1
Preface

Let me begin this preface with a confession of a few of my own biases. First, I
believe that theory and the models that flow from it should provide the tools to
understand, analyze, and solve problems. The test of a model or theory then should not be
based on its elegance but on its usefulness in problem solving. Second, there is little in
corporate financial theory that is new and revolutionary. The core principles of corporate
finance are common sense and have changed little over time. That should not be
surprising. Corporate finance is only a few decades old, and people have been running
businesses for thousands of years; it would be exceedingly presumptuous of us to believe
that they were in the dark until corporate finance theorists came along and told them what
to do. To be fair, it is true that corporate financial theory has made advances in taking
commonsense principles and providing structure, but these advances have been primarily
on the details. The story line in corporate finance has remained remarkably consistent
over time.

Talking about story lines allows me to set the first theme of this book. This book
tells a story, which essentially summarizes the corporate finance view of the world. It
classifies all decisions made by any business into three groups—decisions on where to
invest the resources or funds that the business has raised, either internally or externally
(the investment decision), decisions on where and how to raise funds to finance these
investments (the financing decision), and decisions on how much and in what form to
return funds back to the owners (the dividend decision). As I see it, the first principles of
corporate finance can be summarized in Figure 1, which also lays out a site map for the
book. Every section of this book relates to some part of this picture, and each chapter is
introduced with it, with emphasis on that portion that will be analyzed in that chapter.
(Note the chapter numbers below each section). Put another way, there are no sections of
this book that are not traceable to this framework.

2
Figure 1 Corporate Finance: First Principles



As you look at the chapter outline for the book, you are probably wondering
where the chapters on present value, option pricing, and bond pricing are, as well as the
chapters on short-term financial management, working capital, and international finance.
The first set of chapters, which I would classify as “tools”
chapters, are now contained in the appendices, and I relegated
them there not because I think that they are unimportant but
because I want the focus to stay on the story line. It is important
that we understand the concept of time value of money, but only
in the context of measuring returns on investments better and
valuing business. Option pricing theory is elegant and provides
impressive insights, but only in the context of looking at options embedded in projects
and financing instruments like convertible bonds.

The second set of chapters I excluded for a very different reason. As I see it, the
basic principles of whether and how much you should invest in inventory, or how
generous your credit terms should be, are no different than the basic principles that would
apply if you were building a plant or buying equipment or opening a new store. Put


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another way, there is no logical basis for the differentiation between investments in the
latter (which in most corporate finance books is covered in the capital budgeting
chapters) and the former (which are considered in the working capital chapters). You
should invest in either if and only if the returns from the investment exceed the hurdle
rate from the investment; the fact the one is short-term and the other is long-term is
irrelevant. The same thing can be said about international finance. Should the investment
or financing principles be different just because a company is considering an investment
in Thailand and the cash flows are in Thai baht instead of in the United States, where the
cash flows are in dollars? I do not believe so, and in my view separating the decisions
only leaves readers with that impression. Finally, most corporate finance books that have
chapters on small firm management and private firm management use them to illustrate
the differences between these firms and the more conventional large publicly traded firms
used in the other chapters. Although such differences exist, the commonalities between
different types of firms vastly overwhelm the differences, providing a testimonial to the
internal consistency of corporate finance. In summary, the second theme of this book is
the emphasis on the universality of corporate financial principles across different firms,
in different markets, and across different types of
decisions.

The way I have tried to bring this universality
to life is by using five firms through the book to
illustrate each concept; they include a large, publicly
traded U.S. corporation (Disney); a small, emerging market commodity company
(Aracruz Celulose, a Brazilian paper and pulp company); an Indian manufacturing
company that is part of a family group (Tata Chemicals), a financial service firm
(Deutsche Bank); and a small private business (Bookscape, an independent New York
City bookstore). Although the notion of using real companies to illustrate theory is
neither novel nor revolutionary, there are, two key differences in the way they are used in
this book. First, these companies are analyzed on every aspect of corporate finance
introduced here, rather than just selectively in some chapters. Consequently, the reader
can see for him- or herself the similarities and the differences in the way investment,
financing, and dividend principles are applied to four very different firms. Second, I do


4
not consider this to be a book where applications are used to illustrate theory but a book
where the theory is presented as a companion to the illustrations. In fact, reverting back
to my earlier analogy of theory providing the tools for understanding problems, this is a
book where the problem solving takes center stage and the tools stay in the background.

Reading through the theory and the applications can be instructive and even
interesting, but there is no substitute for actually trying things out to bring home both the
strengths and weaknesses of corporate finance. There are several ways I have made this
book a tool for active learning. One is to introduce concept questions at regular intervals
that invite responses from the reader. As an example, consider the following illustration
from Chapter 7:
7.2. The Effects of Diversification on Venture Capitalist
You are comparing the required returns of two venture capitalists who are interested in
investing in the same software firm. One has all of his capital invested in only software
firms, whereas the other has invested her capital in small companies in a variety of
businesses. Which of these two will have the higher required rate of return?
❒
The venture capitalist who is invested only in software companies.
❒
The venture capitalist who is invested in a variety of businesses.
❒
Cannot answer without more information.

This question is designed to check on a concept introduced in an earlier chapter
on risk and return on the difference between risk that can be eliminated by holding a
diversified portfolio and risk that cannot and then connecting it to the question of how a
business seeking funds from a venture capitalist might be affected by this perception of
risk. The answer to this question in turn will expose the reader to more questions about
whether venture capital in the future will be provided by diversified funds and what a
specialized venture capitalist (who invests in one
sector alone) might need to do to survive in such an
environment. This will allow readers to see what, for
me at least, is one of the most exciting aspects of
corporate finance—its capacity
to provide a


5
framework that can be used to make sense of the events that occur around us every day
and make reasonable forecasts about future directions.

