Aswath

Damodaran

THE OBJECTIVE IN CORPORATE

FINANCE
If you dont know where you are going, it doesnt
maCer how you get there

First Principles
1

Maximize the value of the business (firm)

The Investment Decision

Invest in assets that earn a
return greater than the
minimum acceptable hurdle
rate

The hurdle rate

should reflect the
riskiness of the
investment and
the mix of debt
and equity used
to fund it.

The return
should reflect the
magnitude and
the timing of the
cashflows as welll
as all side effects.

Aswath Damodaran

The Financing Decision

Find the right kind of debt
for your firm and the right
mix of debt and equity to
fund your operations

The optimal
mix of debt
and equity
maximizes firm
value

The right kind

of debt
matches the
tenor of your
assets

The Dividend Decision

If you cannot find investments
that make your minimum
acceptable rate, return the cash
to owners of your business

How much
cash you can
return
depends upon
current &
potential
investment
opportunities

How you choose

to return cash to
the owners will
depend on
whether they
prefer dividends
or buybacks

The ObjecIve in Decision Making

2

In tradiIonal corporate nance, the objecIve in decision making is to

maximize the value of the rm.
A narrower objecIve is to maximize stockholder wealth. When the stock
is traded and markets are viewed to be ecient, the objecIve is to
maximize the stock price.
Maximize equity
value

Maximize
firm value

Assets
Existing Investments
Generate cashflows today
Includes long lived (fixed) and
short-lived(working
capital) assets
Expected Value that will be
created by future investments

Aswath Damodaran

Maximize market
estimate of equity
value

Liabilities

Assets in Place

Debt

Growth Assets

Equity

Fixed Claim on cash flows

Little or No role in management
Fixed Maturity
Tax Deductible

Residual Claim on cash flows

Significant Role in management
Perpetual Lives

Maximizing Stock Prices is too narrow an

objecIve: A preliminary response
3

Maximizing stock price is not incompaIble with

meeIng employee needs/objecIves. In parIcular:
Employees are oVen stockholders in many rms
Firms that maximize stock price generally are protable

rms that can aord to treat employees well.

Maximizing stock price does not mean that

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

Aswath Damodaran

Why tradiIonal corporate nancial theory

focuses on maximizing stockholder wealth.
4

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 raIonal (are they?), stock prices reect
the wisdom of decisions, short term and long term,
instantaneously.
The objecIve of stock price performance provides some
very elegant theory on:
AllocaIng resources across scarce uses (which investments to
take and which ones to reject)
how to nance these investments
how much to pay in dividends

Aswath Damodaran

The Classical ObjecIve FuncIon

5

STOCKHOLDERS

Hire & fire

managers

- Board

- Annual Meeting

Lend Money

BONDHOLDERS/

LENDERS

Maximize

stockholder
wealth

Managers

Protect

bondholder

Interests

Reveal

information

honestly and

on time

No Social Costs

SOCIETY

All costs can be

traced to firm

Markets are

efficient and

assess effect on

value

FINANCIAL MARKETS

Aswath Damodaran

What can go wrong?

6

STOCKHOLDERS

Have little control

over managers

Lend Money

BONDHOLDERS

Managers put

their interests

above stockholders

Managers

Bondholders can

get ripped off

Delay bad

news or

provide

misleading

information

Significant Social Costs

SOCIETY

Some costs cannot be

traced to firm

Markets make

mistakes and

can over react

FINANCIAL MARKETS

Aswath Damodaran

I. Stockholder Interests vs. Management

Interests
7

In theory: The stockholders have signicant control over

management. The two mechanisms for disciplining
management are the annual meeIng and the board of
directors. Specically, we assume that
Stockholders who are dissaIsed with managers can not only
express their disapproval at the annual meeIng, but can use
their voIng power at the meeIng to keep managers in check.
The board of directors plays its true role of represenIng
stockholders and acIng as a check on management.

In PracIce: Neither mechanism is as eecIve in

disciplining management as theory posits.

Aswath Damodaran

The Annual MeeIng as a disciplinary venue

8

The power of stockholders to act at annual meeIngs is

diluted by three factors

Most small stockholders do not go to meeIngs because the cost

of going to the meeIng exceeds the value of their holdings.
Incumbent management starts o with a clear advantage when
it comes to the exercise 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.

Annual meeIngs are also Ightly scripted and controlled

events, making it dicult for outsiders and rebels to
bring up issues that are not to the managements liking.

