Do mergers & acquisitions create shareholder wealth?

Following on nicely from my last blog which discussed different valuation methods which are vital in determining the price to pay for company - this blog is going to focus on the motives behind mergers and acquisitions and discuss whether such activity impacts shareholder wealth. We hear regularly in the news of mergers and acquisitions and last week (25^th March) was no exception. It was announced on Wednesday (25^th March) that US food giant Heinz plans to merge with Kraft Foods Group which could create the world's fifth-largest food and drink company (BBC, 2015). It was revealed that Heinz will hold the controlling interest with shareholders owning 51% of the combined company and Kraft holding a 49% stake (BBC, 2015). 

So what are the motives behind this possible merger?

This is an example of a horizontal merger as both Heinz and Kraft are engaged in similar business activities (Stillman, 1983). By doing this it is likely the combined organisations will benefit from synergies – the idea that the combined entity will operate more efficiently and be of more value than if the two organisations were to remain separate (Davis & Wilson, 2008). Both of the companies are finding it difficult to deal with a transition in the US where consumer attitudes are changing. Consumers are storing less packaged and processed foods, demanding fresh foods which has resulted in limited growth for the companies. Therefore by combining the companies they are hoping to operate more efficiently by benefiting from economies of scale following the merger.

One of the motives behind the merger, as stated by Alex Behring the chairman of Heinz, is to create “a strong platform for both US and international growth”. Given that Kraft generates 87% of its revenue within the US and Heinz generates around 60% of its revenue outside of the US I believe this is a good fit for the combined company. This will enable Heinz to use their global presence to expand Kraft’s products into new markets, as well as allowing Heinz to benefit from Kraft’s strong and established presence in the US. Consequently the merger is likely to facilitate growth both within the US and internationally which could result in high revenues and likewise increase shareholder wealth. 

Another motive behind the merger is that the combined company hopes to make significant cost savings, aiming to cut costs by $1.5bn by 2017. However this is likely to include changes which come at the cost of employees where large amounts of jobs are expected to be cut as well as slashing job perks. Linking this to stakeholder theory it would suggest that organisations should consider the needs of all of their stakeholders however it appears this was not the case whilst agreeing the merger. If they had followed stakeholder theory the merger may not have progressed to this stage as they would have considered the large potential of job losses and without these they may not achieve such large cost savings. In contrast, looking at this from a shareholders perspective, this merger could increase shareholder wealth if the combined entity is to make the planned cost savings it may allow any cash saved to be paid in dividends.

So are motives always in the best interests of shareholders? Unfortunately not.

There may have also been managerial motives behind the merger. This can result in managers making decisions which are in their own best interests, to maximise their utility rather than aiming to maximise shareholder wealth (Amihud, 1986) thus the agency problem is present. There are a number of reasons why managers may do this. Firstly, by merging the two companies the managers will have to be paid significantly more as a result of managing and controlling such a large company, linking to another possible motive of having a desire to build an empire - the prospect of securing an increased remuneration package is likely to be very attractive to managers and could be a significant motivation. Similarly it will increase the status of the managers involved as they would be seen to be leading the merger of the two well-known established companies which will receive a lot of publicity and is likely to be seen as a significant achievement. In addition, given that both companies are experiencing limited growth, it could be argued that the managers at Heinz may have considered this merger to protect their jobs. They may believe that they could be a target for a takeover and in order to protect themselves from being sacked or dominated by an acquiring firm, they made the decision to grow and merge with Kraft to prevent this. Again acting in their personal best interests rather than making decisions which will maximise the wealth of shareholders. Therefore if the motive behind this merger was due to managerial motives it is likely it will destroy shareholder value given that mergers have been shown to decrease wealth.

This leads nicely onto the effects the proposed merger has had for shareholders. Mergers and acquisitions have been heavily researched in order to determine the impact such activity has on shareholder wealth - what impact did the announcement of this proposed merger have for shareholders? Did it create wealth?

Studies have consistently shown that in a merger the target company’s shareholders gain significantly. Jensen and Ruback (1983) found that on average a target company’s share price will increase by 20% (Jensen & Ruback, 1983). Looking at Kraft’s share price (Figure 1) it increased significantly following the announcement of a possible merger and is therefore consistent with this theory, demonstrating how the proposed merger has increased the wealth of Kraft's shareholders. This could be because investors recognise that the merger will bring benefits from synergies and cost savings which essentially could increase their dividends in the longer-term.

Figure 1: Kraft Share Price (Bloomberg, 2015)

 

In terms of the bidding company's share price, Jensen and Ruback’s (1983) findings suggest that the shareholders would experience no gain nor a loss if the merger was successful. Given that Heinz is a private company I am unable to gain access to the share price to determine whether the movement complies with this study. However since Jensen and Ruback’s (1983) study, other studies have provided findings showing how in the short-term the bidding company either experiences no impact or a reduction in shareholder wealth. The results of longer-term studies are less consistent, some showing how it can significantly reduce wealth, some indicating it is value-neutral whereas a few show there is a possibility of increasing wealth.  
 

In contrast, if this merger is unsuccessful, we would expect to see a 5% loss on Heinz’s share price and a 3% loss on Kraft’s share price (Jensen & Ruback, 1983).  Currently we do not know whether the merger will be successful however research has shown that generally mergers are unsuccessful (Banal-Estañol & Seldeslachts, 2011). This could be due to the managerial motives, as discussed above, or hubris which is the concept of managers being over-confident and considering themselves to be better than and above everyone else (Petit & Bollaert, 2012). This can lead to managers being over-confident in their own abilities and very optimistic when considering possible mergers as they believe they have the ability to create a better business. It could be argued that the managers of Heinz have were over-confident when considering the merger as it could be very challenging to merge two companies which are currently experiencing little growth and make the changes required to allow successful growth in the US market which continues to be a challenging environment. In addition, in cases where there is free cash flow there is also scope for managers to reduce value. For example, if there is excess cash, following the objective of shareholder wealth maximisation, managers should look to distribute this back to shareholders. However in reality managers may want to keep this money under their control as distributing this to shareholders could be seen as reducing their power and control therefore they may use this to buy other firms which in turn links back to the managerial motives of status and remuneration. Overall this could reduce shareholder wealth.

