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Here then we have two equivalent decision rules for capital investment:4

•Net present value rule. Accept investments that have positive net present values.

•Rate-of-return rule. Accept investments that offer rates of return in excess of their opportunity costs of capital.5

The Opportunity Cost of Capital

The opportunity cost of capital is such an important concept that we will give one more example. You are offered the following opportunity: Invest $100,000 today, and, depending on the state of the economy at the end of the year, you will receive one of the following payoffs:

$80,000 $110,000 $140,000

You reject the optimistic (boom) and the pessimistic (slump) forecasts. That gives an expected payoff of C1 110,000,6 a 10 percent return on the $100,000 investment. But what’s the right discount rate?

You search for a common stock with the same risk as the investment. Stock X turns out to be a perfect match. X’s price next year, given a normal economy, is forecasted at $110. The stock price will be higher in a boom and lower in a slump, but to the same degrees as your investment ($140 in a boom and $80 in a slump). You conclude that the risks of stock X and your investment are identical.

Stock X’s current price is $95.65. It offers an expected rate of return of 15 percent:

Expected return expected profit 110 95.65 .15, or 15% investment 95.65

This is the expected return that you are giving up by investing in the project rather than the stock market. In other words, it is the project’s opportunity cost of capital.

To value the project, discount the expected cash flow by the opportunity cost of capital:

PV 110,000 $95,650 1.15

This is the amount it would cost investors in the stock market to buy an expected cash flow of $110,000. (They could do so by buying 1,000 shares of stock X.) It is, therefore, also the sum that investors would be prepared to pay you for your project.

To calculate net present value, deduct the initial investment:

NPV 95,650 100,000 $4,350

4You might check for yourself that these are equivalent rules. In other words, if the return 50,000/350,000 is greater than r, then the net present value 350,000 [400,000/(1 r)] must be greater than 0.

5The two rules can conflict when there are cash flows in more than two periods. We address this problem in Chapter 5.

6We are assuming that the probabilities of slump and boom are equal, so that the expected (average) outcome is $110,000. For example, suppose the slump, normal, and boom probabilities are all 1/3. Then the expected payoff C1 (80,000 110,000 140,000)/3 $110.000.

The project is worth $4,350 less than it costs. It is not worth undertaking.

Notice that you come to the same conclusion if you compare the expected project return with the cost of capital:

expected profit

Expected return on project

investment

110,000 100,000 .10, or 10% 100,000

The 10 percent expected return on the project is less than the 15 percent return investors could expect to earn by investing in the stock market, so the project is not worthwhile.

Of course in real life it’s impossible to restrict the future states of the economy to just “slump,” “normal,” and “boom.” We have also simplified by assuming a perfect match between the payoffs of 1,000 shares of stock X and the payoffs to the investment project. The main point of the example does carry through to real life, however. Remember this: The opportunity cost of capital for an investment project is the expected rate of return demanded by investors in common stocks or other securities subject to the same risks as the project. When you discount the project’s expected cash flow at its opportunity cost of capital, the resulting present value is the amount investors (including your own company’s shareholders) would be willing to pay for the project. Any time you find and launch a positive-NPV project (a project with present value exceeding its required cash outlay) you have made your company’s stockholders better off.

A Source of Confusion

Here is a possible source of confusion. Suppose a banker approaches. “Your company is a fine and safe business with few debts,” she says. “My bank will lend you the $100,000 that you need for the project at 8 percent.” Does that mean that the cost of capital for the project is 8 percent? If so, the project would be above water, with PV at 8 percent 110,000/1.08 $101,852 and NPV 101,852 100,000 $1,852.

That can’t be right. First, the interest rate on the loan has nothing to do with the risk of the project: It reflects the good health of your existing business. Second, whether you take the loan or not, you still face the choice between the project, which offers an expected return of only 10 percent, or the equally risky stock, which gives an expected return of 15 percent. A financial manager who borrows at 8 percent and invests at 10 percent is not smart, but stupid, if the company or its shareholders can borrow at 8 percent and buy an equally risky investment offering 15 percent. That is why the 15 percent expected return on the stock is the opportunity cost of capital for the project.

2.2 FOUNDATIONS OF THE NET PRESENT VALUE RULE

So far our discussion of net present value has been rather casual. Increasing value sounds like a sensible objective for a company, but it is more than just a rule of thumb. You need to understand why the NPV rule makes sense and why managers look to the bond and stock markets to find the opportunity cost of capital.

