Business first, Shareholder wealth second!

Dividends! This is the only word that comes into the mind of investors especially shareholders. All they think about is returns, returns, returns. They leave the decision making into the hands of the managers who's obligations are to make sure the shareholder's investment reach as far as possible to create shareholder wealth maximisation whilst at the same time encourage profit maximisation. Shareholder wealth is achieved when the sum of share price and dividends for the year is greater than the previous year's share price as described by Porterfield (1965). However M&M (1961) challenged  that idea by suggesting share prices were determined by future earning potential and not by dividends paid now.

This idea goes further to suggest that a rational investor is indifferent to capital gains and dividends. This i believe means shareholders dont necessarily care about the method of returns but rather the idea of just knowing they are going to be paid. But again M&M argue that it is better for a firm to prioritize the idea of increasing their market value, which in turn will increase share price and in turn increase shareholder wealth. To do so means any little overflow of cash a firm makes should rather be injected into an investment project that generates a positive NPV as this will give a firm the end result it desires, and in the case of surplus after the investment, it should be paid as dividends. Should there be no surplus after the investments, no dividends will be paid.

Based on the M&M idea, i do not think it to be something the shareholders will be finding favourable, especially in the case of those wanting quick dividends returns rather than reinvesting it back into  the business for future potential investments. Most firms in their annual reports make it a duty to highlight the share price trends as well as the dividend rate their company offers as they know  these are the details investors will be looking forward to see. But as it happens there are also some firms who  have alternative thinking shareholders that are after greater market value first and shareholder wealth second. These are the M&M followers i guess. But another approach as to why some firms decision to not pay dividends but rather use surpluses to pay down debt is because it wants to lower their gearing level hence reduce capital  risks. A good example of surpluses used in paying down debt is that of Vodaphone's minority stakes 'Verizon Wireless' who's parent company is Verizon Communications. Apparently the parent company has ordered the Verizon Wireless not to pay dividends (since 2005) and the cash generated by the company should be used to pay down debts (as reported on 4th April on FT.com by Simon Mundy).

The example above simply suggests that most managers are  in the habit of putting the organisation's interest first and then the shareholders second. In a way it makes me think it is quite a logical method, considering it is better knowing the financial position and value of an organisation is going strong than just focusing on the needs of the shareholders. In the real world, shareholders would not exist without a business and without a business there will be no shareholders, so its vice-versa. Therefore if a business stands firm so should shareholder wealth maximisation respectively.

 

Capital Structure- Good returns, Happy shareholders

In a world where everything revolves around finance, there is no doubt in saying business decisions are always financially based whether it is  a profit or non-profit organisation. Finance in the form of capital is what determines the beginning of a business whether it is a large or small corporation. However the bottom line is, capital is what runs and keeps the business going, but what is the consequential side of obtaining that source of finance? There are at least two sources of capital, Equity and Debt, and both are affected by the level of risk, meaning the implication of gearing within a capital structure.

Equity financing is a means of obtaining capital from shareholders, whilst Debt financing is a means of obtaining capital via borrowing and is viewed as a cheaper method of obtaining finance than Equity. The risks involved in these methods of finance is determined by an indicator known as gearing. Dependant on the level of gearing as well as the level of debt, this affects the overall WACC and this determines the level of  rate of return a firm receives based on the investment it finances.

Without one knowing the real methods used in obtaining capital to finance prospective investments, one might think it is quite simple to choose which investment is  more appropriate based on how lucrative the future of the investment might be and ignoring other factors such as the cost of capital. Businesses with strategic visions of growth really do play around with their capital structure to ensure the best method is always favourable to their organisation by providing them not only with good returns but also maximum shareholder wealth. It is now understandable  as to why high importance is given to capital structure as any mistakes done will have a  dramatic  effect on the organisation as a whole and the hope of the shareholders will be shaken. With this  in mind, careful financing of debt with the right level of gearing ensures financial security.

Investment Appraisal and Risk Analysis

The society at large more or less dwells on the perception of having investments just to make good returns, either for profit maximisation or shareholder wealth maximisation depending on the focus of the firm itself.

The issue of investment has a much larger scope than anticipated, for instance not only do we have the basic knowledge of investment; which is present to give us a profit or some kind of an advantage (as stated in lectures), but also in deeper terms, investments involve a lot of calculative estimates to allow further planning which will determine whether or not a project investment is carried out.

There are several ways of investment appraisals which will determine the initial investment and the estimated costs (variable and cost of capital) involved for any project. The methods used to make such calculations include NPV, Payback Period, ARR and IRR. All these methods have different outcomes but only two (NPV and IRR) of them consider the ‘Time Value of Money’ as well as the idea of ‘shareholder wealth maximisation’ for NPV, and these two are much more complicated to calculate unlike the other two methods (ARR and Payback Period). Either way these methods provide different outcomes and depending on the outcome they give or show of a higher profit, will end up being the chosen method for a project, but not with-holding the fact that for a project to be fully considered, risks assessments also have to be acknowledged and taken into account.

