FIN 3701
Introduction
National University of Singapore
Reference: RWJJ Chapter 1
Last Update: 11 January 2026
Learning Outcomes
1. Have a broad overview of what will be covered in this module.
2. Understand the agency relationships in a corporation
Lecture: Introduction 2
Corporate Finance Decisions
• Corporate finance decisions – any decision that has financial
implications
• What are the types of fundamental decisions that a financial
manager has to make?
Lecture: Introduction 3
Corporate Finance Decisions
• Three types of corporate finance decisions:
1. Investment decisions.
2. Financing decisions.
3. Capital repayment decisions.
Lecture: Introduction 4
The Balance-Sheet Model of the Firm
The Capital Budgeting/Investment Decision
Current
Liabilities
Current
Assets
Long-Term
Debt
Fixed Assets
1 Tangible Long-term
investments? Shareholders’
2 Intangible Equity
Lecture: Introduction 5
The Balance-Sheet Model of the Firm
The Capital Structure decision
Current
Liabilities
Current
Assets
Long-Term
How are the Debt
investments
Fixed Assets financed?
1 Tangible
Shareholders’
2 Intangible Equity
Lecture: Introduction 6
The Firm and the Financial Markets
Firm Firm issues securities (A) Financial
markets
Invests
Retained
in assets cash flows (F)
(B)
Short-term debt
Current assets Cash flow Dividends and Long-term debt
Fixed assets from firm (C) debt payments (E)
Equity shares
Taxes (D)
Ultimately, the The cash flows from the
firm must be a Government
firm must exceed the
cash generating cash flows from the
activity. Lecture: Introduction financial markets. 7
Components of Capital Structure and Total
Firm Value
• Two main components of capital structure:
- Debt is a promise by the borrowing firm to repay a fixed dollar amount by
a certain date.
- Equity holders (shareholders) can claim the residual value of a firm that
remains after the debtholders are paid.
• Priority of claim: debtholders > shareholders.
- If the value of the firm is less than the amount promised to the
debtholders, the shareholders get nothing,
but are not required to contribute additional funds to cover the shortfall
(known as limited liability).
Lecture: Introduction 8
Debt and Equity as Contingent Claims
Payoff to Payoff to
debt holders shareholders
If the value of the firm
If the value of the firm is is less than $D, share
more than $D, debt holders get nothing.
holders get a maximum
of $D.
$D
$D
$D
Value of the firm ($X)
Value of the firm ($X)
If the value of the firm is
If the value of the firm is less than
more than $D, shareholders
$D, they get whatever the firm is
get everything above $D.
worth.
Algebraically, the bondholder’s Algebraically, the
claim is: Min[$D,$X] shareholder’s claim is:
Max[0,$X – $D]
Lecture: Introduction 9
Combined Payoffs to Debt and Equity
Combined Payoffs to debt holders
and shareholders If the value of the firm X is less than $D, the
shareholder’s claim is: Max[0,$X – $D] = $0
and the debt holder’s claim is Min[$D,$X] =
$X.
The sum of these is = $X (value of the
Payoff to firm)
$D shareholders
Payoff to debt holders If the value of the firm X is more than $D,
the shareholder’s claim is: Max[0,$X –
$D] = $X – $D and the debt holder’s
$D claim is: Min[$D,$X] = $D.
Value of the firm (X)
The sum of these is = $X (value of the
Debt holders are promised $D. firm)
Lecture: Introduction 10
Does Capital Structure matter for the firm
value?
• The value of the firm can be thought of as a pie.
• The goal of the manager is to increase the size of the pie.
• The Capital Structure decision can be viewed as how best to cut the
pie.
• If how you cut the pie (Capital Structure) affects its size (firm or
project value), then the capital structure decision matters.
S B
Lecture: Introduction 11
Forms of Business Organizations
• Sole proprietorship
• It is a business owned and run by one person.
• There is no separation between the business and the owner.
• The owner is personally liable for all the debts. He has unlimited liability.
• Partnership
• It is like a sole proprietorship but has more than one owner.
• In a general partnership, all partners are liable for the firm’s debt.
• In a limited partnership, there are general partners and limited partners. A limited
partner does not participate in the management of the business. His liability is
limited to the capital provided.
Lecture: Introduction 12
Forms of Business Organizations
• Corporation
• It is a legally defined, artificial being, separate from its owners. The owners are
not liable for any obligation of the corporation. Their liability is limited to the
capital invested.
