Aswath Damodaran 0

THE OBJECTIVE IN DECISION

MAKING
“If you don’t know where you are going, it does’nt
matter how you get there”
 First Principles
1

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

Aswath Damodaran
1
Characteristics of a Good Objective

• It is clear and unambiguous: An ambiguous objective will lead

to decision rules that vary from case to case and from decision
maker to decision maker.
• It comes with a timely measure that can be used to evaluate
the success or failure of decisions: Objectives that sound good
but do not come with a measurement mechanism are likely to
fall.
• It does not create costs for other entities or groups that erase
firm-specific benefits and leave society worse off overall: As an
example, assume that a tobacco company defines its objective
to be revenue growth. Managers of this firm would then be
inclined to increase advertising to teenagers, because it will
increase sales. Doing so may create significant costs for society
that overwhelm any benefit arising from this objective.
 The Objective in Decision Making
2

 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

2
Aswath Damodaran
 Maximizing Stock Prices is too “narrow” an
objective: A preliminary response
3

 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.
Aswath Damodaran
3
 Why traditional corporate financial theory
focuses on maximizing stockholder wealth.
4

 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

Aswath Damodaran
4
 The Classical Objective Function
5

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

Aswath Damodaran
5
The Classical Objective Function (Cont.)

There is a scenario in which managers can concentrate on

maximizing stock prices to the exclusion of all other
considerations and not worry about side costs. For this
scenario to uphold, the following assumptions have to hold:
• The managers of the firm put aside their own interests and
focus on maximizing stockholder wealth:
i. Threat of firing
ii. Managers own stock
• The lenders to the firm are fully protected from
expropriation by stockholders:
i. Reputation effect (actions hurting the lenders reduce
future borrowing capacity)
ii. Imposing covenants (preventing the firm in taking any
action that hurts them)
The Classical Objective Function (Cont.)

• The managers of the firm do not attempt to mislead

or lie to financial markets about the firm’s future
prospects: There is sufficient information for markets
to make judgements about the effects of actions on
long-term cash flows and value.
• There are so social costs or benefits: All costs
created by the firm in the pursuit of maximizing
stockholder wealth can be traced and charged to the
firm.
 What can go wrong? Real-World Problems that Trigger a Breakdown
in the Stock Price Maximization Objective
6

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

Aswath Damodaran
6
 I. Stockholder Interests vs. Management Interests

 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.
Aswath Damodaran
7
 The Annual Meeting as a Disciplinary Venue
8

 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 (institutional investors), the path of
least resistance, when confronted by managers that they do
not like, is to "vote with their feet", which is to sell their
stock and move on.
 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.
Aswath Damodaran
8
 And institutional investors go along with
incumbent managers…
9

Aswath Damodaran
9
 Board of Directors as a Disciplinary
Mechanism
10

 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 it 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. 10
Aswath Damodaran
 III. Board of Directors as a Disciplinary
Mechanism (Cont.)
10

 Lack of expertise on core business issues, especially

relating to accounting rules
 A large number of directors work for the firm can be
categorized as insiders and are unlikely to challenge
the chief executive officer (CEO)
 Many directors hold only small or token stakes in
the equity of their corporations
 In most of the cases, the CEO chairs the board of
directors

10
Aswath Damodaran
 The CEO often hand-‐picks directors..
11

 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 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.

Aswath Damodaran
11
 Directors lack the expertise (and the willingness)
to ask the necessary tough questions..
12

 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.
Aswath Damodaran
12
 The worst board ever? The Disney Experience -‐
1997
13

Aswath Damodaran
13
 The Calpers Tests for Independent Boards
14

 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.
Aswath Damodaran
14
 Business Week piles on… The Worst Boards in
1997..
15

Aswath Damodaran
15
 Application Test: Who’s on board?
16

 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.

