Corporate Finance Lectures
Summary of the course’s lectures
Joris Wellen – University of Groningen
Overview
Lecture 1 – Introduction: Beyond Perfect Capital Markets..............................................................................3
1.1 Perfect capital markets(?)..............................................................................................................................3
1.2 Information....................................................................................................................................................3
1.3 Fixed Investment Model.................................................................................................................................4
1.4 The funding contract......................................................................................................................................5
Lecture 2 – Debt Overhang, Diversification and Sequential Projects................................................................7
2.1 Recap Fixed Investment Model......................................................................................................................7
2.2 Pre-existing debt: Debt Overhang..................................................................................................................9
2.3 Boosting pledgeable income: Multiple projects (Diversification)................................................................10
2.4 Boosting pledgeable income: Sequential projects.......................................................................................13
Lecture 3 – Asymmetric Information............................................................................................................ 16
3.1 Introduction..................................................................................................................................................16
3.2 Privately known prospects...........................................................................................................................16
3.3 Separating contracts....................................................................................................................................18
3.4 Costly Collateral...........................................................................................................................................18
3.5 Incomplete Insurance...................................................................................................................................21
Lecture 4 – Active and Passive Monitoring.................................................................................................... 23
4.1 Introduction..................................................................................................................................................23
4.2 Active Monitoring.........................................................................................................................................24
4.3 Passive Monitoring.......................................................................................................................................26
Lecture 5 – Corporate Governance............................................................................................................... 28
5.1 Introduction..................................................................................................................................................28
5.2 Interim Action...............................................................................................................................................28
5.3 Control Rights...............................................................................................................................................29
5.4 Contingent Control Rights............................................................................................................................30
5.5 Earnings Manipulation.................................................................................................................................32
Lecture 6 – Earnings Management................................................................................................................ 36
, Corporate Finance for MSc Finance Lectures – University of Groningen –
Joris Wellen
6.1 “Superstar CEOs”..........................................................................................................................................36
6.2 Earnings Manipulation.................................................................................................................................40
6.3 Fixed Investment Model with Manipulation................................................................................................41
Lecture 7 – Guest Lecture: Bank Bailouts and Moral Hazard..........................................................................44
2
,Corporate Finance for MSc Finance Lectures – University of Groningen –
Joris Wellen
Lecture 1 – Introduction: Beyond Perfect Capital
Markets
1.1 Perfect capital markets(?)
In perfect capital markets, all projects that have positive net present
value will be financed. It is irrelevant how projects or firms are financed.
Modigliani and Miller (1958) stated that the value of the firm is not
affected by capital structure, but only by the free cash flows generated by
the assets.
However, there are some imperfections:
1. Taxes (M&M); debt gets preferred treatment by tax office.
2. While total cash flows are not affected by capital structure, the
share of cash flows to tax is.
3. Bankruptcy costs: real costs of reorganizing and informational costs
(loss of confidence, negotiation costs).
4. Agency costs (Jensen and Meckling, 1976): managers’ and
funders’ objectives are not the same. Capital structure helps to
incentivize managers. Therefore, there should be a balance
between debt (effort incentives) and equity financing (risk taking
incentives).
5. Hidden information. Pecking order of financing (Myers and
Majluf): firms prefer to attract finances first from sources that are
least sensitive to the hidden value of the firm. Another form of
hidden information is a signal that your company has high value,
when buying your own stocks for instance.
1.2 Information
Information asymmetries exist between
- Those who provide funding; and
- Those who manage the firm
We explore the consequences of these information problems in a
structured way – describe the firm through the lens of a principal-agent
problem.
Investors
Delegate managerial decision-making
Manager
These have conflicting interests + manager has better information.
Information asymmetry comes in two forms, a hidden action or hidden
information. Moral hazard is taking actions that benefit the manager but
3
, Corporate Finance for MSc Finance Lectures – University of Groningen –
Joris Wellen
not the owners. An example of adverse selection, which is a form of
hidden information, would be creative accounting.
The central question now is: how do we design financing contracts that
assure the funders that their managers will act in the funders’ interest
and tell the truth? This could potentially mitigate the principal-agent
problem.
Tools:
Executive compensation / remuneration: financial incentives to
align interests.
Monitoring: reduce manager’s ability to deviate.
Control: who decides what?
1.3 Fixed Investment Model
An entrepreneur needs outside financing to execute a risky project.
Outside financing is provided by an investor, they have to write a
contract on how to split the proceeds of the investment. The entrepreneur
may mismanage the project by taking a private benefit which lowers the
probability of project success. For instance, investing the money in a
second project from which the investor gets no return.
There is a project with pay-off R or 0, which requires an investment I. The
entrepreneur has assets A, where A < I. The investor provides the
remaining: I – A.
The project produces R with the probability p. p depends on the
unobservable efforts the entrepreneur puts in the project:
In case of effort, the probability of success is high: p_H
In case of no effort, the probability of success is low: p_L, the
entrepreneur receives a private benefit B.
Difference is: ∆ p ≡ p H − p L.
If the entrepreneur exerts effort, the payoff is positive: P_HR – I > 0. In
perfect capital markets such projects should always receive funding.
If the entrepreneur does not exert effort, the payoff is negative: P_LR – I
+ B < 0. If no effort, the project should not receive funds.
