Purpose. Standard finance theory textbooks strongly recommend Discounted Cash Flows (DCF) techniques, based on Weighting Average Cost of Capital (WACC) and the Capital Asset Pricing Model (CAPM). Both WACC and CAPM are strongly based on the theory of finance as developed since 1958 by Modigliani and Miller’s papers and fostered by Jensen and Meckling (1976) with their theory of costs of agency. According to Jensen and Meckling (1976), the firm is a nexus of contracts, a legal fiction, whose existence only saves some of the costs associated to the writing of contracts between all the involved physical individuals. Contracting with the legal fiction in fact saves costs individuals would bear in case they would contract with each other. The firm is ectoplasm, and only single individuals are important. Firm is therefore nothing more than a species of the genus market. It is simply a partition of all contracts taking place on the market. The emerging of the Intellectual Capital-based firm (IC-firm) sheds a new light on the concept of firm, very far from that at the core of finance theory. The IC-firm is an entity with its own relevance and it is autonomous with respect to any individual stakeholder, from the ontological and epistemological perspectives. It is ontologically different than single individual, since the firm is not simply the sum of individuals, but a managed coordination. It is also epistemologically different since its understanding calls for moving away from methodological individualism to the centrality of both institutions and managed organizations. The continuity of the firm is here of paramount importance. Such a proposition shifts the attention from investors’ return to firm’s continuity through achieving dynamic equilibrium conditions, which relate to the IC-firm’s final end: to provide adequate compensation for all its constituents. There is not shareholders’ supremacy, but entity’s supremacy, because the continuity of the entity guarantees the satisfaction of all constituents’ needs. Shareholder is, at the best, the primus inter pares between the various stakeholders of the IC-firm. The firm is a dynamic system, and the complementarities in managing people and other resources enable new resources’ uses and at the same time inhibit from taking advantage from other available opportunities which do not well combine with the set of resources the firm actually manages. Finally, the IC-firm drives attention on the role of organizational processes. Design/methodology/approach –The paper anchors literature on DCF to the theory of the surrounding firm and highlights the main features of that theory comparing to the role and relevance of IC. Once the role of Intellectual Capital is recognised, the IC-firm emerges with strong differences to the one upon which the theory of finance is based. Such an IC-based theory of the firm offers new stimuli for financial valuation and a new interpretation emerges of some phenomena, such as the role of financial slacks, the underinvestment effect and the importance of the whole risk related to the project. Findings – A Minimum Acceptable Rate of Return for alternative investment projects is presented, that takes into account a project’s whole risk and the expandability of the firm’s opportunity set. A role for active risk analysis and management processes is clearly recognised, and the innovative capabilities of the firm are introduced so superseding the market completeness assumption upon which is based the standard finance theory. The research finds that in the new perspective Minimum Acceptable Rates of Return are endogenously and subjectively set and they act more as organizational control tools than as a tool for the fair valuation of investment projects. Finally, different rates act as reference points for the investing side and the financing side. Research limitations/implications – Implications of the paper are mainly for improving consistency in the research of financial valuation methodologies when IC is the main driver of competitiveness and value generation. Practical implications –The paper highlights how the use of DCF as we know it can lead to mistakes without a clear reference to a theory of the firm, and how possible remedies are available. An analysis is offered, that focuses on the main determinants of the Minimum Acceptable Rate of Return for investment project valuation. Originality/value – The paper focuses on the role of the theory of firm for financial valuation, helping avoiding potential mistakes and inconsistencies when IC is considered as the main driver of competitiveness and value.
The end of DCF as we know it. An analysis based on the IC-firm
MARZO, Giuseppe
2013
Abstract
Purpose. Standard finance theory textbooks strongly recommend Discounted Cash Flows (DCF) techniques, based on Weighting Average Cost of Capital (WACC) and the Capital Asset Pricing Model (CAPM). Both WACC and CAPM are strongly based on the theory of finance as developed since 1958 by Modigliani and Miller’s papers and fostered by Jensen and Meckling (1976) with their theory of costs of agency. According to Jensen and Meckling (1976), the firm is a nexus of contracts, a legal fiction, whose existence only saves some of the costs associated to the writing of contracts between all the involved physical individuals. Contracting with the legal fiction in fact saves costs individuals would bear in case they would contract with each other. The firm is ectoplasm, and only single individuals are important. Firm is therefore nothing more than a species of the genus market. It is simply a partition of all contracts taking place on the market. The emerging of the Intellectual Capital-based firm (IC-firm) sheds a new light on the concept of firm, very far from that at the core of finance theory. The IC-firm is an entity with its own relevance and it is autonomous with respect to any individual stakeholder, from the ontological and epistemological perspectives. It is ontologically different than single individual, since the firm is not simply the sum of individuals, but a managed coordination. It is also epistemologically different since its understanding calls for moving away from methodological individualism to the centrality of both institutions and managed organizations. The continuity of the firm is here of paramount importance. Such a proposition shifts the attention from investors’ return to firm’s continuity through achieving dynamic equilibrium conditions, which relate to the IC-firm’s final end: to provide adequate compensation for all its constituents. There is not shareholders’ supremacy, but entity’s supremacy, because the continuity of the entity guarantees the satisfaction of all constituents’ needs. Shareholder is, at the best, the primus inter pares between the various stakeholders of the IC-firm. The firm is a dynamic system, and the complementarities in managing people and other resources enable new resources’ uses and at the same time inhibit from taking advantage from other available opportunities which do not well combine with the set of resources the firm actually manages. Finally, the IC-firm drives attention on the role of organizational processes. Design/methodology/approach –The paper anchors literature on DCF to the theory of the surrounding firm and highlights the main features of that theory comparing to the role and relevance of IC. Once the role of Intellectual Capital is recognised, the IC-firm emerges with strong differences to the one upon which the theory of finance is based. Such an IC-based theory of the firm offers new stimuli for financial valuation and a new interpretation emerges of some phenomena, such as the role of financial slacks, the underinvestment effect and the importance of the whole risk related to the project. Findings – A Minimum Acceptable Rate of Return for alternative investment projects is presented, that takes into account a project’s whole risk and the expandability of the firm’s opportunity set. A role for active risk analysis and management processes is clearly recognised, and the innovative capabilities of the firm are introduced so superseding the market completeness assumption upon which is based the standard finance theory. The research finds that in the new perspective Minimum Acceptable Rates of Return are endogenously and subjectively set and they act more as organizational control tools than as a tool for the fair valuation of investment projects. Finally, different rates act as reference points for the investing side and the financing side. Research limitations/implications – Implications of the paper are mainly for improving consistency in the research of financial valuation methodologies when IC is the main driver of competitiveness and value generation. Practical implications –The paper highlights how the use of DCF as we know it can lead to mistakes without a clear reference to a theory of the firm, and how possible remedies are available. An analysis is offered, that focuses on the main determinants of the Minimum Acceptable Rate of Return for investment project valuation. Originality/value – The paper focuses on the role of the theory of firm for financial valuation, helping avoiding potential mistakes and inconsistencies when IC is considered as the main driver of competitiveness and value.I documenti in SFERA sono protetti da copyright e tutti i diritti sono riservati, salvo diversa indicazione.
