Brealey, Myers. Principles of Corporate Finance. 7th edition

Подождите немного. Документ загружается.

Brealey−Meyers:

Principles of Corporate

Finance, Seventh Edition

III. Practical Problems in

Capital Budgeting

11. Where Positive Net

Present Values Come From

Companies, 2003

CHAPTER 11 Where Positive Net Present Values Come From 309

Visit us at www.mhhe.com/bm7e

c. Would it now make sense to scrap existing plants when they are two rather than

three years old?

d. How would your answers change if the corporate income tax were abolished

entirely?

MINI-CASE

Ecsy-Cola

Libby Flannery, the regional manager of Ecsy-Cola, the international soft drinks empire, was

reviewing her investment plans for Central Asia. She had contemplated launching Ecsy-

Cola in the ex-Soviet republic of Inglistan in 2004. This would involve a capital outlay of $20

million in 2004 to build a bottling plant and set up a distribution system there. Fixed costs

(for manufacturing, distribution, and marketing) would then be $3 million per year from

2003 onward. This would be sufficient to make and sell 200 million liters per year—enough

for every man, woman, and child in Inglistan to drink four bottles per week! But there

would be few savings from building a smaller plant, and import tariffs and transport costs

in the region would keep all production within national borders.

The variable costs of production and distribution would be 12 cents per liter. Company

policy requires a rate of return of 25 percent in nominal dollar terms, after local taxes but be-

fore deducting any costs of financing. The sales revenue is forecasted to be 35 cents per liter.

Bottling plants last almost forever, and all unit costs and revenues were expected to re-

main constant in nominal terms. Tax would be payable at a rate of 30 percent, and under the

Inglistan corporate tax code, capital expenditures can be written off on a straight-line basis

over four years.

All these inputs were reasonably clear. But Ms. Flannery racked her brain trying to fore-

cast sales. Ecsy-Cola found that the “1-2-4” rule works in most new markets. Sales typically

double in the second year, double again in the third year, and after that remain roughly con-

stant. Libby’s best guess was that, if she went ahead immediately, initial sales in Inglistan

would be 12.5 million liters in 2005, ramping up to 50 million in 2007 and onward.

Ms. Flannery also worried whether it would be better to wait a year. The soft drink market

was developing rapidly in neighboring countries, and in a year’s time she should have a much

better idea whether Ecsy-Cola would be likely to catch on in Inglistan. If it didn’t catch on and

sales stalled below 20 million liters, a large investment probably would not be justified.

Ms. Flannery had assumed that Ecsy-Cola’s keen rival, Sparky-Cola, would not also enter

the market. But last week she received a shock when in the lobby of the Kapitaliste Hotel she

bumped into her opposite number at Sparky-Cola. Sparky-Cola would face costs similar to

Ecsy-Cola. How would Sparky-Cola respond if Ecsy-Cola entered the market? Would it de-

cide to enter also? If so, how would that affect the profitability of Ecsy-Cola’s project?

Ms. Flannery thought again about postponing investment for a year. Suppose Sparky-Cola

was interested in the Inglistan market. Would that favor delay or immediate action? Maybe

Ecsy-Cola should announce its plans before Sparky-Cola had a chance to develop its own pro-

posals. It seemed that the Inglistan project was becoming more complicated by the day.

Questions

1. Calculate the NPV of the proposed investment, using the inputs suggested in this case.

How sensitive is this NPV to future sales volume?

2. What are the pros and cons of waiting for a year before deciding whether to invest?

Hint: What happens if demand turns out high and Sparky-Cola also invests? What if

Ecsy-Cola invests right away and gains a one-year head start on Sparky-Cola?

We thank Anthony Neuberger for suggesting this topic.

