Comparison between the method of returning cash to company shareholders adopted by Marks and Spencer to traditional stock repurchase
Fridson & Avarez (2002) demonstrate that A B Share Scheme such as the one adopted by Marks and Spencer is normally used by companies to return excess capital to ordinary shareholders. Such a scheme allows the shareholders to decide the form that the return takes.
Keown, Petty, Martin, & Scott, F (2007) demonstrate that shareholders’ choice of an income payment or a capital gain would depend on their tax requirements and risk profile. since the top rate of personal income tax is substantially higher than the capital gains tax rate, companies whose shareholders are dominantly retail investors would prefer to return cash to shareholders in this way as opposed to paying an income to the shareholders. This option, although not riskless, is more popular with companies.
Under the option adopted by Marks and Spencer, the Shareholders would be given the freedom to choose from three alternatives: an income alternative, an immediate capital alternative, and a deferred capital alternative to get back the cash. There would be no difference in the amount of cash that the shareholders get back under each alternative, so when the shares are redeemed, the amount to be paid by the company to the shareholders would be equal to the dividend paid on the B shares.
A dividend on the B shares equal to the amount that is to be given back to the shareholders would be paid to the shareholders who choose an income receipt. Deferred shares which have limited rights and negligible value would be instantly created from the B shares. The company can buy back these deferred shares immediately after the dividend has been paid to the shareholders. The company is only allowed to pay the dividend from the company’s distributable reserves, so it cannot use funds from any other source to pay the dividends. Only profits available for that purpose can be used for such distribution.
For shareholders who choose the immediate Capital Option, the shares would be retired by the company, and they would be paid for the shares. The company is prohibited from redeeming shares which it had originally issued as nonredeemable. The redemption would only qualify to be treated as a capital payment if the B shares had been issued as bonus shares when they were first issued, and if the company had paid for them from the share premium account. The bonus issue must not be financed from any income type reserve.
Also, the shareholders must not make a profit on the shares by the shares being redeemed at a premium, if the redemption is to qualify for treatment as a capital payment, in that there must be no discrepancy between the nominal value of the redeemable shares created and the total amount of cash being returned on redemption. Redemption at a value that is higher than the par value would mean that the shares have been redeemed at a premium, and would have to be treated as an income distribution for tax purposes since the shareholders would have gained from the redemption.
Salvatore (2006) demonstrates that public companies are only allowed to pay for share redemption from two sources. The company can either pay for the shares by using distributable profits, or by using funds that the company receives from issuing new shares to the public.
The company would prefer to retire the shares rather than repurchase because when it retires them, the company will not pay stamp duty on the value of the B shares retired but when it repurchases, it would have to pay stamp duty.
The deferred Capital alternative would mean that the company makes a capital payment to the shareholders at a later date, which usually falls on a later tax year. Where the payment is deferred for a significant time, the company normally pays an interim dividend to the shareholders.
The option adopted by Marks and Spencer is normally preferred because it minimizes the amount of the reserve that needs to be capitalized by the company for the creation of the bonus shares since the par value of the B shares would be equal to the amount to be given back to the shareholders, and the company saves stamp duty when it redeems the B shares since they are issued as redeemable shares to satisfy capital elections. If the shares were non-redeemable and were repurchased, stamp duty would be payable on their value.
The number of the company’s reserves available for capitalization would dictate the number of B shares that are issued since the company cannot spend more funds on the repurchase than it can afford.
Stock repurchases are mainly considered to benefit shareholders because after a stock repurchase, fewer stocks in the stock market, which means that the few which remain on the market, would have a higher value, thereby increasing the value held by the shareholders that are holding the remaining shares. The value of the outstanding stocks increases without changing the company structure.
The repurchased shares can either be canceled, or they can be put in the company’s treasury.
Stock may also be repurchased to improve ratios which are calculated by dividing a figure by the number of ordinary shares outstanding. Examples of such ratios are the earnings per share, the price-earnings ratio, the return on equity, and the return on assets. When the numbers of shares that are outstanding are reduced by stock repurchase, the values of these ratios would improve.
The company may also buy back its shares so as to get rid of the too many stocks that are available on the market, which resulted from the excessive sale of shares by the shareholders.
