Corporate Finance: Marks & Spencers Capital Restructuring - Literature review Example

Running head: THE CORPORATE FINANCE Corporate Finance: Marks & Spencer's Capital Restructuring Corporate Finance: Marks & Spencer's Capital Restructuring The issues of capital structure optimization, enhancement of the shareholders wealth and payout policy has gained extreme popularity during the second half of the twentieth century. The importance of the wise payout policy choice for the companies' financial wellbeing can be emphasized by the absolute amount of money involved in the process and the fact that the decisions are made repeatedly and regularly. However, it is not the only factor. The most important aspect, perhaps, is the close complexity of relations and interdependence between payout policy and major part of the financial and investment decisions the companies make: Management and the board of directors must decide the level of dividends, what repurchases to make (and the mirror image decision of equity issuance), the amount of financial slack the firm carries (which may be a nontrivial amount; for example, at the end of 1999, Microsoft held over $17b in financial slack), investment in real assets, mergers and acquisitions, and debt issuance. Since capital markets are neither perfect nor complete, all of these decisions interact with one another. (Allen & Michaeli, 2005, p.3) The two classical and the most common types of the payout means are the dividend payment decisions and stock repurchases. Being different in form, both major types of the payout policy will not affect the company's assets, profits, or total value. (Brealey, Myers & Allen, 2005, p.417). The assumptions under which payment of dividends or repurchase of the outstanding stock does not change the total value of the company were first identified and formulated in 1961 by Miller and Modigliani. Their paper is considered to constitute the base for the development of the modern finance theory: Miller and Modigliani (M&M) show that payout policy is irrelevant in competitive markets with no transactions costs, and when investors are fully rational and symmetrically informed. The basic intuition underlying the M&M proposition is that firms are not rewarded for following a particular payout policy because investors with a desire for dividend income can create "homemade" dividends by selling shares at their fair value in the market. (Asparouhova & Lemmon, 2005, p.1) Although the vast majority of the finance literature addresses two classical forms of the payout policy, the dividends and the partial conversion of the company's stock into treasury stock, in reality they are not the only two variants available. The significant number of the hybrid mechanisms that correspond to the current state of the financial markets and needs of the shareholders, management and investors can be thought of. The capital restructuring of Marks & Spencer in 2002 can be considered an example of such a hybrid solution. The company reduced its outstanding share capital by the means of exchange of every twenty one 'old' ordinary shares for seventeen ordinary shares of the recently created corporation. This solution does not resemble the dividend payment, but can be regarded as one of the forms of the stock repurchase as the number of ordinary shares held by the external parties has decreased. In Marks & Spencer's case the payment for the stock repurchased has not been made by means of cash but rather by the issuance of the redeemable 'B-type' shares. As these B-shares can be redeemed for a certain amount of cash, including the interest, at the series of the dates in the future they can be considered debt instruments realisable in the incoming periods. Consequently, one can see the mechanism implemented by Marks & Spencer as the combination of the stock repurchase and payout to the shareholders with the financial leverage. The payout policy works toward the increase in the shareholders' wealth by effective allocation of financial assets. Company's management often has strong incentives to reduce the payout of cash to shareholders. By retaining funds internally, rather than paying them out, managers seeking to expand their domains can bypass the capital markets and avoid the monitoring costs associated with the capital acquisition process. Dennis Logue writes: Jensen observed that conflicts of interest between shareholders and managers over payout policy are especially severe in companies that generate substantial amounts of free cash flow. Shareholders wealth maximization dictates that free cash flow be paid out to the shareholders. The problem is how to get managers to return excess cash to the shareholders instead of reinvesting it in substandard projects and overpriced acquisitions or wasting it on organizational inefficiencies. (Logue, 1995, p.192) The decision of the capital restructuring was made by the Marks & Spencer's management after the disposal of a number of non-core operating assets, which means generation of excessive amount of cash. Firms repurchase stock when they have accumulated a large amount of unwanted cash or wish to change their capital structure by replacing equity with debt (Brealey, Myers & Allen, 2005, p. 418). The objectives