Introduction

In a world where Modigliani-Miller applies, little to say about corporate governance and nancial structure. Since the 70s, attempts to introduce agency problem at various levels of the corporate structure; parallel to this, a huge empirical, institutional and normative literature has been developed.

Modigliani-Miller I
Basic proposition (1958, 61): under some conditions, value of the rm (of all claims over its income) independent of the nancial structure (dividend policy, leverage, collateral or seniority attached to claims). . . size of the pie not affected by the split of the pie:
Irrelevance of leverage: risk-neutral investors; debt and equity only; value of the rm: VE + VD = E[max(0, R D)] + E[min(R, D)] = E(R); . . . maximize the value of the rm and issue only, say, equity.

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Modigliani-Miller II
Irrelevance of dividend/repurchase policies: risk-neutral investors and equity only; at each t, Rt accrued, dt paid, nt1 nt , It sunk; take (state-contingent) policies (It , dt , nt ) as given; ex-dividend price of share: Pt = Et [dt+1 + Pt+1 ]; accounting eq.: Rt + Pt (nt nt1 ) = nt1 dt + It ; the value of equity then: Vt nt Pt = nt E[dt+1 + Pt+1 ] = [Rt+1 It+1 + (nt+1 nt )Pt+1 + nt Pt+1 ] = [Rt+1 It+1 + Vt+1 ] = E[
1

(Rt+ It+ )]

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Structure of the presentation

Corporate Governance (Chapter 1): Taxonomy and anecdotes of moral hazard; Antidotes to moral hazard: Incentives: monetary, implicit, monitoring, product-market competition; Monitoring by: board of directors, large shareholders, raiders, banks. Corporate Financing (Chapter 2): Modigliani-Miller; Debt instruments; Equity instruments; Financing patterns.

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Structure of the presentation

Corporate Governance (Chapter 1): Taxonomy and anecdotes of moral hazard; Antidotes to moral hazard: Incentives: monetary, implicit, monitoring, product-market competition; Monitoring by: board of directors, large shareholders, raiders, banks. Corporate Financing (Chapter 2): Modigliani-Miller; Debt instruments; Equity instruments; Financing patterns.

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Corporate Governance
(Narrow) Denition of: corporate governance relates to the ways in which the suppliers of nance to corporations assure themselves of getting a return on their investment. The very denition hinges on the premise that insiders (managers and entrepreneurs) need not act in the best interest of the providers of funds, ie moral hazard informs their relationship.

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Structure of the presentation

Corporate Governance (Chapter 1): Taxonomy and anecdotes of moral hazard; Antidotes to moral hazard: Incentives: monetary, implicit, monitoring, product-market competition; Monitoring by: board of directors, large shareholders, raiders, banks. Corporate Financing (Chapter 2): Modigliani-Miller; Debt instruments; Equity instruments; Financing patterns.

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Moral Hazard
Insufcient effort, poor supervision of subordinates, bad allocation of timing, overcommitment; Building empires (oil industry example in the 70s); Entrenchment strategies (to defend their position/status): actions that make them indispensable; creative accounting; suboptimal (too low or too high) risk-taking; search for white night; Self-dealing: perks (private jets, tasteful theme-parties in Sardegna with waitresses (un)dressed like Messalina and Cleopatras bathing in pools of champagne, rst row at U2 concerts,. . . ); favor friends for succession; nance political parties.

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Moral Hazard II
Related critiques about actual governance: lack of transparency for compensation package; dramatic increase in level of compensation (average annual income of CEO 531 times the average wage in 2000, 42 in 1982); too weak link between compensation and performance (benets from external factors beyond managerial control; not enough punishment for poor performance; possibility of shorting long positions in the rms stocks at favorable times). Jensen and Murphy (1990); golden parachutes awarded in times of poor performance.

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Monetary Incentives
Salary, bonus (earnings related), stocks and stock options; Ability to unload the exposure to the rms performance is crucial for the effectiveness of the incentive (eg, equity swaps and collars); Bonus (short-term horizon) and shareholdings (long-term horizon) must be complements; Importance of (some) insulation from factors beyond managerial control (no reward for luck) and of relative performance; Stock options or straight shares? better incentives vs. more risk resurrect out of the money options.

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Implicit Incentives
Lower tenure probability and/or threat of external intervention (takeover or proxy ght) following poor performance (evidence in cross-country data). Explicit and implicit incentives, substitutes or complements in the data? Chiappori and Salanie (2003): it depends on the source of heterogeneity in the sample: nancially constrained managers agree both on reductions in performance-based compensation and lower tenure probability (complements); with severe asymmetric information, a condent executive will opt for more explicit incentives and less implicit (substitutes).

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Monitoring and Competition

Active monitoring: forward looking, concerned with increasing rm value, interferes with management, shapes policies and changes decisions. Speculative monitoring: backward looking, concerned with adjusting load position in the rm, change credit policy to the rm, assess rm credit worthiness, suing directors, . . . Product-market competition erodes managerial rents enjoyed in monopolistic contexts; provides better measures of managerial performance; increases threat of bankruptcy and termination for managers; can also induce gambling to beat the market.

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Structure of the presentation

Corporate Governance (Chapter 1): Taxonomy and anecdotes of moral hazard; Antidotes to moral hazard: Incentives: monetary, implicit, monitoring, product-market competition; Monitoring by: board of directors, large shareholders, raiders, banks. Corporate Financing (Chapter 2): Modigliani-Miller; Debt instruments; Equity instruments; Financing patterns.

