**2. The traditional conceptualization of a "firm"**

In the early part of the nineteenth century, business units were owned by individuals or small groups of individuals. In this typical business unit, a firm was managed by an individual or assigned individuals who were appointed by an individual owner [9]. The problems of such private firms included the limitation in size and wealth of firm. This typical type of firm was owned and operated by a small group of people who had limited resources to expand and to manage the firm in the century in which business was becoming bigger and better [9]. More importantly, the continuity of typical single-owners or single-family firms was constrained by the geographical area where the owners or the groups of owners existed. This constraint curbed the size and wealth of a firm in that period.

The first paradigm shift in the conceptualization of a "firm" leads to the new architecture of "corporation," through which its structure is designed to collect the wealth of individuals under a unified management and control system. This feature of corporations is known as "the separation of ownership and control" [9, 21, 53] implying the mechanism wherein owners of a firm can be replaced without disturbing the control or management of a firm. The continuity of a firm is no longer contingent on the owner, or upon the geographical area of its founder. Moreover, this type of firm can obtain a huge amount of funds from its many and various shareholders, by collecting a small amount money from them. More importantly, a new empire or a huge conglomerate business has the possibility of being created through the activities of mergers and acquisitions, through which the activities require significantly large amount of money [8].

Back in the 1960s, many researchers whose works related to the theory of firm or firm value cited the classic paper of Ronald Coase when they wrote about firm theory. Coase [21] was the Nobel Prize laureate in politics and economics and held the view that firms can be composed of many "nexus of contracts" or "nexus of parties" and, when there is a conflict of "property rights," parties within the nexus can bargain or negotiate terms that are more beneficial among them. In the nexus, the "Pareto efficient" is obtained by bargaining among the nexus. Coase's theorem is therefore known as property right theory. The concept of a firm derived from Coase's explanation is the springboard for many subsequent business and finance theories, including the classic paper, *Theory of the firm: Managerial behavior, agency costs and ownership structure,* of Jensen and Meckling [53].

answer to the fundamental question of "what is the meaning of the term 'firm' and what do we know about the value of a firm?" Along with the detailed explanation, the author points to the central theme in major theories and concepts so that the reader can follow the theories and concepts when they are applied to business. Also, some important empirical papers are

The structure of this chapter is as follows. First, the author discusses the relevant concepts as they are presented to us and are used from the past up until current usage. What we have learnt after using this traditional theory for half a century is that the simple focus on single stakeholders creates some important problems that require attention with regard to the drawbacks of the theories in the past. In the second part, the author illustrates the major problems arising from these traditional viewpoints of *firm value theory* and how the modern system of corporate finance can help us to solve this problem. The third part introduces the reader to a theory that challenges long-time traditional use of shareholders' maximization theory (i.e., a theory whose main focus is only on a single group of stakeholders known as *shareholders,*); the more recent theory however focuses on a multifarious-group of stakeholders and is known as *stakeholders theory*. The author shows that stakeholders' theory has been transformed into many versions of the current conceptualization-of-firm theory, such as sustainability con-

In the early part of the nineteenth century, business units were owned by individuals or small groups of individuals. In this typical business unit, a firm was managed by an individual or assigned individuals who were appointed by an individual owner [9]. The problems of such private firms included the limitation in size and wealth of firm. This typical type of firm was owned and operated by a small group of people who had limited resources to expand and to manage the firm in the century in which business was becoming bigger and better [9]. More importantly, the continuity of typical single-owners or single-family firms was constrained by the geographical area where the owners or the groups of owners existed. This constraint

The first paradigm shift in the conceptualization of a "firm" leads to the new architecture of "corporation," through which its structure is designed to collect the wealth of individuals under a unified management and control system. This feature of corporations is known as "the separation of ownership and control" [9, 21, 53] implying the mechanism wherein owners of a firm can be replaced without disturbing the control or management of a firm. The continuity of a firm is no longer contingent on the owner, or upon the geographical area of its founder. Moreover, this type of firm can obtain a huge amount of funds from its many and various shareholders, by collecting a small amount money from them. More importantly, a new empire or a huge conglomerate business has the possibility of being created through the activities of mergers and acquisitions, through which the activities require significantly large

discussed throughout the chapter.

