Crowdfunding - The next big thing?

It is well documented that small, start-up firms face difficulties when it comes to securing external finance, especially following the economic crisis. To address this problem, and in a bid to help close the ‘finance gap’, various crowdfunding platforms have been developed; a new source of finance for start-up firms. With popularity of crowdfunding growing, it is interesting to see how this process works and whether it is successful for both companies and investors.

Crowdfunding helps firms secure funding from large audiences, providing investors with the opportunity to invest very small amounts through online platforms. The minimum investment is usually as little as £10. This blog will focus on equity crowdfunding in which people invest in an unlisted company in exchange for shares. As a shareholder, the investor will benefit if the company is successful; however, they may also lose their investment if it is unsuccessful. Around £84m was raised from equity crowdfunding in 2014, triple the amount from 2013. According to several reports, the platform grew by 410% from 2012-2014, demonstrating its surge in popularity.

An increasing number of companies are using crowdfunding as well as other forms of finance such as venture capital. This is the case for JustPark, who run a mobile app which connects owners of parking spaces with drivers looking for somewhere convenient to park. JustPark is also funded by the international venture capital firm Index Ventures and BMW’s technology incubator. JustPark invited its users to become shareholders in a £1m crowdfunding campaign. The company announced it would use this money to develop new technology and to build its community of users. The minimum investment was set at £10, encouraging even small investors to invest.

Kozinets (1999) developed four member types in an online community; Tourists, Minglers, Devotees and Insiders. The study suggested strategies should be focused on devotees, who have a strong interest and enthusiasm but not many social attachments, and insiders who have both strong social and personal ties. JustPark seemed to adopt this strategy, providing an exclusive offer to users of the app 48 hours prior to the debut. This encouraged those considered ‘insiders’ to invest in the company. JustPark offered up to 4.76% equity, giving the business a valuation of just over £21m.

This strategy proved successful for JustPark, who raised almost half of their £1m target after only 12 hours of its debut on the crowdfunding platform Crowdcube. The campaign is now closed, with JustPark raising £3.7m, marking the world’s most successful equity crowdfunding campaign. The company also benefited from the increased exposure; experiencing a surge in job applications and a 300% increase in downloads of the app. This provided relatively easy access to finance for JustPark, allowing the company to grow and develop its operations.

However, despite the benefits to businesses, there is some concern regarding the risks associated, especially as it is a relatively new phenomenon. The Financial Conduct Authority, the UK regulator, warns that most start-ups fail and investors are likely to lose their money. It also raised concerns over how clearly investors are being told the terms of their investment. Many are exposed to the risk of dilution when more shares are issued. The FCA has made an attempt to oversee the sector, introducing rules limiting the amount that can be invested. However, in reality these rules can easily be avoided as they rely on self-certification.

So, in light of the associated risks, is crowdfunding an innovative platform that will allow businesses to set up and expand, or merely a current trend that will phase out once investors start losing money? The answer is somewhat difficult to comprehend due to how new crowdfunding still is. To companies, at least, it provides access to funding that might otherwise have not been available and provides an alternative to loans. They can also benefit from powerful word-of-mouth marketing and relatively quick access for funds. For them, I believe an obvious answer would be that yes, crowdfunding benefits them.

However, it is much more complex from the perspective of investors. Whilst they have the opportunity to invest small amounts in companies that interest them, returns are not guaranteed and the relatively unregulated nature of crowdfunding remains a concern. Some cases look to be a success, such as the JustPark app which received a surge in downloads following the increased exposure. However, this does not guarantee the company can maintain this in the long term, which could potentially result in the destruction of shareholder wealth. I propose that crowdfunding will appeal to those willing to take a risk and, to an extent, gamble on their investments. This relates to the indifference curve which represents individual preferences and risk profiles. Those who are willing to take a risk may hold a portfolio that has higher associated risk, in turn expecting higher returns. What is apparent is that, should the sector really take off, more regulation is required to encourage stability.

References

Belleflamme, P., Lambert, T. & Schwienbacher, A. (2014). Crowdfunding: Tapping the right crowd, Journal of Business Venturing, 29(5), 585-609. doi:  10.1016/j.jbusvent.2013.07.003

Curtis, S. (2015). JustPark invites users to become shareholders in £1m crowdfunding campaign. Retrieved 25^th April 2015, from http://www.telegraph.co.uk/technology/news/11408609/JustPark-invites-users-to-become-shareholders-in-1m-crowdfunding-campaign.html

Evans, J. (2014). Equity crowdfunding thrive despite high risks. Retrieved 25^th April 2015, from http://www.ft.com/cms/s/0/3ba47796-7624-11e4-9761-00144feabdc0.html#axzz3YEO9E1Tx

Evans, J. (2015). Start-ups pile into crowdfunding platforms. Retrieved 24 April 2015, from http://www.ft.com/cms/s/0/c3d01f9a-b75a-11e4-8807-00144feab7de.html#axzz3YEO9E1Tx

Fleming, S. (2015). Watchdogs home in on financial technology. Retrieved 24^th April 2015, from http://www.ft.com/cms/s/0/97b31b68-9da3-11e4-8ea3-00144feabdc0.html#axzz3YEO9E1Tx

Francis, J. & Kim, D. (2013). Modern Portfolio Theory, Hoboken: John Wiley.

