Richard A Booth

In the market

Manufacturing companies are needing to both compress lead times and handle a wide variety of products without undue cost. The author addresses those either seeking to attack in multiple niches or who feel themselves squeezed by the responsiveness and customisation of competitors.

The Problem with Federal Tender Offer Law

The efficiency and effectiveness of federal tender offer law takes on added importance in light of the increased frequency of both friendly and hostile tender offers. Professor Booth suggests that federal tender offer law effectively favors the bidder at the expense of the target company and discusses potential solutions to this lack of evenhandedness. He argues that current federal law-especially the Williams Act-unduly encourages shareholders to tender, and that parties to tender offers can and often do avoid the Act altogether, thereby negating its protections. Professor Booth considers the dangers of one potential solution, repealing the Act. He determines that the Acts repeal could prove harmful to smaller target companies. He proposes that solutions to the problem take into account the varying needs of different target companies, and weighs the merits offederal law, stock exchange regulation, and state law. He concludes that state law is at this time the most promising source of reform for takeover regulation.

State Takeover Statutes Revisited

I have a confession to make. The title of my article that appeared recently in this review, The Promise of State Takeover Statutes, I was deliberately chosen for its shock value. Since few if any reflective works have supported state takeover statutes,2 it occurred to me that a title suggesting there was something positive in them might get someones attention. Clearly it did. In a recent piece entitled Missing the Point About State Takeover Statutes,3 Professors Lyman Johnson and David Millon take issue with my title. I say that they take issue with my title because it does not appear that they read the article itself. Johnson and Millon have two complaints. First, they point out that partial and two-tier tender offers are far less common today than are tender offers for all of a target companys outstanding common shares.4 The suggestion is that my analysis of state takeover statutes in general and control share acquisition statutes in particular is irrelevant. They neglect to note that I acknowledged the decline of coercive offers.5

Appraisal Rights and Economic Growth

In disputes relating to valuation, the courts prefer the discounted cash flow (DCF) method and the capital asset pricing model (CAPM). The usual approach is to calculate value year-by-year for the coming five years (the projection period) and to use projected average cash flow to calculate value for the period thereafter (the terminal period). Since cash flow differs from GAAP earnings by netting out funds reinvested in the firm (plowback), future returns can be expected to grow. Thus, one must adjust for expected growth during the terminal period. The standard practice is to reduce the discount rate by the projected inflation rate plus the GDP growth rate, since a firm must keep up with inflation (lest it disappear over time) and since economic growth comes from returns generated by business. But if plowback generates return at the same rate ordinarily required of the firm, growth in value will equal plowback. Thus, it is simpler to use projected GAAP earnings as the measure of return. To use cash flow together with an adjusted discount rate is akin to making Maraschino cherries – which are first soaked in lye to remove color and flavor and then soaked in food coloring and sugar to put it back. The question is whether long-term growth in firm value is limited to growth from plowback. There is good reason to think so since opportunities to generate above normal returns (economic rents) are likely to dissipate quickly because of competition. Still, it is possible that firms do grow by more than can be explained by plowback. But data are to the contrary. Since 1930, S&P 500 growth can be fully explained by plowback (GAAP earnings less dividends) together with reinvestment by investors. While plowback has been just enough to match inflation, remaining growth in stock prices is slightly less than would be expected by dividend reinvestment (consistent with diversion of some portion to consumption). The data since 2000 is somewhat different in that plowback has been less than inflation, but stock prices have nonetheless increased consistent with reinvestment. The bottom line is that real stock prices seem to grow slightly more than the real growth rate but a bit less than plowback plus the likely reinvestment rate. It follows that as there is no reason for stockholders to expect any more growth and no need for courts to struggle with estimating growth rates. By using projected GAAP earnings as the measure of average long-term return, the courts can use an unadjusted discount rate to calculate terminal value.

