5/17/2015 Chapter2Derivations

http://pages.stern.nyu.edu/~adamodar/New_Home_Page/AppldCF/derivn/ch2deriv.html#ch2.1 1/2

DiscussionIssuesandDerivations

1. Whatisthedifferencebetweenstockpricemaximization,firmvaluemaximizationandstockholderwealthmaximization?Stockpricemaximizationisthemostrestrictiveofthethreeobjectivefunctions.Itrequiresthatmanagerstakedecisionsthatmaximizestockholderwealth,thatbondholdersbefullyprotectedfromexpropriation,thatmarketsbeefficientandthatsocialcostsbenegligible.Stockholderwealthmaximizationisslightlylessrestrictive,sinceitdoesnotrequirethatmarketsbeefficient.Firmvaluemaxmizationistheleastrestrictive,sinceitdoesnotrequirethatbondholdersbeprotectedfromexpropriation.Thus,whenwemaketheargumentthatanactionbyafirm(suchasinvestingorfinancing)increasesfirmvalue,thisincreaseinfirmvaluewillnecessarilytranslateintoincreasingstockholderwealthandstockpriceonlyifthemorerestrictiveassumptionshold.Conversely,anactionthatincreasesthestockpriceinaworldwherethelessrestrictiveassumptionsdonothold,maynotnecessarilyincreasefirmvalue.

2. Whatistheobjectivefunctionincorporatefinanceforaprivatefirm?Theobjectiveofmaximizingstockpricesisarelevantobjectiveonlyforfirmswhicharepubliclytraded.How,then,cancorporatefinanceprinciplesbeadaptedforprivatefirms?Forfirmswhicharenotpubliclytraded,theobjectiveindecisionmakingisthemaximizationoffirmvalue.Theinvestment,financinganddividendprincipleswewilldevelopinthechapterstocomeapplyforbothpubliclytradedfirms,whichfocusonstockprices,andprivatebusinesses,thatmaximizefirmvalue.Sincefirmvalueisnotobservableandhastobeestimated,whatprivatebusinesseswilllackisthefeedback,sometimesunwelcome,thatpubliclytradedfirmsgetwhentheymakemajordecisions.

3. Whatistheobjectivefunctionforanonprofitorganization?Itismuchmoredifficulttoadaptcorporatefinanceprinciplestonotforprofitorganizations,sincetheirobjectiveisoftentodeliveraserviceinthemostefficientwaypossible,ratherthantomakeprofits.Theobjectivethereforehastobestatedintermsofcostefficiency.Forinstance,theobjectiveofapublicschoolsystemmightbetodeliveraqualityeducation(definedintermsofaskillsetthateverygraduateshouldhave)atthelowestcost.Thisdoesmean,however,thattheskillsethastobebothspecificallydefinedandmeasurable.

4. Aremarketsshortterm?TherearemanywhobelievethatstockpricemaximizationleadstoashorttermfocusformanagerseeforinstanceMichaelPortersbookoncompetitivestrategy.Thereasoninggoesasfollows:Stockpricesaredeterminedbytraders,shortterminvestorsandanalysts,allofwhomholdthestockforshortperiodsandspendtheirtimetryingtoforecastnextquarter'searnings.Managerswhoconcentrateoncreatinglongtermvalue,ratherthanshorttermresults,willbepenalizedbymarkets.Mostoftheempiricalevidencethatexistssuggeststhatmarketsaremuchmorelongtermthantheyaregivencreditfor:(1)Therearehundredsoffirms,especiallysmallandstartupfirms,whichdonothaveanycurrentearningsandcashflows,donotexpecttohaveanyinthenearfuture,butwhicharestillabletoraisesubstantialamountsofmoneyonthebasisofexpectationsofsuccessinthefuture.Ifmarketswereinfactasshorttermasthecriticssuggest,thesefirmsshouldbeunabletoraisefundsinthefirstplace.(2)Iftheevidencesuggestsanything,itisthatmarketsdonotvaluecurrentearningsandcashflowsenoughandvaluefutureearningsandcashflowstoomuch.Studiesindicatethatstockswithlowpriceearningsratios,i.e.,highcurrentearnings,havegenerallybeenunderpricedrelativetostockswithhighpriceearningsratios.(3)Themarketresponsetoresearchanddevelopmentandinvestmentexpenditureisnotuniformlynegative,asthe'shortterm'criticswouldleadyoutobelieve.Instead,theresponseistempered,withstockprices,onaverage,risingontheannouncementofR&Dandcapitalexpenditures.

5/17/2015 Chapter2Derivations

http://pages.stern.nyu.edu/~adamodar/New_Home_Page/AppldCF/derivn/ch2deriv.html#ch2.1 2/2

5. WhatistheGerman/Japanesealternativetostockholderwealthmaximizationanddoesitwork?IntheGermanandJapanesesystemsofcorporategovernance,firmsownstakesinotherfirms,andoftenmakedecisionswhichareinthebestinterestsoftheindustrialgrouptheybelongto,ratherthanintheirownbestinterests.Inthissystem,theargumentgoes,firmswillkeepaneyeoneachother,ratherthancedingpowertothestockholders.Inadditiontobeingundemocraticthestockholdersareafteralltheownersofthefirm,itsuggestsaprofoundsuspicionofhowstockholdersmightusethepoweriftheygetitandisheavilyskewedtowardsmaintainingthepowerofincumbentmanagers.Whilethisapproachmayprotectthesystemagainstthewastethatisabyproductofstockholderactivismandinefficientmarkets,ithasitsowndisadvantages.Industrialgroupsareinherentlymoreconservativethaninvestorsinallocatingresources,andthusaremuchlesslikelytofinancehighriskandventurecapitalinvestmentsbyupstartswhodonotbelongtothegroup.Theotherproblemisthatentiregroupscanbedraggeddownbyindividualfirmsthathaverunintotrouble.