Dividends or no Dividends

Dividend policy is the determination of the proportion of profits paid out to shareholders. The issue is whether shareholder wealth can be enhanced by altering the pattern of dividends not the size of dividends overall. If dividends over the lifetime of a firm are larger then the value will be greater. The board of directors are empowered to recommend the dividend level but it is the right of shareholders as a body to vote at the AGM whether or not it should be paid. Dividends can only be paid out of accumulated distributable profits and not out of capital. The proportion of after-tax earnings paid as dividends varies greatly between firms, from zero to more than 100 per cent. Some shareholders prefer to have a regular income from shares in the form of dividends, these shareholders tend to be people who have invested their savings and need regular income to supplement their income. Whereas other investors are seeking long-term benefits and want to see their share value increase that can then be sold at some time in the future. Some people believe that firms that pay dividends are less risky because you get some money back each year. This belief is common in the popular press and the dividend value can have some effect on share price. Dividends are hard enough to explain when they occur in isolation, a combination of dividends and the simultaneous raising of new capital is very confusing. Yet the simultaneous or near simultaneous payment of dividends and raising of new capital are common in business.

Dividends do not directly reveal the prospects of the firm, so any message they send may be ambiguous. Prosperous firms may withhold dividends because internal financing is cheaper then issuing dividends and floating new securities. Also dividends do not distinguish well-managed prospering firms from others. Someone who observes an increase in the dividend has no good way of telling whether this is a signal of good or bad times. These are hard to evaluate because its difficult to obtain a measure of unanticipated changes in the levels of dividends, and only unanticipated changes could change the prices of shares. Moreover an increase in dividends could be caused either by an increase in the firms profits (implying higher stock prices) or by the commencement of disinvestment as the firm has fewer profitable opportunities (implying lower stock prices). This is consistent with the observation that no-dividend (or low-dividend) stocks are usually “growth” firms, which are regularly in the capital market, and with the impression that such firms start paying dividends only when the rate of their growth has been reduced.

Miller and Modigliani (M&M) said that dividend policy is irrelevant to share value if a few assumptions are made. These assumptions are: no taxes, no transaction costs, same interest rate for borrowers and lenders, all investors have access to information and investors are indifferent between dividends and capital gains.

But in the real world all these assumptions cost and if there is not enough money left to fund future projects the firm would take money from shareholders through a rights issue and this also cost with admin and legal fees, advertising, underwriting fees, brokerage fees and of course taxes.


                                            Apple Inc

                                            Source: Google finance

To bring us up to date, Apple last paid a dividend in 1995. They have now announced that from 30^th September 2012 they will pay a quarterly dividend of $2.65 per share. Was this due to the change in governance rules?. Did the shareholders pressure for a dividend? or did the management get soft-hearted? So it just goes to show that regular dividends are not the always the way to go. I wish I had had the forethought to buy some shares in Apple, but could Apple have now reached a peak in growth and performance.

Ten years ago Apple shares were worth about $10 dollars, now in 2012 after a successful 18 months of sales of Ipad and Iphone they are valued at over $600 dollars. It was revealed that Apple has a cash mountain of $100 billion. Could this be burning a hole in the proverbial pocket? Additionally Apple are to buy back up to $10 billion worth of shares starting in their next financial year. What is the reason for the buy back? Do they want more control over the business? We will just have to wait and see!

Sources: Baker, M. 'A catering theory of dividends'., Easterbrook, F.H. 'Two Agency-Cost Explanations of Dividends', BBC news March 2012.,Google Finance., Arnold, G.

capital structure

Capital structure refers to the way that a company finances its assets through some collection of equity, debt or some other securities. A firms capital structure is then the arrangement or structure of its liabilities. In reality the capital structure may be a highly complex arrangement and consist of many sources. Gearing ratio (or leverage) is that part of the capital employed by a firm which comes from the outside of the business. The Modigliani-Miller theorem forms the basis for modern thinking about capital structure, although it is generally considered to be a purely theoretical system since it disregards many important factors in the capital structure decision making process.

