Corporate Finance

Corporate finance studies how company managers deal with various issues in their firms. What might these issues be? We can imagine literally millions of issues, raising capital, buying back shares, buying another company, extending credit to customers and so on, ad infinitum. There are several ways to visualize how these issues might be related to each other.

The balance sheet approach

One simple way to examine the balance sheet of the firm. The balance sheet of a firm consists of assets and liabilities. In turn, the assets can be divided into fixed assets and working capital. The liabilities can be divided into debt and equity. Looking at the firm from this viewpoint, leads naturally to classifying corporate finance research into several areas.

Areas of corporate finance organized by the balance sheet of the firm

Assets Liabilities
What kind of assets should the firm invest in? What is the optimal mix of liabilities for the firm?
Investment policy: The firm invests internally Capital structure: What is the optimal amount of debt to have?
Mergers and acquisitions: The firm invests externally by buying another firm Equity ownership: What are the issues involved with public shareholders?
Working capital management: What is the optimal amount of working capital? Governance issues: Can the managers be controlled by the owners?
Cash management: What is the optimal amount of cash to have? Payout policy: How should the firm pay out cash from its investments?

The problem with the balance sheet approach however, is that the balance sheet just gives a snapshot of the firm's activities at a point in time. How did it get to that point? To understand that, an alternative approach is to think of the lifecycle of the firm.

The life cycle approach

The lifecycle approach relates firms to human beings. Since firms are essentially created by human beings, everything that applies to a human being will necessarily apply to a firm (in some cases below, the metaphors are a bit strained).


Firms are born because individuals feel they can do something better together than by themselves.

Entrepreneurial finance

An entrepreneur conceives the idea for the firm. He spends time and money trying to develop an initial idea. Should he then approach venture capitalists to finance the idea or try to use his own savings to develop it?

Venture capital

How should venture capitalists evaluate projects brought to them by investors? Which projects should they fund? When should the firm go public?

Security design

An area of finance examines how optimal securities are designed. The idea is that before the firm is born, a rational entrepreneurs will design all the aspects of the security (control rights, cash flow rights, rights in case of distress etc) to get the maximum value from rational investors when he eventually cashes out when the firm goes public.


The initial public offering

The firm is born. Venture capitalists cash out.

Choosing the right hospital: Logistics of the initial public offering

What is the best way to organize the IPO? What should be the role of the investment bank overseeing the IPO? What is the best way to organize the bookbuilding process? When is an auction process optimal?

Parent's reactions: Investor reactions to the initial public offering

What are the market reactions to the offering? What information does the market get when the firm launches an IPO? Can the firm use market reactions to the IPO to get additional information?

Life of the firm

Raising funds: Capital structure

What is the optimal way to raise funds? Equity or debt? The first set of papers in this area started by assuming we live in a world of perfect markets - all information was symmetric, there were no transaction costs (no lawyers) and no government (no taxes). Under this set of very restrictive assumptions, capital structure did not matter. Debt was irrelevant. Obviously this was too restrictive. So gradually each of the restrictions were removed.

Symmetric information and taxes

What happens if taxes were introduced? What are the benfits of debt?

  • Modigliani, Franco, and Merton H. Miller, 1958, The Cost of Capital, Corporation Finance and the Theory of Investment, American Economic Review 48, 261-297.
  • Miller, Merton H., 1977, Debt and taxes, Journal of Finance 32, 261-275.
  • DeAngelo, Harry, and Ronald W. Masulis, 1980, Optimal Capital Structure Under Corporate and Personal Taxation, Journal of Financial Economics 8, 3-29.
  • Graham, John R. 2000, How Big Are The Tax Benefits Of Debt?, The Journal of Finance, Volume LV, No. 5, 1901-1941.
  • Strebulaev, Ilya A, and Baozhong Yang, 2006, The Mystery of Zero Leverage Firms, Working Paper.

Asymmetric information

What happens if information is not symmetric after all?

  • Jensen, Michael C., and William H. Meckling, 1976, Theory of the firm: Managerial behavior, agency costs and ownership structure, Journal of Financial Economics 3, 305-360.
  • Leland, Hayne E., and David H. Pyle, 1977, Informational asymmetries, financial structure, and financial intermediation, Journal of Finance 32, 371-387.
  • Ross, Stephen A., 1977, The determination of financial structure: The Incentive-signalling approach, Bell Journal of Economics 8, 23-40.
  • Myers, Stewart C., 1977, Determinants of corporate borrowing, Journal of Financial Economics 5, 147-175.
  • Myers, Stewart C., and Nicholas S. Majluf, 1984, Corporate financing and investment decisions when firms have information that investors do not have, Journal of Financial Economics 13, 187-221.
  • Parrino, Robert, and Michael S. Weisbach, 1999, Measuring investment distortions arising from stockholder-bondholder conflicts, Journal of Financial Economics 53, 3-42.
  • Harvey, C.R, K.V. Lins, A.H. Roper, 2004, The Effect of Capital Structure when Expected Agency Costs are Extreme, Journal of Financial Economics 74, 3-30.

