V

Assets in Place

Growth Assets

Liabilities

Debt

Equity

^Fixed Claim on cash flows Little or No role in management

Fixed Maturity Tax Deductible

Residual Claim on cash flows Significant Role in management

Perpetual Lives

We will return this framework repeatedly through this book. First Principles

Every discipline has its first principles that govern and guide everything that gets done within that discipline. All of corporate finance is built on three principles, which we will title, rather unimaginatively, as the investment Principle, the financing Principle and the dividend Principle. The investment principle determines where businesses invest their resources, the financing principle governs the mix of funding used to fund these investments and the dividend principle answers the question of how much earnings should be reinvested back into the business and how much returned to the owners of the business.

• The Investment Principle: Invest in assets and projects that yield a return greater than the minimum acceptable hurdle rate. The hurdle rate should be higher for riskier projects and should reflect the financing mix used - owners' funds (equity) or borrowed money (debt). Returns on projects should be measured based on cash flows generated and the timing of these cash flows; they should also consider both positive and negative side effects of these projects.

• 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.

• The Dividend Principle: If there are not enough investments that earn the hurdle rate, return the cash to the owners of the business. In the case of a publicly traded firm, the form of the return - dividends or stock buybacks - will depend upon what stockholders prefer.

While making these decisions, corporate finance is single minded about the ultimate objective, which is assumed to be maximizing the value of the business. These first principles provide the basis from which we will extract the numerous models and theories that comprise modern corporate finance, but they are also common sense principles. It is incredible conceit on our part to assume that until corporate finance was developed as a coherent discipline starting a few decades ago, that people who ran businesses ran them randomly with no principles to govern their thinking. Good businessmen through the ages have always recognized the importance of these first principles and adhered to them, albeit in intuitive ways. In fact, one of the ironies of recent times is that many managers at large and presumably sophisticated firms with access to the latest corporate finance technology have lost sight of these basic principles.

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