Corporate governance tackles the complex relationships between companies and their stakeholders. It's all about balancing the interests of shareholders, managers, and other groups affected by a company's actions.

At its core, governance deals with the principal-agent problem: how to ensure managers act in shareholders' best interests. Mechanisms like performance-based pay and board oversight aim to align these interests and drive better company performance.

Corporate Governance and Stakeholder Relationships

Principal-agent relationship in governance

• Principals are shareholders who own the company and hire agents (managers) to run it on their behalf
• Potential conflicts of interest arise when managers prioritize their own interests over shareholders'
  • Excessive compensation packages for managers
  • Empire building by pursuing projects that increase manager's power but not shareholder value
  • Risk aversion leading to missed opportunities for growth
• Mechanisms to align principal-agent interests
  • Compensation packages tied to company performance (stock options, bonuses)
  • Board of directors provides oversight and represents shareholder interests
  • Threat of takeovers disciplines underperforming companies by replacing ineffective management

Stakeholders and corporate decision-making

• Shareholders are the owners of the company
  • Elect the board of directors to represent their interests
  • Approve major decisions (mergers, acquisitions, changes to bylaws)
  • Exercise shareholder rights (voting, access to information, derivative lawsuits)
• Board of Directors is elected by shareholders
  • Oversees management and company strategy
  • Appoints and dismisses top executives (CEO, CFO)
  • Ensures management acts in the best interest of shareholders
• Management is hired by the board to run day-to-day operations
  • Makes strategic and operational decisions (product development, pricing, marketing)
  • Accountable to the board and shareholders for company performance
• Other stakeholders influence decision-making through various means
  • Employees (unions negotiate wages and benefits)
  • Customers (consumer advocacy groups lobby for product safety and quality)
  • Suppliers (long-term contracts, partnerships)
  • Creditors (debt covenants, credit ratings)
  • Communities (local regulations, public relations)

Management decisions vs company performance

• Capital allocation decisions impact shareholder value
  • Investing in projects with positive net present value (NPV) increases value
  • Poor investment decisions (overpriced acquisitions, unsuccessful R&D) destroy value
• Financing decisions affect the cost of capital and financial risk
  • Optimal capital structure balances cost of debt (interest) and equity (dividends)
  • Excessive debt increases financial risk and may lead to bankruptcy
• Dividend policy balances returning cash to shareholders vs reinvesting in growth
  • Paying dividends provides immediate return to shareholders
  • Retaining earnings allows for reinvestment in profitable projects
• Operational efficiency impacts profitability and cash flow
  • Effective management of costs (lean manufacturing, supply chain optimization)
  • Streamlined processes (automation, outsourcing non-core functions)
  • Productive human resources (employee training, incentive systems)
• Corporate governance aligns management and shareholder interests
  • Strong governance (independent board, transparent reporting) reduces agency costs
  • Weak governance (insider boards, opaque financials) may lead to mismanagement and fraud

Corporate Responsibility and Stakeholder Management

• Corporate governance structures ensure ethical and effective management
• Stakeholder theory emphasizes considering all stakeholders' interests in decision-making
• Executive compensation policies aim to align management interests with shareholders
• Corporate social responsibility initiatives address broader societal and environmental concerns