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Transcript of Corporate Objectives Article
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ALTERNATIVE VIEWS OF THE OBJECTIVE
OF THE FIRM
Simon Keane
ABSTRACT This chapter challenges a fundamental assumption of financetextbooks - that a companys goal should be to increase its share price and that
management should be judged by their success in doing so. The assumption has
become so entrenched in finance theory that it seems unassailable, but it will be
argued here that it is based on a simple error, so simple that, once understood, it is
difficult to understand how the idea of share price maximisation has persisted for so
long. To understand how the error has arisen it is necessary to have regard for
another fundamental assumption of finance, that the securities market is reasonablyefficient in pricing a companys future growth potential. The chapter will conclude
that it is possible to believe either that share price maximisation is a credible
objective or that the securities market is rational, but not both.
The purpose of this chapter is to present a case for concluding that the
conventional share-price maximising rule is fundamentally flawed. It will
be argued that:
After a companys shares have been floated in the market, even the most
successful companies cannot expect to increase their share price beyond
the normal rate of growth,
The appropriate goal for companies is to maximise the value of the firm
subject to maximising the share price, where the share price acts as a
constraint on management behaviour rather than as the target of
management activity.
Managerial performance should not primarily be assessed or rewarded byreference to the companys share price performance.
The share-price maximising rule has fostered an attitude of indifference
to zero-NPV projects, which creates a propensity to underinvest.
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Emphasis on abnormal share price growth as the benchmark of
managerial performance creates a potential bias in financial reporting.
WHY MANAGEMENT CANNOT EXPECT TO
INCREASE THE SHARE PRICE BEYOND
INFLATION AND RETAINED EARNINGS.
The goal of corporate enterprises is generally stated to be the maximisation
of shareholder wealth, and this in practice is usually equated with share price
maximisation (SPM). The logic underlying the practice of equating wealth-maximisation with share price growth is that, if a company undertakes a
succession of positive-NPV decisions throughout its life, thus generating
added wealth for shareholders, the share price should follow suit and rise
accordingly. The share price in effect will respond to the firms capital
investment decisions. The greater the number and value of the positive
NPVs the greater the rise in the share price. The standard assumption,
therefore, is that more efficient managers will tend to generate greater share
price growth than less efficient managers. Hence management should be
encouraged to maximise share price growth and should be judged and
rewarded accordingly. The conventional view is illustrated in Figure 1.Growth in the per share value of the underlying productive assets of the
company is approximately matched by growth in the share price.
We are now going to show that this logic can be valid only if the
market is exceedingly inefficient. Before doing so, however, we need to
emphasise that there are two markets involved in the process of shareholder-
wealth creation, the product market (in which firms undertake real
investments such as the manufacture of cars or computers), and thesecurities market (in which the shareholders finance and trade their claims
to the companies that own the productive assets). The conventional view is
based on the assumption that asset values in these two markets move in
tandem, and we are going to show shortly why this cannot be so.
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The second point to be emphasised is that there are two kinds of share
price growth, normal and abnormal:-
NORMAL GROWTH results from inflation and the retention of earnings,
and possibly from general market growth caused by say systematic declines
in the risk premium. Inflation is outside the control of management and
retained earnings are simply the residual of the dividend payout. Likewise,
the market price for risk is determined by factors outside the control of
individual companies. The combination of normal growth in the share price
and dividends provide the normal rate of return to investors. In an efficient
market all shares are priced to give an expectation of the normal rate of
return and, therefore, an expectation of normal growth.
ABNORMAL GROWTH arises when shareholders receive added value
above the normal rate of return. Thus, if a positive NPV project undertakenby the firm feeds through to the share price this is abnormal growth. It is
abnormal growth that is at issue here. When the textbooks suggest that
management should seek SPM they mean they should seek to achieve
abnormal growth. Otherwise managers would be motivated to retain all
earnings and keep dividends to a minimum.
It might seem that defining growth in the share price resulting from
retained earnings as normal is misleading since a company may earn and
retain abnormalearnings from its investments. Does adjusting share pricegrowth for retention of abnormal earnings not conceal abnormal share price
growth? The answer is no, because abnormal share price growth does not
result from retainingabnormal earnings, but from the abnormal earnings
themselves. For example, assume that a new company is expected to earn
15% on every pound it invests when the normal rate of return is 10%. Its 1
shares will be valued at 150p, an abnormal growth rate of 50%. If, after the
first year, the company pays out its abnormal earnings of 15p in dividends,
shareholders will earn 15p/150p = 10%, the normal return for the risk class.
