Dividend Policy

When to issue a dividend, if at all is the issue many companies face. What is important is the maximisation of shareholder wealth. In the UK dividends are paid every six months with the interim dividend reflecting a company’s half year results and a final dividend when the financial year ends. However, it is known for companies not to follow this pattern of issuing dividends with some companies paying no dividend at all.

Apple Inc. has seen its profits and cash flow sky rocket in the past ten years due to its innovative technology. Yet until recently, when it announced it was going to pay a dividend the company had not issued one since 1995. It was well known that Steve Jobs disliked giving money away which could have been used for R&D or to buy up rivals. However, investors began asking questions after seeing Apple had $97.6bn in cash at the end of 2011. The company has agreed to a pay a quarterly dividend of $2.65 per share from July 2012.

Despite Apple not issuing a dividend they have still maximised shareholder wealth. In ten years the share price of the company has gone from $10 to over $600. Depending on the clientele will determine whether an investor is happy with receiving no dividends or little dividends. People who are retired and who want a steady flow of income will be more inclined to a company which pays high consistent dividends. On the other side of the coin investors who are wealthy will not be concerned with dividends and will prefer an increase in share price to try and make quick returns on their investment.

According to the theory, maximising shareholder wealth means maximising the flow of dividends to shareholders. However, according to Miller and Modigliani (1961) dividend policy is irrelevant to share value if some assumptions are made, such as no taxes and no transactional costs. They propose projects with a positive NPV are what determine value rendering dividend policy useless. However, the problem with this theory is it is based on assumptions and therefore companies see issuing dividends as a way to maximise shareholder value.

Investors welcome dividends because there getting returns on their investments. Surely the issue of dividends cannot be perceived as a negative. Wrong! Some investors may see issuing or increasing dividends as a signal that a company has run out of ideas. Increasing dividends could have a negative effect on a company’s share price giving incorrect signals to the market.

Companies may be thinking about their credit rating when deciding on a dividend policy. If a company issues a consistent dividend policy then it’s perceived as a strong company and therefore achieves a good credit rating. Paying lower interest rates will mean a higher return on projects and thus achieve greater returns to shareholders. Not all companies issue dividends mainly because they can’t afford to. Performance may be poor or their money may be tied up in too many fixed assets.

There is no set formula for how a company structures its dividend policy. Most investors are happy as long as they are seeing good returns on their investment. A company’s performance is what is important because no dividends will be issued if a company is performing badly. 





Sources Used: bbc.co.uk, Arnold: Corporate Financial management (2008)

Capital Structure

Discussed previously has been how companies can raise finance through either debt or equity. However, this blog goes into more detail discussing the capital structure of a company. It is generally well known that that the cost of equity is usually higher than the cost associated with debt. Financing through equity requires higher returns than activities which are financed debt. However, is it really viable for a company to load up on debt because once debt exceeds a certain level its benefits become unapparent?

The question is why is debt finance cheaper? One of the key reasons is because lenders usually require a lower rate of return than ordinary shareholders. In addition to this debt interest is not included in the corporation tax bill thus reducing the amount of tax paid. Therefore companies should increase their gearing level as this would mean the cost of financing their company will reduce. The general aim of gearing is to increase shareholder wealth. However, there comes a point when companies finance too much through debt and problems can arise. After all companies have to pay interest on their debt and need to meet their payments no matter how well the company may be doing.

Explained in a previous blog was the concept of Weighted Average Cost of Capital (WACC). Having more debt can reduce the WACC because debt is cheaper than equity however, having more debt can also increase WACC due to the fact equity holders want more returns. How companies structure their capital will ultimately determine their WACC and more importantly what projects they can undertake to return value back to shareholders. The important thing is that they get it right.

Changing the capital structure of a company can increase both the value of a company and increase the level of shareholder value. However, gearing can also increase the risk to shareholders. Companies which have a high level of gearing are generally perceived as high risk. The diagram below shows how increasing the level of gearing can increase the financial risk to a business.

A previous blog talked about the impact of the credit crunch and how it is still affecting today’s economic environment. Sources of cheap debt were available therefore, it seemed sensible for companies to load up on debt. It was cheaper than sourcing finance through equity and the low interest rates meant there was little risk involved. However, interest rates rose and the risk of companies faltering on their repayments became frequently more apparent.

