Session 1 Introduction

30017 Corporate Finance

Lecture Slides, Academic Year 2021/2022
Session 1: Introduction
Hannes Wagner

1
This version: 18-Jan-22
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Class logistics

12:10pmWelcome and introduction

12:30pmGoals of this course
12:45pmHow to think about investment and financing decisions?
12:50pmWhat is a corporation?
01:00pmThe financial manager - Dealing with uncertainty and ambiguity
01:20pmMaximizing shareholder value, ethical disputes, agency problems
01:30pmWrap-up and Q&A after class
01:40pmSession ends

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Introduction

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Getting in touch

• We chat on Teams
› Team for this class: CF 30017 "Business Class" 21
› No invitation? Send me a chat message
• We meet
› https://hanneswagner.as.me
• Email: If we manage to not use it, we will all be happier

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Course assessment

• 30% Final exam

› Probably online, closed book
• 20% Case write-ups (2 write-ups)
› Group grades, you choose your own groups
• 50% Quizzes
› Mostly take-homes

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How to think about the Quizzes

• The quizzes start easy and get harder over time

• They are designed to make you study continuously
› You like this because… you know this is good for you
› You dislike this because… uhm, human
• They will sometimes have material from the book that we do not cover in class
• They will sometimes have material that neither the book nor the class covers
• Aim for a high score each time—but aiming for a perfect score each quiz is
unlikely to be an efficient use of your time
› “Overcome the need for perfection. Try to decrease your need to be right all the time”.

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Feedback on teaching evaluation results + benchmark distribution

of grades
1) last edition: Top 5% of all compulsory
courses

2) Outperformance on virtually all dimensions

• Slight underperformance on a single

dimension
› Can you guess which one?

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Goals of this Course

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Goals of this course

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Roadmap for the course

Investments Instruments Risk and return Capital structure Technique

Real firms [2] Risk and return Payout policy

[9,10,11] [15]
Fixed Practice
CASE: Unidentified income CASE: Ameritrade problems [8]
industries [3] instruments [5] Market events [17]
[12]
NPV & investment Equity Practice
decisions [4] instruments Leverage problems [16]
[ 6] Risk and COC [18,19,20]
[13,14]
Practice
CASE: Ocean Financing and problems [21]
Carriers [7] valuation [22]

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How to think about investment and financing decisions?

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Corporate Investment and Financing Decisions

• Investment decision
› Purchase of real assets [i.e. assets used to produce goods and services]
• Financing decision
› Sale of financial assets [i.e. financial claims to the income generated by the firm’s real assets]
• Capital structure
› Choice between debt and equity financing

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Corporate Investment and Financing Decisions

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What is a corporation?

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What is a Corporation?

• Corporation
› A business organized as a separate legal entity owned by stockholders
› Key concepts: corporation is a legal person, limited liability, board of directors, private vs
public, separation of ownership and control, corporate taxation
› Yes, ok, fine…
• We focus on corporations since their corporate finance issues are complex and
interesting
› In comparison, the financial decisions of a restaurant are not complex, and less interesting
› Firms that are not corporations—typically smaller firms—are likely sole proprietorships or
partnerships. We focus on those less.

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What is a Corporation? Here is a more difficult setting

Q: What is it specifically that you own if you buy 1,000 shares of Snap Inc stock?
Note that…
› Snap’s public shares were issued somewhat controversially non-voting
› you are entitled to 1,000/1,258,171,112 of any dividends Snap pays, but Snap pays no
dividends, is under no obligation to pay any dividends, and has stated that it does not
“anticipate paying any cash dividends in the foreseeable future”
› you are entitled to 1,000/1,258,171,112 of whatever is left after paying off all debt in case the
firm is liquidated – but that seems unlikely
› You are entitled to 1,000/1,258,171,112 of the proceeds if Snap is sold to another firm – but
that seems unlikely, and shareholders also cannot force a sale
What is the answer?

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The financial manager -

Dealing with uncertainty and ambiguity

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The (financial) manager - dealing with uncertainty and ambiguity

• Let’s make it very specific: It’s April 30, 1997, 7pm. Joy Covey, chief financial officer of online
bookseller Amazon.com is settling into her airline seat and opens the day’s Financial Times. One
headline catches her eye, it reads “Investors Skeptical on Internet Flotations”.
• She and Jeff Bezos, Amazon.com’s founder and CEO have just completed the European leg of
Amazon.com’s road show. During the past 3 days, they have presented the company’s investment
story to dozens of European institutional investors interested in the firm’s pending initial public
offering.
• Covey and Bezos have fielded many difficult questions about the company’s aggressive spending
plans and sustained losses, but investors have seemed to understand the company’s long-term
investment strategy. They also have been willing to accept Covey’s reluctance to disclose key
operating metrics that she and Bezos feel are strategically sensitive.
• They are returning to San Francisco to attend Hambrecht & Quist’s Technology Investor
Conference the next day. There, they will meet scores of tech investors and analysts. After the
conference, they will launch the domestic leg of Amazon.com’s road show, during which they will
make 48 presentations in 20 US cities in 16 days.
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Uncertainty vs Ambiguity

