Corporate Governance and Financial Performance

Corporate governance is concerned with ways in which all parties interested in the well-being of the firm (the stakeholders) attempt to ensure that managers and other insiders take measures or adopt mechanisms that safeguard the interests of the stakeholders. Such measures are necessitated by the separation of ownership from management, an increasingly vital feature of the modern firm. A typical firm is characterized by numerous owners having no management function, and managers with no equity interest in the firm.

Shareholders, or owners of equity, are generally large in number, and an average shareholder controls a minute proportion of the shares of the firm. This gives rise to the tendency for such a shareholder to take no interest in the monitoring of managers, who, left to themselves, may pursue interests different from those of the owners of equity. For example, the managers might take steps to increase the size of the firm and, often, their pay, although that may not necessarily raise the firm’s profit, the major concern of the shareholder.

Financial economists have long been concerned with ways to address this problem, which arises from the incongruence of the interests of the equity owners and managers, and have conducted significant research towards resolving it. The literature emanating from such efforts has grown, and much of the econometric evidence has been built on the theoretical works of Ross (1973), Jensen and Meckling (1976), and Fama (1980).

At the initial levels of the development of the theory of agency, especially as it relates to the firm, concern seemed to focus more on the relationship between the management and shareholders than between them and other categories of stakeholders. The stakeholder theory has of late captured the attention of researchers and a survey of literature on this aspect of corporate finance can be found in the works of John and Senbet (1998). Read about Corporate Governance at Wipro

According to this theory, the firm can be considered as a nexus of contracts between management on the one hand and employees, shareholders, creditors, government and all other stakeholders on the other. Thus, from the point of view of the stakeholder theory, concern should go beyond the traditional management–shareholder relationship to include all other stakeholders such as mentioned above. The stakeholder theory has undergone some refinements in the work of Jensen (2001), who presents what he terms the “enlightened stakeholder theory”. For him, the traditional stakeholder theory encourages managers to be servants of many masters, with no clear guidance whenever trade-offs (or indeed, conflicts) occur, as they often do.

He argues that the absence of any criterion for choice in cases of trade-offs (or conflicts) tends to give managers some discretionary powers to serve the master of their own choice. As we will see in a subsequent section, Jensen proposes a single criterion – addition to the long-term value of the firm – for managers to pursue so that the interests of all key stakeholders can be served. This is based on the idea that changes in the long-term value of the firm would be difficult to materialize if the interest of a key stakeholder were not protected.

Empirical work in the area of corporate governance has undergone a remarkable growth, founded mostly on the basis of management–shareholder conflict and to a lesser but increasing extent on the stakeholder theory. Despite the volume of empirical evidence, there has been no consensus on how to resolve the problem. The lack of consensus has produced a variety of ideas on how to deal with the problem of agency.

The mechanisms we are concerned with in this study can be divided into five: striking a balance between outside and inside directors; promoting insider (i. e. , managers and directors) shareholding; keeping the size of the board reasonably low; encouraging ownership concentration; and encouraging the firm to have a reasonable amount of leverage in the expectation that creditors might take on a monitoring role in the firm in order to protect their debt holdings. 1. 2STATEMENT OF THE PROBLEM 1. 3 RESEARCH OBJECTIVES * To measure the financial performance of a firm in relation to corporate governance. * To examine the relationship between financial performance and the five mechanisms listed above. 1. 4RESEARCH QUESTIONS SCOPE SIGNIFICANCE OF STUDY 2. 0 LITERATURE REVIEW 3. 0 METHODOLOGY

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