All the groups work together to create economic value. Political value is also created, which can be turned into economic value.
Political value comes from the advantage to be won by instituting a change in government policy or regulation in your own favour, or from the gaining of social legitimacy by managing important social issues in such a way as to win support for the enterprise and to enhance its reputation. Some of the stakeholders are more involved in this second network than the first. However, they will negotiate in a way which influences the distribution of economic value.
the board, largely through executive directors. There may be a close and continuing relationship between the two groups. In normal times there is no attempt to directly control the managers, although there is a general oversight over strategy by the board on behalf of the owners.
This separation can be presented more formally. Fama and Jensen (1983: 3) have broken down the decision process, including that relating to investment, into four separate steps:
1. Initiation – the generation of new investment proposals, 2. Ratification – choice of which initiatives to implement, 3. Implementation – execution of ratified decisions, 4. Monitoring – oversight of performance.
They join initiation and implementation under the heading of ‘deci- sion management’ and ratification and monitoring under ‘decision control’ with an assumption that the former process is allocated to managers and the latter to owners, represented by the board of direc- tors. The governance system of an enterprise will determine exactly how these functions are shared between the two groups.
Financial theorists deal with this issue through agency theory (Jensen and Meckling 1976; Fama 1980). Even an enterprise with no debt, financed solely by external equity, has an agency problem, which arises because owners and managers, as principal and agent, have dif- ferent interests and asymmetric information. It is difficult to devise an incentive structure which aligns the two stakeholder groups. Managers have a range of motivating interests including status, power, or posi- tion. These are expressed partly in non-pecuniary benefits, such as large offices, parking spots and company cars, and partly in larger objectives best served by the pursuit of size rather than profit. Where the two objectives diverge, managers favour the former over the latter.
This may mean that there is a tendency to approve of more, larger and riskier, investment projects than would be the case if profit maximisa- tion were the goal. The result may be the adoption of investment pro- jects yielding a negative net present value or a return below the threshold level, or just appraised with overly-optimistic inputs. This can happen since the managers control the input of data needed for any appraisal. The asymmetry in information compounds the problem since it means that managers have the relevant information which owners do not possess. There is a tendency for executive directors to be in a stronger position than independent directors to know whether a particular project is being presented in a favourable light.
Agency costs take three principal forms:
• a loss of enterprise value resulting from poor decisions reflecting a failure to adequately manage the principal/agent relationship,
• the costs of equity holders monitoring the behaviour of their agents, including measurement costs and the costs of putting in control mechanisms to align the interests of various stakeholder groups, including compensation incentives, rules, and appraisal schemes,
• the cost incurred by agents in providing to principals a bond of good behaviour (holding shares or share options of the company might be regarded as such a bond).
There is one very significant constraint on the willingness of managers to take on low-return or risky projects since they are concerned with the possibility of losing their jobs. The average working life of a CEO is short.
The employment of all senior managers is threatened by take-overs, by turnaround situations or simply by a change of CEO. An investment failure may precipitate one of these outcomes. The managers are deterred from making decisions which are likely to lead to these outcomes, including any action which reduces the value of the enterprise below a valuation ratio of one (Tobin’s Q). Managers need to be circumspect in their behaviour; any blatantly self-serving action would reduce share prices and lead to scrutiny by shareholders or creditors.
One important issue, which highlights possible conflicts of interest, is what managers should do with a significant free cash flow. This cash flow is of great importance to the enterprise and its use a critical decision variable. There are three options:
• return it to the shareholders through dividend payments or buybacks
• use it to expand the enterprise, either
• by projects internal to the enterprise, e.g. increased R&D
• by acquisitions
• improve the position of various stakeholders and/or increase the degree of organisational slack
There is a tendency for managers to prefer to use free cash flows to expand the enterprise. In this situation the process of investment appraisal is reversed and managers use the system to confirm decisions they have already made for other reasons. This may be justified if the investment fits into a broader strategy for future growth.
The Investment Process and Decision Making: the Organisational Perspective 119
By contrast, equity holders are deemed interested solely in the value of their ownership share, but receive this value as dividends, buybacks or as potential capital gains. Share values are normally a reflection of dividend or profit flows and their timing. The option of making pay- ments to shareholders or of retention and reinvestment of profit can be viewed differently according to the time horizon of the shareholder.
Some shareholders may be long-term holders of shares and sensitive to the nature of strategic investments. All owners dislike a loss of value to their shares. However, there is always the option of selling their shares and readjusting their portfolio of assets to suit their risk tolerance.
In a world of asymmetric information, changes in dividend pay- ments act as a signalling device. A reduction in dividends may be seen as an admission of declining performance, just as an increase in dividends may be seen as an indication of an exhaustion of strategic ideas for future growth and therefore capital gains. The exact inter- pretation depends on the particular circumstances. It is necessary to look at the role of payout ratios as signalling devices as well as a means for distributing value.