Aswath Damodaran
16
Ownership Structure

The power that stockholders have to influence management

decisions can be affected by how voting rights are apportioned
across stockholders and by who owns the shares in the company:
• Voting rights: The most common structure for voting rights in a
publicly traded company is to have a single class of shares, with
each share getting a vote.
• Founders/owners: In young companies, it is not uncommon to find
a significant portion of the stock held by founders or original
promoters of the firm.
• Passive versus activist investors: The response to poor
management of most institutional investors, including mutual and
pension funds, is to vote with their feet, by selling their stock.
There are a few institutional investors such as hedge funds and
private equity funds that have a much more activist vent to their
investing and seek to change the way companies are run.
Ownership Structure (Cont.)

• Stockholders with competing interests: Not all

stockholders are single minded about maximizing
stockholders wealth. First is employees of the firm: need
to balance their interests as stockholders against their
interests as employees. Second is the government: need
to balance its interests as stockholder in a company (due
to privatization of a government company) against their
other interests such as tax collections and protection of
domestic interests.
• Corporate cross holdings: The largest stockholder in a
company may be another company. In some cases, this
investment may reflect strategic or operating
considerations.
 The Consequences of Stockholder
Powerlessness
1. Fighting hostile acquisitions: Not surprisingly, managers often act to protect
their own interests at the expense of stockholders:
 The managers of some firms that were targeted by acquirers (raiders) for
hostile takeovers were able to avoid being acquired by buying out the
acquirer’s existing stake, generally at a price much greater than the price paid
by the acquirer and by using stockholder cash. This process is called
greenmail, usually causes stock prices to drop, but it does protect the jobs of
incumbent managers.
 Another widely used antitakeover device is a golden parachute, a provision in
an employment contract that allows for the payment of a lump sum or cash
flows over a period, if the manager covered by the contract loses his or her
job in a takeover.
 Firms sometimes create poison pills, which are triggered by hostile takeovers.
The objective is to make it difficult and costly to acquire control.
 The Consequences of Stockholder
Powerlessness (Cont.)
2. Antitakeover amendments: There are several antitakeover
amendments that are designed with the objective of reducing the
likelihood of a hostile takeover. For instance, a super-majority
amendment to take over a firm, which requires to acquire more
than 51% that would normally be required to gain control.
3. Paying too much on acquisitions: There are many ways in which
managers can make their stockholders worse off - by investing in
bad projects, by borrowing too much or too little, and by adopting
defensive mechanisms against potentially value-increasing
takeovers.
 So, what next? When the cat is idle, the mice
will play ....
17

 When managers do not fear stockholders, they will often put

their interests over stockholder interests
No stockholder approval needed….. StockholderApproval 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 (acquirer), 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.

Aswath Damodaran
17
 Overpaying on takeovers
18

 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.

Aswath Damodaran
18
A case study in value destruction:
Eastman Kodak & Sterling Drugs
Kodak enters bidding war Kodak wins!!!!
 In late 1987, Eastman Kodak
entered into a bidding war with
Hoffman La Roche for Sterling
Drugs, a pharmaceutical
company.
 The bidding war started with
Sterling Drugs trading at about
$40/share.
 At $72/share, Hoffman dropped
out of the bidding war, but Kodak
kept bidding.
 At $89.50/share, Kodak won and
claimed potential synergies
explained the premium.
 Earnings and Revenues at Sterling Drugs
20

Sterling Drug under Eastman Kodak: Where is the synergy?

5,000
4,500
4,000
3,500
3,000
2,500
2,000
1,500
1,000
500
0
1988 1989 1990 1991 1992