Gerber, E. & Hui, J. (2013). Crowdfunding: Motivations and deterrents for participation, ACM Transactions on Computer-Human Interaction, 20(6). doi: 10.1145/2530540

Just Park. (2015). Crowdfunding campaign. Retrieved 25^th April 2015, from https://www.justpark.com/invest?source=awin&utm_source=Affiliate_Window&utm_medium=78888&utm_campaign=Affiliate_Window_Sale&awc=6188_1429958842_89a4a124a8f118e4de88be894d4e360b

Kozinets, R. (1999). E-tribalized marketing? the strategic implications of virtual communities of consumption, European Management Journal, 17(3), 252-264. doi:10.1016/S0263-2373(99)00004-3

Winterbottom, A. (2015). BMW-backed car parking app raises half crowdfunding target on debut. Retrieved 25^th April 2015, from  http://www.reuters.com/article/2015/02/13/us-fundraising-uk-justpark-idUSKBN0LH1XJ20150213

Has Royal Dutch Shell paid too much for BG?

One of the key aspects of mergers and acquisitions is the valuation of the target firm. How do bidding companies calculate its worth and, more importantly, how do they know they have secured a good deal? A good deal should technically prioritise shareholder wealth maximisation, whilst a bad deal could destroy it. The same could be said for the target company; how do they evaluate offers for the company and ensure they obtain the highest price possible? Due to the differing needs of both a target and bidding firms, a ‘halfway’ figure must be determined; one that is attractive to both the target and bidding firm.

The oil industry is going through a difficult time with oil prices reaching a 6 month low, discussed in a previous blog. Royal Dutch Shell (Shell) has just announced the takeover of BG in a £47bn deal, making it an incredibly large acquisition. However, the market forecasts dramatic cuts in the profits of Shell, so how do they know they can afford the merger? It seems like a very large price to pay for such a clear gamble relying on the recovery of the oil industry. Shell’s share price was down 8% upon the announcement, leading some analysts to claim Shell have paid too much for BG (figure 1). One potential suggestion is that Shell managers are infected with hubris, resulting in them overpaying for BG as they are overconfident in their ability to run it. Paying too much for a target is an easy way to destroy shareholder wealth. It is interesting to consider the method adopted by Shell to come to the valuation of BG.

Figure 1: Royal Dutch Shell Share Price
Data from London Stock Exchange (2015)

One possible method is stock market valuation, which relies on the efficient market hypothesis. Using this method of valuation, the value is simply the multiplication of the number of shares by the current market value. However, the market is not perfectly efficient in reality implying this is a flawed technique. At best, it may have provided Shell with a minimum value of BG. Shareholders usually require a substantial premium on top of this to be attracted to an offer. In most cases this is around 30%. In the Shell-BG merger, this premium was 50% on BG’s share price on 7^th April. This may provide further evidence Shell overpaid for BG.

A more complex method comes in the form of an asset-based valuation, which values a company by deducting assets from liabilities. This can be achieved most easily by using the book value, simply by taking the amount recorded on the financial statements. Whilst this is easy to do, it will not always result in an up to date value of the asset; potentially not the best guide to an assets current worth. Instead, Shell could have used the net realisable value of the assets, also known as the amount the asset could currently be sold at in the market. Although, this can present problems if an asset is unique to the company, as it would not have a market value. This may have caused problems for Shell regarding the intangible assets of BG which substantially increase the value of the company. For example, BG has a large number of oil and gas reserves, which may be difficult to value if they are unexplored. The exploration activity would also be difficult to value. This suggests asset-based valuation may not have been the most appropriate for Shell to use.

Income-based valuation provides an alternative viewpoint and measures value based on hypothetical forecasts. One of the way of achieving this is through the P/E ratio, which is simply the share price divided by the latest earnings per share. This provides an indication of the return on equity shareholders will receive in the future. Despite being widely used, it is a very basic method making it quite limited. It provides a snapshot of one period, assuming this will remain constant but this is unlikely to be the case. The selection of a benchmark P/E ratio can also be problematic. As Shell and BG are in the same industry this method may have been used, with the industry average set as a benchmark. The P/E model has wide practical application which may have encouraged its use.

Discounted cash flow is an alternative forward looking method. This discounts the future free cash flow of the companies, and allows for future changes. However, it is difficult to account for expected synergies which may affect the valuation as the Shell-BG merger is expected to created around $1bn of synergies. Its main benefit is that it acknowledges the time value of money; however, it may be difficult to decide upon a time period and appropriate terminal value.

Ultimately, it cannot accurately be predicted how Shell came to the valuation of BG. What can be suggested is that I believe Shell will have used a wide range of methods before combining these to establish the most appropriate value. Each method has its drawbacks, and they could result in ambiguous results which makes this the most suitable response. The key thing that Shell should have kept in mind is whether the value was going to create shareholder value. As for the critics who are claiming Shell paid too much for BG; time will tell as the merger unfolds and it can be assessed whether Shell manage to pull of this ‘mega-merger’. In my opinion it is definitely a big risk for Shell to take, as its success depends on the full recovery of the oil industry which cannot be guaranteed. The premium of 50% on top of BG's market value also seems an abnormally high figure, suggesting the managers could potentially have been affected by hubris. If it turns out Shell have overpaid for BG, it will be shareholders that bare the brunt of that and ultimately lose wealth.

References

Arnold, G. (2013). Corporate Financial Management. (5^th ed.), Harlow: Pearson Education.

