Are dividends relevant in the search for shareholder value?!

To recap on previous blogs shareholder value has been considered in terms of investment and finance decisions. Now however dividend decisions must be considered after all these three topics are all closely interlinked… if the company decides not to pay a dividend, it opts to retain the cash within the company which subsequently means they don’t have to borrow additional capital in order to invest in new value adding projects. So, if value has been created it is only right it is returned to those it was created for – the shareholders? This sparks the discussion as to whether companies should prioritise shareholder wealth over that of its stakeholders or even the society?

Adopting the stance of Modigliani & Millar (1961) on dividend theory the timing of the dividend is deemed irrelevant and dividends should be paid as an investment residual when all other positive NPV projects have been invested in. M&M suggested managers should place priority on investing in good projects which in turn increase share price rather than worrying about paying out dividends as both options will have the same outcome in terms of shareholder wealth maximisation. However their theory was based on numerous assumptions including that there is no tax, no transaction costs and that interest rates remain constant, which unfortunately is not the case in reality!

For investors a dividend is often used as an indicator of how well a company is doing, which before this week I thought to be an appropriate measure. However after this week’s lecture it was highlighted that dividends must merely be paid out of residual profits. It does not state that these profits have to have been yielded in this year. Therefore a company in financial difficulty could still pay out a large dividend to its shareholders from residual profits made in previous years when the company was prospering and so disguising the current financial position of the company.

Linking in with my pervious blog on the global financial crisis companies often choose to suspend dividends in times of financial strain or uncertainty. Recently Thomas Cook announced that it would be suspending its dividend payments as it works to ‘rebuild the balance sheet’ (BBC, 2011). Another company struggling to cope in the recession is Mothercare, with store closures, job losses and now the suspension of its dividend (The Telegraph, 2012).

Apple has announced plans to pay its first dividend since 1995 to put to use some of its $95 billion cash pile (BBC, 2012). This is perhaps an example of how M&M suggested that the timing of the dividend is irrelevant as even though Apple has never paid a dividend until now I would still consider the company as being successful.

An alternate view by Linter (1956) uses the ‘bird in hand’ theory to argue dividend relevance. He suggested that investors prefer to receive a dividend rather than having the uncertainty of whether the company has invested their money into positive investments. In this view not paying dividends will lead to a destruction of shareholder wealth as shareholders will no longer purchase their shares and share price will decrease.

In conclusion, it would seem from a company perspective dividends are regarded as relevant as firms spend much time deciding on the level of dividend they pay out. From the theory discussed this week it would seem stable dividends are what companies aim for, this is often due to high dividends being unsustainable in the long run and for fear of losing investors’ confidence if dividends are set too low.

Can strengthening a firm's capital structure help improve shareholder wealth?!

As the basis blogging has been around the issue of shareholder wealth maximisation, the lectures this week highlighted an interesting means of potentially achieving this… Through optimising the company’s capital structure… so what is this all about?

Capital structure refers to the way in which the company’s operations are financed. Previous blogs highlighted that some companies opt for equity finance whereas others rely on debt finance, or a mixture of the two! But how can this influence shareholder wealth? Is it possible to achieve increased wealth for shareholders by tweaking the capital structure of the company? If so shouldn’t everyone be doing this?!

Theory highlights that the cost of equity is usually higher than the costs associated with debt. This is down to a certain level of assurance with debt compared to equity. WACC suggests an optimal capital structure exists between the two exists and that since the cost of debt is lower companies should take advantage of this and load up on debt… so is this advisable?

It would seem up to a certain point this works… however companies must be careful not to overload on debt. Once the cost of debt rises to a level which exceeds the cost of equity the company has gone too far and should stop loading up on debt. This is due to the main advantage that equity finance holds over debt finance. In times of financial distress companies financed via equity can choose not to issue a dividend and retain the money within the company. However those financed by debt do not have the same level of influence over repayments.

