prashantsahni

Which of the following refers to the situation where an active investor does not own the majority of the firm’s shares but persuades other shareholders of her position?

A) The active investor has real control.

B) The active investor has contingent control.

C) The active investor has formal control.

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An active investor must have control to effectuate change. To have control, the shareholder must have either a majority of the firm’s shares (formal control) or be able to persuade other minority shareholders of her position (real control).

prashantsahni

In which of the following situations would an active investor be the least effective monitor of management? The active investor holds a:

A) small block of liquid stock.

B) large block of illiquid stock.

C) small block of illiquid stock.

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If the active investor holds a small block of stock, then they do not have as strong an incentive to monitor management as they would if they held more shares and hence had more at stake. If the stock were liquid, they would also be less likely to be an effective monitor of management because they can easily sell their shares if management misbehaves. If instead the stock was illiquid, the active investor would likely place pressure on management to change because they could not cash out as easily.

prashantsahni

Which of the following prescriptions would least likely improve board of director effectiveness?

A) The board should have an independent chairman.

B) Directors should be subject to maximum equity positions.

C) Self-evaluations of boards should be performed.

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Directors should be required to hold a minimum amount of equity, not limited to a maximum of how much equity they can hold.

prashantsahni

Which of the following would enable a Board of Directors to act in the best long-term interest of the shareholders?

A) A majority of the Board of Directors is comprised of independent members and the Chairman of the Board is also a former Chief Executive Officer of the firm.

B) A majority of the Board of Directors is comprised of independent members and the Board meets regularly outside the presence of management.

C) There are Board members who are closely aligned with a firm supplier and the Board meets regularly outside the presence of management.

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The Chairman of the Board, who is also the CEO or former CEO, may impair the Board members from expressing opinions contrary to management. Also, when Board members’ interests are closely aligned with a firm supplier, customer, pension advisor, etc., independence may be impaired.

prashantsahni

In which of the following situations is the board of directors most likely to become more effective?

A) The firm’s earnings have been increasing and the stock price has been consistently increasing.

B) The economy is in a recession and the firm’s stock price has been consistently declining.

C) The firm has sustained several quarters of losses and the firm’s stock price has been consistently declining.

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If the firm’s earnings have been consistently decreasing, the firm is likely nearing crisis. Boards become more active during periods of crisis or when the stock price declines. It is at these times when the personal relationship between managers and directors deteriorates and that boards find themselves in the public limelight.

prashantsahni

Which of the following statements regarding management compensation is most accurate?

A) Stock-based compensation and bonuses are substitutes whereas explicit and implicit incentives are most often complements.

B) Stock-based compensation and bonuses are complements whereas explicit and implicit incentives are most often complements.

C) Stock-based compensation and bonuses are complements whereas explicit and implicit incentives are most often substitutes.

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Bonuses and stock-based compensation are complements because bonuses reflect the manager’s short-term success whereas stock-based compensation more reflects the manager’s longer-term successes. Implicit incentives are usually substitutes for explicit incentives because the stronger the implicit incentive, the lower the need is for explicit incentives.

prashantsahni

Suppose shareholders wish that the board directors undertook more risk. Which of the following would most likely achieve that goal?

A) The directors were paid with stock and their liability insurance was paid for.

B) The directors were paid with stock options and their liability insurance was their responsibility.

C) The directors were paid with stock options and their liability insurance was paid for.

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If board directors were paid in stock options, they would be encouraged to take more risk. If their liability insurance were paid for, then they would also have an incentive to take greater risk because they would not have to face the potential consequences of their decisions.

prashantsahni

Which of the following statements regarding stock options as management compensation is most accurate?

A) When a stock option is out of the money, the manager has an incentive to take greater risk. When it is in the money, its incentive effect is similar to that of stock compensation.

B) When a stock option is out of the money, the manager has an incentive to take greater risk and its incentive effect is similar to that of stock compensation.

C) When a stock option is in the money, the manager has an incentive to take greater risk and its incentive effect is similar to that of stock compensation.

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When stock options are out of the money, managers have an incentive to take greater risks. The reason is that the option is worthless when the firm’s stock price is less than the option exercise price. If the option is currently in the money, a stock option is similar to stock in terms of its incentive effect. The only difference is that the option will provide lower compensation (the stock price minus the exercise price) relative to an outright payment of stock.

