VIEWS: 6 PAGES: 9 POSTED ON: 11/13/2010
FIRMS AND INDUSTRIES MARRIS’S MODEL OF THE FIRM Given the generally poor presentation of Marris in text-books, -Sawyer (1981, 1979) is hard to follow and Hay and Morris (1991) a bit long-winded - I have tried to produce a simpler, more intuitive approach to the model. (You might wonder - why not just read Marris himself? The answer is that the original Marris presentation has subsequently been refined by others and there is thus a substantial differences between Marris’s original attempt at a model and what we now call the Morris model). The Marris model is worth considering for the following reasons: (i) it is a model which tries to work out the implications of managerial objectives and contrast these with the implications of ownership objectives. (ii) it is a model which helps us to understand the limits to firm growth - in particular the growth of managerial controlled firms. However whilst useful and interesting it is not perfect. It suffers from many faults - methodologically, and theoretically. These faults are not explained or explored here. The starting point in developing the model is to consider the objectives of owners and managers. Owners are believed (quite reasonably) to be interested in maximising the value of their wealth as represented by the shares they hold in the firm. (Of course any particular owner may have shares in many firms - but that is a different matter). The firm would satisfy the wishes of the owners therefore by seeking to maximise its stock market value (SMV) which is the “market value” of the firm quoted in the financial press. (The market value of GEC this week is £5,800m, of Marks and Spencer is £5,700m. Note that this market value is different from the balance sheet value, or asset value, in the annual accounts). Just now the firm would go about maximising shareholders wealth we will consider after we have looked at the objectives of managers. Managers are unlikely to hold a significant proportion of a company’s shares (for a start if they could afford to own even 1% of GEC - which is worth £58m - they would hardly be interested in working for a living!). Therefore if managers effectively control the direction of the modern business it is possible that they would choose to steer it more to suit themselves than the owners - at least to the extent they can get away with it. (When you borrow someone’s car do you drive it the way she wants you to - or the way you like to? Only if she is looking). The question is, to what end would managers be likely to steer the business? The consensus is - from Galbraith, Baumol, Marris, et al - that managers would prefer growth for reasons of prestige, income and excitement. We therefore have to consider what difference this is likely to make to the interests of the owners who want the firm to grow also, but only as long as that helps to maximise their wealth. If at any point growth conflicts with wealth maximising, the owners would not want that growth. The managers would however. So the potential for a conflict arises if at any point growth does conflict with wealth 1 maximising. To examine this possibility we need a model of the growth firm such as we develop below. Begin with the question raised earlier. How would a firm go about maximising shareholders wealth? The stock market value of the firm (SMV) is determined by the income generated for the shareholders in the form of current dividends and expected future dividends. So, D1 D1 SMV D1 ...... (1 d ) (1 d ) 2 where there is a constant amount of dividend, D1, and these are discounted by shareholders at rate d. (The discount rate used by shareholders in this valuation equation depends on their views about the firm’s potential, the risks it faces, and the alternatives available to the shareholders for investing their money). If dividends are likely to grow over time, as the firm grows, this means the SMV equation, has to be revised to read, D1 (1 g) D1 (1 g) 2 SMV D1 ...... (1 d ) (1 d ) 2 This equation shows the connection between SMV, the initial level of dividends D1, the rate at which the firm grows (g) and the shareholders discount rate (d). Now consider the choices facing the firm concerning dividends and growth. If we examine the simplified circular flow diagram outlined in the class we see that there is a connection between the level of dividends paid out and the company’s growth rate. (We assume for simplicity that the firm raises no more finance externally. This option is open to firms in reality and can be dealt with in the Marris model - but it complicates the mathematics without affecting the result). The connection is this. If the company uses its profits to pay dividends, it retains less money in the business. It therefore has less available to finance new investment in increasing supply and demand of and for its products. For example, a company that pays all its profits as dividends doesn’t grow at all. It simply maintains itself from the depreciation fund. At the other extreme, a firm that pays no dividends at all can finance a lot of growth, or at least as much as its profit merit. If it never paid a dividend, however, it would have no value, so this situation would be unlikely to arise. At some point, dividends have to be paid if the firm is to have a SMV. Using these two extreme possibilities gives us the diagram overleaf. 2 100% max D, (set by profitability) max g (set by profitability) 0 GROWTH (g) The diagram shows that there is a trade-off between the proportion of profit paid out by the firm and how much it can grow (including of course dividends growth). Every time the firm reduces the dividend proportion, that it moves down the vertical-axis, it can finance some extra growth, that it moves along the horizontal axis. The investment being financed by paying out less in current dividends eventually produces extra profits and so future dividends can be bigger. (Students make exactly the same sort of decision. They accept lower income now, in order to invest in their future income potential. If they make a good investment choice future income will be higher and compensate them for current losses). The problem for the growing firm is this. It has to consider whether the reduction in current dividends is worth the extra dividends in future. From the shareholders point of view, if value extra dividends > value of reduced in future years present dividends The firm should reduce dividends and grow. In fact, to maximise the SMV for the shareholders the firm should reduce the current dividend until the point is reached where, value of extra dividends = value of reduced in future years present dividend In other words the marginal benefit of the reduced dividend should equal the marginal cost (because it always does in economics!). We can thus see the relationship between the firms dividend policy, its growth, and its SMV in the following diagrams. 