Asw

ath Dam

odaran2

The O

bjective in Corporate F

inance

“If you don’t know w

here you are going, it does notm

atter how you get there”

Asw

ath Dam

odaran

Stern School of Business

Asw

ath Dam

odaran3

First P

rinciples

Invest in projects that yield a return greater than the minim

umacceptable hurdle rate.•

The hurdle rate should be higher for riskier projects and reflect the

financing mix used - ow

ners’ funds (equity) or borrowed m

oney (debt)•

Returns on projects should be m

easured based on cash flows generated

and the timing of these cash flow

s; they should also consider both positiveand negative side effects of these projects.

Choose a financing m

ix that minim

izes the hurdle rate and matches the

assets being financed.If there are not enough investm

ents that earn the hurdle rate, return thecash to the ow

ners of the firm (if public, these w

ould be stockholders).•

The form

of returns - dividends and stock buybacks - will depend upon

the stockholders’ characteristics.

Objective: M

aximize the V

alue of the Firm

Asw

ath Dam

odaran4

The C

lassical View

point

Van H

orne: "In this book, we assum

e that the objective of the firm is

to maxim

ize its value to its stockholders"

Brealey &

Myers: "Success is usually judged by value: Shareholders

are made better off by any decision w

hich increases the value of theirstake in the firm

... The secret of success in financial m

anagement is to

increase value."

Copeland &

Weston

: The m

ost important them

e is that the objectiveof the firm

is to maxim

ize the wealth of its stockholders."

Brigham

and Gapenski: T

hroughout this book we operate on the

assumption that the m

anagement's prim

ary goal is stockholder wealth

maxim

ization which translates into m

aximizing the price of the

comm

on stock.

Asw

ath Dam

odaran5

The O

bjective in Decision M

aking

In traditional corporate finance, the objective in decision making is to

maxim

ize the value of the firm.

A narrow

er objective is to maxim

ize stockholder wealth. W

hen thestock is traded and m

arkets are viewed to be efficient, the objective is

to maxim

ize the stock price.

All other goals of the firm

are intermediate ones leading to firm

valuem

aximization, or operate as constraints on firm

value maxim

ization.

Asw

ath Dam

odaran6

The C

riticism of F

irm V

alue Maxim

ization

Maxim

izing stock price is not incompatible w

ith meeting em

ployeeneeds/objectives. In particular:•

- Em

ployees are often stockholders in many firm

s

•- Firm

s that maxim

ize stock price generally are firms that have treated

employees w

ell.

Maxim

izing stock price does not mean that custom

ers are not criticalto success. In m

ost businesses, keeping customers happy is the route to

stock price maxim

ization.

Maxim

izing stock price does not imply that a com

pany has to be asocial outlaw

.

Asw

ath Dam

odaran7

Why traditional corporate financial theory

focuses on maxim

izing stockholder wealth.

Stock price is easily observable and constantly updated (unlike otherm

easures of performance, w

hich may not be as easily observable, and

certainly not updated as frequently).

If investors are rational (are they?), stock prices reflect the wisdom

ofdecisions, short term

and long term, instantaneously.

The objective of stock price perform

ance provides some very elegant

theory on:•

how to pick projects

•how

to finance them

•how

much to pay in dividends

Asw

ath Dam

odaran8

The C

lassical Objective F

unction

STO

CK

HO

LD

ER

S

Maxim

izestockholderw

ealth

Hire &

firem

anagers- B

oard- A

nnual Meeting

BO

ND

HO

LD

ER

SL

end Money

ProtectbondholderInterestsFIN

AN

CIA

L M

AR

KE

TS

SOC

IET

YM

anagers

Reveal

information

honestly andon tim

e

Markets are

efficient andassess effect onvalue

No Social C

osts

Costs can be

traced to firm

Asw

ath Dam

odaran9

What can go w

rong?

