Should companies remit dividends or are there better uses for the money?

Most shareholders in the UK expect to receive interim and yearly dividend payments from their investments. Companies do not have a legal requirement to pay dividends every year. They can choose to retain the cash which would have been paid in dividends, to either invest in new projects or just to strengthen their cash position.

The vast majority of companies simply pay shareholders dividends every 6 months which reflects the performance of the company in theory. Although dividends do not have to come from that year’s profit, as long as the dividends are paid in cash, they can be from previous years. This can lead to misleading information being given to investors about the financial state of the company.

One company which chooses not to pay dividends is Apple. Recently they announced that they are going to start paying dividends to the shareholders, but this is the first time since 1995. Apple are starting to pay quarterly dividends due to the American requirements of quarterly reporting opposed to interim and final dividends generally seen in the UK. In the past Apple have used the money that would have been paid out as dividends to use for investments in research and development, strategic prepayments and store openings for example, along with building up a cash reserve of $97.6bn.

Through starting to pay dividends, Apple may find that shareholders who preferred to gain value through increased share price may choose to leave and invest elsewhere through Clientele Theory. This is where investors choose companies which work best for them i.e. either a company that pays regular dividend to act as income or does not pay dividend but benefit through capital gains.

In general, it is expected that investors will receive a regular dividend and choose to receive a dividend as opposed to capital gains, but every investor is different as shown through the range of investment opportunities.  Although as shown through Apple, investors are happy to not receive dividends as long as the share price is increasing. A share in Apple ten years ago cost $10; the same share today is worth around $600.

Another option for companies which was suggested by Modigliani and Miller (1961) is for companies to use the amount that would be remitted as dividends, to invest in projects to increase the value of the company which in turn increases shareholder wealth. This is what has happened at Apple since 1995. They argue that any spare money should be invested in projects with a positive NPV and then any remaining cash should then be given out as dividends. Therefore, dividends will only be paid if all positive NPV projects have been pursued and the company has spare cash lying around. Although there are many assumptions and criticisms to this approach, I believe it does make the most sense as a way to increase value for shareholders in the long-term which is the primary aim of companies.

For companies to give dividends out to investors, when there are projects that could increase the overall wealth of the shareholders, then surely they should be pursued instead? By investing in projects with cash that was meant for dividends, should increase the share price in the long term through the positive NPV nature of the investment. Some investors have a preference for dividends over shares for tax reasons and vice versa, so I understand the difficulties businesses face when trying to please all investors.

The Modigliani and Miller view says that dividends should be paid, just not regularly. Personally I believe this to be a better option for the business and long-term value of it. If there are positive projects that can be pursued, then using dividends to pay for them is a better option than borrowing and increasing the gearing of the company. If there are years or periods when there are no suitable investment opportunities then dividends would be paid based on Modigliani and Miller’s view.

Some companies choose to pay very small dividends out such as Microsoft, who generally pay 20 cents a quarter to investors despite having a strong cash position. People are still willing to invest in companies which either does not pay dividends or pay very small ones, showing regular dividends are not always important supporting Modigliani and Miller’s view. Microsoft only began paying dividends in late 2004 and although the yearly amount may be small in comparison to other companies, their dividend amount has increased over the years. Microsoft have been able to pay a small dividend to shareholders along with retaining a strong cash position for future investments.

I believe that dividends are a good thing to show the company is performing well, but agree with the Modigliani and Miller view that regular dividends are not always necessary and further investments should be made with any available money to help increase the value of the company, in turn increasing shareholder value.

(Sources – BBC News, The Financial Times, Modigliani and Miller (1961))

Optimal Capital Structure – is there such a thing?

The idea of an optimal capital structure has been around for many years and relates to the financial makeup of a company and the split between debt and equity finance. The optimal capital structure of any company, relates to the point where debt financing is equal to less than the cost of equity. It is the best debt to equity ratio for the company to maximise its value. Basically, finance the company through debt until the cost of debt becomes higher than or equal to the cost of equity, as generally the cost of equity is higher due to the expected returns. Although, debt financing is risky and in turn adding more debt into the company, will increase the shareholders required rates of returns, due to the extra risk factors.

