Corporate Finance

module: c321 m421 | product: 4535

 Corporate Finance
Centre for Financial and Management Studies
© SOAS University of London
First published: 2005; Revised: 2007, 2008, 2010, 2013, 2014, 2015, 2016, 2018, 2019

All rights reserved. No part of this module material may be reprinted or reproduced or utilised in any form or by any electronic, mechanical,
or other means, including photocopying and recording, or in information storage or retrieval systems, without written permission from the
Centre for Financial and Management Studies, SOAS University of London.
Corporate Finance
Module Introduction and Overview

Contents
1
Introduction to the Module 2

2
The Module Authors 3

3
Study Materials 3

3
Module Overview 4

5
Learning Outcomes 6

6
Assessment 6

Specimen Examination 13

 Corporate Finance

1 Introduction to the Module

In this module you will study the main issues in modern corporate finance.
The subject ‘corporate finance’ is a well-established discipline, which is
concerned with corporations large enough to have issued shares that are
‘quoted’ on a stock market. We must, though, first clarify what we mean by
the main issues, for the issues that are important to one person may be
viewed as less important by others.
The financial manager of a large company, for example, faces a different set
of financial problems compared to the owner of a small business. And a
stock market dealer and financial theorist will also be interested in different
issues in corporate finance, and these will not necessarily be the same issues
that concern the financial manager. The first unit will examine the important
issues from these differing perspectives, and conflicts between their specific
interests will form the background to the theories considered throughout the
module.
Methods used for making capital budgeting decisions will first be presented
in Unit 2, which will focus on capital budgeting decisions ‘under certainty’.
You will learn there how to identify the cash flows associated with an
investment project and how to use them to evaluate investments using the
net present value (NPV) method. You will also learn to analyse other in-
vestment criteria and compare them with the NPV approach in this unit.
Unit 3 will then complement Unit 2 by providing an analysis of the equilib-
rium relationship between risk and return, which leads to the determination
of the appropriate discount rates to be used when evaluating the NPV of
risky investment projects – those where cash flows are uncertain. You will
also study the Capital Asset Pricing Model (CAPM) in this unit.
Unit 4 deals with the efficiency of financial markets and its implications for
long-term corporate financing decisions. The amount of financial resources
that a company gets for every bond or equity issued in the primary market
depends on the price at which these securities are sold when first issued,
and that price is determined by the market. It is for this reason, as you will
learn through studying this unit, that the efficiency of capital markets has
implications for corporate financing decisions. The unit also introduces the
theme of behavioural finance, which may be used to explain departures
from market efficiency.
The effect of dividend policy on share values is explored in Unit 5. The
principal model studied there is the dividend irrelevance proposition of
Modigliani and Miller. You will also learn about the role of asymmetric
information and the signalling hypothesis, and you will examine theories
relating dividends to the conflict of interest between managers and share-
holders. Ways in which variations in dividend policy are affected by the
country’s legal system are also considered in Unit 5.
In Unit 6, you will first study the debt-equity irrelevance theorem, which is
the starting point of all analyses of corporations’ choice of debt-equity ratio.
As you do so, you will examine the capital structure question, looking at
the weighted average cost of capital, the cost of equity in a levered firm,

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 Module Introduction and Overview

corporate and personal taxes and bankruptcy costs. You will also be
introduced to the reasoning behind the arbitrage pricing proof of Modi-
gliani–Miller’s first proposition, which is of great importance to corporate
finance theory.
Unit 7 examines the capital structure question by relaxing some of the
assumptions of the Modigliani–Miller irrelevance proposition. In studying
this unit, you will learn to analyse the impact of information asymmetry on
the financing decisions of firms. You will also learn to analyse the agency
costs of equity and debt and their implications for a firm’s capital structure.
In Unit 8 you will study takeovers in detail. In studying that unit, you will
consider the rationale and pricing of mergers. You will explore the main
empirical facts that dominate the debate on mergers, examine evidence on
the sources of gain from mergers, and analyse agency cost theory and free
cash flow. You will also undertake a critical analysis of changes in corporate
governance and takeover waves.

2 The Module Authors

Bassam Fattouh graduated in Economics from the American University of
Beirut in 1995. Following this, he obtained his Masters degree and PhD from
the School of Oriental and African Studies, University of London, in 1999.
He is a Reader in Finance and Management and academic director for the
MSc in International Management for the Middle East and North Africa at
the Department for Financial and Management Studies, SOAS. He is also
currently Senior Research Fellow and Director of the Oil and Middle East
Programme at the Oxford Institute for Energy Studies at the University of
Oxford. He has published in leading economic journals, including the
Journal of Development Economics, Economics Letters, Economic Inquiry, Macroe-
conomic Dynamics and Empirical Economics. His research interests are mainly
in the areas of finance and growth, capital structure and applied non-linear
econometric modelling, as well as oil pricing systems.
Luca Deidda completed his doctoral studies in 1999, while he was a lecturer
in the Department of Economics at Queen Mary and Westfield College,
University of London. He joined the Centre for Financial and Management
Studies at SOAS in that same year, as lecturer in financial studies. His
research focuses on financial and economic development, markets under
asymmetric information and welfare effects of financial development. He is
currently working at the Università di Sassari, Sardinia.

3 Study Materials
This Study Guide is your central learning resource as it structures your
learning, unit by unit. Each of the eight units should be studied within a
week. The module is designed in the expectation that studying the unit text
and the associated core readings will require 15 to 20 hours each week,
although this will vary according to your familiarity with the unit subject
matter and your own study experience.

Centre for Financial and Management Studies 3

 Corporate Finance

Textbook
You will be supplied with one textbook for this module:
Hillier D, S Ross, R Westerfield, J Jaffe and B Jordan (2016) Corporate
Finance. 3rd European Edition. Maidenhead UK, McGraw-Hill Education.
This is a comprehensive and useful textbook, with challenging questions at
the end of each chapter, which you should find helpful. The textbook has a
companion website, available from: http://highered.mheducation.com/
sites/0077173635/student_view0/index.html
From this Student Edition website you can access case studies, appendices,
some useful formulas and videos.
You will be directed in the unit text when to read from Hillier, Ross, Wester-
field, Jaffe and Jordan.
Throughout the units in this module you will be directed to exercises in your
textbook. Where appropriate, answers will be available on the VLE.

Module Reader
We also provide you with academic articles and other reports and material
that are assigned as core readings in the Study Guide. They make up a Mod-
ule Reader. You are expected to read them as an essential part of the module.

Excel Worksheets
To reinforce your understanding of the worked examples of quantitative
calculations in the text, we provide these in the form of Excel worksheets to
be downloaded from the VLE. This will enable you to carry out further tasks
we specify for you, to see for yourself how the calculations are affected.
Please note that these are not ‘self test’ questions as such and therefore the
workbooks do not carry ‘solutions’ to the exercises.

Virtual Learning Environment

Some of the academic articles and other reports and material that are
assigned as core readings are available as part of the VLE Library resources
and through the University of London Online Library. Some will require
you to have an Athens username and password. You can obtain this from
the University of London Online Library.

3 Module Overview
Unit 1 Perspectives on Corporate Finance
1.1 Introduction
1.2 Core Theories of Corporate Finance
1.3 Key Questions in Corporate Finance
1.4 The Objective of the Firm
1.5 Agency Problems
1.6 Conflict between Shareholders and Bondholders
1.7 Conclusion

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 Module Introduction and Overview

Unit 2 Net Present Value and Capital Budgeting Decisions

2.1 Introduction to Capital Budgeting Decisions
2.2 Investment Principles and Net Present Value
2.3 Capital Budgeting Decisions
2.4 Analysing a Project – A Mini Case
2.5 Sensitivity and Scenario Analysis

Unit 3 Return, Risk, Portfolio and Asset Pricing Models

3.1 Introduction
3.2 Expected Return and Risk
3.3 How is the Equilibrium Return on Risky Assets Determined?
The Capital Asset Pricing Model
3.4 A More General Model – Arbitrage Pricing Theory (APT)
3.5 Conclusion

Unit 4 Issues in Modern Finance: the CAPM, Efficient Market

Hypothesis and Behaviour Finance
4.1 Introduction
4.2 The Use of CAPM for Calculating the Cost of Capital for Risky Projects
4.3 Efficient Capital Markets
4.4 Weak, Semi-strong and Strong Forms of Efficiency
4.5 Anomalies – Are they Meant to be Extinct?
4.6 Implications for Corporate Financing Decisions
4.7 Conclusion

Unit 5 Dividend Policy

5.1 Introduction
5.2 Empirical Evidence on Dividend Policy
5.3 The Irrelevance of Dividend Policy
5.4 Taxes Can Make Dividend Policy Matter
5.5 Asymmetric Information and Signalling
5.6 Dividend Policy and Agency Costs
5.7 Conclusion

Unit 6 Capital Structure I

6.1
Introduction – How Much Debt Should the Firm Issue?

6.2
The Debt-Equity Irrelevance Theorem

6.3
Corporate and Personal Taxes

6.4
Effects of Bankruptcy Costs

6.5
Implications and Limitations of the Trade-off Theory of Optimal Capital Structure

6.6
Conclusion

Unit 7 Capital Structure II – Information Asymmetries and Agency Costs

7.1
Introduction

7.2
Asymmetric Information Explanations of Capital Structure

7.3
Minimising the Agency Costs of Equity and Debt

7.4
Conclusion

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 Corporate Finance

Unit 8 Mergers
8.1 Introduction
8.2 Merger Gains and the Sources of Gain
8.3 Rationale for Mergers to Take Place
8.4 Forms of Takeover
8.5 Some Stylised Facts about Merger Activity
8.6 Review of the Unit’s Questions

5 Learning Outcomes
When you have completed your study of this module you will be able to:
•
describe modern principles of corporate finance and evaluate their
validity
•
rationalise corporate finance decisions in the light of agency problems
and conflict of interest among corporations’ stakeholders
•
analyse firms’ investment decisions
•
discuss firms’ choice of capital structure and its implications for the
value of the firm
•
examine and discuss the key issues related to dividend policy and
their implications for the value of the firm
•
critically assess the reasons behind mergers and acquisitions and their
welfare implications.