Brealey−Meyers:

Principles of Corporate

Finance, Seventh Edition

III. Practical Problems in

Capital Budgeting

12.Making Sure Managers

Maximize NPV

Companies, 2003

CHAPTER TWELVE

310

MAKING SURE

M A N A G E R S

MAXIMIZE NPV

Brealey−Meyers:

Principles of Corporate

Finance, Seventh Edition

III. Practical Problems in

Capital Budgeting

12.Making Sure Managers

Maximize NPV

Companies, 2003

SO FAR WE’VE concentrated on criteria and procedures for identifying capital investments with posi-

tive NPVs. If a firm takes all (and only) positive-NPV projects, it maximizes the firm’s value. But do the

firm’s managers want to maximize value?

Managers have no special gene or chromosome that automatically aligns their personal interests

with outside investors’ financial objectives. So how do shareholders ensure that top managers do not

feather their own beds or grind their own axes? And how do top managers ensure that middle man-

agers and employees try as hard as they can to find positive-NPV projects?

Here we circle back to the principal–agent problems first raised in Chapters 1 and 2. Shareholders

are the ultimate principals; top managers are the stockholders’ agents. But middle managers and em-

ployees are in turn agents of top management. Thus senior managers, including the chief financial of-

ficer, are simultaneously agents vis-à-vis shareholders and principals vis-à-vis the rest of the firm. The

problem is to get everyone working together to maximize value.

This chapter summarizes how corporations grapple with that problem as they identify and commit

to capital investment projects. We start with basic facts and tradeoffs and end with difficult problems

in performance measurement. The main topics are as follows:

• Process: How companies develop plans and budgets for capital investments, how they au-

thorize specific projects, and how they check whether projects perform as promised.

• Information: Getting accurate information and good forecasts to decision makers.

• Incentives: Making sure managers and employees are rewarded appropriately when they add

value to the firm.

• Performance Measurement: You can’t reward value added unless you can measure it. Since

you get what you reward, and reward what you measure, you get what you measure. Make sure

you are measuring the right thing.

In each case we will summarize standard practice and warn against common mistakes. The section

on incentives probes more deeply into principal–agent relationships. The last two sections of the

chapter describe performance measures, including residual income and economic value added. We

also uncover the biases lurking in accounting rates of return. The pitfalls in measuring profitability are

serious but are not as widely recognized as they should be.

311

For most large firms, the investment process starts with preparation of an annual

capital budget, which is a list of investment projects planned for the coming year.

Since the capital budget does not give the final go-ahead to spend money, the de-

scription of each project is not as detailed at this stage as it is later.

Most firms let project proposals bubble up from plants, product lines, or re-

gional operations for review by divisional management and then from divisions

for review by senior management and their planning staff. Of course middle man-

agers cannot identify all worthwhile projects. For example, the managers of plants

A and B cannot be expected to see the potential economies of closing their plants

and consolidating production at a new plant C. Divisional managers would pro-

pose plant C. Similarly, divisions 1 and 2 may not be eager to give up their own

computers to a corporationwide information system. That proposal would come

from senior management.

12.1 THE CAPITAL INVESTMENT PROCESS

Brealey−Meyers:

Principles of Corporate

Finance, Seventh Edition

III. Practical Problems in

Capital Budgeting

12.Making Sure Managers

Maximize NPV

Companies, 2003

Preparation of the capital budget is not a rigid, bureaucratic exercise. There is

plenty of give-and-take and back-and-forth. Divisional managers negotiate with

plant managers and fine-tune the division’s list of projects. There may be special

analyses of major outlays or ventures into new areas.

The final capital budget must also reflect the corporation’s strategic planning.

Strategic planning takes a top-down view of the company. It attempts to identify

businesses in which the company has a competitive advantage. It also attempts to

identify businesses to sell or liquidate and declining businesses that should be al-

lowed to run down.

In other words, a firm’s capital investment choices should reflect both bot-

tom-up and top-down processes—capital budgeting and strategic planning, re-

spectively. The two processes should complement each other. Plant and division

managers, who do most of the work in bottom-up capital budgeting, may not

see the forest for the trees. Strategic planners may have a mistaken view of the

forest because they do not look at the trees one by one.

