V1.1 Introduction
Classical Corporate Finance (Modigliani & Miller, 1958)
Perfect Capital Markets Assumptions
• All projects with positive Net Present Value (NPV) are financed.
• Capital structure is irrelevant: The firm’s value depends solely on free cash flows from assets,
not on how it’s financed.
Capital Market Imperfections
• Taxes: Debt receives tax advantages, making it preferred due to interest deductibility.
• Implications: With tax advantages, higher debt-to-equity ratios (D/E) might be expected in
practice.
Additional Imperfections
• Bankruptcy costs: Includes both direct (legal fees) and indirect costs (e.g., loss of reputation
and renegotiation costs).
• Agency Costs (Jensen & Meckling, 1976):
– Misalignment of objectives between managers and financiers.
– Capital structure can be used to incentivize managers, balancing effort (debt) and
risk-taking incentives (equity).
Hidden Information and Pecking Order Theory (Myers & Majluf )
• Firms prefer funding options in a hierarchy to mitigate adverse selection: Internal funds →
Debt → Equity.
• Signal of high company value can come from actions like stock buybacks.
Information Asymmetry and Agency Theory
• Principal-Agent Problem: Conflict between investors (principals) and managers (agents),
who have better information and may have differing objectives.
• Moral Hazard (Hidden Action): Managers might pursue projects beneficial to them (e.g.,
perks, empire-building) but not necessarily to shareholders.
• Adverse Selection (Hidden Information): Issues arise in assessing the true value of new
investments, leading to risks like creative accounting.
Corporate Governance and Solutions to Agency Problems
• Agency Costs Mitigation: Monitoring (e.g., board oversight), bonding (financial disclosures),
and incentives to align managerial behavior with shareholder interests.
• Conflict Resolution: Use of debt can discipline managers by restricting cash flow discretion
and setting repayment obligations.
Information Asymmetry – Moral Hazard and Adverse Selection
• Moral Hazard: Managers may take hidden actions that favor their own benefit over the
firm’s (like opting for ”pet projects” or minimizing effort).
• Adverse Selection: Difficulty in valuing new projects accurately due to hidden information,
leading to potentially unwise investments or valuation inaccuracies.
1
,Corporate Finance/Governance Objective
Key Question: how to design financing contracts that...
1. Ensure managers act in the interests of the funders.
2. Ensure truthful reporting by managers.
This addresses principal-agent problems, where managers (agents) may have incentives to act in
their own interest instead of the funders’ (principals).
Tools for Mitigating Principal-Agent Problems
• Executive Compensation (financial incentives): Structure remuneration to align managers’
goals with shareholders’ interests, such as through performance-based pay.
• Monitoring: Regular checks and balances to reduce the manager’s ability to deviate from
funders’ goals.
• Control mechanisms:
– Decision-making authority on key matters (e.g., new investments).
– Example: Venture capitalists may replace management if performance declines.
Fundamental Corporate Finance Questions
• Why aren’t all positive NPV projects financed? → Issues like credit rationing can limit
funding.
• How do firms boost financing? → Use of collateral and signaling to reduce inefficiencies.
• Role of Financial Institutions: Why do banks exist, and who monitors them?
• Information in Stock Markets: What motivates investors to gather information?
• Decision Power in Firms: Examining why debt holders gain influence in poorly performing
firms and whether this leads to optimal decision-making.
Goal: To explore the microeconomic foundations of corporate finance theory, along with its
empirical applications, providing a solid theoretical and practical framework for understanding
corporate finance dynamics.
2
, V1.3 Fixed Investment Model
• Scenario: An entrepreneur needs external financing to execute a risky project.
• Investor: Provides financing under a contract that outlines how the proceeds from the
investment will be divided between the entrepreneur and the investor.
Agency Costs and Moral Hazard
Problem: The entrepreneur may act in their own interest by prioritizing private benefits over the
success of the project.
• Example: The entrepreneur might divert funds to another project that provides personal
benefits but doesn’t yield returns for the investor, reducing the probability of success.
The Model
• The project has payoff R if successful, or 0 if it fails.
• The project requires an investment I, and the entrepreneur has assets A (where A < I), so
they need additional funding from an investor.
• The investor provides the remaining I − A.
Project Payoff and Effort Levels
Project Outcome:
• Success probability p depends on the (unobservable) effort level of the entrepreneur:
– High Effort: Results in a higher probability of success pH .
– Low Effort: Leads to a lower probability pL and provides entrepreneur with a private
benefit B.
• Key Difference: ∆p = pH − pL , representing the impact of effort on project success.
Economic Implications of Effort
• High Effort: expected payoff for the project is pH R − I > 0 (positive NPV).
• Low Effort: expected payoff for the project is pL R − I + B < 0, indicating the project is not
viable without proper effort (negative NPV).
• Decision: in theory, projects without effort should not be funded, as they are likely to fail.
