B2FIN024

Corporate Finance

Lecture 1

Introduction to Corporate Finance

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• Readings:
Chapter 1
Berk, J., and DeMarzo, P., Corporate Finance - Global Edition, 5ed. Pearson. 2020. ISBN:
9781292304151

Chapter 1
Hillier, D., Ross, S., Westerfield, R., Jaffe, J., and Jordan, B., Fundamentals of Corporate
Finance, 4ed. McGraw Hill / Europe, Middle East & Africa; 4th edition, October 15,
2021. ISBN-10: 1526848627. ISBN-13: 978-1526848628
 Goal of Financial Management
• What should be the goal of a corporation?
– Maximize profit?
– Minimize costs?
– Maximize market share?
– Maximize the current value of the company’s stock?
• Does this mean we should do anything and
everything to maximize owner wealth?

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Amazon’s Revenue and Net Income from Q1 2009 to Q3 2013 (in
million U.S. $)

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 Primary Goal of Financial Management
• Three equivalent goals of financial management:
– Maximize shareholder wealth
– Maximize share price
– Maximize firm value

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Principal-Agent Relation

Hire

and create
Principal-Agent Relation
 The Agency Problems
• Agency relationship
– Principal hires an agent to represent their interests
– Stockholders (principals) hire managers (agents) to
run the company

• Agency problems
– Problems due to conflicts of interest can exist
between the principal and the agent

• Agency costs
The costs associated with agency problems
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 On November 18, 2008…
the CEOs of the big three automakers flew to Washington in private
luxurious jets to make their case that the auto industry is running out
of cash and needs $25 billion in taxpayer money to avoid
bankruptcy…the cost of the roundtrip is about $20,000.

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 Managing Managers
• Board of Directors
• Managerial compensation
– Incentives can be used to align management and
stockholder interests
– The incentives need to be structured carefully to
make sure that they achieve their goal
• Corporate control
– The threat of a takeover may result in better
management
• Conflicts with other stakeholders
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 Who is ultimately responsible…?

Principles of corporate governance make clear that

the board of directors has ultimate responsibility
for governance.
 Monitoring by the Board of Directors
and Others
In principle, the board of directors hires the
executive team, sets its compensation, approves
major investments and acquisitions, and dismisses
executives if necessary.
 Responsibilities of Board

• Board’s written mandate must include board’s

satisfaction with integrity of CEO and other
executives and that they are creating a culture
of integrity.

• Board must apply high ethical standards and

take into account the interests of stakeholders
 Types of Directors
• Inside Directors
– Members of a board of directors who are
employees, former employees, or family members
of employees
• Grey Directors
– Members of a board of directors who are not as
directly connected to the firm as insiders are, but
who have existing or potential business relationships
with the firm
 Types of Directors (cont'd)

• Outside (Independent) Directors

– Any member of a board of directors other than an
inside or gray director
 Board Independence

• On a board composed of insider, gray, and independent

directors, the role of the independent director is really that of
a watchdog.
– However, because independent directors’personal wealth is likely
to be less sensitive to performance than that of insider and gray
directors, they have less incentive to closely monitor the firm.
– There has been a trend toward more equity-based pay for outside
directors. It is now standard for outside directors to be granted
shares of stock and/or options to more closely align their
interests with the shareholders they serve.
 Board Independence (cont'd)

• Captured
– Describes a board of directors whose monitoring duties have
been compromised by connections, perceived loyalties to
management or compensation/incentive structure
Board Independence (cont'd)
 Board Size and Performance

Researchers have found the surprisingly robust

result that smaller boards are associated with
greater firm value and performance.
– The likely explanation for this phenomenon comes
from the psychology and sociology research, which
finds that smaller groups make better decisions than
larger groups.
 Managing Managers
• Board of Directors
• Managerial compensation
– Incentives can be used to align management and
stockholder interests
– The incentives need to be structured carefully to
make sure that they achieve their goal
• Corporate control
– The threat of a takeover may result in better
management
• Conflicts with other stakeholders
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 Executive compensation serves 3 main
purposes

1) It must attract executives with the skills, experiences,

and behavioral profile necessary to succeed in the
position.
2) It must be sufficient to retain these individuals, so they
do not leave for alternative employment.
3) It must motivate them to perform in a manner
consistent with the strategy and risk-profile of the
organization and discourage self-interested behavior.
What High Performers Want?
(source: SAP Success Factors 2023)

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 Structure of CEO Pay

Executive compensation usually includes:

– Cash Compensation
• Salary and Bonuses
• Other cash
– Long-term incentives
• Stock options
• Restricted stock awards
– Other Long-Term Compensation
• Retirement contributions
• Tax reimbursement
• Life insurance premiums etc.

A good compensation package should be one that ties the managers’

interests to shareholders’ interests and thus reduces agency costs.
 Compensation Policies

• Stock and Options

– Managers’ pay can be linked to the performance of
a firm in many ways.
• Many companies have adopted compensation policies
that include grants of stock or stock options to
executives.
– These grants give managers a direct incentive to increase
the stock price which ties managerial wealth to the wealth
of shareholders.
Based on CEOs Average Salary of 2019

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 CEO Pay in Canada
Compared to the average salary of a Canadian worker, the top 100
CEOs made on average:
• 104 times more in 1998
• .
• 168 times more in 2008
• 155 times more in 2009
• 189 times more in 2010
• 171 times more in 2012
• 195 times more in 2013
• 184 times more in 2014
• 192 times more in 2015
• …

In 2019, Canada’s 100 highest-paid CEOs made on average $10.8 million

— 202 times the overall average income of $53,482 that year. (
Canadian Centre for Policy Alternatives)
Based on CEOs Average Salary of 2023

