Section 2
Adding Value Through Investment
SECTION OVERVIEW
Janette Rutterford
In this section, we look at corporate investment – both in projects and in companies. In a sense, the company can be thought of as a collection of projects, and the Capital Asset Pricing Model teaches us that managers should evaluate each project as a standalone investment, using the hurdle rate appropriate to the project activity and financing rather than using, as many companies in practice do, a company-wide discount rate.
As far as investment in projects or companies is concerned, the use of discounted cash flow techniques and the theoretical dominance of the Net Present Value rule as a decision tool for investment appraisal have long been part of finance textbooks. In this section of the book, we look at the investment decision from different perspectives from that of the methodology of decision-making. First, we explore what happens in the real world when investment decisions are being made and why managers do not in practice always follow the theoretically optimal model. Second, we explore how option valuation, in particular the valuation of “real” options, can be used to improve project appraisal. Third, we look at mergers and acquisitions and why managers keep on buying companies, when the evidence as to their success is fairly thin on the ground.
Isabelle Royer, in “Why Bad Projects Are So Hard to Kill”, shows that, despite a better understanding of the financial tools available for project decision making than in the past, managers still do not take theoretically optimal decisions when looking at potential projects. The article, from the Harvard Business Review, includes a number of case studies of US firms, and looks at reasons why managers find it so hard to abandon projects which do not meet the required hurdle rates. This article is an example of behavioural research discussed in Section 1 on “Trends in Finance Theory” – a willingness to recognise that managers do not always follow the theoretically optimal path (in this case the positive NPV rule) but may sometimes be apparently irrational in their behaviour.
In the second article in this section, “Realizing the Potential of Real Options: Does Theory Meet Practice?”, Alexander Triantis looks at whether real options can actually help when making investment decisions – in other words, do real options add value to the traditional positive NPV approach? Although options to delay projects, abandon projects, scale projects up or down are relatively easy to model, the practical difficulty lies in being able to value real options which differ from financial options by being on real rather than financial assets and so do not have an easy-to-determine market price or, indeed, volatility. Real options became very popular in the late 1990s, being used to explain high valuations of companies such as Amazon or Microsoft, which had, in a sense, options to expand across traditional business boundaries. In the market crash of the early 2000s, real options have somewhat fallen from grace.
However, real options do still have a role to play. They are particularly useful for oil and pharmaceutical companies, both of which have projects which require initial and then subsequent investment, so that the option to abandon at later stages of the project has obvious value. Case Study 3, a McKinsey Quarterly article by K. Leslie and M. Michaels, “Real Options”, looks at two case studies in which the concept if not the detail of real options was applied to two different industries – electricity generation and oil. They illustrate how the process of thinking through investment decisions in a real options framework is a powerful tool in financial strategy, and in adding value to the organisation.
The remaining article and case study in this section are concerned with mergers and acquisitions. There are essentially two types of article in the classical M&A literature. The first type looks at whether mergers and acquisitions have added value. This type of article takes a database of mergers and acquisitions, for different time periods, industries, countries or even cross-border, and looks at a period of years after the deal to see whether value has been added or, to use a picturesque term, destroyed. A typical result is to show that little or no value is added by M&A, and what value is added tends to accrue to the disposing shareholders rather than to those of the acquiring company.1 Of course, the method of financing affects these results. If companies use their equity to buy companies, the disposing shareholders essentially share the benefits or costs of the merger. The second type of article looks at the M&A cycle phenomenon. It has long been recognised that M&A takes place in waves, peaking when the stock market is high, and with few deals when the market falls.2 If buying a company whose shares are quoted on the stock market, this seems to imply that managers are paying over the odds. However, if they are using their own shares, which might also be overvalued, to pay for the acquisition, managers might actually be more rational than they initially appear. Recently, authors such as Andreas Shleifer and Robert Vishny3 have applied behavioural finance concepts to looking at whether markets or managers are rational or irrational when they issue new equity.
However, there are problems with including articles from either of these “typical” debates. The first approach generates papers which are long, methodologically complicated and whose results vary according to which period, country, etc. is used. The second literature is still in a state of flux. Behavioural finance and classical finance have yet to come to terms with M&A. Classical finance would imply that few deals would be done given the results, and this is clearly not the case. Behavioural finance would imply that, once factors such as the finance method and the timing of the deals are taken into account, there may be method in managers' apparent madness. In this book, we look at a recent article which is outside both these literatures. “Mergers, MNEs and Innovation – the Need for New Research Approaches”, by Christian Berggren, considers mergers by multinationals and attempts to use alternative approaches to traditional research to look more deeply at why managers undertake M&A. It comes up with some interesting results. Case Study 4, a Financial Times article by Simon London, looks at the recent, rather depressing results on the value added by cross-border mergers and acquisitions. Perhaps the insights provided by Berggren can help to explain these results.
NOTES
1. For example, see E.L. Black, T.A. Carnes and T. Jandik (2001), “The Long-Term Success of Cross-Border Mergers and Acquisitions”, Working Paper, available on http://papers.ssrn.com/paper.taf?abstract_id=270188.
2. This was discussed in R.A. Brealey and S.C. Myers (1996), Principles of Corporate Finance, 5th edn (New York: John Wiley & Sons Inc.).
3. A. Shleifer and R.W. Vishny (2003), “Stock Market Driven Acquisitions”, Journal of Financial Economics, 70(3), pp. 295–311.