6 Assessment
Your performance on each module is assessed through two written assign-
ments and one examination. The assignments are written after Unit 4 and
Unit 8 of the module session. Please see the VLE for submission deadlines.
The examination is taken at a local examination centre in September/
October.

Preparing for assignments and exams

There is good advice on preparing for assignments and exams and writing
them in Chapter 8 of Studying at a Distance by Christine Talbot. We recom-
mend that you follow this advice.
The examinations you will sit are designed to evaluate your knowledge and
skills in the subjects you have studied: they are not designed to trick you. If
you have studied the module thoroughly, you will pass the exam.

Understanding assessment questions

Examination and assignment questions are set to test your knowledge and
skills. Sometimes a question will contain more than one part, each part
testing a different aspect of your skills and knowledge. You need to spot the
key words to know what is being asked of you. Here we categorise the types
of things that are asked for in assignments and exams, and the words used.

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 Module Introduction and Overview

All the examples are from the Centre for Financial and Management Studies
examination papers and assignment questions.

Definitions
Some questions mainly require you to show that you have learned some concepts, by
setting out their precise meanings. Such questions are likely to be preliminary and be
supplemented by more analytical questions. Generally, ‘Pass marks’ are awarded if the
answer only contains definitions. They will contain words such as:


Describe

Contrast


Define

Write notes on


Examine

Outline


Distinguish between

What is meant by


Compare

List

Reasoning
Other questions are designed to test your reasoning, by explaining cause and effect.
Convincing explanations generally carry additional marks to basic definitions. They will
include words such as:


Interpret


Explain


What conditions influence


What are the consequences of


What are the implications of

Judgement
Others ask you to make a judgement, perhaps of a policy or of a course of action. They
will include words like:


Evaluate


Critically examine


Assess


Do you agree that


To what extent does

Calculation
Sometimes, you are asked to make a calculation, using a specified technique, where the
question begins:


Use indifference curve analysis to


Using any economic model you know


Calculate the standard deviation


Test whether
It is most likely that questions that ask you to make a calculation will also ask for an
application of the result, or an interpretation.

Advice
Other questions ask you to provide advice in a particular situation. This applies to law
questions and to policy papers where advice is asked in relation to a policy problem. Your
advice should be based on relevant law, principles and evidence of what actions are
likely to be effective. The questions may begin:

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 Corporate Finance

Advise


Provide advice on


Explain how you would advise

Critique
In many cases the question will include the word ‘critically’. This means that you are
expected to look at the question from at least two points of view, offering a critique of
each view and your judgement. You are expected to be critical of what you have read.
The questions may begin:


Critically analyse


Critically consider


Critically assess


Critically discuss the argument that

Examine by argument
Questions that begin with ‘discuss’ are similar – they ask you to examine by argument, to
debate and give reasons for and against a variety of options, for example


Discuss the advantages and disadvantages of


Discuss this statement


Discuss the view that


Discuss the arguments and debates concerning

The grading scheme: Assignments

The assignment questions contain fairly detailed guidance about what is
required. All assignments are marked using marking guidelines. When you
receive your grade it is accompanied by comments on your paper, including
advice about how you might improve, and any clarifications about matters
you may not have understood. These comments are designed to help you
master the subject and to improve your skills as you progress through your
programme.

Postgraduate assignment marking criteria

The marking criteria for your programme draws upon these minimum core
criteria, which are applicable to the assessment of all assignments:
•
understanding of the subject
•
utilisation of proper academic [or other] style (e.g. citation of
references, or use of proper legal style for court reports, etc.)
•
relevance of material selected and of the arguments proposed
•
planning and organisation
•
logical coherence
•
critical evaluation
•
comprehensiveness of research
•
evidence of synthesis
•
innovation/creativity/originality.
The language used must be of a sufficient standard to permit assessment of
these.

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 Module Introduction and Overview

The guidelines below reflect the standards of work expected at postgraduate

level. All assessed work is marked by your Tutor or a member of academic
staff, and a sample is then moderated by another member of academic staff.
Any assignment may be made available to the external examiner(s).

80+ (Distinction). A mark of 80+ will fulfil the following criteria:

•
very significant ability to plan, organise and execute independently a
research project or coursework assignment
•
very significant ability to evaluate literature and theory critically and
make informed judgements
•
very high levels of creativity, originality and independence of thought
•
very significant ability to evaluate critically existing methodologies and
suggest new approaches to current research or professional practice
•
very significant ability to analyse data critically
•
outstanding levels of accuracy, technical competence, organisation,
expression.

70–79 (Distinction). A mark in the range 70–79 will fulfil the following criteria:
•
significant ability to plan, organise and execute independently a
research project or coursework assignment
•
clear evidence of wide and relevant reading, referencing and an
engagement with the conceptual issues
•
capacity to develop a sophisticated and intelligent argument
•
rigorous use and a sophisticated understanding of relevant source
materials, balancing appropriately between factual detail and key
theoretical issues. Materials are evaluated directly and their
assumptions and arguments challenged and/or appraised
•
correct referencing
•
significant ability to analyse data critically
•
original thinking and a willingness to take risks.

60–69 (Merit). A mark in the 60–69 range will fulfil the following criteria:
•
ability to plan, organise and execute independently a research project
or coursework assignment
•
strong evidence of critical insight and thinking
•
a detailed understanding of the major factual and/or theoretical issues
and directly engages with the relevant literature on the topic
•
clear evidence of planning and appropriate choice of sources and
methodology with correct referencing
•
ability to analyse data critically
•
capacity to develop a focussed and clear argument and articulate
clearly and convincingly a sustained train of logical thought.

50–59 (Pass). A mark in the range 50–59 will fulfil the following criteria:
•
ability to plan, organise and execute a research project or coursework
assignment
•
a reasonable understanding of the major factual and/or theoretical
issues involved
•
evidence of some knowledge of the literature with correct referencing
•
ability to analyse data

Centre for Financial and Management Studies 9

 Corporate Finance

•
examples of a clear train of thought or argument

•
the text is introduced and concludes appropriately.

40–49 (Fail). A Fail will be awarded in cases in which there is:

•
limited ability to plan, organise and execute a research project or
coursework assignment
•
some awareness and understanding of the literature and of factual or
theoretical issues, but with little development
•
limited ability to analyse data
•
incomplete referencing
•
limited ability to present a clear and coherent argument.

20–39 (Fail). A Fail will be awarded in cases in which there is:

•
very limited ability to plan, organise and execute a research project or
coursework assignment
•
failure to develop a coherent argument that relates to the research
project or assignment
•
no engagement with the relevant literature or demonstrable
knowledge of the key issues
•
incomplete referencing
•
clear conceptual or factual errors or misunderstandings
•
only fragmentary evidence of critical thought or data analysis.

0–19 (Fail). A Fail will be awarded in cases in which there is:

•
no demonstrable ability to plan, organise and execute a research
project or coursework assignment
•
little or no knowledge or understanding related to the research project
or assignment
•
little or no knowledge of the relevant literature
•
major errors in referencing
•
no evidence of critical thought or data analysis
•
incoherent argument.

The grading scheme: Examinations

The written examinations are ‘unseen’ (you will only see the paper in the
exam centre) and written by hand, over a three-hour period. We advise that
you practise writing exams in these conditions as part of your examination
preparation, as it is not something you would normally do.
You are not allowed to take in books or notes to the exam room. This means
that you need to revise thoroughly in preparation for each exam. This is
especially important if you have completed the module in the early part of
the year, or in a previous year.
Details of the general definitions of what is expected in order to obtain a
particular grade are shown below. These guidelines take account of the fact
that examination conditions are less conducive to polished work than the
conditions in which you write your assignments. Note that as the criteria of
each grade rises, it accumulates the elements of the grade below. Assign-

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 Module Introduction and Overview

ments awarded better marks will therefore have become comprehensive in

both their depth of core skills and advanced skills.

Postgraduate unseen written examinations marking criteria

80+ (Distinction). A mark of 80+ will fulfil the following criteria:
•
very significant ability to evaluate literature and theory critically and
make informed judgements
•
very high levels of creativity, originality and independence of thought
•
outstanding levels of accuracy, technical competence, organisation,
expression
•
outstanding ability of synthesis under exam pressure.

70–79 (Distinction). A mark in the 70–79 range will fulfil the following criteria:
•
clear evidence of wide and relevant reading and an engagement with
the conceptual issues
•
develops a sophisticated and intelligent argument
•
rigorous use and a sophisticated understanding of relevant source
materials, balancing appropriately between factual detail and key
theoretical issues
•
direct evaluation of materials and their assumptions and arguments
challenged and/or appraised;
•
original thinking and a willingness to take risks
•
significant ability of synthesis under exam pressure.

60–69 (Merit). A mark in the 60–69 range will fulfil the following criteria:
•
strong evidence of critical insight and critical thinking
•
a detailed understanding of the major factual and/or theoretical issues
and directly engages with the relevant literature on the topic
•
develops a focussed and clear argument and articulates clearly and
convincingly a sustained train of logical thought
•
clear evidence of planning and appropriate choice of sources and
methodology, and ability of synthesis under exam pressure.

50–59 (Pass). A mark in the 50–59 range will fulfil the following criteria:
•
a reasonable understanding of the major factual and/or theoretical
issues involved
•
evidence of planning and selection from appropriate sources
•
some demonstrable knowledge of the literature
•
the text shows, in places, examples of a clear train of thought or
argument
•
the text is introduced and concludes appropriately.

