Dividend Policy

In keeping with the main theme of my previous blog posts (shareholder wealth), this post will concentrate on the topic of dividend policy. Many companies are faced with the dilemma of deciding the size of dividend that should be issued or if any dividend should be issued at all rather than retaining funds within the business to help fund future projects for example. From the point of view of the shareholder, wealth can be created from capital gains (an increase in value of the shares owned) or from receiving dividends per share owned by the shareholder.

The 'bird in the hand theory' developed by Linter and Gordon suggests that investors prefer dividends to capital gains as a form of creating shareholder wealth due the uncertainty associated with future capital gains in comparison to the definite gain associated with receiving a dividend. This theory suggests that companies offering high dividends will benefit from a rise in value of their shares as investors will seek to purchase shares in companies offering high dividends and sell shares that offer low or no dividends. Due to the lack of internal information available to investors, the issuing of dividends can be used by investors as a parameter to determine the performance of a company, assuming that a company offering high dividends is performing well and vice-versa.  But is this general assumption accurate? Not necessarily. A company issuing high dividends may be doing so due to a lack of potential future attractive investments being available which in turn could have a detrimental effect on future investment returns. On the other hand, a company offering low or no dividends may have chosen this strategy in order to allocate funds to finance promising investments rather than raising finance externally. These investments could in time prove to bode very well for future returns for the investor. This demonstrates that the size of dividend offered is not sufficient to judge the performance of a company.

A recent example in the news regarding the dividend policy of a company is that of Apple, who announced their first dividend payment since 1995. One may ask why it has taken so long for a company which has recently been dubbed 'the world's most valuable company' to issue dividends to its shareholders? However, it is important to note the meteoric rise in Apple's share value over the past ten years from $10 to over $600. Investors in Apple may not have had the luxury of regular dividends but there is no doubt of the capital gains associated with investing with the company, particularly early investors. This example also contradicts the theory by Linter and Gordon who suggested that companies may suffer from a decrease in share value if they do not issue dividends. Does the case of Apple suggest that dividend payments are not as significant as previously thought when considering shareholder value maximization? It certainly could be argued that way, although I don't believe that this is a typical example as Apple is an extraordinary company. One could argue that if Apple did pay dividends regularly over the past 15 years or so that they may not have been in a position to expand as rapidly as they have done. This goes back to the argument that a company offering no or low dividends may be doing so in order to allocate funds to finance future projects. Either way, I was an Apple shareholder I know I think the news of a proposed dividend would merely be the icing on the cake in comparison to the substantial increase in share value over recent years!

In conclusion, the decision to offer dividends is obviously a contentious topic for the top management of a company and there are many different factors that will ultimately influence the decision. Although offering high dividends to investors may please them in the short term, consideration of future performance must be taken into account as it may not be possible to maintain these high levels of payment, which might become expected, especially if the financing of future projects is jeopardised by the fact that money was spent on issuing dividends.

Capital structure

The balance between debt and ordinary share capital can have an significant influence over the wealth created for shareholders by the company in question. By altering the capital structure of a firm, wealth can be created. Capital structure refers to the level of debt in relation to ordinary share capital (Arnold 2008). Generally speaking it is cheaper to finance a company by using debt finance rather than raising equity finance. This is because lenders of debt finance typically expect lower returns to that of shareholders. Other advantages of using debt finance include the ability to offset any interest from borrowing against pre-tax profits, allowing the company to reduce their tax bill. Another advantage is avoiding the high costs associated with raising equity finance as mentioned in my previous blog concerning raising capital. The capital structure of a company is concerned with the level of gearing a company possesses. By this we mean the proportion of debt in the capital structure of a company (Arnold 2008). So if a there as so many clear advantages associated with using debt finance why do companies often want to reduce their level of gearing and avoid too much of their capital coming from debt? As with most things, there are disadvantages as well as advantages! One main disadvantage with using debt finance in comparison to equity finance is that if the company in question happens to find itself in a period of financial distress due to poor performance for example, they will still be obliged to pay back money borrowed from lenders at the agreed rate. This is all well and good if they are in a position to do so, however if they are heavily financed by debt this may prove to be a big concern. On the other hand, a company which has been financed heavily with equity finance will find itself in a position where it has no obligation to pay dividends to shareholders if they find that they are not in a position to do so and therefore can retain the money within the company, helping them during this time of uncertainty.