Examples have shown that returns per share increase as debt is introduced into the capital structure. However other factors should be taken into consideration, for example the industry in which the company is operating. Some industries for example the tobacco sector will be remain strong during time of recession, whereas others such as the tourism industry are likely to suffer.

An example in the tourism industry is Thomas Cook. Its board of directors are seeking to reduce the debt of the group in an attempt to yield a more appropriate capital structure. This comes amid lower consumer confidence blamed on conflicts in Egypt and Tunisia along with the Thailand floods impacting on company sales (BBC, 2011).

Achieving a more optimal capital structure seems to be an issue for companies experiencing the negative effects of the recession. It has been highlighted in recent news regarding retailer Peacocks entering administration. KPMG stressed that the company’s current capital structure, with total debt of £750m, as unsustainable (BBC, 2012). Adapting the capital structure is therefore necessary for the company’s future. Another retailer looking to its capital structure as a means of riding out the recession is Blacks Leisure who looked at ways of strengthening the firm’s capital structure in order support its plans for future growth and development (BBC, 2011).

To summarise it would seem that managers view an appropriate capital structure as vital for the development and success of the company’s future. So, maybe the fact that it will also help improve shareholder wealth will encourage companies to consider their capital structure in more detail in relation to their future success.

Corporate Social Responsibility - What is it all about?!

Corporate social responsibility is an additional business objective to shareholder wealth maximisation and is becoming more predominant in recent years. So, what is corporate social responsibility?

Hopkins (2007) provides this definition of corporate social responsibility:

“CSR is concerned with treating the stakeholders of the firm ethically or in a responsible manner. ‘Ethically or responsible’ means treating stakeholders in a manner deemed acceptable in civilized societies. Social includes economic and environmental responsibility. Stakeholders exist both within a firm and outside. The wider aim of social responsibility is to create higher and higher standards of living, while preserving the profitability of the corporation, for peoples both within and outside the corporation.”

But are companies being truly CSR focused? Isabel Kelly, a director of Salesforce.com foundation claimed:

“A lot of firms make the mistake that CSR means just writing a big cheque once in a while, or a company boss asking his secretaries to do voluntary work once a year at Christmas"

Socially responsible investment (SRI) by companies lacks consensus globally. Reasons for this include differing cultural norms, along with attitudes and beliefs of individuals. Another key factor is differing expectations as to what is regarded as SRI meaning what one individual might deem an acceptable level may unacceptable to someone else. So, is it possible for people to avoid all companies associated with socially irresponsible projects?

As much as people may disagree with socially irresponsible or unethical business activities, it can sometime be difficult to avoid. For example if an individual is against tobacco produce would it be fair to avoid companies such as Tesco just because one of their product lines is cigarettes?  This makes it hard for individuals to be truly ethical.

Companies on the top end of CSR practices include Waitrose, the Waitrose-John Lewis partnership was rated platinum scoring 95% in the 2011 business in the community corporate responsibility index (John Lewis Partnership, 2011). This clearly demonstrates that companies regard CSR as an important aspect of their company strategy. Another company known for its highly ethical practices is The Body Shop.

An interesting sector to look at in terms of CSR is the higher education sector.

The Department for Trade and Industry defines corporate social responsibility (CSR) as “the integrity with which a company governs itself, fulfils its mission, lives by its values, engages with its stakeholders and measures its impacts and publicly reports on its activities."

It has been suggested that in the competitive environment universities are now faced with CSR could be adopted as a means of obtaining competitive advantage and help companies to remain ahead of the competition (The Guardian, 2011). Richard Goossen, a business consultant, suggested:

“Universities realise that it is a competitive market in terms of creating an ongoing stream of satisfied alumni, attracting new students and addressing the concerns of business supporters, a strategy which incorporates CSR is a start" (The Guardian, 2012).

