Week 9 Family Business

Family business are very unique with major involvement of members of particular family. It is clear that family businesses comprise a very significant proportion of business throughout the world. It is agreed that family business cannot be confined to demographic criteria i.e. number of family members working or the percentage of shareholding of family members in the business. Other factors such as intention, involvement and influence are also becoming increasingly important when defining whether a business is family business or not.(Lumphin et al, 2008)

There are various financial intermediaries which helps the family business in managing their finances. Some are better suited for long term fund requirements and others are better suited for short term requirements.(Allen F. & Santomero A, 1998) The different financial intermediaries that are worth noting are banks, venture capital and informal credit market.

 

The major financing source is Banks, which however are required to limit their exposure to any one borrower to no more than 15 per cent of their equity, and many choose a much smaller threshold. This limit on borrower concentration has the effect of restricting business lending by small banks primarily to small business loans. Moreover, small banks are better for small and medium size firms and family firms as they provide them with personalized services that larger banks generally are unable to provide to these firms. Non-banking financial intermediaries (Insurance companies, pension funds, mutual funds, etc) are normally more operational in rich countries rather than underdeveloped nations. 

 

Informal credit also plays a key role in the financing field which are not regulated by any banking authorities. However, they are very important in the financial system and even more important in developing countries such as India and China because they act as a catalyst between fast growing firms and regulated financial sector. There are three important categories of informal credit lenders. The most important are indigenous bankers who function as commercial banks. They take deposits and give loans but they are not under any formal regulatory authorities. The secondly there are commercial financiers who lend their own funds and finally there are brokers who helps in connecting the lender and the borrowers. (Strahan, P. & Weston, J., 1996)

 

Capital markets are good source of funds as equity capital is not serviced by any interest factor and the shareholders are paid dividend only when company is doing well. But it is also not free from imperfections. (Morris et al, 1997) There is a problem of asymmetric information between provider and user of fund lead to a gap between the cost of external and internal financing which makes raising fund from market expensive on one hand and on the other the investor may be reluctant to invest in a new firm. The capital markets are also an important source of funds for family owned businesses but they are not a viable option for small and medium scale firms as there is a general belief that they would not get correct valuation. Again family firms generally try and keep their financials  undisclosed but when a firm goes for an IPO they have to disclose information that the firm may not be willing to disclose.

 

The work of venture capitalists is not restricted to financing these firms but they also help in overall development of these firms by helping them to overcome their shortcomings. Both types of support imply a positive impact on growth rate of the venture backed firms. Engel (2008) found that venture capital funding has a positive impact on fast growing firms with innovative products.

 

 

                                                                                               Written on 24 March

                                                                                                Revised on 10 May

 

 

 

 

Week 5 Transfer pricing

Transfer pricing is importance to international corporations because their operations extend to countries with diverse taxation regimes and regulatory capacities. The pursuit of profits, cash flows, marketing goals, economies of scale and competitive advantage through joint ventures, subsidiaries and affiliates necessitates estimations of costs to measure performance and taxable profits. In such an environment corporations need to develop processes for allocating  costs and overheads and design strategies for estimating transfer prices for goods and services. Since costs and overhead allocation mechanisms are highly subjective corporations enjoy considerable discretion in allocating them to paricular products and geographical jurisdictions. Such discretion can enable them to minimize taxes and swell profits by ensuring that, wherever possible, most profits are located in  low-tax or low risk jurisdictions. Transfer pricing can enable companies to avoid double taxation.

The offshore companies are typically remunerated using traditional transfer pricing approaches. In case of outsourced services predominantly the cost plus method is applied. However, in view of the substantial cost savings generated through offshoring of activities to low-cost economies and the increasing degree  of complexity of the off shored functions, the tax administrations, in particular of emerging markets such as China and India, have started adopting more aggressive positions with regards to the traditional cost plus mark-ups applied, hence requesting much higher profit margins for the offshore companies. The main concept behind the tax management use of a Tax-Haven by a company is to restructure the company's transactions so that the majority of the taxable profit arises in a very low tax regime. It should be note that the actual operations of the company normally still operate in the original country. A number of companies have inventively restructured them or outsourced their operations to make use of Tax loopholes. The most popular tax heavens are Dublin, Luxembourg, America British Virgin Isles, Cayman Islands, Hong Kong.

Take Jersey as an example, Jersey are tax advantage for customers in that order up to £18 in value are VAT free under the personal import rules. This means that by outsourcing the sale to Indigo Lighthouse, Amazon can enjoy a competitive advantage of 15% (UK VAT) on UK based high street retailers for the same product like HMV or Zavvi. Indigo Lighthouse also deals directly with the contact lens suppliers, including Busch & Lomb, Johnstone & Johnstone, Cooper Vision and Ciba Vision as well as a number of other businesses.

week 4

As a student studing in finance, I cannot imagine the difficulty for a company to raise capital for some projects. The financing process is complicated which involves many factors. 

