Edwin Elton and Martin Gruber Stern School of Business New York University

Second Edition


and Practice

Allen: Financial Markets and Institutions Damodaran: Corporate Finance Elton & Gruber: Modern Portfolio Theory and Analysis S/E French: Options & Futures (forthcoming) Hempel/Coleman/Simonson: Bank Management 4/E Intellipro: The Investment Portfolio Jones: Investments S/E O'Brien: Global Financial Management Poniachek: Cases in International Finance Sulock/Dunkelberg: Cases in Financial Management 2/E Vaughan: Fundamentals of Risk & Insurance 7/E Vaughan: Essentials of Insurance Vaughan/Vaughan: Risk Management

Aswath Damodaran
Stepn School of Business New Yopk Univepsity www.stern.nyu.edu/-adamodap


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Aswath. Corporate finance: theory and practice / Aswath Damodaran, p. em, - (Wiley series in finance) Includes bibliographi cal references and index. ISBN 0-471-28332-0 (cloth: alk. paper) 1, Corporations - Finance. L Title, IL Series.

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\_bout the Author


Aswath Damodaran is a professor of finance at the Stern School of Business at New York University, and teaches the corporate finance and equity valuation courses in the MBA program. He received his MBA and Ph.D. from the University of California at Los Angeles. His research interests lie in valuation and applied corporate finance. He has published articles in the Journal of Financial and Quantitative Analysis, the Journal of Finance, the Journal of Financial Economics, and the Review of Financial Studies, and has written two books on equity valuation (Damodaran on valuation and Investment Valuation) and two on corporate finance (Corporate Finance: Theory and Practice and Applied Corporate Finance: A User's Manual). He has co-edited a book on investment management with Peter Bernstein (Investment Management) and is working on a book on investment philosophies. He was a visiting lecturer at the University of California, Berkeley, from 1984 to 1986, where he received the Earl Cheit Outstanding Teaching Award in 1985. He has been at NYU since 1986, received the Stern School of Business Excellence in Teaching Award (awarded by the graduating class) in 1988, 1991, 1992, and 1999, and was the youngest winner of the University-wide Distinguished Teaching Award (in 1990). He was profiled in Business lIWek as one of the top twelve business school professors in the United States in 1994.

orporate finance encompasses all of a firm's decisions that have financial implications. Thus, there is a corporate financial aspect to almost every action taken by a firm, no matter what functional area claims responsibility for it. A finn's actions can generally be categorized as decisions about where to invest the firm's funds (the investment decision), where to raise these funds (the financing decision), and how much cash to return to the owners (the dividend decision). The value of the firm reflects its success in each of these areas. Firms that allocate resources to "good" projects, finance them with the "appropriate mix" of debt and equity, and reinvest the "right amount" back into operations will have higher value than firms that fail on any of these criteria. Notice that there is nothing in this description that presupposes that firms are large or publicly traded, or that financial markets function efficiently. Although these characteristics may make the job of corporate financial analysis easier, the fundamental principles of corporate finance should apply for all firms - small and large, private and public, domestic and foreign. There is only one way to learn corporate finance well, and that is by analyzing real companies with real problems. Consequently, I have illustrated principles throughout this book with extended applications involving three companies - the publicly traded firms of The Home Depot and Boeing and a private software firm that I call InfoSoft. I have also introduced other companies selectively to illustrate specific problems. These applications are not mere addenda to models, but are an integral part of explaining and developing them. In keeping with the definition of corporate finance given above, I have designed this book for a wide audience. Obviously, it will be most useful for those who plan to make a career in corporate finance, whether at corporations, investment banks, or management consulting firms. At the same time, those in other areas of business, be it marketing, production, or organizational behavior, should find the tools and principles developed here of use in their chosen fields. Finally, several parts of this book would be useful to small business owners and entrepreneurs looking for ways to improve their understanding of the financial aspects of their businesses. There is a wide range of books on corporate finance. The "nuts-and-bolts" books essentially focus on working through problems and exercises. They eschew raising provocative questions, provide closure on complicated questions, and provide the reader with a sense of being in control of the topic. The "big picture" books provide




readers with a state-of-the-art view of corporate finance and a tantalizing vision of things to come. The "practitioner" books focus on corporate financial tools and techniques, and pay little attention to the underlying theory. This book is my attempt to find common ground among theory, applications, and examples, and to provide a guide for those who want not only to practice corporate finance, but also to understand it well enough to develop their own models as they move along. I believe that this book's primary strength is its focus on applying complex theory to real firms, while minimizing the compromises that inevitably have to be made in the process. I have also tried to maintain a balance between immersing readers in the details of corporate financial analysis - the tools and techniques that are used on a day-to-day basis - and the big picture of corporate finance, which allows them to see how these tools and techniques fit together and what common principles apply across all of them. The genesis for this book lay in the classroom, and the result has been shaped by the reactions and responses of students to examples that I have used in my lectures. I have always learned more from the students I teach than they learn from me, and I hope that I have been able to distill some of this learning in this book. It is my goal that the extended examples in this book will induce readers to try out the theory on other companies. By doing so, they will not only come to understand the limitations of the theory better, but also learn how to adapt it to the real world. To make this process easier, the spreadsheets that were used to generate the. applications in this book are provided on the text website. Readers should be able to use these spreadsheets to analyze a project, examine the optimal debt ratio for a firm, estimate how much cash it has available to payout to stockholders, and value the firm.

Arnold R. Cowan Iowa State U11iversity Susan Crain Southern Illinois University at Edwardsvill Maryanne Cunningham Babson College Arneeta Jaiswale Dale University of St. Thomas Richard Defusco University of Nebraska Don DePamphilis Loyola Marymount Shreesh Deshpande University oj San Diego David M. Ellis Babson College Ben Esty Harvard University Lisa Fairchild Loyola College Kathleen Farrell University of Nebraska Sharon H. Garrison Ulliversity of Arizona John Helmuth University of Michigan, Dearborn Kendall Hill University oj Alabama at Birmingham Ron Hoffmeister Arizona State University

Craig Johnson California State University at Hayward Kathleen Kahle University oj PittsbU1;gh Bob Kleiman Oakland University Claudia Kocher University of Michigan at Dearborn Gene Lai University

of Rhode


Malek Lashgari University of Harford Robert LeClair Villanova University Jean-Francois L'Her Ecole des Hautes Etudes Commerciales Bing Liang Case Western Reserve University Erik Lie College oJWilliam and Mary Joseph Lipscomb Texas Christian University Richard Macminn University oJTexas at Austin Sharma Maneesh Indiana University - Purdue Steven Mann Texas Christian University Surendra Mansinghka San. Francisco State University Ilhan Meric Rider University Sunil Mohanty Hofstra University Mahmoud A. Moh'd St. Mary's University Joel Morse University oj Baltimore Majeb R. Muhtaseb California Polytechnic University

I would like to thank all of people in the production and editorial staff at John Wiley and Sons, who guided this book through the publication process. Others who contributed significantly to this book's final form are P. V Viswanath, who provided valuable technical editing help, and Elisa Adams, who made it more readable. I would also like to thank all of the following instructors, whose comments were critical in improving and completing the text.

John Affleck-Graves University of Notre Dame Todd Alisondry Babson College Fernando Alverez Rutgers University Michael Barry Boston College Bernie L. Baurn University ~f California-Santa Cruz

Arvind Bhandari Santa Clara University Hamdi Bilici California State Univeristy at Long Beach Stephen Borde University of Central Florida Luis Calvet University of Ottawa Louis Cheng Murray State University

Edith Hotchkiss Boston College Daniel C. Indro Kent State University Stan Jacobs Cen.tral Washington University Terrence Jalbert University oj Hawaii at Hila Jau-Lien Jeng California State University at Northridge

The first theme of this book is the universality of the basic principles of corporate finance. but as you will see. Part Five returns to the link between valuation and corporate finance decisions. The second theme of this book is that corporate financial theory is grounded in applications. a marketing. and the valuation of any asset. A Real World Focus The proliferation of news and information about decisions corporations make every day suggests that we do not need to use hypothetical businesses to illustrate the Xl . It begins with a discussion of the objective of stock price maximization.ber crunching. Every business. Decisions about how much to reinvest back into the business .and how much to take out of it are the subject of Part Four.the dividend decision . or an advertising decision. which underlies corporate financial theory. the analysis of financial statements. If a theory cannot be applied to real companies with real data. i J very decision that a firm makes has a corporate finance component to it. and follows up with an examination of three basic tools that we use in decision making ~ the concept of present value. has to make decisions about how to raise funds for investments and where to invest these funds. Certainly numbers are central to corporate finance. privately owned or publicly traded. you will not find it in this book. Part Three covers the funding decision and analyzes what the funding options for a firm are and what the best options may be (the financing decision). The third theme is that corporate finance is more than an exercise in num. The focus of Part Two is the decision of whether and where to invest a firm's resources (the investment decision).0st011 College Meir Schneller Virginia Tech Lawrence Schrenk University of Maryland John Shao Oklahoma City University Scott Smart Indiana University Jacky So Southern Illinois University Donald Sorensen University if Wisconsin.. the principles of corporate finance apply not just to corporations and large businesses. Moreover. Peterson Northern State University Gordon Phillips University if Maryland Terry Pope Abilene University Annette Poulsen University qf Ce01gia Ramesh Rao Texas Tech University Dan Richards Tufts University Dan Rogers Northwestern University John Rozycki Drake University Arlyn Rubash Bradley University Patricia Ryan Drake University Peter Ryan University if Ottawa P'Sandas University qf Pennsylvania ~ Wharton School if Business William Sartoris Indiana University Tom Schinunanur 13. even if it is called a strategic. Whitewater Kathrine Spiess University if Notre Dame Jean-Marc Suret Uniuersue Laval Harold Tamule Providence College James Tipton Baylor University Ricardo Valente Universidade do Porto P V Viswanath Pace University ~ Westchester Gautam Von University if New Mexico Mark White University if Virginia Ben Wilner University qf Iowa Drew Winters University if Southern Mississippi Glenn Wolfe University qfToledo David Yermack New York University Jasmine Yur-Austin California State University at Long Beach A Reader's Guide '1 . Part One lays the groundwork for the analysis of these principles. Structure of the Book The book is structured around the three principles that comprise corporate finance. small or large.x PREFACE Jim Musumeci Southern Illinois University Rajesh Narayanan Ohio University Ed Nelling Georgia Tech Philip O'Connor SUNY ~ Bl1falo John E. there is also a great deal of room for innovation and creative problem solving.

We will use The Home Depot to examine some of the corporate finance questions that come up for service firms. I use this setting to describe the notion of market efficiency and why it is so central to corporate finance. Consequently. Thus. I spend a substantial amount of time on the estimation issues associated with applying risk and return models in practice. located at WVv'W:wiley. tools and paint. I have tried to bring to the analysis of these investment decisions the same objectives and analytical tools that I would use on any investment. hardware. Therefore I have chosen three firms to exemplify my points about corporate financial policy: 1. The company also has extensive interests in information. and options can be incorporated into the investment analysis. • Concept checks (CC) appear at intervals throughout the chapters. • Real Companies. I begin with the presentation in Chapter 16 of the entire range of financing choices available to firms. For instance. but this objective is not universally accepted. selling home improvement products such as plumbing. Chapter 5 provides an introduction to valuing all kinds of assets. including military aircraft. In Chapter 12 I discuss the ways in which project interactions. I consider investments in foreign projects (Chapter 11). and investments in existing projects (Chapter 15) within the broader context of investment analysis. 2. In Chapter 17. heating and electrical supplies. These questions allow you to test your understanding of the concepts introduced in the preceding section. when we estimate the risk parameters for firms. • Current data on some of the inputs that we will use in our analysis is also available on the Web site for this book. . While I considered looking at these choices in separate chapters. on financial statements. I do not believe that it makes much sense to talk about investment decision rules before explaining what projects need to make as hurdle rates. I also draw a clear distinction between measuring hurdle rates for a firm (Chapter 7) and for individual projects (Chapter 8). Wherever you see the logo ~ it refers to material on the Web. • Spreadsheet programs are available on the Web to do some of the analysis that will be presented in this book. from default-free zero coupon bonds to equity in high growth companies. synergies. You can find these spreadsheets on the Web site for the book. Turning next to the financing decision. as well as the modifications needed to get the answers. Real Time:' where you can apply the principles presented in the chapter to any firm that you choose to analyze. helicopters. has to face in the course of making investment. In fact. Real Time practice sets at the end of some chapters will allow you to replicate the analysis in that chapter on a company of your choice. In Chapter 4. I think it is more important to present the choices in one chapter and emphasize both the common elements and the differences between them. A significant portion of what we do in finance relates to the time value of money. and we will examine how high growth businesses in uncertain environrnents make decisions. ranging from private equity to preferred stock. but then I present what I hope is a strong case that firms should continue to focus on this objective. The first half of this chapter examines many of the real limitations these critics point to. We will take InfaSoft through the corporate financial decision making process to illustrate some of the issues confronted by private businesses with limited information. We consider the mechanics of time value in Chapter 3. we will draw attention to the data set on the Web that reports average risk parameters by industry. In addition.:11 A READER'S GUIDE A READER'S GUIDE Xlll principles of corporate finance. there are many both within and outside the business community who argue that it is either too narrow an objective or the wrong objective. with a diversified stockholder base. which make small investments that are generally not capital-intensive. financing. space and missile systems. Boeing is the leading manufacturer of commercial jet aircraft in the world and provides related services to the commercial airline industry worldwide. because I believe this distinction is particularly important for firms in multiple lines of business. For those readers Who do not have a finance background. I consider the objective in corporate finance to be the maximization of firm value. • Critical thinking questions (C~) are slightly more involved exercises that emphasize the key points in the chapter. we will I\n Interactive Learning Tool I have developed several features to make the learning in this book as interactive and current as possible: • In Practice examples using the three companies described above allow us to apply corporate finance principles to typical firms. the chapter also provides a measure of how I view a business and its functions. Preceding these illustrations is a logo symbolizing the firm's business. The next 10 chapters cover the investment decision. Many of the chapters are followed by a practice exercise titled "Real Companies. I deal with risk and expected returns in Chapters 6 through 8. 3. and dividend decisions. not only in the context of decisions that firms might have to make on a day-to-day basis but also in the larger context of decisions that individuals make on how much to save for retirement or a child's college education. We will use Boeing to illustrate the issues that a large manufacturing firm. investments in working capital (Chapters 13 and 14). IrifoSoft is a privately owned firm which develops and sells entertainment software. I tried to maintain a balance between accounting mechanics and the imperatives of financial analysis. This emphasis reflects my belief that the biggest challenges with estimating hurdle rates are not theoretical but are related to estimation issues. The chapter includes enough information on how financial statements are constructed to allow you to use it as a reference guide when looking at a company's annual report or 10-K and also presents the questions that we as financial analysts would like these statements to answer. • Each chapter concludes with a number of review questions and problems. It also introduces the notion of price as distinct from value. The Home Depot operates more than 600 stores in the United States and Canada. Chapter 2 is the philosophical core of this book. space and defense systems. floor and wall coverings. there are spreadsheets that calculate the optimal financing mix for a firm as well as valuation spreadsheets. A Chapter-by-Chapter Guide Chapter 1 briefly lays out what I think corporate finance is all about and explains why I have structured the book the way I have.com/college/damodaran.

ranging from cosmetic actions (stock splits and tracking stock) to real actions. The first is how a firm's financing choices vary during its life cycle of growth. The second is the process by which firms make the transition from one stage of financing (owner's funds.lATlON Chapter 24 Chapter 25 Chapter 26 Valuation: Principles and Practice 750 Value Enhancement: Tools and Techniques 791 Acquisitions and Takeovers 834 749 U!U BETWEEN lIAU. maturity. and spinoffs. and whether there will be pressure on a firm to pay this out. followed by an examination of what to do when a firm is underor over-levered and how to determine what kind of financing a firm should use (Chapter 20). and decline. Chapter 22 examines how much a firm can pay in dividends by measuring the cash left over after all reinvestment needs have been met. including the options to expand. In Chapter 27 I attempt to apply option pricing models in a variety of contexts in corporate finance and valuation. to help firms make their financing decisions. financing.A READER'S GUIDE look at two related questions. beginning with a fairly conventional treatment of dividends and the tradeoff on dividend payout. and Side Costs 352 Investments in Noncash Working Capital 389 Investments in Cash and Marketable Securities 423 Investment Returns and Corporate Strategy 451 THE Chapter 16 Chapter 17 Chapter 18 Chapter 19 Chapter 20 II\lG DECISION 481 An Overview of Financing Choices 482 The Financing Process 509 The Financing Mix: Tradeoffs on Theory 537 The Optimal Financing Mix 571 The Financing Mix and Choices 619 THE DIVIDEND Chapter 21 Chapter 22 Chapter 23 Dividend Policy 658 Analyzing Cash Returned to Stockholders 686 Beyond Cash Dividends: Buybacks. the emphasis is on applying the theory. beginning with an analysis of the optimal financing mix for a firm (Chapters 18 and 19). I hope you find material that is interesting and useful to you. Again. abandon. in Chapter 26. divestitures. and Divestitures 718 857 VAU. expansion.portantly. in Chapter 23. Chapters 24 through 26 return to valuation. 1 expand the dividend decision to look at other ways in which firms can affect the value of the stock held by their owners. or delay projects. Finally. Side Benefits. I also use them to value financing flexibility and equity in deeply troubled firrns. as well as different hypotheses about whether dividends increase or decrease value. I can now link valuation to the investment. Finally. I apply the same valuation tools to value control and synergy in acquisitions. in the context of valuing a firm in Chapter 24 and by examining how to increase the value of a firm in Chapter 25. I do this. As you read this book. but more im. I look at the dividend decision. Having laid the corporate financial groundwork. and dividend decisions of a firm. In Chapters 21 through 23. private equity) to another. with reasonable assumptions. I begin by using them to value the options embedded in investment projects.llHION AND CORPORATE FINANCE DECISIONS Chapter 27 Chapter 28 Option Applications in Corporate Finance 887 Back to First Principles 924 Solutions to Odd-Numbered Questions and Problems 933 Index 971 879 xv . I hope you enjoy the creative aspects of corporate financial analysis as much as I have. Chapters 18 through 20 consider three steps in the analysis of a firm's financing mix. Spinoffs. Contents in Brief INTRODUCTION Chapter 1 Chapter 2 Chapter 3 Chapter 4 Chapter 5 Chapter 6 TO CORPORATE FINANCE 1 Introduction to Corporate Finance 3 The Objective in Corporate Finance 11 The Time Value of Money 44 Understanding Financial Statements 68 Value and Price: An Introduction 116 The Basics of Risk 149 INVESTMENT Chapter 7 Chapter 8 Chapter 9 Chapter 10 Chapter 11 Chapter 12 Chapter 13 Chapter 14 Chapter 15 ANALYSIS 185 Estimating Hurdle Rates for Firms 186 Estimating Hurdle Rates for Projects 228 Estimating Earnings and Cash Flows on Projects 256 Investment Decision Rules 285 Investment Analysis with Inflation and Exchange Rate Risk 318 Project Interactions.

and Equity Value 8 The Tools of Corporate Finance 9 Summary 9 The Objective in Corporate Finance 11 Stockholder Wealth Maximization as the Objective in Decision Making 11 Why Do We Need a Unique Objective? 12 The Characteristics of the 'Right' Objective 13 Why Corporate Finance Focuses on Stock Price Maximization 13 When Is Stock Price Maximization the Only Objective a Firm Needs? 14 Stock Price Maximization and Agency Costs 15 Stockholders and Managers 16 Stockholders and Bondholders 21 The Firm and Financial Markets 22 The Firm and Society 27 Stock Price Maximization with Agency Costs 27 Alternatives to Stock Price Maximization 28 A Different System for Disciplining Management (Corporate Governance) 29 Choosing an Alternative Objective 30 Stock Price Maximization with Lower Agency Costs 31 Stockholders and Managers 32 Stockholders and Bondholders 34 Firms and Financial Markets 35 Firms and Society 36 A Postscript .Contents Preface vii A Reader's Guide xi PART ONE Chapter 1 INTRODUCTION TO CORPORATE fiNANCE 1 Introduction to Corporate Finance 3 Corporate Finance and the Firm 3 First Principles of Corporate Finance 4 Corporate Financial Decisions.The Limits of Corporate Finance 37 Summary 38 Real Companies. Real Time: Corporate Governance Analysis 40 Chapter 2 XVll . Firm Value.