BBC News. (2015). Royal Dutch Shell to buy BG Group in £47bn deal. Retrieved 15^th April 2015, from http://www.bbc.co.uk/news/business-32213341

Chazan, G., Barrett, C. & Oakley, D. (2015). Shell’s £47bn swoop on BG Group opens way to wave of energy deals. Retrieved 15^th April 2015, from http://www.ft.com/cms/s/2/140c4f2e-ddb7-11e4-8d14-00144feab7de.html#axzz3ZTGP71bw

Ficenec, J. (2015). Questor share tip: Are Shell shares a buy after BG deal? Retrieved 15th April 2015, from http://www.telegraph.co.uk/finance/markets/questor/11523486/Questor-share-tip-Stay-invested-in-Shell.html

Kavanagh, M. (2015). Five questions for Shell over BG Group deal. Retrieved 15^th April 2015, from http://www.ft.com/cms/s/0/8e708780-ddc1-11e4-8d14-00144feab7de.html#axzz3ZTGP71bw

London Stock Exchange. (2015). Royal Dutch Shell Share Price. Retrieved 8th May 2015, from http://www.londonstockexchange.com/exchange/prices-and-markets/stocks/summary/company-summary-chart.html?fourWayKey=GB00B03MM408GBGBXSET0

Roll, R. (1986). The Hubris Hypothesis of Corporate Takeovers, The Journal of Business, 59(2), 197-216. Retrieved from JSTOR http://www.jstor.org/

Ryan, B. (2007). Corporate Finance and Valuation, London: Thomson Learning.

Sudarsanam, S. (2010). Creating Value from Mergers and Acquisitions, (2^nd ed.), Harlow: Pearson Education.

Watson, D. & Head, A. (2013). Corporate Finance: principles and practices. (6^th ed.), Harlow: Pearson Education.

Will the merger between BT and EE generate shareholder value?

The basic motivation of a merger should be to add value to a company, thereby enhancing shareholder wealth. That said, this is not always the case. There is much debate regarding the success of mergers, with some claiming the majority destroy shareholder value. With this in mind, the recent announcement of BT’s takeover of EE provided an interesting read (Roland & Williams, 2015; Thomas, 2015; Williams, 2015; & Hargreaves Lansdown, 2015); would this takeover succumb to the factors that have previously rendered other mergers disasters? Or would, despite the odds stacked against the success of mergers, it realise the benefits it anticipates from the merger?

A merger is typically classed as a friendly, negotiated deal. So far, the BT-EE merger has been friendly, although approval is still required from shareholders. There are 3 different types of mergers; horizontal, vertical and conglomerate. The BT-EE merger takes the form of a horizontal merger as the two firms are involved in similar business activity. The horizontal nature of the merger means competition clearance is required from the UK Competition and Markets Authority. A vertical merger is a situation in which firms from different stages of the supply chain merge. Businesses in completely separate industries that unite is known as a conglomerate merger, although these are quite rare in the UK.

There are various different motives associated with mergers being undertaken.  The neoclassical theory proposes that managers will only engage in takeover activity if it leads to the creation of shareholder wealth. This is likely to be the case with the BT-EE merger, and most horizontal mergers, as there are various potential synergies from the deal which have the ability to maximise shareholder wealth. Economies of scale play a large role in this, as a larger sized firm may lead to lower costs through the utilisation of resources. BT forecast a large cost saving off the back of the merger, with an expected £360m saved on operating costs and capital expenditure every year by the fourth full year following the transaction. This has a net present value of around £3.5bn before integration costs, falling to £3bn after these costs are taken into account. Spreading costs over an increased range of products creates economies of scale. As BT is aiming for a full union of mobile and fixed telecoms, this is likely to result in new products and services to spread their costs and generate further revenue. Revenue synergies from the wider range of products are expected to amount to a net present value of £1.6bn.

Managerial synergy could also have played a role in the merger, as BT clearly believes they can run EE better than it is currently being run. Inefficient managers can be replaced and expert skills transferred between both companies. This can be seen in the takeover agreement between the two firms, which states Deutsche Telekom, joint owner of EE, have the right to appoint a director to the BT board. The two companies say this creates a platform for them to work together, sharing best practice in the process. These motives behind the BT-EE merger suggest it will generate value for shareholders. BT seems focused on creating synergies, including higher revenues and lower costs, as well as working with EE. At first glance, there does not appear to be any managerial motives, such as higher salaries and remuneration packages, behind the deal.

An alternative argument suggests managers own personal interests could be the motivations behind mergers. This stems from agency theory, which suggests a difference in goals between managers and shareholders may cause managers to prioritise their own needs as opposed to shareholder wealth maximisation. Factors including increased remuneration and power may encourage such behaviour. Evidence has found managers are rewarded off the back of mergers even if they turn out to be unsuccessful. Alternatively, the manager could suffer from 'hubris', leading them to overestimate their abilities to run the merger on completion. This stems from overconfidence. It may be the case that the managers at BT simply wanted to 'enhance their CV' by running a much larger, more dominant company. If this proves to be the case, it is unlikely to merger will be successful in generating shareholder value.

The financing of mergers is most frequently made up of either cash or shares. BT is paying £12.5bn for EE; however, the sellers, Deutsche Telekom and Orange, are receiving most of this in stock. Deutsche Telekom will have a 12% stake in BT, and Orange will have a 4% stake. A major advantage of this is that tax can be avoided for the time being. It also reduces the amount of cash BT must provide as part of the deal.  However, to achieve this BT raised £1bn from the sale of 2.2 million new shares at 455p. This will dilute the position of existing shareholders; not necessarily a popular decision. Despite this, BT will still have to make use of debt to fund the rest of the takeover, and take on EE’s existing debt of £2.1bn. This will affect BT's capital structure as gearing would be increased; the company should ensure this would not increase financial distress costs too dramatically as this may destroy shareholder wealth. Cash may be preferred by the target as it carries a certainty of worth, however, this may be subject to taxation. Despite the limitations associated with each financing method, it appears to me that BT has funded the merger in a way that best suits the company. This has allowed them to strengthen their abilities and improve their free cash flow.

