Surviving the Financial Crisis for Example Woolworths - Case Study Example

International Finance and Financial Management Table of Contents Surviving the financial crisis: Woolworths 3 Dividend Policies, Capital Structure and the Shareholders' Wealth 5 Dividends of Woolworths PLC 7 Capital Structure 8 Maximisation of Shareholders' Wealth 10 Corporate Social Responsibilities 12 Impact of Credit Crunch 13 Investment Appraisal Tools and Mergers towards Shareholders' Value 16 References 21 Bibliography 23 Appendix 26 Surviving the financial crisis: Woolworths Financial crisis is an external factor which can put the entire economy to a stand still. A crisis is said to erupt when the financial valuations of most of the companies deteriorate and there is a considerable credit crunch. If a company does not stay prepared for such a meltdown (as the crisis is often referred as), it is very tough for it to survive. In an outstanding work on the ways of handling the crisis by an organisation, Dominic Barton and his co-authors (Roberto Newell and Gregory Wilson) prescribed five ways of handling financial crisis (Barton, et al., 2002, pp.90-108). According to them, managing the first hundred days of the crisis is the most challenging and so the firm should take the following five tactical measures to face it: Understand and maximise the current cash positions - In the theory it is prescribed that the outset the company should have a clear understanding of its present cash position. They should oversee if the sources of funds have an undisrupted flow and if they are able to pay their creditors. Having a clear understanding, the company should try to maximise the cash positions. In 2008, Woolworths had net cash flow of 39.2 millions in comparison to 27.1 millions in 2007. In due contrast to it, the company had 2.2 millions of net cash flow in 2003. So, it can be said Woolworths took required measures to have the increased cash flow during the time of crisis. Identify and aggressively minimise operational risks - The companies, amidst financial crisis, should try to identify and reduce all sorts of avoidable day-to-day risks. During crisis, it is desirable that the companies follow the basics. The operations generated over 61.7 millions in 2008, a drastic increase over the previous year. Conduct rigorous scenario planning - During crisis the companies should also take a proper stock of the economic scenario. They should strategise on the basis of the GDP growth, currency depreciations, etc. Woolworths Group scrapped the idea of paying interim dividend in 2008 considering the net loss it has incurred and the global meltdown. Review business performance and prepare for divestitures - The company, to sustain and survive the crisis, should continuously review its performance and take necessary steps, as and when required. Also, the company should prepare itself for necessary divestments to increase the cash inflow. As the cash inflow was great for Woolworths, so we can say that the company took regular assessments of its business performance. Maintain the confidence of key stakeholders - Any company that wants to stay floated for long term, knows the value of its stakeholders. Relationship with shareholders, suppliers and customers if once lost can not be regained. The revenue has increased in 2008 compared to 2007 for Woolworths Plc and also there are no bank overdrafts in the year. Dividend Policies, Capital Structure and the Shareholders' Wealth Share-holders are the true owners of any company. And the dividend is the earning of the owner because of his stock holding on the basis of the company's profit. Apart from the capital yield (which a share-holder might earn, if he sale away the share), earning of dividend is the reason of purchasing shares by the shareholder. If a company earns profit from its professional and operational activities, the management can either retain the profit or future investments (called retained profit or retained earning) under the head of 'reserve and surplus' in the balance sheet or the management of the company can distribute the profit among its shareholders on the basis of the proportion of share holding. The management might also decide to keep a portion of profit as the retained earning and distribute the other portion as dividends. The dividends can take the form of cash dividend or stock dividend. Cash dividend is a case where cash is paid separately to the share holder on the basis of his shareholding. But in a stock dividend option, the company pays out extra shares to the shareholders. There are many theories on the distribution of dividend. The few of the widely followed theories are as follows Dividend Irrelevance - This theory was prescribed by Modigliani and Miller. According to this theory, it does not matter if the dividend is paid out to the share holders or is re-invested. The theory says, if the share holder wishes to get the cash in hand, he can always sale the share and get cash. Dividend Clienteles - The diversified shareholders might have different preferences. Some of them might prefer cash dividends while others might prefer stock dividend. Individual shareholders often prefers stock dividend because of tax liability. Again, institutional investors like pension funds or college endowment