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Corporate Governance Issues in Investment Decisions

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In the previous chapter we saw how investors price common stock when they are making investment decisions. Here, we consider the connection between share prices and the investment decisions made by managers using net present value (NPV) analysis and the NPV rule.

Actually, the approach we take is to consider each investment project as a stand-alone independent company. In so doing, we conceptualize the company as being the sum of its investment projects—what it does for a living.

Net present value has a precise meaning with respect to the market value of a company. The NPV of an investment project is the instantaneous change in the market value of the company that will occur if managers decide to go ahead with the investment. For example, suppose the NPV of a new product proposal is $500 million. If investors agree with management's assessment of the project's benefits, the market value of the company will increase by $500 million as soon as management announces that it will go ahead with the new product.

Technically, NPV is defined as the present value of all expected after-tax incremental cash outflows and inflows associated with the project, discounted at the project's riskadjusted required rate of return (which is the same as the project's opportunity cost of capital). And, what amounts to exactly the same thing, we can also define NPV as the present value of the expected after-tax cash inflows less the present value of the expected after-tax cash outflows, with both cash flow streams discounted at the project's risk-adjusted required rate of return.

Note the close correspondence between this definition and our definition of stock price, where we said that the stock price was the present value of the cash flows expected by the investor, discounted at the investor's risk-adjusted required rate of return. In effect, the market value of an entirely equity-financed company (one that has not borrowed any money) that distributes all after-tax cash flows to shareholders as cash dividends is simply the sum of the present values of all its current investments in the products and services that it sells for a living. With some modifications, we can show that this definition of the market value of a company's common stock also holds for companies that have used debt to finance themselves and those that reinvest some or all of the current year's after-tax cash flows in new projects.
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Document Type: Research Article

Publication date: February 25, 2003

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