Chapter 1: Foundations of Corporate Finance
Characteristics and Core Concepts of Corporations
Fundamental Traits of Corporations (Hansmann and Kraakman, 2004): Corporations are defined
by five essential characteristics: legal personality, delegated management, shared ownership,
transferable shares, and limited liability for investors. These traits enable corporations to support
large-scale, risky investments by facilitating diversified ownership and allowing stakeholders to
manage and transfer risk efficiently.
Risk and Capital Structure
Risk Sharing and Shifting: The structure of corporations enables risk-sharing among diverse share-
holders, supporting high-risk projects while limiting individual exposure. However, risk-shifting
conflicts arise between contractual claimants (creditors) and residual claimants (shareholders),
especially under financial distress or near insolvency, as shareholders may prefer high-risk projects
that creditors might resist (Myers, 1977).
Core financial decisions; managing capital allocation across key areas:
• Investment decisions (capital budgeting, mergers, and acquisitions)
• Financial structure (choice between debt and equity financing)
• Payout policies (dividends and share repurchases)
• Risk management (using hedging and operational strategies)
• Governance (alignment of management and stakeholder interests)
• Cash management (how much cash and liquid assets to hold)
Rational Decision-Making Models in Corporate Finance
• Value Creation and Investment: Modigliani & Miller (1958): Argue that in perfect markets,
firm value is determined by its real investment decisions and not by its capital structure. This
”irrelevance theory” assumes no taxes, transaction costs, or bankruptcy costs, highlighting
that value stems primarily from real investment opportunities rather than financing choices.
• Capital Structure in Imperfect Markets: In real-world imperfect markets, financing decisions
become relevant as they can reduce inefficiencies (e.g., through tax shields or avoiding
bankruptcy costs). This adjustment introduces value-maximizing considerations, particularly
when addressing agency and market inefficiencies (Myers, 2003).
Corporate Goals and Financial Markets
Corporate Purpose and Market Dynamics: Graham (2022): Explores the evolving debate on
corporate goals, noting the shift from pure shareholder value maximization to incorporating
stakeholder interests (such as ESG concerns). The role of financial markets, therefore, is not
only to allocate capital efficiently but to support a broader view of firm purpose, adapting to
stakeholder demands and sustainability goals.
Practical Perspectives and Empirical Findings
Capital Structure Theories in Practice (Frank & Goyal, 2022): Empirical evidence shows firms do
not adhere to a universal theory of capital structure. Instead, factors like taxes, bankruptcy costs,
agency conflicts, and behavioral biases collectively shape financing decisions. Firms exhibit mean
reversion in leverage, where they adjust toward an optimal leverage ratio over time, indicating a
dynamic approach rather than strict adherence to theoretical targets.
1
,Chapter 2: Corporate Purpose and Stkeholder Theory
Competing Views on Corporate Purpose
• Friedman Doctrine (Friedman, 1970): Argues that the primary corporate objective should
be shareholder value maximization. This view supports the idea that management’s main
responsibility is to generate financial returns for shareholders.
• Stakeholder Theory (Business Roundtable, 2019): Proposes that firms balance the interests
of all stakeholders—including employees, customers, and communities—rather than focusing
solely on shareholders. This view reflects a growing call for corporations to incorporate social
responsibility into their business models.
Theoretical Approaches to Corporate Purpose
• Residual Claimants Theory: Shareholders are seen as residual claimants, meaning they
receive the last claim on the firm’s cash flows after contractual obligations are met. This
role traditionally justifies shareholder primacy in governance, aligning corporate purpose
with maximizing shareholder value.
• Stakeholder Value Maximization (Mehrotra and Morck, 2017): Proposes a multi-objective
approach, balancing shareholder and stakeholder interests. However, this approach risks
inefficiencies and agency conflicts as management must navigate potentially conflicting goals,
which can dilute focus and accountability.
• Enlightened Shareholder Value (Jensen, 2002): Suggests prioritizing long-term shareholder
value as a primary goal while considering stakeholder interests to promote sustainable growth.
This approach aims to indirectly benefit stakeholders, avoiding the challenges of multiple
conflicting objectives while fostering broader value creation.
Capital Structure and Stakeholder Implications
Debt vs. Equity Trade-offs:
• Debt Financing: Prioritizes creditor security with predictable cash flows but increases
financial distress risk. Highly leveraged firms may focus on cash flows and creditor protection,
which can conflict with broader stakeholder goals.
• Equity Financing: Benefits shareholders who, as residual claimants, bear more financial risk
but support riskier, growth-focused strategies that can indirectly benefit stakeholders in the
long term.
Implications of Capital Structure on Corporate Purpose:
• A highly leveraged firm might emphasize short-term performance to meet debt obligations,
potentially limiting its capacity to invest in long-term stakeholder-focused initiatives.
• Firms with stable leverage ratios often balance debt and equity to support financial sta-
bility and stakeholder considerations, suggesting an alignment with stakeholder theory by
maintaining predictable outcomes for creditors while allowing for growth and flexibility.