Personally, I believe a structure that is less focused on debt and has a lower gearing level is better, regardless of whether it is classed as being the ‘optimal capital structure’. The lower the debt, the lower the risk in a way, as even in a recession debts still have to be paid, whereas dividends do not have to be issued.  Through the latest recession, many companies have gone into administration through reliance on debt and high levels of gearing. Examples include Peacocks, Blacks Leisure, La Senza and major banks have been guilty of having reliance on debt finance. The theoretical ideal believes that through not reaching the optimal point, companies are basically ‘robbing’ shareholders of potential wealth. While this may be true, the idea of shareholder wealth is to create wealth over a long period which is sustainable. If companies reach the optimal point and are highly geared, in times of economic hardship this could affect the shareholder negatively, compared to a competitor which has a higher percentage of equity.

Some companies also take this view and actively work to reduce the amount of debt and gearing levels they have within the company. For example in 2009, De Beers raised a rights issue, in order to improve their capital structure and reduce the amount of debt through increased equity. This happened at a time when diamond prices were at a low and through decreasing the amount of debt, reduced the demands upon them during a recession. This was through reducing the required monthly repayments of the loans, as shareholders do not have to legally receive a dividend each year, unlike loans which have to be repaid on time.

Increasing debt level can help to reduce the tax bill of the organisation as debt interest payments are tax deductable, unlike dividend payments which are paid after tax, again increasing the cost of equity compared to debt. I can fully understand why companies use debt as a financing tool, due to the low cost available to them, but there is a risk of becoming dependent upon debt like Thomas Cook did and when recession strikes, high debt levels can case large problems which raises the question is debt really the cheapest option when an economic downturn occurs?

When Modigliani and Millar (1958) wrote their first major paper on optimal structure, they made the assumption that tax was not a relevant factor. This lead to them having to revise their paper in 1963 to take into account the affect tax can have upon businesses, although they seemed to say the best option was to load up on debt, moving companies away from the traditional model of capital structure and the optimal capital structure.

Personally, I agree with the traditional model, where loading up on debt and having a high gearing level impacts the required returns due to the high risks involved. We have all seen the prices that are paid for having unsustainable debt levels, although, every company is different and recession proof industries may be able to cope with high debt levels. The optimal capital structure of a company has to stem from the strategy of the business and the views of existing shareholders. If shareholders are debt adverse, then they will dramatically increase the required rate of returns, meaning debt finance may not be the best option.

I can see why companies try and chase the optimal capital structure of their business, due to the benefits of reduced Weighted Average Cost of Capital, but is it in the company’s best interest to spend a considerable amount of time on this when the resources can often be put to better uses? Industries have a ‘norm’ and companies aim to be within their industry norm to prevent investors feeling they are risky. We have all seen the impacts of being too debt dependent, through the latest recession and many companies going out of business, so surely it is in the company and shareholders best interests to pursue a capital strategy which works best for them and enables them to run the business efficiently?

References – BBC News, Modigliani and Millar, Arnold – Corporate Financial Management, The Financial Times

Socially responsible investment – are they really an option for individual investors?

Investors are looking for highest returns possible when choosing investment opportunities and it is becoming easier to purchase shares individually, without going through a third party broker. This has increased the opportunities for individual investors, as previously many of them would have not invested due to having to go through a third-party. This change in availability has increased the number of potential investors, along with reducing barriers to entry for small investors.

Investors today are becoming more socially aware and some only wish to invest in companies they view as being socially responsible. Can investors afford to pick and choose investments? Or should they just be focused on the returns. Companies have to declare what they are doing in terms of being socially responsible, is this a waste of resources for them and taking them away from their primary objective of increasing shareholder value?

