Is there a trade-off between present cash dividends and future capital gains?

There is always controversy around corporate dividend policy, which is really challenging for the directors and financial manager of a company. Since different investors have different views on present cash dividends and future capital gains, it also brings up the controversy around the effect of dividends on share price：whether it is relevant to dividend policy or not.

Representative of one standpoint is two Noble Laureates, Modigliani & Millar (1961), who states that investors don't really choose between future gains and cash dividends, i.e. dividend policy irrelevance. They believe that investors do not state any preference between current dividends and capital gains. They say that dividend policy is irrelevant and is not deterministic of the market value. Therefore, the shareholders are indifferent between the two types of dividends. All they want are high returns either in the form of dividends or in the form of re-investment of retained earnings by the firm.

However, M & M’s arguments are based on some assumptions such as no transaction costs, no taxes, everyone has free access to all relevant information, etc., which is often not the case in reality. There are always transaction costs and time cost for every investor who sells and purchases stocks. And income tax is at 10%, 23% and 40% while capital gains are taxed at 35% in Britain.

These bring up another standpoint, which people like James E. Walter and Myron J. Gordon believe, that current cash dividends are less risky than future capital gains. Thus, they say that investors prefer those firms which pay regular dividends and such dividends affect the market price of the share, i.e. relevance of dividend policy. They have the following reasons.

Clientele effect suggests the company should not change its dividend policy substantially as some of its investors (its established clientele) decide to sell the security due to the change. Since investors are attracted to a particular kind of security, changes in dividend policy will obey their current preference.

Investors don’t have access to internal information thus they see dividends as signals of the company’s performance and future prospects. High dividend suggests good news while low dividend indicates bad news. Though in reality these might not be true since there’s a trade-off between dividends and attractive investments, the market tend to be short-sighted and irrational.

Uncertainty of future gains is another concern. Thus, Investors would rather have the money now than leave it tied up in uncertain investments, i.e. they prefer stable or higher dividends. There are other reasons such as owner control (agency theory), management desire to avoid the risk of a future dividend cut, stability raises credit standing for debt issues, etc.

What is the preferred distribution method of companies nowadays? The liability strategies group of Deutsche Bank once undertook a survey upon this issue. They started by asking companies which distribution methods they had employed over the last five years. Respondents could select more than one option. Figure 1 provides an overview of the responses for those firms that employed at least one of the methods.

Figure 1:  Distribution Methods

Regular cash dividends are clearly the preferred distribution mechanism, employed by 93% of all respondents, followed by share repurchases which have been employed by 39% of all firms. As for which factors firms take into account when deciding on the choice among regular dividends, special dividends, and share repurchases, they undertook the survey further. Figure 2 lists five possible factors together with the number of respondents ranking these factors as important or very important, corresponding to a 4 or 5 on a scale ranging from 0 to 5.

Figure 2:  Factors Determining the Method of Distribution

None of the factors receive overwhelming support, but they all receive moderate support. The signal sent to capital markets is considered to be important by 39% of the survey participants, followed by the flexibility, which is listed as being important by 36% of the participants. Tax efficiency, attractiveness to investors, and accounting implications follow with 31%, 30% and 29% of the firms ranking these factors at the high end of the scale. These suggest relevance of dividend policy.

Let us see contemporary issues for instance. On May 8^th BT announced news that it has completed a transformational year with a 15 percent rise in its annual dividend. We can see a sharp rise of share value (+10.80, +2.87%) on the very day from Figure 3. Higher dividend is a signal of good news which suggests better performance and prospects of the company and strengthens investors’ confidence.

Figure 3:  stock price of BT Group (BT.A:LSE)

Crowdfunding

An inherent problem that entrepreneurs might encounter at the beginning of their entrepreneurial initiative is to attract outside capital, given the lack of collateral and sufficient cash flows and the presence of significant information asymmetry with investors. More recently, some entrepreneurs have started to rely on the Internet to directly seek financial help from the general public instead of approaching financial investors such as business angels, banks or venture capital funds. This technique, called crowdfunding. 

In simple terms, crowdfunding is the financing of a project or a venture by a group of individuals instead of professional parties (like, for instance, banks, venture capitalists or business angels). In theory, individuals already finance investments indirectly through their savings, since banks act as intermediary between those who have and those who need money. In contrast, crowdfunding occurs without any intermediary: entrepreneurs “tap the crowd” by raising the money directly from individuals. The typical mode of communication is through the Internet. Crowdfunding projects can range greatly in both goal and magnitude, from small artistic projects to entrepreneurs seeking hundreds of thousands of dollars in seed capital as an alternative to traditional venture capital investment. 

