Financial engineering - Essay Example

This could be to maximize the wealth Of its owners the shareholders), subject to various guidelines and constraints and with regard to the other groups with an interest in what the company does. Guidelines and constraints include behaving in an ethical way in compliance with laws and regulations. Some other definitions that have been provided are as follows: ‘Corporate governance is the system by which companies are directed and controlled’ (Academy Report, 1992). The Academy Report was a major UK inquiry into corporate governance, and this is a generally accepted definition.

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Governance is about seeing that is run properly. All companies need overdoing as well as managing ‘(Professor Bob Trickier, 1984). Corporate governance is concerned with how powers are shared and exercised by different groups to ensure that the objects of the company are achieved. Key issues in the corporate Government the rights of the shareholders and other interest groups such as the employees, how powers are shared and exercised by the directors, and the holders of power in a company A company is a ‘legal entity. As a person, it is able to enter into contracts and make business transactions.

It can own assets and owe money to others, and it can sue and be sued in law. Human beings have to make decisions and arrange transactions in the company’s name. Just as a country has citizens, a company has members. The members of a company are its owners, the ‘equity shareholders or the “members”. Membership changes, as investors buy and sell the company’s shares. The citizens of a country, even a democracy, have relatively few powers. Power is in the hands of the legislative (parliament) and the executive (the government). In a similar way, shareholders have a relatively few powers, which are restricted mainly to certain voting rights.

Power is in the hands of the board Of directors. Corporate governance is not primarily concerned with day-to-day management of operations by business executives. The powers of executive managers are to direct business operations are one aspect of governance. Similarly, corporate governance is not concerned with formulating business strategy, although the board of directors is expected to take strategic decisions. SHAREHOLDER A person who holds shares in a company. Shares may be held by the share owner or by a nominee who acts on behalf of the owner. (The US name for shares is “stock”. Corporate governance is a matter of much greater importance for large public companies where the separation of ownership from management is much wider than for small private companies. Institutional investors hold vast portfolios of shares and other investments. Investors need to know that their money is reasonably safe. Should there be any doubts about integrity or intentions of the individual in charge of a company, the value of the company the value of the company’s shares will be affected and the company will have difficulty raising any new capital.

Likewise, if there is weak corporate governance in a country generally, the country will trudge to attract foreign investment. It might seem self evident that good (or adequate) corporate governance supports capital markets. However, the impetus for the development of many, but not all the cords Of best practice and stricter regulatory regimes has come largely from scandals and setbacks, where evidence of bad corporate governance has emerged, and company share prices and the stock market generally have suffered as a result.

STAKEHOLDERS IN A COMPANY A stakeholder in a company is someone who has interest or ‘stake’ in it, and is affected by what the company does. Each stakeholder or stakeholder group an therefore expect the company to behave or act in particular way. A stakeholder can also expect to have some way in some of the decisions a company takes and some of the actions it takes. The balance of power between different stakeholder groups, and the way in which power is exercised, are key issues in corporate governance. A public company has a number of different stakeholder groups: Its members or equity shareholders are the owners.

In a small company, the owners may be directors. In a large public company, the directors may own some shares, but are not usually the largest shareholder. The interest of the shareholders is likely to be focused on the value of their shares and dividend payments. However, the powers of the shareholders in large public companies are usually fairly restricted and shareholders have to rely on the board of directors to act in their best interests. A different situation arises when there is a majority shareholder or a significant.

A shareholder with a controlling interest is able to influence decisions of the company through an ability to control the composition of the board of directors. When there is a majority shareholder, the interests of the minority shareholders may be disregarded. The board of directors is responsible for giving direction to the company. It delegates most Of executive powers to the Managing Director, but reserves some of the decision making powers to itself, such as decisions about raising finance, paying dividends and making major investments.

Executive management is held accountable to the board of their performance. A board of directors is made up of both executives and non-executives. Executive directors are individuals who combine their role as director with their position within the executive management of the company. Non-executive members perform the functions f the director only, without any executive responsibilities. Executive directors combine their role as a fully paid employee. As they often enjoy the benefits of a performance bonus, their interests are likely to differ from those of the non-executives.

The board may take the decisions collectively, but it is a collection of individuals, each with his or her personal interests and ambitions. Some individuals are more likely to dominate the decisions by a board and to exert strong influence over their colleagues. In particular, the most influential individuals are likely to be the chairperson, who can either be non-executive or alternatively can have some executive responsibilities, and the chief executive officer (CEO). The chairperson is responsible for the functioning of the board.