Aswath Damodaran

And insItuIonal investors go along with

incumbent managers
9

Aswath Damodaran

Board of Directors as a disciplinary mechanism

10

Directors are paid well: In 2010, the median board member at a Fortune
500 company was paid $212,512, with 54% coming in stock and the
remaining 46% in cash. If a board member was a non-execuIve chair, he
or she received about $150,000 more in compensaIon.
Spend more Ime on it than they used to: A board member worked, on
average, about 227.5 hours a year (and that is being generous), or 4.4
hours a week, according to the NaIonal Associate of Corporate Directors.
Of this, about 24 hours a year are for board meeIngs. Those numbers are
up from what they were a decade ago.
Even those hours are not very producIve: While the Ime spent on being
a director has gone up, a signicant porIon of that Ime was spent on
making sure that they are legally protected (regulaIons & lawsuits).
And they have many loyalIes: Many directors serve on three or more
boards, and some are full Ime chief execuIves of other companies.

Aswath Damodaran

10

The CEO oVen hand-picks directors..

11

CEOs pick directors: A 1992 survey by Korn/Ferry revealed that 74% of

companies relied on recommendaIons from the CEO to come up with
new directors and only 16% used an outside search rm. While that
number has changed in recent years, CEOs sIll determine who sits on
their boards. While more companies have outsiders involved in picking
directors now, CEOs exercise signicant inuence over the process.
Directors dont have big equity stakes: Directors oVen hold only token
stakes in their companies. Most directors in companies today sIll receive
more compensaIon as directors than they gain from their stockholdings.
While share ownership is up among directors today, they usually get
these shares from the rm (rather than buy them).
And some directors are CEOs of other rms: Many directors are
themselves CEOs of other rms. Worse sIll, there are cases where CEOs
sit on each others boards.

Aswath Damodaran

11

Directors lack the experIse (and the willingness)

to ask the necessary tough quesIons..
12

Roberts Rules of Order? In most boards, the CEO

conInues to be the chair. Not surprisingly, the CEO sets
the agenda, chairs the meeIng and controls the
informaIon provided to directors.
Be a team player? The search for consensus overwhelms
any aCempts at confrontaIon.
The CEO as authority gure: Studies of social psychology
have noted that loyalty is hardwired into human
behavior. While this loyalty is an important tool in
building up organizaIons, it can also lead people to
suppress internal ethical standards if they conict with
loyalty to an authority gure. In a board meeIng, the
CEO generally becomes the authority gure.

Aswath Damodaran

12

The worst board ever? The Disney Experience -

1997
13

Aswath Damodaran

13

The Calpers Tests for Independent Boards

14

Calpers, the California Employees Pension fund,

suggested three tests in 1997 of an independent
board:
Are a majority of the directors outside directors?
Is the chairman of the board independent of the company

(and not the CEO of the company)?

Are the compensaIon and audit commiCees composed
enIrely of outsiders?

Disney was the only S&P 500 company to fail all

three tests.

Aswath Damodaran

14

Business Week piles on The Worst Boards in

1997..
15

Aswath Damodaran

15

ApplicaIon Test: Whos on board?

16

Look at the board of directors for your rm.

Are there any external measures of the quality of corporate

governance of your rm?

How many of the directors are inside directors (Employees of the rm,
ex-managers)?
Is there any informaIon on how independent the directors in the rm
are from the managers?

Yahoo! Finance now reports on a corporate governance score for

rms, where it ranks rms against the rest of the market and against
their sectors.

Is there tangible evidence that your board acts independently

of management?

Check news stories to see if there are acIons that the CEO has wanted
to take that the board has stopped him or her from taking or at least
slowed him or her down.

Aswath Damodaran

16

So, what next? When the cat is idle, the mice

will play ....
17

No stockholder approval needed.. Stockholder Approval needed

When managers do not fear stockholders, they will oVen put

their interests over stockholder interests

Greenmail: The (managers of ) target of a hosIle takeover buy out the

potenIal acquirer's exisIng stake, at a price much greater than the
price paid by the raider, in return for the signing of a 'standsIll'
agreement.
Golden Parachutes: Provisions in employment contracts, that allows
for the payment of a lump-sum or cash ows over a period, if
managers covered by these contracts lose their jobs in a takeover.
Poison Pills: A security, the rights or cashows on which are triggered
by an outside event, generally a hosIle takeover, is called a poison pill.
Shark Repellents: AnI-takeover amendments are also aimed at
dissuading hosIle takeovers, but dier on one very important count.
They require the assent of stockholders to be insItuted.
Overpaying on takeovers: AcquisiIons oVen are driven by
management interests rather than stockholder interests.