To finish, an interesting article regarding the top 10 trends in corporate social responsibility came to my attention:

http://www.forbes.com/sites/forbesleadershipforum/2012/01/18/the-top-10-trends-in-csr-for-2012/

In this article, which can be accessed via the above link, Tim Mohin highlights the use of social media as an important tool for communicating CSR projects, suggesting websites such as Facebook are vital in any successful CSR initiative. He also emphasises the issue of collaboration, with CSR being a potential differentiator for companies to compete. This supports the views of Richard Goossen on the universities using CSR to remain ahead of competition as highlighted above.

The damaging effects of the recession...

The ‘recession’, the ‘credit crunch’, the ‘economic crisis’ - all of these phrases have been battered around in the media since 2007. It seems everything that’s happening around us in the economy is because of this… so, what is this all about and who is it affecting the most?

A recession refers to ‘a severe shortage of money or credit’ (BBC, 2009) and it is important to address how we ended up in this situation. The UK market was experiencing a sustained period of stability, combined with low rates of inflation, interest rates and steady growth. This all seems great, doesn’t it? However it would seem these factors were all precursors of the crisis which was to follow… Shouldn’t these signs have been picked up on? After all this is not the first financial crisis to face the world, the Asian financial crisis for example. Overconfidence became an issue - this led to a period of irresponsible lending. Debt rose at the same times as huge increases in house prices, leading to house prices increasing higher than income. Subsequently lenders were seen to be offering mortgages in excess of 100% of the value of the property (Mizen, 2008).

A high level of innovation within mortgages appears to be at the root of the current crisis, making it more complex than those in the past. The growth in sub-prime mortgages in the US was a major issue. But why? What are these so called sub-prime products?

These new assets were sold to investors in the form of repackaged debt therefore enabling them to receive a higher credit rating and so being seen as relatively ‘safe’ (Mizen, 2008)! This however was definitely not the case! The value of these products was closely linked to the housing market, which at this period was experiencing great levels of growth. Problems began to come to public attention when these prices fell, sending the financial markets in to a state of panic, with the banking system not being strong enough to cope with the substantial losses which were to come!

However it is believed this current recession stems as far back as 2001, with the September 11 terrorist attacks, which prompted Alan Greenspan to cut short term interest rates in the US, and the burst of the dotcom bubble (Mizen, 2008). If this is the case how come the warning signs were ignored and public knowledge and concerns didn’t arise until late 2007. Again common precursors were seen including high levels of stability across markets, higher levels of net saving and great innovation relating to mortgage backed securities.

Century Financial were amongst the first to file for bankruptcy. Credit ratings on all subprime products were quickly downgraded from their safe AAA rating. This led to reluctance by banks to lend to one another, reducing the liquidity in markets which was so crucial. Severe loss of trust in interbank trading was brought about by fear of the scale of risk they were actually facing (Mizen 2008).

Thinking back to the collapse of Northern Rock in the UK, I remember seeing the queues of people outside on the news and finding it pretty comical – I thought people were overreacting immensely! However after learning more about the situation this week it’s brought to light how severe the situation actually was and indeed is.

Everything seemed to happen so suddenly just one this after another! A catastrophic crash in everything which seemed at the time to be perfectly fine! Now it seems ridiculous than no one picked up on the signs... Why were banks so overconfident! Considering we’ve seen these bubbles burst before…

Even recently the rippling/domino effect of the recession is still affecting the business world. Walking down Northumberland Street a growing number of empty stores can be seen as the consumer recession persists (FT, 2012)… Many companies are still having to scale down operations or completely close in wake of the so called ‘retail recession’, La Senza has become victim to this having to close around half of its stores (BBC, 2012). 

Peacocks was another store to face administration, having been bought out by Edinburgh Woollen Mill some jobs have been saved however significant redundancies have been made (BBC, 2012) with the number of stores being halved (FT,2012) and signs like the one to the right seem to be present on high streets across the country...

Clearly there have been some exceptions with companies including WH Smith, Associated British Foods (ABF) and Dunelm riding high. On the high street Primark is a clear winner, owned by ABF, its share price has increased 18% in the past year.  

