Do shareholders care about corporate investment returns?

This paper considers the apparent contradiction between the results of Artto (1997), who claims that shareholders in the paper industry have gained reasonable returns, and Pohjola (1996), who argues that a large shareholder value has been lost (the Artto–Pohjola Paradox). We show under fairly general conditions that the shareholders may enjoy reasonable return while the managers are simultaneously destroying value of the firm by allocating funds to bad investments. In this case the firm’s shareholders suffer an opportunity loss equal to the value that could have been created if the firm had paid the funds out to them and they had invested the funds in equivalently risky projects. The paradox occurs if the growth rate of a firm’s market value of equity is high enough to guarantee a nonnegative return for the shareholders but too low in the sense that the shareholders would have earned more had the funds invested at the return (at least) equal to the opportunity cost of capital. Our results support Jensen’s (1986) argument of the incentives of corporate managers to invest inefficiently, since here the shareholders do not necessarily challenge the management due to the fact that they may be perfectly happy and satisfied in financial terms.