Real Time: Accounting Information and Financial Analysis 113 172 PART nr/o ENT ANALYSIS Estimating Hurdle Rates for Firms 186 The Cost of Equity and Capital 186 Why Do We Need Hurdle Rates for Firms? 187 Cost of Equity 187 Riskless Rate 188 Risk Premium 190 Betas 196 Estimating the Cost of Equity 210 Risk.'111 CONTENTS The Time Value of Money 44 The Intuitive Basis for the Time Value of Money 44 Cash Flows and Time Lines 45 Time Value of Money: Compounding and Discounting 46 Compounding 46 Discounting 48 The Frequency of Discounting and Compounding 49 Time Value of Money: Annuities and Perpetuities 52 Annuities 52 Growing Annuities 60 Perpetuities 62 Growing Perpetuities 62 Summary 63 Determinants of Option Value 136 A Simple Model for Valuing Options 137 The Binomial Model 137 Market Prices and Value 141 The Pricing Process 142 Information. Real Time 183 rapter 4 Understanding Financial Statements 68 The Basic Accounting Statements 68 Informational Needs 69 Asset Measurement and Valuation 72 Accounting Principles Underlying Asset Measurement 72 Measuring Asset Value 72 How Well Do Accountants Categorize Assets and Measure Value? 76 Measuring Financing Mix 81 Accounting Principles Underlying Liability and Equity Measurement 81 Measuring the Value of Liabilities and Equities 81 How Well Do Accountants Measure the Financing Mix of the Firm? 86 Measuring Earnings and Profitability 89 Accounting Principles Underlying Measurement of Earnings and Profitability 89 Measuring Accounting Earnings and Profitability 89 How Well Do Accountants Measure Profitability? 99 Measuring Risk 100 Accounting Principles Underlying Risk Measurement 100 Accounting Measures of Risk 101 How Well Do Accountants Measure the Risk in a Business? 106 Other Issues in Analyzing Financial Statements 107 Differences in Accounting Standards and Practices 107 Summary 110 Real Companies. Real Time: Risk and Return: Analysis for the Firm 225 Chapter 8 Estimating Hurdle Rates for Projects 228 What Is a Project? 229 229 Hurdle Rates for Firms versus Hurdle Rates for Projects and Investments Equity Risk and Cost of Equity for Project 230 Sources of Equity Risk in a Project 230 Diversifiable and Nondiversifiable Project Risk 232 Project Equity Risk and the Marginal Investor 233 Measuring Cost of Equity for Projects 237 Default Risk and Cost of Debt for Projects 244 Financing Mix and Cost of Capital for Projects 245 Adjusting for Project Risk 246 . Expectations and Prices 142 Market Efficiency 143 Testing Market Efficiency 144 Summary 146 CONTENTS XlX rapter 3 Chapter 6 The Basics of Risk 149 What Is Risk? 149 Motivation and Perspective in Analyzing Risk 150 Equity Risk and Expected Return 151 Defining Risk 151 Diversifiable and Nondiversifiable Risk 155 Models Measuring Market Risk 163 A Comparative Analysis of Risk and Return Models Models of Default Risk 175 The Determinants of Default Risk 175 Bond Ratings and Interest rates 176 Summary 179 Real Companies. and Private Firms 211 From Cost of Equity to Cost of Capital 212 Calculating the Cost of Debt 212 Calculating the Cost of Hybrid Securities 214 Calculating the Weights of Debt and Equity Components Estimating the Cost of Capital 218 Best Practices at Firms 219 Summary 220 185 Chapter 7 iapter 5 Value and Price: An Introduction 116 Why Do We Need Valuation? 116 Valuing an Asset with Guaranteed Cash Flows 117 Default-free Zero-coupon Bond 117 Default-free Coupon Bond 118 Bond Value and Interest Rate Sensitivity and Duration 119 Introducing Uncertainty into Valuation 121 Valuing an Asset with Default Risk 121 Valuing an Asset with Equity Risk 124 Valuing an Asset with an Infinite Life 127 Equity and Firm Valuation 127 Dividends and Equity Valuation 128 • A Broader Measure of Cash Flows to Equity 131 From Valuing Equity to Valuing the Firm 133 Valuing an Asset with Contingent Cash Flows (Options) 134 Cash Flows on Options 135 216 Real Companies. Cost of Equity.

Real Time: Analyzing Investment Decision Rules Only If Feasible 316 Chapter 11 Investment Analysis with Inflation and Exchange Rate Risk 318 Chapter 14 Noncash Working Capital 389 Working Capital in Investment Analysis 391 Measuring and Estimating Working Capital Needs 392 The Effect of Working Capital on Cash Flows 394 Working Capital and Net Present Value 396 The Tradeoff from Reducing Working Capital 396 The Effect on Cash Flows 397 The Effect on Liquidity 397 The Effect on Operations 398 The Optimal Level of Working Capital 398 Industry Differences in Management of Working Capital 400 Components of Noncash Working Capital 402 Inventory 402 The Granting of Trade Credit: Accounts Receivable 410 The Use of Trade Credit: Accounts Payable 414 Summary 417 Rea! Companies. Real Time: Estimating Earnings and Cash Flows 284 Chapter 10 Investment Decision Rules 285 Mutually Exclusive Projects 352 Projects with Equal Lives 353 Projects with Different Lives 356 The Replacement Decision: A Special Case of Mutually Exclusive Projects 361 Capital Rationing 362 Reasons for Capital Rationing Constraints 363 Sources of Capital Rationing 364 Project Selection with Capital Rationing 366 Side Costs of Projects 369 Opportunity Costs 369 Product Cannibalization 373 Side Benefits of Projects and Project Synergies 377 Options Embedded in Projects 379 Ingredients of an Option 379 The Option to Delay a Project 379 The Option to Expand a Project 381 The Option to Abandon a Project 382 Incorporating Options into Investment Analysis 383 Summary 383 Chapter 13 Investments in Noncash Working Capital 389 What Is an Investment Decision Rule? 285 Categorizing Investment Decision Rules 286 Accounting Income-Based Decision Rules 286 Cash Flow-Based Decision Rules 292 Discounted Cash Flow Measures 296 Comparing Investment Decision Rules 307 Net Present Value and Internal Rate of Return: A Closer Look 307 What Approaches Do Firms Use in Investment Analysis? 310 Summary 312 Real Companies.xx CONTENTS CONTENTS XXI Adjusting Discount Rates 246 Adjusting Expected Cash Flows 247 Risk Adjustment Practices 249 Common Errors in Project Risk Assessment 250 Summary 250 Real Companies. and Side Costs 352 Estimating Project Revenues and Expenses 256 Experience and History 257 MarketTesting 259 Scenario Analysis 260 Estimation Error and Risk 263 Converting Operating Forecasts into Accounting Forecasts 263 Why Forecast Accounting Earnings? 263 From Forecasts to Operating Income 263 From Operating Income to Net Income on Projects 267 From Project Earnings to Project Cash Flows 269 From Project Cash Flows to Incremental Cash Flows 273 Nonincremental Cash Flows 273 The Argument for Incrementa! Cash Flows 275 An Argument for Time Weighting Cash Flows 277 The Process of Time Weighting 278 Project Decisions and Time-weighted Cash Flows 278 The Case for Time-weighted Cash Flows 279 Summary 279 Real Companies. Real Time: Analyzing Inflation and International Risk 350 Operating Cash 423 Reasons for Holding Operating Cash 424 How Much Operating Cash to Hold 424 The Effect of Operating Cash on Value 427 Reducing the Need for Operating Cash 428 Near-Cash Investments 429 Near-Cash Investment Choices 429 Cash versus Near-cash Investments 433 The Effect of Near-cash Investments on Value 435 Investments in Risky Securities 440 Reasons for Holding Risky Securities 440 Accounting for Investments in Risky Securitles 442 The Effect of Risky Investments on Firm Value 443 Cash Holdings at U. Side Benefits. Real Time: Risk and Return 254 Chapter 9 Estimating Earnings and Cash Flows on Projects 256 Chapter 12 Project Interactions. Real Time: Analyzing Working Capital Policy 421 Investments in Cash and Marketable Securities 423 Dealing with Inflation in Project Analysis 318 Understanding Inflation 319 Dealing with Expected Inflation in Project Analysis 320 Dealing with the Effects of Unanticipated Inflation on Net Present Value 322 Analyzing Foreign Projects 325 An Introduction to Exchange Rates 325 Estimating Discount Rates for Foreign Projects 331 Estimating Cash Flows for a Foreign Project 335 Other Issues in Estimating Cash Flows on Foreign Projects 339 Domestic Projects with International Exposure 340 Managing Project Risk 341 • Should Project Risk Be Managed? 341 How Do You Manage Project Risk? 342 Summary 347 . Firms 444 . Real Companies.S.

and Regulatory Authorities 640 The Effects of Asymmetric Information 641 Implications for Agency Costs 642 Summary 649 Real Companies. Risk. Real Time: Capital Structure Choices 569 CO NTENTS XXl11 Real Time: Analyzing Cash and Marketable Securities 449 hapter 15 Investment Returns and Corporate Strategy 451 Analyzing a Firm's Existing Projects 452 Analyzing an Individual Project Using Cash Flows 452 Analyzing a Firm's Project Portfolio 453 The Sources of Good Projects 458 Competitive Product Markets. Real Time: Analyzing a Firm's Existing Investments 458 559 479 ART THREE ~hapter 16 THE FINANCING DECISION 481 Chapter 19 An Overview of Financing Choices 482 The Distinction between Debt and Equity 482 Equity Financing Options 484 Equity Choices for Private Firms 484 Equity Choices for Publicly Traded Firms 485 Debt Financing Options 488 Bank Debt 488 Bonds 489 Leasing 492 Hybrid Securities 498 Convertible Debt 498 Preferred Stock 501 Option-linked Bonds 503 Summary 504 Real Companies. Real Time: Analyzing a Firm's Current Financing Choices The Optimal Financing Mix 571 Operating Income Approach 571 Steps in Applying the Operating Income Approach 571 Limitations of the Operating Income Approach 574 Refinements on the Operating Income Approach 574 Cost of Capital Approach 574 Cost of Capital and Firm Value 575 Steps in Cost of Capital Approach 577 Constrained Cost of Capital Approaches 589 Extensions 01 the Cost of Capital Approach 592 Leverage and the Return Differential 596 Steps in the Return Differential Approach 596 Limitations of the Return Differential Approach 599 Adjusted Present Value Approach 600 Steps in the Adjusted Present Value Approach 600 Benefits and Limitations of the Adjusted Present Value Approch Comparative Analysis 605 Comparing to Industry Average 605 Controlling for Differences among Firms 606 Selecting the Optimal Debt Ratio 608 Summary 608 Real Companies. Gradual Change. Equity Research Analysts. Real Time: The Optimal Financing Mix 616 507 604 ~hapter17 The Financing Process 509 Financing Choices and a Firm's Life Cycle 509 Internal versus External Financing 510 Growth. or Immediate Change 620 Implementing Changes in Financial Mix 623 Choosing the Right Financing Instruments 631 Matching Financing Cash Flows with Asset Cash Flows 632 Tax Implications 639 Views of Ratings Agencies. Loss of Flexibility 549 Summarizing the Debt Tradeoff 550 The Tradeoff for Equity Investors 550 The Managerial View of the Tradeoff 552 No Optimal Capital Structure 553 The Irrelevance of Debt in a Tax-free World 554 The Irrelevance of Debt with Taxes 555 The Consequences of Debt Irrelevance 557 The Significance of the Miller-Modigliani Theorem 558 Optimal Capital Structure 559 The Case for an Optimal Capital Structure 559 Empirical Evidence on the Existence of an Optimal Capital Structure How Firms Choose their Capital Structures 560 The Financing Mix and a Firm's Life Cycle 561 A Financing Mix Based on Comparable Firms 563 Following a Financing Hierarchy 563 Summary 565 Real Companies. Real Time: Examining a Firm's Financial Transitions Chapter 20 The Financing Mix and Choices 619 Choosing a Financing Mix 619 No Change.Ul CONTENTS Summary 446 Real Companies. Real Time: Mechanics of Moving to the Optimal Financing Mix 653 535 Chapter 18 The Financing Mix:Tradeoffs and Theory The Benefits of Debt 538 The Tax Advantages of Debt 538 The Discipline of Debt 540 The Costs of Debt 542 Expected Bankruptcy Costs from Debt The Agency Costs of Borrowing 545 537 542 . and Financing 511 How Firms have Actually Raised Funds 512 The Process of Raising Capital 518 Private Firm Expansion: Raising Funds from Private Equity 518 From Private to Publicly Traded Firm: The Initial Public Offering 520 The Choices for a Publicly Traded Firm 528 Summary 532 Real Companies. and Good Projects Management Actions and Investment Returns 462 Acquisitions 463 Corporate Strategy and Project Quality 464 Underperforming Projects: Reasons and Response 466 Reasons for Project Failure 466 The Response to Bad Investments 469 Summary 474 Real Companies. Barriers to Entry.

Splitoffs. Real Time: Acquisitions Analysis 876 749 rapter 22 Chapter 25 Chapter 26 hapter 23 836 . Real Time: The Tradeoff on Dividend Policy 684 Analyzing Cash Returned to Stockholders 686 Cash Returned to Stockholders 687 The Effects of Buying Back Stock 687 The Magnitude of Stock Buybacks 687 A Cash Flow Approach to Analyzing Dividend Policy 689 Step 1: Measuring Cash Available to Be Returned to Stockholders 689 Step 2: Assessing Project Quality 694 Step 3: Evaluating Dividend Policy 697 Step 4: Interaction between Dividend Policy and Financing Policy 702 A Comparable-firm Approach to Analyzing Dividend Policy 704 Using Firms in the Industry 704 Using the Market 706 Managing Changes in Dividend Policy 708 Empirical Evidence 708 Lessons for Firms 710 Summary 710 Real Companies. Spinoffs. Real Time: Choosing a Way of Returning Cash to Stockholders 747 Dividend Policy 658 Background on Dividend Policy 658 The Dividend Process 659 Measures of Dividend Policy 660 Empirical Evidence on Dividend Policy 661 The Dividend Irrelevance School 666 Assumptions Needed for Dividend Irrelevance 666 A Proof of Dividend Irrelevance 667 Dividend Policy when Dividends are Irrelevant 669 The "Dividends Are Bad" School 669 Taxing Ordinary Income and Capital Gains 670 Timing of Tax Payments 670 Measuring the Dividend Tax Disadvantage 671 The "Dividends are Good" School 674 Some Reasons for Paying Dividends that Do Not Measure Up 674 Some Good Reasons for Paying Dividends 676 Summary 682 Real Companies. and Splitups 732 Equity Carve-outs (ECOs) 735 Tracking Stock 739 Comparing the Alternatives 741 Common Objectives 741 Key Differences 742 Choosing between the Alternatives 743 VALUATION Valuation: Principles and Practice 750 Discounted Cash Flow Valuation 750 Cash Flow to the Firm 751 Expected Growth 757 Discount Rate 760 Asset Life 761 The Missing Pieces of Value 765 The Final Estimate of Value 769 Valuing Equity Directly 774 Relative Valuation 775 Standardized Values and Multiples 775 Determinants of Multiples 776 The Use of Comparable Firms 778 Reconciling Different Valuations 783 Summary 784 Real Companies.IV CONTENTS CONTENTS xxv lHT fOUR iapter 21 THE DIVIDEND DECISION 857 PART FIVE Chapter 24 Summary 744 Real Companies. Real Time: Value Enhancement 832 Acquisitions and Takeovers 834 Background on Acquisitions 834 Classifying Acquisitions 835 The Process of an Acquisition 835 A Brief History of Mergers and Acquisitions in the United States Empirical Evidence on the Value Effects of Takeovers 837 Steps in an Acquisition 838 Developing an Acquisition Strategy 839 Choosing a Target Firm and Valuing Control/Synergy 843 Structuring the Acquisition 857 Following Up on the Acquisition 863 Takeover Restrictions 866 Restrictions on Acquisitions 867 Analyzing Management and Leveraged Buyouts 868 Summary 872 Real Companies. Internal Rate of Return. Real Time: A Framework for Analyzing Dividends 715 Beyond Cash Dividends: Buybacks. and Discounted Cash Flow Value 823 CFROI and Firm Value: Potential Conflicts 826 A Postscript on Value Enhancement 826 Summary 827 Real Companies. and Divestitures 718 Alternative Ways of Returning Cash to Stockholders 719 Equity Repurchases 719 Forward Contracts to Buy Equity 725 Actions that Affect Number of Shares Outstanding 726 Stock Splits 726 Stock Dividends 729 Actions that Affect Claims on Assets 729 Divestitures 730 Spinoffs. Real Time: Valuation 789 Value Enhancement:Tools and Techniques 791 Value-Creation: A Discounted Cash Flow (DCF) Perspective 791 Value-Creating and Value-Neutral Actions 792 Ways of Increasing Value 793 The Value Enhancement Chain 807 Alternatives to the TraditionalValuation Model 810 Economic Value Added 812 Cash Flow Return on Investment 822 Cash Flow Return on Investment.

... but not Blind Faith. PART •••••••••••••••••••••••••••••••••••••••••••••••••••••• ••••••••••••••••• •• • •••••••••••••• ONE H ••••••••••••• r ••••• _ Option Applications in Corporate Finance 881 Basics of Option Pricing 881 Alternatives to the Binomial Model 882 Extensions of Option Pricing 886 Options in Investment Analysis 889 The Option to Delay a Project 889 The Option to Expand a Project 897 When Are Delay and Expansion Options Valuable? 901 The Option to Abandon a Project 903 Option Applications in Valuation 905 Valuing Firms with Patents or Licenses 905 Valuing Natural Resource Firms 906 Valuing Equity in Troubled Firms 907 Option Pricing in Capital Structure and Dividend Policy Decisions The Conflict between Bondholders and Stockholders 914 Security Design and Valuation 915 Value of Financial Flexibility 916 Summary 919 Back to First Principles 924 Back to First Principles 924 The Investment Principle 924 The Financing Principle 925 The Dividend Principle 926 Interrelationships and Life Cycle Effects 926 Interrelationship between Principles 927 The Life Cycle Effect 927 Core Propositions/Beliefs 929 Faith in Markets. ~ . Not the Past 930 Show Me the Money 930 Manage for the Marginal Investor 931 Summary 932 Solutions to Odd-Numbered Index 971 Questions and Problems Introduction to Corporate Finance 913 iapter 28 933 1 .. . 929 The Future..vi CONTENTS THE LINK B UN VALU FINANCE DECISIONS apter 27 ION A c ORATE 879 ...

we are referring to the value of both categories of investments . privately run or publicly traded.firms can raise money from two sources. both businesses hope to keep investing in the future. while the bookstore owner has to consider whether to invest her own savings (equity) or take out a bank loan (debt) to expand.Introduction to Corporate Finance HE CHIEF financial officer at Boeing and the owner of a small bookstore face the same fundamental choices.investments already made and investments yet to be made. Here. Boeing has to decide whether it should invest billions of dollars in a new Super Jumbo jet. and it owns the technology that goes into these planes. Boeing. To finance these assets. for instance. both Boeing and the bookstore are firms. AJternatively. First. Thus. owns a large number of plants that manufacture its commercial aircraft. capable of carrying 500 or more passengers. and the private bookstore owner has to make the same judgment about how much she can afford to take out of her business. Consider first what they have in common. At regular intervals. The small bookstore owns both the retail space where its operates and the books that it has in that space. and engaged in any kind of operation . though on vastly different scales. being a publicly traded finn.manufacturing. The private bookstore owner is faced with the question of whether to add a cafe to her bookstore to compete with the Barnes and Noble superstore nearby. Boeing has to determine how much of what it makes on its current investments should be returned to its stockholders. they can borrow the money from a bank or other lenders. can issue stock and 3 . Boeing has to decide between raising the money by issuing new stock (equity) or bonds (debt). Corporate Finance and the Firm Corporate finance can be described as the study of the decisions that every finn has to make. Both businesses own assets that currently generate earnings.We term these funds equity. When we talk about the value of the firm. Boeing. or service. a distinction emerges between Boeing and the small bookstore. Corporate finance provides the answers to all three of these questions for both the chief financial officer of Boeing and the private bookstore owner. We categorize this type of financing as debt. they can use the funds of the owner or owners of the businesses. but what is a firm? We use the term to mean any business large or small. to grow and prosper. retail. In addition.

the proportion of the owner's funds (equity) or borrowed money (debt). we convert this risk measure into a hurdle rate for both entire businesses and individual projects.We summarize this generic view of a firm in Figure 1. should reflect whether the money is raised from debt or equity. it should not make the investment. we measure the return on a proposed investment decision and compares it to a minimum acceptable hurdle rate in order to decide whether or not the project is acceptable. After all. On the other hand. can use $5 billion to invest in a new generation of aircraft or to expand its defense contracting business. it is one of the ironies of recent years that many managers at large and presumably sophisticated firms with access to the latest corporate finance technology have lost sight of these basic principles. which we term a hurdle rate. 10. if Boeing anticipates making only 7% on its Super Jumbo. we turn our attention to measuring the returns on a project.. This minimum return. We need to be able to consolidate these earnings and investments into one measure of return for purposes of comparison to the hurdle rate. we extend the investment principles developed in the earlier chapters for longer term assets to shorter term bonds in financial markets to raise equity and debt. which we term the investment principle. replacing the existing air conditioner at the bookstore with a newer. The owner can invest her own savings in the business. and we extend these principles to cover both domestic and foreign investments. In fact. These are all investments designed to generate revenues and profits for these firms. The hurdle rate has to be set higher for riskier projects and has to reflect the financing mix used. being a private business. ~irst Principles of Corporate Finance Every discipline has its first principles. These first principles provide the basis from which we will extract the numerous models and theories that comprise modern corporate finance.55%.1 A Simple iew of a Firm TO CORP01!. and the dividend principle. for instance.ATE FINANCE FIRST PRINCIPLES OF CORPORATE FINANCE 5 investments than they bear as a cost of raising the money for these investments. or borrow from the bank. If this shortfall persists. has fewer options.32%. we will stretch the definition of investment to include strategic decisions regarding which markets to enter and whether to make acquisitions of other companies. In corporate finance. Let us take a look at each.2 illustrates the comparison and our conclusions. All of corporate finance is built on three such principles. • The Investment Principle: The investment principle states simply that flrms should invest in assets only when they are expected to earn a return greater than a minimum acceptable return. • The Dividend Principle: Firms sometimes cannot find investments that earn their minimum required return or hurdle rate. which would be equity. the financing principle. and her minimum acceptable rate is 12. and the minimum that it needs to make is 9. a decision by Boeing to install computers to manage how much it has in inventory may save the firm substantially in inventory costs. Good businesspeople through the ages have always recognized the importance of making more on their . Similarly. For instance. that is. It would be arrogant to assume that until corporate finance began to develop as a coherent discipline a few decades ago. but they are also common-sense principles. she should invest. will require additional investments in the future. In Chapters 7 and 8. The Investment Principle Firms have scarce resources that must be allocated among competing uses. we introduce the fundamental principles that we believe should determine how returns are measured on investments. the biggest single investment that Boeing has made in the last few years. In Chapters 9. we examine how best to bring in all the side costs and benefits that most projects create for a business into returns. There is another type of investment whose benefits show up not as higher revenues but as lower costs. In the context of the hurdle rate specified in the investment principle. In fact. people who ran businesses did so randomly with no principles to govern their thinking. In Chapter 12. more efficient one may not generate revenues. we begin the process of estimating this minimum rate by defining risk and developing a procedure for measuring it. In Chapters 13 and 14.000 that she plans to borrow to expand her bookstore space or to add a cafe. if the bookstore owner believes she can make 18% on the cafe expansion. Figure 1. and J 1. and what returns those investing the money could have made elsewhere on similar investments. but it could save costs. both Boeing and the small bookstore owner have to estimate what kind of return they would require at the minimum to invest in their proposed investments. there are differences in the way in which we apply the theory in each case. Thus. which would be debt. Boeing. While much of what corporate finance has to say applies to both. The bookstore owner can use the $50. Boeing acquired McDonnell Douglas in 1997 for $10 billion. Having established the hurdle rate. and will earn different amounts each year.1. firms have to return any cash they generate to the owners. The small bookstore. • The Financing Principle: The financing principle posits that the mix of debt and equity chosen to finance investments should maximize the value of the investments made.CHAPTER ONE ! INTRODUCTION gure 1. In other words. the Boeing Super Jumbo project can be expected to last over 30 years. choosing a nUx of debt and equity that minimizes this hurdle rate allows the firm to take more new investments and increase the value of existing investments. In Chapter 6. and then compare the returns they expect to make on these investments to the minimum.

