# Corporate Governance

Business I · Economics of the Firm · https://tryals.app/learn/business-i/corporate-governance

## Who Watches the Managers?

In large corporations, owners (**shareholders**) and operators (**managers**) are different people. This separation causes the **principal-agent problem**: agents may pursue empire-building or a quiet life instead of owner value, hiding behind an information gap.

**Agency costs** measure everything this divergence burns: wasted expenses, missed opportunities, and the costs of monitoring.

**Corporate governance** realigns these interests via:

- **Board of directors**: Hires and fires executives.
- **Incentive pay**: Ties executive wealth to owner outcomes.
- **Transparency**: Audited accounts shrink hidden info.
- **Takeover threat**: Sagging stock invites replacement.

**Pitfall:** Incentive pay is not a cure-all. Bonuses tied strictly to quarterly earnings often encourage dangerous accounting games and slashed R&D.

## The Governance Toolkit

Effective governance balances multiple overlapping mechanisms to keep executives accountable to long-term firm goals.

| Mechanism | How it realigns interests |
|---|---|
| **Independent directors** | Provide unbiased judgment without management ties |
| **Incentive pay** | Aligns manager wealth directly with owner outcomes |
| **Audited disclosure** | Shrinks the information gap exploited by agents |
| **Takeover threat** | Underperformance invites hostile replacement |

**Shareholder vs Stakeholder**: The Anglo-Saxon model focuses strictly on shareholder value. European models weigh employees, creditors, and communities. Modern codes blend both to build durable, long-run value while answering to all affected groups.

## Practice questions

8 of this lesson's 14 practice questions, with answers. The full set is in the app.

### 1. Why can a _badly designed_ bonus scheme make governance worse rather than better?

A. It eliminates the need for a board of directors
B. Bonuses are always too small to change behavior
C. Managers legally cannot receive performance pay
D. It can reward short-term earnings manipulation

**Answer:** D. It can reward short-term earnings manipulation

**Why:** Incentive pay transmits whatever signal it measures. Key it to short-run reported earnings and you incentivize accounting games, deferred maintenance, and risk-shifting, alignment turned against the aligner.

Page: https://tryals.app/practice/business-i/corporate-governance/why-can-a-badly-designed-bonus-scheme-make-governance-worse-rather

### 2. A CEO paid mostly in share options presides over a huge, badly-timed bet that pays off. Which governance problem does the outcome hide?

A. The board should have fired the CEO before the outcome was known
B. Options align the CEO with shareholders, so no governance problem exists
C. Options reward the upside and cap the downside at zero
D. The problem is that options are taxed differently from salary

**Answer:** C. Options reward the upside and cap the downside at zero

**Why:** An option is worthless below the strike and unbounded above, so it prices volatility rather than performance and pays the same for luck as for skill. Aligning incentives is not the same as aligning them correctly, which is why the shape of the payoff matters more than its size.

Page: https://tryals.app/practice/business-i/corporate-governance/a-ceo-paid-mostly-in-share-options-presides-over-a-huge-badly-timed

### 3. Which are recognized governance mechanisms for disciplining managers?

A. Equity-linked compensation
B. The threat of hostile takeover
C. Guaranteeing managers lifetime tenure
D. An independent board of directors

**Answer:** A. Equity-linked compensation; B. The threat of hostile takeover; D. An independent board of directors

**Why:** Boards monitor, equity aligns, takeovers punish. Unconditional tenure removes the very accountability the other three create.

Page: https://tryals.app/practice/business-i/corporate-governance/which-are-recognized-governance-mechanisms-for-disciplining-managers

### 4. Agency cost is defined as value lost to diverging interests PLUS the cost of monitoring. Why is monitoring counted as part of the problem rather than the solution?

A. Because shareholders cannot legally monitor managers directly
B. Because monitoring costs are borne by the manager rather than the owner
C. Because monitoring consumes real resources that produce nothing
D. Because monitoring is usually ineffective at changing manager behaviour

**Answer:** C. Because monitoring consumes real resources that produce nothing

**Why:** Both terms are costs of the same defect. That is why governance is a trade-off rather than a fix: at some point another euro of monitoring saves less than a euro of misalignment.

Page: https://tryals.app/practice/business-i/corporate-governance/agency-cost-is-defined-as-value-lost-to-diverging-interests-plus-the

### 5. Order the market-for-corporate-control mechanism from cause to consequence.

**Answer:**

1. Management persistently underperforms
2. The share price sags below the firm’s potential value
3. An acquirer sees profit in buying and fixing the firm
4. A takeover bid is launched for the discounted shares
5. Incumbent management is replaced

**Why:** The share price converts bad management into a takeover opportunity, and the mere anticipation of this chain disciplines managers who never face a bid.

Page: https://tryals.app/practice/business-i/corporate-governance/order-the-market-for-corporate-control-mechanism-from-cause-to

### 6. Under the stakeholder model, managers should weigh the interests of employees, creditors, and the community alongside shareholders.

**Answer:** True

**Why:** That is the model’s defining claim, in contrast with the shareholder-primacy view; most modern governance codes blend elements of both.

Page: https://tryals.app/practice/business-i/corporate-governance/under-the-stakeholder-model-managers-should-weigh-the-interests-of

### 7. Match each governance mechanism to the problem it attacks.

**Answer:**

- Independent board → Monitoring managers the owners cannot watch
- Stock options → Aligning manager wealth with firm value
- External audit → Verifying the accounts managers report
- Takeover threat → Disciplining persistent mismanagement via the share price

**Why:** Four guardrails, one target: shrinking the gap between the agent’s interest and the principal’s.

Page: https://tryals.app/practice/business-i/corporate-governance/match-each-governance-mechanism-to-the-problem-it-attacks

### 8. Sort each cost: is it a **direct agency cost** (value the agent burns) or a **monitoring cost** (spent watching the agent)?

**Answer:**

- Direct agency cost: CEO buys a rival mainly to run a bigger empire, Luxury corporate jet for routine trips
- Monitoring cost: Annual external audit fees, Compensation consultants designing the bonus plan, Board committee time reviewing executive decisions

**Why:** Agency costs come in two flavors: the value the divergence destroys, and the value spent policing it. Governance minimizes their *sum*.

Page: https://tryals.app/practice/business-i/corporate-governance/sort-each-cost-is-it-a-direct-agency-cost-value-the-agent-burns-or