Revenue Operating Earnings

Aswath Damodaran
20
 Kodak Says Drug Unit Is Not for Sale … but…
21

 An article in the NY Times in August of 1993 suggested that Kodak was eager to
shed its drug unit.
🞑🞑 In response, Eastman Kodak officials say they have no plans to sell Kodak’s Sterling Winthrop
drug unit.
🞑🞑 Louis Mattis, Chairman of Sterling Winthrop, dismissed the rumors as “massive speculation,
which flies in the face of the stated intent of Kodak that it is committed to be in the health
business.”
 A few months later…Taking a stride out of the drug business, Eastman Kodak said
that the Sanofi Group, a French pharmaceutical company, agreed to buy the
prescription drug business of Sterling Winthrop for $1.68 billion.
🞑🞑 Shares of Eastman Kodak rose 75 cents yesterday, closing at $47.50 on the New York Stock
Exchange.
🞑🞑 Samuel D. Isaly an analyst , said the announcement was “very good for Sanofi and very good
for Kodak.”
🞑🞑 “When the divestitures are complete, Kodak will be entirely focused on imaging,” said George
M. C. Fisher, the company's chief executive.
🞑🞑 The rest of the Sterling Winthrop was sold to Smithkline for $2.9 billion.

Aswath Damodaran
21
 The connection to corporate governance: HP
buys Autonomy… and explains the premium
22

Aswath Damodaran
22
 A year later… HP admits a mistake…and explains
it…
23

Aswath Damodaran
23
 Application Test: Who owns/runs your firm?
24

 Look at: Bloomberg printout HDS for your firm

 Who are the top stockholders in your firm?
 What are the potential conflicts of interests that you see
emerging from this stockholding structure?
Government
Outside stockholders Managers
- Size of holding - Length of tenure
- Active or Passive? - Links to insiders
- Short or Long term? Control of the firm

Employees Lenders

Inside stockholders
% of stock held
Voting and non-voting shares
Control structure

Aswath Damodaran
24
Case 1: Splintering of Stockholders
Disney’s top stockholders in 2003

Aswath Damodaran
25
Case 2: Voting versus Non-‐voting Shares &
Golden Shares: Vale

Valespar ownership Brazilian Govt. Valespar

4% 1%
Brazilian retail
5% Litel Participaço 49.00 %
Brazilian
Brazilian Institutional
6%
Govt. Eletron S.A. 0.03%
6%
Bradespar S.A. 21.21 %
Mitsui & Co. 18.24 % Brazilian retail
18%
BNDESPAR 11.51 %

Valespar Golden (veto)

Non/Brazilian 54% Brazilian Institutional Non.Brazilian
(ADR&Bovespa) shares owned 18% (ADR&Bovespa)
29% 59%
by Brazilian govt

Common (voting) shares Preferred (non-voting)

3,172 million 1,933 million
Vale Equity

Vale has eleven members on its board of directors, ten of

whom were nominated by Valepar and the board was
chaired by Don Conrado, the CEO of Valepar.
Aswath Damodaran
26
Case 3: Cross and Pyramid Holdings
Tata Motor’s top stockholders in 2013

Aswath Damodaran
27
Case 4: Legal rights and Corporate
Structures: Baidu
 The Board: The company has six directors, one of whom is Robin Li,
who is the founder/CEO of Baidu. Mr. Li also owns a majority stake
of Class B shares, which have ten times the voting rights of Class A
shares, granting him effective control of the company.
 The structure: Baidu is a Chinese company, but it is incorporated in
the Cayman Islands, its primary stock listing is on the NASDAQ and
the listed company is structured as a shell company, to get around
Chinese government restrictions of foreign investors holding
shares in Chinese corporations.
 The legal system: Baidu’s operating counterpart in China is
structured as a Variable Interest Entity (VIE), and it is unclear how
much legal power the shareholders in the shell company have to
enforce changes at the VIE.

Aswath Damodaran
28
 Things change.. Disney’s top stockholders in
2009
29

Aswath Damodaran
29
 II. Stockholders' objectives vs. Bondholders'
objectives
30

 In theory: there is no conflict of interests between

stockholders and bondholders.
 In practice: Stockholder and bondholders have
different objectives. Bondholders are concerned
most about safety and ensuring that they get paid
their claims. Stockholders are more likely to think
about upside potential

Aswath Damodaran
30
 Examples of the conflict..
31

 A dividend/buyback surge: When firms pay cash out as

dividends, lenders to the firm are hurt and stockholders
may be helped. This is because the firm becomes riskier
without the cash.
 Risk shifting: When a firm takes riskier projects than
those agreed to at the outset, lenders are hurt. Lenders
base interest rates on their perceptions of how risky a
firm’s investments are. If stockholders then take on
riskier investments, lenders will be hurt.
 Borrowing more on the same assets: If lenders do not
protect themselves, a firm can borrow more money and
make all existing lenders worse off.