To conclude, there are many motives which could be argued to be behind the merger of Heinz and Kraft including benefiting from cost savings and tackling the challenging business environment to managerial motives which have significant scope to destroy shareholder value. Given that studies have consistently shown that the bidding company often experiences a reduction in wealth, I believe it is vital merger and acquisition decisions are made with correct motives in mind, for example to benefit from synergies in order to increase shareholder value. Whilst both of these companies are currently facing difficulties, I think if the merger was successful, it would benefit both of the companies in the long-term as they can combine their expertise and experience in order to expand and enter new markets, creating value for shareholders whilst doing this.

 

References

Amihud, Y. (1986). Conglomerate mergers, managerial motives and stockholder wealth. Journal of Banking & Finance, 10(3), 401-410. doi:10.1016/S0378-4266(86)80029-2

Banal-Estañol, A., & Seldeslachts, J. (2011). Merger failures. Journal of Economics & Management Strategy, 20(2), 589-624. doi:10.1111/j.1530-9134.2011.00298.x

BBC (2015). Kraft shares soar on Heinz merger. Retrieved 29^th March 2015, from http://www.bbc.co.uk/news/business-32050266

Bloomberg (2015). Kraft Foods Group Inc. Retrieved 29^th March 2015, from http://www.bloomberg.com/quote/KRFT:US

Davis, D. D. & Wilson, B. J. (2008). Strategic buyers, horizontal mergers and synergies: An experimental investigation. International Journal of Industrial Organization, 26(3), 643-661. doi:10.1016/j.ijindorg.2006.12.004

Jensen, M. C., & Ruback, R. S. (1983). The market for corporate control. Journal of Financial Economics, 11(1), 5-50. doi:10.1016/0304-405X(83)90004-1

Petit, V., & Bollaert, H. (2012). Flying too close to the sun?: Hubris among CEOs and how to prevent it. Journal of Business Ethics, 108(3), 265-283. doi:10.1007/s10551-011-1097-1

Stillman, R. (1983). Examining antitrust policy towards horizontal mergers. Journal of Financial Economics, 11(1), 225-240. doi:10.1016/0304-405X(83)90012-0

 

Valuing companies – Where to start?

We always read in the news of mergers and acquisitions – but how do companies go about valuing companies in order to determine a fair offer? There are a number of methods which companies can use but there appears to be no one preferred or “correct” way to do this and there are a lot of assumptions involved - within this blog I am going to look at two recent cases to discuss the possible methods behind this. The first case is BHS, where it was announced on 12^th March that owner Sir Philip Green had sold the company which he bought for £200m in 2000 for just £1 to Retail Acquisitions (Financial Times, 2015). The second case is TSB who received a takeover approach from Sabadell, a Spanish bank, for £1.7bn (Financial Times, 2015). Clearly there is a big difference in value here – so how may have the companies determine these prices?

Firstly looking at stock market valuation which simply takes the number of issued shares and multiplies them by the market price. This is a simple technique and gives an idea to the buying company as to what the purchase price could be. Technically if the efficient market hypothesis applies then using this technique should give an accurate value of a company. However as discussed in my second blog, the stock market is not perfectly efficient and so it is unlikely this method will give a true valuation. It must be considered that managers within the organisation are likely to have internal information which could significantly impact the value of the firm. This could result in a target company rejecting a bid as they believe it does not provide a true reflection of the value of the company. Whilst this method is not widely used, it could be argued that Sabadell used this approach to value TSB as they offered 340p per share which was only 4% above their share price on the day the offer was made.

However there are limitations of using stock market valuation. Firstly the quoted share price does not reflect the value of all of the shares as these shares are only a fraction of the total amount and therefore does not fully represent a true value of a company. Another problem with this approach is that whilst it gives the buyer a possible share purchase price it does not reflect a company’s true worth giving no appreciation of future cash flows. Given that BHS was part of a wider group which was not listed on the stock exchange, this method could not have been used during valuation. With Sabadell offering slightly higher than what TSB's share price was, this could be due to the value which comes with TSB’s established brand name and reputation.

Another approach which can be used to value a company is net asset valuation (NAV). This technique uses the value of net assets from the balance sheet in order to determine the value of a company and includes two techniques; book value and net realisable value (ACCA, 2012). Book value is based on historical costs which are easily available as they are simply taken from the balance sheet. However a problem with this approach is, for example, an asset bought 10 years ago it is unlikely to be worth the same value today and therefore provides an inaccurate figure. In addition, given that it solely relies on balance sheet figures it gives no consideration to intangible assets such as a company's brand name or research and development. Net realisable value is likely to be a slightly more accurate approach in comparison because it uses the amount which would be generated if a company was to sell its assets on the open market today.

However there are significant limitations with utilising either of the NAV methods. Firstly, the value determined from this approach does not take into consideration future profits of the company, dividends or growth prospects as it is entirely based on the company’s assets. In addition, it does not include intangibles, for example a company’s brand, reputation and employees. These intangible assets for many organisations are likely to be of significant value to a company, particularly for organisations which are serviced based. Therefore this method is inappropriate to value TSB given that it is primarily a service based organisation and therefore relies heavily on having experienced employees as well as maintaining a strong brand name which is not captured using this method. It could be argued that this approach could have been used to value BHS. Whilst it is a well-known company and recognised brand, it is a loss making company and given this situation, the future prospects of the company are very poor.

