Department of Accounting and Finance

FINANCIAL MANAGEMENT

AAF002-3

An investigation into the effect of Corporate Governance in

shareholders’ wealth maximization – the case of AMEC Plc

By

Trinh Phuong Thao

1126458

An assignment submitted in partial fulfillment of the assessment for the Financial Management

(AAF002-3) unit

January 7, 2013

Assignment 1

An investigation into the effect of Corporate Governance in

shareholders’ wealth maximization – the case of AMEC Plc

Abstract

From late 1980s, a series of corporate scandals has occurred drawing people’s attention to

corporate governance issues. In order to prevent those failures from spread, Corporate

Governance Code has been developed base on several leading theories in economics and

finance with the purpose of improving corporate governance standards to be more

effective and suitable for continuously changing business environment. Indicated in this

report is the outcome of reviewing main related theories as well as the evaluation of the

applications of the Code to a selected company, namely AMEC Plc, in order to clarify

how corporate governance could contribute to the maximization of shareholder value.

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Table of Contents

I. Introduction...................................................................................................................4

1. Report objectives....................................................................................................4

2. Company overview................................................................................................4

II. Theoretical foundation..................................................................................................5

1. Shareholders’ wealth maximization.......................................................................5

2. Agency theory........................................................................................................6

3. Corporate Governance Code..................................................................................6

III. Evaluation of AMEC’s corporate governance..............................................................7

1. Leadership..............................................................................................................7

2. Effectiveness..........................................................................................................8

3. Accountability........................................................................................................9

4. Remuneration.......................................................................................................10

5. Relations with shareholders.................................................................................11

IV. Relation between company performance and corporate governance..........................11

V. Conclusion..................................................................................................................13

VI. Recommendations.......................................................................................................13

Appendix............................................................................................................................15

A. Foundation of Shareholders’ wealth maximization paradigm.............................15

B. Description of Agency theory..............................................................................15

C. The development of corporate governance code..................................................17

D. AMEC’s risk management system.......................................................................18

E. AMEC’s remuneration package...........................................................................19

F. AMEC’s ownership structure...............................................................................20

Reference...........................................................................................................................21

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I. Introduction

1. Report objectives

In the last two decades collapsed several prominent firms such as Enrol,

Worldcom and Royal Bank of Scotland, which has to a certain degree broken the

confidence of investors. The cause of those events has been blamed for the failures of

corporate governance since it is considered “the system by which companies are directed

and controlled” (Cadbury Committee, 1992). Therefore, Corporate Governance Code has

been developed from mainstream theories in economics and finance to propose

instruction framework for companies to follow in order to achieve better shareholder

value. This report is carried out with three main objectives:

- To review some leading theories influencing the development of corporate

governance;

- To evaluate corporate governance system of AMEC Plc which is chosen as a case

study to examine the relationship between those theories and actual application of

corporate governance; and

- To refer to the question of how corporate governance contribute to shareholders’

wealth maximization.

2. Company overview

AMEC was first founded in 1848 in the UK. For more than 160 years of

continuous growth, the company has become a large supplier of consultancy, engineering

and project management services in several sectors including oil and gas, minerals and

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metals, clean energy, environment and infrastructure. With the head office in London,

their business has expanded to 40 countries around the world with over 27,000

employees.

Their recorded revenues in 2011 were £3,261 million, an increase of 10.5% over

financial year 2010, which gives a profit of £232 million. Their adjusted diluted earnings

per share also increase from 62.5p to 70.5p and the dividend per share for the year is

30.5p in total.

II. Theoretical foundation

1. Shareholders’ wealth maximization

In modern financial management implies a main idea of why businesses exist. The

answer makes corporate owners’ wealth maximization the primary objective of business,

which means operations are run to increase the market value of ordinary shares. The

foundation of this paradigm as well as a simple comparison between it and profit

maximization model will be stated more clearly in Appendix A.

This paradigm run across this report as it is considered to be the aim of corporate

governance. The analysis of AMEC’s control system will be performed by reference to

whether those arrangements support or restrict shareholder value maximization.