The Fallacy of Adjusting Valuation for Growth and Inflation

It has become almost standard practice in Delaware appraisal proceedings for the courts to adjust discount rates downward by the projected rate of inflation and GDP growth so as to reflect the prospect of higher future returns because of these factors. Since the value of a business varies inversely with the discount rate, the result of applying lower discount rates is that appraisal plaintiffs enjoy larger awards. But these adjustments to discount rates determined under the capital asset pricing model (CAPM) are wholly erroneous. They reflect a basic misunderstanding of CAPM as well as the discounted cash flow (DCF) method of valuation.First, these adjustments ignore the fact that returns from both inflation and growth are already built into the market rate of return as determined under CAPM since that rate is derived from historical averages that include both inflation and growth. Thus, to subtract these components of the required rate of return from the discount rate is to negate the model itself.Second, to adjust the discount rate because of the prospect of growth reflects a misunderstanding of cash flow as a measure of return. Ordinarily, growth requires reinvestment of some portion of available cash. But cash flow is a measure of the potential for distributions to investors. If cash is used to grow the business, it cannot also be distributed to investors. Thus, it is wrong to adjust the discount rate for growth without also adjusting return (as measured by cash flow) for capital spending. If both such adjustments are made, the resulting valuation is unaffected (except where growth opportunities offer rates of return higher than the cost of capital).The result of these errors is to increase values found in appraisal proceedings, to raise deal prices, and to encourage litigation, all to the ultimate detriment of stockholder wealth. The simple solution is to require appraisal plaintiffs to demonstrate – by company-specific evidence – that the subject company has identified and can exploit investment opportunities that will yield returns in excess of its cost of capital – economic rents – for some determinable period of time. But it is never appropriate to adjust for growth or inflation in perpetuity as many courts have recently ruled.

Securities Litigation and Innovation

A central goal of any economy is to achieve rapid and sustained growth. This cannot happen without continued innovation. This landmark Handbook brings together many of the world’s legal scholars to examine features of the legal infrastructure that affect both innovation and growth. Individual chapters explore different legal subject areas, in most cases offering recommendations for rule changes that could accelerate growth, primarily in the context of the US economy. The introductory chapter provides a framework for these discussions and explains why it is time for legal scholarship and research to move in that direction.

Discounts and Other Mysteries of Corporate Finance

Introduction ................................................... 1055 I. Dividends and Discounts .................................. 1062 A. The Irrelevance Proposition .......................... 1063 B. Standard Responses to the Irrelevance Proposition ..... 1064 1. The Bird-in-the-Hand Theory ..................... 1065 2. The Clientele Effect ............................... 1065 3. The Signaling Hypothesis ......................... 1066 C. The Downward-Sloping Demand Hypothesis .......... 1070 1. Why Internal Capital Is Cheaper .................. 1071 2. Why Investors Often Prefer Dividends ............. 1073 II. Disparate Valuation ....................................... 1077 A. The Value of Control ................................ 1079 B. The Value of Diversification .......................... 1081 III. Other Evidence of Downward-Sloping Demand ............ 1087 A. Share Repurchases ................................... 1087 B. Initial Public Offerings ................................ 1091 C. Tender Offers ........................................ 1095 D. Market Mechanisms .................. ................ 1097 1. Limit Orders ..................................... 1097 2. Shareholder Vote Requirement for Certain Large Issues ............................................ 1098 E. Company-Specific Phenomena ......................... 1099 1. Increase Accompanying Listing on the Standard & Poors 500 ........................................ 1099 2. Differing Sensitivities to Market Risk of Larger and Smaller Companies ............................... 1100 F. Marketwide Phenomena .............................. 1102 IV. The Implications of Downward-Sloping Demand ........... 1103 A. Implications for Tender Offer Regulation .............. 1104 1. The Law Should Treat Large and Small Companies Differently ........................................ 1104 2. The Misguided Quest for Equal Treatment of Shareholders ...................................... 1106