In this week seminar, we are required to have a group work to propose a plan to collect fundings from the public. Our group attempted to sell record pens. After the discussion, the first step is to calculate the cost of this programme, which involves raw material, staff costs, transportation costs, administration costs and advertisement expanses. Then we decided to make a market research to find out what kind of group are interested in record pens. It can be found that record pens may be welcomed by international students and some multinational corporations. Therefore, the next plan is to advertise among these groups. In order to motivate individuals to fund for this project, our team has make a preferential policy for those who have invested for our company. The preferential policy is when an individual invests £50, we reward £60 after sell one dozen of record pens (suppose the price is £10 and the cost of one record pen is £4 so that £50 can produce twelve record pens, hence the total cost is £48 and the total profit is £72, our company still earn £12 after reward individuals for £60). This policy can attract more individuals to invest because they can also earn extra 10 pounds. By adopting crowdfunding, some small enterprises do not need consider the high interest rate if they borrow money from banks, which benefits the company reducing the operating cost. However, the teacher pointed out that the plan must consider technical costs due to the fact it might record noises when people are writing and this can affect the sound quality if the pen is recording.

There are several reasons for corporations to adopt crowdfunding. Firstly, companies make use of the crowd mainly for costreduction reasons. By participating in the product design and improvement, users contribute to creating value for the company. Moreover, this allows the company to reduce the length of new product development as well as its costs, have a better customer acceptance, and increase the customers’ perception of product newness. Within the crowdfunding activities, consumers and individuals provide needed capital to the company to make its investments such as acquire new assets or pay employees.

Besides, crowds may at times be more efficient. According to Brabham (2008), the efficiency of crowds in solving problems of companies is related to its composition; the more diverse it is, the more efficient it can be. In other terms, members of the crowd may build up their own solution using others’ suggestions and hence end up having better solutions overall. While crowdfunding can be useful for companies seeking solutions to their problems, it can also provide valuable signals on the market potential of a product they wish to launch. At times the use of crowdfunding can be seen as an excuse to generate hype around a new product in order to create a marketing campaign in which consumers are able to participate. 

In the meantime, several platforms have emerged that help intermediate between crowdfunders and individuals with a project. Sellaban accounted for one of the most famous crowdfunding companies, launched in 2006, it acts as intermediary between new music bands and their fans, who can invest in the production of a band’s first CD. In exchange, investors obtain rewards, like a free copy of the CD or benefits from its sales. In roughly three years, the company raised more than US$ 3 million from individuals in order to promote new artists. In total, almost 4,000 artists received support from more than 65,000 investors.

Stock Market

When investors or individuals put money into the stock market, their goal is to receive a return on the capital invested. Many investors try not only to make a profitable return, but also want to outperform or beat the stock market. For this situation, Eugene Fama suggests that at any given time, prices fully reflect all available information on a particular stock and no investor has an advantage in predicting a return on a stock price because no one has access to information not already available to everyone else.

Many financial researches recognize that the financial markets are informationally efficient as the market prices fully show publicly available information. But the market may not attain such efficiency when publicly available information is costly to produce and when investors can always purchase better information at a higher price. While, when investors stop to buying information and trade shares, the amount of information purchased by the public and the quality of information reflected in the market price can be endogenous. Therefore, market efficiency relies on the cost structure of producing information, investors’ behaviors and risky return.

Market efficiency does not require prices to be equal to fair value all the time. Generally, stock prices would be over or lower than the actual prices but eventually revert back to their mean values. This is because the deviations form a stock’s fair prices are in themselves random, investment strategies that result in beating the market cannot be consistent phenomena. Furthermore, the hypothesis argues that an investor who outperforms the market does so not out of skill but out of luck. However, we cannot deny that in the real world of investment, there exists investors that have beaten the market, for instance, Warren Buffet, whose investment strategy focuses on undervalued stocks, made millions and set an example for numerous followers.

There are three levels of efficiency, weak form efficiency, semi strong form efficiency and strong form efficiency, which are used to reflect in prices and to define whether the market is efficiency. For weak form efficiency, share prices fully reflect all information contained in past price movements. But it is useless for investors to gain profit based on share price history. Semi strong form efficiency, share price indicates all the relevant publicly available information, which implies that there is no advantage in analyzing publicly available information after it has been released, because the market has already absorbed it into the price, therefore, investors technical analysis cannot result in profits but internal information may bring in profits. Strong form efficiency, all relevant information, including that which is privately held, is reflected in the share price. In this market, even insiders are unable to make abnormal profits for investors.