In the previous example there was just one person (you) making 100 percent of the investment and receiving 100 percent of the payoffs from the new office building. In corporations, investments are made on behalf of thousands of shareholders with varying risk tolerances and preferences for present versus future income. Could a positive-NPV project for Ms. Smith be a negative-NPV proposition for Mr. Jones? Could they find it impossible to agree on the objective of maximizing the market value of the firm?

The answer to both questions is no; Smith and Jones will always agree if both have access to capital markets. We will demonstrate this result with a simple example.

How Capital Markets Reconcile Preferences for Current vs. Future Consumption

Suppose that you can look forward to a stream of income from your job. Unless you have some way of storing or anticipating this income, you will be compelled to consume it as it arrives. This could be inconvenient or worse. If the bulk of your income comes late in life, the result could be hunger now and gluttony later. This is where the capital market comes in. The capital market allows trade between dollars today and dollars in the future. You can therefore eat moderately both now and in the future.

We will now illustrate how the existence of a well-functioning capital market allows investors with different time patterns of income and desired consumption to agree on whether investment projects should be undertaken. Suppose that there are two investors with different preferences. A is an ant, who wishes to save for the future; G is a grasshopper, who would prefer to spend all his wealth on some ephemeral frolic, taking no heed of tomorrow. Now suppose that each is confronted with an identical opportunity—to buy a share in a $350,000 office building that will produce a sure-fire $400,000 at the end of the year, a return of about 14 percent. The interest rate is 7 percent. A and G can borrow or lend in the capital market at this rate.

A would clearly be happy to invest in the office building. Every hundred dollars that she invests in the office building allows her to spend $114 at the end of the year, while a hundred dollars invested in the capital market would enable her to spend only $107.

But what about G, who wants money now, not in one year’s time? Would he prefer to forego the investment opportunity and spend today the cash that he has in hand? Not as long as the capital market allows individuals to borrow as well as to lend. Every hundred dollars that G invests in the office building brings in $114 at the end of the year. Any bank, knowing that G could look forward to this sure-fire income, would be prepared to lend him $114/1.07 $106.54 today. Thus, instead of spending $100 today, G can spend $106.54 if he invests in the office building and then borrows against his future income.

This is illustrated in Figure 2.1. The horizontal axis shows the number of dollars that can be spent today; the vertical axis shows spending next year. Suppose that the ant and the grasshopper both start with an initial sum of $100. If they invest the entire $100 in the capital market, they will be able to spend 100 1.07$107 at the end of the year. The straight line joining these two points (the innermost line in the figure) shows the combinations of current and future consumption that can be achieved by investing none, part, or all of the cash at the 7 percent rate offered in the capital market. (The interest rate determines the slope of this line.) Any other point along the line could be achieved by spending

tween the $106.54 present value and the $100 initial investment. Despite their different tastes, both A and G are better off by investing in the office block and then using the capital markets to achieve the desired balance between consumption today and consumption at the end of the year. In fact, in coming to their investment decision, both would be happy to follow the two equivalent rules that we proposed so casually at the end of Section 2.1. The two rules can be restated as follows:

•Net present value rule. Invest in any project with a positive net present value. This is the difference between the discounted, or present, value of the future cash flow and the amount of the initial investment.

•Rate-of-return rule. Invest as long as the return on the investment exceeds the rate of return on equivalent investments in the capital market.

What happens if the interest rate is not 7 percent but 14.3 percent? In this case the office building would have zero NPV:

NPV 400,000/1.143 350,000 $0

Also, the return on the project would be 400,000/350,000 1 .143, or 14.3 percent, exactly equal to the rate of interest in the capital market. In this case our two rules would say that the project is on a knife edge. Investors should not care whether the firm undertakes it or not.

It is easy to see that with a 14.3 percent interest rate neither A nor G would gain anything by investing in the office building. A could spend exactly the same amount at the end of the year, regardless of whether she invests her money in the office building or in the capital market. Equally, there is no advantage in G investing in an office block to earn 14.3 percent and at the same time borrowing at 14.3 percent. He might just as well spend whatever cash he has on hand.

In our example the ant and the grasshopper placed an identical value on the office building and were happy to share in its construction. They agreed because they faced identical borrowing and lending opportunities. Whenever firms discount cash flows at capital market rates, they are implicitly assuming that their shareholders have free and equal access to competitive capital markets.

It is easy to see how our net present value rule would be damaged if we did not have such a well-functioning capital market. For example, suppose that G could not borrow against future income or that it was prohibitively costly for him to do so. In that case he might well prefer to spend his cash today rather than invest it in an office building and have to wait until the end of the year before he could start spending. If A and G were shareholders in the same enterprise, there would be no simple way for the manager to reconcile their different objectives.