40–49 (Fail). A Fail will be awarded in cases in which:

•
there is some awareness and understanding of the factual or
theoretical issues, but with little development
•
misunderstandings are evident
•
there is some evidence of planning, although irrelevant/unrelated
material or arguments are included.

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 Corporate Finance

20–39 (Fail). A Fail will be awarded in cases which:

•
fail to answer the question or to develop an argument that relates to
the question set
•
do not engage with the relevant literature or demonstrate a knowledge
of the key issues
•
contain clear conceptual or factual errors or misunderstandings.

0–19 (Fail). A Fail will be awarded in cases which:

•
show no knowledge or understanding related to the question set
•
show no evidence of critical thought or analysis
•
contain short answers and incoherent argument.
[2015–16: Learning & Teaching Quality Committee]

Specimen exam papers

CeFiMS does not provide past papers or model answers to papers. Modules
are continuously updated, and past papers will not be a reliable guide to
current and future examinations. The specimen exam paper is designed to
be relevant and to reflect the exam that will be set on this module.
Your final examination will have the same structure and style and the range
of question will be comparable to those in the Specimen Exam. The number
of questions will be the same, but the wording and the requirements of each
question will be different.
Good luck on your final examination.

Further information
Online you will find documentation and information on each year’s examina-
tion registration and administration process. If you still have questions, both
academics and administrators are available to answer queries.
The Regulations are also available at www.cefims.ac.uk/regulations/,
setting out the rules by which exams are governed.

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 DO NOT REMOVE THE QUESTION PAPER FROM THE EXAMINATION HALL

UNIVERSITY OF LONDON

CENTRE FOR FINANCIAL AND MANAGEMENT STUDIES

MSc Examination
Postgraduate Diploma Examination
for External Students





FINANCE (BANKING)
FINANCE (ECONOMIC POLICY)
FINANCE (FINANCIAL SECTOR MANAGEMENT)
FINANCE (QUANTATITIVE FINANCE)
FINANCE AND FINANCIAL LAW

Corporate Finance
Specimen Examination
This is a specimen examination paper designed to show you the type of examination you will
have at the end of this module. The number of questions and the structure of the
examination will be the same, but the wording and requirements of the questions will be
different.

The examination must be completed in  hours.

Answer  questions, at least  question from 

 
and at least 
question from 
 . The third question may be selected from either section.

The examiners give equal weight to each question and you are advised to distribute
your time approximately equally between the three questions. The examiners wish
to see evidence of your ability to use technical models and of your ability to
critically discuss their mechanisms and application.

Candidates may use their own electronic calculators in this examination provided
they cannot store text; the make and type of calculator MUST BE STATED
CLEARLY on the front of the answer book.

PLEASE TURN OVER

 Corporate Finance

Answer THREE questions, at least ONE question from each section

Section A
Answer at least ONE question from this section.

1. a) You have been asked to consider investing in shares of

two firms, Transcorp Plc and Hydrapol Plc. Transcorp
Plc have an expected return of 15 per cent with a stand-
ard deviation of 31 per cent. Hydrapol Plc shares are
expected to produce a return of 17 per cent with a
standard deviation of 45 per cent.

i) You have decided to create a portfolio compris-

ing of the two shares. Calculate the rate of return
and standard deviation of a portfolio composed
of 30 per cent of Transcorp’s shares and 70 per
cent of Hydrapol’s shares, if the correlation coef-
ficient between the share returns is 0.55. (30% of the marks)

ii) Assume that the risk free rate is 3 percent, the

market portfolio has an expected return of 10 per
cent with a standard deviation of 25 percent, and
the capital asset pricing model (CAPM) holds.
Using the CAPM, calculate the expected return
of Transcorp shares if the covariance between
Transcorp and the market portfolio is 0.0775 (or
7.75 if the unit/scale of calculation is in percent-
age). (20% of the marks)

b) Critically discuss whether the arbitrage pricing model

is superior to the CAPM. (50% of the marks)

2. Qisda is a drinks manufacturing firm that wishes to set up a

small fresh juice retail business. The new enterprise is ex-
pected to have a net cash inflow of £88,000 in its first year. The
cash flows are then projected to grow at a rate of 6% per year
thereafter in perpetuity. The project will be all equity financed,
and the capital required to fund the business is £960,000.

a) If the appropriate return expected by shareholders is

12% should Qisda undertake the project? Show how
you arrived at this decision. (30% of the marks)

b) Analysts are sceptical about what they consider to be an

optimistic growth rate and have instead suggested that
the management team consider the minimum growth
rate (i.e. hurdle rate) required for the project to be ac-
ceptable. What is this rate? (10% of the marks)

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 Specimen Examination

c) Compare and contrast sensitivity analysis and scenario

analysis. (20% of the marks)

d) Demonstrate how sensitivity analysis and scenario

analysis can help Qisda to examine their juice project.
(40% of the marks)

3. a) EasyCat Air has a current period cash flow of £5.5

million and pays no dividends. The present value of the
company’s future cash flows is £110 million. The com-
pany is entirely financed with equity and has 1 million
shares outstanding. We can assume for simplicity that
the dividend tax rate is zero.

i) What is the share price of the EasyCat Air’s equity?

(10% of the marks)

ii) Suppose the board of directors of EasyCat an-

nounces its plan to pay out 60 per cent of its
current cash flow as cash dividends to its share-
holders. Demonstrate how you could achieve a
zero payout policy on your own, if you own
1,000 shares of EasyCat Air’s equity. (Hint: con-
sider how many additional shares you could buy
with your dividend income.) (30% of the marks)

b) It is often the case in many countries that investors

prefer (i) dividend paying stocks to non-dividend pay-
ing stocks, and (ii) share-buyback stocks to non-share-
buyback stocks. How are we to interpret these observa-
tions if dividend policy is considered to be irrelevant?
(60% of the marks)

4. a) Briefly explain why we should care about capital

structure in the context of financial management.
(10% of the marks)

b) In a world where the Modigliani and Miller theory of

capital structure (their original version in 1958) holds,
does moderate borrowing increase the required return
on a firm’s equity? Does it necessarily follow that in-
creases in debt increase the riskiness of the firm?
Explain. (30% of the marks)

PLEASE TURN OVER

Centre for Financial and Management Studies 15

 Corporate Finance

c) How do corporate taxes affect the Modigliani–Miller

theory of capital structure (e.g. their 1963 version of the
model)? Illustrate your answer with a practical or nu-
merical example. (30% of the marks)

d) Discuss the challenges involved when determining

optimal capital structure. (30% of the marks)

Section B
Answer at least ONE question from this section.


5. The figure below details the cumulative abnormal returns
(CAR) for 415 silver mining companies announcing discover-
ies of new deposits between 1970 and 2010. Month 0 in the
diagram is the announcement month. The dispersion of CARs
around the event day raises some question about market effi-
ciency.

15

10
CAR (%)

0
-6 -4 -2 0 2 4 6 8

Time in months relative to event month

-5



a) If we are to assume that no other information is re-
ceived and the equities are not subject to any market
level moves, can we say that the diagram is consistent
with market efficiency? Discuss your answer with ref-
erence to the Efficient Market Hypothesis. (60% of the marks)

b) Critically discuss whether you believe that theories put

forward from the psychological perspective are enough
to challenge more orthodox ideas about asset pricing.
Illustrate your answers with examples from academic
research and real world events. (40% of the marks)

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 Specimen Examination

6. “The information asymmetry argument derived from

signaling theory is the most commonly used theoretical
framework.” (Taken from Tsang, E.W. and Blevins, D.P., 2015,
‘A critique of the information asymmetry argument in the
management and entrepreneurship underpricing literature’,
Strategic Organization, 13(3), pp. 247-258)
Assess to what extent the asymmetry argument accounts for a
wide range of financial decisions for a firm.

7. “The directors of such [joint-stock] companies, however, being

the managers rather of other people’s money than of their
own, it cannot well be expected, that they should watch over it
with the same anxious vigilance with which the partners in a
private copartnery frequently watch over their own. Like the
stewards of a rich man, they are apt to consider attention to
small matters as not for their master’s honour, and very easily
give themselves a dispensation from having it. Negligence
and profusion, therefore, must always prevail, more or less, in
the management of the affairs of such a company.”(Adam
Smith, 1776)

a) Does the separation between ownership and control

compromise the shareholder’s interests? Illustrate why
you agree/disagree with the sentiments expressed by
Smith. (30% of the marks)



b) Describe the mechanisms available to shareholders to
protect their assets against reckless managerial behav-
iour. (30% of the marks)

c) In firms the relationship between shareholders and

bondholders is not always an easy one. Describe how in
a leveraged firm shareholders can take advantage of
bondholders, and detail the mechanisms that are in
place to prevent them from doing so. (40% of the marks)

PLEASE TURN OVER

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 Corporate Finance


Office International Plc and Office Regional Plc are office
supply retailers listed in the London Stock Exchange. Their
recent financial reports show that Office International has
1,650 stores worldwide and 38,000 employees whilst Office
Regional has 880 stores in Europe and 29,000 employees.