Governments, banks and major companies have all gone kaput because they loaded up on too much debt. When companies think about their capital structure they often only think about the short term consequences. A recent example of a company loading up on too much debt is the retailer Peacocks. Back in January the company entered into administration having tried unsuccessfully to restructure its £240m debts. The company has recently been bought out by Edinburgh Woollen Mill; the deal will save around 6000 jobs. However, unfortunately the deal means 224 stores will be forced to close in the UK leading to 3100 redundancies.   

The problem companies’ face regarding their capital structure is a challenging one. While sourcing through debt finance can reduce the WACC and make more projects worthwhile it can also drastically increase the risk of a company. Companies not only have the responsibility to shareholders but to their employees as well. 3100 people are out of a job due to Peacock’s inability to impose a sustainable capital structure, how many more job losses will we see in the future?

Sources Used: bbc.co.uk, Multinational Finance (Mffett et al. 2009), Northumbria university eLearning portal.

Socially Responsible Investment (SCI)

When companies make an investment decision the first thought that comes to mind is will it return a profit? However, many investors when investing now think about the social, environmental and ethical implications of their investment. This type of thinking has been given the name socially responsible investment (SRI) and is an ever increasing phenomenon.

Although investors take into account the social implications of their investment they do aim to make a return on their investment. Companies cannot just invest in projects because it’s nice and ethical. They have a responsibility to shareholders to maximize their returns. As many experts point out SRI will merely just be a niche market if SRI only seeks low returns.  

Research carried out by Bauer, Koedijk and Otten (2002) found that over a period from 1990-2001 looking at 103 German, US and UK mutual funds no significant difference was found between normal and SRI investments. This kind of research is promising to know and shareholders will be happy that they are investing in ethically sound companies while still returning a profit.

So, it will no longer do for a company to go quietly about its business. In these modern times when information is available so freely companies must show they are acting socially responsible. Even China is now starting to adopt SRI as it continues to conform to western business practices. SRI comes under the umbrella of corporate responsibility. Although, most companies enforce the view that they are ethically aware of their business practices there are still cases of misbehavior.

Such cases of misbehavior are regular occurrences in the news; with the most popular quoted case of unethical behavior being Primark. Receiving bad press for its use of child workers however, does not seem to have affected the chain too much. While some investors may now be deterred from investing in Primark others will not care. Fundamentally people have differing values across cultures and individuals have different values within cultures.

In a world where people are increasingly concerned with the environment and with how workers are treated SRI is only going to gain importance. Companies are increasingly incorporating ethical issues into their core strategies. In today’s world companies can no longer just think about maximizing profit they must also take into account the ethical implications of achieving returns on their investments.

Sources Used: bbc.co.uk, FT, Daily Mail, Bauer, Koedijk and Otten (2002). 

Credit Crunch!

Five years ago people were happy with a secure job and plenty of credit available to buy whatever their needs desired. Living in blissful harmony if you mentioned the word credit crunch people would have thought you were talking about some tasty new cereal.

O.K maybe the past seems a little better than what it was but compared today’s economy it was heaven!

Ahead of the budget next week Chancellor George Osborne has a difficult task coming up with a solution to end the UK’s economic plight. The UK has already been warned it could lose its AAA status within the next two years if it doesn’t sort out its public debt. There are also talks that the Chancellor may scrap the 50p tax rate. It would seem strange to give the rich a tax break when the average Joe is struggling to make ends meet. However, the argument for this is that if the rate is lowered more high earners will settle in the UK thus more tax will be raised offsetting the short term losses.

The UK economy is struggling like many of the world’s leading economies. The reason being it is still suffering the consequences of the credit crunch. The impact of the credit crunch has been so huge that in 2008 the term was accepted into the oxford English dictionary! For those of you who don’t know what is meant by a credit crunch, it is basically a severe shortage of money or credit available to lend.  

