Chapter 1 Notes
There are several more established textbooks than Aswath Damodaran’s. We choose this textbook because it offers a life cycle perspective, which makes the understanding of investment, financing and dividend principle much easier. In addition, the life cycle perspective makes it easy to find parallels in our life and in business
To finance assets, firms can raise money from two sources. First, they can borrow the money from a bank or other lenders. We categorize this type of financing as debt. Alternatively, they can use the funds of the owner or owners of the businesses. We term these funds equity. A familiar example of housing financing may help illustrate the choice between debt and equity, between sole ownership and shared ownership. When you buy a house, you will first decide how much you will use your own money, which is equity. When you don’t have enough money, you will get a mortgage from a bank, which is debt. You could also buy the house together with other people, which is shared equity. How many families share the ownership of houses with others? Yes. Very few. So are firms. By far, most firms have single owners. But it is often difficult for single ownership firms to grow big. And successful single owner firms often have difficulty to split ownership when the founder dies or retires. So most large firms have shared ownership structures.
Three major problems in corporate finance: Investment, Financing and Dividend distribution.
The Investment Principle: The investment principle states simply that firms should invest in assets only when they are expected to earn a return greater than a minimum acceptable return. This minimum return, which we term a hurdle rate, should reflect whether they money is raised from debt or equity, and what returns those investing could have made elsewhere on similar investments.
Comments: We can see that the investment principle is not clean, for hurdle rate is not cleanly defined. It depends on the mix of financing, the next step in decision making. We believe that investment and financing should be considered together from a unified principle. An early attempt is made in a paper on the unified theory of investment and financing.
The Financing Principle: The financing principle posits that the mix of debt and equity chosen to finance investment should maximize the value of the investments made. In the context of the hurdle rate specified in the investment principle, choosing a mix of debt and equity that minimizes this hurdle rate allows the firm to take more new investments and increase the value of existing investments.
Comments: Whose value to maximize? Equity holders? Or equity holders and bond holders? Since firms are mainly controlled by equity owners, firms activities will reflect mainly the interest of equity owners. This means that minimizing hurdle rate, which is a combined rate from costs of equity and debt, will not be the central criteria in financing decision. In Chapter 2 and other chapters, we will have more detailed discussion.
In the literature, “in general, the biggest benefit of
borrowing is the tax advantage that accrues from the fact that interest
payments are tax deductible”. (p. 6) However, in reality, “financial managers
seem to weigh financial flexibility and potential dilution much more heavily
than bankruptcy costs and taxes in their capital structure decisions
(Damodaran, 2001, p. 558).” This is very clear in cases where debt has no tax
deduction. For example, in
“In the balance, debt is beneficial as long as the marginal benefits of borrowing exceed the marginal cost. “ (p. 6) From our discussion, however, it is not very clear what are the benefits and the magnitudes of the benefits of debt financing. So intuition plays an important role in financing decisions.
In reality, firms usually tap internal fund first, then debt. If debt financing causes too high leverage, then equity financing. This is called pecking order in financing.
The Dividend Principle: Firms sometimes cannot find investments that earn their minimum required return or hurdle rate. If this shortfall persists, firms have to return any cash they generate to the owners.
Comments: This is not necessarily the case. Owners of small firms may need to depend on company earning for a living. Even when the rate of return is high, owners have to withdraw part for a living. The same is true for public companies. Even companies with steady growth may distribute dividend, while at the same time borrowing money. The distribution of dividend is the only credible signal to shareholders that the firm is making money. Otherwise, any firm can claim doing well. For example, firms like Enron, Notel often made acquisitions which they claim worth more than they paid. Warren Buffet may not distribute dividend. But he earned this right in a hard way.
Dividend principle can be thought as a natural extension to investment and financing principle. When no investment project with proper financing tools can be found, cash should be distributed.
