1.

Agency Problem

DEFINITION of 'Agency Problem'

A conflict of interest inherent in any relationship where one party is expected to act
in another's best interests. The problem is that the agent who is supposed to make
the decisions that would best serve the principal is naturally motivated by selfinterest, and the agent's own best interests may differ from the principal's best
interests. The agency problem is also known as the "principalagent problem."
In corporate finance, the agency problem usually refers to a conflict of interest
between a company's management and the company's stockholders. The manager,
acting as the agent for the shareholders, or principals, is supposed to make
decisions that will maximize shareholder wealth. However, it is in the manager's
own best interest to maximize his own wealth. While it is not possible to eliminate
the agency problem completely, the manager can be motivated to act in the
shareholders' best interests through incentives such as performance-based
compensation, direct influence by shareholders, the threat of firing and the threat of
takeovers.

2. Corporate governance and financial performance

Definition of Corporate governance

The system of rules, practices and processes by which a company is directed

and controlled. Corporate governance essentially involves balancing the
interests of the many stakeholders in a company - these include its
shareholders, management, customers, suppliers, financiers, government
and the community. Since corporate governance also provides the framework
for attaining a company's objectives, it encompasses practically every
sphere of management, from action plans and internal controls to
performance measurement and corporate disclosure.
It can be also defined as Corporate governance is a term that refers broadly to
the rules, processes, or laws by which businesses are operated, regulated, and
controlled. The term can refer to internal factors defined by the officers,
stockholders or constitution of a corporation, as well as to external forces such as
consumer groups, clients, and government regulations

The corporate governance framework consists of

(1) explicit and implicit contracts between the company and the stakeholders
for distribution of responsibilities, rights, and rewards,
(2) procedures for reconciling the sometimes conflicting interests of
stakeholders in accordance with their duties, privileges, and roles, and
(3) procedures for proper supervision, control, and information-flows to serve
as a system of checks-and-balances. Also called corporation governance. See
also Cadbury rules and governance.

Definition Financial performance

A subjective measure of how well a firm can use assets from its primary
mode of business and generate revenues. This term is also used as a general
measure of a firm's overall financial health over a given period of time, and
can be used to compare similar firms across the same industry or to compare
industries or sectors in aggregation.
There are many different ways to measure financial performance, but all
measures should be taken in aggregation. Line items such as revenue from
operations, operating income or cash flow from operations can be used, as
well as total unit sales. Furthermore, the analyst or investor may wish to look
deeper into financial statements and seek out margin growth rates or any
declining debt.

Relationship between corporate governance and firm firms financial

performance
The belief that governance best practices lead to superior firm performance is
widespread. But as academic research and this article demonstrate, most studies
prove that there is no link between governance and performance. Nor is there proof
that the highly desirable director independence has a positive impact on firm
performance.

During the bull market of the 1990s, the American model of corporate governance was heralded
as the most successful in the world at creating value. Indeed, corporate law scholars Henry
Hansmann and Reiner Kraakman predicted, in a 2000 paper provocatively titled The End of
History for Corporate Law, that global corporate governance would converge around the U.S.
shareholder-oriented model as a result of its exemplary record at creating value. The corporate
scandals that began in October 2001 with the collapse of Enron and that continue to the present

day have shaken investors faith in the capital markets and the efficacy of existing corporate
governance practices in promoting transparency and accountability. The Conference Boards
Commission on Public Trust and Private Enterprise remarked in January 2003 that he events of
the last year suggest that, in many instances, compact among shareowners, boards, and
management has been significantly weakened, diminishing the trust investors and the general
public have in our system of corporate governance.
Congress and regulators responded to this crisis of confidence by imposing new corporate
governance requirements on public companies. For their part, investors started to take corporate
governance issues more seriously. Moodys Investor Services announced plans to incorporate
governance assessments into credit ratings. To date, these and other measures have been
premised on the assumption that corporate governance affects financial performance in some
way. As an empirical matter, however, that proposition is far from settled. Indeed, researchers
disagree on the existence and strength of the relationship between various corporate governance
features and performance.
This article summarizes the results of studies that attempt to correlate corporate governance with
firm performance. Because the literature is so vast, this article will address only governance
issues relating to the board of directors and takeover defenses, which have received the bulk of
the attention from researchers, and are considered particularly important by institutional
investors.
Double Space
Since the wave of corporate scandals began, a consensus has developed around the
importance of good corporate governance to individual companies and the U.S.
economy as a whole. Companies are under more pressure than ever before to adopt
governance best practices and to convince investors that their governance is
responsible. The easy course may be simply to adopt a one-size-fits-all model, and
there are features-such as independent board committees-that make sense across
the board. But as the academic research shows, there is no governance magic
bullet, and no substitute for thoughtful, contextual analysis.