Corporate Finance – Aswath Damodaran (unfinished)

This course can be found in full on YouTube. It consists of 36 videos, each around 20 minutes in length. The notes herein are a summarised version of Damodaran’s course, for my personal reference.

Introduction

We can view a company from the perspective of an accounting balance sheet (backwards looking), or a financial balance sheet.

• Assets consist of assets in place, the existing investments that currently generate cash flow, and growth assets.
• Liabilities consist of debt (first claim on cash flows), and equity.

Corporate finance is about maximising the value of a firm. There are three broad decisions any company (regardless of size, sector, location) has to make:

• The Investment Decision: return on assets should be greater than a minimum acceptable hurdle rate
  • the hurdle rate should reflect the riskiness of the investment and the debt/equity mix (i.e how it is funded)
  • the return is a function of the magnitude and timing of cash flows.
• The Financing Decision: choose a debt/equity mix that maximises firm value, e.g. by choosing debt that matches the tenor of your assets.
• The Dividend Decision: if you can’t find investments that meet the hurdle rate, you should return cash via dividends or buybacks.

In practice, because the “value of a firm” is unobservable, stock price is used as a proxy. However, using stock price maximisation as the sole objective of corporate finance requires a number of assumptions:

• Equity holders have the power to change management – hence management’s goal is to maximise their wealth)
  • in reality, shareholders may not use their proxy rights
  • managers can build in poison pills, golden parachutes, or overpay on takeovers. All at the cost of shareholders.
  • post-war Germany and Japan managed this by having a cross-holding system, where other managers remove bad managers.
• Managers don’t abuse their lenders – otherwise they would try to give to equity holders at the lenders’ cost (e.g. the LBO of RJR Nabisco)
• Markets are efficient and management does not misinform the public - so that stock price is a proxy for value
  • many traders trade on short term prospects
  • many companies delay/spin bad news as possible.
• There are no social costs – this is a completely untrue assumption, e.g. Amazon’s workers.

Hurdle rates

This section is essentially about estimating the cost of capital. Please see the notes on Valuation for this.

Measuring investment returns

• Revenues are booked using accrual accounting - revenues are shown when the goods/services are exchanged, not when you receive payment.
• You can convert to cash accounting by adding back non-cash expenses, but subtracting capex and the change in working capital.
• The ideal measure of return is a time-weighted incremental cash flow return, and this should be compared to the hurdle rate of the investment (not the WACC of the company, although you can fall back on the WACC).
  • incremental means that we ignore sunk costs and add back expenses that would be there regardless of the investment
• In practice, we would invest in projects if the NPV (using the hurdle rate to discount cash flows) is greater than zero, or if the IRR greater than the cost of capital.
  • often it is fair to use the growing perpetuity formula for long term projects
  • the NPV calculation assumes that earlier cash flows are reinvested at the cost of capital, whereas the IRR assumes that earlier cash flows are reinvested at the IRR.
• a project might have multiple IRRs if the cash flow profile is nonstandard (i.e some negative cash flows in later years).

Valuation

This section is a condensed version of Damodaran’s Valuation Course. See my notes on this.