Course Information

• Course: Corporate Finance

• Instructor: Ziwei Wang (zwang.econ@foxmail.com)
• Lecture time: Wednesdays 9:50am—12:15pm
• O ce hours: Wednesdays 2:00pm—4:00pm @ C260 EMS
Please let me know before you drop by.

• TA: Zicong Ou (欧⼦聪, 623429366@qq.com)

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Textbooks
• Jonathan Berk and Peter DeMarzo, Corporate Finance, 5th edition, Pearson.
• Richard Brealey, Stewart Myers, and Franklin Allen, Principles of Corporate
Finance, 13th edition, McGraw-Hill.

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Grading
• Homework assignments (bi-weekly): 15%
Late submissions will not be accepted.

• Report: 15%
I need you all to help me decide.

• Midterm exam (around week 9): 30%

• Final exam (date TBD): 40%

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Format of the Report
• Option 1: Case study. Students divide into groups (6—7 each), study a case
related to our course material, and give a 20-minute presentation in class.

• Cases from last year: 瑞幸咖啡财务造假案，SKP⼊股武汉万达汉街项⽬案，

Bernard Mado 的庞⽒骗局案，1995—2001互联⽹泡沫, and etc.

• Option 2: Book review. Students divide into small groups (4 each), read a
book related to our course material, and write a 10-page book review.

• Potential choices: Irrational Exuberance, Animal Spirits, Phishing for Phools,

and etc.

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Course Contents: Part I
• Chapter 1: The corporation and nancial markets
What is a corporation?

• Chapter 3: Financial Decision making and the law of one price

If equivalent investment opportunities trade simultaneously in di erent
competitive markets, then they must trade for the same price in all markets.

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 Course Contents: Part II
• Chapter 4: The time value of money
One dollar today is worth more than one dollar tomorrow.

• Chapter 5: Interest rates

Di erent ways to quote interest rates and the determinants of them.

• Chapter 6: Valuing bonds

The simplest nancial instrument — How to price them?

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Course Contents: Part III
• Chapter 7: Investment decision rules
How to decide whether you should invest in a project (given its cash ow).

• Chapter 8: Fundamentals of capital budgeting

How to determine the free cash ow of a project?

• Chapter 9: Valuing stocks

How to estimate the value of a rm’s equity?

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Course Contents: Part IV
• Chapter 10: Capital markets and the pricing of risk
Common risk and independent risk are di erent.

• Chapter 11: Optimal portfolio choice and CAPM

What should be the market return on a stock?

• Chapter 12: Estimating the cost of capital

Use CAPM to compute the cost of capital we need in investment decisions.

• Chapter 13: Investor behavior and capital market ine ciency

CAPM assumes that all investors are rational — In reality, they’re not.

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Course Contents: Part V
• Chapter 14: Capital structure in a perfect market
Capital structure does not matter in a perfect market.

• Chapter 15: Debt and taxes

Debt has a tax bene t.

• Chapter 16: Financial distress, managerial incentives, and information

Too much debt is dangerous — “Tradeo theory.”

• Chapter 17: Payout policy

How should a rm pay back to shareholders.

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Chapter 1
The Corporation and
Financial Markets
Ziwei Wang
Wuhan University
Dartmouth College v. Woodward (1819)
• Dartmouth College was incorporated
in 1769 as a private educational
institution governed by a self-
perpetuating board of trustees.

• In 1816 the state legislature e ectively

took control of Dartmouth due to
political reason.

• Dartmouth sued for its independence

and the case made it to the Supreme
Court under Chief Justice John
Marshall in 1818.

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Dartmouth College v. Woodward (1819)
• The court struck down the New Hampshire law,
ruling that a corporation was a “contract” and that
“the state legislatures were forbidden to pass any
law impairing the obligation of contracts.”

• Chief Justice John Marshall wrote that by

establishing a corporation, Eleazar Wheelock had
created “an arti cial being, invisible, intangible,
and existing only in contemplation of the law.”

• He explained that “by these means, a perpetual

succession of individuals are capable of acting for
the promotion of the particular object, like one
immortal being.”

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Dartmouth College v. Woodward (1819)
• The precedent was set: Owners of businesses could incorporate and still
enjoy the protection of private property, as well as protection from seizure,
both guaranteed by the U.S. Constitution.

• The modern business corporation was born.