Office International is considering the acquisition of Office
Regional via an all-share offer to exchange one of its shares for
two of Office Regional’s shares.
Additional information relating to each company is given
below:

Office Office International
International Office Regional after merger
before merger before merger (expected)
Earnings £2 million £2 million £4 million
Number of shares 10 million 10 million 15 million
Earnings per share 20 pence 20 pence 26.67 pence
Price to earnings ratio 10 5 10
Share price £2.00 £1.00 £2.67

a) Explain possible motives for Office International’s ac-

quisition of its rival Office Regional, and evaluate
whether or not the acquisition is likely to be considered
favourably by the shareholders of both Office Interna-
tional and Office Regional. Your answer must address
the flows regarding the post-merger estimation sum-
marised in the fourth column of the table. (70% of the marks)

b) Assume that Office International announces the deal to

merge with its rival Office Regional. Discuss what anti-
takeover tactics Office Regional could pursue.
(30% of the marks)

[END OF EXAMINATION]

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Corporate Finance
Unit 1 Perspectives on Corporate
Finance

Contents
1.1
Introduction 3

1.2
Core Theories of Corporate Finance 4

1.3
Key Questions in Corporate Finance 6

1.4
The Objective of the Firm 9

1.5
Agency Problems 11

1.6
Conflict between Shareholders and Bondholders 19

1.7
Conclusion 20

References 21

 Corporate Finance

Unit Overview
Unit 1 introduces the module by explaining the key questions in corporate
finance and providing a brief description of the theoretical concepts that will
be developed through the various units. Following this introduction, you
will study the origin and the nature of conflicts of interest that may arise
among the various stakeholders of a firm, such as shareholders,
bondholders, and managers.

Learning outcomes
When you have completed your work on this unit, you will be able to:
•
explain and discuss the objective of the firm
•
assess how the objective of the firm relates to conflicts of interest
among stakeholders
•
critically assess conflict of interest between (a) shareholders and
managers (b) shareholders and bondholders, and their implications for
the value of the firm
•
evaluate corporate governance structures and their effectiveness.

Reading for Unit 1

Textbook
Hillier D, S Ross, R Westerfield, J Jaffe and B Jordan (2016) Corporate
Finance. 3rd European Edition. Maidenhead UK, McGraw-Hill Education.
Chapter 1 ‘Introduction to Corporate Finance’ and Chapter 2 ‘Corporate
Governance’.

Module Reader
Jensen MC (2001) ‘Value maximization, stakeholder theory, and the corporate
objective function’. Journal of Applied Corporate Finance, 14 (3), 8–21.
Cohen N (2014) ‘US companies fend off activists with poison pills’,
Financial Times, April 23.
The Economist (2009) ‘Executive Pay: Maligned, or misaligned?’ September 17.
Paulin G (2009) ‘Changing the Economics of Executive Compensation'.
Businessweek, 13 October.
Ward L and J Treanor (2002) ‘Investors to vote on top pay’. The Guardian,
26 June.
Groom B (2014) ‘Gap widens between UK executive pay and results’. The
Financial Times, 23 January.
Allen F, E Carletti and R Marquez (2014) ‘Stakeholder Governance,
Competition, and Firm Value’. Review of Finance, 19 (3), 1315–46.
D Frank (1989) ‘Capital markets: Pity the poor old retailer bondholder’. The
Banker, 1 February.
Shleifer A and R Vishny (1997) ‘A survey of corporate governance’. The
Journal of Finance, 52 (2), 737–61.

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 Unit 1 Perspectives on Corporate Finance

1.1 Introduction
In this module you will study the main issues in modern corporate finance.
First, however, as I indicated in the Module Introduction, I need to clarify
what I mean by the main issues, because the issues that are important to one
person may be viewed as less important by others. The financial manager of
a large company, for example, faces a different set of financial problems
from the owner of a small business.
That particular difference – between the small company and a large
company’s financial manager – is not relevant to this module, because the
theories, examples and empirical studies in corporate finance concentrate on
the finance of corporations whose shares are traded on a well-organised
stock market. In some examples, their bonds or other debt instruments are
also assumed to be traded on markets.
But there could still be other ways in which people differ over what the
important issues are. Consider the perspectives of people in three different
positions:
•
The financial manager of the corporation, or any employee whose
work requires financial decisions, may wish to study corporate finance
in order to learn some simple rules for decision-making. We usually
see their decisions as determining the corporation’s demand for
finance. A major question facing financial managers is whether their
decisions on how to finance the company affect the firm’s value. It is a
question underlying much of corporate finance.
•
A stock market dealer or portfolio manager (such as a pension fund
manager) may seek, instead, to learn how to evaluate corporations’
financial positions in order to be able to allocate their portfolio
between the shares of different companies. We usually see such
decisions as determining the supply of finance to corporations
although they relate to both existing and newly issued shares.
•
An economic or financial theorist examines corporate finance to
analyse its role in the economy. The purpose is to explain the
observable financial decisions of corporations and portfolio managers,
and to explain the behaviour of the securities markets that results from
the decisions of those and other agents. Traditionally, the securities
markets considered in corporate finance are ‘spot’ or ‘cash’ stock
markets dealing in company shares and bonds. But modern finance
also includes large and growing markets in ‘derivatives’, especially
options and futures, which are contracts relating to the future prices of
the underlying shares or bonds. To ‘explain the behaviour’ of any of
the financial markets involves explaining how the prices of shares,
bonds and derivatives are determined.
Although those three perspectives are rather different, the subjects studied
in this and other corporate finance modules do address issues that are
important from any of those viewpoints. For example, a model you will
study in one unit is the capital asset pricing model (CAPM). The CAPM
demonstrates how the risk on a security may be divided into diversifiable
(specific) risk and non diversifiable (market) risk, and it shows how in
principle the equilibrium return on a security is a function of its non

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diversifiable risk. Do company financial managers, pension fund portfolio

managers, and economic theorists all need to understand that model?
The financial manager needs to know it in order to understand the basis on
which the company’s shares are priced and that, in turn, is necessary for
estimating the company’s cost of capital, which is a key variable in the
company’s planning. Note that this does not really meet the objective I
suggested previously – the manager’s need ‘to learn some simple rules for
decision making’. The capital asset pricing model, and the other models
and theories taught in this module, are abstract and sophisticated theories,
which are open to discussion and, indeed, may be wrong. Studying them
is quite different from learning some simple rules; it is the difference
between studying the principles of automobile engineering and learning
how to drive a car. However, the models and theories are important to the
financial manager, because they enable the manager to understand the
principles which lie behind the simple decision-making rules used in the
corporation and, therefore, to judge the relevance of the rules and how to
modify them in different circumstances.
The portfolio manager needs to know the CAPM because knowledge of the
relation between risk and return on securities enables him or her to
determine an optimal allocation of funds between different securities.
The interest of economic and financial theorists in the CAPM and similar
models derives from their general aim of modelling the behaviour of
markets and prices to understand their role in the economy; in this case it
involves modelling the relation between financial markets and the returns
and risks in the ‘real’ sectors of the economy.

1.2 Core Theories of Corporate Finance

One thing should stand out from the above introduction. The module is
not a ‘how to do it’ or ‘cookbook’ type of module, because it does not give
you simple financial rules which you have to learn and apply. It is a
principles module rather than an applications module, because you will
study the theoretical principles relating to corporate finance. Moreover,
you will study some of the discussions around those theories – the
controversies and criticisms that always surround theoretical propositions.
The core theories of corporate finance have been developed at different
times over the past four or five decades. One by one, different theorists
have published propositions that have enabled us to understand and
analyse problems that we could not previously solve, and together those
theories now comprise the central body of the science that we call
corporate finance.
The main theories we include are:
Net Present Valuation and (Hirshleifer, 1985)
Separation Theorem
Equity Valuation Model (Gordon and Shapiro, 1956)
Irrelevance of Debt-Equity Ratio (Modigliani and Miller, 1958)

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 Unit 1 Perspectives on Corporate Finance

Irrelevance of Dividend Policy (Modigliani and Miller, 1961)

Agency Theory Models (Jensen and Meckling, 1976)
Capital Asset Pricing Model (Sharpe, 1964; Lintner, 1965)
Efficient Markets Hypothesis (Fama, 1970)

In addition, there are two further theorems that have a central role in
modern corporate finance but are omitted from this module:
Portfolio Allocation Theory (Markowitz, 1952)
Option Pricing Model (Black and Scholes, 1973)

Portfolio allocation theory underlies the capital asset pricing model. The
option-pricing model has become an especially important part of the
analysis of markets in corporate finance since 1973. In that year, the classic
theorem of Fischer Black and Myron Scholes on the prices of ‘traded options’
was published, and a market in standardised traded options was opened in
Chicago. One reason why the theory of option pricing has become such an
important part of corporate finance theory is that since 1973 a number of
new markets in traded options have been established and grown so that
many corporations are able to use traded options as a means to reduce risk
by hedging, and their use for that purpose has become widespread. Another
reason is that, even if corporations did not use traded options, the principles
of the theory of option pricing can be used more widely to analyse several
other investment decisions facing corporations and investors. After careful
thought, we decided to leave out those two topics because they are fully
treated in another of this programme’s modules, Risk Management: Principles
and Applications.
I said that those theories have, one by one, enabled us to understand and
analyse problems we could not previously solve, but that does not mean that
each theory is correct or generally recognised as true. Indeed, almost all of
them have been criticised and have stimulated much controversy. As a
result, we now know that some of the original propositions are only valid if
special, unrealistic, assumptions are made. That is especially the case with
the Modigliani-Miller theorem on the irrelevance of debt-equity ratios,
which is widely taken to be the starting point for modern corporate finance.
In other words, the theory’s main proposition does not accurately describe
reality. Nevertheless, such theories are still the foundation for modern
corporate finance theory because they have given us a new way of thinking
about the problems; they are fundamental because even their critics organise
their arguments in terms defined by the original theories.
This module is organised around those core theories; in most units you will
study one of the core theories, its strengths and its weaknesses. In that way,
your studies will give you a comprehensive understanding of modern
corporate finance. However, the order in which you study the theories is not
the same as the order in which they were published, as the module is
structured in a way that enables you to build on the concepts cumulatively.