The third approach which can be used to value a company is categorised as an income based valuation method; discounted cash flow (DCF) valuation. This requires the combined cash flows post-acquisition to be determined and estimate a discount value to make adjustments to this (Penman & Sougiannis, 1998). Using this method, the maximum a company should be prepared to pay is the difference between the present values of cash flows before and after the acquisition. If the combined entity’s is less than the separate entities then this will destroy shareholder value - and thinking about it logically why would companies want to merge if the combined entity is of less value? A benefit of using this approach is that it incorporates the time value of money, therefore appreciates that money available at a later date is worth less than money available now because of future earnings potential.

Like the other approaches to valuation, discounted cash flow valuation also has its limitations. Firstly it is difficult to decide an appropriate discount rate as well as the number of years of which future cash flows are discounted over and determining when this will end. It is important to note that it may take a few years before a newly formed entity could begin to recognise its true earnings potential. Secondly, in reality when valuing a company for an acquisition it is very hard to predict what benefits will arise from the combined entity and therefore it is difficult to incorporate this into the future cash flow predictions. In reality, it is likely that there will be a big difference between what is predicted compared to what actually happens. Furthermore deciding the growth rate of the cash flows can be difficult and various business risks and challenges need to be taken into consideration when doing this. Therefore DCF is subject to a number of assumptions, which altered, could provide different values. It is unlikely this method was used for BHS as I believe Sir Philip Green simply wanted to get rid of the company due to the difficulties it was facing. Even if this was not the case it will be very difficult to forecast cash flows given that it is currently a loss making company. On the other hand, for valuing TSB, this may not be the preferred method as the company has not long been separated from Lloyds TSB therefore the recent cash flows are unlikely to be a true representation as to what future ones may be and therefore provides very little guidance to predict future cash flows, particularly as a combined entity. This reinforces the point that predicted cash are likely to be very different to actual cash flows which could have lead Sabadell to coming to a very inaccurate value.

Another income based valuation method is the PE ratio. This is one of the most popular methods and it considers risk and gives an indication of future company performance (Arnold, 2012). However, like all valuations methods as discussed, it also comes with its limitations. The ratio needs to be compared with other firms otherwise it provides very little meaning. It is usually difficult to select these firms as there are many factors which this selection could be based on, for example size, revenues and profitability. Like DCF, it also requires cash flows to be forecasted for the combined entity and assumes they will remain the same over time - when in reality this is likely to change. 

To conclude, there are many methods which can be used to value a company and as demonstrated throughout this blog they are all subject to their limitations. It is very difficult to judge which method, if any at all, was used to come to a value for BHS because I think Sir Philip Green just wanted to sell the company regardless of how much it was worth due to the losses it is making. I think it would have been inappropriate for Sabadell to value TSB using NAV given that it does not give any consideration to intangibles, which as discussed are a significant part of the company. The company may have used a combination of methods - whist I have discussed methods within this blog, it is important to recognise that there are other methods which could have been used and in most cases it is unlikely that we are able to judge which method a company has used. I believe there is no ideal method to value a company and I believe companies should use a variety of methods which will provide a range of figures allowing a company to gain a greater appreciation and perhaps come to a more accurate value. Therefore I think it is fair to conclude that valuing companies is more of an art than a science.

References

ACCA (2012). Business Valuations. Retrieved 23^rd March 2015, from http://www.accaglobal.com/content/dam/acca/global/PDF-students/2012s/sa_feb12_f9_valuationsv2.pdf

Arnold, G. (2012). Corporate financial management. (5^th ed.). New York: Pearson.

BBC (2015). TSB confirms £1.7bn takeover move by Spain's Sabadell. Retrieved 23^rd March 2015, from http://www.bbc.co.uk/news/business-31848517

Financial Times (2015). Sir Philip Green sells BHS for £1. Retrieved 23^rd March 2015, from http://www.ft.com/cms/s/0/70dfb9c8-c8a6-11e4-8617-00144feab7de.html#axzz3VD2iJ52f

Penman, S. H., & Sougiannis, T. (1998). A comparison of dividend, cash flow, and earnings approaches to equity valuation. Contemporary Accounting Research, 15(3), 343-383. doi:10.1111/j.1911-3846.1998.tb00564.x

 

Is shareholder wealth impacted by changing a company's dividend policy?

As discussed in my previous blogs generally the sole guiding objective of a company is to maximise shareholder wealth - by changing a company's dividend policy will this impact shareholder wealth? A dividend policy is the strategy a company uses when determining the proportion of profits to be paid out to shareholders. Typically this is done twice a year with an interim and final year dividend however companies are under no obligation to do so. I have learned during lectures that there are many factors which need to be considered when determining a company’s dividend policy which I will discuss throughout this blog. Recently two oil companies - Eni and Statoil - made announcements surrounding their dividends providing a good opportunity to compare the impact this has had on each company. Eni, an Italian oil company, announced last week (13^th March) its plans to axe its spending following the oil price crash by cutting its dividend along with selling billions of dollars of assets (Financial Times, 2015). In contrast, Norwegian oil company Statoil did the opposite - announcing their intentions on 5^th February 2015 that they were “highly committed” to maintaining their dividend policy despite the difficult trading environment and competitors cutting their dividends (Bloomberg, 2015).

Will this change impact shareholder wealth?
 

No - says Miller and Modigliani (1961), referred to as M&M, who claim that dividends are irrelevant to a company’s value; instead this is determined by a company’s investment policy (Miller & Modigliani, 1961). Essentially they believe investment decisions are what determines a companies future earnings potential which is what impacts the share price and shareholder wealth. Therefore M&M argue that dividends represent a residual payment and should only be distributed if there is cash left over after investing in all possible projects with a positive NPV. Likewise if there is no cash left over, a dividend would not be paid and as a result, over the years, we would see highly fluctuating dividends. This suggests that companies should be focusing on their investment policy rather than spending time altering their dividend policy as it has no impact on shareholder wealth. 

