The Financial Crisis and Ireland

December 16, 2011 Leave a comment

Recession to Depression

Christine Lagarde (basically) announced yesterday that the world is moving from a recession into a depression. She warned us of the prospect of

“economic retraction, rising protectionism, isolation and . . . what happened in the 30s [Depression]”

In the same speech she goes on to say:

“There is no economy in the world, whether low-income countries, emerging markets, middle-income countries or super-advanced economies that will be immune to the crisis that we see not only unfolding but escalating”

Escalating? Did the head of the IMF really just tell us that not only are we not out of the woods yet, but were in for more doom and gloom? Worryingly, I’m not surprised. It was inevitable I suppose. The recent European soivergn debt crisis has thrust the world back to those terrifying days of 2008, when the ‘credit crunch’ and the collapse of the US housing bubble dragged us (us being the entire global economy) from boom to bust in a matter of months.

This made me think. What’s actually happened to the world? And more importantly, what happened to Ireland? Before I go into any analysis or comment, I’m going to go on the record and say that the Financial Crisis of 2008 and the more recent Eurozone crisis are both incredibly broad and well-disputed topics in the world of finance. It would be impossible for me to fully and eloquently explain exactly what happened and who’s fault it is (editor’s note – It was actually all Anglo’s fault!). It would be highly ambitious of me to condense all that rabble into one puny blog post.  What I can do is run through it in an Irish context, and point out how major global events, predicated the massive changes in how we the Irish people viewed global finance.

‘Crisis in Confidence’

Jimmy Carter’s famous speech in July of 1979 warned of a crisis in the spirit of the nation. That speech backfired on him, but it was a good summary of what was going on with the American people. People didn’t believe in their government, trust had been lost. [1]After the Housing Bubble collapsed in the US, a ‘crisis of confidence’ emegerged. Banks stopped lending to eachother. No-one knew which bank had the most toxic assets. Credit dried up and the globe plunged into a recession.

Ireland during the boom years was a nation that had no shortage of confidence. The Celtic Tiger was in full swing and GDP along with standards of living were at all time highs. Irish growth rates exceeded European growth rates for 19 consecutive years (1987-2006), and average growth rates over the periods from 1970 to 2004, consistently outperformed the US and the EU.[2] The banks, emboldened by the boom, doubled their assets in just three years and started lending erroneous amounts to every average joe. Mortgages were being given to people who couldn’t pay them back. Moody’s recently painted a profile of this unfortunate crowd: “The average Irish mortgage defaulter is likely to be a self-employed person who borrowed at the peak of the boom in 2006 or 2007 and does not live in Dublin or Cork”. Really sounds to me like that good financial advice from their banks was absent. Go figure.

Joe could be rich if he wanted, and the jump to upper middle class was to enticing to let pass. To quote an unknown user in the politics.ie forum, the ‘gimme’ mentality at the time of the boom is still embedded in Joe, “gimme me job back, gimme sky high rip-off cost of living prices and most importantly gimme a 40 year mortgage so I can boast to me friends about how much my house is worth.”

Of course when the bubble burst, our banks were in deep trouble (Anglo, Anglo, Anglo…). Fear struck the government that the banking sector would collapse, due to the ridiculous amounts of virtually unpayable debt on their books. So, what do they do? Guarantee the banks senior debt. Government spending skyrockets, and the level of debt increases. Government debt now totals 200% of GDP.

(Here’s a fun fact our debt is now (as % of GDP): 1,382%)

Bailouts

The banks are bailed out, with help from the EU and the IMF, and the taxpayer has to foot some of the bill. Bankers, once heroes, are now vilified in the media. Private Bondholders now hold a large portion of our debt, and the Government is standing firm, refusing to give them a ‘haircut’, or payback a portion of what they lent. The taxpayer is furious. Joe is furious. Even now, the banks are refusing to budge. Matthew Elderfield, head of financial regulation at the central bank of Ireland “the government has taken a clear decision that action will not be taken against the senior bondholders of these four institutions, as they represent the basis of the restructured banking system for the future”.[3]

Problem is, if the government doesn’t pay back their private creditors, the government defaults. If we default we drag down the rest of the EU. EU doesn’t want that to happen. We then keep lending, and we then pay back all our European friends before we pay back the common people. Public dissent is understandably extremely high.

