Corporate Finance

Introduction 
 29

Equity Debt Equity Debt

Rip-off by shareholders

Managers vs Shareholders

Investment in projects generates cash flows, which can either be reinvested in the business or returned to
shareholders in the form of dividends who in turn can decide where to invest their money. Managers, as
agents of shareholders, have discretion over investment of residual cash flow. Increasing dividends reduces
the resources under the manager’s control and limits growth. Since managers are appraised on the basis of
growth, it is likely that they may pursue unprofitable projects that do not yield adequate returns; leaving the
shareholders in a lurch. This leads to conflict of interest between managers and shareholders. Conflict is
more severe in those firms that generate substantial cash flows but do not have profitable investment avenues.
Of course, empire building is no longer in fashion, but high growth is still in vogue. In theory, the shareholders
elect the board to oversee the Chief Executive Officer (CEO) on their behalf. But in practice, the CEO, who
chairs the board, exercises considerable influence on the board, instead of the other way round (i.e., the
board deciding CEO compensation). Typically, boards are populated with friends and relatives of the CEO.^7
Erring managers may be replaced if the market for corporate control is active. The threat of acquisition by
another company and the subsequent emotional upheavals keeps managers on their toes. Yet, takeovers are
an expensive disciplining tool, entailing large administrative and legal expenses. Add the premium over
the market price an acquirer has to pay. Moreover, most acquirers do not acquire companies with the objective
of holding on to them forever. Acquired companies are milked in 3–5 years and resold to another acquirer.

Shareholder vs Shareholder

In all but few advanced economies—like the US, UK, and Japan—most publicly traded firms are closely
held with the majority shareholder playing an active role in the management. The majority shareholder often
serves as the chairman of the board. A study of the world’s top 27 stock markets suggests that only 36 percent
of the largest publicly traded firms are widely held, i.e., with no shareholders holding more than 20 percent
of the votes (La Porta et al., 1999). Most of the widely held firms are concentrated in US, UK, and Japan.
Most large publicly traded firms have a controlling shareholder, which may be a family, a state or another
company. The 10 largest families in Indonesia, the Philippines and Thailand control half the corporate struc-
ture in terms of market capitalization; while the 10 largest in Korea and Hong Kong control about a third.^8
In the Philippines and Indonesia the control of about 17 percent of market capitalization can be traced to a
single family. Indonesia’s Suharto family, led by Suharto’s children, relatives and business partners, control
417 listed and unlisted companies. Control is defined as 20 percent of voting rights and a widely held com-
pany is one in which no owner has significant rights. In many East Asian countries control is enhanced
through pyramid structures and cross holdings. Exhibit 1.3 presents the control of publicly traded companies
in East Asia in 1996.

(^7) Latham, Mark (1999). ‘The Corporate Monitoring Firm’, Corporate Governance: An International Review, Vol. 7, No. 1.
(^8) Claessens, Stijn, Simeon Djankov, and Larry Lang (2000). World Bank Discussion Paper No. 409.