Empirical Findings on Corporate Purpose and Capital Structure
• Aggregate Leverage Stability (Frank & Goyal, 2022): Empirical evidence shows firms tend
to maintain stable leverage over time, suggesting a focus on long-term financial stability.
This stability could reflect a balanced approach to capital structure that considers both
shareholder returns and stakeholder security.
• Movements toward debt financing are often seen in firms prioritizing predictable creditor
returns, aligning with stakeholder theory by reducing financial volatility, whereas equity
financing aligns with shareholder primacy by supporting risk-taking and growth.
2
, Chapter 3: Capital Structure Decisions
Core Decision Areas in Capital Structure
• Equity financing: Provides shareholders with voting rights and dividends, aligning their
interests with long-term residual claimants. Equity holders benefit when the firm succeeds
but bear more risk as they are paid after debt holders.
• Debt Financing: Offers fixed interest payments and priority in bankruptcy to creditors,
providing security but increasing the firm’s risk of financial distress as leverage rises.
• Agency-Based Trade-Off: Firms balance the agency costs of equity (e.g., potential for over-
investment) with those of debt (e.g., under-investment due to debt overhang) to find an
optimal leverage ratio that minimizes costs while maximizing firm value (Myers, 1977).
Key Theories in Capital Structure
1. Trade-off Theory (Myers, 1984): Argues that firms seek an optimal capital structure by
balancing the tax shield benefits of debt against the costs of financial distress. Firms adjust
their leverage based on these factors to maximize firm value.
2. Pecking Order Theory (Myers & Majluf, 1984): Firms prefer financing sources with least
information asymmetry, prioritizing internal funds first, then debt, and finally equity issuance.
This hierarchy reflects the desire to avoid costs and market reactions tied to external financing.
3. Market Timing Theory: Suggests that managers issue debt or equity based on favorable
market conditions, such as issuing equity when stock prices are high or using debt during
low-interest environments. This opportunistic approach reflects market sentiment as a factor
in financing decisions.
Key Empirical Findings
• Trade-off Theory in Practice: Firms exhibit dynamic leverage adjustments, balancing tax
advantages against the risk of financial distress, aligning with trade-off theory predictions in
real-world capital structure management.
• Pecking Order Theory Evidence: Firms show a preference for internal financing over external
debt, and debt over equity issuance, supporting the hierarchy outlined by pecking order
theory in practice.
• Market Timing Evidence: Empirical data indicates that equity issuance often coincides with
high stock prices, suggesting firms capitalize on favorable market conditions, consistent with
market timing theories.
3
Characteristics and Core Concepts of Corporations
Fundamental Traits of Corporations (Hansmann and Kraakman, 2004): Corporations are defined
by five essential characteristics: legal personality, delegated management, shared ownership,
transferable shares, and limited liability for investors. These traits enable corporations to support
large-scale, risky investments by facilitating diversified ownership and allowing stakeholders to
manage and transfer risk efficiently.
Risk and Capital Structure
Risk Sharing and Shifting: The structure of corporations enables risk-sharing among diverse share-
holders, supporting high-risk projects while limiting individual exposure. However, risk-shifting
conflicts arise between contractual claimants (creditors) and residual claimants (shareholders),
especially under financial distress or near insolvency, as shareholders may prefer high-risk projects
that creditors might resist (Myers, 1977).
Core financial decisions; managing capital allocation across key areas:
• Investment decisions (capital budgeting, mergers, and acquisitions)
• Financial structure (choice between debt and equity financing)
• Payout policies (dividends and share repurchases)
• Risk management (using hedging and operational strategies)
• Governance (alignment of management and stakeholder interests)
• Cash management (how much cash and liquid assets to hold)
Rational Decision-Making Models in Corporate Finance
• Value Creation and Investment: Modigliani & Miller (1958): Argue that in perfect markets,
firm value is determined by its real investment decisions and not by its capital structure. This
”irrelevance theory” assumes no taxes, transaction costs, or bankruptcy costs, highlighting
that value stems primarily from real investment opportunities rather than financing choices.
• Capital Structure in Imperfect Markets: In real-world imperfect markets, financing decisions
become relevant as they can reduce inefficiencies (e.g., through tax shields or avoiding
bankruptcy costs). This adjustment introduces value-maximizing considerations, particularly
when addressing agency and market inefficiencies (Myers, 2003).
Corporate Goals and Financial Markets
Corporate Purpose and Market Dynamics: Graham (2022): Explores the evolving debate on
corporate goals, noting the shift from pure shareholder value maximization to incorporating
stakeholder interests (such as ESG concerns). The role of financial markets, therefore, is not
only to allocate capital efficiently but to support a broader view of firm purpose, adapting to
stakeholder demands and sustainability goals.
Practical Perspectives and Empirical Findings
Capital Structure Theories in Practice (Frank & Goyal, 2022): Empirical evidence shows firms do
not adhere to a universal theory of capital structure. Instead, factors like taxes, bankruptcy costs,
agency conflicts, and behavioral biases collectively shape financing decisions. Firms exhibit mean
reversion in leverage, where they adjust toward an optimal leverage ratio over time, indicating a
dynamic approach rather than strict adherence to theoretical targets.