The huge amount of borrowing by the banking sector in foreign debt markets, ridiculously overpriced property markets, and very unsafe lending by the banking sector for speculative property development were prime reasons for the crash. One could argue that the Irish credit crisis would have occurred even in the absence the knock-on effects of the U.S. liquidity-credit crisis, due to the fragility of the foundations and ethics of the Irish banking sector. We must not forget that our staunch refusal to face the truth that we were in actual fact living beyond our means was another catalyst. The bubble was always going to burst, but when you’re climbing up the ladder, you never look down, not until you’ve fallen off it that is.[4]

I’d like to finish off on a quote from Patrick Neary, the chief financial regulator at the time. I think this sums up perfectly the heady optimism and self-delusion that most of the country got caught up in during the Tiger years. He told us in September 2008 that it is…

“…Important to point out that Irish banks have only very limited exposures to US subprime losses and related credit products.”

In fairness that was in part true, but what he failed to note was Ireland’s reliance on the domestic property bubble. He went on to say:

“Irish banks are resilient and have good shock absorption capacity to cope with the current situation.”

Hindsight can be hilarious sometimes.

[2] ‘Cia World Factbook’, http://www.cia.gov/ library/publications/the-world-factbook – accessed on 15-12-1011

[4] Connor, Gregory; Flavin, Thomas; O’Kelly Brian, ‘The U.S. and Irish Credit Crises: Their Distinctive Differences and Common Features’

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Mergers and Acquisitions: Corporate Soap Operas or Expansionary Necessities?

December 15, 2011 Leave a comment

There is nothing more sensational and dramatic in the world of corporate finance when two of its giants clash head on and join forces. Yes, the rare occasion when there is a perfect harmonization of financial practice between former rivals is a grand sight to behold. The merger between Exxon and Mobil in 1999 is probably one of the biggest and most successful mergers in recent history. Exxon was a direct descendant of John D. Rockefellers Standard Oil Company of New Jersey/Exxon and Mobil was also a descendant of Standard Oil Company New York/Mobil. The $73.7billion dollar agreement to merge was the largest in US corporate history at the time, and resulted in what is now the world’s largest oil company. Production is over 3.2m barrels a day[1]. Synergies resulting from the deal were predicted to be $2.8bn dollars. A year later they announced that it was in fact $4.6bn.[2] The reunion of these two Oil giants resulted in the largest divesture ever, with the newly formed company having to shed 2175 stations in the north east of America.  The new company’s profits increased roughly 5.5 times in ten years[3]

A great success story that really highlights the massive benefits of mergers isn’t it? How come all the competitors in the world aren’t joining hands and reaping the rewards? First of all there’s the regulators. Exxon-Mobil spent one year in the regulatory process, really only winning their case due to the fact that state-owned oil companies were so massive, that the joining of these two non-governmental companies was necessary to be a player in the global markets. Second, there is the very real risk that the two companies will not ‘fit’. Most likely, the merger will fail because the companies don’t spend enough time evaluating the impact these mergers will have on their staff.

“Mergers have an unusually high failure rate, and it’s always because of people issues” – Ron Elsdon, Director of retention services at DBM, a human resources consultancy in New York.

AOL Time Warner is the big ugly poster boy of failed mergers. When the deal was struck in 2000, the $182bn deal was the biggest corporate merger in recorded history. The new company posted losses of $99bn two years later. Jeff Bewkes called it ‘the biggest mistake in corporate history’. The companies demerged in 2009. The merger was a failure because AOL and Time Warner were unable to encourage a climate within the two companies to initiate the ‘synergies’ that were proposed.

 “…It is impossible to manufacture synergies, oftentimes they are just nothing more than serendipities.” – Peter S. Fader, Wharton marketing professor.[4]

This alludes to the truism that 70% of all synergies are never realized.[5]

So Mergers are big news when they happen, and can either make or break the two companies. But what is a merger exactly? And what is the difference between a merger and an acquisition?

