Corporate Finance Three Principles

Back in 2009 when I was preparing for the Chartered Financial Analyst (CFA) exam Level II, one of my studymates introduced me to the website of Aswath Damodaran. Damodaran is a Finance professor at Stern School of Business at New York University, who teaches Corporate Finance, Valuation, and Portfolio Management. This website was very resourceful when I was learning financial modeling.

Recently I revisited the website and learned that the website not only offered financial modeling tutorial, but also concepts for Corporate Finance. I like Professor Damodaran's perspective of Corporate Finance principles in this audio, and I summarized the content as below:

In order to maximize the value of the business, all of Corporate Finance is built on three principles:

1. The Investment Principle: determines where businesses invest their resources - invest in assets and projects that yield a return greater than the minimum acceptable hurdle rate. The hurdle rate should be higher for risky project. This includes assets or projects that will either generate more revenue, or cut down costs. This basically covers the whole "Assets" section on the balance sheet, such as decisions about how much and what inventory to maintain and whether and how much credit to grant to customers. This also includes which markets to enter and acquisitions of other companies. There might be regulatory and other real-world constraints on the financing mix that a business can use.

2. The Financing Principle: Choose a financing mix (debt and equity) that maximizes the value of the investments made and match the financing to nature of the assets being financed. That is, we want to pick a financing mix that minimize the hurdle rate. With a public-traded company, debt may take the form of bonds and equity is usually common stock. In a private business, debt is more likely to be bank loans and an owner's savings represents equity. Have outlined the optimal financing mix, we turn our attention to the type of financing a business should use, such as whether it should be long-term or short-term, whether the payments on the financing should be fixed or variable, and if variable, what it should be a function of. Using a basic proposition that a firm will minimize its risk from financing and maximize its capacity to use borrowed funds if it can match up the cash flows on the debt to the cash flows on the assets being finance, we design the perfect financing instrument for a company. We then add additional considerations relating to taxes and external monitors (equity research analysts and rating agencies) and arrive at strong conclusions about the design of the financing.

3. The Dividend Principle: How much earnings should be reinvested back into the business and how much should be returned to the owners of the business -If there are not enough investments that earn the hurdle rate, return the cash to the owners of the business.

Ultimate Objective: Maximize the value of the business. Consequently, any decision (investment, financing, or dividend) that increases the value of a business is considered a good one, and vice versa. The value of a company is the present value of its expected cash flows, discounted back at a rate that reflects both the riskiness of the projects of the company and the financing mix used to finance them.


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