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1.3 Key Questions in Corporate Finance

Theoretical and empirical studies of corporate finance comprise an
extremely large body of literature and deal with a very large number of
specialised questions. The main journal for articles on research in corporate
finance is the Journal of Finance (published in the United States by the
American Finance Association); followed by the Journal of Financial
Economics. Other specialist journals exist, and articles on corporate finance
are also published in a large number of wider-ranging economics journals.
Underlying all the specialised research questions in corporate finance is one
fundamental question: ‘What is the relation between:
•
corporations’ decisions on investing in productive (‘physical’) assets
and issuing financial liabilities; and
•
markets in the financial liabilities (equities and debt) which they
issue?’
Since that fundamental question underlies all the models and analyses in
this module, I would like you to make a special note of it. I will refer to it
explicitly at several points in the module, but I hope that even when I do not
explicitly mention it you will be able to remember it and work out its
connection to whichever question or model you are studying at the time.
That fundamental question enables us to divide the core theorems and
issues of corporate finance into two broad types:
•
those that focus primarily on the corporation’s decision problems; and
•
those that focus primarily on the way financial markets operate.
That division is simple and it is not absolutely precise, because theories have
both elements, but it helps at this stage. To give you a taste of what is to
come, let me summarise which core theorems relate to which of those two
perspectives, and give some indication of their location in this module.

1.3.1 Theorems focusing on corporations’ decision problems

The theories that you will study in this area are Hirshleifer’s Net Present
Value Rule (NPV) and two theorems from Modigliani and Miller, on
Dividend Policy and Debt–Equity Ratios.

Net Present Value Rule (Hirshleifer, 1958)

This is the fundamental model of how corporations should decide whether
to invest in a project (the ‘investment decision’, or ‘capital budgeting decision’). It
introduces a connection with the firm’s choice of finance, because the price
of finance (the cost of capital) is an element in calculating the present value of
an investment project. When Hirshleifer demonstrated its importance for
modern analysis, he also demonstrated the Fisher Separation Theorem; its
important conclusion is that, because a project can be combined with a
financial operation, borrowing or lending, the amount a corporation should
choose to invest in physical capital is independent of the preferences of
individual owners and managers. If the Fisher Separation Theorem is valid,
managers can be separate from owners without harming their interests.

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Net present value also provides a model that is used for valuing shares and,
therefore, for understanding how the price of shares is determined. A
particularly valuable simplification of that model gives us a useful tool for
valuing the shares of growing companies: that version is known as the
Growth Model, developed as a core theorem by MJ Gordon and E Shapiro.
Such methods will be discussed in the early units of the module.

The Modigliani-Miller Theorem on Dividend Policy

The price of shares often appears to be affected by the corporation’s policy
on paying dividends and, in practice, corporations give a lot of attention to
the difficult problem of determining their dividend payouts (the ‘dividend
decision’). However, in 1961, Franco Modigliani and Merton Miller
demonstrated that under certain conditions the dividend payout policy
would have no influence on share price. Subsequently, many writers have
shown that there are several plausible conditions under which firms’
dividend payments will, after all, affect their share price. This is one good
example of an issue where, even when later authors are disagreeing with the
original theorem, they still nevertheless frame their models in relation to the
seminal arguments of Modigliani and Miller. You will study those models in
Unit 5.

Modigliani-Miller Theorem on Debt-Equity Ratios

(Modigliani and Miller, 1958)
This is the starting point for all analyses of corporations’ choice of debt-
equity ratio, which is the most basic aspect of their decision on how to
finance an investment project (the ‘financing decision’). The theorem gives the
remarkable result that under certain conditions the choice of debt-equity
ratio is irrelevant; in particular, the debt-equity ratio the firm chooses does
not influence its cost of capital. By showing that under certain conditions the
debt-equity decision is irrelevant, the Modigliani-Miller Theorem provided
the basis for theorems and studies to identify which conditions are
significant and to show how, if those conditions do not exist, firms should
(or do) make relevant decisions regarding leverage. As Milton Harris and
Artur Raviv say in their 1991 survey:
The modern theory of capital structure began with the celebrated paper
of Modigliani and Miller (1958). They (MM) pointed the direction that
such theories must take by showing under what conditions capital
structure is irrelevant. Since then, many economists have followed the
path they mapped.
Source Harris and Raviv, 1991: 297.

You will study this model in Unit 6 of the module.

 Review Question
From what you have read so far, what do you think are the three basic questions of
corporate finance?

You have read analytically if you identified the questions underlying the
three decisions discussed above. They are the following:

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•
Investment decision (capital budgeting): How should corporations

decide whether or not to invest in a project?
•
Financing decision (capital structure): How much cash must be raised
for the required real (physical) investments?
•
Dividend decision: How much should the firm return to its financial
investors (shareholders) in the form of dividend payments?
The area of ‘Agency Theory’ that looks at the relations between different sets
of stakeholders within a company – particularly its shareholders who own it
and the managers who run it – is also an area of dispute pertinent to
corporate decision-making. However, we will introduce some elements of
agency theory at greater length in this unit, and you will be reading a
separate section on this shortly. Agency theory is a perspective on intra-firm
decision-making that invites the possibility of legal arguments and solutions
to the problems it highlights, which is one reason we go into it at some
length here in this first unit.

1.3.2 Theorems focusing on the operation of financial markets

The connection between this type of theory and those that focus on
corporations’ decision problems is not immediately obvious. The latter
assume that the corporation is considering the issue of new equities and
bonds, but when – as in this case – we consider the operation of financial
markets and their pricing of equities, our concern is mainly with transactions
in stocks that were issued in the past and are now traded between one
portfolio owner and another. However, trading in existing stocks is linked to
the corporation’s new issues. First, both should reflect assessments of the
corporation’s expected future performance. Second, trading in existing stocks
establishes prices and yields which determine the yields the corporation will
have to pay on new stock if it issues more equity to finance the investment
project. In other words, the price and yields of existing stock partly determine
the cost of capital the firm has to consider when it makes its investment
decision.
Many of the core theories in corporate finance are concerned with this type
of problem: the operation of financial markets.

The Capital Asset Pricing Model

The CAPM analyses the principles of rational choice that are involved in
investing a portfolio between a number of financial securities. Portfolio
Allocation Theory concentrates on the underlying principles of choice that
a rational individual or fund manager may follow. The Capital Asset
Pricing Model builds on those principles to develop simple rules and to
demonstrate how those rules should explain what determines the prices of
individual securities. In particular, these theories show how portfolio
investment decisions and the security prices that result from the sum of
individual portfolio decisions may take account of the risk carried by each
security. Those results have a direct implication for the link between
financial markets and corporations’ investment decisions, because the cost
of capital that affects the firm’s evaluation of investment projects should
depend on risk or, more precisely, on how much of that firm’s risk cannot

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 Unit 1 Perspectives on Corporate Finance

be diversified away. More risky firms should expect the yield demanded
by equity holders to include a risk premium related to the size of non-
diversifiable risk.
The capital asset pricing model will be presented in Unit 3.

The Efficient Markets Hypothesis

This theorem postulates a simple connection between the firm’s investment
decision and the market for its financial liabilities. Its main proposition is
that, because the stock market is an ‘efficient market’ (in a carefully defined
sense), the price of the firm’s shares fully reflects the firm’s ‘fundamentals’ –
or, in other words, it fully reflects the value of the expected future profits on
the firm’s physical (and other) capital. The Efficient Markets Hypothesis is
introduced, though not studied in detail, in this module, but its main
implications are considered in many units of the module. As you will see, in
most parts of this module we assume its basic argument to be valid, because
(even though it is highly questionable in reality) it greatly simplifies the
models discussed here if we can assume that share prices always equal their
fundamental values.
The efficient markets hypothesis and its implications for corporate financing
decisions will be discussed in Unit 4.

1.4 The Objective of the Firm

Many financial economists consider that the growth of corporate finance
theory can be traced to its choice of a single objective. According to the
classical viewpoint, the objective of the firm is to maximise the value or
wealth of its owners (i.e. its shareholders). Consequently, the investment,
financing and dividend decisions that increase the value of shareholders are
considered ‘good’ whereas those that decrease the value of shareholders are
considered ‘poor’. The choice of this objective function has provided
corporate finance theory with a unifying theme and internal consistency, but
this has come at a cost. In fact, a significant part of the disagreement
between corporate finance theorists is centred on different views about the
appropriate objective function of the firm. An alternative to the idea of
shareholder supremacy, the perspective from stakeholders, has recently
become popular. In section 1.5, you will be asked to read a few sections from
the article by Allen and his co-authors (2014) for a good summary.
While the debate on the objective of firm is ongoing, this module implicitly
assumes that the objective is to maximise the shareholder value over the long
term. The shareholder value maximisation refers to the increase of their
purchasing power via capital and income gains from shareholding.
Nonetheless, it is worth noting that the objective function of ‘shareholder
value maximisation’ is valid only under certain assumptions. The most
important of these assumptions is that there are no agency problems between
the various stakeholders in the firm. In order to understand the essence of the
agency problem, let’s look first at how traditional models of corporate finance
viewed the firm. In elementary economic theory and in the early theory of
corporate finance, the firm is presented as a mysterious ‘empty box’. We can

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 Corporate Finance

analyse what goes in: factors of production, reducible to capital and labour –
and what comes out: consumer goods or capital goods – but what goes on
inside the firm is not analysed in depth. The internal operations are
summarised in a production function as a technical relationship linking inputs
and outputs.
In reality, however, inside the ‘box’ of the firm, the operations involve the
interaction of people with specialised roles and positions. The stakeholders
in the firm are many. There are the shareholders, the managers, the
bondholders, the customers, the workers and the society at large. The core of
the agency problem is that each group has its own interests and objectives,
and consequently conflicts of interest may arise between these different
groups. These conflicts of interest create costs for the firms, known as agency
costs. Many financial economists doubt the validity of the objective of
shareholder value maximisation, considering it invalid in the presence of
agency costs.
Given the central importance of agency problems in evaluating the objective
function of the firm as well as to our understanding of the workings of
corporations, we will next study the main features of agency theory in this
introductory unit. Agency theory has become one of the most important
recent advances in corporate finance with very wide ranging implications
for different aspects of corporate finance, especially for the financing and
dividend decisions of firms.

