1

CORPORATE FINANCE

Debashis Saha, Associate Professor, Finance & Banking, JU

1
 What is corporate finance?
7

◻ Every decision that a business makes has financial implications, and

any decision which affects the finances of a business is a corporate
finance decision.
◻ Defined broadly, everything that a business does fits under the rubric
of corporate finance.

Debashis Saha,
Associate 2
Professor, Finance
& Banking, JU
 Course Objectives
8

◻ To give you the capacity to understand the

theory and apply, in real world situations, the
techniques that have been developed in
corporate finance.
🞑 Motto for class: If it cannot be applied, who cares?.
◻ To give you the big picture of corporate finance
so that you can understand how things fit
together.
🞑 Motto for class: You can forget the details, but don’t miss
the storyline.
◻ To show you that corporate finance is fun.
Debashis Saha,
Associate 3
Motto for class: Are we having fun yet?
Professor,
🞑 Finance
& Banking, JU
 The Traditional Accounting Balance Sheet
9

The Balance Sheet

Assets Liabilities
Current Short-term liabilities of the
Long Lived Real Fixed firm
Liabiltie
Assets Assets
Short-lived Current sDebt Debt obligations of
Assets Assets firm
Investments in securities Financial Other
Investments Other long-term
& assets of other firms Liabilitie
obligations
Intangible s
Assets which are not
Assets Equit Equity investment in
physical, like patents &
y firm
trademarks

Debashis Saha,
Associate 4
Professor, Finance
& Banking, JU
 The Financial View of the Firm
10

Assets Liabilities
Existing Investments Fixed Claim on cash flows
Assets in Debt
Generate cashflows Little or No role in
Place
today management Fixed Maturity
Includes long lived (fixed) Tax Deductible
and
short-lived(workin
Expected Value that will be Growth Equit Residual Claim on cash flows
g capital) assets
created by future Assets y Significant Role in
investments management Perpetual Lives

Debashis Saha,
Associate 5
Professor, Finance
& Banking, JU
 First Principles & The Big Picture
1
1

Maximize the value of the business (firm)

The Investment Decision The Financing Decision The Dividend Decision

Invest in assets that earn a Find the right kind of debt If you cannot find investments
return greater than the for your firm and the right that make your minimum
minimum acceptable hurdle mix of debt and equity to acceptable rate, return the cash
rate fund your operations to owners of your business

The hurdle rate The return How much How you choose
The optimal The right kind cash you can
should reflect the should relfect the to return cash to
mix of debt of debt return the owners will
riskiness of the magnitude and
and equity matches the depends upon depend whether
investment and the timing of the
maximizes firm tenor of your current & they prefer
the mix of debt cashflows as welll potential
value assets dividends or
and equity used as all side effects. investment buybacks
to fund it. opportunities

Debashis Saha,
Associate 6
Professor, Finance
& Banking, JU
 Theme 1: Corporate finance is “common sense”
12

◻ There is nothing earth shattering about any of the first

principles that govern corporate finance. After all, arguing
that taking investments that make 9% with funds that cost
10% to raise seems to be stating the obvious (the investment
decision), as is noting that it is better to find a funding mix
which costs 10% instead of 11% (the financing decision) or
positing that if most of your investment opportunities
generate returns less than your cost of funding, it is best to
return the cash to the owners of the business and shrink the
business.
◻ Shrewd business people, notwithstanding their lack of
exposure to corporate finance theory, have always
recognized these fundamentals and put them into practice.
Debashis Saha,
Associate 7
Professor, Finance
& Banking, JU
 Theme 2: Corporate finance is focused…
13

◻ It is the focus on maximizing the value of the business

that gives corporate finance its focus. As a result of this
singular objective, we can
🞑 Choose the “right” investment decision rule to use, given a
menu of such rules.
🞑 Determine the “right” mix of debt and equity for a specific
business
🞑 Examine the “right” amount of cash that should be returned to
the owners of a business and the “right” amount to hold back
as a cash balance.
◻ This certitude does come at a cost. To the extent that
you accept the objective of maximizing firm value,
everything in corporate finance makes complete sense.
If you
Debashis Saha, do not, nothing will.
Associate 8
Professor, Finance
& Banking, JU
 Theme 3: The focus in corporate finance
changes across the life cycle…
14

The Lightbulb (Idea) Moment

The Bar Mitzvah

The End Game

The Midlife Crisis
The Scaling up Test
The Product Test
Revenues
$ Revenues/
Earnings

Earnings
Time

Growth stage Stage 1 Stage 2 Stage 3: High Stage 4 Stage 5 Mature Growth Stage 6
Start-up Young Growth Growth Mature Stable Decline

Have an idea for Create a business Build the Grow your Defend your Scale down
Description a business that model that business, business, business from your business
meets an unmet converts ideas converting shifting from new as market
need in the into potential potential into losses to competitors & shrinks.
market. revenues & revenues. profits find new
earnings markets

