32 Corporate Finance
limited rights to elect the number of directors and such other matters. Two Swedish firms—Astra and Scania—
have issued two classes of shares—A and B. The A class shares have one vote each and B shares carry one-tenth
vote each. ABB has 24,345,619 shares with 0.1 vote per share and a par value of 5 SEK, as well as 66,819,757
shares with one vote per share and a par value of 5 SEK. Investors, in general, are better protected in coun-
tries where the one-share, one-vote rule is enforced. In the absence of such a law, the insiders of the company
can have disproportionate control on the company in relation to their investment.
MAXIMIZE EQUITY VALUE OR FIRM VALUE?
There is a misconception that maximization of equity value and maximization of firm value are the same.
They are not the same. Even though equity is a part of the firm’s capital structure, there is also debt and many
financial instruments with both debt and equity features that managers should take into account. As described
in earlier sections shareholders can increase their wealth at the expense of other investors. To illustrate, sup-
pose there is a way in which managers could increase the value of equity by Re 1 if they could reduce the
value of debt by Rs 3. This would reduce the value of the firm by Rs 2. What should the managers do now?
Should they go ahead with the rip-off?^12 The answer is no; although managers are supposed to act on behalf
of shareholders who have voted them to power.
CORPORATE GOVERNANCE
The term governance refers to exercise of power; authority, direction, and control. A firm is a collection of
physical assets that are jointly owned. Corporate governance refers to the allocation of ownership. It explains
how power is shared, contracts are written and enforced, the role of Board of Directors and CEO, management
compensation, and so on. The root of the problem lies in the separation of ownership and control. Modern
corporations are run by managers on behalf of shareholders. In many companies the senior executives hold
little or no equity stake. How do you make someone who has no stakes in a company behave like a true
representative of the shareholders? The obvious answer is to force the top executives to buy stocks. In many
companies the Board spends less than a few hours (!) in decision making. The CEO and other Board members
who are employees of the company wield substantial power. The outside directors who have no experience
in related businesses cannot make meaningful contribution to the company. It is important to appoint com-
petent outside directors to balance the power and let decision making to the CEO. The CEO would be the
only insider on the Board. The outside directors should spend a minimum number of hours on the company’s
affairs, spend time with the customers and employees
Does Corporate Governance Matter?
Do good governance practices lead to an increase in market value of the firm? One set of studies conducted
in the US finds that the correlation between corporate governance attributes and firm performance is either
(^12) Assuming that bondholders will not recognize this ex-ante and demand compensation for the loss of wealth.