The second active experience in this book is found in the Live Case Studies at the
end of each chapter. These case studies essentially take the concepts introduced in the
chapter and provide a framework for applying them to any company the reader chooses.
Guidelines on where to get the information to answer the questions are also provided.

Although corporate finance provides an internally consistent and straightforward
template for the analysis of any firm, information is
clearly the lubricant that allows us to do the analysis.
There are three steps in the information process—
acquiring the information, filtering what is useful
from what is not, and keeping the information
updated. Accepting the limitations of the printed page on all of these aspects, I have put
the power of online information to use in several ways.
1. The case studies that require the information are accompanied by links to Web sites
that carry this information.
2. The data sets that are difficult to get from the Internet or are specific to this book,
such as the updated versions of the tables, are available on my own Web site
(www.damodaran.com) and are integrated into the book. As an example, the table
that contains the dividend yields and payout ratios by industry sectors for the most
recent quarter is referenced in Chapter 9 as follows:
There is a data set online that summarizes dividend yields and payout ratios for
U.S. companies, categorized by sector.
You can get to this table by going to the website for the book and checking for
datasets under chapter 9.
3. The spreadsheets used to analyze the firms in the book are also available on my Web
site and are referenced in the book. For instance, the spreadsheet used to estimate the
optimal debt ratio for Disney in Chapter 8 is referenced as follows:


6
Capstru.xls : This spreadsheet allows you to compute the optimal debt ratio firm
value for any firm, using the same information used for Disney. It has updated
interest coverage ratios and spreads built in.
As with the dataset listing above, you can get this spreadsheet by going to the
website for the book and checking under spreadsheets under chapter 8.

For those of you have read the first two editions of this book, much of what I have
said in this preface should be familiar. But there are three places where you will find this
book to be different:
a. For better or worse, the banking and market crisis of 2008 has left lasting wounds
on our psyches as investors and shaken some of our core beliefs in how to
estimate key numbers and approach fundamental trade offs. I have tried to adapt
some of what I have learned about equity risk premiums and the distress costs of
debt into the discussion.
b. I have always been skeptical about behavioral finance but I think that the area has
some very interesting insights on how managers behave that we ignore at our own
peril. I have made my first foray into incorporating some of the work in
behavioral financing into investing, financing and dividend decisions.
As I set out to write this book, I had two objectives in mind. One was to write a book that
not only reflects the way I teach corporate finance in a classroom but, more important,
conveys the fascination and enjoyment I get out of the subject matter. The second was to
write a book for practitioners that students would find useful, rather than the other way
around. I do not know whether I have fully accomplished either objective, but I do know
I had an immense amount of fun trying. I hope you do, too!




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CHAPTER 1
THE FOUNDATIONS
It’s all corporate finance.

My unbiased view of the world

Every decision made in a business has financial implications, and any decision
that involves the use of money is a corporate financial decision. Defined broadly,
everything that a business does fits under the rubric of corporate finance. It is, in fact,
unfortunate that we even call the subject corporate finance, because it suggests to many
observers a focus on how large corporations make financial decisions and seems to
exclude small and private businesses from its purview. A more appropriate title for this
book would be Business Finance, because the basic principles remain the same, whether
one looks at large, publicly traded firms or small, privately run businesses. All businesses
have to invest their resources wisely, find the right kind and mix of financing to fund
these investments, and return cash to the owners if there are not enough good
investments.

In this chapter, we will lay the foundation for the rest of the book by listing the
three fundamental principles that underlie corporate finance—the investment, financing,
and dividend principles—and the objective of firm value maximization that is at the heart
of corporate financial theory.
The Firm: Structural Set-Up

In the chapters that follow, we will use firm generically to refer to any business,
large or small, manufacturing or service, private or public. Thus, a corner grocery store
and Microsoft are both firms.

The firm’s investments are generically termed assets. Although assets are often
categorized by accountants into fixed assets, which are long-lived, and current assets,
which are short-term, we prefer a different categorization. The assets that the firm has
already invested in are called assets in place, whereas those assets that the firm is



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expected to invest in the future are called growth assets. Though it may seem strange
that a firm can get value from investments it has not made yet, high-growth firms get the
bulk of their value from these yet-to-be-made investments.

To finance these assets, the firm can raise money from two sources. It can raise
funds from investors or financial institutions by promising investors a fixed claim
(interest payments) on the cash flows generated by the assets, with a limited or no role in
the day-to-day running of the business. We categorize this type of financing to be debt.
Alternatively, it can offer a residual claim on the cash flows (i.e., investors can get what
is left over after the interest payments have been made) and a much greater role in the
operation of the business. We call this equity. Note that these definitions are general
enough to cover both private firms, where debt may take the form of bank loans and
equity is the owner’s own money, as well as publicly traded companies, where the firm
may issue bonds (to raise debt) and common stock (to raise equity).

Thus, at this stage, we can lay out the financial balance sheet of a firm as follows:
We will return this framework repeatedly through this book.
First Principles

Every discipline has first principles that govern and guide everything that gets
done within it. All of corporate finance is built on three principles, which we will call,
rather unimaginatively, the investment principle, the financing principle, and the dividend
principle. The investment principle determines where businesses invest their resources,
the financing principle governs the mix of funding used to fund these investments, and
the dividend principle answers the question of how much earnings should be reinvested
back into the business and how much returned to the owners of the business. These core
corporate finance principles can be stated as follows:



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• The Investment Principle: Invest in assets and projects that yield a return greater
than the minimum acceptable hurdle rate. The hurdle rate should be higher for riskier
projects and should 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.
• The Financing Principle: Choose a financing mix (debt and equity) that maximizes
the value of the investments made and match the financing to the nature of the assets
being financed.
• The Dividend Principle: If there are not enough investments that earn the hurdle rate,
return the cash to the owners of the business. In the case of a publicly traded firm, the
form of the return—dividends or stock buybacks—will depend on what stockholders
prefer.

