|In making business decisions,
it is often said that corporate managers are supposed
to maximize shareholder value. How do managers know
whether their business decisions are maximizing
New projects. Here's the rule.
Managers generally should not invest in a new business
project that offers a rate of return less than the
company's capitalization rate. To do so would reduce
the valuation of the business. If the new project
has the same risk as the overall business, the "Gordon
model" tells us that a new project with a rate
of growth less than the company's capitalization
rate (discount rate) will have negative value. If,
however, the new project diminishes the overall
risk of the business, undertaking it may result
in a new capitalization rate and greater net value
for the overall business.
Dividend policy. When faced with
the choice of investing in a new project or payment
of the dividends to shareholders, which should managers
choose? That is, should managers re-invest earnings
or pay them as dividends?
Here's the rule. Managers should reinvest earnings
if the reinvested amounts will permit the business
to earn more than its cost of capital - that is,
the net present value of the reinvestment (using
the company's cost of capital as the discount
rate) is positive. But managers should pay dividends
if reinvested amounts would not earn more than
cost of capital. That is, if the reinvested amounts
would have an internal rate of return less than
the cost of capital, shareholders (not the company)
should get the money to invest.
[better for managers to pay dividends and
have zero growth or retain earnings and
have growth equal to cost of capital.
Answer: [indifferent - both are the same
/ show with table] If a company has excess
cash and few worthwhile projects (that is,
NPV<0 or IRR<the cost of capital),
distributing that excess cash to stockholders
as dividends is wise. However, when a firm
is faced with many good projects (NPV>0
or IRR>cost of capital) and excess cash,
more value will be created by investing
in these projects instead of returning cash
If a company has earnings, won't some shareholders
prefer to have cash now - rather than let the
company reinvest the earnings? Perhaps so. But
even if the company does not pay dividends, sharheolders
can create "home made dividends" by
selling some of their shares and obtaining capital
gains that reflect the reinvested, unpaid earnings.
These capital gains should reflect the increase
in market value resulting from the reinvested
earnings, and thus simulate the payment of a dividend.
So long as the capital gains are at least equal
to the unpaid dividend, even cash-hungry shareholders
should be happy. (Under the current tax laws,
shareholders should actually prefer taking their
cash as capital gains, since income tax on cpaital
gains is lower than on ordinary dividends.) This
assumes that the stock market properly measures
the present value of reinvestment projects and
that the company does not sqaunder excess cash
on bad projects or acquisitions.
A common policy among public companies is to maintain
regular dividends over an extended period of time,
no matter the actual level of cash flow. Even if
the company suffers a loss for the year, the regular
dividend will be paid out of accumulated earnings
from prior years. Some describe this by saying dividends
tend to be "sticky." The signaling effect
of dividends explains this aspect of dividend policy.
In a market with assymetric information, dividends
are seen as a way for management to "signal"
positive information otherwise unavailable to
the public. If a company has an extraordinary
year and generates significant cash flows, the
best move may not be to pay out a huge dividend.
While paying out the dividend may send a positive
signal to the market and result in a higher stock
price, more than immediate consequences must be
examined. Management must first determine if this
dividend can be sustained for the long haul, because
if it cannot, reducing the dividend the next year
might eliminate the gain in the stock price from
increasing the dividend (Evidence does indicate
that the signaling effect of increases and decreases
are not symmetric -- increases tend to raise stock
prices more than decreases lower the price). Thus,
only sustained increases in cash flows should
prompt a dividend increase. The same is true on
the other side as well -- only sustained decreases
in cash flows--not a one-time dip in earnings
-- should prompt a reduction in dividends. Texas
Instruments has maintained steady
and increasing dividends for the past twenty
years, in spite of uneven cash flows.
Of course, firms do exist that pay no dividends
at all. Warren Buffett's Berkshire Hathaway has
never paid a dividend, as all cash is reinvested
into the company. Many young or newly public companies
need all available cash to sustain their growth
and will not have any excess from which to pay
Capital allocation and project
What if the board is presented
with more than one project, but has limited
resources and cannot undertake all value-added
endeavors? The three methods for assessing
a project -- NPV, IRR, and PI -- suggest
that the managers should simply take the
project that produces the highest value.
But things in the real world
are hardly ever that easy. In their article,
"Why the NPV Criterion Does Not Maximize
NPV" (SSRN), Berkovitch and Israel
identify situations where exclusive use
of the NPV method leads to inefficient
capital allocations. Instead, they argue
that while the method is proper for measuring
the project's addition to firm value,
it does not succeed in maxmizing shareholder
value. The reason for this is not a fundamental
flaw in the NPV formula but rather lies
in the fact that NPV, compared to IRR
and PI, is biased for large-scale projects.
bent on increasing their own stature,
will submit the larger of two projects,
assuming they both have positive NPVs,
even though the smaller alternative might
increase shareholder value more. However,
IRR and PI eliminates these potential
agency considerations. The authors find
support for their argument in real-world
business where many companies do not rely
on NPV in their capital allocation process.
Use of market price to evaluate corporate
law. It has become fashionable to evaluate
corporate law rules according to whether they
have an effect on public stock prices. Good rules
should increase price, bad rules the opposite.
But is stock price a good criterion? Professor
Lynn Stout argues no. Share Price as a Poor
Criterion for Good Corporate Law, SSRN
Paper 660622 (Jan 2005):
Academics, reformers, and business leaders all
yearn for a single, objective, easy-to-read measure
of corporate performance that can be used to judge
the quality of public corporation law and practice.
This collective desire is so powerful that it
has led many commentators to grab onto the first
marginally plausible candidate: share price.