No one believes unreservedly that capital markets are perfectly competitive. Later in this book we will discuss several cases in which differences in taxation, transaction costs, and other imperfections must be taken into account in financial decision making. However, we will also discuss research which indicates that, in general, capital markets function fairly well. That is one good reason for relying on net present value as a corporate objective. Another good reason is that net present value makes common sense; we will see that it gives obviously silly answers less frequently than its major competitors. But for now, having glimpsed the problems of imperfect markets, we shall, like an economist in a shipwreck, simply assume our life jacket and swim safely to shore.

2.3 A FUNDAMENTAL RESULT

Our justification of the present value rule was restricted to two periods and to a certain cash flow. However, the rule also makes sense for uncertain cash flows that extend far into the future. The argument goes like this:

1.A financial manager should act in the interests of the firm’s owners, its stockholders. Each stockholder wants three things:

a.To be as rich as possible, that is, to maximize current wealth.

b.To transform that wealth into whatever time pattern of consumption he or she desires.

c.To choose the risk characteristics of that consumption plan.

2.But stockholders do not need the financial manager’s help to achieve the best time pattern of consumption. They can do that on their own, providing they have free access to competitive capital markets. They can also choose the risk characteristics of their consumption plan by investing in more or less risky securities.

3.How then can the financial manager help the firm’s stockholders? There is only one way: by increasing the market value of each stockholder’s stake in the firm. The way to do that is to seize all investment opportunities that have a positive net present value.

Despite the fact that shareholders have different preferences, they are unanimous in the amount that they want to invest in real assets. This means that they can cooperate in the same enterprise and can safely delegate operation of that enterprise to professional managers. These managers do not need to know anything about the tastes of their shareholders and should not consult their own tastes. Their task is to maximize net present value. If they succeed, they can rest assured that they have acted in the best interest of their shareholders.

This gives us the fundamental condition for successful operation of a modern capitalist economy. Separation of ownership and control is essential for most corporations, so authority to manage has to be delegated. It is good to know that managers can all be given one simple instruction: Maximize net present value.

Other Corporate Goals

Sometimes you hear managers speak as if the corporation has other goals. For example, they may say that their job is to maximize profits. That sounds reasonable. After all, don’t shareholders prefer to own a profitable company rather than an unprofitable one? But taken literally, profit maximization doesn’t make sense as a corporate objective. Here are three reasons:

1.“Maximizing profits” leaves open the question, Which year’s profits? Shareholders might not want a manager to increase next year’s profits at the expense of profits in later years.

2.A company may be able to increase future profits by cutting its dividend and investing the cash. That is not in the shareholders’ interest if the company earns only a low return on the investment.

3.Different accountants may calculate profits in different ways. So you may find that a decision which improves profits in one accountant’s eyes will reduce them in the eyes of another.

2.4 D O MANAGERS REALLY LOOK AFTER THE INTERESTS OF SHAREHOLDERS?

We have explained that managers can best serve the interests of shareholders by investing in projects with a positive net present value. But this takes us back to the principal–agent problem highlighted in the first chapter. How can shareholders (the principals) ensure that management (their agents) don’t simply look after their own interests? Shareholders can’t spend their lives watching managers to check that they are not shirking or maximizing the value of their own wealth. However, there are several institutional arrangements that help to ensure that the shareholders’ pockets are close to the managers’ heart.

A company’s board of directors is elected by the shareholders and is supposed to represent them. Boards of directors are sometimes portrayed as passive stooges who always champion the incumbent management. But when company performance starts to slide and managers do not offer a credible recovery plan, boards do act. In recent years the chief executives of Eastman Kodak, General Motors, Xerox, Lucent, Ford Motor, Sunbeam, and Lands End were all forced to step aside when each company’s profitability deteriorated and the need for new strategies became clear.

If shareholders believe that the corporation is underperforming and that the board of directors is not sufficiently aggressive in holding the managers to task, they can try to replace the board in the next election. If they succeed, the new board will appoint a new management team. But these attempts to vote in a new board are expensive and rarely successful. Thus dissidents do not usually stand and fight but sell their shares instead.

Selling, however, can send a powerful message. If enough shareholders bail out, the stock price tumbles. This damages top management’s reputation and compensation. Part of the top managers’ paychecks comes from bonuses tied to the company’s earnings or from stock options, which pay off if the stock price rises but are worthless if the price falls below a stated threshold. This should motivate managers to increase earnings and the stock price.