When making investment, financing and dividend decisions, corporate finance is
single-minded about the ultimate objective, which is assumed to be maximizing the value
of the business. These first principles provide the basis from which we will extract the
numerous models and theories that comprise modern corporate finance, but they are also
commonsense principles. It is incredible conceit on our part to assume that until corporate
finance was developed as a coherent discipline starting just a few decades ago, people
who ran businesses made decisions randomly with no principles to govern their thinking.
Good businesspeople through the ages have always recognized the importance of these
first principles and adhered to them, albeit in intuitive ways. In fact, one of the ironies of
recent times is that many managers at large and presumably sophisticated firms with
access to the latest corporate finance technology have lost sight of these basic principles.
The Objective of the Firm

No discipline can develop cohesively over time without a unifying objective. The
growth of corporate financial theory can be traced to its choice of a single objective and
the development of models built around this objective. The objective in conventional
corporate financial theory when making decisions is to maximize the value of the
business or firm. Consequently, any decision (investment, financial, or dividend) that



1.4
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increases the value of a business is considered a good one, whereas one that reduces firm
value is considered a poor one. Although the choice of a singular objective has provided
corporate finance with a unifying theme and internal consistency, it comes at a cost. To
the degree that one buys into this objective, much of what corporate financial theory
posits makes sense. To the degree that this objective is flawed, however, it can be argued
that the theory built on it is flawed as well. Many of the disagreements between corporate
financial theorists and others (academics as well as practitioners) can be traced to
fundamentally different views about the correct objective for a business. For instance,
there are some critics of corporate finance who argue that firms should have multiple
objectives where a variety of interests (stockholders, labor, customers) are met, and there
are others who would have firms focus on what they view as simpler and more direct
objectives, such as market share or profitability.

Given the significance of this objective for both the development and the
applicability of corporate financial theory, it is important that we examine it much more
carefully and address some of the very real concerns and criticisms it has garnered: It
assumes that what stockholders do in their own self-interest is also in the best interests of
the firm, it is sometimes dependent on the existence of efficient markets, and it is often
blind to the social costs associated with value maximization. In the next chapter, we
consider these and other issues and compare firm value maximization to alternative
objectives.
The Investment Principle

Firms have scarce resources that must be
allocated among competing needs. The first and
foremost function of corporate financial theory is to
provide a framework for firms to make this decision
wisely. Accordingly, we define investment decisions to include not only those that create
revenues and profits (such as introducing a new product line or expanding into a new
market) but also those that save money (such as building a new and more efficient
distribution system). Furthermore, we argue that decisions about how much and what
inventory to maintain and whether and how much credit to grant to customers that are
Hurdle Rate: A hurdle rate is a
minimum acceptable rate of return for
investing resources in a new investment.



1.5
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traditionally categorized as working capital decisions, are ultimately investment decisions
as well. At the other end of the spectrum, broad strategic decisions regarding which
markets to enter and the acquisitions of other companies can also be considered
investment decisions.

Corporate finance attempts to measure the return on a proposed investment
decision and compare it to a minimum acceptable hurdle rate to decide whether the
project is acceptable. The hurdle rate has to be set higher for riskier projects and has to
reflect the financing mix used, i.e., the owner’s funds (equity) or borrowed money (debt).
In Chapter 3, we begin this process by defining risk and developing a procedure for
measuring risk. In Chapter 4, we go about converting this risk measure into a hurdle rate,
i.e., a minimum acceptable rate of return, both for entire businesses and for individual
investments.

Having established the hurdle rate, we turn our attention to measuring the returns
on an investment. In Chapter 5 we evaluate three alternative ways of measuring returns—
conventional accounting earnings, cash flows, and time-weighted cash flows (where we
consider both how large the cash flows are and when they are anticipated to come in). In
Chapter 6 we consider some of the potential side costs that might not be captured in any
of these measures, including costs that may be created for existing investments by taking
a new investment, and side benefits, such as options to enter new markets and to expand
product lines that may be embedded in new investments, and synergies, especially when
the new investment is the acquisition of another firm.
The Financing Principle

Every business, no matter how large and complex, is ultimately funded with a mix
of borrowed money (debt) and owner’s funds (equity). With a publicly trade firm, debt
may take the form of bonds and equity is usually common stock. In a private business,
debt is more likely to be bank loans and an owner’s savings represent equity. Though we
consider the existing mix of debt and equity and its implications for the minimum
acceptable hurdle rate as part of the investment principle, we throw open the question of
whether the existing mix is the right one in the financing principle section. There might
be regulatory and other real-world constraints on the financing mix that a business can



1.6
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use, but there is ample room for flexibility within these constraints. We begin this section
in Chapter 7, by looking at the range of choices that exist for both private businesses and
publicly traded firms between debt and equity. We then turn to the question of whether
the existing mix of financing used by a business is optimal, given the objective function
of maximizing firm value, in Chapter 8. Although the trade-off between the benefits and
costs of borrowing are established in qualitative terms first, we also look at quantitative
approaches to arriving at the optimal mix in Chapter 8. In the first approach, we examine
the specific conditions under which the optimal financing mix is the one that minimizes
the minimum acceptable hurdle rate. In the second approach, we look at the effects on
firm value of changing the financing mix.
When the optimal financing mix is different from the existing one, we map out
the best ways of getting from where we are (the current mix) to where we would like to
be (the optimal) in Chapter 9, keeping in mind the investment opportunities that the firm
has and the need for timely responses, either because the firm is a takeover target or
under threat of bankruptcy. Having outlined the optimal financing mix, we turn our
attention to the type of financing a business should use, such as whether it should be
long-term or short-term, whether the payments on the financing should be fixed or
variable, and if variable, what it should be a function of. Using a basic proposition that a
firm will minimize its risk from financing and maximize its capacity to use borrowed
funds if it can match up the cash flows on the debt to the cash flows on the assets being
financed, we design the perfect financing instrument for a firm. We then add additional
considerations relating to taxes and external monitors (equity research analysts and
ratings agencies) and arrive at strong conclusions about the design of the financing.
The Dividend Principle

