The Fallacies of Corporate Investment Appraisal: A discussion of Share Price Maximization

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1 Inernaional Conference on Logisics Engineering, Managemen and Compuer Science (LEMCS 2015) The Fallacies of Corporae Invesmen Appraisal: A discussion of Share Price Maximizaion Wang Xue College of Airpor Engineering and Transporaion Managemen Civil Aviaion Fligh Universiy of China Guanghan, China Janewang0128@126.com Absrac For a long ime, share price growh has been regarded as he primary benchmark of success in managemen decision-making for lised enerprises. However, his viewpoin may lead o bias of he managemen objecive, underinvesmen in capial budgeing, and inappropriae reward scheme for managemen. Based on he fundamenal heory of corporae finance, he paper ends o find ou he fallacies of share price maximizaion heory and some inappropriae crieria for invesmen appraisal. The heory of Capial Marke Efficiency, Capial Srucure, equaions of Ne Presen Value and decision making crieria such as Payback and Inernal Rae of Reurn will be used o suppor he analysis. The paper illusraes ha alhough share price has imporan effecs on financial managemen of a lised corporae, i may be misleading and cause fallacies in managemen. Some frequenly used crieria may resul in misakes in invesmen decision making. I is imporan ha managers pursue a valid objecive and make invesmen decisions based on raional crieria. In summary, his paper gives financial managers general suggesions on corporae goal seing and capial budgeing bu sill he problems can be solved by furher sudies. Keywords-Share Price Maximizaion; Company Objecive; Marke Efficiency; Invesmen Decision; Ne Presen Value I. INTRODUCTION As a corporae manager, he mos fundamenal asks are pursuing a valid goal for he corporae and making invesmen decisions based on appropriae crieria. Any misakes in fulfilling hese asks may resul in loss or even bankrupcy o he corporae. Therefore, i is imporan o pursue a valid objecive and find appropriae benchmarks of success in managemen decision-making. In a radiional poin of view, financial managers in a lised corporaion make decisions for he shareholders because he shareholders own and conrol he corporaion. Therefore, he primary objecive of he corporaion is o add value for he shareholders [1]. As a resul, share price maximizaion (SPM) has been viewed as a financial objecive in many companies for a long ime. However, i is debaed ha SPM as a benchmark of success in managemen decision-making is irraional even misleading. Some frequenly used crieria such as IRR and Payback in invesmen appraisal are also flawed. The paper will find ou he fallacies of share price effecs in corporae financial managemen such as evaluaion of corporae value, capial budgeing and invesmen decision-making. II. MARKET AND SHARE PRICE Before discussing he validiy of share price maximizaion in realiy, he efficien-marke hypohesis should be inroduced firs. A. Efficiency of Capial Marke As Ross e al menioned, an efficien capial marke is one in which sock prices fully reflec available informaion [1]. The efficien level of a capial marke is deermined by precise definiion of informaion [2]. Informaion is commonly classified ino hree ypes: informaion on pas prices, available informaion in public and all informaion including he former wo ypes and all informaion in privae. According o differen effecs of informaion ypes, he marke can be caegorized o he weak form efficiency, semi-srongform efficiency and srong-form efficiency [3]. If he capial marke is srong-form efficien, he share price will fully reflec all he informaion in he marke even some informaion is hold by some company insiders. The efficiency level of one capial marke is relaed o many facors, such as he governmen policies, he mauriy of he marke, he echnical echnologies used for he marke and he raionaliy of he major invesors. In a srong efficien marke, share price is able o represen he corporae value o some exen while in a weak efficien marke share price can be overvalued or undervalued for a long period due o he lae arrival or even false informaion. Before esimaing share prices, an invesigaion should be aken firs o define he efficiency level of he capial marke especially in emerging or less-developed markes. B. Produc Marke and Share Price In a perfecly compeiive produc marke, posiive- NPV invesmens are hard o find. Therefore, here can be no expecaion o earn abnormal reurn in sock invesmen [4]. The company s share price will remain a horizonal line afer is floaion The auhors - Published by Alanis Press 941