Project Authorizations

Once the capital budget has been approved by top management and the board of

directors, it is the official plan for the ensuing year. However, it is not the final sign-

off for specific projects. Most companies require appropriation requests for each

proposal. These requests include detailed forecasts, discounted-cash-flow analy-

ses, and backup information.

Because investment decisions are so important to the value of the firm, final ap-

proval of appropriation requests tends to be reserved for top management. Compa-

nies set ceilings on the size of projects that divisional managers can authorize. Often

these ceilings are surprisingly low. For example, a large company, investing $400 mil-

lion per year, might require top management approval of all projects over $500,000.

Some Investments May Not Show Up in the Capital Budget

The boundaries of capital expenditure are often imprecise. Consider the invest-

ments in information technology, or IT (computers, software and systems, train-

ing, and telecommunications), made by large banks and securities firms. These

investments soak up hundreds of millions of dollars annually, and some multiyear

IT projects have costs well over $1 billion. Yet much of this expenditure goes to in-

tangibles such as system design, testing, or training. Such outlays often bypass

capital expenditure controls, particularly if the outlays are made piecemeal rather

than as large, discrete commitments.

Investments in IT may not appear in the capital budget, but for financial insti-

tutions they are much more important than outlays for plant and equipment. An

efficient information system is a valuable asset for any company, especially if it al-

lows the company to offer a special product or service to its customers. Therefore

outlays for IT deserve careful financial analysis.

Here are some further examples of important investments that rarely appear on

the capital budget.

Research and Development For many companies, the most important asset is

technology. The technology is embodied in patents, licenses, unique products or

services, or special production methods. The technology is generated by invest-

ment in research and development (R&D).

312 PART III

Practical Problems in Capital Budgeting

Brealey−Meyers:

Principles of Corporate

Finance, Seventh Edition

III. Practical Problems in

Capital Budgeting

12.Making Sure Managers

Maximize NPV

Companies, 2003

R&D budgets for major pharmaceutical companies routinely exceed $1 billion.

Glaxo Smith Kline, one of the largest pharmaceutical companies, spent nearly $4

billion on R&D in 2000. The R&D cost of bringing one new prescription drug to

market has been estimated at over $300 million.

Marketing In 1998 Gillette launched the Mach3 safety razor. It had invested $750

million in new, custom machinery and renovated production facilities. It planned

to spend $300 million on the initial marketing program. Its goal was to make the

Mach3 a long-lived, brand-name, cash-cow consumer product. This marketing

outlay was clearly a capital investment, because it was cash spent to generate fu-

ture cash inflows.

Training and Personnel Development By launch of the Mach3, Gillette had hired

160 new workers and paid for 30,000 hours of training.

Small Decisions Add Up Operating managers make investment decisions every

day. They may carry extra inventories of raw materials or spare parts, just to be

sure they won’t be caught short. Managers at the confabulator plant in Quayle City,

Arkansas, may decide they need one more forklift or a cappuccino machine for the

cafeteria. They may hold on to an idle machine tool or an empty warehouse that

could have been sold. These are not big investments ($5,000 here, $40,000 there) but

they add up.

How can the financial manager assure that small investments are made for the

right reasons? Financial staff can’t second-guess every operating decision. They

can’t demand a discounted-cash-flow analysis of a cappuccino machine. Instead

they have to make operating managers conscious of the cost of investment and

alert for investments that add value. We return to this problem later in the chapter.

Our general point is this: The financial manager has to consider all investments,

regardless of whether they appear in the formal capital budget. The financial man-

ager has to decide which investments are most important to the success of the com-

pany and where financial analysis is most likely to pay off. The financial manager

in a pharmaceutical company should be deeply involved in decisions about R&D.

In a consumer goods company, the financial manager should play a key role in

marketing decisions to develop and launch new products.