If the company instead decided to retain its abnormal earnings of 15p, the
shares would then be priced at 165p. The growth in the share price from150p to 165p is, again normal, being 10%. Therefore, adjusting the
growth in the share price for retained earnings, whether normal or abnormal,
to determine whether there is any abnormal growth is perfectly valid. In this
example the abnormal growth is zero whether the company pays or retains
its abnormal earnings.
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To show why SPM is a misguided goal for an established company, it
is convenient to start with a simple set of conditions in both the product
market and securities market and gradually proceed to more real-world
conditions.
PERFECTLY COMPETITIVE PRODUCT MARKETS
Assume first that the product market is perfectly competitive. Both
corporate assets and the companys shares would be expected to earn only
the normal return for risk. Even in such a competitive world, however, there
is still a need for enterprises to undertake real investments, otherwise
investors would have no mechanism for investing in shares that offered the
normal rate of return for risk-taking. But it would make no sense under
these circumstances to argue that managers goal is to maximise the share
price. There can be no expectation of achieving abnormal share pricegrowth. Figure 2 shows that, when adjusted for inflation and retained
earnings, the share price could be expected to remain at the present level
indefinitely, matching precisely the net asset value of the underlying assets.
The role of management would be to undertake as many nonnegative NPV
projects as possible simply to satisfy the demands of new savers and
investors. In capital budgeting terms this would imply a goal of :
Maximising the PV of the firms investmentssubject to maximising NPV.
In other words a company should seek to maximise the scale of its
investment program, but always subject to the proviso that it observes the
nonnegative NPV criterion. The term subject to maximising NPV is the
appropriate way of denoting this criterion, because, although there could be
no expectation of achieving a positive NPV investment in a perfectly
competitive product market, the company should always avoid negative
NPVs and give priority to any positive NPV investment should ever a
windfall opportunity arise. In practice, therefore, the goal would be
interpreted as avoiding negative NPVs rather than having the expectation of
achieving positive NPVs. It can be denoted more briefly as follows:
MAX PVMAX NPVIt would be a mistake to imagine that it would be an easy matter to achieve
this goal because, in a perfectly competitive product market, it would be
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difficult enough to find and to successfully implement even Zero-NPV
projects. The constraint MAX NPV, as indicated,is designed to prevent
managers from seeking to achieve growth without meeting the minimum-
return requirement.
THE FIRMS OVERALL OBJECTIVE IN
PERFECTLY COMPETITIVE PRODUCT MARKETS
The above capital budgeting goal can be used to develop a more
broadly-based corporate goal as follows:
TO MAXIMISE THE VALUE OF THE FIRM, SUBJECT TO
MAXIMISING THE SHARE PRICE
or MAX Vt MAX PtThe significance of this goal is that the managers should seek to
maximise the long-term value of the firm by undertaking all projects that do
not reduce the share price. Managers can expect to increase V (by
maximising PV), but, due to the absence of positive NPV opportunities, they
cannot expect to increase the share price when adjusted for retained earnings
and inflation. The significance of stipulating long-term value is that if the
choice is between an investment of 10M with 0-NPV now or an investment
of 100M in one years time a preference should probably be given to the
latter. The role of the share price is not to provide managers with a target to
maximise but to act as a constraint on their investment or other decisions.
Projects are desirable provided they are not at the expense of the share price.
WEALTH CREATION AND WEALTH INCREMENTS
Another way of interpreting MAX Vt and MAX PV is wealth
creation. Pure wealth creation consists of converting investible funds intoreal assets that earn the required return for the level of risk assumed. Hence
if a firm has a choice between two projects, one costing 10M and the other
5M, both with zero NPVs, then under normal circumstances it should
choose the 10M project because this involves creating more wealth. The
creation of wealth is the primary goal of business enterprise.
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A positive NPV is more than wealth creation. It is a wealth
increment, an addition to shareholder wealth resulting from the exploitation
of imperfections in the market. If a company is presented with a potential
wealth increment then this has priority over the wealth creation process. In
other words a positive NPV is always to be preferred over a zero NPV and a
higher NPV over a lower NPV. What we must not do, however, is forget
that, however welcome wealth increments might be, they are not
preconditions of business enterprise. Whether or not positive NPVs present
themselves, the fundamental role of business remains is wealth creation.
It might seem that, to increase V, the firm has to increase the share
price since the value of an (all-equity) firm is NxP where N = the number of
outstanding shares. But the fact that P cannot be increased does not
preclude increasing NxP. If new projects are undertaken that satisfy the
MAX PVMAX NPV criterion these will be financed by increasing N.This, of course, is not to say that the firm should simply increase N to
maximise V, since new capital should be raised only when it can be used for
nonnegative investments. In effect, in a perfectly competitive world, the
firm can only increase the value of the firm by creating new wealth rather
than by a series of wealth increments.