It has been claimed innovation in the sector may be the way forward – Richard Hyman, strategic retail advisor to Deloitte expressed that during the noughties the consumer meant retailers “didn’t need to be very good at retailing” to be successful.  He said it was “all about managing the expansion programme and the supply chain, as opposed to anything imaginative and inspirational.”

He stated:

“The middle ground is challenged. Consumers are used to a constant diet of sales and promotions. Many retailers are no longer masters of their destiny, but have to follow what the shop next door does” (FT, 2012).

Sources used:

Mizen, P. (2008) The Credit Crunch of 2007-2008: A Discussion of the Background, Market Reactions, and Policy Responses. Federal Reserve Bank of St. Louis Review. Available at: http://web-docs.stern.nyu.edu/salomon/docs/crisis/FRBStLouisMizen.pdf (Accessed: 13 March 2010)

http://www.ft.com/cms/s/0/3d3c6ef6-5e4e-11e1-85f6-00144feabdc0.html#axzz1pC6pNkdM

Merger & Acquisitions – Are managers really pursuing shareholder wealth maximisation?

My last blog discussed FDI as a means of expanding operations. This week’s blog will focus on another means – through merger and acquisition activity. Why is it that companies opt for this approach?

There are several motivations for this kind of activity. The main reason is synergy, being the idea that together the two companies will create higher value. Other benefits of M&A’s include the ability to take advantage of economies of scale, buying power and to gain tax advantages all of which may be able to bring the company a vital source of competitive advantage.

An issue which must be taken into consideration here is the motivations for M&A’s. Are managers entering into such strategies with the ultimate aim of maximising shareholder wealth in mind? Or, are managers acting in a self-utilising manner and therefore really out for personal gain? This could take the form of gaining status and power over the organisation, or they could be thinking in terms of career development.

Reflecting on learning from this week’s lecture the analogy of the princess and the frog caught my attention and was an interesting way of Warren Buffet capturing the issue of management attitudes. He compared the process of M&A’s to the fairytale of the princess of the frog in that managers have a high opinion of their ability to buy poor performing companies and bring them back to life as successful and profitable activities. However is this actually the reality? I think not. Many cases have brought to light failures in M&A activity.

A classic example can be looked at here as to how mergers can go wrong. Time Warner and AOL, in this case the M&A took place during a tech bubble which subsequently burst however this is not the only reason for the problems. AOL dragged time Warner down with the combined company publishing a $100bn loss coupled with a $10 decrease in share price at the time. It was a case of culture clashes which caused the merger to go horribly wrong (BBC, 2003). This is clearly a great example of when vision and strategy fails to meet reality.

Merger activity can be undertaken for the wrong reasons and this is an area to keep a check on… In this respect companies use such activity as a defence mechanism for survival. However this strategy turns itself into a vicious cycle. Once bigger in size the company may then attract attention from elsewhere around the globe looking to expand into their market and may be seen as a new potential target. This may result in the company having to take over another company as a secondary defence mechanism and so on… Why do managers of these companies do this? Why not just let the company be bought out? Well statistics paint a very dim picture for companies subject to takeover with life expectancy being as little as 2 years. Therefore managers may be in pursuit of this defence mechanism for sake of job preservation rather than shareholder wealth maximisation. Is this necessarily a bad thing? After all wouldn’t it be better for the shareholders to be put second in the short run rather than the business seizes to exist?

According to a study carried out by KPMG "83% of all mergers and acquisitions (M&As) failed to produce any benefit for the shareholders and over half actually destroyed value" (ITAP, 2010)

This links in to the impact M&A activity has on company stakeholders. Let’s think about customers for example, M&A activity could be beneficial to them in that a greater choice will be made available, however on the other hand it must be ensured that an oligopoly is not formed as competition is vital as a means of driving down prices in the market which consumers can then take advantage of. Without this competitive environment companies can yield too much over the industry and community in which they operate. Suppliers will also be impacted in a similar way as if the bigger company now yields too much power they can use their increased negotiating skills to force down prices, also the joint entity is unlikely to need 2 lots of suppliers therefore many will miss out and jobs could be at risk.

