Corporate Finance Lecture Note Packet 1 The Objective and Investment Analysis Aswath Damodaran B40 2302 20 Stern School of Business 1 The Objective in Corporate Finance If you don t know where you are going it does not matter how you get there 2 First Principles Invest in projects that yield a return greater than the minimum acceptable hurdle rate The hurdle rate should be higher for riskier projects and reflect the financing mix used owners funds equity or borrowed money debt Returns on projects should be measured based on cash flows generated and the timing of these cash flows they should also consider both positive and negative side effects of these projects Choose a financing mix that minimizes the hurdle rate and matches the assets being financed If there are not enough investments that earn the hurdle rate return the cash to the owners of the firm if public these would be stockholders The form of returns dividends and stock buybacks will depend upon the stockholders characteristics Objective Maximize the Value of the Firm 3 The Classical Viewpoint Van Horne In this book we assume that the objective of the firm is to maximize its value to its stockholders Brealey Myers Success is usually judged by value Shareholders are made better off by any decision which increases the value of their stake in the firm The secret of success in financial management is to increase value Copeland Weston The most important theme is that the objective of the firm is to maximize the wealth of its stockholders Brigham and Gapenski Throughout this book we operate on the assumption that the management s primary goal is stockholder wealth maximization which translates into maximizing the price of the common stock 4 The Objective in Decision Making In traditional corporate finance the objective in decision making is to maximize the value of the firm A narrower objective is to maximize stockholder wealth When the stock is traded and markets are viewed to be efficient the objective is to maximize the stock price All other goals of the firm are intermediate ones leading to firm value maximization or operate as constraints on firm value maximization 5 The Criticism of Firm Value Maximization Maximizing stock price is not incompatible with meeting employee needs objectives In particular Employees are often stockholders in many firms Firms that maximize stock price generally are firms that have treated employees well Maximizing stock price does not mean that customers are not critical to success In most businesses keeping customers happy is the route to stock price maximization Maximizing stock price does not imply that a company has to be a social outlaw 6 Why traditional corporate financial theory focuses on maximizing stockholder wealth Stock price is easily observable and constantly updated unlike other measures of performance which may not be as easily observable and certainly not updated as frequently If investors are rational are they stock prices reflect the wisdom of decisions short term and long term instantaneously The objective of stock price performance provides some very elegant theory on how to pick projects how to finance them how much to pay in dividends 7 The Classical Objective Function STOCKHOLDERS Hire fire managers Board Annual Meeting BONDHOLDERS Lend Money Maximize stockholder wealth Managers Protect bondholder Interests Reveal information honestly and on time No Social Costs SOCIETY Costs can be traced to firm Markets are efficient and assess effect on value FINANCIAL MARKETS 8 What can go wrong STOCKHOLDERS Have little control over managers BONDHOLDERS Lend Money Managers put their interests above stockholders Managers Significant Social Costs SOCIETY Bondholders can Some costs cannot be get ripped off traced to firm Delay bad Markets make news or mistakes and provide misleading can over react information FINANCIAL MARKETS 9 I Stockholder Interests vs Management Interests In theory The stockholders have significant control over management The mechanisms for disciplining management are the annual meeting and the board of directors In Practice Neither mechanism is as effective in disciplining management as theory posits 10 The Annual Meeting as a disciplinary venue The power of stockholders to act at annual meetings is diluted by three factors Most small stockholders do not go to meetings because the cost of going to the meeting exceeds the value of their holdings Incumbent management starts off with a clear advantage when it comes to the exercise of proxies Proxies that are not voted becomes votes for incumbent management For large stockholders the path of least resistance when confronted by managers that they do not like is to vote with their feet 11 Board of Directors as a disciplinary mechanism 12 The CEO often hand picks directors The 1992 survey by Korn Ferry revealed that 74 of companies relied on recommendations from the CEO to come up with new directors Only 16 used an outside search firm While that number has changed in recent years CEOs still determine who sits on their boards Directors often hold only token stakes in their companies The Korn Ferry survey found that 5 of all directors in 1992 owned less than five shares in their firms Most directors in companies today still receive more compensation as directors than they gain from their stockholdings Many directors are themselves CEOs of other firms 13 Directors lack the expertise and the willingness to ask the necessary tough questions In most boards the CEO continues to be the chair Not surprisingly the CEO sets the agenda chairs the meeting and controls the information provided to directors The search for consensus overwhelms any attempts at confrontation 14 Who s on Board The Disney Experience 1997 15 The Calpers Tests for Independent Boards Calpers the California Employees Pension fund suggested three tests in 1997 of an independent board Are a majority of the directors outside directors Is the chairman of the board independent of the company and not the CEO of the company Are the compensation and audit committees composed entirely of outsiders Disney was the only S P 500 company to fail all three tests 16 Business Week piles on The Worst Boards in 1997 17 Application Test Who s on board Look at the board of directors for your firm Analyze How many of the directors are inside directors Employees of the firm exmanagers Is there any information on how independent the directors in the firm are from the managers 18 So
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