When a company grows rapidly, for example when contemplating investment in capital equipment or an acquisition, its current financial resources may be inadequate. Few growing companies are able to finance their expansion plans from cash flow alone. They will need to consider raising finance from other external sources to achieve their objectives (Arnold G, 2008).

Before raising capital, an important term needs to be addressed is the rate of return (Arnold G, 2008). If the rate of return is too close to the cost of capital, it risks profitability of the project if any unforeseen circumstances arise. As the example of Sky, after they released their broadband package in 2006, they predicted a post tax return of 15% by 2011. It would be expected that to ensure profitability, the return however shrinks to 10.5 per cent post tax, compared with Sky's group weighted average cost of capital (WACC), estimated at about 9 per cent. The new investment that does little more than meet its cost of capital in five years is hardly compelling - particularly given that Sky's assumptions on further price deflation in broadband provision may prove conservative.

Another important issue is to find the best method to fund these returns. The two main methods are debt and equity. In debt, bankers request interest payments and capital repayments, while in equity, the borrowed money is usually secured on business assets or the personal assets of shareholders and/or directors. It should be noted that bank also has the power to place a business into administration or bankruptcy if it defaults on debt interest or repayments or its prospects decline. In contrast, equity investors take the risk of failure like other shareholders, whilst they will benefit through participation in increasing levels of profits and on the eventual sale of their stake (McNulty, J., Yeh, T.D., Schulze, W. & Lubatkin, M, 2006). 

Today, the most popular and secure method is selling its shares on a stock exchange. Usually there is no obligation to pay dividends. Additional, the capital does not have to be repaid. However, this method suffers limitations that the return required to satisfy shareholders, moreover, it may loss of control and dividends cannot be uses to reduce taxable profit. If the company can give up an amount of ownership in the business, raising finance through equity is an optimal choice. It is should be note that raising equity finance need a long time, and the cost of listing shares on the stock market, you have to plan a hell of a long way in advance (Brealey, Richard, Myers, Stewart & Allen Franklin, 2006).

The main source of business finance is venture capital (Lumby S, 2003). It is a general term to describe a range of ordinary and preference shares where the investing institution acquires a share in the business. Venture capital is intended for higher risks such as startup situations and development capital for more mature investments. Replacement capital brings in an institution in place of one of the original shareholders of a business who wishes to realize their personal equity before the other shareholders. There are over 100 different venture capital funds in the UK and some have geographical or industry preferences. There are also certain large industrial companies which have funds available to invest in growing businesses and this 'corporate venturing' is an additional source of equity finance.

Raising finance is often a complex process. Business management need sto assess several alternatives and then negotiate terms which are acceptable to the finance provider. During the finance raising process, accountants are often called to review the financial aspects of the plan. Their report may be formal or informal, an overview or an extensive review of the company's management information system, forecasting methods and their accuracy, review of latest management accounts including working capital, pension funding and employee contracts etc. This due diligence process is used to highlight any fundamental problems that may exist.

Reference

Arnold, G. (2008). Corporate financial management (4th ed.). Harlow: Financial Times Prentice Hall

Brealey, Richard, Myers, Stewart and Allen Franklin (2006). Principles of Corporate Finance, 8TH Edition

Lumby, S. and Jones, C. (2003) Corporate Finance- theory and practice, 7th ed. Thompson.

McNulty, J., Yeh, T.D., Schulze, W. & Lubatkin, M. (2002) What's Your Real Cost of Capital? Harvard Business Review.

Week 11 Dividend Policy

The primary objective of financial management is the maximization of shareholder's wealth. To achieve this objective, management, the custodians of shareholders' interests, are faced with three important categories of decision making namely, investment, financing and dividend decisions. Investment decisions determine the total value and types of assets a firm employs. Financing decisions determine the capital structure of the firm and forms the source on which investment decisions are made. Dividend decisions in the form of dividend policies, which form the focus of this study, involve the determination of the pay out policy that management follows in determining the size and pattern of cash distributions to shareholders over time (Lease, 2000). According to Botha (Feldstein&Green,2002), the investment, financing and dividend decisions are interdependent and must be resolved simultaneously. A combination of these policy decisions should theoretically maximize shareholders' wealth.

Growth in the valuation model of share price represents the earnings generated by investment decisions in projects that create excess cash flows. Management has to decide how these earnings are to be allocated, either by reinvesting in the assets of the firm or by way of a distribution to shareholders in the form of a dividend. In making its decision, management has to constantly strive to increase the value of the firm. This increased value of the firm results in a concomitant increase in the value of shareholders' wealth

In order to create excess cash flows, management has to invest in project that have positive net present values (NPV'S). This is known as applying the NPV rule. The excess cash flows generated by positive NPV projects result in higher earnings. According to Frankfurter (2002), management can either decide to distribute these earnings as a cash dividend or reinvest them in the firm to generate even higher cash flows in the future. The decision to pay a dividend would depend on whether the firm can invest the excess earnings  in positive NPV projects in the future. In maximizing shareholders' wealth, management should only invest in projects with positive NPV values otherwise excess earnings should be paid out to shareholders in the form of a dividend.

