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Decision evaluation for owner wealth
Decision Evaluation for Owner Wealth This framework for evaluating managerial decisions from the owners' viewpoint uses capital market theory concepts. Each decision is viewed according to its effect on return and risk.
PHILIP L. COOLEY AND R O D N E Y L. R O E N F E L D T
Both authors are faculty members in the area of finance at The University of South Carolina.
The establishment of objectives for the hierarchy of planning within the firm is a widely accepted principle. This happy s t a t e of agreement disintegrates rapidly, however, when attempts are made to define the objectives. For example, should the firm's primary objective be profit maximization, maximization of the owners' wealth, or consumer service? Or should the major objective focus on employment for employees and management, or benefits to society in general? Complete answers to these questions have yet to be developed; observers cannot even agree concerning the more fundamental question of h o w management can best represent the financial interests of the owners of the firm. The following discussion concerns this question of representing the financial interests of owners. While cognizant of the unresolved issues of multiple firm objectives, the authors have formulated ~ framework for evaluating managerial decisions that is based only on the financial goal of owner wealth maximization.
definitive attacks have been made on its merits as a firm objective. Strict interpretation of profit maximization as a guide to managerial decision making has been shown to yield suboptimal results for owners as well as other firm participants. As argued b y Ezra Solomon, profit maximization has three flaws that lessen its usefulness for decision making: Its meaning is Unclear, resulting in several interpretations. Should we maximize short- or long-term profits? And should profits be defined as revenues minus costs, return on assets, return on equity, or some other such measure? Profit-maximization ignores the higher values of early benefits compared to later benefits. Clearly, $1,000 in today's coffers is preferred to the legitimate promise of $1,000 five years from now. "The third and most important objection is that the profit-maximization criterion ignores the quality of the expected benefits." For two projects promising equal returns, the one with a higher degree of certainty usually is preferred. 1
The consequences of overlooking the risk dimension o f decision making has been demonstrated more recently b y Weston. Use of the d u P o n t return on investment (ROI) method for planning and control is shown to be ineffective when statically interpreted. In addition to continual review of ROI standards and achievements, Weston argues that the
W H Y NOT PROFIT M A X I M I Z A T I O N ? The assertion that firms maximize p r o f i t s - o r should maximize profits-persists even though
AUGUST, 1974
1. Ezra Solomon, The Theory o f Financial Management (New York: Columbia University Press, 1963),.p. 19.
67
PHILIP L. COOLEY AND RODNEY L. ROENFELDT
FIGURE 1 Value of the Firm and Investor Expectations E XPECTE D RETURN
MANAGERIAL DECISIONS PAST CURRENT EXPECTED
68
risks surrounding a projected ROI must be consideredi "The implication that a fixed minimum ROI rate had been a rigid requirement of all types of opportunities, regardless of the degree of risk, suggests the application of the method in a mechanistic way. ''2 One solution to the risk-return problem, as well as to other problems identified by Solomon, is adoption of the wealth maximization objective. Achievement of this objective necessarily requires a proper trade-off between risk and return. A manager may incorporate considerations of risk and return into his thinking by making decisions which result in greatest capitalized cash flows. Under this approach, expected cash flows from risky projects are discounted at higher rates than those from less risky projects. Risky projects are thereby penalized according to their risk and selected only if a maximization of capitalized cash flows results. A variant of this procedure is to adjust the uncertain cash flows to equipreferable certain cash flows, and to use a discount factor reflecting a risk-free investment. In either case, both quantity and quality of returns are considered.