Take the HP acquired Autonomy as an example. The US stock market can be considered in the level of semi strong form efficiency market. As the management overprice the Autonomy's share price, HP made a $8.8 billion loss after 15 months of the acquisition.This is owing to the fact that Autonomy has inflated in their accounting data, which belongs to a insider information. If the HP's managers has discovered the forge before the acquisition, they would not overprice the share price and result in great losses.

It is important for the market to be efficient. Because a more efficient market encourages individuals invest in private enterprise. If shares are incorrectly priced many savers will refuse to invest because of a fear that when they come to sell the price may be perverse and may not represent the fundamental attractions of the firm. Secondly, as the object of one company is to create shareholders value, this provides a signal for company managers to make a sound decision. In addition, share prices signal the rate of return investors demand on securities of a particular risk level. If the market is inefficient the risk return relationship will be unreliable so that managers might misestimate the price, leading to excessive high cost capital. Thirdly, valuation of the stock market helps the company allocate resources, including operating efficiency and pricing efficiency.

                                                 

Merger and Acquisition (M&A)

Last week I talked about the how the multinational companies direct invest in the foreign business market, which relates to the method of investment. This week I am going to discuss about one of the method: merger and acquisition.

According to Arnold (2008) merger is used mean the combing of two business entities under common ownership while an acquisition includes one company essentially taking over another company. Although the motivations may differ, the essential feature of both mergers and acquisitions involves one firm emerging where once there existed two firms. Another term frequently employed within discussions on this topic is takeover. A so called friendly takeover is often a euphemism for a merger. A hostile takeover refers to unwanted advances by outsiders. Thus, the reaction of management to the overtures from another firm tends to be the main influence on whether the resulting activities are labeled friendly or hostile.

There are a number of possible advantages that may result in a merger or acquisition. One of the most often cited benefits is to achieve economies of scale. Economies of scale may be defined as a lowering of the average cost to produce one unit due to an increase in the total amount of production. The idea is that the larger firm resulting from the merger can produce more cheaply than the previously separate firms. Efficiency is the key to achieving economies of scale, through the sharing of resources and technology and the elimination of needless duplication and waste. Economies of scale sounds good as a rationale for merger, but it may show that combining separate entities into a single, more efficient operation is not easy to accomplish in practice.

Another competitive advantage is to enlarge market presence and market share. After the combination, larger entity may have the ability to buy bulk quantities at discounts, the ability to store and inventory needed production inputs, and the ability to achieve mass distribution through sheer negotiating power. Greater market share also may contribute to advantageous pricing, since larger firms are able to compete effectively through volume sales with thinner profit margins. This type of merger or acquisition often results in the combining of complementary resources, such as a firm that is very good at distribution and marketing merging with a very efficient producer. The shared talents of the combined corporation may mean competitive advantages versus other, smaller competition.

There still exits restrictions and risks in a merger or acquisition, the major risk in M&A processes results from the fact that they are complex and time consuming, as the combination may last for several years. Furthermore, mergers and acquisition are very often connected with high operating costs as a result of the organizational and personal changes, severance pay for dismissed workers, technical and technological changes, training workers, etc. Barriers and the limitations which can appear before, during or after the consolidation process. Hence, it can be divided into internal which have their source in the enterprise and external on which the company only has limited influence.

The internal restrictions, which include workers’ resistance to changes or gaining funds for transactions, can be eliminated by proper actions undertaken by the management , for instance, preliminary research about the corporate financial possibilities and informing employees about planned changes. The external factors is the economic factor, such as the economic situation, GDP, legal and administrative solutions, the level of interest rate as well as political tensions, whose elimination or moderation is more difficult to control.

Apart from the unpredict changes of outside, lacking of suitable preparation and analysis prior to the completion of the transaction can also lead to a failure merger. One example of this is the merger of Daimler Benz AG ( Germanys) and CHrysler Corporation (USA) in 1998 resulting in a new connected company. However, a number of acquisitions proved to be misconceived and economically groundless. I 2004 the market value of the whole company was over half lower than the accumulated value of both companies before merger and in 2007 they decided to divide the company again. Therefore, before deciding to merger, the buyer company needs to make a prudent analysis of another corporate financial statement, avoiding unnecessary losses.