IMPERFECTLY COMPETITIVE PRODUCT MARKET
In the real world the product market is unlikely to be perfectlycompetitive. When a firm acquires a competitive advantage there is a
reasonable expectation of earning an abnormally high return, in effect to
achieve a positive NPV investment. The issue is how will the stock market
react to such investments.
ASSUMING THE STOCK MARKET HAS PERFECT FORESIGHT.
If the securities market had perfect foresight then, at flotation of the
companys shares, the price will full reflect the firms abnormal return
potential such that, thereafter, the growth in the price can be expected to be
no more than normal. This is illustrated in Figure 3. Adjusting for inflation
and retained earnings, the share price can be expected to remain at its
present level notwithstanding the growth in the underlying assets. The role
of the securities market is to price new shares such that these become zero-
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NPV investments to subsequent shareholders, even when the underlying
investments of the company are positive NPV investments.
This makes sense. In an ideal world, it is only the first generation of
shareholders that should benefit from the abnormal returns of the firm
because they were the ones that backed the original concept. The initial
abnormal share price growth is their reward for their entrepreneurship in
creating a vehicle with the abnormal-return potential. Thereafter, any
second-generation shareholders should expect to earn no more than the
normal return for risk-taking. Hence the role of a rational securities market
is to convert the shares into zero-NPV investments as soon as possible. It
must be emphahsised that the underlying real investments continue to have
positive NPVs.
The implication is that the firms capital budgeting objective remainsunchanged, namely
MAX PVMAX NPVThis again can be interpreted as implying that managers should seek to
maximise the value of the firm by undertaking all projects with zero and
positive NPVs but always giving preference to positive NPV projects.
Innovative firms can expect to increase both PV and NPV. It is important to
note that established firms in more mature industries may not have much
prospect of finding abnormal return opportunities, but they should still seekto Max PV by undertaking as many zero NPV projects as possible.
Obviously, if they can find positive NPV projects these must take priority
but they do not depend for their existence on such projects.
THE FIRMS OVERALL OBJECTIVE IN IMPERFECTLY
COMPETITIVE PRODUCT MARKETS
The overall objective also remains unchanged, namely
MAX VT MAX PTThis, however, needs to be interpreted carefully. Managers can expect to
increase VTbut not PT. The associated abnormal share price growth took
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place at flotation when the stock market fully discounted all the firms future
positive NPV potential. The significance ofMAX PT is that managers mustnot expand at the expense of the share price. This implies not rejecting any
positive NPV projects since the price reflects the expectation that these
projects will be accepted and will decline if rejected, and not accepting anynegative NPV projects.
It follows that the conventional objective of SPM is meaningless in
these conditions since even the best of managers cannot expect to achieve
abnormal share price growth after the initial price adjustment. No matter
how innovative managers might be the perfect foresight of the market will
ensure that the their abnormal return potential is fully discounted in the share
price when the shares are first floated.
Over the life of the company the returns on the shares will match theearnings from the firms real assets, but the timing of the two streams are
quite different. The underlying asset earnings roughly coincide with the
events that generate them, but shares prices are essentially expectations-
based in the sense that they seek to anticipate the earnings. Because the
market is assumed here to have perfect insight the abnormal component of
the earnings is totally captured in the share price on a single day at flotation,
so delivering the rewards to the founder shareholders. The implication of
the conventional SPM paradigm in Figure 1 is that the market waits for the
underlying events to occur before it reacts. The market is assumed to bereactive rather than anticipatory, a clear sign of an inefficient market.
Of course it is true that NPV measures are themselves expectations-
based, and it might seem that attributing the above effect to the fact that
shares are expectations-based is unconvincing. Might it not still be possible
for expectations-based share prices and the expectations-based product
market to move in tandem. However, the two measures are not
expectations-based to the same degree. The NPV measure is based on the
expectations of the earnings (more precisely the cash flows) from the
specific project, but the share price is based on expectations of the entirefuture stream of NPVs. The price does not simply anticipate the future
flows from the firms current projects but those of subsequent projects. The
market does not wait for the projects or the earnings to occur before
recognising their impact on the wealth of existing shareholders.
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THE FIRMS OBJECTIVE WHEN THE STOCK MARKET
LACKS PERFECT FORESIGHT
The above argument based on the expectations-based character of the
securities market may seem logical given the assumption of perfectforesight. But it is obvious that the stock market is unable to predict the
future perfectly and it remains to consider how this affects the above
objective. Although it may seem counterintuitive it will be shown that the
objective remains unaffected by relaxation of the perfect foresight
assumption. It is true that, at flotation, the market will not foresee the future
perfectly but it can, and has to make an informed guess about the companys
future profitability. The share price will reflect the markets best estimate.
