What is the dark side of corporate finance theory?

What is the dark side of corporate finance theory?

There is a gradual increase in the number of people at companies who feel uncomfortable with conventional numerical targets such as ROE. Why is this happening? Based on a unique perspective and theoretical background that is unaffected by trends and norms, the popular book “New Interpretation of Corporate Finance Theory-Is it true that we should expand corporate value?” ? Professor Hisao Miyagawa, the author of the book , says that there is actually a historical “discrepancy” in the fundamental theory of corporate value. What is that “discrepancy”?

In short, what should I do?

If a member of society asked me, “What will I be able to do after studying corporate finance?” is probably the same as asking Both will be able to handle complex situations that arise in practice. I might give an abstract answer like that. What about complicated situations? However, I won’t know until that time.

A situation in which a player throws an easy-to-catch ball thrown by an opponent and catches it in front of his/her chest, and then throws the ball toward the opponent’s chest so that the opponent can easily catch it, is almost unheard of during a baseball game. However, it is necessary to repeat that movement on a daily basis and have knowledge of how to swing your arm, how your fingers are hooked on the ball, and the position of the ball pocket where the ball enters the glove. Because of that, I can catch a ball with a complicated rotation when it flies to my feet, and I can toss the ball well according to the complicated timing of the second that runs to enter the base cover. . This is because the abstracted knowledge of playing catch is instantaneously matched to the complex and concrete situation in front of us.

A competent athlete in any sport is able to accept and respond to complex situations as they are. Part 1 of this column [link added] The young CFO of a start-up company introduced at the beginning said, “Corporate finance theory is not at all different from reality,” because he understands complex reality as complex reality. , I think it’s because I have the ability to drop it into an abstract theory. So he can think for himself. However, many people like to simplify complex situations. Then he asks, “Putting aside the theory, what should I do?”

What bothers me in college is that students want simple, easy-to-understand answers. Not just college students. The world is now somehow bypassing complexity and fighting! I tend to want to simplify everything in a refreshing way. Looking at university students, it seems that the number of such people will increase in the future. They don’t put much effort into thinking about questions or providing their own insights, believing that there is always a simple ‘correct’ answer. Even worse, they try to find the most efficient way to find the correct answer.

It’s “correct”, so it’s not wrong. However, I think that universities tend to think about such things as whether the answer to the question really solves the problem, or whether the setting of the question is appropriate in the first place. Mintzberg’s “great class,” which I introduced in my last column, suggested this. I would like working people to study voluntarily like this.

Inconsistency in corporate finance as a theory?

Now, many companies set ROE, ROA, or return on capital indicators such as ROIC as management goals. For example, reading a company’s integrated report and looking for a company that doesn’t have such financial targets is as difficult as trying to find garlic-free dishes in an Italian restaurant. This is largely due to the fact that the Corporate Governance Code (CG Code), which has the subtitle “For the improvement of corporate value,” encourages management that is conscious of “the company’s cost of capital.”

It’s not wrong. However, it is also true that many people feel uncomfortable. This is probably because the originally complex story of corporate value and cost of capital is simplified into accounting financial ratios such as ROE and ROIC . In fact, it’s a bit of a dark spot in the history of corporate finance as a theory.

It’s no longer a heavy topic in this column, but corporate value is defined as the present value of the cash flow expected to be obtained by the company in the future discounted by the cost of capital. Expressed as a fraction, put the expected future cash flow in the numerator and put the cost of capital representing risk in the denominator. If the cash in the numerator is expected to be large, or the risk in the denominator is expected to be small, the value will be large.

In other words, the numerator is the cash flow that the investor is expected to receive in the future. So, for example, future cash flow for a person who bought an interest-bearing government bond is the coupon received each year and the principal returned at maturity. Stocks, on the other hand, have no maturity. Therefore, the stock value is calculated on the assumption that the company will continue to exist indefinitely.

The principle model that expresses stock value is called the dividend discount model, and the premise of this model is that shareholders will forever receive cash in the form of dividends every year. This model was first proposed by Gordon in 1959 and is called the Gordon model (*1). Gordon believes that risk increases when a company raises new funds from outside to operate its business, and that it would increase shareholder value by operating the business with the profits it earns and paying dividends without fail. At that time, however, the concept of risk was not well understood. This is the point.

The concept of risk had to wait at least five years after Gordon’s paper until William Sharp’s paper(*2). Following Sharpe’s paper in 1964, research by economists such as Lintner and Mossin finally gave rise to CAPM (Capital Asset Pricing Model) theory in the late 1960s. They finally succeeded in formulating risk mathematically. This is the stage at which the cost of capital, or the discount rate of the discounted present value model, is finally known.

However, in fact, this CAPM theory is called a one-period model, and it assumes that what is invested at point 1 will be recovered at point 2. Although the discounted present value is a long-term concept (multi-term model) that assumes that the company will continue to exist forever, the essential discount rate (capital cost) used there is a short-term concept (single-term model). This means that there is an inconsistency .

For those who feel uncomfortable with ROE targets

Decision-making to increase corporate value in actual management should be made on the premise that the company is sustainable, but the risks and expected returns that are taken into account are theoretically based on short-term models. is supposed to

In other words, it is often said that management should be conscious of the cost of capital in order to increase corporate value, but in fact, the cost of capital was not originally prepared from the beginning to calculate corporate value. The cost of capital is simply derived from portfolio theory, which clarifies the question of what is the optimal portfolio for investors, focusing on a one-period mean-variance model. It is inevitable that there will be a sense of incongruity in practice, since the relationship with one-period accounting figures such as ROE and ROIC is brought into the equation. Moreover, although ROE and ROIC are past results, capital costs are forecasts for the future.

Please refer to my book for more details , but I am not saying that ROE and ROIC are wrong or useless. These indicators are suitable as a yardstick for measuring management results, and are extremely appropriate as targets for managing management processes. However, if simplifications such as “In short, what should we do?”

Explain why the financial ratio is important to the people who work for the company or who are the shareholders of the company, and what will happen if the financial ratio target is achieved, without simplifying complex variables. I think it’s important to explain, but what do you think?

CG code comes up with the expression “comparability”. Although it is not limited to CG codes, it seems that it is believed that it is convenient for users to simplify the disclosure contents of companies so that investors can compare them. However, a company’s competitive advantage lies in its differentiation from other companies. It does not necessarily appear by comparing numerical values ​​arranged in common. This is a repeat of my previous column, but I was originally talking about the complex issue of corporate value. It would be difficult to ask you to simplify.

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