It seems that during the recent times of the global financial crisis, the importance of capital structure has become even more prevalent. Many companies have found themselves in a position of financial uncertainty, and restructuring their finances has become a clear focus to them to try and alleviate the problems that have arisen. A recent example of a company which has altered it's capital structure is that of EuroTunnel. The operator of the channel tunnel has found itself returning to profit this year and has decided to buy back some of it's debt to reduce interest repayments. By reducing it's level of gearing it is hoped that the company will have a more appropriate capital structure to cope better with any problems that may arise in future years. The company was able to do this due to record levels of passengers in 2011. In my opinion, the decision to alter the capital of the structure of the company following a successful year is a wise one as it will hopefully allow them to cope better in the future if passenger levels drop again for whatever reason.

As mentioned before, the effects of the global recession have been a strong incentive for many companies to re-consider the capital structure of the firm. Getting the balance right between debt and equity can ultimately decide the fate of the company. I think the move by EuroTunnel to alter the capital structure of the firm whilst in a position to do so was a very good one and shows a level of long-term vision being held by the directors. Despite not being obliged to pay shareholder dividends during rough times, surely the chance of keeping the company solvent should be of paramount importance to any set of directors, with the hope of dividends being available in future years when the company becomes more prosperous.

Corporate Social Responsibility

Corporate social responsibility (CSR) has become a much more dominant objective for many companies in recent times. Whereas once profit maximisation at whatever cost seemed to be the priority of many businesses, now there seems to be much more consideration taken into account of how a company effects all stakeholders that are influenced by it's operations, not just shareholders. This blog aims to affirm the theory that profit maximisation does not need to be sacrificed by a business in the pursuit of operating in a socially responsible manner.

My previous blog regarding foreign direct investment briefly touched on the subject of CSR. Nike and Apple and their controversial operations in their Asian factories were discussed, highlighting the bad publicity that was gained when the poor working conditions in which many of their workers were subjected to, was discovered.

There have several other instances of firms that have hit the headlines for all the wrong reasons. One notable example is that of Body Shop. For a company that prided itself on being a ideal model of a social responsible company, it came a shock to many when certain discoveries showed that in fact they weren't such a leading example. The Body Shop had tried to maintain the image of a cosmetic company that only used natural products, yet it was revealed in a groundbreaking article in 1994 that many of their products contained extensive amounts of artificial colourings. Furthermore, the company had insisted that it gave much of it's profits to charity, but it was later discovered that this was not that case and that during the first 11 years of trading it donated nothing, with very insignificant amounts given after that period. The misleading image shown by the company had a very negative effect on it's share price, with the market value of the shares dropping by 50% once the story broke. This is a perfect example of the increasing importance of companies having to consider how they operate, not focusing purely on making healthy returns. It is clear from this example that indeed not operating in an ethical manner can have a dramatic effect on the image and value of a company.

The company has since dramatically transformed it's image, to be known as a prime example of a company that holds CSR as an integral part of it's strategy.

From an investment point of view, there is some ambiguity regarding what is considered as social responsible investing (SRI). Differing opinions as to whether a company operates in an ethical manner or not can often be an issue. Additionally, there maybe differences in opinion as to what extent a company is responsible for operations in which it is involved with. For example, an investor who maintains strict principles against investing in tobacco companies because of the obvious health implications that are associated with smoking may face a dilemma when considering whether or not to invest in a company that sells tobacco products despite not being involved directly in the manufacture of them. I think it ultimately relates to personal opinion, and some decisions regarding investing in social responsible companies will easier to make than others.