When a company needs to expand or replace some expensive machinery it may not have enough liquid assets and therefore needs to borrow additional finance. Financing a company through borrowing is cheaper than issuing shares. This is because lenders require a lower rate of return than shareholders and the debt can be offset against pre-tax profit thereby reducing the tax bill. The relationship between debt and equity is the gearing ratio, also called leverage.

The two main feature are explained as follows:

The first feature to consider is that, since interest expense is tax deductible, then the more debt used by the firm, the more wealth created via lower tax payments. This is called a tax shield, which has an evident cash value to shareholders, a ready and apparent gain to gearing. As a firm uses more and more debt, the tax shield will become larger and larger, adding value to the firm. the initial value of the firm is the value of the equity, since at zero debt, the firm is financed totally by equity. As debt is added to the capital structure (the debt ratio increases), the value of the firm rises proportionally because of the tax shelter benefit.

The second feature is that risk increases as the firm adds debt to the capital structure. Debt would be very beneficial at low levels, since it is so much cheaper and provides the tax shield. But as large proportions of debt are taken on, the firm begins to be financially distressed by trying to meet interest payment obligations. The more debt the firm adds, the more financially distressed it becomes, less able to service interest expenses for extreme debt levels. Financial distress costs would include higher returns from both creditors and shareholders, as well as costs directly involved with avoiding bankruptcy and costs associated with financial distress and bankruptcy. These costs, at some point, begin to offset the positive effects of the tax shield, and the value of the firm begins to level off, and then to decline.

If the gearing ratio is too high then there is a risk of financial distress so it is better to keep the ratio low. But to obtain the best return it is assumed that there is an optimal level of gearing that could be calculated and maximise shareholder wealth. The problem is what information needs to be used to obtain the this optimum level. Firms would want to use debt, up to the point where the value of the firm is maximized, the optimal capital structure (optimal debt ratio). This is what we would conclude to be a fully rational capital structure decision. Deviations away from this optimal point will result in a sub-optimal capital structure, and the firm would no longer be maximizing shareholder wealth. The idea of maximizing the value of the firm can also be perceived in terms of minimizing the firm's weighted average cost of capital (WACC). As the firm begins to add debt to its capital structure, the WACC falls because the firm is using more of the cheaper form of financing, debt. At some point, however, the WACC will begin to rise as both creditors and shareholders begin requiring ever-increasing returns as risk rises.

Soureces: Arnold, G., Stretcher, R. and Johnson, S. 'Capital Structure: professional management guidance'

CSR to SRI

SRI had an important role in helping to cause the end of the apartheid government in South Africa. From the 1970s to the early 1990s, large institutions avoided investment in South Africa under apartheid. The subsequent negative flow of investment eventually forced a group of businesses, representing 75% of South African employers, to draft a charter calling for an end to apartheid. While the SRI efforts alone did not bring an end to apartheid, it did focus persuasive international pressure on the South African business community and the white minority government.

The mid and late 1990s saw the rise of SRI’s focus on other issues, including tobacco stocks, mutual fund proxy disclosure, and other diverse focuses. Since the late 1990s, SRI has become increasingly defined as a means to promote environmentally sustainable development. Many investors consider effects of global climate change a significant business and investment risk.

CSR corporate social responsibility has now moved to include SRI socially responsible investment in some cases. Mainly due to pressure from investors but also because the fund managers were missing out on money from investors who would not invest in funds that were not ethical. So the fund managers started new funds that were acceptable to the investors. Remember the fund managers job is to get investors money and invest to make more money for the investors and themselves. Now quite a few banks and insurance companies also have SRI funds as well as the unrestricted funds. The Coop bank which has always been ethical and now comes under the umbrella of CIS, cooperative insurance services, has several funds listed as SRI. Other banks such as Barclays and HSBC also have SRI funds to suite ethical investors.

A definition of CSR is 'Actions that appear to further some social good' so a company has to go beyond the norm for the benefit of some social good. This could be helping poverty in a third world country or child slavery or helping impoverished communities. Whereas SRI would be making sure that the investors money is only used in instances that does not involve weapons for example, but should only be used for a positive purpose to benefit society.