What is Socially Responsible Investment?

The idea of socially responsible investments (SRI) has been around for many years, with the origins being drawn back to the Quakers and Methodists, and even earlier. The beginning of SRI was rooted in religious ideas to define what was right or wrong.

Renneborg et al (2008) define SRI as ‘an investment process that integrates social, environmental and ethical considerations into investment making decisions’. The definition of SRI has developed since its beginnings and moved away from religious factors.

The meaning of SRI will be different depending on individual views and beliefs. For example some investors may only want to avoid weapons companies, whereas other investors may have a longer set of investment criteria. Individual investors tend to have a larger amount of criteria than institutional investors.

UKSIF (The Sustainable Investment and Finance Association) promote ‘responsible investment and other forms of finance that support sustainable economic development, enhance quality of life and safeguard the environment’. They provide help for consumers wishing to make socially responsible investments with a list of companies who are ‘members’ of UKSIF and provide SRI opportunities. This helps to promote SRI along with making it an opportunity for all investors to get involved in, regardless of whether they are core or broad investors.

There have been many empirical studies to investigate if SRI provides lower returns than other investments, due to the smaller number of SRI investment opportunities. There has been no real link between SRI and low returns.

Therefore, I believe that SRI is a good thing as investors are able to choose investment opportunities which fit their beliefs and values and are able to make a real difference to the way businesses operate. The power of SRI can be seen through the requirements that have been in place in many countries since 2000 and require companies to explain what they are doing to promote SRI if any. This has shown that socially responsible investments are clearly very important to a range of investors.

In terms of companies having to produce SRI and reports, I believe that they are also important as through producing these reports and explicitly stating what they are doing, they are increasing the number of potential investors, which in terms leads to increased funds for development. As there is no link between SRI and reduced returns, for me personally, SRI is definitely something that I would consider in the future.

(Sources – Reeneborg et al (2008), UKSIF, http://www.neiw.org)

Are the Bankers really to blame for the latest recession?

During 2007, panic hit the financial markets and started a knock on effect within the global economy. Banks were verging on collapse, many had to be bailed out by governments and some even went under. This continued into 2008 and even today we are still feeling the effects of the 2007/2008 recession globally.

When it first started in 2007, no one could have predicted the domino effect it would have and the number of people that would be directly affected by the financial crisis. Through banks collapsing and the financial industry being affected, it appears that every one like you and I have been affected in some way or another. Now nearly 5 years on every time you sit and watch the evening news there seems to be a story that can draw its origins back to the 2007/2008 crash.

Even though most people would agree and the press certainly believe that the mess we are in now is mainly due to the bankers and their extravagant ways and the culture of the banking industry, are they really to blame? Are bankers and the banking sector just an unfortunate scapegoat in this whole incident? Prior to the financial crash the economy was based on debt. Loans were used by businesses and consumers alike to fund their day to day lifestyle. You could argue that, this was unsustainable and cracks had to start appearing somewhere.

The start of the problem can be traced back to the US sub-prime mortgage market and the way loans were given out to potentially unsuitable customers, then debts being traded between banks with untrue credit ratings.  So potentially the cause could be argued originated from banks providing loans to unsuitable borrowers for more than the full value of the property.  

I believe that a small amount of ‘blame’ could be placed on the customers and businesses who took out these loans often worth more than the actual capital required. I agree that the banks should not have given money out like it was water, but the people who took the loans probably knew deep down that they would struggle to repay the loans and did not consider what would happen if interest rates changed. If going by this argument, today’s society could also take its share of the blame. Consumers have to have the latest gadget and product and are willing to borrow more and more to finance their ‘ideal’ lifestyle. I believe personally that if you cannot afford it and it is not necessary then it’s not worth going into debt just to ‘keep up with the Joneses’.