An example of a company that has undoubtedly shrived from maintaining a social responsible stance is Pret a Manger. This company considers the impact of every level of its operations, from using recycled materials in its packaging to shipping ingredients as opposed to using air freight in an attempt to cause less damage to the environment. Pret's popularity has without doubt been effected by it's socially responsible efforts. It is fair to suggest that if they tried to cut costs by operating in a less ethical manner that they would notice an negative effect on sales. This again goes to show that considering CSR is something that companies will clearly benefit from, as well as having an obvious positive effect on many other stakeholders in the process.

Credit Crunch

Since 2007 stories of the 'credit crunch' have been continually been headline news. The BBC defines the credit crunch as 'a severe shortage of money or credit' and this phenomenon has had a profound effect on the world economy. The start of the crisis has been pin pointed to the 9th August when "French bank BNP Paribas told investors they will not be able to take money out of two of its funds because it cannot value the assets in them, owing to a "complete evaporation of liquidity" in the market" (BBC). This news resulted in a sharp rise in the cost of credit. But was this the actual start of all the trouble? It is believed that the 'borrowing culture' particularly in western countries has lead to the economic downturn. In the years leading up to 2007 levels of borrowing were very high. A particular problem was the ease in which people were able to arrange mortgages, sometimes far bigger than the actual value of the property in question. Mortgage lenders were given attractive financial incentives to sell mortgages, resulting in not much consideration regarding whether or not repayments would be met. Since the crisis began mortgages have been increasingly difficult to obtain. Today's situation is very different to the years leading up to the crisis. Today banks are much less keen to lend money, causing problems particularly for first time home buyers who are finding it increasingly difficult to get on the property ladder. Following the dot.com bubble bursting and the terrorist attacks of 9/11, the US Federal reserve tried to stimulate the economy by reducing interest rates to just 1%. The cheap available credit encouraged borrowing and in many cases people were borrowing more money than they were able to pay back. As mentioned before, mortgages were offered to people who were unable to make repayments. These are known as sub prime mortgages and these were ultimately what caused the economic downturn. Banks would pool these loans together, creating collateralized debt obligations (CDOs). It soon became apparent that these CDOs were not worthy of the AAA credit rating attached to them. Once this was realised banks became unwilling to lend to each other. Subsequently many banks faced tremendous difficulties. In the UK, Northern Rock had to be bailed out by the bank of England after it became unable to pay back loans from the money market. Northern Rock's business model was heavily reliant on the inter-bank market so once other banks stopped lending money it had a dramatic effect on the fortunes of the company. Northern Rock used this short term method of finance to fund lending of mortgages. Following the announcement of the bail out, depositors withdrew £1bn in one day in what was the biggest bank run in over 100 years as they were fearful that they would lose their savings. The UK government responded by guaranteeing their savings but the damage was already done.

There was also a dramatic turn of fortunes for many other companies, particularly in the retail sector. Even today, many well known high street retailers are falling into administration. In recent news, companies such as HMV and Game have announced their problems and have been drastically reducing their operations in an attempt to survive.

It seems a stark contrast to the seemingly trouble free years the proceeded the credit crunch. It is not the first time a 'bubble' has burst and it will undoubtedly not be the last but looking back it seemed quite obvious that there would be problems associated with the heavy borrowing culture that engulfed the western world. Despite the credit crunch starting over 5 years ago, the world is still greatly affected by it and many leading economists suggest that it could be until as late as 2016 before the UK can officially say it is out of 'recession'. So the future still looks bleak and I have no doubt that we will see the demise of even more well established businesses. Hopefully a valuable lesson will be learned from all the events that have occurred and perhaps people will more cautious about borrowing money which they are unable to pay back.