Debashis Saha,
Associate 9
Professor, Finance
& Banking, JU
 Theme 4: Corporate finance is universal…
15

◻ Every business, small or large, public or private, US or emerging

market, has to make investment, financing and dividend decisions.
◻ The objective in corporate finance for all of these
businesses remains the same: maximizing value.
◻ While the constraints and challenges that firms face can
vary dramatically across firms, the first principles do not
change.
🞑 A publicly traded firm, with its greater access to capital markets and more
diversified investor base, may have much lower costs of debt and equity
than a private business, but they both should look for the financing mix
that minimizes their costs of capital.
🞑 A firm in an emerging markets may face greater uncertainty, when
assessing new investments, than a firm in a developed market, but both
firms should invest only if they believe they can generate higher returns
on their investments than they face as their respective (and very different)
hurdle rates.

Debashis Saha,
Associate 10
Professor, Finance
& Banking, JU
 Theme 5: If you violate first principles, you will
pay a price (no matter who you are..)
16

◻ There are some investors/analysts/managers who

convince themselves that the first principles don’t
apply to them because of their superior education,
standing or past successes, and then proceed to put
into place strategies or schemes that violate first
principles.
◻ Sooner or later, these strategies will blow up
and create huge costs.
◻ Almost every corporate disaster or bubble has
its origins in a violation of first principles.
Debashis Saha, Associate Professor, Finance & Banking, JU
11
 0

THE OBJECTIVE IN CORPORATE

FINANCE
“If you don’t know where you are going, it does’nt
Debashis Saha,
Associate
matter how you get there” 12
Professor, Finance
& Banking, JU
 First Principles
1

Maximize the value of the business (firm)

The Investment Decision The Financing Decision The Dividend Decision

Invest in assets that earn a Find the right kind of debt If you cannot find investments
return greater than the for your firm and the right that make your minimum
minimum acceptable hurdle mix of debt and equity to acceptable rate, return the cash
rate fund your operations to owners of your business

The hurdle rate The return should How much How you choose
The optimal The right kind
should reflect the reflect the cash you can to return cash to
mix of debt of debt
riskiness of the magnitude and return the owners will
and equity matches the
investment and the timing of the depends upon depend on
maximizes firm tenor of your
the mix of debt cashflows as welll current & whether they
value assets
and equity used as all side effects. potential prefer dividends
to fund it. investment or buybacks
opportunities

Debashis Saha,
113
Associate
Professor, Finance
& Banking, JU
 The Objective in Decision Making
2

◻ 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.
Maximize equity Maximize market
Maximize value estimate of equity
firm value
value Assets Liabilities
Existing Investments Fixed Claim on cash flows Little
Assets in Place Debt
Generate cashflows today or No role in management Fixed
Includes long lived (fixed) and Maturity
short-lived(working Tax Deductible
capital) assets

Expected Value that will be Growth Assets Equity Residual Claim on cash flows
created by future investments Significant Role in management
Perpetual Lives
A swath Damodaran
Debashis Saha,
214
Associate
Professor, Finance
& Banking, JU
 Maximizing Stock Prices is too “narrow” an
objective: A preliminary response
3

◻ 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 profitable
firms that can afford to treat 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.
Debashis Saha,
Associate 3
Professor, Finance
& Banking, JU
 Why traditional corporate financial theory
4
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:
🞑 Allocatingresources across scarce uses (which investments to
take and which ones to reject)
🞑 how to finance these investments
🞑 how much to pay in dividends
Debashis Saha,
Associate 4
Professor, Finance
& Banking, JU
 The Classical Objective Function
5

STOCKHOLDERS

Hire & Maximize

fire stockholder
managers wealth
-Board
Lend Money
-Annual Meeting No Social Costs
BONDHOLDERS/ Managers SOCIETY
LENDERS Protect All costs can be
bondholder traced to firm
Interests
Markets are
Reveal
information efficient and
honestly and assess effect on
on time value
FINANCIAL MARKETS

Debashis Saha,
Associate 5
Professor, Finance
& Banking, JU
 What can go wrong?
6

STOCKHOLDERS

Have little control Managers put

over managers their interests
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

Debashis Saha,
Associate 6
Professor, Finance
& Banking, JU
 I. Stockholder Interests vs. Management
7
Interests
◻ In theory: The stockholders have significant control over
management. The two mechanisms for disciplining
management are the annual meeting and the board of
directors. Specifically, we assume that
🞑 Stockholders who are dissatisfied with managers can not only
express their disapproval at the annual meeting, but can use
their voting power at the meeting to keep managers in check.
🞑 The board of directors plays its true role of representing
stockholders and acting as a check on management.
◻ In Practice: Neither mechanism is as effective
in disciplining management as theory posits.
Debashis Saha,
Associate 7
Professor, Finance
& Banking, JU
 The Annual Meeting as a disciplinary venue
8