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Four Types of Firms
• Sole proprietorship 独资企业
• Partnerships 合伙企业
• Limited liability companies (LLC) 有限责任公司
• Corporations 公司

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Four Types of Firms

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 Sole Proprietorship
• A sole proprietorship is a business owned and run by one person.
• The principal limitation of a sole proprietorship is that there is no separation
between the rm and the owner—the rm can have only one owner.

• The owner has unlimited personal liability for any of the rm’s debts.
• The life of a sole proprietorship is limited to the life of the owner. It is also
di cult to transfer ownership of a sole proprietorship.

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 Partnerships
• A partnership is identical to a sole proprietorship
except it has more than one owner.

• All partners are liable for the rm’s debt. That is,
a lender can require any partner to repay all the
rm’s outstanding debts.

• The partnership ends on the death or withdrawal

of any single partner.

• A limited partnership is a partnership with two

kinds of owners, general partners and limited
partners.

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Limited Liability Companies
• A limited liability company (LLC) is a limited partnership without a general
partner.

• All the owners have limited liability, but unlike limited partners, they can also
run the business.

• The owners own the assets of the business because of the investments they
have made.

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 Corporations
• “Corp” traces back to the Latin word corpus, which means “body.”
• The distinguishing feature of a corporation is that it is a legally de ned,
arti cial being (a judicial person or legal entity), separate from its owners.

• It can enter into contracts, acquire assets, and incur obligations.

• The entire ownership stake of a corporation is divided into shares known as
stock. The collection of all the outstanding shares of a corporation is known
as the equity of the corporation.

• An owner of a share of stock in the corporation is known as a shareholder,

stockholder, or equity holder and is entitled to dividend payments.

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Corporations
• 中华⼈⺠共和国公司法（2018年修订）第⼀章第三条
• 公司是企业法⼈，有独⽴的法⼈财产，享有法⼈财产权。公司以其全部财产对
公司的债务承担责任。
有限责任公司的股东以其认缴的出资额为限对公司承担责任；股份有限公司的
股东以其认购的股份为限对公司承担责任。

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 Tax Implications for Corporate Entities
• Because a corporation is a separate legal entity, a corporation’s pro ts are
subject to taxation separate from its owners’ tax obligations.

• In e ect, shareholders of a corporation pay taxes twice.

• First, the corporation pays tax on its pro ts, and then when the remaining
pro ts are distributed to the shareholders, the shareholders pay their own
personal income tax on this income.

• This system is sometimes referred to as double taxation.

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Tax Implications for Corporate Entities
Problem (Example 1.1 in textbook)

You are a shareholder in a corporation. The corporation earns $8 per share

before taxes. After it has paid taxes, it will distribute the rest of its earnings to
you as a dividend. The dividend is income to you, so you will then pay taxes on
these earnings. The corporate tax rate is 25% and your tax rate on dividend
income is 20%. How much of the earnings remains after all taxes are paid?

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The Corporate Management Team
• In a corporation, direct control and ownership are often separate.
• Rather than the owners, the board of directors and chief executive o cer

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possess direct control of the corporation.

• The board of directors is a group of people who have the ultimate decision-
making authority in the corporation. They are elected by shareholders.

• The chief executive o cer (CEO) is charged with running the corporation day-
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to-day by instituting the rules and policies set by the board of directors.

• The most senior nancial manager is the chief nancial o cer (CFO), who
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often reports directly to the CEO.

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The Corporate Management Team

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 Investment Decisions
• The nancial manager’s most important job is to make the rm’s investment
decisions.

• Investments can involve the purchase of tangible assets—assets that you can
touch and kick. A company can also invest in intangible assets, such as
research and development (R&D), advertising, and computer software.

• These investment decisions fundamentally shape what the rm does and

whether it will add value for its owners.

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Investment Decisions
• According to a senior Apple executive, the
company likely spent over $150 million to
develop the original iPhone.

• Many top engineers in the company were being

sucked into the project, forcing slowdowns in the
timetables of other work.

• If the iPhone were a dud, it put the whole

company at risk because this is the only thing it
was really working on.

• But iPhone changed the world.

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Investment Decisions
• Autonomy was acquired by Hewlett-Packard (HP) in
October 2011. HP paid $11.1 billion for Autonomy.