                                                        

Take the example of the Co-op who were the first supermarket to sell only Fairtrade Bananas, the growers formed a cooperative and became members of fairtrade that ensured that a premium from the sale of bananas was returned to the growers. This helped the growers to improve their community by building schools and improving there way of life. The Co-op followed later by being the first to sell only fairtrade chocolate. Now other supermarkets have followed and are doing the same. So the Co-op is not only being CSR but also SRI.

Sources: Co-op Annual Report, Wikipedia, EIRIS Report

Rock of the North

In August 2007 the United Kingdom experienced its first bank run in over 140 years. The over publicised queues outside the bank in Newcastle did not help because it encouraged the savers to remove their savings which exacerbated the problem even more. Although Northern Rock was not a particularly large bank (it was at the time ranked 7th in terms of assets) it was nevertheless a significant retail bank and a substantial mortgage lender. In fact,only ten years earlier it had converted from a mutual building society whose activities were limited by regulation largely to retail deposits and mortgages. From the outset, it adopted a securitisation and funding strategy which was increasingly based on secured wholesale money (by issuing mortgage-backed securities) and other capital market funding. At its peak, Northern Rock had assets of over £ 100 billion and a growth rate of around 20 percent for over a decade. Everything was operated within the rules set by the FSA and Bank of England.

 

 


                                   

The bank became heavily dependent on short-term funding in the money and capital markets. And while the business model was successful for some years, the risk eventually emerged in the context of global financial turbulence focussed initially on sub-prime mortgage lending in the US. As the amount of savers deposits were not enough to provide new mortgages to customers the bank raised funds by using the existing mortgages as collateral.

On the face of it the Northern Rock crisis pales into insignificance within the global context. Nevertheless, the Northern Rock is particularly significant because it represents in a single case virtually everything that can go wrong with a bank. Consider the business model of the bank and how, in particular, it exposed the bank to a low-probability-high-impact risk.

While there is no doubt that Northern Rock’s business model was extreme, one can argue that its underlying philosophy was shared by many other banks. The combination of aggressive asset growth, minimisation of capital, and funding risks designed to maximise rates of return on equity as a common denominator.

The Rock's model suggests that, the lower are the cash-assets and capital-assets ratios, the riskier are the banks’ operations.

A decade before the Northern Rock crisis, little attention was given to crisis management arrangements.

The point is made that the retail depositors’ run was specific to the UK .

The Northern Rock episode revealed a unique new role of the government in effectively over-ruling the established Financial Services Compensation Scheme (FSCS) by intervening to guarantee all deposits at a troubled bank.

In 1997, the in-coming Labour government announced a major overhaul of the institutional arrangements for financial regulation and supervision. Since the 2000 Financial Services and Markets Act, the UK has adopted a unified supervisory model. In particular, the supervision of banks was taken away from the Bank of England and all regulation and supervision of financial institutions and markets was vested in the newly-created Financial Services Authority. While responsibility for systemic stability and the provision of market liquidity remained with the Bank of England, it was no longer to be responsible for supervising the institutions that made up the system. There were several ways in which the crisis was managed badly there were public disputes between the three agencies, the Treasury, Bank of England and FSA. The major conclusion of the tripartite authorities following the Northern Rock experience is that the UK needs a special resolution regime for banks.

There is an overwhelming case for having prudential regulation and supervision of all financial firms located in a single agency. Whether it is optimal to have the central bank responsible for systemic stability while not at the same time being responsible for prudential regulation and supervision of the institutions that make up the system. Equally, whether it can act as an effective lender-of-last-resort without having prudential oversight of banks.

The reaction of giving a stronger role to the central bank in times of stress makes sense as it is the organisation responsible for financial stability and in the main such actions can take place without access to taxpayer money, which would require ministerial consent.

There are 5main lessons from this experience that need to be considered in all countries and not just in the UK:
1. Deposit insurance needs to be designed so that;
a. The large majority of all individual’s balance are fully coverd;
b. Depositors can all have access to their deposits without a material break.
2. The activation of emergency liquidity assistance arrangements needs to give confidence that those being assisited will survive, and should be seen as the system working as it should, rather than signalling some breakdown;
3. There needs to be a regime of prompt corrective action for supervisors whereby prescribed actions of increasing severity are required within short time according to a set triggers based on capital adequacy and risks of failure.
4. There needs to be a legal framework such that the fuctions of systemic importance in banks that fail can be kept operating without a material break;
a. Such ‘failure’ should occur before the bank becomes insolvent so that there is little change of losses to the taxpayer;
b. This will normally invovle a special insolvency regimes for banks.
5. Some designated insititution to be in change of intervention in failing banks to ensure rapid and concerted action.