Comparison between the method of returning cash company shareholders adopted by Marks and Spencer to increased dividend payout
Increased dividend payout would mean that the company pays more dividends to shareholders and retains fewer funds for reinvestment on profitable projects.
This may indicate to the market that the company does not have profitable investment opportunities and that is why it is paying more dividends. Lack of investment opportunities would mean that the company would offer its shareholders less return on their investment.
The option adopted by Marks and Spencer is, therefore, more preferable than increasing the dividend payout because shareholders who prefer dividends can sell their shares to the company and create their own dividends. Shareholders who do not mind staying without dividends can hold on to their shares.
Graham, Smart, & Megginson (2009) demonstrate that dividend policy can be influenced by several factors, such as legal rules, such as the insolvency rule, which prohibits insolvent companies from paying dividends; and the undue retention of earnings rule, which requires companies to only retain funds that are enough for present and future investment needs.
There are other factors to consider when deciding on the dividend policy to adopt, such as whether the firm has any need for funds, the restrictive covenants in contracts that prohibit the company from paying dividends, whether the company has enough cash flows to support the policy, and whether the company can borrow more funds.
There are different types of dividends that can be adopted by firms:
Emery, Finnerty, & Stowe (2007) demonstrate that this is where the shareholders are used to receiving a certain amount of dividend from the firm, and at a certain time. For example, the shareholders may expect dividends of fifty cents per share around September of every year. In other words, the company pays a constant amount of dividends per share. Such a policy is not good because the shareholders will be expecting the company to pay the dividend whether it makes enough profits to support the dividend or not. Failure to pay the dividend would send negative signals to the shareholders about the company’s performance.
Bragg (2007) demonstrates that this occurs when the company pays more dividends than it normally pays, and such a situation usually occurs once after a long time. The extra dividend comes as a surprise, as the shareholders are not expecting it. Such a dividend would sometimes send a positive signal to the shareholders because they would believe that the company has performed so well that it has extra cash to distribute. Other times, such an extra dividend would not be healthy for the company because the shareholders would imagine that the company had no profitable investment opportunities to invest in, and that is why it is paying the excess funds as extra dividends. The shareholders would take it to mean that the directors of the company are not working hard enough to maximize their wealth by looking for profitable investment opportunities.
Stock dividends and stock splits
Block & Hirt (2007) demonstrate that a stock dividend is where shares are issued to ordinary shareholders instead of, or in addition to cash dividends.
Stock splits occur where the company’s shares are multiplied such that shareholders have more shares than they originally held in the company. For instance, the shares can be split into two, which means that every shareholder will have two shares instead of one that was previously held. Every shareholder would therefore end up with double the number of shares previously held. If the shares are split into four, a shareholder would have four shares for every one share previously held. This would mean that each shareholder ends up with four times the number of shares previously held.
Graham, Smart, & Megginson (2009) demonstrate that this is where the company buys back its ordinary shares from its shareholders. It is normally done when the value of the company’s shares has fallen substantially. In such a case the management would buy back the shares to restore the value of shares.
Stickney, Weil, & Schipper (2009) demonstrate that this is a dividend that is paid in between the two Annual General Meetings before the accounts are finalized. It is normally triggered by abnormal profits earned by the company during the year and is usually paid in cash. This type of dividend can only be declared after depreciation for the full year has been provided for in full. It is only provided for by the company’s articles of association and does not require any approval of the Annual General Meeting.
Emery, Finnerty, & Stowe (2007) demonstrate that such dividends are paid when the company has earned enough profits during the year to justify the payment of dividends but lacks sufficient cash flows to pay the dividends in cash. The company’s shareholders are therefore issued shares and debentures of other companies instead of a cash dividend. Such dividend is generally unpopular with shareholders, because the shares or debentures, so paid are worthless. This type of dividend is currently not allowed by the Companies Act.
Mukherjee & Mohammed (2005) demonstrate that this is where shareholders are given long-term debentures or bonds or notes instead of cash dividends. Such dividend has the same effects as in scrip dividend. This type of dividend makes the shareholders secure creditors. This type of dividend is very rare.
Fridson & Avarez (2002) demonstrate that this type of dividend is paid in the form of assets, instead of cash. The types of assets that are used for such dividends are those which are no longer required in the business, such as investments or stock of finished goods.