The start of the credit crunch has been pinpointed to the 9 August 2007 when BNP Paribas announced negative news causing a spike in the cost of credit. However, many people believe that the origin of the crisis which has unfolded in recent times can be traced back to the early 2000s. The dot com bubble had ended and terrorists had just attacked the twin towers, the world quite frankly was in disarray. To in store confidence back into business the US Federal Reserve slashed interest rates to just 1%. This meant credit was cheap and the economy thrived on cheap money. Banks could afford to lend cheaper and the low interest rates were carried on to the wider public through cheap mortgages. The problem was that the interest rates were held too low too long. It was not until 2004 that the US raised them unfortunately they rose too sharply and by 2006/2007 were above 5%.

This is where the problem really started and the credit crunch was about to hit home. The interest rates had been low and this meant that because more people had access to mortgages house prices began to rise due to the demand. The problem was that banks started to lend to people who they really shouldn’t have, they were undertaking subprime lending. The banks were lending to people who would have difficulty maintaining the repayment level. Due to the fact house prices were increasing, banks thought this was a safe idea. Unfortunately for them they were extremely wrong.

It was bad enough banks were lending these subprime mortgages but even worse was the fact they were trading them through collateral debt obligations (CDOs). I’ll try to explain what these are as simply as possible! Basically the mortgages the banks were lending were all bundled together. The mortgages were then given different risk classes such as AAA, BBB etc. known as tranches. The owners of the CDOs earned money from the interest mortgage owners paid each month. The riskier tranches obviously received higher interest because of the risk involved. They effectively got paid last after all the cash had been collected. The problem was that these riskier tranches were re-bundled into secondary CDOs. They were then given the same risk structure as the primary CDO. The problem being the risk structure was inaccurate. This meant investors were buying AAA tranches from the secondary CDO which should have in fact been rated as BB. When the housing market bubble burst in 2007/2008 people were unable to pay their mortgages. Therefore, owners of these CDOs at the bottom end unfortunately were not getting paid. Owners who thought they had an AAA CDO but didn’t, realised just what a mess they were about to face!

An explanation of CDOs can be better explained in the video below:

So that is how the credit crunch came about, over confidence and too much fiddling in the financial markets. Banks have gone bust, leading businesses have failed and unemployment seems to keep rising. Five years on from the credit crunch we are still living with its consequences. How long before things start to pick up again, who knows? America is showing signs of the recovery with employment improving and the dollar strengthening, however, only time will tell.

Sources Used: bbc.co.uk, youtube, FT 

Glencore and Xstrata – Will they won’t they?

In last week’s blog I touched on the fact companies carry out mergers and acquisitions as part of FDI. However, I did not go into too much detail about the benefits and drawbacks of such an activity. This blog will focus on such issues and discuss the case of Glencore International plc. and Xstrata plc.

Generally speaking it is well known that companies which acquire other companies lose money. So that begs the question why do companies go about doing such an activity when their aim should be to maximise shareholder value? It could be a number of reasons such as: Taking control of a key supplier, the quest for growth or getting quick access to a market.

The factors just described could also be reasons for mergers. Arnold (2008) however, sets out the following motives for why two companies may merge: Synergy, bargain buying, managerial motives and third party motives. Another factor to why companies may merge or acquire a company is hubris, another word for arrogance, it states managers may become over optimistic causing them to make errors. The fundamental principle of any merger and acquisition however, is: ‘Are we maximising shareholder wealth?’ If the answers no, then investors should be asking why not?

All over the news in the past few months has been the possible merger of Glencore and Xstrata. These two companies are leaders in the commodities market focusing primarily on non-renewable resources. If the companies do merge then we would describe it as a horizontal merger. Due to the fact the two companies are engaged in similar lines of activities. Mentioned in a previous post they both have their HQ’s in Barr, Switzerland and both chief executives are from South Africa. The merger sounds perfect yet the two companies are still trying to win over investors. 

Speculation of the possible merger began surfacing in early February and the share price for both companies shot up. The diagrams below show this. 

Glencore share price



Xstrata Share Price

 

However, since the speculation of a possible merger between the two companies came to the surface the share price has dropped suggesting that investors on both sides are clearly not happy. The official announcement of a possible merger was announced on the 7^th February. Glencore outline the nature of the merger below.