of the changes in the capital structure are usually to increase value to the owners, both old and new, by improving operating efficiency exploiting debt capacity, and redeploying assets. However, in some cases, the objective is less strategic, in an operating sense, and not necessarily value maximizing, being directed simply to effect a change in corporate control or to defend against a loss of control. (Altman, 1993, p. 136) We can say that the combination of Marks & Spencer's ordinary and redeemable shares fulfils the mission of increasing the shareholders' wealth effectively. By 'stock repurchase' the shareholders get the excessive cash to be paid out rather than potentially invested into under-profitable projects. Moreover, use of the redeemable shares as means of payment allows the shareholders to choose the date in the future at which shares would be exchanged for cash themselves and, therefore, to choose the timely pattern of consumption they consider being optimal. It is also a good variant for the corporation itself as it provides it with certain amount of borrowed funds without additional increase in agency costs and allows to 'stretch' the cash payment into the future. With the implementation of the capital restructuring scheme Marks & Spencer is forced to address the financial market conditions. By issuing large amounts of debt and using the proceeds either to pay a big dividend or to buy back stock, management is committed to using corporate cash flows for principal and interest payments: Because the value of equity equals the value of the firm less the value of its debt, using excess cash to make debt payments effectively returns this cash to shareholders. Any expansion must henceforth be financed with new capital, subjecting management's investment plans to the exacting discipline of the market. (Logue, 1995, p.193) Another threat that often forces the management to pursue one of the possible payout policies, which may have taken place in M&S case, is the opportunity of the hostile takeover by another company. If the firm's resources are used and allocated inefficiently, the shareholders can agree to sell their shares for a price that is higher than current market price to the company which still will be able to receive profit by implementation of effective financial management. It is also worth to assess the M&S situation from the standpoint of the alternative payout policy theories. By combining the trade-off and asymmetric information theories, the following statements can be obtained: Debt financing provides benefits because of the tax deductibility of interest, so firms should have some debt in their capital structures. However, financial distress and agency costs place limits on debt usage - beyond some point, these costs offset the tax advantage of debt. Finally, because of asymmetric information, firms should maintain some reserve borrowing capacity in order to be able to take advantage of good investment opportunities without having to issue stock at low prices; thus, "the actual debt ratio will generally be lower than that suggested by the trade-off models"( Brigham & Gapenski 1997 p. 648). Marks & Spencer' management is not an exception with regard to its choice of the stock repurchases over dividends payments. Nowadays repurchases are often favoured over the dividends due to the flexibility offered by the method: They can be used in an attempt to time the equity market or to increase EPS. Executives believe that institutions are indifferent between dividends and repurchases and that payout policies have little impact on their investor clientele. In general, management views provide little support for agency, signaling, and clientele hypotheses of payout policy. Tax considerations play a secondary role. (Brav, 2005, n/p) Allen and Michaeli in their study of the payout policies used had also pointed out "the increased tendency to use open market share repurchases". They argue that the changes in the payout policies preferences are not caused by the company's intentions to signal their true value to the market players. "Both dividends and repurchases seem to be paid to reduce potential overinvestment by management. Evidence suggests that the rise in the popularity of repurchases increased overall payout and increased firms' financial flexibility" (p.2). References Allen, F. & Michaeli, R. (2002). Payout Policy. Retrieved on November 22, 2005, from Altman, E. (1993). Corporate financial distress and bankruptcy. New York: John Wiley & Sons, Inc. Asparouhova, E., & Lemmon, M. (2005). Payout policy, investor rationality, and market efficiency: evidence from laboratory experiments. Retrieved on November 22, 2005, from home.business.utah.edu/finea/dividends_atlanta.pdf Brav, A., Graham, J.R., Harvey, C.R. & Michaely, R. (2005). Payout policy in the 21st century. Tuck Contemporary Corporate Finance Issues III Conference Paper. Retrieved on November 22, 2005, from Brealey, R.A., Myers, S. C., & Allen, F.(2005). Corporate Finance. McGraw Hill/Irwin. Brigham, E., & Gapenski, L. (1997). Financial management: theory and practice. Philadelphia: The Dryden Press. Logue, D. (1995). Short-term & long-term financial management. Cincinnati: South-Western Publishing. Read More