Connection Between Corporate Governance and Company Valuation in Emerging Market Countries - Assignment Example

Connection between corporate governance and company valuation in emerging market countries Contents Literature Review 3 Answer 7 Answer 2 9 Answer3 10 Answer 4 12 Answer 5 14 References 16 Literature Review A number of studies and reports have been presented by different academicians and scholars with an objective of establishing a linkage between the different corporate governance practices and then valuation of the firms, especially in the emerging countries like China, India, Russia, Brazil etc. Different researchers have provided evidences to establish strong connections between corporate governance, legal infrastructure, corruption and the value and performance of the firms. According to the work proposed by LaPorta, Silanes and Shleifer (1999), the different features of the corporate governance structures like the protection of the interests of minorities and in adequate rights of investors lead to poor performance within the firm and low value creation for the business (LaPorta, Silanes and Shleifer, 1999, pp.471-517). In many similar studies, researchers have indicated that the firms which follow lesser or no stringent rules in the corporate governance practices generally tend to have lower valuation in the market. Klapper and Love (2012) have focused their study on the emerging markets and indicate that poor corporate governance practices can increase the risks that are associated with the investments in the emerging markets (Klapper and Love, 2004, p.703-725). In a particular study on the emerging market of Korea, Black and Kim (2003) have pointed out that corporate governance is a significant dynamic of the market value of the firms in Korea, especially for the public companies (Black, Bernard and Kim, 2010, pp.414-425). Black (2001) also establishes a significant linkage between the corporate governance and the value of firms in the market of Russia. Black, Bernard, Love and Rachinsky (2006), suggests that whereas in developed countries like the United States and Europe the corporate governance practices are not as critical as factors like ownership structure from deciding the value of the firm, in developing economies the role of corporate governance in deciding the value of the businesses is significant (Black, Love and Rachinsky, 2006, pp.361-379). Transparency can be implemented by stringent corporate governance practices and transparency is a critical factor in preventing the conflict of interest of the controlling shareholders and the minor shareholders. The conflict of interest between the controllers of the business and the external finance sources of the business may result in the development of the principal agent problem. The principal agent problem will create agency costs that are likely to have a major negative impact on the value of the firm. The major implications of the agency costs caused by low transparency level are the ability of the firm to capitalize on external growth opportunities and the dividend policies of the firm. The firms operating in the emerging countries are inclined to protect the interests of both the majority and the minority shareholders by paying higher dividends. This is because of the recognition of the fact that when the interests of the shareholders are protected, it is likely that they would contribute to the growth and investment for the firm. In contrast, the shareholders who are paid less do not want to hold on to the investments in the company, irrespective of what the investment conditions imply. This factor can lead to misallocation and mishandling of funds and are likely to decrease the value of the firm. Thus, the conflict of interests arising from improper regulatory structures and the lack of transparency are a huge threat for the firms in the developing economies due to their effect of decreasing the value of the firms. Other researchers like Love (2010), examine the relation between corporate governance and the valuation of firms by emphasizing on the transparency factors from the viewpoint of the investors. According to the work presented by Love (2010), transparency involved in corporate governance practices has several positive strategic implications because the investors can get meaningful and proper information which help them in deciding and monitoring their investments (Love, 2010, pp.121-124). This benefit would directly influence a positive increase in the value of the firm in the market. Durnev and Kim (2005) analyze the direct relationship between corporate governance processes and corruption in the firms operating in the developing economies like Indian, China and Russia. They suggest that the firms face administrative corruption issues when the structure of the corporate governance practices is loosely maintained within the businesses. Their findings indicate that in countries where there is a lack of stringent corporate governance practices, a common result is the development of corruption due to lack of transparency within the business and with the shareholders. This leads to an immediate decrease in the value of the firms in the market because of the impairment of the investor interests (Durnev and Kim, 2005, pp.1461-1493). Poor corporate governance policies is known to impair the trust of the investors and corruption leading to the increase in the cost of capital which decreases the operating performance levels as well as the value of the firm. The different legal structures and policies aimed at protecting the investors’ interest are major drivers of the mechanisms of corporate governance and the dividend payout, market valuations, external costs of finance etc. followed in different firms in the developing markets. According to the suggestion