◻ 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 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 meetings are also tightly scripted and
controlled events, making it difficult for outsiders and
rebels to bring up issues that are not to the
management’s liking.
Debashis Saha,
Associate 8
Professor, Finance
& Banking, JU
 And institutional investors go along with
9
incumbent managers…

Debashis Saha,
Associate 9
Professor, Finance
& Banking, JU
 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--executive
chair, he or she received about $150,000 more in compensation.
◻ Spend more time 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 National Associate of Corporate Directors.
Of this, about 24 hours a year are for board meetings. Those numbers are
up from what they were a decade ago.
◻ Even those hours are not very productive: While the time spent on
being a director has gone up, a significant portion of that time was spent
on making sure that they are legally protected (regulations & lawsuits).
◻ And they have many loyalties: Many directors serve on three or
more boards, and some are full time chief executives of other
companies.

Debashis Saha,
Associate 10
Professor, Finance
& Banking, JU
 The CEO often hand--picks directors..
1
1
◻ CEOs pick directors: A 1992 survey by Korn/Ferry revealed that 74%
of companies relied on recommendations from the CEO to come up
with new directors and only 16% used an outside search firm. While
that number has changed in recent years, CEOs still determine who sits
on their boards. While more companies have outsiders involved in
picking directors now, CEOs exercise significant influence over the
process.
◻ Directors don’t have big equity stakes: Directors often hold only token
stakes in their companies. Most directors in companies today still receive
more compensation as directors than they gain from their stockholdings.
While share ownership is up among directors today, they usually get
these shares from the firm (rather than buy them).
◻ And some directors are CEOs of other firms: Many directors are
themselves CEOs of other firms. Worse still, there are cases where CEOs
sit on each other’s boards.

Debashis Saha,
Associate 11
Professor, Finance
& Banking, JU
 Directors lack the expertise (and the
12 willingness) to ask the necessary tough
questions..
◻ Robert’s Rules of Order? In most boards, the CEO
continues to be the chair. Not surprisingly, the CEO sets
the agenda, chairs the meeting and controls the
information provided to directors.
◻ Be a team player? The search for consensus
overwhelms any attempts at confrontation.
◻ The CEO as authority figure: Studies of social
psychology have noted that loyalty is hardwired into
human behavior. While this loyalty is an important tool
in building up organizations, it can also lead people to
suppress internal ethical standards if they conflict with
loyalty to an authority figure. In a board meeting, the
Debashis Saha,
12
CEO generally becomes the authority figure.
Associate
Professor, Finance
& Banking, JU
 The worst board ever? The Disney Experience
13
-- 1997

Debashis Saha,
Associate 13
Professor, Finance
& Banking, JU
 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 compensation and audit committees composed
entirely of outsiders?
◻ Disney was the only S&P 500 company to fail
all three tests.
Debashis Saha,
Associate 14
Professor, Finance
& Banking, JU
 Business Week piles on… The Worst Boards in
15
1997..

Debashis Saha,
Associate 15
Professor, Finance
& Banking, JU
 Application Test: Who’s on board?
16

◻ Look at the board of directors for your firm.

🞑 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?
◻ Are there any external measures of the quality of
corporate governance of your firm?
🞑 Yahoo! Finance now reports on a corporate governance score for
firms, where it ranks firms 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 actions 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.
Debashis Saha,
Associate 16
Professor, Finance
& Banking, JU
 So, what next? When the cat is idle, the mice
will play ....
17

◻ When managers do not fear stockholders, they will often

put their interests over stockholder interests
No stockholder approval needed….. Stockholder Approval needed

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

potential acquirer's existing stake, at a price much greater than the
price paid by the raider, in return for the signing of a 'standstill'
agreement.
🞑 Golden Parachutes: Provisions in employment contracts, that allows
for the payment of a lump--sum or cash flows over a period, if
managers covered by these contracts lose their jobs in a takeover.
🞑 Poison Pills: A security, the rights or cashflows on which are triggered
by an outside event, generally a hostile takeover, is called a poison pill.
🞑 Shark Repellents: Anti--takeover amendments are also aimed at
dissuading hostile takeovers, but differ on one very important count.
They require the assent of stockholders to be instituted.
🞑 Overpaying on takeovers: Acquisitions often are driven by
management interests rather than stockholder interests.
Debashis Saha,
Associate 17
Professor, Finance
& Banking, JU
 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 firms do not seem to
share the enthusiasm of the managers in these firms.
Stock prices of bidding firms decline on the takeover
announcements a significant proportion of the time.
◻ Many mergers do not work, as evidenced by a
number of measures.
🞑 The profitability of merged firms relative to their peer groups,
does not increase significantly after 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 acquisitions did not work.
Debashis Saha,
Associate 18
Professor, Finance
& Banking, JU
A case study in value destruction:
Eastman Kodak & Sterling Drugs
Kodak enters bidding war Kodak wins!!!!
◻ In late 1987, Eastman Kodak
entered into a bidding war with
Hoffman La Roche for Sterling
Drugs, a pharmaceutical
company.
◻ The bidding war started with
Sterling Drugs trading at about
$40/share.
◻ At $72/share, Hoffman dropped
out of the bidding war, but Kodak
kept bidding.
◻ At $89.50/share, Kodak won
and claimed potential synergies
explained the premium.

