Butwhataboutmarketcrises?
41
¨ 
¨ 
Marketsaretheproblem:Manycri8csofmarketspointtomarket
bubblesandcrisesasevidencethatmarketsdonotwork.For
instance,themarketturmoilbetweenSeptemberandDecember
2008ispointedtoasbackingforthestatementthatfreemarkets
arethesourceoftheproblemandnotthesolu8on.
Thecounter:Therearetwocounterargumentsthatcanbe
offered:
¤ 
¤ 
Theeventsofthelastquarterof2008illustratethatwearemore
dependentonfunc8oning,liquidmarkets,withrisktakinginvestors,than
everbeforeinhistory.Aswesaw,nogovernmentorotheren8ty(bank,
BuffeJ)isbigenoughtostepinandsavetheday.
Thefirmsthatcausedthemarketcollapse(banks,investmentbanks)were
amongthemostregulatedbusinessesinthemarketplace.Ifanything,
theirfailurescanbetracedtotheiraJemptstotakeadvantageof
regulatoryloopholes(badlydesignedinsuranceprograms…capital
measurementsthatmissriskyassets,especiallyderiva8ves)
AswathDamodaran
41
IV.FirmsandSociety
42
¨ 
¨ 
Intheory:Allcostsandbenefitsassociatedwitha
firm’sdecisionscanbetracedbacktothefirm.
Inprac8ce:Financialdecisionscancreatesocialcosts
andbenefits.
Asocialcostorbenefitisacostorbenefitthataccruesto
societyasawholeandnottothefirmmakingthedecision.
n  Environmentalcosts(pollu8on,healthcosts,etc..)
n  QualityofLife'costs(traffic,housing,safety,etc.)
¤  Examplesofsocialbenefitsinclude:
n  crea8ngemploymentinareaswithhighunemployment
n  suppor8ngdevelopmentininnerci8es
n  crea8ngaccesstogoodsinareaswheresuchaccessdoesnot
exist
¤ 
AswathDamodaran
42
SocialCostsandBenefitsaredifficulttoquan8fy
because..
43
¨ 
¨ 
¨ 
Cannotknowtheunknown:Theymightnotbeknownat
the8meofthedecision.Inotherwords,afirmmay
thinkthatitisdeliveringaproductthatenhances
society,atthe8meitdeliverstheproductbutdiscover
aWerwardsthatthereareverylargecosts.(Asbestoswas
awonderfulproduct,whenitwasdevised,lightandeasy
toworkwith…ItisonlyaWerdecadesthatthehealth
consequencescametolight)
Eyesofthebeholder:Theyare‘person-specific’,since
differentdecisionmakerscanlookatthesamesocial
costandweightthemverydifferently.
Decisionparalysis:Theycanbeparalyzingifcarriedto
extremes.
AswathDamodaran
43
Atestofyoursocialconsciousness:
Putyourmoneywhereyoumouthis…
44
¨ 
¨ 
AssumethatyouworkforDisneyandthatyouhaveanopportunity
toopenastoreinaninner-cityneighborhood.Thestoreis
expectedtoloseaboutamilliondollarsayear,butitwillcreate
much-neededemploymentinthearea,andmayhelprevitalizeit.
Wouldyouopenthestore?
¤ 
¤ 
¨ 
Ifyes,wouldyoutellyourstockholdersandletthemvoteonthe
issue?
¤ 
¤ 
¨ 
Yes
No
Yes
No
Ifno,howwouldyourespondtoastockholderqueryonwhyyou
werenotlivinguptoyoursocialresponsibili8es?
AswathDamodaran
44
Sothisiswhatcangowrong...
45
STOCKHOLDERS
Have little control
over managers
Lend Money
BONDHOLDERS
Managers put
their interests
above stockholders
Managers
Significant Social Costs
SOCIETY
Some costs cannot be
traced to firm
Bondholders can
get ripped off
Delay bad
Markets make
news or
mistakes and
provide
misleading can over react
information
FINANCIAL MARKETS
AswathDamodaran
45
Tradi8onalcorporatefinancialtheorybreaks
downwhen...
46
¨ 
¨ 
¨ 
¨ 
Managerialself-interest:Theinterests/objec8vesofthe
decisionmakersinthefirmconflictwiththeinterestsof
stockholders.