Critics have tried to identify the major cause of the global economic downturn. Pin pointing the cause is difficult. Many people have identified numerous events which causes knock on events to happen, but no starting point has been agreed in reality. One event that is seen as a major cause is the collapse of Lehman Brothers. They collapsed due to high debt levels.

An alternative argument in the Lehman Brother case could be that the Federal Reserve played a major part through not coming to the aid of Lehman Brother like it did with other banks. Though Lehman Brother’s being allowed to collapse, this started a catastrophic spiral of events that were felt around the world.

The collapses and problems in 2007 and 2008 have lead to a huge sovereign debt crisis especially in the Euro area. Countries are having their credit ratings downgraded due to potentially not being able to repay their loan repayments. The country struggling the most is Greece who are having to implement huge austerity cuts in order to meet repayments.

People again are saying that it is the banks fault for lending to countries, but I personally feel that the governments have to take their fair share of the blame. In the UK government spending was reaching extreme levels and I believe that changes had to be made in order to make the country self sufficient again. Governments were implementing huge initiatives with public money and then spending public money and needing to borrow extra. In Britain the taxes received did not cover the annual expenditure and this has been going on for many years. Today the majority of European countries have debt of at least 50% of the country GDP, so it is going to be a long struggle to regain control of public spending.

Personally, I do believe that the bankers were a major cause of the financial crash but in my opinion there are equally important factors that all helped cause the crash. For the press and media it is easy to latch onto one group and place blame on them, but it has had a negative impact on the reputation of the financial industry which is a major source of income for the country. So, all causes should be identified as opposed to using one group as the main targets.

(References – BBC News, Sky News, Wall Street Journal and The Economist.)

Pharmaceutical Mergers and Acquisitions

Mergers and acquisitions go through stages based upon economic conditions. The current stage is fuelled by debt as companies are using debt to fund mergers and acquisitions. Some of the companies that are being bought are suffering from high debt levels and facing administration.  An example of this is Peacocks who are being bought by Edinburgh Woollen Mill.

There is high sector concentration with mergers and acquisitions. This is due to the risk factor. Shareholders do not need companies to protect themselves against risk through diversification, as shareholders can easily diversify their own portfolio cheaper and quicker. This means companies generally stick to industries similar to their core business activity.

One industry that uses mergers and acquisitions for many reasons is the pharmaceutical industry.  They keep to the sector concentration theory as they buy either competitor pharmaceutical companies or research and development facilities. Through mergers and acquisitions, pharmaceutical companies are able to purchase competitors patents, access new therapy areas reducing the R&D investment and gain access to international markets.

For this industry, I believe that mergers and acquisitions serve a real purpose as even though they may not create a vast amount of shareholder wealth, they are providing services to a wider population. Many pharmaceutical companies admit that shareholders are not their main priority. For example, Johnson and Johnson put the patient’s needs first and work to satisfy their needs and requirements as opposed to increasing shareholder wealth.

Currently gaining access to international markets is becoming increasingly important due to the healthcare reforms in developed countries. Governments are reducing their expenditure on innovative healthcare products and moving towards cheaper generic products, therefore savings that mergers can create are important. Emerging markets are spending more on products making them an increasingly important market for companies to enter and create a presence.

Pharmaceutical mergers are normally a form of ‘synergy’ due to the share of resources and the combined companies being worth more together than apart due to economies of scale and market power. Critics of mergers within the pharmaceutical industry have claimed that shareholder wealth is being destroyed rather than created.

The majority of pharmaceutical companies have under gone a merger at some point in their history. Examples include SmithKline Beecham and Glaxo Wellcome to form GlaxoSmithKline and Merck and Schering-Plough joined together in 2009.

One company who may wish to consider mergers and acquisitions are AstraZeneca. They recently announced redundancies due to the large number of patents expirations within the near future and increase competition from generic products. An option for them to gain patents without spending huge amounts on R&D and by-pass the lengthy testing phase which can take up to 10 years. If they purchased a company with existing patents they could use the high revenues towards R&D and new product development.