Following M&M’s theory, when Eni announced they were cutting the dividend I would expect the company’s share price to remain relatively stable. However following the announcement of the dividend cut Eni's share price fell by 7% (Figure 1) which goes against M&M’s theory and suggests that a company’s dividend policy does impact value and shareholder wealth. CEO of Eni, Claudio Descalzi, stated that this decision was made with the aim of building a more robust company which will be capable of facing the challenging business environment with the lower oil prices. This implies that the company is focusing on long-term sustainable growth and hopefully wealth will be restored in the future as a result of this.

Figure 1: Eni Share Price (London Stock Exchange, 2015)

Looking at Statoil's share price this also goes against M&M's theory. Following their announcement to maintain their dividend policy their share price increased (Figure 2). Again this suggests that by altering the dividend policy it does impact value and shareholder wealth. 
 

Figure 2: Statoil Share Price (London Stock Exchange, 2015)

 

However, common to M&M’s theories, this theory was also based on a set of unrealistic assumptions. For example they assumed perfect capital markets where there is no transaction costs and no tax - which world do they live in?!

There are many theories and factors which oppose the views of M&M, including those listed below which will be discussed in more detail:

• Gordon's (1962) "bird in the hand argument"
• Clientele Effect
• Taxation
• Signalling

 

Gordon’s (1962) “bird in the hand” argument suggests that investors would prefer dividends now rather than company's retaining cash to allow possible, uncertain gains in the future (Gordon, 1962). This implies that because the future is unpredictable, investors would prefer a pay-out now rather than having it tied up in uncertain investments which may not provide a return. Given that Eni are cutting dividends to retain cash it could result in shareholders withdrawing from the company to seek alternative investments which are paying dividends. Consequently the share price would decrease leading to a reduction in shareholder wealth, thus suggesting that a companies dividend policy does in fact impact shareholder wealth.

Another theory opposing M&M's view is the clientele effect which suggests that shareholders are attracted to certain types of dividend policies (Jain & Chu, 2014) and therefore implies that a company’s dividend policy does affect value. For example pension companies seek constant, stable dividends and so whether an investor chooses to invest in a company is likely to be determined by the dividend policy and whether it suits their needs. This implies that companies need to understand the preferences of their shareholders in order to keep them happy, prevent them from selling their shares and to attract new investors. With Eni making the decision to cut their dividends, if shareholders require a stable income it may result in them selling their shares as it no longer meets their needs which will have a negative impact on value and shareholder wealth. It could be argued that the opposite will happen to Statoil. Given that they are maintaining their dividend it could suggest that they understand the needs of their investors. By announcing their dividend intentions it will reassure investors as they know it will continue to meet their preferences but may also attract new investor’s seeking a stable dividend thus increasing shareholder wealth.

Clientele theory is reinforced by taxation (bearing in mind that M&M assumed no taxes) as investors who are subject to paying lower tax prefer dividends whereas those subject to higher tax prefer lower dividends or capital gains (Jain & Chu, 2014). This further suggests that certain investors are attracted to particular companies depending on their dividend policy and reinforces that changing the policy could decrease shareholder wealth. Therefore companies must carefully consider the affects which changing their dividend policy could have.

Another factor which suggests a company's dividend policy affects shareholder wealth is the concept of signalling. Signalling gives investors an idea about the expected future performance of a company (Karpavičius, 2014). This is based around the idea of information asymmetry as investors don’t have access to internal information and so depending on a company’s decision regarding dividend pay-outs it can signal to investors how well the company is expected to perform in the future. For example, if high dividends are paid this signals good news to the market that the company is optimistic about the future which is likely to see an increase in the company's share price. Likewise if lower dividends are paid, or cut as in Eni's case, it suggests the company may be struggling and are concerned about the future performance of the company. Therefore dividends can be seen as an information transferring mechanism from inside a company to the market place. With Eni announcing the dividend cut, this theory suggests that the company may be concerned about the future due to the current difficult trading environment as a result of the oil price crash. Following the announcement the share price dropped. In contrast, by maintaining their dividend Statoil are signalling to investors that they are optimistic about the future, this was met with an increased share price. The concept of signalling clearly suggests that dividends are significant determinants of a company’s share price and therefore a company's policy does impact shareholder wealth.

 
To conclude, whilst I agree with M&M's theory that a company's investment decisions are essential to a company's profitability, as demonstrated with Eni and Statoil, I believe that a company’s dividend policy does have a significant impact on a company’s share value and therefore does affect shareholder wealth. Whilst there is no obvious way for a company to determine their policy I believe this is something that will be established over time and as discussed throughout this blog there are many factors which a company must consider when making decisions in relation to dividends. For example they should understand the preferences of their current shareholders and consider how they will react to significant changes in dividends. Personally, I think company's should aim to have a stable dividend policy with consistent pay-outs and stable growth as I believe this will retain investors as well as attracting new ones.