PRICE E F F E C T S OF D E C I S I O N S
Ultimately, the effects of managerial decisions are absorbed into the value placed on the firm in the market. Decisions based on the wealth 2. J. Fred Weston, "ROI Planning and Control," Business Horizons, XV (August 1972), pp. 35-42.
r
VALUE OF FIRM
PERCEIVED RISK
maximization objective result in a risk-return balance which leads to a maximum firm valuation by investors. The cumulative effects of all wealth maximization decisions-for example, financial, marketing, and production decisions-determine the levels of risk and return expected by potential capital suppliers. As illustrated in Figure 1, the expectations of marginal capital suppliers lead to the firm's market value. Past, current, or expected decisions which are judged to add disproportionate risk to the firm for the expected return depress firm value. Conversely, firm value increases when the level of expected return is more than usual for the added risk exposure. In the absence of current managerial decisions which depart significantly from past policy and with little change in expected decisions, risk-return expectations are largely a function of decisions made in the p a s t often the distant past. For instance, the line of business in which a firm is classified changes infrequently and is often a result of decisions made early in the firm's life cycle. Capital structure decisions-that is, proportions of debt and e q u i t y - t e n d to change slowly as do decisions regarding dividend levels. Other decisions, such as product pricing or basic productive processes, may change more quickly. All managerial decisions are more or less subject to change, and it is this departure from the historical norm that leads to changes in investors' expectations. The moderating effect of current managerial decisions on past decisions for an individual firm and the market as a whole is
BUSINESS HORIZONS
Decision Evaluation for Owner Wealth
FIGURE 2 Value Changes for the Firm and Market PAST MANAGERIAL DECISIONS FOR A FIRM LINE OF BUSINESS CAPITAL STRUCTURE PRODUCTI VE PROCESSES PROMO TIONA L POL ICIES DIVIDEND POLICY
O u} m LU
£3 1
< Z <
ENVIRONMENTAL STIMULUS ENERG Y CRISIS POLITICAL ENVIRONMENT ECONOMIC BOOM ECONOMIC RECESSION
Z LU rr
~
SALES GROWTH EPS GROWTH PROFITABtL ITY DIVIDENDS VARIABILITY
~
SECURITYPRICE CHANGE FOR A FIRM
O
X I
kU
(J £b
LLI
c/)
INVESTOR EXPECTATIONS t OF ENTIRE MARKET 1
uJ -> L~
MARKET PRICE " l INDEX CHANGE
tr
X
LU
illustrated in Figure 2. Past decisions form the basis for investor-expectation of the several financial aspects of the firm, but current decisions can change these expectations. Firm and aggregate market values change, dependi n g on how such decisions coupled with environmental changes are translated into perceived risk and expected return in the market. In general, based on past research, expected returns from individual firms tend to vary in unison with expectations for the entire market. In addition, empirical evidence leads to the presumption that investors expect higher returns from firms whose returns vary positively with market returns. 3 The theoretical explanation for this behavior is that security returns which tend to move with general market returns cannot be used to reduce the overall variability of an investor's portfolio return. Security returns which move opposite to general market returns are, therefore, highly valued; when added to a portfolio, certainty of the portfolio return is increased. 3. J a c k L. Treynor, " H o w to Rate Management of Investment F u n d s , " Harvard Business Review (JanuaryFebruary 1965), pp. 63-75.