1.4.1 Shareholders and Managers

When we move away from simple models of the firm, we can see that
conflicts of interest may also arise in the firm’s day-to-day operations.
Modern theories of corporate finance, developed especially since 1976, focus
on such conflicts of interest. I have mentioned several potential conflicts of
interest; now, which are the main ones on which corporate finance theory
concentrates? Two of the principal concerns of corporate finance are the
conflict of interest between:
•
shareholders and managers
•
shareholders and bondholders.
In Section 1.5 we will deal with the first type of conflict, referred to in the
literature as the ‘principal–agent problem’.
Jensen (2001) ‘Value

Reading maximization,
stakeholder theory, and
I would like you now to read Jensen’s article on the role of the corporate objective function. the corporate objective
function’. Reproduced

 When you have finished studying the article and taking notes, please answer the in the Module Reader
from the Journal of
following questions. Applied Corporate
Finance.

What problems does Stakeholder Theory face?

What similarities are there between Stakeholder Theory and the Balanced Scorecard
approach?

From the article’s discussion, can you consider whether maximising shareholder
values is equivalent to maintaining social welfare?

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 Unit 1 Perspectives on Corporate Finance

1.5 Agency Problems

The essence of the agency problem between shareholders and managers is
the separation of ownership and control. Financial investors (shareholders)
hire managers/entrepreneurs because they need to use their specialised
expertise in managing the company and generating returns on their
investments. The entrepreneur/manager in turn needs outside funds to
finance productive projects. The main question, which forms the subject
matter of what is known as corporate governance, is this:
•
Once investors (shareholders) have committed their money to the
company, how can they prevent managers from expropriating their
funds and/or prevent managers from wasting their money on
unproductive projects?
Thus, the agency problem in this context refers to the problems that
investors have in assuring that that managers don’t expropriate their funds
(take the funds for themselves) or spend them unproductively.
In principle, investors and mangers can draw up a contract in which
investors provide the necessary money on the condition that they retain
complete control rights over the firm’s operations and the allocation of
funds.
However, this raises the question as to why firms need managers in the first
place. If investors want to retain complete control, then there is no need for
managers. As such, the design of such contracts is both infeasible and
impractical. Alternatively, the managers and financiers can sign a contract
that specifies what managers should do with the funds and how the returns
from investment should be distributed among stakeholders. However, the
design of such contracts is technically infeasible due to various factors such
as the difficulty of foreseeing all future contingencies. This is further
complicated by the fact that managers and investors are not likely to share
the same information.
The infeasibility of designing ‘complete contracts’ that protect the rights of
shareholders everywhere in the world means that significant control rights
remain in the hands of managers. In practice, controlling rights are likely to
be even more concentrated in managers’ hands than theory suggests,
because dispersed shareholders, in addition to being poorly informed,
don’t exercise the few control rights they have. In addition, there is the
issue of contract enforcement by courts. Even in countries with the most
developed legal systems, enforcement involving legal issues related to
manager-shareholder contracts is complex and the courts don’t deal with
many of the conflicts that arise between shareholders and managers.
Managers, as rational individuals, seek to look after their own self-interest.
Thus, if they are left alone, they will not act in the best interests of
shareholders. In fact, the concentration of controlling rights in the hands of
managers means that managers have both the power and the incentive to
expropriate the wealth of shareholders. They can do this in various ways.
Managers can simply leave with the money; or they can engage in ‘transfer
pricing’, where they set up independent companies and sell the goods from
the main company to the independent companies at low prices; or they can

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sell the assets of the company to relatives at cheap prices. In most countries,
the law protects investors against such abuses, and expropriation is likely to
take different forms. The most common one is managers’ consumption of
perquisites (‘perks’) such as jet planes, big offices, excessive pay, more
leisure, etc. … Other forms include ‘empire-building’ and expanding the
firm beyond what is rationally feasible. Many observers consider that such
expansions increase managerial benefits at the expense of shareholders.
Another channel through which managers can expropriate shareholders’
wealth is by the management team remaining in their jobs even when their
services are no longer needed and/or when they are performing poorly. In
fact, some economists consider that the resistance of managers to takeovers
aimed at their removal represents the most significant form of expropriation
of wealth from shareholders.

Management resistance to takeovers

Perhaps the best evidence on agency problems comes from the literature on
takeovers. In Unit 8 you will study takeovers in detail, but for now let’s
anticipate some of the ideas presented there. One of the effects of takeovers
is usually the removal of the incumbent management. In fact, the removal of
the incumbent management might well be one reason that motivated the
takeover in the first place. Because of fear of losing their jobs, managers
usually resist takeovers. In resisting takeovers, they may adopt anti-takeover
actions that impose significant costs on shareholders.
For instance, they can design contracts that compensate them in case of loss
of control due to the takeover. In corporate literature jargon, these are
referred to as ‘golden parachutes’. Golden parachutes are widely used to
restrict takeovers, and they usually benefit managers at the expense of
shareholders, especially when these contracts are offered to large numbers
of managers. Alternatively, managers can resist takeovers through targeted
repurchases (also known as ‘greenmail’ because it is similar to ‘blackmail’,
but in this case money is offered rather than demanded) in which the
management makes an offer to repurchase shares from a subset of
shareholders at a premium, but the offer is not extended to other
shareholders. By buying out the shareholders who are likely to threaten the
incumbent management, managers protect themselves from a takeover that
would result in loss of control.
The management can also devise a ‘poison pill’, which refers to a security or
a provision that changes the fundamental aspects of the corporate rules.
These ‘pills’ are triggered by takeovers and are ‘poisonous’ because they
significantly increase the cost to the acquirer. They are designed to make the
takeover unattractive and hence serve the management in maintaining
control. Interestingly, these anti-takeover actions occur without the approval
of shareholders.
Cohen (2014) ‘US

Reading companies fend off
activists with poison
Various observers consider that managers do use poison pills in order to protect them- pills’ Reproduced in the
Module Reader from
selves and retain their private benefits of control rather than to promote the interests of the Financial Times.

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 Unit 1 Perspectives on Corporate Finance

shareholders. Your next reading, entitled ‘US companies fend off activists with poison
pills’, investigates such corporate self-defences. Please study it now.

 After reading this article, answer the following questions:


According to the article, what are pros and cons of poison pills?

Do you think that poison pills enhance or harm the interests of shareholders?

Poison pills come in different forms. Identify three such forms.

Now let’s stand back for a moment and reflect on the question of ‘agency
costs’ as a whole. In corporate finance, agency cost models represent a
turning point, largely because they recognise a phenomenon which occurs in
practice but which is assumed away in the fundamental models of corporate
finance. However, as you have seen above, agency costs are real and should
be included in any analysis of the firm.

Reading Shleifer & Vishny,

(1997) Part I of ‘A
survey of corporate
In order to enhance your understanding of the nature of agency problems, I would like governance’.
you now to turn to your Reader and to the Introduction and Part I (pages 737 to 748) of Reproduced in the
Module Reader from
the article by Shleifer and Vishny (1997) ‘A Survey of Corporate Governance’ Journal of The Journal of Finance.
Finance, Vol. 52 (2).

 Your notes should amplify and clarify the points raised in this section.
What are the main the implications of agency problems for the objective
function of shareholder wealth maximisation? To put it differently, how can
the objective of shareholder wealth be justified in the presence of agency
problems? Some financial economists have argued that the interests of
shareholders and managers cannot diverge widely. If managers don’t
pursue the objective of wealth maximisation, then there are control
mechanisms in place that provide shareholders with enough powers to
ensure that the interests of managers are aligned with theirs. In other words,
managers who don’t meet this objective face discipline from shareholders
and markets. This is a valid point to a large extent. In fact, there are many
mechanisms that provide shareholders with power over management.
However, many critics argue that these mechanisms protect shareholders
only partially.

Reading
Hillier et al (2016)
Section 1.2 ‘The goal of
financial management’
Before discussing these mechanisms in detail, I would like you to read sections 1.2 of and Section 2.2 ‘The
agency problem and
Chapter 1 and 2.2 of Chapter 2 of your textbook, Corporate Finance, by Hillier, Ross, control of the
Westerfield, Jaffe and Jordan. corporation’ in
Corporate Finance.
 Once you have finished reading, answer the following questions.

What are the two types of agency costs?

How are managers bonded to shareholders?

What are the main managerial roles?

Centre for Financial and Management Studies 13

 Corporate Finance

In brief, the two types of agency cost are the monitoring costs of the
shareholders and the incentive fees paid to the managers.
The bases of the management/shareholder bond are the following:
•
management contracts and incentives are built into compensation
arrangements
•
competition in the managerial labour market makes managers perform
in the best interests of stockholders
•
managers could lose their jobs if a firm is taken over because the firm
is considered to be poorly managed
•
shareholders determine the membership of the board of directors,
which selects management.
The main managerial goals are the maximisation of corporate wealth,
growth and company size.