Finally I would like to say that the depositors never lost any of their money because it was covered by the government. But the original shareholders did loose money because although Northern Rock previously had assets of over £1 billion when the government took over they only paid the shareholders a fraction of the true worth. The share holders were, and still are, very unhappy about this and formed the 'Northern Rock Shareholder Action Group'. They say “ We believe it is morally and legally wrong for the Government to dictate the terms of reference for the determination of compensation to be paid to Northern Rock shareholders. We have therefore supported a legal challenge to the approach the Government has taken with a view to obtaining a fair value based on a truly independent and unbiased valuation process using normal commercial principles.”


Sources: The Failure of Northern Rock: A multi dimensional case study, Northern Rock shareholder group,

Virgin Rock & Roll

So Virgin Money has bought Northern Rock. But not all of it. Northern Rock was nationalised in early 2008 and split in two in 2010. But only the banking and mortgage lending arm of the old Northern Rock bank that are now housed in Northern Rock Asset Management, and lives under the umbrella of a state agency called UK Financial Investments. This part has been bought for £747 million by Sir Richard Branson's Virgin Money.

So what about Virgin Money? Where did it come from? How did it start?.Virgin Money was started in 1995 as a seller of financial investments. It grew into an online financial "supermarket", offering things like credit cards, insurance policies, personal loans, pensions, investments, mortgages and ISAS. But it did not have any high street branches it was all 'online', not even any conventional bank current accounts.

But at the start of 2010, it formally acquired a banking licence, paving the way for it to become a proper deposit-taking bank.

Now having got a licence Mr Branston was in a good position to get some real branches for his bank. And this is where Northern Rock comes in, with an offer to buy it from the government holding company. But How will this fit with virgin Moneys customers?

Virgin has more than 3 million customers to add to the one million savers and borrowers and 75 high street branches of Northern Rock. This all looks very rosy but it all depends on how to two sets of customers merge together. Virgin still has a lot of work to do re-branding all the branches with the Virgin Logo. And remember it is 'small' compared to the big four or five banks who have hundreds of branches each. But its a start and if Sir Richard's previous enterprises are anything to go by it will get a lot bigger.

What will happen to the customers of Northern Rock after the acquisition?. Under the rules of the Financial Services Compensation Scheme (FSCS), savers' funds are guaranteed to be safe up to a limit of £85,000 per saver per institution. But as Virgin and Northern Rock are keeping their banking licences a customer would be covered up to £85,000 in each 'bank'.

Sir John Vickers',( Independent commission on banking) argued strongly that more High Street banks should be created to stop banks "exploiting lack of customer awareness or poor regulation".

It is expected It will start to offer current accounts in 2013 and later start lending to small businesses. So we have a merger between Virgin Money and Northern Rock following the acquisition from the state agency called UK Financial Investments.

Remember Northern Rock was split up in 2010. So what happened to the other part?.More than £28bn has been injected by the government into the Northern Rock in the past few years. Although some has already been repaid, the bulk of that debt to the taxpayer lives on with Northern Rock Asset Management, which still owes the Treasury £21bn. Whether the taxpayer i.e. you and me, will ever get our money back remains to be seen. Maybe over a long period of time after loans and mortgages have been repaid we might break even, but I doubt it.

Sources: BBC News, Virgin, FSCS.

Juice Stuff

Juice is a popular category; its retail value in China was expected to grow 94% by 2012 compared to 30% for carbonated soft drinks. In one high profile incident the Chinese government rejected Coke's $2.4 billion bid to buy Huiyan juice, a leading juice company in China.

