The Optimum Dividend Policy

A dividend is the distribution of value to shareholders (Shanken and Tajirian, 1997), which tends to be paid annually or bi-annually. Without any future dividend income for shareholders, the value of the company is essentially zero. It is these expected future cash flows which provide value to the shares. However, companies face a common problem of deciding on the optimum dividend to pay out to shareholders. It is the dividend policy of the company which answers this question. This blog will explore the optimum dividend policy for companies to possess, assessing whether shareholder wealth can be enhanced by altering the pattern and size of the dividend payments over time.

I suppose initially the company has the option of paying a high dividend or low dividend relative to earnings. Paying a low dividend would arguably give the company more cash to invest into new products, which in turn could increase shareholder wealth in the long term. Paying a high dividend does not allow for this, as the company will have less cash available to invest into new projects. Whilst this is true, shareholders do not have access to internal information and may therefore assume a low dividend reflects bad news and a high dividends reflects good news. As a shareholder, I would prefer a low dividend as I believe this allows for shareholder wealth to be maximised as the business can invest in new projects to increase potential future earnings, however I believe this needs to be communicated correctly to the shareholders to ensure they are aware that this is the direction that the business is taking and thus maintain a reasonable share price.

The second option the company has is the option of paying stable or fluctuating dividends. Fluctuating dividends would refer to altering the dividend amount depending on the level of earnings whereas stable dividends would refer to paying a similar level of dividends regardless of that period’s earnings. A fluctuating dividend is likely to allow the company more control of their finances as they can assess their earnings and then determine the optimum dividend payments. A stable dividend could prove the company problems in period’s where earnings may not be as high as expected as they may not has the cash available along with the company being left with excess cash in times of high earnings. However with stability, shareholder will know what they are due to receive which essentially lowers risk and uncertainty. As a shareholder I would personally prefer fluctuating dividends as I believe that this provides the business with more flexibility to maximise shareholder wealth, however if stable dividends would maintain a high share price due to reduced uncertainly then obviously this is more ideal.

Whilst these considerations have been discussed, Miller and Modigliani (1961) argue that in fact dividend policy is irrelevant to share value. They argue that share price is in fact determined by future earnings potential through the availability of projects with positive NPV’s and therefore the pattern of dividends makes no difference. Essentially they state that dividends represent a residual payment which is made after all projects with positive NPV’s have been undertaken. Whilst this argument makes sense, it is based on a number of assumptions such as investors having access to all relevant information, no taxes, no transaction costs and an indifference in preference between dividends and capital gains for example. In my opinion, in the real world, such assumptions are not the case and in fact not only do investors have different views, along with having to consider a number of costs such as tax and transaction costs, but investors are short sighted and therefore would rather money now in dividends than have to wait based on potential future earnings.

Overall as a shareholder, I have a mixed view on the issue of dividend policy. Personally, I would rather low dividends so that the company can invest funds to maximise future returns. I would also prefer fluctuating dividends so that the company can assess earnings and base dividends around these, again to maximise my wealth. However I believe that investors in general would not support these views as most investors are short sighted and want relatively high, stable returns. Therefore overall, even though beneficial to the shareholder, I believe low fluctuating dividends would actually destroy share value due to a lack of demand for the shares. Therefore in order to maintain an optimum share price along with maintaining the potential for high future returns, I believe that the best dividend policy would be for firms to provide investors with stable dividends along with a stable growth in the size of these. I believe this would attract investors though secure dividend payments along with allowing for a reasonable level of investment, to grow shareholder wealth in the future.

References in this blog

Miller, M. H., & Modigliani, F. (1961). Dividend policy, growth, and the valuation of shares. the Journal of Business, 34(4), 411-433.

Shanken, J., & Tajirian, A. (1997). Equity Factors and the Market Portfolio. Unpublished manuscript, University of California, Berkeley.

Debt Financing vs Equity Financing

When it comes to debt finance and equity finance, there is often debate as to which way is the best to finance a business? Dobson (1999) explains how the ultimate objective of a business is to maximise shareholder wealth. Therefore shareholder wealth maximisation is likely to be the main consideration of firms when deciding which method of finance is best. For the purposes of this blog, debt finance will refer to the raising of capital through the issue of bonds and equity financing will refer to the raising of capital through the issue of equity in a firm. This blog will assess the advantages and disadvantage of each of these sources of finances and finally consider which is best for a firm.

Equity Finance

The main advantage of equity finance is that it avoids the burden of debt. Therefore it is a much less risky option and much more affordable option as nothing is required to be paid back. This also allows for the firm to take a longer term view as they do not need to worry about generating short term returns in order to maintain debt repayments. However equity financing does also carry disadvantages. Firstly the firm is actually selling ownership which means that current ownership becomes diluted. Unlike debt financing, investors will also expect profits to be paid back in the form of dividends. Investors will also have to be consulted before decisions and will want the firm to be run in their own interests, which may not always be best.

Debt Finance

Debt finance tends to be cheaper to firms that equity finance as the lenders tend to require a lower rate of return than shareholders. Debt finance can also reduce the amount of tax that is paid as debt can be offset against profits as interest is tax deductable. Other costs such as issuing and transaction costs also tend to be lower, along with certainty regarding the amount that will be repaid. However debt financing does carry disadvantages. Unlike equity finance, money must be repaid on a set date as it is essentially a loan. A firm that is too highly geared may find it difficult to repay loans on time, which can also lead to other factors such as a short term approach taken by the firm to ensure sufficient cash is generated. Firms taking on debt finance therefore run the risk of bankruptcy through failure to repay loans, making such option riskier.

