Corporate Objectives Article

8/14/2019 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.

Documents

Corporate Objectives Article