Investments risks are such that unforeseen circumstances or events may occur so in order to make better projections for future projects, risks have to be considered by making calculations for risks allowance in the estimated budgets. Businesses nowadays conform to either of the three (Sensitivity analysis, Scenario analysis and Profitability analysis) analysis to judge the financial risks involved in the world in general. In some cases risk allowances can easily be made except in the instance of natural disasters etc; there are some events that even with risk analysis it was not enough to resolve the issue. Such issues include the current financial climate of what we now know as the ‘credit crunch’ (though not a natural disaster but even the risk analysis could not justify this crisis caused by the US economy which we’re all still paying for worldwide) as well as the most recent natural disaster event that is currently on the news and has once again shaken up the financial economy which is the Japan earthquake and Tsunami. The Japan crisis has caused a lot of more uncertainties especially with the added crisis of the nuclear plant that blew up.

Certainly no matter how much estimated projections can be made by management in terms of plans to carry out projects, it is my belief that investment appraisals and risks analysis is just not enough to make a satisfied judgement on projects, considering the occurrences of natural disasters e.g. the Tsunami, Nuclear explosions and even the war currently taking place in Libya. Businesses or projects are just a ‘give and take’ in terms of risks and investments, its either you’re in or you’re out!     

Aftermath of the credit crisis- Lehman Brothers

The credit  crunch has not only occurred once but twice. The first being in 1929 followed by the Wall Street crash in 1928. The second occurrence on the 'credit crunch' was said to have begun in August 2007 although there are still some arguments to suggest otherwise. Nontheless the credit crunch began as a result of money shortages where banks were not willing to lend to any other banks. This then led to a high on the amount of Mergers & Aquisitions (M&A) considering some companies were no longer able to survive alone and needed another to depend on hence the mergers and takeovers.

One of the first major US bank that was allowed to collapse without any assistance from the US Federal Reserve was the 'Lehman Brothers'. Being a huge financial provider/lender it was a huge and yet negative news when they announced of their of approximately $3.9bn in early September and just a couple of days after the that announment, they decided to file for 'chapter 11' bankruptcy protection in September 2008. After this event, the banking industry began going downhill as the banking system was being demolished, this definately had an adverse effect on the banking industry globally as a whole.

Looking at the effects of the credit crunch today (four years later) especially in the case of the Lehman Brothers the financial economy is still upon the verge of a rival from the recession, and the famous Lehman Brothers just before their announcement of bankruptcy they deposited an amount of $2bn with Citibank in June 2008 which they are trying to recover from current legal proceedings. One of the current issues on the business news lately was that the Lehman Brothers have appointed their trustee (James Giddens) to carry on the legal proceedings against Citibank for not returning the $1bn deposit given to them for foreign exchange settlement services. So now the trustee is sueing them and seeking $1.3bn for the Lehman Brothers' creditors. Citi group on the other hand are stating their refusal towards this matter and classifying the matter as an 'unjustified claim'.

I think that the decision Lehman Brothers did so secure their $2bn deposit with Citibank was a wise idea considering they later filed for chapter 11 bankruptcy as the US Federal Reserve refused to bail them out financial. So really even though they owed a few millions to Citibank that did not mean it was within the right of Citibank to keep hold of that deposited money and say they used it to cover up the debts and costs they were owed by the Lehman Brothers. Surely even in the court this idea would have to be considered as am sure a contract of some kind was signed prior to the filing of bankruptcy. So what will the future hold for other companies that were affected by the 'credit crunch'.

Are mergers always good or bad?: why merge?

The main aim of a business who has investors such as that of 'shareholders' is to increase shareholder wealth so in the case of mergers and aquisitions, i would expect this theory to remain a top priority for the merged companies.

Though mergers are suppose to benefit both shareholders and the organisation as a whole in both companies i believe this depends on how successful or unsuccessful the takeover is for the target and bidding company as described in a survey by Jensoon and Ruback (1983) on US firms.

Mergers and aquisitions are actually risks due to uncertainties, because no matter what the figures may represent, one cannot always tell the outcome of a takeover until after a few months or years. This will inturn be reflected in the joint company figures as well as that of the dividends (if any) for shareholders. There are a few reasons which have been highlighted by a survey by Coopers and Lybrand, which state the possible reasons behind a merger failure and a merger success. The reasons they highlighted made alot of sense and in the case of why mergers fail; i think the reasons given are something that can be seen as 'common-sense' by companies which should be avoided before embarking on a takeover or any joint venture.