hinsafdar

The board of directors of Worldwide Graphics has hired Bloom and Moore Consultants to investigate the corporate governance of Worldwide Graphics (WG). There have been some complaints from shareholders that the executives at WG have not been managing the firm in the best interest of the shareholders. The board of directors has requested an assessment of the managers’ incentive structure and an assessment of the decisions of the executives over the past few years. The board of directors specifically ask for Bloom and Moore to look for possible cases where WG executives are not acting in the best interests of WG shareholders. Furthermore, labor groups and the community where WG has its headquarters have been pressuring WG management to address the welfare of employees and the community. In essence, they want WG to maximize the welfare of all stakeholders and not just shareholders.When given a job such as this, the consultants Fred Bloom and Steven Moore typically assess the board of directors and their incentive structure too. Bloom and Moore have found that poor corporate governance often starts with problems in the board of directors. Among their findings, Bloom and Moore find that only a small minority of the WG board members are WG executives, and the majority of all the board members serve on the boards of several other companies. Bloom feels that the members being on other boards is a good thing because it means the board members have a lot of experience. Bloom and Moore also find that the board members receive a flat fee and do not get stock options. Moore feels this fee structure is good because it increases the board members’ objectivity.
One of the accusations made by the shareholders is that WG executives have not been taking adequate risk. In essence, the shareholders have complained that the managers have been avoiding projects with higher risk and higher return because high risk projects have a higher probability of negative outcomes, which jeopardize the jobs of the managers. In examining the activities of WG managers, Bloom and Moore find that there had been a great deal of expansion and, in the past year, even an acquisition by WG of another firm. Bloom and Moore discuss if such expansion is incongruous with the accusation of WG managers not taking risk.
Bloom and Moore find that the executives of WG have been given stock options as part of their compensation, but the board members do not receive cash bonuses based upon the net income of WG. Bloom says that stock options help in aligning the interests of executives with shareholders, and bonuses based upon income would only be a substitute and not a compliment to stock options. Moore says that stock options and bonuses based upon income are more complements than substitutes. They also discuss if giving stock options to board members as compensation help motivate the board to monitor and direct the WG executives to act on behalf of the shareholders.
Bloom and Moore also recommend that WG use more debt in its financing. They both recognize that firms with higher total debt ratios seem to be managed better and in a fashion that has the shareholder interests in mind. Bloom says that a higher debt ratio leads to managers having less cash to siphon off to provide the executives with perks. Moore says that recent changes in the law, as a result of recent corporate scandals, have allowed debt-holders to form voting blocks to influence the board decisions.
There has been an outcry for WG executives to try to maximize the welfare of parties other than WG shareholders, e.g., employees and the community. In responding to this outcry, Bloom and Moore should:

A) point out that such pursuits are illegal given the fiduciary responsibility that WG executives have for WG shareholders.

B) recommend that WG employ the Cadbury metric to pursue this goal.

C) point out that no adequate, widely-used metric for pursuing such a goal exists.

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The only correct answer is that there is no widely-used and adequate metric for pursuing the goal of maximizing the welfare of multifarious stakeholders. It is legal, but there is no such thing as a Cadbury metric. (Study Session 12, LOS 28.c)

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In their discussion concerning whether stock options and bonuses based upon income are substitutes or complements:

A) Bloom is correct and Moore is incorrect.

B) Bloom is incorrect and Moore is correct.

C) Bloom and Moore could both be correct. It depends upon the circumstances.

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It is true that stock options and bonuses are not substitutes because their values are based upon two different variables. The value of options is based upon market data, and the value of a bonus is based upon accounting income. (Study Session 12, LOS 28.b)

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There are only a minority of executive directors on WG‘s board of directors, and most of the members are also members of other boards. With respect to the effectiveness of the board, the fact that there is only a minority of executives on the board is:

A) positive for board effectiveness, and the members being on other boards is positive for board effectiveness.

B) positive for board effectiveness, but the members being on other boards is negative for board effectiveness.

C) negative for board effectiveness, but the members being on other boards is positive for board effectiveness.

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Fewer executives on the board is usually seen as a positive thing for shareholders. One way WG executives could make the board less effective, however, is to see to it that the board members are on several other boards so that they are overcommitted and cannot perform well on the board of WG. (Study Session 12, LOS 28.c)

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Bloom and Moore investigate whether AG executives have been avoiding risks and the effect of the executives expanding and making acquisitions.

A) These actions are both moral hazard problems, but they are mutually exclusive.

B) Avoiding risks is a moral hazard problem, but making acquisitions is not a moral hazard problem.

C) These actions are both moral hazard problems, and they can occur together.

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Managers avoiding risk is a moral hazard problem in that the managers avoid profitable ventures that have a good chance of increasing the value of the firm, but the venture could lead to the managers losing their job if the venture fails. Making acquisitions or “empire building” can be a problem. The acquisitions can be low risk and low return projects and congruous with the other case where the managers are not acting on behalf of the shareholders. (Study Session 12, LOS 28.a)

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Bloom and Moore discuss whether to give the board of directors stock options as part of their compensation. Giving stock options to the board of directors:

A) has not proven effective at all in increasing the board’s incentives to act on behalf of shareholders.

B) can increase the board’s incentives to act on behalf of shareholders, but its effectiveness is limited.

C) can be effective, but it is usually too costly to implement.

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Providing directors with stock options rather than fixed fees goes in the right direction, but it has its limitations for the same reason that managers’ stock options have limitations. In particular, if the managers go for a risky strategy that reduces investor value but raises the value of their stock options, directors may have little incentive to oppose the move if they themselves are endowed with stock options. (Study Session 12, LOS 28.b)

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In the discussion concerning why firms with a higher debt ratio may be run better and more in the interest of shareholders:

A) Bloom is correct and Moore is incorrect.

B) both Bloom and Moore are correct.

C) Bloom is incorrect and Moore is correct.

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Bloom is correct in that debt imposes a discipline and natural restriction on the use of the cash flow. Moore is wrong because there has not been any legislation concerning allowing debt-holders to form voting blocks. (Study Session 12, LOS 28.b)

hinsafdar

If a manager is confident in her abilities, then:

A) implicit incentives such as the manager losing her job act as a complement for explicit incentives, such as stock options.

B) implicit incentives such as the manager losing her job act as a substitute for explicit incentives, such as stock options.

C) implicit incentives such as stock options act as a substitute for explicit incentives, such as the manager losing her job.

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Stock options are explicit incentives. An example of an implicit incentive would be the manager losing her job. If a manager is confident in her abilities, then she would be willing to accept a higher probability of being fired for increased compensation. In this case, a strong implicit incentive would be accompanied by an attractive compensation package and the two types of incentives would be measured as substitutes.