           

                                                                         Huiyuan Juice  

                                       

Foreign Direct Investment from all sources in China in 2010 rose to a record $105.7 billion, underscoring confidence in the growth forecasts. The Coca-Cola Company built its first bottling plant in China in the decade after the First World War and was the first company to distribute its products in China after Deng Xiaoping opened the country to foreign investors in1975. Today Coca-Cola has an ownership stake in 24 bottling joint ventures – in most cases indirectly through two Hong Kong based companies it partially owns: Swire Beverages and Kerry Group. Coca-Cola also operates a wholly foreign owned enterprise that produces beverage concentrate in Shanghai and is the direct joint-venture partner in a similar facility in Tianjin.

                                                        

                                                       Coca-Cola       Coca-cola's own Juice

The benefits of the company's success are widespread that in addition to the 14,000 employees Coca-Cola directly supports in China, the company's suppliers, distributors, wholesalers, and retailers employ an additional 400,000 people. Coca-Cola has updated the country's old state-owned facilities introduced improved product – quality testing, and provided training programs for managers in the industry. The company's total investment in China during the last 20 years has exceeded $1.1 billion. As well as selling its own brands it has also developed local brands through Tianjin Jin Mei Beverage Co. Coca-Cola is expected to invest $4 billion over the next 4 years to expand into other beverages such as fruit juice, which is very popular, and dominated by local producers.

Staying on top in China's beverage industry will not be easy for Coca-Cola. The company, along with other foreign soft-drink companies, is eager to see China reform its administrative policies: a new bottling plant currently requires a three-year wait for government approval, and concentrate production volume must be re-authorized annually. China's World Trade Organization agreements with the United States and the European Union do not address soft drinks specifically, though they do address national treatment issues that could level the playing field between foreign and local competitors. Another major hurdle facing the company is an increasingly competitive domestic beverage industry--in part because of Coca-Cola's own efforts to develop the industry's supply and distribution links. 

Why did Coca-Cola opt for joint ventures and local distributors? Probably, because of the problem of how to deal with local customs and markets. Joint ventures are the only way of doing business for a foreign business in china. And local distributors are the best way of understanding how to do business and communicate with local conditions. 

Sources: Coca-cola, & coca-cola china, Huiyuan Juice

FOREX OR NOT FOREX THAT IS THE QUESTION?

Sage is a global company for software and software service, they have 6.3 million companies and organizations using its software and services. And 70% of its profits were earned from outside of UK, the business involves working with 24 countries and they have subsidiary companies in those countries. So we can imagine the currency exchange rates could mean a lot to them. And I start wondering how are they going to be dealing with this multinational currency exchange? Whether they can make money out of it or loose it that's all going to affect their share value in the end.

   

From the 2010 financial report I have seen that they use a number of methods to help with this problem. They used a multi-currency revolving credit facility that matures in 2015 to replace an earlier facility that they cancelled, no doubt they calculated that the new facility would save them money. They also have long-term borrowings, short-term borrowings, short-term bank deposits and cash at bank and in hand.

According to Arnold there are risks such as Transaction, Translation and Economic. The Transaction risk happens when you might receive payment from a foreign country using their own currency that you will have to exchange to sterling. The agreed selling price may not be equal to the received price after the foreign exchange transaction – you might gain or you might loose. In fact Sage translation difference gained £140.6m in 2009 but only £10.5m in 2010 according to their 2010 financial report. The Translation risk happens when the company needs to express the foreign currency into, say, sterling so it can be included in the financial report. But although the foreign currency may have a 'good' figure in its own country after converting into sterling it is subject to the spot price on the day which may give a false impression on the balance sheet. This could then cause an Economic risk to the company which could affect the share value. It may be that Sage uses multilateral netting or Matching to reduce the cost of exchanging currency. Multilateral Netting is where subsidiaries settle intra-organisational currency debts for the net amount owed In a currency rather than the gross amount. Organisations, such as Sage, who have a matrix of currency liabilities between numerous subsidiaries in different parts of the world need a central treasury so that there is full knowledge at any particular time of the overall exposure of the firm and its component part.

They have certainly used cash flow hedging by borrowing in the money markets. This means they can get the money to cover their exports until they receive the payment from the importer to pay back the borrowed money. This improves their flexibility and helps to insulate their economic risk.

Even in these uncertain times I think Sage is doing well and their financial advisers must be doing their job well also to ensure the financial efficiency of the firm.

Sources: Sage Annual Report, FAME, Arnold, G.