Through numerous mergers and acquisitions within the pharmaceutical industry, a set of ‘key players’ have emerged which effectively keeps new developing businesses out of the industry. As the companies are judged by size and activity, it may lead to moves that are not in the shareholders’ best interests and are done to increase the status and power of the company.

Within the pharmaceutical industry, mergers and acquisitions increase consumer access to products and provide essential funding for R&D activities. It does also lead to increased prices due to the power of the key companies, which in turn leads to NHS trusts in the UK not being able to afford these life-saving treatments. Is it unfair that companies are able to create monopolies and try everything within their power to deny generic drugs access to the market?

Generics are cheaper versions of drugs that are off patent and within the pharmaceutical market is a huge business. Doctors and hospitals tend to offer generics opposed to branded products, so you could argue the leading businesses are trying to protect themselves by doing what they can to reduce generic competitors. Without the big companies creating innovative products, generic competitors would not have the ideas to create cheaper versions of patented products.

I believe that for a vital industry such as the pharmaceutical market, any method which is able to advance medication and increase access to these life saving products is worthwhile. Advancing treatment areas could be at the expense of shareholders due to the lower returns, caused by the lack of focus on them. This is the nature of the market and if the shareholders do not agree with how the healthcare services work then they can easily move their investment, to one which provides higher returns. Personally I would invest in the pharmaceutical market as at some point each and every one of us will use a selection of these innovation treatments that help to save millions of lives every day.

Therefore within the pharmaceutical industries, I believe mergers and acquisitions are a great way of sharing technology and lowering costs. Another method that pharmaceutical companies use are joint ventures as ways to create new innovative medicines that offer value for money.

(Sources - The Financial Times. Wall Street Journal, BBC News, GSK, and Pharmaweb).

The Car Industry and Foreign Direct Investment

Foreign Direct Investment (FDI) is a method companies use to invest and expand in another country. This can either be done through Greenfield investment, through the acquisition of another company or through joint ventures. Each method offers different advantages and disadvantages and decisions are based around the purpose of the FDI and what works best for the company.

There are many reasons why companies use FDI instead of licensing or exporting. Licensing can spread knowledge which can reduce any competitive advantage the company currently has. Exporting is expensive and there can be trade barriers depending on the country of import. Hymer (1976) identified these two factors as the main reasons companies choose FDI.

Recently Fiat has announced plans to invest in Russia. They are spending $1.1bn to build a Greenfield project in St Petersburg, which they hope will help them to enter the Russian market successfully. In addition to the purpose built plant, they are also entering into a partnership with local company ZIL to assemble the cars. FDI has been chosen over importing due to the high costs of getting the cars from Italy to Russia.

Within the car industry joint ventures are common as they enable the companies involved to reduce costs and share technologies to produce a style of car. An example of a successful joint venture is PSA Peugeot Citroën and Toyota. They created a joint venture in 2005 to produce a small city car. They produce three cars: the Peugeot 107, Citroën C1 and Toyota Aygo. The three cars share the same technology with the only differences being cosmetic for example the rear lights. This means production costs are low, meaning that the high costs of shipping them from the specially made plant in the Czech Republic does not create a high selling price.

Through the joint venture they were able to develop an affordable range of cars built for city driving and target an increasingly important market due to the low emissions and cheap running costs. If they had all individually created a car, the costs would be much higher and that could have affected the sales figures.  They were able to share technology and built a specialist plant in Koln to assemble the cars. They then adapted the cars to target their own potential customers with minor cosmetic changes.

The potential problems of building a plant to produce the cars in Koln such as high import duties can be reduced through bi-lateral trade agreements and double-taxation treaties between governments. These will help reduce the costs of transportation and make it cheaper to import rather than build in the desired country.

Personally I feel that FDI is a great choice not just for companies to expand but also for the local economies. When companies chose to develop either through a joint venture, buying a company out or Greenfield investment, jobs within the local economies are either created or retained.