STO

CK

HO

LD

ER

S

Managers put

their interestsabove stockholders

Have little control

over managers

BO

ND

HO

LD

ER

SL

end Money

Bondholders can

get ripped off

FINA

NC

IAL

MA

RK

ET

S

SOC

IET

YM

anagers

Delay bad

news or

provide m

isleadinginform

ation

Markets m

akem

istakes andcan over react

Significant Social Costs

Some costs cannot be

traced to firm

Asw

ath Dam

odaran10

I. Stockholder Interests vs. M

anagement

Interests

Theory: T

he stockholders have significant control over managem

ent.T

he mechanism

s for disciplining managem

ent are the annual meeting

and the board of directors.

Practice: N

either mechanism

is as effective in discipliningm

anagement as theory posits.

Asw

ath Dam

odaran11

The A

nnual Meeting as a disciplinary venue

The pow

er of stockholders to act at annual meetings is diluted by three

factors•

Most sm

all stockholders do not go to meetings because the cost of going

to the meeting exceeds the value of their holdings.

•Incum

bent managem

ent starts off with a clear advantage w

hen it comes to

the exercising of proxies . Proxies that are not voted becomes votes for

incumbent m

anagement.

•For large stockholders, the path of least resistance, w

hen confronted bym

anagers that they do not like, is to vote with their feet.

Asw

ath Dam

odaran12

Board of D

irectors as a disciplinary mechanism

The A

verage Director: U

nderworked and O

verpaid

0 20 40 60 80

100

120

140

19851988

19921996

2000

Year

Hours worked per year

0 5000

10000

15000

20000

25000

30000

35000

40000

45000

50000

Annual Pay

Hours w

orked per yearA

nnual Pay

Asw

ath Dam

odaran13

The C

EO

hand-picks most directors..

The 1992 survey by K

orn/Ferry revealed that 74% of com

panies reliedon recom

mendations from

the CE

O to com

e up with new

directors;O

nly 16% used an outside search firm

.

Directors often hold only token stakes in their com

panies. The

Korn/Ferry survey found that 5%

of all directors in 1992 owned less

than five shares in their firms.

Many directors are them

selves CE

Os of other firm

s.

Asw

ath Dam

odaran14

Directors lack the expertise to ask the

necessary tough questions..

The C

EO

sets the agenda, chairs the meeting and controls the

information.

The search for consensus overw

helms any attem

pts at confrontation.

Asw

ath Dam

odaran15

The B

est Boards in 1997...

Asw

ath Dam

odaran16

And the W

orst Boards in 1997..

Asw

ath Dam

odaran17

Who’s on B

oard? The D

isney Experience -

1997

Asw

ath Dam

odaran18

A C

ontrast: Disney vs. C

ampbell S

oup in 1997

BE

ST P

RA

CT

ICE

S C

AM

PB

EL

L SO

UP

D

ISNE

Y

Majority of outside directors

Only one insider

7 of 17 mem

bers

among 15 directors

are insiders

Bans insiders on nom

inating Yes

No: C

EO

is

comm

ittee chairm

an of panel

Bans form

er execs from board

Yes

No

Mandatory retirem

ent age 70, w

ith none N

one

over 64

Outside directors m

eet w/o C

EO

Annually

Never

Appointm

ent of 'lead director'' Yes

No

Governance com

mittee

Yes

No

Self-evaluation of effectiveness Every tw

o years N

one

Director pensions

None

Yes

Share-ownership requirem

ent 3,000 shares

None

Asw

ath Dam

odaran19

Application T

est: Who’s on board?

Look at the board of directors for your firm

. Analyze

•H

ow m

any of the directors are inside directors (Em

ployees of the firm,

ex-managers)?

•Is there any inform

ation on how independent the directors in the firm

arefrom

the managers?