2 When he marke is no perfecly compeiive, here seems o be opporuniies for some firms o gain abnormal reurn by exploiing posiive-npv projecs. However, as Findlay and Williams menioned, even hese excess reurn opporuniies exised, invesors sill could no expec abnormal reurn on he share price growh [5]. The shares are priced by he sock marke according o he ne presen values of all projecs over he firm s life ime. The pricing funcion of sock marke refers o he expecaions of he fuure by invesors. Invesors make he invesmen decision according o he firm s poenial, which can be represened by is fuure projecs. Share price also depends a lo on he marke efficiency as menioned before. In his scheme, he marke has an abiliy o predic he fuure sream of Ne Presen Values (NPVs) of all he projecs raher han waiing for hem o occur. Tha means he share price reflec no only curren projecs bu also fuure earnings poenial. When he sock marke has a perfec foresigh, he poenial of he firm s fuure abnormal reurn is all discouned ino he iniial share price and generaion shareholders can expec o gain nohing bu normal reurn for risk. NPV can be calculaed as follows under a cerain discoun rae (r) if fuure cash flows are caegorized ino an iniial invesmen (I 0 ) and periodical earnings (E ) along is lifeime (T). CF E NPV (1 ) (1 r) T T I 0 1 r 1 The relaionship beween share price, sreams of NPVs and earnings can be shown as follows. Figure 1. Relaionship beween share price, NPVs and earning I is doubed by Pena [6] ha he informaion deficiency could las long due o informaion cos. However, as Copeland and Weson suggesed, he efficiency of marke is relaive o informaion which excludes cos of acquiring, ransmiing and evaluaing messages [2]. For invesors, spending money on securiy analysis before invesmen and random selecion of shares are jus alernaive sraegies which are idenical. Even when he marke predics he fuure imperfecly, he share price will reflec he marke esimaion o he bigges exen. There can be equal cerainy for he marke o overesimae and underesimae he price, so abnormal reurn on share price growh sill canno be expeced. III. FALLACIES OF SPM According o he se-of-conracs heory [7], a firm can be viewed as a se of conracs while he shareholders as equiy invesors are he principals of he firm. The managers as he agens in he corporae firm will usually aemp o maximize he shareholder s wealh by aking acions ha increase he value per share of he firm s sock. Arnold also suggesed ha he goal of a firm is o maximize is shareholders wealh because shareholders own he firm, and hus deserve any surplus he firm produces [8]. I is hen saed in many exbooks ha he financial objecive of he firm is o maximize share price. However SPM can lead o several fallacies. A. Underinvesmen bias leaded by SPM objecive The hough of share price maximizaion may lead o underinvesmen and consequenly resul in loss of firm value. There are hree fallacies leading o underinvesmen which are he posiive-npv fallacy, he reinvesmen fallacy and invesmen efficiency fallacy. 1) Firm value and share price Denoe P as he firm s share price, V as firm value. For a pure equiy firm, is firm value can be simply calculaed as: V N P 942

3 I can be seen ha firm value and share price canno be equaled. The company canno expec share price growh o add firm value [4]. Someimes he wo elemens may even conradic o each oher. Though growh in V canno be expeced o resul from growh in P, managers canno add he firm value a he expense of share price. As a resul, managers may give up some projecs which can add value o he firm bu bring down he share price. In he real world, he value of he firm (V) is defined as V B+S Where B is he marke value of he deb and S is he marke value of he equiy. The capial srucure can be shown as he Fig. 2. Value of firm Figure 2. Pie Model of Capial Srucure Bonds Socks The capial srucure of a corporae should be raionally leveraged by choosing a deb-equiy raio ha makes he oal value maximum. Taking axes and bankrupcy coss ino consideraion, he composiion of he firm s value is illusraed in Fig. 3 and should be calculaed as in Equaion (4). Value of firm Bondholder Tax Shareholder Bankrupcy Figure 3. The Pie Model wih Real-world Facors The value of he firm will be paid ou o bondholders, shareholders, axes (governmen) and bankrupcy claims. V=B+S+G+A Where G sands for he governmen and axes while A sands for bankrupcy coss. In he real world, a firm s value is no only relaed o share price bu also many oher facors. According o he equaion above, SPM is no he only way o add firm, bu may be a barrier for managers o add he firm value by changing oher facors. If puing share price in he firs place when making a decision, some profiable projecs may be rejeced. 