The intuition behind discounted cash flow analysis is that a project must generate a higher rate of return than the one that can be earned in the capital markets. Only if this is true will a project’s NPV be positive. A significant part of corporate strategy analysis is seeking investment opportunities that can produce positive NPV.
Simple “number crunching” in a discounted cash flow analysis can sometimes erroneously lead to a positive NPV calculation. In calculating discounted cash flows, it is always useful to ask: What is it about this project that produces a positive NPV? or Where does the positive NPV in capital budgeting come from? In other words, we must be able to point to the specific sources of positive increments to present value in doing discounted cash flow analysis. In general, it is sensible to assume that positive NPV projects are hard to find and that most project proposals are “guilty until proven innocent.”
Here are some ways that firms create positive NPV:
1. Be the first to introduce a new product.
2. Further develop a core competency to produce goods or services at lower cost than competitors.
3. Create a barrier that makes it difficult for other firms to compete effectively.
4. Introduce variations on existing products to take advantage of unsatisfied demand.
5. Create product differentiation by aggressive advertising and marketing networks.
6. Use innovation in organizational processes to do all of the above.
This is undoubtedly a partial list of potential sources of positive NPV. However, it is important to keep in mind the fact that positive NPV projects are probably not common.
Our basic economic intuition should tell us that it will be harder to find positive NPV projects in a competitive industry than a noncompetitive industry.
Now we ask another question: How can someone find out whether a firm is obtaining positive NPV from its operating and investment activities? First we talk about how share prices are related to long-term and short-term decision making. Next we explain how managers can find clues in share price behavior on whether they are making good decisions.
Corporate Strategy and the Stock Market
There should be a connection between the stock market and capital budgeting. If a firm invests in a project that is worth more than its cost, the project will produce positive NPV, and the firm’s stock price should go up. However, the popular financial press frequently suggests that the best way for a firm to increase its share price is to report high short-term earnings (even if by doing so it “cooks the books”). As a consequence, it is often said that U.S. firms tend to reduce capital expenditures and research and development in order to increase
short-term profits and stock prices.1 Moreover, it is claimed that U.S. firms that have valid long-term goals and undertake long-term capital budgeting at the expense of short-term profits are hurt by shortsighted stock market reactions. Sometimes institutional investors are blamed for this state of affairs. By contrast, Japanese firms are said to have a long-term perspective and make the necessary investments in research and development to provide a competitive edge against U.S. firms.
Of course, these claims rest, in part, on the assumption that the U.S. stock market systematically overvalues short-term earnings and undervalues long-term earnings. The available evidence suggests the contrary. McConnell and Muscarella looked closely at the effect of corporate investment on the market value of equity. They found that, for most industrial firms, announcements of increases in planned capital spending were associated with significant increases in the market value of the common stock and that announcements of decreases in capital spending had the opposite effect. The McConnell and Muscarella research suggests that the stock market does pay close attention to corporate capital spending and it reacts positively to firms making long-term investments.
In another highly regarded study, Woolridge studied the stock market reaction to the strategic capital spending programs of several hundred U.S. firms.3 He looked at firms announcing joint ventures, research and development spending, new-product strategies, and capital spending for expansion and modernization. He found a strong positive stock reaction to these types of announcements. This finding provides significant support for the notion that the stock market encourages managers to make long-term strategic investment decisions in order to maximize shareholders’ value. It strongly opposes the viewpoint that markets and managers are myopic.
How Firms Can Learn about NPV from the Stock Market:
The AT&T Decision to Acquire NCR and to Change Its CEO
Therefore, it is not surprising that the stock market usually reacts positively to the proposed capital budgeting programs of U.S. firms. However, this is not always the case. Sometimes the stock market provides negative clues to a new project’s NPV.
Consider AT&T’s repeated attempts to penetrate the computer-manufacturing industry. On December 6, 1990, AT&T made a $90 per share or $6.12 billion cash offer for all of NCR Corporation’s common stock. From December 4, 1990, to December 11, 1990, AT&T’s stock dropped from $303⁄ 8 per share to $291 ⁄ 2, representing a loss of about $1 billion to the shareholders of AT&T.