AUGUST, 1974
z
er"
¢r
O
l PASTMANAGERIAL DECISIONS " FOR ALL FIRMS
INVESTOR EXPECTATIONS OF A FIRM
The relationship between expected return and its comovement with the market return (comovement of returns is frequently indicated by the firm's "beta" and is interpreted as market risk) is illustrated in Figure 3. FIGURE 3 Expected Return and Comovement With Market Return EXPECTED RETURN FROM SECURITY
B
EQUILIBRIUM LINE
C
EXPECTED COMOVEMENT OF SECURITY RETURN WITH MARKET RETURN
69
PHILIP L C O O L E Y A N D R O D N E Y
L. R O E N F E L D T
FIGURE 4 Matrix of Managerial Decision Effects EXPECTED RETURN FROM SECURITY
70
EXPECTED COMOVEMENT OF SECURITY RETURN WITH MARKET RETURN INCREASE
NO EFFECT
DECREASE
INCREASE
DECISION (1)
DECISION (2)
DECISION (3)
NO EFFECT
DECISION (4)
DECISION (5)
DECISION (6)
DECREASE
DECISION (7)
DECISION (8)
DECISION (9)
Exemplified b y the equilibrium line, increases in degree of comovement are associated with increases in expected return. Expected returns from the theoretical Firm A are completely independent of movements in market returns, resulting in expectations which are lower than those for Firms B and C. Both Firms B and C are shown in a state of disequilibrium. Apparently, either environmental changes or various decisions made b y the managers of B have caused return expectations to exist temporarily which are higher than normal for the level of risk. Acting as a countervailing power, investors will bid up the firm's stock price because of its favorable risk-return relationship, forcing the firm's expected return back into equilibrium. Adverse environmental impacts or poor managerial decisions have lowered expected returns from Firm C. As marginal bids for C stock are lowered, the expected return will rise toward equilibrium and existing owners will suffer a wealth loss.
MANAGERIAL
DECISION
FRAMEWORK
Whether from fortuitous circumstances or managerial decisions, the share price's return to equilibrium will produce a gain in wealth for shareholders of Firm B and a loss in wealth for shareholders of Firm C. To the
extent that those wealth changes are due to managerial decisions, the respective managements may be evaluated from the owners' point of view. Each managerial decision can be evaluated b y its combined effect on the owners' expected return and the comovement of those returns with general market returns.
Decision Classification Using scales with three levels--increase, no effect; and d e c r e a s e - e a c h managerial decision is classified in Figure 4 according to its effect on expecte d return and comovement of security and market returns. Decision (1) tends to increase b o t h expected return and comovement. Whether the decision has a desirable impact on owners' wealth depends on the relative increases in expected return and com°vement. Decision (3) is most desirable from the owners' viewpoint since expected return is increased simultaneously with an expected decline in comovement of returns. The most undesirable types of managerial decisions are reflected in the matrix cell labeled Decision (7), where an increase in comovement is accompanied b y a decline in expected return. Decision (5) commands little interest from owners because it produces no effect on expected return or its comovement.
BUSINESS HORIZONS
Decision Evaluation for Owner Wealth
FIGURE 5 Managerial D e c i s i o n E f f e c t s in E x p e c t e d R e t u r n , C o m o v e m e n t S p a c e
EXPECTED RETURN FROM SECURITY
DECISION (2)
. ~ , 0 6 " 0 / ~ 1 0
DECISION(6) ~
£)
--... DECISION (8) 71 EXPECTEDCOMOVEMENTOF SECURITYRETURNWITH MARKET RETURN I n t e r p r e t a t i o n o f the m a n a g e r i a l decision e f f e c t s is aided b y r e f e r r i n g to Figure 5, w h i c h places t h e m into a risk-return space similar to t h a t s h o w n in Figure 3. Managerial decisions are s h o w n to consist of f o u r basic t y p e s : Wealth improvement--Decisions 2, 3, and 6 cause temporary disequilibrium and an increase in market value of the firm upon restoration to equilibrium. Wealth deterioration--Decisions 4, 7, and 8 cause temporary disequilibrium and a decrease in market value of the firm upon restoration to equilibrium. Wealth maintenance--Decision 5 does not cause a temporary disequilibrium, and the current wealth of owners is therefore maintained. Wealth change indeterminant--Decisions 1 and 9 may or may not cause a temporary disequilibrium, depending upon the relative increases or decreases in expected retum and comovement. Wealth may therefore be increased, decreased, or maintained.
