Circularity and the Undervaluation of Privatised Companies
16 Pages Posted: 25 Jun 2002
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)).
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