From a financial point of view it would initially appear that if a firm need to generate capital, the best option is debt financing as it is the cheapest method for raising capital. Therefore this would assume that taking on greater levels of debt compared to equity reduces the weighted average cost of capital (WACC) which benefits shareholders as overall costs are reduced. However a number of financial experts suggest that as levels of risk are increased due to greater risk involved regarding the repayment of debt, shareholders actually in turn demand a greater return. Therefore as shareholders require a greater return to compensate for the enhanced risk undertaken by the company, this can actually lead to a destruction of wealth overall as share price in fact decreases due to the increased requirement outweighing any benefits of financing through debt. I think it would be fair to say that each situation and each company is different and there is no right or wrong answer to the best method of financing. However in order to ensure that shareholder wealth is maximised, firms do need to ensure that if financing through debt, levels are controlled to reduce the risk of bankruptcy and therefore ensure shareholders do not require excessive returns to compensate, thus diminishing wealth.  

References in this blog

Dobson, J. (1999). Is Shareholder Wealth Maximization Immoral?. Financial Analysts Journal, 69-75.

Just How Important Is Consumer Confidence in Global Financial Markets?

In 2008, Warren Buffet described confidence as being the oxygen to an economy. Buffett explained how confidence is key to the economy when explaining, “I don’t think I’ve ever seen people as fearful economically as they are right now.” Essentially confidence is a major factor within the economy, as if people are not confident in a financial system, they will not use it. We only need to look at the current situation in Cyprus to see how a lack of confidence can damage an economic system.

Essentially Cyprus is now in a situation whereby it either accepts the proposed bank levy on savings or leaves the Euro. Neither of these options are good for Cyprus as a nation, or its people, however due to the situation the nation has got itself into, it has no choice. However, as mentioned, the crisis in Cyprus is one of confidence. Firstly the nation’s banking system has been damaged. This is due to consumer losing trust in the system, which was inevitable once the government initially contemplated the possibility of taking away part of the country’s bank deposits. Restoring this trust and confidence will be a long and difficult process, however is the only way the economy can return to a fit state. Secondly, and perhaps more importantly, consumers trust in the Cypriot government and European Union has been damaged, which again is difficult to restore.

So having considered the loss of confidence within the Cypriot economy currently, we should consider why this is actually a bad thing. Essentially if consumers are not confident in their economy, they will not use it. This has been demonstrated by the reported queues at cash machines this week in Cyprus, with limits imposed on withdrawals. It will be interesting to see what happens once Cypriot banks unfreeze accounts, however an obvious prediction would be that the majority of people take their money out of their accounts. This would be a reasonably normal concept to see when consumers lose faith in the state of an economy, however with the added potential for a tax on savings, in this case it is even more likely. So why is this bad then? Well firstly if everyone wants to withdraw their funds, the bank will simply not have the cash to pay this out. This is because a bank works by taking cash from people in the short term and lending this out in the long term in the ‘maturity transformation’ sense, keeping only a small amount of cash to cover the day to day needs of people. Whilst in the short terms banks simply do not have the cash to pay people out, the bigger picture is that banks will have less money, meaning they have less ability to generate funds and therefore the economy will begin to stagnate and growth will be minimal.

The original question posed at the start of this blog was to examine just how important confidence is within an economy. Confidence is essential for an economy to run smoothly, a point highlighted by Warren Buffet. If people trust an economy and are confident within it, then they are likely to be happy to invest their money, allowing banks to use this to lend out, essentially increasing their profits but also increasing the money flow within an economy along with economic growth. However, when looking at the example of Cyprus, we can see just how catastrophic it can be if confidence is removed from an economy. Therefore in my opinion and probably in the general opinion of most people, confidence is one of the key factors to maintain within an economy in order to ensure economic stability.

Was the Financial Crisis Avoidable?

‘The global financial crisis’, ‘the credit crunch’ and ‘the recession’ are just a handful of titles describing the largest worldwide financial crisis since the Wall Street crash and Great Depression of the 1930’s. The financial crisis arguably began in August 2007 when BNP Paribas refused withdrawals from hedge funds due to “a complete evaporation of liquidity.” This was essentially the catalyst to the situation, however this blog will assess whether the crisis could have been avoided long before this date, or whether it really was an unavoidable ticking time boom waiting to happen.

Before we assess whether the financial crisis was avoidable, it would be a good starting point to discuss the actual causes of the crisis in the first place. In my opinion, it would be fair to say that there is no simple answer to this, with the crisis more than likely being a result of a number of factors and failures within the financial industry.  Barack Obama claimed that a ‘culture of irresponsibility’ was responsible for the crisis. This is probably true in most places with excessive borrowing due to factors such as a lack of corporate governance and dysfunctional incentive systems causing firms to collapse. As discussed through a number of my blogs, with greater risk, comes the potential for greater reward, however in the case of the financial crisis in 2007, firms took on too greater risk which did not pay off.