Figure 1: Model with Agency Costs
3
Classical Corporate Finance (Modigliani & Miller, 1958)
Perfect Capital Markets Assumptions
• All projects with positive Net Present Value (NPV) are financed.
• Capital structure is irrelevant: The firm’s value depends solely on free cash flows from assets,
not on how it’s financed.
Capital Market Imperfections
• Taxes: Debt receives tax advantages, making it preferred due to interest deductibility.
• Implications: With tax advantages, higher debt-to-equity ratios (D/E) might be expected in
practice.
Additional Imperfections
• Bankruptcy costs: Includes both direct (legal fees) and indirect costs (e.g., loss of reputation
and renegotiation costs).
• Agency Costs (Jensen & Meckling, 1976):
– Misalignment of objectives between managers and financiers.
– Capital structure can be used to incentivize managers, balancing effort (debt) and
risk-taking incentives (equity).
Hidden Information and Pecking Order Theory (Myers & Majluf )
• Firms prefer funding options in a hierarchy to mitigate adverse selection: Internal funds →
Debt → Equity.
• Signal of high company value can come from actions like stock buybacks.
Information Asymmetry and Agency Theory
• Principal-Agent Problem: Conflict between investors (principals) and managers (agents),
who have better information and may have differing objectives.
• Moral Hazard (Hidden Action): Managers might pursue projects beneficial to them (e.g.,
perks, empire-building) but not necessarily to shareholders.
• Adverse Selection (Hidden Information): Issues arise in assessing the true value of new
investments, leading to risks like creative accounting.
Corporate Governance and Solutions to Agency Problems
• Agency Costs Mitigation: Monitoring (e.g., board oversight), bonding (financial disclosures),
and incentives to align managerial behavior with shareholder interests.
• Conflict Resolution: Use of debt can discipline managers by restricting cash flow discretion
and setting repayment obligations.
Information Asymmetry – Moral Hazard and Adverse Selection
• Moral Hazard: Managers may take hidden actions that favor their own benefit over the
firm’s (like opting for ”pet projects” or minimizing effort).
• Adverse Selection: Difficulty in valuing new projects accurately due to hidden information,
leading to potentially unwise investments or valuation inaccuracies.
1
,Corporate Finance/Governance Objective
Key Question: how to design financing contracts that...
1. Ensure managers act in the interests of the funders.
2. Ensure truthful reporting by managers.
This addresses principal-agent problems, where managers (agents) may have incentives to act in
their own interest instead of the funders’ (principals).
Tools for Mitigating Principal-Agent Problems
• Executive Compensation (financial incentives): Structure remuneration to align managers’
goals with shareholders’ interests, such as through performance-based pay.
• Monitoring: Regular checks and balances to reduce the manager’s ability to deviate from
funders’ goals.
• Control mechanisms:
– Decision-making authority on key matters (e.g., new investments).
– Example: Venture capitalists may replace management if performance declines.
Fundamental Corporate Finance Questions
• Why aren’t all positive NPV projects financed? → Issues like credit rationing can limit
funding.
• How do firms boost financing? → Use of collateral and signaling to reduce inefficiencies.
• Role of Financial Institutions: Why do banks exist, and who monitors them?
• Information in Stock Markets: What motivates investors to gather information?
• Decision Power in Firms: Examining why debt holders gain influence in poorly performing
firms and whether this leads to optimal decision-making.
Goal: To explore the microeconomic foundations of corporate finance theory, along with its
empirical applications, providing a solid theoretical and practical framework for understanding
corporate finance dynamics.
2
, V1.3 Fixed Investment Model
• Scenario: An entrepreneur needs external financing to execute a risky project.
• Investor: Provides financing under a contract that outlines how the proceeds from the
investment will be divided between the entrepreneur and the investor.
Agency Costs and Moral Hazard
Problem: The entrepreneur may act in their own interest by prioritizing private benefits over the
success of the project.
• Example: The entrepreneur might divert funds to another project that provides personal
benefits but doesn’t yield returns for the investor, reducing the probability of success.
The Model
• The project has payoff R if successful, or 0 if it fails.
• The project requires an investment I, and the entrepreneur has assets A (where A < I), so
they need additional funding from an investor.
• The investor provides the remaining I − A.
Project Payoff and Effort Levels
Project Outcome:
• Success probability p depends on the (unobservable) effort level of the entrepreneur:
– High Effort: Results in a higher probability of success pH .
– Low Effort: Leads to a lower probability pL and provides entrepreneur with a private
benefit B.
• Key Difference: ∆p = pH − pL , representing the impact of effort on project success.
Economic Implications of Effort
• High Effort: expected payoff for the project is pH R − I > 0 (positive NPV).
• Low Effort: expected payoff for the project is pL R − I + B < 0, indicating the project is not
viable without proper effort (negative NPV).
• Decision: in theory, projects without effort should not be funded, as they are likely to fail.
Figure 1: Model with Agency Costs
3
