Introductory Corporate Finance: Introduction to Corporate Finance - Stakeholder Theory

What This Is

Stakeholder Theory is a management approach that emphasizes the importance of considering the interests of all stakeholders, including shareholders, employees, customers, suppliers, and the community, in addition to maximizing shareholder value. This theory is crucial in corporate finance as it helps companies make decisions that balance competing interests and create long-term value. For example, consider Tesla's decision to invest in renewable energy and electric vehicles, which not only benefits shareholders but also contributes to a sustainable future and enhances the company's reputation.

Key Formulas & Models

• WACC = wd × rd(1?T) + wps × rps + we × re – weighted average cost of capital; used as discount rate.
  • wd: weight of debt
  • rd: cost of debt
  • T: tax rate
  • wps: weight of preferred stock
  • rps: cost of preferred stock
  • we: weight of equity
  • re: cost of equity
• ROE = Net Income / Total Equity – return on equity; measures profitability.
  • Net Income: earnings after taxes and interest
  • Total Equity: shareholders' equity
• DFL = EBIT / (1 - T) – debt-free leverage; measures EBIT sensitivity to sales.
  • EBIT: earnings before interest and taxes
  • T: tax rate
• DOL = Q(P-V) / (Q(P-V)-F) – degree of operating leverage; measures EBIT sensitivity to sales.
  • Q: quantity sold
  • P: price per unit
  • V: variable costs per unit
  • F: fixed costs
• Sustainable Growth Rate = ROE × (1 - Retention Ratio) – measures a company's ability to sustain growth.
  • ROE: return on equity
  • Retention Ratio: percentage of earnings retained by the company
• FCF = EBIT + Depreciation - Capital Expenditures - Change in Working Capital – free cash flow; measures a company's ability to generate cash.
  • EBIT: earnings before interest and taxes
  • Depreciation: non-cash expense
  • Capital Expenditures: investments in assets
  • Change in Working Capital: changes in accounts receivable, inventory, etc.
• WACC = (E/V) × Re + (D/V) × Rd × (1 - T) – weighted average cost of capital; used as discount rate.
  • E: market value of equity
  • V: total market value
  • Re: cost of equity
  • D: market value of debt
  • Rd: cost of debt
  • T: tax rate

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 return on equity (ROE) using the formula ROE = Net Income / Total Equity.
3. Calculate the debt-free leverage (DFL) using the formula DFL = EBIT / (1 - T).
4. Measure the degree of operating leverage (DOL) using the formula DOL = Q(P-V) / (Q(P-V)-F).
5. Compute the sustainable growth rate using the formula Sustainable Growth Rate = ROE × (1 - Retention Ratio).
6. Calculate the free cash flow (FCF) using the formula FCF = EBIT + Depreciation - Capital Expenditures - Change in Working Capital.

Common Mistakes

• Mistake: Using book value instead of market value for WACC.
  • Correction: Use market value to reflect the current market price of equity and debt.
  • Counterexample: Assume a company has a book value of $100 million and a market value of $150 million. Using book value would result in an incorrect WACC.
• Mistake: Ignoring flotation costs when calculating WACC.
  • Correction: Include flotation costs to reflect the actual cost of issuing new debt or equity.
  • Counterexample: Assume a company issues new debt with a flotation cost of 2%. Ignoring this cost would result in an incorrect WACC.
• Mistake: Confusing sunk cost with opportunity cost.
  • Correction: Sunk costs are costs that have already been incurred and cannot be changed, while opportunity costs are the benefits that could have been obtained from alternative uses of resources.
  • Counterexample: Assume a company invested $100 million in a project that is no longer viable. The sunk cost is $100 million, but the opportunity cost is the potential benefit of investing in an alternative project.

Exam / CFA Tips

• Tip: Be able to distinguish between M&M Proposition I (no taxes) and M&M Proposition II (with taxes).
  • Why: M&M Proposition I states that firm value is independent of capital structure, while M&M Proposition II states that firm value increases with debt due to the interest tax shield.
• Tip: Understand the difference between IRR and NPV ranking.
  • Why: IRR ranking prioritizes projects with higher internal rates of return, while NPV ranking prioritizes projects with higher net present values.
• Tip: Be able to explain the dividend irrelevance theorem.
  • Why: The dividend irrelevance theorem states that the value of a firm is independent of its dividend policy, as long as the firm maintains a stable dividend payout ratio.

Quick Practice Problem

A company has EBIT of $10 million, interest of $2 million, and a tax rate of 25%. Compute the debt-free leverage (DFL).

Answer: DFL = $10 million / (1 - 0.25) = $13.33 million

Explanation: The debt-free leverage measures the company's EBIT sensitivity to sales, and is calculated by dividing EBIT by (1 - tax rate).

Last-Minute Cram Sheet

• WACC = wd × rd(1?T) + wps × rps + we × re – weighted average cost of capital
• ROE = Net Income / Total Equity – return on equity
• DFL = EBIT / (1 - T) – debt-free leverage
• DOL = Q(P-V) / (Q(P-V)-F) – degree of operating leverage
• Sustainable Growth Rate = ROE × (1 - Retention Ratio) – measures a company's ability to sustain growth
• FCF = EBIT + Depreciation - Capital Expenditures - Change in Working Capital – free cash flow
• WACC = (E/V) × Re + (D/V) × Rd × (1 - T) – weighted average cost of capital
• 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
• IRR ranking prioritizes projects with higher internal rates of return, while NPV ranking prioritizes projects with higher net present values
• The dividend irrelevance theorem states that the value of a firm is independent of its dividend policy, as long as the firm maintains a stable dividend payout ratio