A study by Jensen & Ruback (1983) found the bidding company on average to gain 4% on its share price in comparison to the target company which gains on average 30%. A great case in recent news highlights this pattern.

Tata communications an affiliate of the Tata group which famously acquired steel maker Corus in 2007, has announced it may make an offer to acquire Cable & Wireless Worldwide (CWW) the troubled telecommunications company. The announcement saw Tata shares rise 4% whereas CWW shares rose 25% (Financial Times, 2012) almost exactly following this pattern. This M&A is however still in its preliminary stages and if the deal goes ahead the question remains, is M&A activity actually in the best interests of the shareholders? Or is this like the case of the princess and the frog in that Tata management feel they can bring this troubled company back to life? This will be a case to look out for…

Sources:

Jensen, M. C. & Ruback, R. S. (1983) The Market for Corporate Control: The Scientific Evidence. Journal of Financial Economics, 11, pp. 5-50, SSRN [Online] Available at SSRN: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=244158  (Accessed: 9 March 2012).

Why Foreign Direct Investment?

Foreign direct investment (FDI) is concerned with purchase of physical assets or ownership rights of a company in another country. It can take the form of a ‘greenfield investments’ which is a blank canvas approach to the market in that the company will have to invest heavily in infrastructure. In contrast managers could opt for international merger and acquisition activity which could be seen as the easier option in that an infrastructure base is already set up and ready to go. But why do companies choose to go down the route of FDI anyway? After all other options in international trade are available for example exporting.

Well in recent years changes to the global economy as a whole have facilitated the use of FDI. Factors such as increased economic trade and greater market integration have been a starting point and therefore countries have recognised the need to reduce barriers to global trade. Transnational companies (TNCs) have been the biggest beneficiaries of this trend of global integration.

In turn this has led to a much greater number of TNCs indulging in FDI. Governments have had a supporting role in this and have helped put policies in place to encourage FDI projects. Examples include bilateral trade agreements and double taxation treaties both of which are positive indicators of world trade.

However it needs to be considered whether FDI is being targeted at the correct markets? After all surely it’s the developing economies who would receive the most out of such projects? It seems however that the majority of FDI funds are being directed and received within developed economies. This is likely to be down to TNC corporations being weary of underdeveloped markets, infrastructure and stability to sustain successful strategies in these countries.

Reflecting back on last week’s blog regarding corporate tax, levels of taxation can also be a major influence on the location of FDI. After London, Belfast is the most attractive city in the UK for FDI, particularly in technology and financial services (BBC, 2010) – could this have anything to do with the lower rate of corporate tax of 12.5% in comparison to the 28% faced by companies based in London?

So how can countries in the emerging world attract FDI and more importantly is attracting FDI something they regard as important for future development? Factors which may be used to their advantage to attract FDI include natural resources which may not be found in other locations, cost of labour and taxation rates as highlighted by last week’s blog post.

FDI is often thought of as being extremely beneficial to the host country bringing in much needed capital to the economy, expertise and improvements to infrastructure, in turn improving the quality of living for the population. However are these benefits so great in reality? It has been argued potential costs can actually impact on the host country due to the presence of the TNCs. These mainly derive from the power of such companies may yield. This could have a negative impact on local competition due to the strength of their brand recognition. Also TNCs can have an impact on the decisions of the host country government due to them being reliant on the economic power of the TNC. Issues such as environmental, human rights and corruption will also have to be taken into consideration. After all, high profile companies such as Primark have been in the spotlight with regards to child labour (the guardian, 2008).

