CORPORATE FINANCE:
Theory and Practice

ASWATH DAMODARAN


STERN SCHOOL OF BUSINESS
NEW YORK UNIVERSITY
ISBN: 0-471-07680-5, 876 Pages, Cloth
Copyright 1997

PREFACE

Corporate finance covers any decisions made by firms that have financial implications. Thus, there is a corporate financial aspect to almost every action taken by a firm, no matter what functional area claims responsibility for it. There are three basic questions that corporate finance attempts to answer ñ

The value of the firm reflects its success in each of these areas. Firms which allocate resources to ìgoodî projects, finance them with the ìappropriate mixî of debt and equity and reinvest the ìright amountî back into operations will have higher value than firms that fail on any or all of these criteria. Notice that there is nothing in this description that presupposes that firms are large or publicly traded, or that financial markets function efficiently. While these characteristics may make the job of corporate financial analysis easier, the fundamental principles of corporate finance should apply for all firms ñ small and larger, private and public, domestic and foreign.

There is only one way to learn corporate finance well, and that is by analyzing real companies with real problems. Consequently, we will use extended applications with two companies - the Home Depot and Boeing - to illustrate principles all through this book. We will also use other companies selectively through the book to illustrate specific problems. The applications developed here are not mere addendum to models, but are an integral part of explaining and developing them.

In keeping with the encompassing definition of corporate finance given above, this book is designed for a wide audience. Obviously, it will be most useful for those who plan to make a living in corporate finance, whether at corporations, investment banks or management consulting firms. At the same time, those in other areas of business, be it marketing, production or organizational behavior, should find the tools and principles developed here of use in their chosen fields. Finally, there are several parts of this book that would be useful to small business owners and entrepreneurs, looking for ways to improve their understanding of the financial aspects of their businesses.

There is a wide range of books on corporate finance. First, there are the 'nuts and bolts' books, essentially focusing on working through problems and exercises. They eschew raising provocative questions, provide closure on complicated questions and provide the reader with a sense of being in control of the topic. Next, there are the 'big picture' books that provide readers with the state of the art in corporate finance and a tantalizing vision of things to come. Finally, there are the ìpractitionerî books that focus on corporate financial tools and techniques, and pay little attention to the underlying theory. This book is my attempt to find common ground between theory, applications and examples, and to provide a guide for those who not only want to practice corporate finance, but to understand it well enough to develop their own models as they move along.

I believe that this bookís primary strength is its focus on applying complex theory to real firms, while minimizing the compromises that inevitably have to be made in the process. I have also tried to maintain a balance between immersing readers in the details of corporate financial analysis ñ the tools and techniques that are used on a day to day basis ñ and the big picture of corporate finance that allows them to see how these tools and techniques fit together and what the common principles are that apply across all of them.

The genesis for this book lay in the class room, and it has been shaped by the reactions and responses of students to examples that I have used in my lectures. The ideas were also tested out on instructor focus groups to examine whether they worked for others, and to fill in gaps in the material that were viewed as important. In order to ensure the accuracy of the examples, problems and extended applications that run through this book, two technical proofreaders proofed the manuscript for errors.

This book has six parts to it. The first part provides an introduction to corporate finance, starting with the description of corporate finance in chapter 1, and extending to a discussion in chapter 2 of the objective of maximizing stockholder wealth that provides the basis for much of modern corporate finance. The next four chapters provide the basic tools that corporate finance draws upon ñ present value principles and formulae in chapter 3, basic accounting principles and financial statement analysis in chapter 4, and models for measuring and rewarding risk in chapters 5 and 6.

The second part of the book looks at the investment decision. In chapter 7, we introduce the basic decision rules available, some based on accounting income and some on cash flows, and examine their strengths and weaknesses. In chapter 8, we consider the process of estimating cash flows in a project. In chapter 9, we examine the effects of having limited access to capital on project choice, as well as ways of choosing among mutually exclusive projects. In chapters 10 and 11, we present ways of dealing with uncertainty in investment analysis, and in chapter 12, we explore the capital budgeting process itself by looking at what makes projects have positive net present values and ways of following up on projects, after they have been chosen. In chapter 13, we consider a special category of investment analysis ññ leasing ññ and examine the issues that are specific to it. Finally, in chapter 14, we consider an important aspect of investment analysis by looking at investments in working capital.

The third section of the book looks at the financing decision. In chapter 15, we consider the financing choices that firms have in raising funds in both private and public markets. In chapter 16, we evaluate some lessons that can be learnt from studies of market efficiency by firms considering what types of financing to use and when to use them. In chapter 17, we establish the basic tradeoff on the use of debt - the tax benefits and discipline that debt creates on the one hand against the bankruptcy risk and loss of flexibility that may flow from using too much debt. We also examine the specific conditions under which debt is irrelevant. In chapter 18, we introduce several practical approaches that can be used to determine the optimal debt ratio for a firm, and consider their limitations. In chapter 19, we provide a framework for determining the right kind of financing for a firm - short term or long term, fixed rate or floating rate ñ based upon its asset mix.

The fourth section of the book examines the decision on how much and how to return cash to the owners of the business. In chapter 20, we examine the most common approach for returning cash to stockholders, which is cash dividends and examine the issues that have to be weighed in deciding how much to pay in dividends. In chapter 21, we develop a framework for analyzing a firmís cash flows and coming up with the appropriate amount to return to its stockholders. Finally, in chapter 22, we expand our discussion to examine whether the cash should be returned in the form of dividends, equity repurchases or forward contracts to buy back stock.

The fifth section of the book, links the investment, financing and dividend decisions to the value of the firm. Chapter 23 provides an introduction to discounted cash flow models for value and relative valuation models (such as multiples) and the reasons for the differences between the two approaches. Chapter 24 extends this discussion to look at corporate restructuring effects on value, and value enhancement strategies being adopted by many firms. Chapter 25 discusses the special issues relating to valuing mergers, including the value of control and synergy.

The final section looks at a diverse set of topics. Chapter 26 looks at the additional issues, such as currency and political risk, that arise as a consequence of investing in foreign markets. Chapters 27 and 28 develop the basics of option pricing and applications of option pricing models in corporate finance, including the options to expand and delay projects in investment analysis and the value of flexibility in financing decisions. Chapter 29 examines whether and how firms should manage risk, and chapter 30 expands on the use of corporate financial models for small and private companies.

Each chapter begins with an opener that describes the issues that will be examined in it and goes on to first develop the theory before moving on to in practice applications to a few companies that are used repeated through the book (Home Depot and Boeing). Important concepts, principles and equations are highlighted and a key terms are defined in a running glossary through the book. Each chapter ends with a conclusion that summarizes the key lessons from the chapter. In keeping with the view that corporate finance can be learnt only by doing, there are exercises at the end of each chapter that range from short concept questions to extended problems. The solutions to the odd numbered questions are provided at the end of the book.

It is my hope that the extended examples in this book will induce readers to try out the theory on other companies. By doing so, they will not only understand the limitations of the theory better, but also learn how to adapt it for use in the real world. To make this process easier, there is a accompanying diskette containing spreadsheets that were used to generate the applications in this book. Readers should be able to use these spreadsheets to analyze a project, examine the optimal debt ratio for a firm, estimate how much cash it has available to pay out to stockholders and value the firm.

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