Figure 4 is almost identical to Figure 3 except that the wavy line implies that
the share price, being no more than a guess, is likely to deviate from its
initial level when the unexpected occurs and the market is compelled torevise its estimate. In effect, the initial estimate will almost certainly be
wrong, but we have to ask ourselves in what direction will the error be? If
the market underestimates the firms future abnormal earnings the price will
be too low and can be expected to increase until in reaches its correct
level. If the market overestimates the firms future potential the price can be
expected to decline. But, to expect share price growth as a matter of routine
from successful companies, the market has to have a systematic tendency to
underestimate. Clearly then, if the market is not systematically biased, it
should, in average, be about right. If the markets estimates are onaverage unbiased the implication is that, whilst the firm can expect the share
price to be subject to constant revision, it cannot expect the revisions to be
systematically in an upward direction. In effect, we can expect the share
price to change after the initial price adjustment but we cannot expect it to
exhibit abnormal growth.
The goal therefore remains unchanged:
MAX VT
MAX PT
The implication is that managers can expect to increase VT but cannot
on average expect to increase the post-flotation Pt beyondthe normalgrowth rate. The expected outcome of this goal for the average successful
company is illustrated in Figure 5. Because the markets foresight is
imperfect managers can expect the share price to change in response to
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surprise events but they cannot expect the change to be mainly in an
upwards direction. The price already reflects the markets expectations of
their ability to generate positive NPV projects, and even the best of
managers cannot expect to perform better than expected.
This conflicts with the conventional view that the share price responds
to NPV decisions rather than anticipates them. The implication of this view
is that the market systematically waits for the firm to undertake its
investments before capturing their abnormal profits in the price without
making any prior effort to estimate their profit potential. If the market
behaved in this manner, then any investor who purchased shares on the
firms known investment potential could expect to earn abnormal returns.
SOME COUNTERARGUMENTS
The notion that, after the shares have been floated, resourceful
managers cannot expect to increase their share price more than inefficient
managers is clearly difficult to accept initially, and a number of contrary
arguments need to be considered.
1) It requires too high a level of stock market efficiency to assume that
the market can predict the companys entire positive NPV future.
At first sight it would seem too great a task for the market to price away
the future abnormal earnings potential of a company at flotation. How, it
might be asked, could the market possibly predict a positive NPV to be
undertaken in 30 or 50 years hence? Many experts, indeed, argue that the
market cannot see more than two years ahead. But for the purposes of the
argument the market does not need to see the future precisely. All that is
required is that it make an informed guess about the future in the light of the
available information at the time about the firms product and managerial
ability. It will be seen that the degree of efficiency needed by the market for
this purpose is significantly less than that needed to support the Efficient
Market Hypothesis taken for granted by most finance textbooks. To supportEMH the market must value shares better than expert analysts can. To
support the present argument all that is required is that market values are
free of systematic bias.
For example, assume that a company is estimated by the market to
make a series of positive NPV decisions over its life that generate an average
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return of say 18%. This is only a guess by the market. If the original
investment by the founder shareholders was 1 per share, and assuming that
the required minimum return from shares of this risk class is 10% then the
effect of the markets guess is to value the shares at .18/.10 = 1.80. The
founder shareholders have made a windfall gain of 80% to reward them for
their entrepreneurship in founding a company with abnormal return
potential. New shareholders, however, will have to pay 1.80 for the
average return of 18p per share, thus giving them a prospective return of
10% which is the normal rate for the risk class. This is fair because the new
shareholders do nothing but provide risk capital and are rewarded
accordingly.
Now of course it is a fair assumption that the markets guess of 18%
will prove to be wrong in the light of subsequent events. But the issue is not
whether the guess will be wrong but in what direction it is likely to bewrong. If we posit the conventional view that managers can reasonably
expect to increase the price in tandem with their future NPV decisions the
implication is that the market routinely underestimates companies future
potential at flotation. The guess then is not simply wrong but is
systematically biased downwards in estimating managerial potential. But
we have no grounds in logic or in evidence to assume such a bias. If it
existed we have seen that it would imply that an investor could, by buying a
random portfolio of well-managed companies, routinely expect to earn a
succession of abnormal returns. This, of course, would be totally
inconsistent with the concept of a reasonably efficient market.
If we assume that the market is unbiased when it makes its informed
guess about a companys future, then the market price should on average
discount the firms future potential. The company is bound at times to
surprise the market, and this will necessitate a revision in the share price, but
surprises are just as likely to be unfavourable as favourable. Knowing that
the share price will inevitably change in the future does not amount to an
expectation that the price will respond overall in a given direction.