Postaudits

Most firms keep a check on the progress of large projects by conducting postaudits

shortly after the projects have begun to operate. Postaudits identify problems that

need fixing, check the accuracy of forecasts, and suggest questions that should

have been asked before the project was undertaken. Postaudits pay off mainly by

helping managers to do a better job when it comes to the next round of invest-

ments. After a postaudit the controller may say, “We should have anticipated the

extra working capital needed to support the project.” When the next proposal ar-

rives, working capital will get the attention it deserves.

Postaudits may not be able to measure all cash flows generated by a project. It

may be impossible to split the project away from the rest of the business. Suppose

CHAPTER 12

Making Sure Managers Maximize NPV 313

This figure is for drugs developed in the late 1980s and early 1990s. It is after-tax, stated in 1994 dol-

lars. The comparable pretax figure is over $400 million. See S. C. Myers and C. D. Howe, A Life-Cycle

Model of Pharmaceutical R&D, MIT Program on the Pharmaceutical Industry, 1997.

Brealey−Meyers:

Principles of Corporate

Finance, Seventh Edition

III. Practical Problems in

Capital Budgeting

12.Making Sure Managers

Maximize NPV

Companies, 2003

that you have just taken over a trucking firm that operates a merchandise delivery

service for local stores. You decide to revitalize the business by cutting costs and

improving service. This requires three investments:

1. Buying five new diesel trucks.

2. Constructing a dispatching center.

3. Buying a computer and special software to keep track of packages and

schedule trucks.

A year later you try a postaudit of the computer. You verify that it is working

properly and check actual costs of purchase, installation, and training against pro-

jections. But how do you identify the incremental cash inflows generated by the

computer? No one has kept records of the extra diesel fuel that would have been used

or the extra shipments that would have been lost had the computer not been in-

stalled. You may be able to verify that service is better, but how much of the im-

provement comes from the new trucks, how much comes from the dispatching

center, and how much comes from the new computer? It is impossible to say. The

only meaningful way to judge the success or failure of your revitalization program

is to examine the delivery business as a whole.

314 PART III Practical Problems in Capital Budgeting

Even here you don’t know the incremental cash flows unless you can establish what the business

would have earned if you had not made the changes.

12.2 DECISION MAKERS NEED GOOD INFORMATION

Good investment decisions require good information. Decision makers get such in-

formation only if other managers are encouraged to supply it. Here are four infor-

mation problems that financial managers need to think about.

Establishing Consistent Forecasts

Inconsistent assumptions often creep into investment proposals. Suppose the

manager of your furniture division is bullish on housing starts but the manager of

your appliance division is bearish. This inconsistency makes the furniture divi-

sion’s projects look better than the appliance division’s. Senior management ought

to negotiate a consensus estimate and make sure that all NPVs are recomputed us-

ing that joint estimate. Then projects can be evaluated consistently.

This is why many firms begin the capital budgeting process by establishing fore-

casts of economic indicators, such as inflation and growth in gross national prod-

uct, as well as forecasts of particular items that are important to the firm’s business,

such as housing starts or the price of raw materials. These forecasts can then be

used as the basis for all project analyses.

Reducing Forecast Bias

Anyone who is keen to get a project accepted is likely to look on the bright side

when forecasting the project’s cash flows. Such overoptimism seems to be a com-

mon feature in financial forecasts. Overoptimism afflicts governments too, prob-

ably more than private businesses. How often have you heard of a new dam,

highway, or military aircraft that actually cost less than was originally forecasted?

Brealey−Meyers:

Principles of Corporate

Finance, Seventh Edition

III. Practical Problems in

Capital Budgeting

12.Making Sure Managers

Maximize NPV

Companies, 2003

You will probably never be able to eliminate bias completely, but if you are

aware of why bias occurs, you are at least part of the way there. Project sponsors

are likely to overstate their case deliberately only if you, the manager, encourage

them to do so. For example, if they believe that success depends on having the

largest division rather than the most profitable one, they will propose large ex-

pansion projects that they do not truly believe have positive NPVs. Or if they be-

lieve that you won’t listen to them unless they paint a rosy picture, you will be

presented with rosy pictures. Or if you invite each division to compete for limited

resources, you will find that each attempts to outbid the other for those resources.