Aswath Damodaran

17

Overpaying on takeovers
18

The quickest and perhaps the most decisive way to

impoverish stockholders is to overpay on a takeover.
The stockholders in acquiring rms do not seem to share
the enthusiasm of the managers in these rms. Stock
prices of bidding rms decline on the takeover
announcements a signicant proporIon of the Ime.
Many mergers do not work, as evidenced by a number
of measures.
The protability of merged rms relaIve to their peer groups,
does not increase signicantly aVer mergers.
An even more damning indictment is that a large number of
mergers are reversed within a few years, which is a clear
admission that the acquisiIons did not work.

Aswath Damodaran

18

A case study in value destrucIon:

Eastman Kodak & Sterling Drugs
Kodak enters bidding war

In late 1987, Eastman Kodak

entered into a bidding war with
Homan La Roche for Sterling
Drugs, a pharmaceuIcal
company.
The bidding war started with
Sterling Drugs trading at about
$40/share.
At $72/share, Homan dropped
out of the bidding war, but Kodak
kept bidding.
At $89.50/share, Kodak won and
claimed potenIal synergies
explained the premium.

Kodak wins!!!!

Earnings and Revenues at Sterling Drugs

20

Sterling Drug under Eastman Kodak: Where is the synergy?

5,000

4,500

4,000

3,500

3,000

2,500

2,000

1,500

1,000

500

0

1988

1989

Revenue

Aswath Damodaran

1990

1991

1992

Operating Earnings

20

Kodak Says Drug Unit Is Not for Sale but

21

An arIcle in the NY Times in August of 1993 suggested that Kodak was eager to
shed its drug unit.

In response, Eastman Kodak ocials say they have no plans to sell Kodaks Sterling Winthrop
drug unit.
Louis Mass, Chairman of Sterling Winthrop, dismissed the rumors as massive speculaIon,
which ies in the face of the stated intent of Kodak that it is commiCed to be in the health
business.

A few months laterTaking a stride out of the drug business, Eastman Kodak said
that the Sano Group, a French pharmaceuIcal company, agreed to buy the
prescripIon drug business of Sterling Winthrop for $1.68 billion.

Shares of Eastman Kodak rose 75 cents yesterday, closing at $47.50 on the New York Stock
Exchange.
Samuel D. Isaly an analyst , said the announcement was very good for Sano and very good
for Kodak.
When the divesItures are complete, Kodak will be enIrely focused on imaging, said George
M. C. Fisher, the company's chief execuIve.
The rest of the Sterling Winthrop was sold to Smithkline for $2.9 billion.

Aswath Damodaran

21

The connecIon to corporate governance: HP

buys Autonomy and explains the premium
22

Aswath Damodaran

22

A year later HP admits a mistakeand explains

it
23

Aswath Damodaran

23

ApplicaIon Test: Who owns/runs your rm?

24

Look at: Bloomberg printout HDS for your rm

Who are the top stockholders in your rm?
What are the potenIal conicts of interests that you see
emerging from this stockholding structure?
Government

Outside stockholders
- Size of holding
- Active or Passive?
- Short or Long term?

Managers
- Length of tenure
- Links to insiders

Control of the firm

Employees

Lenders

Inside stockholders
% of stock held
Voting and non-voting shares
Control structure

Aswath Damodaran

24

Case 1: Splintering of Stockholders

Disneys top stockholders in 2003

Aswath Damodaran

25

Case 2: VoIng versus Non-voIng Shares &

Golden Shares: Vale

Brazilian(retail(
5%(
Brazilian(Ins=tu=onal(
6%(

Brazilian(
Govt.(
6%(

Non/Brazilian(
(ADR&Bovespa)(
29%(

Valespar(ownership
Litel&Participao
49.00%
Eletron&S.A.
0.03%
Bradespar&S.A.
21.21%
Mitsui&&&Co.
18.24%
BNDESPAR
11.51%
Valespar(
54%(

Brazilian(Govt.( Valespar(
4%(
1%(

Brazilian(retail(
18%(

Golden (veto)
shares owned
by Brazilian govt

Common (voting) shares

3,172 million

Brazilian(Ins<tu<onal(
18%(

Non.Brazilian(
(ADR&Bovespa)(
59%(

Preferred (non-voting)
1,933 million

Vale Equity

Aswath Damodaran

Vale has eleven members on its board of directors, ten of

whom were nominated by Valepar and the board was
chaired by Don Conrado, the CEO of Valepar.