of Klapper and Love (2002), the corporate governance structures exist in a positive correlation with the country policies incorporated to protect the investor interests. Thus, it is critical for the firms in developing economies to adopt robust corporate governance practices within their businesses. Researchers indicate that since the emerging countries tend to have weaker rules enforced, therefore the corporate governance practices of firms in the emerging markets have effects of higher magnitude on the value of the firms in the market. The aspect of corporate governance in emerging markets can be viewed from two perspectives. The first perspective includes the patterns of governance and the extent of the relation between the corporate governance and the regulatory practices of the emerging countries. The second perspective shows how the corporate governance procedures impact the firm value in the markets of developing countries. Cheung,Yan-Leung, Connelly, Limpaphayom and Zhou (2007) finds that in the emerging economies like Hong Kong, India etc. the investors tend to invest more on the shares of companies which follow a stringent corporate governance structure. Their work is supported by similar studies presented by many other researchers which clearly indicate that a better corporate governance ensures more trust of the investors and a lower level of administrative corruption within the firm (Cheung, Yan-Leung, Connelly, Limpaphayom and Lynda Zhou, 2007, pp.86-122). Both these factors help in increasing the value of the firm. The adoption of stringent corporate governance practices ensures low volatility and higher returns for the large firms in developing countries like India and Russia. In India, the companies which react adequately to the plans of the regulatory bodies like the Securities and Exchange Board of India (SEBI) are known to infuse more trust into the investors and the value of these companies are much higher in the market. Different researches have proposed extensive literary work aimed at establishing the positive relation between corporate governance and value of the firms in the developing markets. The different cross-country analysis done by researchers like Klapper and Love (2004) and Love (2007) indicate that the firm values are consistently dependent on the firm-level corporate governance practices. But these studies are criticized as they have some weaknesses. One of the drawbacks include the fact that these studies are over reliant on the indices from Credit Lyonnais Securities Asia (CLSA) and Standard and Poor’s (S&P), both of which are indicated to have certain in built imperfections. Both these indices take into account the large firms in each country; therefore the consideration is not uniform. Another drawback is that both these indices have restricted variables of control indicating a level of biasness in the process. Researchers show that studies base on individual countries are much more significant than the cross-country studies as they help to analyze the relation between corporate governance and firm values for both large and small businesses. Also, the country specific indices reflect the governance rules and practices in that country. The most established independent country studies done in order to evaluate the corporate governance practices in emerging markets include the study of Brazil market by De Carvalho (2010), Leal and Carvalhal (2007), Russia market by Black (2001), Black, Love and Rachinsky (2006), Korea market by Black, Jang and Kim (2006) and Hong Kong market by Cheung, Connelly, Limpaphayom and Zhou (2007). The researches have presented a number of studies indicating the major effect of corporate governance on firm values. On the contrary, researchers like Khanna, Kogan and Palepu (2006), suggest that the effect of corporate governance on the value of various firms varies across countries due to the different regulatory and legal structures followed in the different countries (Khanna, Kogan and Palepu, 2006, pp.69-90). This indicates that a certain level of flexibility in the corporate governance practices is expected in firms so that they can react to the changes in the regulatory policies and that stringent corporate governance practices are required in the developing countries as these markets demonstrate a lower level of regulatory and legal structures. Answer 1 Agency problem is one of the major problems in the context of economics. The relationship between economic agents is often defined as principal-agent relationship. The interest of the agent is often found to clash with that of the principle. It is found that is most cases such problems arise out of the problems of asymmetric information between the two parties where the principle is found to be less informed about the market in comparison with the agent. This leads the agent to take care more of its own interests rather than that of its principles. In the context of an organization the shareholders are considered to be the principal, while the management of the organization is considered to be the agents who carry out the various duties on behalf of the shareholders. In this context one of the major problems that is noticeable is that there exists information asymmetry among the CEO or the management of the organization and the shareholders. Many of the actions that are taken by the management are not conveyed to the shareholders of the company. Most of the firms or the management is found to be risk averse or risk neutral. The reason behind this is that any loss on part of the firm would affect the employees as well as the manager of the company in the way of loss of their compensation. Thus from the point of view of their expected gains the managers and the employees of the organization would try to retain either a risk