funds prefer high dividends because of tax-exemptions (Graham, John. & Kumar, Alok.,2004). If the dividend is received in cash, he is bound to pay tax as per schedule and cannot defer it. But if dividend is paid in stock, the shareholder will have to pay tax only when it is sold, which can be delayed . Again many shareholders might prefer high dividend pay-out ratio while others might long for low dividend pay-out ratio and want more amounts to be reinvested. Signaling - According to the dividend signaling theory, the good firm will declare more dividends over his competitor whose performance is not so good. It assumes that if the company has better returns or possibilities of better returns, it would declare higher dividend pay-out ratio. Signaling theory is also used to differentiate among the performances of the company when other information is not available. Dividends of Woolworths PLC Studying the payments of dividend of Woolworths on the basis of net profits earned from 2002 to 2008, it is found that the dividend pay-out ratio has differed to great extent. The analysis of the profit earnings of the Woolworths shows that it has wide deviations in its performance. While the net profit was 47.2 millions in the year 2002 and had a dividend pay-out percentage of 35.8, the net profit reduced to 2 million in 2005. Now to pacify the shareholders, the company had to declare 270% dividend. But again in 2007 the earned profit amounted to 39.1 millions. With a careful study of the dividends, it can be said that the company tried to maintain a considerable amount of dividend payment towards its shareholders over the span of last six years. For the purpose, it allowed the dividend pay-out percentages to have wide variations. The amounts distributed as dividend has been in between 16.9 million to 25.7 million and has increased year on year basis (except in 2005). To provide for considerable dividend to the shareholders, the company has also approved retained losses in some of the years. The objective of having such a dividend policy is to generate consistent flow of earnings to the shareholders and to retain the confidence of the stakeholders at large. Capital Structure The capital structure of a company is the mix that it takes to raise the required funds. The company either raises money through issue of share capital (called equity) or through the means of borrowings (i.e. the debt). It must be noted that the equity funds (own capital of the shareholders) are the costliest source to the company where as the debt funds are cheap compared to it. Also, a firm can earn tax shield if it has debt capital, as there is a tax rebate on the payment of interest of loan. Ideally, any company provides for both the means. Modigliani and Miller, the two renowned economists, have prescribed certain theories on the capital structure decisions of any company. Proposition of Modigliani-Miller approach says that the financing structure of the company is irrelevant. According to them, whatever be the way of raising finance, it does not affect the performance of the company. The theory is based on certain assumptions. In modern days, the theory does not hold good as there is utmost importance on the way the fund is raised. Debt-Equity ratio is calculated by dividing the long-term debt by the total equity. The long term debt is the loan or the borrowing of the company which is taken for a period more than one year. The total equity represents the owner's capital of the company. The comparison of debt-equity ratio among various companies with in an industry indicates if the company can raise funds through the loan capital i.e. if it is trusted by its loaners. Again if the company has a stable business, it has a high debt-equity ratio in comparison to the companies that has a cyclical business like that of manufacturing of recreation vehicles (Financial Ratio Analysis, n.d.). Analysing the debt-equity ratios of Woolworths PLC (from 2004 to 2008), we find: It can be said that the prime source of additional investments for Woolworths is not that of loans. Especially in the years of 2006 and 2007, loan capital contributed a meager amount. The study also shows that the company could not leverage the fund requirements. Rather it depended on the owner's capital. It might also happen that the lenders did not have enough confidence on the company because of the certain issues which Woolworths faced time to time and so did not lend credit to the company. The drastic change of the debt equity ratio is observed in the year 2006 in comparison to 2005. It remained almost same in 2007 and improved in 2008. Maximisation of Shareholders' Wealth The separation of ownership and control in modern day companies has led to various objectives for the different interest groups. While for the management, the objective is the increased profit, for the shareholders (or the owners) in is the maximisation of their wealth. The shareholder's wealth is the expected future returns of a company. It can be increased or maximized over a period of time by declaring stable rates of dividend or by taking adequate measures to increase the stock price of the company. The steady rate of dividend ensures a regular income for the owners. Similarly, if the stock prices trade at a higher price, the