Aswath Damodaran
31
 An Extreme Example: Unprotected Lenders?
32

Aswath Damodaran
32
 III. Firms and Financial Markets
33

 In theory: Financial markets are efficient. Managers

convey information honestly and and in a timely manner
to financial markets, and financial markets make
reasoned judgments of the effects of this information on
'true value'. As a consequence-‐
🞑🞑 A company that invests in good long term projects will be
rewarded.
🞑🞑 Short term accounting gimmicks will not lead to increases in
market value.
🞑🞑 Stock price performance is a good measure of company
performance.
 In practice: There are some holes in the 'Efficient
Markets' assumption.

Aswath Damodaran
33
 Managers control the release of information to
the general public
34

 Information management (timing and spin):

Information (especially negative) is sometimes
suppressed or delayed by managers seeking a better
time to release it. When the information is released,
firms find ways to “spin” or “frame” it to put
themselves in the best possible light.
 Outright fraud: In some cases, firms release
intentionally misleading information about their
current conditions and future prospects to financial
markets.
Aswath Damodaran
34
 Evidence that managers delay bad news?
35

DO MANAGERS DELAY BAD NEWS?: EPS and DPS Changes- by

Weekday

8.00%

6.00%

4.00%

2.00%

0.00%

-2.00%

-4.00%

-6.00%
Monday Tuesday Wednesday Thursday Friday

% Chg(EPS) % Chg(DPS)

Aswath Damodaran
35
 Some critiques of market efficiency..
36

 Investor irrationality: The base argument is that

investors are irrational and prices often move for not
reason at all. As a consequence, prices are much more
volatile than justified by the underlying fundamentals.
Earnings and dividends are much less volatile than stock
prices.
 Manifestations of irrationality
 Reaction to news: Some believe that investors overreact to
news, both good and bad. Others believe that investors
sometimes under react to big news stories.
 An insider conspiracy: Financial markets are manipulated by
insiders; Prices do not have any relationship to value.
 Short termism: Investors are short-‐sighted, and do not consider
the long-‐term implications of actions taken by the firm
Aswath Damodaran
36
 Are markets short sighted and too focused
on the near term? What do you think?
37

 Focusing on market prices will lead companies towards short

term decisions at the expense of long term value.
a. I agree with the statement
b. I do not agree with this statement
 Allowing managers to make decisions without having to
worry about the effect on market prices will lead to better
long term decisions.
a. I agree with this statement
b. I do not agree with this statement
 Neither managers nor markets are trustworthy. Regulations/
laws should be written that force firms to make long term
decisions.
a. I agree with this statement
b. I do not agree with this statement
Aswath Damodaran
37
 Are markets short term? Some evidence that
they are not..
38

 Value of young firms: There are hundreds of start-‐up and

small firms, with no earnings expected in the near future,
that raise money on financial markets. Why would a myopic
market that cares only about short term earnings attach high
prices to these firms?
 Current earnings vs Future growth: If the evidence suggests
anything, it is that markets do not value current earnings and
cashflows enough and value future earnings and cashflows
too much. After all, studies suggest that low PE stocks are
under priced relative to high PE stocks
 Market reaction to investments: The market response to
research and development and investment expenditures is
generally positive.