One of the key factors linked blamed for the crisis was the sub-prime lending business, whereby financial institutions offered mortgages to individuals with poor credit histories, packaged these as mortgaged backed securities in the form of collateralised debt obligations and sold them on globally to investors. As interest rates rose, homeowners could not afford the repayments and defaulted on their debt in large numbers, affecting bank’s liquidity and therefore ability to repay investors. The existence of an off balance sheet and almost unregulated ‘shadow banking system’ made up of investment banks and hedge funds, allowed institutions to leverage themselves so highly, that they were essentially loaning out money which they could not support through capital in the event of credit defaults. The lack of legislation and regulation in such shadow industry allowed firms to act upon their own accords. This combined with dysfunctional remuneration packages, in that employees were rewarded for short term success and therefore taking risks, encouraged employees to increase their firm’s leverage and therefore issue increased mortgages and loans.  Eventually the whole system failed, as financial institutions had too much debt and not enough capital to support this debt, which combined with vast credit defaults, lead to illiquidity of banks, resulting in a number of collapses and government bail outs to resolve the situation.

Essentially Barack Obama’s simple claim regarding a ‘culture of irresponsibility’ was correct, as responsibility on a number of levels arguably could have prevented the crisis. Firstly corporate governance needs to be applied internally by firms. The most widely used definition of corporate governance is "the system by which companies are directed and controlled" (Cadbury, 1992), therefore explaining how firms need to conduct themselves in the correct way to ensure their success. Clearly this was not the case as corporate governance surrounding leverage limits along with dysfunctional behaviour was not in place, leading to financial institutions making huge losses. Such corporate governance was highlighted to myself first hand whilst on placement at UBS in 2011, whereby rogue trader, Kweku Adoboli was allowed to incur losses of around $2 billion due to a lack of corporate governance controls in place and remuneration packages encouraging such risk raking. In the weeks after this event, corporate governance controls were noticeable tightened as all staff were made to complete rigorous training exercises and compliance's role became more apparent in the day to day running of the organisation. Another example of irresponsibility could be through the lack of legislation by governments. If governments had stronger legislation upon the shadow banking industry or minimum levels of capital firms had to hold for example, then firms would have been less likely to have been able to get into the situation they did. Such regulation has now been put into place, such as the recent Basel III regulation which encourages financial institutions to increase liquidity and reduce leverage through strengthened capital requirements. Finally along with financial institutions and governments, I believe consumers and individuals themselves are partly to blame for the irresponsibility leading to the financial crisis. Individuals should be responsible for the levels of debt they take on and take responsibility for repayment of this debt. As individuals took on too much debt, mainly in the form of mortgages it led to the crisis. In order to prevent this there may be a strong argument for more stringent credit rating controls imposed by rating agencies as individuals tend to be optimistic when it comes to accumulating debt.

Phil Angelides, chairman of the Financial Crisis Inquiry Commission conceded in his final report on the causes of the crisis, “we conclude first and foremost that this crisis was avoidable." (cited by Rooney, 2011). After briefly assessing the causes of the crisis in this blog, I would agree that the financial crisis could have been avoided, or at least its consequences could have been reduced. I believe firms could have imposed more stringent corporate governance controls to control their policies along with ensuring leverage and liquidity levels remained reasonable. I believe this could have also been supported by stricter legislation imposed on financial institutions by governments, mainly in the ‘shadow industry’ of investment banks and hedge funds. I believe firms could have incentivised and remunerated staff in different ways, to encourage them to focus on longer term wealth maximisation aims in line with shareholders rather than a short term risk taking approach. Finally I believe the credit rating agencies could have imposed more stringent controls on individuals to ensure that credit defaults are minimalized. I also believe that consumers could have taken more responsibility in terms of the amount of debt they took on to ensure that they were in satisfactory positions to repay debts, which also would have been aided by stronger credit controls. I believe that if all parties took such steps, the financial crisis would not have been able to reach the severity level it did, and therefore financial institutions, individuals and the government should consider such steps in the future to prevent a similar worldwide crisis.

References in this blog

Cadbury, A. (1992) The Report of the Committee on the Financial Aspects of Corporate Governance. London: Gee.

Rooney, B. (2011) “Financial Crisis Was Avoidable: FCIC.” Retrieved from: http://money.cnn.com/2011/01/27/news/economy/fcic_crisis_avoidable/index.htm (Accessed 16/03/2013)

Would a ‘megamerger’ between Vodafone and Verizon be a good thing?

It has been widely reported this week that two of the largest communication firms in the world, Vodafone and Verizon, are in talks regarding a merger. Some reports have touted this as a ‘megamerger’ worth figures in the region of $250 billion which would result in one of the largest mergers in history, creating a communications giant. Such deal would be considered a horizontal merger whereby two companies in similar lines of activities combine (Arnold, 2008), which could result in great benefits to a number of parties. With Vodafone shares jumping 7% this week on the back of such rumours, this blog aims to analyse the potential benefits of such a deal.

Whilst there are a wide range of reasons to merge two companies, a key reason for a horizontal merger is the benefits achieved through economies of scale. Economies of scale are essentially the cost advantages a firm achieves through its size. Whilst Vodafone and Verizon are likely to experience economies of scale currently due to their large respective sizes, such merger could enhance this further as size would increase. Another key reason for such merger could be the increase in market power achieved by the newly created firm who would essentially become, as mentioned, a communications giant within the industry. Market power is also enhanced as competition is reduced, as these two firms who previously may have seen each other as competition are now working in synergy. There could be an element of risk diversification in this deal, as although the companies operate in the same industry, Verizon focuses predominately on broadband communications and Vodafone focuses predominately on telecommunications operations. This factor could also open up a wide range of opportunities for the firm as sharing knowledge between these two areas could allow the firm to excel in all areas of the industry along with the sheer size and scope of the organisation potentially allowed the new firm to consider entering new markets. There could also be a wide range of other benefits to the new firm resulting from the merger in terms of physical resources, human resources and financial resources as the firm would have access to a wider range of assets, a wider range of staff and therefore knowledge pool, along with generating greater sums of cash and in turn greater profits.

