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ch2 PDF
ch2 PDF
“If you don’t know where you are going, it does not
matter how you get there”
Aswath Damodaran
Stern School of Business
Aswath Damodaran 2
First Principles
Q Invest in projects that yield a return greater than the minimum
acceptable hurdle rate.
• The hurdle rate should be higher for riskier projects and reflect the
financing mix used - owners’ funds (equity) or borrowed money (debt)
• Returns on projects should be measured based on cash flows generated
and the timing of these cash flows; they should also consider both positive
and negative side effects of these projects.
Q Choose a financing mix that minimizes the hurdle rate and matches the
assets being financed.
Q If there are not enough investments that earn the hurdle rate, return the
cash to the owners of the firm (if public, these would be stockholders).
• The form of returns - dividends and stock buybacks - will depend upon
the stockholders’ characteristics.
Objective: Maximize the Value of the Firm
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The Classical Viewpoint
Q Van Horne: "In this book, we assume that the objective of the firm is
to maximize its value to its stockholders"
Q Brealey & Myers: "Success is usually judged by value: Shareholders
are made better off by any decision which increases the value of their
stake in the firm... The secret of success in financial management is to
increase value."
Q Copeland & Weston: The most important theme is that the objective
of the firm is to maximize the wealth of its stockholders."
Q Brigham and Gapenski: Throughout this book we operate on the
assumption that the management's primary goal is stockholder wealth
maximization which translates into maximizing the price of the
common stock.
Aswath Damodaran 4
The Objective in Decision Making
Q In traditional corporate finance, the objective in decision making is to
maximize the value of the firm.
Q A narrower objective is to maximize stockholder wealth. When the
stock is traded and markets are viewed to be efficient, the objective is
to maximize the stock price.
Q All other goals of the firm are intermediate ones leading to firm value
maximization, or operate as constraints on firm value maximization.
Aswath Damodaran 5
The Criticism of Firm Value Maximization
Q Maximizing stock price is not incompatible with meeting employee
needs/objectives. In particular:
• - Employees are often stockholders in many firms
• - Firms that maximize stock price generally are firms that have treated
employees well.
Q Maximizing stock price does not mean that customers are not critical
to success. In most businesses, keeping customers happy is the route to
stock price maximization.
Q Maximizing stock price does not imply that a company has to be a
social outlaw.
Aswath Damodaran 6
Why traditional corporate financial theory
focuses on maximizing stockholder wealth.
Q Stock price is easily observable and constantly updated (unlike other
measures of performance, which may not be as easily observable, and
certainly not updated as frequently).
Q If investors are rational (are they?), stock prices reflect the wisdom of
decisions, short term and long term, instantaneously.
Q The objective of stock price performance provides some very elegant
theory on:
• how to pick projects
• how to finance them
• how much to pay in dividends
Aswath Damodaran 7
The Classical Objective Function
STOCKHOLDERS
Hire & fire Maximize
managers stockholder
- Board wealth
- Annual Meeting
Lend Money No Social Costs
BONDHOLDERS Managers SOCIETY
Protect Costs can be
bondholder traced to firm
Interests
Reveal Markets are
information efficient and
honestly and assess effect on
on time value
FINANCIAL MARKETS
Aswath Damodaran 8
What can go wrong?
STOCKHOLDERS
Managers put
Have little control their interests
over managers above stockholders
Lend Money Significant Social Costs
BONDHOLDERS Managers SOCIETY
Bondholders can Some costs cannot be
get ripped off traced to firm
Delay bad
news or Markets make
provide mistakes and
misleading can over react
information
FINANCIAL MARKETS
Aswath Damodaran 9
I. Stockholder Interests vs. Management
Interests
Q Theory: The stockholders have significant control over management.
The mechanisms for disciplining management are the annual meeting
and the board of directors.
Q Practice: Neither mechanism is as effective in disciplining
management as theory posits.
