corporate finance: instructor's manual applied corporate finance

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  • Aswath Damodaran 1

    Corporate Finance: Instructors ManualApplied Corporate Finance - Second Edition

    Aswath Damodaran

    Stern School of Business

    This is my attempt at an instructors manual. It is built around the slides I use

    for my corporate finance class at Stern (which last 14 weeks and 26 sessions).

    The notes for the slides are included. Please use what you want, abandon what

    does not work and add or modify as you go along. You can download the

    powerpoint slides on my website!

  • Aswath Damodaran 2

    The Objective in Corporate Finance

    If you dont know where you are going, it does not matter how you getthere

  • This is the big picture of corporate finance.

    Tie in the course outline to the big picture. (I put session numbers on this page

    to show when we will be doing what)

    Emphasize the common sense basis of corporate finance. Note that people have

    been running businesses, and some of them very well, for hundreds of years

    prior to the creation of corporate finance as a discipline.

    Talk about the three major components of corporate finance - the investment,

    financing and dividend decisions, and how corporate finance views these

    decisions through the prism of firm value maximization.

    Aswath Damodaran 3

    First Principles

    ! Invest in projects that yield a return greater than the minimum acceptablehurdle rate.

    The hurdle rate should be higher for riskier projects and reflect the financing mixused - owners funds (equity) or borrowed money (debt)

    Returns on projects should be measured based on cash flows generated and thetiming of these cash flows; they should also consider both positive and negativeside effects of these projects.

    ! Choose a financing mix that minimizes the hurdle rate and matches the assetsbeing financed.

    ! If there are not enough investments that earn the hurdle rate, return the cash tothe owners of the firm (if public, these would be stockholders).

    The form of returns - dividends and stock buybacks - will depend upon thestockholders characteristics.

    Objective: Maximize the Value of the Firm

  • Aswath Damodaran 4

    The Classical Viewpoint

    ! Van Horne: "In this book, we assume that the objective of the firm is to

    maximize its value to its stockholders"

    ! Brealey & Myers: "Success is usually judged by value: Shareholders are

    made better off by any decision which increases the value of their stake in the

    firm... The secret of success in financial management is to increase value."

    ! Copeland & Weston: The most important theme is that the objective of the

    firm is to maximize the wealth of its stockholders."

    ! Brigham and Gapenski: Throughout this book we operate on the assumption

    that the management's primary goal is stockholder wealth maximization

    which translates into maximizing the price of the common stock.

    I picked four widely used books and quoted the value maximization objective

    statement from each of the books to illustrate two points:

    Value maximization as an objective function is pervasive in corporate

    financial theory

    Not enough attention is paid to defending this objective function in

    most corporate finance books. The assumption is that all readers will

    accept this objective function, which is not necessarily true.

    It is also interesting that these four books also state the objective functions

    differently - Van Horne as stockholders value maximization , Brealey and

    Myers and Copeland and Weston as stockholder wealth maximization and

    Brigham and Gapenski as the maximization as the stock price.

    Question to ask :

    Are these objective functions equivalent?

    If not, which assumption is the least restrictive and which is the most

    restrictive?

    What are the additional assumptions needed to get from the least to the most

    restrictive objective functions?

  • This is the answer to the question posed in the previous overhead.

    There are alternative objective functions (Maximize market share, maximize

    earnings, maximize growth )

    These are intermediate objective functions - maximizing market share by itself is

    valuable insofar as it increases pricing power and thus, potentially the market

    value.

    Aswath Damodaran 5

    The Objective in Decision Making

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

    maximize the value of the firm.

    ! A narrower objective is to maximize stockholder wealth. When the stock is

    traded and markets are viewed to be efficient, the objective is to maximize the

    stock price.

    ! All other goals of the firm are intermediate ones leading to firm value

    maximization, or operate as constraints on firm value maximization.

  • Aswath Damodaran 6

    The Criticism of Firm Value Maximization

    ! Maximizing stock price is not incompatible with meeting employee

    needs/objectives. In particular:

    - Employees are often stockholders in many firms

    - Firms that maximize stock price generally are firms that have treated employees

    well.

    ! Maximizing stock price does not mean that customers are not critical to

    success. In most businesses, keeping customers happy is the route to stock

    price maximization.

    ! Maximizing stock price does not imply that a company has to be a social

    outlaw.

    Open up the discussion to what arguments student might have or might have

    heard about stock price maximization. The three that I have heard most often are

    listed above.

    Stock price maximization implies not caring for your employees. Use a

    recent story of layoffs to illustrate this criticism (Eastman Kodak

    announced it was laying of 15,000 employees and stock price jumped

    $3.50). Then note that this is the exception rather than the rule. AConference Board study from 1994 found that companies whose stock

    prices have gone up are more likely to hire people than one whose stock

    prices have gone down. Also note that employees, especially in high tech

    companies, have a large stake in how well their company does because

    they have stock options or stock in the company.

    Note that customer satisfaction is important but only in the context that

    satisfied customers buy more from you. What would happen to a firm

    that defined its objective as maximizing customer satisfaction?

    A healthy company whose stock price has done well is much more likely

    to do social good than a company which is financially healthy. Again,

    note that there are social outlaws who might create social costs in the

    pursuit of stock price maximization (Those nasty corporate raiders..) but

    they are the exception rather than the rule.

  • Aswath Damodaran 7

    Why traditional corporate financial theory focuses on

    maximizing stockholder wealth.

    ! Stock price is easily observable and constantly updated (unlike other

    measures of performance, which may not be as easily observable, and

    certainly not updated as frequently).

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

    decisions, short term and long term, instantaneously.

    ! The objective of stock price performance provides some very elegant theory

    on:

    how to pick projects

    how to finance them

    how much to pay in dividends

    Emphasize how important it is to have an objective function that is observable

    and measurable. Note that stock prices provide almost instantaneous feedback

    (some of which is unwelcome) on every decision you make as a firm.

    Consider the example of an acquisition announcement and the market reaction

    to it. Stock prices of the acquiring firm tend to drop in a significant proportion

    of acquisitions. Why might markets be more pessimistic than managers about

    the expected success of an acquisition? Because the track record of firms onacquisitions is not very good.

  • Aswath Damodaran 8

    The Classical Objective Function

    STOCKHOLDERS

    Maximize

    stockholder

    wealth

    Hire & fire

    managers

    - Board

    - Annual Meeting

    BONDHOLDERSLend Money

    Protect

    bondholderInterests

    FINANCIAL MARKETS

    SOCIETYManagers

    Reveal

    information

    honestly and

    on time

    Markets are

    efficient and

    assess effect on

    value

    No Social Costs

    Costs can be

    traced to firm

    This is the utopian world. None of the assumptions are really defensible as

    written, and skepticism is clearly justified:

    Why do we need these assumptions?

    Since, in many large firms, there is a separation of ownership from

    management, managers have to be fearful of losing their jobs and go out

    and maximize stockholder wealth. If they do not have this fear, they will

    focus on their own interests.

    If bondholders are not protected, stockholders can steal from them and

    make themselves better off, even as they make the firm less valuable.

    If markets are not efficient, maximizing stock prices may not have

    anything to do with maximizing stockholder wealth or firm value.

    If substantial social costs are created, maximizing stock prices may

    create large side costs for society (of which stockholders are members).

    Note that corporate finance, done right, is not about stealing from other groups

    (bondholders, other stockholders or society) but about making the firm more

    productive and valuable.

  • Aswath Damodaran