The above paragraph suggested some benefits I believe Verizon and Vodafone would experience from merging the two firms, however I feel it is also important to consider the potential benefits on other stakeholder groups. Firstly would consumers benefits from the new global giant? Well in theory if the firm achieved greater economies of scale and increased efficiency, thus reducing costs, they would be in a position to reduce prices. However this may not actually be the case, as instead the firm may be in such a dominant position over consumers and other firms due to increased market power that they instead raise prices and reap the rewards through greater profits. However, the new global giant created is likely to have access to a greater research and development department which may benefit consumers through new products for example to meet ever changing demand. Another key stakeholder group is the employees of both firms involved. It is often the case after a merger that a number of staff roles become redundant as roles in the newly created firm are shared. However it depends on the strategy the firm wishes to follow, as increasing the size of the firm could alternatively result in jobs actually being created. There are also a wide range of other stakeholders who would be affected by the merger of Verizon and Vodafone, such as shareholders who in this case may gain through increased share price of the new global giant, advisors who are likely to gain through high fees resulting from the transaction, governments who will receive taxes from the organisation and local communities who may benefit from increased employment opportunities and improved infrastructure for example.

Whilst this blog has considered the benefits of a potential merger between Verizon and Vodafone, there is of course the flip side, as such merger is likely to result in a number of potential disadvantages. As mentioned there may be employment implications such as jobs becoming redundant due to overlapping job roles. There may also be other issues to consider such as the new company exploiting tax loopholes to avoid payment of tax in a number of ways. However along with these issues there are likely to be vast disadvantages resulting from what would become one of the largest companies in the world, not just the industry. Whilst the new firm would not be a monopoly, it would possess significant power in the communications industry which it could use in a number of ways. For example the firm would have more power over suppliers and more power over market prices which benefits the firm at the expense of suppliers and customers. Such a large firm may even experience diseconomies of scale, as production costs may instead increase due to the size of the organisation. Other typical disadvantages of mergers include ‘culture clashes’ whereby the two firms corporate cultures struggle to integrate, leading to friction within the new organisation or poor ‘consumer perception’, whereby consumers may not like the idea of such a large corporation in the industry and choose not to use it.

So, should they do it? Well obviously the whole process and decision is a little more complex than I have made it seem in this short blog however the concept is true. In this case, a global giant would be created, which based on the evidence suggested in news reports and rumours this week, is a realistic prospect. I feel it would be very interesting for such a large merger to occur. I personally feel the key benefits would be through aspects such as R&D as such a giant would be in a position to create new products which could potentially change the communications industry as a whole. I also feel that if power and dominance was not exploited, then the firm could achieve benefits in the form of economies of scale which could be reflected in areas such as prices, thus benefiting consumers. It is not really possible to tell the impact on areas such as employment, however the potential for job creation is present. I also feel that the shareholders would benefits from such a merger, arguably a view supported by the market based on the 7% increase this week simply on the back of ‘rumours.’ It will be interesting to see what happens regarding this merger in the near future, but in my often optimistic view, I would support it.

Reference in this blog

Arnold, G (2008) Corporate Financial Management. Fourth Edition. Harlow. Financial Times, Prentice Hall.

Would it be beneficial to return to a Bretton Woods style system?

Back in the 1930’s it became almost common practice for countries to deliberately devalue their currencies in order to encourage business from abroad, whether that be in the form of increasing exports or encouraging foreign direct investment (FDI) within their nation. In order to avoid an economic disaster, world leaders and economists met in the mountains of New Hampshire in July 1944 at a place called ‘Bretton Woods’ to establish a system to essentially stabilise the economy.

Throughout these days a system was established which incorporated a number of factors. Firstly the international monetary fund (IMF) was set up to provide short term help for counties with balance of payments difficulties. Secondly the World Bank was set up which provided long term loans to nations and therefore facilitate investment mainly for production purposes. Thirdly the international trade organisation (ITO) was set up to compliment both the IMF and the World Bank, designed with the intention of encouraging free trade. However along with setting up  these organisations, the main outcome of the ‘Bretton Woods’ meeting was to fix each nation’s currency against the US Dollar, which itself was underpinned by the price of gold. This system was designed to remove foreign exchange risk (currency risk), promote international trade and increase globalisation, and in the main, until its demise in 1971, worked reasonably well.

So the main focus of this blog is to consider whether it would be beneficial to return to a system similar to that of Bretton Woods. Now obviously there would be no need to create organisations such as the IMF, World Bank or ITO as these have already been established, however what would be the implications of returning to a world of fixed currencies rather than floating currencies?

I suppose to answer this question we should look at the benefits and negatives resulting from the original system. Firstly there would be the implication of choosing which currency to tie to gold, to essentially fix every other price to. Back in the old system, the US Dollar was used, which gave the United States’ currency a dominant position. However global central banks deliberately pegged their currencies at a low level in order to support exports to the US which lead to the accumulation of massive dollar reserves in the hands of central banks. As central banks held vast quantities of surplus dollars, this meant the US cost of borrowing decreased, allowing it to consume beyond its means, strengthening its economy further against others. In theory this compromised the existence of the Bretton Woods system in the first place, which set out to avoid the problem of deliberate devaluation of currencies. If we did look to return to such a system, such problems are likely to occur again, as there has to be some form of ‘negotiation’ when fixing the currencies which nations are likely to turn in their favour.

