Intro to Finance: Introduction to Finance - Goal of the, Firm Shareholder Wealth Maximization vs. Profit Maximization Stakeholder Theory

What This Is

The goal of the firm is a fundamental concept in finance that determines how a company should make decisions to maximize its value. The two main theories are Shareholder Wealth Maximization (SWM) and Stakeholder Theory. SWM focuses on maximizing the value of the firm for its shareholders, while Stakeholder Theory considers the interests of all stakeholders, including employees, customers, and the environment. For example, Apple's goal is to maximize shareholder wealth by increasing its stock price and dividend payments.

Key Formulas & Symbols

• SWM = Max (PV of future cash flows) where PV = present value, r = discount rate, and cash flows are expected to be received in the future.
• WACC = (E/V x Re) + (D/V x Rd x (1 - T)) where E = market value of equity, D = market value of debt, V = total market value, Re = cost of equity, Rd = cost of debt, and T = tax rate.
• Cost of Equity = Rf +-× (Rm - Rf) where Rf = risk-free rate,-= beta of the stock, Rm = market return, and Rf is the risk-free rate.
• Cost of Debt = (1 - T) × Rd where Rd = cost of debt, T = tax rate, and Rd is the cost of debt.
• Market Value of Equity = Number of shares × Current stock price.
• Market Value of Debt = Face value of debt × (1 + coupon rate).
• Stakeholder Theory = Max (Utility of all stakeholders) where utility is a measure of satisfaction or happiness.

Step-by-Step Calculation

1. Calculate the cost of equity using the CAPM formula: Cost of Equity = Rf +-× (Rm - Rf).
2. Calculate the cost of debt using the formula: Cost of Debt = (1 - T) × Rd.
3. Calculate the weighted average cost of capital (WACC) using the formula: WACC = (E/V x Re) + (D/V x Rd x (1 - T)).
4. Calculate the present value of future cash flows using the formula: PV = FV / (1 + r)^n.
5. Calculate the free cash flow to the firm (FCFF) using the formula: FCFF = EBIT - (CapEx + ?NWC).
6. Calculate the terminal value of the firm using the formula: TV = FCFF / (WACC - g).

Common Mistakes

• Mistake: Using book value instead of market value for WACC.
• Correction: Use market value of equity and debt to calculate WACC, as it reflects the current market value of the firm's capital structure.
• Mistake: Confusing IRR and NPV ranking.
• Correction: IRR is the rate of return that makes NPV equal to zero, while NPV is the present value of future cash flows.
• Mistake: Ignoring taxes when calculating WACC.
• Correction: Include the tax rate when calculating WACC to reflect the tax benefits of debt.

Exam / CFA Tips

• Tip: Be careful with question wording, as it may imply a specific approach or formula.
• Tip: Use the CAPM to estimate the cost of equity, as it is a widely accepted and reliable method.
• Tip: Make sure to include taxes when calculating WACC, as it can have a significant impact on the result.

Quick Practice Problem

Apple's current stock price is $150, and it has 5 million shares outstanding. The risk-free rate is 2%, and the market return is 8%. The beta of Apple's stock is 1.2. What is the cost of equity for Apple?

Answer: 10.4% (Rf +-× (Rm - Rf) = 2% + 1.2 × (8% - 2%) = 10.4%)

Last-Minute Cram Sheet

• The dividend discount model (DDM) requires g < r – otherwise the model explodes.
• WACC = (E/V x Re) + (D/V x Rd x (1 - T)).
• Cost of Equity = Rf +-× (Rm - Rf).
• Cost of Debt = (1 - T) × Rd.
• Market Value of Equity = Number of shares × Current stock price.
• Market Value of Debt = Face value of debt × (1 + coupon rate).
• Stakeholder Theory = Max (Utility of all stakeholders).
• FCFF = EBIT - (CapEx + ?NWC).
• TV = FCFF / (WACC - g).
• The weighted average cost of capital (WACC) is a weighted average of the cost of equity and debt.
• The cost of equity is a function of the risk-free rate, beta, and market return.