Examples of FDI occurring within the emerging economies are becoming more prominent though. North Korea for example has the potential to attract FDI funds due to its vast natural resources such as timber, coal and gold which China desires. The UN Conference on Trade and Development estimates that FDI in 2010 was $38million (£24m) most of which comes from China (BBC, 2012).

It is also clear that emerging economies are seeking to attract FDI.  The Shanghai Commission of Commerce yesterday released information yesterday regarding intentions of the region to attract around US$10 billion in foreign direct investment annually by 2015. The city will attract this FDI through “its mature market system, skilled workforce, efficient government and transparent laws to draw foreign investors instead of using preferential policies to lure them” (Easyday, 2012). Surly this shatters some of the misconceptions about FDI being damaging for emerging economies? It would seem they are in reality going out of their way to attract it as a means of development!

Corporate tax: Are companies right to avoid it?

Keeping costing to a minimum has always been a philosophy in the business world, after all why would anyone want to pay more out than they should? However in these challenging economic times this has become the vital issue for businesses whose structure must operate in the most cost effective manner.

The concept of tax avoidance comes in here - this must not be confused with tax aversion which is illegal! Tax avoidance however is completely legal and so has prompted many companies to tax advantage of lower tax rates offered around the globe by restructuring their business and locating their headquarters in countries which will benefit their operations. With countries like Bahrain, Bermuda and the Cayman islands offering 0% tax rates, is it surprising so many companies are choosing to go down the restructuring route?! From a manager point of view if maximising shareholder wealth should be their priority then isn’t this a method of achieving this? It would certainly seem that way, by reducing their tax bill in some cases by billions, this will help improve profits and increase capital available for dividends.

I am going to use the case of Google again in my blog this week - the company was mentioned in my second blog in terms of stock market efficiency. Here however the company has received scrutiny over its tax-avoidance techniques with payments as low as £1.2million for the UK operation revealed despite its parent company in the US making massive profits! Matt Brittin who heads up the UK subsidiary of the company said: “We have an obligation to our shareholders to set up a tax-efficient structure, and our present structure is compliant with the tax rules in all the countries where we operate" (London Evening Standard, 2011).

According to Bloomberg (2011) Google managed to reduce its tax bill by $3.1billion over the past 3 years by using techniques which divert profits through Ireland, the Netherlands and Bermuda. Through this shifting of income they have managed to take advantage of an average overseas tax rate of 2.4% despite operating in some of the world’s highest taxed countries! Google’s ability to achieve this relies on transfer pricing which allows income to be allocated in tax havens, like Bermuda, and expenses allocated to the countries with higher tax rates. It is estimated this costs the US government as much as $60billion every year!

However is this really ethical? I certainly don’t think so - after all isn’t it the company’s duty to contribute to the society in which it operates? By avoiding tax the home government whether it be the UK or elsewhere  is missing out on vast amounts of income which will have a detrimental effect on the country we live in, with the only option left for them to make cuts or attempt to generate the money from elsewhere – probably our pockets! In this respect I think it is unfair for multi-million pound companies to avoid what it is their moral duty to pay!

On the other hand, thinking about this from a manager’s point of view allows me to see why this happens. As I brought up in my first blog, bonus culture in today’s business world is often linked to maximising shareholder wealth - tax management is seen as a wealth generating strategy. So if I was managing one of these firms pressure to perform and meet targets would make it almost impossible to avoid such strategies!

So, it is clear tax avoidance is a popular strategy in the business world. The UK government has assured public it will do more to try and put a stop to big companies abusing the system. It has also been claimed that some large corporations have developed ‘unduly cosy’ relationships with HMRC; with the public accounts committee claiming around £25billion of tax is currently outstanding (BBC, 2012).

Goldman Sachs faced legal proceedings from UK Uncut last year over claims that HMRC waivered the banks interest payment on their tax bill - this claimed ‘error’ was estimated at between £5-8million by the National Audit Office (BBC, 2011). If this is the case it’s no wonder the public are becoming increasingly frustrated about the situation!