Another key problem was that over time the world economy grew and needed more liquidity or reserve assets. Also as the world economy grew, the increased world demand for the dollar as reserve assets meant that US had to maintain increasing trade deficits. As the US was forced to swap dollars for gold, it had to admit that it could no longer keep its pledge to exchange gold for $35 per ounce. Between Bretton Woods’ establishment in 1944 and its demise in August 1971, the U.S. exported almost half of its gold reserves. In the 12 months leading up to the end of Bretton Woods, the Fed lost nearly 15% of its total gold reserves. Given this, it would have to be assumed that the Bretton Woods system would not be able to be implemented again, as no single nation would allow itself to be fixed to the price of gold based on the evidence regarding the Fed losing a vast quantity of its gold reserves.

However whilst this blog has assumed the Bretton Woods system was negative, it actually worked reasonably well through its existence, thus creating a potential argument for its reincarnation. As mentioned foreign exchange risk between currencies was removed. This means that exposures such as transaction risk, translation risk and economic risk were also removed which encouraged investment in foreign nations, thus promoting international trade which led to globalisation. Therefore if such a system was reintroduced, it would arguably lead to increased FDI across the world. When applying this to Dunning’s (1988) eclectic paradigm, such ownership, location and internalisation advantages may exist however firms may be discouraged from investing in nations which traditionally have unstable currencies. However under a Bretton Woods style system, raw material seekers or product efficiency seekers for example, may be more encouraged to invest in nations which may otherwise have had unstable currencies as this risk is removed.

However whilst it may be a ‘nice’ idea to return to the Bretton Woods system, in reality it would never be implemented. In my opinion, no nation would agree to be the main nation and therefore fix its price to gold, as maintaining trade deficits in situations whereby countries wish to purchase gold reserves could ultimately lead to the collapse of a nation’s economy. Also it would reduce liquidity as the foreign exchange market would essentially become non-existent along with arguably the main problem being actually deciding upon the price to fix each individual currency at. I believe that in the current world economic climate, FDI and therefore globalisation will remain without the need for a new system, as companies are constantly seeking nations to invest within which may have raw material, production efficiency or knowledge advantages for example. The potential for FDI is also constantly being strengthened, an issue highlighted earlier this week when David Cameron travelled to India to sign trade agreements, encouraging investment between nations.

Reference in this blog

Dunning, J. (1988) The eclectic paradigm of international production: A restatement and some possible extensions. Journal of International Business Studies. Volume 19 Issue 1. pp. 1–31.

Should a company engage in tax avoidance schemes?

The debate surrounding tax avoidance is an ongoing issue for firms to consider. Google’s chairman Eric Schmidt recently stated publically ‘I’m very proud of our tax avoidance scheme,’ demonstrating how some firms actively seek to avoid tax in the most efficient ways. However whilst this reduces tax and in turn increases profits and therefore shareholders wealth, it can be viewed as unethical by consumers who tend to believe companies should pay the correct level of taxes. So what actually is tax avoidance? Well, in its simplest form, Clausing (2009) explains “tax avoidance takes the form of income shifting” going on to state how “financial responses to corporate taxation include efforts to shift income to more lightly taxed locations.” Therefore tax avoidance is essentially the legal, yet unethical shifting of profits to areas with low tax rates in order to reduce their taxation bill. There are a vast number of ways companies can do this from changing the location of assets and employment to altering the structure of affiliate finance or changing transfer prices between different divisions of the company and therefore different countries. I have chosen to discuss this topic this week focussing on Starbucks, due to its recent media limelight in late 2012 surrounding tax avoidance.

To give some background, Starbucks reportedly paid minimal taxes on profits due to transferring profits to tax ‘tax haven’s,’ therefore ensuring that profits arise in countries which have very low tax rates. Starbucks did this is numerous ways, primarily through transfer pricing between divisions in different countries with examples including charging high licensing fees to the UK branch to reduce profits in this area along with purchasing coffee beans for high prices from Dutch branches to increase profits where corporation tax is low. On the outset this may appear unethical, as the organisation is essentially avoiding paying taxes to the UK government. However, Starbucks is a publically listed business and will ultimately want to generate maximum profits, a view likely to be shared by stakeholders such as shareholders and employees. Tax avoidance is a way in which profits can be maximised, therefore resulting in potential benefits such as higher shareholder equity and increased job security for employees for example. When looking further into ethically theory, Crane and Matten (2010) describe that “according to utilitarianism, an action is morally right if it results in the greatest amount of good for the greatest amount of people affected.” Therefore it could be argued that if a great number of stakeholders benefit from this tax avoidance, which is legal, there is a reasonable argument to justify it.

The issue of tax avoidance will have both positive and negative implications for companies as it did in the case of Starbucks. Whilst they are not breaking any laws, transferring profits to lowly taxed areas and therefore away from the UK is likely to be viewed unfavourably by UK citizens. It is difficult to trace to an extent as they are manipulating the system in complex ways, however when it becomes public as it did in October 2012, this can have a negative effect on the business. The ‘Press Association’ (2012) stated “the owner of coffee chain Costa has revealed a surge in sales as rivals Starbucks were criticised for their tax arrangements.” This report suggests that after the tax avoidance became public, customers moved to competing firms which shows how Starbucks lost out. However there is no tangible figure to suggest the impact of this compared the reward in terms of tax saved over the years.