Firms that violate this basic rule do so at their own risk.3 summarizes the two questions that the financing principle attempts to answer.3 Financing The Principle . or the entire amount from its equity investors. The decision of how much to reinvest and how much to return to owners is at the core of the dividend principle. and short-term assets should be financed with short-term debt. have to make on how much to give customers. when the cash flow generated by existing investments is greater than the funds needed to take on good investments (those that earn returns that exceed the hurdle rate). There will be a stage in every firm's life cycle.We believe that firms should try to match the characteristics of the financing as closely as possible to the characteristics of the assets being financed. the firm has to figure out ways of returning excess cash to the owners.CHAPTER ONE I INTRODUCTION igure 1. but it also provides insight into what types of financing a company should use. The Dividend Principle How can firms reward their owners? One way is to reinvest the owners' funds back into new investments and increase the value of their ownership stake in the business. we expand the discussion of dividend policy to include other actions that change the nature of what stockholders own or the units of ownership in the firm and that consequently affect the value of these units. they have to select a mix of debt and equity to finance their investments. Thus. debt can be short term or long term. what it is. This tradeoff is then converted into tools that can be used to help a firm decide on its optimal financing mix in Chapters 19 and 20. In the balance. and then examining the process of raising funds in Chapter 17. this may just mean the owner is withdrawing a portion of his or her funds from the business. if so. The tradeoff on dividend policy is introduced in Chapter 21. assets and to the day-to-day decisions that managers inventory to hold and whether and how much credit Chapter 15. Finally. the biggest benefit of borrowing is the tax advantage that accrues from the fact that interest payments are tax deductible.5 billion of the $5 billion that it needs for its new investment. The other is to allow them to withdraw their funds from the business and invest them. in analysis and try to look at the management and investment The Financing Principle Firms have to make two broad choices when it comes to financing. when they used short-term debt to finance their long-term assets (house mortgages). as well as the way strategic analysis are linked. When a firm is small and faced with attractive investment opportunities. available funds should probably be reinvested back into the business. The tradeoff of taking on debt is introduced in Chapter J 8. for instance. As a cautionary tale. The downside of borrowing is that the firm may be unable to meet these payments. We introduce the financing decision by first discussing the alternative financing vehicles that are available to both private and public firms in Chapter 16. where we discuss both the benefits and costs of borrowing. Indonesian firms in the mid-1990s that used dollar-based debt to finance their local rupiah-based investments were unable to make their debt payments when the Indonesian currency plummeted against the dollar in 1996 and 1997. Similarly. that its optimal mix is 30% debt and 70% equity. Corporate finance not only helps firms decide whether to borrow money in the first place. It should therefore borrow $1. In general. Within the broad categories of debt and equity exist a number of different financing instruments. A fundamental question that we have to address is whether there is. in fact. Boeing can raise all of the billions it needs for the Super Jumbo from debt. debt is beneficial as long as the marginal benefits of borrowing exceed the marginal costs. long-term assets (such as an investment in a Super Jumbo jet) should be financed with Figure 1. for instance. By weighing the benefits against the costs. it means the payment of a dividend to shareholders or a stock buyback. In Chapter 23. in which case the lenders may take control of its assets. In a publicly traded corporation. Figure 1. however. For instance. and the process by which a firm can decide on the right amount to return to its stockholders is examined in Chapter 22. Boeing may find. First. and it can be in dollars or in Japanese yen. In private businesses. elsewhere. consider the fact that savings and loans in the United States faced financial ruin in the early 1980s. just some of it from debt. an optimal mix of debt and equity and. At that point.2 rvestment The Principle TO CORPORATE FINANCE FIRST PRINCIPLES OF CORPORATE FINANCE 7 long-term debt. we go beyond the numbers in investment roots of good projects.

There are two problems with this definition. The financing decisions affect the value of a firm through the hurdle rate. strategic. and dividend decisions. customers) are met. In general. 1 We qualify this statement because certain accounting assets like goodwill lay claim to me. this objective of firm value maximization is often narrowed further. the value of the equity in a firm cannot exceed the value of the firm. In the next chapter. Investors base expectations about the firm's future on the quality of the finn's projects (its investment decisions) and the amount of its earnings it reinvests (its dividend decision). labor. is determined by the cash flows that these assets are expected to generate and the uncertainty associated with these cash flows. we consider both the strengths and weaknesses of the objective of firm value maximization and compare it to alternative objectives. and dividend decisions. which allows us to compare cash received or paid at different points in time and to weight them based on when they occur. By extension. The second is that this definition almost entirely misses the value that will be created by future investments. financing. and stockholders and managers. especially if the asset was acquired or developed well in the past. financing. The third tool is an understanding of how to value an asset. 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 the firm. financial. the value of the equity in the firm should be what is left after the value of all debt outstanding is netted out against the value of the firm. The objective in conventional corporatefinancial theory is to maximize the value if the firm. Given our very simple description of the firm. on the other. some argue that firms should have multiple objectives where a variety of interests (stockholders. the investment principle. The first. Summary Corporate finance covers all decisions made by businesses that affect their finances. We introduce the basic models available to value a firm in Chapter 24. then. We introduce the time value of money and expand on its applications in Chapter 3. since much of the information that we get and provide in finance comes from these statements. and advertising decisions are all corporate finance decisions. and dividend decisions. We review the basic accounting principles in Chapter 4 and consider how best to modify them for purposes of financial analysis. but we return to the subject in far more detail in Chapter 24. Since most investments generate cash flows at different points in time. In the course of decision making. but they do not do this job completely or very well. The first of these tools is the time value of money. of the firm itself. To achieve this objective.wring the value of expected growth. while others would have firms focus on what they view as simpler and more direct objectives such as market share or profitability. As we will see in the next chapter. Since the firm is fmanced with a combination of debt and equity. Accountants often use this as their measure of value and call it book value. 1 We will argue that the value of the assets of a finn and. and the conflicts of interest that arise between stockholders and bondholders. . The second tool is an understanding of financial statements.to maximize firm value. it is important that we examine it much more carefully and address some of the very real concerns and. We introduce the basics of valuation for firms and stocks in Chapter 5. we examine the determinants of value and how firms can best increase their value. may not reflect what that asset is worth today. ultimately. The Tools of Corporate Finance In the process of developing the rnodels that can be used to make sensible investment. Although the choice of this objective has provided corporate finance with a unifying theme and internal consistency. any decision (investment. we will draw on a number of tools that apply across all these decisions. and we round off our discussion with an analysis of the value of various options that a finn acquires in the course of business in Chapter 27. being able to convert and consolidate these cash flows is critical to good decision making. specifies that firms should not invest in assets that earn less than a minimum acceptable hurdle rate. except in the case where a firm has no debt outstanding. The effects of mergers and acquisitions on value are described in Chapter 26. it follows that firm value must be linked to the three corporate finance decisions that have just been outlined . These expectations will change from day to day as new information comes out about the firm and the macroeconomic environment changes.orporate Financial Decisions. We determine the value of a firm not only by how well it manages its existing assets. it can be argued that the value of an asset is what you paid for it. whereas a decision that reduces firm value is considered a "poor" one. Consequently. financing. marketing. nd Equity Value If the objective in corporate finance is to maximize firm value. and we relate them back to managelTlent decisions in Chapter 25. three core corporate financial principles must be observed. In the process.but also by how well it invests in new assets. . in practice.investment.CHAPTER ONE I INTRODUCTION TO CORPORATE FINANCE THE TOOLS OF CORPORATE FINANCE 9 The Objective of the Firm No discipline can develop cohesively over time without a unifying objective. We will term this measure of value the market value. to maximizing stockholder value and still further to maximizing the stock price. Firm Value. criticisms it has garnered. what is it that determines firm value? At one level. on the one hand. there is only one objective in corporate finance . Given the significance of the value maximization objective for both the development and applicability of corporate financial theory. the value of the equity in a firm will not generally be equal to the value of the firm. This neat formulation of value is put to the test by the interactions among the investment. then. For instance. by extension. The growth of corporate financial theory can be traced to its choice of a single objective and its development of models built around this objective. it has come at a cost. The first is that what you paid for an asset. or dividend) that increases firm value is considered a "good" one.

how to finance them. Alternatively. especially one that is publicly traded. is structured. Stockholder Wealth Maximization in Decision Making as the Objective In the introductory chapter. or they could evaluate the project based on the effect it would have on earnings in the next few years. and lenders to the firm. The finn borrows money either fi'om banks or by issuing bonds. In this chapter. p~sits that. To see why. The managers make the decisions on which investments to take. Boeing should invest in the Super Jumbo if the investment will make it a more valuable firm. we stated. The objective of maximizing firm value applies just as much for private businesses and small firms as it does for Boeing. In this chapter. financing. Airbus. consider how a firm. We then follow up by examining some of its limitations. ~rms should use a mix of debt and equity that maximizes their value. we begin by looking at how we get from firm value maximization to stockholder wealth maximization and why we choose it as our only objective. the dividend pnnciple . they could push the project forward noting the positive effect it would have on revenues in future years. we end the chapter with a strong argument for why it makes sense to focus on stockholder wealth maximization. given the different interests and incentives of managers. specifying what assets the firm will offer as security on the borrowing and 11 . The Objective In Corporate Finance N DECIDING whether to invest in a Super Jumbo Jet or how to raise funds for the investment. Investment. Although we consider alternatives to the value maximization objective. and dividend decisions. despite its flaws. argues that firms that do not have enough investments that earn the hurdle rate b return the cash to the owners of the business. with the stock price reflecting this wealth. They could argue that the investment would increase their market share at the expense of their prime competitor. The stockholders of the firm hire managers to run the firm for them. should be directed toward this objective.10 CHAPTER ONE / iNTRODUCTION TO CORPORATE HNANCE where the hurdle rate will reflect the risk of the investment and the mix of debt and equity used by the firm. Corporate finance's focus on maximizing stockholder wealth as a unifying objective is both its strength and its weakness. What is the right measure of the value of this project? The answer from corporate finance is emphatic. stockholders. the managers at Boeing could focus on a number of different measures to evaluate the investment. The third. we noted that the objective in corporate finance is to maximize the value of the firm. The second. these lenders enter into agreements with the firm. we recast this objective more narrowly. the financing principle. this will also make its stockholders wealthier. By extension. and how much to return to stockholders.

This is an ambiguous objective since it does not answer at least two questions. operating earnings. Therefore. In fact. higher earnings. it is the managers of the firm. measure of stockholder wealth. If a project increases both market share and current earnings. if stock price maximization is the objective. concentrated on increasing their market share. The first is that stock prices are the most observable cif all measures that can be used to judge the performance of a publicly traded firm." Exactly how is customer satisfaction defined. If objectives are prioritized. and developing theory becomes much more difficult with multiple objectives. A theory developed around multiple objectives of equal weight will create quandaries when it comes to making decisions. and by so doing. convinced that greater market share would provide more pricing power and. and if we do need one. rather than the owners. such as profits or growth. we could argue that the lenders can protect themselves contractually and that managers should therefore focus on maximizing the wealth of those who hired them in the first place .2 CHAPTER TWO / THE OBJECTIVE IN CORPORATE FINANCE STOCKHOLDER WEALTH MAXIMIZATION AS THE OBJECTIVE IN DECISION MAKING 13 what the finn can and cannot do in future periods. If we choose multiple objectives. ranging from reasonable ones like maximizing return on investment to obscure ones like maximizing the size of the firm. For instance. The reality. An objective specifies what a decision maker is trying to accomplish. may create significant costs for society that will overwhelm any benefits arising from the objective. the objective of maximizing stockholder wealth can be narrowed even further to maximizing stock prices. many of the largest airline" companies in the United States. consider a retail firm that defines its objective as "maximizing customer satisfaction. objective. Should the top priority be maximizing current earnings. managers receive instantaneous feedback on every action . The Characteristics of the "Right" Objective When it comes to decision making. assume that a tobacco company defines its objective to be revenue growth. a manager choosing between two alternatives will choose the one that increases stock price more. or should it be maximizing market share? Because there is no gain from having multiple objectives. stock prices are updated constantly to reflect new information coming out about the firm. As an example. Thus. a firm that had focused not on market share but on profitable routes. for instance. who make the decisions about where to invest or how to raise funds for an investment. the stock price is an observable and real measure of stockholder wealth. but what if the project being analyzed increases market share while reducing current earnings? The firm should not invest in the project if the current earnings objective is considered. If no objective is chosen.however. the objective is stated in terms of maximizing some function or variable.Doing so. why can't we have several? Let us start with the first question. For instance. since it will increase sales. This is a narrower objective because it is predicated on the assumption that the stock price is a good. there is no systematic way to make the decisions that every business will be confronted with at some point in time. Managers of this firm will then be inclined to increase advertising to teenagers. In most cases. How can it know whether the objective it has chosen is the "right" objective? A good objective should have the following characteristics: (1) It is clear and unambiguous. Although the stock price is the market's measure of stockholder wealth. the objective is narrowed from maximizing firm value to maximizing stockholder value or stockholder wealth. There are three reasons for the focus on stock price maximization in traditional corporate finance. three managers looking at the same project could come to three separate conclusions about it. Unlike earnings or sales. we have to estimate it based on assumptions we make about a finn's future prospects. In a publicly traded company. a firm whose objective is to increase growth in the long term. The first is growth in what variable? Is it in revenue. Why Do We Need a Unique Objective? Let us start with a description of what an objective is and the purpose it serves in developing theory. it provides measures that can be used to choose between alternatives. but it should invest in it based on the market share objective. without an objective. An objective that is ambiguous will lead to decision rules that vary from case to case and from decision maker to decision maker. we are faced with the same stark choices as in the choice of a single Why Corporate Finance Focuses on Stock Price Maximization Even though stock price maximization as an objective is the narrowest of the value maximization objectives. by extension. Although the firm includes both equity investors and lenders. was that by the end of the decade the most profitable firm in this sector was Southwest Airlines. or a longer period? (2) It comes with a clear and timely measure that can be used to evaluate the success or failure of decisions. we would argue that there should be only one objective. which are updated once every quarter or year. however. To illustrate. we are faced with a different problem. not only will managers be unable to make decisions based on this objective. Thus. Thus. In most firms. we consider the case that can be made for stock price maximization being the only objective that a firm needs to have. it is the most prevalent one. and how is it to be measured? If no good mechanism exists for measuring customers' satisfaction with their purchases. and no statements could be made about their relative value. five years. Consider. such as United and American. but the firm will also have no way of holding them accountable for any decisions they do make. So why do we need an objective. How do we measure stockholder wealth? In private firms. (3) It does not create costs for other entities or groups that erase firm-specific benefits and leave society worse off overall. In the 1980s. Consequently. how could Boeing's managers decide whether the investment in a new Super Jumbo was a good one? There would be a menu of approaches for picking projects. assume that a firm chooses as its objectives maximizing market share and maximizing current earnings. In this section. net income. Objectives that sound good but do not come with a measurement mechanism are likely to fail.the stockholders. many of the airlines that had concentrated on market share ended up losing money. if not perfect. the firm will encounter no problems. a firm can choose between a number of different objectives. We begin with why we need an objective in the first place and what propels us to choose stock price maximization as that objective. or earnings per share? The second is in the definition of the long term: Is it three years. or minimizing some function or variable. such as risk or costs. The costs of choosing the wrong objective can be significant. it is possible for markets to make mistakes in their assessments.

udfectthe longterm iffects if the firm's decisions. there is a possibility that maximizing stock prices can create costs for others. the stock price is a real measure of stockholder wealth. Unlike accounting measures such as earnings or sales measures such as market share. Under what conditions would his argument hold? Under what conditions might it break down? When Is Stock Price Maximization the Only Objective a Finn Needs? In classical corporate finance. if they so desire. or infrastructure costs. There are no burdens that are created for society. employees. there is no debate about what the stock price is. and stock prices reflect stockholder wealth. at least. which examine the effects of the firm's decisions on current operations. who. The managers of the firm put aside their own objectives and focus on maximizing stockholder wealth as measured by the stock prices. since stockholders can sell their stock and receive the price now.1 Stock Price in An 15 they take from investors in markets. 3. In the following section. in a market with rational investors. the absence of social costs implies that wealth maximization by firms results in wealth maximization for society. the managers of firms need to concentrate only on maximizing stock prices and can set aside all other concerns they might have for other claim holders. This is summarized in Figure 2. it is appropriate if the following assumptions hold: 1. Second. The first is that stockholders might be concerned about the damage to the firm's reputation if they take actions that hurt lenders and about the consequences of that damage for future borrowing. suggesting that markets are much more skeptical about managerial claims. The lenders to the firm feel secure that their interests will be protected and that the firm will live up to its contractual obligations. when firms maximize stock prices. pollution. in the process of stockholder wealth maximization. In a rational market. and thus firm value is maximized as stockholder wealth is maximized. we consider the relationships between the different players involved in this process. 4. we examine the conditions under which these costs can be minimized or eliminated. The second is that lenders might be able to protect themselves fully when they lend by writing in restrictions (covenants) that proscribe the firm's taking any actions that hurt the lenders.2.4 CHAPTER TWO I THE OBJECT[VE [N CORPORATE FINANCE STOCK PRICE MAXIMIZATION AND AGENCY COSTS Figure 2. This might occur either because they are terrified of the power stockholders have to replace them or because they own enough stock in the firm that maximizing stockholder wealth becomes their primary objective as well. . and there. it is the most timely and measurable of all objectives because it is constantly updated in financial markets. managers focus on stock price maximization because of the power stockholders have over them.maximizing stock prices. Consequently. 2. in the form of health. for things to go wrong. The assumptions needed for the classical objective are summarized in Figure 2. Maximization Ideal World assumed to be reasoned and rational in their assessments of these actions and the consequent effects on stock price.1: AI (Chainsaw) Dunlap. Although managers consistently paint a rosy picture of every acquisition they plan. Finally.1. the stock price reflects the long-term effects of these decisions on value. With these assumptions. managers can concentrate on one objective . Markets are Stock Price Maximization and Agency Costs In the ideal world that we described in the last section. however. the stock price of the acquiring firm drops in a significant proportion of acquisitions. was responsible for turning the company around and making millions for stockholders. Even if markets err in their estimates. In this section. All costs created by firm in its pursuit of stockholder wealth maximization can be traced and charged to the firm. Thus. and we look at the potential. • The second reason is that stock prices. maximizing stock prices also maximizes stockholder wealth. First. no other group is hurt as stockholders maximize wealth. Although this single-rnindedness sounds extreme and may actually be damaging to other claim holders in the firm (lenders. stock price maximization as an objective meets at least the first two criteria that we required of a good objective. The managers of the firm do not attempt to mislead or lie to financial markets about their future prospects. as chief executive officer at Scott Paper. A good illustration is the response of markets to a firm announcing that it is planning to acquire another firm. This might occur for one of two reasons. The bondholders are protected as stockholder wealth is maximized. is sufficient information for markets to make judgments about the effects of the firm's actions on its value. it can be argued that an erroneous estimate of long-term value is better than a precise estimate of current earnings because one stock price reflects the future and is based on all available information. the stock price represents the investors' attempt to measure this value. it is clear and unambiguous for publicly traded firms: at any point in time. With regard to the third criterion. Since the information revealed to markets is unbiased and timely. has argued that CEOsof firms should focus solely on maximizing stock prices and that the actions they take in the process enrich society as well. CT (Critical Thinking Question) 2. and society). stockholders can cash in on the gain immediately. Finally. Thus.

and through them the incumbent management of the firm. This is the equivalent of having an election in which the incumbent gets the votes of anybody who does not show up to vote. leading to a large proportion of absentees. bondholders. On major decisions. when they are dissatisfied with incumbent management. As elected representatives of the stockholders. For larger stockholders with significant holdings in a large number of securities. in the process of maximizing stock prices. decide to change the board of directors. which contains two mechanisms designed to provide power to stockholders. We consider the agency costs in four categories.544 in 1988. 2 3 4 Korri/Ferrv surveys the boards of large corporations and provides insight into their composition.insurance and pension benefits being the largest component. 74% of the 426 companies it The core of the problem is that stockholders. there is the potential for a conflict between stockholder and managerial interests. . managers. First. especially relating to accounting rules and tender offers. Finally. where stockholders can voice their displeasure with incumbent management and remove them if necessary. These conflicts create costs for the firm that are called agency costs. conflicts of interests may arise between these different groups. This understates the true benefits received by [he average director in a firm. It does not allow them to ask open-ended questions of management. the cost of going to a meeting exceeds the benefit. and so they rely instead on outside experts. and there are recent trends toward greater activism.CHAPTER TWO I THE OBJECTIVE IN CORPORATE ure 2. and was paid $32. stockholders can. down from 108 in 1988. 2. voting for incumbent management is often the default option. sell their stock and move on. and these costs can result in stock price maximization gomg awry. Stockholders and Managers The assumption that stockholders can hire and fire managers is grounded in the corporate charter. An activist posture among stockholders would go a long way toward making managers more responsive to their interests. In their 1992 survery. partly because of other commitments and partly because many of them serve on the boards of several corporations. Although their legal justification is obvious. the easiest option. we examine the differing incentives of stockholders in a firm and lenders to the firm. we examine the relationship between managers of a firm and the stockholders who hire them. which in turn can lead to decision rules that maximize not stockholder or firm wealth but managerial utility. as we will see later in this chapter. it does mention that their average compensation has climbed to $37. Most individuals who serve as directors cannot spend much time on their fiduciary duties. Korn/Ferry's annual survey of boards also found that. and society have very different interests and incentives. 1. the directors are obligated to ensure that managers are looking out for stockholder interests.2 Why Stock ce Maximization irks FINANCE STOCK PRICE MAXIMIZATION AND AGENCY COSTS 17 stockholders who cannot attend the meeting can still exercise their voting power by filling out a proxy. When managers act as agents for the stockholders. we consider the conflicts that arise when firms.4 Although the 1998 survey does not measure the hours directors spent on their duties. an executive search firm. at least in theory. the practical power of either mechanism to enforce stockholder control is debatable. The 1 A proxy enables stockholders to vote in absentia for boards of directors and for resolutions that will be coming to a vote at the meeting. The capacity of the board of directors to discipline managers and keep them responsive to stockholders is also diluted by the following factors. Though most directors are outsiders. such as the acquisitions of other firms. since it does not coun t benefits and perquisites .924. At this meeting. The other is the board of directors. whose fiduciary duty it is to ensure that managers serve the stockholders. They can change the top management of the firm and have a substantial influence on how it is run. publishes a periodical survey of directorial compensation and time spent by directors 011 their work which illustrates this point very clearly. and even among those who do. we look at the process by which firms reveal information about themselves to financial markets. This advantage is magnified if incumbent managers get to vote proxies that were never sent back to the firm. For most small stockholders. in 1988. Those absent stockholders do have a choice of exercising their power with proxies. Consequently. 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. it reported that the average director spent 92 hours a year on board meetings and preparation in 1992. that is. up from $19. they are not independent. Third. insofar as the company's CEO has a major say in who serves on the board. Next. managers have to get the board's approval. is to vote with their feet. and the costs that arise from this conflict. and we analyze the financial market response to the information.352. 1 The power of stockholders to exercise control by voting at annual meetings is diluted by two factors. The Board of Directors The board of directors is the body that oversees the management of a publicly traded firm.? Many stockholders do not bother to fill out their proxies. but incumbent management starts off with a clear advantage." an executive recruiter. Hewitt Associates. create substantial costs for society as a whole. if the managers have not done a satisfactory job. 3. Korn/Ferry. reports that 67% of 100 firms that they surveyed offer retirement plans for their directors. The Annual Meeting The stockholders in publicly traded firms are called to gather once every year at an annual meeting. The first is the annual meeting.