and f o u r w e a l t h effects span all the possible effects o f m a n a g e r i a l decisions. While the p r o p o s e d f r a m e w o r k m a y be c o n c e p t u a l l y appealing, m o d i f i c a t i o n s o f curr e n t m a n a g e r i a l decisions require a c c u r a t e k n o w l e d g e o f the m o d i f i c a t i o n s ' effects o n e x p e c t e d r e t u r n and c o m o v e m e n t . T h e framew o r k illustrated is an organizing device for a v a r i e t y o f m a n a g e r i a l decisions in w h i c h the m a n a g e r is a t t e m p t i n g to increase the w e a l t h of t h e owners r e p r e s e n t e d . In o r d e r to m o v e the f r a m e w o r k b e y o n d the classificatory stage, e m p i r i c a l evidence w h i c h shows the i m p a c t of decisions on e x p e c t e d r e t u r n and c o m o v e m e n t is n e e d e d .
T h e nine t y p e s o f decisions s h o w n in Figures 4 a n d 5 a n d the f o u r w e a l t h e f f e c t s a b o v e are d e f i n e d to add s t r u c t u r e to all possible decision effects. Nine decision e f f e c t s
Empirical Evidence
AUGUST, 1974
E m p i r i c a l evidence of the e f f e c t s o f m o s t m a n a g e r i a l decisions is c u r r e n t l y lacking. A
PHILIP L. COOLEY AND RODNEY L. ROENFELDT
few studies have been conducted which consider the impact of financial decisions only. However, even in these studies, the effects Of financial variables on expected return and comovement are not investigated together. From some recent studies, it appears that decisions to increase debt in the capital structure also increase the comovement of returns. Other research indicates that this same decision results in a higher expected return. 4 Tentatively, then, a leverage increase is a managerial decision in the Decision (1) category, which displaces the firm upward and to the right in Figure 5. Although the general direction is given, it is unclear to what extent the direction would deviate from the equilibrium line. Another financial decision variable considered in these studies is the amount of earnings paid out in dividends. Generally, increasing dividend payout reduces b o t h comovement and expected return. Dividend 72 4. William Beaver, Paul Kettler, and Myron Scholes, "The Association between Market Determined and Accounting Determined Risk Measures," The Accounting Review, XLV (October 1970), pp. 654-82; and Dennis E. Logue and Larry J. Merville, "Financial Policy and Market Expectations," Financial Management, I (Summer 1972), pp. 37-44. Marc Nerlove, "Factors Affecting Differences Among Rates of Return on Investments in Individual Common Stock," Review of Economics and Statistics, L (August 1968), pp. 312-31 ; and Fred Arditti, "Risk and the Required Return on Equity," Journal of Finance, XXII (March 1967), pp. 19-36.
payout thus appears to be in the Decision (9) category. Liquidity decisions, indicated b y current ratios, were shown to have little effect on either comovement or expected return. Therefore, a firm in equilibrium would tend to remain in equilibrium for most liquidity decisions; this type of decision would be classified as Decision (5). These decisions are representative of those for which substantial empirical agreement has been found. Additional research is needed concerning the impact of both financial and nonfinancial decisions on risk and return. The authors are currently examining the simultaneous effects of financial decisions on risk and return. Continuation
of the ese ch in capital market theory holds some promise of leading to better managerial decisions in the pursuit of explicit firm objectives. Many questions remain unanswered, however, especially concerning the exact nature of the effects of managerial decisions on stockholder wealth. Casting the decisions in an expected return, comovement framework provides a w a y of viewing and evaluating managerial response to problem situations. This initial step of modeling the important variables is necessary for theory development and practicable evaluation of managerial decisions.
OOOOODOOOOOOOOOOOOOOOOOOOOOOOOOQOOOOODDDOOOOOOOOOODOOOOOOOODOOOOOOOOOOOOOQO
If t h e i n v e s t m e n t c o m m u n i t y does n o t u n d e r s t a n d a c o m p a n y , it is p r o b a b l y m o r e t h e f a u l t o f t h a t c o m p a n y t h a n of a n y o n e else. T h e r e s p o n s i b i l i t y f o r p r o p e r l y i n f o r m i n g investors a n d t h e i r advisors a b o u t a c o m p a n y lies w i t h t h e c o m p a n y itself. --Martin Zausner
Corporate Policy and the Investment Community 0000000000000000000000000000(30000000000000000000000000000000000000000000000
BUSINESS HORIZONS
PHILIP L. COOLEY AND R O D N E Y L. R O E N F E L D T
Both authors are faculty members in the area of finance at The University of South Carolina.
