Circularity and the Undervaluation of Privatised Companies

16 Pages Posted: 25 Jun 2002

See all articles by Anna (Ania) Zalewska

Anna (Ania) Zalewska

University of Bath - Centre for Governance, Regulation and Industrial Strategy; School of Management

Paul A. Grout

University of Bristol - Leverhulme Centre for Market and Public Organisation (CMPO)

Abstract

Circularity arises in regulation if the value of a company's assets used to set prices is itself determined by future earning capacity. The view that it is not possible to determine values and prices in these circumstances has become well established in the literature. Textbooks have traditionally focused on replacements costs or book value as the appropriate valuation for regulatory purposes. However, regulatory authorities tend to argue that if these are used as the asset base in privatisations where shareholders have paid less than this for the assets then there appears to be an unfair transfer from customers to shareholders. Typically, the procedure used to avoid this transfer has been the implementation of a market value (debt plus equity) approach as the asset base. However, as is recognised in the literature, this brings the circularity problem back to the fore. In this paper we formalise this precise circularity result. We show that the view that is never possible to tie down values and prices is not particularly robust but that there are more subtle versions that contradict some of the basic predictions whilst retaining a form of circularity. Second, we show that there is a theoretical relationship between the use of market values (with its inherent circularity) and undervaluation of privatised assets. The paper is implicitly concerned with valuations set in a stock market but, since the model is driven by common present valuation of cash flows, the general principles should carry over to situations where the valuation is determined by auction. Indeed, as long as potential bidders have privately known signals drawn from a common, strictly-increasing, atom-less distribution then the revenue equivalence theorem suggests that this should be true for all well known types of auctions (see, for example, Bulow and Klemperer (1996) and Riley and Samuelson (1981)).

Suggested Citation

Zalewska, Anna and Grout, Paul A., Circularity and the Undervaluation of Privatised Companies. EFMA 2002 London Meetings. Available at SSRN: https://ssrn.com/abstract=315140 or http://dx.doi.org/10.2139/ssrn.315140

Anna Zalewska (Contact Author)

University of Bath - Centre for Governance, Regulation and Industrial Strategy; School of Management ( email )

Claverton Down
Bath, BA2 7AY
United Kingdom
+44 0 1225 384354 (Phone)
+44 0 1226 384354 (Fax)

Paul A. Grout

University of Bristol - Leverhulme Centre for Market and Public Organisation (CMPO) ( email )

Mary Paley Building
12 Priory Road Department of Economics
Bristol BS8 1TN
United Kingdom

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