Debashis Saha,
Associate 31
Professor, Finance
& Banking, JU
 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 1990 1991 1992

Revenue Operating Earnings

Debashis Saha,
Associate 20
Professor, Finance
& Banking, JU
 Kodak Says Drug Unit Is Not for Sale …
21 but…
◻ An article in the NY Times in August of 1993 suggested that Kodak was eager
to shed its drug unit.
🞑 In response, Eastman Kodak officials say they have no plans to sell Kodak’s Sterling Winthrop
drug unit.
🞑 Louis Mattis, Chairman of Sterling Winthrop, dismissed the rumors as “massive speculation,
which flies in the face of the stated intent of Kodak that it is committed to be in the health
business.”
◻ A few months later…Taking a stride out of the drug business, Eastman Kodak
said that the Sanofi Group, a French pharmaceutical company, agreed to buy the
prescription 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 Sanofi and very good
for Kodak.”
🞑 “When the divestitures are complete, Kodak will be entirely focused on imaging,” said
George
M. C. Fisher, the company's chief executive.
🞑 The rest of the Sterling Winthrop was sold to Smithkline for $2.9 billion.

Debashis Saha,
Associate 21
Professor, Finance
& Banking, JU
 The connection to corporate governance: HP
buys Autonomy… and explains the premium
22

Debashis Saha,
Associate 22
Professor, Finance
& Banking, JU
 A year later… HP admits a mistake…and
23
explains it…

Debashis Saha,
Associate 23
Professor, Finance
& Banking, JU
 Application Test: Who owns/runs your firm?
24

◻ Look at: Bloomberg printout HDS for your firm

◻ Who are the top stockholders in your firm?
◻ What are the potential conflicts of interests that you
see emerging from this stockholding structure?
Government
Outside stockholders Managers
- Size of holding -Length of
- Active or Passive? tenure
Control of the firm -Links to
- Short or Long term?
insiders

Employees Lenders

Inside stockholders
% of stock held
Voting and non-voting shares
Control structure
Debashis Saha,
Associate 24
Professor, Finance
& Banking, JU
 Case 1: Splintering of Stockholders Disney’s
top stockholders in 2003

Debashis Saha, 25
Associate
Professor, Finance
& Banking, JU
Case 2: Voting versus Non--voting Shares &
Golden Shares: Vale

Valespar ownership Brazilian Govt. Valespar

Brazilian retail 4% 1%
5% Litel Participaço 49.00%
Brazilian
Brazilian Institutional Govt. Eletron S.A. 0.03%
6%
6%
Bradespar S.A. 21.21%
Mitsui & Co. 18.24% Brazilian retail
18%
BNDESPAR 11.51%

Valespar Golden (veto)

Non−Brazilian Brazilian Institutional Non−Brazilian
(ADR&Bovespa) 54% shares owned by 18% (ADR&Bovespa)
29% 59%
Brazilian govt

Common (voting) shares Preferred (non-voting)

3,172 million 1,933 million
Vale Equity

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.
Debashis Saha, 26
Associate
Professor, Finance
& Banking, JU
Case 3: Cross and Pyramid Holdings Tata
Motor’s top stockholders in 2013

Debashis Saha, 27
Associate
Professor, Finance
& Banking, JU
 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 times the
voting rights of Class A shares, granting him effective control
of the company.
◻ The structure: Baidu is a Chinese company, but it is
incorporated in the Cayman Islands, its primary stock listing
is on the NASDAQ and the listed company is structured as a
shell company, to get around Chinese government
restrictions of foreign investors holding shares in Chinese
corporations.
◻ The legal system: Baidu’s operating counterpart in China is
structured as a Variable Interest Entity (VIE), and it is
unclear how much legal power the shareholders in the shell
Debashis Saha, 28
company
Associate have
Professor, Finance
to enforce changes at the VIE.
& Banking, JU
 Things change.. Disney’s top stockholders in
29
2009

Debashis Saha,
Associate 29
Professor, Finance
& Banking, JU
 II. Stockholders' objectives vs. Bondholders'
30
objectives
◻ In theory: there is no conflict of interests
between stockholders and bondholders.
◻ In practice: Stockholder and bondholders have
different objectives. Bondholders are concerned
most about safety and ensuring that they get paid
their claims. Stockholders are more likely to think
about upside potential