Asw

ath Dam

odaran20

Disney’s B

oard in 2002

Reveta F. Bowers:Head of School for the Center for Early Education

John E. Bryson:Chief Executive Officer of Edison International

Roy E. Disney: Nephew of the late Walt Disney

Michael D. Eisner: Chief Executive Officer of the Company

Judith L. Estrin:President and Chief Executive Officer of Packet Design

Stanley P. Gold: CEO of Shamrock Holdings, Inc., an investment firm

Robert A. Iger: President and Chief Operating Officer of the Company

Monica C. Lozano: President and Chief Operating Officer of La Opinion

George J. Mitchell:United States Senator from 1980 to 1995

Thomas S. Murphy: Chairman of the Board and CEO of Capital Cities/ABC

Leo J. O'Donovan, S.J:Professor of Theology at Georgetown University

Sidney Poitier: Actor, director and writer

Robert A.M. Stern:Architect, teacher and writer

Andrea L. Van de Kamp:Chairman of Sotheby's West Coast

Raymond L. Watson:Vice Chairman of the Board of The Irvine Company

Gary L. Wilson:Chairman of the Board of Northwest Airlines Corporation

Asw

ath Dam

odaran21

So w

hat next? When the cat is idle, the m

icew

ill play ....

When m

anagers do not fear stockholders, they will often put their

interests over stockholder interests•

Greenm

ail: The (m

anagers of ) target of a hostile takeover buy out thepotential acquirer's existing stake, at a price m

uch greater than the pricepaid by the raider, in return for the signing of a 'standstill' agreem

ent.

•G

olden Parachutes: Provisions in em

ployment contracts, that allow

s forthe paym

ent of a lump-sum

or cash flows over a period, if m

anagerscovered by these contracts lose their jobs in a takeover.

•P

oison Pills: A

security, the rights or cashflows on w

hich are triggeredby an outside event, generally a hostile takeover, is called a poison pill.

•Shark R

epellents: Anti-takeover am

endments are also aim

ed atdissuading hostile takeovers, but differ on one very im

portant count. They

require the assent of stockholders to be instituted.

•O

verpaying on takeovers

No stockholder approval needed….. Stockholder Approval needed

Asw

ath Dam

odaran22

Overpaying on takeovers

The quickest and perhaps the m

ost decisive way to im

poverishstockholders is to overpay on a takeover.

The stockholders in acquiring firm

s do not seem to share the

enthusiasm of the m

anagers in these firms. Stock prices of bidding

firms decline on the takeover announcem

ents a significant proportionof the tim

e.

Many m

ergers do not work, as evidenced by a num

ber of measures.

•T

he profitability of merged firm

s relative to their peer groups, does notincrease significantly after m

ergers.

•A

n even more dam

ning indictment is that a large num

ber of mergers are

reversed within a few

years, which is a clear adm

ission that theacquisitions did not w

ork.

Asw

ath Dam

odaran23

A C

ase Study: K

odak - Sterling D

rugs

Eastm

an Kodak’s G

reat Victory

Asw

ath Dam

odaran24

Earnings and R

evenues at Sterling D

rugs

Sterling Drug under E

astman K

odak: Where is the synergy?

0500

1,000

1,500

2,000

2,500

3,0003,500

4,000

4,500

5,000

19881989

19901991

1992

Revenue

Operating E

arnings

Asw

ath Dam

odaran25

Kodak S

ays Drug U

nit Is Not for S

ale(N

YT

imes, 8/93)

An article in the N

Y T

imes in A

ugust of 1993 suggested that Kodak w

as eagerto shed its drug unit.

•In response, E

astman K

odak officials say they have no plans to sell Kodak’s

Sterling Winthrop drug unit.

•L

ouis Mattis, C

hairman of Sterling W

inthrop, dismissed the rum

ors as “massive

speculation, which flies in the face of the stated intent of K

odak that it iscom

mitted to be in the health business.”

A few

months later…

Taking a stride out of the drug business, E

astman K

odaksaid that the Sanofi G

roup, a French pharmaceutical com

pany, agreed to buythe prescription drug business of Sterling W

inthrop for $1.68 billion.•

Shares of Eastm

an Kodak rose 75 cents yesterday, closing at $47.50 on the N

ewY

ork Stock Exchange.

•Sam

uel D. Isaly an analyst , said the announcem

ent was “very good for Sanofi and

very good for Kodak.”

• “W

hen the divestitures are complete, K

odak will be entirely focused on im

aging,”said G

eorge M. C

. Fisher, the company's chief executive.