Behavioral Issues

Raising funds: Equity ownership

Is equity ownership good?

  • Jensen, Michael C., 1986, Agency costs of free cash flow, corporate finance and takeovers, American Economic Review 76, 323-329.
  • Stulz, René M., 1990, Managerial discretion and optimal financing policies, Journal of Financial Economics 26, 3-27.
  • Myers, Stewart C., 2000, Outside equity, Journal of Finance 55, 1005 - 1037.

Rasing funds: Seasonal equity offerings

A survey in seasonal equity offerings

Doing something with the funds: Investment policy

Obviously a firm should always invest in positive NPV projects.

Doing something with the funds: Working capital management

What is the optimal amount of working capital? What is the value of liquidity?

Paying out the profits: Payout policy

What should a firm do with the profits? Should it pay to back to the shareholders or should it retain it within the firm for further investment? If it chooses to pay back to the shareholders, what form should the payment take? Dividends or share repurchases?

  • Miller, Merton H., and Franco Modigliani, 1961, Dividend policy, growth, and the valuation of shares, Journal of Business 34, 411-433.
  • Miller, Merton H., and Myron S. Scholes, 1978, Dividends and taxes, Journal of Financial Economics 6, 333-364.
  • Bhattacharya, Sudipto, 1979, Imperfect information, dividend policy, and “the bird in the hand” fallacy, Bell Journal of Economics'' 10, 259-270.
  • Miller, Merton H., and Kevin Rock, 1985, Dividend policy under asymmetric information, Journal of Finance 40, 1031-1051.
  • Allen, Franklin, Antonio E. Bernardo, and Ivo Welch, 2000, A theory of dividends based on tax clienteles, Journal of Finance 55, 2499-2536.
  • DeAngelo, Harry, Linda DeAngelo and Douglas Skinner, 2004, Are Dividends Disappearing: Dividend Concentration and the Consolidation of Earnings, Journal of Financial Economics.
  • DeAngelo, Harry and Linda DeAngelo, 2006, The irrelevance of the MM dividend irrelevance theorem, Journal of Financial Economics 79, 293-315.
  • John C. Handley, 2007, Dividend Policy: Reconciling DD with MM, Journal of Financial Economics forthcoming.
  • DeAngelo, Harry and Linda DeAngelo, 2006, Capital structure, payout policy, and financial flexibility, working paper, Marshall School of Business, University of Southern California.
  • Gentry, Kemsley and Mayer, 2003, Dividend Taxes and Share Prices Evidence from Real Estate Investment Trusts, Journal of Finance, FEB 2003.
  • Grullon, Gustavo and Michaely, Ron, 2002, Dividends, Share Repurchases, and the Substitution Hypothesis, Journal of Finance, Volume 57, Issue 4, 1649-1684.
  • Massa,Massimo, Zahid Rehman and Theo Vermaelen, 2007, Mimicking repurchases, Journal of Financial Economics 84 (2007) 624-666
  • Rhodes-Kropf, Matthew, David T. Tobinson and S. Viswanathan 2005, Valuation waves and merger activity: The empirical evidence, Journal of Financial Economics 77 (2005) 561-603

Other activities

Living together: Joint ventures

Why do firms form joint ventures? What determines whether a venture will be successful or not?

When a bully takes your lunch money: Tunneling and expropriation

Marriage: Mergers and acquisitions

Why do firms buy other firms? What determines whether a merger will be successful?

Why do mergers cluster at points in time?

How do international mergers and acquisitions differ from domestic deals?

Getting rid of the kids: Equity carveouts and spin offs

Sometimes subsidiaries might be better off on their own. Firms carve them out or spin them off.

Divorces: Executive turnover

Executives are paid large sums of money to manage the firm. What happens if they do not? If they do succeed, do they move on?


Slacking: Corporate governance

Managers are human beings. They will slack if not monitored correctly.

Corporate Governance Mechanisms and Cash Flow Forecasts Disclosure

Calling the cops: Law and finance

A strand of literature argues that optimal financial policies make no sense unless we consider the legal system in the countries. If the legal system is not good, shareholders will be expropriated.

Death: Bankruptcies and liquidation

What are the effects of financial distress?

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