1
,Chapter 2: Corporate Purpose and Stkeholder Theory
Competing Views on Corporate Purpose
• Friedman Doctrine (Friedman, 1970): Argues that the primary corporate objective should
be shareholder value maximization. This view supports the idea that management’s main
responsibility is to generate financial returns for shareholders.
• Stakeholder Theory (Business Roundtable, 2019): Proposes that firms balance the interests
of all stakeholders—including employees, customers, and communities—rather than focusing
solely on shareholders. This view reflects a growing call for corporations to incorporate social
responsibility into their business models.
Theoretical Approaches to Corporate Purpose
• Residual Claimants Theory: Shareholders are seen as residual claimants, meaning they
receive the last claim on the firm’s cash flows after contractual obligations are met. This
role traditionally justifies shareholder primacy in governance, aligning corporate purpose
with maximizing shareholder value.
• Stakeholder Value Maximization (Mehrotra and Morck, 2017): Proposes a multi-objective
approach, balancing shareholder and stakeholder interests. However, this approach risks
inefficiencies and agency conflicts as management must navigate potentially conflicting goals,
which can dilute focus and accountability.
• Enlightened Shareholder Value (Jensen, 2002): Suggests prioritizing long-term shareholder
value as a primary goal while considering stakeholder interests to promote sustainable growth.
This approach aims to indirectly benefit stakeholders, avoiding the challenges of multiple
conflicting objectives while fostering broader value creation.
Capital Structure and Stakeholder Implications
Debt vs. Equity Trade-offs:
• Debt Financing: Prioritizes creditor security with predictable cash flows but increases
financial distress risk. Highly leveraged firms may focus on cash flows and creditor protection,
which can conflict with broader stakeholder goals.
• Equity Financing: Benefits shareholders who, as residual claimants, bear more financial risk
but support riskier, growth-focused strategies that can indirectly benefit stakeholders in the
long term.
Implications of Capital Structure on Corporate Purpose:
• A highly leveraged firm might emphasize short-term performance to meet debt obligations,
potentially limiting its capacity to invest in long-term stakeholder-focused initiatives.
• Firms with stable leverage ratios often balance debt and equity to support financial sta-
bility and stakeholder considerations, suggesting an alignment with stakeholder theory by
maintaining predictable outcomes for creditors while allowing for growth and flexibility.
Empirical Findings on Corporate Purpose and Capital Structure
• Aggregate Leverage Stability (Frank & Goyal, 2022): Empirical evidence shows firms tend
to maintain stable leverage over time, suggesting a focus on long-term financial stability.
This stability could reflect a balanced approach to capital structure that considers both
shareholder returns and stakeholder security.
• Movements toward debt financing are often seen in firms prioritizing predictable creditor
returns, aligning with stakeholder theory by reducing financial volatility, whereas equity
financing aligns with shareholder primacy by supporting risk-taking and growth.
2
, Chapter 3: Capital Structure Decisions
Core Decision Areas in Capital Structure
• Equity financing: Provides shareholders with voting rights and dividends, aligning their
interests with long-term residual claimants. Equity holders benefit when the firm succeeds
but bear more risk as they are paid after debt holders.
• Debt Financing: Offers fixed interest payments and priority in bankruptcy to creditors,
providing security but increasing the firm’s risk of financial distress as leverage rises.
• Agency-Based Trade-Off: Firms balance the agency costs of equity (e.g., potential for over-
investment) with those of debt (e.g., under-investment due to debt overhang) to find an
optimal leverage ratio that minimizes costs while maximizing firm value (Myers, 1977).
Key Theories in Capital Structure
1. Trade-off Theory (Myers, 1984): Argues that firms seek an optimal capital structure by
balancing the tax shield benefits of debt against the costs of financial distress. Firms adjust
their leverage based on these factors to maximize firm value.
2. Pecking Order Theory (Myers & Majluf, 1984): Firms prefer financing sources with least
information asymmetry, prioritizing internal funds first, then debt, and finally equity issuance.
This hierarchy reflects the desire to avoid costs and market reactions tied to external financing.
3. Market Timing Theory: Suggests that managers issue debt or equity based on favorable
market conditions, such as issuing equity when stock prices are high or using debt during
low-interest environments. This opportunistic approach reflects market sentiment as a factor
in financing decisions.
Key Empirical Findings
• Trade-off Theory in Practice: Firms exhibit dynamic leverage adjustments, balancing tax
advantages against the risk of financial distress, aligning with trade-off theory predictions in
real-world capital structure management.
• Pecking Order Theory Evidence: Firms show a preference for internal financing over external
debt, and debt over equity issuance, supporting the hierarchy outlined by pecking order
theory in practice.
• Market Timing Evidence: Empirical data indicates that equity issuance often coincides with
high stock prices, suggesting firms capitalize on favorable market conditions, consistent with
market timing theories.
3