Mergers and Acquisitions are always bandied around together in the same context, and one would be led to believe they are the same. There is a difference. An acquisition is when one company (usually in a hostile manner) takes over another company and absorbs it into itself. It is a clearly established coup, for example when Vodafone ‘acquired’ Mannesmann in an $183bn dollar deal. Mannesmann essentially disappeared and became part of the Vodafone corporate machine. A merger occurs when two similar sized companies come together in an agreement to share assets and go forward as a single company. True mergers are pretty rare, and one could even argue that the Exxon-Mobil merger was just an acquisition of Mobil by Exxon.

There are three types of Merger & Acquisition (M&A)

Horizontal – When two rivals or competitors in the same industry or market combine. E.g. Exxon and Mobil.

Vertical – This is when two companies along the same supply chain integrate with each other. There is backward and forward integration. For example, Ford motor company in the early 20th century bought the steel mills, the shipping companies and the raw material providers all the way back along its supply chain. Forward integration would be like if Aer Lingus bought a travel agent that sells the seats on its flights.

Conglomerate – A conglomerate is when a business starts to expand outside of its industry and involves itself in a wide range of different ones. General Electric or Richard Branson’s Virgin are both conglomerates, with business interests across a huge spectrum of industries.

Why expand? There are many benefits to M&A when it goes well. First a firm has to decide if artificial expansion is the right choice for them. One of the most common methods firms choose when expanding is corporate diversification. Porter (1987) suggests that the following tests be evaluated to decide whether the expansion will add value to the company.

Attractiveness Test – Acquiring firm must assess whether target firm offers new opportunities for profit growth, or if the existing comparative advantages it possesses can be extended into new markets.

Cost of Entry Test – Cost of entry must not exceed expected returns. Must compare cost of entering new market with other available financial investments available.

Better off Test –Will the firm be better off in the long run? Firm must effectively approach M&A using portfolio management, restructuring, skill transfer or activity sharing.[6]

The costs associated with these mergers are absolutely astronomical. Take the examples I’ve used today, Exxon-Mobil, AOL-Time Warner and Vodafone-Massemann. The combined value of these M&A’s is $330bn dollars! And with only 35% of M&A’s creating shareholder wealth, there must be some major pros in favor of them.

Synergy – The famous adage that 2+2 = 5. The combined company is worth more than the sum of its parts. Usually involves job losses when the new firm becomes more ‘streamlined’.

Economies of Scale – Bigger deals, bigger order size, bigger discounts. Bigger is always better.

New Capabilities and Resources – Some companies spend years developing groundbreaking technologies or revolutionary products. If you’re a big fish, sometimes it’s just easier to buy the company that makes this technology. Pfizer bought Warner-Lambert to gain access to the drug Lipitor.

The endgame is simple. It’s much easier and quicker to increase profits and grow as a company by buying out your competitors. This underlying motivation will mean that M&A will always be on the table. Even when one (merger) wave recedes, another is guaranteed to follow. It’s gravity, which is science, and science is never wrong. It all boils down to that simple ‘get rich quick, at the expense of everyone or anything in our way!’ mentality inherent in every one of us corporate slugs. Rest assured, there will always be enough drama for us in the real world when we get bored of Coronation Street.

[2] Weston, Fred, 2002, ‘Exxon-Mobil Merger: an Archetype’, UCLA, los Angeles, Forthcoming Journal of Applied Finance, Financial Management Association

[3] http://www.iccjournal.biz/exxon_mobil.htm

[4] Verma, Kamal Kishmore, 2010 ‘The AOL/Time Warner Merger: Where Traditional Media Met New Media’, Wharton Business Review

[5] Brian M. Lucey

[6] Katz, J, & Simanek, A 1997, ‘Corporate mergers and aquisitions: One more wave to..’, Business Horizons, 40, 1, p. 32, Business Source Complete, EBSCOhost, viewed 15 December 2011.

