The Optimum Level of Cash Balances - Assignment Example

Part A Explain why investors get worried about companies that hold “too much” cash. CFOs of large companies are hesitant to refund the cash held in excess in the business through declaring dividends as they are of the opinion that this strategy may be viewed that the company is not so efficient to seek other unconventional investment strategies to expand their business. However, having excess cash in business may become disastrous and may result in ill-fated or costly buy-outs. For example, GO Plc had excessive cash reserves in their balance sheet with zero debt balance. The cash reserves had not been used to pay dividends to the shareholders despite the strong pressure from Go Plc shareholders for declaring special dividends. However, the board decided to acquire Forthnet in Greece on the premise that overseas buy-out will result in higher revenues in the long run. Regrettably, the acquisition of Forthnet was proved to be disastrous for Go Plc, and this demonstrates that how holding excessive cash could destabilise an earlier profit-making company. The choice by Go Plc to go for acquisition instead of paying out the excess cash to shareholders by way dividend has been exceptionally disadvantageous as corroborated by constant fall in its share price and the erosion of shareholder value immediately after the acquisition. The optimum level of cash balances that a company can have is the cash balances to meet their expenses, interest and capital expenditures and some level of cash balances to meet any extraordinary scenarios. Anything more than that will be regarded as too much cash reserves held by a company. The quick ratio and the current ratio will help to understand whether a company is having adequate cash reserves to cater their real time cash needs. Naturally, investors get worried about companies that hold “too much” cash because huge cash balances minimise the shareholder’s value as they offer lesser returns on their capital. The main contention of the David Einhorn, who is the manager of Greenlight Hedge Fund who successfully obtained an injection from the court against Apple Inc to declare dividend from its cash reserves there by compelling to declare the dividend from the Apple’s cash reserves. Hence, there is a likelihood that the value of shares of the Apple may increase by $50 per share or more after such a dividend declaration. Further, Apple shareholders are more worried that Apple may use these excess cash balances for negative mergers or acquisitions. This is supported by the precedents such as Microsoft’s blunder acquisition of aQuantive at $6.3 bn, EBay’s bad acquisition of Skype in a $2.8 bn deal, and Quaker Oats fumble acquisition of Snapple at $1.4 bn which finally, it had to write it off. For the corporate managers, excess cash generates greater pressure on them to make the cash to earn for the business. Many CFOs are of the view that share buybacks or higher dividend to shareholders as a slow-growth initiative. Thus, Apple’s shareholders are more concerned that the Apple may use these cash reserves for carrying out acquisition initiatives that may become a failure in the long-run. They cite that this had happened to Microsoft, Quaker Oats and EBay in the recent past. It is to be noted that Apple’s accomplishment over the last 10 years has been pushed by vibrant invention programs like iPad, iPod, iPhone, etc. Thus, in the case of Apple, its organic growth helped to create poignant shareholder value in the recent past as the share price of Apple was skyrocketed around $700 per share during the first half of 2013. Comparing to organic growth, acquisitions offer no or little value, since acquiring companies make the acquisition by paying full price for the assets acquired and in the majority of the cases, these costly acquisitions proved to be failures. Studies by KPMG and McKinsey proved that only about 20 to 40% of all the acquisitions enhanced the value to the shareholders with the remaining 60% reporting failure. Further, Apple shareholders are of the view that the majority of the acquisitions in the past have diverted companies from carrying out inventions and innovations . These companies have not taken into account that the acquisitions will result in the vast drain on the company’s resources and time. Further , in the majority of the cases, organic growth of companies has been hampered due to acquisition or merger. (Popelka 2013). If a company reports too much cash balances in its financial report, then, it means that its shareholders will have only lower rate of returns on their investment. Further, idle cash in the company balance sheets will hamper further employment opportunities as it remains unproductive. Further, for tax payers, if the companies keep their cash balances outside the US, mainly to lessen their tax burden, then, it will connote that there will be additional tax burden to be met by the individual tax payers. Further, Apple shareholders are more worried about that Apple may use these excess cash balances on negative mergers or acquisitions Part B If you were a shareholder in Apple, would you prefer the company to fund a share repurchase using its excess cash or the proceeds of a bond issue? The major international companies are employing the strategy of buy-back shares thereby returning the excess cash to their investors instead of paying higher or special or additional dividends. Buy-back of shares helps to cancel the existing shares of a company so that profits are shared by lesser volume of shares. Over time, this strategy adds increased earnings per share. Under accounting parlance, higher earnings per share will result in lower price to earnings’ multiple and hence, it will result in a higher share price. A major benefit of a buy-back strategy is that it facilitates a company to employ its excess cash holdings without increasing the dividend. Some companies may be hesitant to announce a dividend as they may be of view that it may not be feasible to declare the dividend in the future and hence, these companies prefer to buy-back of shares instead of paying an additional or increased dividend pay-out. Further , a share buy-back is also usually considered as an indicator to the market that such company shares are viewed as under-valued and could have a direct psychological impact on the market. It is to be noted that impact on a company’s return on equity will be greater if the share price of a buy-back is lower. In the recent past , the