averse position in the decisions that they make. In most of the cases the attitude that a form as a whole portrays reflects the attitude that each of the managers or the employees have towards the organization. Therefore the extent to which the employees and the managers of a firm are risk averse would determine how much the firm would perform in scenario of risk. Since the rewards that the employees of the organization are directly related to the overall output and performance of the firm, the managers would make the decisions in such a way that their compensation is maximized. There are a number of ways in which these costs may arise. First of all, the agents might make use of the resources of the firms for their own interests. Secondly it may also rise at the time of contracting the managers for the various kinds of responsibility of the firm. It may crop up if there arises any case of divergence of the control of the board or in a situation of ownership of the managers. This kind of situation would come up when the managers would try to maximize their wealth rather than trying to maximize the wealth of the shareholders. There is a need to formulate the contracts between the managers and the shareholders which are appropriate and the control mechanisms should be designed with care. Though the CEO of the organization has very little control over the ownership rights of the company, he would be interested to increase the value of the organization for the investors of the company. The risk aversion behavior of the managers would be reduced only when the managers are less focused on their own secure jobs and would take up ventures that would prove to be beneficial for the organization. Answer 2 The horizon problem is a phenomenon which suggests that a manager who has plans of leaving a firm would have lesser interest to work for the benefits of the firm than a manager who plans to stay in the firm for a long time. The horizon problem has increased threat when a manager plans to leave a particular firm but stays in the job market. Equity is used as an effective component of pay for the managers to minimize the horizon problem in different firms. Equity as a pay component is useful in managing and retaining the skilled managers within the firm. A properly designed stock package and stock option package can be highly critical in retaining the managers thereby reducing the horizon problem with respect to the organization. The increased use of equity in the pay structure is known to improve the connection between the remuneration of the managers and the performance and retention of the managers in the firm. The trend of payment to the managers on the basis of equity is increasing across the global as it is identified as one of the major factors influencing the managers to stay within the organization and perform better thereby decreasing the horizon problem to a large extent. Accounting information plays a major role in designing the pay packages and bonuses for the managers with an aim to decrease the horizon problem. The financial accounting information is the quantitative information data that is used to assess the performance levels and the financial position of different firms. The accounting information consists of the data combined from corporate accounting and financial reporting system validated by the external auditors for public disclosure purposes. Thus, accounting information acts as the major source of validated information about the financial position of the company which helps in reducing the various issues like agency problem and horizon problem within the business. The accounting information acts as a major driver of corporate governance mechanisms to reduce the administrative corruption level in different firms. The employment of accounting information in designing the contractual terms of the bonus packages is critical as they ensure transparency, accountability and reliability. The accounting information is a critical factor in designing the compensation contracts of the managers. The clear and reliable accounting information helps the company to design better compensation packages by streamlining the interests of the managers and shareholders with the objectives of the company. The implementation of performance measures based on accounting information has increased in the contractual terms of bonus pays as the transparency required in designing the corporate compensation is highly dependent on the financial reporting disclosures, accounting policies and government disclosures. Both cash bonus plans and stock option plans are based on the accounting information of the company. This helps prevent corruption as managers are offered increasing pay through stock options and cash bonuses that influences them not to twist the accounting information’s of the company. Answer 3 In most of the organizations there are varied norms regarding the employee compensation. The salaries of the employees are divided into fixed and bonus components. In has been found that thought the basic pay of the executives have doubled over a period of five years to an average of $1.8 million. Thus the pay of the executives has increased to a greater extent compared to that of the junior or the middle level executives of the company. The earnings of the company have increased to a greater extent. The bonus pay of the employees is mainly the performance based pay. The incentive payments of the employees may be short term or long term. The fixed pay of the employees would include the basic salary along with the necessary superannuation and the different types of perquisites which would remain same irrespective of the level of the payments of the employees. Along with this there are provisions for retirement benefits as well as entitlements to paid leaves. On