Aswath Damodaran
38
 If markets are so short term, why do they react to big
investments (that potentially lower short term earnings) so
positively?
39

Aswath Damodaran
39
 But what about market crises?
40

 Markets are the problem: Many critics of markets point to market

bubbles and crises as evidence that markets do not work. For
instance, the market turmoil between September and December
2008 is pointed to as backing for the statement that free markets
are the source of the problem and not the solution.
 The counter: There are two counter arguments that can be
offered:
🞑🞑 The events of the last quarter of 2008 illustrate that we are more
dependent on functioning, liquid markets, with risk taking investors, than
ever before in history. As we saw, no government or other entity (bank,
Buffett) is big enough to step in and save the day.
🞑🞑 The firms that caused the market collapse (banks, investment banks) were
among the most regulated businesses in the market place. If anything,
their failures can be traced to their attempts to take advantage of
regulatory loopholes (badly designed insurance programs… capital
measurements that miss risky assets, especially derivatives)

Aswath Damodaran
40
 IV. Firms and Society
41

 In theory: All costs and benefits associated with a

firm’s decisions can be traced back to the firm.
 In practice: Financial decisions can create social costs
and benefits.
🞑🞑 A social cost or benefit is a cost or benefit that accrues to
society as a whole and not to the firm making the decision.
 Environmental costs (pollution, health costs, etc..)
 Quality of Life' costs (traffic, housing, safety, etc.)
🞑🞑 Examples of social benefits include:
 creating employment in areas with high unemployment
 supporting development in inner cities
 creating access to goods in areas where such access does not
exist

Aswath Damodaran
41
 Social Costs and Benefits are difficult to quantify
because ..
42

 Cannot know the unknown: They might not be known at

the time of the decision. In other words, a firm may
think that it is delivering a product that enhances
society, at the time it delivers the product but discover
afterwards that there are very large costs. (Asbestos was
a wonderful product, when it was devised, light and easy
to work with… It is only after decades that the health
consequences came to light)
 Eyes of the beholder: They are ‘person-‐specific’, since
different decision makers can look at the same social
cost and weight them very differently.
 Decision paralysis: They can be paralyzing if carried to
extremes.
Aswath Damodaran
42
 A test of your social consciousness:
Put your money where you mouth is…
43

 Assume that you work for Disney and that you have an opportunity
to open a store in an inner-‐city neighborhood. The store is
expected to lose about a million dollars a year, but it will create
much-‐needed employment in the area, and may help revitalize it.
 Would you open the store?
🞑🞑 Yes
🞑🞑 No
 If yes, would you tell your stockholders and let them vote on the
issue?
🞑🞑 Yes
🞑🞑 No
 If no, how would you respond to a stockholder query on why you
were not living up to your social responsibilities?

Aswath Damodaran
43
 So this is what can go wrong...
44

STOCKHOLDERS

Managers put
Have little control their interests
over managers 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

Aswath Damodaran
44
 Traditional corporate financial theory breaks
down when ...
45

 Managerial self-‐interest: The interests/objectives of the

decision makers in the firm conflict with the interests of
stockholders.
 Unprotected debt holders: Bondholders (Lenders) are
not protected against expropriation by stockholders.
 Inefficient markets: Financial markets do not operate
efficiently, and stock prices do not reflect the underlying
value of the firm.
 Large social side costs: Significant social costs can be
created as a by-‐product of stock price maximization.

Aswath Damodaran
45
 When traditional corporate financial theory
breaks down, the solution is:
46

 A non-‐stockholder based governance system: To choose a

different mechanism for corporate governance, i.e, assign the
responsibility for monitoring managers to someone other
than stockholders.
 A better objective than maximizing stock prices? To choose a
different objective for the firm.
 Maximize stock prices but minimize side costs: To maximize
stock price, but reduce the potential for conflict and
breakdown:
🞑🞑 Making managers (decision makers) and employees into stockholders
🞑🞑 Protect lenders from expropriation
🞑🞑 By providing information honestly and promptly to financial markets
🞑🞑 Minimize social costs

Aswath Damodaran
46
 I. An Alternative Corporate Governance System
47

 Germany and Japan developed a different mechanism for

corporate governance, based upon corporate cross holdings.
🞑🞑 In Germany, the banks form the core of this system.
🞑🞑 In Japan, it is the keiretsus
🞑🞑 Other Asian countries have modeled their system after Japan, with family
companies forming the core of the new corporate families
 At their best, the most efficient firms in the group work at bringing
the less efficient firms up to par. They provide a corporate welfare
system that makes for a more stable corporate structure
 At their worst, the least efficient and poorly run firms in the group
pull down the most efficient and best run firms down. The nature
of the cross holdings makes its very difficult for outsiders (including
investors in these firms) to figure out how well or badly the group
is doing.