The fault in such cases is your own—if you hold up the hoop, others will try to

jump through it.

Getting Senior Management the Information That It Needs

Valuing capital investment opportunities is hard enough when you can do the en-

tire job yourself. In real life it is a cooperative effort. Although cooperation brings

more knowledge to bear, it has its own problems. Some are unavoidable, just an-

other cost of doing business. Others can be alleviated by adding checks and bal-

ances to the investment process.

Many of the problems stem from sponsors’ eagerness to obtain approval for

their favorite projects. As a proposal travels up the organization, alliances are

formed. Preparation of the request inevitably involves compromises. But, once a

division has agreed on its plants’ proposals, the plants unite in competing against

outsiders.

The competition among divisions can be put to good use if it forces division

managers to develop a well-thought-out case for what they want to do. But the

competition has its costs as well. Several thousand appropriation requests may

reach the senior management level each year, all essentially sales documents pre-

sented by united fronts and designed to persuade. Alternative schemes have been

filtered out at an earlier stage. The danger is that senior management cannot ob-

tain (let alone absorb) the information to evaluate each project rationally.

The dangers are illustrated by the following practical question: Should we an-

nounce a definite opportunity cost of capital for computing the NPV of projects in our

furniture division? The answer in theory is a clear yes, providing that the projects of

the division are all in the same risk class. Remember that most project analysis is done

at the plant or divisional level. Only a small proportion of project ideas analyzed sur-

vive for submission to top management. Plant and division managers cannot judge

projects correctly unless they know the true opportunity cost of capital.

Suppose that senior management settles on 12 percent. That helps plant man-

agers make rational decisions. But it also tells them exactly how optimistic they

have to be to get their pet project accepted. Brealey and Myers’s Second Law states:

The proportion of proposed projects having a positive NPV at the official corporate hurdle

rate is independent of the hurdle rate.

This is not a facetious conjecture. The law was tested in a large oil company, whose

capital budgeting staff kept careful statistics on forecasted profitability of proposed

projects. One year top management announced a big push to conserve cash. It im-

posed discipline on capital expenditures by increasing the corporate hurdle rate by

several percentage points. But staff statistics showed that the fraction of proposals

CHAPTER 12

Making Sure Managers Maximize NPV 315

There is no First Law; we thought that “Second Law” sounded better. There is a Third Law, but that is

for another chapter.

Brealey−Meyers:

Principles of Corporate

Finance, Seventh Edition

III. Practical Problems in

Capital Budgeting

12.Making Sure Managers

Maximize NPV

Companies, 2003

with positive NPVs stayed rock-steady at about 85 percent of all proposals. Top man-

agement’s tighter discipline was repaid with expanded optimism.

A firm that accepts poor information at the top faces two consequences. First,

senior management cannot evaluate individual projects. In a study by Bower of a

large multidivisional company, projects that had the approval of a division general

manager were seldom turned down by his or her group of divisions, and those

reaching top management were almost never rejected.

Second, since managers

have limited control over project-by-project decisions, capital investment decisions

are effectively decentralized regardless of what formal procedures specify.

Some senior managers try to impose discipline and offset optimism by setting

rigid capital expenditure limits. This artificial capital rationing forces plant or di-

vision managers to set priorities. The firm ends up using capital rationing not be-

cause capital is truly unobtainable but as a way of decentralizing decisions.

Eliminating Conflicts of Interest

Plant and divisional managers are concerned about their own futures. Sometimes

their interests conflict with stockholders’ and that may lead to investment deci-

sions that do not maximize shareholder wealth. For example, new plant managers

naturally want to demonstrate good performance right away, in order to move up

the corporate ladder, so they are tempted to propose quick-payback projects even

if NPV is sacrificed. And if their performance is judged on book earnings, they will

also be attracted by projects whose accounting results look good. That leads us to

the next topic: how to motivate managers.