3 max g (set by profitability) GROWTH (g) GROWTH (g) As current dividends are reduced the extra growth generated in future dividends compensates for this loss. (Assuming the firm has a few decent investment projects open to it). This is good for shareholders so the SMV increases. But after a point the decrease in current dividends no longer produces enough future dividends to compensate the shareholders. Dividends are growing faster, but not enough to compensate for present reductions. At this point SMV falls with extra growth. So a distinctive relationship emerges between SMV and growth. In principle there will be a unique growth rate that maximises SMV. If the firm grows too slow because it pays out too much in present dividends, it will not maximise SMV. If the firm grows too fast, by paying out too little in present dividends, it will also fail to maximise SMV. So there is a unique growth rate which will maximise the SMV of the firm (ceteris paribus). This in fact can be worked out mathematically, but not here. See Hay and Morris if you want the proof. What the maths show is intuitively obvious really. As you reduce current dividends you need to grow faster and faster to compensate. But this becomes harder and harder to do for reasons we will outline below. Because it gets progressively harder to obtain the extra growth to justify reducing current 4 dividends the SMV eventually peaks and thereafter declines. So pushing growth beyond that point is bad for your shareholders. Of course managers will desire to push growth beyond that point. But how much beyond? Are there any limits to management’s capacity to ignore shareholders and push growth too far. This will also be considered below. First, why does it get harder and harder to expand future dividends enough to compensate for reduced current dividends? This is because the money the firm is retaining, rather than paying out as dividends, has to earn its keep in order to generate enough extra money in future to pay the extra dividends. In other words it has to earn a decent return. In fact it should be intuitively obvious (if it isn’t, think about it harder) that the money kept by the firm has to earn at least the rate which the shareholders use to discount the dividend stream. This is the shareholder’s opportunity cost of capital. From the shareholder’s point of view if the firm can’t earn a return higher than this with their money, then the firm should give the money back to them as current dividends. Therefore it gets harder to expand future dividends enough to compensate for any present reduction because for various reasons it gets harder to keep finding investments which yield returns in excess of the shareholders discount rate. The reasons include, (a) The investment opportunities facing the firm may be numerous - new machinery, more advertising, price cuts, more R&D, etc - but the returns from each investment vary. Some will offer high returns, some medium, some low. If the firm appraises each possible investment using standard appraisal methods (such as net present value) it will be able to list them in order of their potential returns. Obviously it will chose the best prospects first and then work through them until it reaches the point where the next investment fails to produce a return which exceeds the shareholders discount rate (which is also called the firms cost of capital). At this point it stops. So even if the firm has a lot of investment options, it will have a limited number which guarantee returns exceeding the discount rate. Really profitable investments are limited for the average firm. (b) But even if they aren’t a second problem arises. The firm’s capacity to “manage” a number of investment projects simultaneously strains the capacity of its top management. Top management has the job to determine the firms growth strategy, train new members of the management team, plan and implement the investments needed to pursue the chosen strategy, in addition to “running” day-to-day aspects of the business. It is argued (originally by Penrose, so it is called the Penrose effect in her honour) that increased growth will inevitable strain the capacity of management to do all of this and this will lead to increasing “costs” of growth taking the form of poor investment planning, poor management training, and declining operating efficiency. This all seems fairly plausible. 5 The effect of trying to grow too rapidly then will impinge on the profitability of current operations and investment returns. This means that in practice investment will produce lower returns than in principal (i.e. on paper) and this reduces the value of the growing dividend stream. (If you want to see a “model” of the Penrose effect see Hay and Morris (1991) p.349). (c) A third problem for the firm is that as it chooses faster and faster growth rates, implying more and more investment in R&D, advertising, plant, and people, shareholders might begin to worry about the risks of it all going wrong. They appreciate in principal that more investment now might produce growing dividends in the future, but they realise that the future is uncertain and get concerned about the risks they involve. This will cause them to think again about the discount rate they apply to the firm’s income stream and they may chose to reflect the increasing risk by raising the discount factor, say for 10% to 11% or 12%. That would mean expected future dividend growth being discounted more strongly and lead to a reduced SMV for a given level of dividend growth. Remember the fundamental reality: all investment is gambling. (d) Investment prospects don’t just appear from nowhere. They are not, as economists say, exogenous. Firms have to invest real resources in searching for and developing investment ideas. For example market research, technology research, product research, analysing competitors, paying consultants, and so on. This is not a costless exercise. In fact it is a very expensive and risky exercise because many companies send money on these things and have nothing to show for it. Thus the search for investment