 

References

Bloomberg (2015). Statoil CEO Says `Highly Committed' to Dividend Policy. Retrieved 16^th March 2015, from http://www.bloomberg.com/news/videos/2015-02-06/statoil-ceo-says-highly-committed-to-dividend-policy

London Stock Exchange (2015). ENI. Retrieved 16th March 2015, from http://www.londonstockexchange.com/exchange/prices-and-markets/international-markets/indices/company-summary.html?symbol=ENI&market=MTA

London Stock Exchange (2015). STATOIL ASA STATOIL ORD SHS. Retrieved 16th March 2015, from http://www.londonstockexchange.com/exchange/prices-and-markets/stocks/summary/company-summary-chart.html?fourWayKey=NO0010096985NONOKEQS

Financial Times (2015). Eni to cut dividend and suspend share buyback. Retrieved 16^th March 2015, from http://www.ft.com/cms/s/0/c6ff2624-c994-11e4-b2ef-00144feab7de.html#axzz3UXyAnaFA

Gordon, M. J. (1962). The savings investment and valuation of a corporation. The Review of Economics and Statistics, 44(1), 37-51. Retrieved from http://www.jstor.org/

Jain, P. & Chu, Q. C. (2014). Dividend clienteles: A global investigation. Review of Quantitative Finance and Accounting, 42(3), 509-534. doi:10.1007/s11156-013-0351-2

Karpavičius, S. (2014). Dividends: Relevance, rigidity, and signaling. The Journal of Corporate Finance, 25, 289-312. doi:10.1016/j.jcorpfin.2013.12.014 

Miller, M. H. & Modigliani, F. (1961). Dividend policy, growth, and the valuation of shares. The Journal of Business, 34(4), 411-433. doi:10.1086/294442

 

Can a company's capital structure maximise shareholder wealth?

The capital structure of a company is how it finances its activities - usually through a combination of both debt and equity. Last week it was announced that Norwegian oil producer, Det Norske Oljeselskap ASA (Det Norske), was reviewing their funding options in order to create the optimal capital structure to increase the cash flow it needs for new projects whilst doing this at the lowest cost to shareholders (Bloomberg, 2015). Hersvik, CEO of Det Norske, has noted that the company is able to raise more debt and may also issue more shares - but how should they decide the proportion of debt and equity? Does an optimal capital structure exist? And can this increase shareholder wealth?

The weighted average cost of capital (WACC) is a way of calculating the costs of a company’s capital sources, both debt and equity, which determines the lowest rate of return needed on an investment to satisfy investors (Reilly & Wecker, 1973). This allows a company to determine which investments they can afford and therefore defines the company’s strategic option set as it acts as a hurdle rate for investment appraisal. As a result companies generally seek a low WACC (Watson & Head, 2013), allowing them to pursue more projects which maximise shareholder wealth. The recent oil price crash has reduced Det Norske's cash flows which are needed as they are wanting to take on new projects. By reducing the WACC it will allow the company to invest in these new projects as the company will require a lower rate of return. At first glance, you may think the decision is easy for Det Norske - increase debt as it is cheaper than equity, therefore lowers the WACC thus increasing their scope of possible investments which could increase shareholder wealth.

Decision made?! Not quite.

Whilst increasing debt does decrease the WACC as it is a cheaper source of finance, the traditional view of capital structure suggests that there becomes a point where a company can have too much debt. After this point it starts to become more costly, thus suggesting there is an optimal capital structure (Brusov et al, 2011). Essentially, debt finance is cheaper as lenders require a lower rate of return in comparison to ordinary shareholders. This is because, due to uncertainties and no guarantee of receiving dividends or capital gains, they often demand a higher return to compensate for the risks they are taking, thus increasing the cost of equity. Furthermore the transaction costs associated with raising debt are generally less than those involved in issuing shares and paying dividends and debt interest can be offset with pre-tax profits - reducing the overall tax bill for a company. However the traditional view suggests that there becomes a point where the cost of equity will start to increase as shareholders demand higher returns for the risks they are taking as highly geared companies are seen as risky investments. So it is at this point where a company achieves their optimal capital structure - before the level of debt causes the cost of equity to rise. I take the view that up until this point it seems logical to take on more debt as it is cheaper. However after this point, if a company continues to take on more debt the risk of financial distress increases along with the possibility of liquidation (this concept is summarised in Figure 1). As a result the WACC will increase thus reducing company value and shareholder wealth. Therefore if a company is above or below the optimal level, they are destroying shareholder value. It appears that Hersvik supports this traditional view as he clearly suggests there is an optimal capital structure and he is aiming to achieve it.

Gearing levels, cost of finance and risk of financial distress (Adapted from Arnold, 2012)

 

Whilst Hersvik has noted that the company is able to raise more debt and the equity ratio requirement of 25% has been removed, the company reported a net loss of $287m which could provide problems when trying to raise more debt. Lenders are likely to require higher returns meaning higher interest rates, thus increasing the cost of debt. Furthermore the company will not benefit from being able to offset the debt interest with pre-tax profit. Having said this, it is likely that raising debt will still be significantly cheaper than the costs associated with issuing shares. In addition, due to the current situation and issues Det Norske is facing with the oil price crash this will increase the risk of financial distress and shareholders will demand higher returns to compensate for the risks they are taking, increasing the cost of equity. This demonstrates how there is a fairly complex relationship between debt and a company's capital structure.

An alternative view, which significantly differs from the traditional view, was taken by Nobel Prize winners Modigliani and Miller (1958) who suggested that company value is independent of its capital structure. Instead, the value of a company is entirely dependent on business risk (Modigliani & Miller, 1958). Essentially this view suggests that no matter how much companies play around with their capital structure, it will not change the WACC, thus no optimal capital structure exists. Therefore Modigliani and Miller (1958) would argue that Hersvik's is wasting his time in aiming to achieve an optimal capital structure as such a thing does not exist. The theory behind this was that as the levels of debt increased, the cost of equity would also increase leaving the WACC the same. This suggests that Det Norske should focus on making good investments rather than altering their capital structure as cash flows generated from operations is the only way to increase company value and maximise shareholder wealth. However, in order to make this theory work in practice a set of unrealistic assumptions were made which have been heavily criticised. For example, they assumed that there is no taxation, as discussed above - debt receives a tax benefit, and they assumed there are no costs of financial distress and liquidation when in reality businesses clearly face the costs associated with these for example bankruptcy costs.

