THE INTERNAL GOVERNANCE OF FIRMS VIRAL V. ACHARYA, STEWART C.

MYERS, and RAGHURAM G. RAJAN∗SFITSORIS KONSTANTINOS S.N:431167

PURPOSE OF RESEARCH WE EXAMINE HOW INTERNAL GOVERNANCE

ENSURE THE SUBSTANCIAL VALUE OF THE FIRM WITH FEW OR NO EXTERNAL GOVERNANCE.

BOTH CEO AND MANAGER CONTRIBUTE TO FIRM’S CASH FLOW MOST EFFECTIVE INTERNAL GOVERNANCE.

WE PRESENT A THEORY OF INVESTMENT AND DIVIDENT POLICY CEO MAINTAIN BALANCE BETWEEN INTERNAL AND EXTERNAL CONTROL.

INTODUCTION KEY PLAYERS CURRENT CEO SUBORDINATE MANAGER - NEXT CEO SHAREHOLDERS COMMON ASSUMPTION DIVERSE AGENTS WITH DIFFERENT AIMS

BASIC INGREDIENTS OF FIRM’S CASH FLOW FIRM’S CAPITAL STOCK CEO’S ABILITY TO MANAGE YOUNG MANAGER’S EFFORT

CONTENTI) simple two-period model of

internal governanceII) Extent analysis to an overlapping

generations model III) examine rolling partnership.IV)Analyze external governance by

public shareholders

I) Simple two-period model of internal governance CONSIDER A FIRM WITH A CEO AND A MANAGER. Manager’s effort : s Capital : k

CEO’s proceeds –max : C(k0, s) − (k− k0). Franchise value v(k,s) that manager inherits.

CEO INVESTS IF FIRM’S CAPITAL STOCK AND MANAGERIAL EFFORT ARE COMLEMENTS FOR ITS V.

MANAGER EXERT EFFORT INTERNAL GOVERNANCE

II) Extent analysis to an overlapping generations model. EACH AGENT CAN WORK AT MOST FOR TWO PERIODSPeriod t t+11) CEO HIRES MANAGER

2)CEO COMMITS TO END OF PERIOD CAPITAL STOCK (k)

3)MANAGER ENGAGES IN LEARNING EFFORT

4)CASH GENERATED

INVESTMENT MADE

CEO GETS RESIDUAL

5)CEO RETIRES

MANAGER BECOMES CEO

HE THEN HIRES A NEW MANAGER.

Firstly, we assume that there is no outside financing and manager’s wages are normalized to zero. CEO APPROPRIATES : Ct – (Kt – Kt-1 )

The firm generates C.F at the end of each period

Ct(kt−1, sCEO, st) = θt (kt−1) ^γ [ f (sCEO) + g(st) ]

This setup ensures the strategic complementary of capital stock and managerial learning for firm value.

First-Best case BENCHMARKS CEO IS FAR-SIGHTED MANAGER INTERNALIZES ALL THE EFECTS OF HIS LEARNING.

The first-best outcome is investment and managerial learning pairs(kt, st), for all t, that maximize the sum of all current and future cash flows net of investment and learning effort. INFERENCE CAPITAL STOCK :CORRELATED ONLY WITH

Θt+1. MANAGERIAL LEARNING :DEPENDS ON BOTH

CONSTRAINED EFFICIENT CASE BENCHMARKSCEO IS FAR-SIGHTED

MANAGER DOES NOT INTERNALIZE THE EFFECTS OF HIS LEARNING. CEO (t ) TRY BOTH TO MAXIMIZE THE DISCOUNTED

SUM OF CASH FLOW NET OF INVESTMENT-LEARNING COSTS AND INCENTIVIZE THE MANAGER

INFERENCE

CAPITAL STOCK : CORRELATED ONLY WITH Θt+1

MANAGERIAL LEARNING: DEPENDS ONLY ON Θt

MYOPIC CEO CASE BENCHMARKS MYOPIC CEO – MORAL HAZARD MANAGER DOES NOT INTERNALIZE THE

EFFECTS OF HIS LEARNING.