the other hand the bonus payment for the executives would mainly comprise of the cash components as well as the stock options or the shares of the company. The executives may also be entitled to performance rights of the company. These are special kinds of rights that are provided to the employees of the organization in case any executive have performed in a situation of crisis or have been able to exhibit any special kind of performance for the benefit of the organization. The main reason for providing stock options to the employees of the company is that the employees being a shareholder would try to increase the output of the company and hence would be able to understand the interests of the shareholders. The purpose of providing the equity based payments is that the executives would consider the value of the company to contribute to a part of his wealth. The non-salary components are generally considered to be provided to the employees so that they are motivated to do the work. Apart from the basic salary, the performance linked salaries ensure that the employees remain motivated and they perform more than the stipulated amount of work that the executives have been assigned. The risk profile that each of the executives of the company acts in a positive way in the designing of the incentive based payments. The risk taking attitude or alternatively the risk aversion attitudes of the employees are challenged by the implementation of such methods. If an employee does not want to take any risk for securing his income, such kind of pay structures would lure the executives to take proper risk. Some of the companies which are in the growth stage of their phase of development, it is essential to take risks that would help the companies to take leap for a better opportunity. The costs to the company in case of the non recourse loans may be comparatively less. However, it might pose a threat to a small scale organization in the emerging economies because there is a lot of risk of default on these types of loans. Again in case of providing the facilities like paid leaves or superannuation would cost comparatively less to the company. The main reason for superannuation is that calculated from the point of view of time value of money this component would secure the future of the executives at a future date. The sum is fixed in such way that the executives would be able to maintain themselves well even after leaving the organization or after retirement. This is also done to retain the connection of the employees with the organization a long lasting one and to maintain better relationships with the various kinds of stakeholders. Answer 4 Most of the senior managers of an organization have a tendency to work for the short term result of the company rather than planning for the long term results. There is often a tendency of trade off between the short term results and the long terms results. In the present day most of the managers are found to be aiming mainly at the getting financial results of the company that would help the company in the short run rather than the long term. This preference of the managers is reflected in the entire process of decision making that the managers take. From the point of view of improper corporate governance it is found that the managers try to maximize the present price of the shares rather than looking at improving the long term benefits of the organization. In the cases of efficient capital market there would not be any situation of information asymmetry. This would mean that the prices of the shares would reflect the performance of the organization in the long run. In such cases there would be no use of taking short term strategies for the speculators and the investors. However, empirical studies on the capital markets have shown that the capital markets put more importance to the short term gains and rise in the price of the shares rather than the long term benefits of the companies. In other words there is a strong focus on the short term costs and benefits that a firm incurs rather than the long term implications for the firms. Thus the managers take those strategies which are considered to be suboptimal from the point of view of the firm rather than being optimal which would mean that the long term gains would be considered. The above analysis would imply that the investors would prefer to have a high current result rather than a long term sustainable level of results. The main reason for this is asymmetric information as well as the fact the shareholders considers the long term opportunity cost for holding the shares instead of cash is much high for a longer time horizon. The investors are in general not capable to estimate the consequences of the long term decisions that the managers of a firm take. They can comprehend the short term gains from investing in a particular company. Thus the investors engage themselves into a process of over discounting the time value of the shares. On the other hand the compensation that the executives of a company derive is another major reason for the short sightedness of the shareholders of the company. In most cases the employees are often provided with the stock options which the employees may liquidate in order to make a short term gain out of their holdings of the stocks of the company. Hence the focus of the managers is also the short term results of the company rather than the long term gains which would persist in the long run. Thus this particular problem arises when the ownership of the company and the control of the regular operations of the company are separated from one another. Thus in most of the organizations it can be seen that the managers prefer to accept the compensation in form of direct cash rather than stock options which only transfer a part of the ownership