•T

he rest of the Sterling Winthrop w

as sold to Smithkline for $2.9 billion.

Asw

ath Dam

odaran26

Application T

est: Who ow

ns/runs your firm?

Look at: B

loomberg printout H

DS for your firm

Looking at the top 15 stockholders in your firm

, consider thefollow

ing:•

How

many of the top 15 investors are institutional investors?

•H

ow m

any of the top 15 investors are individual investors?

•A

re managers significant stockholders in the firm

?

Asw

ath Dam

odaran27

Disney’s top stockholders in 2002

Asw

ath Dam

odaran28

II. Stockholders' objectives vs. B

ondholders'objectives

In theory: there is no conflict of interests between stockholders and

bondholders.

In practice: Stockholders may m

aximize their w

ealth at the expense ofbondholders.•

Increasing dividends significantly: When firm

s pay cash out as dividends,lenders to the firm

are hurt and stockholders may be helped. T

his isbecause the firm

becomes riskier w

ithout the cash.

•T

aking riskier projects than those agreed to at the outset: Lenders base

interest rates on their perceptions of how risky a firm

’s investments are. If

stockholders then take on riskier investments, lenders w

ill be hurt.

•B

orrowing m

ore on the same assets : If lenders do not protect them

selves,a firm

can borrow m

ore money and m

ake all existing lenders worse off.

Asw

ath Dam

odaran29

Unprotected Lenders?

Asw

ath Dam

odaran30

III. Firm

s and Financial M

arkets

In theory: Financial markets are efficient. M

anagers conveyinform

ation honestly and truthfully to financial markets, and financial

markets m

ake reasoned judgments of 'true value'. A

s a consequence-•

A com

pany that invests in good long term projects w

ill be rewarded.

•Short term

accounting gimm

icks will not lead to increases in m

arketvalue.

•Stock price perform

ance is a good measure of m

anagement perform

ance.

In practice: There are som

e holes in the 'Efficient M

arkets'assum

ption.

Asw

ath Dam

odaran31

Managers control the release of inform

ation tothe general public

There is evidence that•

they suppress information, generally negative inform

ation

• they delay the releasing of bad new

s–

bad earnings reports

–other new

s

•they som

etimes reveal fraudulent inform

ation

Asw

ath Dam

odaran32

Evidence that m

anagers delay bad news..

DO

MA

NA

GE

RS

DE

LAY

BA

D N

EW

S?: E

PS

and DP

S C

hanges- byW

eekday

-6.0

0%

-4.0

0%

-2.0

0%

0.0

0%

2.0

0%

4.0

0%

6.0

0%

8.0

0%

Mo

nd

ay

Tu

es

da

yW

ed

ne

sd

ay

Th

urs

da

yF

rida

y

% C

hg

(EP

S)

% C

hg

(DP

S)

Asw

ath Dam

odaran33

Even w

hen information is revealed to financial

markets, the m

arket value that is set bydem

and and supply may contain errors.

Prices are much m

ore volatile than justified by the underlyingfundam

entals•

Eg. D

id the true value of equities really decline by 20% on O

ctober 19,1987?

financial markets overreact to new

s, both good and bad

financial markets are short-sighted, and do not consider the long-term

implications of actions taken by the firm

•E

g. the focus on next quarter's earnings

financial markets are m

anipulated by insiders; Prices do not have anyrelationship to value.

Asw

ath Dam

odaran34

Are M

arkets Short term

?

Focusing on market prices w

ill lead companies tow

ards short termdecisions at the expense of long term

value.

I agree with the statem

ent

I do not agree with this statem

ent

Asw

ath Dam

odaran35

Are M

arkets Short S

ighted? Som

e evidencethat they are not..

