Applied Corporate Finance Book
§1: The foundations
The three fundamental principles underlying corporate finance are the investment, financing
and dividend principles. The firm’s investments are assets. Investments that the firm has
already made are called assets in place and investments that the firm is expected to make in
the future are growth assets. To finance these assets the firm can promise investors a fixed
claim with a limited or no role in operations (debt) or offer a residual claim on the cash flow
with a greater role (equity).
The investment principle determines where businesses invest their resources. Invest in
assets that yield a return greater than the minimum acceptable hurdle rate. Returns are
measured based on cash flows generated. Investment decisions are those creating revenues
and profits, and those that save money. The hurdle rate is a minimum acceptable rate of
return for investing resources.
The financing principle governs the mix of funding used to fund these investments. Choose a
financing mix that maximizes the value of the investments made and match the financing to
the nature of the assets being financed. Using the proposition that firms minimize risk and
maximize capacity to use debt if it can be matched with cash flows, the financing
instruments can be designed. With additional considerations relating to taxes and external
monitors we arrive at the final design of financing.
The dividend principle answers the question of how much earnings should be reinvested
back into the business and how much returned to the owners of the business. If there are
not enough investments that earn the hurdle rate, return the cash to the owners of the
business. The form of the return will depend on what stockholders prefer. Every business
that thrives reaches a stage in its life when the cash flows generated by existing investments
are greater than the funds needed to take on good investments. This excess cash can be
returned to the owners. Whether stockholders want this depends on their trust in
management.
Corporate finance’s ultimate objective is to maximize the value of the business to its owners.
However, there are concerns and criticisms such as multiple firm objectives.
The value of a firm is the present value of its expected cash flows discounted back at a rate
that reflects both the riskiness of the projects of the firm and the financing mix used to
,finance them. The financing decisions affect firm value through the discount rate and
through expected cash flows.
Fundamental corporate finance propositions:
1. Corporate finance has an internal consistency that flows from tis choice of
maximizing firm value as the only objective function and its dependence on bedrock
principles: risk has to be rewarded, cash flows matter more than accounting income,
markets are not easily fooled and every firm decision impacts its value.
2. Corporate finance must be viewed as an integrated whole rather than a collection of
decisions.
3. Corporate finance matters to everybody.
4. Corporate finance is fun.
5. The best way to learn corporate finance is by applying its models and theories to real-
world problems.
,§2: The objective in decision-making
An objective offers a systematic way to make decisions for the firm. Multiple objectives
offers no gain and make decisions more difficult, so there should be only one objective. A
good objective should be (1) clear and unambiguous, (2) come with a timely measure to
evaluate performance and (3) it doesn’t create costs for other entities or groups that erase
firm-specific benefits and leave society worse off overall (CSR). The general agreement is
that the business objective is to maximize value.
As stakeholders have different objectives, there can be conflicts of interest. Stockholder
wealth maximization can be in conflict with employee concerns (job security) and customers
(low prices). The overall objective can be to maximize the value of the entire business,
maximize the value of the equity stake or maximize the stock price (narrowest). Potential
side costs increase as the objective is narrowed. Decisions for overall firm value can create
social costs. Agency problems can lead to decisions in favour of managers at the cost of
stockholders. Focusing on stockholder wealth can lead to expropriation of bondholders. As
for stock price, inefficiencies in financial markets may lead to misallocation of resources and
bad decisions.
There are three reasons to focus on stock price maximization. First, stock prices are the most
observable to judge performance (continuous updates). Secondly, assuming investors are
rational and markets are efficient stock prices will reflect the long-term effect of decisions
made by the firm (forward-looking). Third, it allows us to determine the best way to pick
projects and finance them. Private firms lack the feedback but also focus on maximizing
value. It is more difficult to adapt it to non-profit organizations. Stock price maximization is
the right objective if:
- Managers act in the best interests of stockholders due to threat of replacement or
equity holdings.
- Lenders to the firm are fully protected from expropriation. This is due to a reputation
effect for lending in the future and lenders protecting themselves with covenants.
- Financial markets are efficient. There is sufficient information for markets to make
judgments about the effects of actions on long-term cash flows and value.
- There are no social costs. All costs can be traced and charged to the firm.
, There are potential shortcomings. Stockholders discipline managers through annual
meetings and with the Board of Directors. Most stockholders don’t go to annual meetings,
with the easier option to sell the stock. The BOD ensures that managers look out for
stockholder interests. The capacity of the BOD to discipline management and keep them
responsive to stockholders is diluted:
1. Directors find themselves unable to spend enough time on management oversight.
Due to scandals the time spent has increased.