shareholder's can sale it and earn capital yield (The Role and Objective of Financial Management, n.d.). According to another school of thought, for the purpose of long term wealth maximisation, the company should forego all types of dividend or profit distribution and re-invest or retain the profits for future expansions and investments (Scenario Two, August 2008). But it has been widely felt that retaining of the entire profit does not essentially serve the purpose. So generally a middle path is followed and while a certain amount of profit is distributed to the owners, a part of it is retained for future plans. Today, corporate social responsibility is also believed to be a measure of long term wealth maximisation for a company. It is said that with increasing corporate social responsibility measures of the company, the owners have a special sense of belonging with it, which is viewed as wealth. Also, CSR improves the status of the company to its customers which increases its profitability. To maximise long term wealth of the shareholders, the company should also lay due emphasis on the research and development of its product and business line and should strive to have continuous innovation. Woolworths Plc always tried to maintain a steady distribution of dividends irrespective of its profitability. The reason behind it is to keep the share holders satisfied and so that the stock prices does not get affected by the lack of profitability. Also, if dividends are not paid on regular basis, the company becomes a target for acquisitions. But despite of taking all the required measures, the earning per share of the Woolworths Plc has been fluctuating between positives and negatives. The following table compares the basic earning per share and the adjusted basic earning per share on y-o-y basis for the company: So, it can be said that the measures initiated by the management to put up a brave face by declaring steady dividends (even more than the profits earned in some of the years) did not hold good in the long run as the adjusted basic earning per share depicts a poor show. The management should be more concerned with the performance of the company to maximise shareholder's wealth in the long run. Corporate Social Responsibilities Woolworths Plc, the renowned business group also actively participated in various CSR activities and tried to contribute to the society. According to the annual reports, some of the major initiatives were as follows: The group acknowledged and tried to implement ethical practices in its supply chain of the Asian countries like China, India and Bangladesh The group undertook various local educational and charitable measure in the United Kingdom The group repeatedly acknowledged its obligations towards energy consumption and recycling of wastes. The group also had replaced 100-watt bulbs by energy-saving bulbs at competitive price The group also pledged to take positive actions to tackle the threat of climate change of the earth among its customers, employees and stakeholders Woolworths also assisted many schools to improve their playgrounds and the quality of the play time of their pupils The group also promoted high ethical standards in every part of its business and took initiatives to reduce crime against retail through campaigning Impact of Credit Crunch The recent financial crisis, which started of as a mortgage failure in the United States market, had a world wide toll. Most of the globally reputed companies faced the heat and many of them just failed to withstand the pressure. The mortgage failure in the United States soon turned out to be the worst credit crisis since the great depression of 1929-1933. Though it started in the US market, because of the inter-related economic structure, it soon spread to the other countries as well. In the United States, 150 year old investment bank like Lehman Brothers became bankrupt. The world's reinsurer, American International Group, Inc also had to be bailed out by the tax-payer's money. The Europe and the Asia market were also not immune to the global meltdown. Number of companies resorted to the measures like lay-offs and retrenchments of their employee force. Few of the companies also extracted their business. As the performance of the companies deteriorated because of the liquidity crunch, the stock market also behaved very cruelly. All of the global markets experienced a free fall. Millions of pounds just evaporated. I t added to concerns of the managements. As people withdrew money from the market, the credit crunch became more intense. The stock market efficiency theory says that the stock price of any company reflects all the information available regarding the company. According to the theory, it is not essential that every investor should be equally equipped with all the information. The theory also allows the fact that all the investor might not have logical expectations about the returns expected. Rather it is believed that if the information is available to any of the investor, it will be soon available to the entire array of the shareholders. According to the sock market efficiency theory, as all the information are available to all the shareholders (if not primarily but in due course of time), so no particular shareholder can predict the