corporate finance: instructor's manual applied corporate finance
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Aswath Damodaran 1
Corporate Finance: Instructors ManualApplied Corporate Finance - Second Edition
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
! 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
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
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
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
! 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
! Maximizing stock price does not mean that customers are not critical to
success. In most businesses, keeping customers happy is the route to stock
! Maximizing stock price does not imply that a company has to be a social
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
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
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
Hire & fire
- Annual Meeting
assess effect on
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.