It follows therefore that the initial pricing of the companys entire
future earnings potential does not require an exceptional belief in market
efficiency. It is sufficient that the market makes a reasonable estimate that is
free of systematic bias. The conventional view is based on the assumption
that the market responds to a companys investment decisions. A rational
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market, however, anticipates a companys investment potential and responds
only to revised estimates of that potential.
2) Many companies do achieve exceptionally high share price growth,
and obviously the credit should go to the management.
Certainly we observe many companies shares increasing by far
greater amounts than can be explained as normal growth. The argument
here, however, is not that management is unable to achieve abnormal growth
in the share price, but that, from the current level of the share price, it
generally cannot expectto achieve further growth. The price already reflects
the abnormal earnings potential of the company, and to achieve further
growth in the share price, the company has to perform better than expected.
If management does succeed in performing better than expected, then
certainly this is to their credit, but they cannot expect to perform betterthan expected.
It follows, for example, that, if company A has an excellent
management team, their share price should reflect their excellence when
management begin their term of office. If the company performs as
expected, with excellence, the share price will thereafter show only normal
growth. The failure to achieve abnormalgrowth is not due to anyshortcoming in managements performance but to the efficiency of the
market in anticipating their excellence in the initial share price. The
abnormal growth took place before management achieved its performance.
If management B is perceived by the market to have a mediocre
management team their share price will also reflect this at the outset. If,
subsequently, their performance is somewhat better than mediocre the share
price will rise during their term of office to correct the markets earlier
estimation. Obviously management should be congratulated for performing
better than expected, and the abnormal share price growth will reflect this,
but it could not be said that Bs management is superior to As. The share
price growth of B is more a function of the markets inability to predict thefuture exactly than of the skill of the managers.
It follows that the behaviour of the share price is not a good indicator
of contemporary management performance. Those companies that have
exhibited the greatest amount of abnormal growth are those that surprised
the market most. This is as much a comment on the information available
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to the market at the time of the initial pricing as it is on the relative
performance of that particular management team.
3) Managementis better informed about the company and thereforehas different expectations about the future than the market.
It is true that there is information asymmetry between a firms managers
and the securities market, and that the expectations of the two will often be
different. The effect of this is that management will frequently be in a
privileged position in being able to predict forthcoming price changes when
the market finally receives the new information. But this privileged position
does not justify an overall expectation of share price growth. Managements
privileged position applies equally to bad and good information. And
although good managers should perhaps expect to enjoy better times than
poor managers, this should be reflected in the markets estimate. They donot have any greater expectation of enjoying the prospect of more favourable
surprises than poor managers.
4) The share price goal should still be used to motivate management.
Properly motivated managers will make a special effort to raise the
share price and should perform better than less motivated
managers.
If the implications of this are that managers should be remuneratedaccording to the companys share price growth, it is not clear why this is in
fact fair once the role of the share price in anticipating their performance is
understood. Thus if a company insists on using SPM to motivate managers
with the expectation of inducing managers to make a special effort, then the
market should factor in this expectation into the initial share price. As a
consequence, managers may indeed be trying harder but still cannot expect
the share price to show abnormal growth. If it is argued that the market
could not anticipate this greater effort then the implication is that investors
could expect to achieve abnormal returns simply by holding shares in
companies with highly-motivating pay schemes. There is no way ofavoiding the choice between believing in the efficiency of the securities
market and believing that share prices track rather than anticipate managerial
performance.
The above argument does not imply that the share price should not
enter into managerial performance evaluation and reward mechanisms.
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Managers should be rewarded for achieving abnormal growth and penalised
for failing to achieve normal growth. In an unbiased market, however,
management remuneration should, on average, be unaffected by such a
reward scheme.
It is worth noting that the share price is often criticised in practice as an
unreliable performance indicator because its information content may be
contaminated by extraneous factors. The logic of the above analysis, howev-
er, is that, even if free of contamination, the price is informationally too rich
to signal the impact of contemporary financial decisions. The starting value
would be dominated by predictions of the approaching management
performance, and the finishing value by predictions of the performance of
subsequent generations of management. The complete history of the share
value over the life of the company, from inception through flotation to
dissolution, must necessarily reflect management's overall performanceduring the life of the company, but the price behaviour for a given period
will rarely reflect the performance of the contemporary management team.
5) Management can surely expect to increase the share price when
faced with a takeover bid
When a company receives notice of an impending bid, the management
can obviously expect the share price to increase. Indeed is management's
role under these circumstances not to secure as high a price as possible from
their negotiation efforts?
