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Corporate Finance: Instructor’s Manual Applied Corporate Finance - Second Edition Aswath Damodaran Stern School of Business Aswath Damodaran 1 This is my attempt at an instructor’s 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! The Objective in Corporate Finance “If you don’t know where you are going, it does not matter how you get there” Aswath Damodaran 2 First Principles ! Invest in projects that yield a return greater than the minimum acceptable hurdle rate. • The hurdle rate should be higher for riskier projects and reflect the financing mix used - owners’ funds (equity) or borrowed money (debt) • Returns on projects should be measured based on cash flows generated and the timing of these cash flows; they should also consider both positive and negative side effects of these projects. ! Choose a financing mix that minimizes the hurdle rate and matches the assets being financed. ! If there are not enough investments that earn the hurdle rate, return the cash to the owners of the firm (if public, these would be stockholders). • The form of returns - dividends and stock buybacks - will depend upon the stockholders’ characteristics. Objective: Maximize the Value of the Firm Aswath Damodaran 3 • 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. 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. Aswath Damodaran 4 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? 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 5 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. 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. Aswath Damodaran 6 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. A Conference 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. 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 Aswath Damodaran 7 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 on acquisitions is not very good. The Classical Objective Function STOCKHOLDERS Hire & fire Maximize managers stockholder - Board wealth - Annual Meeting No Social Costs Lend Money Managers BONDHOLDERS SOCIETY Protect 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 8 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. What can go wrong? STOCKHOLDERS Managers put Have little control their interests over managers above stockholders Significant Social Costs Lend Money Managers BONDHOLDERS 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 9 This is my worst case scenario: •Stockholders have little or no control over managers. Managers, consequently, put their interests above stockholder interests. •Bondholders who do not protect themselves find stockholders expropriating their wealth. •Information conveyed to markets is noisy, biases and sometimes misleading. Markets do not do a very good job of assimilating this information and market price changes have little to do with true value. •Firms in the process of maximizing stockholder wealth create large social costs. In this environment, stockholder wealth maximization is not a good objective function. I. Stockholder Interests vs. Management Interests ! In theory: The stockholders have significant control over management. The mechanisms for disciplining management are the annual meeting and the board of directors. ! In Practice: Neither mechanism is as effective in disciplining management as theory posits. Aswath Damodaran 10 In theory, stockholders are supposed to come to the annual meeting, and make informed judgments about whether they want to keep incumbent management in place. The board of directors is supposed to protect the stockholders.