26

Case 3: Cross and Pyramid Holdings

Tata Motors top stockholders in 2013

Aswath Damodaran

27

Case 4: Legal rights and Corporate

Structures: Baidu

The Board: The company has six directors, one of whom is Robin Li,
who is the founder/CEO of Baidu. Mr. Li also owns a majority stake
of Class B shares, which have ten Imes the voIng rights of Class A
shares, granIng him eecIve control of the company.
The structure: Baidu is a Chinese company, but it is incorporated in
the Cayman Islands, its primary stock lisIng is on the NASDAQ and
the listed company is structured as a shell company, to get around
Chinese government restricIons of foreign investors holding
shares in Chinese corporaIons.
The legal system: Baidus operaIng counterpart in China is
structured as a Variable Interest EnIty (VIE), and it is unclear how
much legal power the shareholders in the shell company have to
enforce changes at the VIE.

Aswath Damodaran

28

Things change.. Disneys top stockholders in

2009
29

Aswath Damodaran

29

II. Stockholders' objecIves vs. Bondholders'

objecIves
30

In theory: there is no conict of interests between

stockholders and bondholders.
In pracIce: Stockholder and bondholders have
dierent objecIves. Bondholders are concerned
most about safety and ensuring that they get paid
their claims. Stockholders are more likely to think
about upside potenIal

Aswath Damodaran

30

Examples of the conict..

31

A dividend/buyback surge: When rms pay cash out as

dividends, lenders to the rm are hurt and stockholders
may be helped. This is because the rm becomes riskier
without the cash.
Risk shiVing: When a rm takes riskier projects than
those agreed to at the outset, lenders are hurt. Lenders
base interest rates on their percepIons of how risky a
rms investments are. If stockholders then take on
riskier investments, lenders will be hurt.
Borrowing more on the same assets: If lenders do not
protect themselves, a rm can borrow more money and
make all exisIng lenders worse o.

Aswath Damodaran

31

An Extreme Example: Unprotected Lenders?

32

Aswath Damodaran

32

III. Firms and Financial Markets

33

In theory: Financial markets are ecient. Managers

convey informaIon honestly and and in a Imely manner
to nancial markets, and nancial markets make
reasoned judgments of the eects of this informaIon on
'true value'. As a consequence-
A company that invests in good long term projects will be
rewarded.
Short term accounIng gimmicks will not lead to increases in
market value.
Stock price performance is a good measure of company
performance.

In pracIce: There are some holes in the 'Ecient

Markets' assumpIon.

Aswath Damodaran

33

Managers control the release of informaIon to

the general public
34

InformaIon management (Iming and spin):

InformaIon (especially negaIve) is someImes
suppressed or delayed by managers seeking a beCer
Ime to release it. When the informaIon is released,
rms nd ways to spin or frame it to put
themselves in the best possible light.
Outright fraud: In some cases, rms release
intenIonally misleading informaIon about their
current condiIons and future prospects to nancial
markets.

Aswath Damodaran

34

Evidence that managers delay bad news?

35

DO MANAGERS DELAY BAD NEWS?: EPS and DPS Changes- by

Weekday
8.00%
6.00%
4.00%
2.00%
0.00%
-2.00%
-4.00%
-6.00%
Monday

Tuesday

Wednesday

% Chg(EPS)

Aswath Damodaran

Thursday

Friday

% Chg(DPS)

35

Some criIques of market eciency..

36

Investor irraIonality: The base argument is that

investors are irraIonal and prices oVen move for not
reason at all. As a consequence, prices are much more
volaIle than jusIed by the underlying fundamentals.
Earnings and dividends are much less volaIle than stock
prices.
ManifestaIons of irraIonality

ReacIon to news: Some believe that investors overreact to

news, both good and bad. Others believe that investors
someImes under react to big news stories.
An insider conspiracy: Financial markets are manipulated by
insiders; Prices do not have any relaIonship to value.
Short termism: Investors are short-sighted, and do not consider
the long-term implicaIons of acIons taken by the rm

Aswath Damodaran

36

Are markets short sighted and too focused

on the near term? What do you think?
37

Focusing on market prices will lead companies towards short

term decisions at the expense of long term value.
a.
b.

Allowing managers to make decisions without having to

worry about the eect on market prices will lead to beCer
long term decisions.
a.
b.

I agree with the statement

I do not agree with this statement

I agree with this statement

I do not agree with this statement

Neither managers nor markets are trustworthy. RegulaIons/

laws should be wriCen that force rms to make long term
decisions.
a.
b.