It is true that the target company in a bid can expect its share price to
rise and has, indeed, an obligation to secure the best possible price, but this
does not imply an expectation of share price growth in a general sense. A
takeover is not typical of a company's normal relationship to the share price
since the shareholders are effectively being invited to sell their shares.
Moreover, the situation exemplifies the difference between short and long-
term expectations about share price behaviour. The probability of a bid
sometime in the future is always impounded in the share price. Whenmanagement receives information that raises this probability to a certainty,
it can expect the share price to rise on disclosure of the bid, possibly even to
a level above the bid price if the company has a negotiating advantage not
currently reflected in the bid price. But this is fundamentally no different
from any other example of information asymmetry, except that the
privileged information in a bid situation happens to be favourable to the
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share price. There are equally many situations where the short-term
expectation may be of a price decrease (for example, when a company
makes a bid, or is about to announce a decline in earnings) without this
influencing the expectations of the long-term price direction. In terms of
the long-term expectation, because companies on average cannot in advance
expect to have a greater probability of being the target of a bid than is
already reflected in the price, the fundamental principle remains true that
management cannot expect the share price to increase in the future as a
result of takeover bids.
In summary, then, these counter-arguments do not undermine the
conclusion that companies, however well managed, cannot expect to achieve
abnormal growth in the share price. The fundamental goal of corporate
enterprise is the creation of wealth rather than the attainment of wealthaccretions for succeeding generations of shareholders, although such
accretions are to be given priority if they arise. This results in a much more
positive attitude towards zero-NPV investments than is to be found in
standard finance texts. The motivation for undertaking such investments
needs now to be considered.
WHY ZERO-NPV INVESTMENTS ARE DESIRABLE
The above analysis implies that zero-NPV projects are not only acceptable
but, under competitive conditions, may be the best that some firms can hope
to find. If you refer, however, to a sample of standard text-books in finance
you will find mixed opinions regarding zero-NPV investments. Some will
dismiss them as unacceptable because they cannot possibly increase the
share price. Some will treat them with ambiguity because, although they
offer the minimum acceptable rate of return, they do not offer the prospect of
a price increase. Others view them as acceptable because by definition they
earn the minimum acceptable rate without explaining how this view can be
reconciled with the share price maximising rule. This confusion is a naturalconsequence of the fallacy that SPM is the primary goal of business.
Because we are accustomed to thinking in terms of share price
maximisation as the framework for decision-making a number of questions
need to be answered about the relevance of zero-NPV projects.
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A) Perhaps there are enough positive NPV projects to make zero-
NPV projects reduntant?
This would imply that the number of positive-NPV projects
exceeds the amount of capital available to finance them, in effect a universal
state of severe capital rationing. It is not clear how such a state could persist
since the implication is that the cost of capital (the minimum acceptable rate
of return) is too low. A rise in the cost of capital would give marginal
acceptable projects a zero NPV. In addition, we have to ask if the low
investment in the shipping, motor and mining industries in the UK are due to
an excess of investment opportunites that cannot attract appropriate finance
or the failure to find an adequate number of investments expected to earn a
satisfactory return? Is it not realistic to assume that if these industries had
managed to offer returns proportional to their risk they would have
survived? Is it not also realistic to assume that mature, competitiveindustries can expect to find it difficult to achieve excess returns from their
assets with each generation of new investment? The most realistic
assumption is that, in a progressively increasing competitive global market,
positive-NPV projects are becoming increasing more difficult to find and
sustain. It is exceedingly unlikely that all companies have and continue to
sustain a competitive advantage.
It is important to note that even if we make the heroic assumption that
all companies can maximise their value without resorting to ignore zero-
NPV projects this does not affect the argument that SPM is an inappropriate
goal. Market prices will reflect the expectation of these abnormal returns
such that the shares will offer new investors the expectation of earning only
a normal return.
B) Why should existing shareholders authorise management to
undertake new projects with zero-NPVs?
Because we are conditioned to perceiving the role of companies as
being centred on achieving abnormal share price growth, it is not obviouswhy existing shareholders should welcome new investments with zero
NPVs. Such projects do not seem to have any benefits for current
shareholders. Why should they endorse the issue of new shares to finance
projects that create new wealth but lack an attendant wealth increment?
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Secondly, the appeal of buying new rather than outstanding shares is
that the latter are free of brokerage costs, and also tend to be issued at a
slight discount to make them attractive. From the companys perspective
the NPV of the project, whether zero or positive, should be calculated to
take account of these issue costs.