Five months later, when these firms finally agreed to a deal, AT&T’s stock dropped again. Why did AT&T buy NCR, a large computer manufacturer? Why did the stock market reaction suggest that the acquisition was a negative NPV investment for AT&T? AT&T was apparently convinced that the telecommunications and computer industries were becoming one industry. AT&T’s basic idea was that telephone switches are big computers and success in computers means success in telephones. The message from the stock market is that AT&T could be wrong. That is, making computers is basically a manufacturing business and telephone communications is basically a service
business. The core competency of making computers (efficient manufacturing) is different from that of providing telecommunications for business (service support and software). Of course, even if AT&T had acquired NCR for the “right” reasons, it is possible that it paid too much. The negative stock market reaction suggests that AT&T shareholders believed that NCR was worth less than its cost to AT&T. On September 20, 1995, when AT&T announced its intention to spin off NCR (as well as Lucent), its stock price increased by about 11 percent. On the other hand, when it was announced, on November 5, 1992, that AT&T was negotiating the purchase of one-third of McCaw Cellular Communications with the option to obtain voting control, AT&T’s stock price jumped from $426⁄ 8 to $443 ⁄ 8, representing a gain in market value close to $2 billion.
Two years later,the Federal Communications Commission approved the acquisition of all of McCaw by AT&T, and AT&T’s stock price was holding at over $55 per share. The positive stock market reaction suggests that the shareholders of AT&T believe that AT&T’s acquisition of McCaw is a positive NPV decision. AT&T could use McCaw’s cellular telephone network to bypass local telephone companies for completing long distance telephone calls, eliminating the access fees normally paid to them. Perhaps because of AT&T’s spotty acquisition record, its stock price rose 13.5 percent when on October 17,
1997, it was learned that Robert Allen would step down and Michael Armstrong would become the new CEO. On June 24, 1998, when it was disclosed that AT&T appeared close to a deal to acquire TCI for $30 billion, AT&T’s stock jumped 4 percent.The market believed that by buying TCI, which owned a large portfolio of cable lines, AT&T might be able to bypass the local phone monopolies of the “baby bells.”TCI would offer AT&T a detour around the “last mile” and ultimately be part of AT&T’s broadband strategy. AT&T’s market share of long-distance business continues to fall and there have been reports of pressure by the credit rating agencies for it to reduce its $62 billion of debt and $3 billion of interest costs.
AT&T’s stock price fell by more than 60 percent during the year 2000, a year that included AT&T’s announced breakup into three companies: wireless, broadband, and business services. The stock market appeared to be very skeptical of AT&T’s ability to carry out its long term strategy.
At the end of the year, it was reported that AT&T was expected to reduce its dividend by about 60 percent from its current level. This would be the first time in the company’s more than 100-year history that it had cut its dividend. Upon the report of a dividend cut, AT&T’s stock price increased.
Overall, the evidence suggests that firms can use the stock market to help potentially short-sighted managers make positive net present value decisions. Unfortunately only a few firms use the market as effectively as they could to help them make capital budgeting decisions.
Simple “number crunching” in a discounted cash flow analysis can sometimes erroneously lead to a positive NPV calculation. In calculating discounted cash flows, it is always useful to ask: What is it about this project that produces a positive NPV? or Where does the positive NPV in capital budgeting come from? In other words, we must be able to point to the specific sources of positive increments to present value in doing discounted cash flow analysis. In general, it is sensible to assume that positive NPV projects are hard to find and that most project proposals are “guilty until proven innocent.”
Here are some ways that firms create positive NPV:
1. Be the first to introduce a new product.
2. Further develop a core competency to produce goods or services at lower cost than competitors.
3. Create a barrier that makes it difficult for other firms to compete effectively.
4. Introduce variations on existing products to take advantage of unsatisfied demand.
5. Create product differentiation by aggressive advertising and marketing networks.
6. Use innovation in organizational processes to do all of the above.
This is undoubtedly a partial list of potential sources of positive NPV. However, it is important to keep in mind the fact that positive NPV projects are probably not common.
Our basic economic intuition should tell us that it will be harder to find positive NPV projects in a competitive industry than a noncompetitive industry.
Now we ask another question: How can someone find out whether a firm is obtaining positive NPV from its operating and investment activities? First we talk about how share prices are related to long-term and short-term decision making. Next we explain how managers can find clues in share price behavior on whether they are making good decisions.
Corporate Strategy and the Stock Market
There should be a connection between the stock market and capital budgeting. If a firm invests in a project that is worth more than its cost, the project will produce positive NPV, and the firm’s stock price should go up. However, the popular financial press frequently suggests that the best way for a firm to increase its share price is to report high short-term earnings (even if by doing so it “cooks the books”). As a consequence, it is often said that U.S. firms tend to reduce capital expenditures and research and development in order to increase
short-term profits and stock prices.1 Moreover, it is claimed that U.S. firms that have valid long-term goals and undertake long-term capital budgeting at the expense of short-term profits are hurt by shortsighted stock market reactions. Sometimes institutional investors are blamed for this state of affairs. By contrast, Japanese firms are said to have a long-term perspective and make the necessary investments in research and development to provide a competitive edge against U.S. firms.