Unprotecteddebtholders:Bondholders(Lenders)are
notprotectedagainstexpropria8onbystockholders.
Inefficientmarkets:Financialmarketsdonotoperate
efficiently,andstockpricesdonotreflecttheunderlying
valueofthefirm.
Largesocialsidecosts:Significantsocialcostscanbe
createdasaby-productofstockpricemaximiza8on.
AswathDamodaran
46
Whentradi8onalcorporatefinancialtheory
breaksdown,thesolu8onis:
47
¨ 
¨ 
¨ 
Anon-stockholderbasedgovernancesystem:Tochoosea
differentmechanismforcorporategovernance,i.e,assignthe
responsibilityformonitoringmanagerstosomeoneother
thanstockholders.
AbeJerobjec8vethanmaximizingstockprices?Tochoosea
differentobjec8veforthefirm.
Maximizestockpricesbutminimizesidecosts:Tomaximize
stockprice,butreducethepoten8alforconflictand
breakdown:
¤ 
¤ 
¤ 
¤ 
Makingmanagers(decisionmakers)andemployeesintostockholders
Protectlendersfromexpropria8on
Byprovidinginforma8onhonestlyandpromptlytofinancialmarkets
Minimizesocialcosts
AswathDamodaran
47
I.AnAlterna8veCorporateGovernanceSystem
48
¨ 
GermanyandJapandevelopedadifferentmechanismfor
corporategovernance,baseduponcorporatecrossholdings.
¤ 
¤ 
¤ 
¨ 
¨ 
InGermany,thebanksformthecoreofthissystem.
InJapan,itisthekeiretsus
OtherAsiancountrieshavemodeledtheirsystemaWerJapan,withfamily
companiesformingthecoreofthenewcorporatefamilies
Attheirbest,themostefficientfirmsinthegroupworkatbringing
thelessefficientfirmsuptopar.Theyprovideacorporatewelfare
systemthatmakesforamorestablecorporatestructure
Attheirworst,theleastefficientandpoorlyrunfirmsinthegroup
pulldownthemostefficientandbestrunfirmsdown.Thenature
ofthecrossholdingsmakesitsverydifficultforoutsiders(including
investorsinthesefirms)tofigureouthowwellorbadlythegroup
isdoing.
AswathDamodaran
48
II.ChooseaDifferentObjec8veFunc8on
49
¨ 
Firmscanalwaysfocusonadifferentobjec8vefunc8on.
Exampleswouldinclude
maximizingearnings
¤  maximizingrevenues
¤  maximizingfirmsize
¤  maximizingmarketshare
¤  maximizingEVA
¤ 
¨ 
Thekeythingtorememberisthattheseare
intermediateobjec8vefunc8ons.
Tothedegreethattheyarecorrelatedwiththelongtermhealth
andvalueofthecompany,theyworkwell.
¤  Tothedegreethattheydonot,thefirmcanendupwitha
disaster
¤ 
AswathDamodaran
49
III.MaximizeStockPrice,subjectto..
50
¨ 
¨ 
Thestrengthofthestockpricemaximiza8onobjec8ve
func8onisitsinternalselfcorrec8onmechanism.Excesseson
anyofthelinkageslead,ifunregulated,tocounterac8ons
whichreduceoreliminatetheseexcesses
Inthecontextofourdiscussion,
¤ 
¤ 
¤ 
¤ 
managerstakingadvantageofstockholdershasledtoamuchmore
ac8vemarketforcorporatecontrol.
stockholderstakingadvantageofbondholdershasledtobondholders
protec8ngthemselvesatthe8meoftheissue.
firmsrevealingincorrectordelayedinforma8ontomarketshasledto
marketsbecomingmore“skep8cal”and“puni8ve”
firmscrea8ngsocialcostshasledtomoreregula8ons,aswellas
investorandcustomerbacklashes.
AswathDamodaran
50
TheStockholderBacklash
51
¨ 
¨ 
¨ 
Ac8vistIns8tu8onalinvestorshavebecomemuchmore
ac8veinmonitoringcompaniesthattheyinvestinand
demandingchangesinthewayinwhichbusinessisdone.
TheyhavebeenjoinedbyprivateequityfundslikeKKRand
Blackstone.
Ac8vistindividualslikeCarlIcahnspecializeintakinglarge
posi8onsincompanieswhichtheyfeelneedtochangetheir
ways(Blockbuster,TimeWarner,Motorola&Apple)and
pushforchange.