Most businesses would undoubtedly like to have unlimited investment
opportunities that yield returns exceeding their hurdle rates, but all businesses grow and
mature. As a consequence, every business that thrives reaches a stage in its life when the
cash flows generated by existing investments is greater than the funds needed to take on
good investments. At that point, this business has to figure out ways to return the excess
cash to owners In private businesses, this may just involve the owner withdrawing a



1.7
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portion of his or her funds from the business. In a publicly traded corporation, this will
involve either paying dividends or buying back stock. Note that firms that choose not to
return cash to owners will accumulate cash balances that grow over time. Thus, analyzing
whether and how much cash should be returned to the owners of a firm is the equivalent
of asking (and answering) the question of how much cash accumulated in a firm is too
much cash.
In Chapter 10, we introduce the basic trade-off that determines whether cash
should be left in a business or taken out of it. For stockholders in publicly traded firms,
we note that this decision is fundamentally one of whether they trust the managers of the
firms with their cash, and much of this trust is based on how well these managers have
invested funds in the past. In Chapter 11, we consider the options available to a firm to
return assets to its owners—dividends, stock buybacks and spin-offs—and investigate
how to pick between these options.
Corporate Financial Decisions, Firm Value, and Equity Value

If the objective function in corporate finance is to maximize firm value, it follows
that firm value must be linked to the three corporate finance decisions outlined—
investment, financing, and dividend decisions. The link between these decisions and firm
value can be made by recognizing that the value of a firm is the present value of its
expected cash flows, discounted back at a rate that reflects both the riskiness of the
projects of the firm and the financing mix used to finance them. Investors form
expectations about future cash flows based on observed current cash flows and expected
future growth, which in turn depend on the quality of the firm’s projects (its investment
decisions) and the amount reinvested back into the business (its dividend decisions). The
financing decisions affect the value of a firm through both the discount rate and
potentially through the expected cash flows.

This neat formulation of value is put to the test by the interactions among the
investment, financing, and dividend decisions and the conflicts of interest that arise
between stockholders and lenders to the firm, on one hand, and stockholders and
managers, on the other. We introduce the basic models available to value a firm and its
equity in Chapter 12, and relate them back to management decisions on investment,



1.8
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financial, and dividend policy. In the process, we examine the determinants of value and
how firms can increase their value.
A Real-World Focus

The proliferation of news and information on real-world businesses making
decisions every day suggests that we do not need to use hypothetical examples to
illustrate the principles of corporate finance. We will use five businesses through this
book to make our points about corporate financial policy:
1. Disney Corporation: Disney Corporation is a publicly traded firm with wide holdings
in entertainment and media. Most people around the world recognize the Mickey
Mouse logo and have heard about or visited a Disney theme park or seen some or all
of the Disney animated classic movies, but it is a much more diversified corporation
than most people realize. Disney’s holdings include cruise line, real estate (in the
form of time shares and rental properties in Florida and South Carolina), television
(Disney cable, ABC and ESPN), publications, movie studios (Miramax, Pixar and
Disney) and consumer products. Disney will help illustrate the decisions that large
multi-business and multinational corporations have to make as they are faced with the
conventional corporate financial decisions—Where do we invest? How do we finance
these investments? How much do we return to our stockholders?
2. Bookscape Books: This company is a privately owned independent bookstore in New
York City, one of the few left after the invasion of the bookstore chains, such as
Barnes and Noble and Borders. We will take Bookscape Books through the corporate
financial decision-making process to illustrate some of the issues that come up when
looking at small businesses with private owners.
3. Aracruz Celulose: Aracruz Celulose is a Brazilian firm that produces eucalyptus pulp
and operates its own pulp mills, electrochemical plants, and port terminals. Although
it markets its products around the world for manufacturing high-grade paper, we use
it to illustrate some of the questions that have to be dealt with when analyzing a
company that is highly dependent upon commodity prices – paper and pulp, in this
instance, and operates in an environment where inflation is high and volatile and the
economy itself is in transition.



1.9
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4. Deutsche Bank: Deutsche Bank is the leading commercial bank in Germany and is
also a leading player in investment banking. We will use Deutsche Bank to illustrate
some of the issues the come up when a financial service firm has to make investment,
financing and dividend decisions. Since banks are highly regulated institutions, it will
also serve to illustrate the constraints and opportunities created by the regulatory
framework.
5. Tata Chemicals: Tata Chemicals is a firm involved in the chemical and fertilizer
business and is part of one of the largest Indian family group companies, the Tata
Group, with holdings in technology, manufacturing and service businesses. In
addition to allowing us to look at issues specific to manufacturing firms, Tata
Chemicals will also give us an opportunity to examine how firms that are part of
larger groups make corporate finance decisions.
We will look at every aspect of finance through the eyes of all five companies, sometimes
to draw contrasts between the companies, but more often to show how much they share.
A Resource Guide

To make the learning in this book as interactive and current as possible, we
employ a variety of devices.
This icon indicates that spreadsheet programs can be used to do some of the
analysis that will be presented. For instance, there are spreadsheets that calculate the
optimal financing mix for a firm as well as valuation spreadsheets.
This symbol marks the second supporting device: updated data on some of the
inputs that we need and use in our analysis that is available online for this book. Thus,
when we estimate the risk parameters for firms, we will draw attention to the data set
that is maintained online that reports average risk parameters by industry.
At regular intervals, we will also ask readers to answer questions relating to a
topic. These questions, which will generally be framed using real-world examples,
will help emphasize the key points made in a chapter and will be marked with this
icon.