4 Firm Value - Theory and Empirical Evidence

cepts, triple bottom lines, or the CSR theory.

**2. The traditional conceptualization of a "firm"**

curbed the size and wealth of a firm in that period.

amount of money [8].

Property right theory was defined as "separation of ownership and control" by Jensen and Meckling [53] and signified the separation of ownership and control that underlines the main nexus of firms into two groups. One is the group who has the property rights as the "owners" of firms. The other one is the section of the management who has the right to operate or "control" firms. The relationship between the groups is called the principal-agent relationship. Nexuses have many types of this kind of relationship, that is, the owners (principal) and management (agent), the shareholders and bondholders, or the minority shareholders and owners-managers.

In the standard contractual concept, shareholders offer money as capital to a firm in return for residual claims on returns of capital after money is paid to other groups. The attribute of the residual claim of shareholders is used to distinguish them from others. With this standard concept, it is clear that the shareholders are the group who provide capital to contribute to the overall operation of the firm. Even other groups, such as bondholders or preferred stockholders, can also provide some forms of capital to the firm, but they have no right to directly or indirectly control a firm. The standard argument holds that shareholders, with only residual claims, would bargain for corporate control in return for their residual risk bearers on the claims. Equipped with the power of corporate control, shareholders can assign control to their agents who will work in the firm so as to maximize benefit for them in returns. Clearly, this side of the theory is known as "shareholders theory" [11]. Viewed from the eyes of this separation, modern forms of firms have a lot of advantages as explained earlier, such as continuity, ample resources to expand the boundaries of a firm, and the independence of a firm's site location and owners' locations. Firm theory enjoys these advantages and applies them to the expansion of a given firm to harvest an industrial revolution. The theory also encourages owners to think in more revolutionary ways about their firms.

However, Jensen and Meckling [53] did not just describe the meaning of the term "firm" according to their own view. The great beauty of their work is in showing how we can exploit the fruitful nature of the concept of the "separation of ownership and control" as a magnifier to examine the peripheral events around a firm. They manage to fit the concepts very well with the overall business environment. Furthermore, the concepts can be used as heuristic tools for owners, managers, or any stakeholders to understand the causes and effects in relation to the value of firms and to understand the appropriate solutions for problems related to the principal-agent relationship. Problems arising from this relationship are known as agency problems (see [30, 53]). The problems propose that whenever we have this relationship in the environment (not just in business), we are surrounded by the agency problem. Smith and Zsidisin [73, 74] used the agency framework to understand the trade-off involved in the selection of various approaches of student evaluation. The agency problem further proposes that it is not beyond reasonable expectation that both parties in the relationship have their own interests and incentives in order to maximize their own interests and wealth. It is this conflict of interest which is the root of the agency problem.

be achieved by external mechanism (the market for corporate control) and internal mechanism. The supreme objectives of corporate governance are set to ensure that shareholders as financiers get a return on their financial investment [71]. Corporate governance involves issues of practices to solve the complex issues among contract participants (social, employees, debt holders, and minority shareholders). However, the ultimate objective of corporate governance is still to focus on the wealth of the residual claimants who possess the highest bargaining power in the firm. Empirical research on the issues of corporate governance around the word have major research questions, especially with regard to their effectiveness over firm

Firm Value

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Renders and Gaeremynck [66] used a sample from 14 European countries and showed that governance within a high-quality disclosure environment leads to a higher firm value. Saona and Martin [68] used a sample from Latin American firms and assessed whether within country changes in governance and changes in ownership concentration can predict a change in the value of firms. The results are in contrast to expectations, that is in immature financial markets, (as found in Latin America), firms take advantage of both the asymmetries of information and the multiple frictions in order to produce inflated valuations. These results cor-