There are hundreds of start-up and sm

all firms, w

ith no earningsexpected in the near future, that raise m

oney on financial markets

If the evidence suggests anything, it is that markets do not value

current earnings and cashflows enough and value future earnings

and cashflows too m

uch.•

Low

PE stocks are underpriced relative to high PE

stocks

The m

arket response to research and development and

investment expenditure is generally positive

Asw

ath Dam

odaran36

Market R

eaction to Investment A

nnouncements

Type of A

nnouncement

Abnorm

al Returns on

Announcem

ent Day

Announcem

ent Month

Joint Venture Form

ations0.399%

1.412%

R&

D E

xpenditures0.251%

1.456%

Product Strategies0.440%

-0.35%

Capital E

xpenditures0.290%

1.499%

All A

nnouncements

0.355%0.984%

Asw

ath Dam

odaran37

IV. F

irms and S

ociety

In theory: There are no costs associated w

ith the firm that cannot be

traced to the firm and charged to it.

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 N

OT

to the firm m

aking the decision.–

-environmental costs (pollution, health costs, etc..)

–Q

uality of Life' costs (traffic, housing, safety, etc.)

•E

xamples of social benefits include:

–creating em

ployment in areas w

ith high unemploym

ent

–supporting developm

ent in inner cities

–creating access to goods in areas w

here such access does not exist

Asw

ath Dam

odaran38

Social C

osts and Benefits are difficult to

quantify because ..

They m

ight not be known at the tim

e of the decision (Exam

ple:M

anville and asbestos)

They are 'person-specific' (different decision m

akers weight them

differently)

They can be paralyzing if carried to extrem

es

Asw

ath Dam

odaran39

A H

ypothetical Exam

ple

Assum

e that you work for D

isney and that you have an opportunity toopen a store in an inner-city neighborhood. T

he store is expected tolose about $100,000 a year, but it w

ill create much-needed

employm

ent in the area, and may help revitalize it.

Questions:

•W

ould you open the store?

Yes

No

•If yes, w

ould you tell your stockholders and let them vote on the issue?

Yes

No

•If no, how

would you respond to a stockholder query on w

hy you were

not living up to your social responsibilities?

Asw

ath Dam

odaran40

So this is w

hat can go wrong...

STO

CK

HO

LD

ER

S

Managers put

their interestsabove stockholders

Have little control

over managers

BO

ND

HO

LD

ER

SL

end Money

Bondholders can

get ripped off

FINA

NC

IAL

MA

RK

ET

S

SOC

IET

YM

anagers

Delay bad

news or

provide m

isleadinginform

ation

Markets m

akem

istakes andcan over react

Significant Social Costs

Some costs cannot be

traced to firm

Asw

ath Dam

odaran41

Traditional corporate financial theory breaks

down w

hen ...

The interests/objectives of the decision m

akers in the firm conflict

with the interests of stockholders.

Bondholders (L

enders) are not protected against expropriation bystockholders.

Financial markets do not operate efficiently, and stock prices do not

reflect the underlying value of the firm.

Significant social costs can be created as a by-product of stock pricem

aximization.

Asw

ath Dam

odaran42

When traditional corporate financial theory

breaks down, the solution is:

To choose a different m

echanism for corporate governance

To choose a different objective:

To m

aximize stock price, but reduce the potential for conflict and

breakdown:

•M

aking managers (decision m

akers) and employees into stockholders

•B

y providing information honestly and prom

ptly to financial markets

Asw

ath Dam

odaran43

An A

lternative Corporate G

overnance System

Germ

any and Japan developed a different mechanism

for corporategovernance, based upon corporate cross holdings.•

In Germ

any, the banks form the core of this system

.

•In Japan, it is the keiretsus

•O

ther Asian countries have m

odeled their system after Japan, w

ith family

companies form

ing the core of the new corporate fam

ilies

At their best, the m

ost efficient firms in the group w

ork at bringing theless efficient firm

s up to par. They provide a corporate w

elfare systemthat m

akes for a more stable corporate structure

At their w

orst, the least efficient and poorly run firms in the group pull

down the m

ost efficient and best run firms dow

n. 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.

Asw

ath Dam

odaran44

Choose a D

ifferent Objective F

unction

Firms can alw

ays focus on a different objective function. Exam

plesw

ould include•

maxim

izing earnings

•m

aximizing revenues

•m

aximizing firm

size

•m

aximizing m

arket share

•m

aximizing E

VA

The key thing to rem

ember is that these are interm

ediate objectivefunctions.•

To the degree that they are correlated w

ith the long term health and value

of the company, they w

ork well.