The establishment of objectives for the hierarchy of planning within the firm is a widely accepted principle. This happy s t a t e of agreement disintegrates rapidly, however, when attempts are made to define the objectives. For example, should the firm's primary objective be profit maximization, maximization of the owners' wealth, or consumer service? Or should the major objective focus on employment for employees and management, or benefits to society in general? Complete answers to these questions have yet to be developed; observers cannot even agree concerning the more fundamental question of h o w management can best represent the financial interests of the owners of the firm. The following discussion concerns this question of representing the financial interests of owners. While cognizant of the unresolved issues of multiple firm objectives, the authors have formulated ~ framework for evaluating managerial decisions that is based only on the financial goal of owner wealth maximization.
definitive attacks have been made on its merits as a firm objective. Strict interpretation of profit maximization as a guide to managerial decision making has been shown to yield suboptimal results for owners as well as other firm participants. As argued b y Ezra Solomon, profit maximization has three flaws that lessen its usefulness for decision making: Its meaning is Unclear, resulting in several interpretations. Should we maximize short- or long-term profits? And should profits be defined as revenues minus costs, return on assets, return on equity, or some other such measure? Profit-maximization ignores the higher values of early benefits compared to later benefits. Clearly, $1,000 in today's coffers is preferred to the legitimate promise of $1,000 five years from now. "The third and most important objection is that the profit-maximization criterion ignores the quality of the expected benefits." For two projects promising equal returns, the one with a higher degree of certainty usually is preferred. 1
The consequences of overlooking the risk dimension o f decision making has been demonstrated more recently b y Weston. Use of the d u P o n t return on investment (ROI) method for planning and control is shown to be ineffective when statically interpreted. In addition to continual review of ROI standards and achievements, Weston argues that the
W H Y NOT PROFIT M A X I M I Z A T I O N ? The assertion that firms maximize p r o f i t s - o r should maximize profits-persists even though
AUGUST, 1974
1. Ezra Solomon, The Theory o f Financial Management (New York: Columbia University Press, 1963),.p. 19.
67
PHILIP L. COOLEY AND RODNEY L. ROENFELDT
FIGURE 1 Value of the Firm and Investor Expectations E XPECTE D RETURN
MANAGERIAL DECISIONS PAST CURRENT EXPECTED
68
risks surrounding a projected ROI must be consideredi "The implication that a fixed minimum ROI rate had been a rigid requirement of all types of opportunities, regardless of the degree of risk, suggests the application of the method in a mechanistic way. ''2 One solution to the risk-return problem, as well as to other problems identified by Solomon, is adoption of the wealth maximization objective. Achievement of this objective necessarily requires a proper trade-off between risk and return. A manager may incorporate considerations of risk and return into his thinking by making decisions which result in greatest capitalized cash flows. Under this approach, expected cash flows from risky projects are discounted at higher rates than those from less risky projects. Risky projects are thereby penalized according to their risk and selected only if a maximization of capitalized cash flows results. A variant of this procedure is to adjust the uncertain cash flows to equipreferable certain cash flows, and to use a discount factor reflecting a risk-free investment. In either case, both quantity and quality of returns are considered.
