The Credit Crunch and Shareholders Wealth: the Profitability and Growth of the Companies - Essay Example

Credit Crunch and Shareholders' Value 'Credit crunch' and 'maximizing shareholders value' are two different terminologies that needed to be analyzed during the impact of credit crunch. 'Credit crunch' is a latest addition to economic terminology No body knows who coined this but the term 'credit crunch' came to the fore when US Federal bank used it in 1967. Simply speaking credit crunch means an economic crisis when banks are very cautious about lending money to customers or each other. It is a situation where there is excess demand for credit on the prevailing interest rates. One can also interpret credit crunch as a situation when credit is rationed because of factors other than price mechanism. Banks start charging high interest rates for lending that becomes restrictive and selective. This impacts money (credit) market as mortgages becomes expensive. Stock markets start fluctuating wildly. Savings get reduced affecting pensioners a great deal. Use of credit cards becomes costlier. Foreclosures of mortgages and repossession of mortgaged properties become frequent feature of credit market, and worst the rate of bankruptcy rises. Credit crunch does not necessarily mean a period of recession. It is in fact a voluntary extension or interruption of monetary policy pursued by the federal bank. The success of any monetary policy depends upon attitude of lending institutions. 'Even if Fed increases the level of bank funds during a weak economy, banks may be unwilling to extend credit to some potential borrowers, and the result is credit crunch.'(Jeff Madura, page 93)1. The government some times introduces a sort of restrictive monetary policy that accentuates credit crunch. Jeff Madura (page 93) while explaining the effects of restrictive monetary policy states that 'as the money supply is reduced, and interest rates rise, some potential borrowers may be unable to obtain loans because interest payments would be too high. Thus the effects of restrictive monetary policy are magnified because higher interest rates not only discourage some potential borrowers but also prevent others from obtaining loans. Overall the credit crunch may partially offset the desired effects of a simulative monetary policy and magnify the restrictive monetary policy.' The prime objective of every company these days is to create and enhance the shareholders' value. Let us first understand the meaning of the term 'shareholders' value' before analyzing the effects of credit crunch on shareholders' value. Shareholder makes investment in order to earn good dividends and capital gains when shareholder happens to sell the investment. In other words a shareholder is concerned about cash flows he receive from the investment and also about the appreciation of the value of investment that will result in after tax future cash flows. Ultimately the value of an investment is related to cash flows from such investment. Cash flows are connected directly to profitability of the firm and thus cash payout can be increased by increasing profitability. 'Since investors value cash payouts, managers increase shareholders value when they increase the present value of the firm's net cash flows, primarily by finding new ways to either increase revenues or reduce costs. Generating more cash or receiving it earlier increases shareholders value. Manipulating the timings of sales or expenses to increase reported earnings, however, will actually decrease shareholders value if it reduces the cash that can ultimately be paid out to shareholders.'(James A. Brickley, Clifford W. Smith, and Jerold L., page 23)2 It can be said that profitability that generates more cash flows in fact add to shareholders value, and vice versa. The focus is on cash payouts or cash flows on investments of shareholders. Also it is clear that profitability or growth of the company, that is ultimately important to generate cash flows, is the vital factor that affects the shareholders' value. Growth of a company is directly related to general upward economic trends that stimulates demand for credit. Whereas credit crunch is a symptom of negative economic growth and under negative economic growth the demand for credit goes down. Also it becomes difficult to assess the reason for decline in growth of credit. It may be due to decline in demand for credit or due restriction on supply of credits from financial institutions like banks. Some time both factors work together to reduce the growth of credit as is currently happening under the present financial and economic crisis. 'On the one hand demand for credit declined as consumption and investments were sharply reduced because of uncertainty, over capacity, weakening economic conditions, and the negative wealth effect arising from a fall in asset prices. On the other hand, borrowers lost creditworthiness which made banks reluctant to lend.' (Carl- John Lindgren, page 2006)3 Credit crunch also works in another way to affect the object of companies to maximize the shareholders value. Shareholders sometimes prefer equity investments in companies that are highly geared so far as their capital structure is concerned. In a highly geared company the ratio of debt capital is higher than equity capital. With the result equity holders stand a chance of profiting from trading in equity. As equity holders are residual beneficiaries, the profit remaining after fixed rate interest charge of debt capital all belong to equity holders. This is highly beneficiary situation under the inflationary trends or rising growth era. But when there is economic slowdown and credit crunch prevails in the lending market, companies find it difficult to raise debt capital because of various reasons like loss of credit worthiness that make financial institution reluctant to lend. Naturally the companies will resort to equity capital for raising funds under such a scenario. With the result the freshly raised equity dilutes the existing equity capital and this dilution will affect the growth and maximization of shareholders value. Nancy Tengler (page 78) has aptly explained such a scenario. According to her 'If a company uses too much debts, the equity investor benefits from the interest tax shield in the short run. However, in the long run a potential economic or industry slowdown could limit the company's ability to service its debts, which in turn could cause the company to issue more equity and thus dilute the current shareholder base. However, if a company uses equity to raise capital that can also be cause of concern. The concern is that growth may not materialize or could be short lived, with the eventual consequences of equity dilution.' This dilution of existing share capital base will affect the shareholders value in such investments. Credit crunch reduces profitability because of increasing interest rates. As has been witnessed recently the credit crunch forces governments and central banks to issue a severely restrictive monetary policy for the economy. Deposits