Nevertheless, not all mergers lead to unfavorable results. A significant example can be quoted is Facebook announced that they had bought messaging app Whatsapp in a deal worth a total of $19bn (£11.4bn) in cash and shares on 20th February, 2014. It is the social networking giant's biggest acquisition to date. The deal to buy it includes $4bn in cash and approximately $12bn worth of Facebook shares, plus an additional $3bn in stock to Whatsapp's founders and employees at a later date. 

Conventional wisdom seems to be saying that Facebook paid too much to acquire Whatsapp, a mobile texting startup that is enjoying meteoric success in  developing countries. However, from the perspective of market share, the price chart indicates that the Facebook has experienced a raising tendency as a whole, even though there is a slight drop (5%) after buying the Whatsapp. As Whatsapp enables people for free massages, more people start to use this application, and Whatsapp actually has greater penetration in a lot of international markets than Facebook. Therefore, such purchase benefits Facebook bringing in more overseas individuals to join in, especially young adults. 

Foreign Direct Investment

Foreign direct investment (FDI), in its classical definition, is defined as a corporation from one country making a physical investment into building a factory in another country. However, given rapid growth and change in global business, the majority companies prefer making a portfolio investment, which can be less time consuming and easy to manage. It may take many forms, for instance, a direct acquisition of a foreign company, construction of a facility, or investment in a joint venture or strategic alliance with a local company with attendant input of technology, licensing of intellectual property. 

FDI could provide a firm with new markets and marketing channel, cheaper production facilities, access to new technology, skills and financing. For a host country which receives the investment, providing a source of advanced technologies, capital, processes and management skills enable promote local economic growth. Therefore, FDI plays an extraordinary and growing role in current global business. Faced with changes in technology, increasing liberalization of the national regulatory framework governing investment in enterprises and changes in capital markets, profound changes have occurred in FDI. In the new information age, decline in global communicative costs have made management of foreign investments far easier than in the past. 

As corporations want to earn a positive return on the investment, a great number of firms merger or acquire a foreign corporation. Also, mergers sometimes occur when business firms require diversification. This means one company do not put all its fundings in one industry, but make an acquisition of a foreign company, which benefits the corporation to reduce their investment risk. In other words, the acquiring firm no longer has all its eggs in one basket. However, in the diverse economic and political climate, they may need to have great capacity to tackle other risks, such as the foreign exchange rate risk (which has discussed in last week).

The party making the investment is usually known as the parent enterprise, and the party invested in can be referred to as the foreign affiliate. Together, these enterprises form what is known as a Transnational Corporation (TNC). In the last few years, TNC from developed counties play a significant part in FDI, however, the government of developing country encourage their corporations to invest in foreign country when recognized the importance of FDI. Take Chinese investment in the US as an example. Chinese foreign direct investment in the United States is an attractive and vital source of investment which is particularly welcomed, especially as the US begins to recover from the worst economic downturn since the financial crisis in 2008. Although sensitivities exist with respect to foreign investment in America’s most strategy sectors, overall, Chinese investment is fundamentally beneficial for the US economy as it creates opportunities of employment, maintains existing ones, provides new sources of capital and ultimately serves to strengthen the commercial ties between the two counties.

China’s remarkable economic growth stems in part from its ascendance as a trade and export powerhouse. However, to achieve future sustainable development, China must move beyond the export driven model and strengthen the investment and capital relationship with the multinational companies. AS a result of the global economic, in 2009, the figure of Chinese FDI had reached $6.4billion. Hair Group, as one of the multinational corporations, expand market into the US providing a good example of a successful globalization strategy. Before entering the US market, Hair Group first extended its brand in Asia in order to build its presence and develop international brand recognition. Having penetrated neighboring Asian markets, Hair Group setted up the value of $35million refrigerator products in 2000, and in 2005 the group acquired Maytag Corporation, which is a venerable US appliance marker for $1.28 billion. 

With the expansion of Hair Group in US, benefits brought in. First of all, transfer the technology, which is not just restricted to actual technologies, involving sharing skills, manufacturing methods and even entire facilities as well. It can also refer to the knowledge passed by scientific research institutions. Furthermore, foreign direct investment assumes the creation of new jobs. As investors build new corporations in the new country they create new job openings and opportunities. This leads to an increment in income and the development of competition. New jobs offer more buying power to the population of that country which in turn leads to economic boosts. Another of the advantages is the rise of the income for the receiving country. With higher wages and more jobs, the income of the entire country rises as well. Overall, all these in turn spurs economic growth in US.