000 worth of stock in the firm. and The Home Depot offers other benefits to di rectors. The board of directors' failure to protect stockholders can be illustrated with numerous examples from the United States. found that 27 directors at 275 of the largest corporations in the United States owned no shares at all and about 5% of all directors owned fewer than five shares. and the search for consensus generally overwhelms any attempts at confrontation. . • To assess accountability to shareholders. Directors have to retire on their seventy-second birthday. 1997. Although there is an impetus toward reform. while Disney topped the list for worst boards. • No insiders on audit. it has to be noted that these revolts have been sparked not by board members but by large institutional investors. three of which we examine here. pany's core business and at least one CEOof a company of similar size or stature. What makes for an effective board? Business Week. it is tough to gauge how active these directors are. and compensation committees.and if the board stood for election every year. More points were awarded if a b~ard had at least one outsider experienced in the com- Looking at the analysis in aggregate. Many directors hold only small or token stakes in the equity of their corporations. chairs the meeting. August 12. If the annual meeting and the board of directors are largely ineffective in the United States at exercising control over management. It is tough to gauge how active they are. especially when their interests conflict with those of stockholders. The net effect of these factors is that the board of directors often fails at its assigned role. • To measure director quality. The CEOs of other companies are the favored choice for directors. as has been argued in the previous section. Consider a very simple example of this conflict. but they tend to be co-founders and large stockholders who are likely to put their interests as stockholders ahead of their interests as directors of the firm. and Boeing does offer other benefits to directors. Additional points were scored if all directors attend 75% or more of meetings or if a board has no more than 15 directors.000 of stock. while only 16% used a search firm. using a variety of mechanisms. we find that neither firm seems to have a captive board and both boards have distinguished members on them. assume that you know that the hostile acquisition will mean an end to your tenure as manager. Again. Campbell Soup topped the list for best boards. where inside directors were defined to be employees or managers of the firm. we assess how they would score using the Business Week criteria: Boeing Board Size Board independence 15 directors High. and compensation committees. but you also believe your stockholders are getting a good deal. they are even more powerless in Europe and Asia as institutions that protect stockholders. • Directors have no or negligible consulting or legal fee from firm. a high scoring board had no insiders on its audit. we cannot eA'Pect managers to maximize stockholder wealth. the survey awarded points if fully employed directors sat on no more than three corporate boards and retired directors on no more than six. nominating. Korn/Ferry did find a shift toward more independence on this issue. You can either put stockholder interests first and accept the hostile acquisition. In the accompanying table. As the manager in this firm. or you can put your own interests ahead of those of the stockholders and fight the hostile bid. helping to align their interests with those of investors. The managers of some firms that were targeted by acquirers (raiders) for hostile takeovers in the 1980s were able to avoid being acquired by buying out the raider's 5 See BI<sil1ess Week. in an issue that focused on the best and worst boards. the survey gave a company points when all of its directors owned a minimum of $100. or other fees from the company: and no interlocking directorships (CEOswho sat on each other's boards). 5. there were no insiders on the compensation committee. Accountability stockholders to Quality of Directors Source: 14·DEFfiling with the SECfor Boeing (March 1999) and The Home Depot (April 1999). Only one-third of the directors are up for reelection each year.a benefit many believe makes directors less likely to challenge the CEO . because • Has four inside directors (including two co-founders). Boards that failed to evaluate their performance also lost points. . a consultant. nominating. More points were awarded if a company did not offer pension benefits to its directors . but this should not blind us to a more troubling fact. All except one director own more than $10. because • Has only one inside director (Boeing's CEO). making it difficult for them to empathize with the plight of shareholders when stock prices go down. and controls the information. The Consequences of Stockholder Powerlessness If neither the annual meeting nor the board of directors keeps managers who are responsive to stockholders. Not surprisingly. There are two retired CEOs and one chief operating officer on the board. Assume that you are the manager of a firm that is the target of a hostile acquisition bid and that the potential acquirer is offering to pay 50% more than the current market price. The Home Depot 11 directors Low. Stockholders exercise more power over management in the United States than in any other financial market. 4. Only three members of the board are up for election each year. many managers choose to do the latter. with almost three-quarters of firms reporting the existence of a nominating committee that is at least nominally independent of the CEO. Institutional Shareholder Services. • Some directors have other business connections to the firm. leading to a potential conflict of interest when CEOs sit on each other's boards. In its 1998 survey. The CEO sets the agenda. a board scored points if it had no more than two inside directors. Neither Boeing nor The Home Depot made either list. All directors own more than $10. • On the plus side.s • To judge independence. legal.000 worth of stock in the firm. no outside members who directly or indirectly drew consulting. In addition.3 CHAPTER TWO / THE OBJECTIVE IN CORPORATE FINANCE STOCK PRICE MAXIMIZATION AND AGENCY COSTS 19 surveyed relied on the CEO's recommendations to come up with new directors. measured each board's independence. and accountability by looking at the following. There are a significant number of retired CEOs of large firms on the board. The Home Depot does have more insiders on its board. which is to protect the interests of stockholders. quality.

Although it is dangerous to draw strong conclusions from stock price reactions alone. and Netter (1988). 1988. Antitakeover amendments have the same objective as greenmail and poison pills. dissuading hostile takeovers. the stock price of Eastman Kodak dropped 15%. when AT&T tr ied to acquire NCR in 1991. In all three cases. generally at a price mnch greater than the price paid by the raider. 9 The term "won" is a misnomer here. . After a hotly contested battle with Hoffinan La Roche. Consider. What does overpaying on a takeover do? It transfers wealth from the stockholders of the acquiring firm to those of the acquired firm. of overpaying on takeovers is given by Roll. and the amounts involved can be staggering in some cases. who posits that man- ~Jarrell.by investing in bad projects. Antitakeover amendments do increase the bargaining power of managers when negotiating with acquirers and could work to the benefit of stockholders. Rather. of $2. Managers can nuke their stockholders worse off in nmny ways . for instance. the drop in Kodak's value is strikingly close to the market premium.1: Managers involved in making acquisitions often argue that the immediate response of stockholders to acquisition announcements is flawed because stockholders do not have the information to make this judgment. These illustrations are not meant to imply that managers are venal and selfish. Kodak bid $90. Greenmail. A winner's curse might well apply. NCR had a super-majority antitakeover amendment. managerial interests are being served at the expenses of stockholder interests.there is synergy. called greenmail.a decline in the market value of equity of approximately $2." but only if managers act in the best interests of stockholders.3 Eastman of STOCK PRICE MAXIMIZATION AND AGENCY COSTS 21 existing stake in the firm. Caves. The objective is to make it difficult and costly to acquire control. but it does protect the jobs of incumbent managers. 1988 for Sterling Drugs.1 billion for the equity in the firm). They require the assent of stockholders to be instituted. Source: Shapiro (1990) Eastman Kodak in 1988. the target firm is undervalued and badly managed. Do you agree? Stockholders and Bondholders 6 As an example. Another widely used antitakeover device is the golden parachute. Eastman Kodak won" the bidding war and acquired Sterling Drugs on January 22. 7 In a world where stockholders and bondholders never experience conflicts of interest. but they differ on one very important count. or by adopting defensive mechanisms against potentially value-increasing takeovers. an acquirer has to acquire more than the 51% that would normally be required to gain control. Figure 2. the managers of the firms doing the acquiring will argue that they never/ overpay on takeovers and that the high premiums paid in acquisitions can be justified for any number of reasons . On the announcement of the takeover on January 22. a provision in an employment contract that allows for the payment of a lump sum or cash flows over a period of time if the manager covered by the contract loses his or her job in a takeover. stockholder wealth maximization is likely to take second place to management objectives. The quickest and perhaps the most decisive way to impoverish stockholders is to overpay on a takeover. Finally.3 charts the divergent paths of stockholders' wealth in Sterling Drugs and Eastman Kodak around the acquisition. which would be an unfair charge. 30 days prior to acquisition.CHAPTER TWO / THE OBJECTIVE IN CORPORATE FINANCE Figure 2. it can be argued. at $90. and Henry (1986) examined 133 mergers between 1976 and 1984 and found that the stock prices of bidding firms declined in 53% of the cases.the rights or cash flows on which are triggered by hostile takeovers. Of course. and so on. all designed with the objective of reducing the likelihood of a hostile takeover. they are manifestations of a much more fundamental problem: when there is conflict of interest between stockholders and managers. since the amounts paid on takeovers tend to dwarf those involved in the other decisions listed above.90 on January 22. There are several types of antitakeover amendments. The market value of equity for Sterling Drugs had been $3.95% in the 1960s to 2% in the 1970. a super-majority amendment: to take over a firm that adopts this amendment. that is. has negative consequences for stock prices. Brickley.0 billion. therefore everybody else at the auction thinks that he or she paid too much. NCR's managers used this requirement to force AT&T to pay a much higher price for the NCR shares. Smith. v' CC (Concept Check) 2.90 per share (which worked out to $5.2 billion. the takeover of Sterling Drugs by Kodak's Acquisition Sterling Drugs. This process. for instance. in an extensive study of returns to bidder firms.1 billion it paid. You. Consider. firms sometimes create securities called poison pills . there are strategic considerations. The stockholders in acquiring firms do not seem to share their managers' enthusiasm for acquisitions since the stock prices of bidding firms decline on the takeover announcements a significant proportion'' of the time. golden parachutes. bondholders might not have to worry about protecting themselves from stock- One explanation given for the phenomenon agerial hubris (pride) drives the process. to -1% in the 1980s. and poison pills do not require stockholder approval and are usually adopted by compliant boards of directors. The winner bids the highest price. The term "winner's curse" was coined to describe the winner of a bidding war at an auction. by taking on too much or too little debt. note that excess returns on these firms' stocks around the anuouncement of takeovers declined from an average of 4.

The Information Problem Market prices are based on information. and unless you can adjust the interest rate you charge to reflect this change. that attempt to measure equity and firm value. firms sometimes suppress or delay information. a tobacco and food giant. there is a risk that bondholders. The objective of maximizing stockholder wealth may result in stockholders taking actions that harm the overall firm but increase their wealth at the expense of bondholders. value in stock prices. As the RJR Nabisco illustration makes clear. lay claim to whatever is left over after lenders have been paid. delayed. Nabisco Source: 23 holder actions. consider again the difference between the way equity investors and lenders view their investment in a business. Since existing bondholders in Nabisco were not contractually protected against such an eventuality. some of which we examine in this book. may be taken advantage of in a variety of ways. The measure of success or failure is there for all to see. using the same assets it provided to you as collateral for the loan. The second problem is that many financial theorists and practitioners argue that markets are not efficient. they announced plans to borrow in excess of $15 billion. The trouble with market prices. Consider one of the largest and most public examples of this kind of transaction. market prices will reflect true value. however. In their defense. The downside. In the real world. profitable firm with little risk of default. To the extent that financial markets make effective use of the information that is available to make measured and unbiased estimates of future prospects. Bondholders assumed that since these firms made repeated forays into financial markets to borrow money. This loss of wealth may seem unfair to existing bondholders. you charge the firm a low interest rate on the loan. In the world of classical theory. decisions that maximize stock prices may not be consistent with long-term value maximiza ti 0 n . To see why. a group of investors announced that they had decided to buy RJR Nabisco back from the stockholders. based on their assessment of the risk of the firm they are lending to. To the extent that this information is hidden. however. Successful managers raise their firms' stock prices. market prices will deviate from true value. of course. and some decisions can transfer wealth from one group (usually bondholders) to the other (usually stockholders). even when information is freely available.4 indicates.4 Bond Price Bloomberg. the advantages of shifting from maximizing stockholder wealth to maximizing stock prices is obvious. Lenders usually lend money at a rate they negotiate at the time of the loan. stockholders and bondholders have different objectives. making it difficult to establish clear standards for success and failure. The firm has become much riskier. The equity investors in this firm have essentially made you worse off with their subsequent borrowing. Consequently. the prices of their bonds dropped as much as 20% on the announcement. information is revealed promptly and truthfully to financial markets. Their failure to protect themselves. Because we must be able to measure success clearly with an objective. who do not protect themselves. was viewed as a large. RJR Nabisco. In both cases. on the other hand. is that stockholder or firm wealth is not easily measurable. however. bondholders tend to view the risk in project choice and other decisions much more negatively than stockholders. they could not renegotiate the rate to reflect the higher risk of default that Nabisco was exposed to. Equity investors. In such markets. On October 20. and the interest rate on the bonds was set accordingly. especially when it contains bad news. In the real world. Bonds issued by Nabisco reflected this low default risk. or misleading. and in some cases. but they are based on a large number of essentially subjective inputs on which people may disagree. you will find yourself getting too Iowa rate. misleading or The Finn and Financial Markets Maintaining an objective that focuses on stockholdet or firm wealth rather than stock prices or the firm's market value. It is true that there are valuation models. There are two potential barriers to using stock prices as a measure of managerial success. has an advantage since it does not require any assumptions about how well financial markets work at capturing this stockholder . As a consequence. Until 1988. the firm goes out and borrows significantly more money. since they do not get to participate on the upside if the projects succeed and could bear a significant portion of the cost if they fail. as Figure 2. both public and private. the fear of losing credibility and reputation would keep them honest. Consequently. exposed them to this considerable loss. and unsuccessful ones do not. even in an otherwise efficient market. 1988. for they had no say in this transaction in the first place. For instance. assume that you lend money to a business you perceive to be safe. Soon after borrowing from you. The first is that information is the lubricant that enables markets to be efficient. it has to be pointed out that the bond issues for most large firms at the time of this action had few or no protections against such actions.CHAPTER TWO / THE OBJECTIVE IN CORPORATE FINANCE STOCK PRICE MAXIMIZATION AND AGENCY COSTS Figure 2. is that markets can make mistakes. This conflict lies at the heart of the notion that what is good for stockholders (increasing the stock price) may not necessarily be good for lenders to the firm. given the risk that you now bear. To finance this transaction. both the measurers and the measured will accept the market price as the appropriate mechanism for judging success and failure.

a company that was built up through acquisitions over a decade. based primarily on anecdotal evidence. though their conclusions do not necessarily follow. especially if allowance is made for the fact that the act of trading itself reveals some information to others. Although it would be dangerous to evaluate management performance using stock prices on a weekly or monthly basis. some firms release intentionally misleading information about their current conditions and future prospects to financial markets.l-' It has a very large number of adherents in financial markets. Although there is substantial empirical evidence-? that luanagers delay bad news. from firm to firm. Consider the case of Cendant. which cannot be explained by one-time occurrences (like accounting changes) or pure luck. and still others are flatout wrong. The evidence presented by those who hold this view.CHAPTER TWO / THE OBJECTIVE IN CORPORATE FINANCE STOCK PRICE MAXIMIZATION AND AGENCY COSTS 25 fraudulent information is released to markets. short-term investors. to fundamentalists. One criticism has been that financial markets are too volatile. managers at Cendant would have been richly rewarded until 1998 as the stock price rose largely as a consequence of their manipulation of information. provide good signals of shifts in future prospects. The extent of the problem is likely to vary widely among firms. where foreign investors may know Iittle or nothing about most of the firms that they are investing in. it is not clear that delayed information by itself will cause prices to deviate dramatically from value. Some of the facts they cite cannot be denied. with smaller firms much more likely to get away with suppressing bad news than larger firms. and that short-term price movements have little to do with information. and there are many. Most large movements in market prices can be explained by the arrival of information. 11 Some larger firms are so concerned about this that they actually choose to go to markets early with bad news 12 13 Shiller (2000) makes the case for this point of view in his book Irrational Exuberance. In their zeal to keep investors happy and raise market prices. The extent of the problem varies from market to market. and analysts. the firm was viewed as a case study of a firm that had made strategic acquisitions and managed to report higher earnings as it grew. The implications of such fraudulent behavior for corporate finance can be profound because managers are often evaluated on the basis of stock price performance. Stock prices are determined by traders. The most damning indictment against financial markets in particular. is that they promote a focus on short-term results. for instance. managers that financial markets cannot be trusted to react appropriately to new information and that panic trading may cause prices to change more than they should. Thus. and corporate financial theory in general. a matter of days rather than weeks or months. who use chart patterns to decipher changes in moods. all of whom hold the stock for short periods and spend their time trying to forecast next quarter's earnings. The stock price tumbled on the news as investors reassessed their forecasts for the firm. there is the hope that if bad news is delayed long enough.the "excess volatility" in prices becomes less of an issue when measurement is made on an annual basis or over several years.I! Finally. Some of the criticisms that have been mounted against financial markets are legitimate. is primarily anecdotal. if not all. there is no guarantee that what emerged as the market price would be an unbiased estimate of true value. Furthermore. If the problem is sizable in financial markets in the United States ~ and it is ~ then it is even greater in other markets. The fundamentals would include cash flows. all the planning by managers may come to naught if analysts following the firm dig up the information and reveal it to financial markets. Managers who concentrate on creating long-term value rather than short-term results will be penalized by markets. At the other extreme is a contingent of theorists who argue that market movements can be explained entirely by information. it becomes much more difficult and dangerous to withhold information from markets. The reasoning goes as follows. others are overblown. delays are small. . not only on information but sometimes in the absence of it. Are Markets Inefficient? Even if information flowed freely and with no distortion to financial markets. when it was revealed that the firm had used questionable accounting practices and that earnings had been vastly overstated in earlier years. it will either go away or be paired with some good news about the firm. where firms often are the sole providers of information. there is a sense among some. First. and even within markets. but they all need to be considered seriously. rather than allow investors to respond to rumors and' exaggerations. especially during short time periods. Many investors hold their stock for 10 Penman (1987) notes that earnings report' from firms that are delayed beyond their expected date tend to contain bad news and that the magnirude of the 'bad news is correlated to the length of the delay. In fact. In emerging markets. but they do so because changes in earnings. These misrepresentations can cause stock prices to deviate significandy from value. For most companies. and there are few penalties for providing misleading information. Analysts do spend a considerable amount of time forecasting next quarter's earnings. Anyone who has observed the working of a financial market during the course of a trading day knows that markets are volatile and that prices often move dramatically. Managers try to control how and when information about their firms reaches financial markets for two reasons. The success story unraveled in 1998. who look for bargains in the fimdamentalsl ' of firms. Second. It is human nature to try to control how and when bad news is revealed to others. that this volatility is caused by the shifting moods and perceptions of irrational investors. ranging from technicians. the assets owned by the firm and expected growth potential. The prudent course may be to stay the middle ground. and they may not matter for investors who measure success or failure using longer time intervals. Do firms sometimes suppress bad news about their performance and future prospects from financial markets? The answer has to be yes. but market mood swings can cause sudden and dramatic fluctuations in prices. Are markets too volatile? One school of thought argues that there is no question that they are. the problem of suppressed information is likely to be acute. Damodaran (1991) notes a tendency on the part of firms to delay bad earnings and dividend reports until Friday each week. Given the number of analysts following larger firms. many would argue that the fault lies deeper ~ that investors are much too irrational and unreliable to come up with a good estimate of the true value. For most of the period. markets react to delays by assuming the worst and marking down prices.

firms can create substantial costs for society while they focus on maximizing stock prices. and do not expect to have any in the near future. Since this issue has become so controversial. There are no easy answers to the question of how best to deal with these consequences. 1. Hundreds of firms. with stock prices on average rising on the announcement of R&D and capital expenditures. No competing measure comes close to providing as timely or as comprehensive a measure of a firm's standing. It is also worth noting that many of the managers who criticize markets for being short term work for firms whose stock prices have gone down significantly. the social costs are considerable but cannot be traced to the firnl. • Finally. 3. Devinney. described below. Studies indicate that stocks with low price-earnings ratios. do not have any current earnings and cash flows. Figure 2. If the evidence suggests anything. the only way to resolve it is through empirical evidence.2: If you are convinced that financial markets-are not efficient. Clearly. tI' CC 2. A Synthesis: Financial Market and Stock Price Maximization The information that flows into financial markets is often delayed. if not restricted contractually. expenditures. and firms are aware of these costs. 2. do you have to abandon the objective of value maximization? Why or why not? Stock Price Maximization with Agency Costs In this section. there is a great deal of value to knowing how investors perceive the firm's actions. incorrect. is consistent with a market that does look at long-term potential. They may have a slightly vested interest in getting investors to buy into their arguments.the stock price. The ethical and moral dilemmas of forcing managers to choose between survival (which may require stockholder wealth maximization) and the broader interests of society can be debated. as the "short-term" critics would lead you to believe. these firms would be unable to raise funds in the first place. One is to view it as a cautionary note. may increase stock prices by transferring wealth from those who have lent them money. may choose to ignore them and maximize stock prices. and the prices that flow out are erroneous estimates of the true value. An objective of maximizing firm or stockholder wealth implicitly assumes either that the costs to society are small enough to be ignored or that they can be traced to the firm and the firm can be forced to bear the costs. To be fair. the managers. But what about those cases where firms create substantial costs for society without being aware of them? Johns Manville Corporation. Most of this evidence. may not make decisions to maximize stockholder wealth but may instead choose to further their own interests. The value of having market prices is best illustrated when working with a private firm as opposed to a public firm. But this cannot take away from the central contribution of financial markets. especially small and start-up firms. and positions are often strongly held. and there may never be a solution to satisfy the purists who would like to see a complete congruence betweensocial interests and firm interests. Are these assumptions justifiable? In some cases. ethicists might argue that wealth maximization has to be sublimated to the broader interests of society. Although managers of the public firm may resent 14 Chan. but it is consistent with a market that values longterm performance. the assumptions can be violated in a number of areas. high current earnings. Stock . They may be endemic to a system of private enterprise. The market response to research and development and investment expenditure is not uniformly negative. the second-guessing guessing of analysts and investors. but they are still able to raise substantial amounts of money on the basis of expectations of success in the future. Chaney. produced asbestos in the 19505 and 1960s with the intention of making a profit and was unaware of its potential to cause cancer. for instance. Thirty years later. though aware of the costs. There are two ways to consider the evidence. If markets were in fact as short term as the critics suggest. The Firm and Society Most management decisions have social consequences. but no simple solution can be offered in this book. the lawsuits from those afflicted with asbestos-related cancers drove the firm to bankruptcy. In particular. • Stockholders. Martin. and it is not consistent with the arguments made by those who believe that markets are short term.!" None of this evidence proves that financial market participants think of the longterm consequences of decisions. and Winer (1991) found a neutral reaction to new product announcements. and misleading. we have taken a look at each of the assumptions we made earlier to justify our focus on stock price maximization. Instead. • Firms may increase stock prices by feeding misleading or fraudulent information to markets that do not efficiently assimilate the information in the first place. have generally been underpriced relative to stocks with high price-earnings ratios. the response is tempered. given the limited power that stockholders have over them. conflicts between the interests of the firm and the interests of society are not restricted to the objective of maximizing stockholder wealth. and Kensinger (1990) found that markets react positively to announcements of R&D expenditures. and McConnell and Muscarella (1985) noted that stock prices increase all the announcement of capital. • Managers. but that is still entirely consistent with a market that focuses on long-term results. They assimilate and aggregate a remarkable amount of information about current conditions and future prospects into one measure . In the cases where substantial social costs exist.:6 CHAPTER TWO / THE OBJECTIVE IN CORPORATE FINANCE STOCK PRICE MAXiMIZATION AND AGENCY COSTS 27 short periods of time. Accordingly.5 summarizes the problems we have developed in this section. it is that markets do not value current earnings and cash flows enough and value future earnings and cash flows too much. that is.

