© Subhankar Nayak, 2022
EC623/MF703:
Financial Economics
(Seminar in Corporate Finance)
WINTER 2022
© Subhankar Nayak, 2022
1: CORPORATIONS –
STRUCTURE, DYNAMICS AND
DECISION ISSUES
Corporations as special business entities; structural
model of corporations; dynamics arising thereof &
decision issues of corporate executives
© Subhankar Nayak, 2022
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Forms of Business Entities
1. Sole Proprietorship or Family Firm
◼ owned by a single person or family
◼ 100% control, lower taxes
◼ but unlimited liability, limited capital, high mortality
2. Partnership
◼ high control, more capital, lower risk, expertise sharing
◼ but unlimited liability
3. Corporation
◼ limited liability, access to lot more capital
◼ but higher taxes (double taxation), disclosure and regulation
requirements, loss of control, conflict issues
© Subhankar Nayak, 2022
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Comparisons
Characteristic Sole
Proprietorship
Partnership Corporation
Ownership Sole owner Multiple owners Unlimited ownership
Legal requirements and
regulation
Few; entity easily
formed
Few; entity easily
formed
Numerous legal
requirements
Legal distinction
between owner and
business
None None Legal separation
between owners
and business
Liability Unlimited Unlimited but
shared among
partners
Limited
Ability to raise capital Very limited Limited Nearly unlimited
Transferability of
ownership
Non-transferable
(except by sale of
entire business)
Non-transferable Easily transferable
Owner expertise in
business
Essential Essential Unnecessary
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Overview
 Design of corporations & underlying dynamics
 Foundation for all topics in this course
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Demand-Supply Model of Finance
 Corporations: constitute demand side→ need capital to
undertake projects so as to grow
 Market (consisting of investors): constitute supply side→
retain surplus disposable capital (after paying taxes & meeting
consumption needs) → willing to provide capital in order to
grow wealth
Surplus of wealth
 supply money
Need money for projects etc.
 demand money
Corporations
(Net Borrowers)
Market
(Investors)
Invest Cash
(buy stocks & bonds)
Interest &
Dividends
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Investors: Debtholders
 One type of investors or claimants or
stakeholders in a corporation
 Primary Claimants
 Low risk, low returns form of investors
 Third party lenders, no ownership stake
 Guaranteed payoffs on a fixed schedule
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Investors: Equityholders
 Another type of investors or claimants or
stakeholders in a corporation
 Residual Claimants
 Higher risk, higher returns form of investors
 Ownership Stake: Shareholders own the
company
 Flexible & discretionary payoffs
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Fundamental Issue 1
1. Why do investors invest (provide capital to corporations)?
 Because expect (their) capital to grow (to reflect risk & time
commitment)
 Expected (Interests + Dividends) > Cash investments
 Concept of Asset Pricing
Surplus of wealth
 supply money
Need money for projects etc.
 demand money
Corporations
(Net Borrowers)
Market
(Investors)
Invest Cash
(buy stocks & bonds)
Interest &
Dividends
© Subhankar Nayak, 2022
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Fundamental Issue 2 (1st Part)
2. How do investors know how much to pay (for stocks/bonds)?
 Requirements:
a) investors possess all pertinent info at low cost
b) prices are “fair”
 Concept of Market Efficiency
Surplus of wealth
 supply money
Need money for projects etc.
 demand money
Corporations
(Net Borrowers)
Market
(Investors)
Invest Cash
(buy stocks & bonds)
Interest &
Dividends
© Subhankar Nayak, 2022
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Fundamental Issue 2 (2nd Part)
2. How do investors know how much to pay (for stocks/bonds)?
 Requirements:
c) investors know how much the corporation is worth
 Concept of Corporate Valuation
Surplus of wealth
 supply money
Need money for projects etc.