316 PART III

Practical Problems in Capital Budgeting

J. L. Bower, Managing the Resource Allocation Process: A Study of Corporate Planning and Investment, Divi-

sion of Research, Graduate School of Business Administration, Harvard University, Boston, 1970.

12.3 INCENTIVES

Managers will act in shareholders’ interests only if they have the right incentives.

Good capital investment decisions therefore depend on how managers’ perfor-

mance is measured and rewarded.

We start this section with an overview of agency problems encountered in cap-

ital investment, and then we look at how top management is actually compen-

sated. Finally we consider how top management can set incentives for the middle

managers and other employees who actually operate the business.

Overview: Agency Problems in Capital Budgeting

As you have surely guessed, there is no perfect system of incentives. But it’s easy

to see what won’t work. Suppose shareholders decide to pay the financial managers

a fixed salary—no bonuses, no stock options, just $X per month. The manager, as

the stockholders’ agent, is instructed to find and invest in all positive-NPV projects

open to the firm. The manager may sincerely try to do so, but will face various

tempting alternatives:

Reduced effort. Finding and implementing investment in truly valuable

projects is a high-effort, high-pressure activity. The financial manager will be

tempted to slack off.

Brealey−Meyers:

Principles of Corporate

Finance, Seventh Edition

III. Practical Problems in

Capital Budgeting

12.Making Sure Managers

Maximize NPV

Companies, 2003

Perks. Our hypothetical financial manager gets no bonuses. Only $X per

month. But he or she may take a bonus anyway, not in cash, but in tickets

to sporting events, lavish office accommodations, planning meetings

scheduled at luxury resorts, and so on. Economists refer to these

nonpecuniary rewards as private benefits. Ordinary people call them

perks (short for perquisites.)

Empire building. Other things equal, managers prefer to run large businesses

rather than small ones. Getting from small to large may not be a positive-NPV

undertaking.

Entrenching investment. Suppose manager Q considers two expansion plans.

One plan will require a manager with special skills that manager Q just

happens to have. The other plan requires only a general-purpose manager.

Guess which plan Q will favor. Projects designed to require or reward the

skills of existing managers are called entrenching investments.

Entrenching investments and empire building are typical symptoms of

overinvestment, that is, investing beyond the point where NPV falls to zero.

The temptation to overinvest is highest when the firm has plenty of cash but

limited investment opportunities. Michael Jensen calls this a free-cash-flow

problem: “The problem is how to motivate managers to disgorge the cash

rather than investing it below the cost of capital or wasting it in organizational

inefficiencies.”

Avoiding risk. If a financial manager receives only a fixed salary, and cannot

share in the upside of risky projects, then safe projects are, from the

manager’s viewpoint, better than risky ones. But risky projects can have

large, positive NPVs.

A manager on a fixed salary could hardly avoid all these temptations all of the

time. The resulting loss in value is an agency cost.

Monitoring

Agency costs can be reduced in two ways: by monitoring the managers’ effort and

actions and by giving them the right incentives to maximize value.

Monitoring can prevent the more obvious agency costs, such as blatant perks or

empire building. It can confirm that the manager is putting sufficient time on the

job. But monitoring costs time, effort, and money. Some monitoring is almost al-

ways worthwhile, but a limit is soon reached at which an extra dollar spent on

monitoring would not return an extra dollar of value from reduced agency costs.

Like all investments, monitoring encounters diminishing returns.

Some agency costs can’t be prevented even with spendthrift monitoring. Sup-

pose a shareholder undertakes to monitor capital investment decisions. How could

he or she ever know for sure whether a capital budget approved by top manage-

ment includes (1) all the positive-NPV opportunities open to the firm and (2) no

projects with negative NPVs due to empire-building or entrenching investments?

The managers obviously know more about the firm’s prospects than outsiders ever

can. If the shareholder could list all projects and their NPVs, then the managers

would hardly be needed!