• By nature, uncertainty is not well defined. Uncertainty captures different notions and describes
different economic implications, e.g. “uncertainty from flip of a fair coin”; “uncertainty from lack of
knowledge about 1,000th digit of π”; “uncertainty inherent in Eurozone GDP forecast”.
• Among the different forms of uncertainty, ambiguity, is the most ill-defined
• Ambiguity as a type of uncertainty goes back to Daniel Ellsberg 1961 (and PhD thesis in economics from
Harvard in 1962):
“the nature of one’s information concerning the relative likelihood of events… a quality
depending on the amount, type, reliability, and ‘unanimity’ of information, and giving rise
to one’s degree of ‘confidence’ in an estimation of relative likelihoods” (1961, p. 657)

• Ellsberg suggested two thought-experiment decisions problems, which remain the motivating factors
of research on ambiguity and ambiguity aversion;
• Most frequently cited is the Ellsberg Paradox – tests show that individuals broadly prefer known
probabilities to unknown probabilities; a preference for known-probability over ambiguous bets is
referred to as ambiguity aversion.
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Dealing with ambiguity – a key managerial skill

• The Amazon setting illustrates ambiguity of a (financial) manager and how to

deal with it.
• Being able to deal with ambiguity is a key skill for you to develop.
• We will practice this skill throughout the course
› Dealing with ambiguity tends to be an unpleasant sensation
› How unpleasant? Use the next slides to start your self-assessment

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Intuition: Levels of uncertainty

• Information is obtained from trends, multiple data sources, analyses, etc. Factors that are currently unknown can
frequently be knowable. Uncertainty that remains after the best possible analysis is residual uncertainty. This residual
uncertainty can come in different levels:
• Level one: “Clear future”
› A single forecast can be developed that is sufficiently precise for decision making
› Examples: Baseline forecast of the future you make in the Ocean Carriers case study
• Level two: “Alternative futures”
› The future can be described by a few discrete scenarios. Analysis cannot identify the specific scenario, but it can establish
probabilities.
› Examples: Pending legislation, strategies chosen by competitors, ECB/Fed stress testing of banks, climate change scenario analysis of
Chevron. Extensions of Ocean Carriers baseline? Ameritrade analysis? Corporate Finance exam
• Level three: “A range of futures”
› Key variables influence the outcome, that lies within a range, with no natural discrete scenarios. Some or all strategic choices differ
from the choices made if the outcome were predictable
› Examples: Market entry in a new country, future asset prices, technology cost estimates, global warming. Applications for internships.
• Level four: “True ambiguity”
› Uncertainty itself is unknown, the range of potential outcomes and their probabilities cannot be predicted, it may even be impossible
to identify or predict all variables that determine outcomes; over time Level four tends to migrate to a lower level
› Examples: Fintech, country defaults, political assassinations, Brexit, self-driving cars, 2008 financial crisis. Your career path.
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Dealing with ambiguity

What is the skill?

“Can effectively cope with change; can shift gears comfortably; can decide and act without having the
total picture; can comfortably handle risk and uncertainty.” (Microsoft Education)
Level 1: Basic Level 2: Intermediate Level 3: Advanced Level 4: Expert
Copes with change and shifts Effectively copes with change Anticipates impact of change; Anticipates impact of change,
gears when necessary and shifts gears comfortably plans how to shift gears and directs self and others in
smoothly shifting gears

Suggests a plan of action Decides and acts without Uses ingenuity to compensate Uses ingenuity in dealing with
without having the total having the total picture without having the total ambiguous situations, and
picture picture guides others to cope
effectively

Tolerates risk and uncertainty Handles risk and uncertainty Rises to the challenge, Thrives on situations
comfortably accepting risk and involving risk and uncertainty
uncertainly as normal