Further, as the financial system develops, firm values drop. Research in this field attempts to associate various factors with monitoring ability and test them on the relationship with firm value. Mayer [59] discussed the interaction between competition, ownership structure governance, and performance. The author shows that corporate systems across countries are different and relate to ownership and the control of a firm (these variables are explained in the next section). Ownership concentration is higher in continental Europe and Japan than it is in the United Kingdom and the United States of America [59]. The next section provides an empirical test of some essential factors that are known to affect monitoring and hence affect firm value. One set of the data regarding the governance system can be obtained from the effective board of directors. Board characteristics are directly a proxy for monitoring capability and are associated with firm value. Whole volumes of prior literature have discussed this topic ([14, 32, 33, 50, 45, 57]). Compositions of board [1, 33, 49] studied in literature, include board size, board independence, and CEO entrenchment. The size of board or the number of directors on the board affect monitoring activities and henceforth can capture the level of corporate governance in a firm. A larger board size, it is argued, can lead to communication problems and higher agency problems. Free-rider problems from inert committees in largesized board rooms give rise to greater CEO power. Larger-board firms are expected to have lower monitoring costs [49]. Previous empirical studies have evidenced that board size is

Board independence and a higher percentage of independent directors tend to capture the monitoring capability of the board. Hence, it can be a proxy for the level of governance and it

The diversity of board of directors also affects the capability to monitor and hence is further associated with the overall firm value. Empirical evidence has shown that diversity can

is used widely in literature in the area of board structure [13, 15, 23, 27, 62, 70, 78].

performance, which are directly linked to shareholders [5, 59, 66, 68].

relate with and confirm the expropriation of minority shareholders.

negatively correlated with a firm's performance [1, 29, 38, 81].

Traditional views of firms and the view of Jensen and Meckling or Coase still focus on the shareholders as the prime nexus or the most important group in the firm since they have the highest bargaining power in the firms as described earlier. To maximize the value of a firm, agents or managers need to put all resources into maximizing the value of the principal for the shareholders. Theoretically and according to the expected conflict of interest that might occur, the misalignment from the maximization of the value of a firm is generally found and hence reduces a firm's value. Managers can allocate firm resources to benefit themselves in many ways such as to use a luxurious office or use expensive car(s) or other perks for their management position.

In the Enron case and in many other such cases, it was found that managers attempted to adjust financial statements for their own benefit. One important issue in accounting research is the extent to which managers alter reports to benefit themselves [7]. Empirical evidence shows that income-increasing earning management is more pervasive than income-decreasing earning management. Also, there is evidence that managers have incentives to increase income to hide any deterioration of performance [7]. Jensen and Meckling call the activities managers use to maximize their own wealth as "shirk" or "perquisite" or "perk," through which these behaviors can directly and indirectly reduce a firm's value. On the other side, (the point of view of the agent-principle relationship), any set of activities that reduce shirk or perk actually enhance the value of the firm. The demand for maximization of a firm's value or of shareholders' value calls for an effective set of activities that can be solved or can mitigate the agency problem.

#### **2.1. Corporate governance**

If the "shirk" or "perk" is not beyond the expectations or the principles of owners of the firm, they will formulate a set of mechanisms to control the deviation from shareholders' wealth maximization. These take the form of "auditing" activities and monitoring activities. The auditing method is the inspection of managers through the prism of financial management and has been used in business and accounting for a long time. However, the regular occurrence of fraudulent management in many firms demonstrates to us that the effectiveness of auditing activities alone cannot counter unethical business practices. Auditing is one set of activities designed by incumbent owners to monitor the behavior of managers. Issues of corruption, the rule of law, and legal enforcement demand a more effective set of monitoring activities, which have come to be known as corporate governance [68].