I agree with this statement

I do not agree with this statement

Aswath Damodaran

37

Are markets short term? Some evidence that

they are not..
38

Value of young rms: There are hundreds of start-up and

small rms, with no earnings expected in the near future,
that raise money on nancial markets. Why would a myopic
market that cares only about short term earnings aCach high
prices to these rms?
Current earnings vs Future growth: If the evidence suggests
anything, it is that markets do not value current earnings and
cashows enough and value future earnings and cashows
too much. AVer all, studies suggest that low PE stocks are
under priced relaIve to high PE stocks
Market reacIon to investments: The market response to
research and development and investment expenditures is
generally posiIve.

Aswath Damodaran

38

If markets are so short term, why do they react to big

investments (that potenIally lower short term earnings) so
posiIvely?
39

Aswath Damodaran

39

But what about market crises?

40

Markets are the problem: Many criIcs of markets point to market

bubbles and crises as evidence that markets do not work. For
instance, the market turmoil between September and December
2008 is pointed to as backing for the statement that free markets
are the source of the problem and not the soluIon.
The counter: There are two counter arguments that can be
oered:

The events of the last quarter of 2008 illustrate that we are more
dependent on funcIoning, liquid markets, with risk taking investors, than
ever before in history. As we saw, no government or other enIty (bank,
BueC) is big enough to step in and save the day.
The rms that caused the market collapse (banks, investment banks) were
among the most regulated businesses in the market place. If anything,
their failures can be traced to their aCempts to take advantage of
regulatory loopholes (badly designed insurance programs capital
measurements that miss risky assets, especially derivaIves)

Aswath Damodaran

40

IV. Firms and Society

41

In theory: All costs and benets associated with a

rms decisions can be traced back to the rm.
In pracIce: Financial decisions can create social costs
and benets.

A social cost or benet is a cost or benet that accrues to

society as a whole and not to the rm making the decision.
n Environmental costs (polluIon, health costs, etc..)
n Quality of Life' costs (trac, housing, safety, etc.)
Examples of social benets include:
n creaIng employment in areas with high unemployment
n supporIng development in inner ciIes
n creaIng access to goods in areas where such access does not
exist

Aswath Damodaran

41

Social Costs and Benets are dicult to quanIfy

because ..
42

Cannot know the unknown: They might not be known at

the Ime of the decision. In other words, a rm may
think that it is delivering a product that enhances
society, at the Ime it delivers the product but discover
aVerwards that there are very large costs. (Asbestos was
a wonderful product, when it was devised, light and easy
to work with It is only aVer decades that the health
consequences came to light)
Eyes of the beholder: They are person-specic, since
dierent decision makers can look at the same social
cost and weight them very dierently.
Decision paralysis: They can be paralyzing if carried to
extremes.

Aswath Damodaran

42

A test of your social consciousness:

Put your money where you mouth is
43

Assume that you work for Disney and that you have an opportunity
to open a store in an inner-city neighborhood. The store is
expected to lose about a million dollars a year, but it will create
much-needed employment in the area, and may help revitalize it.
Would you open the store?

If yes, would you tell your stockholders and let them vote on the
issue?

Yes
No

Yes
No

If no, how would you respond to a stockholder query on why you

were not living up to your social responsibiliIes?

Aswath Damodaran

43

So this is what can go wrong...

44

STOCKHOLDERS

Have little control

over managers

Lend Money

BONDHOLDERS

Managers put

their interests

above stockholders

Managers

Significant Social Costs

SOCIETY

Some costs cannot be

traced to firm

Bondholders can

get ripped off

Delay bad

Markets make

news or

mistakes and

provide

misleading
can over react

information

FINANCIAL MARKETS

Aswath Damodaran

44

TradiIonal corporate nancial theory breaks

down when ...
45

Managerial self-interest: The interests/objecIves of the

decision makers in the rm conict with the interests of
stockholders.
Unprotected debt holders: Bondholders (Lenders) are
not protected against expropriaIon by stockholders.
Inecient markets: Financial markets do not operate
eciently, and stock prices do not reect the underlying
value of the rm.
Large social side costs: Signicant social costs can be
created as a by-product of stock price maximizaIon.