Mergers and Acquisitions

Mergers and acquisitions involve two separate companies combing to make one company. As the names suggest, a merger relates to two companies often of similar size combining to make one bigger company. Acquisitions on the other hand involves one company taking over another company which will then cease to exist. There have been several notable mergers and acquisitions in the past, and M&A activity often finds itself in the news headlines. But is the process of making a bigger company by combining two smaller companies always a good thing? Most mergers and acquisitions take place with the aim of increasing total revenue by combining two companies together and also reduce expenditure. Savings can be found in the form of reducing the total wage bill by decreasing staff numbers as many job roles will have two people fulfilling them since two companies have now become one. It is also hoped that the newly formed, bigger company will have more purchasing power and therefore be able to negotiate lower prices from suppliers, again a form of cost cutting. Such economies of scale are perceived as being a significant benefit of merging with or acquiring another company. Additionally this process could allow for a greater share in the market for the new, bigger company which now might find it has significant competitive advantage as one large entity. Furthermore, merging or acquiring a new company is often used a method of gaining access to new markets. For example, in 1998 Tesco purchased the Lotus chain of supermarkets from the Charoen Pokphand group to create Tesco Lotus, Tesco's first Asian Venture. This is an example of one method of Foreign Direct Investment (FDI) as mentioned in the previous blog, and allowed Tesco to quickly establish itself in the Thai food retailing market.

So the advantages of M&A seem plentiful but at what cost? Financially speaking, the cost of acquiring another company can astronomical. Typically a company wishing to buy another company will pay a 30% premium on the share price. Examples of large deals include the acquisition of Mannesmann by Vodafone in 2000 for around $185 billion and America Online (AOL) acquiring Time Warner in 2001 for over $180 billion. Following the acquisition of Mannesmann, Vodafone's share price dropped quite noticeably. Taking into account the general theme of these blogs, the maximisation of shareholder wealth, it could be argued that an M&A activity that decreases the value of a company's share price is certainly not in the interest of increasing shareholder wealth and therefore a bad idea. It has been argued that acquisitions have occurred based on a number of different decisions not related to increasing shareholder wealth. The status of the management of the acquiring company is likely to improve following an acquisition, and this fact alone may be enough of an incentive for a CEO to orchestrate a takeover. Although this may benefit the CEO personally, making him a better known business leader, acquiring a company for this reason alone is certainly not considering the interests of the shareholders. CEOs of smaller companies may also decide to acquire another company in the hope that this will prevent their own company being subject to a takeover. Being acquired by another company is likely to lead to the dismissal of much of the existing management, on average within two years of being taken over. Although it is easy to identify motive for acquiring another company to avoid being taken over yourself, this again is not in the interests of the shareholder. Such conflicts of interest  can allow for acquisitions to occur for the 'wrong reasons' in the eye of perhaps everyone other than the CEO of the company!

Quite often mergers and acquisitions are seen as anti competitive processes and are prevented from occurring by governing bodies. In a recent case, the purchase of airline BMI by IAG (who also own British Airways) came under scrutiny for being potentially anti-competitive. Rival airline Virgin argue that the deal will create a monopoly especially on routes between Heathrow and Scotland and north-western England. Virgin say that such dominance over these routes will result in increased prices and reduced services which will be against the interests of consumers. In response to the deal, the UK's Office of Fair Trading (OFT) has announced that it will not make a review and that the European Commission will be left with the decision of whether or not to approve it.

So overall it appears that M&A activity is not necessarily always a good thing. It can result it job losses, decreased competition, higher prices for the consumers and a reduction in shareholder wealth for investors. The desire to create a bigger company purely to become more powerful is not the right reason to conduct a merger or acquisition in my opinion. With so many other stakeholders being affected, it is crucial that such activity takes place for the right reasons.

FDI - a plan for world prosperity or an exploitative tool for MNCs to become more powerful?