D) A bank deposit is a zero-NPV investment, and, therefore, if
management is to be rewarded according to the scale of the
enterprise, why should they not simply deposit money in the bank to
maximise VT?
To reward management for maximising Vt would certainly seem to be
an invitation to them to raise capital and deposit it in risk-free
investments. This would appear to satisfy both components of the MAX
VT MAX PT objective. This is an illusion, however. The transactionwould not in fact satisfy both conditions of the MAX VT MAX PTcriterion. Raising new capital involves transaction costs, and therefore
the process of raising capital simply to deposit it in a bank account would
have a negative NPV and result in reduction of the share price. It does not
pay firms to do what investors are readily able to do for themselves.
In conclusion, then zero-NPV projects are desirable to all stakeholders in the
company, to the employees and management because they expand the
industrial base, to existing shareholders because they help attract efficientmanagers, and to new investors because they permit access to the company
on favourable terms. The traditional goal of SPM, by breeding indifference
to such projects, promotes an underinvestment bias.
THE ROLE OF THE SHARE PRICE IN CORPORATE FINANCIAL
REPORTING
Finally, some comment has to be made the implications of this change ofperspective for financial reporting practices. The simple act of predicating
share price growth as a fundamental objective has potentially adverse
implications for corporate financial reporting practice. Financial reports
provide the link between management's wealth-creating activity and the
share price. If the market is to fulfil its valuation role effectively, the
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financial disclosure process needs to be comprehensive and unbiased.
For this, the financial reporter must recognise the market's information-
processing capacity and must understand the market's response
to information disclosure. A SPM philosophy militates against this
understanding for a number of reasons:
i) Since the concept of share price maximisation fosters distrust in the
market's ability to take a long-term perspective, it is likely to distort
management's expectations about the role of financial reports. Scepticism
about the market's farsightedness has always been used to justify limiting
the publication of future-oriented information in corporate financial reports.
If managers believe that an efficient response to the announcement of new
projects should typically lead to proportionate increase in the share price
they will tend to be disillusioned by the apparent lack of impact of
financial disclosure on market prices. This lack of response is more oftenthan not because the market has anticipated the earnings potential of the
company. Failure to understand this will tend to fuel general scepticism
about the market's information-processing efficiency, and to reinforce
traditional concern by managers for the form as much as for the substance of
financial reports.
ii) In addition to the risk of bias created by the practice of linking
management rewards to share price performance, the very notion that the
company should seek to influence the share price in a particular direction is
inconsistent with the principle of neutrality, and appears to legitimise the
practice of presenting corporate information in a favourable light.
Furthermore, since the operationality of the SPM rule depends on market
prices suffering from systematic undervaluation, advocacy of the rule carries
the risk of being interpreted as justifying some degree of disclosure bias to
counteract the systematic bias of the market.
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CONCLUSION
The share price has an important role in financial decision-making in
that it helps signal whether decisions conform to the market criterion,but share price growth should not be perceived as the primary target of a
companys decisions. The conventional focus on share price growth distorts
the investment decision framework because it fails to recognise that the
essential role of the price is to anticipate the firms investment potential
rather than to respond to the firms investment history. It remains a puzzle
why finance texts premise their arguments on the assumption that security
markets are efficient in valuing future abnormal growth potential and, at the
same time, advise managers to pursue abnormal share price growth for
successive generations of shareholders.
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SUMMARY
1. The traditional text-book objective of shareholder-wealth maximisation is
normally interpreted to imply that management should seek to achieve shareprice growth above the normal growth associated with inflation and retained
earnings.
2. This objective implicitly suggests that the securities market suffers from an
inherent bias in its pricing of shares. A company cannot on average expect to
achieve abnormal share price growth unless the market systematically
undervalues the companys earnings potential.
3. An unbiased market will attempt to price away this potential at the
beginning of a companys life such that any abnormal growth in the shares
will generally be telescoped into a single valuation at formation. This is thereward to the founder shareholders for their entrepreneurial in contribution.
4. After this initial pricing the market will constantly revise its valuation, but
there can be no expectation of achieving abnormal share price growth for
subsequent shareholders. To suggest otherwise is to predicate a biased
securities market that consistently undervalues a companys profit potential.
5. The choice is therefore between believing in the traditional share price
maximising paradigm or in a rational securities market. It is not possible to
believe in both.
6. Assuming as unbiased market, the appropriate goal of management should
be to maximise thevalue of the firm subject to maximising the share price.
Management can expect to increase the former but not the latter.
7. The primary function of business enterprise is to create wealth and this
necessitates a positive attitude towards zero NPV investments.