Corporate governance is defined as "a set of mechanisms through which outsider investors protect themselves against expropriation by the insiders." Governance implementation can be achieved by external mechanism (the market for corporate control) and internal mechanism. The supreme objectives of corporate governance are set to ensure that shareholders as financiers get a return on their financial investment [71]. Corporate governance involves issues of practices to solve the complex issues among contract participants (social, employees, debt holders, and minority shareholders). However, the ultimate objective of corporate governance is still to focus on the wealth of the residual claimants who possess the highest bargaining power in the firm. Empirical research on the issues of corporate governance around the word have major research questions, especially with regard to their effectiveness over firm performance, which are directly linked to shareholders [5, 59, 66, 68].

problems (see [30, 53]). The problems propose that whenever we have this relationship in the environment (not just in business), we are surrounded by the agency problem. Smith and Zsidisin [73, 74] used the agency framework to understand the trade-off involved in the selection of various approaches of student evaluation. The agency problem further proposes that it is not beyond reasonable expectation that both parties in the relationship have their own interests and incentives in order to maximize their own interests and wealth. It is this conflict

Traditional views of firms and the view of Jensen and Meckling or Coase still focus on the shareholders as the prime nexus or the most important group in the firm since they have the highest bargaining power in the firms as described earlier. To maximize the value of a firm, agents or managers need to put all resources into maximizing the value of the principal for the shareholders. Theoretically and according to the expected conflict of interest that might occur, the misalignment from the maximization of the value of a firm is generally found and hence reduces a firm's value. Managers can allocate firm resources to benefit themselves in many ways such as to use a luxurious office or use expensive car(s) or other perks for their

In the Enron case and in many other such cases, it was found that managers attempted to adjust financial statements for their own benefit. One important issue in accounting research is the extent to which managers alter reports to benefit themselves [7]. Empirical evidence shows that income-increasing earning management is more pervasive than income-decreasing earning management. Also, there is evidence that managers have incentives to increase income to hide any deterioration of performance [7]. Jensen and Meckling call the activities managers use to maximize their own wealth as "shirk" or "perquisite" or "perk," through which these behaviors can directly and indirectly reduce a firm's value. On the other side, (the point of view of the agent-principle relationship), any set of activities that reduce shirk or perk actually enhance the value of the firm. The demand for maximization of a firm's value or of shareholders' value calls

for an effective set of activities that can be solved or can mitigate the agency problem.

activities, which have come to be known as corporate governance [68].

If the "shirk" or "perk" is not beyond the expectations or the principles of owners of the firm, they will formulate a set of mechanisms to control the deviation from shareholders' wealth maximization. These take the form of "auditing" activities and monitoring activities. The auditing method is the inspection of managers through the prism of financial management and has been used in business and accounting for a long time. However, the regular occurrence of fraudulent management in many firms demonstrates to us that the effectiveness of auditing activities alone cannot counter unethical business practices. Auditing is one set of activities designed by incumbent owners to monitor the behavior of managers. Issues of corruption, the rule of law, and legal enforcement demand a more effective set of monitoring

Corporate governance is defined as "a set of mechanisms through which outsider investors protect themselves against expropriation by the insiders." Governance implementation can

of interest which is the root of the agency problem.

management position.

6 Firm Value - Theory and Empirical Evidence

**2.1. Corporate governance**

Renders and Gaeremynck [66] used a sample from 14 European countries and showed that governance within a high-quality disclosure environment leads to a higher firm value. Saona and Martin [68] used a sample from Latin American firms and assessed whether within country changes in governance and changes in ownership concentration can predict a change in the value of firms. The results are in contrast to expectations, that is in immature financial markets, (as found in Latin America), firms take advantage of both the asymmetries of information and the multiple frictions in order to produce inflated valuations. These results correlate with and confirm the expropriation of minority shareholders.

Further, as the financial system develops, firm values drop. Research in this field attempts to associate various factors with monitoring ability and test them on the relationship with firm value. Mayer [59] discussed the interaction between competition, ownership structure governance, and performance. The author shows that corporate systems across countries are different and relate to ownership and the control of a firm (these variables are explained in the next section). Ownership concentration is higher in continental Europe and Japan than it is in the United Kingdom and the United States of America [59]. The next section provides an empirical test of some essential factors that are known to affect monitoring and hence affect firm value.