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2. Agency theory

There are various theories associated with the development of corporate

governance but agency theory can be considered the most influencing theory. The main

concept of it is about the relationship “when one part (the ‘principles’) contracts with

another part (the ‘agents’) to make decisions on behalf of the principals” (Daniel and

Alina Badulescu, 2008). In the context of corporate governance, the principle means

shareholders and the agent is talked about management. A detailed description of this

theory is put in the Appendix B along with the brief mention of some other corporate

governance theories.

This theory will be used as the main one in the analysis and evaluation of AMEC’s

corporate governance. It is very suitable since the company is a public limited firm where

the directors of the company do not hold a large proportion of its ownership.

Consequently, the conflicts of interest as well as the need for a mechanism to put the

control back to the hand of shareholders will arise. The analysis of AMEC’s control

system will focus on how it contributes to the purpose of reducing agency costs.

3. Corporate Governance Code

The UK Corporate Governance Code is designed to provide the guide of best

practice related to corporate governance with the aim of improving the effectiveness of

control and ensuring the benefit of shareholders. It has been continuously improved from

1992 with many reviews and modification. The newest edition of the Code is Combined

Code 2010 which applies to all quoted companies. It consists of main principles,

supporting principles and provisions in five main areas, namely Leadership,

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Effectiveness, Accountability, Remuneration and Relations with shareholders. The case

study of AMEC corporate governance will be examined in accordance with this Code.

For details of the development process of the Code, see Appendix C.

III. Evaluation of AMEC’s corporate governance

A company’s corporate governance consists of numerous arrangements in many

business and management aspects. Much time and effort is required to run an in-depth

investigation into the whole system. This report will concentrate only on remarkable

features of AMEC’s corporate governance that directly influences the benefits of their

shareholders. Mostly under this section is the evaluation of the company control system,

if there is a need for further description and analysis of the mechanism they use, it will be

put on the Appendix.

1. Leadership

Corresponding to the Combined Code, there is a distinction between Chairman

who runs the board and Chief Executive who runs the company business in AMEC Plc,

which prevents any individual from having too much power to dominate the firm. Thanks

to this restricted authority of directors, resource misusage as well as unethical behavior

which are considered agency costs can be diminished. Chairman and Chief Executive can

oversee each other reducing the possibility of fraud, so this separation is in great help for

AMEC’s shareholders to ensure their managers to take appropriate actions.

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The board holds regular meetings throughout the year. In 2011, there were ten

board meetings and twelve committee meetings. This figure can be considered high

number compared to AMEC’s competitors of similar size. One of its advantages is that

non-executive directors had favorable conditions to closely grasp the company situation

in order to effectively support or challenge executive directors. However, how the board

spent their time is not clearly stated in AMEC’s corporate governance, which may create

ambiguity and make the evaluation of the board more difficult.

2. Effectiveness

In relation to the company’s size, the size of the board, formed of eight people, is

fairly small. The board of their competitors often consists of ten to twelve directors.

Moreover, though AMEC agrees to the new supporting principle B.6 of the Code to take

gender as a relevant factor of effectiveness, there is no woman in AMEC’s board. Both of

these characteristics limit the board diversity, which may bring some weaknesses due to

the lack of different perspectives to AMEC’s corporate governance system. However,

AMEC at least pays attention to the balance between executive and non-executive

directors among its board.

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Chairman13%

Non-execu-tive Director

50%

Executive Director

38%

Chart 1: Balance of Executive and Non-executive Directors of AMEC

Source: Adapt from AMEC’s Annual Report 2011

As can be seen from the chart, then number of non-executive directors excluding

Chairman is greater than the one of executive directors, which is completely complied

with the requirements of the Code. This system is used to ensure the neutrality of the

board in the issue of interest conflicts arising from agency theory, which safeguards the

benefits of shareholders.

3. Accountability

Risk management is one of the strengths of AMEC’s corporate governance. For

detailed review of this system, see Appendix D.

AMEC’s key risks, especially financial risks, are carefully stated in their annual

report along with the methods of mitigation. They are divided into detailed item,

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concretely analyzed, with general direction of settlement. Therefore, AMEC’s

shareholders can understand clearly the risks that the firm has to face and obviously

express their attitude towards risk to board of directors, which supports in reducing the

possibility for directors to take inappropriate high risks for short-term profits. In other

words, the clear structure of risk management of AMEC greatly contributes to the work

of returning control back to company’s shareholders.