CHAPTER 12

Making Sure Managers Maximize NPV 317

A. Shleifer and R. W. Vishny, “Management Entrenchment: The Case of Manager-Specific Invest-

ments,” Journal of Financial Economics 25 (November 1989), pp. 123–140.

M. C. Jensen, “Agency Costs of Free Cash Flow, Corporate Finance and Takeovers,” American Economic

Review 76 (May 1986), p. 323.

Brealey−Meyers:

Principles of Corporate

Finance, Seventh Edition

III. Practical Problems in

Capital Budgeting

12.Making Sure Managers

Maximize NPV

Companies, 2003

Who actually does the monitoring? Ultimately it is the shareholders’ responsi-

bility, but in large, public companies, monitoring is delegated to the board of direc-

tors, who are elected by shareholders and are supposed to represent their interests.

The board meets regularly, both formally and informally, with top management.

Attentive directors come to know a great deal about the firm’s prospects and per-

formance and the strengths and weaknesses of its top management.

The board also hires independent accountants to audit the firm’s financial

statements. If the audit uncovers no problems, the auditors issue an opinion that

the financial statements fairly represent the company’s financial condition and are

consistent with generally accepted accounting principles (GAAP, for short).

If problems are found, the auditors will negotiate changes in assumptions or pro-

cedures. Managers almost always agree, because if acceptable changes are not made,

the auditors will issue a qualified opinion, which is bad news for the company and its

shareholders. Aqualified opinion suggests that managers are covering something up

and undermines investors’ confidence that they can monitor effectively.

A qualified opinion may be bad news, but when investors learn of accounting

problems that have escaped detection by auditors, there’s hell to pay. On April 15,

1998, Cendant Corporation announced discovery of serious accounting irregulari-

ties. The next day Cendant shares fell by about 46 percent, wiping $14 billion off

the market value of the company.

Lenders also monitor. If a company takes out a large bank loan, the bank will

track the company’s assets, earnings, and cash flow. By monitoring to protect its

loan, the bank protects shareholders’ interests also.

Delegated monitoring is especially important when ownership is widely dis-

persed. If there is a dominant shareholder, he or she will generally keep a close eye

on top management. But when the number of stockholders is large, and each stock-

holding is small, individual investors cannot justify much time and expense for

monitoring. Each is tempted to leave the task to others, taking a free ride on oth-

ers’ efforts. But if everybody prefers to let somebody else do it, then it won’t get

done; that is, monitoring by shareholders will not be strong or effective. Econo-

mists call this the free-rider problem.

Compensation

Because monitoring is necessarily imperfect, compensation plans must be de-

signed to give managers the right incentives.

318 PART III

Practical Problems in Capital Budgeting

Cendant was formed in 1997 by the merger of HFS, Inc., and CUC International, Inc. It appears that

about $500 million of CUC revenue from 1995 to 1997 was just made up and that about 60 percent of

CUC’s income in 1997 was fake. By August 1998, several CUC managers were fired or had resigned, in-

cluding Cendant’s chairman, the founder of CUC. Over 70 lawsuits had been filed on behalf of investors

in the company. Investigations were continuing. See E. Nelson and J. S. Lubin. “Buy the Numbers? How

Whistle-Blowers Set Off a Fraud Probe That Crushed Cendant,” The Wall Street Journal (August 13,

1998), pp. A1, A8.

Lenders’ and shareholders’ interests are not always aligned—see Chapter 18. But a company’s ability

to satisfy lenders is normally good news for stockholders, particularly when lenders are well placed to

monitor. See C. James “Some Evidence on the Uniqueness of Bank Loans,” Journal of Financial Econom-

ics 19 (December 1987), pp. 217–235.

The free-rider problem might seem to drive out all monitoring by dispersed shareholders. But in-

vestors have another reason to investigate: They want to make money on their common stock portfo-

lios by buying undervalued companies and selling overvalued ones. To do this they must investigate

companies’ performance.