These criticisms led to Modigliani and Millar (1963) reviewing their theory to include tax. This dramatically changed their conclusions where they suggested that companies should be highly geared because of the measurable tax benefit (Modigliani & Millar, 1963). Therefore as the companies gearing increased, the WACC would decrease due to the tax benefit of debt. This would suggest that Det Norske should scrap the idea of raising finance through equity, load-up heavily on debt which would result in WACC being at its lowest and company value at its highest. Therefore, the theory now suggested that in fact there was an optimal capital structure - being highly geared. Clearly I would not recommend this for Det Norske or any company as it does not take into account the risk of financial distress which in reality does exist and will have a negative effect on a company’s value. By heavily increasing debt levels shareholders will demand higher returns to compensate for the risks they are taking, lenders will require higher interest rates and it is highly unlikely that potential investors will be attracted to the business.

To conclude, I personally believe that an optimal capital structure does exist as it seems logical that there becomes a point where having too much debt causes the cost of equity to increase as shareholders become worried. I also believe that when a company achieves such a structure it will increase shareholder wealth as they are able to broaden their strategic option set, thus increasing their scope for investments. In addition, I take the view that there is no generic ideal combination of the structure but that this varies depending on the company, the industry and the economic climate. It is impossible for me to predict what decisions Det Norske will make in terms of their capital structure but I think it is crucial they consider the benefits and drawbacks of both equity and debt finance as well as the business risks they are currently facing and how shareholders will react to the decisions they make. It will be interesting to see what decisions they make and whether they believe they were able to achieve their optimal capital structure.

References

Arnold, G. (2012). Corporate financial management. New York: Pearson.

Bloomberg (2015). Billionaire Roekke’s Det Norske Reviews Funding as Oil Drops. Retrieved 3^rd March 2015 from http://www.bloomberg.com/news/articles/2015-02-25/billionaire-roekke-s-det-norske-reviews-funding-amid-oil-drop

Brusov, P., Filatova, T., Orehova, N. & Brusova, N. (2011). Weighted average cost of capital in the theory of modigliani-miller, modified for a finite lifetime company. Applied Financial Economics, 21(11), 815-824. doi:10.1080/09603107.2010.537635

Modigliani, F. & Miller, M. H. (1958). The cost of capital, corporation finance and the theory of investment. The American Economic Review, 48(3), 261-297. Retrieved from http://search.proquest.com/?accountid=12860

Modigliani, F. & Miller, M. H. (1963). Corporate income taxes and the cost of capital: A correction. The American Economic Review, 53(3), 433-443. Retrieved from http://www.jstor.org/

Reilly, R. R. & Wecker, W. E. (1973). On the weighted average cost of capital. Journal of Financial and Quantitative Analysis, 8(1), 123-126. doi:10.2307/2329754

Watson, D. & Head, A. (2013). Corporate finance: Principles and practice. New York: Pearson.

 

Is the stock market efficient? The case of BT and EE

I briefly mentioned in my previous that when the announcement of Tesco's profit over-statement hit the headlines the share price plummeted - this concept is going to be the focus of this blog - stock market efficiency. 

In an efficient market place all known information is reflected within the share price which will essentially rise when good news is released and fall if bad news is released - but is this currently being achieved in reality? A current example which I am going to use to answer this question is the BT and EE acquisition. It was confirmed last week that BT, the UK’s largest telecoms and broadband network, had acquired Britain’s largest mobile phone network EE. The £12.5bn deal was completed on Thursday (5th February) following several weeks of speculation as to whether a move was going to take place (Financial Times, 2015).

The Efficient Market Hypothesis (EMH) implies that a company’s share price will fully reflect all available information, such that when new information is released it is incorporated into a share price rapidly and rationally (Basu, 1977). This therefore implies that investors undertaking statistical analysis into stock prices, in no way can “beat the market” and make higher returns as everyone has access to all current information and this is immediately reflected in the share price.

So was the market efficient in incorporating BT's announcement of the EE acquisition into the share price?

 

Figure 1: Share price reactions to information announcements (Arnold, 2013)

As shown in Figure 1, in a perfectly efficient market as soon as BT’s announcement of the EE acquisition was made, the share price would change rapidly, either rising or falling depending as to whether investors perceived this as good or bad news. This therefore suggests investors make quick and rational decisions. However in reality this is generally not the case and there are a number of reactions which could happen (lines 1-4). So what reaction did the market take for BT? On 24th November 2014 BT's share price (Figure 2) rose suggesting that investors anticipated that BT was going to make a move which they perceived as a good decision for the company - this follows line 2 in the above figure. This was due to speculation within the news that BT could potentially be acquiring either EE or 02. This explains why following the official announcement last week the share price did not change significantly - the market had already anticipated this information and so it was already incorporated into the share price. This suggests that the market is not perfectly efficient and therefore goes against the EMH.

Figure 2: BT’s Share Price (London Stock Exchange, 2015)

Kendal's (1953) theory of “random walks” suggests that share prices reflect all known information, they changed in a completely random fashion and consequently past performance cannot be used in any way to predict the future performance of a company (Agwuegbo et al, 2010). Looking at BT’s share price I agree with Kendal's theory as following the speculation of an acquisition in November the share price increased. Prior to this information being released I believe it could not have been predicted as to what direction the share price would have moved in. Likewise, news is completely random - how can people predict what is coming and consequently whether the share price would rise or fall?

However a challenge to Kendal's theory is that currently there are very highly paid jobs - chartists, for example, who aim to forecast future stock market trends based on past share price movements. Is this the case or it is simply just luck?!

Fama (1970) extended the random walks theory and identified three forms of efficiency; weak (past information), semi-strong (past and publically available information) and strong (all information - both public and private) form. The most likely and most justified form of efficiency for the UK market is semi-strong form which is where share prices efficiently adjust to reflect all information which is publically available as well as information from the past. It also suggests that investors react quickly and rationally to new information and so there is no benefit in analysing public information after it has been released (Fama, 1970). I believe semi-strong efficiency has been demonstrated from the BT share price as when the information of a possible acquisition was released in November the share price increased rapidly and significantly to reflect this information.