Despite potential synergies and opportunity to maximise shareholder wealth, there has been widespread criticism of mergers. Grubb & Lamb (2000) claimed that only 20% of all mergers succeed; hardly enticing odds for shareholders facing the prospect of a merger. Evidence regarding whether bidding firms generate value through mergers is somewhat ambiguous. Jenson & Ruback (1983) showed share price increased by 4% on average following a successful bid, and dropped 1% following an unsuccessful bid. The BT-EE merger certainly follows this proposal, with BT experiencing a 4.5% increase in share price on the day the final terms of the merger were announced. Shares reached their highest point in 14 years, showing the positive reaction from the marketplace. However, it remains to be see whether this success will continue once the merger is undertaken. Alternative studies have found successful mergers reduce the wealth of bidding firms shareholders (Firth, 1980). This implies the motivations behind the takeover may play a role in determining whether the merger is successful; it will create shareholder wealth if shareholders interests were prioritised when creating the deal. Target firms seem to benefit from mergers more; Jenson & Ruback (1983) found shares increased by 30% upon successful bids, dropping 3% for any unsuccessful bids. This led some to claim the increase in wealth of target shareholders is at the expense of bidding shareholders

The forecasts provided by BT of the synergies expected from the deal seem well thought out. They recognise the cost of integration and time required to make the merger a success, stating benefits will be realised in the fourth full year from the transaction. The marketplace reacted well upon the announcement of the merger and I believe this signals that the deal has the potential to generate shareholder wealth. Having said that, the merger still requires approval from shareholders and clearance from UK authorities, showing it is still in its early days. On the basis of this, I am inclined to refrain from full judgement of the merger, at least for now. Therefore, it remains to be seen whether the BT-EE merger will relish in the predicted success, generating value for shareholders, or fall foul to the curse of mergers falling flat and destroying shareholder value.

References

Arnold, G. (2013). Corporate Financial Management. (5^th ed.), Harlow: Pearson Education.

Hargreaves Lansdown. (2015). BT Group plc. Retrieved 24 March 2015, from http://www.hl.co.uk/shares/shares-search-results/b/bt-group-plc-ordinary-5p/share-research

Jensen, M. & Ruback, R. (1983). The market for corporate control: The scientific evidence, Journal of Financial Economics, 11(1-4), 5-50. doi: 10.1016/0304-405X(83)90004-1

Firth, M. (1980). Takeovers, Shareholders Returns, and the Theory of the Firm, The Quarterly Journal of Economics, 94(2), 235-260. Retrieved from JSTOR http://www.jstor.org/

Roland, D. & Williams, C. (2015). BT unveils £1bn share placing to help fund EE takeover. Retrieved 23 March 2015, from http://www.telegraph.co.uk/finance/newsbysector/mediatechnologyandtelecoms/telecoms/11407624/BT-unveils-1bn-share-placing-to-help-fund-EE-takeover.html

Roll, R. (1986). The Hubris Hypothesis of Corporate Takeovers, The Journal of Business, 59(2), 197-216. Retrieved from JSTOR http://www.jstor.org/

Thomas, D. (2015). BT shares surge as £12.5bn takeover of EE is finalised. Retrieved 23 March 2015, from http://www.ft.com/cms/s/0/4a88704e-ae20-11e4-8188-00144feab7de.html#axzz3VEtETs3w

Thomas, D. & Massoudi, A. (2015). BT seals the £12.5bn deal to buy EE. Retrieved 23 March 2015, from http://www.ft.com/cms/s/0/9a74a0ec-ac6c-11e4-9aaa-00144feab7de.html#axzz3VEtETs3w

Watson, D. & Head, A. (2013). Corporate Finance: principles and practices. (6^th ed.), Harlow: Pearson Education.

Williams, C. (2015). BT begins 48-hour ‘£17bn’ spending binge with EE takeover. Retrieved 23 March 2015, from http://www.telegraph.co.uk/finance/newsbysector/mediatechnologyandtelecoms/telecoms/11394138/BT-begins-48-hour-17bn-spending-binge-with-EE-takeover.html

Has Centrica's change in dividend policy cost them market value?

The proportion of profits a company pays to its shareholders is known as the dividend policy. In the UK, dividends are usually paid every 6 months in the form of an interim dividend for the first half years trading, followed by a final dividend at the year end. The dividend policy of a company should link with the overall objective of maximising shareholder wealth at every opportunity. It is argued by some that dividend policy should remain stable so shareholders know what to expect, making the flurry of news articles regarding the change in the dividend policy of Centrica an interesting read (Farrell, Kavanagh, Bloomberg, Financial Times & Patron. 2015). Centrica announced plans to cut their dividend for the first time since it was created in 1997. The large scale drop of 30% led to queries regarding what caused this sudden change in dividend policy and whether it maximised the wealth of shareholders.

Despite the argument that dividend policy is of importance to shareholders, this is not unanimous. Miller & Modigliani (1961) argued that if a few assumptions were made, including no transaction costs, no taxation and perfectly efficient markets, dividend policy is irrelevant to the value of shares. They claim share value is a result of corporate earnings, reflecting investment policy, rather than the amount of dividends paid. Consequently, investment policy is the only factor determining market value, implying value is independent of the dividend paid. Miller & Modigliani also claimed that rational investors are indifferent to whether they receive dividends or capital gains. The important factor is that a company maximises shareholder value through the adoption of an optimal investment policy, in which they invest in all projects with a positive NPV. Any remaining earnings can then be paid out as a dividend. If a shareholder wants a dividend and the company chooses not to pay one, they can create their own through the sale of shares.

According to this policy, Centrica’s market value would not be affected by the decision of the company to cut the dividend. This is not because they are 'not bothered' about receiving a dividend, but rather due to an indifference to the timing of the dividend. Shareholders would recognise appropriate investments had been made which would contribute to expected future dividends. However, this is not the case for the shareholders in Centrica, as share price fell by 8.3% following the announcement of the dividend cut. Critics of this theory would argue this is because in the real world taxation and transaction costs do exist; making dividend policy much more complex and disputable. 