One set of the data regarding the governance system can be obtained from the effective board of directors. Board characteristics are directly a proxy for monitoring capability and are associated with firm value. Whole volumes of prior literature have discussed this topic ([14, 32, 33, 50, 45, 57]). Compositions of board [1, 33, 49] studied in literature, include board size, board independence, and CEO entrenchment. The size of board or the number of directors on the board affect monitoring activities and henceforth can capture the level of corporate governance in a firm. A larger board size, it is argued, can lead to communication problems and higher agency problems. Free-rider problems from inert committees in largesized board rooms give rise to greater CEO power. Larger-board firms are expected to have lower monitoring costs [49]. Previous empirical studies have evidenced that board size is negatively correlated with a firm's performance [1, 29, 38, 81].

Board independence and a higher percentage of independent directors tend to capture the monitoring capability of the board. Hence, it can be a proxy for the level of governance and it is used widely in literature in the area of board structure [13, 15, 23, 27, 62, 70, 78].

The diversity of board of directors also affects the capability to monitor and hence is further associated with the overall firm value. Empirical evidence has shown that diversity can improve a firm's performance [1, 47]. The gender of executives is believed to be another factor that has improved board monitoring Adams and Ferreira [1] by adding "multiple diversity facets to the oversight lens" [57].

facilitate a monitoring system that is tailored to their own requirements. The former hypothesis regarding firm value is destroyed, while the latter hypothesis proposes that firm value should improve [77]. Evidence shows that owner-manager conflict in nonfamily firms is more costly than a conflict between family and nonfamily shareholders in founder-CEO firms [77].

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After a long debate over the effectiveness of corporate governance, with the ultimate objective focusing on the wealth of shareholders, literatures have turned to ask questions about other stakeholders such as customers, social groups, or environmental lobbyists. Social pressures are the main driving forces of the strategic management in terms of both not only shareholders but also social issues too. The strategic management of many modern businesses includes the corporate social responsibility (CSR) of their strategic policy. CSR is also one attribute of corporate governance. However, researchers are still not clear about the benefit of CSR to

In the context of the agency problem, managers of firms are inclined to invest for their own interests (i.e., for reputation) even in the cases of negative NPV projects. If an agency problem is manifested in the good policies (CSR in this case), the relative problem should be reduced

If CSR is one attribute of corporate governance in terms of a tool to eliminate the agency problem and hence improve overall firm performance, one should observe the positive relationship between corporate governance and sustainability. Boghesi et al., [12] using the Governance Index or *G-index* as a proxy for the level of corporate governance in a firm (see [39]) find no relationship between *the G-Index* and the level of CSR. However, one may find that the level of CSR is higher for low insider firms (firms in which managers own a lower percentage of shares) and low institutional holdings. These findings suggest that investing in the CSR may not be due to the interest of shareholders but from the personal interest of managers. The theoretical implication from the agency problem is that if the CSR or other ethical policies are created in the service of a manager's private benefit, then strong governance should reduce the CSR or other goodness policies ([2, 18, 41]; and [12]) In fact, the managerial ownership or the *high institutional percentage of shares* in a firm represents institutional pressure which, in the context of this chapter, may not have much involvement in explaining the firm's investment in CSR activities. Thus, one could conclude that investment in CSR originates from *the personal motivation of managers rather than from institutional force*. Furthermore, findings about ownership structure and corporate governance are not consistent among different researchers. Barnea and Rubin [6] found a negative relationship between insider ownership and CSR, while Harjoto and Jo [41] found a positive relationship between institutional ownership and CSR activities; however, Boghesi et al. [12] found the opposite relationship—firms with larger institutional ownership are negatively related to the CSR. From the perspective of these research findings, the CSR might not be the ideal solution for the alignment of the managers' interests with the shareholders' interests.

when an efficient corporate governance mechanism is enforced.

**4. Corporate social responsibility**

shareholders.