When looking back at Google, it is reported that Google legally avoided $2 billion in worldwide income taxes in 2011, mainly through sheltering its revenues in Bermuda. As a company, Google are simply exploiting legal loopholes to maximise profits and therefore maximise shareholder wealth. They are simply using tax avoidance schemes to bend the rules in the most strategic, tax efficient way, not break them. Whilst consumers may view this as an arrogant, unethical approach taken by Google, will they stop using the service Google offers? I don’t believe they will, or at least I do not believe enough people will change avoid Google to make it beneficial to not exploit such advantages. I also believe as mentioned that their approach to the situation is one which will be strongly shared by shareholders, thus essentially justifying Google’s stance on the matter.

So after looking at the examples of Starbucks and Google in terms of their views and experiences of tax avoidance, should companies engage in such tax avoidance practices and therefore exploit the system in a legal yet unethical manner? I personally believe Google’s approach to their situation is the correct one. If I was a shareholder in Google, I would want the company to maximise my wealth and if this can be done in legal ways, even if these may be viewed as unethical, I would actively encourage this. I also believe that their open stance on the matter is the correct one to take, as they are not ‘covering up’ their tax avoidance practices which avoids reputational issues in the event they are discovered such as the situation at Starbucks. Also stakeholders in the business such as shareholders and employees know where they stand and therefore it is essentially their choice to engage with and be part of the business. The ultimate question would be along the lines of, ‘Why would a company choose to pay more taxes when it doesn’t need to?’ An argument for this may be to improve the overall image of the company, however as a shareholder, I would much rather a highly profitable company which maximises my personal wealth, rather than a ‘nice’ company which acts ethically.

References within this blog

Crane, A and Matten, D (2010) Business Ethics: Managing Corporate Citizenship and Sustainability in the Age of Globalization. Third Edition, Oxford University Press.

The Press Association (2012) Tax row perks up Costa coffee sales. Aol Money. Available at: http://money.aol.co.uk/2012/12/11/tax-row-perks-up-costa-coffee-sales/ (accessed 24/02/13)

What really is the best method of issue when initially floating of the stock market?

Nowadays, two of the most common ways of raising finance for a firm are through debt finance and raising equity capital. Debt finance in most instances is essentially taking out a loan, whether that be in the form of bonds, bank loans or debentures for example, however the other option a firm has is to sell shares in the company, essentially selling a portion of ownership within that company in order to raise capital. Unlike debt financing, there is no obligation to repay these funds, with the shareholders’ main aim is likely to be ‘wealth maximisation’, therefore essentially raising the long term flow of dividends and in turn the value of their holding. If this is the route a firm wishes to pursue in order to raise capital, then they have to list their shares on a stock exchange. In this case, there are a number of different methods a firm has to choose from, with the aim of this blog to explore which is really the best method for companies.

To make this blog slightly more interesting than reading a textbook, we will consider the example of a football club and therefore consider the alternative methods of issue available if Ipswich Town Football Club (ITFC) chose to raise capital though listing on an equity exchange. In reality this is not too much of a fictitious example as there are a number of professional football teams in the UK listed mainly on the London Stock Exchange main market and Alternative Investment Market (AIM). The AIM market tends to attract firms slightly smaller in size to those listing on the LSE main market due to its lower cost and regulatory requirements, however either exchange is arguably suitable for an ambitious club possessing the history and stature such as that of ITFC.

When it comes to listing on the stock market, a firm is likely to have a sponsor (or nominated advisor for the AIM) in the form of an investment bank or stockbroker for example, who essentially is an expert in the field and therefore guides or advises the company through this process. However we will assume that we do not have this luxury to provide us with their expert opinion on which is the most suitable method of floatation and therefore assess each option individually. So what are the main options available?

·         Offer for Sale

·         Offer for Sale (by tender)
·         Offer for Subscription
·         Placing
·         Intermediaries Offer

The offer for sale method of flotation on the stock market is arguably the most simple of them all. Essentially the shares are offered at a fixed price determined by the company directors. Therefore the directors of ITFC along with the sponsor or nominated advisor would decide on a price and offer the shares at this set price. A variation of this method is the method of offer for sale by tender. With this method, investors are encouraged to ‘bid’ based around a target price at the price they wish to pay for the shares. The bids are then gathered to determine a strike price which would sell all of the shares for the maximum value. Investors who have bid below the strike price receive no shares and those optimistic investors who have bid above the strike price receive the shares receive the shares at the determined strike price.  If ITFC decide to issue shares through the tender method an element of risk is incurred, as although it may result in a larger sum overall being raised, investors may be put off by the task of valuing the company themselves along with ITFC incurring greater costs administering the bidding process.

Similarly to the offer for sale method of floatation is the offer for subscription method. With the offer for sale method, underwriters will usually be in place to purchase shares if they are not purchased on the market by investors. However with the offer for subscription method, underwriters are not used and instead if the share issue does not raise a set minimum, the offer is aborted and the whole issue is abandoned. For example ITFC could choose to offer shares at a price of £100 per share, however if the market deemed this too high, thus resulting in only 50% of offered shares being purchased by investors, then with this method they would have the option to abandon the whole idea altogether. This method tends to be more focused around the initial issuing of larger ‘funds’ such as pooled unit trusts for example where a set amount needs to be raised to make it worthwhile to pursue the idea. In the case of ITFC floating, I feel an offer for sale would be suffice with the underwriter purchasing the remaining shares in such a situation.

