Aswath

Damodaran 1

THE OBJECTIVE IN CORPORATE

FINANCE
If you dont know where you are going, it doesnt
matter how you get there
 First Principles
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Maximize the value of the business (firm)

The Investment Decision The Financing Decision The Dividend Decision

Invest in assets that earn a Find the right kind of debt If you cannot find investments
return greater than the for your firm and the right that make your minimum
minimum acceptable hurdle mix of debt and equity to acceptable rate, return the cash
rate fund your operations to owners of your business

The hurdle rate The return How much How you choose
should reflect the The optimal The right kind
should reflect the cash you can to return cash to
riskiness of the mix of debt of debt
magnitude and return the owners will
investment and and equity matches the
the timing of the depends upon depend on
the mix of debt maximizes firm tenor of your
cashflows as well current & whether they
and equity used value assets
as all side effects. potential prefer dividends
to fund it. investment or buybacks
opportunities

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 The Objective in Decision Making
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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.
Maximize equity Maximize market
Maximize value estimate of equity
firm value
value
Assets Liabilities
Existing Investments Fixed Claim on cash flows
Generate cashflows today Assets in Place Debt Little or No role in management
Includes long lived (fixed) and Fixed Maturity
short-lived(working Tax Deductible
capital) assets

Expected Value that will be Growth Assets Equity Residual Claim on cash flows
created by future investments Significant Role in management
Perpetual Lives
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 Maximizing Stock Prices is too narrow an
objective: A preliminary response
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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 profitable
firms that can afford to treat 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.
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 Why traditional corporate financial theory
focuses on maximizing stockholder wealth.
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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:
Allocating resources across scarce uses (which investments to
take and which ones to reject)
how to finance these investments
how much to pay in dividends

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 The Classical Objective Function
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STOCKHOLDERS

Hire & fire Maximize

managers stockholder
- Board wealth
- Annual Meeting

Lend Money No Social Costs

BONDHOLDERS/ Managers SOCIETY
LENDERS Protect All costs can be
bondholder traced to firm
Interests
Reveal Markets are
information efficient and
honestly and assess effect on
on time value

FINANCIAL MARKETS

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 What can go wrong?
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STOCKHOLDERS

Have little control Managers put

over managers their interests
above stockholders

Lend Money Significant Social Costs

BONDHOLDERS Managers SOCIETY
Bondholders can Some costs cannot be
get ripped off traced to firm
Delay bad
news or Markets make
provide mistakes and
misleading can over react
information

FINANCIAL MARKETS

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 I. Stockholder Interests vs. Management
Interests
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In theory: The stockholders have significant control over

management. The two mechanisms for disciplining
management are the annual meeting and the board of
directors. Specifically, we assume that
Stockholders who are dissatisfied with managers can not only
express their disapproval at the annual meeting, but can use
their voting power at the meeting to keep managers in check.
The board of directors plays its true role of representing
stockholders and acting as a check on management.
In Practice: Neither mechanism is as effective in
disciplining management as theory posits.
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 The Annual Meeting as a disciplinary venue
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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.
Annual meetings are also tightly scripted and controlled
events, making it difficult for outsiders and rebels to
bring up issues that are not to the managements liking.

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 And institutional investors go along with incumbent
managers
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 Board of Directors as a disciplinary mechanism
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Directors are paid well: In 2010, the median board member at a Fortune
500 company was paid $212,512, with 54% coming in stock and the
remaining 46% in cash. If a board member was a non-executive chair, he
or she received about $150,000 more in compensation.
Spend more time on their directorial duties than they used to: A board
member worked, on average, about 227.5 hours a year (and that is being
generous), or 4.4 hours a week, according to the National Associate of
Corporate Directors. Of this, about 24 hours a year are for board
meetings. Those numbers are up from what they were a decade ago.
Even those hours are not very productive: While the time spent on being
a director has gone up, a significant portion of that time was spent on
making sure that they are legally protected (regulations & lawsuits).
And they have many loyalties: Many directors serve on three or more
boards, and some are full time chief executives of other companies.

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 The CEO often hand-picks directors..
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CEOs pick directors: A 1992 survey by Korn/Ferry revealed that 74% of

companies relied on recommendations from the CEO to come up with
new directors and only 16% used an outside search firm. While that
number has changed in recent years, CEOs still determine who sits on
their boards. While more companies have outsiders involved in picking
directors now, CEOs exercise significant influence over the process.
Directors dont have big equity stakes: Directors often hold only token
stakes in their companies. Most directors in companies today still receive
more compensation as directors than they gain from their stockholdings.
While share ownership is up among directors today, they usually get these
shares from the firm (rather than buy them).
And some directors are CEOs of other firms: Many directors are
themselves CEOs of other firms. Worse still, there are cases where CEOs
sit on each others boards.

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 Directors lack the expertise (and the willingness)
to ask the necessary tough questions..
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Roberts Rules of Order? 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.
Be a team player? The search for consensus overwhelms
any attempts at confrontation.
The CEO as authority figure: Studies of social psychology
have noted that loyalty is hardwired into human
behavior. While this loyalty is an important tool in
building up organizations, it can also lead people to
suppress internal ethical standards if they conflict with
loyalty to an authority figure. In a board meeting, the
CEO generally becomes the authority figure.
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 The worst board ever? The Disney Experience -
1997
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 The Calpers Tests for Independent Boards
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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.
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 Business Week piles on The Worst Boards in 1997..
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 Application Test: Whos on board?
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Look at the board of directors for your firm.

How many of the directors are inside directors (Employees of the firm,
ex-managers)?
Is there any information on how independent the directors in the firm
are from the managers?
Are there any external measures of the quality of corporate
governance of your firm?
Yahoo! Finance now reports on a corporate governance score for firms,
where it ranks firms against the rest of the market and against their
sectors.
Is there tangible evidence that your board acts independently
of management?
Check news stories to see if there are actions that the CEO has wanted
to take that the board has stopped him or her from taking or at least
slowed him or her down.

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 So, what next? When the cat is idle, the mice
will play ....
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When managers do not fear stockholders, they will often put

their interests over stockholder interests
No stockholder approval needed.. Stockholder Approval needed

Greenmail: The (managers of ) target of a hostile takeover buy out the

potential acquirer's existing stake, at a price much greater than the
price paid by the raider, in return for the signing of a 'standstill'
agreement.
Golden Parachutes: Provisions in employment contracts, that allows
for the payment of a lump-sum or cash flows over a period, if
managers covered by these contracts lose their jobs in a takeover.
Poison Pills: A security, the rights or cashflows on which are triggered
by an outside event, generally a hostile takeover, is called a poison pill.
Shark Repellents: Anti-takeover amendments are also aimed at
dissuading hostile takeovers, but differ on one very important count.
They require the assent of stockholders to be instituted.
Overpaying on takeovers: Acquisitions often are driven by
management interests rather than stockholder interests.

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 Overpaying on takeovers
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The quickest and perhaps the most decisive way to

impoverish stockholders is to overpay on a takeover.
The stockholders in acquiring firms do not seem to share
the enthusiasm of the managers in these firms. Stock
prices of bidding firms decline on the takeover
announcements a significant proportion of the time.
Many mergers do not work, as evidenced by a number of
measures.
The profitability of merged firms relative to their peer groups,
does not increase significantly after mergers.
An even more damning indictment is that a large number of
mergers are reversed within a few years, which is a clear
admission that the acquisitions did not work.

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