Debashis Saha,
Associate 30
Professor, Finance
& Banking, JU
 Examples of the conflict..
31

◻ A dividend/buyback surge: When firms pay cash out as

dividends, lenders to the firm are hurt and stockholders
may be helped. This is because the firm becomes riskier
without the cash.
◻ Risk shifting: When a firm takes riskier projects than
those agreed to at the outset, lenders are hurt. Lenders
base interest rates on their perceptions of how risky a
firm’s 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 firm can borrow more money and
make all existing lenders worse off.
Debashis Saha,
Associate 31
Professor, Finance
& Banking, JU
 An Extreme Example: Unprotected Lenders?
32

Debashis Saha,
Associate 32
Professor, Finance
& Banking, JU
 III. Firms and Financial Markets
33

◻ In theory: Financial markets are efficient. Managers

convey information honestly and and in a timely manner
to financial markets, and financial markets make
reasoned judgments of the effects of this information on
'true value'. As a consequence--
🞑A company that invests in good long term projects will be
rewarded.
🞑 Short term accounting gimmicks will not lead to increases in
market value.
🞑 Stock price performance is a good measure of company
performance.
◻ In practice: There are some holes in the
'Efficient Markets' assumption.
Debashis Saha,
Associate 33
Professor, Finance
& Banking, JU
 Managers control the release of information
to the general public
34

◻ Information management (timing and spin):

Information (especially negative) is sometimes
suppressed or delayed by managers seeking a better
time to release it. When the information is released,
firms find ways to “spin” or “frame” it to put
themselves in the best possible light.
◻ Outright fraud: In some cases, firms release
intentionally misleading information about their
current conditions and future prospects to financial
markets.
Debashis Saha,
Associate 34
Professor, Finance
& Banking, JU
 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 Thursday Friday

% Chg(EPS) % Chg(DPS)

Debashis Saha,
Associate 35
Professor, Finance
& Banking, JU
 Some critiques of market efficiency..
36

◻ Investor irrationality: The base argument is that

investors are irrational and prices often move for not
reason at all. As a consequence, prices are much more
volatile than justified by the underlying fundamentals.
Earnings and dividends are much less volatile than stock
prices.
◻ Manifestations of irrationality
◻ Reaction to news: Some believe that investors overreact
to news, both good and bad. Others believe that investors
sometimes under react to big news stories.
◻ An insider conspiracy: Financial markets are manipulated
by insiders; Prices do not have any relationship to value.
◻ Short termism: Investors are short--sighted, and do not
consider the long--term implications of actions taken by the
firm
Debashis Saha,
Associate 36
Professor, Finance
& Banking, JU
 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. I agree with the statement
b. I do not agree with this statement
◻ Allowing managers to make decisions without having to
worry about the effect on market prices will lead to better
long term decisions.
a. I agree with this statement
b. I do not agree with this statement
◻ Neither managers nor markets are trustworthy.
Regulations/ laws should be written that force firms to make
long term decisions.
a. I agree with this statement
b. I do not agree with this statement

Debashis Saha,
Associate 37
Professor, Finance
& Banking, JU
 Are markets short term? Some evidence that
they are not..
38

◻ Value of young firms: There are hundreds of start--up and

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

Debashis Saha,
Associate 38
Professor, Finance
& Banking, JU
 If markets are so short term, why do they react to big
investments (that potentially lower short term earnings) so
positively?
39

Debashis Saha,
Associate 39
Professor, Finance
& Banking, JU
 But what about market crises?
40

◻ Markets are the problem: Many critics 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 solution.
◻ The counter: There are two counter arguments that can
be offered:
🞑 The events of the last quarter of 2008 illustrate that we are more
dependent on functioning, liquid markets, with risk taking investors, than
ever before in history. As we saw, no government or other entity (bank,
Buffett) is big enough to step in and save the day.
🞑 The firms 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 attempts to take advantage of
regulatory loopholes (badly designed insurance programs… capital
measurements that miss risky assets, especially derivatives)

Debashis Saha,
Associate 40
Professor, Finance
& Banking, JU
 IV. Firms and Society
41

◻ In theory: All costs and benefits associated with a

firm’s decisions can be traced back to the firm.
◻ In practice: Financial decisions can create social
costs and benefits.
🞑A social cost or benefit is a cost or benefit that accrues to
society as a whole and not to the firm making the decision.
■ Environmental costs (pollution, health costs, etc..)
■ Quality of Life' costs (traffic, housing, safety, etc.)
🞑 Examples of social benefits include:
■ creating employment in areas with high unemployment
■ supporting development in inner cities
■ creating access to goods in areas where such access does not
exist
Debashis Saha,
Associate 41
Professor, Finance
& Banking, JU
 Social Costs and Benefits are difficult to
quantify because ..
42

