Dividend Policy- Don't Rock the Boat

Dividend wealth is an interesting topic for conversation when it comes to rewarding shareholder investment.  My original thoughts on dividends were that such insignificant figures would make little difference regarding fluctuations.  This was before I was made to realise the scale of investment made in companies from insurance and pension funds.  It’s a crazy concept that the future of our retirement is massively dependent on the dividend policy of these huge companies.

There are arguments, when considering NPV that would recommend company profits would be better investing in ventures with a positive rating.  Such ventures would be claimed to raise the value of a company, thus boosting shareholder wealth.  Only residual cash left from profitable ventures would be repaid as dividends using this concept.

Modigliani & Miller echo such sentiments, claiming that dividend policy has no effect on company value.

In reality however, it can rarely be seen that dividend policy has no effect on company value.  Of course, in a ideal world where humans are rational, the understanding that dividends may be low due to a high level of invest activity which would boost their wealth.

Unfortunately, humans are very irrational and such fluctuations would likely lead to a mass exodus.  If several shareholder looked to sell their shares at the same time, the share price would fall.  Although M&M’s idea is theoretically true, in the real world dividends play a huge role.

Looking at the BP Gulf of Mexico oil spill, the announcement that BP would be halving their dividend payment resulted in panic from UK pension funds, fearing such a decrease could cost the UK millions in the long run.  Although not the only factor, BP’s share price suffered badly as a result of this announcement.

It can therefore be seen that shareholders, being the irrational, over-emotional being that they are crave stability.  A constant, un-fluctuating dividend yield is met favourably, thus companies have reacted to this by attempting to maintain a steady dividend payout, regardless of good or poor performance. 

Although investors may look on such a decision favourably, I would consider it a bit of a shame that shareholders are so insistent at focussing on their short term gains, that they cannot see the bigger picture- that maybe a company’s surplus cash could be put to better use, which would eventually lead to an increase in their own wealth.  To ask shareholder to think long term is quite possibly too much of a revolutionary step I fear. 

Captial Structure: Is there an optimal level?

Optimal capital structures are an interesting (and complicated) area of research.  Personally, I’m quite a fan of the traditional view.  At the risk of sounding like a grumpy old man; back in the day, people seemed to be more sensible.  What happened to the days of companies having a concern for their levels of debt?  Of course, debt is cheap but debt is also constant.  What the good times are here, having a cheap source of capital is great... but what about the bad times?

The traditional approach considered the idea that although debt was cheap, WACC would only decrease to a certain point, where the financial risk was considered to be too high, thus seeing WACC decrease as equity was used as a source of capital.  The optimal capital structure was seen as a delicate balancing act.  ‘Was’ being the key word...

It seems in current times, or at least before 2007, shareholders were content with the risk involved in taking on massive amounts of debt because of the returns they were seeing.  Satisfied that they were maximising shareholder wealth, companies were happy to take on more and more debt.  Then came the point when the ‘credit crunch’ sunk its teeth into a bloated and unsuspecting world.  Suddenly debt finance became impossible as banks collectively panicked over their enormous shortfalls from carelessly loaning out money to any person that could ‘walk and chew gum at the same time’.  Companies like PC World that based their short term cash flow forecasts under the assumption of acquiring cheap debt struggled for survival, and shareholder wealth was obliterated.  Oh for the good old days.

A reason for this blasé attitude appears to stem from the research of Modigliani & Millar (1958), who suggested there was no optimal capital structure, and company value is based on business risk.  The assumptions made in this study were rightfully torn apart by academics, who found the idea of assuming no tax to be laughable.  With nothing being ‘certain but death and taxes’, I’m inclined to agree with the academics.  After a rethink, which included tax, it was found that debt was a significantly cheaper source of capital which would lead to company value being improved if this emphasis on debt was used.

Of course, humans seem to crave an excuse to do something if they can justify it, thus the loading on of debt became almost commonplace.  After the deregulation, which stems from the 1980’s, banks took this opportunity to greater levels which has finally resulted in the chaos we see today.  Only after such a major failure has any action been taken to rectify this, with the introduction of Basel III as an attempt to rectify this problem. 

Personally, although you cannot deny the benefits of debt, the level we have allowed our businesses, governments and ourselves to become reliant on debt is ridiculous.  It is a damning assessment to look at our inability to be sensible and level headed.  As soon as the banks were deregulated, greed seemed to override common sense.  Is there an optimal capital structure?  Most definitely.  Are we anywhere near it?  Looking at the mess we’re in after our love affair with debt, probably not.  Oh for the good old days...

Investment Appraisal

Investment appraisal appears to merge two of the most important issues in the world of business finance; planning and shareholder wealth. An interesting thing about investment appraisal is the reliance on figures that are at best speculative. Can there be any real value to a practise that relies on estimation and assumption? Can the reliance on these tools actually create risk?

