Theoretical frameworks - Agency theory, transaction cost theory, stakeholder theory

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Useful to have theoretical frameworks to base guidelines or series of rules of corporate governance on. Agency and Transaction Cost theories - can be used to justify shareholder approach, Stakeholder Theory - justify stakeholder approach.

Agency Theory - developed by Meckling and Jensen 1971. Based on separation of ownership and control in a company. Agency relationship is form of contract between owners and managers. Owners must delegate decision-making. Jenson & Meckling suggested that nature of governance in company reflects the conflicts of interest between owners & managers. Agency theory based on view that system of corp governance should be designed to minimise the agency problem and reduce agency costs.

Summary of Agency Theory

Large companies - separation of ownership from control. Professional managers appointed to act as agents for company

Individuals driven by self-interest

Conflicts of self-interest arise between shareholders and managers (shareholders want long term wealth and profitability, managers want status and financial gain)

Managers, driven by self interest, cannot be relied upon to act in best interests of shareholders = problem in agency relationship

Agency problem = cost

Aim should be to minimise cost

Conflicts arise in different ways:

Moral hazard - manager wants benefits like status, company car etc - may pursue strategy of growth through acquisitions to gain more power, even though takeovers may not be in interest of s/holder

Level of effort - manager may not work as hard as if they were owner (could result in smaller profits, lower share price)

Earning retention - earnings of managers often related to size of company (annual sales revenue / value of assets). Managers may want to increase size of company rather than pay out dividends

Time horizon - shareholders long term view

Agency costs:

Cost of monitoring - financial reporting / audits

Bonding costs - costs incurred in providing incentives to managers to act in best interest of sharenolders

Residual loss - cost to shareholder incurred when managers take decisions that are not in the best interests of the shareholders, but rather the managers - i.e. managers pay too much for large acquisition.

Transaction cost theory

Economic theory but also takes into account that people with differing views and objectives run companies

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