Foreign Direct Investment (FDI) refers to the purchase of physical assets or a significant amount of the ownership of a company in another country to gain a measure of management control (Wild, Wild & Han 2004). Over the past few decades FDI has occurred much more frequently due to a number of factors including increased international trade, closer financial links developing between countries and the removal of capital controls. Overall the world economy has become much more interdependent and FDI is seen as a process that is mutually beneficial to both the companies investing abroad as well as the country receiving investment. It can allow companies to reach and enter new markets, potentially reaping a host of benefits such as lower production costs and access to new technology as well as access to new capital and a skilled workforce. On the other side, the countries receiving foreign investment can benefit from a boost to their economy. Multinational Corporations (MNCs) who conduct FDI can offer thousands of new jobs within the countries they invest in, many of which historically have had high unemployment rates.

Overall it is suggested that FDI is a win-win situation for all involved, but is this really the case? In theory, trade and investment between countries should be a good thing. Open markets create wealth, bind nations together and help create a more prosperous world. Some may argue that large companies should provide more employment for the country in which they originate instead of outsourcing work abroad in pursuit of cheaper production costs. There are many examples of companies who do this, including Apple who outsource the production of their products to Foxconn (a Chinese company) and also Nike who outsource the production of many of their products to Asian countries, benefiting from cheap labour.  

When asked if he would consider increasing production of Nike products in the U.S, co-founder Phil Knight famously went on record to say that U.S workers would not want to make shoes for a living. So what is the problem? The countries receiving investment can benefit from more jobs being available to their population and the company involved can benefit from having access to a low cost labour force who are happy to take the jobs, unlike their local workforce. In theory it is a win-win situation, but what has happened in reality for both Nike and Apple seems to be a stark contrast.
Nike has been criticised on a number of occasions for the poor working conditions that their workers face in their Asian factories. Despite claiming that this no longer occurs, evidence from as recent as 2001 suggests that workers are still being exploited. In a documentary featuring the existence of child labour, the BBC revealed girls working up to 16 hours a day, 7 days a week in Nike shoe factories. More recently Apple has received a lot of negative attention regarding the Chinese company to which they outsource the production of many of their products. Again it is alleged that the workers are over worked, under paid and exposed to poor working conditions. Shockingly there has also been reports of Foxconn employees committing suicide whilst at work in response to the poor conditions they have to deal with. Is this really what FDI is all about? Rich, powerful multinational businesses exploiting poorer countries and their populations in order to increase profits and gain even more power? To me this is not a mutually beneficial situation.

Another concern is the seemingly obvious trend of FDI occuring mostly between countries with developed economies. The world's largest economy, the USA, is also the country which has received the largest amount of FDI. Other countries receiving a large amount of FDI include Hong Kong, the UK and other wealthy European countries including France and Germany. MNCs seem to be reluctant to invest in countries which could benefit most from investment, particularly countries in sub-Saharan Africa. Quite often the opportunity to enter these new markets with a potentially very low cost work force is heavily outweighed by the negative factors associated with these particular countries. A lack of adequate infrastructure is often a a major problem. Political instability is also a common feature of these countries. In the example of Zimbabwe, which would clearly benefit from FDI, Robert Mugabe's regime allows for a particularly unpredictable environment for potential investment in the country. When you look at FDI in this way, it suggests that rather than helping to create a more prosperous world, it actually could result in increasing the gap between the rich nations and the poorer ones.

There are many examples which display the positive effects of FDI, even in Africa. Botswana benefited significantly from FDI, mainly in its diamond mining industry. Between 1970 and 2000 it was the worlds fastest growing economy and saw a big shift in the major source of it's GDP from agriculture to mining. In recent news India has announced that it will open it's doors to FDI in it's food retailing industry which will be good news for many large retailers such as Tesco who have already successfully invested in several other countries including Thailand, South Korea and the US. However, this news has been met by severe opposition from traditional local businesses who are dreading the prospect of such large, powerful organisations being allowed to compete in the market.
I think that this could be a big problem for much of the local population particularly those who currently sell groceries. If food retailing trends in India follow what has occurred in the UK for example, local businesses may be forced to close as a result of being unable to compete with large supermarkets.

