Section 3
Adding Value through Financing
SECTION OVERVIEW
Janette Rutterford
The last ten or twenty years have seen a radical shift in the approach to corporate finance. In the old days, corporate finance was somehow a given, with industry norms for debt-equity ratios, borrowing limits imposed by banks and little emphasis on adding value through financing. Managers concentrated on investment rather than financing decisions. This approach could be vindicated by the early research into the firm's capital structure and dividend policy by Franco Modigliani and Merton Miller. This showed that, in perfect markets, with no corporate taxes, neither dividend policy nor capital structure could be altered to add value to the firm.
However, once taxes were introduced, the irrelevance proposition broke down. The 1963 paper by Franco Modigliani and Merton Miller, which showed that, once corporate taxes were taken into account, capital structure did matter1, can be blamed for the dramatic rise in leveraged buyouts2 which we saw particularly in the 1980s and 1990s. In the late 1990s, companies reacted to the threat of leveraged buyouts by reorganising their own capital structures through share repurchases, using debt to buy back equity and increasing their leverage as a result. The twenty-first century has seen the rise of private equity funds and venture capital funds, both of which specialise in acquiring companies and, as part of their “value added”, restructuring the capital structure to include more cost-effective debt.
Not all firms have followed the high leverage route. For example, Samsung, a large and quoted South Korean electronics firm, is striving to reduce its debt-equity ratio to zero. With a Modigliani and Miller approach, this would destroy rather than add value. There must be factors other than corporate taxes which explain the capital structure choices that firms make. One factor which appears relevant is bankruptcy risk – the higher the leverage, the higher the probability of bankruptcy. Above a certain level of debt, lenders will charge a premium which may wipe out its tax advantage. Also, not all firms pay taxes against which to offset their debt interest. New firms, or highly capital-intensive firms, may not be able to benefit from the “Modigliani and Miller” effect. Also, alternative models, such as “pecking order” theory, use agency theory, in particular the asymmetry of information built into the relationship between insider managers and outsider investors, to explain capital structure choice.
The optimal dividend policy literature had the same roots as that on optimal capital structure. For dividends, however, a puzzle appeared. Given that, in the US, where the theory was developed, there was until very recently double taxation of dividends, the puzzle was why companies would pay dividends at all. This was not the case for the UK, for example, where the imputation tax system in operation between 1973 and 1997 positively encouraged companies to pay dividends since non-taxpaying investors such as pension funds could claim tax relief direct from the government on any dividends paid.
However, the dividend policy literature, dominated as it has been by US authors and the US tax system, developed models similar to those developed for capital structure to explain the apparently irrational payment of dividends. Agency theory was again employed, in particular the role of dividends as signals by good managers to differentiate themselves from bad managers who would not have cash from which to pay dividends. It is only recently that US academics came to realise that firms were beginning to behave in accordance with Modigliani and Miller. Research carried out by Eugene Fama and Kenneth French, published in 2001,3 showed that only a minority of US firms were paying dividends while the majority were not paying any at all.
In choosing articles for this section, I have had in mind that the literature on optimal capital structure and optimal dividend policy is probably the largest in the finance field. Since my PhD was in this area, I can still remember the piles of articles – two to three feet high – that I had to get through before I could write a literature survey. With this in mind, as an overview of where we are now in the optimal capital structure debate, I have chosen a recent article by Michael Barclay and Clifford Smith Jr., “The Capital Structure Puzzle: Another Look at the Evidence”, which provides an up-to-date summary of the competing theories of optimal capital structure as well as the evidence to support them.
“Disappearing Dividends: Changing Firm Characteristics or Lower Propensity to Pay?”, by Eugene Fama and Kenneth French, is a readable article on how and why US firms are no longer paying dividends. Indeed, when I was working as a consultant to a broking firm which valued equities in the stock market boom of the late 1990s, it was acknowledged by analysts that they disapproved of firms which paid dividends. It seemed to imply that they did not – as they should – have an excess of positive Net Present Value projects in which to invest. In fact, Fama and French find that it is the new firms with low profitability and high growth opportunities which do not pay dividends. Large stable firms tend to be both ones which pay dividends and which also do share repurchases. A striking exception to this rule is Microsoft, which paid no dividends at all until 2004, when it paid one so large that it had a major boosting effect on the US economy. Case Study 14, in the last section of this book, discusses Microsoft's dividend policy, as well as other financial strategy issues.