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✄ .In each chapter, we will introduce a series of boxes titled “In Practice,” which will
look at issues that are likely to come up in practice and ways of addressing these
issues.
We examine how firms behave when it comes to assessing risk, evaluating
investments and determining the mix off debt and equity, and dividend policy. To
make this assessment, we will look at both surveys of decision makers (which
chronicle behavior at firms) as well as the findings from studies in behavioral finance
that try to explain patterns of management behavior.
Some Fundamental Propositions about Corporate Finance

There are several fundamental arguments we will make repeatedly throughout this
book.
1. Corporate finance has an internal consistency that flows from its choice of
maximizing firm value as the only objective function and its dependence on a few
bedrock principles: Risk has to be rewarded, cash flows matter more than accounting
income, markets are not easily fooled, and every decision a firm makes has an effect on
its value.
2. Corporate finance must be viewed as an integrated whole, rather than a collection of
decisions. Investment decisions generally affect financing decisions and vice versa;
financing decisions often influence dividend decisions and vice versa. Although there are
circumstances under which these decisions may be independent of each other, this is
seldom the case in practice. Accordingly, it is unlikely that firms that deal with their
problems on a piecemeal basis will ever resolve these problems. For instance, a firm that
takes poor investments may soon find itself with a dividend problem (with insufficient
funds to pay dividends) and a financing problem (because the drop in earnings may
make it difficult for them to meet interest expenses).
3. Corporate finance matters to everybody. There is a corporate financial aspect to almost
every decision made by a business; though not everyone will find a use for all the
components of corporate finance, everyone will find a use for at least some part of it.
Marketing managers, corporate strategists, human resource managers, and information



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technology managers all make corporate finance decisions every day and often don’t
realize it. An understanding of corporate finance will help them make better decisions.
4. Corporate finance is fun. This may seem to be the tallest claim of all. After all, most
people associate corporate finance with numbers, accounting statements, and hardheaded
analyses. Although corporate finance is quantitative in its focus, there is a significant
component of creative thinking involved in coming up with solutions to the financial
problems businesses do encounter. It is no coincidence that financial markets remain
breeding grounds for innovation and change.
5. The best way to learn corporate finance is by applying its models and theories to real-
world problems. Although the theory that has been developed over the past few decades
is impressive, the ultimate test of any theory is application. As we show in this book,
much (if not all) of the theory can be applied to real companies and not just to abstract
examples, though we have to compromise and make assumptions in the process.
Conclusion

This chapter establishes the first principles that govern corporate finance. The
investment principle specifies that businesses invest only in projects that yield a return
that exceeds the hurdle rate. The financing principle suggests that the right financing mix
for a firm is one that maximizes the value of the investments made. The dividend
principle requires that cash generated in excess of good project needs be returned to the
owners. These principles are the core for what follows in this book.




2.1
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CHAPTER 2
THE OBJECTIVE IN DECISION MAKING
If you do not know where you are going, it does not matter how you get there.










Anonymous

Corporate finance’s greatest strength and greatest weakness is its focus on value
maximization. By maintaining that focus, corporate finance preserves internal
consistency and coherence and develops powerful models and theory about the right way
to make investment, financing, and dividend decisions. It can be argued, however, that all
of these conclusions are conditional on the acceptance of value maximization as the only
objective in decision-making.

In this chapter, we consider why we focus so strongly on value maximization and
why, in practice, the focus shifts to stock price maximization. We also look at the
assumptions needed for stock price maximization to be the right objective, what can go
wrong with firms that focus on it, and at least partial fixes to some of these problems. We
will argue strongly that even though stock price maximization is a flawed objective, it
offers far more promise than alternative objectives because it is self-correcting.
Choosing the Right Objective

Let’s start with a description of what an objective is and the purpose it serves in
developing theory. An objective specifies what a decision maker is trying to accomplish
and by so doing provides measures that can be used to choose between alternatives. In
most firms, the managers of the firm, rather than the owners, make the decisions about
where to invest or how to raise funds for an investment. Thus, if stock price
maximization is the objective, a manager choosing between two alternatives will choose
the one that increases stock price more. In most cases, the objective is stated in terms of
maximizing some function or variable, such as profits or growth, or minimizing some
function or variable, such as risk or costs.

So why do we need an objective, and if we do need one, why can’t we have
several? Let’s start with the first question. If an objective is not chosen, there is no




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systematic way to make the decisions that every business will be confronted with at some
point in time. For instance, without an objective, how can Disney’s managers decide
whether the investment in a new theme park is a good one? There would be a menu of
approaches for picking projects, ranging from reasonable ones like maximizing return on
investment to obscure ones like maximizing the size of the firm, and no statements could
be made about their relative value. Consequently, three managers looking at the same
project may come to three separate conclusions.
If we choose multiple objectives, we are faced with a different problem. A theory
developed around multiple objectives of equal weight will create quandaries when it
comes to making decisions. For example, assume that a firm chooses as its objectives
maximizing market share and maximizing current earnings. If a project increases market
share and current earnings, the firm will face no problems, but what if the project under
analysis increases market share while reducing current earnings? The firm should not
invest in the project if the current earnings objective is considered, but it should invest in
it based on the market share objective. If objectives are prioritized, we are faced with the
same stark choices as in the choice of a single objective. Should the top priority be the
maximization of current earnings or should it be maximizing market share? Because there
is no gain, therefore, from having multiple objectives, and developing theory becomes
much more difficult, we argue that there should be only one objective.
There are a number of different objectives that a firm can choose between when it
comes to decision making. How will we know whether the objective that we have chosen
is the right objective? A good objective should have the following characteristics.
a. 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. Consider,
for instance, a firm that specifies its objective to be increasing growth in the long
term. This is an ambiguous objective because it does not answer at least two
questions. The first is growth in what variable—Is it in revenue, operating
earnings, net income, or earnings per share? The second is in the definition of the
long term: Is it three years, five years, or a longer period?
b. It comes with a timely measure that can be used to evaluate the success or failure
of decisions. Objectives that sound good but don’t come with a measurement