• Within a year, HP had written o $8.8 billion of

Autonomy's value. HP claimed this resulted from
"serious accounting improprieties" and "outright
misrepresentations" by the previous management.

• The former CEO, Mike Lynch, alleged that the

problems were due to HP's running of Autonomy.

• The acquisition was a disastrous investment, and

HP’s CEO was red in short order.

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 Financing Decisions
• Once the nancial manager has decided which investments to make, he or
she also decides how to pay for them.

• Large investments may require the corporation to raise additional money.

• The nancial manager must decide whether to raise more money from new
and existing owners by selling more shares of stock (equity) or to borrow the
money (debt).

• This choice between debt and equity nancing is called the capital structure
decision.

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Financing Decisions
• In some ways, nancing decisions are less important
than investment decisions.

• As of today (Sep 13, 2023), Microsoft is traded at

$333.09 per share, with a market cap of $2.47 trillion.

• This value came from Microsoft’s product

development, from its brand name and worldwide
customer base, from its research and development,
and from its ability to make pro table future
investments.

• Microsoft’s nancing strategy is very simple: It carries

no debt to speak of and nances almost all
investment by retaining and reinvesting cash ow.

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Financing Decisions

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Financing Decisions

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 The Goal of the Firm
• Many corporations have thousands of owners (shareholders). Each owner is
likely to have di erent interests and priorities.

• They may have di erent attitudes towards risks or desire di erent time pattern
of consumption.

• How then can the nancial manager help the rm’s stockholders? There is
only one way: by increasing their wealth. That means increasing the market
value of the rm and the current price of its shares.

• “Pro t maximization” is not a well-de ned nancial objective.

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 Agency Problems
• Owners would like to maximize the value of the rm.
• Managers have little incentive to work in the interests of the shareholders
when this means working against their own self-interest.

• Economists call this an agency problem—when managers, despite being

hired as the agents of shareholders, put their own self-interest ahead of the
interests of shareholders.

• Insu cient e ort / extravagant investment / entrenchment strategies.

• This is also called the principal-agent problem. It is common in real life.

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Agency Problems
• L. Dennis Kozlowski, the former chief
executive of Tyco International Ltd., threw a
week-long birthday party for his wife.

• It was an extravagant, Roman Empire-

theme event on the Italian island of Sardinia.

• The party cost $2 million, and Tyco picked

up half of the tab for the event, which took
place at the same place as a Tyco meeting.

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Agency Problems
• The board can alleviate the agency problem by providing monetary incentives
that align the objectives of the two parties.

• For example, compensation of top managers can be linked to the

corporation’s pro ts or perhaps to its stock price.

• There are also some implicit incentives: possibility of being red, a takeover,
or a bankruptcy.

• Shareholders can engage in active monitoring.

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The CEO’s Performance
• If shareholders are unhappy with a CEO’s performance, they could, in
principle, pressure the board to oust the CEO.

• Disney’s Michael Eisner, Hewlett Packard’s Carly Fiorina, and Barclay’s

Antony Jenkins were all reportedly forced to resign by their boards.

• Despite these high-pro le examples, directors and top executives are rarely
replaced through a grassroots shareholder uprising.

• Instead, dissatis ed investors often choose to sell their shares. Stock price
drops and corporate leaders learns that investors are unhappy.

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The CEO’s Performance
• In some corporations, however, the senior executives are entrenched because
boards of directors do not have the will to replace them.

• In that case, the expectation of continued poor performance will decrease the
stock price.

• A hostile takeover can happen, where an individual or organization—

sometimes known as a corporate raider—can purchase a large fraction of the
stock and acquire enough votes to replace the board of directors and the
CEO.

• Consequently, when a corporation’s shares are publicly traded, a “market for

corporate control” is created that encourages managers and boards of
directors to act in the interests of their shareholders.

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 An (Unsuccessful) Hostile Takeover
• Microsoft o ers $44.6 billion to acquire Yahoo! in 2008.
• Yahoo! was seen as something of a basket case at the time, continuously
shedding workers, issuing pro t warnings, and generally showing an inability
to o er any answer to Google’s domination of internet search.

• Yahoo formally rejected the bid, claiming that it “substantially undervalues”

the company and was not in the interest of its shareholders.

• The company was subsequently sued by its shareholders for neglecting their
duciary responsibility to shareholders.

• Three years later Yahoo had a market capitalization of $22.24 billion.