Vocalstockholders,armedwithmoreinforma8onandnew
powers:Atannualmee8ngs,stockholdershavetakento
expressingtheirdispleasurewithincumbentmanagementby
vo8ngagainsttheircompensa8oncontractsortheirboardof
directors
AswathDamodaran
51
TheHos8leAcquisi8onThreat
52
¨ 
Thetypicaltargetfirminahos8letakeoverhas
¤  areturnonequityalmost5%lowerthanitspeergroup
¤  hadastockthathassignificantlyunderperformedthe
peergroupovertheprevious2years
¤  hasmanagerswhoholdliJleornostockinthefirm
Inotherwords,thebestdefenseagainstahos8le
takeoveristorunyourfirmwellandearngood
returnsforyourstockholders
¨  Conversely,whenyoudonotallowhos8le
takeovers,thisisthefirmthatyouaremostlikely
protec8ng(andnotawellrunorwellmanagedfirm)
¨ 
AswathDamodaran
52
Inresponse,boardsarebecomingmore
independent…
53
¨ 
¨ 
¨ 
¨ 
Boardshavebecomesmallerover8me.Themediansizeofaboard
ofdirectorshasdecreasedfrom16to20inthe1970stobetween9
and11in1998.Thesmallerboardsarelessunwieldyandmore
effec8vethanthelargerboards.
Therearefewerinsidersontheboard.Incontrasttothe6ormore
insidersthatmanyboardshadinthe1970s,onlytwodirectorsin
mostboardsin1998wereinsiders.
Directorsareincreasinglycompensatedwithstockandop8onsin
thecompany,insteadofcash.In1973,only4%ofdirectors
receivedcompensa8onintheformofstockorop8ons,whereas
78%didsoin1998.
Moredirectorsareiden8fiedandselectedbyanomina8ng
commiJeeratherthanbeingchosenbytheCEOofthefirm.In
1998,75%ofboardshadnomina8ngcommiJees;thecomparable
sta8s8cin1973was2%.
AswathDamodaran
53
Disney:Eisner’srise&fallfromgrace
¨ 
¨ 
¨ 
¨ 
InhisearlyyearsatDisney,MichaelEisnerbroughtaboutlong-delayedchangesin
thecompanyandputitonthepathtobeinganentertainmentgiantthatitis
today.Hissuccessallowedhimtoconsolidatepowerandtheboardsthathe
createdwereincreasinglycap8veones(seethe1997board).
In1996,EisnerspearheadedthepushtobuyABCandtheboardrubberstamped
hisdecision,astheyhadwithothermajordecisions.Intheyearsfollowing,the
companyranintoproblemsbothonitsABCacquisi8onandonitsother
opera8onsandstockholdersstartedtogetres8ve,especiallyasthestockprice
halvedbetween1998and2002.
In2003,RoyDisneyandStanleyGoldresignedfromtheDisneyboard,arguing
againstEisner’sautocra8cstyle.
Inearly2004,Comcastmadeahos8lebidforDisneyandlaterintheyear,43%of
DisneyshareholderswithheldtheirvotesforEisner’sreelec8ontotheboardof
directors.Followingthatvote,theboardofdirectorsatDisneyvotedunanimously
toelectGeorgeMitchellastheChairoftheboard,replacingEisner,whovowedto
stayonasCEO.
Aswath Damodaran
54
Eisner’sconcession:Disney’sBoardin2003
55
Board Members
Reveta Bowers
John Bryson
Roy Disney
Michael Eisner
Judith Estrin
Stanley Gold
Robert Iger
Monica Lozano
George Mitchell
Thomas S. Murphy
Leo O’Donovan
Sidney Poitier
Robert A.M. Stern
Andrea L. Van de Kamp
Raymond L. Watson
Gary L. Wilson
AswathDamodaran
Occupation
Head of school for the Center for Early Education,
CEO and Chairman of Con Edison
Head of Disney Animation
CEO of Disney
CEO of Packet Design (an internet company)
CEO of Shamrock Holdings
Chief Operating Officer, Disney
Chief Operation Officer, La Opinion (Spanish newspaper)
Chairman of law firm (Verner, Liipfert, et al.)