PRICE E F F E C T S OF D E C I S I O N S
Ultimately, the effects of managerial decisions are absorbed into the value placed on the firm in the market. Decisions based on the wealth 2. J. Fred Weston, "ROI Planning and Control," Business Horizons, XV (August 1972), pp. 35-42.
r
VALUE OF FIRM
PERCEIVED RISK
maximization objective result in a risk-return balance which leads to a maximum firm valuation by investors. The cumulative effects of all wealth maximization decisions-for example, financial, marketing, and production decisions-determine the levels of risk and return expected by potential capital suppliers. As illustrated in Figure 1, the expectations of marginal capital suppliers lead to the firm's market value. Past, current, or expected decisions which are judged to add disproportionate risk to the firm for the expected return depress firm value. Conversely, firm value increases when the level of expected return is more than usual for the added risk exposure. In the absence of current managerial decisions which depart significantly from past policy and with little change in expected decisions, risk-return expectations are largely a function of decisions made in the p a s t often the distant past. For instance, the line of business in which a firm is classified changes infrequently and is often a result of decisions made early in the firm's life cycle. Capital structure decisions-that is, proportions of debt and e q u i t y - t e n d to change slowly as do decisions regarding dividend levels. Other decisions, such as product pricing or basic productive processes, may change more quickly. All managerial decisions are more or less subject to change, and it is this departure from the historical norm that leads to changes in investors' expectations. The moderating effect of current managerial decisions on past decisions for an individual firm and the market as a whole is
BUSINESS HORIZONS
Decision Evaluation for Owner Wealth
FIGURE 2 Value Changes for the Firm and Market PAST MANAGERIAL DECISIONS FOR A FIRM LINE OF BUSINESS CAPITAL STRUCTURE PRODUCTI VE PROCESSES PROMO TIONA L POL ICIES DIVIDEND POLICY
O u} m LU
£3 1
< Z <
ENVIRONMENTAL STIMULUS ENERG Y CRISIS POLITICAL ENVIRONMENT ECONOMIC BOOM ECONOMIC RECESSION
Z LU rr
~
SALES GROWTH EPS GROWTH PROFITABtL ITY DIVIDENDS VARIABILITY
~
SECURITYPRICE CHANGE FOR A FIRM
O
X I
kU
(J £b
LLI
c/)
INVESTOR EXPECTATIONS t OF ENTIRE MARKET 1
uJ -> L~
MARKET PRICE " l INDEX CHANGE
tr
X
LU
illustrated in Figure 2. Past decisions form the basis for investor-expectation of the several financial aspects of the firm, but current decisions can change these expectations. Firm and aggregate market values change, dependi n g on how such decisions coupled with environmental changes are translated into perceived risk and expected return in the market. In general, based on past research, expected returns from individual firms tend to vary in unison with expectations for the entire market. In addition, empirical evidence leads to the presumption that investors expect higher returns from firms whose returns vary positively with market returns. 3 The theoretical explanation for this behavior is that security returns which tend to move with general market returns cannot be used to reduce the overall variability of an investor's portfolio return. Security returns which move opposite to general market returns are, therefore, highly valued; when added to a portfolio, certainty of the portfolio return is increased. 3. J a c k L. Treynor, " H o w to Rate Management of Investment F u n d s , " Harvard Business Review (JanuaryFebruary 1965), pp. 63-75.