Aswath Damodaran
47
 II. Choose a Different Objective Function
48

 Firms can always focus on a different objective function.

Examples would include
🞑🞑 maximizing earnings
🞑🞑 maximizing revenues
🞑🞑 maximizing firm size
🞑🞑 maximizing market share
🞑🞑 maximizing EVA
 The key thing to remember is that these are
intermediate objective functions.
🞑🞑 To the degree that they are correlated with the long term health
and value of the company, they work well.
🞑🞑 To the degree that they do not, the firm can end up with a
disaster

Aswath Damodaran
48
 III. Maximize Stock Price, subject to ..
49

 The strength of the stock price maximization objective

function is its internal self correction mechanism. Excesses on
any of the linkages lead, if unregulated, to counter actions
which reduce or eliminate these excesses
 In the context of our discussion,
🞑🞑 managers taking advantage of stockholders has led to a much more
active market for corporate control.
🞑🞑 stockholders taking advantage of bondholders has led to bondholders
protecting themselves at the time of the issue.
🞑🞑 firms revealing incorrect or delayed information to markets has led to
markets becoming more “skeptical” and “punitive”
🞑🞑 firms creating social costs has led to more regulations, as well as
investor and customer backlashes.

Aswath Damodaran
49
 The Stockholder Backlash
50

 Activist Institutional investors have become much more

active in monitoring companies that they invest in and
demanding changes in the way in which business is done.
They have been joined by private equity funds like KKR and
Blackstone.
 Activist individuals like Carl Icahn specialize in taking large
positions in companies which they feel need to change their
ways (Blockbuster, Time Warner, Motorola & Apple) and
push for change.
 Vocal stockholders, armed with more information and new
powers: At annual meetings, stockholders have taken to
expressing their displeasure with incumbent management by
voting against their compensation contracts or their board of
directors

Aswath Damodaran
50
 The Hostile Acquisition Threat
51

 The typical target firm in a hostile takeover has

🞑🞑 a return on equity almost 5% lower than its peer group
🞑🞑 had a stock that has significantly under performed the
peer group over the previous 2 years
🞑🞑 has managers who hold little or no stock in the firm
 In other words, the best defense against a hostile
takeover is to run your firm well and earn good
returns for your stockholders
 Conversely, when you do not allow hostile
takeovers, this is the firm that you are most likely
protecting (and not a well run or well managed firm)
Aswath Damodaran
51
 In response, boards are becoming more
independent…
52

 Boards have become smaller over time. The median size of a board
of directors has decreased from 16 to 20 in the 1970s to between 9
and 11 in 1998. The smaller boards are less unwieldy and more
effective than the larger boards.
 There are fewer insiders on the board. In contrast to the 6 or more
insiders that many boards had in the 1970s, only two directors in
most boards in 1998 were insiders.
 Directors are increasingly compensated with stock and options in
the company, instead of cash. In 1973, only 4% of directors
received compensation in the form of stock or options, whereas
78% did so in 1998.
 More directors are identified and selected by a nominating
committee rather than being chosen by the CEO of the firm. In
1998, 75% of boards had nominating committees; the comparable
statistic in 1973 was 2%.

Aswath Damodaran
52
Disney: Eisner’s rise & fall from grace

 In his early years at Disney, Michael Eisner brought about long-‐delayed changes in
the company and put it on the path to being an entertainment giant that it is
today. His success allowed him to consolidate power and the boards that he
created were increasingly captive ones (see the 1997 board).
 In 1996, Eisner spearheaded the push to buy ABC and the board rubberstamped
his decision, as they had with other major decisions. In the years following, the
company ran into problems both on its ABC acquisition and on its other
operations and stockholders started to get restive, especially as the stock price
halved between 1998 and 2002.
 In 2003, Roy Disney and Stanley Gold resigned from the Disney board, arguing
against Eisner’s autocratic style.
 In early 2004, Comcast made a hostile bid for Disney and later in the year, 43% of
Disney shareholders withheld their votes for Eisner’s reelection to the board of
directors. Following that vote, the board of directors at Disney voted unanimously
to elect George Mitchell as the Chair of the board, replacing Eisner, who vowed to
stay on as CEO.