•T

o the degree that they do not, the firm can end up w

ith a disaster

Asw

ath Dam

odaran45

Maxim

ize Stock P

rice, subject to ..

The strength of the stock price m

aximization objective function is its

internal self correction mechanism

. Excesses on any of the linkages

lead, if unregulated, to counter actions which reduce or elim

inate theseexcesses

In the context of our discussion,•

managers taking advantage of stockholders has lead to a m

uch more

active market for corporate control.

•stockholders taking advantage of bondholders has lead to bondholdersprotecting them

selves at the time of the issue.

•firm

s revealing incorrect or delayed information to m

arkets has lead tom

arkets becoming m

ore “skeptical” and “punitive”

•firm

s creating social costs has lead to more regulations, as w

ell as investorand custom

er backlashes.

Asw

ath Dam

odaran46

The S

tockholder Backlash

Institutional investors such as CalPE

RS and the L

ens Funds havebecom

e much m

ore active in monitoring com

panies that they invest inand dem

anding changes in the way in w

hich business is done

Individuals like Michael Price specialize in taking large positions in

companies w

hich they feel need to change their ways (C

hase, Dow

Jones, Readers’ D

igest) and push for change

At annual m

eetings, stockholders have taken to expressing theirdispleasure w

ith incumbent m

anagement by voting against their

compensation contracts or their board of directors

Asw

ath Dam

odaran47

The H

ostile Acquisition T

hreat

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 perform

ed the peer group over theprevious 2 years

•has m

anagers who hold little or no stock in the firm

In other words, the best defense against a hostile takeover is to run

your firm w

ell and earn good returns for your stockholders

Conversely, w

hen you do not allow hostile takeovers, this is the firm

that you are most likely protecting (and not a w

ell run or well m

anagedfirm

)

Asw

ath Dam

odaran48

An U

pdate in 2002: The P

ower of S

tockholderP

ressure - The M

ost Improved B

oards

CE

ND

AN

T: M

oved to upgrade governance after an accounting scandal in 1998 and a lawsuit

settlement in 1999. Shareholders now

approve all stock-option plans for top execs. External auditors

are barred from consulting w

ork. Severance deals were curtailed. T

he board pushed to eliminate

staggered board elections after a shareholder proposal failed.L

UC

EN

T: G

ets low m

arks from governance experts because of a $679 m

illion revenue restatement

and a $200 billion loss in market cap since D

ecember, 1999. Perform

ance is still in the tank, but thecom

pany has taken steps to improve governance. T

he six-mem

ber board has a lead independentdirector. C

onducts annual self-evaluations. Meets privately w

ith internal and external auditors. Has

added two independent directors and has plans for three m

ore.C

OM

PU

TE

R A

SSOC

IAT

ES

: Having landed on the W

orst Boards list tw

o years ago for awarding

top execs a massive pay package, this com

pany has made im

provements. It hired H

arvard's JayL

orsch to advise it on governance, then put him on the board; recruited form

er SEC

chief accountantW

alter P. Schuetze for its audit comm

ittee. Prohibits directors from selling stock until they leave.

WA

LT

DISN

EY

: Finally taking steps to improve a reputation for lousy governance. U

nder pressurefrom

director Stanley P. Gold, m

anager of the Disney fam

ily fortune, and other shareholders, thecom

pany has severed business relationships with tw

o directors. Tightened board's definition of

independence. Recruited governance expert Ira M

illstein to advise board.W

AST

E M

AN

AG

EM

EN

T: A

fter emerging from

an accounting scandal in 1998 and acquisition byU

SA W

aste in the same year, the com

pany has reformed. E

ight new m

embers, all independent, are

on the nine-mem

ber board, and the audit comm

ittee is headed by Jack Pope, former C

FO at U

nitedA

irlines and Am

erican Airlines. Side deals betw

een directors and company are banned. A

nti-shareholder governance policies, including staggered board elections, are changed.