8. Managers should be rewarded primarily by reference to the scale of the
enterprise and to their wealth-creating activity, subject always to the
discipline of the share price. They cannot be expected to deliver a succession
of wealth accretions to shareholders.
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TUTORIAL TOPICS
1. What interpretation do you think is normally given to the text-book goal of shareholder
wealth maximisation?
2. Consider the main factors that contribute to share price growth and indicate which of
these factors can be attributed to management skill.
3. Share prices have tended to grow over the last 100 years. Is it not appropriate that
management should expect to increase the share price and should be judged by their
success in doing so?
4. Is it realistic to assume that the market can estimate the positive NPV potential of the
firm over its entire life?
5. Do you think that when the market attempts to estimate the companys future earnings
potential at flotation it will tend to a) be right b) be wrong c) underestimate d)
overestimate?
6. Which is fairer a) that the first generation of shareholders should on average secure all
the benefit of the firms abnormal return potential or b) the benefit should be
distributed evenly over all subsequent generations of shareholders?
7. Would the conventional goal of share price maximisation make sense in a world with
perfectly competitive product markets? Would businesses have a role if there was
perfect competition?
8. Management has better information about the companys prospects than the market.
Does this entitle them to assume that they can generate abnormal share price growth?
11. If we interpret the share price as representing the markets expectation of anagementsfuture performance, is it reasonable to assume that efficient managers have a greater
prospect of outperforming the markets expectations than inefficient managers?
12. Is it possible to reconcile the text-book assumption that the securities market is efficient
and precludes investors from the expectation of earning abnormal returns and the text-
book suggestion that managements role is to deliver a succession of abnormal price
increases to shareholders?
13. Does the objective MAX VT MAX PT imply that managers should be judged by theirsuccess in increasing the share price?
14. VT can be defined as nPt where n = the number of outstanding shares. Does MAX VTtherefore not imply that management can expect to increase Pt?
15. Even if management cannot be expected to generate abnormal
share price growth is it not good practice to encourage them to
maximise the share price in order to motivate them.
16. How would you explain to management that zero-NPV projects are desirable?
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PROBLEMS
2. A company is presented with the three investment opportunities.
A B C
Outlay 5M 3M 20M
NPV 1M 1M 0
Discuss the relative desirability of the three projects
a) under the conventional share-price-maximising goal
b) under the goal of MAX VT MAX PT3. A company with 100m shares of 1 each obtains a listing in the securities
market. The company is expected to earn 25% on its assets base of 100M
for the indefinite future. The minimum required return on shares of thisrisk class is 12%.
a) What issue price should the company seek, ignoring transaction
costs?
b) At this price what return can subsequent buyers of the shares
expect to assuming an inflation rate of zero and that the company
pays out all its earnings in dividends, what direction can be
expected for the share price in the future.
c) What interpretation should be give to the difference between the
original investment per share in (1) and the flotation price
calculated in a) above
c) If an identical company in every respect issues shares with an
expected return of 15%, indicate which new issue you would
choose to subscribe to, giving reasons.
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P
NAV
`
YEARS
CONVENTIONAL VIEW: EXPECTED SHARE PRICE GROWTH
RELATIVE TO NET ASSET VALUE PER SHARE
FIGURE 1
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P
NAV
YEARS
EXPECTED ABNORMAL SHARE PRICE GROWTH RELATIVE TO NAVGIVEN a)PERFECTLYCOMPETITIVE PRODUCT MARKETS AND b)
PERFECTFORESIGHT IN SECURITIES MARKET
FIGURE 2
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P
NAV
+ FLOTATION
YEARS
EXPECTED ABNORMAL SHARE PRICE GROWTH GIVEN
a) IMPERFECTLY COMPETITIVE PRODUCT MARKETS AND
b) PERFECT FORESIGHT BY SECURITIES MARKET.
FIGURE 3
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P
NAV
YEARS
EXPECTED ABNORMAL SHARE PRICE GROWTH GIVENa) IMPERFECTLYCOMPETITIVE PRODUCT MARKETS AND
b) IMPERFECTFORESIGHT IN SECURITIES MARKET
FIGURE 4
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V
P
YEARS
EXPECTED OUTCOME OF MAX VT MAX PT OBJECTIVEFOR ESTABLISHED COMPANIES GIVEN
a) IMPERFECTLYCOMPETITIVE PRODUCT MARKETSb b) IMPERFECTFORESIGHT IN SECURITIES MARKET
c) SECURITY PRICES ADJUSTED FOR INFLATION AND RETAINED
EARNINGS.
FIGURE 5
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READINGS
1. All standard finance texts. These rather than journal articles provide the
best insight into the conventional interpretation of the share price
maximising objective and its implications for financial decision-making.