Managerial Economics Study Set 11

Business

Quiz 18 :

Organization Structure and Corporate Governance

Quiz 18 :

Organization Structure and Corporate Governance

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Executive stock options are often seen as a simple and effective solution to the "other people's money" problem that can occur when managers with little ownership interest mismanage firm investment opportunities. Can you foresee any advantages and/or potential pitfalls to the use of executive stock options for this purpose?
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Other people's money problem refers to the carelessness of principal's money by the agents. Now to solve this particular problem one option put forward is to provide managers executive stock options. The rationale here is that if managers money also involve in the company then the money they are handling that will not be other people's money because they themselves will own a portion of their stock. In addition, in this kind of arrangement own binding rule is that a manager cannot sale his ownership of company's stock at his will; it can only be sold after some time of his retirement. Hence, this kind of arrangement of tying managers' remuneration to the long-term performance of the company is useful in solving the 'other people's money' problem.
In spite of the specific advantage, this measure has a serious disadvantage too. This is because providing ownership to the managers mean that the power and owners interest in the company will be somewhat compromised.

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Agency Costs. Indicate whether each of the following transaction costs is explicit or implicit, and describe how it is a manifestation of a particular type of agency problem. A. A trader at an investment banking firm loses millions of corporate dollars through unsuccessful rank speculation. B. A manager fails to achieve optimum efficiency by letting past-due accounts languish unpaid. C. Senior executives decline value-increasing investment projects in order to make cash flow targets during the last year of employment. D. Value-increasing product development projects are postponed in order to boost near-term accounting performance. E. Executives manipulate accounting data to boost managerial compensation by placing dismal operating performance in a better light.
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A) The loss can be regarded as 'other people's money' type of agency cost. This is because if personal money is not involved in an investment decision, then people might become a bit careless while taking the final call. This is an important agency problem. This may arise for manager's myopic decision or various other issues.
B) The loss can be regarded as managers' myopic behavior. Managers' shortsighted behaviors in most of the cases create such problems.
C) The loss can be regarded as 'end of game' problem. This is a kind of horizon problem. It implies that at the end of one's carrier one would like to go for the projects, which will yield short-term gains by compromising potentially robust project, which may yield higher return in long term. This is a common problem among senior executives.
D) The given situation comes under manager's myopic behavior about obtaining short-term profit by neglecting value-increasing projects. Sometimes managers may be opportunistic to take undue risks in the short run projects by compromising long-term returns.
E) The given situation comes under income inflation kind of problem. Insiders or high rank executive managers manipulate company balance sheet in order to portray a better picture and send wrong signals to the stockholders.

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Executive Stock Options. Warren Buffett, the chairman and CEO of Berkshire Hathaway, Inc., is an outspoken critic of executive stock option plans, at least as they are commonly employed. In a typical stock option plan, top executives are given the right to buy company stock at the current price for a period of up to 10 years in length. Such options have obvious economic value given the 10 + percent long-run rate of return on common stocks. Nevertheless, the costs of executive stock option-based compensation are typically not reflected in the company's income statement. A. Explain how the failure to include stock option-based compensation costs in the firm's income statement could lead to a type of information asymmetry problem. B. How could the potential for such a problem be avoided? In other words, how would you design an effective executive stock option-based compensation plan?
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A) The failure to incorporate the stock option based compensation costs in the firm's income statement could obviously lead to information asymmetry problem for outside stockowners. This is because if it is not incorporated in the income statement then it actually deflates firm's cost or expenditure part, which misleads stockholders about firm's actual financial health.
B) One method of solving this problem is to try to incorporate this cost in the income statement. The government might enforce it or somehow if it can be enforced in that case it will be able to give proper information about firm's credibility to the outside stockowners.