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Dividends, dividend policies and the Ford Motor Company

December 14, 2011 2 Comments

After reading that Ford (the second largest car-maker in the US) are going to start paying out dividends again after a five year hiatus, I found myself wondering if firms that issue dividends a better investment opportunity than those who don’t? Will Bill Ford’s (Ford group’s executive chairman, and Ford family member) announcement that:

“We have made tremendous progress in reducing debt and generating consistent positive earnings and cash flow…The board believes it is important to share the benefits of our improved financial performance with our shareholders”[1]

Affect the markets opinion of their stock? Well, yes it did. Going against my assumption that the stock would rise in response, it actually dropped 2.78% over the course of the day; although they initially rose they could not sustain the rise. Does this mean that the market is too volatile, and Ford re-instated their dividends prematurely? Well, maybe not. This move was widely expected, and there was also likely pressure from the Ford family (who collectively own 71 million shares) to reinstate the dividend. They are looking at a $3.5million payout in the first quarter of next year. It could also be seen as a step towards returning to their investment grade status that they lost in 2006. This would allow investment banks and mutual funds with strict policies to buy their bonds and provided investment. [2]

Ford CEO Alan Mullaly and Chairman Bill Ford Jr.

Looking at the stock price in recent days, the move seemed to have a counter-intuitive effect. From my reading, market watchers are concluding that since the dividend is quite small (20c per share per year), it’s not enough to get the dividend investors to bite. What the analysts are saying essentially, is that since Ford is such a global company, and that it does a lot of business in Europe, making a bet on Ford’s common stock (which is now paying the dividend) is akin to making a bet on the future of Europe. If Europe collapses, so will the stock. This is probably why investors are still wary of the stock, even in the face of new dividend payments.

So again I return to my initial question. Dividends are a nice bonus for holding a companies stock, but is there more to them than just a simple top up at year-end? How much can Dividend Policy tell us about a company? Do dividends make a share more attractive, or in Ford’s recent case, does it just benefit the large shareholders? To answer this I have to go back to the raw basics.

What is a dividend?

In its most simple form, a dividend is a payout by a firm to its shareholders. It is the portion of corporate profits paid out to stockholders. The corporation has two options, re-invest their profits into investment projects to increase the firm’s wealth (retained earnings) or distribute it to the shareholders. [3]

Dividends are the company’s way of rewarding its shareholders for their investment and faith in the company. It is a type of goodwill, and instills trust in its stakeholders. But is that all? We need to go deeper to find out. We need to take a look at the workings behind the release of dividends. How much? When to we release them? What could we do with the money we’re spending on dividends?

Dividend Policy

Analyzing Dividend Policy can really help us in determining the direction a business is taking, and if they are utilizing their resources wisely. This in turn can help us make a more informed decision when investing. Here are some questions we would ask when analyzing Dividend Policy:

  • How much could the company have paid out during the period in question?
  • How much did they actually pay out?
  • Do I trust the management of this company with excess cash? Did they invest well this period? Has the stock performed well?

How much a company can pay out is called the Free Cash flow to Equity measure. It is a measure of how much cash left that the business can pay out after all claimholders have been paid.[4]

Net income – (1-δ) (Capital Expenditures – Depreciation)

–       (1- δ) (Working Capital Needs)

= Free Cash Flow to Equity

δ= Debt/Capital Ratio

Ford’s FCFE was about $21Billion dollars in September according to a Moody’s Investors Services Report. Bruce Clark, senior vice president for Moody’s Investors Service, said “he expected Ford’s cash flow in 2012 to easily support paying a dividend.” [5]

So that’s all well and good, but Ford haven’t paid dividends in 5 years. Over the last 10 quarters it has earned over 17bn dollars and has focused on restructuring and improving liquidity. This brings me to the next question. Have the past five years been good for the company? Is it a good idea to stop investing in growth and start paying out? We can use a dividend matrix to help clear this up.