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mechanism are likely to fail. For instance, consider a retail firm that defines its
objective as maximizing customer satisfaction. How exactly is customer
satisfaction defined, and how is it to be measured? If no good mechanism exists
for measuring how satisfied customers are with their purchases, not only will
managers be unable to make decisions based on this objective but stockholders
will also have no way of holding them accountable for any decisions they do
make.
c. 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 benefits arising from the objective. Some may disagree with the inclusion of
social costs and benefits and argue that a business only has a responsibility to its
stockholders, not to society. This strikes us as shortsighted because the people
who own and operate businesses are part of society.
The Classical Objective

There is general agreement, at least among corporate finance theorists that the
objective when making decisions in a business is to maximize value. There is some
disagreement on whether the objective is to maximize the value of the stockholder’s stake
in the business or the value of the entire business (firm), which besides stockholders
includes the other financial claim holders (debt holders, preferred stockholders, etc.).
Furthermore, even among those who argue for stockholder wealth maximization, there is
a question about whether this translates into maximizing the stock price. As we will see
in this chapter, these objectives vary in terms of the assumptions needed to justify them.
The least restrictive of the three objectives, in terms of assumptions needed, is to
maximize the firm value, and the most restrictive is to maximize the stock price.
Multiple Stakeholders and Conflicts of Interest

In the modern corporation, stockholders hire managers to run the firm for them;
these managers then borrow from banks and bondholders to finance the firm’s operations.




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Investors in financial markets respond to information about the firm revealed to them by
the managers, and firms have to operate in the context of a larger society. By focusing on
maximizing stock price, corporate finance exposes itself to several risks. Each of these
stakeholders has different objectives and there is the distinct possibility that there will be
conflicts of interests among them. What is good for managers may not necessarily be
good for stockholders, and what is good for stockholders may not be in the best interests
of bondholders and what is beneficial to a firm may create large costs for society.

These conflicts of interests are exacerbated further when we bring in two
additional stakeholders in the firm. First, the employees of the firm may have little or no
interest in stockholder wealth maximization and may have a much larger stake in
improving wages, benefits, and job security. In some cases, these interests may be in
direct conflict with stockholder wealth maximization. Second, the customers of the
business will probably prefer that products and services be priced lower to maximize
their utility, but again this may conflict with what stockholders would prefer.
Potential Side Costs of Value Maximization

As we noted at the beginning of this section, the objective in corporate finance
can be stated broadly as maximizing the value of the entire business, more narrowly as
maximizing the value of the equity stake in the business or even more narrowly as
maximizing the stock price for a publicly traded firm. The potential side costs increase as
the objective is narrowed.
If the objective when making decisions is to maximize firm value, there is a
possibility that what is good for the firm may not be good for society. In other words,
decisions that are good for the firm, insofar as they increase value, may create social
costs. If these costs are large, we can see society paying a high price for value
maximization, and the objective will have to be modified to allow for these costs. To be
fair, however, this is a problem that is likely to persist in any system of private enterprise
and is not peculiar to value maximization. The objective of value maximization may also
face obstacles when there is separation of ownership and management, as there is in most
large public corporations. When managers act as agents for the owners (stockholders),
there is the potential for a conflict of interest between stockholder and managerial




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interests, which in turn can lead to decisions that make managers better off at the expense
of stockholders.

When the objective is stated in terms of stockholder wealth, the conflicting
interests of stockholders and bondholders have to be reconciled. Since stockholders are
the decision makers and bondholders are often not completely protected from the side
effects of these decisions, one way of maximizing stockholder wealth is to take actions
that expropriate wealth from the bondholders, even though such actions may reduce the
wealth of the firm.

Finally, when the objective is narrowed further to one of maximizing stock price,
inefficiencies in the financial markets may lead to misallocation of resources and to bad
decisions. For instance, if stock prices do not reflect the long-term consequences of
decisions, but respond, as some critics say, to short-term earnings effects, a decision that
increases stockholder wealth (which reflects long-term earnings potential) may reduce the
stock price. Conversely, a decision that reduces stockholder wealth but increases earnings
in the near term may increase the stock price.
Why Corporate Finance Focuses on Stock Price Maximization

Much of corporate financial theory is centered on stock price maximization as the
sole objective when making decisions. This may seem surprising given the potential side
costs just discussed, but there are three reasons for the focus on stock price maximization
in traditional corporate finance.
• Stock prices are the most observable of all measures that can be used to judge the
performance of a publicly traded firm. Unlike earnings or sales, which are updated
once every quarter or once every year, stock prices are updated constantly to reflect
new information coming out about the firm. Thus, managers receive instantaneous
feedback from investors on every action that they take. A good illustration is the
response of markets to a firm announcing that it plans to acquire another firm.
Although managers consistently paint a rosy picture of every acquisition that they
plan, the stock price of the acquiring firm drops at the time of the announcement of
the deal in roughly half of all acquisitions, suggesting that markets are much more
skeptical about managerial claims.