prospects necessary for the promotion of firm growth is likely to eat into profits and the faster the company tries to grow the harder it has to look and the more it has to spend on such activities (the search exercise is probably subject to diminish returns). Therefore since increasing growth involves investment (in plant, people, etc), and since identifying and appraising these investments is expensive, growth will impinge as profitability and dividend prospects. This is a bit different to incorporate in the simple model outlined above. Intuitively it means that the growth rate chosen by the firm affects the level of current profits and thus the level of current dividends. So the D1 in our SMV equation is not independent of the chosen growth rate. Faster growth lowers the actual level of D1 and requires a higher proportion be diverted to growth. As a result the value-growth trade-off because even worse than it might otherwise be. We have now shown that the trade-off between current dividends and future growth leads ultimately to a trade-off between SMV and growth. That there is likely to be a particular growth rate that owners would choose to maximise SMV if they were in effective control. We have argued that managers will push growth beyond this point however, so we must now consider the question: how far beyond the point which maximises SMV will the managers push growth? What acts to limit managerial behaviour. 6 Presumably something does because otherwise we would see a lot of companies growing very rapidly with very low SMV which is not empirically the case. The limits on the pursuit of growth: managers do face a limit to their capacity to pursue growth. This is because of the existence of the so-called market for corporate control (MCC for short). (At least in Britain and the US this is the case. Japan and West Germany do things differently). The MCC is literally a market for corporate control. It is where the control of companies is bought and sold and the usual principles of markets apply. In this market there are people looking around to make money. They operate by spotting companies which are performing less well than their potential. This could be for many reasons. Poor mangers, bad luck, over-manning, and so on but the reason that interests us is when the managers are pushing growth beyond the level which maximises SMV. If the management of a given firm tries to push growth too far for the shareholders liking what happens? The SMV declines. The company is now worth less than it would be worth if growth was at the shareholders desired level. If someone (Jimmy Goldsmith, Lord Hanson) spots the differential they get funds together and buy the underperforming company, operate it to maximise value rather than growth, and make a few bob (or more likely a few billion) for their troubles. This is called “releasing value”, asset mining, or by some, asset-stripping. The potential is enormous and the profits for corporate raiders can be very great. However, there is a drawback which limits the raiding process. It is very expensive and quite risky. For a start the amount of time and effort needed to put together a major takeover is substantial. There are legal fees, merchant bank fees, broker’s fees, consultant’s fees. Just look at the money Guinness was throwing around when they raided Distillers. A few million here and a few million there and pretty soon you are talking real money. Plus you have to pay for the money you borrow to buy the takeover victim. This purchase price always involves a hefty premium on current stock market values for the simple reason that the people who currently hold the shares now know the someone (the raider) needs to buy them all to get complete control. So if they are sensible they wait until the raider’s price gets bid up before they sell out. The premium, plus the costs of the raid, eat into, in fact often exceed, the raider’s potential profits (I know this means the raider must be irrational or mistaken. Often people are indeed both despite what economics text books assume). Also to be considered are the post-acquisition costs of asset realignment, redundancy, and so on. The fact that raiding is expensive creates a widow of opportunity for management controllers. They can push growth to the point where the SMV is below the maximum potential as long as they are careful not to push it to the point where despite the costs and risks involved it becomes attractive to a raider. We can summarise this condition as follows (and you could look at it using the value-growth diagram also). SMV (with managerial control) > SMV (maximum) - raiding costs. Managers can in principle push growth to the point just before it becomes attractive for a raider to mount a raid. Of course they might not push it this far. For a start they 7 might not be too sure precisely where the point is. If they were risk-averse they might keep growth nearer the SMV maximising level just to be on the safe side. Furthermore managers might feel they benefit from keeping up the firm’s SMV as well as its growth (in micro-theory language they have a utility function with two arguments). It is therefore impossible to say precisely where the managerial firm will settle except to say somewhere in the range shown in the diagram below range within which there is discretion min V to invite a raid g (V max) g The Marris model thus tells us: First, that value and growth maximisation are different. So managerial firms could produce results that differ from owner controlled firms. Not better or worse, just different. Second, the limit to the pursuit of corporate growth (ceteris paribus) is the market for corporate control. If this market becomes cheaper to use managerial firms face greater constraints. But note an interesting paradox. If firms are all owner controlled the owners could grow them even faster then managers could, if they were prepared to sacrifice wealth. There is no constraint on owners making this sacrifice if they so wish. It would be irrational from a wealth maximising point of view out who believes that people are necessarily rational? John Scouller 8 REFERENCES D. Hay and D. Morris Industrial Economics (1991), (Chapter 10) R. Marris Managerial Capitalism (1964) E. Penrose The Theory of Growth of the Firm (1959) For those prepared to follow the mathematical route, Herendeen’s (1976) presentation is commendable, but not easy. J.B. Herendeen The Economics of Managerial Capitalism (1976) 9 ism (1976) 9
"FIRMS AND INDUSTRIES"