Overall I think the idea of FDI is often different to the reality. Although there is much to gain from internationalisation, open markets and increased trade between nations, there are also many problems that can occur. If MNCs strive to keep the interests of the local population as a high priority I think that FDI can indeed increase the overall prosperity of the world.

Corporate International Tax Management

"In this world nothing is certain but death and taxes" - Benjamin Franklin

The quote above is a very famous saying by former US president Benjamin Franklin and
illustrates the truth that taxes are an unavoidable part of life. But is this necessarily true? In reality, tax evasion describes the action of avoiding tax by illegal means and is potentially a very serious crime both on an individual but also corporate level. However, tax avoidance is an often controversial procedure whereby an individual or corporation uses the tax system to their own advantage and as a result benefits from paying lesser amounts of tax. The current UK main rate of corporation tax is 25%, so it easy to see why companies would pursue legal methods of paying a lesser rate. The controversy arises from the assumption that the ordinary citizens of the UK will suffer from large companies avoiding paying the level of tax that is required. With less tax being received from these companies, governments will need to obtain the funds from elsewhere or potentially reduce spending on public services due to less taxation revenues being obtained.

One policy that was introduced initially to protect tax payers has been used as a means for some tax payers to actually avoid paying the required rate. Double taxation treaties have been agreed between several countries, aiming to avoid people and businesses paying tax twice on the same income. An example would be if a company based in one country produced a good in another country but shipped it back to the original country. A double taxation treaty between the two countries would mean that the company would not pay tax on a particular income more than once. However, many companies abuse this policy by relocating operations or even just relocating the head office of their company to a country with a low tax rate. By doing this they can choose to pay tax at the lower rate and avoid paying the higher rate tax required in their original country. A relatively recent example of this occurred with Hendersons the asset management group.

In 2008, they decided to register their headquarters in the Republic of Ireland. Moving from the UK to the Republic of Ireland allowed them to take advantage a lower rate of tax (12.5% in Ireland compared to 25% in the UK). Despite the high initial cost of the move (thought to be around £4.5m), the group have been reported saying that the long-term tax benefits will prove much more significant than than the cost of the move. Hendersons are not the only company to have decided on such a move, many other UK companies have been attracted to relocating part of their business to Ireland due to fact it shares a common time zone and language with the UK as well as the obvious tax benefits. It is clear from this example that companies are more than willing to adjust their operations in an effort to avoid paying higher level of tax.

Another method companies use to avoid tax is known as transfer pricing. Transfer pricing allows multinational companies to transfer profits and costs to different subsidiaries in an effort to avoid paying higher levels of tax. An example of transfer pricing occurs with the three main companies in the banana industry. Del Monte, Dole and Chiquita (all US companies) pay a very small amount of tax in the US and also in the Latin countries where the majority of their bananas are produced. By shifting certain costs to the subsidiaries in the US and the Latin countries where the tax rate is relatively high they are able to report lower levels of profit and therefore are eligible to pay lower rates of tax. On the other side, profits are transferred to subsidiaries in countries where there is a very low or even zero level of tax. This allows them to pool most of their profits together in a country where the tax level is low and therefore have a significantly reduced tax bill. This can be achieved by subsidiaries in countries with a higher level of tax over invoicing subsidiaries in countries with a lower level of tax.

Transfer pricing is often used by companies today, and again is a controversial process. Is it fair that rich, multinational companies bend the rules in their favour so that they end up paying less tax? They are clearly benefiting from avoiding tax but who suffers? In the case of Del Monte, Dole and Chiquita, avoidance of higher levels of tax through transfer pricing could have a serious effect on poor countries in Latin America. Multinational companies like these are avoiding paying tax in certain countries in an effort to increase overall profits, but as a result ordinary people could suffer from less tax being obtained in their home countries resulting in less spending on public services. This is a very contentious topic and questions the ethics of large corporations. Personally I can see why companies would want to reduce their tax bill, and within reason that is ok. But the extent of which some companies exploit current tax systems in a very questionable, but never the less legal way is immoral.