Introductory Corporate Finance: Introduction to Corporate Finance - Goal of the, Firm Shareholder Wealth Maximization Profit Maximization vs. SWM&Agency Problem Agency Costs Mechanisms to Reduce Agency Costs

What This Is

The goal of the firm is to maximize shareholder wealth, which is achieved by maximizing the present value of expected future cash flows. This concept is crucial in corporate finance as it guides decision-making and resource allocation within the firm. For instance, consider Tesla, a company with a market capitalization of $1 trillion. If Tesla's management prioritizes shareholder wealth maximization, they would focus on increasing the present value of expected future cash flows by investing in projects with high expected returns, reducing costs, and optimizing capital structure.

Key Formulas & Models

• WACC = wd × rd(1?T) + wps × rps + we × re – weighted average cost of capital; used as discount rate.
  • wd: proportion of debt in capital structure
  • rd: cost of debt
  • T: corporate tax rate
  • wps: proportion of preferred stock in capital structure
  • rps: cost of preferred stock
  • we: proportion of equity in capital structure
  • re: cost of equity
• Sustainable Growth Rate = ROE × (1 - Retention Ratio) – measures the maximum rate of growth a firm can sustain.
  • ROE: return on equity
  • Retention Ratio: proportion of earnings retained within the firm
• Dividend Payout Ratio = DPS / EPS – measures the proportion of earnings distributed to shareholders.
  • DPS: dividend per share
  • EPS: earnings per share
• Free Cash Flow = EBIT - (Capital Expenditures + Change in Working Capital) – measures the cash generated by a firm's operations.
  • EBIT: earnings before interest and taxes
  • Capital Expenditures: investments in property, plant, and equipment
  • Change in Working Capital: changes in accounts receivable, inventory, and accounts payable
• Degree of Operating Leverage (DOL) = Q(P-V) / (Q(P-V)-F) – measures the sensitivity of EBIT to sales.
  • Q: quantity sold
  • P: price per unit
  • V: variable costs per unit
  • F: fixed costs
• Agency Problem = U(?) - U(?') – measures the difference between the manager's and shareholder's utility functions.
  • U(?): utility function of the manager
  • U(?'): utility function of the shareholder
• Agency Costs = (U(?) - U(?')) × (? - ?') – measures the costs associated with the agency problem.
  • ?: profit of the firm
  • ?': profit of the firm without the agency problem

Step-by-Step Calculation

1. Calculate the weighted average cost of capital (WACC) using the formula WACC = wd × rd(1?T) + wps × rps + we × re.
2. Determine the sustainable growth rate using the formula Sustainable Growth Rate = ROE × (1 - Retention Ratio).
3. Calculate the dividend payout ratio using the formula Dividend Payout Ratio = DPS / EPS.
4. Compute the free cash flow using the formula Free Cash Flow = EBIT - (Capital Expenditures + Change in Working Capital).
5. Measure the degree of operating leverage (DOL) using the formula DOL = Q(P-V) / (Q(P-V)-F).

Common Mistakes

1. Mistake: Using book value instead of market value for WACC.
   • Correction: Use market value for WACC as it reflects the current market price of the firm's securities.
2. Mistake: Ignoring flotation costs when calculating WACC.
   • Correction: Include flotation costs in the WACC calculation to reflect the true cost of capital.
3. Mistake: Confusing sunk cost with opportunity cost.
   • Correction: Distinguish between sunk costs (irrecoverable costs) and opportunity costs (foregone benefits).

Exam / CFA Tips

1. Tip: Be able to distinguish between M&M Proposition I (no taxes) and M&M Proposition II (with taxes).
2. Tip: Understand the difference between IRR and NPV ranking.
3. Tip: Recognize the distinction between dividend irrelevance and bird-in-hand.

Quick Practice Problem

A company has EBIT of $10M, interest $2M, tax 25% – compute DFL (Degree of Financial Leverage).

Answer: DFL = 5

Explanation: DFL = (EBIT / (EBIT - Interest)) = ($10M / ($10M - $2M)) = 5

Last-Minute Cram Sheet

1. WACC = wd × rd(1?T) + wps × rps + we × re – weighted average cost of capital.
2. In M&M Proposition I (no taxes), firm value is independent of capital structure – but with taxes, value increases with debt due to the interest tax shield.
3. Sustainable Growth Rate = ROE × (1 - Retention Ratio) – measures the maximum rate of growth a firm can sustain.
4. Dividend Payout Ratio = DPS / EPS – measures the proportion of earnings distributed to shareholders.
5. Free Cash Flow = EBIT - (Capital Expenditures + Change in Working Capital) – measures the cash generated by a firm's operations.
6. Degree of Operating Leverage (DOL) = Q(P-V) / (Q(P-V)-F) – measures the sensitivity of EBIT to sales.
7. Agency Problem = U(?) - U(?') – measures the difference between the manager's and shareholder's utility functions.
8. Agency Costs = (U(?) - U(?')) × (? - ?') – measures the costs associated with the agency problem.
9. Sunk cost is irrecoverable, while opportunity cost is the foregone benefit.
10. DFL = (EBIT / (EBIT - Interest)) – measures the sensitivity of EBIT to interest rates.