Aswath Damodaran

45

When tradiIonal corporate nancial theory

breaks down, the soluIon is:
46

A non-stockholder based governance system: To choose a

dierent mechanism for corporate governance, i.e, assign the
responsibility for monitoring managers to someone other
than stockholders.
A beCer objecIve than maximizing stock prices? To choose a
dierent objecIve for the rm.
Maximize stock prices but minimize side costs: To maximize
stock price, but reduce the potenIal for conict and
breakdown:

Making managers (decision makers) and employees into stockholders

Protect lenders from expropriaIon
By providing informaIon honestly and promptly to nancial markets
Minimize social costs

Aswath Damodaran

46

I. An AlternaIve Corporate Governance System

47

Germany and Japan developed a dierent mechanism for

corporate governance, based upon corporate cross holdings.

In Germany, the banks form the core of this system.

In Japan, it is the keiretsus
Other Asian countries have modeled their system aVer Japan, with family
companies forming the core of the new corporate families

At their best, the most ecient rms in the group work at bringing
the less ecient rms up to par. They provide a corporate welfare
system that makes for a more stable corporate structure
At their worst, the least ecient and poorly run rms in the group
pull down the most ecient and best run rms down. The nature
of the cross holdings makes its very dicult for outsiders (including
investors in these rms) to gure out how well or badly the group
is doing.

Aswath Damodaran

47

II. Choose a Dierent ObjecIve FuncIon

48

Firms can always focus on a dierent objecIve funcIon.

Examples would include
maximizing earnings
maximizing revenues
maximizing rm size
maximizing market share
maximizing EVA

The key thing to remember is that these are

intermediate objecIve funcIons.

To the degree that they are correlated with the long term health
and value of the company, they work well.
To the degree that they do not, the rm can end up with a
disaster

Aswath Damodaran

48

III. Maximize Stock Price, subject to ..

49

The strength of the stock price maximizaIon objecIve

funcIon is its internal self correcIon mechanism. Excesses on
any of the linkages lead, if unregulated, to counter acIons
which reduce or eliminate these excesses
In the context of our discussion,

managers taking advantage of stockholders has led to a much more

acIve market for corporate control.
stockholders taking advantage of bondholders has led to bondholders
protecIng themselves at the Ime of the issue.
rms revealing incorrect or delayed informaIon to markets has led to
markets becoming more skepIcal and puniIve
rms creaIng social costs has led to more regulaIons, as well as
investor and customer backlashes.

Aswath Damodaran

49

The Stockholder Backlash

50

AcIvist InsItuIonal investors have become much more

acIve in monitoring companies that they invest in and
demanding changes in the way in which business is done.
They have been joined by private equity funds like KKR and
Blackstone.
AcIvist individuals like Carl Icahn specialize in taking large
posiIons in companies which they feel need to change their
ways (Blockbuster, Time Warner, Motorola & Apple) and
push for change.
Vocal stockholders, armed with more informaIon and new
powers: At annual meeIngs, stockholders have taken to
expressing their displeasure with incumbent management by
voIng against their compensaIon contracts or their board of
directors

Aswath Damodaran

50

The HosIle AcquisiIon Threat

51

The typical target rm in a hosIle takeover has

a return on equity almost 5% lower than its peer group
had a stock that has signicantly under performed the

peer group over the previous 2 years

has managers who hold liCle or no stock in the rm

In other words, the best defense against a hosIle

takeover is to run your rm well and earn good
returns for your stockholders
Conversely, when you do not allow hosIle
takeovers, this is the rm that you are most likely
protecIng (and not a well run or well managed rm)

Aswath Damodaran

51

In response, boards are becoming more

independent
52

Boards have become smaller over Ime. The median size of a board
of directors has decreased from 16 to 20 in the 1970s to between 9
and 11 in 1998. The smaller boards are less unwieldy and more
eecIve than the larger boards.
There are fewer insiders on the board. In contrast to the 6 or more
insiders that many boards had in the 1970s, only two directors in
most boards in 1998 were insiders.
Directors are increasingly compensated with stock and opIons in
the company, instead of cash. In 1973, only 4% of directors
received compensaIon in the form of stock or opIons, whereas
78% did so in 1998.
More directors are idenIed and selected by a nominaIng
commiCee rather than being chosen by the CEO of the rm. In
1998, 75% of boards had nominaIng commiCees; the comparable
staIsIc in 1973 was 2%.