Contemporary economic and corporate theory (as
well as recent business history) nevertheless
warn us against unthinking acceptance of share
price as a measure of corporate performance. This
Essay offers a brief reminder of some of the many
reasons why stock prices often fail to reflect
performance, including the problem of private
information; obstacles to effective arbitrage;
investors' cognitive defects and biases; options
theory and the problem of multiple residual
claimants; and the problem of corporate spillover
effects that erode diversified shareholders' returns.
These considerations argue against assuming there
is a tight connection between stock prices and
underlying corporate wealth generation. A corporation
or a corporate law system designed around the
philosophy that anything that raises share price
is good is likely to produce a firm that cooks
its books; that avoids long-term projects that
won't appeal to unsophisticated investors; that
investment fads and fancies; that tries to opportunistically
exploit creditors, employees, and customers; and
that pursues business strategies that harm its
diversified shareholders' other investment interests.
The Essay concludes that, if we allow our desire
universal performance measure to blind us to the
fallibility of share price, we court costly error.
The Essay examines three recent examples of just
such erroneous triumphs of hope over experience:
the rise and fall of the Revlon doctrine; the
1990s infatuation with options-based executive
academics' current preoccupation with event studies,
regressions on Tobin's Q, and other forms of empirical
scholarship that attempt to judge the quality
of corporate law and practice according to changes
in share price.
David Puddy, CEO of Arby's, has decided the restaurant
needs to diversify its business into other areas.
Puddy is not familiar with the idea of core competencies
and proposes to the board of directors that the
company begin selling a line of high-end automobiles,
similar to a Saab.
Puddy has determined that such a venture would
entail an initial outlay (including any change
in working capital) of $300 million for market
studies, design development, construction of an
assembly plant, and advertising. Puddy has also
determined the project will lose $25 million in
year one and $3 million in year two. However,
Puddy predicts sales will go up and "conservatively"
estimates the project will net $75 million in
year three, $150 million in year four, and $350
million in year five. Assuming Puddy's figures
are reasonable, should the board approve his plan?
Assume Arby's cost of capital is 15%. What if
Arby's cost of capital is 12%?
Answer: An analyst will need
to determine if undertaking the proposal will
increase shareholder value. Among the more popular
methods to conduct this evaluation are determining
the project's net present value (NPV), internal
rate of return (IRR), or profitability index (PI).
NPV. The NPV is just the present
value of future cash flows of the project minus
its initial investment.
Cash flow in
NPV of project
The NPV of this project is below zero. Thus,
the project will not increase shareholder value
and should not be undertaken.
IRR. The IRR is the rate of
return that discounts any future cash flows to
an amount equal to the initial investment. In
other words, the IRR is the discount rate that
will produce an NPV of zero. This can be determined
though trial and error or a quicker way, the IRR
function in Excel. As we have already determined
that the NPV is relatively close to 0, we know
that the IRR for this series of cash flows can't
be much less than 15%. The actual IRR
on this series of cash flows is 13.75%.
Thus, as the IRR is below the firm's cost of capital,
this project will not increase shareholder value.
Compare other secenarios on attached
PI. The profitability index
is simply the ratio of the present value of the
project's cash flows to its initial cost. A project
that adds value will have a PI of at least 1.0.
PV of Year 1
PV of Year 2
PV of Year 3
PV of Year 4
PV of Year 5
PI = .95
Again, this technique shows the project will
not increase shareholder value as the profitability
index is less than 1.0.
Lowering the cost of capital to 12% will obviously
have an impact on our analysis.
Changing the cost of capital will have no impact
on the actual determination of the project's IRR.
However, the change does bring the cost of capital
below the project's IRR. Thus, with the adjusted
cost of capital, all methods indicate that the
project should be undertaken as it will increase
Suppose Puddy's great idea turns out poorly.
The company loses money. Could you, as an Arby's
shareholder, sue the board of directors for their
negligence? Probably not. Corporate officers are
afforded substantial protection under the business
judgment rule. Judge Winter in Joy v. North,
692 F.2d 880 (2d Cir.1982), explained:
While it is often stated that corporate directors
and officers will be liable for negligence in
carrying out there duties, all seem agreed that
such a statement is misleading. Where as an
automobile drive who makes a mistake in judgment
as to speed or distance injuring a pedestrian
will likely be called upon to respond in damages,
a corporate officer who makes a mistake in judgment
as to economic conditions, consumer tastes,
or production line efficiency will rarely, if
ever, be found liable for damages suffered by
the corporation. Whatever the terminology, the
fact is that liability is rarely imposed upon
corporate directors or officers simply for bad
judgment and this reluctance to impose liability
for unsuccessful business decisions has been
doctrinally labeled the business judgment rule.
Judge Winter gives three reasons for the rule:
- Shareholders voluntarily assume the risk of
bad business judgment. In fact, a key determinant
in choosing investments is the management ability
of the underlying company. Investors have broad
range of companies and investments, some of
which offer less vulnerability to mistakes of
- Litigation coming after the fact is not the
best place to rehash corporate business decisions.
Reconstructing the atmosphere and circumstances
existing when the decision was made is not an
easy task. Also, business decisions often are
made without perfect information or long deliberation.
Decisions made in the heat of the moment may
seem totally irrational today, but at the time,
such a decision was entirely reasonable.
- Significant investment returns are not realized
without risk. The law should not create incentives
for entrepreneurs to not take risks. In addition
and similar to the first point, investors have
numerous options available to diversify their
risk such that judicial intervention is unnecessary.
In conclusion, Winter states that the business
judgment rule protects corporate decision-making
unless the decision “lacks a business purpose,
is tainted by conflict of interest, is so egregious
as to amount to a no-win decision, or results
from an obvious and prolonged failure to exercise
oversight or supervision.”
How should the Arby’s board’s decision