Although this approach may protect the system against the waste that is a byproduct of stockholder activism and inefficient markets. His view of the world is not unique and is shared by many corporate executives. the owners of the firm . where funds such as Allied Partners (run by Dillon Read). lenders. firms will keep an eye on each other rather than ceding power to the stockholders. 17 Many Korean industrial groups (called [haehols). How effective will this legal mechanism be at reducing problems? What are its costs? Alternatives to Stock Price Maximization In the last section we considered some of the problems associated with stock price maximization.!? In fact. which were patterned after the Japanese keiretsu. In addition to being undemocratic . and stockholders can sue managers for breach of fiduciary responsibility. The German industrial groups revolve around leading commercial banks. In the presence of these agency costs. the argument goes. . The first is to use a different system for controlling management. may have to be applied more cautiously in some markets (the less liquid markets of Latin America. Consequently. where poor management can be penalized without yielding power to stockholders. Corporate Partners (run by Lazard Preres). asking managers to focus on maximizing stock prices may not be the best course of action in some circumstances. the troubles that Japanese firms had dealing with poor investments in the 1990s suggests that these alternative corporate governance systems. even though they might not maximize profits in the short term. managers. a leading thinker on corporate strategy. like Deutsche Bank or Dresdner. n1.anagers. these problems tend to fester and price maximization. Given these problems. The other problem is that entire groups can be dragged down by individual firms that have made bad decisions. have a more difficult time adapting to and dealing with problems that ate widespread. He contrasts them with Japanese firms. after all. where stockholders act to discipline and replace errant managers and stock prices measure their success. In the German and Japanese systemsl'' of corporate governance.5 >roblems and Stock 'rice Maximization A Different System for Disciplining Management (Corporate Governance) In the system we have described thus far. as they see it. The second is to drop the stock price maximization objective and adopt an alternative objective. firms own stakes in other firms and often make decisions in the best interests of the industrial group they belong to rather than their own. These executives maintain that there are alternatives to the market-based corporate governance systems. it has its own disadvantages.lenders. we could consider two alternatives to stock price maximization. even in the United States. Michael Porter. lenders can sue if they feel they have been unfairly victimized. 15 There is some movement toward "relationship investing" in the United Scates. and the theory that flows from it. stockholders bear the burden of replacing incompetent management. and society. The other way to view it is to consider alternatives to stock price maximization as the objective in decision making. The Japanese industrial groups called keitetsus are based primarily On cross-holdings of companies and evolved from family-owned businesses. Industrial groups are inherently more conservative than investors in allocating resources and thus are much less likely to finance high-risk and venture capital investments by upstarts who do not belong to the group.the stockholders are. Some observers believe that this is too much of a responsibility to put on investors who.these systems suggest a profound suspicion of how stockholders might use the power if they got it and are heavily skewed toward maintaining the power of incumbent managers.firms can be sued for creating social costs. One mechanism that can help balance the competing interests is the legal mechanism . investors can sue firms that release misleading information. though efficient in dealing with individual firms that are poorly run. In these systems. with the banks holding substantial stakes in a number of industrial concerns. Ie There are subtle difference between the Japanese and the German systems. He suggests that investors should form longterm relationships= with firms and work with them to devise long-term strategies. and Lens (run by activist Robert Monks) have attempted to create long-term relationships with the managers of firms.~8 CHAPTER TWO! Agency THE OBJECTIVE IN CORPORATE FINANCE ALTERNATIVES TO STOCK PRICE MAXIMIZATION 29 'igure 2. we can call this a market-based corporate governance system in which investors in the marketplace govern how corporations are run.2: Many of the problems associated with stock price maximization arise from the different objectives of stockholders. and for some firms (smaller firms) than for others. for instance) than in others. CT 2. Most of these problems stem from the differing interests and incentives brought to the process by stockholders. often operate with poor information and have short time horizons. were pushed to the verge of bankruptcy in 1990$ because one or two errant firms in the group borrowed too much. has argued that firms in the United States are hamstrung by the fact that investors are short term and demand quick returns. which he argues can afford to adopt strategies that make sense in the long term. and society.

as their examples of why market share was a good focus discovered the harsh downside of this focus in the 1990s. flaws. but that the alternatives come with their own sets of problems and it is not at all obvious that switching is beneficial. For instance. Japanese banks spent much of the 1990s denying the existence of such loans on their books. One of the strengths of stock price maximization as an objective is that groups learn from their mistakes and try to correct them in subsequent periods. whose mission might be to provide reasonable health care at an affordable cost. Empire building may no longer be in vogue. What do we do next? Here we maintain that stock price maximization can be rescued as an objective if we can figure out a way to reduce agency costs. There can be no sensible rationale for these objectives. including some in the United States. is Is there a way we can measure the effectiveness of alternative corporate governance systems? Macey (1998) proposes that corporate governance systems be measured on three dimensions . easy access of firms that want capital to financial markets. say a hospital. It is not clear what "reasonable" and "affordable" mean in this context. and the ease with which inefficient management is replaced. German. and Japanese corporate governance systems. firms like Gulf and Western and ITT. CT 2. step in and provide subsidies to this firm. managers who take advantage of their stock- 18 Kaplan (1997) compares the U. have objectives that are social welfare functions. the emphasis on current profitability may result in shortterm decisions that maximize profits now at the expense of long-term profits and value. There seemed to be no strategic imperative to these acquisitions other than the CEOs' desire to increase the sizes of their corporate empires. Social Welfare Objectives Some firms. The alternatives to stock price maximization. It is not that there are no alternatives. the notion that profits can be measured more easily than value may be incorrect. Stock price maximization is flawed by the conflicts between stockholders and managers. and firms and society. have just as many. In the 19705. Japanese firms inundated global markets with their products and focused their attention on increasing market share. although financial markets pushed corporate banks in the United States to confront their poor real estate loans in the late 1980s. given the leeway that accountants have to shift profits across periods.. and the increase in market share is accompanied by lower or even negative earnings. The tough part is replacing it with another objective. If. These objectives involve at least two problems. but there are limits to how much they can do so.the capacity to restrict management's ability to obtain private benefits from control. to also target market share as an objective. Second. . system provides better incentives for firms performing well and that it is easier for companies in the United States to return cash to the stockholders. of course. First. This is especially true when the alternative objective is evaluated on the basis of the three criteria we used to assess the wealth maximization objective: Is the objective clear and unambiguous? Does it come with a measure that can be used to evaluate success and failure easily and promptly? Does it create side costs that may exceed the overall benefits? Let us consider four commonly offered alternatives to stock price maximization. but there have been cases in which corporations have made decisions that increase their size and perceived power at the expense of stockholder wealth and profitability.3. especially government-owned firms. Maximization of Market Share In the 1980s. Do you still need an objective? How would you come up with an objective and put it into practice in decision making in the organization? v' CC2. He argues that the corporate governance system in the United States does a better job than alternative systems on all three counts. Proponents of this objective note that market share is observable and measurable like market price. In concrete terms. For instance. but it is a clear consequence of stockholders failing to have or to exercise much power over their managers. Size/Revenue Objectives There are a whole set of objectives that have little to do with stockholder wealth but focus instead on the size of the firm. if not more.o CHAPTER TWO I THE OBJECTIVE IN CORPORATE FINANCE STOCK PRICE MAXIMIZATION WITH LOWER AGENCY COSTS 31 grow over time. especially when scarce resources have to be allocated among competing uses. with strong CEOs at their helm. higher market share does not yield higher pricing power.S. even though it may lead to losses. however. Choosing an Alternative Objective Given its limitations. this meant that investments that increased market share more were viewed more favorably than investments that increased them less. If this is true. Their apparent success at converting this market share to profits led other firms. Governments can. Assume that you have been hired to run a not-for-profit organization. were built up through acquisitions into giant conglomerates. Thus. the easy answer may be to cast aside stock price maximization as an objective. maximizing market share is entirely consistent with our objective of maximizing firm value. He finds that the U. firms that concentrate on increasing market share can find themselves worse off as a consequence. however. A less extreme case would be not-for-profit firm. and does not require any of the assumptions about efficient financial markets that are needed to justify the stock price maximization objective. stockholders and lenders. Comment.3: Corporate governance is best left to managers because they are much more likely to think about the long term than stockholders.S. Profit Maximization Objectives Some objectives focus on profitability rather than value. for instance. a firm that is directed to maximize the employment it provides in the area in which it operates will make decisions in accordance with this directive. Many of the same Japanese firms that corporate strategists used Stock Price Maximization with Lower Agency Costs We seem to have painted ourselves into a corner. Underlying the market share maximization objective is the belief (often unstated) that higher market share will mean more pricing power and higher profits in the long term. Their rationale is that profits can be measured more easily than value and that higher profits translate into higher value in the long term.

while it reduces the conflict of interest between stockholders and managers. The third is to have more "activist" institutional stockholders. only 4% of directors received compensation in the form of stock or options. A study by Bhide. in most cases. the reality was that. For instance. Warren Buffett. Increasing Stockholder Power Stockholders can increase their power over management in many ways. . insiders whom many boards had in the 1970s. The chasm between the two groups can be bridged. whereas 78% did so in 1998. namely. • Directors are increasingly compensated with stock and options in the company instead of cash. Korn/Ferry's 1998 survey of boards of directors at 900 large U. who playa larger role in issues such as the composition of the board of directors. In this section. The smaller boards are less unwieldy and more effective than the larger boards. there are conflicts of interests between stockholders and managers. keeping managers in check by introducing a cost to bad management. making them more effective advocates for stockholders. badly managed firms were much more likely to become targets of hostile takeover bids. In short. One implication of this finding is that takeovers operate as a disciplinary mechanism. stepped in as interim CEO at Salomon Brothers when the firm had legal problems in the early 1990s and saw its stock price drop.2 CHAPTER TWO / THE OBJECTIVE IN CORPORATE FINANCE STOCK PRICE MAXIMIZATION WITH LOWER AGENCY COSTS 33 holders soon find themselves faced with stockholder revolts and hostile takeovers. If this is done. In recent years. 75% of boards had nominating committees. and had provided sub-par returns to their stockholders. One way to reduce this conflict is to provide managers with an equity stake in the firms they manage. It is not surprising. In contrast to the six or more. Stockholders and Managers Clearly. Financial markets punish firms that have provided misleading or fraudulent information with lower stock prices. the question of whether to pass antitakeover amendments. and firms that create social costs pay a price in both legal costs and lost revenues. that legal attempts to regulate and restrict takeovers have had negative consequences for stock prices. The median size of a board of directors decreased from 16 to 20 in the 1970s to between 9 and 11 in 1998." while the firms being taken over were viewed as hapless victims. it may exacerbate the other conflicts of interest highlighted in the prior section. The Threat of a Takeover The perceived excesses of many takeovers in the 1980s drew attention to the negative consequences of such actions. In 1998. • There are fewer insiders on the board. only two directors in most boards in 1998 were insiders. Is there a payoff to having a more active board? MacAvoy and Millstein (1998) present evidence that companies with active boards.annual meetings and boards of directors . however. Can you think of a scenario in which the two groups might have conflicting interests? More Effective Boards of Directors In the last section. The second is to have a large stockholder become part of incumbent management and have a direct role in decisions that the finn makes. by closing the gap between their interests or by increasing stockholder power over managers. In movies and books. we mentioned several limitations with boards of directors. who was a large investor in the firm. found that target firms in hostile takeovers in 1985 and 1986 were generally much less profitable than their competitors. and overall management policy. therefore. corporations revealed the following: • Boards have become smaller over time. the raiders who were involved in these takeovers were portrayed as "barbarians.often fail in their role of discipline management. It was initiated in 1989 with much support from the state's chambers of commerce. Although this may have been true in some cases. v CC 2. the comparable statistic in 1973 was 2%. and that managers in these firms had significantly lower holdings of the equity.. we discuss ways to reduce the agency costs that are part of this process and restore stock price maximization as the firm's objective.S. so that they can make better judgments on how well the management is doing. The first is to demand better and more updated information. institutional investors have used their considerable power to pressure managers into becoming more responsive to their needs. This stock compensation makes it more likely that directors will think like stockholders. • More directors are identified and selected by a nominating committee rather than being chosen by the CEO of the firm. earned much higher returns on their capital than firms that had less active boards. the potential for conflict will exist. Lenders who have been hurt by stockholder actions try to protect themselves in subsequent lending. It may increase the potential for expropriation of wealth from bondholders and the probability that misleading information may be conveyed to financial markets. in the form of either stock or options on the stock. Making Managers Think More Like Stockholders As long as managers have interests that are distinct and different from those of the stockholders they serve. the very threat of a takeover is sufficient to make firms restructure their assets and become more responsive to stockholder concerns. Often. for instance.4: The interests of institutional investors and individual investors may some. One example was the antitakeover law devised by the Pennsylvania legislature to protect companies incorporated in the state against hostile takeovers. In 1973. times diverge. and the traditional mechanisms for stockholder control . for which activism was measured based on both assessments by the California Public Employees Retirement System (CALPERS) and indicators of board behavior. companies that were taken over deserved to be taken over. The last few years have witnessed encouraging trends both in the composition and behavior of boards. There is a downside to this approach. the benefits that accrue to management from higher stock prices may provide an inducement to maximize stock prices.

2. specifically to provide bondholders with the power to veto actions that are not in their best interests. in the event of such actions. so markets cannot be made more efficient by edict. another way bondholders can reduce that conflict is to own an equity stake in the firm. Many bond agreements have covenants that do the following: 1. 3. 1. The story of the Pennsylvania antitakover law would not be complete without documenting the stockholders' reactions to it. again after adjusting for what the market did during the period. Many bond agreements restrict how much firms can pay in dividends by tying dividend payments to earnings. firms may find themselves having to turn down profitable opportunities because of bondholder-imposed constraints and having to pay (indirectly) for the legal and monitoring costs associated with the constraints. they do come with a price tag. 2. . Seemity Innovations The RJR Nabisco illustration in the previous section provided an example of an "extreme" acti~:m (a leveraged buyout) that transferred wealth from existing bondholders to the equity investors in the firm. There are no easy solutions to these problems. the more likely it is that markets will be inefficient. these firms lost 6. made a bond issue in which bondholders would have had the right to put the bonds back to the firm at face value if the issue was downgraded below investment grade. however. firms will always have a vested interest in what information they reveal to markets and when. who are not hired and fired by the firms they analyze. One way in which ·bondholders can protect themselves is to attach 19 Harris Corporation and Northwest Pipeline. The information that firms convey to financial markets contains errors and so is sometimes misleading. an active market for information has to exist in which analysts. therefore. giving them the right to sell their bonds back to the firm at face value. To provide balance.~ CHAPTER TWO / THE OBJECTIVE IN CORPORATE FINANCE STOCK PRICE MAXIMIZATION WITH LOWER AGENCY COSTS 35 Karpoff and Malatesta (1990) examined the consequences of this law for the stock prices of Pennsylvania firms and found that they dropped (after adjusting for market movements).l? In some cases. this example illustrates the power stockholders can have if they choose to exercise it. Some bond agreements require firms to get the consent of existing bondholders before borrowing more. Improving the Quality of Information Although regulatory bodies like the Securities and Exchange Commission can require firms to reveal more information and penalize firms that provide misleading and fraudulent information. Restrict dividend policy. The market price that emerges from financial markets is often wrong. Over the whole period. the first day a news story was carried on the law. increases in dividends. partly because of inefficiencies in markets and partly because of errors in the information. At the minimum. a provision (called a protective put) to their bonds. the quality of information cannot be improved with information disclosure laws alone. paying more dividends. In particular.58% on October 13. This requirement is included to protect the interests of existing secured bondholders. Investors shonld have access to information about the stocks being traded and the resources to trade on the information. and increasing leverage. and one of a series of a "designated events" occurred (including a merger. Their threats worked because most firms chose to opt out of the law. make the firm riskier to lenders. Bondholders have learned from events such as this one and have added special clauses to bonds designed to protect them against expropriation. There are ways in which bondholders can obtain at least partial protection against some of these actions. some actions will improve the quality of information and reduce deviations between price and value. widespread disagreement will arise over what is required to make markets more efficient.0st irect way for bondholders d to protect themselves is to write covenants in their bond agreements specifically prohibiting or restricting actions that may be harmful to lenders. by taking cash out of the firm. In particular. Restrict additional leverage.90% of their value. 1989. Although covenants can be effective in protecting bondholders against some abuses. a major dividend payment. Some bond agreements put restrictions on where firms can invest and how much risk they can take on in their new investments. In either case. they expressed their displeasure to managers and threatened to sell their stock in these firms. Firms and Financial Markets Stockholders and Bondholders The conflict of interests between stockholders and bondholders can lead to actions that transfer wealth to the former from the latter by the firm investing in risky projects. the right to exercise these puts is triggered by the firm being taken over. Making Markets More Efficient Just as better. Trading should be both inexpensive and easy. these are the necessary (though not sufficient) conditions for more efficient markets: 1. The higher transactions costs are and the more difficult it is to execute a trade. They can buy stock in the firm at the same time as bonds. a subsidiary of Williams Companies. In the long term. Equity Stakes Since the primary reason for the conflict of interest between stockholders and bondholders lies in the nature of their claims. bondholders who feel that equity investors have enriched themselves at their expense can become stockholders and share in the spoils. without compensating bondholders for the loss of wealth associated with these actions. they have a greater incentive to unearth negative information about the firm and to disseminate that information to their clients. Bond Covenants The 111. or a major stock repurchase). on average. information cannot be legislated into existence. Although analysts are jnst as likely to make mistakes as the firm. or they can be allowed to convert their bonds into stock. In fact. Institutional investors in the firms that would have been covered by the law chose to fight it. Restrict the firm's investment policy Taking on riskier projects than anticipated can lead to a transfer of wealth from stockholders to bondholders. from the first news story to the introduction of the bill into the Pennsylvania legislature. In general. collect and disseminate information.

