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Introduction to Corporate Finance

Aswath Damodaran

Stern School of Business

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What is corporate finance?

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.

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The Three Major Decisions in Corporate Finance

The Allocation decision• Where do you invest the scarce resources of your business?

• What makes for a good investment? The Financing decision

• Where do you raise the funds for these investments?

• Generically, what mix of owner’s money (equity) or borrowed money(debt) do you use?

The Dividend Decision• How much of a firm’s funds should be reinvested in the business and how

much should be returned to the owners?

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The Traditional Accounting Balance Sheet

AssetsLiabilitiesFixed AssetsDebtEquityShort-term liabilities of the firmIntangible AssetsLong Lived Real AssetsAssets which are not physical,like patents & trademarksCurrent AssetsFinancial InvestmentsInvestments in securities &assets of other firmsShort-lived AssetsEquity investment in firmDebt obligations of firmCurrent LiabiltiesOther LiabilitiesOther long-term obligationsThe Balance Sheet

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The Financial View of the Firm

AssetsLiabilitiesAssets in PlaceDebtEquityFixed Claim on cash flowsLittle or No role in managementFixed MaturityTax Deductible

Residual Claim on cash flowsSignificant Role in managementPerpetual Lives

Growth AssetsExisting InvestmentsGenerate cashflows todayIncludes long lived (fixed) and

short-lived(working capital) assets

Expected Value that will be created by future investments

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First Principles of Corporate Finance

Invest in projects that yield a return greater than the minimum acceptable hurdle rate.

• The hurdle rate should be higher for riskier projects and reflect the financing mix used - owners’ funds (equity) or borrowed money (debt)

• Returns on projects should be measured based on cash flows generated and the timing of these cash flows; they should also consider both positive and negative side effects of these projects.

Choose a financing mix that minimizes the hurdle rate and matches the assets being financed.

If there are not enough investments that earn the hurdle rate, return the cash to stockholders.

• The form of returns - dividends and stock buybacks - will depend upon the stockholders’ characteristics.

Objective: Maximize the Value of the Firm