18.3How Management Control Distorts Investment Decisions

Analyzing the separation between the ownership and control of corporations provides

a great deal of insight into how a firm makes investment decisions. This section exam-

ines a firm’s investment policies in two situations. First, when a self-interested man-

ager controls most of the firm’s investment decisions; and second, when a large outside

shareholder has influence over the firm’s strategy for investing, but only indirect con-

trol over specific investment choices.

The Investment Choices Managers Prefer

An important premise of this chapter is that there are significant benefits associated

with controlling a large corporation, and that top executives prefer investments that

enhance and preserve those benefits. As discussed below, a firm’s investment choice

can affect control benefits in a number of ways.

¹⁰The

authors of this study noted that, in many cases, individuals purchase large blocks of shares in

closed-end funds and improve the fund’s value either by forcing managers to liquidate the funds or,

alternatively, by turning the fund into an open-end fund. Since those cases where large shareholders

improve value will not exist in a sample of existing closed-end funds, one should not conclude from the

evidence in this study that large shareholders always diminish the value of closed-end funds.

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How Managerial Incentives Affect Financial Decisions

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Making Investments That Fit the Manager’s Expertise.If benefits from control-

ling a corporation are sufficiently large, a CEO’s desire to remain on the job will

also be very large, providing the CEO with an incentive to bias financing and invest-

ment decisions in a manner that makes it more difficult to replace him in the future

[see Shleifer and Vishny (1989)]. To become entrenched, managers may choose to

make irreversible investments in projects for which they have a particular expertise,

so that they will not become expendable in the future. For this reason, oil firms may

have continued to invest in oil exploration in the early 1980s despite falling oil

prices.

Managers also may wish to rely on implicit contracts and personal relationships in

their business dealings to make it more difficult for potential replacements to com-

pletethe deals that they initiated. Consider, for example, the threat by Steven Spielberg

in the late 1980s to stop making movies with Warner Brothers if its CEO back then,

Stephen Ross, left the company. This of course made Ross’s job much more secure and

probably allowed him to extract greater perquisites than he might otherwise have

obtained.

Making Investments in Visible/Fun Industries.Most of us would probably prefer

managing a media company to a chemical company. There are clearly more opportu-

nities for doing interesting things and meeting interesting people at a movie studio than

at a refinery. Although we have no reason to believe that Seagram’s purchase of Uni-

versal Studios, transforming the firm from a beverage company into a media company,

was a bad investment, we would guess that the Bronfman family, who control Seagram,

probably at least subconsciously considered the personal benefits associated with being

in the movie business when they made the acquisition.

Making Investments That Pay Off Early.An additional consideration is that man-

agers may want to make investments that help the current stock price of the firm even

when they hurt it in the long run. Having favorable financial results in the short run

may allow a manager to raise capital at more favorable rates and, perhaps, both increase

his compensation and reduce the chance that he will lose his job. Chapter 19 describes

how these advantages create a tendency for managers to select projects with a short

payback period over higher NPVinvestments that require a longer payback period.

Making Investments That Minimize the Manager’s Risk and Increase the Scope

of the Firm.The high personal cost of a firm’s bankruptcy provides an additional

bias to the investment and financing choices of managers. Gilson (1990) reported that

only 43 percent of the chief executive officers and 46 percent of the directors keep their

jobs subsequent to the bankruptcy of their firms.

The fear of bankruptcy may explain why managers prefer large empires to small

empires and, hence, often choose to expand their companies faster than they should,

investing more of the company’s earnings and distributing less in dividends than is opti-

mal for value maximization. Managers also may have a tendency to be more risk averse

in their choice of investments than they should be, especially in terms of their treat-

ment of those risks that shareholders can avoid through diversification. Only system-

atic risk matters to shareholders. From the manager’s perspective, however, unsystem-

atic risk as well as systematic risk may be of importance because both affect the

probability of the firm getting into financial trouble and ultimately the probability of

the manager retaining his or her job. This same logic suggests that managers also may

prefer less than the value-maximizing level of debt in their capital structures.