So what we can look at is if the company has a Cash Surplus or a Cash Deficit. Ford has an overwhelming surplus at their disposal. We then look to see if they have a history of good or bad projects. We can check the return on capital here against the Weighted Average Cost of Capital. We then put the company into it’s respective box and compare it across the market. Microsoft paid no dividends in 1996, yet it had a FCFE of around $2.1bn dollars. It was re-investing this into stellar projects, with rocketed the share price and drove it to being one of the biggest companies in the world. Since the downturn, Ford have been carefully building their way up to becoming a blue chip company once more. The company’s revenues were $6.6bn dollars for the year through September 30th, a significant increase from the dark days of 2006, when it narrowly avoided a Government bailout and was forced to stop dividends in the first place. From looking at this matrix I think that Ford can enjoy maximum dividend flexibility, and have waited the right amount of time to reinstate the dividends. It shows that the management is serious about returning the company to its former glory while still taking the shareholders into consideration. I expect that this dividend will grow progressively over the next few years, and depending on how next year goes with the euro, could be one to look into in the future.

So yes, dividends and their policy can tell us whether a company is a good investment, and in the case of Ford, while shortsightedness and concern over the future of the Euro may make this seem like the only the Big Shareholders will benefit, we only have to look at the company’s strong revival from the downturn, and its commitment to its shareholders to see that Ford are only going to get stronger and increase the dividend payout. If you expect the Eurozone to strengthen next year, buy Ford.

[3] Sullivan, Arthur; Steven M. Sheffrin (2003). Economics: Principles in action. Upper Saddle River, New Jersey 07458: Pearson Prentice Hall. pp. 273. ISBN 0-13-063085-3.)

[4] Damodaran, Aswath (2009). Framework for Analyzing Dividend Policy: Stern, NYU. Pp. 5

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What is Risk? How can we Control it?

December 9, 2011 Leave a comment

Risk vs. Systematic Risk

Risk is Uncertainty. Well, it’s the uncertainty that actually matters. If your uncertain as to whether that sauce on your dinner plate is horseradish or mayonnaise, well then your not taking any risk by trying it to see. However, if you were allergic to horseradish, then there would be a considerable amount of risk involved if you were to try it.

Risk Management and Control have become extremely topical since the crisis, as many of the leading banks and financial institutions were found in the wake of the crisis, to have had insufficiently accounted for the amount of risk they were actually facing. Why should we worry about managing this risk? In July, regulator warned banks against shedding risk staff. The Financial slowdown that we have experienced this year has forced executives to look for cost cutting measures, and risk management professionals are finding their jobs under threat. An article in the FT points out that,[1]

‘Robust (risk management) systems – as well as risk managers that had their chief executives ear – emerged during the crisis as critical factors that separated banks that weathered the downturn successfully from those that failed’

Therefore, shedding risk management staff at this point in time would be very counter intuitive. This is not the end of crisis, and the future looks volatile. To take a quote from a web article I read, “If you don’t attack risk, it will attack you!” Cheesy, but worryingly true.[2]

So we now know that risk is just the level of uncertainty we are faced with, and that risk is a bad thing. Risk in our own assets can be managed, however. And with careful management, as well as the correct use of information and financial instruments we can reduce our exposure to risk.

So what tactics can we employ to ‘attack’ this risk? Well there are primarily three big weapons in our arsenal. For the Purpose of Scope, I’m going to focus on Research and Hedging.

Research is usually the first line of defense against risk. Information is power. As Sun Tzu tells us in the ‘Art of War’, “If you know your enemy and know yourself, you need not fear the result of a hundred battles.” So we must look to the past, to find answers to potential problems in the future. Risk researchers try to,

“Identify and quantify the relationship between a potential risk agent and physical harm observed in humans or other living organisms”. (Renn, 1998)[3]

As a result of this inference, Risk Modeling is crucial to separate the wheat from the chaff, i.e. the how much of the risk in X can be explained by Y? Regression analysis is just one of the many methods we can employ to analyze risk. For example, here is the output of a regression analysis I performed using excel. Where the term ‘R Square’ accounts for the percentage of the variation in our desired variable is explained by the variables set out in our model. I.e., the model here shows that only 3% of the variation in Income (the model was a regression of Mean Annual Income against variables such as education, gender, age etc.) explained by being MALE. If we were to run a regression of say, how much of the variation in stock price is explained by an increase or decrease in the FTSE 100 index, we could come up with a reasonable percentage value to help us assess the riskiness of that stock.