2. Directors lack expertise on core business issues and rely on managers and experts.
3. Directors can be insiders not willing to challenge the CEO. Outside directors are also
not always independent, as the CEO has a major say in who serves on the Board. A
solution are nominating committees being independent of the CEO.
4. Directors hold low equity and feel little empathy for stockholders when prices
decline.
5. In the US the CEO chairs the BOD.
For these reasons, the BOD often fails to protect the interests of stockholders.
The ability of stockholders to discipline managers can be affected by how voting rights are
apportioned across stockholders and by who owns the shares. Companies increasingly have
two classes of shares, with one class featuring disproportionate voting rights. This limits
control over management. Young companies often have a significant portion of stocks held
by the founders. This can lead to small shareholder expropriation. The presence of active
(institutional) investors increases the power of all stockholders, in contrast to passive
holders. Stockholders can also have competing interests (employee holders). The largest
stockholder may also be another company (cross holdings). This can be used to wield power
disproportionate to an investor’s stake. Summarizing, corporate governance is strongest for
companies with one class of shares, limited cross holdings and a large activist investor base.
If the institutions of corporate governance fail to keep management responsive to
stockholders, we cannot expect managers to maximize stockholder wealth. Managers often
protect their own interests at the expense of stockholders when fighting hostile
acquisitions. Greenmail, golden parachutes and poison pills don’t require stockholder
approval and serve managerial interests rather than stockholders’. Antitakeover
amendments also dissuade hostile takeovers but require the assent of stockholders to be
instituted. They increase bargaining power when negotiating with acquires and could be
beneficial to stockholders, only if management acts in their best interests. The easiest way to
impoverish stockholders is to pay too much for acquisitions. Bidder returns often decline.
Summarizing, when there is a conflict of interest between stockholders and managers,
stockholder wealth maximization is likely to take second place to management objectives.
Directors are often loyal to the CEO, outweighing their responsibilities to stockholders. This
loyalty can be reduced by dissenting peers and discordant authority figures. Boards will
never be optimally independent due to group consensus and information cascades (imitate
informed player). The California Public Employees Retirement System suggested checks:
1. Are a majority of the directors outside directors?
2. Is the chairman of the board independent of the company?
3. Are the compensation and audit committees composed entirely of outsiders?
§1: The foundations
The three fundamental principles underlying corporate finance are the investment, financing
and dividend principles. The firm’s investments are assets. Investments that the firm has
already made are called assets in place and investments that the firm is expected to make in
the future are growth assets. To finance these assets the firm can promise investors a fixed
claim with a limited or no role in operations (debt) or offer a residual claim on the cash flow
with a greater role (equity).
The investment principle determines where businesses invest their resources. Invest in
assets that yield a return greater than the minimum acceptable hurdle rate. Returns are
measured based on cash flows generated. Investment decisions are those creating revenues
and profits, and those that save money. The hurdle rate is a minimum acceptable rate of
return for investing resources.
The financing principle governs the mix of funding used to fund these investments. Choose a
financing mix that maximizes the value of the investments made and match the financing to
the nature of the assets being financed. Using the proposition that firms minimize risk and
maximize capacity to use debt if it can be matched with cash flows, the financing
instruments can be designed. With additional considerations relating to taxes and external
monitors we arrive at the final design of financing.
The dividend principle answers the question of how much earnings should be reinvested
back into the business and how much returned to the owners of the business. If there are
not enough investments that earn the hurdle rate, return the cash to the owners of the
business. The form of the return will depend on what stockholders prefer. Every business
that thrives reaches a stage in its life when the cash flows generated by existing investments
are greater than the funds needed to take on good investments. This excess cash can be
returned to the owners. Whether stockholders want this depends on their trust in
management.
Corporate finance’s ultimate objective is to maximize the value of the business to its owners.
However, there are concerns and criticisms such as multiple firm objectives.
The value of a firm is the present value of its expected cash flows discounted back at a rate
that reflects both the riskiness of the projects of the firm and the financing mix used to
,finance them. The financing decisions affect firm value through the discount rate and
through expected cash flows.
Fundamental corporate finance propositions:
1. Corporate finance has an internal consistency that flows from tis choice of
maximizing firm value as the only objective function and its dependence on bedrock
principles: risk has to be rewarded, cash flows matter more than accounting income,
markets are not easily fooled and every firm decision impacts its value.
2. Corporate finance must be viewed as an integrated whole rather than a collection of
decisions.
3. Corporate finance matters to everybody.
4. Corporate finance is fun.
5. The best way to learn corporate finance is by applying its models and theories to real-
world problems.