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 The Pay Clock
Average Amount Earned So Far
 Pay and Performance Sensitivity

Recent research has found evidence suggesting

that many executives have engaged in backdating
their option grants.
 Pay-for-Performance?
• Institute for Policy Studies (U.S.): in 2012, about
“40% of top-paid CEOs busted, bailed out or
booted”
– 22% received taxpayer bailouts after the 2008 financial
crash.
– 8% were fired for poor performance but received golden
parachutes valued, on average, at $48 million US.
– 8% ran afoul of the law and paid fraud-related fines or
settlements.
Are CEOs Overpaid?
Two Competing Hypotheses on Managerial Pay

CEO Excess Power

or
Optimal Contracting
CEO pay has decreased since 2000
Down over 40% in real terms

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The Ratio between the Top and the
Bottom is Arbitrary
“Arguing over whether a CEO should or
shouldn't be earning 50, 100 or 1,000
times what a worker earns is meaningless,
because there is no objective standard,...
It's completely arbitrary”
(Edwin Locke, industrial organizational psychologist, U. of Maryland, 2016)

How much is too much?

 There is a market for CEOs
• The question isn't whether CEOs are paid too much but
whether or not they are paid above their market value.
• Companies have to offer huge salaries to attract
candidates already earning millions of dollars elsewhere.
• Whether it's fair that a CEO's salary is so much higher
than that of an average worker is not a relevant question
for the board of directors...
• The relevant question is whether the board is paying the
CEO the market wage. If the board is paying the CEO
above a market wage, that is a problem.
Critics Focus on the Highest-paid CEOs
(Kaplan, 2012)
How about CEOs of Smaller Firms?
(Kaplan, 2012)
Top CEOs VS. Top Hedge Fund Managers
(Kaplan, 2012)
Top CEOs VS. Lawyers at Top Law Firms
(Kaplan, 2012)

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Top CEOs VS. Top Athletes
(Kaplan, 2012)
 CEO turnover has increased since 1997

Turnover levels including takeovers:

• 13% per year from 1992 to 1997
• 16% per year from 1998 to 2016

Turnover levels not including takeovers:

– 10% per year from 1992 to 1997
– 12% per year from 1998 to 2016

CEO tenures have declined.. CEO job appears riskier than

what it used to be!
 Managing Managers
• Board of Directors
• Managerial compensation
– Incentives can be used to align management and
stockholder interests
– The incentives need to be structured carefully to
make sure that they achieve their goal
• Corporate control
– The threat of a takeover may result in better
management
• Conflicts with other stakeholders
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 CEO Turnover
• Different types of turnover:
– Voluntary turnover
• Due to poor health/death
• Retirement
• Resignation with succession in place
• CEO stays as chairman after resignation

– Involuntary turnover
• Resignation due to poor performance
• Scandal
• Merger (takeover)
• …

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 Examples of Corporate Scandals
• Enron Corporation
• Worldcom
• Parmalat
• GlobalCrossing
• Aledphia
• Fannie Mae & Freddie Mac
• BearSterns
• Meryl Lynch
• AIG
• Lehman Brothers
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“The cockroach theory of financial scandals says that, for every
one you see, hundreds more are hiding in the woodwork”
“When Scandals Go Global,” Business Week, February 2, 2004, p. 96.

Only 1 in 4 corporate frauds is detected in the U.S. (Dyck, 2014)

Even the ones we knew of…
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 Managing Managers
• Board of Directors
• Managerial compensation
– Incentives can be used to align management and
stockholder interests
– The incentives need to be structured carefully to
make sure that they achieve their goal
• Corporate control
– The threat of a takeover may result in better
management
• Conflicts with other stakeholders
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Stakeholders

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The Stakeholder Theory

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 Social Responsibility and Ethical Investing

• Investors are increasingly demanding that

corporations behave responsibly
• Issues include how a corporation treats the
community in which it operates, their customers,
corporate governance, their employees, the
environment and human rights
• Controversial business activities include alcohol,
gaming, genetic engineering, nuclear power,
pornography, tobacco and weapons
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 Relation between CSR and Profitability ?

Ed Zander, former Chairman and CEO of Motorola:

“strong economic performance and good social and environmental
performance are not mutually exclusive. In fact, I believe that good
corporate citizenship improves our bottom line. It's not surprising
that many analysts and investors are paying closer attention to a
company's corporate citizenship efforts for purely fiduciary
reasons. Firms with social citizenship records and a real
commitment to corporate responsibility are arguably more
sustainable, better managed and, therefore, better long-term
investments.”

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Jantzi Social Index (JSI) Total Returns
(November 2013)

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 How to Induce Executives to
Behave in a Socially Responsible
Manner ?

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Can Companies' CSR Policies Lead
to Corporate Irresponsibility?

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BP’s managers missed key safety warning signs,
causing worst offshore oil spill in US history
April 20, 2010

Tony Hayward, CEO, July 2010 60

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 What is the role of financial markets in
corporate finance?
• Cash flows to and from the firm

• Money vs. capital markets

• Primary vs. secondary markets

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Cash Flows to and from the Firm

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 Financial Institutions
• Financial institutions act as intermediaries
between suppliers and users of funds
• Institutions earn income on services provided:
– Indirect finance – Earn interest on the spread
between loans and deposits
– Direct finance – Service fees (i.e. bankers
acceptance and stamping fees)

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 Trends in Financial Markets and
Management
• Financial Engineering
• Derivative Securities
• Advances in Technology – i.e. E-business, Fintech
• Deregulation
• Corporate Governance Reform
• Hedge Funds
• Shareholder Activisms

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 Summary
• You should know:
– The primary goal of the firm
– What an agency relationship and agency cost are
– What ethical investing is
– The role of financial markets

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