of the company to the managers. This is because the managers can make use of the cash at the present day and the opportunity cost of bonus in form of the stock options is much higher than that of the cash bonus that is provided by the firms and the CEOs of the company. They often take the compensations in forms of the cash bonuses so that the executives are not accountable to the shareholders. Answer 5 In the country of Australia there are a number of laws that ensure that the shareholders have the right to vote for and decision the kind of remuneration and the kind of compensation that the top executives of the company would be deemed to be eligible to get. The Australian Prudential Regulation Authority is responsible for the decision making process in the requirements of adequate capital that is necessary for the remuneration practices of the organization. The shareholders of a company are to a large extent affected by the kind of remuneration that the top executives demand from the company. In the scenario of the financial crisis it was important for the organization to design the remuneration packages of the senior officials in such a way that the interests of the shareholders of the company remains aligned with that of the executives who carry on the day to day process and take part in the decision making of the organization. There is also a necessity for the managers to maintain a transparency in the process of deciding about the pay package of the senior executives of the company. At the same time the CEO and the other topmost executives of the company need to be accountable to the shareholders of the organization. A need to create a robust and transparent regulatory framework was felt that would define the way the organizations would model the pay structures as well as the system of reward of the executives and the directors of the corporate in Australia. The short term bonuses are important for the organizations because they would help the organization to create an atmosphere of competitiveness and would generate leadership skills for the employees. This would motivate the executives to perform better in the organization in each and every quarter of the business and this level of motivation would not fade away with time. On the other hand, if the executives are eligible for the long term high bonuses then they would be able to relate themselves more with the organization. As result of this the interest of the executives and the directors would be more aligned with that of the shareholders. The shareholders would prefer and vote for that executive who considers the organization to be his own and therefore tries to enhance the organizational performance and productivity especially in case of the emerging nations. The pros of the performance based pay are that the organizations are able to reduce the amount of agency cost through the performance based pays. This comprise of the bonus component of the salaries of the executives of the company. Since most of the bonus that the executives get form the organization come from the variable component in form of the stock options they would try to maximize the value of the stocks so that the amount of cash that they get by liquidation of the stocks or selling the stocks in the secondary market is much higher. Thus the ownership of the equity in form of the stock options links the wealth of the executives with the prices of the stocks and hence with the increase in the price of the shares the net worth of the executives would also go up. The problem with the long term incentives like loans with recourse would pose a problem for the company in the long run. This is because in such kind of loans the company bears the responsibility to repay the loan in case of default on part of the executive to pay the loan. Thus the company is exposed to a long term risks on behalf of the employees. This might lead to a problem of getting debt from any financial institution. It is also noticed that since most of the CEO are persons who have experience in large organization and are considered to be highly esteemed people of the society, they demand a huge amount of salary in most of the emerging nations. They are also engaged in tough process of decision making which is considered to be extremely challenging. Thus the management generally does not disregard the demand of the executives regarding the high payment. References Black, B. & Kim, W. 2010. The Effect of Board Structure on Firm Value: A Multiple Identification Strategies Approach Using Korean Data. Corporate Governance: An International Review. Vol. 17, pp. 414-425. Black, B., Love, I. & Rachinsky, M. 2006. Corporate Governance Indices and Firms Market Values: Time-Series Evidence from Russia. Emerging Markets Review. Vol. 7, pp.361-379. Cheung, S., Yan-Leung, J., Connelly, T., Limpaphayom, P. & Zhou, L. 2007. Do investors really value corporate governance? Evidence from the Hong Kong market. Journal of International Financial Management and Accounting. Vol. 18, pp. 86-122. Durnev, A., & Kim, E. H. 2005. To Steal or Not to Steal: Firm Attributes, Legal Environment, and Valuation. Journal of Finance. Vol. 60, pp. 1461-1493. Khanna, T., Kogan, J. & Palepu, K. G. 2006. Globalization and Similarities in Corporate Governance: A Cross-country Analysis. Review of Economics and Statistics. Vol. 88, pp. 69-90. Klapper, L. F. & Love, I. 2004. Corporate Governance, Investor Protection and Performance in Emerging Markets. Journal of Corporate Finance. Vol. 10, pp. 703-728. LaPorta, R. Silanes, F and Shleifer, A. 1999. Corporate Ownership around the World. Journal of Finance. Vol. 54, pp. 471-517. Love, I. 2010. Corporate Governance and Performance around the World: What We Know and What We Don’t. World Bank Research Observer, Vol. 16(1), pp. 121-124. Read More