4. Remuneration

Compliance with the Code, the company clearly discloses the system of

remuneration calculation. The remuneration package of AMEC Plc consists of four

components which are set up for different purposes of motivation. An in-depth analysis

of this will be presented in Appendix E.

AMEC’s remuneration package is design to prevent underperforming reward. The

policy as well as formula to calculate the award is stated clearly. The use of financial

ratios that measures overall company performance as indicators for the bonus payment

reduces the difficulty in remuneration computation. However, how the amount paid links

to individuals’ actual performance is still in ambiguity. It is found to be insufficient to

shareholders since they want to know whether bonus schedule is reasonable or not in

accordance with directors’ virtual contribution. The announcement related to this issue

needs further development through implementation of best practice guidelines rather than

by Regulation.

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5. Relations with shareholders

Because of AMEC’s share ownership structure where a large number of small

ownership exists, there is a high probability of free rider problem. The details on this

structure are stated in Appendix F.

In order to prevent this problem, AMEC’s board of director needs to take the

active role in engaging with the company’s owners and they are doing quite well. Apart

from common communication tools of annual reports and accounts, presentations, annual

general meetings and website information, AMEC’s directors, especially new appointed

Chairman, take the initiative in contacting and learning about the view of investors. They

hold both scheduled and unexpected meetings with significant shareholders. In December

2011, a wide group of investors has been invited to attend the group lunch arranged by

the Chairman. Moreover, he also writes to all major shareholders to remind them that

meetings and telephone calls from these investors are welcome. On the other hand, the

company forms an investor relation team to respond to the meeting request of

shareholders. Last but not least, the AMEC’s board of directors continuously seeks for

deeper knowledge of their investors by employing a third party to run perception research

on shareholders’ view annually.

IV. Relation between company performance and

corporate governance

AMEC Plc closely complies with the Code 2010, which help them support their

corporate governance to be more effective in order to improve company operations with

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the final objective of increasing shareholder value. To have a better vision of how AMEC

perform in 2011, let’s look at the table below.

Table 1: AMEC’s financial ratios

2011 2010 2009 2008

Net working capital turnover 5.12 4.48 3.99 4.18

EBITA1 299.00 269.00 208.30 184.90

Earnings per share (pence) 70.50 62.50 46.90 63.10

Dividend per share (pence) 30.50 26.50 17.70 15.40

Source: AMEC’s Annual Report 2011

The first ratio presents the ability of AMEC to generate work out of their working

capital, which shows a development in the efficiency of asset utilization. This can be

achieved by improving the company internal control for smoother operation.

Concurrently, the firm’s level of profitability is implied under EBITA ratio, which has

continuously increased from 2008. On the other hand, the last two indicators reveal the

ability to make profit from the shares of AMEC. For current shareholders of the

company, these ratios indicate return of their money. These ratios of AMEC have gone

up for four-year period, which can imply an increase in their shareholders’ wealth.

This profit can only be achieved if the operation of the company successfully takes

place and resource misusage is mitigated, which is supported by corporate governance.

Like this, the maintenance of appropriate governance system has created a favorable

environment for the company to continue and improve their operations, which is

necessary to maximize shareholder value.

1 Earnings before interest, tax and intangible amortization

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V. Conclusion

To sum up, this report provides an overview about the application of corporate

governance base on the foundation of Agency theory into the specific case of AMEC Plc.

The investigation into outstanding features of their governance system as well as the

analysis of the relation between these features and company performance shows that

good corporate governance has certain positive impacts in the result of the firm operation,

which directly contributes to the maximization of shareholders’ wealth.

VI. Recommendations

Despite many strong points in the corporate governance of AMEC Plc, there are

several features to which the company should pay more attention in order to improve

their control system.

First, it is recommended for AMEC’s board of directors to carefully disclose the

allocation of time spending in the discussion and development of different aspects in the

management of the company. It will help them to organize their work more effectively

and illuminate the shareholders’ inquiries at the same time.

Next, the company is suggested to increase the diversification of member within

the board. A wider group of style and perspective will positively influence the method of

working and management.

