CRITICAL ANALYSIS AND COMMENT

Investment appraisal decision rules are the generally accepted criteria for either accepting a project or rejecting that project. The principle of maximising shareholders wealth as a corporate objective has generally become equated with maximising the company’s share price. This is evidenced by the fact that many leading finance authors have taken this to be valid. For example, Hillier et al 2010 states:

“..the financial manager acts in the shareholders’ best interests by making decisions that increases the value of the stock”. Gitman 1991 also said that “..financial managers only accepts those actions which are expected to increase the share price”.

It is the conventional rule of traditional finance to accept only those projects which their NPVs come out as positive. This conventional rule of corporate finance is fundamentally wrong and indefensible as this article will prove. The conventional rule will be looked at under three different states of economic conditions/ assumptions of products and equity market.

The conventional rule of accepting only projects with positive NPVs can only make sense if and only if (a) stock market prices systematically undervalue corporate growth potential, and (b) product markets are inherently uncompetitive. Before proceeding, it would be wise if a clear distinction is made between a normal and an abnormal/ supernormal share price growth. The normal share price growth is a function of inflation and retained earnings, and the supernormal share price growth is generated when a company invests in projects with positive NPVs. The normal growth is okay, what we are however arguing is that abnormal growth is not feasible under certain economic conditions and should therefore not be used as a precondition for investment or to judge the performance of a particular manager.

ASSUMPTION A / ECONOMIC CONDITION A

Under this assumption, product markets are assumed to be perfectly competitive and equity markets have perfect foresight. What this implies is that there is absence of any significant opportunity to earn abnormal high returns that will translate into projects with positive NPVs. The best that a manager can do is to identify a project that meets the minimum criterion- having a non negative NPV.

Making share price growth a target here will clearly be meaningless and irrational. The share price here has no more than a secondary role, i.e. acting as a constraint on expansion rather than as target of investment. At this point, one might be asking; what becomes the motivation of existing shareholders to sanction or endorse the execution of projects with non-negative NPV? Well, the simple answer to this question is; to retain good managers and their services as their remuneration is linked to the size of the company.

ASSUMPTION B/ ECONOMIC CONDITION B

Product markets are assumed to be imperfectly competitive and equity markets again have perfect foresight. Under this assumption, the market allows some actual projects with positive NPVs to be spotted, thereby creating an opportunity for share prices to be improved. Again, the market having a foresight already knows and prices all unexpected future positive NPVs into the price of the share at floatation, creating a windfall for the founder shareholders for their ingenuity in spotting projects with positive NPVs. The presence of positive NPVs does not change the decision rule, it simply meets the expectation of the market which is already incorporated into the share price but, its achievement will only be rewarded by normal growth. I will conclude this section by drawing your attention to the statement of Prof. Simon Keane “a positive NPV is a bonus, not a precondition for investment”.

This also shows that it is impossible for the activities of good managers to guarantee a share price growth as the market already knows that and incorporate same into the share price. A greater NPV is, of course, always preferable to a lesser one, but the only precondition for making investment decision is that the project should have a non-negative price reaction

ASSUMPTION C / ECONOMIC CONDITION C

The assumption here is that product markets are assumed to be imperfectly competitive and equity market has as imperfect foresight. Under this last assumption, the inability  of the securities markets to accurately predict the future is recognised but, the market nonetheless assumed to be forward looking and relatively efficient in processing information, including information about the future corporate earnings potential. Markets do not need to accurately capture all future positive NPVs, all that is needed is a simple guess. Provided the market is not systematically biased, the effect of the price correction on the share price can either be positive or negative. This again makes it unreasonable and irrational for expectation of abnormal share price growth to be the objective of management.

For share price growth to be a valid pre-condition of new investment without leading to underinvestment, not only would the stock market need to be short sighted but the product market would also need to be unrealistically uncompetitive to the extent that all firms continually face a surplus of positive NPV projects.

THE IDEAL EXPECTATIONS FORM MANAGERS OF A COMPANY

It is irrational and unfair to expect managers to perform beyond what you expect from them. The share prices already reflect how management is expected to perform and will only show abnormal growth only if managers perform better than expected. Managers can only make abnormal profit by chance unless share prices are systematically undervalued.

NEGATIVE IMPACTS OF USING SHARE PRICE GROWTH AS A PERFORMANCE MEASURE

The generally wide held belief that creation and acceptance of positive NPV projects that will increase the share price of a company is normal has some consequences that many people are yet to realise.

Using share prices movement as a basis for managerial appraisal and remuneration will lead to incorrect investment decisions being taken by the assessor. This in most cases leads to significant underinvestment as managers only look for projects with positive NPVs.

WHAT SHOULD BE THE RIGHT INVESTMENT APPRAISAL DECISION RULE?

The right investment appraisal decision rule is that managers should accept all projects that have a non-negative NPV. Remember that having a non negative NPV simply means that the project meets what the market requires of it. If you think that the project is discounted at the wrong cost of capital, then the right thing to do should be to re-evaluate the discounting cost of capital and not to expect managers to perform more than you expected them to do.

On this note, the right objective of the firm as opposed to what many textbooks stated should be to maximise the value of a firm subject to maintaining current share price. This objective can be represented mathematically as: Max V | Max P. Where V= value of the firm, and Max P is acting as a constraint on current share price. This implies that managers would be unwise not to take any opportunity of making abnormal growth that presents itself. This however does not make share price growth a pre-condition for investment or managerial compensation.

I hope you did enjoy this critique of the current investment appraisal decision rule? I would be happy if you would deem it fit to drop one or two lines of comment.