◻ Cannot know the unknown: They might not be known

at the time of the decision. In other words, a firm may
think that it is delivering a product that enhances
society, at the time it delivers the product but discover
afterwards that there are very large costs. (Asbestos
was a wonderful product, when it was devised, light
and easy to work with… It is only after decades that
the health consequences came to light)
◻ Eyes of the beholder: They are ‘person--specific’,
since different decision makers can look at the same
social cost and weight them very differently.
◻ Decision paralysis: They can be paralyzing if carried
to extremes.
Debashis Saha,
Associate 42
Professor, Finance
& Banking, JU
 A test of your social consciousness:
Put your money where you mouth
43

is…
◻ 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?
🞑 Yes
🞑 No
◻ If yes, would you tell your stockholders and let them vote on
the issue?
🞑 Yes
🞑 No
◻ If no, how would you respond to a stockholder query on why
you were not living up to your social responsibilities?

Debashis Saha,
Associate 43
Professor, Finance
& Banking, JU
 So this is what can go wrong...
44

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

Debashis Saha,
Associate 44
Professor, Finance
& Banking, JU
 Traditional corporate financial theory breaks
down when ...
45

◻ Managerial self--interest: The interests/objectives of

the decision makers in the firm conflict with the
interests of stockholders.
◻ Unprotected debt holders: Bondholders (Lenders)
are not protected against expropriation by
stockholders.
◻ Inefficient markets: Financial markets do not operate
efficiently, and stock prices do not reflect the underlying
value of the firm.
◻ Large social side costs: Significant social costs can
Debashis Saha,
45
Associate
be created
Professor, Finance as a by--product of stock price
& Banking, JU
 When traditional corporate financial theory
46
breaks down, the solution is:
◻ A non--stockholder based governance system: To choose a
different mechanism for corporate governance, i.e, assign
the responsibility for monitoring managers to someone
other than stockholders.
◻ A better objective than maximizing stock prices? To
choose a different objective for the firm.
◻ Maximize stock prices but minimize side costs: To
maximize stock price, but reduce the potential for conflict
and breakdown:
🞑 Making managers (decision makers) and employees into stockholders
🞑 Protect lenders from expropriation
🞑 By providing information honestly and promptly to financial markets
🞑 Minimize social costs

Debashis Saha,
Associate 46
Professor, Finance
& Banking, JU
 I. An Alternative Corporate Governance
47
System
◻ Germany and Japan developed a different 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 after Japan, with family
companies forming the core of the new corporate families
◻ At their best, the most efficient firms in the group work at
bringing the less efficient firms up to par. They provide a corporate
welfare system that makes for a more stable corporate structure
◻ At their worst, the least efficient and poorly run firms in the group
pull down the most efficient and best run firms down. The nature
of the cross holdings makes its very difficult for outsiders (including
investors in these firms) to figure out how well or badly the group
is doing.

Debashis Saha,
Associate 47
Professor, Finance
& Banking, JU
 II. Choose a Different Objective Function
48

◻ Firms can always focus on a different objective

function. Examples would include
🞑 maximizing earnings
🞑 maximizing revenues
🞑 maximizing firm size

🞑 maximizing market share

🞑 maximizing EVA

◻ The key thing to remember is that these

are intermediate objective functions.
🞑 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 firm can end up with a
disaster
Debashis Saha,
Associate 48
Professor, Finance
& Banking, JU
 III. Maximize Stock Price, subject to ..
49

◻ The strength of the stock price maximization objective

function is its internal self correction mechanism. Excesses on
any of the linkages lead, if unregulated, to counter actions
which reduce or eliminate these excesses
◻ In the context of our discussion,
🞑 managers taking advantage of stockholders has led to a much more
active market for corporate control.
🞑 stockholders taking advantage of bondholders has led to bondholders
protecting themselves at the time of the issue.
🞑 firms revealing incorrect or delayed information to markets has led to
markets becoming more “skeptical” and “punitive”
🞑 firms creating social costs has led to more regulations, as well as
investor and customer backlashes.
Debashis Saha,
Associate 49
Professor, Finance
& Banking, JU
 The Stockholder Backlash
50

◻ Activist Institutional investors have become much more

active 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.
◻ Activist individuals like Carl Icahn specialize in taking large
positions in companies which they feel need to change their
ways (Blockbuster, Time Warner, Motorola & Apple) and
push for change.
◻ Vocal stockholders, armed with more information and new
powers: At annual meetings, stockholders have taken to
expressing their displeasure with incumbent management by
voting against their compensation contracts or their board of
directors

Debashis Saha,
Associate 50
Professor, Finance
& Banking, JU
 The Hostile Acquisition Threat
51

◻ The typical target firm in a hostile takeover has

🞑a return on equity almost 5% lower than its peer group
🞑 had a stock that has significantly under performed the
peer group over the previous 2 years
🞑 has managers who hold little or no stock in the firm