• Often ownership and control are separate. The firm is managed by the board of
directors (BOD) and the chief executive officer (CEO).
Lecture: Introduction 13
Distinguishing Features
Corporation Partnership
Liquidity Shares can be easily exchanged without Subject to substantial restrictions on
the termination of the corporation. transferability. No
Common stocks can be listed. established market for trading.
Taxation Double taxation: both corporate income Partners pay personal taxes
and dividends are taxable. on partnership profits.
Liability Limited liability. General partners may
have unlimited liability;
limited partners enjoy limited
liability.
Voting Rights Usually, each share gets one vote. General partner is in charge; limited
partners may have some voting
rights.
Lecture: Introduction 14
Corporate Structure - Separation of
Ownership and Control
15
Corporations
• With the separation of ownership and control, managers are
expected to make decisions to maximize shareholder wealth.
• But do they?
Lecture: Introduction 16
Manager vs Shareholder
• Managers might have their own interests, e.g., buying a corporate
jet.
• These interests might be different from those of shareholders
(owners).
• If the manager does not own substantial shares, effectively, other
shareholders pay for the corporate jet.
• This can be especially prevalent in large corporations since the
manager’s share of the firm will be small.
Lecture: Introduction 17
Principal-Agent Relations
• An agency relationship exists whenever a principal hires an agent to
act on their behalf.
- Delegation of decision-making authority.
• Within a corporation, agency relationships exist between.
- Shareholders and managers.
- Shareholders and creditors (we will cover this later).
Lecture: Introduction 18
Agency Problem Example:
RJR Nabisco Perk Consumption
Ross Johnson, CEO of RJR
• In “Barbarians at the Gate,” former WSJ reporters Bryan Burrough
and John Helyar wrote that
• Mr. Johnson and his colleagues crisscrossed the world in 10 corporate
airplanes, sometimes dubbed the RJR Air Force.
• His office at RJR headquarters in Atlanta featured a $51,000 vase, a
$36,000 end table and a $100,000 rug.
Lecture: Introduction 19
Solution 1: Interest Alignment
• At 100% ownership, the
manager is spending everything
out of her own pocket;
• As the outside ownership
becomes larger, the share of the
costs borne by the outside
shareholders becomes larger.
• Especially important in large
corporations since large firms’
managers generally own only a
small percentage of the stock.
Lecture: Introduction 20
Solution 1: Interest Alignment
• What can be a solution for this principal-agent problem?
• A substantial increase in the manager’s share of the company
means transferring a large amount of wealth to the manager,
especially in large corporations, and hence might not be feasible.
• Which one of these compensation plans motivates the manager to
spend less on perks?
Lecture: Introduction 21
Google Compensation Package
Sundar Pichai, CEO
• Using options in the compensation package makes the payoff of
the CEO very sensitive to firm performance.
• Google CEO Pichai is being granted
- a $240 million stock package
- on top of a $2 million annual salary to take effect in 2020.
- The stock package is tied to performance metrics.
• He’s received numerous stock grants over the last decade, including
one for $250 million in 2014 and a pair of grants in the years
afterward totaling $300 million, that have put his net worth close to
$1 billion.
Lecture: Introduction 22
Solution 2: Internal Monitoring
• Shareholders elect BOD;
• BOD have the ultimate
decision-making authority in
the corporation. They have
legal power to
• select and monitor CEO
• make large investment outlays
• declare dividends
• issue securities
• ……
• If the CEO does not run the
corporation in the interest of
shareholders, he will be
replaced by the BOD.
Lecture: Introduction 23
Solution 3: External Monitoring
• In many corporations, the board
is “captured” by an entrenched
CEO, maybe because the board
comprises people who are close
friends of the CEO and lack
objectivity.
• If the CEO is entrenched and
performs poorly, the share price
will drop. Low share prices may
lead to a hostile takeover, where
an individual or organization
purchase a large fraction of the
shares and get enough votes to
replace the BOD and the CEO.
Lecture: Introduction 24
Agency Costs
• Agency costs are costs of the conflict of interest between
shareholders and management. These costs may be direct or
indirect.
- Direct agency costs include perks consumed, and expenses to monitor
management.
- Indirect agency costs include lost opportunities, e.g., foregoing a positive
NPV project because of the possibility that things may turn out badly,
causing him to lose his job.
Lecture: Introduction 25