4
Summary of the course’s lectures
Joris Wellen – University of Groningen
Overview
Lecture 1 – Introduction: Beyond Perfect Capital Markets..............................................................................3
1.1 Perfect capital markets(?)..............................................................................................................................3
1.2 Information....................................................................................................................................................3
1.3 Fixed Investment Model.................................................................................................................................4
1.4 The funding contract......................................................................................................................................5
Lecture 2 – Debt Overhang, Diversification and Sequential Projects................................................................7
2.1 Recap Fixed Investment Model......................................................................................................................7
2.2 Pre-existing debt: Debt Overhang..................................................................................................................9
2.3 Boosting pledgeable income: Multiple projects (Diversification)................................................................10
2.4 Boosting pledgeable income: Sequential projects.......................................................................................13
Lecture 3 – Asymmetric Information............................................................................................................ 16
3.1 Introduction..................................................................................................................................................16
3.2 Privately known prospects...........................................................................................................................16
3.3 Separating contracts....................................................................................................................................18
3.4 Costly Collateral...........................................................................................................................................18
3.5 Incomplete Insurance...................................................................................................................................21
Lecture 4 – Active and Passive Monitoring.................................................................................................... 23
4.1 Introduction..................................................................................................................................................23
4.2 Active Monitoring.........................................................................................................................................24
4.3 Passive Monitoring.......................................................................................................................................26
Lecture 5 – Corporate Governance............................................................................................................... 28
5.1 Introduction..................................................................................................................................................28
5.2 Interim Action...............................................................................................................................................28
5.3 Control Rights...............................................................................................................................................29
5.4 Contingent Control Rights............................................................................................................................30
5.5 Earnings Manipulation.................................................................................................................................32
Lecture 6 – Earnings Management................................................................................................................ 36
, Corporate Finance for MSc Finance Lectures – University of Groningen –
Joris Wellen
6.1 “Superstar CEOs”..........................................................................................................................................36
6.2 Earnings Manipulation.................................................................................................................................40
6.3 Fixed Investment Model with Manipulation................................................................................................41
Lecture 7 – Guest Lecture: Bank Bailouts and Moral Hazard..........................................................................44
2
,Corporate Finance for MSc Finance Lectures – University of Groningen –
Joris Wellen
Lecture 1 – Introduction: Beyond Perfect Capital
Markets
1.1 Perfect capital markets(?)
In perfect capital markets, all projects that have positive net present
value will be financed. It is irrelevant how projects or firms are financed.
Modigliani and Miller (1958) stated that the value of the firm is not
affected by capital structure, but only by the free cash flows generated by
the assets.
However, there are some imperfections:
1. Taxes (M&M); debt gets preferred treatment by tax office.
2. While total cash flows are not affected by capital structure, the
share of cash flows to tax is.
3. Bankruptcy costs: real costs of reorganizing and informational costs
(loss of confidence, negotiation costs).
4. Agency costs (Jensen and Meckling, 1976): managers’ and
funders’ objectives are not the same. Capital structure helps to
incentivize managers. Therefore, there should be a balance
between debt (effort incentives) and equity financing (risk taking
incentives).
5. Hidden information. Pecking order of financing (Myers and
Majluf): firms prefer to attract finances first from sources that are
least sensitive to the hidden value of the firm. Another form of
hidden information is a signal that your company has high value,
when buying your own stocks for instance.
1.2 Information
Information asymmetries exist between
- Those who provide funding; and
- Those who manage the firm
We explore the consequences of these information problems in a
structured way – describe the firm through the lens of a principal-agent
problem.
Investors
Delegate managerial decision-making
Manager
These have conflicting interests + manager has better information.
Information asymmetry comes in two forms, a hidden action or hidden
information. Moral hazard is taking actions that benefit the manager but
3
, Corporate Finance for MSc Finance Lectures – University of Groningen –
Joris Wellen
not the owners. An example of adverse selection, which is a form of
hidden information, would be creative accounting.
The central question now is: how do we design financing contracts that
assure the funders that their managers will act in the funders’ interest
and tell the truth? This could potentially mitigate the principal-agent
problem.
Tools:
Executive compensation / remuneration: financial incentives to
align interests.
Monitoring: reduce manager’s ability to deviate.
Control: who decides what?
1.3 Fixed Investment Model
An entrepreneur needs outside financing to execute a risky project.
Outside financing is provided by an investor, they have to write a
contract on how to split the proceeds of the investment. The entrepreneur
may mismanage the project by taking a private benefit which lowers the
probability of project success. For instance, investing the money in a
second project from which the investor gets no return.
There is a project with pay-off R or 0, which requires an investment I. The
entrepreneur has assets A, where A < I. The investor provides the
remaining: I – A.
The project produces R with the probability p. p depends on the
unobservable efforts the entrepreneur puts in the project:
In case of effort, the probability of success is high: p_H
In case of no effort, the probability of success is low: p_L, the
entrepreneur receives a private benefit B.
Difference is: ∆ p ≡ p H − p L.
If the entrepreneur exerts effort, the payoff is positive: P_HR – I > 0. In
perfect capital markets such projects should always receive funding.
If the entrepreneur does not exert effort, the payoff is negative: P_LR – I
+ B < 0. If no effort, the project should not receive funds.
4