2) Feasibiliy of zero-npv projecs I is menioned in Smallwood s paper ha he had never known a projec wih zero-npv o be acceped and he regarded abnormal reurn as a precondiion of invesmen [9]. To his laer argumen, i has been discussed ha even when he marke is no ha efficien o esimae he share price perfecly, he flucuaion of he price is due o he unexpeced evens raher han poenial of abnormal earnings. As o he former poin, i is exacly how he companies ac o resul in underinvesmen. I is cied in Arnold s book ha Michael Heseline, he one-ime presiden of he Board of Trade, complained ha Business are no invesing enough because of heir excessive expecaions of invesmen reurns. [8] Many companies expec oo high a rae of reurn so ha ignore zero-npv invesmens compleely. Under he objecive of share price maximizaion, firms end o fall in he posiive-npv fallacy. There is no doub ha posiive-npv pro jecs are more welcome han zero- NPV ones. However, posiive-npv canno be he precondiion of invesmens. Wheher subscribe o SPM or no, many managers and scholars ake no accoun of zero- NPV invesmens. In fac, in a perfec marke, companies can only expec o inves in zero-npv projecs o add he firm value. Fro m anoher perspecive, alhough projecs wih zero- NPV seem o make no economic benefis, hey can however bring ou social benefis. Managers should make sure he role he firm plays before evaluae he projecs. Someimes even negaive-npv projecs are acceped o fulfill some social responsibiliies or o solve non-financial problems. 3) The firm s objecives According o he discussion above, i can be concluded ha he overall objecive of he firm is o maximize firm value subjec o maximize he share price or MAX V MAX P no maer wheher he marke is perfecly compeiive or no. This objecive implicaes ha he capial budgeing objecive of a firm is o ake nonnegaive-npv projecs as many as possible in order o gaher capial. B. SPM leads o misjudgemen of managemen When some firms se heir objecive as SPM, hey view share price growh as a crierion of managemen in consequence. This is in fac meaningless because managers canno be expeced o increase share price a all. 1) Managers can no be judged by share price growh Due o he marke s predicion, a sock is priced aking ino accoun all he poenial abnormal earnings including managemen performance a he very beginning. In oher words, a firm s managemen qualiy has been refleced in is share price. The expecaion of earning abnormal reurn 943

4 by choosing a good managed firm insead of a poor managed one in fac makes no sense. This does no mean expecing comparable performance from badly managed companies o well managed companies [10]. Of course good managers are more likely o perform beer han he poor ones. However, his performance poenial has been discouned ino he share price and if here is error of he marke predicion, he chance of share price growh and decrease equal even when he firm is well managed. Besides, according o an analysis of performance pay over 2,000 CEOs, i is suggesed by Jensen and Murphy ha he relaion beween CEO wealh and shareholder wealh is small [11]. Therefore, i is nonsense o relae share price growh o managemen reward scheme. Share price growh can be used as an incenive force o managers bu is never raional o be an assessmen of managemen, eiher reward basis. 2) Valid assessmens of managemen According o he overall objecive of he firm, managers should exploi projecs wih posiive and zero NPVs as many as possible. Therefore, managemen performance should be assessed primarily by reference o he number of projecs underaken and NPVs no relaing o he share price or wheher he performance of he firm is improved while he share price remain fla or increase. IV. CRITERIA OF INVESTMENT DECISIONS Besides a valid overall objecive for he company, here should be raional crieria for financial managers o make appropriae decisions when choosing projecs. Many exbooks sugges ha he ideal crierion of capial appraisal is a combinaion of NPV, IRR and someimes Payback. NPV is undoubedly he bes valuaion mehod for new projecs. The following conen will discuss he raionaliy of he oher wo especially IRR. A. Payback Payback is defined as a measure of projecs from he perspecive of how long i akes o recoup he iniial invesmen [12]. As mos exbooks referred, he wo weaknesses of Payback are ha i ignores he ime value of money (Saic Payback ime) and sreams of cash flows beyond he payback period. However, he inheren flaw of Payback is ha i is in fac a hough of ani-invesmen. Even i can be amended o discoun Payback and reflec he ime value of money, i sill implicaes ha he firm should ge he invesmen money back as soon as possible. If payback is he primary crierion when evaluaing projecs, shor erm invesmen will definiely be chosen raher han long erm ones because he invesmen capial can be recovered sooner. In ha case, managers will rejec long erm invesmens even hey conribue o he firm value. To achieve he financial objecive, he company should inves as much and as long as possible. B. IRR IRR, Inernal