RECOMMENDED ALL-SHARE MERGER OF EQUALS OF

GLENCORE INTERNATIONAL PLC AND XSTRATA PLC

TO CREATE UNIQUE $90 BILLION NATURAL RESOURCES GROUP

The above statement states a merger of equals however; Xstrata earns almost double the EBITDA of Glencore at $6.4bn. This is somewhat surprising given Glencore’s revenue is over five times that of Xstrata standing at $186bn. Clearly Glencore is a bit more inefficient than Xstrata. If the merger takes place and the integration of the company’s goes smoothly then profits could sky rocket. Xstrata’s greater efficiency would help to turn Glencore’s massive revenues into more profit. A global mining and commodities powerhouse would be created.

Glencore has offered Xstrata shareholders a merger ratio of 2.8 New Glencore Shares for every Xstrata Share held. Clearly if it’s a merger of equals then why does Glencore have to pay such a premium? To the Xstrata shareholders however, they feel this figure undervalues the company and are therefore holding out. This is one of the fundamental problems with mergers and acquisitions. The agreement on the right price! The bidding company usually pays over the odds.

Will the merger of Xstrata and Glencore take place? Probably unless the regulatory bodies intervene seeing the merger as a limit of competition. Will the merger benefit shareholders? Time will tell. Hopefully increased profits will occur resulting in a higher share price and an increase in dividends. On the other hand the merger could turn out to be a disaster. Different attitudes and cultures could cause friction in the boardroom and with this will come failure.

Sources Used: Arnold: Corporate Financial management (2008), FT, The Guardian, http://www.glencore.com/, http://www.xstrata.com/, investopedia

FDI - The Good, The Bad and The Ugly

What is Foreign Direct Investment (FDI)? Moffet et al. explain it is the purchase of physical assets, such as a plant and equipment, in a foreign country, to be managed by the parent corporation. There are typically two ways a firm can go about implementing FDI. The first option can be through Greenfield investments and the second option is through merger and acquisition activity. The first type of investment is simply establishing a production or service facility starting from scratch from a green field. The latter describes how companies can opt to enter into a merger by combining their business entities under common ownership or opt to acquire a firm to gain access to a foreign market it wishes to invest in.

Of course with any kind of investment there are the pros and cons. For the country gaining FDI increased tax revenues will help contribute to their GDP. Employment and wages will increase and declining markets will be replaced. Human and technology transfer will occur with an improvement in infrastructure. For the firm investing the access to a new market offers the potential of new customers and greater profits thus maximising shareholder’s wealth.

On the negative side the domestic government may lose control in its efforts to attract FDI. MNEs are notably wealthier and more powerful than many countries. Take Proctor and Gamble for example, they state on their website that their market capitalization is greater than the GDP of many countries. They go on to say that with this stature comes both responsibility and opportunity. The opportunity is being able to influence governmental decisions. Another problem is that the benefits of FDI may only be felt by a small proportion of the nation. Especially if the FDI is in primary activities such as oil as there are little spill over effects. For the businesses investing there is the major risk of failure, thus losing the money invested. Market volatility, political issues and uncertainty help to reduce the success rates of FDI.

In order for FDI to be successful it needs to be a win/win situation benefiting both the MNC and the host country.

The good

FDI can be extremely successful when done right and I can’t write a blog on FDI without mentioning the case of Botswana and De Beers. De Beers is a family of companies that dominate the diamond mining, diamond trading and industrial diamond manufacturing sectors. In the 1970s they decided to invest in Botswana. The success was so great that over a period from 1970 to 2000 Botswana was the fastest growing economy in the world.

The bad

FDI can go badly wrong for the parent company; a classic example is the case of Enercon of Germany, one of the world’s biggest makers of wind turbines. The company has been in India since the mid-1990s however; in March 2011 it began experiencing problems. The company lost its entire Indian subsidiary, a major operation with annual sales of more than $566m. The reason was a dispute with its local partner and a run in with the Mumbai law enforcement authorities. The company then lost control of its patents in India and began to fear its technology would be copied in a country where wind energy is a growing market. Other companies also face problems from India in which joint ventures have to be entered into. RTT News says FDI in India fell 33% in December 2011.

