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The IUP Journal of Applied Finance :
Economic Profit, NPV and CAPM: Biases and Violations of Modigliani and Miller's Proposition
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For one-period projects under certainty, the notion of Net Present Value (NPV) formally translates the notion of economic profit, where the discount rate is the cost of capital. Under uncertainty, the cost of capital is the expected rate of return of an equivalent-risk alternative that the investor might undertake and is often found by taking recourse to the Capital Asset Pricing Model (CAPM). This paper shows that the notions of disequilibrium NPV and economic profit for risky one-period projects are not equivalent: NPV-minded agents are open to framing effects and arbitrage losses, which imply violations of Modigliani and Miller’s Proposition I. The notion of disequilibrium (present) value, deductively derived from the CAPM by several researchers and widely used in applied corporate finance, should therefore be dismissed.

 
 
 

Economic profit and (net) present value are often viewed as two sides of the same coin. While the former is one of the building blocks of economic theory, the latter is a cornerstone in financial economics. Economic profit is a fundamental notion in economic theory since Marshall (1890). It represents the “excess profit that is gained from an investment over and above the profit that could be obtained from the best alternative foregone” (Rao, 1992, p. 87). That is, economic profit from an investment is the difference between profit from that investment and profit from the best alternative foregone. In other terms, the profit of the foregone alternative acts as an opportunity cost (Buchanan, 1969). Many synonyms have been coined in the literature to mean ‘economic profit’, ‘excess profit’ (Preinreich, 1938); ‘excess realizable profit’ (Edwards and Bell, 1961); ‘excess income’ (Peasnell, 1982); ‘abnormal earnings’ (Ohlson, 1995); ‘supernormal profit’ (Begg et al., 1984, p. 121); ‘residual income’ (Solomons, 1965; Biddle et al., 1999; and Martin et al., 2003); and ‘economic value added’ (Stewart, 1991). The concept of ‘goodwill’ (Preinreich, 1936) is also strictly related to that of excess profit. Net Present Value (NPV) is a fundamental notion in finance since Fisher (1930), although “the technology of discounting is not an invention of the 20th century” (Miller and Napier, 1993, p. 640). Discounted-cash-flow analysis was known and (sometimes) employed since the 18th century (Parker, 1968; Edwards and Warman, 1981; and Brackenborough et al., 2001).

Over the past two decades, there have been numerous studies on predatory pricing in the field of economics and whether firms can choose to cut prices to lower their rival’s profits and induce them to leave the market. Some economists have claimed that predation has occurred, while others have argued that this technique would not be rational (McGee, 1958). In fact, in the late 1970s, most believed that predatory price cutting would rarely, if ever, be profitable. Soon after, many game theoretic papers concluded that with the existence of asymmetric information, an established firm can benefit from manipulating potential entrants’ beliefs about the returns to entering an industry (Kreps and Wilson, 1982). In a similar vein, this study considers the manipulation of both competitors’ and outside investors’ belief. Studies made earlier relied on reputation effects in which the predator preys to signal information about himself; however, later studies, including Fudenberg and Tirole (1986), examine a ‘signal-jamming’ theory of predation in which the predator preys to jam or interfere with the potential entrants inference about their own profitability. Thus, the predator’s characteristics are common knowledge and he preys not to signal information about himself but rather to ‘jam’ or interfere with the inference problem faced by the entrant. This study is unique in the sense that it examines the competition among firms in the case of predatory pricing, and analyzes the factors that prevent the new entrants into the market. Other studies which have examined the entry of competitors include Verrecchia (1990) and Wagenhofer (1990). These authors find that the disclosure of bad news deters the entry of competitors.

In corporate finance, mergers and acquisitions (M&A) have been a common phenomenon in order to take advantage of synergies such as economies of scale and scope, technology sharing, and managerial expertise. A merger or acquisition is one way to gain instant access to markets as well as a method to become the top dog in an industry. Carnival Cruise Lines’ fear of losing its number one place in the industry drove it to take defensive actions in order to prevent such a merger. Although Fain claimed that Carnival’s offer was not real, getting involved in a bidding war for a potential target may not necessarily be the best defensive measure to undertake. This could become very costly. Hence, it would be important to find out if there are cheaper means to acquire the same result, which is the failure of a competitor’s intended action. If Carnival’s offer truly is not real, but only to ‘scuttle’ the merger meeting as Fain claims, then Carnival is attempting to ‘jam’ or interfere with Royal’s shareholder’s decision-making process. Thus, they are attempting to signal jam.

 
 
 

Applied Finance Journal, Economic Profit, Financial Economics, Net Present Value, NPV, Corporate Finance, Mergers and Acquisitions, M&A, Decision Making Process, Net Future Value, Security Market Line, Modigliani and Miller’s Proposition I, Capital Asset Pricing Model, CAPM.