exact movement of the share price without any inside information. As the share prices already reflect all the information available in the market, so it is expected to rise or fall only when something crucial happens either to the company or the economy as a whole (McKinley, Cris. n.d.). As the companies raise funds from the share market, with the liquidity crisis in place, it took a violent hit. Retail investors were no more willing to invest in to the equity. And a company like Woolworths Plc, which was not performing at its best for couple of years, the credit crisis came as a havoc hit. The company can also raise funds through other means like borrowings or debts. To raise funds through debt capital, it is required that the company has enough credibility in the market. The loaners must be sure that they will get their money back after completion of the term. Also, the reward of the loan i.e. the interest should be paid regularly. But as the company like Woolworths, Plc was not performing up to the mark; the available loan was also shrinking. Studying the balance sheet, it has been said that the debt-equity ratio was much lesser incase of Woolworths, Plc compared to the industry. As the borrowings were minimal, so it seems that Woolworths, Plc could not leverage itself. The benefits of tax-shield were also not available to the company. As the credit crisis ht the market and people were less interested to invest in to the equity, it would have been wise for the Woolworths, Plc to raise money through debts. But it was not the case. During the crisis, many indirect factors can also have a toll on the suffering company. The borrowing rates (from the market) may not be enough to lure the public. In that case, the company should resort to other means and instruments of fund raising. Studying the share price movements of Woolworths Plc, we find since January 2007, it has a consistent downward shift. While in January 2007, the share price was above 30 per share, it reduced to below 10 per share in 2008. The movements in the share prices shows that the fall of this massive retail chain is more because of its internal performance than the credit crunch. The market price of the share of Woolworths, Plc deteriorated from the end of 2006 here as the credit crisis hit the market only in 2008. It can be said that the liquidity crunch fastened the fall of this reputed retail chain but was not the only cause of its fall. Figure 1 Share Price of Woolworths, Plc from July 2006 to January 2009 (Share Charts of Woolworths, n.d.) Investment Appraisal Tools and Mergers towards Shareholders' Value A merger is said to take place when two similar sized companies decide to come together and operate as a single entity. Acquisition is said when one comparatively large company decides to acquire or eat-up a relatively smaller company and started functioning as one and single entity. In both the cases of mergers and acquisitions, two different entities decide to operate together. So, there is always a certain risk involved with the concept. The risks are generally involved with the two different cultures that the company has. If the culture of one company does not gel in with the other, the entire process of merger might fell. So traditionally, mergers and acquisitions have been believed as the risky propositions! To offset the risk, the purchasing company (i.e. the acquiring company) should value the other company with due seriousness. The price to be quoted by the acquiring company should be based upon thorough research. There are various valuation methods used by the acquiring companies. One of the most used valuation model is that of 'Discounted Cash Flow' method. As per the 'Discounted Cash Flow' or DCF method, the prices of assets are valued on the basis of time value of money. All the future values of the assets are discounted and their present value is calculated. In the DCF method, at the outset the discounting rate is calculated. Then the current earnings and cash flows are estimated. With the current earning and interest, the growth rate is taken into consideration to find the estimated earnings (Damodaran, Aswath. n.d.) Some of the other investment appraisal tools that are often used are those of payback periods, internal rate of return and net present value. These methods are traditional in nature. Payback period is the period which is required to raise the sum that has been invested initially. The merit of this method is that it is simple to understand and easy to calculate. But the limitation of the payback period method is that it does not consider time value of money. The second traditional method of the investment analysis tool is the IRR (Internal Rate of Return) method. Internal rate of return is the rate at which the stream of net present value equal to zero. In other words, IRR is the annualised compounded rate that is expected to be earned from the investment. The third method i.e. the NPV (Net Present Value) method is used to appraise long term investment proposals. It is the total cash inflow of a particular time series. The mergers and acquisitions are done with certain objectives. The objectives might be that of increasing the reach of the company utilising the establishment of the other company. The objective of merger might