Brealey, Myers, and Allen on Valuation, Capital Structure, and Agency Issues

In these “extracts” from the world's best‐selling graduate textbook, the authors offer a number of suggestions for practitioners, including: • When valuing a company or an investment project, managers should start whenever possible with the asset's market price as the best initial estimate and then make adjustments that reflect their own private information. One obvious example of this process is when companies are evaluating possible acquisitions. • When valuing a company or an asset, don't worry about risks that you can hedge separately. For example, foreign exchange risk can be hedged using forwards or futures, and there is no need to form an opinion on the future path of exchange rates. • A positive NPV for a project is credible only if the company has some special advantage that competitors cannot match. That requires an understanding of the sources of the competitive advantage and how long they are likely to last. • Although market inefficiencies may offer economic rents from “convergence trades,” as a general rule nonfinancial corporations gain nothing, on average, by speculating in financial markets. • Since corporate managers know more about their company than outside investors, investors are likely to infer from corporate decisions to issue equity that the firm is overvalued (otherwise, why not issue debt instead?). And issuing overpriced stock to invest in projects that offer below‐normal rates of return is a sure way to destroy value. • To make the most of their growth opportunities and create value for outside investors, most public companies require a co‐investment of insiders' human capital with outsiders' financial capital. Such co‐investment in turn implies a larger return to managers' and employees' human capital than that suggested by either the conventional prescription of shareholder value maximization (or even the financial economist's model of firm value maximization).