Ex-CEO, Capital Cities ABC
Professor of Theology, Georgetown University
Actor, Writer and Director
Senior Partner of Robert A.M. Stern Architects of New York
Chairman of Sotheby's West Coast
Chairman of Irvine Company (a real estate corporation)
Chairman of the board, Northwest Airlines.
55
ChangesincorporategovernanceatDisney
56
1. 
2. 
3. 
4. 
5. 
6. 
7. 
Requiredatleasttwoexecu8vesessionsoftheboard,withouttheCEO
orothermembersofmanagementpresent,eachyear.
Createdtheposi8onofnon-managementpresidingdirector,and
appointedSenatorGeorgeMitchelltoleadthoseexecu8vesessionsand
assistinsetngtheworkagendaoftheboard.
Adoptedanewandmorerigorousdefini8onofdirectorindependence.
Requiredthatasubstan8almajorityoftheboardbecomprisedof
directorsmee8ngthenewindependencestandards.
Providedforareduc8onincommiJeesizeandtherota8onof
commiJeeandchairmanshipassignmentsamongindependent
directors.
Addednewprovisionsformanagementsuccessionplanningand
evalua8onsofbothmanagementandboardperformance
Providedforenhancedcon8nuingeduca8onandtrainingforboard
members.
AswathDamodaran
56
Eisner’sexit…andanewagedawns?Disney’s
boardin2008
57
AswathDamodaran
57
ButasaCEO’stenurelengthens,does
corporategovernancesuffer?
1. 
2. 
3. 
4. 
Whiletheboardsizehasstayedcompact(attwelvemembers),
therehasbeenonlyonechangesince2008,withSheryl
Sandberg,COOofFacebook,replacingthedeceasedSteveJobs.
TheboardvotedreinstateIgeraschairoftheboardin2011,
reversingadecisionmadetoseparatetheCEOandChair
posi8onsaWertheEisneryears.
In2011,IgerannouncedhisintenttostepdownasCEOin2015
butDisney’sboardconvincedIgertostayonasCEOforanextra
year,forthe“thegoodofthecompany”.
Thereweresignsofres8venessamongDisney’sstockholders,
especiallythoseinterestedincorporategovernance.Ac8vist
investors(CalSTRS)star8ngmakingnoiseandIns8tu8onal
ShareholderServices(ISS),whichgaugescorporategovernanceat
companies,raisedredflagsaboutcompensa8onandboard
monitoringatDisney.
Aswath Damodaran
58
Whataboutlegisla8on?
59
Everycorporatescandalcreatesimpetusfora
legisla8veresponse.ThescandalsatEnronand
WorldComlaidthegroundworkforSarbanes-Oxley.
¨  Youcannotlegislategoodcorporategovernance.
¨ 
¤  Thecostsofmee8nglegalrequirementsoWenexceedthe
benefits
¤  Lawsalwayshaveunintendedconsequences
¤  Ingeneral,lawstendtobeblunderbussesthatpenalize
goodcompaniesmorethantheypunishthebad
companies.
AswathDamodaran
59
IsthereapayofftobeJercorporate
governance?
60
¨ 
Inthemostcomprehensivestudyoftheeffectofcorporategovernance
onvalue,agovernanceindexwascreatedforeachof1500firmsbased
upon24dis8nctcorporategovernanceprovisions.
¤ 
¤ 
¤ 
¨ 
¨ 
Buyingstocksthathadthestrongestinvestorprotec8onswhilesimultaneously
sellingshareswiththeweakestprotec8onsgeneratedanannualexcessreturnof
8.5%.
Everyonepointincreaseintheindextowardsfewerinvestorprotec8onsdecreased
marketvalueby8.9%in1999
Firmsthatscoredhighininvestorprotec8onsalsohadhigherprofits,highersales
growthandmadefeweracquisi8ons.
Thelinkbetweenthecomposi8onoftheboardofdirectorsandfirmvalue
isweak.Smallerboardsdotendtobemoreeffec8ve.
Onapurelyanecdotalbasis,acommonthemeatproblemcompaniesand
isanineffec8veboardthatfailstoasktoughques8onsofanimperial
CEO.
AswathDamodaran
60
TheBondholders’DefenseAgainstStockholder
Excesses
61
¨ 
¨ 
Morerestric8vecovenantsoninvestment,financinganddividend
policyhavebeenincorporatedintobothprivatelending
agreementsandintobondissues,topreventfuture“Nabiscos”.