An example of a company that offers Risk Management consultancy would be Accenture. Headquartered in Dublin, the firm employs over 260,000 people worldwide and provides consultancy work for 96 of the Fortune Global 100 companies. Many companies would hire firms such as Accenture to assess their risk and provide insights and forecasts. In their brochure for their ‘Collateral Management Offering 2011”, under the heading of Risk Management they offer to assess Market Risks, Liquidity Risks, Credit Risks and Operational Risks.[4]

Hedging

Hedging can be thought of as damage control. It helps us minimize our losses in the wake of a negative event. Hedging does not actually prevent the negative event from happening, but if it does, we would be prepared to take the hit and move on. When deciding a hedging policy it is crucial to strike a balance between uncertainty and the risk of opportunity loss.

Take a company who are listed on the Irish Stock exchange, but 50% of their product is sold in US dollars to customers all over the world. The US dollar is known as the price denomination here as the product is denominated in US Dollars.

An Irish company, GlásCo have just struck a deal worth $20m dollars, and expect to be paid in two months time. Now since GlásCo have decided not to hold their assets in dollars due to foreign exchange risk, they will want to repatriate those dollars to euros at some stage. This is where hedging using financial instruments comes in.

A forward contract can be used here to reduce uncertainty. A forward contract is an agreement between two parties to either buy or sell and asset at some future date, at a price agreed today. Forward contracts are an excellent way to hedge uncertainty in the market, but there is also the risk of opportunity loss on the asset. 
[5]

The firm can enter into a forward contract to buy $20m dollars worth of euro on the day the deal is finalized, at an agreed exchange rate. This then significantly reduces the uncertainty that is posed by volatility in the forex markets.

Risk is in financial markets is inevitable. Its how we control it an manage it that defines how well we deal with it. Now more than ever is risk management and risk control crucial to the survival of a firm. Recently we have seen Irish companies bite the bullet and finally admit they are preparing for the worst-case scenario that the Euro will break up.

“We anticipate there would be costs for us as an Irish-listed company, with the level of measures needed for a currency changeover — and the costs of that are difficult to calculate,” – Greencore boss Patrick Coveney[6]

They’ve got the right idea, but I can’t help feeling a bit terrified that they are conceding it as a potential event. However, it also conveys that business is taking this seriously, and do not want to stick their heads in the sand and ignore the ominous clouds of market meltdown.

Mixed emotions. Better go and get that check up on my horseradish allergy. Christmas is coming up and my family insists on roast beef with the turkey. Risk prevention at its most basic.

[3] Three decades of risk research: accomplishments and new challenge, Journal of Risk Research 1 (1), 497 (1998)

[5] John C Hull, Options, Futures and Other Derivatives (6th edition), Prentice Hall: New Jersey, USA, 2006,

[6] ‘Big companies prepare euro break-up plans, Irish Times, Dec 4 2011.’ – http://www.independent.ie/business/irish/big-companies-prepare-euro-breakup-plans-2953461.html

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Corporate Investments – Debt or Equity?

October 25, 2011 Leave a comment

Let us ponder Bonds and Stocks, or to categorize them correctly: Debt and Equity.

That age-old dilemma of choice between the two has been the source of many a disagreement. What we can all agree on though, is no matter what decision is made, that choice can always lead to some sort of controversy. The issue of Corporate Investment seemed like an incendiary enough topic in the debate, so naturally enough I zoned in on it. What it all essentially boils down to is that question we all spend hours fretting over – how can I pay as little tax as possible? (Actually maybe it’s just me who is considering moving all my taxable assets to the Channel Islands? I hear Jersey has fantastic real estate). Funnily enough, corporations are not unlike savvy business students like myself when it comes to ‘organising’ their finances.

I was reading an article online recently on the issue of Debt and Equity tax treatment in the UK and was surprised to see how highly leveraged the corporate sector was in favour of Debt. Basically, firms are encouraged to borrow when they make investments as the interest payments are tax-deductible, but if they make the same investment from their own pocket (i.e. from their equity) they are given no such relief. This led me to investigate whether firms are inclined to engage in heavy borrowing, in order to avoid taxation.