◻ In other words, the best defense against a

hostile takeover is to run your firm well and earn
good returns for your stockholders
◻ Conversely, when you do not allow hostile
takeovers, this is the firm that you are most likely
protecting
Debashis Saha, (and not a well run or well managed firm) 51
Associate
Professor, Finance
& Banking, JU
 In response, boards are becoming more
independent…
52

◻ Boards have become smaller over time. 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 effective 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
options in the company, instead of cash. In 1973, only 4% of
directors received compensation in the form of stock or
options, whereas 78% did so in 1998.
◻ More directors are identified and selected by a nominating
committee rather than being chosen by the CEO of the firm.
In 1998, 75% of boards had nominating committees; the 52
Debashis Saha,
Associate
comparable
Professor, Financestatistic in 1973 was 2%.
& Banking, JU
 Disney: Eisner’s 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 captive 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
acquisition and on its other operations and stockholders started to get
restive, especially as the stock price halved between 1998 and 2002.
◻ In 2003, Roy Disney and Stanley Gold resigned from the Disney board,
arguing against Eisner’s autocratic style.
◻ In early 2004, Comcast made a hostile bid for Disney and later in the year,
43% of Disney shareholders withheld their votes for Eisner’s reelection 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.
Debashis aha, 53
65
Associate
Professor, Finance
& Banking, JU
 Eisner’s concession: Disney’s Board in 2003
54

Board Members Occupation

Reveta Bowers Head of school for the Center for Early Education,
John Bryson CEO and Chairman of Con Edison
Roy Disney Head of Disney Animation
Michael Eisner CEO of Disney
Judith Estrin CEO of Packet Design (an internet company)
Stanley Gold CEO of Shamrock Holdings
Robert Iger Chief Operating Officer, Disney
Monica Lozano Chief Operation Officer, La Opinion (Spanish newspaper)
George Mitchell Chairman of law firm (Verner, Liipfert, et al.)
Thomas S. Murphy Ex-CEO, Capital Cities ABC
Leo O’Donovan Professor of Theology, Georgetown University
Sidney Poitier Actor, Writer and Director
Robert A.M. Stern Senior Partner of Robert A.M. Stern Architects of New York
Andrea L. Van de Kamp Chairman of Sotheby's West Coast
Raymond L. Watson Chairman of Irvine Company (a real estate corporation)
Gary L. Wilson Chairman of the board, Northwest Airlines.

Debashis Saha,
Associate 54
Professor, Finance
& Banking, JU
 Changes in corporate governance at Disney
55

1. Required at least two executive sessions of the board, without

the CEO or other members of management present, each year.
2. Created the position of non--management presiding director, and
appointed Senator George Mitchell to lead those executive sessions
and assist in setting the work agenda of the board.
3. Adopted a new and more rigorous definition of director independence.
4. Required that a substantial majority of the board be
comprised of directors meeting the new independence
standards.
5. Provided for a reduction in committee size and the
rotation of committee and chairmanship assignments among
independent directors.
6. Added new provisions for management succession
planning and evaluations of both management and board
performance
7. Provided for enhanced continuing education and training for
board members.
Debashis Saha,
Associate 55
Professor, Finance
& Banking, JU
 Eisner’s exit… and a new age dawns?
56
Disney’s board in 2008

Debashis Saha,
Associate 56
Professor, Finance
& Banking, JU
 But as a CEO’s tenure lengthens, does
corporate governance suffer?
1. 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.
2. The board voted reinstate Iger as chair of the board in
2011, reversing a decision made to separate the CEO and
Chair positions after the Eisner years.
3. In 2011, Iger announced his intent to step down as CEO in
2015 but Disney’s board convinced Iger to stay on as CEO for an
extra year, for the “the good of the company”.
4. There were signs of restiveness among Disney’s stockholders,
especially those interested in corporate governance. Activist
investors (CalSTRS) starting making noise and Institutional
Shareholder Services (ISS), which gauges corporate governance at
companies, raised red flags about compensation and board
monitoring at Disney.
Aswath
DebashisDamodaran
Saha,
57
69
Associate
Professor, Finance
& Banking, JU
 What about legislation?
58

◻ Every corporate scandal creates impetus for a

legislative response. The scandals at Enron and
WorldCom laid the groundwork for
Sarbanes--Oxley.
◻ You cannot legislate good corporate governance.
🞑 The costs of meeting legal requirements often exceed the
benefits
🞑 Laws always have unintended consequences
🞑 In general, laws tend to be blunderbusses that penalize
good companies more than they punish the bad
companies.
Debashis Saha,
Associate 58
Professor, Finance
& Banking, JU
 Is there a payoff to better corporate
governance?
59

◻ In the most comprehensive study of the effect of corporate

governance on value, a governance index was created for each of 1500
firms based upon 24 distinct corporate governance provisions.
🞑 Buying stocks that had the strongest investor protections while simultaneously
selling shares with the weakest protections generated an annual excess return of
8.5%.
🞑 Every one point increase in the index towards fewer investor protections decreased
market value by 8.9% in 1999
🞑 Firms that scored high in investor protections also had higher profits, higher sales
growth and made fewer acquisitions.
◻ The link between the composition of the board of directors and firm
value is weak. Smaller boards do tend to be more effective.
◻ On a purely anecdotal basis, a common theme at problem companies
and is an ineffective board that fails to ask tough questions of an imperial
CEO.