Mergers are always meant for good but there are different motives as to why a firm would merge. For some it maybe for synergy, bargain buying, managerial motives, but i think most would merge because of 'market power' as this will enable a firm more sector control and global integration. Companies that plan to be successful after M&A, would have previously outlines a clear purpose for their actions, and would have analysed both company cultures as well as possible gains in order to ensure the success of their M&A.

Earlier in the week was the news of a merger between DemandTec to aquire M-Factor, which took place on March 9th 2011. M-Factor provides predictive analytics software for marketing and trade whilst DemandTec specialises in connecting retailers and consumer products companies. Together the companies are hoping to collaborate and produce a hightech "science-driven framework for optimising marketing mix ...". Prior to the aquisition the firms highlighted the gains of their current aquisition, this meaning they might have followed the 'reasons for success of M&A' as described by Cooper and Lybrand. Altogether their reasons of this aquisition i think is an opportunity for grwoth and integration, but the success of these two companies will depend on the company cultures and how well they operate within their sector for a competitive advantage before they would even think of obtaining 'market power'. But again only time will define the success of this aquisition, for now all looks 'bright and beautiful'.

China opportunities - Tesco's International Strategy

With the current manufacturing boom in China, it has now become the land of opportunities for many international investors around the world. I mean with room for cheaper labour and ability to for international companies to set up their manufacturing departments in such a land, what else can be more lucrative for organisations than to try and cut costs and aim at making thier shareholders happy due to the possibilies of higher profits.

Such thoughts might just have been what was going through the minds of the Tesco executives when they decided to invest in Asia especially China and Korea where they saw a more 'foreseeable future' in terms of not just international growth but overall growth for its organisation. At the moment Tesco's biggest competitor is Sainsburys with a current-year earnings multiple of 14.6 and Tesco's current-year earnings multiple being just 12.9 times. This is definately far less than sainsbury's but with Tesco investing in developing countries such as China and other Asian countries (as well as the Tesco banking group) this has given them some kind of competitive advantage over their competitors one way or another.

Currently Korea is Tesco's number two best seller, and part of the reason for this is due to the strategies (skills, resources, experience) that have been implemented which will be deployed to their stores in China. As one can see Tesco are using the 'Foreign Direct Investment' (FDI) method to their advantage as they use this power to exploit new markets in countries that have future prospects. With FDI i think Tesco has made the right moves as tax in Asian countries are cheaper than that of the UK plus there is rapid technology change happening in Asia faster than anywhere else in the world meaning one can implement technical changes into the Tesco operations much quicker and cheaper again giving them more competitive advantage over their competitors. Personally not only is FDI beneficial to Tesco but also to its host countries in Asia as it allows them to benefit from global growth hence increase their economical growth. With better infrastructure, low tax, cheaper labour, better currency exchange, who would not want to exploit the great opportunities of Asia especially China being one of the largest economies of the world?! The future is bright, the future is Asia.

Multinationals and Corporate Risks

Global trading is part of the reason behind interdependence of countries thus the move towards businesses becoming multinationals via FDIs. This move has encouraged and exploited a lot of businesses both foreign and domestic allowing organisational growth.

With foreign trade, comes the baggage of exposure risks and different investment schemes. Currently due to the recent economical crisis that is making most companies struggle through this recession period has proved that a times the whole aspect of an organisation both domestic and foreign can be adversely affected. Take for example, the article by James Rossiter (The Times, 2008) about Tesco and its joint ventures. As a result of the economic crisis a firm such as Tesco (who strategically expanded their business to cut costs i.e tax) must have suffered from all aspects of its business worldwide due to the effect of the economic climate. Such economic crisis brought about so many risks exposures which firms had to embrace whether it was transactional, translation or economic. In the case of Tesco, all three of these exposures were exercised as these were macro-economic factors that could not be avoided regardless of the provisions made. The economic external environment is one of the main causes of market volatility as it directly affects inflation, tax and exchange rates.

Still using Tesco as an example, i believe the organisation made a great strategic move to spread its business as a multinational via joint ventures.  This has allowed the organisation to  reach some form of economies of scale especially with regards to tax evasion. Businesses with sound focus on achieving profit or shareholder maximisation could adopt the strategies of Tesco enabling them to get the best in terms of foreign investment and global integration helping them to spread their products and services in a manner that is cost effective as a whole.

In general the issue of corporate risks for multinationals is not something that can be avoided but its something that can be dealt with in order to minimise the impact of risk exposures on an entity via better preparations and provisions. Drawing a curtain on the negative part of multinational risks and exposure, the movement of global trade has provided the opportunity for business growth and integration. So whether a company's vision is to maximise profit or provide the shareholders with the best returns, the best way is through FDI enabling cost efficiencies.