CEO’S INCOME EXTRACTED FROM THE CURRENT PERIOD’S CASH FLOW INVESTMENT : θt (kt−1) ^γ [ f (sCEO) + g(st) ] – ( kt – k t-1 )

Other essential propositions of the mechanism of internal governance

EMPLOYEES OR MID-CAREER MANAGERS ARE THE MOST CONCERNED AND ABLE TO ACT AGAINST SHORT-SIGHTED CEOS

THE EXISTENCE OF FUTURE FIRM SPECIFIC RENTS,MAKE THEM FAR MORE EFFECTIVE IN EXERTING INTERNAL GOVERNANCE.

III) PARTNERSHIPS AND EFFICIENCYWT: IN A COMPETITIVE LABOR MARKET,CEO SETS

MANAGER’S WAGE AT THE RESERVATION LEVEL OF ZERO REPRESENTING THE PRESENT VALUE OF THE MANAGER’S FUTURE CASH FLOW AS CEO MINUS HIS CURRENT INVESTMENT IN LEARNING

We achieve the constraint efficient outcome- When there are no constraints on junior managers’ ability to borrow against future returns to their human capital and managers are hired in a competitive labor market, a “rolling partnership”—attains the efficient investment, limited only by the moral hazard problem of managerial effort.

IV ) EXTERNAL GOVERNANCE MANAGER HAS NO WEALTH AND CANNOT

BORROW. OUTSIDE SHAREHOLDERS WITH PROPERTY

RIGHTS.

OUTSIDE SHAREHOLDERS CAN REALIZE : β/£. CEO MAKE A DIVIDENT COMMITMENTdt: NET DIVIDEND PAYOUT EQUITY HOLDERS SERVE AS INTERMEDIARIES

BETWEEN SUCCESIVE GENERATIONS OF CEO.

CEO’S MAXIMIZATION PROBLEM

maxθt (kt−1)^γ [ f (sCEO) + g(st)] − (kt − kt−1) − dt

s.t. β(kt − kt−1) + dt ≥ rβkt−1

MANAGER’S PARTICIPATION CONSTRAINT U’(kt)

1/(1 +r ) ( [θt+1γ kt^γ−1 {f (st) + g(st+1)} ]+ (1 −

β) − βr )

LIMITING CASE : β=1 FULLY FINANCED BY SHAREHOLDERS

WHEN β <[ 1/(1+ r)] the right-hand of is always positive and participation constraint is never hit

WHEN β >[ 1/(1+ r)] manager’s participation level falls to zero CEO PAYOUT DIVIDENDS ( dt >0 ).

SO IF CRITICAL VALUE B ( [ 1/(1+ r),1] ) WHEN β> BFirm reaches a steady state in which the equilibrium utility for all future CEOs is zero (they are at their participation constraint and earn no rents net of effort).

IPO – INVESTMENT WITH AND WITHOUT EQUITY a) beta=0,5 t=10

IPO – INVESTMENT WITH AND WITHOUT EQUITY b) beta=0,99999 t=10

NET DIVIDENDS AND EQUITY ISSUANCE –DIVIDEND POLICY POST IPO a)beta=0.5 t=10

NET DIVIDENDS AND EQUITY ISSUANCE Bb)beta=0.999999 t=10

MANAGER’S UTILITY NET OF THE EFFORT INCURED ON LEARNING AS A MANAGER WITH LOW,HIGH ,NO GOVERNANCE.

How Do Internal Governance and External Governance Interact?

IPO expands investment and managerial effort for two reasons. First, the IPO changes the CEO’s investment

incentives in the period of the IPO With the internal governance only both capital

stock and effort would subsequently decline to the steady state consistent

With the external governance only the CEO would have no reason to invest for the future