Agency problems that are likely to be faced by Vodafone
From the financial statements, it is evident that the company reinvests most of its earnings, which suggests that the company follows a residual dividend policy. This is a dividend policy whereby earnings are invested in profitable projects before dividends are declared. In other words, the dividend is only paid when there are no profitable projects.
Erich (n.d) demonstrates that an agency relationship exists when one party, referred to as the principal, appoints another party, referred to as the agent, to act on behalf of the principal. The principal normally expects the agent to act in his best interest but in most cases, the agent acts in his interest at the expense of the principal.
In business, the shareholders are the principals, and they appoint Directors and managers as their agents. The directors and managers are expected to use their delegated authority to maximize the shareholders’ wealth since the shareholders are the owners of the business.
In most cases, the directors and managers use their positions to maximize their wealth at the expense of the shareholders. They do this by paying themselves huge bonuses and undertaking projects which do not maximize the shareholders’ wealth but offer them some kickbacks. This results in the agency problem. As a result of this agency problem, the shareholders normally take some actions to resolve or avoid the problem. Some of the actions that are taken by the shareholders to resolve the agency problem are implementing internal controls to check the managers of the business, such as the appointment of auditors, introducing performance-based reward schemes such as profit-based bonuses, promotions based on performance, contingency fees, commissions based on sales, and executive stock options.
In the case of Vodafone, the remuneration committee has awarded the top management very high pay perks, at the expense of the shareholders.
The impact that recent write-offs of assets and heavy indebtedness can have on the valuation of the company
A company’s value is normally based to a large extent on the net assets of the company. The write-off of a company’s assets reduces the value of the assets that are reported on the company’s balance sheet. This would result in the company’s value being seen as less based on the value of the assets that are reported on its balance sheet.
Wilkinson (2005) demonstrates that a highly leveraged firm is one that makes a very high gross profit as a percentage of sales, while a firm that makes a lower gross profit as a percentage of sales is said to have lower leverage.
Emery, Finnerty, & Stowe (2007) demonstrate that A company that has a higher degree of operating leverage faces a greater risk of forecasting error since large errors in cash flow projections can be caused by a relatively minor error in the sales forecast. A company that has a lower degree of operating leverage faces a lower risk of forecasting error.
Stickney, Weil, & Schipper (2009) demonstrate that the value of borrowed funds normally reduces the net assets of a company. A company that is highly geared is normally seen as having less value because if the creditors demand their funds, the company would have nothing to operate on.
In the case of Marks and Spencer, the write-off of assets has resulted in a lower value of the company’s assets, which may result in the company’s value is lower. Also, the heavy indebtedness may harm the company’s value.
Mukherjee & Mohammed (2005) demonstrate that when preparing projected financial statements, the financial position of the company needs to be evaluated. The following are some points that can be used to evaluate the financial position of the company:
- Find out whether the company’s operational activities are good enough
- Find out If the company is well established financially
- Find out the condition of the market, whether the market is growing, has reached equilibrium, or is shrinking.
- Find out the status of the company as compared to its competitors
- Find out the company’s strengths, weaknesses, product, economic cycle, and hazards that accompany the production of goods.
- Find out how the management’s performance contributes to the company’s growth.
- Find out how the company has been performing in the past.
From the above discussion, it is clear that the option adopted by Mark and Spencer is the best, that it is better than traditional stock repurchase and increasing the dividend payout.
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Bragg, S. (2007). Financial statement analysis: a controllers’ guide. John Wiley & Sons, Inc.
Emery, D., Finnerty, J., & Stowe, J. (2007). Corporate Financial Management. Prentice Hall: Pearson Education, Inc.
Erich, H. (n.d). Financial analysis tools and techniques: a guide for managers. Hill: McGraw.
Fridson, M, Avarez, F. (2002). Financial statement analysis: a practitioners’ guide. John Wiley & Sons, Inc.
Graham, J., Smart, S., Megginson, W. (2009). Corporate Finance: Linking Theory to what Companies Do. South Western Educational Publishing.
Keown, A., Petty, W., Martin, J, and Scott, F (2007). Foundations of Finance. Prentice Hall Publishing.
Mukherjee H., & Mohammed, H. (2005). Corporate Accounting. Tata McGraw-Hill.
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Wilkinson, N. (2005) Managerial economics: a problem-solving approach. Cambridge University Press.