Aswath Damodaran
53
 Eisner’s concession: Disney’s Board in 2003
54

Board Members Occupation

Reveta Bowers Head of school for the Center for Early Education,
John Bryson CEO and Chairman of Con Edison
Roy Disney Head of Disney Animation
Michael Eisner CEO of Disney
Judith Estrin CEO of Packet Design (an internet company)
Stanley Gold CEO of Shamrock Holdings
Robert Iger Chief Operating Officer, Disney
Monica Lozano Chief Operation Officer, La Opinion (Spanish newspaper)
George Mitchell Chairman of law firm (Verner, Liipfert, et al.)
Thomas S. Murphy Ex-CEO, Capital Cities ABC
Leo O’Donovan Professor of Theology, Georgetown University
Sidney Poitier Actor, Writer and Director
Robert A.M. Stern Senior Partner of Robert A.M. Stern Architects of New York
Andrea L. Van de Kamp Chairman of Sotheby's West Coast
Raymond L. Watson Chairman of Irvine Company (a real estate corporation)
Gary L. Wilson Chairman of the board, Northwest Airlines.

Aswath Damodaran
54
 Changes in corporate governance at Disney
55

1. Required at least two executive sessions of the board, without the CEO
or other members of management present, each year.
2. Created the position of non-‐management presiding director, and
appointed Senator George Mitchell to lead those executive sessions and
assist in setting the work agenda of the board.
3. Adopted a new and more rigorous definition of director independence.
4. Required that a substantial majority of the board be comprised of
directors meeting the new independence standards.
5. Provided for a reduction in committee size and the rotation of
committee and chairmanship assignments among independent
directors.
6. Added new provisions for management succession planning and
evaluations of both management and board performance
7. Provided for enhanced continuing education and training for board
members.

Aswath Damodaran
55
 Eisner’s exit… and a new age dawns? Disney’s
board in 2008
56

Aswath Damodaran
56
But as a CEO’s tenure lengthens, does
corporate governance suffer?
1. While the board size has stayed compact (at twelve members),
there has been only one change since 2008, with Sheryl
Sandberg, COO of Facebook, replacing the deceased Steve Jobs.
2. The board voted reinstate Iger as chair of the board in 2011,
reversing a decision made to separate the CEO and Chair
positions after the Eisner years.
3. In 2011, Iger announced his intent to step down as CEO in 2015
but Disney’s board convinced Iger to stay on as CEO for an extra
year, for the “the good of the company”.
4. There were signs of restiveness among Disney’s stockholders,
especially those interested in corporate governance. Activist
investors (CalSTRS) starting making noise and Institutional
Shareholder Services (ISS), which gauges corporate governance at
companies, raised red flags about compensation and board
monitoring at Disney.

Aswath Damodaran
57
 What about legislation?
58

 Every corporate scandal creates impetus for a

legislative response. The scandals at Enron and
WorldCom laid the groundwork for Sarbanes-‐Oxley.
 You cannot legislate good corporate governance.
🞑🞑 The costs of meeting legal requirements often exceed the
benefits
🞑🞑 Laws always have unintended consequences
🞑🞑 In general, laws tend to be blunderbusses that penalize
good companies more than they punish the bad
companies.