The ugly

Things can get ugly when it comes to FDI. China is one country which in recent years has increased its FDI. The country is one of the main buyers of South Sudanese oil as well as the biggest investor in Sudan. Recently Chinese construction workers were returned by Sudanese Rebels after being kidnapped and held in captivity. This is one reason why companies tend to shy away from investing in countries such as Sudan which happen to need investment the most. Unfortunately FDI takes place the most between developing countries that need it least.

FDI can offer its advantages and when it comes good it’s great but there are also substantial risks. Therefore, companies play it safe by investing primarily in developed countries where there is less risk of kidnap!

Sources Used: Moffet et al. (2009), RTT News, FT.com

Multinational Tax Management

When people think about tax they gulp, it is the bane of society to most people.  Purposely not paying tax is what we call tax evasion, this is illegal. What is not illegal however, is tax avoidance. In a business sense avoiding higher taxes puts your business in a tax optimal position. What is clear is that most people do not like paying taxes, however unless we are rich and powerful we have to put up with it. If you are rich and powerful i.e. Mick Jagger or a large corporation there are ways to avoid paying high tax rates in some of the countries you operate in.

Quoting Hryck and Andreoli: ‘It has always been appropriate to organizations business transactions to minimize a company’s tax burden’. Corporation tax is the tax companies have to pay for the profits they earn, however, this is not a fixed amount and can vary from country to country. Corporation tax has a direct impact on the value of a company’s stock therefore it is only right that a company seeks the lowest rate. In the global world we now live in tax rates can make a substantial difference to where a multinational firm will locate their Headquarters. Competition between countries to attract international business creates pressure to lower corporate tax rates.

The economic climate we are currently facing has only increased the need to attract corporations. In the news of late has been the USA announcing that they are planning to cut their corporate tax rate from 35%-28%. With one of the highest corporate tax rates of the developed nations in the words of Barrack Obama ‘It’s not right and it needs to change. The non-profit group Citizens for Tax Justice working alongside the Institute on Taxation and Economic Policy looked at 280 of the biggest and most profitable U.S. companies. They found the following results:

A quarter of them paid less than 10% in taxes over the three years 2008 to 2010.

Only about a quarter of the companies studied paid close to the official 35% rate

The average annual tax rate for all 280 was 18.5% over the three years, barely half the official rate, yet they reported almost $1.4 trillion in pre-tax profits

How and where do these companies avoid paying taxes? In terms of location they move their headquarters to tax havens. All over the news in the past few weeks has been the possible merger of mining giants Glencore and Xstrata. These companies are run by South African citizens, listed on the LSE and have their Headquarters just two miles apart in the mountainous city of Zug in Switzerland. The basic rate of corporation tax here is 15.4% compared with 25% in the U.K and 28% in South Africa. In 2010 Glencore had profits of $3.8bn if the company had their headquarters in the USA they would be paying nearly 20% more in corporate taxes. It’s not rocket science to why Glencore and Xstrata are located where they are.

Another way companies go about avoiding tax is through transfer pricing. I’ll try to explain this as simply as possible. A Company has a subsidiary in another country. The tax rate for the subsidiary is higher than that of the company.  Therefore, if profits are more where the subsidiary is located the company will lose more through tax. What the company will do, is charge a higher transfer price on good and services sold to the subsidiary. Therefore, profits decrease for the subsidiary and increase for the company. The company is able to retain more cash which would have been lost through tax. This is basically very cheeky and governments do try and implement regulations to stop transfer pricing going on but it can be a hard task.

To put it politely the public get annoyed by companies trying tirelessly to avoid tax. However, shareholders should be happy because after all the companies are doing this to maximise shareholder value aren’t they? What we can learn about multinational firms is that they are very manipulative and will do everything in their means to avoid tax. However, if this was the case then every company in the world would be located in the Bahamas! Other things such as the country’s infrastructure have to be taken into account. It may not be feasible for businesses to move to a tax friendly country. A business’s strategy and structure has to be taken into account. Some businesses may even see it as unethical and feel it is their responsibility to stay and pay taxes in their domestic nation.

Sources Used: FT, Bloomberg, InvestorWords, Hryck, D. & Andreoli, B. (2005), Arnold: Corporate Financial management (2008), Moffett et al: Fundamentals of Multinational Finance. (2009)