1.5.1 Legal protection

The first discipline mechanism comes from within the company. If
managers don’t meet the objective of shareholder wealth maximisation,
they will face the threat of being fired by shareholders or by the board of
directors. In principle, investors gain significant control rights in the
company in exchange for their investment. One important control right is
exercised through annual meetings where shareholders can vote on
important corporate matters. More importantly, shareholders are given the
right to elect the members who serve on the board of directors.
The board of directors is the apex of the internal control system of the
corporation. In principle, the board of directors has responsibility for the
entire functioning of the firm. As elected representatives of shareholders,
they are also responsible for monitoring the performance of management
and ensuring that managers are acting on behalf of shareholders’ interests.
In theory, the board enjoys considerable power to fulfil its tasks where it can
hire, fire, and compensate managers.
Although shareholders have significant legal rights, the power to control
management in practice is rather limited due to various factors. In practice,
managers frequently interfere in the voting process and conceal information
from their opponents. For instance, employee stockholders may be
threatened with layoffs if they vote against the management, or the
management team may simply fail to notify shareholders about annual
meetings. The requirement that shareholders must attend annual meetings
to vote can be expensive for small shareholders and has the effect of
excluding these shareholders from voting. Furthermore, in many countries
ownership is dispersed – that is, there is no major shareholder (core
investor) who has both the power and the incentive to monitor and
discipline incompetent management. These problems are particularly acute
in developing and transition economies.
The problem with dispersed ownership is that no particular small investor
gains any advantage over other shareholders from monitoring management,
because all shareholders gain from more monitoring. This means that there
is a ‘free rider’ problem: other investors can free-ride on monitoring

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 Unit 1 Perspectives on Corporate Finance

activities. Furthermore, the existence of a large number of investors can lead

to a co-ordination failure problem: investors will try to free-ride, believing
that others are monitoring, when in fact no one is.
Few boards have done their job properly in practice, with the majority of
boards being captured by management. Even in the United States, boards of
directors are unlikely to be able to remove managers if they are performing
poorly. Evidence shows that boards of directors tend to replace management
only after disastrous results, such as when the firm is already suffering
serious problems. The reasons for this poor performance are various. The
most important of them are the following:
•
The Chief Executive Officer (CEO) and other managers (referred to as
insiders) usually serve on the board of directors. Even outsiders are
not necessarily independent since the management team has a say in
who serves on the board.
•
Most individuals who serve on the board can’t spend much time on
their duties, partly because they have other commitments and partly
because they serve on other boards. Even those directors who put in
the effort to understand the workings of the corporation may lack the
necessary expertise and rely instead on outside experts. This is
reinforced further by several information problems such that the CEO
always determines the agenda and the information given to the board.
Information problems limit the effectiveness of the board in
monitoring, even if the directors have sufficient expertise.
•
The board culture is one of passivity where directors usually agree
with management rather than confront them. This ineffectiveness is
reinforced by rewarding consent and discouraging conflict. The
rewards come not only in the form of salaries, but also in the form of
benefits and perquisites such as insurance and pension benefits.
•
Problems arise from the fact that managers and non-manager board
members have only small stakes in their corporation. Encouraging
outside members to hold substantial equity interests would provide
better incentives for directors to monitor management.
The Economist (2009)

Readings ‘Executive pay:
maligned, or
One of the possible ways that managers can expropriate wealth from shareholders is misaligned?’
and
through excessive pay. The two articles in the Module Reader entitled ‘Executive Pay:
Paulin (2009)
Maligned, or misaligned?’ and ‘Changing the Economics of Executive Compensation’ ‘Changing the
focus on the excessive salaries and bonuses paid to company executives and on how such Economics of executive
compensation' from
bonuses can harm the interest of shareholders and stakeholders. These articles also Businessweek.
describe various ways by which managers seek to look after their own interests. Please Both reproduced in the
study them now. Module Reader.

 After reading these articles, answer the following questions:


In assessing executive pay, is it accurate just to look at basic salaries and bonuses?
What else might one look at?

What are possible reasons behind the continuous increase of executive pay?

Who do you think plays an active role in curbing excess pay and protecting the
interests of shareholders and stakeholders?

Centre for Financial and Management Studies 15

Corporate Finance

In addition to shareholders’ rights, the obligation those rights places on

management is usually supplemented by an affirmative duty of loyalty of
managers to shareholders. For instance, there are legal restrictions on
managerial self-dealings such as outright theft, excessive compensation, or
the issuance of additional shares to managers and their relatives. There are
also legal restrictions on management’s actions such as demanding that
investors consult the board of directors. In addition, there are restrictions
that ensure that minority shareholders should be treated as well as insiders.
In the US, shareholders have the right to sue if the managers have violated
the duty of loyalty. Despite all these legal restrictions, however, enforcement
mechanisms in most countries are ineffective and strictness in rules varies
considerably across countries.
Shleifer & Vishny

Reading (1997) Part III of ‘A
survey of corporate
In order to enhance your understanding of the links between corporate agency governance’.
Reproduced in the
problems and the external financing of corporations, please now turn back to your Module Reader from
Reader and read Part III of the article by Shleifer and Vishny, ‘A Survey on Corporate The Journal of Finance.
Governance’, pages 750 to 753.

If legal protection does not provide shareholders with enough power to

align their interests with those of managers, does this mean that the gap
between shareholders and managers is so wide that the objective function of
maximising shareholders’ wealth is not realistic? According to many
financial economists, the answer is no! First, the objective function of
maximising shareholders’ wealth is self-correcting. Excesses by managers
lead to reactions by shareholders that reduce the likelihood of the same
actions being repeated. Furthermore, the legal system usually responds to
curb managers’ excesses, as you will see in the exercise below. Second, there
are other mechanisms that help close the gap between the interests of
shareholders and managers, and increase the power of the former over the
latter. These alternative mechanisms with the available legal rights help
alleviate the problems associated with the separation of ownership and
control.
Ward & Treanor (2002)

Reading ‘Investors to vote on
top pay’ from The
For some time now, shareholders have been calling for legislation to give them an annual Guardian
and
vote on directors’ salaries. Some governments finally responded by passing new regula-
Groom (2014) ‘Gap
tions aimed at curbing excessive payments. For example, the US government introduced widens between UK
the Dodd-Frank act in 2010. In the UK the rules on executive pay came into force in 2013. executive pay and
results’ from The
The article entitled ‘Investors to vote on top pay’ highlights the main features of this new Financial Times
legislation, and you should read this now. (The original regulatory documents are Both reprioduced in the
available from Module Reader.

http://www.legislation.gov.uk/uksi/2013/1981/pdfs/uksi_20131981_en.pdf)
In the earlier reading by George Paulin (2009) ‘Changing the Economics of Executive
Compensation’ the last paragraph asks ‘So, in five years, will anything be different?’. In
answering this, look at the recent article from The Financial Times entitled ‘Gap widens
between UK executive pay and results’.

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 Unit 1 Perspectives on Corporate Finance

 When you have finished these readings and written notes on them, please answer
the following question:

Do you think the new legislation will be effective in curbing directors’ excessive
salaries and bonuses? Comment on your reasoning.

1.5.2 Large investors

One mechanism highly emphasised in the literature is the role of large or
‘core’ investors. It is argued that investors can become more effective by
being large. Large shareholdings provide incentives for shareholders to
collect information and monitor management, facilitate the coordination of
effort to control management, and give investors enough power to put
pressure on management. In the case of 51% ownership, the shareholders
have enough interest in value maximisation and have enough controlling
rights to put pressure on managers to align the interests of managers with
theirs. In the US and UK, large or majority shareholdings are relatively
uncommon. This is in contrast with Germany where large banks, through
proxy voting arrangements, control a large share of the votes. Furthermore,
banks have significant cash flow stakes as direct shareholders.
There is some evidence to support large shareholders’ controlling power.
Large shareholdings are usually associated with the higher turnover of
management, because firms with large shareholders are more likely to
replace managers with poor performance than firms without large
shareholders. There is also some evidence from Japan that large
shareholdings reduce discretionary spending, especially on advertising,
research and development (R&D), and entertainment expenses. This
evidence suggests that large shareholders play a role in corporate
governance.
Like large shareholders, significant lenders such as banks can be potentially
active investors monitoring closely the performance of managers and
replacing managers who produce poor performance. However, their power
comes from different sources. Banks usually lend short term, which means
that firms have to come back to them regularly for funding. Second, violation
of restrictions on the debt contract, or default, gives creditors large control
rights. Furthermore, in some countries banks vote by proxy on behalf of other
equity holders, which gives them significant controlling rights.

 Review Question
A study has shown that around the world a large shareholding is the exception rather
than the rule. Based on the discussion of this subsection, how would you explain this
observation?

1.5.3 Threat of takeovers

During a particular wave of takeovers in the US, in the 1980s, various
studies suggested that many of the firms that were taken over were poorly

Centre for Financial and Management Studies 17

 Corporate Finance

managed, and that they under-performed when compared to their

competitors and provided low rates of return to their shareholders. By
taking over such badly managed firms, the acquirers could make substantial
profits through removing the incumbent management and restructuring the
assets of the firm. As such, badly managed firms became the target of hostile
takeovers. This issue will be discussed in detail in Unit 8. However, one
implication of this finding is relevant for the discussion here: the threat of
takeovers can act as a disciplinary mechanism on managers, forcing them to
align their interests with those of shareholders.

Reading
Shleifer & Vishny
(1997) Parts IV and V
of ‘A survey on
I would like you to turn to your Reader and read Parts IV and V of the article by Shleifer corporate governance’.
Reproduced in the
and Vishny, ‘A Survey on Corporate Governance’, pages 753 to 761. Module Reader from

 Once you have read these sections, please answer the following questions: the Journal of Finance.


What are the main disadvantages of having large investors and creditors?

What are the main limitations of using takeover threats to discipline management?

Large investors are not diversified and hence are excessively risky; large
investors represent their own interests, which may not conform to the
interests of other shareholders, especially minority shareholders, which may
lead to straightforward expropriation, the accumulation of personal benefits
and distortion to the incentives of other stakeholders.
Management has developed anti-takeover mechanisms to protect
themselves; takeovers require highly liquid markets that are absent in many
countries; takeovers usually prove to be very expensive, which also
discourages them. For instance, if raiders have to pay on average a 20%
higher price than the pre-acquisition price while the estimated benefit from
control and changing management is only 10%, then the takeover will not be
profitable. Thus, bad managers have a cushion before they are actually taken
over.