,§2: The objective in decision-making
An objective offers a systematic way to make decisions for the firm. Multiple objectives
offers no gain and make decisions more difficult, so there should be only one objective. A
good objective should be (1) clear and unambiguous, (2) come with a timely measure to
evaluate performance and (3) it doesn’t create costs for other entities or groups that erase
firm-specific benefits and leave society worse off overall (CSR). The general agreement is
that the business objective is to maximize value.
As stakeholders have different objectives, there can be conflicts of interest. Stockholder
wealth maximization can be in conflict with employee concerns (job security) and customers
(low prices). The overall objective can be to maximize the value of the entire business,
maximize the value of the equity stake or maximize the stock price (narrowest). Potential
side costs increase as the objective is narrowed. Decisions for overall firm value can create
social costs. Agency problems can lead to decisions in favour of managers at the cost of
stockholders. Focusing on stockholder wealth can lead to expropriation of bondholders. As
for stock price, inefficiencies in financial markets may lead to misallocation of resources and
bad decisions.
There are three reasons to focus on stock price maximization. First, stock prices are the most
observable to judge performance (continuous updates). Secondly, assuming investors are
rational and markets are efficient stock prices will reflect the long-term effect of decisions
made by the firm (forward-looking). Third, it allows us to determine the best way to pick
projects and finance them. Private firms lack the feedback but also focus on maximizing
value. It is more difficult to adapt it to non-profit organizations. Stock price maximization is
the right objective if:
- Managers act in the best interests of stockholders due to threat of replacement or
equity holdings.
- Lenders to the firm are fully protected from expropriation. This is due to a reputation
effect for lending in the future and lenders protecting themselves with covenants.
- Financial markets are efficient. There is sufficient information for markets to make
judgments about the effects of actions on long-term cash flows and value.
- There are no social costs. All costs can be traced and charged to the firm.
, There are potential shortcomings. Stockholders discipline managers through annual
meetings and with the Board of Directors. Most stockholders don’t go to annual meetings,
with the easier option to sell the stock. The BOD ensures that managers look out for
stockholder interests. The capacity of the BOD to discipline management and keep them
responsive to stockholders is diluted:
1. Directors find themselves unable to spend enough time on management oversight.
Due to scandals the time spent has increased.
2. Directors lack expertise on core business issues and rely on managers and experts.
3. Directors can be insiders not willing to challenge the CEO. Outside directors are also
not always independent, as the CEO has a major say in who serves on the Board. A
solution are nominating committees being independent of the CEO.
4. Directors hold low equity and feel little empathy for stockholders when prices
decline.
5. In the US the CEO chairs the BOD.
For these reasons, the BOD often fails to protect the interests of stockholders.
The ability of stockholders to discipline managers can be affected by how voting rights are
apportioned across stockholders and by who owns the shares. Companies increasingly have
two classes of shares, with one class featuring disproportionate voting rights. This limits
control over management. Young companies often have a significant portion of stocks held
by the founders. This can lead to small shareholder expropriation. The presence of active
(institutional) investors increases the power of all stockholders, in contrast to passive
holders. Stockholders can also have competing interests (employee holders). The largest
stockholder may also be another company (cross holdings). This can be used to wield power
disproportionate to an investor’s stake. Summarizing, corporate governance is strongest for
companies with one class of shares, limited cross holdings and a large activist investor base.
If the institutions of corporate governance fail to keep management responsive to
stockholders, we cannot expect managers to maximize stockholder wealth. Managers often
protect their own interests at the expense of stockholders when fighting hostile
acquisitions. Greenmail, golden parachutes and poison pills don’t require stockholder
approval and serve managerial interests rather than stockholders’. Antitakeover
amendments also dissuade hostile takeovers but require the assent of stockholders to be
instituted. They increase bargaining power when negotiating with acquires and could be
beneficial to stockholders, only if management acts in their best interests. The easiest way to
impoverish stockholders is to pay too much for acquisitions. Bidder returns often decline.
Summarizing, when there is a conflict of interest between stockholders and managers,
stockholder wealth maximization is likely to take second place to management objectives.
Directors are often loyal to the CEO, outweighing their responsibilities to stockholders. This
loyalty can be reduced by dissenting peers and discordant authority figures. Boards will
never be optimally independent due to group consensus and information cascades (imitate
informed player). The California Public Employees Retirement System suggested checks:
1. Are a majority of the directors outside directors?
2. Is the chairman of the board independent of the company?
3. Are the compensation and audit committees composed entirely of outsiders?