Contrastingly, the traditional view argues dividend policies do influence share valuations (Lintner 1956, Gordon 1959). This approach believes shareholders prefer a certain dividend to be paid now rather than receiving the equivalent value through an investment with uncertain future value. Hence, dividends are considered more reliable than capital gains. This would explain the drop in Centrica’s share price following the dividend cut; shareholders perceive the cut as a return with much less guarantee.

Clientele effect goes some way to explain this, proposing that shareholders prefer a dividend pattern which matches their desired consumption pattern. Some clientele may not be interested in receiving dividends in the short term, and vice versa. This implies companies should aim to provide a stable and consistent dividend so investors know the investment will suit their preferences. This is apparent in the case of Centrica who, as a utility that has never lowered its dividend up until this point, has become popular with investors looking for a high dividend income. It therefore seems rational to suggest some shareholders in Centrica will have purchased the shares at least partly because the dividend policy suits them, putting pressure on Centrica to maintain a stable, consistently high dividend. The graph below demonstrates the extent of the change in dividend policy by Centrica. Total dividends per share have historically increased continuously, no doubt reinforcing the shock of the dividend cut. The cut threatened Centrica’s status as one of the FTSE 100’s highest yielding stocks, strengthening the argument shareholders in Centrica expect large dividends.

Made by blog author
Data obtained from Centrica (2014)

Another potential explanation for the drop in share price after Centrica announced its dividend cut is the belief that dividends convey information about the future of a company. An unexpected decline in the dividend, as is the case with Centrica, may signal a pessimistic view of the future. Shareholders may become uneasy and, due to a lack of other information, lose confidence in the company. Despite Centrica providing an explanation for the dividend cut, stating it is necessary for the continued success of the business, it would appear shareholders are not keeping this in mind. Investors often tend to have a short sighted view of the market; thus, are not taking the potentially positive future results from the dividend cut.

Ultimately, I believe it is clear clientele effect has played some role in reactions of Centrica’s shareholders; lending support to the traditional view of dividend policy. Having gained a reputation as one of the FTSE 100’s highest yielding stocks, it is apparent investors have come to expect this which is likely to have played some role in the decision to purchase shares in Centrica.  Upon the announcement of a dividend cut, share price dropped as the dividend policy was no longer stable. This exposed shareholders to potentially volatile dividends which were unlikely to meet their particular requirements. Consequently, the confidence shareholders have in Centrica is likely to have started declining.


References

Arnold, G. (2013). Corporate Financial Management. (5^th ed.), Harlow: Pearson Education.

Baker, H., Powell, G. & Veit, E. (2002). Revisiting the dividend puzzle: Do all of the pieces now fit?, Review of Financial Economics, 11(4), 241-261. doi: 10.1016/S1058-3300(02)00044-7

Bloomberg. (2015). Centrica slumps most since 2008 after cuts dividend on loss. Retrieved 9^th March 2015, from http://www.bloomberg.com/news/articles/2015-02-19/centrica-cuts-dividend-after-posting-1-6-billion-full-year-loss

Centrica, (2014). Annual Report. Retrieved 9th March 2015, from http://www.centrica.com/files/reports/2014ar/Centrica_AR2014_Annual_Report.pdf

Farrell, S. (2015). Centrica slashes dividend after annual profit falls. Retrieved 9^th March 2015, from http://www.theguardian.com/business/2015/feb/19/centrica-slashes-dividend-after-annual-profit-falls

Financial Times. (2015). Centrica: upstream without a paddle. Retrieved 9^th March 2015, from http://www.ft.com/cms/s/3/d943a040-b840-11e4-86bb-00144feab7de.html#axzz3USwO1NUm

Gordon, M. (1962). The Savings Investment and Valuation of a Corporation, The Review of Economics and Statistics, 44(1), 37-51. doi: 10.2307/1926621

Kavanagh, M. (2015). Centrica slashes dividend as losses bite. Retrieved 9^th March 2015, from http://www.ft.com/cms/s/0/83d6d11a-b80c-11e4-86bb-00144feab7de.html#axzz3USwO1NUm

Linter, J. (1956). Distribution of Incomes of Corporations Among Dividends, Retained Earnings, and Taxes. The American Economic Review, 46(2), 97-113. Retrieved from JSTOR http://www.jstor.org/

Miller, M. & Modigliani, F. (1961). Dividend Policy, Growth, and the Valuation of Shares, The Journal of Business, 34(4), 411-433. Retrieved from JSTOR http://www.jstor.org/

Patron, E. (2015). Centrica: What the analysts say. Retrieved 9^th March 2015, from http://www.ft.com/cms/s/0/c603dfea-b822-11e4-86bb-00144feab7de.html#axzz3USwO1NUm

Watson, D. & Head, A. (2013). Corporate Finance: principles and practices. (6^th ed.), Harlow: Pearson Education.

Is there an optimal capital structure?

As mentioned in my previous blog, the recent fall in crude oil has impacted many large oil companies. On 4^th March, oil and gas producer Afren announced it was defaulting on a $15m interest payment (Kavanagh & Wallis 2015, Aglionby & Thomas 2015, & Casiraghi, 2015). This default casts doubt on their capital structure, leading me to assess the options available to firms when deciding upon their capital structure.