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• If investors are rational and markets are efficient, stock prices will reflect the long-
term effects of decisions made by the firm. Unlike accounting measures like earnings
or sales measures, such as market share, which look at the effects on current
operations of decisions made by a firm, the value of a stock is a function of the long-
term health and prospects of the firm. In a rational market, the stock price is an
attempt on the part of investors to measure this value. Even if they err in their
estimates, it can be argued that an erroneous estimate of long-term value is better than
a precise estimate of current earnings.
• Finally, choosing stock price maximization as an objective allows us to make
categorical statements about the best way to pick projects and finance them and to test
these statements with empirical observation.
2.1. : Which of the Following Assumptions Do You Need to Make for Stock
Price Maximization to Be the Only Objective in Decision Making?
a. Managers act in the best interests of stockholders.
b. Lenders to the firm are fully protected from expropriation.
c. Financial markets are efficient.
d. There are no social costs.
e. All of the above.
f. None of the above

In Practice: What Is the Objective in Decision Making in a Private Firm or a
Nonprofit Organization?

The objective of maximizing stock prices is a relevant objective only for firms
that are publicly traded. How, then, can corporate finance principles be adapted for
private firms? For firms that are not publicly traded, the objective in decision-making is
the maximization of firm value. The investment, financing, and dividend principles we
will develop in the chapters to come apply for both publicly traded firms, which focus on
stock prices, and private businesses, which maximize firm value. Because firm value is
not observable and has to be estimated, what private businesses will lack is the




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feedback—sometimes unwelcome—that publicly traded firms get from financial markets
when they make major decisions.

It is, however, much more difficult to adapt corporate finance principles to a not-
for-profit organization, because its objective is often to deliver a service in the most
efficient way possible, rather than make profits. For instance, the objective of a hospital
may be stated as delivering quality health care at the least cost. The problem, though, is
that someone has to define the acceptable level of care, and the conflict between cost and
quality will underlie all decisions made by the hospital.
Maximize Stock Prices: The Best-Case Scenario

If corporate financial theory is based on the objective of maximizing stock prices,
it is worth asking when it is reasonable to ask managers to focus on this objective to the
exclusion of all others. 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 unfold, the following assumptions have to hold.
1.
The managers of the firm put aside their own interests and focus on
maximizing stockholder wealth. This might occur either because they are
terrified of the power stockholders have to replace them (through the annual
meeting or via the board of directors) or because they own enough stock in the
firm that maximizing stockholder wealth becomes their objective as well.
2.
The lenders to the firm are fully protected from expropriation by stockholders.
This can occur for one of two reasons. The first is a reputation effect, i.e., that
stockholders will not take any actions that hurt lenders now if they feel that doing
so might hurt them when they try to borrow money in the future. The second is
that lenders might be able to protect themselves fully by writing covenants
proscribing the firm from taking any actions that hurt them.
3.
The managers of the firm do not attempt to mislead or lie to financial markets
about the firm’s future prospects, and there is sufficient information for markets
to make judgments about the effects of actions on long-term cash flows and value.
Markets are assumed to be reasoned and rational in their assessments of these
actions and the consequent effects on value.




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4.
There are no social costs or social benefits. All costs created by the firm in its
pursuit of maximizing stockholder wealth can be traced and charged to the firm.
With these assumptions, there are no side costs to stock price maximization.
Consequently, managers can concentrate on maximizing stock prices. In the process,
stockholder wealth and firm value will be maximized, and society will be made better off.
The assumptions needed for the classical objective are summarized in pictorial form in
Figure 2.1.
Figure 2.1 Stock Price Maximization: The Costless Scenario
STOCKHOLDERS
Maximize
stockholder
wealth
Hire & fire
managers
BONDHOLDERS
Lend Money
Protect
Interests of
lenders
FINANCIAL MARKETS
SOCIETY
Managers
Reveal
information
honestly and
on time
Markets are
efficient and
assess effect of
news on value
No Social Costs
Costs can be
traced to firm

Maximize Stock Prices: Real-World Conflicts of Interest

Even a casual perusal of the assumptions needed for stock price maximization to
be the only objective when making decisions suggests that there are potential
shortcomings in each one. Managers might not always make decisions that are in the best
interests of stockholders, stockholders do sometimes take actions that hurt lenders,
information delivered to markets is often erroneous and sometimes misleading, and there
are social costs that cannot be captured in the financial statements of the company. In the




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section that follows, we consider some of the ways real-world problems might trigger a
breakdown in the stock price maximization objective.
Stockholders and Managers

In classical corporate financial theory, stockholders are assumed to have the
power to discipline and replace managers who do not maximize their wealth. The two
mechanisms that exist for this power to be exercised are the annual meeting, wherein
stockholders gather to evaluate management performance, and the board of directors,
whose fiduciary duty it is to ensure that managers serve stockholders’ interests. Although
the legal backing for this assumption may be reasonable, the practical power of these
institutions to enforce stockholder control is debatable. In this section, we will begin by
looking at the limits on stockholder power and then examine the consequences for
managerial decisions.
The Annual Meeting

Every publicly traded firm has an annual meeting of its stockholders, during
which stockholders can both voice their views on management and vote on changes to the
corporate charter. Most stockholders, however, do not go to the annual meetings, partly
because they do not feel that they can make a difference and partly because it would not
make financial sense for them to do so.1 It is true that investors can exercise their power
with proxies,2 but incumbent management starts of with a clear advantage.3 Many
stockholders do not bother to fill out their proxies; among those who do, voting for
incumbent management is often the default option. For institutional stockholders with
significant holdings in a large number of securities, the easiest option, when dissatisfied
with incumbent management, is to “vote with their feet,” which is to sell their stock and
move on. An activist posture on the part of these stockholders would go a long way

1An investor who owns 100 shares of stock in, say, Coca-Cola will very quickly wipe out any potential
returns he makes on his investment if he or she flies to Atlanta every year for the annual meeting.
2A proxy enables stockholders to vote in absentia on boards of directors and on resolutions that will be
coming to a vote at the meeting. It does not allow them to ask open-ended questions of management.
3This advantage is magnified if the corporate charter allows incumbent management to vote proxies that
were never sent back to the firm. This is the equivalent of having an election in which the incumbent gets
the votes of anybody who does not show up at the ballot box.