The next potential method of issue I feel would be appropriate to discuss is placing. Placing is where the sponsor or advisor dealing with the floatation sells the shares to institutions it regularly deals with. For example the sponsor, who is likely to have a wide range of contacts in the industry, may contact different pension funds to sell the shares in this way. This method is likely to be much cheaper than the alternatives as it incurred much lower publicity, marketing and legal costs. However this method of issue severely limited the spread of shareholders by only offering the shares to set institutions, which could lead to issues such as an illiquid secondary market for example. This method tends to be used for small offerings where the costs of an offer for sale are too high. However I feel that a company the size of ITFC would be able to manage these costs and therefore placing should not be used as the sole method. Another common method, often used alongside placing is that of an intermediaries offer. Like placing, the sponsor/advisors contact base is utilised by offering shares for sale with set stockbrokers who in turn offer the shares to their clients. This offer allows a large number of clients to be targeted, however relies heavily on individual stockbrokers carrying out their role, limiting the control of both ITFC and the sponsor in this situation.

So we have analysed each of the alternatives in terms of the potential methods of issue, should Ipswich Town Football Club choose to raise equity capital. Which is the best method is open to interpretation however in most cases I would suggest the best method would be that which is likely to raise the most from the issue of shares. In this case I would suggest the best option would be the offer for sale by tender. This method, which allows investors to bid at the price they wish to pay, will ensure that all shares are sold and at the strike value which maximises the sum being raised. Whilst this method carries high administrative costs, along with there being an element of risk as investors may be put off due to it being up to them to value the company themselves, I feel that investing in a exciting venture like a football club, should provide sufficient interest to encourage investors to bid in sufficient quantities in an offer for sale by tender issuing. In my opinion, this theory is also true across the board when it comes to methods of issue, as I personally believe the additional cost and slight risk involved in offering shares for sale by tender is worth encountering due to the potential for raising larger sums from the floatation offering.

Stock Market Efficiency: A football industry analogy

A textbook definition of market efficiency would describe it along the lines of:

An efficient market is one where the undervaluing and overvaluing of shares does not occur and therefore, abnormal profits cannot be achieved. This is because current and past information is immediately reflected in share prices, resulting in the efficient pricing of all shares on the market. This does not necessarily mean that all share prices are equal to their true value. It simply means that errors made in pricing shares are unbiased and that price deviations from the true value are random. Another factor to consider is the efficient market hypothesis (EMH) which explains how in an efficient market, when new information becomes available, it is incorporated into the share price rapidly and rationally.  

However for the purposes of this blog, we are going to explore this concept using the analogy of football with players as assets instead of shares. So:

An efficient market would be one where the undervaluing and overvaluing of players does not occur. For example in an inefficient market, Ipswich Town may value their centre midfielder Luke Hyam at £2 million. However Alex Ferguson may spot potential talent in the player that Ipswich and other clubs have not seen and sign him for Manchester United at this price to only discover he is actually a £10 million player profiting abnormally from this purchase. However in an efficient market his value would be £10 million as every piece of current information (including potential future growth) is included in the price. When applying the efficient market hypothesis to this example, in the situation of a match, if Luke Hyam makes a good tackle his value may increase rapidly and rationally to £10.1 million (rapidly as it occurs as soon as the tackle is made and rationally as it is a relatively small factor providing only a 1% increase), however if he incurred a potentially career threatening injury his value may decrease to £2.5 million (with the significant price drop reflecting the potential severity of the information).

An efficient market compared to an inefficient market does have its advantages. Firstly it encourages share buying as individuals can be confident that they will get a fair value for their shares when buying and selling them. In our example, managers may be reluctant to buy players if they feel they may be paying an unfair price for them, or if they feel that when it comes to selling the player, the price they receive may not represent their true value. The second advantage of an efficient market is that it provides company managers with the correct signals. Therefore managers can see exactly the impact that the market places on their decisions. Again using our example, the Ipswich Town management may decide to invest in a new training facility, meaning that players can improve their skills and maximise their potential. In an efficient market, if the market views this as positive, it may be reflected by an increase in player values, giving signals to the management that they have performed well. A final advantage is that efficient markets help to allocate resources. Under allocative efficiency, ways are found to ensure that resources are allocated where they can be most productive. If shares are priced efficiently more funds should be allocated to those industries with the potential for higher growth to ensure that the economy as a whole is as efficient as possible. Linking this back to the football example, this suggests that in an efficient market, young players with high potential should be valued higher than those who are soon to retire, to ensure resources are allocated efficiently across the board.

Successful analysts and investors such as Warren Buffet (whose fund management company, Berkshire Hathaway, returned an average annual gain of almost 20% from 1965 to date) would argue that market efficiency does not and will never exist in reality, allowing people such as himself to continue achieving abnormal returns. However does the concept of market efficiency have any disadvantages for investors? I suppose the main disadvantage on the buying side would be that it does not allow investors to exploit inefficiencies which would significantly benefit them. For example if Ipswich Town wanted to improve their team, they could send out their scouting network around the world to find undervalued players and sign them, either to then sell them on for a higher value to make a profit, or to improve their team at a lower cost as a result of market inefficiency. In this situation, Ipswich Town would have benefitted from the market inefficiency. However this would have come at a cost for the exploited teams that have lost players, who in an efficient market would have been valued correctly and therefore valued at a higher price. Linking this back to the stock market, whilst undervalued shares in an inefficient market benefit the buying party, they come at a cost for the selling party who is not achieving a fair value from their sale, suggesting that efficient market provide fairness for all.