Companies must decide on the level of debt and equity used to finance their business. Debt finance is much cheaper than equity; however, it has to be repaid whereas equity does not. The traditional view suggests that because debt is cheaper due to tax advantages, increasing gearing would reduce the weighted average cost of capital (WACC). Hence, shareholder wealth is increased as cash flows are discounted at a lower level.  Despite this, the traditional view suggests as gearing rises, the associated risks to shareholders increase due to the large interest payments faced. Whilst debt repayments remain constant, demand may not. This is certainly applicable in the case of Afren who, having generated $1.2bn of debt, were faced with a 60% drop in the price of crude oil. As debt repayments must be maintained, the company was faced with serious cash flow difficulties leading to their default on interest payments. To avoid instances like this, the traditional view proposes there is an optimal capital structure; if gearing is too low shareholder value opportunities may be missed, alternatively if it is too high risks are heightened, seen in the case of Afren.

Contrastingly, Modigliani & Miller (1958) found that WACC remains constant regardless of gearing levels, implying shareholder wealth cannot be maximised through capital structure. However, this paper was highly criticised for its major assumptions that there is no tax, financial distress or bankruptcy costs. In response to this, Modigliani & Miller reviewed their paper in 1963 to include the effect of taxation. Through this modification they found the optimal capital structure is as much gearing as possible due to the tax advantage of debt finances which decreases the WACC, thus maximising shareholder wealth. It could be argued Afren took this approach as they have extremely high levels of debt. Whilst this initially maximised shareholder wealth, with share prices reaching an all-time high in October 2013 of 166p, it is now having the opposite effect. Share prices hit a yearlong low in January, and reduced almost 27% to 6.6p the day the interest default was announced. Standards & Poor rating agency also reduced the company to a double C status, defining them as highly vulnerable; a further concern for shareholders.

Afren’s difficulties can potentially be explained through the work of Miller (1977) who again revisited the initial paper, this time including bankruptcy costs. As gearing levels increase, so do interest payments and the risk of being declared bankrupt. Miller found tax advantages from increased debt were counterbalanced by the increased risk. This increases the rate of return demanded by shareholders, thus Miller concluded WACC remains relatively unaffected by capital structure; parallel to the initial study. However, this could also bring us back to the beginning of the blog, in which it was suggested there is an optimal capital structure involving appropriate gearing and equity levels. If gearing is increased to an optimal level, tax advantages can be gained and risk can be maintained at a moderate level. It would seem Afren increased gearing too much, not foreseeing the drop in crude oil prices. Afren are in a dangerous position, having defaulted on a $15m interest payment and with nearly $400m of debt due to mature next year. In a bid to help the situation the company are seeking a capital restructuring, potentially increasing equity holdings. Afren need to raise in excess of $200m to achieve this, a figure higher than its market value. If this is achieved, Afren have warned this new equity will ‘substantially dilute the interests of the company’s current shareholders’.

In my opinion, by maximising gearing Afren have ultimately ended up damaging shareholder wealth despite having maximised it for a short period of time, suggesting this capital structure is not sustainable in the long term. Uncertainty in the economy, still prevailing since the financial crisis, further enhances the risk of high gearing levels. Therefore, I believe there is an optimal capital structure that involves the balance of making the most of low cost debt and its associated tax relief, whilst avoiding financial distress and bankruptcy costs. Having said this, I don’t believe there is a ‘right’ answer; each company will face its own risks and should therefore determine what the best capital structure for their particular needs is.

References

Aglionby, J. & Thomas, N. (2015), Afren defaults on $15m interest payment. Retrieved on 4^th March 2015, from http://www.ft.com/cms/s/0/e7d380c2-c23f-11e4-bd9f-00144feab7de.html#axzz3Ti5FZYjU

Arnold, G. (2013). Corporate Financial Management. (5^th ed.), Harlow: Pearson Education.

Casiraghi, L. (2015). Afren defaults on bond as it holds out for restructure deal. Retrieved 4^th March 2015, from http://www.bloomberg.com/news/articles/2015-03-04/afren-defaults-on-bond-as-it-holds-out-for-restructuring-deal

Kavanagh, M. (2015). Afren shares plunge more than 65% on funding crisis. Retrieved 2^nd March 2015, from http://www.ft.com/cms/s/0/781cc12e-a612-11e4-abe9-00144feab7de.html#axzz3Ti5FZYjU

Kavanagh, M. & Wallis, W. (2015). Seplat granted extension for Afren offer. Retrieved 1^st March 2015, from http://www.ft.com/cms/s/0/9b7d2688-a89f-11e4-97b7-00144feab7de.html#axzz3Ti5FZYjU

Modigliani, F. & Miller, M. (1958). The cost of capital, corporation finance and the theory of investment, The American Economic Review, 48(3), 261-297. Retrieved from JSTOR http://www.jstor.org/

Modigliani, F. & Miller, M. (1963). Corporate Income Taxes and the Cost of Capital: A Correction, The American Economic Review, 53(3), 433-443. Retrieved from JSTOR http://www.jstor.org/

Miller, M. (1977). Debt and Taxes, The Journal of Finance, 32(2), 261-275. doi: 10.1111/j.1540-6261.1977.tb03267.x

Watson, D. & Head, A. (2013). Corporate Finance: principles and practices. (6^th ed.), Harlow: Pearson Education.

Perfect Market Efficiency: Reality or an idealistic view?

The recent fall in crude oil prices has created large disruption to global oil companies, including Exxon Mobil who experienced a 21% fall in profits during Q4 2014 (Carroll 2015, Krauss 2015 & Driver 2015). This led me to question how efficiently the market is responding to such changes and what, if any, there impact is on Exxon’s share price.