Aswath Damodaran 10
The Annual Meeting as a disciplinary venue
Q The power of stockholders to act at annual meetings is diluted by three
factors
• Most small stockholders do not go to meetings because the cost of going
to the meeting exceeds the value of their holdings.
• Incumbent management starts off with a clear advantage when it comes to
the exercising of proxies. Proxies that are not voted becomes votes for
incumbent management.
• For large stockholders, the path of least resistance, when confronted by
managers that they do not like, is to vote with their feet.
Aswath Damodaran 11
Board of Directors as a disciplinary mechanism
The Average Director: Underworked and Overpaid
140 50000
45000
120 Hours worked per year
Annual Pay
40000
100 35000
Hours worked per year
30000
80
Annual Pay
25000
60
20000
40 15000
10000
20
5000
0 0
1985 1988 1992 1996 2000
Year
Aswath Damodaran 12
The CEO hand-picks most directors..
Q The 1992 survey by Korn/Ferry revealed that 74% of companies relied
on recommendations from the CEO to come up with new directors;
Only 16% used an outside search firm.
Q Directors often hold only token stakes in their companies. The
Korn/Ferry survey found that 5% of all directors in 1992 owned less
than five shares in their firms.
Q Many directors are themselves CEOs of other firms.
Aswath Damodaran 13
Directors lack the expertise to ask the
necessary tough questions..
Q The CEO sets the agenda, chairs the meeting and controls the
information.
Q The search for consensus overwhelms any attempts at confrontation.
Aswath Damodaran 14
The Best Boards in 1997...
Aswath Damodaran 15
And the Worst Boards in 1997..
Aswath Damodaran 16
Who’s on Board? The Disney Experience -
1997
Aswath Damodaran 17
A Contrast: Disney vs. Campbell Soup in 1997
BEST PRACTICES CAMPBELL SOUP DISNEY
Majority of outside directors Only one insider 7 of 17 members
among 15 directors are insiders
Bans insiders on nominating Yes No: CEO is
committee chairman of panel
Bans former execs from board Yes No
Mandatory retirement age 70, with none None
over 64
Outside directors meet w/o CEO Annually Never
Appointment of 'lead director'' Yes No
Governance committee Yes No
Self-evaluation of effectiveness Every two years None
Director pensions None Yes
Share-ownership requirement 3,000 shares None
Aswath Damodaran 18
Application Test: Who’s on board?
Q Look at the board of directors for your firm. Analyze
• How many of the directors are inside directors (Employees of the firm,
ex-managers)?
• Is there any information on how independent the directors in the firm are
from the managers?
Aswath Damodaran 19
Disney’s Board in 2002
Reveta F. Bowers:Head of School for the Center for Early Education
John E. Bryson:Chief Executive Officer of Edison International
Roy E. Disney: Nephew of the late Walt Disney
Michael D. Eisner: Chief Executive Officer of the Company
Judith L. Estrin:President and Chief Executive Officer of Packet Design
Stanley P. Gold: CEO of Shamrock Holdings, Inc., an investment firm
Robert A. Iger: President and Chief Operating Officer of the Company
Monica C. Lozano: President and Chief Operating Officer of La Opinion
George J. Mitchell:United States Senator from 1980 to 1995
Thomas S. Murphy: Chairman of the Board and CEO of Capital Cities/ABC
Leo J. O'Donovan, S.J:Professor of Theology at Georgetown University
Sidney Poitier: Actor, director and writer
Robert A.M. Stern:Architect, teacher and writer
Andrea L. Van de Kamp:Chairman of Sotheby's West Coast
Raymond L. Watson:Vice Chairman of the Board of The Irvine Company
Gary L. Wilson:Chairman of the Board of Northwest Airlines Corporation
Aswath Damodaran 20
So what next? When the cat is idle, the mice
will play ....
Q When managers do not fear stockholders, they will often put their
No stockholder approval needed….. Stockholder Approval needed