Aswath Damodaran

52

Disney: Eisners rise & fall from grace

In his early years at Disney, Michael Eisner brought about long-delayed changes in
the company and put it on the path to being an entertainment giant that it is
today. His success allowed him to consolidate power and the boards that he
created were increasingly capIve ones (see the 1997 board).
In 1996, Eisner spearheaded the push to buy ABC and the board rubberstamped
his decision, as they had with other major decisions. In the years following, the
company ran into problems both on its ABC acquisiIon and on its other
operaIons and stockholders started to get resIve, especially as the stock price
halved between 1998 and 2002.
In 2003, Roy Disney and Stanley Gold resigned from the Disney board, arguing
against Eisners autocraIc style.
In early 2004, Comcast made a hosIle bid for Disney and later in the year, 43% of
Disney shareholders withheld their votes for Eisners reelecIon to the board of
directors. Following that vote, the board of directors at Disney voted unanimously
to elect George Mitchell as the Chair of the board, replacing Eisner, who vowed to
stay on as CEO.

Aswath Damodaran

53

Eisners concession: Disneys Board in 2003

54

Board Members
Reveta Bowers
John Bryson
Roy Disney
Michael Eisner
Judith Estrin
Stanley Gold
Robert Iger
Monica Lozano
George Mitchell
Thomas S. Murphy
Leo ODonovan
Sidney Poitier
Robert A.M. Stern
Andrea L. Van de Kamp
Raymond L. Watson
Gary L. Wilson
Aswath Damodaran

Occupation
Head of school for the Center for Early Education,
CEO and Chairman of Con Edison
Head of Disney Animation
CEO of Disney
CEO of Packet Design (an internet company)
CEO of Shamrock Holdings
Chief Operating Officer, Disney
Chief Operation Officer, La Opinion (Spanish newspaper)
Chairman of law firm (Verner, Liipfert, et al.)
Ex-CEO, Capital Cities ABC
Professor of Theology, Georgetown University
Actor, Writer and Director
Senior Partner of Robert A.M. Stern Architects of New York
Chairman of Sotheby's West Coast
Chairman of Irvine Company (a real estate corporation)
Chairman of the board, Northwest Airlines.
54

Changes in corporate governance at Disney

55

1.

2.

3.
4.

5.

6.

7.

Required at least two execuIve sessions of the board, without the CEO
or other members of management present, each year.
Created the posiIon of non-management presiding director, and
appointed Senator George Mitchell to lead those execuIve sessions and
assist in sesng the work agenda of the board.
Adopted a new and more rigorous deniIon of director independence.
Required that a substanIal majority of the board be comprised of
directors meeIng the new independence standards.
Provided for a reducIon in commiCee size and the rotaIon of
commiCee and chairmanship assignments among independent
directors.
Added new provisions for management succession planning and
evaluaIons of both management and board performance
Provided for enhanced conInuing educaIon and training for board
members.

Aswath Damodaran

55

Eisners exit and a new age dawns? Disneys

board in 2008
56

Aswath Damodaran

56

But as a CEOs tenure lengthens, does

corporate governance suer?
1.

2.

3.

4.

While the board size has stayed compact (at twelve members),
there has been only one change since 2008, with Sheryl
Sandberg, COO of Facebook, replacing the deceased Steve Jobs.
The board voted reinstate Iger as chair of the board in 2011,
reversing a decision made to separate the CEO and Chair
posiIons aVer the Eisner years.
In 2011, Iger announced his intent to step down as CEO in 2015
but Disneys board convinced Iger to stay on as CEO for an extra
year, for the the good of the company.
There were signs of resIveness among Disneys stockholders,
especially those interested in corporate governance. AcIvist
investors (CalSTRS) starIng making noise and InsItuIonal
Shareholder Services (ISS), which gauges corporate governance at
companies, raised red ags about compensaIon and board
monitoring at Disney.

Aswath Damodaran

57

What about legislaIon?

58

Every corporate scandal creates impetus for a

legislaIve response. The scandals at Enron and
WorldCom laid the groundwork for Sarbanes-Oxley.
You cannot legislate good corporate governance.

The costs of meeIng legal requirements oVen exceed the

benets
Laws always have unintended consequences
In general, laws tend to be blunderbusses that penalize
good companies more than they punish the bad
companies.
Aswath Damodaran

58

Is there a payo to beCer corporate

governance?
59

In the most comprehensive study of the eect of corporate governance

on value, a governance index was created for each of 1500 rms based
upon 24 disInct corporate governance provisions.

Buying stocks that had the strongest investor protecIons while simultaneously
selling shares with the weakest protecIons generated an annual excess return of
8.5%.
Every one point increase in the index towards fewer investor protecIons decreased
market value by 8.9% in 1999
Firms that scored high in investor protecIons also had higher prots, higher sales
growth and made fewer acquisiIons.