 demand money
Corporations
(Net Borrowers)
Market
(Investors)
Invest Cash
(buy stocks & bonds)
Interest &
Dividends
© Subhankar Nayak, 2022
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Fundamental Issue 3
3. How do shareholders take charge?
 Shareholders own the corporations
 But a public company has too many shareholders to run the
corporation on their own behalf
 Concepts of (a) Separation of Ownership & Control
+ (b) Delegation of Authority
Surplus of wealth
 supply money
Need money for projects etc.
 demand money
Corporations
(Net Borrowers)
Market
(Investors)
Invest Cash
(buy stocks & bonds)
Interest &
Dividends
© Subhankar Nayak, 2022
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Separation of Ownership &
Delegation of Authority
Shareholders
Board of
Directors
Corporate
Management
Team(actual owners;
but too numerous to
run the firm)
(2-15 member
boards headed by
a Chairman; may not
be independent)
(CEO + CFO + COO
+ other
management)
SHAREHOLDER
VOTING
NOMINATION
Apple Inc.
Shares authorized = 50.40 billion
Shares outstanding = 16.41 billion
Float = 16.39 billion
% insider ownership = 0.07%
% institutional ownership = 58.70%
% retail ownership = 41.23%
Apple BoD
• 9 members
• 1 insider (CEO), 8 independent
• Chairman: independent
• All committees: independent
• Efficient governance
Apple Inc.
17 member
executive team
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Separation of Ownership &
Delegation of Authority
1. Separation of ownership & control:
◼ Shareholders → are owners; management → retain control
2. Delegation of authority: from left to right, i.e., from
shareholders to management
 Fundamental philosophy of corporate existence:
1. Protection of shareholder interests
2. Maximization of shareholder value
Shareholders
Board of
Directors
Corporate
Management
Team
SHAREHOLDER
VOTING
NOMINATION
© Subhankar Nayak, 2022
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Fundamental Issue 4
4. What if the managers violate the fundamental philosophy?
 Managers have information asymmetry, greater power & self-
interests different from investors Management may try to
benefit itself at the cost of investors
 Concepts of Information Asymmetry & Agency Problems
Surplus of wealth
 supply money
Need money for projects etc.
 demand money
Corporations
(Net Borrowers)
Market
(Investors)
Invest Cash
(buy stocks & bonds)
Interest &
Dividends
© Subhankar Nayak, 2022
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Fundamental Issue 5
5. How do investors/market mitigate agency problems, i.e., ensure
proper usage of invested capital by corporate managers?
 Through effective monitoring & incentivization
 Concepts of
A. Suitable contract design
B. Effective performance measurement & incentive design
Surplus of wealth
 supply money
Need money for projects etc.
 demand money
Corporations
(Net Borrowers)
Market
(Investors)
Invest Cash
(buy stocks & bonds)
Interest &
Dividends
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Mitigating Agency Problems – I
Debtholders
1. Design Indentures
2. Impose detailed Debt Covenants
3. Use Trustees
4. Possess power to initiate Bankruptcy if
indentures/covenants violated
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Mitigating Agency Problems – II
Equityholders
1. Proper performance measurement
➢ measure and monitor performance of
management to ensure whether managerial actions
are optimal & aligned with shareholder interests
2. Efficient incentive design and structuring of
executive compensation
➢ design incentive and structure compensation for
management such that they are suitably motivated
& managerial actions become aligned with
shareholder interests
© Subhankar Nayak, 2022
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Decisions By Corporate Managers
1. Investment Decisions: what projects to undertake to make the corporation
“grow” → Capital Budgeting
2. Financing Decisions: in what form to raise capital (for projects) & how to
compete in the marketplace for scarce capital → Capital Structure &
Raising Capital
3. Payout Decisions: How to “pay back” (compensate) investors (for capital
borrowed) → Payout Policy
4. Restructuring Decisions: how to redesign the corporation for enhanced
efficiency & value → Corporate Restructuring
 Additional responsibilities of corporate managers to assuage information
asymmetry & agency problems :
A. Signalling: to convey “credible” info about quality & responsibility
B. Corporate Governance: suitable design of corporation, its culture,
mechanisms & all relationships