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Coase Theorem. According to the Coase Theorem, resource allocation will be efficient so long as transaction costs remain low and property rights can be freely assigned and exchanged. A. Does the Coase Theorem imply that government has little if any role to play in the market economy? Explain. B. According to the Coase Theorem, are efficient and equitable economic outcomes assured? Explain.
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In a typical corporation, who are the "principals" and who are the "agents"? What is the firm's agency problem?
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Institutional Stock Ownership. During the amazing bull market of the 1990s, an investment strategy of simply mimicking the Standard Poor's 500 Index became popular. The S P 500 is a value-weighted market index of 500 common stocks thought to measure overall movement in the aggregate stock market. Under this investment strategy, the amount invested in each stock is proportionate to each component's share of the total market valuation of all 500 companies. If the largest component, ExxonMobil, accounts for roughly 3.4 percent of the index, and the second largest component, GE, accounts for roughly 2.8 percent, index followers simply invest 3.4 percent of their portfolio in ExxonMobil, 2.8 percent in GE, and so on. A. Explain how the stock market's ability to discipline the managers of underperforming firms could be reduced if all investors simply purchased index funds that mimicked the S P 500. B. Explain how institutional investors, even those with index funds, actually discipline the managers of underperforming firms in practice.
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Ownership Structure. Describe each of the following factors as being responsible for increasing, decreasing, or having no effect on the amount of concentrated inside equity. Explain why. A. High research and development expenditure requirements B. A corporate history of poor operating performance C. High levels of brand-name recognition D. Intense news coverage of corporate activities E. Imposition of rate of return regulation
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Describe three basic needs that must be met in the design of any organization.
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Sarbanes-Oxley Act. The Sarbanes-Oxley Act, named for sponsors Sen. Paul Sarbanes, D-Md., and Rep. Michael Oxley, R-Ohio, is the most sweeping law affecting corporations since the 1930s. It is having a dramatic effect on the costs companies pay for independent audits of the financial numbers reported to the outside world. In many cases, companies now pay double historical auditing costs to get auditors to attest that all corporate internal controls have been checked and given their seal of approval. This is a big change for companies that have long accepted internal controls that are less than perfect, and for good reason. A company could eliminate padded travel expenses if it wanted to hire a small army in accounting to verify every taxicab receipt. However, such detailed oversight would often cost much more than direct savings. Critics of traditional failures in corporate governance point out that internal control has an importance beyond that of simply catching the occasional fraud. By going through the effort of complying with Sarbanes-Oxley, many companies are unearthing operating inefficiencies. A. Critics of Sarbanes-Oxley contend that the act results in excessive compliance costs. Explain why risk-adverse corporate management may be overstating such costs. B. Supporters of Sarbanes-Oxley argue that the act will produce significant net benefits as corporations improve both the transparency and accuracy of financial reporting. Describe some of the improvements in management efficiency that might be spurred by corporate compliance with Sarbanes-Oxley.
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What are agency costs? Describe some agency costs common among U.S. corporations.
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Information Asymmetry Problem. Shareholders face a daunting information asymmetry problem when it comes to measuring the performance of the CEO. As head of the corporation, the CEO is in charge of the firm's management information system. Accounting methods always leave room for managerial interpretation, and this flexibility can and has been used to understate expenses and inflate reported earnings. When CEO compensation is tied to various accounting performance targets, it is a bit like asking students to fill out their own final grade report. At a minimum, shareholders should not be surprised when accounting data place firm and managerial performance in a favorable light. Shareholders must take steps to guard against significant manipulation of accounting standards and/or accounting bias that results in a meaningful distortion of accounting performance. A. What pitfalls are faced by independent auditors and boards of directors in their efforts to maintain the firm's accounting statements as independent and unbiased indicators of firm and managerial performance? B. What corporate governance mechanisms might be used to guard against the manipulation of the firm's accounting statements?
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Describe four essential components of an effective decision management and control system.
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The personal computer has evolved from a tool for computation to an Internet-centered communications device. Is this likely to change corporate structures by increasing the efficiency of smaller, more nimble corporations?
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Describe the difference between vertical and horizontal business relationships.
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Organization Structure. Determine whether each of the following statements is true or false. Explain why. A. A vertical relation is a business connection between companies at the same point along the production-distribution chain. B. A work slowdown due to an unexpected strike by unionized workers is a type of decision cost. C. A merger between rival retailers Wal-Mart and Target would be horizontal in nature. D. When a corporation files for bankruptcy, it is an admission that the organization was unable to minimize transaction costs. E. Because the Internet allows customers to lower information costs, it will have the obvious long-run effect of reducing costs and boosting corporate profits.
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Cite three important categories of transaction costs encountered within the firm, and give some examples.
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Other People's Money Problem. In 2002, Congress held hearings to investigate the collapse of Houston-based energy giant Enron Corp., aiming to discover how to protect against similar disasters. The spectacular implosion of Enron led to the largest corporate bankruptcy in U.S. history and billions of dollars in losses for investors in the company's debt and equity securities. According to a 217-page report from a panel of Enron's independent directors, Enron's former CFO Andrew Fastow and former chief executive Jeffrey Skilling devised a complex scheme involving limited partnership arrangements that allowed some of the company's top executives to take millions of dollars "they should never have received." The document also revealed that Enron's former chief executive and chairman Kenneth Lay personally approved partnership arrangements that led to enormous liabilities being kept off of Enron's balance sheet, thereby misleading investors as to the company's financial soundness. Enron's collapse was not only scrutinized by more than a dozen Congressional committees, but it also became the subject of a criminal investigation by the U.S. Department of Justice. A. Explain how the Enron fiasco can be seen as a manifestation of the other people's money problem. B. How could it have been avoided?
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Decision Authority. At the end of World War II, goods production and services provision were each responsible for roughly one-half of economic activity and total employment in the United States. Today, the provision of services is responsible for roughly two-thirds of employment and three-quarters of total employment. A. Can you explain the decline of centralized decision authority and the emergence of the "flat" organization style, as a natural result of these trends in aggregate economic activity and employment? B. Is the emerging use of personal computers as Internet-centered communications devices likely to favor flat organization? Why or why not?
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What is the Coase Theorem, and why is it important in managerial economics?
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Discuss important differences between centralized and decentralized allocations of decision authority within an organization. Are these methods of decision authority allocation mutually exclusive?
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