As lawsuits by smokers against tobacco firms have mounted. firms will become socially conscious only if it is in their best economic interests to do so.5: Many emerging financial markets are characterized by the absence of quality information about firms. if costly. Ultimately.we would select constrained wealth maximization for a very simple reason. You would like to create the conditions needed for managers of firms in the economy to focus on maximizing stock prices. Some companies. is based on a misunderstanding of what corporate finance is about. They go too far when they therefore conclude that corporate financial theory has no basis. they created a group to monitor working conditions in Asian factories. The trust that corporate finance places in well-functioning financial markets exposes it to a different group of critics who argue. however. however.greenmail. have established reputations for being good corporate citizens and have managed to use it to their benefit. with some justification. that markets are not efficient. As noted earlier. the stock prices of these firms have languished as investors hold back to see the economic costs of this legal action. including the loss of factory jobs and the increase in wealth inequality. the excesses of some managers in the 1980s . golden parachutes. The actions taken by stockholders to transfer wealth from bondholders led to more stringent restrictions in bond agreements and new types of bonds. and maximizing stockholder wealth with constraints . The legal system can also provide a partial.4: Assume that you have been appointed economic czar of an emerging market economy. For example. Misleading or delayed information from firms often leads to sharp drops in the stock prices of these firms and an extended period during which the firm's credibility is lost. they will likely start considering the consequences of their actions for society.:'6 CHAPTER TWO / THE OBJECTIVE IN CORPORATE FINANCE A POSTSCRIPT Figure 2. clothing manufacturers and retailers that were accused of using child labor in their factories in Asia found that some of their customers were not buying their products. Figure 2. It is only if stock prices are used as a measure of success or failure that assumptions are made about market efficiency. An Argument for Stockholder Wealth Maximization Given the alternatives ----c choosing a different corporate governance system.6 Stock Price Maximization Constrained THE LIMITS OF CORPORATE FINANCE 37 Restrictions imposed on trading. Finally. Many observers maintain that the failures of corporate America. What are the consequences for value maximization mization? in these markets? What about stock price maxi- Firms and Society There will always be social costs associated with actions taken by firms operating in their own best interests. For instance. can be traced to its dependence on corporate finance. of course. Some of it. even though the firm may not be under any legal obligation to do so. Most of the criticism exaggerates the role corporate finance plays in significant decisions made by firms. " CC 2.may seem like good public policy. Thus. It is the only one of the three that is self-correcting. often lead to market inefficiencies. Much of corporate financial theory is built on the objective of stockholder wealth maximization and that theory holds whether or not markets are efficient. restricting investors from selling stock that they have borrowed. but it can create a scenario in which bad news about a company cannot be reflected adequately in prices. where attempts are made to minimize or alleviate social costs. in the sense that excesses by any stakeholder attract responses from others. What actions would you take to facilitate this transition? A Postscript - The Limits of Corporate Finance Corporate finance has come in for more than its share of criticism in the last decade. CT 2. and extreme volatility.6 summarizes some of these changes. The problem with this approach.. Some of the criticism is justified and is based on the limitations of a single-minded pursuit of stockholder wealth. One solution is for firms to maximize firm or stockholder value subject to a "good citizen" constraint. though well intentioned. but they are also too nebulous to be factored explicitly into analyses. picking an alternative objective. solution to the social cost problem. and so on gave rise to more activist institutional investors in the 19905. thin trading. The basic conundrum is that social costs cannot be ignored in making decisions. if firms that create large social costs find customers not buying their products and investors avoiding their stock. In response. and market value affected by such actions. firms that create social costs have seen their profitability . called short sales. is that the definition of a good citizen is likely to vary from firm to firm and from manager to manager.

profitability. d ••••••• • .. •••• ..••••• Although the objective in corporate finance is to maximize firm value.. where stakeholders include stockholders. 1. Under what conditions will maximizing firm value also enrich society? 4.. b. and decisions to be made that create large costs for society. Stock prices are much too volatile for financial markets to be efficient. managers. There are no objectives or decision rules that perfectly factor in societal concerns. Furthermore.. 5. lose out... c. A closely held firm (insiders hold 40% of the 100. CT 2. There is a conflict of interest between stockholders and managers...internal as well as external...... why might these disciplinary mechanisms not work? 2.. These differences. In practice... either because it is being undersold by competitors or because its products are technologically obsolete. Given the limitations of the alternatives.stockholders. Stock price maximization as the only objective can be problematic when the different players in the firm . bondholders. some have argued that firms should maximize stakeholder wealth rather than stockholder wealth.. The conflict between wealth maximization for the firm and social welfare is the reason business schools include ethics in the curriculum..5% and a tax rate of 40% where none is specified.. What is the difference between maximizing stockholder wealth and stock prices? Under what assumptions are the two equivalent? 3... what types of firms (in terms of size. while other companies do so very infrequently. employees........ it is true that value maximization for stockholders may mean that other stakeholders. simply because many of these concerns are subjective and difficult to quantify. many argue for an alternative to stock price maximization.. Maximizing stock prices does not make sense because investors focus on short-term results and not on longterm consequences.. lenders. and a slow death. if the firm is really in trouble. in practice we often adopt the narrower objective of maximizing a firm's stock price.. stockholders to try to take advantage of lenders....all have different interests and work at cross purposes... stock price maximization as an objective is self-correcting.. in some sense.. stockholders are expected to exercise control over managers through the annual meeting or the board of directors. In theory. When firms restructure or liquidate. Evaluate how each of the following events would alter the balance of power.. 4... In any firm. such as customers and employees. The firm decides to expand its board of directors from 11 members to 22 members and allows the CEO to pick the additional directors.. even if this emphasis implies that workers lose their jobs and take cuts in pay. • .nance or a different objective. Stockholders can transfer wealth from bondholders through a variety of actions.. •• . An activist investor manages to get three of his nominees elected to the board of directors at the expense of management nominees. and society. ••• •• ........ because of its emphasis on the "bottom line" and market prices. each of the alternatives.. As a measurable and unambiguous measure of a firm's success. managers... though the criticism may be better directed at the violators... stock price offers a clear target for managers in the course of their decision making. In the presence of these agency problems.. excesses by anyone of the groups (whether it be managers or stockholders) lead to reactions by the other groups that reduce the likelihood that the behavior will be repeated. and society . and by punishing firms that lie to financial markets or create large social costs.. assumes that managers will not make decisions that create large social costs.5: In recent years. Questions . Some companies need to access capital markets repeatedly to raise money.. First.. comes with limitations. Comment. The descendants of those critics have labeled corporate finance as unethical. and lenders. can lead managers to put their interests over those of the stockholders who hired them... 5. •••• . d.... we can reduce the agency problems between the different groups substantially by trying to align the interests of stock- Problems In the problems below.. •• . a. How would the following actions by stockholders transfer wealth from bondholders? (a) An increase in dividends (b) A leveraged buyout (c) Acquiring a risky business How would bondholders these actions? protect themselves against 3. Which type of firm will be less inclined to mislead financial markets and why? 6. Many of the leveraged buyouts in the 19805 involved managers borrowing money and buying firms back from stockholders. In other words.. Comment. decisions that increase market value also make customers and employees better off. the balance of power between stockholders and managers is a function of a number of factors . ••••• • •• ·....O+ u .. When might this strategy work. firms to mislead financial markets.. While this path is alluring. Some corporate strategists have suggested that firms focus on maximizing market share rather than market prices.. . What are the advantages and disadvantages of this alternative objective? How would you put this objective into practice? holders... the choice is not between liquidation and survival but between a speedy resolution. which result in agency costs.38 CHAPTER TWO / THE OBJECTIVE IN CORPORATE FINANCE PROBLEMS 39 Economics was once branded the gospel of Mammon because of its emphasis on money.000 shares) issues 500.. Events can cause the power to shift toward managers or toward stockholders or leave the balance unchanged.... however. L . you can usc a market risk premium of 5.. If these buyouts were motivated in part by the desire to eliminate the separation of ownership and management. in the form of debt and equity... Thus. including using a different system of corporate gover. corporate financial theory.... it exposes corporate financial theory to ethical and moral criticism.. Second. In most cases. and performance) would have been the best candidates for these leveraged buyouts? Summary •••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••• H TO •••••••••••••••••••••• ~ . What is the difference between maximizing firm value and maximizing stockholder wealth? Under what assumptions are the two equivalent? 2. stock price maximization is the best of a set of imperfect choices for two reasons. The state passes a law restricting hostil e takeovers..000 new nonvoting shares to the public to raise fresh capital.......... which is what corporate financial theory would recommend.... while the firm declines over time and costs society considerably more in the process. 1.. When it is violated.. and when might it fail? .... This assumption that most decision makers are ethical and will not create unreasonable costs for society or for other stakeholders is unstated but underlies corporate financial theory.

how has it earned this reputation? • If the firm has been a recent target of social criticism. Reader's Digest has voting and nonvoting shares.. Assume that you are a large holder of the nonvoting shares.. is the CEO take to get to the top? (Did he or she come or from outside?) did the CEO make last year? What components) in the company does the CEO own? form did the compensation take? (Salary. bonds that are convertible into stock at the option of the bondholders) provide one form of protection against expropriation by stockholders. Will these compensation schemes make managers more responsive to stockholders? Why or why not? Are lenders to the firm affected by these compensation schemes? 9. do you think this is sensible? If so. how responsive to stockholders? and lenders to the firm? If so. Would you recommend stock price maximization as the objective? If not. why' If not. The Chief Executive Officer • Who is the CEO of the company? How long has he or she been CEO? part of the family? If not.e. Do you agree? Can you provide an example in which social responsibility and firm value maximization go hand in hand? 12. does the problem of social costs cease to exist? Why or why not? 15. Companies outside the United States often have two classes of stock outstanding. why not? markets? How do markets get informa- and manage its image in society? Framewerk for Analysis 1. About 70% of the voting shares are held by charitable institutions that are headed by the CEO of Reader's Digest. Would you be concerned about this setup? What are some of the actions you might push the firm. Bondholder Concerns • Does the firm have any publicly • Are there are bond covenants firm as part of the borrowing? • Do any holder traded debt? that have been imposed on the (that you can uncover) dr the bonds issued by the firm come with special protections against stock- expropriation? 4. as well as its largest lender. One argument made for having legislation restricting hostile takeovers is that unscrupulous speculators may take over well-run firms and destroy them for personal gain. • Is this a company • Is there a potential is it managed? where there is a separation is management between management and ownership? how has it responded? If so. Some have argued that convertible bonds (i. giving them the right to buy stock in the firm at a fixed price. Financial Market Concerns • How many analysts follow the firm? • How much trading volume is there on this stock? 5. Antitakeover amendments can be in the best interests of stockholders. What are the consequences for corporate governance? 8. It is often argued that managers. and option • How much stock and options 2. The other class is nonvoting and represents the bulk of traded shares. Societies attempt to keep private interests in line by legislating against behavior that might create social costs (such as polluting the water). clients. information on the CEO and the and is primarily in the filings made by the firm with the Securities conflict bet. Societal Constraints To analyze the corporate power in the firm lies governance structure of the firm and to assess where or with stockholders the • What does the firm say about its social responsibilities? • Does the firm have a particularly good or bad reputation as a corporate citizen? with incumbent management in the • If it does. Assume that you are advising a Turkish firm on corporate financial questions and that you do not believe that the Turkish stock market is efficient. what would you recommend? 13. In recent years. have to choose between being socially responsible and carrying out their fiduciary duty. How long have they served as directors? • How many of the directors • How many of the directors customers . what career from within the • If it is a "family-run" path did the CEO organization • How much company. when asked to maximize stock price. REAL TIME 41 6. One class of shares is voting and is held by the incumbent managers of the firm.. Deutsche Bank is the largest stockholder in DaimlerChrysler. Under what conditions is this likely to be true? 7. bonus. What is the basis of this argument? 14. For instance. )? • How many of the directors • Do any of the directors are CEOs of other companies? or represent those who do? are "inside" have other connections have large stockholdings 3. What are some of the potential conflicts that you see in these dual holdings? 11. If the legislation is comprehensive enough.o CHAPTER TWO I THE OI3JECTIVE IN CORPORATE FINANCE • How does this firm interact tion about the firm? • How does this firm view its social obligations with financial REAL COMPANIES. large banks are often large lenders and large equity investors in the same firm. top managers have been given large packages of options. how Information board of directors Sources in the United States. In Germany. AHowing for the possibility that this could happen.ween stockholders For firms that are incorporated . to take to protect your interests? 10. The Board of Directors • Who is on the board of directors of the company? directors? to the firm (as suppliers.

..... their relationship with the firm....... November ..... 255-276.4-2 CHAPTER TWO / THE OBJECTIVE IN CORPORATE FINANCE New Korn/Ferry Study Points to Dramatic Changes in America's Interna1999.....]. The relationship between firms and financial markets is an uneasy one. A.. Finally.... Shapiro. Martin. does give us a window on those firms that pass the tests (arbitrary though they sometimes are) imposed by these funds for a finn to be viewed as "socially responsible... A... New 1989. Articles and books referenced in the chapter Chan. R.... and N. Agency Costs and Ownership nal of Financial Economics... A Karpoff.. J... .. and C. MacAvoy...... the archives of financial publications (the Financial Times. "The Active Board of Directors and Its Effect on the Performance of Large Pubhcly Traded Companies. Japan and the United York: Macmillan. 1 Penman..... Shiller... E ... M.. 607-623.." [ourna! oj Financial Ecof1ol11ics 25... 199-228.. Competitive Strategy: Techniques for Analyzing Industries and Competitors... C.. and W.. Kensinger. N.. 573-610.. For larger and more heavily followed firms. ]... Devinney. The list of analysts following a firm can be obtained from publications such as the Nelson Directory of Securities Research.asuring the Effectiveness of Different CorpOl'ate Governance Systems: Towards a More Scientific Approach. In particular. 1976..... S." Business Week.... Related Web Sites http://www. Information on a firm's relationships with bondholders usually resides in the firm's bond agreements and loan covenants. "The Weekend Rcm'clA! oj Financial Studies 2(4).. Malatesta....... REFEREN CES 43 Exchange Cormnission.com/college/ damodaran Structure.'Journal of Business 64.. S....." 1991.com/college/ darnodaran References ..... Modem Releases: A Study of Earnings and Dividend Announcements.... and R. Wall Street Journal...... 1998.. "Corporate fonnance..... Winer. H... and details on compensation for both directors and top managers. A classic article on the conflict between Online Sources of Information http://www...... "Corporate Research and Development Expenditures and Share Value... Minow..." Kaplan.. For firms that are not listed in the United States.. 26. obtaining clear information on the reputation of a firm as a corporate citizen is very difficult since it is only the outliers (the worst and the best corporate citizens) that make the news... The proliferation of socially responsible mutual funds. W..• 1987. Although this information may not always be available to the public.. S. R. 86-93. University Press.. M. the 14-DEF will list the directors in the firm. the absence of readily accessible information on directors and top management is revealing about the power that resides with incumbent managers.............. "Corporate Capital Expenditure Decisions and rhe Market Value of the Firm... General References For more on corporate governance: Monks. 1998....... McConnell.. Chaney.. 399-422. A Comparison Governance and Corporate Per- States.. Forbes.. Governance. P. R.wi1ey... 1997.." Joumal Financial Economics 18(2).."Jourrwl ~f pplied Corporate Finance 9(4)......"Journal of Applied Corporate Finance 10(4). 011 Macey. NJ: Princeton Articles in the financial press referenced in the chapter "The Best and the Worst Boards.... 1997... however.. However. Barron's) can be useful sources of information.... Millstein. 291-322.. M.... "Me.. K......... Irrational Exuberance... 2000.. and L M." Jensen... T.. 1283-1322...]. and]...... Porter... Impact of New Product Introduction FirmS.....• 1980. the presence of constraints shows up indirectly in the firm's bond ratings and when the firm issues new bonds. C. Meckling. 1994.. 1990. Oxford: Blackwell.. this information is much more difficult to obtain. 1985..... "The Joumal qf Financial Economics 26.16-25.. New York: Free Press.. P.. H ... Corporate stockholders and managers. Korn/Ferry tional' wwwkornterrvccrr..J..]... "Theory of the Firm: Managerial Behavior.. Princeton." Columbia Law Review 98... A. "The Wealth Effects of Second-Generation State Takeover Legislation.... S.. H.... Damodaran.. You can also get information on trading done by insiders from the SEC filings. Corporate Finance.."Joul'- Corporate Boardrooms over Past 25 Years. "The Distribution the Market Value of Effect in Information Time and Seasonalities in Aggregate Stock Returns. of Germany. Muscarella...wiley.. M.. 1989.. 1990."Jourof Earnings News over of Hal oj Financial ECOflO111ics 4... and P. G.....]......

Assuming that you are guaranteed this return by the borrower. and that is the term we will nse through the rest of this chapter.and an interest rate to compensate for the loss in purchasing power that comes with inflation. we will present cash flows on a time line that shows both the timing and the am. if you could earn 5% in a savings account in a bank. there are three components of this return: the expected inflation rate. in which case it will have to incorporate a premium for uncertainty. the managers at Boeing. How much would you need to be offered? That will depend upon how strong your preference for current consumption is. yon would prefer to spend the dollar and consnme the goods today. In other examples. with stronger preferences leading to higher real interest rates. when we talk about the return you can make by investing a dollar today elsewhere. When there is uncertainty about the yield on an investment. say a government security. Thus. If there is uncertainty about whether you will earn the return.CASH FLOWS AND TIME LINES 45 The Time Value of Money 'DOLLAR TODAY is worth more than a dollar in the future because we can invest the dollar elsewhere and earn a return on it.we are often called upon to analyze investments spread out over time. The "discount rate" is therefore a more general term than "interest rates" when it comes to time value. we measure the return not as an interest rate but as an expected return. to get yon to postpone the consumption. or vice versa. the discount rate is the rate of return that you can expect to make on an investment with a similar amount of uncertainty. Consequently. Most people can grasp this argument without the use of models and mathematics. The first is that the presence if iliflation means that the dollar today will buy more in terms' of real goods than the same dollar a year from now. but we have $400 in nominal cash flows over the next four years. you would dem. What are the implications for discount rates? The Intuitive Basis for the Time Value of Money Why is a dollar today worth more to you than a dollar a year from now? The simplest way to explain the intuition is to note that you could have invested the dollar elsewhere and earned a return on it. there are two reasons why yon need to earn the interest rate to save. Thus far. In summary then.ount of each cash flow. The measurement of the time value of money is also central to corporate finance. Thus. it is clear that we cannot do so without an understanding of how to compare dollars at different points in time. Thus. we have no cash flows at time 0. have to consider what they will have to spend not only today but also in the future. we have assumed you are guaranteed the return on your savings. Note that the interest rate you can make on a guaranteed investment. and it should be greater as the uncertainty increases. or price appreciation. Therefore. no inflation and the dollar today and the dollar a year from now purchased exactly the same quantity of goods. you prifer present consumption to future consumption. and measure this against what they expect to earn today and far into the future. whose earnings will be generated over extended time periods. This return is what we call a discount rate. cash flows of $100 received at the end of each of the next four years can be depicted on a time line like the one depicted in Figure 3. We consider a variety of such examples in this chapter. A cash flow that occurs at time 0 does not need to be adjusted for time value. In this chapter. the interest rate will be the discount rate. Thus. the other variable that we will talk about in this chapter is cash flows. In investment analysis. the borrower must offer you some compensation in the form of an interest rate on your savings. b it is worth considering what goes into this interest rate. Given that our objective in corporate finance is to maximize value. The interest rate that includes the expected inflation in addition to the real interest rate is called a nominal interest rate. time 0 refers to the present. CT 3. However. from saving for retirement or tuition to buying a house or a car. In the figure. we will use the expected retnrn on investments of similar risk as the discount rate. The principles that we learn in this chapter also become crucial when we value assets or entire businesses. The second reason is that like most individuals. this is called a real interest rate. This third component is compensation for the uncertainty that you are exposed to. even if there were 44 Cash Flows and Time Lines In addition to discount rates. in the form of interest. the dollar today would be worth $1. When there is no certainty about what you will make on yonr investment.1. In examples in which the amount we will receive or payout is known with a fair degree of certainty. there is a third component to the return that you would need to make on your investment. the fact .1: Economists and government officials have been wringing their hands over the desire for current consumption that has led American families to save less and consume more of their income. What makes the time value of money compelling is the fact that it has applicability in a range of personal decisions. A cash flow is either cash that we expect to receive (a cash inflow) or cash that we expect to payout (a cash outflow). and a premium for uncertainty. Central to the notion of the time value of money is the idea that the money can be invested elsewhere to earn a return. when analyzing the Super Jumbo investment. Since this chapter is all about the significance of comparing cash flows across time. In this case. a real interest rate. can be used as the discount rate when your investment is expected to yield a guaranteed return. where there is uncertainty about the fntnre. Althouzh we often take the interest rate we can earn on our savings as a given.05 a year from today. we use the concept of time value of money to calculate exactly how much a dollar received or paid some time in the future is worth today. dividends.

ine for Cash Flows: .542 at the end of 10 years. you would need to end up with more than $89. The differences in future value from investing at these different rates of return are small for short compounding periods (such as one year) but become larger as the compounding period is extended. is more than nine times larger than the future value of investing in treasury bonds at an average return of 5%. As the length of the compounding period is extended. these cash flows should be worth more because we get each $100 one year earlier than in the previous case. which. the interest earned in each year itself earns interest in future years.2. as in the previous one.06) 10 = $89. once converted into cash flows today.000 elsewhere and end up with more than $89.000 will be worth $53.1 A Time . This can also be written more formally as: Future Valueat end of year 2 that they occur at different points in time means that the cash flows really cannot be compared to each other.I~~mm~1 1 2 3 4 $100 $100 $100 $100 future. In this chapter. .100in Cash Flows ~eceived at the End )f Each of the Next 4 (ears o ~~~~&&~~~I ~~mm. Ibbotson Associates found that stocks on the average made about 11% a year. Why do we care about the future value of an investment? It provides us with a measure that we can use to compare alternatives to leaving the money in the bank.180 Note that the future value at the end of 10 years would then be: Future Valueat end of 10 years = $. we call this the compounding period. This is the future value at the end of the first year. Assuming that these returns continue into the future. you could argue for taking this investment. The cash flow that we receive at the point in time "1" refers to the cash flow that occurs at the end of period 1. In a study of returns on stocks and bonds between 1926 and 1998. is the first year. while government bonds on average made about 5% a year. Figure 3. In sum. with a 40year time horizon. We can write this value more formally as: Future Valueat end of year 1 = $50.000 earning interest.3 provides the future values of $100 invested in stocks and bonds for periods extending up to 40 years.06) = $50. can be written as: Future Valueof Cash Flow = CPo (1 + 1)1 The future value will increase with time and increase as the discount rate increases.542 to compensate for the uncertainty. The portion of the time line between 0 and 1 refers to period 1. We will also reverse this process and ask a different question.180 ($53. a private business that manufactures software. if you could invest the $50. That is. we examine ways to convert cash flows in the future into cash flows today. In computing the future value of $50. 56. it is worth noting that while we receive $400 in this case. and that you have $50. $100 in one year should be worth less than $100 today but more than $100 in two years. that investment will increase in value. yield a present value (PV). Again. For instance. the deposit would have grown further to $56.000(1.000(1. If it were riskier. the future value increased as we increased the number of years for which we invested our money. the $50. How much would $100 in year 1 be worth in year 4? This process of converting cash flows today or in the future into cash flows even further into the future is called compounding and the resulting value is called a future value (FV).000 in the bank earning 6% interest for the foreseeable Figure 3.1.06)(1. t/ CC3. aSSU111ing this investment isjust as safe as leaving your money in the bank. What would the future value be if you intended to withdraw all the interest income from the account each year? Time Value of Money: Compounding and Discounting In this section. in this example. and the cash flows. $100 1 $100 2 Year $100 3 0 I I 4 In the preceding example. and why we do it.~6 CHAPTER THREE / THE TIME VALUE OF MONEY Cash Flows TIME VALUE OF MONEY: COMPOUNDING AND DISCOUNTING 47 :igure 3. at the end of one year. Note that in time value terms. Compounding Assume that you are the owner of InfoSoft.000 in the example above. the value of a cash flow today (CFo) at the end of a future period (t). the time line would have been redrawn as it appears in Figure 3. In Practice 3.1.000 + interest of 6% on $53. the future value of investing in stocks.000). $400 over the next four years should be worth less than $400 today. small differences in discount rates can lead to large differences in future value. Note the difference between a period of time and a point in time in Figure 3.5. Bonds. we assumed that interest earned was allowed to remain in the account and earn more interest.000 ($50. at an average return of 11%. which is equivalent to saying that you would need a higher rate of return than 6%. when the discount rate is given (as r).000(1. Over time. Thus.2 ATime Line for Cash Flows: $100in Cash Received at the Beginning of EachYear for the Next 4 Years Cash Flows $100 ~~~.000 + interest of 6% on $50. In general.06)2 = $.06) = $53.000 Year At the end of year 2. = $50. a cash flow that occurs at the beginning of year 2 is the equivalent of a cash flow that occurs at the end of year 1. we consider how to discount and compound a simple cash flow.000(1. This process is called discounting.542 In addition to the initial investment of $50.000).1: The Power 01 ConlPollndllnn and Bills Stocks. For instance. Had the cash flows occurred at the beginning of each year instead of at the end of each year.