If managers and directors do not maximize value, there is always the threat of a hostile takeover. The further a company’s stock price falls, due to lax management or wrong-headed policies, the easier it is for another company or group of investors to buy up a majority of the shares. The old management team is then likely to find themselves out on the street and their place is taken by a fresh team prepared to make the changes needed to realize the company’s value.

These arrangements ensure that few managers at the top of major United States corporations are lazy or inattentive to stockholders’ interests. On the contrary, the pressure to perform can be intense.

2.5 S H O U L D MANAGERS LOOK AFTER THE INTERESTS OF SHAREHOLDERS?

We have described managers as the agents of the shareholders. But perhaps this begs the question, Is it desirable for managers to act in the selfish interests of their shareholders? Does a focus on enriching the shareholders mean that managers must act as greedy mercenaries riding roughshod over the weak and helpless? Do

they not have wider obligations to their employees, customers, suppliers, and the communities in which the firm is located?8

Most of this book is devoted to financial policies that increase a firm’s value. None of these policies requires gallops over the weak and helpless. In most instances there is little conflict between doing well (maximizing value) and doing good. Profitable firms are those with satisfied customers and loyal employees; firms with dissatisfied customers and a disgruntled workforce are more likely to have declining profits and a low share price.

Of course, ethical issues do arise in business as in other walks of life, and therefore when we say that the objective of the firm is to maximize shareholder wealth, we do not mean that anything goes. In part, the law deters managers from making blatantly dishonest decisions, but most managers are not simply concerned with observing the letter of the law or with keeping to written contracts. In business and finance, as in other day-to-day affairs, there are unwritten, implicit rules of behavior. To work efficiently together, we need to trust each other. Thus huge financial deals are regularly completed on a handshake, and each side knows that the other will not renege later if things turn sour.9 Whenever anything happens to weaken this trust, we are all a little worse off.10

In many financial transactions, one party has more information than the other. It can be difficult to be sure of the quality of the asset or service that you are buying. This opens up plenty of opportunities for financial sharp practice and outright fraud, and, because the activities of scoundrels are more entertaining than those of honest people, airport bookstores are packed with accounts of financial fraudsters.

The response of honest firms is to distinguish themselves by building long-term relationships with their customers and establishing a name for fair dealing and financial integrity. Major banks and securities firms know that their most valuable asset is their reputation. They emphasize their long history and responsible behavior. When something happens to undermine that reputation, the costs can be enormous.

Consider the Salomon Brothers bidding scandal in 1991.11 A Salomon trader tried to evade rules limiting the firm’s participation in auctions of U.S. Treasury bonds by submitting bids in the names of the company’s customers without the customers’ knowledge. When this was discovered, Salomon settled the case by paying almost $200 million in fines and establishing a $100 million fund for payments of claims from civil lawsuits. Yet the value of Salomon Brothers stock fell by

8Some managers, anxious not to offend any group of stakeholders, have denied that they are maximizing profits or value. We are reminded of a survey of businesspeople that inquired whether they attempted to maximize profits. They indignantly rejected the notion, objecting that their responsibilities went far beyond the narrow, selfish profit motive. But when the question was reformulated and they were asked whether they could increase profits by raising or lowering their selling price, they replied that neither change would do so. The survey is cited in G. J. Stigler, The Theory of Price, 3rd ed. (New York: Macmillan Company, 1966).

9In U.S. law, a contract can be valid even if it is not written down. Of course documentation is prudent, but contracts are enforced if it can be shown that the parties reached a clear understanding and agreement. For example, in 1984, the top management of Getty Oil gave verbal agreement to a merger offer with Pennzoil. Then Texaco arrived with a higher bid and won the prize. Pennzoil sued—and won— arguing that Texaco had broken up a valid contract.

10For a discussion of this issue, see A. Schleifer and L. H. Summers, “Breach of Trust in Corporate Takeovers,” Corporate Takeovers: Causes and Consequences (Chicago: University of Chicago Press, 1988).

11This discussion is based on Clifford W. Smith, Jr., “Economics and Ethics: The Case of Salomon Brothers,” Journal of Applied Corporate Finance 5 (Summer 1992), pp. 23–28.

far more than $300 million. In fact the price dropped by about a third, representing a $1.5 billion decline in the company’s market value.

Why did the value of Salomon Brothers drop so dramatically? Largely because investors were worried that Salomon would lose business from customers that now distrusted the company. The damage to Salomon’s reputation was far greater than the explicit costs of the scandal and was hundreds or thousands of times more costly than the potential gains Salomon could have reaped from the illegal trades.