Newtypesofbondshavebeencreatedtoexplicitlyprotect
bondholdersagainstsuddenincreasesinleverageorotherac8ons
thatincreaselenderrisksubstan8ally.Twoexamplesofsuchbonds
¤ 
¤ 
¨ 
PuJableBonds,wherethebondholdercanputthebondbacktothefirm
andgetfacevalue,ifthefirmtakesac8onsthathurtbondholders
Ra8ngsSensi8veNotes,wheretheinterestrateonthenotesadjuststo
thatappropriateforthera8ngofthefirm
Morehybridbonds(withanequitycomponent,usuallyintheform
ofaconversionop8onorwarrant)havebeenused.Thisallows
bondholderstobecomeequityinvestors,iftheyfeelitisintheir
bestintereststodoso.
AswathDamodaran
61
TheFinancialMarketResponse
62
¨ 
¨ 
¨ 
¨ 
Whileanalystsaremorelikelys8lltoissuebuyrather
thansellrecommenda8ons,thepayofftouncovering
nega8venewsaboutafirmislargeenoughthatsuch
newsiseagerlysoughtandquicklyrevealed(atleasttoa
limitedgroupofinvestors).
Asinvestoraccesstoinforma8onimproves,itis
becomingmuchmoredifficultforfirmstocontrolwhen
andhowinforma8ongetsouttomarkets.
Asop8ontradinghasbecomemorecommon,ithas
becomemucheasiertotradeonbadnews.Inthe
process,itisrevealedtotherestofthemarket.
Whenfirmsmisleadmarkets,thepunishmentisnotonly
quickbutitissavage.
AswathDamodaran
62
TheSocietalResponse
63
Iffirmsconsistentlyfloutsocietalnormsandcreate
largesocialcosts,thegovernmentalresponse
(especiallyinademocracy)isforlawsand
regula8onstobepassedagainstsuchbehavior.
¨  Forfirmscateringtoamoresociallyconscious
clientele,thefailuretomeetsocietalnorms(evenif
itislegal)canleadtolossofbusinessandvalue.
¨  Finally,investorsmaychoosenottoinvestinstocks
offirmsthattheyviewassociallyirresponsible.
¨ 
AswathDamodaran
63
TheCounterReac8on
64
STOCKHOLDERS
1. More activist
investors
2. Hostile takeovers
Managers of poorly
run firms are put
on notice.
Protect themselves
BONDHOLDERS
1. Covenants
2. New Types
Managers
Firms are
punished
for misleading
markets
Corporate Good Citizen Constraints
SOCIETY
1. More laws
2. Investor/Customer Backlash
Investors and
analysts become
more skeptical
FINANCIAL MARKETS
AswathDamodaran
64
Sowhatdoyouthink?
65
¨ 
Atthispointin8me,thefollowingstatementbestdescribes
whereIstandintermsoftherightobjec8vefunc8onfor
decisionmakinginabusiness
a. 
b. 
c. 
d. 
e. 
f. 
g. 
h. 
i. 
Maximizestockprice,withnoconstraints
Maximizestockprice,withconstraintsonbeingagoodsocialci8zen.
Maximizestockholderwealth,withgoodci8zenconstraints,and
hope/praythatthemarketcatchesupwithyou.
Maximizeprofitsorprofitability
Maximizeearningsgrowth
Maximizemarketshare
Maximizerevenues
Maximizesocialgood
Noneoftheabove
AswathDamodaran
65
TheModifiedObjec8veFunc8on
66
¨ 
Forpubliclytradedfirmsinreasonablyefficientmarkets,
wherebondholders(lenders)areprotected:
¤ 
¨ 
Forpubliclytradedfirmsininefficientmarkets,where
bondholdersareprotected:
¤ 
¨ 
Maximizestockholderwealth:Thiswillalsomaximizefirmvalue,
butmightnotmaximizethestockprice
Forpubliclytradedfirmsininefficientmarkets,where
bondholdersarenotfullyprotected
¤ 
¨ 
MaximizeStockPrice:Thiswillalsomaximizefirmvalue
Maximizefirmvalue,thoughstockholderwealthandstock
pricesmaynotbemaximizedatthesamepoint.
Forprivatefirms,maximizestockholderwealth(if
lendersareprotected)orfirmvalue(iftheyarenot)
AswathDamodaran
66