Some techniques used, such as payback period and accounting rate of return may provide insight into if/when the project can be profitable. The assumptions however compromise the techniques in their simplistic nature; rarely will a business' cashflow be so constant as to make payback period a reliable tool. The same issue can be said regarding accounting rate of return, with the use of profitability being far too easy to manipulate.

Despite it's obvious flaws, the considerations that are made involving time value of money are of great use to anyone considering an investment. If a business could be deemed to be marginally successful based on the current value of money, the risk of inflation diminishing any potential profits is far too significant not to consider.

Net present value (NPV) is also to analyse which objectives will generate shareholder wealth through goal congruence. If the calculated NPV figure is positive, it is recommended that investment should be made. The calculation of NPV has been criticised as being too complicated. As much as this may be the case, the evidence of it's use over many decades suggests that the benefits that can be reaped from this tool is such that the complications are justified.

The big debate revolves around whether people can deem the estimates made in investment appraisal to be accurate enough to trust. Personally, I would suggest that estimations in their very definition should not be trusted as absolute fact. Of course the estimation is, in successful investments, based on a great deal of market research which adds far more value and reliability to this tool. Based on the amount of research, and the fact that the people making these appraisals for multinational companies are making obscene amounts of money, the world of investment appraisal is a tool that companies would be foolish not to use. As always, it's a case of 'fail to plan, plan to fail'.

The Global Financial Crisis- A warning of things to come?

The start of my university life back in September 2007 coincided almost perfectly with the emergence of the dreaded credit crunch.  Walking down Northumberland Street to see countless people queuing outside of Northern Rock provided me with a great source of entertainment.  I saw it as a massive overreaction made by people that consider the scaremongering of the media to be gospel truth.  To an extent, I was correct; government policy protected the first £75,000 in a person’s bank account.  To actually learn the extent of the problems the economy faced on a global scale is quite terrifying, and utterly infuriating.

The level of confidence in the marketplace before the financial crisis was incredible.  The house market was booming, credit was cheap, and everything was rosy.  Collateralised debt obligations were a big source of this increased liquidity in the market, which promised a source of cash depending on the rating assigned by the credit rating agencies.  The rate of return in the AAA rated assets were so high, even banks were utilising these options.

Incredibly, these banks that were supplying long term mortgages were investing in assets that depended on the success of the mortgages they were issuing.  Confidence was so high in these assets, banks built up assets around these CDOs.  The problem arose when the house market began to decline, which saw the increase on defaults on mortgage payments.  All of a sudden, these ‘safe’ assets became far less secure. 

The cash shortages created a chain reaction that went on to cripple the banking sector, leading to panic amongst the public that their hard earned saving were at serious risk.  Suddenly cash became a rare commodity and successful businesses were finding it increasingly difficult to fund their operations as a result of this shortage.  The decision made by the UK government to offer a bailout option to the banks illustrates how severe the situation became, with the bailout dwarfing the annual cost of running the NHS.

The use of the word ‘confidence’ in this blog to describe the mood towards the marketplace is perhaps a poor choice.  Confidence implies a belief in the ability to succeed, yet the banks ability to succeed was so heavily hinged on the housing market and CDO’s, that the word ‘arrogance’ seems more appropriate.  The importance of planning, spreading risk and assuring cash is always available has been emphasised at every aspect of my business education.  How is it that bankers were so blind to this? 

The arrogance in assuming the bubble could never burst, that market value will continue to increase is beyond belief.  To not consider the possibility of a problem emerging in the future as a result of ‘putting all your eggs in one basket’ is madness.  To find a source of this particular financial crisis and focus on avoiding that particular mistake again is to miss to the point in my opinion however.

Maybe there will be greater regulation in future regarding the assumed security of investment assets, but in 10 years time, house prices will still demand staggering mortgages, banks will still take out loans to fund these mortgages and the world will run on the assumption that credit will be available to them to get by.

It is frustrating to think that we, the taxpayer are the victims in this financial crisis and I sincerely doubt we will ever get so much as a ‘thank you’ from Northern Rock or RBS.  It is scary to think that we appear to have applied a band aid to a broken leg in making no drastic changes to the regulations surrounding business.  Maybe we will learn from our mistakes and prosper from a more restrained credit system.  I worry however that we will continue to make the same fundamental mistakes in future.  Maybe the next time we see a credit crunch, the ramifications could be far more serious than public spending cuts and increases in tax.

Mergers and Acquisitions: Shareholders Worst Nightmare?

Mergers and acquisitions are an interesting concept when linked to shareholder wealth.  With much of the emphasis on businesses based around maximising the wealth of shareholders, you have to ask how exactly mergers and acquisitions achieve this for the bidding company.  Looking at Jensen and Ruback’s study, rarely do you observe any significant gain for the bidding shareholder’s company.  If the bid fails, it can be expected that both sets of shareholders will see a loss.