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Strategy, Second Edition		Decisions

638Part VIncentives, Information, and Corporate Control

Of course, the reduction of risk is not the only reason that explains why managers

want to increase the size of their companies. There is added prestige associated with

being the chief executive of a larger company. In addition, it is easier to justify higher

salaries for individuals managing larger organizations. Indeed, compensation consul-

tants include the size of a manager’s organization as a key input in making compen-

sation recommendations.

The tendency of managers to overinvest the firm’s internally generated cash can be

illustrated by the situation at RJR Nabisco before its leveraged buyout (LBO) in 1988.

About one and one-half years before its LBO, RJR Nabisco’s baking unit devised a plan

to completely revamp and modernize its baking facilities at a cost of $2.8 billion. The

annual savings from this modernization would have been only $148 million, providing a

pretax return of only about 5 percent.¹¹After the LBO, which substantially cut the

resources available for investment, the modernization plan was scaled back considerably.

Summarizing Management Investment Distortions.Result 18.4 summarizes the

preceding discussion about the ways in which investments chosen by managers may

differ from investments selected purely on the basis of value maximization.

Result 18.4

Managers may prefer investments that enhance their own human capital and minimize risk.This implies that:

•	Managers may prefer larger, more diversified firms.
•	Managers may prefer investments that pay off more quickly than those that would maximize the value of their shares.

Outside Shareholders and Managerial Discretion

Up to this point, we have assumed that managers control the investment choice. How-

ever, large outsideshareholders, knowing that managers have a tendency to skew deci-

sions in directions that benefit them personally, have an incentive to reduce manage-

ment’s discretion. These outside shareholders may favor investments in fixed assets and

other technologies that limit the manager’s future discretion.

Allied Industries

Consider the hypothetical example of Allied Industries, a conglomerate with business units

in a number of industries. Its CEO and major shareholder, John Osborne, has appointed

James Brandon to run its farm machinery division. Brandon is a good choice for this posi-

tion because he understands farm machinery better than anyone in the world. As a cham-

pion of quality, he represents a commitment to customers that Allied’s farm machinery will

be the best on the market.

Unfortunately, Brandon’s commitment to quality is also his biggest weakness. Osborne

is worried that Brandon will spend too much money to produce the “perfect” tractor when

an “almost perfect” tractor would still be the best on the market.

Before completely turning over the division to Brandon, Osborne must decide between

two production processes: a labor-intensive process and a capital-intensive process. The

labor-intensive process requires more upfront training costs, but the yearly cost of the

capital-intensive process is actually the higher of the two processes given the high mainte-

nance costs of the machinery. Osborne would certainly prefer the labor-intensive process if

he were running the farm equipment division himself. In addition to its lower costs, the

labor-intensive process provides the flexibility to improve the quality of the product by

¹¹The Wall Street Journal,Mar. 14, 1989.

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Markets and Corporate	and Corporate Control	Incentives Affect Financial	Companies, 2002
Strategy, Second Edition		Decisions

Chapter 18

How Managerial Incentives Affect Financial Decisions

639

increasing costs. However, since he wishes to delegate all future decisions to Brandon, he

believes that the capital-intensive technology will be the better alternative because he does

not wish to give Brandon too much discretion in choosing the quality of the product.

Trading Off the Benefits and Costs of Discretion.The Allied Industries example

illustrated a negative aspect of flexibility. However, as Chapter 12 noted, under uncer-

tainty, flexible investment designs can add value to a firm since flexibility increases a

firm’s operating options. The value of that flexibility is greater, the greater is the uncer-

tainty. Hence, the costs associated with having to limit flexibility because of incentive

problems is greater, the greater the level of uncertainty. With sufficient uncertainty, it

is better for the outside shareholders to expend more effort monitoring management but

also to allow managers greater flexibility and discretion. However, when there is very

little uncertainty, the outside shareholders may want to limit the manager’s flexibility.

In sum, we have the following result:

Result 18.5

Allowing management discretion has benefits as well as costs.

•	The benefits of discretion are greater in more uncertain environments.
•	The costs of discretion are greater when the interests of managers and shareholdersdo not coincide.

Therefore, we might expect to find more concentrated ownership and more managerial dis-

cretion in firms facing more uncertain environments.