AUGUST, 1974
z
er"
¢r
O
l PASTMANAGERIAL DECISIONS " FOR ALL FIRMS
INVESTOR EXPECTATIONS OF A FIRM
The relationship between expected return and its comovement with the market return (comovement of returns is frequently indicated by the firm's "beta" and is interpreted as market risk) is illustrated in Figure 3. FIGURE 3 Expected Return and Comovement With Market Return EXPECTED RETURN FROM SECURITY
B
EQUILIBRIUM LINE
C
EXPECTED COMOVEMENT OF SECURITY RETURN WITH MARKET RETURN
69
PHILIP L C O O L E Y A N D R O D N E Y
L. R O E N F E L D T
FIGURE 4 Matrix of Managerial Decision Effects EXPECTED RETURN FROM SECURITY
70
EXPECTED COMOVEMENT OF SECURITY RETURN WITH MARKET RETURN INCREASE
NO EFFECT
DECREASE
INCREASE
DECISION (1)
DECISION (2)
DECISION (3)
NO EFFECT
DECISION (4)
DECISION (5)
DECISION (6)
DECREASE
DECISION (7)
DECISION (8)
DECISION (9)
Exemplified b y the equilibrium line, increases in degree of comovement are associated with increases in expected return. Expected returns from the theoretical Firm A are completely independent of movements in market returns, resulting in expectations which are lower than those for Firms B and C. Both Firms B and C are shown in a state of disequilibrium. Apparently, either environmental changes or various decisions made b y the managers of B have caused return expectations to exist temporarily which are higher than normal for the level of risk. Acting as a countervailing power, investors will bid up the firm's stock price because of its favorable risk-return relationship, forcing the firm's expected return back into equilibrium. Adverse environmental impacts or poor managerial decisions have lowered expected returns from Firm C. As marginal bids for C stock are lowered, the expected return will rise toward equilibrium and existing owners will suffer a wealth loss.
MANAGERIAL
DECISION
FRAMEWORK
Whether from fortuitous circumstances or managerial decisions, the share price's return to equilibrium will produce a gain in wealth for shareholders of Firm B and a loss in wealth for shareholders of Firm C. To the
extent that those wealth changes are due to managerial decisions, the respective managements may be evaluated from the owners' point of view. Each managerial decision can be evaluated b y its combined effect on the owners' expected return and the comovement of those returns with general market returns.
Decision Classification Using scales with three levels--increase, no effect; and d e c r e a s e - e a c h managerial decision is classified in Figure 4 according to its effect on expecte d return and comovement of security and market returns. Decision (1) tends to increase b o t h expected return and comovement. Whether the decision has a desirable impact on owners' wealth depends on the relative increases in expected return and com°vement. Decision (3) is most desirable from the owners' viewpoint since expected return is increased simultaneously with an expected decline in comovement of returns. The most undesirable types of managerial decisions are reflected in the matrix cell labeled Decision (7), where an increase in comovement is accompanied b y a decline in expected return. Decision (5) commands little interest from owners because it produces no effect on expected return or its comovement.
BUSINESS HORIZONS
Decision Evaluation for Owner Wealth
FIGURE 5 Managerial D e c i s i o n E f f e c t s in E x p e c t e d R e t u r n , C o m o v e m e n t S p a c e
EXPECTED RETURN FROM SECURITY
DECISION (2)
. ~ , 0 6 " 0 / ~ 1 0
DECISION(6) ~
£)
--... DECISION (8) 71 EXPECTEDCOMOVEMENTOF SECURITYRETURNWITH MARKET RETURN I n t e r p r e t a t i o n o f the m a n a g e r i a l decision e f f e c t s is aided b y r e f e r r i n g to Figure 5, w h i c h places t h e m into a risk-return space similar to t h a t s h o w n in Figure 3. Managerial decisions are s h o w n to consist of f o u r basic t y p e s : Wealth improvement--Decisions 2, 3, and 6 cause temporary disequilibrium and an increase in market value of the firm upon restoration to equilibrium. Wealth deterioration--Decisions 4, 7, and 8 cause temporary disequilibrium and a decrease in market value of the firm upon restoration to equilibrium. Wealth maintenance--Decision 5 does not cause a temporary disequilibrium, and the current wealth of owners is therefore maintained. Wealth change indeterminant--Decisions 1 and 9 may or may not cause a temporary disequilibrium, depending upon the relative increases or decreases in expected retum and comovement. Wealth may therefore be increased, decreased, or maintained.