In fact, firms overwhelmingly borrow to finance investment for this exact reason. An interesting statistic from Sageworks, a financial data analyzing company, tells us that ‘From 2003 to 2008 the liabilities of small companies ballooned from roughly equal to sales to three times sales’.[1]

Debt or Equity?

What is then happening is that these companies are becoming so indebted that they are at risk of defaulting. Ironically, the more leveraged a firm is in favour of debt, the less they will invest in the future. A negative relationship has been observed between the degree of financial leverage and the level of R&D expenditure that firms undertake. These companies are essentially laden with debt from the initial investment, which stunts their potential future growth.[2]

The incentive to finance investments with debt has led to a borrowing ‘binge’ in recent years. The FT have written an article about the ‘evils’ of debt and why we should convert all equity to debt, an interesting read on a proposed (albeit radical) solution.

Now to the controversy. The courts have been inundated with cases covering the issue. Usually, the IRS (or its equivalent outside the US) bring pesky firms or investors to court, trying to classify their investment as ‘equity’. This is to bring in the tax that these wily cowboys (The firms in question, obviously) are avoiding by claiming the investment as Debt and the taxable dividends as non-taxable repayments.

The distinction between Debt and Equity should be relatively clear and one would assume, universally accepted. However, when it comes to Corporate Investment, determining whether said investment is Debt or Equity becomes a highly factual issue, where there is much debate as to what the corporation is treating its investment as. This debate is relevant due to the how the Law treats both in relation to taxation. [3]

US tax law treats debt and equity differently. The obvious difference is that interest payments on debt are deductible, while dividend payments (on equity) are not. This is where things get interesting. It is hard to distinguish between the two.

Debt is, as Robert Flannigan puts it is:

“...term capital that is advanced for a fixed return without rights to participate in the control of the undertaking…”

And Equity:

“…”Permanent” capital that is at risk of loss in exchange for rights to participate in the control and residual gain of an undertaking…”

A case in the US against Castle Harbour by the IRS investigated the determinants of investment, asking:

“…whether the funds were advanced with reasonable expectations of repayment regardless of the success of the venture (indicative of debt) or were placed at the risk of the business (indicative of an equity investment)…”[4]

These questions allowed the court to rule in favour of the IRS, which strangely enough were lobbying for the investment to be treated as debt. (The investor claimed it was privately financed). They may have won the case, but the precedent set by it could see them lose these tax proceeds four or five-fold in future.

Now, at the end of the day are these firms doing anything wrong? Other than leaving themselves highly leveraged and at risk of debt exposure, why is it so bad? Mainly because taxpayers are footing the cost of these big corporations investing activities (in essence, it could be argued that they are forced to pay a larger portion of the overall tax revenue). Although it’s not quite ‘tax avoidance’, the whole process could fall under the umbrella term of ‘tax arbitrage’ where a firm:

“…attempt(s) to profit on price differences on the same security resulting from different tax systems…”[5]

Ah. Tax Arbitrage. Maybe I should look into that before I start packing up my stuff and setting up shop with the Barclay Brothers down South.

(P.S. Here is a nice video from the FT Lex team that discusses the ending of the Debt Bias in the UK tax system. Enjoy.)

[2] Singh, M., & Faircloth, S. (2005). The impact of corporate debt on long-term investment and firm performance. Applied Economics, 37(8), 875-875-883.

[3] Burke, J. R. (2006). Debt vs. equity: The saga continues. The Tax Adviser, 37(9), 507-507-508.

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Welcome to my Blog!

October 10, 2011 Leave a comment

Hello Everyone,

In the near future, expect to see some interesting and thought provoking articles which will ask provocative questions such as:

  •  How do we value simple stocks and bonds? What can bond prices tell us about the macroeconomy? Is it a question of Debt vs. Equity?
  • How can we deal with risk in assets and what is risk anyhow?
  • Dividends and dividend policy, what works and what can we learn from it?
  • and many more..

I will draw from sources such as the Financial Times and the Economist, along with financial blogs like the irisheconomy.ie and brianmlucey.wordpress.com.

I look forward to writing and hearing back any criticisms from you my audience.

Thank you and enjoy!

Martin Browne

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