1.5.4 A summary of the main arguments on shareholders and

managers
In short, managers and shareholders have their own interests and objectives
and, consequently, conflicts of interest may arise between these different
groups. Given that controlling rights are concentrated in the hands of
managers, the managers can put their own interests above the interests of
shareholders. However, there are various mechanisms that help close the
gap between the interests of shareholders and those of managers and
increase the power of the former over the latter.
These include legal protection of shareholders, the role of large investors and
threats of takeovers. Furthermore, there are some specific contractual
mechanisms, discussed throughout this module, which can close the gap
further. It is also important to note that there have been improvements in the
internal control mechanisms of corporations. However, these mechanisms
don’t completely eliminate the agency problem. Hence, whether the objective

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 Unit 1 Perspectives on Corporate Finance

of stockholder wealth maximisation is valid or not depends on the magnitude

of the agency costs. Given that financial economists have different views
regarding the severity of agency costs and the effectiveness of the various
mechanisms in aligning shareholders and managers’ interests, the debate on
what is the proper objective function of the firm is likely to continue.

Reading Allen et al (2014)

‘Stakeholder
governance,
To reinforce your understanding of the various issues covered so far, I would like you to competition, and firm
read sections 1, 5 and 6 of the article [skip sections 2, 3, and 4 on the model develop- value. Reproduced in
the Module Reader
ment] in the Module Reader entitled ‘Stakeholder Governance, Competition, and Firm from the Review of
Value’. The authors provide an abstract model which attempts to compare the sharehold- Finance.
er-based corporate governance system in the US on the one hand and the stakeholder-
based corporate goverance system of Europe and Japan on the other. You do not need to
understand the detail of the model presented in this article. However, you should read
about the issues the authors are trying to solve, and about the empirical predictions from
the model.

 After reading this article, answer the following questions:


What are the main objectives of stakeholder-oriented firms?

To what extent does the theory help to explain diffrences between Ger-
man/Japanese firms and US firms with regard to:
i)
their comparative advantages, and
ii)
financing patterns.

1.6 Conflict between Shareholders and Bondholders

In a world with no conflicts of interest, bondholders have no need to protect
themselves from shareholders. In reality, however, there are various ways
through which shareholders may expropriate wealth from bondholders if
bondholders are not adequately protected. Agency costs of debt exist
because shareholders’ actions can damage the interests of bondholders.
For example, shareholders may obtain credit from bondholders, supposedly
to finance a particular set of physical assets, but they then have an incentive
to invest the funds in a different way. When they have obtained the funds,
they have an incentive to invest them in projects that are more risky than the
bondholders would like. As you will see in Unit 5, the reason for this is that
if the risky project actually yields a high return the equity owners receive a
large proportion of it; but if it fails the cost to the shareholders is restricted
by limited liability and the bondholders bear the cost since the loan cannot
be repaid.
Another example is when bondholders lend money to a firm which was
perceived to be safe when the loan was first made, but which soon after
borrowing went back to financial markets to borrow more, using the same
assets as collateral. This subsequent borrowing increases the riskiness of the
firm, but bondholders don’t have the power to alter their interest rates to
reflect the new higher risk. This results in lower bond prices and loss of
value to bondholders. In some extreme cases, shareholders can directly

Centre for Financial and Management Studies 19

 Corporate Finance

expropriate bondholders by borrowing money and then distributing it to

themselves by paying high dividends. Although these actions are likely to
cause the value of the firm to decline, shareholders may be willing to do this
if the transfer of wealth from bondholders outweighs the loss to their wealth
due to a decrease in the value of the firm.
Rational bondholders usually know the ‘games’ played by shareholders
and hence they devise mechanisms to protect themselves against wealth-
expropriating actions. The most direct way for bondholders to protect
themselves is to impose restrictions in their bond agreements. These
restrictions are usually known as ‘covenants’ and they are intended to
prohibit firms from taking actions that can harm bondholders – such as
restrictions on dividend payments, on additional leverage, and on
investment policy. The bondholders can also attach a provision to their
bonds that gives them the right to sell back the bond at face value if
shareholders take certain actions. It is important to note that although these
contracts provide bondholders with protection, the contracts are not
‘complete’, in the sense that they are not able to cover all possible
eventualities and hence cannot fully protect bondholders from
shareholders’ actions.

Reading Frank (1989) ‘Capital

markets: Pity the poor
old retailer
In 1988, RJR Nabisco announced that it would buy out public stockholders and that the bondholder’.
bid was to be financed by large amounts of debt. Within hours of the announcement, the Reproduced in the
Module Reader from
price of its bonds plummeted. The article entitled ‘Capital Markets: Pity the Poor Old The Banker.
Retailer Bondholder’ from The Banker analyses this episode in detail and shows how
bond prices reacted to this news. The article also proposes methods to protect the
interests of bondholders.

 After reading the article, answer the following questions:


Why did existing bondholders feel they were ‘stabbed in the back’?

How much did bondholders lose from the management’s actions?

What impact did this episode have on the market for corporate bonds?

How can bondholders protect themselves against actions that harm their interests?

1.7 Conclusion
Corporate finance is about investment and financing decisions of
corporations. In this unit you have considered a set of theoretical concepts
that are directly or indirectly related to those decisions. Moreover, you also
studied what may be the objective that motivates such decisions, and how
conflicts of interest among corporations’ stakeholders might arise as to
which particular investment or financing-related decision should be
undertaken.
In the next seven units, as explained in this introductory unit, you will
engage in the study of the most relevant theoretical principles underlying
corporate finance. The logic of the module structure is to deal with
investment decisions first, then financing issues, and then more complex

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 Unit 1 Perspectives on Corporate Finance

concepts such as capital structure, dividend policy and mergers and

acquisitions. Unit 2 provides the general theoretical background to making
investment decisions under certainty. Unit 3 extends the theory discussed in
Unit 2 to the case of uncertainty. There you will learn the role of models of
capital market equilibrium such as the CAPM. The concepts developed in
Units 2 and 3 are of crucial importance to the understanding of the rest of
the module. Also both these units, and specially Unit 3, are the most
technical ones, from a mathematical point of view.
It is for these reasons that these two units are particularly demanding, and we
strongly advise you to study these units carefully.

References
Allen, F, E Carletti and R Marquez (2014) ‘Stakeholder Governance,
Competition, and Firm Value’, Review of Finance, February 13.

Black F and M Scholes (1973) ‘The pricing of options and corporate

liabilities’, Journal of Political Economy, Vol. 81, May/ June, pp 637–54.

Cohen, N (2014) ‘US companies fend off activists with poison pills’, Financial
Times, April 23.

Fama EF (1970) ‘Efficient capital markets: a review of theory and empirical

work’, Journal of Finance, Vol. 25, May, pp 383–417.

Frank D (1989) ‘Capital Markets: Pity the Poor Old Retailer Bondholder’, The
Banker, 1 February, London: Financial Times Business.

Gordon MJ and E Shapiro (1956) ‘Capital Equipment Analysis: the Required

Rate of Profit’, Management Science, Vol. 3, October, pp. 102–10.

Groom, B (2014) ‘Gap widens between UK executive pay and results’, The
Financial Times, 23 January: http://www.ft.com/cms/s/0/92a3db66-835b-
11e3-aa65-00144feab7de.html#axzz3ATeRwvBd

Harris M and A Raviv (1991) ‘The Theory of Capital Structure,’ Journal of

Finance, Vol. 46, No. 1, March, pp. 297–355.

Hillier D, SA Ross, R Westerfield, J Jaffe and B Jordan (2016) Corporate

Finance, Third European Edition, Maidenhead UK: McGraw-Hill.

Hirshleifer, J (1958), ‘On the theory of optimal investment decision’, Journal

of Political Economy, Vol. 66, August, pp 329–52.

Jensen, MC (2001) ‘Value maximization, stakeholder theory, and the

corporate objective function’, Journal of Applied Corporate Finance, 14, no. 3,
pp. 8–21.

Jensen MC and W Meckling (1976) ‘Theory of the firm: managerial

behaviour, agency costs and capital structure’, Journal of Financial Economics,
Vol. 3, pp 305–60.

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Corporate Finance

Lintner J (1965) ‘The valuation of risk assets and the selection of risky
investments in stock portfolios and capital budgets’, Review of Economics and
Statistics, Vol. 47, February, pp. 13–37.

Markowitz HM (1952) ‘Portfolio selection’, Journal of Finance, Vol. 7, March,

pp 77–91.

Miller MH and F Modigliani (1961) ‘Dividend Policy, Growth and the

Valuation of Shares’, Journal of Business, Vol. 34, October, pp. 411–33.

Modigliani F and MH Miller (1958) ‘The cost of capital, corporation finance,

and the theory of investment’, American Economic Review, Vol. 48, June, pp.
261–97.

Paulin, G (2009) ‘Changing the Economics of Executive Compensation',

Businessweek, October 13: http://www.businessweek.com/stories/2009-10-
13/changing-the-economics-of-executive-compensationbusinessweek-
business-news-stock-market-and-financial-advice

Sharpe WF (1964) ‘Capital asset prices: a theory of market equilibrium under

conditions of risk’, Journal of Finance, Vol. 19, September, pp. 425–42.

Shleifer A and RW Vishny (1997) ‘A survey of corporate governance’, The

Journal of Finance, Vol. 52, No. 2, pp 737–61.

The Economist (2009) ‘Executive Pay: Maligned, or misaligned?’, September

17, London: Pearson.

Ward L and J Treanor (2002) ‘Investors to vote on top pay’, The Guardian
Archive, 26 June, London: The Scott Trust.

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