Aswath Damodaran 0

CORPORATE FINANCE
B40.2302
LECTURE NOTES: PACKET 1
Aswath Damodaran
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THE OBJECTIVE IN CORPORATE

FINANCE
“If you don’t know where you are going, it does not
matter how you get there”
The End Game in Business?

¨ Businesses have always struggled with mission statements.

Put simply, what should the end game of a business?
¤ The simplest and most pragmatic answer is that it is to sell products
and services that customers want, while generating the most they can
in profits for their owners, over the long term.
¤ The pushback, often from non-business critics, has been that
businesses should also serve society, not just minimizing social costs
but also providing social benefits.
¨ In recent years, that pushback has found backing within
business, with movements to expand business missions:
¤ To put business sustainability first
¤ To maximize the value to all stakeholders, not just owners
¤ To incorporate environmental, social and governance goals

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A business has many stakeholders…

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 In running a business, one of these stakeholders
has to be given primacy…
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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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 Giving corporate finance its focus…
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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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 Why traditional corporate financial theory
focuses on maximizing stockholder wealth.
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¨ You can have only one objective, i.e., one interest

group, whose interests get placed first.
¨ Corporate finance picks shareholders because they have a
residual claim, whereas every other claimholder has a
contractual claim that they can negotiate to protect their
interests.
¨ If the company is traded, the stock price gets chosen
as the optimizing metric because:
¤ Stock price is easily observable and constantly updated
¤ If investors are rational, stock prices reflect the wisdom of
decisions, short term and long term, instantaneously.

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 The Strawman Version: Cutthroat
Corporatism
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 Real Choices or False Ones?
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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. Companies that consistently
flout social norms will find themselves losing business
and facing regulation/targeted taxes.
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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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 Utopian Corporatism
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 So this is what can go wrong...
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¨ M
1. Annual meetings
are too tightly
STOCKHOLDERS
Businesses create side
scripted & Managers put costs and side benefits to
Have little control their interests society that cannot be
controlled
over managers above stockholders traced back to the firm.
2. Boards are rubber
stamps for CEOs

Lend Money Significant Social Costs

BONDHOLDERS Managers SOCIETY
Bondholders can Some costs cannot be
get ripped off traced to firm
Delay bad
Covenants and lender news or Markets make Markets are sometimes
protections provide only provide mistakes and short term & oftentimes
partial defense against misleading can overreact irrational.
shareholder overreach. 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 also
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, or do nothing, if they are passive investors (index
funds)
¨ 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 management’s liking.
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 And institutional investors go along with incumbent
managers…
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 Boards of directors are often rubber
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stamps…
¨ 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 decreased 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 don’t 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 other’s boards.

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 And lack the expertise (and the willingness) to
ask the necessary tough questions..
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¨ Robert’s 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: Who’s 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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