It has been identified however that there are anomalies in the stock market which suggests that there are occasions where it can be predicated, thus at these time it is inefficient. For example, the time of the day and month effect where at particular times it has been found that investors can achieve abnormal returns despite information being already publically available.

Furthermore, one of the key criticisms of the EMH is that occasionally investors make errors which may result in share prices deviating significantly from its true value - this is behavioural finance. The EMH implies that investors are rational however behavioural finance suggests they are not. For example, in reality emotions can influence how an individual acts and because of this do not always make rational decisions. An example of this is when investors are overconfident which can lead to an overreaction. This could explain the early rise in BT’s share price before the official announcement was made. It could be argued that investors were overconfident as they invested purely based on speculation – it was not certain that BT were going to acquire one of the companies and if they did there was no indication that it was going to work out well. It will be interesting to reflect on this in a few years time to determine whether it was a good thing that they were overconfident - is it working well? Are investors getting returns? Because of these anomalies and behavioural finance it is difficult to argue that stock markets are perfectly efficient and therefore challenges the EMH.

As discussed in my previous blog, shareholder owned companies generally follow the guiding objective of maximising shareholder wealth where executives should act with this in mind and therefore make decisions in order to achieve this. However, if the market is inefficient and shareholders act irrationally then this objective is unachievable and pointless - how will managers know what decisions they have to make to increase shareholder wealth? The rise in BT's share price suggests investors were rational and implies the goal of shareholder wealth maximisation is achievable. Additionally, the increased share price suggests the acquisition has maximised shareholder wealth and therefore appears to be a good decision made by the executives. I believe shareholders will take the view that the company is getting into a new market with a well-known and established company who already has the knowledge of what it takes to succeed. Furthermore there is potential to grow, for example BT can now sell packages which include mobile, and maximise the long-term value of the company. 

In summary, I believe the stock market cannot be predicted and share price movements are completely random. This is because news cannot be predicted and therefore you can never truly know how the share price will change until news is released. For BT I think the market is of semi-strong form as the share price rose indicating that investors reacted promptly and rationally. Whilst there was an early reaction, which at first could have been interpreted as investors beating the market or being overconfident, this was due to the speculation that something was going to happen. Because of this and in answer to the question I posed at the beginning - is an efficient market achieved in reality? - Whilst I believe the stock market is far from inefficient, it is not perfectly efficient - and after all, we don't live in a perfect world!

References

Agwuegbo, S. O. N., Adewole, A. P. & Maduegbuna, A. N. (2010). A random walk model for stock market prices. Journal of Mathematics and Statistics, 6(3), 342-346. doi:10.3844/jmssp.2010.342.346

Arnold, G. (2013). Corporate financial management. (5th ed.). Harlow: Pearson

Basu, S. (1977). Investment performance of common stocks in relation to their price-earning ratios: A test of the efficient market hypothesis. The Journal of Finance, 32(3), 663-682. Retrieved from http://web.a.ebscohost.com/ehost/search/

Fama, E. F. (1970). Efficient capital markets: A review of theory and empirical work. The Journal of Finance, 25(2), 383-417. doi:10.1111/j.1540-6261.1970.tb00518.x

Financial Times (2015). BT seals £12.5bn deal to buy EE. Retrieved 10^th February 2015, from http://www.ft.com/cms/s/0/9a74a0ec-ac6c-11e4-9aaa-00144feab7de.html#axzz3RL5gLwDx

London Stock Exchange (2015). BT.ABT GROUP PLC ORD 5P. Retrieved 10^th February 2015, from http://www.londonstockexchange.com/exchange/prices-and-markets/stocks/summary/company-summary.html?fourWayKey=GB0030913577GBGBXSET1

Will the Tesco turnaround plan maximise shareholder wealth?

The assumed primary objective or sole guiding principle in a shareholder owned company is shareholder wealth maximisation, that is, to act in a way which is in the best interests of its owners (Loderer et al, 2010). In my opinion this is perfectly logical given the fact that shareholders have incomplete contracts and so bear the risk that something could go wrong within the company and for this they should be rewarded. However, considering Tesco's situation over the past few months it appears they have most definitely not been following this principle. In September it was unveiled that the supermarket giant had overstated profits for the period by £263m (Financial Times, 2014). By doing this, clearly, they are not acting in the best interests of their shareholders, but what drove the executives to do this?

Agency theory is the assumption that the interests of the agents (the executives) and the interests of the owners (the shareholders) deviate from one another (Hill, 1992). Therefore there is a separation between ownership and control. This can result in managers making decisions for their own benefit to maximise their own utility rather than acting in the best interests of the shareholders by making decisions which create value. It could be argued that the executives at Tesco manipulated profits with the desire of gaining their bonuses or because they were under pressure to appear to be doing a good job and have 'rising' profits after a bumpy, poor performing couple of years. Either way, it destroyed shareholder value as shares crashed to an 11-year low and the end of year dividend was scrapped following the announcement. Clearly this overstatement was not made with shareholder wealth maximisation in mind and demonstrates how there is significant scope to destroy shareholder value through the agency problem.

But are the executives the only ones to blame? Tesco announced that at the time there was no CFO appointed after their current officer had resigned and was not due to start until December. It could be argued that the company was not being run correctly and there are potentially governance issues as well as auditor problems. However Jensen (2010) suggests that the problem lies with governments by not effectively setting rules and regulations for companies to follow to avoid these issues (Jensen, 2010), therefore suggesting Tesco are not the only ones to blame. 

So what are Tesco's plans to turn the company around and generate shareholder value?

It is only now that we are beginning to see the real effects this has had on Tesco and what they are planning to do to regain investor confidence and steps they are taking to create value.