The link between the composiIon of the board of directors and rm value
is weak. Smaller boards do tend to be more eecIve.
On a purely anecdotal basis, a common theme at problem companies and
is an ineecIve board that fails to ask tough quesIons of an imperial
CEO.

Aswath Damodaran

59

The Bondholders Defense Against Stockholder

Excesses
60

More restricIve covenants on investment, nancing and dividend

policy have been incorporated into both private lending
agreements and into bond issues, to prevent future Nabiscos.
New types of bonds have been created to explicitly protect
bondholders against sudden increases in leverage or other acIons
that increase lender risk substanIally. Two examples of such bonds

PuCable Bonds, where the bondholder can put the bond back to the rm
and get face value, if the rm takes acIons that hurt bondholders
RaIngs SensiIve Notes, where the interest rate on the notes adjusts to
that appropriate for the raIng of the rm

More hybrid bonds (with an equity component, usually in the form

of a conversion opIon or warrant) have been used. This allows
bondholders to become equity investors, if they feel it is in their
best interests to do so.

Aswath Damodaran

60

The Financial Market Response

61

While analysts are more likely sIll to issue buy rather

than sell recommendaIons, the payo to uncovering
negaIve news about a rm is large enough that such
news is eagerly sought and quickly revealed (at least to a
limited group of investors).
As investor access to informaIon improves, it is
becoming much more dicult for rms to control when
and how informaIon gets out to markets.
As opIon trading has become more common, it has
become much easier to trade on bad news. In the
process, it is revealed to the rest of the market.
When rms mislead markets, the punishment is not only
quick but it is savage.

Aswath Damodaran

61

The Societal Response

62

If rms consistently out societal norms and create

large social costs, the governmental response
(especially in a democracy) is for laws and
regulaIons to be passed against such behavior.
For rms catering to a more socially conscious
clientele, the failure to meet societal norms (even if
it is legal) can lead to loss of business and value.
Finally, investors may choose not to invest in stocks
of rms that they view as socially irresponsible.

Aswath Damodaran

62

The Counter ReacIon

63

STOCKHOLDERS

1. More activist

investors

2. Hostile takeovers

Managers of poorly

run firms are put

on notice.

Protect themselves

BONDHOLDERS

Managers

1. Covenants

2. New Types

Firms are

punished

for misleading

markets

Corporate Good Citizen Constraints

SOCIETY

1. More laws

2. Investor/Customer Backlash

Investors and

analysts become

more skeptical

FINANCIAL MARKETS

Aswath Damodaran

63

So what do you think?

64

At this point in Ime, the following statement best describes

where I stand in terms of the right objecIve funcIon for
decision making in a business
a.
b.
c.
d.
e.
f.
g.
h.
i.

Maximize stock price, with no constraints

Maximize stock price, with constraints on being a good social ciIzen.
Maximize stockholder wealth, with good ciIzen constraints, and
hope/pray that the market catches up with you.
Maximize prots or protability
Maximize earnings growth
Maximize market share
Maximize revenues
Maximize social good
None of the above

Aswath Damodaran

64

The Modied ObjecIve FuncIon

65

For publicly traded rms in reasonably ecient markets,

where bondholders (lenders) are protected:

For publicly traded rms in inecient markets, where

bondholders are protected:

Maximize stockholder wealth: This will also maximize rm value,

but might not maximize the stock price

For publicly traded rms in inecient markets, where

bondholders are not fully protected

Maximize Stock Price: This will also maximize rm value

Maximize rm value, though stockholder wealth and stock

prices may not be maximized at the same point.

For private rms, maximize stockholder wealth (if

lenders are protected) or rm value (if they are not)

Aswath Damodaran

65

First Principles
66

Maximize the value of the business (firm)

The Investment Decision

Invest in assets that earn a
return greater than the
minimum acceptable hurdle
rate

The hurdle rate

should reflect the
riskiness of the
investment and
the mix of debt
and equity used
to fund it.

The return
should reflect the
magnitude and
the timing of the
cashflows as welll
as all side effects.

Aswath Damodaran

The Financing Decision

Find the right kind of debt
for your firm and the right
mix of debt and equity to
fund your operations

The optimal
mix of debt
and equity
maximizes firm
value

The right kind

of debt
matches the
tenor of your
assets

The Dividend Decision

If you cannot find investments
that make your minimum
acceptable rate, return the cash
to owners of your business

How much
cash you can
return
depends upon
current &
potential
investment
opportunities

How you choose

to return cash to
the owners will
depend on
whether they
prefer dividends
or buybacks

66