4. Discussion

The preceding example has illustrated that managers maximize the financial value of their firm by following the NPV rule without taking into consideration the specific consumption preferences of the investors. Investors can find their individual optimal mix between current and future consumption by buying and selling shares (or borrowing) in the capital markets.

  

While the NPV rule is simple and powerful, it is important to understand that it hinges on the assumption that investors have equal access to well-functioning capital markets. This is such an important assumption that we have to stress it out again: Whenever we use the NPV rule (and the discounted cash flow analysis behind that rule), we assume that investors have access to competitive capital markets!

 

This would seem to be a sensible assumption in the case of large established firms, whose shares are traded in a liquid stock market. Think, for example, of Apple, General Motors, or Royal Dutch Shell. Each of these companies has thousands if not millions of shareholders with excellent market access. There is no need for Apple's managers to focus too much in their shareholders' consumption preferences. They should stick to our simple rule to maximize value and let the capital markets sort out the timing of consumption.

 

But what about smaller, privately held firms? There, the situation is less clear. In fact, it is relatively easy to come up with scenarios in which capital markets do not work smoothly and therefore jeopardize the NPV rule:

  • Owner-controlled firms: Imagine that uncle Fred from the previous example is the founder and majority shareholder of the firm. He does not want to sell any shares because he wants to keep the company under his control. At the same time, because the firm is not publicly traded, his shares have a low lending value so that he cannot finance consumption today by borrowing against his shares. In such a constellation, it is conceivable that uncle Fred will urge the CEO to forego the project, even if this decision lowers firm value. Because financial markets do not work smoothly, it will be hard to reconcile the preferences of uncle Fred and Trisha.
     
  • Privately held firms in general: The same logic can be extended to privately held firms in general. For these firms, it is often impossible to buy and sell shares, also because transfer is generally restricted by a shareholder agreement. Absent a liquid stock market, it is not clear whether shareholders with different consumption preferences will agree on the firm's optimal investment policy.
     
  • Startups and innovative projects: It is also not clear that investors will agree on the NPV of the project in question. Take the case of a startup with an innovative business idea. Very often, entrepreneurs are much more optimistic about their projects and therefore assign higher valuations to their firms than potential investors. In our example, it could be that external investors believe that the assumed project payoff of $25 million in 1 year is excessive. Consequently, they revise the valuation downwards, which will make it hard to agree on a price with uncle Fred. These challenges are particularly pronounced in situations where there is only one entrepreneur and one investor. 
     
  • Taxes and other market frictions: Taxes could also throw a spanner in the works. Different shareholders could be subject to different taxation and therefore have different payout preferences.

  

All these situations are real. In fact, there are comparatively few firms with "unobstructed" capital market access.  In the U.S., for example, only about 3'700 of the roughly 5.9 million firms are publicly traded. That is approximately 1 out of 1'600 firms!

  

In these firms, it is often not enough to "blindly" follow the NPV rule. To find an investment policy that is suitable for the majority of shareholders, the NPV rule needs to be combined with considerations about the risk and liquidity preferences of the investors.

    

Many of the modules on this platform deal with these important considerations or "frictions." For example:

  • Capital Structure Decisions discusses how to incorporate taxes and other side-effects into financing decisions;
  • Payout Policy shows the key trade-offs in the payout decision and proposes a structured approach towards a sustainable payout policy;
  • Startup Financing and Deal Structuring shows how we can make financing deals smarter by incorporating the different expectations of entrepreneurs and investors.