In January, Dave Lewis, the companies CEO of five months was presented with the challenge of turning Tesco around. Lewis revealed plans to 'beef-up' their corporate finance department who will concentrate on investment opportunities, portfolio reviews and disposals in order to strengthen the balance sheet (Financial Times, 2015). Following this, plans were announced to make cost cuts of £250m which will begin by closing 43 unprofitable stores and cancelling plans for 49 new stores. Is this creating long-term shareholder value? Arguably not as they are not investing in the future of the organisation and new store openings are vital to the success of supermarkets. However I believe it is likely that shareholders will recognise that this is the only option available to Tesco given September's events and the generally poor performance of the company. Closing the unprofitable stores is an action consistent with point three of the value action pentagon which suggests that one way to create value is to divest assets from operations with a negative performance spread in order to utilise this capital more efficiently elsewhere (Arnold, 2013). This will allow capital which was previously tied up in unprofitable stores to be employed more productively. A further example of how Tesco is doing this comes after the announcement that they are closing their e-book selling service after posting a pre-tax loss of £2m on sales of just £70,000 in 2013. This business appears to have been a value-destroyer from the start for the company. Whilst they have been unable to find a buyer for this business, it further demonstrates how the company is making decisions to prevent any further damage as capital which would usually been spent within these units can now be invested more efficiently elsewhere.

However it was announced today (3rd February 2015) that Tesco are paying out £2.2m in severance pay to the former chief executive and finance director (BBC, 2015). The company suspended the payments while the scandal was investigated, however after seeking legal advice it was made clear that Tesco cannot withhold these payments. This is a further dent in shareholder value as a result of the scandal where otherwise the money could have been efficiently invested within the business to maximise shareholder returns.

Whilst some may argue that Tesco are beginning to turn their current situation around, I was shocked when I came across the below graph (Figure 1). The graph shows an increase in Tesco's EPS – great for shareholders right? WRONG. It shows that whilst EPS is rising, more capital is being employed to achieve this at ever lower returns suggesting that returns on new investments were inadequate and in most cases possibly negative. Whilst it only shows up until 2011, looking at the general trend over those 13 years I believe it is unlikely to have changed considerably. This is clearly destroying shareholder value as the capital is not being invested efficiently and is a further example of agency theory as the company is not acting in the best interests of the shareholders. It also demonstrates how one figure can make it appear that a company is performing well whilst on further investigation other figures suggest otherwise. This is why many academics acknowledge that shareholders should not solely rely on EPS to determine a company's performance as it does not always show the true picture (Rappaport, 2006).

Figure 1: Tesco's EPS and ROCE 1998-2011 (Financial Times, 2014)

 

Figure 2: Tesco PLC Share Price (London Stock Exchange, 2015)

Although it has been a very bumpy past few months for Tesco and its shareholders, looking at the company's share price (figure 2) it appears the market is regaining some confidence - shares jumped by 20% in January after the "turnaround" plan was announced. I believe the only way is up for Tesco and given the plans they have revealed, I think they are focusing on turning the company around and creating value for shareholders in the process to some extent. I think it is also worth noting that the other three supermarkets, which along with Tesco are referred to as the "big four", are also delaying expansion plans with some even closing stores. Whilst I believe Tesco is without doubt in the worst position I believe investors will gain some comfort knowing that competitors are struggling too. Nevertheless the ROCE figure over past years provides significant worry. It will be interesting to see how Tesco performs over the coming year and what further actions they take and whether they are ones which truly maximise shareholder wealth.

References

Arnold, G. (2013). Corporate financial management. (5th ed.). Harlow: Pearson
 

BBC (2015). Tesco's ex-boss and finance officer to share £2m payout. Retrieved 3rd February 2015, from http://www.bbc.co.uk/news/business-31122025
 

BBC (2015). Tesco to close 43 stores despite better Christmas sales. Retrieved 3rd February 2015, from http://www.bbc.co.uk/news/business-30712762
 

Financial Times (2014). How investors ignored the warning signs at Tesco. Retrieved 4th February 2015, from http://www.ft.com/cms/s/0/8f866d16-3280-11e4-93c6-00144feabdc0.html?siteedition=uk#axzz3QiBvu91J
 

Financial Times (2014). Tesco reveals it overstated first-half results by £250m. Retrieved 3rd February 2015, from http://www.ft.com/cms/s/0/67fb8db4-421e-11e4-9818-00144feabdc0.html#axzz3QiBvu91J
 

Financial Times (2015). Tesco to beef up corporate finance department. Retrieved 3rd February 2015, from http://www.ft.com/cms/s/0/07ed51ec-a31b-11e4-bbef-00144feab7de.html?siteedition=uk#axzz3QiBvu91J
 

Financial Times (2015). Tesco to close ebook-selling service. Retrieved 3rd February 2015, from http://www.ft.com/cms/s/0/48e6c4b4-a567-11e4-ad35-00144feab7de.html#axzz3QiBvu91J
 

Hill, C. W. L. (1992). Stakeholder-agency theory. Journal of Management Studies, 29(2), 131-154. doi:10.1111/j.1467-6486.1992.tb00657.x

Loderer, C., Roth, L., Waelchli, U., & Joerg, P. (2010). Shareholder value: Principles, declarations, and actions. Financial Management, 39(1), 5-32. doi:10.1111/j.1755-053X.2009.01064.x

London Stock Exchange (2015). TSCO TESCO PLC ORD 5P. Retrieved 3rd February 2015, from http://www.londonstockexchange.com/exchange/prices-and-markets/stocks/summary/company-summary.html?fourWayKey=GB0008847096GBGBXSET0

Rappaport, A. (2006). 10 ways to create shareholder value. Harvard Business Review, 84(9), 66-77. Retrieved from http://web.b.ebscohost.com