Finally, it is necessary to improve the disclosure of remuneration calculation

related to individuals’ actual performance to give the shareholder a clearer view of the

relation between bonus expense and directors’ contribution.

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Appendix

A. Foundation of Shareholders’ wealth maximization

paradigm

The model of shareholders’ wealth maximization is developed base on the classic

competitive markets assumption. The shareholders are residual claimants, so “they can

add to their wealth only after satisfying all the prior claims of every other participant”

(Sivarama Krishnan, 2009). Therefore, this model benefits both shareholders and the

society since all the people involved and resources used have been compensated before

the come of shareholders’ wealth.

This paradigm is different from profit maximization despite some overlap between

the two objectives. According to Geoffey Poitras (1994), “profit maximization is

designed for the traditional microeconomic world” of no uncertainty, fixed capital stock

and no distinction between owner and manager. The main shortcoming of this model is

that it encourages managers to take high-risk projects for short-term profits. On the

contrary, shareholders’ wealth maximization is concerned with the present discounted

value of the stream of dividends paid in the future. Hence, it takes into account both

current and future profits and earnings per share, the timing, duration, and risk of

investment, and all other relevant factors.

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B. Description of Agency theory

Since managers (the agent side) do not own the company and just manage money

of other people (the principle side), they will not care about it with the same interest as

for their own money. Therefore, a number of problems may arise when the separation

between ownership and control exists. The biggest disadvantage of this distinction is the

opportunism of the agent which happens when managers misuse company resources to

take advantage rather than maximize profit for shareholders. Also, directors’ and

shareholders’ attitudes toward risk may differ making managers take inappropriate risks.

Moreover, managers can have advantage in this relationship for they are the ones

working directly with resources and information. Therefore, corporate governance is a

mechanism used to take the control back to the owners. Its main purpose is to align

shareholders and managers’ interests and to minimize the problems of opportunism.

Apart from this theory, there are several different ones that is also widely known

in corporate governance. The table below summarizes some of them.

Table 2: Corporate governance theory

Theory name Summary

Agency

Agency theory identifies the agency relationship where one party, the

principal, delegates work to another party, the agent. In the context of

a corporation, the owners are the principal and the directors are the

agent.

Transaction cost

economics

Transaction cost economics views the firm itself as a governance

structure. The choice of an appropriate governance structure can help

align the interests of directors and shareholders.

Stakeholder Stakeholder theory takes account of a wider group of constituents

rather than focusing on shareholders. Where there is an emphasis on

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stakeholders, then the governance structure of the company may

provide for some direct representation of the stakeholder groups.

StewardshipDirectors are regarded as the stewards of the company’s assets and

will be predisposed to act in the best interest of the shareholders.

Class hegemony

Directors view themselves as an elite at the top of the company and

will recruit/promote to new director appointments taking into account

how well new appointments might fit into that elite.

Managerial

hegemony

Management of a company, with its knowledge of day-to-day

operations, may effectively dominate the directors and hence waken

the influence of the directors.

Source: C. mallin (2010), Corporate Governance

3rd Edition, Oxford University Press, p. 14

C. The development of corporate governance code

The development of UK Corporate Governance Code has taken place for about ten

years, started in 1992 with the Cadbury Report published. The table below will highlight

the milestone in this process.

Table 3: Development milestones of UK Corporate Governance Code

Year Event

1992 Cadbury Report published

1995 Greenbury Report published

1998Hampel Report published

Combined Code published

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1999 Turnbull Guidance published

2001 Myners Report published

2002

US Sarbanes-Oxley Act introduced

Modern Company Law Review published

Financial Services Authority Review published

2003

Higgs Report published

Smith Report published

Combined Code modified for the first time

2005 Company Law Reform Bill published

2006Companies Act 2006 published

Combined Code modified for the second time

2008 Combined Code modified for the third time

2009 Walker Review published

2010 Combined Code modified for the fourth time

D. AMEC’s risk management system

In AMEC’s corporate governance, the role and responsibility of each management

level in risk control is clearly defined in order to ensure the control system to be

consistently carried out. The Risk Committee under Chief Executive is responsible for

the review and overall supervision of risk category management while lower hierarchies

undertake specific actions to identify, mitigate and monitor particular risks. This clear

division of responsibility makes the work of risk control to take place more smoothly.