There are 3 different types of stock market efficiency; Operational, Allocational and Pricing. The focus of this blog will be pricing; assessing how well a market responds to new information. In an efficient capital market share prices accurately reflect all information that is publically available, rendering it impossible to develop trading rules to ‘beat the market’. The efficient market hypothesis (EMH) states any new information revealed about a company will be incorporated into the share price rapidly and logically. Therefore, stock market efficiency means share prices reflect their true economic value. Would it not, therefore, be rational to expect the 21% drop in Exxon’s profit to be reflected by a reduced market value?

EMH argues news is unpredictable making future price changes impossible to forecast. Kendall (1953) provided evidence of a random walk hypothesis, finding no logical link between one price movement and succeeding ones. It follows that share prices will be random, since they reflect new information which is unpredictable. On the basis of this, it could be argued statistical, technical analysis of share prices is effectively irrelevant. Conversely, a counter argument could be presented in the fact that many large companies still employ technical analysts implying they find their skills to be useful.

Fama (1970) developed Kendall’s initial findings, proposing three forms of market efficiency. The first was weak form, proposing share prices reflect all historical movements and information. Any profits generated in excess of the market return will be done so by chance. There is an array of evidence strongly supporting this theory. In terms of Exxon, the announcement of a 21% fall in profits during the fourth quarter of 2014 should not be immediately incorporated into their share price. Supporting this, on 2^nd February, the day of the announcement, Exxon’s shares ended the day’s trading 2.5% higher, outpacing the gain in the overall market. Does this lack of immediate reflection in the share price imply a slow reaction from the market? 

                                                                                                                 Figure 1. Exxon Mobil share price. 
                                                                                                                 Note. NASDAQ, 2015

Perhaps, but as displayed in figure 1, Exxon’s share price fell by almost 5% in the 6 days leading up to the announcement. This premature impact on the share price could lead some to conclude investors had an indication about the fall in profits, seemingly possessing some level of insider knowledge. This would provide support for strong form market efficiency, in which share prices reflect all information regardless of whether it is publically available. In this situation no one can make abnormal returns. However, in instances involving insider dealing, in which an insider or group has access to information that is not publically available, abnormal returns have been seen. This form is best viewed as a benchmark against which market inefficiency can be judged.

A much more credible explanation, at least in my opinion, is that investors were aware of the impact the falling oil industry would have in the forthcoming profit announcement from Exxon. Oil markets are oversupplied whilst demand is declining, resulting in falling prices. The price of crude oil, seen as the international benchmark, fell by more than a third in the final quarter of 2014. It surely then came as no surprise that Exxon’s fourth quarter profits were negatively impacted, arguably explaining the drop in share price in the days leading up to the announcement.

This argument provides support for the semi-strong form of market efficiency; share prices reflect all historic movements as well as publically available information. Semi-strong market efficiency supports EMH, arguing share prices react quickly and logically to new information. The 2.5% increase on the day Exxon announced their profit, and the subsequent increase the following day, could be a result of the company’s statement regarding dividends. They announced the 9.5% increase in dividends remains unaffected, which may have restored investor confidence. It may also be worth noting that due to the current uncertainty of the oil industry, in which prices plummeted further in January, share prices are likely to be volatile for the coming months.

The efficient market theory has been heavily criticised for various reasons, including behavioural issues. Investors may not always make rational decisions, but may be overruled by cognitive reflexes such as overconfidence. However, stock market efficiency is vital for shareholder wealth maximisation; an important aspect of most businesses, discussed in my previous blog. Market efficiency makes this seem like a realistic goal, although some have claimed it may tempt managers to hold back negative information. It is clear the market is not perfectly efficient, as it is impossible for market values to reflect all information. Rather, investors rely on a flow of information to the market to allow share prices to incorporate new information and reflect their true value. In my opinion Kendall’s Random walk hypothesis provides the best account of share prices. Information cannot be predicted, nor can the way in which investors will react to this news. Therefore, accurate forecasts cannot be made, suggesting share prices are in fact ‘random’.

References

Arnold, G. (2013). Corporate Financial Management. (5^th ed.), Harlow: Pearson Education.

Carroll, J. (2015). Exxon Profit Declines After Oil Market Collapse. Retrieved 18 February 2015, from http://www.bloomberg.com/news/articles/2015-02-02/exxon-profit-declines-as-oil-industry-reels-from-market-collapse

Driver, A. (2015). Exxon fourth-quarter profit tops estimate, share buyback slasher in half. Retrieved 18 February 2015, from http://www.reuters.com/article/2015/02/02/us-exxon-results-idUSKBN0L618820150202

Fama, E. (1970). Efficient Capital Markets: A Review of Theory and Empirical Work, The Journal of Finance, 25(2), 383-417. Retrieved from JSTOR http://www.jstor.org/

Kendall, M. (1953). The Analysis of Economic Time-Series – Part 1: Prices, Journal of the Royal Statistical Society, 116(1), 11-34. Retrieved from JSTOR http://www.jstor.org/

Krauss, C. (2015). Exxon Mobil Revenue and Profit off 21% on Oil Decline. Retrieved 19 February 2015, from http://www.nytimes.com/2015/02/03/business/energy-environment/exxon-mobil-q4-earnings-decline.html?_r=0

NASDAQ. (2015). Exxon Mobil share price. Retrieved 18 February 2015, from http://www.nasdaq.com/symbol/xom/interactive-chart

Watson, D. & Head, A. (2013). Corporate Finance: principles and practices. (6^th ed.), Harlow: Pearson Education.

Tesco's shareholder wealth maximisation - Or lack of?

The primary objective of value based management is long term, sustainable shareholder wealth maximisation. A company’s share price is considered an indicator of shareholder wealth maximisation, as it considers future dividend payments and investor views. It follows that shareholders, as the owners of the company who bear the most risk, deserve a proportion of company profits. By maximising shareholder value, a company can expect to attract further investment and be viewed as successful in the financial market.