The third article in this section looks at share repurchases, a phenomenon which really took off in the 1990s. Companies restructured their balance sheets, using debt to buy back equity, and taking advantage of a lower Weighted Average Cost of Capital. The article, by Richard Dobbs and Werner Rehm, is called “The Value of Share Buybacks” and looks at reasons other than the Modigliani and Miller tax relief on interest rationale, including behavioural reasons, to explain why so many firms carry out share buybacks. Case Study 5, “Capital Ideas” by Keith Boyfield, looks at a particular industry, the utility sector, to show how capital structure decisions are no longer cast in stone and how private equity and other financial market participants are devoting time and energy to optimising capital structures.
Case Study 6, “Death of the Dividend?”, by Adrian Wood, is an up-to-date survey of what European companies are doing with their dividends. This gives a broader perspective than just a US view, and shows that signaling still seems to be a major factor in the dividend decision.
Case Study 7, “Sciona: A Venture Capital Case Study”, is a short case study which illustrates how, in practice, an outside financing agency, in this case a venture capital company, becomes involved over a number of different stages in a small company financing.
The remaining article and case study of this section are devoted to the topic of new equity issues or, using US terminology, Initial Public Offerings or IPOs. Here, we are concerned with how, when and why companies come to the equity markets for finance. The finance literature on IPOs is similar to that on M&A in the sense that there are numerous articles which analyse the pricing of new issues over different periods, types of company and on different stock markets. What is similar, too, is the consistency of results. While the M&A literature confirms that little or no value is added through M&A deals, the IPO literature is fairly unanimous on two issues.
The first is that IPOs are under-priced as far as the issuer is concerned in that, on average, shares stand at a higher price at the close of the first day of issue than the issue price. The implication for companies is that they receive less in funds than they could – referred to as “leaving money on the table”. The implication for investors is that buying shares at an IPO and selling at the close of the first day of trading is a profitable undertaking for “stags” hunting the new issue premium.4 Possible explanations for the “under-pricing” phenomenon are that the methods of issue are not optimal from the issuer point of view.
The second “new issue puzzle” is that investors buying at the close of day one – without the new issue premium – will do less well than will investors buying equivalent risk/sector “seasoned” equities. Possible explanations for this second phenomenon are that investors and analysts are irrational in the sense that they are over-optimistic when they buy new companies. New issues follow a cycle as do mergers and acquisitions. Thus, new issues occur at a time when shares are naturally expensive and may be over-priced as a result. It may also be that analysts are over-optimistic in their earnings forecasts. There is evidence that analysts do ratchet down their forecasts during the five-year period after the IPO, becoming more realistic in their forecasts as time goes on.5
In this section of the book, we concentrate on the first phenomenon – the underpricing of new issues. Jay Ritter has produced a number of articles on this topic. The article included here, “Initial Public Offerings”, is a chapter from a book, summarising the results so far and the possible reasons for the under-pricing. It is also worth visiting Jay Ritter's home page(http://bear.cba.ufl.edu/ritter) for further articles and up-to-date numbers on new issue premia.
Case Study 8 is a series of press cuttings dating from before, during and after the 2004 IPO for Google. This issue was not only interesting because of the difficulty in valuing such a young, high-growth company, but also because the IPO method used tried to get round some of the disadvantages outlined in the Ritter article. The third interesting point to note in the press cuttings is the changing value attributed to Google both in terms of its changing share price and its potential. Note the dates of each of the articles and the value that Google had at the time. As far as analysts were concerned, noone was quite clear whether Google was just another “dot com” boom and bust, or the exception that proved the rule. When you have finished reading the case, look up the Google share price. Who was right and who was wrong?
NOTES
1. F. Modigliani and M.H. Miller (1963) “Corporate Income Taxes and the Cost of Capital: A Correction”, American Economic Review, Vol. 53, No. 3, pp. 433–43.
2. A leveraged buyout is the acquisition of a company usually by a private consortium using substantial amounts of debt, some of which might have “junk” status.
3. E.F. Fama and K.R. French (2001) “Disappearing Dividends: Changing Firm Characteristics or Lower Propensity to Pay?”, Journal of Financial Economics, Vol. 60, No. 1, pp. 3–43.
4. The first mention of “stags” in new issues was during the railway share boom in England in the 1840s. See J. Rutterford (2005) “The Company Prospectus: Marketing shares on the London Stock Exchange, 1850 to 1940”, presented at the European Business History Association Conference, Frankfurt, September.
5. For an interesting paper on the “New Issue Puzzle”, read P. Dechow, A. Hutton, and R. Sloan (1997) “Solving the New Equity Puzzle”, Financial Times, Mastering Finance Series, Summer.