rae of reurn, is he annualized effecive compounded reurn rae or rae of reurn ha makes he NPV of all cash follows from an invesmen equal o zero [1]. I is widely used and ofen be viewed as an alernaive way of NPV. NPV N n 0 C n (1 r) n 0 Given he invesmen period (n), cash flows C n and he oal number of periods N, IRR (r) can be calculaed. Bu he calculaion resul may have some shorcomings: IRR does no exis, muliple IRR exis, IRR is incompaible wih NPV [13]. Moreover, IRR canno be used o value projecs unless hey are sricly idenical. To prove his poin, he raioning and non-raioning of he capial should be menioned firs. 1) Raioning and Nonraioning I is misconceived by many people ha he marke is raioning. They hink ha because of shor of capial, companies have limied capial o inves in he projecs. However, as long as he company has a projec o assess, i indicaes ha here is enough capial o underake his projec. 2) Flaws of IRR I is generally argued ha flaws of IRR are muliple raes of reurn and he scale problem [1]. Acually if IRR is valid, he muliple raes of reurn will no affec he decision making. The only difference beween i and he single rae of reurn is ha he value of IRR is a range raher han a poin. To he scale problem, he exbooks sugges ha an incremenal IRR approach can solve i. Though sounds reasonable, his approach in fac falls ino he reinvesmen fallacy. In a non-raioning environmen, he company will no lack he capial of he incremenal invesmen. I is meaningless o compare he incremenal IRR wih he small budge IRR. Therefore, his mehod is no advisable. The real problem of IRR approach is from is subsanial fallacy. IRR requires he projecs o be compared sricly having equal lives, equal oulays and same cash paerns. This requiremen can only be achieved in he securiies marke. In a produc marke, IRR can never be used o rank projecs. However as a radiional invesmen appraisal crierion, IRR is no abandoned due o he shorages bu revised and used o inroduce new crieria based on i such as AIRR in recen years [14]. C. Raional crieria for decision making To summarize, NPV is he only valid measuremen of invesmens. IRR canno be used because is scale problem while Payback resul in ani-invesmen. Use IRR as a supplemen of NPV will only be conflicing and misleading. V. CONCLUSION I is imporan for firms o se a raional objecive and choose appropriae decision crieria when valuing invesmen projecs. SPM is misleading and canno be used as he primary benchmark of managemen success. Insead of he widely acceped SPM, companies should ake firm value maximizing subjec o maximize share price as heir objecive. In consequence, managers performance canno be judged enirely by he share price growh. To reach he firm s overall objecive, valid crieria of invesmen appraisal is essenial. NPV should be he prime measure of invesmen decision. IRR and Payback can be used unil he flaws are correcly revised and no conflic wih NPV. 944

5 ACKNOWLEDGMENT The auhor is graeful o he anonymous referees, o he family and friends who help and suppor me along he ime. REFERENCES [1] Ross, S.A., Weserfield, R.W., and Jaffe, J., Corporae Finance [M], 9h ed., The McGraw-Hill, 2010, pp [2] Copeland, T.E. and Weson, J.F., Financial Theory and Corporae Policy [M], 3rd ed., Addison-Wesley Publishing Company, [3] Fama, E.F., Efficien capial markes: A review of heory and empirical work [J], Journal of Finance, May. 1970, pp [4] Keane, S.M., A reappraisal of share price maximizaion as a corporae financial objecive [J], European Journal of Finance, Vol. 1, 1995, pp [5] Findlay, M. and Williams, E., Owners Surplus, he Marginal Efficiency of Capial and Marke Equilibrium [J], Journal of Business Finance and Accouning, Spring. 1979, pp.2 8. [6] Pena, J.I., Commen [J], The European Journal of Finance, Vol. 1, 1995, pp [7] M. C. Jensen and W. Meckling, Theory of he Firm: Managerial Behavior, Agency Coss and Ownership Srucure [J], Journal of Financial Economics Vol. 3, [8] Arnold, G., Corporae Financial Managemen [M], 5rd ed., Pearson Educaion Limied, 2012, pp [9] Smallwood, C.R., Commen [J], The European Journal of Finance, Vol. 1, 1995, pp [10] Quick, G., Commen: An analys s reacion [J], The European Journal of Finance, Vol. 1, 2011, pp [11] Jensen, M., and Murphy, K., Performance pay and opmanagemen incenives [J], Journal of Poliical Economy, Vol. 98, 1990, pp [12] Shapiro, A.C., Capial Budgeing and Invesmen Analysis [M], Pearson Prenice Hall, 2004, p. 18. [13] Guerra, M.L., Magni, C.A. and Sefanini, L., Inerval and fuzzy Average Inernal Rae of Reurn for invesmen appraisal, Fuzzy Ses and Sysems, Vol. 257, Dec. 2014, pp [14] Alshuler, D., and Magni, C.A., Why he IRR is no he rae of reurn for your invesmen- inroducing AIRR o he real esae communiy [J], Real Esae Porf. Manag., Vol. 18(2), 2012, pp