Aswath Damodaran
58
 Is there a payoff to better corporate
governance?
59

 In the most comprehensive study of the effect of corporate governance

on value, a governance index was created for each of 1500 firms based
upon 24 distinct corporate governance provisions.
🞑🞑 Buying stocks that had the strongest investor protections while simultaneously
selling shares with the weakest protections generated an annual excess return of
8.5%.
🞑🞑 Every one point increase in the index towards fewer investor protections decreased
market value by 8.9% in 1999
🞑🞑 Firms that scored high in investor protections also had higher profits, higher sales
growth and made fewer acquisitions.
 The link between the composition of the board of directors and firm value
is weak. Smaller boards do tend to be more effective.
 On a purely anecdotal basis, a common theme at problem companies and
is an ineffective board that fails to ask tough questions of an imperial
CEO.

Aswath Damodaran
59
 The Bondholders’ Defense Against Stockholder
Excesses
60

 More restrictive covenants on investment, financing and dividend

policy have been incorporated into both private lending
agreements and into bond issues, to prevent future “Nabiscos”.
 New types of bonds have been created to explicitly protect
bondholders against sudden increases in leverage or other actions
that increase lender risk substantially. Two examples of such bonds
🞑🞑 Puttable Bonds, where the bondholder can put the bond back to the firm
and get face value, if the firm takes actions that hurt bondholders
🞑🞑 Ratings Sensitive Notes, where the interest rate on the notes adjusts to
that appropriate for the rating of the firm
 More hybrid bonds (with an equity component, usually in the form
of a conversion option or warrant) have been used. This allows
bondholders to become equity investors, if they feel it is in their
best interests to do so.

Aswath Damodaran
60
 The Financial Market Response
61

 While analysts are more likely still to issue buy rather

than sell recommendations, the payoff to uncovering
negative news about a firm is large enough that such
news is eagerly sought and quickly revealed (at least to a
limited group of investors).
 As investor access to information improves, it is
becoming much more difficult for firms to control when
and how information gets out to markets.
 As option trading has become more common, it has
become much easier to trade on bad news. In the
process, it is revealed to the rest of the market.
 When firms mislead markets, the punishment is not only
quick but it is savage.
Aswath Damodaran
61
 The Societal Response
62

 If firms consistently flout societal norms and create

large social costs, the governmental response
(especially in a democracy) is for laws and
regulations to be passed against such behavior.
 For firms catering to a more socially conscious
clientele, the failure to meet societal norms (even if
it is legal) can lead to loss of business and value.
 Finally, investors may choose not to invest in stocks
of firms that they view as socially irresponsible.

Aswath Damodaran
62
 The Counter Reaction
63

STOCKHOLDERS

1.More activist Managers of poorly

investors run firms are put
2. Hostile takeovers on notice.

Protect themselves Corporate Good Citizen Constraints

BONDHOLDERS Managers SOCIETY
1. Covenants 1. More laws
2. New Types 2. Investor/Customer Backlash
Firms are
punished Investors and
for misleading analysts become
markets more skeptical

FINANCIAL MARKETS

Aswath Damodaran
63
 So what do you think?
64

 At this point in time, the following statement best describes

where I stand in terms of the right objective function for
decision making in a business
a. Maximize stock price, with no constraints
b. Maximize stock price, with constraints on being a good social citizen.
c. Maximize stockholder wealth, with good citizen constraints, and
hope/pray that the market catches up with you.
d. Maximize profits or profitability
e. Maximize earnings growth
f. Maximize market share
g. Maximize revenues
h. Maximize social good
i. None of the above

Aswath Damodaran
64
 The Modified Objective Function
65

 For publicly traded firms in reasonably efficient markets,

where bondholders (lenders) are protected:
🞑🞑 Maximize Stock Price: This will also maximize firm value
 For publicly traded firms in inefficient markets, where
bondholders are protected:
🞑🞑 Maximize stockholder wealth: This will also maximize firm value,
but might not maximize the stock price
 For publicly traded firms in inefficient markets, where
bondholders are not fully protected
🞑🞑 Maximize firm value, though stockholder wealth and stock
prices may not be maximized at the same point.
 For private firms, maximize stockholder wealth (if
lenders are protected) or firm value (if they are not)
Aswath Damodaran
65
 First Principles
66

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

Aswath Damodaran
66