Reinvestment and risk

At the heart of the concept of the corporation is the assumption that it will generate profits (or savings), and dispose of them in the best interests of its owners, the shareholders. In the absence of taxation, management would determine what percentage of earnings should be reinvested in the corporation to maintain its position in the market and take advantage of opportunities for growth and competitive advantage, versus what should be paid out to the owners as compensation for the capital they have contributed to the corporation by purchasing its stock.

Structures of taxation which treat corporate earnings, individual income, debt service payments, and dividends differently shift the optimum strategy. Uncertainty regarding future tax policy and time lags while market participants adjust their strategies in the face of changes in taxation further complicate the process of arriving at optimal strategies. Nevertheless, taxation at the levels currently obtaining in the West affects the key decisions in deployment of corporate resources only on the margin (except for the double taxation of corporate earnings paid out as dividends; this will be discussed in greater detail below).

If the management of a corporation were omniscient, discharging their fiduciary duty to the shareholders would entail calculating the future gains to be realised by retaining corporate earnings and spending them to further develop the corporation, versus rebating them to the shareholders so that the funds may be invested as the shareholders see fit, presumably with a return no less than the discount rate--the zero risk time value of money, for which the short-term government security in a given currency serves as a proxy.

An underlying assumption of stock market investment has always been that the management of a successful corporation in a viable market could be expected to reinvest earnings in their business with an eventual yield greater than that of risk-free investments. In other words, management's knowledge and the position of the company in the marketplace will result in an expected yield that exceeds the return of zero-risk short-term debt instruments. Were this not the case, what would induce investors to forsake risk-free investments to entrust their funds to a venture where, in the direst extreme, they could lose all of their capital? For taking a chance on the future of the company, the investor demands a ``risk premium''-greater total return, on the average, as compensation for assuming the risk.

In recent years an historic reversal of this situation has occurred, and it is at the heart of the takeover boom and the slow-motion liquidation of many long-established corporations. The historical discount rate for long-term (e.g. 30-year) money over the last several hundred years has been between 2% and 3%. Consider an oil company which long-term experience indicates can invest in wildcat exploration combined with an ongoing drilling program in established oil-bearing leased areas to yield a 6% contribution to future earnings from funds committed to exploration and development. Were the long term government bond yielding 3%, most investors would gladly endorse this investment in the future value of their shares, as the potential gain would be twice that of the risk-free alternative.

As I write this paper, the interest rate paid by risk-free 90 day United States Treasury Bills is 8%-more than two and a half times the historical discount rate and a third again more than the yield that the best managements have obtained by reinvesting in their businesses in the last two hundred years. Why, then, do managements continue to drill oil wells, fund superconductivity research, launch new brands of deodorant, devise new ways of delivering sugar to the children of America, and otherwise contribute to the common wealth of humanity? I suggest it's because they don't know what else to do.

If you're an oil man, you drill, even if others snicker as your instinct becomes obsolete in an age where reserves can be purchased cheaper on the open market than sought by exploration. If you're a soap man, you try to find a new niche for the soap to wash expensive athletic sneakers. If you're a cereal murderer, you seek new ways to package and promote white sugar, and so on.... And do you ever think about the alternative of just buying a Treasury Bill or giving the cash back to the shareholders? Well...no.

But somebody does--the ``corporate raider''--that's what he's paid to do. His economic function is performing arbitrage between the returns to be had by reinvestment in a company's business versus liquidation and return of capital to the shareholders.