General comments: The most fundamental difficulty in corporate finance, as well as in most other subjects in social sciences and life sciences, is to evaluate the level of uncertainty in the future. In this course, starting from Chapter 6, we will discuss how this difficulty can be mitigated in various ways. Another important problem is the trade off between flexibility and control, between safety and leverage, as shown in the choice between equity and debt.
p. 7. As a cautionary tale, consider the fact that savings
and loans in the
Comments: All banking institutions used short-term debt to finance long-term assets. Their risk taking is also their source of profit. That is why banks are explicitly or implicated guaranteed by governments. The source of S&L crisis is the legislative changes aimed to bail out S&L industry when interest rates skyrocketing, rendering their assets worth less than the liabilities. These legislative changes created the opportunities of short term profits for many businesspeople, which sow the seeds of later crisis. The Asian financial crisis was caused by IMF practice to protect large international lenders by guarantee their loans. The reduced risk caused interests on dollar denominated loans much lower than interests on local currencies, which forced local companies to borrow dollar denominated loans. More detailed analysis can be found from my paper: Credit Distortion and Financial Crisis. In essence, most systematic deviations from common sense are caused by systematic distortion from above. Patterns in financial markets often reflect the interactions of human beings and the structures of human institutions.
The objective of the Firm:
“The objective in conventional corporate finance theory is to maximize the value of the firm. … As we will see in the next chapter, this objective of firm value maximization is often narrowed further, in practice, to maximizing stockholder value and still further to maximizing the stock price. “ (p. 8)
Comments: If we take this narrow perspective, it will be very difficult to understand many phenomena in firms. For example, why a cleaner in Canfor earns much more than a cleaner in McDonald. We will discuss more in the next chapter.
Life cycle of firms
and human beings:
There are three basic principles in corporate finance: the investment principle, the financing principle and the dividend principle. We will discuss human life from these three principles.
A young firm often tries different kinds of businesses before settle on one. Similarly, a small child often tries different things. One year, she may learn skating, next year, skiing, then, soccer, swimming and many other things. You may find your favorite sport eventually and stick to one or several you do best. When a firm is young, it may try out many different things before settling down on one or several main businesses. When a firm is young, a lot of investments are needed. When a firm matures, little investment is needed. It turns into a cash cow. Similarly, when a person is young, she needs to attend school and receive a lot of different trainings. When she is at a mature age, she takes very little training but earns a high income.
The ability to learn new things changes with age, both with humans and with firms. A child can pick up a new language easily. An adult almost impossible. A child can learn new skills, such as skating, with great ease. For an adult, it often takes great courage to step on ice for the first time. The same is with firms. Young firms can change direction very easily. But established firms can rarely invest in new types of business with ease. This is because small fixed cost systems are more flexible than high fixed cost systems.
A firm can be financed by either equity or debt. A small child is mainly financed by her parents, that is, financed by equities. When she grows up and earns an income, she has more abilities to get debt financing. For example, she can apply a mortgage or obtain a credit card easily if she has steady income. When she gets older, she may have paid off her mortgages and other debts. At this stage, she mainly finances her activities with her own internally generated funds, that is, her own incomes. You will find similar financing patterns for firms. It is almost impossible to get debt financing for start up firms. They generally are funded by owners’ own money, or equities. When a firm generates more steady income and accumulate tangible and intangible assets, they can get debt financing easier to expand. At mature stage, firms rarely need external financing. Internally generated funds are often more than enough to cover investment needs.
A firm’s value is total sum of dividends discounted over time. A small child apparently doesn’t pay out dividend, just like a young firm rarely pays out much dividend. When a person grows up, her ability to help others grows. The most substantial dividend for a person must be her children. If we look at patterns of child bearing over the years, the ages that people start to have children become older and older. This pattern is similarly reflected in corporate dividend payouts. The time that a firm starts to pay out dividend has increased over time and the payout ratio has declined over time because the cost of investment has increased over time. Similarly, people start to have children later because of the longer years of school education and longer period of training in works. Is it a good trend? Canadian birthrate has dropped to 1.5 per woman, which is unsustainable. The high tech firms, which pay out scanty dividends, have dropped sharply in their value since 2000. In general, higher dividend growth is equal to high earning growth (Arnott and Asness, 2003). In any business, common sense is our most important asset. By offering a unified understanding of human life and corporate life, we can extend our everyday experiences directly to financial matters.
The main reason we adopt this textbook is that it provides a Life Cycle Theory in understanding corporate finance. The other reason is that it provides a real company approach systematically.