The process of risk management is also stated clearly. First, the company

identifies key risks along with their impacts and probability of occurring. Concurrently,

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risk owners as well as the conditions of happening are stuck with them to create the risk

register. Then, action plans are built to reduce or eliminate the risks. On the other hand,

the solution for risk response is investigated at the same time for precautions in case the

risk actually occurs.

E. AMEC’s remuneration package

In four elements of AMEC’s remuneration package, base salary is fixedly set at a

competitive level of the industry. It is reviewed annually to take new market changes into

account with the objective of keeping a reasonable competitive wage level compared to

AMEC’s competitors.

The second element of remuneration system is pension arrangements and other

benefits including provision, allowance and expense insurance for directors’ facilities to

ensure high-standard treatment at work.

The next component is annual bonus which is used to encourage short-term

achievement. It is calculated by reference to a set target of earnings before interest, tax

and intangible amortization (EBITA), cash flow and personal targets; all of which are

different from year to year and between individuals. AMEC set out a threshold to start

receiving bonus if the directors reach it. The bonus will increase in accordance with the

rise of achievement. Besides, there is a target level, which is usually higher than actual

result of previous year, to be a measure for the managers to receive maximum bonus if

their performance exceeds that figure.

Last but not least, long-term incentive providing share award aims at long-run

motivation. These shares are only vested after three years once the requirements of

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performance targets are also satisfied. It includes a basic award up to 175 per cent of

basic salary and a matching award up to 75 per cent of the salary. The basic element is

absolute while the second component is paid depending on directors’ own investment in

company shares in three-year period. The measure for this incentive stays at the

development of total shareholder return (TSR) and earnings per share growth. This

system is built to align the benefits of executive directors and the ones of shareholders in

order to reduce interest conflicts come from the separation of control and ownership.

F. AMEC’s ownership structure

According to the company’s disclosure, there are only two institutional investors

who have more than 3 per cent of the firm voting rights and none of their shareholdings

reaches 10 per cent. The chart below shows the proportion of ownership of AMEC Plc.

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Blackrock, Inc Legal & General As-surance

Group of ownership below 3% each

Share owner-ship

0.0994 0.0396 0.861

5.00%15.00%25.00%35.00%45.00%55.00%65.00%75.00%85.00%

Chart 2: Ownership structure of AMEC PlcSh

are

owne

rshi

p

Source: Adapt from AMEC’s Annual Report 2011

Since the control rights are dispersed in the hand of numerous shareholders,

investor activism is more difficult to achieve. There is no single shareholder encouraged

to carefully supervise corporate management of the company, which may lead to the

situation where the power is seized and used by the managers for misleading purpose.

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Reference

1. C. Mallin (2010), Corporate Governance 3rd Edition, Oxford University Press,

Oxford.

2. B. Elliott and J.Elliott ( 2010), Financial Accounting and Reporting 15th Edition,

Prentice Hall.

3. P. Atrill (2009), Financial Management for Decision Makers 5th Edition, Prentice

Hall.

4. UK Corporate Governance Code 2010.

5. AMEC’s Annual Report 2011.

6. S. Krishman and C. Oklahoma, ‘Stakeholders, Shareholders and Wealth

Maximization’, 2009.

7. G. Poitras, ‘Shareholder Wealth Maximization, Business Ethics and Social

Responsibility’, 1994.

8. ABI Research: Corporate governance ‘pays’ for shareholder and company

performance, ABI, 27 February 2008, REF: 12/08.

9. S. Turnbull, ‘Corporate Governance: Its Scope, Concerns and Theories’, 1997.

10. C. Jackson and A. Williams, ‘Corporate Governance Development in the UK and

Continental Europe’, 2006.

11. Kingston City Group, ‘Corporate Governance Developments in the UK’.

12. A. Agrawal and S. Chadha, ‘Corporate Governance and Accounting Scandals’, 2003.

13. OECD, ‘Corporate Governance and the Financial Crisis: Key Findings and Main

Messages’, 2009.

14. D. Badulescu and A. Dadulescu, ‘Theoretical Background of Corporate Governance’,

2008.

15. Deloltte, ‘Report on the impact of the Directors’ Remuneration’, 2004.

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