Debashis Saha,
Associate 59
Professor, Finance
& Banking, JU
 The Bondholders’ Defense Against
Stockholder Excesses
60

◻ More restrictive covenants on investment, financing 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
actions that increase lender risk substantially. Two examples
of such bonds
🞑 Puttable Bonds, where the bondholder can put the bond back to the firm and get
face value, if the firm takes actions that hurt bondholders
🞑 Ratings Sensitive Notes, where the interest rate on the notes adjusts to that
appropriate for the rating of the firm
◻ More hybrid bonds (with an equity component, usually in
theDebashis
form of a conversion option or warrant) have been
Saha,
used. This allows bondholders to become equity investors,60if
Associate

they feelJUit is in their best interests to do so.

Professor, Finance
& Banking,
 The Financial Market Response
61

◻ While analysts are more likely still to issue buy rather

than sell recommendations, the payoff to uncovering
negative news about a firm is large enough that such
news is eagerly sought and quickly revealed (at least to a
limited group of investors).
◻ As investor access to information improves, it is
becoming much more difficult for firms to control when
and how information gets out to markets.
◻ As option 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 firms mislead markets, the punishment is not
only
Debashis quick but it is savage.
Saha,
Associate 61
Professor, Finance
& Banking, JU
 The Societal Response
62

◻ If firms consistently flout societal norms and

create large social costs, the governmental
response (especially in a democracy) is for laws
and regulations to be passed against such
behavior.
◻ For firms 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 firms that they view as socially
irresponsible.
Debashis
Associate
Saha,
62
Professor, Finance
& Banking, JU
 The Counter Reaction
63

STOCKHOLDERS

1. More activist Managers of poorly

investors run firms are put
2. Hostile takeovers on notice.

Protect themselves Corporate Good Citizen Constraints

BONDHOLDERS Managers SOCIETY
1. Covenants 1. More laws
2. New Types 2. Investor/Customer Backlash
Firms are Investors and
punished
for misleading analysts become
markets more skeptical

FINANCIAL MARKETS

Debashis Saha,
Associate 63
Professor, Finance
& Banking, JU
 So what do you think?
64

◻ At this point in time, the following statement best

describes where I stand in terms of the right objective
function for decision making in a business
a. Maximize stock price, with no constraints
b. Maximize stock price, with constraints on being a good social citizen.
c. Maximize stockholder wealth, with good citizen constraints, and
hope/pray that the market catches up with you.
d. Maximize profits or profitability
e. Maximize earnings growth
f. Maximize market share
g. Maximize revenues
h. Maximize social good
i. None of the above
Debashis Saha,
Associate 64
Professor, Finance
& Banking, JU
 The Modified Objective Function
65

◻ For publicly traded firms in reasonably efficient

markets, where bondholders (lenders) are protected:
🞑 Maximize Stock Price: This will also maximize firm value
◻ For publicly traded firms in inefficient markets,
where bondholders are protected:
🞑 Maximize stockholder wealth: This will also maximize firm value,
but might not maximize the stock price
◻ For publicly traded firms in inefficient markets,
where bondholders are not fully protected
🞑 Maximize firm value, though stockholder wealth and stock
prices may not be maximized at the same point.
◻ For private firms, maximize stockholder wealth (if
lenders are protected) or firm value (if they are not)
Debashis Saha,
Associate 65
Professor, Finance
& Banking, JU
 First Principles
66

Maximize the value of the business (firm)

The Investment Decision The Financing Decision The Dividend Decision

Invest in assets that earn a Find the right kind of debt If you cannot find investments
return greater than the for your firm and the right that make your minimum
minimum acceptable hurdle mix of debt and equity to acceptable rate, return the cash
rate fund your operations to owners of your business

The hurdle rate The return should How much How you choose
The optimal The right kind
should reflect the reflect the cash you can to return cash to
mix of debt of debt
riskiness of the magnitude and return the owners will
and equity matches the
investment and the timing of the depends upon depend on
maximizes firm tenor of your
the mix of debt cashflows as welll current & whether they
value assets
and equity used as all side effects. potential prefer dividends
to fund it. investment or buybacks
opportunities

Debashis Saha,
Associate 66
Professor, Finance
& Banking, JU