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toward making managers more responsive to their interests, and there are trends toward
more activism, which will be documented later in this chapter.
The Board of Directors

The board of directors is the body that oversees the management of a publicly
traded firm. As elected representatives of the stockholders, the directors are obligated to
ensure that managers are looking out for stockholder interests. They can change the top
management of the firm and have a substantial influence on how it is run. On major
decisions, such as acquisitions of other firms, managers have to get the approval of the
board before acting.
The capacity of the board of directors to discipline management and keep them
responsive to stockholders is diluted by a number of factors.
1. Many individuals who serve as directors do not spend much time on their fiduciary
duties, partly because of other commitments and partly because many of them serve
on the boards of several corporations. Korn/Ferry,4 an executive recruiter, publishes a
periodical survey of directorial compensation, and time spent by directors on their
work illustrates this very clearly. In their 1992 survey, they reported that the average
director spent 92 hours a year on board meetings and preparation in 1992, down from
108 in 1988, and was paid $32,352, up from $19,544 in 1988.5 As a result of scandals
associated with lack of board oversight and the passage of Sarbanes-Oxley, directors
have come under more pressure to take their jobs seriously. The Korn/Ferry survey
for 2007 noted an increase in hours worked by the average director to 192 hours a
year and a corresponding surge in compensation to $62,500 a year, an increase of
45% over the 2002 numbers.
2. Even those directors who spend time trying to understand the internal workings of a
firm are stymied by their lack of expertise on many issues, especially relating to
accounting rules and tender offers, and rely instead on outside experts.

4Korn/Ferry surveys the boards of large corporations and provides insight into their composition.
5This understates the true benefits received by the average director in a firm, because it does not count
benefits and perquisites—insurance and pension benefits being the largest component. Hewitt Associates,
an executive search firm, reports that 67 percent of 100 firms that they surveyed offer retirement plans for
their directors.




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3. In some firms, a significant percentage of the directors work for the firm, can be
categorized as insiders and are unlikely to challenge the chief executive office (CEO).
Even when directors are outsiders, they are often not independent, insofar as the
company’s CEO often has a major say in who serves on the board. Korn/Ferry’s
annual survey of boards also found in 1988 that 74 percent of the 426 companies it
surveyed relied on recommendations by the CEO to come up with new directors,
whereas only 16 percent used a search firm. In its 1998 survey, Korn/Ferry found a
shift toward more independence on this issue, with almost three-quarters of firms
reporting the existence of a nominating committee that is at least nominally
independent of the CEO. The latest Korn/Ferry survey confirmed a continuation of
this shift, with only 20% of directors being insiders and a surge in boards with
nominating committees that are independent of the CEO.
4. The CEOs of other companies are the favored choice for directors, leading to a
potential conflict of interest, where CEOs sit on each other’s boards. In the Korn-
Ferry survey, the former CEO of the company sits on the board at 30% of US
companies and 44% of French companies.
5. Many directors hold only small or token stakes in the equity of their corporations.
The remuneration they receive as directors vastly exceeds any returns that they make
on their stockholdings, thus making it unlikely that they will feel any empathy for
stockholders, if stock prices drop.
6. In many companies in the United States, the CEO chairs the board of directors
whereas in much of Europe, the chairman is an independent board member.

The net effect of these factors is that the board of directors often fails at its
assigned role, which is to protect the interests of stockholders. The CEO sets the agenda,
chairs the meeting, and controls the flow of information, and the search for consensus
generally overwhelms any attempts at confrontation. Although there is an impetus toward
reform, it has to be noted that these revolts were sparked not by board members but by
large institutional investors.

The failure of the board of directors to protect stockholders can be illustrated with
numerous examples from the United States, but this should not blind us to a more
troubling fact. Stockholders exercise more power over management in the United States




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than in any other financial market. If the annual meeting and the board of directors are,
for the most part, ineffective in the United States at exercising control over management,
they are even more powerless in Europe and Asia as institutions that protect stockholders.
Ownership Structure

The power that stockholders have to influence management decisions either
directly (at the annual meeting) or indirectly (through the board of directors) can be
affected by how voting rights are apportioned across stockholders and by who owns the
shares in the company.
a. Voting rights: In the United States, 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. Increasingly, though, we are seeing companies like Google, News Corp and
Viacom, with two classes of shares with disproportionate voting rights assigned to
one class. In much of Latin America, shares with different voting rights are more the
rule than the exception, with almost every company having common shares (with
voting rights) and preferred shares (without voting rights). While there may be good
reasons for having share classes with different voting rights6, they clearly tilt the
scales in favor of incumbent managers (relative to stockholders), since insiders and
incumbents tend to hold the high voting right shares.
b. Founder/Owners: In young companies, it is not uncommon to find a significant
portion of the stock held by the founders or original promoters of the firm. Thus,
Larry Ellison, the founder of Oracle, continues to hold almost a quarter of the firm’s
stock and is also the company’s CEO. As small stockholders, we can draw solace
from the fact that the top manager in the firm is also its largest stockholder, but there
is still the danger that what is good for an inside stockholder with all or most of his
wealth invested in the company may not be in the best interests of outside
stockholders, especially if the latter are diversified across multiple investments.
c. Passive versus Active investors: As institutional investors increase their holdings of
equity, classifying investors into individual and institutional becomes a less useful

6 One argument is that stockholders in capital markets tend to be short term and that the investors who own
the voting shares are long term. Consequently, entrusting the latter with the power will lead to better
decisions.




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exercise at many firms. There are, however, big differences between institutional
investors in terms o