Over the past 6 months supermarket giant Tesco has experienced a very public fall from grace. As a consequence, many believe shareholder wealth has been destroyed. During the fourth quarter of 2014, Tesco issued its fourth profit warning in six months, concluding a disastrous year for the company. The announcement stated trading profits for the year ending February 2015 would not exceed £1.4bn. With already reduced market forecasts of £1.9bn, this is a £500m reduction. Whilst profits do no directly affect shareholder wealth, they do influence it. Profit warnings are perceived by financial markets as a sign of financial weakness. This fall in profits may have been the initial source of investors beginning to lose confidence. In my opinion, this fall in confidence is likely to have been reinforced by top shareholders in Tesco selling shares in the months around this.

Market share is considered to be associated with shareholder wealth and is usually set as a strategic objective to help maximise this wealth. Improving market share generates economies of scale, creates barriers to entry for potential competitors and encourages brand loyalty. Such benefits all link to shareholder wealth, albeit indirectly. An obsession with margins and an obsessive quest for market share has negatively impacted other aspects of Tesco, including shareholder wealth. Tesco are under increasing pressure to protect market share from upcoming, low cost supermarkets such as Aldi. Despite their attempts, Tesco’s market share fell from 29.9% to 29.1% over the course of 2014. Conversely, the market shares of Aldi and Lidl grew. Analysts have predicted a prolonged price war in the supermarket industry, leading to the demise of many of the current companies. Tesco admitted it is losing an escalating supermarket price war to discount rivals Aldi and Lidl, which could be a cause for concern for shareholders.

In late 2014, Tesco admitted misstating its profits by £263m, representing another blow to the company. This arose as Tesco had been doing deals with suppliers over promotions, but failing to report them accurately. Returns were recorded too early and costs were pushed back. The practice of stretching accounting regulations to the limit eventually catches up with companies, as it did with Tesco. Such practices stop the company meeting investor expectations and partly destroy market value. The incident reduced the value of Tesco by billions. Consequently, eight executives were suspended whilst an investigation was carried out. Four of these are now believed to have left the company. However, today Tesco announced they would make a pay out to the ousted CEO and ex-finance chief. This pay-out has a combined value of almost £2.2m, further undermining shareholders and questioning Tesco’s creation of shareholder wealth.

Perhaps not surprisingly, share prices of Tesco have plummeted in light of these events. Share price halved over a twelve month period, falling by 44% over the past year, compared to a 2% rise for the wider FTSE100, seen in the graph below. During this period the share price reached its lowest in 14 years. Accordingly, this dramatically reduced shareholders capital gains. In August, Tesco cut their dividend by 75%. They have recently announced they will pay no dividend for the financial year 2014/15 in a bid to reduce capital expenditure. Whilst this reduces shareholder wealth, it shows their commitment to the long term success of the company which may help improve shareholder wealth in the future.

 The share price is gradually recovering and is currently up 2.1%. It is nearing pre-overstatement level for the first time in 4 months. Despite this, some have claimed the fall out of the events discussed above have caused investors to lose interest in waiting for a recovery which still seems a long way off. However, there is some hope for Tesco who announced the biggest overhaul in their history last month. This includes closing 43 stores, cutting thousands of jobs and scrapping the dividend. The company is also close to naming their next chairman.  I believe Tesco lost sight of their strategic objectives that assisted them in maximising shareholder wealth in their quest for high profits and market share without consciously recognising it. With some restructuring and refocus, the company has the ability to gradually restore the confidence of shareholders, albeit through an uphill, time consuming battle. The ongoing supermarket price war, which will impact the supermarket industry as a whole, is likely to remain a concern for shareholders of Tesco well into the future.

REFERENCES

Arnold, G. (2013). Corporate Financial Management. (5^th ed.), Harlow: Pearson Education.

BBC. (2014). Tesco shares plunge after profit warning. Retrieved 3 February 2015, from http://www.bbc.co.uk/news/business-30391447

Economic Times. (2015). Tesco pays out to ousted CEO Phil Clarke and ex-finance chief Laurie McIlwee. Retrieved 3 February 2015, from http://economictimes.indiatimes.com/news/international/business/tesco-pays-out-to-ousted-ceo-phil-clarke-and-ex-finance-chief-laurie-mcilwee/articleshow/46108077.cms

Felsted, A., Oakley, D. & Barrett, C. (2014). Tesco issues fourth profit warning in a year. Retrieved 3 February 2015, from http://www.ft.com/cms/s/0/f7fe75c0-7f72-11e4-b4f5-00144feabdc0.html#axzz3QgHTlpkR

Financial Times. (2015). Tesco to cut spending to £1bn, axes dividend. Retrieved 3 February 2015, from http://www.ft.com/fastft/258262/tesco-cut-spending-1bn-axes-divi

Neilan, C. Tesco's share price nears pre-overstatement level for the first time in four months. Retrieved 3 February 2015, from http://www.cityam.com/207114/tescos-share-price-nears-pre-overstatement-level-first-time-four-months

Rappaport, A. (2006) Ten Ways to Create Shareholder Value, Harvard Business Review, 84 (9), pp. 66-77. Retrieved from Serials Solutions http://jr3tv3gd5w.search.serialssolutions.com/

Watson, D. & Head, A. (2013). Corporate Finance: principles and practices. (6^th ed.), Harlow: Pearson Education.

Wood, Z. (2014). Tesco shares fall to touch 14-year low as annual profits face £500m dip. Retrieved 3 February 2015, from http://www.theguardian.com/business/2014/dec/09/tesco-share-price-falls-500m-profit-plunge-dave-lewis