Investments When Entire Stock Market Is Under Or Over Valued

Should management proceed with investing in a project with a satisfactory NPV (Net Present Value) if it has sufficient funds to do so, and if (a) the entire stock market is significantly undervalued and may well rise by 25 or 30% over the next year, or (b) the entire stock market is significantly overvalued and may well fall by 25 or 30% over the next year?

In case (a), it could be argued that management should postpone the investment for a year, and invest the cash in a general portfolio of shares, realize them after a year, then take up the postponed investment, and use the capital gain either for future investment or a special dividend payment to shareholders. However, most shareholders do not expect or want the company to use their money for speculative share investments since most companies are unlikely to possess the appropriate skills to do so. Imagine if the market went down instead of up! Thus, a speculative investment should be considered as inappropriate for all but specialist investment companies. Having removed this possibility, we should, however, consider whether there is any advantage in postponing the investment until shares have risen by the expected amount. Unless the postponement would result in a higher present NPV due to the actual rise in share prices, the company should not postpone the investment. It is noted that a higher NPV due to the rise in share prices is not likely to occur: it means that the rise would create a better market for the project’s output.

In case (b), a similar conclusion should be reached. Unless postponement of the investment either results in a higher present NPV from the fall of share prices–an almost inconceivable possibility–or the fall in share prices would cause the company to regret the investment, the investment should not be postponed. A situation where a fall in share prices may cause the company to regret the investment could arise with projects whose products are particularly sensitive to share price falls (e.g., certain luxury products and services).

Let us now consider the above-mentioned cases (a) and (b) if a company contemplates a rights issue to finance the planned investment rather than using existing resources. To analyze these situations, we should ask ourselves what the shareholders would or could have done with the money if they had not subscribed to the rights issue (that is, an issue which grants a shareholder the right to subscribe at a comparatively favorable price to new issues of the company’s stock in proportion to present holdings). It is reasonable to assume that any money shareholders would use to subscribe for the rights issue would be invested in other shares in the absence of the rights issue. Would they either have gained or lost in cases (a) and (b) from investing in other shares?

In case (a), the shareholders would have seen their money appreciate by the rise in the general stock price index, which seems to argue for a postponement. However, there is no reason to assume that the company’s shares will not rise more or less in step with the general stock price index. Consequently, the existing shareholders would have suffered no loss, and proceeding with the rights issue is fully justified. In case (b), a similar conclusion is reached. Subject only to the qualifications given above, concerning the effect of postponing the investment on its NPV, we conclude that proceeding with the rights issue is in the interest of the existing shareholders.

Finally, we should consider the aforementioned cases (a) and (b) when a company is contemplating raising capital from new shareholders. In case (a), where the general price share is expected to rise, the existing shareholders would be better off if the new issue were postponed until after the increase in share prices, since the same money could then be raised by issuing significantly fewer shares. Thus, in this case, it is in the interests of the existing shareholders to postpone the investment except in the rare situation where the NPV now to the existing shareholders of postponement is lower. In case (b), where the general price share is expected to fall, there is a gain rather than a loss to the existing shareholders from proceeding with the new issue. Postponement until prices had fallen would mean giving up more shares to outsiders to raise the money to finance the investment. Thus, proceeding with the investment is in the interests of the existing shareholders except in the rare circumstances where its postponement results in a sufficiently increased NPV to the existing shareholders to more than compensate for the extra number of shares they would have to give up.

We conclude this article by stating that a company’s management can ignore the likely future level of general share prices, and proceed with any investment with a satisfactory NPV, except in one instance. This exception is when the company contemplates raising capital from new shareholders, and the general level of share prices is expected to rise in the next year or so.

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