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Self-development: Essential questions
To improve your skills, ask yourself these
questions on a regular basis:
1. What decision must I make to minimize
risk in spite of not having all the
information?
2. What new project can I undertake today,
even though I have other things in the
works?
3. How can I prepare others right now for
the impact of an anticipated change?
4. What disjointed task or project can I
organize?
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Introduction
5. Is there someone with whom I must
“clear the air” or make amends?
6. What big task can I break down into
smaller tasks to facilitate its completion?
To avoid overdoing dealing with ambiguity,
ask yourself:
1. Am I making decisions too quickly
without a reasonable amount of data?
2. Am I trying to reinvent the wheel rather
than using what I know?
3. Am I overanalyzing a problem?
© Hannes Wagner
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Self-development: Remedies
Learning on your own: These self-development remedies will help you
build your skill(s).
• Try incrementalism: Make a series of small decisions, get instant
feedback, make course corrections, get more data, and move
forward. Repeat the process until the bigger problem is in hand.
Do small things quickly, and be willing to take a little heat if the
decision needs to be modified.
• Overcome the need for perfection: Try to decrease the need to be
right all the time. Worry less about what people will say. Spend
less time waiting for the perfect solution or gathering all the data
to make the perfect decision in order to avoid criticism. Reach a
balance between thinking and taking action.
• Become more comfortable being a pioneer: Explore new ground;
go places and do things about which you have little knowledge.
• Organize: Set tight priorities and focus on them. Be disciplined
and don’t get bogged down in trivia.
• Define the problem: Ask questions and determine the causes of
the problem before attempting to craft solutions.
• Visualize the problem: Put complex processes and problems in a
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visual format, such as a storyboard or a flow chart. Make a list of
pros and cons.
• Develop a philosophical stance toward failure or criticism:
Increase your ability to learn from your mistakes by designing
immediate feedback loops. Learn from mistakes and move on.
• Deflate stress: Analyze what makes you anxious, and short-circuit
the process before it takes hold. Drop the issue for a short while if
you get emotional.
• Embrace change: Be willing to let go of one way of doing things
to try something new. Invite new ideas, and experiment until you
are comfortable with change.
• Move on to new projects without having finished others: Allow
yourself to feel good about fixing mistakes and moving on, rather
than being motivated solely by finishing everything you start.
© Hannes Wagner
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Maximizing shareholder value, ethical disputes, agency problems

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The Financial Goal of the Corporation
• Shareholders want three things
› To maximize current wealth
› To transform wealth into
most desirable time pattern
of consumption
› To manage risk
characteristics of chosen
consumption plan
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• So, shareholders desire wealth
maximization…
• …but managers have many constituencies,
“stakeholders”
• “Agency problems” represent the conflict
of interest between management and
owners
• We will for the purpose of this course
usually, but not always, take the
perspective of shareholders
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Who actually gets to tell executives and directors what to do?

There are (roughly) three basic models of who gets to tell executives and directors what to do:
1. The “shareholder primacy” model [mostly our viewpoint in this course]
› It says that directors (and executives) are answerable to the shareholders. Here, the shareholders are
more or less the owners of the firm. They vote to elect directors and are therefore the bosses. Directors
should try to make shareholders happy. This is a very standard and popular model that intuitively fits a
lot of basic facts of corporate life.
2. The “director primacy” model
› It says that executives are answerable to the board of directors, and the directors are answerable to
themselves. The corporation is its own thing, and the directors are the only people who speak for that
thing, and they have to put the interests of the corporation as they conceive them ahead of the demands
of anyone else, even shareholders. This model sound very weird to a lot of people when put so bluntly,
but it actually has some strong support in law and practice.
3. The “stakeholder capitalism” model
› It says that directors and executives are answerable to shareholders, and customers, and employees,
and society, and so forth, in various hard-to-reconcile ways.
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What do you believe? It is okay if we disagree on this—as long as we

agree on our calculations.

• You can, and people do, believe in any of these three models. But they obviously have different
implications. You can tell what people believe in by observing what they want.
• If you believe in shareholder primacy, you will want
› More disclosure, more (or at least equal) voting rights, things like “proxy access”, majority election rules
for board members – and so on! In short, you will want shareholders to have more control of companies.
• If you believe in director primacy, you will want
› Limits on activist shareholders, poison pills, staggered boards – and so on! In short, you will want to
reduce direct shareholder democracy and give more power to boards.
• If you believe in stakeholder capitalism, you will want
› Various things. This is a distinctly minority view in US corporate governance and stakeholders are highly
diverse and more vague than the other categories, so there is no single unified list of what you will want
(one obvious candidate is you want worker representation on the board). Overall, you will however want
to reduce shareholder democracy and to reduce director power.

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Agency Problems and Agency Costs

• Agency problem
› Managers are agents for stockholders and are tempted to act in
their own interests rather than maximizing value
• Agency cost
› Value lost from agency problems or from the cost of mitigating
agency problems

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How do we manage those agency conflicts?

Agency conflicts between managers and shareholders lead to agency costs

How can agency costs be mitigated?
1 - Compensation plans
2 - Board of directors
3 - Takeovers
4 - Specialist monitoring
5 – Auditors
Yet, still…

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What did we generate? Next steps

1. Firms/managers face two big decisions: 1) how to invest? 2) how to finance the investments?
2. Shareholders want managers to maximize shareholder value. Managers may not always have the
same goal; in a principal agent setting, shareholders are the principals, managers are the agents,
agency costs arise
3. Our focus is mostly on corporations that are publicly traded, have limited liability, and are
financially sophisticated.
4. Decision making and financial analysis in such organizations involves high levels of ambiguity.
Dealing with ambiguity is a key skill in a modern economy.

NEXT STEPS
Having set the stage with the big picture concepts that we have in the background., we will start
digging into financial data and see how real firms look like in Session 2. Bring your tablet/laptop!

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