famous UK based companies like Vodafone plc , Rio Tinto plc and GlaxoSmithKline plc engaged in the share buy-back. In June 2011, Berkshire Hathaway announced share buy-back. At that time, the company had a whooping cash balance of $47.9 billion in cash and there had been fall in the company’s share price twenty percent and due to this, it announced buy-back of its shares from the market with a condition that it would not pay more than ten percent as the premium to its book value, and also it would see that the aggregate cash position of the company does not fall below $ 20 billion. Share buy-backs may demonstrate to be good mechanism to pump much required liquidity, particularly in the secondary market. If a company decides to contribute a small part of its reserves or its aggregate dividend distribution accrued over past years to carry out a buyback on the market, it will offer an exit mechanism for those shareholders to avail that opportunity and will assist to enhance for the company’s shares , a two-way market. Thus, a frequent usage of buy-back strategies, particularly in the equity market is the best illustration of how to establish a more liquid market. (Rizzo 2011). In spite of its record growth , share prices of Apple Inc fell sharply in the last quarter of 2013 as it share price quoted $500 in 2013 whereas it quoted $700 in the first quarter 2013. Hence, Apple Inc has decided to go for buy back as it will increase the share value considerably. By employing buy-back through issue of bonds , Apple Inc borrowing strategy is very obvious as Apple will lessen share count by about ten percent and will pay a just 3% dividend , while at the same time , Apple will pay just 4% interest to their bondholders by which Apple would enjoy about a return at 9%.(Robertson 2013). Ordinary investors may wonder why Apple Inc has announced bond issue for buyback purpose when it has huge cash and bank balances in its balance sheet. Why Apple Inc has not utilised the available cash reserves to buy back its shares. As per estimates by analysts, Apple Inc has about $ 145 billion in cash. However, it has only about $45 billion cash in US. The balances of $ 100 billion of Apple’s cash reserves are held in jurisdictions outside US as they have been earned in foreign jurisdictions. If Apple Inc wants to plough back these cash reserves into USA, then, it has to pay around $ 35 billion as income tax to US government. However , Apple Inc is handicapped in using these $100 billion cash reserves kept outside either to pay a higher dividend to its shareholders or to use the same for buy back of its own shares from the market. Hence, Apple Inc is issuing bonds, mainly to pay either dividends or to engage in buy-back. Thus, the cash reserves piled up in the offshore are acting as some sort of guarantee to the bond issue. According to Apple’s Inc press note, issuing of floating rate bonds which matures in 2016 & in 2018 will help it to avoid payment of around $ 36 billion as tax if it repatriates the cash reserves of $102.3 billion in foreign jurisdictions as Apple Inc is planning to pay its shareholders around $ 55 billion through 2015 mainly to recompense for a stock that has been knocked by symptoms of sluggish growth. (Worstall 2013). Apple Inc decided in 2013 to issue $17 bn bonds instead of using its cash reserves kept in foreign jurisdictions, mainly to save income tax to the tune of $ 9 bn .(£5.8 bn) mainly to buy-back shares from its unhappy shareholders. As the Apple’s share price is constantly falling down thereby reaching record heights and due to this, Apple’s management is intending to buy back around $100 bn shares from the market in the coming twenty-four months. Lower interest rates in USA have facilitated U.S companies to issue bonds at cheaper cost thereby assisting them to shun repatriating their huge amount of cash held in foreign jurisdictions. For instance, in the last quarter of 2012, Oracle issued bonds at an interest rate of 2.5% and employed these funds, mainly to buy back its shares from the market. (Linebaugh 2013). Apple’s main objective is to reap the benefit of low tax rates in the foreign jurisdictions and low interest rates in the USA to issue bonds and pay back to investors to increase the value of its shares. Microsoft also adopted the same strategy and raised around $2.7 bn by issuing bonds in May 2013 in the USA. It is said that Apple Inc and other major companies in the USA have been lobbying to reduce the present corporate tax rates so that they can bring back their cash resources presently parked outside USA. (Rushe 2013). The main reason for the Apple Inc to issue bonds instead of using cash reserves held in foreign bank accounts is to avoid a 35% income-tax on the cash transferred to USA and to enjoy lesser interest rates prevailing in the US market. Thus, by issuing bond, Apple is able to earn a larger return on the sum it raises as it will be enjoying the lesser interest rates on these bonds and hence, it will be enjoying leverage. The difference between income earned on the proceeds of the bond and the interest it will be paying to the bond holders will be used as a leverage to increase the rate of return to its shareholders. Further, interest which is payable to bond holders will be tax-deductible expenses. Further, as the bond holders do not have any voting rights, the Apple shareholders will retain the authority over the company affairs. (McQuaig & Bille 2007: 822). In view of the above, I strongly suggest that Apple Inc decision to issue bonds to fund its buy-back is backed with prudent financial and taxation austerity measures. List of References Linebaugh, K. (2013) Firms Keep Stockpiles of “Foreign Cash “in U.S. [online] available from [accessed 5 February 2014] McQuaig, D & Bille, P. (2007).College Accounting. New York: Cengage Learning. Popelka, L. (2013). Too Much Cash Isn’t Good for Apple. [online] available from < http://www.businessweek.com/articles/2013-02-26/too-much-cash-isnt-good-for-apple> [accessed 5 February 2014] Rizzo, E (2013) Returning Excess Cash to Shareholders [online] available from [accessed 5 February 2014] Robertson, A. (2013). Why is Apple Issuing $17 billion in Debt when it has $145 billion in cash? [online] available from accessed 4 February 2014> Rushe, D. (2013). Apple Saves $9 billion with Bond Manoeuvre. [online] available from [accessed 4 February 2014] Worstall, T. (2013). With All of Apple’s Cash, Why it is issuing Bonds? [online] available from [accessed 4 February 2014] Read More