The CEO or the Managing Director is the senior executive director and is accountable to the board Of the executive management of the company. The term ‘CEO’ derives from the US, but is now widely used in UK (where the term managing director is also used). The main interest of individual executive directors is likely to be power and authority, a high remuneration package and a wealthy lifestyle. As will be seen in future structures “independent” non executive directors, who have no link to management and do not represent a major shareholder, provide Board deliberations with objective beatifications.

Management is responsible for running the business operation and is accountable to the board of directors (and more particularly to the CEO). Individual managers, like executive directors may want power, statuses are and a high remuneration. As employees, they may see their stake in a company in terms Of the need for career and an income. Employees have a stake in their company because it provides them with a job and an income. They too have an expectation about what their company should do for them, and these could be security of employment, good pay and suitable working conditions.

Some employee rights are protected by employment law, but the powers of employees are generally limited. Lenders and other creditors have an indirect interest in a company, because they expect to be paid what they are owed . Elf they deal with the company regularly, or over long time, they will expect the company to do business with them in accordance with their contractual agreements. If the company becomes insolvent unpaid creditors will take a more significant ole in its governance ,depending on the insolvency laws in the country, for example by taking legal action to take control of the business or its assets.

Representatives Of investment of institutions have some influence over public companies whose shares are traded on a stock market . Representatives bodies include insures and pension funds. These bodies may try to coordinate the activities of their members, for example, by encouraging them to vote in a particular on resolution at the annual general meetings of companies in which they are shareholders. The bodies represent the opinions of the investment community in general

The general public are also stakeholder in large companies, often because they rely on the goods or service provided by a company to carry on their life. For example , households expect utility companies to provide an uninterrupted supply of water, electricity or gas to their home, or provide a convenient and reliable transport service to and from work ,and at a reliable price. Pressure groups, such as environment protection groups, sometimes try to influence the decision of companies.

KEY OBJECTIVES IN COOPERATE GOVERNMENT The following are key issues in regard to corporate Governance: (1) A large many has a large number of stakeholders and has to balance the demands and needs of each of them. Although some stakeholder groups have power to decide or influence actions by the company, others do not have much influence and rely on the ‘enlightenment’ the company’s managers (primarily the directors) to take decisions that are in their interests and beneficial for them. (2) Conflict of interest between different stakeholder groups.

For example, employees may want high salaries, which their company cannot afford without cutting dividends to shareholders. A major once with corporate governance is the conflict of interests between the board of directors (and its individual directors) and other stakeholder groups, particularly the shareholders and employees. When directors take decisions that are in their personal best interests, and regardless of other stakeholders, should this be allowed or how can it be prevented?

The directors, particularly the executive directors have greater access to the information system of their company and so know more about what is going on. They are also often in a position to control or to manipulate the information that is released to the hardliners or employees. This could result in insider trading or market manipulations, which are criminal offences in terms of the Security Services Act. Shareholders have to rely on the board of directors to govern their company competently and in their best interest.

They are able to monitor the performance of the company (and by implication, its directors), primarily through the company’s annual report and financial statements. They make their decisions to invest in the company’s shares and hold on to them, largely on the basis of information supplied by the directors in the company’s name. Their only reassurance that the information they are supplied is correct is the honesty of the directors and the assertion by the company’s auditors that the published financial statements give a true and fair view of the company’s profitability and financial position.

WHY CORPORATE GOVERNANCE IS NECESSARY The interest of those who have effect control over a firm can differ from the interest of those who supply the firm with external finance, the problem, commonly referred to as a principal-agent problem, grows out of the separation of ownership and control and of corporate outsiders and insiders. In the absence of protection that good governance provides, asymmetries of information and difficulties of monitoring results in capital providers, who lack control over the corporation, finding it risky and costly to protect themselves from the opportunistic behavior of managers and controlling shareholders.

The relationship between the shareholders and the board of directors is at the centre of many of the problems that arise in the corporate governance. Many of the guidelines in the codes of conduct for corporate governance and codes of best practice and directed towards reducing the attention for conflict, by seeking to put some restraints on individual directors, particularly the CEO and other executive directors, and by trying to reconcile the interest of the two stakeholder groups.

KEY ISSUES IN CORPORATE GOVERNANCE At the heart of the debate about corporate governance lie the conflicts or potential conflicts of interest, between shareholders and either the board of directors as whole or individual board members. The directors may be tempted to take risks and make decisions aimed at boosting short term performance. Many shareholders are more concerned about the longer term, he continuing survival of their company and the value of their investment. If a company gets into financial difficulties, professional managers can move on to another company to start all over again, where as shareholders suffer a financial loss.

