the main agency problem？ What are the other concerns for agency problems？ To ease these agency problems，what else can be done besides the internal and external mechanisms of corporate governance？

Key Concepts and Skills

1.Three forms of business organizations and their advantages and disadvantages.

2.Three main questions that corporate finance aims to address.

3.The goals of financial management.

4.The formation and resolution of agency problems.

本章重点与难点

1.企业的三种组织形式及各自的优缺点。

2.公司金融要解决的三个主要问题。

3.公司金融的目标。

4.代理问题的形成及解决。

Self-Test Questions

Ⅰ.True（T） or False（F） Questions

1.Compared with sole proprietorships or partnerships，the greatest advantages of corporations are limited liability，easy transfer of equity，and easy access to external capital.（）

2.If capital markets are fully efficient，share prices can truly reflect the value of shareholder .wealth.（）

3.The shareholders.claim to the company's profits is fixed.（）

4.In order to ensure that the financial objectives of the business are met，the owners.dismissal of managers is the best option for shareholders to reconcile their own objectives with those of managers.（）

5.The biggest disadvantage of a corporation compared to a sole proprietorship or partnership is the limited size of the company.（）

6.The criterion for determining whether a financial decision is feasible is net present value，not accounting profit.（）

7.The theory of valuation is about intrinsic value，net added value and valuation models，which is the most fundamental theory of corporate finance.（）

8.Moral risk and adverse selection are the main manifestations of managers.deviation from financial objectives.（）

9.The main reason for the principal-agent relationship between shareholders and managers is the separation of ownership and management.（）

10.In a corporation，shareholders have unlimited liability for the assets and a residual claim to the firm value.（）

Ⅱ.Short Answer Questions

1.What are the three basic questions Financial Managers must answer？

2.What are the three major forms of business organization？

3.What is the goal of financial management？

4.What are agency problems，and why do they exist within a corporation？

本章习题答案