Although the downside of this is that FDI typically is between developed countries, rather than investments in developing countries that would really benefit from investments and job creation. Once companies have invested it is important that the jobs are sustainable and are not negatively affecting the local economy. A problem of FDI is that when large companies enter local markets they often create problems for local companies who are unable to compete with the lower prices offered by the large multinational companies.

The current problem with FDI is that it tends to be between developed countries that do not need large cash investments. If companies invest in developing countries, FDI is one of the first things to be reduced during times of financial hardship. When companies do invest in developing countries, they often take employees from a certain sector which creates the question does FDI create jobs or just substitute one job for another? Either way, FDI does help the local economy and provides an essential transfer of resources such as knowledge or capital.

How do companies use different international tax rates to their advantage?

Tax is a major issue for companies today and can affect competitiveness of the company. All companies would like to lower the tax bill; this creates more shareholder value which is the overall aim of companies. Internationally, corporate tax rates vary dramatically and companies are looking to move to ‘tax havens’ in order to reduce their tax outgoings.

Well known tax havens are Ireland and Switzerland. Within Switzerland the Canton of Zug has one of the lowest corporate tax rates in the country, today around 12-25%. Many companies have offices or headquarters there including Boots, Siemens, Zstrata, Tata AG and Johnson and Johnson. Ireland has a corporate tax rate of 12.5- 25%.  These rates are significantly lower than the 28% paid in the UK and companies who operate from Switzerland or Ireland can make real savings on their tax bill.

There are 26 Cantons in Switzerland which make up the federal state and each canton has its own constitution, legislation, government and courts which is why tax rates can vary within Switzerland itself. Switzerland in general is seen as a tax haven for companies.

Some people would argue that it can be viewed as ‘un-fair’ that businesses move around to gain benefits from lower taxes. In some ways they would be right as everyone else has to pay income tax so why should companies get away with avoidance? Companies offer great benefits to the local communities they are based in. They move so that they can benefit from lower tax bills which creates more available funds for investments and growth, which achieves the long-term objective of maximising shareholder value.

Johnson and Johnson’s pharmaceutical and biotechnology sectors are primarily located within Europe, in particularly Ireland, Belgium and Switzerland. The facilities there can produce the products and they have R&D facilities. They then sell the products to relevant subsidiaries around the world. Through the method of transfer pricing they are able to retain a large amount of profits within Switzerland and Ireland where the tax rate is lower. The UK subsidiary can benefit through only paying tax once due to double taxations treaties with Ireland since 1998, Switzerland since 1977 and Belgium since 1987.

Through techniques like over invoicing, profits can accumulate in the lower tax regions. Johnson and Johnson report figures as a whole and by sector and as long as the figures remain in the correct sector it does not cause an issue to top managers or investors.

One disadvantage to having facilities in different countries is the affect currency variations have upon pricing. The Johnson and Johnson (J&J) plants in Europe all invoice out in GBP so the European based subsidiaries take the risk, rather than the UK subsidiaries purchasing the goods. The invoice is created on the day the goods leave the warehouse, so by the time payment is due, currency exchange rates can have changed dramatically especially with the current problems in the Euro Zone which is a form of transaction exposure.

Another type of currency exposure J&J have to deal with is translation exposure. This is due to all reports having to be produced in USD, as they are incorporated there and trade on the NYSE. Each subsidiary company hedges to protect against currency differences.

The savings companies’ makes in re-locating to countries with lower tax rates must more than compensate for the currency risks that occur through the currency variations. I therefore can see why people do oppose companies moving to gain tax breaks, but I can see why companies do it. They have more income which they can use for other projects or investments which could help the community in the longer term. Governments today are trying to reduce these ‘tax havens’ so companies cannot save large amounts by moving country. This may work for a while until they are able to find another area which offers low taxation rates.

(References – BBC News, Bloomberg, The Financial Times, Johnson and Johnson and Corporate Financial Management – Drury.)