Issues in corporate governance where a conflict of interest might be apparent are: Financial reporting and auditing Director’s remuneration Company- stakeholder relations Risk taking Effective communication between the directors and shareholder (I) Financial Reporting and auditing The directors may try to disguise the true financial performance of their many by ‘dressing up’ the published financial statements and giving less than honest statements. ‘Window dressed’ financial statements and make it difficult for investors to reach a reasoned judgment about the financial position of the company.

Concerns about misleading published financial statements provided an early impetus in sass’s and early 1 ass’s to the movement for better corporate governance in the I-J. Accounting irregularities in a number Of companies led to a lightening Of accounting standards, although the problems of window dressing are unlikely ever to disappear completely. Concerns about financial reporting in the US emerged with the collapse of energy corporation Enron in 2001, which filed for bankruptcy after ‘adjusting’ its financial statements.

This was followed by similar problems at other US companies such as telecommunication group World (which admitted to fraud in its accounting), Global Crossing and Rank Xerox. Problems have emerged in some European Companies, most notably at the Italian group Parallax at the end of 2003. A corporate governance issue is the question of the extent to which the directors were aware in each case of the impending collapse of their company, and if they new the problems why shareholders were not informed much sooner.

When the annual financial statements of a company prove to have been misleading questions are inevitably raised about the effectiveness of the external auditors. There are two main issues relating to the external audit of a company. One is whether it should be the job of the auditors to discover the financial fraud and material errors. The second is the problem of the relationship between a client company and its auditors, and the extent to which the auditors are independent and free from the influence of the Meany’s management.

If auditors are subject to influence from the client company, they might be persuaded to agree with a controversial method of accounting for particular transactions, which shows the company’s performance or financial position in a better light. Arthur Anderson, which collapsed in 2002, appears to have lacked independence from major clients such as Enron. In South Africa several of the corporate abuse cases have resulted in claims that the auditors did not carry out their duties in a professional manner.

South African listed companies are now required to port in terms of international Financial Reporting Standards (FIRS). Audits in South Africa are required to follow international auditing standards. (ii) Directors may reward themselves with huge salaries and other rewards, such as bonuses, a generous pension scheme, share options and other benefits. Institutional shareholders do not object to high remuneration for directors. However, they take the view that rewards should depend largely on the performance of the company and the benefits obtained for the shareholders.

The main complaint about ‘fat cat’ directors remuneration is that when the many does well , the directors are rewarded well , which is fair enough, but when the company does badly, the directors may continue to be paid just as well interest in arguments about directors pay has varied in the past between different countries. In the KICK, concerns led to the establishment of the Greenberg Committee in the 1 CSS and the production of the Greenberg report. Director’s remuneration has remained a contentious issue ever since.

In 2002 UK company law was changed by the Directors Remuneration Report Regulations 2002, requiring listed companies to produce a director s enumeration Report annually to invite shareholders to vote on the report ant the company’s GM. (iii) Company stakeholder relationship Most decision making powers in a company are held by the board of directors. The corporate governance debate has been about the extent to which professional managers, acting as board of directors; exercise those powers in the interests of their shareholders and other stakeholders in the company, and whether the powers of directors should be restricted.

This aspect of corporate governance is about: The structure of the board of directors and the role of the independent non- executive board of directors The powers of shareholders under company law and whether these should be extended by corporate law reform-for example, by giving shareholders the right to approve the company’s remuneration policy or its remuneration packages for board members (see chapter 8 for more details). Whether shareholders should actually make full use of the powers they already have, for example for voting not to re-elect directors. Iv) Corporate governance and risk management As a general rule, investors expect higher rewards to compensate them for taking higher business risks. I f a company makes decisions that increase the call of the risks it faces, profits and dividends should be expected to go up. Another issue in corporate governance is that the directors of companies might take decisions intended to increase profits without giving due regard to the risks. In some cases, companies may continue to operate without regard to the changing risks profile of their existing businesses.

When investors buys shares in a company, they have an idea of the type of the company they are buying into, the nature of its business, the probable returns it will provide for shareholders and the nature of its business and financial risks. To shareholders, investment risks are important, as well as high returns. Directors, on the other hand, are rewarded on the basis of returns the companies achieve, linked to profits or dividend growth, and their remuneration is not linked in any direct way to the risk aspects of their business.

