Objectives in Corporate Finance

Topics: Stock, Stock market, Board of directors Pages: 24 (4327 words) Published: April 26, 2012
The Objective in Corporate Finance

“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


First Principles

Invest in projects that yield a return greater than the minimum acceptable hurdle rate.

• The hurdle rate should be higher for riskier projects and reflect the financing mix used - owners’ funds (equity) or borrowed money (debt) • Returns on projects should be measured based on cash flows generated and the timing of these cash flows; they should also consider both positive and negative side effects of these projects.

Choose a financing mix that minimizes the hurdle rate and matches the assets being financed. If there are not enough investments that earn the hurdle rate, return the cash to the owners of the firm (if public, these would be stockholders).

• The form of returns - dividends and stock buybacks - will depend upon the stockholders’ characteristics.

Objective: Maximize the Value of the Firm

Aswath Damodaran


The Classical Viewpoint

Van Horne: "In this book, we assume that the objective of the firm is to maximize its value to its stockholders" Brealey & Myers: "Success is usually judged by value: Shareholders are made better off by any decision which increases the value of their stake in the firm... The secret of success in financial management is to increase value." Copeland & Weston: The most important theme is that the objective of the firm is to maximize the wealth of its stockholders." Brigham and Gapenski: Throughout this book we operate on the assumption that the management's primary goal is stockholder wealth maximization which translates into maximizing the price of the common stock.

Aswath Damodaran


The Objective in Decision Making

In traditional corporate finance, the objective in decision making is to maximize the value of the firm. A narrower objective is to maximize stockholder wealth. When the stock is traded and markets are viewed to be efficient, the objective is to maximize the stock price. All other goals of the firm are intermediate ones leading to firm value maximization, or operate as constraints on firm value maximization.

Aswath Damodaran


The Criticism of Firm Value Maximization

Maximizing stock price is not incompatible with meeting employee needs/objectives. In particular:

• - Employees are often stockholders in many firms • - Firms that maximize stock price generally are firms that have treated employees well.

Maximizing stock price does not mean that customers are not critical to success. In most businesses, keeping customers happy is the route to stock price maximization. Maximizing stock price does not imply that a company has to be a social outlaw.

Aswath Damodaran


Why traditional corporate financial theory focuses on maximizing stockholder wealth.

Stock price is easily observable and constantly updated (unlike other measures of performance, which may not be as easily observable, and certainly not updated as frequently). If investors are rational (are they?), stock prices reflect the wisdom of decisions, short term and long term, instantaneously. The objective of stock price performance provides some very elegant theory on: • how to pick projects • how to finance them • how much to pay in dividends

Aswath Damodaran


The Classical Objective Function
STOCKHOLDERS Hire & fire managers - Board - Annual Meeting Lend Money BONDHOLDERS Maximize stockholder wealth


No Social Costs SOCIETY Costs can be traced to firm Markets are efficient and assess effect on value FINANCIAL MARKETS

Protect bondholder Interests Reveal information honestly and on time

Aswath Damodaran


What can go wrong?
STOCKHOLDERS Have little control over managers Managers put their interests above stockholders


Significant Social Costs Lend Money Managers SOCIETY Bondholders can Some...
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