Assume that it wants to set aside the money today to ensure that it will have $2 billion at the end of the eighth year and that it can earn 7% on its investments. One way of answering the question of what $2 billion in eight years is worth today is to reverse the question and ask how much Boeing would need to invest today to end up with $2 billion at the end of year 8. based Discounting converts $2 billion in cash flows in year 8 into cash flow today . ' . after entering into a contract to pay $2 billion in eight years. We could. The present value of $2 billion in eight years can be written as: Present Val ue 0 f P ayment = $2. Instead of looking at how much a dollar invested today will be worth in the future. What exactly does that mean? With a 10% discount rate.that is. Singapore Airlines would need to set aside only $701 million to reach $2 billion at the end of year 8.164 million today. Why do we discount? Discounting allows us to convert cash flows in the future into cash flows today.10)8 Figure 3. the present value of a cash flow can be written as follows: Present Valueof a Cash Flow = ---- CFt (1 + r)t Discounting Discounting operates in the opposite direction from compounding. the present value of each of these cash flows can be aggregated or cumulated. by themselves. Assume that Singapore Airlines is willing to place an order to buy $2 billion worth of Super Jumbo Jets eight years from now. What if it could earn a rate higher than 7%? Or what if the rate of return were much lower? The higher the return that Singapore Airlines can earn on its investments. we assumed that Singapore Airlines could make 7% on its investments and calculated that it would need to set aside $1.07)8 = $1 164 . It is also interesting to look at present value from the perspective of Singapore Airlines. we could consider how much we would need to invest today to have $2 billion in eight years: CPr The present value will decrease the further into the future a cash flow is expected to be received and as the discount rate increases. COMPOUNDING AND DISCOUNTING 49 Figure 3. Bonds Solving for the cash flow today. 8 Year The Frequency of Discounting and Compounding In the preceding examples. we ask what a dollar received or paid in the future will be worth today. In Practice 3.164 million today to arrive at a value of $2 billion in eight years. Singapore Airlines.000 -~-----=c(1. At a 14% rate of return. Consider the investment in the Super Jumbo that Boeing is considering making. and the perceived uncertainty associated with the anticipated cash flow.4 Present V<'l.5. Boeing would be indifferent between receiving $933 million today and $2 billion in eight years. the lower is the present value and the less is the amount that the firm would need to set aside to get $2 billion at the end of eight years.i 2 3 4 Cash inflow: $2 billion 5 6 7 In the preceding example. to ensure that it had $2 billion at the end of eight years. $2 billion in eight years is worth $933 million in present value terms.2: The Present Value ERects of Discount Rates = $2 billion = CPo (1. Our measure of how much a future cash flow is worth today will depend on our preferences for current consumption over future consumption. The time line for $2 billion received in eight years can be shown in Figure 3. so that we can compare them and aggregate them for purposes of analysis. if eFt is the cash flow at the end of some future year t and r is the discount rate.1 0)8 = $933 million Thus. the cash flows were discounted and compounded annually . answer the question of whether the present value of the cash inflows on this project will exceed the present value of the cash outflows. the Boeing Super Jumbo investment might have cash inflows and outflows occurring each year for the next 30 years. interest payments and income were computed at the end of each year. our views about inflation. Although this will weigh in positively on whether Boeing will make this investment.3 Effect of Compounding Periods: Stocks versus T. for instance.pared to each other. Assuming that Boeing's discount rate for this investment is 10%. for instance.lue a Cash Flow of o ~LZI 1 . To illustrate. will have an expected cash outflow of that amount at the end of the eighth year. it is worth less than an order on which Boeing would receive $2 billion today. cannot be com."" muuon Singapore Airlines would have to set aside $1. This is illustrated in Figure 3. earning 7% a year. Generalizing.48 CHAPTER THREE / THE TIME VALUE OF MONEY TIME VALUE OF MONEY. we get: CFo = $2 billion (1. Although these cash flows.4.

when adjusted for monthly compounding. can be computed as follows Effective Interest Rate . then. It can be computed as follows: Effective Interest Rate = [ 1 0. consumers were faced with a blizzard of rates.000 with continuous compounding compounding = $50. by increasing the effective discount rate.06)(IO)=$91. such as on a monthly or semiannual basis.542 was based on the assumption that the bank computed interest income on the income at the end of each of the next 10 years.000 at the end of 10 years with continuous would then be: Future Value of$50. Although the stated annual rate on the investment in our example is 6%.D6-1 = 6.~6 to In the context of discounting. however. but there are 20 six-month compounding periods in 10 years. the present and future values may be very different from those computed on an annual basis.542 to $90. in which case it is called continuous compounding. given that there are t compounding ods every year.3% In general.18% The future value of $50. however.000 exp(O.106 (1 + 0. more frequent compounding. Consequently.09% In general. At the limit. A similar compounding benefit occurs with each interest payment from the bank. A loan with an annual interest rate of 8. Where does the increase in value from $89. We can then compute the future value of the investment at the end of 10 years as follows: Future Value at end of year 10 = $50.306 The interest rate every six months is now 3% (6%/2). The future value of$89.970 peri- [ 0. the effective annual rate is much higher when compounding occurs every six months. It should come as no surprise then that loan sharks use daily compounding to keep track of the amounts owed to them. this interest income now earns interest over the remaining six months of the first year. Thus.50 CHAPTER THREE I THE TIME VALUE OF MONEY TIME VALUE OF MONEY: COMPOUNDING AND DISCOUNTING 51 Figure 3. the interest may be compnted more frequently. the effective annual interest rate. banks in the United States were allowed to advertise using any interest rate they chose on both deposits and mortgage loans.000 In our example above. some effective. will have an effective interest rate of Effective Interest Rate = 1+ -1-2- = $50.06) 120 = $90. in which case the future value and the effective interest rate would be even higher.06]2 + -2-1 = 6.306 come from? It arises from the fact that the interest income is now computed at the end of six months to be $1. for example. If the compounding were done every month instead of every six months. some stated. the future value of a cash flow. where there are t compounding ods each year and n is the number of years.500. As compounding becomes continuous. and some adjusted. consider the investment of$50. Assume instead that the bank computed interest every six months.000 in the bank earning 6% a year that we considered in the section on compounding. for instance. the annual interest rates quoted on loans can be deceptive because they are actually too low. the effective interest rate can be computed as follows: Effective Interest Rate = [ Stated 1+ Annual Interest Rate DO ]~ _ 1 = expst>tedrate -1 on the balance at the beginning of the year. To illustrate. = $90.3: Loans Most home mortgage loans in the United States require monthly payments and consequently have monthly compounding.00%. In these cases. = l peri- 1+ Stated Annual Interest Rate t ]. the bank could compound at every instant in time.08] 12 -1 = 8. -1 The bank can compute interest on a weekly or daily basis. the future value would be: Future Value at end of year 10 (monthly compounding) In Practice 3.5 Present Value of $2 Billion in 8 Years This analysis can be reframed in terms of the interest rate that you earn on your investment. can be written as follows: Future Value of Cash Flow = Cash Flow today [ 1 + __ S_ta_te_d_A_n_n_u_a_I_In_t_e_re_s_t _R_a_t_e ]n*t Prior to 1968. the effective interest rate when a 6% annual rate is compounded continuously would be: Effective Interest Rate = expO. which could not . reduces the present value. In some cases.000 ( 1 + -12 0.

which has been amended several times since its passage. This analysis is based on the assumption that the cash flows occur at the end of each year. assume that an individual sets aside $2. the future value of an annuity (A).5: Individual Retirement Accounts (IRA) Individual retirement accounts (lRAs)allow some taxpayers to set aside $2. n) = A .000 invested in year 2 = $5.000 $5.066+1. If the income had been taxed at 40%.000 1.8%.08 = $518.000 (1.000 = $5. [(1 + r)I! .000 (1. starting when she is 25 years old.000) is the annual cash flow on the annuity. Under this law. instead.06)8 + $5. For instance.52 CHAPTER THREE! THE TIME VALUE OF MONEY TIME VALUE OF MONEY: ANNUITIES AND PERPETUITIES 53 be compared across institutions. or at the beginning of each period.000 $5.000(1. In Practice 3.064+1. Which is the cheapest loan? Computing the future values of all 10 investments and then adding them up.447 Future Value of$5. $5.113 Figure 3.000 invested at the end of year 1 would earn interest at 6% for nine years to be worth $8. each cash flow would earn an additional year of interest. .000 $5.063+1.06)9 = $8. received or paid. with continuous compoundlnq.447 by the end of the tenth year. There are a couple of special types of cash flows.067+1.000(1.000 $5.06)4 + $5.000 $5.000 (1. requiring that more information be provided on the true cost of borrowing to enable consumers to compare interest rates on loans. and you want to estimate how much you would have at the end of 10 years..000 at the end of each year for the next 10 years. Congress passed a law called the Truth-in-Lending Act. the after-tax return would have dropped to 4.I. that you intend to set aside $5. The first loan has a stated interest rate of 8%.1 ] r This future' value will be higher than the future value of the same annuity at the end of each period.062+1. with different approaches to computing interest.000 each Year for 10 Years $5. on a mortgage loan. An annuity can occur at the end of each period.. It can be presented in a time line as shown in Figure 3.8%.904 In general.065+1. the notation we will use throughout this book for the future value of an annuity will be FV (A.127 As you can see. FV of a Begmnmg-of-the-Penod Annuity = A (1 Annuities An annuity is a stream of constant cash flows that occur at regular intervals for a fixed period of time.0610 . resulting in a much lower expected value: Expected Value of IRAset aside at 65 if taxed = $2. these fixed charges would include the closing costs that are normally paid at the time the loan is taken.000 set aside at the end of each year for the next 10 years would be worth.000 (1.06)6 +1) + $5.000 $5.06)9 + $5.000 $5.1 ] [ 0.5%. we could estimate the future value of each deposit at the end of the tenth year. Assume.000(1.0840. as in this time line.000 (1.06)2 + $5.06)8 = $7. This would result in a future value for the annuity that is greater by this factor: .000 at the end of every year.6. the funds available at retirement drop by more than 55%.2: Assume that you are comparing interest rates on several loans.000 .06 = $65.06) + $5. with compounding occurring every week. The second loan has a stated interest rate of 7. If they occurred at the beginning of each year instead. We will look at those cash flows next.000 1. Compounding an Annuity To estimate how much $5.04840 0. at the end of each year for 11 years with a discount rate r can be calculated as follows: FVof an Annmty = FV (A. Future Value of $5.000 (1. for an expected retirement at the age of 65. The expected value of the account on her retirement date can be calculated as follows: Expected Value of IRA set aside at 65 = $2.000 $5.000 $5.5 Year 6 7 8 9 10 1.1 ] [ 0. If an individual starts setting aside money in an IRAearly in her working life.969 + r) [ (1 + 1)" . and that she expects to make 8% a year on her investments.069+1.000 a year for retirement. The tax exemption adds substantially to the value because it allows the investor to keep the pre-tax return of 8% made on the IRA investment. The annual percentage rate includes an amortization of any fixed charges that have to be paid up front for the initiation of the loan.000 [ ° ~:mwflllllill 1 2 3 4 .06) 7 + $5.000 today at 6% and estimating how much it would be worth at the end of 10 years. Thus. In 1968.068+ 1. The third loan has a stated interest rate of 7.06 This can be simplified to yield the following: Cumulated Future Value = $5. .000 (1.048 1] = $230.06)3 + $5.06)5 + $5. we obtain: Cumulated Future Value = $5.000 (1.1 ] r Time Value of Money: Annuities and Perpetuities The mechanics of time value of money described in the last section can be extended to compute the present value or future value of any set of cash flows. financial institutions must provide an annual percentage rate (APR) in conjunction with any offer they might be making.n).000 (1. Thus. Consider again the exam-plewe used earlier of investing $50.6 Annuity of $5. and the interest earned on these accounts is exempt from taxation. with the loss of the tax exemption.I. The amount set aside each year ($5. CT 3. its value at retirement can be substantially higher than the amount actually put in.000 invested in year 1 ~ $5. assuming an interest rate of 6%. in which discounting and compounding can be simplified. For instance. with compounding occurring every month.

For instance.000 4 $3. $3.06)25 1 0.08)40 .. To estimate how much the annual savings would need to be.p. The future value of this annuity would be: Expected Value of IRA (beginning of year) = $2. = $20 1.544 at the end of each year for the next 40 years and an annual return of 8% a year produce a future value of $400.000 $3.r. there was discussion of a comprehensive settlement between tobacco firms in the United States and the federal govermnent. at a 6% discount rate. 1.1 0. in present value dollars.000 each year for next five years".000 [1- r ] {l + r)n .814 v" CC 3.08 In general.n).06 = $255.06 billion ~18 =.67 billion + --2- 1 1.1 = $1.. The analysis can be modified fairly simply to answer this question.814 $3.n) = A [ 1.679 $2..n) = FV l Assume again that you are the owner of Infosoft and that you have a choice of buying a copier for $11. Alternatively.06 + --3- 1 1.0840 0.135 $1.000 cash down or paying $3. Annual Savings 1.12 $10.000 a year for five years for the same copier.000 at the end of the fortieth year. the payment needed to arrive at a required future value can be calculated as follows: Annual Cash Flow given Future Value = A(FII.08 TIME VALUE OF MONEY: ANNUITIES AND PERPETUITIES 55 This can be simplified to yield a shortcut to computing the present value of an annuity: PV of$20 billion for 25 years = $20 billion [ J 1--- . Thus.392 $2. let us consider how much the cost of the agreement would have been to tobacco firms. The present value of the payments can be computed by taking each payment and discounting it back to the present. If.000 $3. can be calculated as follows: PV of on Annuily = PVIA. we assumed that the payments were made at the end of each year. if it had been approved.. Each payment can be discounted back to the present to yield the values in Figure 3. Assume that the tobacco firms collectively would have to guarantee the payments and that the discount rate is 6%.000 3 $3.06 1 = $255. is $18.2: How much would you need to save each year for the next 40 years to arrive at a future value of $400.000 at the End of Each of Next 5 Years PV $2. $3. however. for the next 40 years.000 at the beginning of each of the next five years can be calculated to be: PV of $3.~ 1 -1] Accordingly.~ lo= $12. the notation we will use in the rest of this book for the present value of an annuity will be PV(A.08) [ 1.000 5 ° The present value of each of the remaining 24 payments can be com. in which an investor or a company is saving to meet a goal and wants to estimate how much to save in each period to reach it.000 each year for next five years = $3.000 + $3. which would you rather do? Consider the present value of paying $3.000 a year for five years. Although the agreement was never ratified by Congress. the present value of the payments can be calculated using the shortcut described earlier. the present value would be much higher.. + --251. = $400.906 $1. the gains from making payments at the beginning of each period can be substantial.. we can do the following: Expected Value of IRA set aside at 65 = $400. In general.000 [ 1 . the present value of$20 billion in one year.000(1.1 PVof 0. the present value of an annual cash flow (A) each year for n years. If the discount rate is 12%.112 0 f $ 20 billi on 111 one year .000. consider a different scenario. whereby the tobacco firms would pay approximately $20 billion a year for 25 years in exchange for immunity from lawsuits on smoking-related deaths.54 CHAPTER THREE I THE TIME VALUE OF MONEY Consider also the effect of setting aside the savings at the beginning of each year instead of the end of each year.67 billion As you can see.000 0.08 ] [ (1.$559.000 .8).7.12 (~l= 0. the payments were due at the beginning of each year. 8 7 billi1011 1 Figure 3. assume in the example just described that the individual can save money at the end of each year for the next 40 years in an IRA account.562 (1.544 Annual savings of $1. with a discount rate J.puted similarly and then added up to yield the 'rollowing: Cumulated 1 Present Value = $20 billion (-.87 billion. you would want to buy the copier on the installment plan. earning 8% a year.000 ~] $3. As a final example..I.06 + .0840 . and wants to have accumulated savings of $400.7 Payment of $3.000 if you saved at the beginning of each year instead of the end? Discounting an Annuity In 1997 and 1998. In this case. therefore.06 1 ) r ¥Z j 2 I I I I I .Annual Savings [ Solving for the annual savings. since each payment would be discounted back one less year (Figure 3.702 $10.. The present value of $3. computed as follows: CT Present Value The present value of the installment payments is less than the cash-down price.

The New York State lottery.. assuming a discount rate of 6%.'. the prizes are paid out as annuities over very long time periods. was expected to generate funds for education ~ since 50% of the revenue generated from the lottery was supposed to go toward education. The player's ego is satisfied by the size of the nominal contract.00 Annuities 0.000 3 $3. As the first player to crack the $100 million barrier. It is therefore surprising sometimes to see lottery prizes that exceed the revenues from ticket sales. however. .112 0 TIME VALUE OF MONEY: ANNUITIES AND PERPETUITIES $3. he clearly will not be pleading poverty in the near future.:)"-' 1 Ifthe discount rate is 10%. In present value terms.56 CHAPTER THREE / THE TIME VALUE OF MONEY $3. (A:::: $1.0 Cash Flow million million million Annuilles In general. the present value is also at that point. and the annual cash flow needs to be estimated.000 $3. - (1. The process of computing the present value.000 at the Beginning of Eachof Next 5 Years ~r I 1 ~sr $3.09 of ""'. that present value is brought back to the present. thus reducing the present value of the contract. resulting in a present value that is much lower than the announced prize.000 2 $3. the use of nominal dollars in estimating the size of these contracts is actually misleading because the contracts are generally multiyear contracts.412 million The use of nominal values for contracts does serve a useful purpose.~ In Practice 3.137 million.1010 = $948 million ~i 0. Thus. Both the player and the team signing him up can declare victory in terms of getting the best deal. How much can you afford to payout each year.5) ::::$758 million (A:::: $1. which are expected to be the following: PV 0. 10%. Second. where the borrower receives the loan today (present value) and pays it back in equal monthly installments over an extended period of time. the standard present value of the annuity is computed over the period that the annuity is received. for instance.135 $1. for instance. PresentValue::::$758 million + $706 million + $948 rnillion e $83.000 $2. The present value of $2 million paid 1 1 A common error is to assume that since the first payment in this annuity is at the end of the sixth year.000 PV $3.) = A [ 1.679 $2. the present value of $300 million each year for five years is computed to be $1."". this present value is really as of the end of the fifth year. Consider. PresentValue of third annurty e .000 4 57 Figure 3.10) $400 million x PV 1.' It is discounted back five more years to arrive at today's present value. 1998. for example.8 Payment of $3.. as states recognize their potential to create revenues for a variety of causes. the present value of the cash flows is known. lower than the $35 million that the state I n Y"~ CC3. moves the cash flows back one year prior to the first cash flow.3: Assume that you run the lottery and you want to ensure that 50% of ticket revenues go toward education. however.906 $12.06 1= The present values of the second and third annuities can be calculated in two steps. the contract is worth $83.10%. .000 5 I I I I V" out each year for 20 years is significantly receives today.0 $400. while the team's financial pain can be minimized by spreading the payments over more time.392 $2.5) 1. Although the contracts are undoubtedly large. the present value of these three annuities can be calculated as follows: Sense Sports contracts for big-name players often involve mind-boggling amounts of money.. This is often the case with home and automobile loans. while preserving the nominal prizes at $40 million.105 ::::$706 million PresentValue of second annuity:::: $300 million x PV .0 $300. 00. the present value of an annuity where the cash flows are at the beginning of each period for the next n periods can be written as follows: Suppose you are the pension fund consultant to The Home Depot and that you are trying to estimate the present value of its pension obligations. for instance. requires the payment of approximately $15 million a year for seven years. the $105 million contract signed by Kevin Brown to play baseball for the Los Angeles Dodgers on December 12. the payment can be calculated from the equation we developed for estimating the present value of an annuity in the last section: PV of '0 Annuity = PV(A . can a lottery payout $40 million in prizes on ticket sales of $35 million and still claim to generate revenues for education? The answer is that while the sales are in current dollars.8: How Do They Do That? LOllery Prizes State-run lotteries have proliferated in recent years. In these cases. The contract. which is $706 million. Estimating an Annual Cash Flow In some cases.74 million. First.10%.74 million $2. which in this case is the end of the fifth year. How. PVof $15 million eachyearfor nextsevenyears= $15 mi'!lion [1 - PresentValue of first annuity e $200 million x PV (A:::: $1."' = A> A [.. for the second annuity. assuming a discount rate of 10%? In Practice 3.9: Present Value of Years 1~5 6~10 11~20 Annual $200.