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Corporate Bankruptcy
• When a corporation borrows money, the holders of the rm’s debt also become
investors in the corporation.

• If the corporation fails to repay its debts, the debt holders are entitled to seize
the assets of the corporation in compensation for the default.

• To prevent such a seizure, the rm may attempt to renegotiate with the debt
holders, or le for bankruptcy protection in a federal court.

• Ultimately, however, if the rm is unable to repay or renegotiate with the debt

holders, the control of the corporation’s assets will be transferred to them.

• Thus, when a rm fails to repay its debts, the end result is a change in
ownership of the rm, with control passing from equity holders to debt holders.

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 Corporate Bankruptcy
• Bankruptcy need not result in a liquidation of the rm.
• Even if control of the rm passes to the debt holders, it is in the debt holders’
interest to run the rm in the most pro table way possible.

• Airline companies such as United Airlines, US Airways, Air Canada, Delta

Airlines have been moving in and out of bankruptcy since 2002.

• In November 2011, American Airlines became the latest airline to declare

bankruptcy.

• It continued to operate while it cut costs and reorganized, returning to

pro tability in mid-2012. American ultimately settled with creditors in
December 2013 as part of a merger agreement with US Airways.

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The Stock Market
• Shares of public companies are traded on organized markets called a stock
market (or stock exchange).

• These markets provide liquidity and determine a market price for the
company’s shares.

• This liquidity is attractive to outside investors, as it provides exibility

regarding the timing and duration of their investment in the rm.

• In addition, the research and trading of participants in these markets give rise
to share prices that provide constant feedback to managers regarding
investors’ views of their decisions.

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The Stock Market

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Primary and Secondary Stock Markets
• When a corporation itself issues new shares of stock and sells them to
investors, it does so on the primary market.

• After this initial transaction between the corporation and investors, the shares
continue to trade in a secondary market between investors without the
involvement of the corporation.

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 Traditional Trading Venues
• A rm needs to choose one stock exchange to be listed.
• In the U.S., the two most important exchanges are NYSE and Nasdaq.
• Prior to 2005, almost all trade on the NYSE took place on the exchange’s
trading oor in lower Manhattan.

• Market makers posted two prices for every stock in which they made a
market: the price at which they were willing to buy the stock (the bid price)
and the price at which they were willing to sell the stock (the ask price).

• They provided liquidity by ensuring that market participants always had

somebody to trade with.

• The bid-ask spread is the pro t to the market makers.

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Traditional Trading Venues
• Nasdaq was founded in 1971. It never had a trading oor.
• All trades were completed over the phone or on a computer network.
• On the NYSE, each stock had only one market maker, while on the Nasdaq,
stocks had multiple market makers (an average of 14 market makers per
stock) who competed with one another.

• For decades, the NYSE didn’t allow small, new companies to list. As a result,
NASDAQ was a place where newer companies could list their IPOs.

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New Competition and Market Changes

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New Competition and Market Changes
• In 2005, the NYSE and Nasdaq exchanges accounted for over 75% of all
trade in U.S. stocks.

• Since that time, competition from new, fully electronic exchanges and
alternative trading systems has caused their market share to decline.

• Today, these new entrants handle more than 50% of all trades.
• The role of an o cial market maker has largely disappeared.

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New Competition and Market Changes
• Anyone can make a market in a stock by posting a limit order—an order to
buy or sell a set amount at a xed price.

• For example, a limit buy order might be an order to buy 100 shares of IBM at
a price of $138/share.

• The bid-ask spread of a stock is determined by the outstanding limit orders.

• The limit sell order with the lowest price is the ask price. The limit buy order
with the highest price is the bid price.

• Traders who post limit orders provide the market with liquidity.

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New Competition and Market Changes

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New Competition and Market Changes
• Traders who place market orders—orders that trade immediately at the best
outstanding limit order—are said to be “takers” of liquidity.

• Providers of liquidity earn the bid-ask spread, but in so doing they risk the
possibility of their orders becoming stale: When news about a stock arrives
that causes the price of that stock to move, smart traders will quickly take
advantage of the existing limit orders by executing trades at the old prices.

• So-called high frequency traders (HFTs) are a class of traders who, with the
aid of computers, will place, update, cancel, and execute trades many times
per second in response to new information as well as other orders, pro ting
both by providing liquidity and by taking advantage of stale limit orders.

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