be also to achieve additional services. But one of the major objectives of any type of merger or acquisition is that to create shareholder's value. According to a study, it has been observed that 20% of the mergers happen to enhance the shareholder's value (Unlocking Shareholders Value: The Key to Success, n.d.). As we know the shareholders are the true owners of the company, so it can be said that if the merger is successful and can improve the performance of the combined entity, it will create shareholder's wealth. But if the merger is not successful, it might prove fatal for the shareholders. According to the global research report on mergers and acquisition (prepared by the leading audit firm, KPMG), a success of merger depends upon six factors namely Synergy - The firms decide to come together with the objective of creating synergies among themselves. The merging companies often believe that it they can work as a single entity, an economy of scale can be created. The synergies help to increase the revenue and also to reduce the cost. Due diligence - It is the way of investigating the target firm if it can fit in with the company. It can take the form of market reviews, assessment of risks and review of the management competencies. There is great importance related to due diligence to make a merger successful. Proper integration - As two different companies come together incase of mergers and acquisitions, proper integration holds the key to success. All the functions of both the companies should be integrated together in such a way that the optimum output can be obtained. Management team - This is the most vital step for the success of a merger. The picking up of the management team should be done with due considerations of the performance of the probable managers. They should not be selected on the basis of quota of any company. Cultural factors - One of the crucial factors in case of merger, cultural factors, if cannot be handled properly, can be fatal for the amalgamated company. As the culture differs from company to company, it is expected that the two merging companies will also have different cultures. The difference in culture should be integrated and there should be a new cultural framework for the new entity so that a sense of belonging is raised for the new company. Communication - People are generally averse to any kind of change. As almost every situation (that they were used to do with) changes incase of a merger, it is found that the workforce often becomes hostile. To avoid such an outcome, the company management should take every possible step to clarify the necessity of any new action to the workers and help them to accept those with an open mind (KPMG, 1999). Still it has been found that nearly 80% of the mergers have been unsuccessful to serve its purpose. The mergers are done to increase the shareholders' value greater to the extent which two individual companies can provide for. The shareholder's value can be analysed with the financial statements. If the merger fails (which is the fate that most of the merger meets), it can be drastic. In that case, either the two companies should separate each other or else, the entire setup may be compelled by the circumstances to wind up. In such a case, the entire shareholder value gets destroyed. So, it is certain that mergers are risky propositions as it can destroy the entire shareholder value (in case of winding up) but still it is taken with the objective of creating or enhancing the value of the shareholders. References Barton, Dominic. Newell, Roberto. Wilson, Gregory. 2002. Dangerous Markets - Managing in Financial Crisis. New York: John Wiley & Sons, Inc Damodaran, Aswath. No Date. Discounted Cash Flow Valuation : Basics. [pdf] New York University. Available at: http://pages.stern.nyu.edu/adamodar/pdfiles/eqnotes/basics.pdf [Accessed on 19 May 2009]. Financial Ratio Analysis. No Date. University of Notre Dame. [Online] Available at: http://www.nd.edu/mgrecon/simulations/micromaticweb/financialratios.html [Accessed on 19 May 2009]. Graham, John. & Kumar, Alok.,2004. Do Dividend Clienteles Exist Evidence on Dividend Preferences of Retail Investors. [pdf] Minnesota: University of Minnesota. 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Villamil, A.P., No Date. The Modigliani-Miller Theorem, University of Illionis. [pdf] Available at: http://www.econ.uiuc.edu/avillami/PalgraveRev_ModiglianiMiller_Villamil.pdf [Accessed on 19 May 2009]. Why Economists Failed to Predict the Financial Crisis, 2009. Knowledge @ Wharton, University of Pennsylvania. [Online] Available at: http://knowledge.wharton.upenn.edu/article.cfmarticleid=2234 [Accessed on 19 May 2009]. Woolworths Group plc, 2003. Annual Report and Accounts 2003, London : Woolworths Group Woolworths Group plc, 2004. Annual Report and Accounts 2004, London : Woolworths Group Woolworths Group plc, 2005. Annual Report and Accounts 2005, London : Woolworths Group Woolworths Group plc, 2006. Annual Report and Accounts 2006, London : Woolworths Group Woolworths Group plc, 2007. Annual Report and Accounts 2007, London : Woolworths Group Woolworths Group plc, 2008. Annual Report and Accounts 2008, London : Woolworths Group Appendix Figure 1 - Share price chart of Woolworths Group, Plc, Page - 14 Read More