the discount rate I.34) for you to take the second deal. the monthly payment on a $15. Many of them have the present value and future value of annuity equations built ]=1 436 . Although tables are convenient (they are available in the appendix to this book). the annual cash flow can be calculated as follows: Annual Cash Flow given Present Value"" A(PV.__ 1_ (1.00 (1 + r)" To illustrate.99.01 1. can then be multiplied by the annuity of $15 million to yield a value of $83.5824 • You can borrow $15.473. can be calculated using this equation: Monthly Interest Rate on Loan > APR --12- 0. Although these equations are not particularly complicated." . As was the case with the future value of annuities. while the monthly payment on the same loan at an annual rate of 12% is $498.000 0. making it the better one.000 [ 1- 0.866. (1.11 (1. for instance) and for specific periods (10 years but not 13 years.74 million = $15 In Practice 3. we would have obtained the present value factor for 6% and seven years: [ ] = 5.~ 0. Monthly Rate of lnterest « -- AND PERPETUITIES 59 If we know the present value. Monthly Rate of Interest PV of$1 each year for next seven years (at 6%)== 1. To illustrate how such tables are constructed. • You can reduce the sticker price by $1. yielding a present value of savings of Monthly Payment on Mortgage"" $200.0025)36 This factor.0067)360 1 The present value of the savings is greater than the price discount of $1. they are restrictive because they usually report factors only for certain discount rates (6% but not 6. we have computed present value through equations.I.866. These tables summarize what are called present value and future value factors that can be used to compute the present or future value of a single cash flow or an annuity.06 loan Now suppose you are trying to buy a new car that has a sticker price of $15.21. suppose you borrow $200.(1. dealer offers you two deals: The If we had isolated only the second term in the equation. Options for Computing Time Value of Money In the chapter so far.10: Cash DIscount versus a lower Interest An Automobile million 1--(1. The monthly savings is $61.000 [ 0.will be discounted back one less period (month). for instance). On the special financing deal.34 This monthly payment will be higher if the loan has a higher interest rate. mortgage holders have been provided the option of making their payments at the beginning of each month rather than the end of the month.06f 0.000 at a special annual percentage rate of 3% for 36 months .74 million. In this case. which could also be found in the table summarizing present value factors for annuities under 6% and seven years. there is an effect on the required monthly payment. $15.99 [ 1 ~ ~]= 0. we modify the equation to allow for the fact that each paytTlent.000 to buy a house on a 30-year mortgage with monthly payments. One alternative is the use of time value tables. for 36 months. you must calculate the monthly payments on each one. consider the earlier example in which we computed the present value of Kevin Brown's contract with the Los Angeles Dodgers for $15 million a year for seven years. The monthly payments on this loan. for instance. at a 6% discount rate. The annual percentage rate on the loan is 8%. To determine which is the better deal.0067) == $1.08%.08 "" -1-2- "" 0.01 $1.n) 12% 12 "" PV [1- = 1% _1' _1_] Monthly Payment on Discount Deal = $14. and the number of years for which the annuity is to be paid or received.58 CHAPTER THREE I THE TIME VALUE OF MONEY TIME VALUE OF MONEY: ANNUITIES On the normal financing.000 11 [ .0067 ] 1 "" $1. Another way of looking at these choices is to compare the present value of the savings you get from the lower rate against the dollar value of the discount. In recent years.000.000 and borrow $14. Monthly Payment on Mortgage"" $200. Financial calculators today are powerful enough to compute the time value of almost any type of cash flow.0025 Monthly Payment on Special Financing Deal:. PVof$15 million each year for n[extsever yeajrs= $83.80 every month by making the payments at the beginning of the month rather than the end of the month. j ( 1) (1.22.. two alternatives are widely used for compounding and discounting.01)36 ] ==$465.25% 0. The dealer would therefore have to offer a much larger discount (>$1.0067)360 Present Value of Monthly Savings = $61.0067 The monthly payments are lower on the special financing deal.. .000.0067 1 [ .06 = -- 3% 12 = 0.463.000 loan at an annual rate of 3% is $436. with the payments occurring at the end of each month.000 at the normal financing rate of 12% per annum. The second alternative is to use a financial calculator.31 The homeowner can save $9. To estimate the monthly payment at the beginning of each month rather than the end.

03 In general.~ = $16.9 Rent of $20.03 C umu Iate d PHI resent va ue 0f rent al payments r=xzu. the present value is equal to the sum of the nominal annuities over the period.4: If both the growth rate and the discount rate increase by 1 %.000 Growing at 3% a Year for Next 5 Years 0 r=~ 20. in the above example.03 ] + -4 5 1. for instance.000 ounces of gold every year.03 [ (1.000(1.000 a year.xls allows you to estimate the present value of a growing annuity.com/collegef damodaran In Practice 3. assume that you rent your office space and that the rent currently is $20. for instance. the time period (seven years).11: The Value a Gold Suppose you have the rights to a gold mine for the next 20 years.000(1. Assume that the discount rate is 10%. during which you plan to extract 5. but so does the numerator. Assume also that there is an inflation clause in the agreement that allows the owner of the office building to increase your rent at the rate of inflation.102 1. using my HP-17B calculator.10 (1. the present value of a growing annuity can be calculated by using the following equation: PV of a Growing Annuity = A(l + g) [1-~] (1+ 1')" r-g 20.:::S20. the present value of the rental payment in year 1 can be written as: Present Valueof year 1 rental payment = You'lI see this symbol throughout the book.03 The present value of the gold expected to be extracted from this mine is $16.03) t 20.10 1.10 1.000 x 1.000(1. it is an increasing function of the expected growth rate in gold prices. if the discount rate is 10%.03)5] 2 3 4 5 .10 v' CC3..wiley. Thus. In that case. .10-0.03)3 3 Year 20. which is expected to be 3% a year.000(1. PV of a Growing Annuity for n years (when r = g) = n A Note also that the growing annuity equation works even when the growth rate is greater than the discount rate.000 X 5). if both the growth Figure 3.03 + -1. we obtain the following: $20000 r1..03)5 5 I I I I 2 When g is greater than r. The present value can be computed as follows: PVof extracted gold = $300 x 5. For the example above.10-0. Spreadsheet pvalc. including whether the payment is at the beginning or end of each period and how many periods of compounding and discounting there are in each year.60 CHAPTER THREE I THE TIME VAlUE OF MONEY TIME VALUE OF MONEY: ANNUITIES AND PERPETUITIES 61 into them and thus require the user to input only the key variables. The net effect is that the present value can still be computed .. Figure 3.145. rate in rental payments and the discount rate were 12%. --1. Thus. It is important to keep track of these options and ensure that they are correctly set.000(L03) [ 1- (1JO)5 Figure 3. The expected rental cost for the next five years.2 Growing Annuities In the last section. The only note of caution that we would add is that most financial calculators now allow for myriad options. the present value of $20.03)20 ] 1.000 ($20. It signifies that a dataset or spreadsheet can be found on the book's web site.it will not become negative. if A is the current cash flow and g is the expected growth rate.000 . we can discount each cash flow back separately and add up the discounted values.03 + -1.980 0. As an example.03 $20. -1. but it is expected to increase 3% a year.000 a year for the next five years would be $100. The current price per ounce is $300. the denominator becomes negative.03)4 4 The present value of a growing annuity can be calculated in all cases except the one for which the growth rate is equal to the discount rate. will the present value of the gold to be extracted from this mine increase or decrease? Why? Summing up the values across all five years then. The growth effect is exactly offset by the discounting effect. To compute the present value of these rental payments.03)2 2 20. Bookmark the following URLon your web browser now so that you can easily access these files: www.10 Present VaIue of Extracted Gold as a Function of Growth Rate 0.000(1.03 + -1.9.103 1.10 illustrates the present value as a function of the expected growth rate. we would have input the payment ($15 million).74 million. 1. A growing annuity is a cash flow that grows at a constant rate for a specified period of time. and the discount rate (6%) and used the present value button on the calculator to arrive at the value of$83.146 million. we looked at ways in which we can compound and discount an annuity.. can then be written as shown in Figure 3.

Unlike traditional bonds that repay the principal at the end of a specified period (called the maturity date). when using this formula.. The other case is preferred stock...12 .... Growing Perpetuities In corporate finance. What if you were able to receive a constant cash flow forever? An annuity that lasts forever is called a perpetuity.g is the constant growth rate.....m:~:::t:::.. the numerator is the expected cash flow in the next year and thus reflects the expected inflation of 3 %.. Since any asset that grows at a rate higher than the growth rate of the economy forever will eventually become the economy.. First.. r. by which we examine how much a dollar today will be worth in the 3 This is approximately the nominal growth rate (including inflation) of the grows at a slightly higher rate (5.. consider an investment where you will make income of$60 a year in perpetuity....... the present value of the cash flows from Disneyland can be calculated: Present Value of Cash Flows = $100 mill ion (1. L ... If Disneyland generated $100 million in cash flows for Disney last year....oney. the discount rate that Disney would use to analyze these cash flows is 12%. The first is compounding..12-0.. Assuming that the park can be maintained with new investments each year....s. the final component is the uncertainty associated with whether we will receive the dollar in the future.. since we are called upon to analyze projects that generate cash flows over multiple years and value assets with the same characteristics.3 1 A Assume that you have been called upon to compute the present value of the expected cash flows on a theme park (say.. but the average growth rate forever is 5%.. Second..g 1 Summary . we can use the annuity equation that we developed earlier and look at the present value as the number of periods approach infinity (00).. the British and Canadian governments issued such bonds... we can rule it out by making sure that we are re~sonable in our estimates of the constant growth The time value of money is a central factor in corporate finance..03) (0. PV 0[' Perpetuity ~ A [ 1...... the second is the desire for consumption now over consumption in the future....03)50 Valueof theme park (with 50-yearlife) = $100million (1. and r is the discount rate.... can be computed to be $667.. The present value of this investment. it is almost never reasonable to assume constant growth rates that exceed 5 to 6%.127million 1 formula provides a shortcut to estimating the value of any CT 3. this equation simplifies to the following: where the numerator is the expected cash flow next year...... Two points are worth repeating.62 CHAPTER THREE / THE TIME VALUE OF MONEY TIME VALUE OF MONEY: ANNUITIES AND PERPETUITIES 63 Perpetuities An annuity is a constant cash flow for a specific time period.3: Assume that you have a cash flow that is expected to grow at different rates each year over time. assuming that the interest rate today is 9%.. Why do we prefer a dollar today to a dollar in the future? The firsr reason is that the presence of inflation reduces the purchasing power of the dollar over time. every period.03 Thus.. again with increasing earnings each period..03) 1[ 0.. In both scenarios.127 million: (1. In the United States.... but a stream of cash flows that grows over that period. we can draw on the 0. but can also increase ticket prices at about the inflation rate. ... and a few are still in existence.. and the expected inflation rate is 3%. economy.....~ rate.. We can take two basic actions in computing the time value of nl.. For instance. Can you use the growing perpetuity formula? Why or why not? equation forag::. the present value of a growing perpetuity is infinite and thus cannot be computed.. To compute the present value of a perpetuity.. A(l +~) PV of a Growmg Perpetuity = ---r. we are often called upon to value publicly traded firms... In some cases..0. Although there is a mathematical possibility of the growth rate exceeding the discount rate. These three factors are measured in a discount rate. which at least in theory have infinite lives and could conceivably keep growing over these lives... the constant growth rate in this equation has to be less than or equal to the growth rate of the economy.. The global economy .. u. preferred stock also has an infinite life.... A growing perpetuity is a cash flow that is expected to grow at a constant rate forever.. To estimate the value of a growing perpetuity. if we assumed a 50-year life for the park. this present value is a fairly good approximation for a long-lived investment.5% to 6.... we would argue that Disney can not only keep generating cash flows for very long periods from this park.. The owner of preferred stock gets a fixed dollar payment. even though it might not last forever.:t:o ~~:~ng)~~ [1.. we have to analyze projects that could last for very long periods.12)50 = $1. Disneyland) for Disney.......g As long as g is less than I.. ......5%)....03) = $1 144 million ... the growing perpetuity long-term investment..09 = $667 This approach is useful in at least two cases. we have to value not just an infinite stream of cash flows. As an example... In the late 1800s and early 1900s.. for instance. When the growth rate is equal to or exceeds the discount rate.. called a preferred dividend. a consol never matures and pays a fixed coupon forever. if not forever. we would estimate the value of $100 million growing at 3% a year for 50 years to be $1. One is the case of a consol bond. Present Value = --- $60 0..

.... how much would you expect to have at the end of the fifteenth year' 3. what is your annual effective interest rate? 4...n) PV 1-~~"y........... and payments will be made monthly Estimate your monthly payments. If the car costs $60..r............n) CFo (1 PV(A.g ... The third are perpetuities. ························P....g.... Assuming that he wishes to withdraw equal installments from these savings for the next 25 years of his life... How much would you need to set aside at the end of each year for the next 10 years to cover the expected liability? 2............... (1 + f)" Questions .n) Annuity given Present Value A (Pt{r... You have a loan of$100.. The fourth are growing perpetuities.... You are valuing real estate...... If you quit your job and plan to withdraw $100.... we can use shortcuts to estimate the present value of four types of cash flows.....000 in rental income.... .......... You have just been left an inheritance of $1 million.000 each year from the inheritance.... which are annuities that last forever................'!.. what is the value of the business? PV of Simple Cash Flow FV of Simple Cash Flow Present Value of Annuity PV (Fv........." . 4... If you pay 1% a 1110nth in interest on a loan... You are reviewing an advertisement by a finance company offering loans at an annual percentage rate of 9%" If the interest is compounded weekly.. growing at 3% a year forever. what it does not tell us is the timing of the reductions.... when that dollar is invested to earn a rate of return... which are growing annuities that last forever..... how would your answer change if the money were set aside at the beginning of each year? 6...... If the appropriate discount rate is 9%.. how much will each installment amount to ifhe is earning 5% on his savings? 8.. The annual percentage rate OIl the loan is 8%...... 5. which is a cash flow growing at a constant rate each period for a certain number of periods......... The building that you are valuing is expected to generate $25..oo) A(l + g) r.. A bill that is designed to reduce the nation's budget deficit passes both houses of Congress. A company is planning to set aside money to repay $100 million in bonds that will be coming due in 10 years. how much will you expect to have at the end of the fortieth year? 5. when it comes due? 2.'· . a. You are examining whether your savings will be adequate to meeting your retirement needs" You saved $1.... we reverse the process and ask how much a dollar in the future will be worth today By discounting cash flows to today.000 a year for the next 10 years and $30.......... which is currently earning an interest rate of 5%.. how long will it last? 7... how much money would the company need to set aside at the end of each year for the next 10 years to be able to repay the bonds when they come due? b.. Congress tells us that the bill will reduce the deficit by $500 billion over 10 years........ how much would you need to set aside today to repay the loan...........000 a year for the following 10 years.. In discounting..... if your discount rate is 9% and the annuities are paid at the end of each year? How much would you be willing to pay if they were at the beginning of each year? 9......500 last year.... estimate your monthly payments" 3.I.... You have a relative who has accumulated savings of $250.. what is the present value of the rental income? 6.... A Summary Type of Cash Flow qf Present Vc!lue Formulas Notation Formula C~.... You are planning to buy a car worth $20.... 1 r 1 Annuity given Future Value (1 + g)" Present Value of Growing Annuity PV(A.r..... How much would you be willing to pay for these annuities.. you can usc a market risk premium of 5"5% and a [ax rate of 40% where none is specified...n) A A [l-~ 1 [(1 + I...... You are offered a special set of annuities by your insurance company...... and you use a discount rate of 10%" a.g. whereby you will receive $20. growing 3% a year for the next 20 years" With a discount rate of 8%....000 each year for the next 40 years and earn a 5% interest rate on your savings... The first of these are annuities. what is the effective interest rate on this loan? 7......... put no money down. You have an expected liability (cash outflow) of $500...n) A(1 + g) [ 1-~ 1 f-g Present Value of a Perpetuity PV (A.. If you save $15...OO) A Present Value of a Growing Perpetuity PV(A.. The second are growing annuities........... You have just taken a 30-year mortgage loan for $200.......000 over his working lifetime and now plans to retire.... which are constant cash flows each period for a certain number of periods.000 (with no discount) at a special financing rate of 3%..... and you expect your annual savings to grow 5% a year for the next 15 years" If you can invest your money at 8%.. Assuming that you can earn 6% on your investments.. • The dealer offers to lend you $20. Future Value of Annuity FV (A. H u . and agree to make the payments in equal monthly installments over the next 60 months.I....... You buy a new Porsche convertible.. The business is expected to generate cash flows of $1 million.......... How much would you need right now as savings to cover the expected liability? b... You have been offered a share of a new business. 1... Which of the two deals described next would you choose' • The dealer offers to take 10% off the price and lend you the balance at the regular financing rate (which is an annual percentage rate of 9%)....000.... we are able to make cash flows that we receive at different points in time comparable... With a discount rate of 15%.....................000 in 10 years........ 1.64 CHAPTER THREE / THE TIME VALUE OF MONEY PROBLEMS 65 future.. Although the present value of a set of cash flows can always be computed by discounting each cash flow to the present and adding up the values..000 and the car dealer charges you 1% a month (as interest).......I....000.000 coming due in five years..1] [ + f)" Problems In [he problems below..

Bills and Inflation Yi'arbook. You want to move to the Bahamas when you retire. what is the present value of his contract? b.. borrowing $200.. Cissell..5 million (Sign-up Bonus) $4 milli on $4 million $4 million $4 million $7 million 14. How much of his income would he need to save each year for the next 10 years to be able to afford these planned withdrawals ($80. You are 35 years old today and are considering your retirement needs. Assume that interest rates decline to 4% 10 years from now. Related Web Sites o (now) 1 2 3 Articles and books referenced in the chapter Ibbotson Associates. with a closing cost that will be 3% of the loan..... what would your assessment be of the value of the store? b.66 CHAPTER THREE I THE TIME VALUE OF MONEY Year 1 2 3 4 5 6 7 8 9 10 Defidt Reduction $25 $30 $35 $40 $45 $55 $60 $65 $70 $75 Billion Billion Billion Billion Billion Billion Billion Billion Billion Billion The houses are roughly equivalent.000 a year (starting at the end of year 66 and continuing through the end of year 100) after that. The store generated a cash flow to its owner of $1 00.000..000 in savings..000 to make the move (on your 65th birthday) and that your living expenses will be $30..) How much would he need in the bank 10 years from now to be able to do this? b. Stocks.. Your opportunity cost is 8%.. how would you do it? (You can adjust only the sign-up bonus and the final year's cash flow..000 a year for the following 25 years. Cissell.. Given the refinancing cost (3% of the loan).. Boston: Houghton Mifflin. would your eli en t have to lower his annual withdrawal. C. making $100.000 $6.... would you refinance this loan? d.. how much would you need to save each year for the next 30 years to be able to afford this retirement plan? c..... and D. You can afford to pay the References . If you did not have any current savings and do not expect to be able to start saving money for the next five years. . What would the growth rate need to be to justify a price of $2. How much would interest rates have to go down before it would make sense to refinance this loan (assuming that you are going to stay in the house for five years)? player only $1.. Which one is less expensive? b. New York State has a pension fund liability of$25 billion. Once he retires 10 years from now. You bought a house a year ago for $250.. a. Estimate the annuity needed each year for the next 10 years. assuming that he still plans to withdraw cash each year for the next 25 years? 18.... Can you meet the agent's demand without relaxing your financial constraint on how much you can afford to pay him? REFERENCES 67 a.. how much would you have to set aside each year after that to be able to afford this retirement plan? 15. which house is less expensive? 13. if any.wiley.. It claims the difference as budget savings this year. Chicago: Ibbotson Associates... You can refinance your mortgage at this rate. He claims that this is not true in a present value sense and that he will really be making the following amounts for the next five years: Year Amount $5. You are an investment advisor who has been approached by a client for help on his financial strategy.000 a year) after the tenth year? c. General References You can obtain present value factors and derivations of present value formulas: http://wwv-. If the rate of return required on this store is 10%. at 8% a year. You can ignore taxes.7 million a year. The legislature changes the investment rate to 8% and recalculates the annuity needed to arrive at the future value..You have $100.. Bonds. You plan to stay in this house for the next five years.000 a year. b... If you wanted to raise the nominal value of his contract to $30 million.) 11. due in 10 years.. You expect to retire at age 65.com/college/damodaran 4 5 a... Interest rates have since come down to 9%. How much.....) 12.. Plaspholcr. 1990.. future value....000 in savings in the bank. 1998. How much would your monthly payments be if you could refinance your mortgage at 9% (with a 30-year term loan)? c. a.000 $12.. a small manufacturing firm. tax-free. Do you agree? b. how much could you afford to pay? 17. Assuming that Bonilla can make 7% on his investments. Chatham Price of the house Annual property tax $400.. If you can invest money. assuming that the interest rate that can be earned on the money is 6%. and 30-year mortgage rates are at 8%. H. The player's agent insists that the player will not accept a contract with a nominal value less than $5 million.000 .... The firm currently has $5 million in the fund and expects to have cash inflows of $2 million a year for the first five years followed by cash outflows of $3 million a year for the next five years.. If property taxes are expected to grow 3% a year forever. a... a.. Estimate the total payments (mortgage and property taxes) you would have on each house.. How much money \ViII be left in the fund at the end of the tenth year? If the federal government can borrow at 8%. a.. Assume that interest rates are at 8%.. while preserving the present value. what is the true deficit reduction in the bill? 10.. (His actuary tells him he will live to be 90 years old... a.000 to put as a down payment. You estimate that it will cost you $300... He is 55 years old and expects to work for 10 more years. Assume that you are the nnnager of a professional soccer team and that you are negotiating a contract with your team's star player..... . He has $250. How much are your monthly payments on your current loan (at 10%)? b. Are mortgage payments and property taxes directly comparable? Why or why not? c.. Each year the legislature is supposed to set aside an annuity to arrive at this... Ignore tax effects....5 million a year over three years (the remaining life of his contract). This annuity is based on what the legislature believes it can earn on this money..000 in the most profitable year of operation and is expected to have growth of about 5% a year in perpetutity. If you were required to pay a perpetuity after the tenth year (starting in year 11 and going through infinity) out of the balance left in the pension fund...000 South Orange $300. he would like to be able to withdraw $80. You are trying to assess the value of a small retail store that is up for sale..5 million for this store? 16. T11r Mathematics of Finance. You are comparing houses in two towns in New Jersey.. How much will you need to have saved by your retirement date to be able to afford this course of action? b.. R.000 at 10% on a 30-year term loan (with monthly payments).. and your actuarial tables suggest that you will live to be 100. You have been hired to run a pension fund for TelDet Inc. Poor Bobby Bonilla! The newspapers claim that he is making $5.... (He expects to make a return of 5% on his investments for the foreseeable future. You already have $50..

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