Reference
Arnott, R. and Asness, C. (2003). Surprise! Higher Dividends = Higher Earnings Growth, Financial Analyst Journal, 59, No. 1, 70-87.
The structure of the
course:
Corporate finance theory will be covered in three courses in second, third and fourth year respectively. In this first course on corporate finance, we will cover three topics.
General Background about Teaching in
Finance
The rapid advance of internet technology brings extraordinary changes to the ways of teaching. Authors can reach out to students directly in many aspects. The use of spreadsheets makes the solutions of many problems self evident. Students also gain access to much of a top teacher in the world can offer. The use of spreadsheets makes the learning process much more individualized. All these make the traditional style lecturing less necessary.
The advance of technology allows instructors to devote more time to deep analysis. In this course we will show that the science of finance is still in a fast evolving state and revolutionary changes will bring us much deeper and simpler understanding about the business world.
General Background about Research in
Finance
Some theories, originated from a
very technical area, because of their deep insight and analytical power, become
the foundation of much broader fields. Modern astronomy, founded by Copernicus,
Kepler,
In this notes, we will examine the parallels between finance and astronomy to understand why the progress in financial research will revolutionize the whole foundation of social science.
We will discuss several common properties of finance and astronomy that make them the pioneer subjects that trigger much deeper changes in the foundation of sciences.
First, both the study of astronomy and finance are heavily data driven. Astronomy is the oldest precise science. Data of celestial observation have been accumulated over thousand of years. As observation became more accurate over time, it became easier to test alternative theories. Financial data are the most frequently and abundantly recorded data set. For each stock, each transaction price, bid-ask price, the size of the trade, and many other information are recorded on computerized systems. The abundance of real time financial data makes financial theories much easier to test than economic theories, since economic data are less frequent, less reliable and often subject to different interpretation.
The second is the simplicity of astronomy and finance. Astronomy, which Wiener termed as “an ideally simple science”, studied the orbits of isolated planets with little disturbance from other sources. Finance studies cash flows under uncertainty or price innovation of market securities, abstracted from all the intrigues of social and organizational complexities. Although many complicated forces are at work in the financial market, the low transaction costs determines that prices alone already reflect most of the interaction of these forces.
The simplicity of astronomy and finance makes the alternative theories easy to test. In astronomy, two alternative theories at the time were the earth centered universe and the sun centered universe. As the data became very accurate and sophisticated mathematical tools were developed, the alternative theories became easy to test. In finance, the default theories are the irrelevance of financial structure in corporate finance and efficient market theory in investment. Both theories are empirically testable. This is in sharp contrast to the general economic theory, where utility function can be defined in many different ways. It is difficult to test whether economic agents maximize “utility” because it cannot be precisely defined.
Third,
it is usually in simple subjects where sophisticated mathematical theories are
developed and applied with great effectiveness. Calculus was invented by
Fourth, both astronomy and finance are of immense practical value. A new theory doesn’t grow from vacuum. Before a new theory germinates, there always exists an established paradigm in any area of research. Before Copernican theory, theology was the foundation of the cosmology. Currently, general equilibrium theory is the foundation of economics and finance. Given the dominant status of theology then and the neoclassical economics today, why Copernican theory in astronomy and new theories in finance, such as behavioral finance, got established. This is because both astronomy in Copernicus’ day and finance today have tremendous practical values. People tend to neglect the ideological differences on issues of practical values. For example, in general economic theory, dissident opinions rarely surface in major economic journals, although the problems of neoclassical economics are apparent to many people. In finance, however, papers on alternative theories, such as behavioral finance, have already occupied top tier finance journals for a long time.
Fifth,
both astronomy and finance were pure mathematical theories initially but
gradually turned to physics. Astronomy was a part of mathematical science in
the ancient time. But starting from Kepler, people looked for physical causes
to offer a unified understanding of celestial movements. Eventually,
The simplicity of research subjects, the objectivity of research methodologies and powerful mathematics enabled the researchers in astronomy to break into the dominant paradigms of the time: the earth centered universe. In the process, a physical theory, rational mechanics, was developed to understand much broader phenomena. Since then, rational mechanics has become the dominant paradigm in natural science and social science. These same qualities in financial research help us establish a new paradigm: the analytical thermodynamic theory in social science and life science.