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Debt and Equity and . . .

more than 1 R; ownership of the claims matters; control rights attached to claims; R not easily veried in small rms, subject to accounting creativity in larger rms; intermediate claims between debt and equity . . .

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. . . Intermediate claims
secured debt: right to seize assets used as collateral in the lending contract; convertible debt (similar to bond+warrant): protects debtholders against excessive risk-taking over and above covenants;

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Departing from MM
Tax relative advantages of claims; Clientele effects on the supply side of nancing (eg: prudential and regulatory constraints on asset side of intermediaries balance sheet); Enforcement of nancial contracts (eg: in France poor protection to secured creditors, higher short term debt than US); Here emphasis on informational and control issues: managerial decisions cannot be perfectly specied contractually; incentives given to managers in order to curb moral hazard affect the size of the pie; thus the split of the pie matters.

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Typical Debt Contract

Principal, maturity, rate of interest, scheduling, indexation, call provisions; Mechanism for transmitting timely and credible information to the lender; Warranties by the rm; Afrmative covenants, negative covenants; Default and remedy conditions.

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Security, Liquidity and Maturity

Security (affects the availability of credit): lending against assets (secured); against cash ow (unsecured). Liquidity (informational asymmetries crucial): debt publicly placed (directly or by underwriter) on the primary market and then traded on the secondary, more liquid; privately placed and not traded after (exception: securitization of bank loans), less liquid. Maturity: short-term credit (loan commitments, lines of credit, commercial paper, trade credit) vs. long-term (bank loans, priv. or publ. placed debt).

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Credit analysis
The ve Cs of credit: capability, capital, collateral and coverage, insurance against death of key person; Rating agencies (Moodys and S&P): avoid the repetition of same costly credit analysis; paid by issuer (no free-riding); prot from reputation (also a barrier to entry); AAA, AA,. . . , B investment grade bonds; below, junk"; generally, only investment grade bonds are issued; AAA has cumultive default rate of 0.1% over the rst ten years, B 31.9% (Altman 1989); agency problems here too.

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Covenants
Prevent value-reducing actions, both non increasing risk (such as excessive payments to shareholders, issuance of new secured debt) and increasing risk (aka asset substitution); Dene measures and triggers for shift of control (direct but more often indirect): leverage constraints, minimum net worth, minimum liquidity (proxy for solvency problems); Informational covenants; Prevent creative accounting (eg, off balance liabilities such as a lease or pledge to rescue subsidiary).

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Dichotomies in the credit market

Lenders: sophisticated, concentrated, institutional; private placements; more defaults; active screening; superior information; more covenants; secured, senior claims; slightly shorter maturity; easier renegotiation; reputational externalities and lower issue costs for the borrower. dispersed lenders: . . . . Borrowers: high quality, well capitalized, certied, larger; longer-term debt; less liquidity crises; less private placements; less subject to credit crunches. low quality . . . .

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Lifecycle of equity nancing

In earlier stages, start-up nancing provided by: venture capitalists; large customers (biotech and and pharmaceutical rms in the 90s; moral hazard here too, one of the guises: researcher interested in academic publications more than economic prot); LBO specialists (more mature less risky rms). Later stages: Initial and seasoned public offerings.

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Venture Capital
Common in High-Tech (Apple, Google,. . . ) but also other industries (FedEx); Very risky projects; Very concentrated positions in the start-up (average equity stake of the lead venture capitalist is 19%); direct presence in the board; Rough Screening and close monitoring; Very structured deals (stages of nancing, covenants to re managers, exit mechanisms, . . . ); Importance of reputation: limited partners piggyback leader; reduces underpricing at IPO.

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IPOs and SPOs

IPOs: Costs: informational; underwriting fees (7 % of transact value in 90s); severe underpricing (27 billion left on the table in 90s; winners course?); losing control rights. Benets: new sources of nance; facilitate exit; market-based measures of assets and managerial compensation; reputation and visibility. Italy (Pagano et al 1998): IPO more likely in industries with rms with high market to book; if larger; cost of credit down after; at IPO, 6 times as old and 8 as large than US rm. . . . SPOs: through underwriters (rm commitment or best effort contracts); dual role of stock analysts.

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Sources of Corporate Finance

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Payout Policy and Leverage

Trade-off (at time 0) between retentions and repayments (at time 1):

Thus, contract at time 0 must specify the level of repayment and the structure of repayment (nancial structure).

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Level of Repayment
The evidence seems to conrm the following (incomplete) predictions:

But, for instance, in the presence of moral hazard at time 0 (eg, managers able to affect midstream earnings) high midstream earnings command lower repayments and higher reinvestment in the rm.

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Financial Structure
Evidence on leverage: depends on the sample used (eg, smaller non-listed vs. larger listed rms, heavily regulated vs. deregulated industries), the measures used (eg, weighted vs. non-weighted means), the sample period (eg, strong dependence on the business cycle; White (1991) with large non-weighted 1985 sample of US rms nds that the aggregate market-based average equity/(debt+equity) ratio is 0.32; the typical debt/equity ratio around 2. Empirical regularities: safe rms, steady cash ows, high collateral have higher debt/equity ratios; vice versa for risky or high market-to-book rms.

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