To analyse the extent to which markets are efficient, American economist Eugene Fama (1970) devised a three tier grading system based on different types of investment approaches which produce abnormal returns. These are described in further detail and linked to the footballing example below:

1) Weak Form Efficiency. This type of efficiency claims that all past price movements of a stock are contained in the current share price and therefore abnormal returns cannot be achieved from such technical analysis. When applying this to the example within this blog, weak form efficiency would suggest that a player’s current value is based upon all previous movements of his value and therefore analysing how his value has changed over time to predict his future value will not achieve abnormal profit.

2) Semi-strong Form Efficiency. This type of efficiency claims that share prices incorporate all of the relevant publically available information. Therefore fundamental analysis such as analysing the economic climate nor technical analysis such as analysing past price movement can achieve an abnormal profit as all of these factors are incorporated into the current share price. When applied to the example this would suggest that a player’s value fully reflects all publically available information such as training facilities available, the coaching team and potential future improvement, therefore suggesting that a player’s value will be efficient and that no advantage can be gained from analysing such factors.

3) Strong Form Efficiency. This type of efficiency claims that all information, privately and publically held is incorporated into share prices. Therefore all of the people know all of the information and no abnormal returns can be made, not even from insider trading. In an efficient market a director may purchase (illegally) shares in their company if they know positive news is to be released which will result in the share price rocketing up. However in a strong form efficient economy, everybody would have this same information about the future price rise. When applying this to the footballing analogy, Mick McCarthy (Ipswich Town Manager) may discover in training that a player is actually not as good as the public believes he is as he loses the ball every time he is in possession. In an inefficient market he may try to sell this player for his higher perceived value, however in a strong from efficient economy, all information about this player’s ability will be available to the public and no abnormal returns can be achieved.

What Do Shareholders Really Want?

Shareholders are essentially individuals or companies who have decided that their funds would be better invested in the share of ownership of a company rather than investing this money elsewhere, such as in a bank or in other asset classes. But what do these shareholders really want to happen to their funds?

Now, I own shares, mainly in the volatile oil and gas sector, which probably portrays my personal perception and acceptance of the risk and reward concept. But what do I want to happen with these shares? Well, I suppose the ideal situation would be for the price of these shares to rocket sky high so I could sell them and buy Ferrari’s and go travelling forever. However unless something crazily unforeseen occurs, this is not a realistic objective of holding these. A more realistic view would be for my personal wealth to be maximised through maximum long term dividends and in turn, increased share price. This shareholder wealth maximisation view is one likely to be held by the majority of shareholders in business, however in reality is arguably not as easy as it sounds. The long term approach is key to shareholder wealth maximisation. Essentially a business could increase short term profit and pay large dividends with relative ease, however this is unlikely to be beneficial in the long term. To analyse this concept further here is an example:

Manchester United Football Club could sell their star players, their entire first team and make hundreds of millions of pounds which could then be paid out to shareholders in the form of dividends. On the outset this high dividend payment may appear favourable, however the impact this would have on shareholders is likely to be negative. This is because they would then be left with a weak team which would be unlikely to achieve any form of success both domestically and on a European scale. Other areas such as sponsorship would also likely suffer as companies would have less desire to be involved a less successful, less star-filled club along with lower attendances and less matches shown on television for example. Therefore future dividend payments would significantly decrease due to the club’s poorer financial position and the lower potential flow of future dividends and less potential success will lead to the share price falling, thus decreasing long term shareholder wealth. Now using football is probably not the best example, but this concept applies to all companies and demonstrates how profitability can be maximised in the short term, yet this is not necessarily beneficial for long term shareholder wealth maximisation.

As mentioned the concept of shareholder wealth maximisation is not as easy as it sounds. This is because the agents acting on behalf of shareholders, therefore the directors and managers within companies tend to have conflicting interests to those of the shareholders. As a shareholder, I want the directors to maximise my wealth by improving the long term prospects and success of the company. However it is often discussed how directors do not share this view and are more concerned with their own personal success. For example increasing their own pay, avoiding risky projects and focusing on short term profitability are all areas which benefit directors yet do not maximise shareholder wealth. Increasing profitability may look like a director has performed well and increase their yearly bonus, however if they have reduced investment into research and development to achieve this, then it is at the detriment of the long term success of the business. This conflict of interest between shareholders and directors/managers is known commonly as agency theory in business.

In order to avoid such agency issues and managerialism, methods must be implemented to align the actions of directors with the interests of shareholders to essentially achieve a goal congruence between the two. I feel one of the best approaches in this situation is to introduce incentives such as share options, thus giving directors and managers the chance to buy shares in the future at a price determined at the current date. Such a scheme is likely to encourage directors to focus on the maximisation of share price and therefore essentially shareholder wealth, discouraging managers from an otherwise short term focus. There are also a number of other ideas to consider such as offering managers bonuses based on share price growth or offering pension plans to retain directors for longer periods of time. Whilst such methods come at a cost for shareholders, they are likely to increase their long term wealth, which when linking back to the title of this blog, I feel is what shareholders such as myself really want.