Asw

ath Dam

odaran49

The B

ondholders’ Defense A

gainst Stockholder

Excesses

More restrictive covenants on investm

ent, financing and dividendpolicy have been incorporated into both private lending agreem

entsand into bond issues, to prevent future “N

abiscos”.

New

types of bonds have been created to explicitly protectbondholders against sudden increases in leverage or other actions thatincrease lender risk substantially. T

wo exam

ples of such bonds•

Puttable Bonds, w

here the bondholder can put the bond back to the firmand get face value, if the firm

takes actions that hurt bondholders

•R

atings Sensitive Notes, w

here the interest rate on the notes adjusts to thatappropriate for the rating of the firm

More hybrid bonds (w

ith an equity component, usually in the form

ofa conversion option or w

arrant) have been used. This allow

sbondholders to becom

e equity investors, if they feel it is in their bestinterests to do so.

Asw

ath Dam

odaran50

The F

inancial Market R

esponse

While analysts are m

ore likely still to issue buy rather than sellrecom

mendations, the payoff to uncovering negative new

s about afirm

is large enough that such news is eagerly sought and quickly

revealed (at least to a limited group of investors)

As inform

ation sources to the average investor proliferate, it isbecom

ing much m

ore difficult for firms to control w

hen and howinform

ation gets out to markets.

As option trading has becom

e more com

mon, it has becom

e much

easier to trade on bad news. In the process, it is revealed to the rest of

the market (See Scholastic)

When firm

s mislead m

arkets, the punishment is not only quick but it is

savage.

Asw

ath Dam

odaran51

The S

ocietal Response

If firms consistently flout societal norm

s and create large social costs,the governm

ental response (especially in a democracy) is for law

s andregulations to be passed against such behavior.•

e.g.: Law

s against using underage labor in the United States

For firms catering to a m

ore socially conscious clientele, the failure tom

eet societal norms (even if it is legal) can lead to loss of business and

value•

e.g. Specialty retailers being criticized for using under age labor in othercountries (w

here it might be legal)

Finally, investors may choose not to invest in stocks of firm

s that theyview

as social outcasts.•

e.g.. Tobacco firm

s and the growth of “socially responsible” funds

(Calvert..)

Asw

ath Dam

odaran52

The C

ounter Reaction

STO

CK

HO

LD

ER

S

Managers of poorly

run firms are put

on notice.

1. More activist

investors2. H

ostile takeovers

BO

ND

HO

LD

ER

S

Protect themselves

1. Covenants

2. New

Types

FINA

NC

IAL

MA

RK

ET

S

SOC

IET

YM

anagers

Firms are

punishedfor m

isleadingm

arkets

Investors andanalysts becom

em

ore skeptical

Corporate G

ood Citizen C

onstraints

1. More law

s2. Investor/C

ustomer B

acklash

Asw

ath Dam

odaran53

So w

hat do you think?

At this point in tim

e, the following statem

ent best describes where I

stand in terms of the right objective function for decision m

aking in abusiness

Maxim

ize stock price or stockholder wealth, w

ith no constraints

Maxim

ize stock price or stockholder wealth, w

ith constraints on beinga good social citizen.

Maxim

ize profits or profitability

Maxim

ize market share

Maxim

ize Revenues

Maxim

ize social good

None of the above

Asw

ath Dam

odaran54

The M

odified Objective F

unction

For publicly traded firms in reasonably efficient m

arkets, where

bondholders (lenders) are protected:•

Maxim

ize Stock Price: This w

ill also maxim

ize firm value

For publicly traded firms in inefficient m

arkets, where bondholders are

protected:•

Maxim

ize stockholder wealth: T

his will also m

aximize firm

value, butm

ight not maxim

ize the stock price

For publicly traded firms in inefficient m

arkets, where bondholders are

not fully protected•

Maxim

ize firm value, though stockholder w

ealth and stock prices may not

be maxim

ized at the same point.

For private firms, m

aximize stockholder w

ealth (if lenders areprotected) or firm

value (if they are not)