Risk management is now recognized as an ingredient of sound corporate governance, for which the board is responsible. Internal controls, the Fraud Prevention Plan and the “going concern” statement, (in the latter the board states that in its opinion there is no reason to believe that the equines enterprise will not be operating in 12 months from the date of the statement), are related to the I-J risk management function. Takeovers may also be a contentious matter. A company’s board of directors and individual directors may try to grow their company by buying up target companies, almost regardless of the price they have to pay.

The results of a successful large takeover bid at an excessive price are likely to be: More power and higher status for the company’s board and individual directors (justifying higher salaries) A good deal for the shareholders in the target company A loss of wealth for the company’s own shareholders when the takeover falls to achieve the expected effect on the company’s profits and the share price eventually falls A common denominator in past corporate failures has been a lack of effective control over the company and the absence of risk management procedures and systems.

The problem with corporate collapse could be dishonest management finally being exposed, but is more likely to be the consequence of a well intentioned board of directors failing to carry out its effective system of risk management. Shareholders should feel infinite that the board is aware of the risks faced by the company, and that a system for monitoring and controlling risk is in place. (v) Information and communication Another issue in corporate governance is communication between the board of directors and the company’s shareholders.

Shareholder, particularly those with large financial investment in the company, should be able to voice out their concerns to directors and expect to have account taken of their opinions. Small shareholders should at least be informed about the developments in the company, its financial position and its intentions for the true, even if their opinions carry comparatively little weight. The responsibility for improving communications rests with the board and the main nutritional shareholders.

Companies should make better use of annual report and financial statements to report to shareholders on a range of issues and policies. The annual report and financial statement should not be simply a brief director’s report and a set of financial statements. The company should explain should also its operations and financial position (in an operational and financial Review) and report on a range of governance issues, such as directors remuneration, internal controls and risk management and policies on health, safety and environment. Many companies now use their website to report on such matters.

A company should also encourage greater shareholder attendance and participation at annual general meetings, as a method of improving communications and dialogue. Electronic communication, including voting, should also be considered. For their part, institutional investors should develop voting policies, and apply these in general meetings. Where necessary, investors may vote against the board to alert the directors to the strength of their views. Investors are paying greater attention to the corporate governance and corporate values of companies in which they invest.

A prime example of this is the USA based Scalpers organization, which invests in companies with good corporate governance standards and through the exercise of its voting powers, encourage a limited number of ailing companies. (vi) The extent of corporate governance legislation Companies are constrained or limited by the law in what they can do. For example, laws regulate the way in which companies deal with other people, vying rights to creditors and customers, and provide some protection for employees and for society at large.

They are also subject to various regulations and codes of practice from external bodies, such as the Listings Requirements of SSE Limited, the Securities Services Act, which includes provisions to outlaw insider trading and market manipulation, and the The following are matters for consideration: The extent to which corporate governance practices should be forced on companies by legislation How much should be left to regulation by SSE Limited, and How much corporate governance should be a matter for companies to decide or themselves, perhaps within a published framework of best practice guidelines For example: Company law provides some framework for corporate governance, but arguably not enough. The law is reinforced for listed companies (I. E. Companies whose shares are traded on the main board of SSE Limited) by regulations in the listings Regulations, which require companies to comply with certain aspects of corporate governance, but do not provide a comprehensive statutory regime, in that an explain or comply rule applies.

The USA taken a statutory rather than a voluntary principles-based approach o corporate governance to corporate governance. Following the financial scandals at corporation such as Enron and World, statutory rules on corporate governance were introduced by the Serbians-Solely Act. It remains to be seen whether the voluntary or regulatory approach will be more successful. (vii) Ethical issues Ethical considerations are at the root of many perceived problems with corporate governance in practice. Individuals are expected to behave in an ethical way. Companies may be aware of the need to maintain a culture of corporate ethics, providing a code of conduct that all directors and employees re expected to follow.

The COED, in the introduction to its principles of corporate governance, states that from a company’s perspective, corporate governance is about: “Maximizing value subject to meeting the corporation’s financial and other legal and contractual obligation. This inclusive definition stresses the need for boards of directors to balance the interest of shareholders with those of other stakeholders- employees, customers, appliers, investors, communities- in order to achieve long term sustained value. ” The strength of this approach to corporate governance is its general acceptance. Many people hold the view that public companies are in business to earn profits for the benefit of their shareholders. Successful companies are perceived as those paying dividends to shareholders and whose share price goes up.