Cash Is King On October 1 1974

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Exhibit 5.9 Evidence That the Market Reacts Favorably to Increases in Investment

Exhibit 5.9 Evidence That the Market Reacts Favorably to Increases in Investment

dividends over the next several years. For a random sample of 20 Fortune 500 companies, as shown in Exhibit 5.8, an average of only 9.2 percent of the total share value could be accounted for by dividends expected in the next five years. The largest percentage of value that the next five years' dividends could explain was 20.4 percent for BankBoston. From this test, the market appears to take a long view. More rigorous analyses described next support this view.

We showed earlier that pure accounting manipulation does not fool the market. But managers can take other actions to improve earnings at the expense of long-term cash flow. They can reduce spending on research and development or capital goods. Cutting spending on research and development will increase earnings and cash flow in the short run, potentially at the expense of developing profitable products in the long run. Similarly, cutting back on capital spending will increase short-term profits because new capital projects often earn low profits in their early years.

Securities and Exchange Commission economists examined the stock price reaction to announcements by 62 companies that they were embarking on R&D projects.8 As Exhibit 5.9 shows, the market had a significant positive reaction to these announcements.

8 Office of the Chief Economist, ''Institutional Owners, Tender Offers, and Long-Term Investment," Washington, DC: Securities and Exchange Commission, 1985.

The evidence on capital spending supports the DCF model as well. McConnell and Muscarella examined the stock market's reaction to announcements of increased capital spending.9 For a sample of 349 such announcements (containing no other company-specific information) by industrial companies from 1975 to 1981, the stock market on average reacted positively to spending increases and negatively to spending decreases:

Market adjusted Sample size return (percent)

Industrial companies

• Budget decreases 76 -1.8 Public utility companies

The authors also found that these results held for all industries except oil and gas exploration and development. Apparently, the market did not believe that oil and gas exploration was a profitable investment at the time. Given the subsequent decline in oil prices and the high cost of exploration in the United States relative to other parts of the world, the market was probably right. In any case, it is clear that the market does not arbitrarily penalize companies for making long-term investments.

Another supporting piece of research on long-term investments comes from Woolridge.10 He examined the two-day stock market reaction (market-adjusted) to strategic investment announcements by 634 companies. He found a significant positive reaction for all the categories of investments he studied:

Cumulative 2-day market adjusted

Type of investment Sample size return (percent)

Capital expenditures 260 +0.35

Product strategies 168 +0.84

R&D expenditures 45 +1.20

Joint venture formations 161 +0.78

Total sample 634 +0.71

9 J. McConnell and C. Muscarella, "Corporate Capital Expenditure Decisions and the Market Value of the Firm," Journal of Financial Economics (March 1985), pp. 399-422.

10 J.R. Woolridge, "Competitive Decline and Corporate Restructuring: Is a Myopic Stock Market to Blame?" Journal of Applied Corporate Finance, vol. 1, no. 1 (spring 1988), pp. 26-36.

Conversely, the market also reacts favorably when companies write off bad investments, despite the negative short-term earnings impact. While the complex nature of write-offs prohibits comprehensive statistical analysis, Mercer looked at 40 major write-offs from 1984 to 1986 and found that 60 percent of them resulted in share price increases.11 Furthermore, 75 percent of writedowns resulting from abandonment of entire businesses were associated with share price increases.

More evidence supporting the view that the market values cash, not earnings, emerges from changes in leverage and their impact on share prices and earnings per share. Copeland and Lee (1988) studied 161 exchange offers and stock swaps from 1962 to 1984.12 The study showed that the earnings-per-share impact of the transaction did not matter. What mattered was whether the transaction was leverage-increasing or leverage-decreasing. Following are the average percentage changes in share value upon the announcement of the transactions relative to the changes in the market average:

EPS-increasing transactions EPS-decreasing transactions (percent) (percent)

Leverage-increasing transactions 3.77 8.41

Leverage-decreasing transactions -1.18 -0.41

On average, leverage-decreasing transactions resulted in negative share price reactions, regardless of the earnings-per-share impact. Copeland and Lee also concluded that the most likely explanation for the direction of the share price movements was that investors interpret leverage-changing transactions as management signals of the direction of cash flow. Such transactions could signal strong cash flows in the future, leading corporate insiders to increase their share holdings in the company.

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