and f o u r w e a l t h effects span all the possible effects o f m a n a g e r i a l decisions. While the p r o p o s e d f r a m e w o r k m a y be c o n c e p t u a l l y appealing, m o d i f i c a t i o n s o f curr e n t m a n a g e r i a l decisions require a c c u r a t e k n o w l e d g e o f the m o d i f i c a t i o n s ' effects o n e x p e c t e d r e t u r n and c o m o v e m e n t . T h e framew o r k illustrated is an organizing device for a v a r i e t y o f m a n a g e r i a l decisions in w h i c h the m a n a g e r is a t t e m p t i n g to increase the w e a l t h of t h e owners r e p r e s e n t e d . In o r d e r to m o v e the f r a m e w o r k b e y o n d the classificatory stage, e m p i r i c a l evidence w h i c h shows the i m p a c t of decisions on e x p e c t e d r e t u r n and c o m o v e m e n t is n e e d e d .
T h e nine t y p e s o f decisions s h o w n in Figures 4 a n d 5 a n d the f o u r w e a l t h e f f e c t s a b o v e are d e f i n e d to add s t r u c t u r e to all possible decision effects. Nine decision e f f e c t s
Empirical Evidence
AUGUST, 1974
E m p i r i c a l evidence of the e f f e c t s o f m o s t m a n a g e r i a l decisions is c u r r e n t l y lacking. A
PHILIP L. COOLEY AND RODNEY L. ROENFELDT
few studies have been conducted which consider the impact of financial decisions only. However, even in these studies, the effects Of financial variables on expected return and comovement are not investigated together. From some recent studies, it appears that decisions to increase debt in the capital structure also increase the comovement of returns. Other research indicates that this same decision results in a higher expected return. 4 Tentatively, then, a leverage increase is a managerial decision in the Decision (1) category, which displaces the firm upward and to the right in Figure 5. Although the general direction is given, it is unclear to what extent the direction would deviate from the equilibrium line. Another financial decision variable considered in these studies is the amount of earnings paid out in dividends. Generally, increasing dividend payout reduces b o t h comovement and expected return. Dividend 72 4. William Beaver, Paul Kettler, and Myron Scholes, "The Association between Market Determined and Accounting Determined Risk Measures," The Accounting Review, XLV (October 1970), pp. 654-82; and Dennis E. Logue and Larry J. Merville, "Financial Policy and Market Expectations," Financial Management, I (Summer 1972), pp. 37-44. Marc Nerlove, "Factors Affecting Differences Among Rates of Return on Investments in Individual Common Stock," Review of Economics and Statistics, L (August 1968), pp. 312-31 ; and Fred Arditti, "Risk and the Required Return on Equity," Journal of Finance, XXII (March 1967), pp. 19-36.
payout thus appears to be in the Decision (9) category. Liquidity decisions, indicated b y current ratios, were shown to have little effect on either comovement or expected return. Therefore, a firm in equilibrium would tend to remain in equilibrium for most liquidity decisions; this type of decision would be classified as Decision (5). These decisions are representative of those for which substantial empirical agreement has been found. Additional research is needed concerning the impact of both financial and nonfinancial decisions on risk and return. The authors are currently examining the simultaneous effects of financial decisions on risk and return. Continuation
of the ese ch in capital market theory holds some promise of leading to better managerial decisions in the pursuit of explicit firm objectives. Many questions remain unanswered, however, especially concerning the exact nature of the effects of managerial decisions on stockholder wealth. Casting the decisions in an expected return, comovement framework provides a w a y of viewing and evaluating managerial response to problem situations. This initial step of modeling the important variables is necessary for theory development and practicable evaluation of managerial decisions.
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If t h e i n v e s t m e n t c o m m u n i t y does n o t u n d e r s t a n d a c o m p a n y , it is p r o b a b l y m o r e t h e f a u l t o f t h a t c o m p a n y t h a n of a n y o n e else. T h e r e s p o n s i b i l i t y f o r p r o p e r l y i n f o r m i n g investors a n d t h e i r advisors a b o u t a c o m p a n y lies w i t h t h e c o m p a n y itself. --Martin Zausner
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