Of course, these claims rest, in part, on the assumption that the U.S. stock market systematically overvalues short-term earnings and undervalues long-term earnings. The available evidence suggests the contrary. McConnell and Muscarella looked closely at the effect of corporate investment on the market value of equity. They found that, for most industrial firms, announcements of increases in planned capital spending were associated with significant increases in the market value of the common stock and that announcements of decreases in capital spending had the opposite effect. The McConnell and Muscarella research suggests that the stock market does pay close attention to corporate capital spending and it reacts positively to firms making long-term investments.
In another highly regarded study, Woolridge studied the stock market reaction to the strategic capital spending programs of several hundred U.S. firms.3 He looked at firms announcing joint ventures, research and development spending, new-product strategies, and capital spending for expansion and modernization. He found a strong positive stock reaction to these types of announcements. This finding provides significant support for the notion that the stock market encourages managers to make long-term strategic investment decisions in order to maximize shareholders’ value. It strongly opposes the viewpoint that markets and managers are myopic.
How Firms Can Learn about NPV from the Stock Market:
The AT&T Decision to Acquire NCR and to Change Its CEO
Therefore, it is not surprising that the stock market usually reacts positively to the proposed capital budgeting programs of U.S. firms. However, this is not always the case. Sometimes the stock market provides negative clues to a new project’s NPV.
Consider AT&T’s repeated attempts to penetrate the computer-manufacturing industry. On December 6, 1990, AT&T made a $90 per share or $6.12 billion cash offer for all of NCR Corporation’s common stock. From December 4, 1990, to December 11, 1990, AT&T’s stock dropped from $303⁄ 8 per share to $291 ⁄ 2, representing a loss of about $1 billion to the shareholders of AT&T.
Five months later, when these firms finally agreed to a deal, AT&T’s stock dropped again. Why did AT&T buy NCR, a large computer manufacturer? Why did the stock market reaction suggest that the acquisition was a negative NPV investment for AT&T? AT&T was apparently convinced that the telecommunications and computer industries were becoming one industry. AT&T’s basic idea was that telephone switches are big computers and success in computers means success in telephones. The message from the stock market is that AT&T could be wrong. That is, making computers is basically a manufacturing business and telephone communications is basically a service
business. The core competency of making computers (efficient manufacturing) is different from that of providing telecommunications for business (service support and software). Of course, even if AT&T had acquired NCR for the “right” reasons, it is possible that it paid too much. The negative stock market reaction suggests that AT&T shareholders believed that NCR was worth less than its cost to AT&T. On September 20, 1995, when AT&T announced its intention to spin off NCR (as well as Lucent), its stock price increased by about 11 percent. On the other hand, when it was announced, on November 5, 1992, that AT&T was negotiating the purchase of one-third of McCaw Cellular Communications with the option to obtain voting control, AT&T’s stock price jumped from $426⁄ 8 to $443 ⁄ 8, representing a gain in market value close to $2 billion.
Two years later,the Federal Communications Commission approved the acquisition of all of McCaw by AT&T, and AT&T’s stock price was holding at over $55 per share. The positive stock market reaction suggests that the shareholders of AT&T believe that AT&T’s acquisition of McCaw is a positive NPV decision. AT&T could use McCaw’s cellular telephone network to bypass local telephone companies for completing long distance telephone calls, eliminating the access fees normally paid to them. Perhaps because of AT&T’s spotty acquisition record, its stock price rose 13.5 percent when on October 17,
1997, it was learned that Robert Allen would step down and Michael Armstrong would become the new CEO. On June 24, 1998, when it was disclosed that AT&T appeared close to a deal to acquire TCI for $30 billion, AT&T’s stock jumped 4 percent.The market believed that by buying TCI, which owned a large portfolio of cable lines, AT&T might be able to bypass the local phone monopolies of the “baby bells.”TCI would offer AT&T a detour around the “last mile” and ultimately be part of AT&T’s broadband strategy. AT&T’s market share of long-distance business continues to fall and there have been reports of pressure by the credit rating agencies for it to reduce its $62 billion of debt and $3 billion of interest costs.
AT&T’s stock price fell by more than 60 percent during the year 2000, a year that included AT&T’s announced breakup into three companies: wireless, broadband, and business services. The stock market appeared to be very skeptical of AT&T’s ability to carry out its long term strategy.
At the end of the year, it was reported that AT&T was expected to reduce its dividend by about 60 percent from its current level. This would be the first time in the company’s more than 100-year history that it had cut its dividend. Upon the report of a dividend cut, AT&T’s stock price increased.
Overall, the evidence suggests that firms can use the stock market to help potentially short-sighted managers make positive net present value decisions. Unfortunately only a few firms use the market as effectively as they could to help them make capital budgeting decisions.
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