into bank get sharply affected because liquidity starts depleting from money market. Banks start facing liquidity problems because of this sharp decline in deposits and very tight reserve positions. As a matter of fact people some time get panicky and start withdrawing theirs savings and other deposits from banks. As a result of current credit crunch such a scene was witnessed in UK recently. As per a report by Peter Kenny (17 October 2007)4 "Northern Rock: the stricken lender has become one of the major causalities of credit crisis, after it had to go to the Bank of England for an emergency loan. After this fact was discovered many of the bank's 1.5 million savers queued at all hours of the day and night in order to withdraw their savings amidst fear that bank might be on the verge of collapse- a sad state of affair for a lender that enjoyed a reputation as the fifth largest mortgage lender in the UK. In the space of few days over two billion pounds were withdrawn from Northern Rock by worried savers. Not only this damaged the company financially but it also did not favour in terms of its reputation, and many experts predicted that even if the bank survived the financial losses it would not the damage to its reputation. Northern Rock also saw its share price plummet at the start of chaos with over 80% being shaved of share values." From this episode the impact of credit crunch on the shareholders value can assessed very easily. When a mere rumor could wash away 80% of shareholders value, the actual crunch would have brought the company to doorstep of bankruptcy immediately bringing down the shareholders wealth to zero value. With liquidity problems on the fore because of credit crunch, the banks are forced to issue large CDs bidding higher interest rates and also indulge in heavy borrowings from central bank. Such increased borrowings by banks and issue of commercial papers become the cause of increasing interest rates in money market. Naturally increasing interest rates increase the cost of production and cost of sales affecting the profitability. A downward trend starts on return on equity and earning per share. With the result shareholders' value start showing a downtrend mainly because of increasing interest rates. Businesses, large or small, depend a great deal on bank's line of credits beside reinvestment of existing profits. With dwindling profits during period of credit crunch, the reinvestments of profits into the companies become a redundant issue. With interest rates rising the companies either have to suffer losses or get satisfied with lowering profitability. There remains no way out except to face reduction of profitability instead of closing down in the wake of unpredictable liquidity position. Under such circumstances value of shareholders investments is hit badly as the situation before investors now remains that of saving their original investments. With dwindling demands of their product because of current liquidity crunch with consumers some companies are unfortunately just at the doorsteps of bankruptcy. Rick Newman (February 6, 2009)5 has reported on Yahoo Buzz that 15 companies might not survive 2009. He states that "with consumers shutting their wallets and corporate revenue plunging, the business landscape may start to reassemble a graveyard in 2009. Household names like Circuit City and Linen n city have already perished. And chances are, those bankruptcies were just an early warning sign of a much wider epidemic." The warning is sever but it shows how credit crunch, affecting badly the liquidity of consumers, can wash away the companies bringing down the shareholders value to zero in those companies. The shareholders wealth in those companies will remain of no value as they would be expecting only claims from bankrupted companies. Assessing shareholders wealth means assessing the market value of the investments of shareholders .In financial terminology the maximization of shareholders value, related to the growth of the company, is a factor of price/ earning (P/E) ratio. The value of company increases with increase in P/E ratio. The company has to focus on two factors in order to boost on the objective of maximization of shareholders' wealth. The first is growth rate and the other is discount rate. These two factors are the drivers to the price/ earning ratio that ultimately pushes growth of value of the company. Theoretically speaking growth rate that pushes the price earning (P/E) ratio is inversely related to discount rate. Whenever discount rate goes up it affects the growth rate adversely and price/ earning ratio goes down affecting directly to the value of company or the shareholders' wealth. According to experts credit crunch affected period is not a normal investment period and therefore P/E ratio might not be true indicator of shareholders' wealth in a company. Of course this is a considerable factor but the factors that really make or break shareholders wealth during credit crunch period are four factors, namely Cash flow generated by the company, Interest coverage ratio, Customers creditworthiness, and company's growth history. Credit crunch affect all these factors directly. Cash flows are the results of liquidity maintained by the company and companies, those are able to generate cash flows for dividend pay outs and also cash flows when a shareholder intends to liquidate its investment during credit crunch period, are the companies that contribute to the value of shareholders wealth. Second factor that indicate the ability of company to maximize its shareholders wealth is Interest coverage ratio. When during credit crunch periods the company's EBIT (earning before interest and taxes) is able to cover strongly its interest cost, it should be assumed that company will add value to shareholders cause even during difficult credit crunch period. Thirdly, when doubtful allowances of receivables are showing a rising trend as compared to average collection period, it should be assumed the company is facing collection problems and may not help in maximizing the shareholders wealth. And lastly it is the background or history of the company that shows the strength of the company to survive in credit crunch period and add value to shareholders' investments. All this depend upon the reserves of retained profits in hands of the company during credit crunch period. In short credit crunch is an indication of circumstances that affect directly to the liquidity of the company as well as liquidity of its consumers. During the period of credit crunch banks do not help companies in adding value to shareholders' wealth as their increased interest rates reduce the profitability and growth of the companies. These are maintenance of factors like cash flows, interest coverage ratio, customers' credit worthiness and history of the company with reserves of retained profits that matter in maintaining or increasing the value of shareholders investments. Otherwise credit crunch carries only doom for companies that destroy shareholders wealth instead of adding value to it. References: Read More