Looking at the recent case of JD looking to takeover JJB, the initial announcement from JD stating their intentions was met with JJB’s shares rising over 30%, whereas JD’s shares rose a modest 1.5%.  Evidently, JJB’s shareholders saw this as a far more exciting prospect than that of JD’s. 

 As a shareholder, Warren Buffet seems to meet mergers and acquisitions with a degree of hostility, citing the loss of wealth on the acquiring shareholders to be a key reason.  It seems JD’s shareholders have a similar opinion.  Why would they wish for their company to shell out for a target company’s shares at a massive premium rate? 

Mergers and acquisitions seem to display an area of business where the objectives of shareholders and management differ.  Some of the pro-M&A arguments revolve around the cliché lines of ‘increased efficiencies’ and ‘synergy benefits’, but looking into quotes from John Kay, there seem to be a degree of egoism from management.  “The thrill of the chase” is an irresponsible mentality from managers tasked with the duty of maximising the wealth of the shareholders.  With Buffet’s analogy of ‘frogs to princes’, the cynicism shareholders can hold towards M&A’s to be evident.

Of course there can be genuine advantages involved for businesses if made correctly.  For companies looking to expand their operations to other countries, investing in an already established framework can save a considerable amount of time and money that starting from scratch.  Wallmart’s takeover of Asda is a great example of how to expand to other countries, and with Tesco’s faltering attempting to start from scratch in America; it shows that M&A’s are not always a bad thing.

Coopers and Lybrand saw the significant causes of merger failure to be based around the differing cultures of organisations- with possible hostility being created between the two companies, and a lack of planning post-acquisition.  Astonishing to think that some companies can be so blasé when it comes to assuming the chase is the difficult part.  A lack of planning causing failure is inexcusable and egotistical.

With it coming to light just a few days ago that JD have pulled out of the JJB takeover, and JJB quoted as saying that JD’s bid plan “lacked certainty”, perhaps the takeover would have been met with the exact problems that have been observed in the past.  Maybe JD have dodged a bullet here, and looking at their share price rising by 5.3% compared to JJB’s fall of 10% after this announcement, it looks like JD’s shareholders are breathing a sigh of relief that they won’t have to be ‘kissing any frogs’ any time soon.

A favour to ask

Hello

I'm just posting this to ask a favour of you in regards to my dissertation research. 

If you could spare a minute of your time to fill in a survey I have created, it would be hugely appreciated!

The link to the survey is:

http://www.surveymonkey.com/s/RTSRJBW

Thank you!

Also, seeing how this is a business blog, I thought I might draw your attention to the Forbes rich list article from the BBC website:

http://www.bbc.co.uk/news/business-12691377

The richest man on the planet, Carlos Slim saw his personal wealth rise £12.65bn this year.  To think that any one person is deserving of that amount of wealth is a tough pill to swallow.  Surely this amount of money is doomed to be hoarded, generating little benefit to the rest of society.  Hats off to the man, he has divulged in philanthropic activities and has been quoted as having little care for rich lists, it just amazes me that he has gained this amount of wealth in a country where per capita income is less than $15,000 a year.  How have we let the world get to a state where rich are allowed to prosper to such an extent?  From this article that dates back to 2006, the UN highlights that 1% of the global population holds 40% of its wealth.

 Personally I think it has become out of control.  I don’t want to come across as a raving Socialist, but how can this be right?  To quote The Wire, “F**k "right," it ain't about "right," it's about money”.  How depressingly accurate...

Foreign Direct Investment

FDI- Foreign Direct Investment.

A long term investment that ideally acts as a mutually beneficial venture between the involved parties. In my eyes, FDI is the perfect concept of how capitalism should work. You go into a country and provide them with jobs, improve the standard of living of potentially thousands of people and boost the country's economy; in return you are given a benefits that could only be dreamed of in your home country. Sounds perfect.

Yet looking at the real life examples, this 'win/win' concept rarely seems to happen. On either side, there are examples of people taking advantage of each other. When you look at companies like Nike, the sweatshops that have been discovered show a capitalisation on a workforce that are treated hugely unethically. There is a fine line between co-operation and taking advantage of each other. Far too often, we see this being the case. Nike being one a a long, long list of companies that have been exposed as to treating this foreign workforce as slaves.

On the other hand, there are examples that can be seen from the World Investment Report that shows an ever increasing investment in developing countries. When you the the benefits that China and India have experienced, and in turn, the positive impact that companies and consumers all over the world have experienced as a result of effective FDI, you can see that it is a brilliant concept.

The reasonable cost of the goods that we can purchase in this country are a direct result of these companies taking advantage of these clear and obvious benefits of things such as transport costs, avoiding export constraints in the case of the European Union, the 'win/win' can be massive.

The shame is when you see the countries that are in such dire need of trade, such as Africa that are being ignored. In a perfect world, I would love to see these countries utilised more in future. The capitalist dream needs to be expanded to benefit more areas to capitalise on more trade opportunities and improve the standard of living of people that are struggling to survive. FDI in these areas could be the key to this.