Kaen(2003) states if dividends are paid out to shareholders only after surplus earnings have been invested in positive NPV projects then the firm follows a residual dividend policy. In this situation, the payments of dividends are closely linked to the availability of excess earnings due to the availability of positive NPV projects. Because of this link between dividends and earnings, dividends will mimic earnings from one period to another. If earnings are good and there are only a limited number of positive NPV projects to invest in then the residue of earnings are high and high dividends will be paid to shareholders. The opposite would be true if the situation is reversed. This volatility in dividend payments to shareholders from period to period would negatively influence share price because of the difficulty in predicting future dividends, a key determinant of share price.

A managed dividend policy, on the other hand, attempts to smooth dividend payments relative to earnings and investments. By following this policy, management attempts to fix dividend payments to certain levels of earnings and will only increase dividend payments once an increased level of earnings can be sustained. According to Lease et al (2000), under a managed dividend policy, managers are managing the dividend level and growth. Dividends grow in even increments and are predictable. Shareholders would have much more confidence in predicting the dividend in the following year than would shareholders under a residual policy.

Week 10 Capital Structure

A firm's basic capital resource comes from the stream of cash flow produced by its assets. Once there is a gap between internal equity and the cash that the firm need, the firm must finance this gap by issuing equity, debt or hybrid securities. The term capital structure referss to the mix of different types of securities ( long-term debt, common stock, preferred stock, convertible debt, etc) issued by a company to finance its assets ( Song, 2005). There is always a question: How do firms choose their capital structure? A lot of theories have been developed to answer this puzzling question.

Many factors have been identified as the important determinant of capital structure: leverage increases with fixed assets, non-debt tax shields, investment opportunities and firm size, and decreases with volatility, advertising expenditure, and the probability of bankruptcy, profitability and uniqueness of the product.

The financial literature offers two comppeting models of financial deisions: static trade-off and pecking order theory. In the trade-off model, firm identify their optimal leverage by weighting the costs of financial distress and the tax benefits. At the optimal leverage level, the benefit of the last unit of debt just offsets the cost. In contrast, pecking order theory arises due to the existence of asymmetric information and transaction costs. In this theory, firms raise funds in a particular sequence and follow two rules. Firstly, corporations prefer internal financing than external ones. Secondly, firms always issue the safest securities first.

It seems that one is competing the other one and they seem both reasonable to some extent. Scholars always try to run a between them in order to find the circumstances in which one is superior to another (Fama and French 2002). They find that pecking order works best for large, mature companies that have access to public bond markets. These firms rarely raise equity and they prefer internal financing to external ones, yet turn to debt markets rather than equity when external financing is needed. This is not consistent with smaller, younger, growth firms, which are mmore likely to rely on equity instead of debt. Here, the pecking order theory stumbles(Frank and Goyal 2003). The trade-off theory still retains some explanatory power once pecking order motives are accounted for. The theory is particularly helpful in explaining inter-industry differences and works best for those companies with tangible assets. It suggests that the debt ratio is lower in volatile industries where value depends on intangible assets and growth opportunities.

Nevertheless, it has to be noted that many scholars have proved that there is in fact no conflict between these two theories. Rajan and Zingales (1995) constructed a study of debt versus equity choice by large firms and they find that large firms tend to have higher debt ratios; firms with high propositions of fixed assets to total assets have higher debt ratios; more profitable firms have lower debt ratios and firms with higher ratios of market-to-book value have lower debt levels. These results interpret evidences for both the trade-off and pecking order theories. Fama and Frech (2002) stated that though motivated by different forces, the two models share many predictions about dividends and leverage. Confirmed predictions shared by the trade-off and pecking order models are that more profitable firms and firms with fewer investments have higher dividend pay outs.

To sum up, it is always too simplistic to say one is superior to another. Either one is good at explaining certain issues and has obtained a number of empirical supports. More appropriately speaking, pecking order theory is offered as a complement to rather than a substitution for the traditional trade-off model.

Week 8 Credit crunch

Credit crunch refers to the severe shortage of money or credit, which stems from the unusual economic situation in the country during the recent decade. United States had experienced a long period of low nominal short-term interest rates, low inflation and fairly steady growth. Also debt to disposable income ratios were at a high level. Household net saving rates (savings to disposable income) had been falling for a decade and were close to zero in 2006.

Many reasons can lead to credit crunches. Accounting to Owens and Schreft(1995). political or regulatory interference with the credit allocation process causes credit crunches. In addition, securitization of bank loans also has a significant influence. The securitization of consumer  credits, mortgages and commercial and industrial loans was growing in 1990s. These assets did not show in the bank's balance sheet and are not considered to be bank loans. In fact, the credit slowdown could be the spurious result of increased securitization processes in banking institutions. Consumer credit securitizations are small  compared to the total bank lending and commercial and industrial loans in fact decreased. Overzealous regulation is another factor of credit crunch. That refers to the examination practices that have forced banks to make high capital charges against loan losses and to have a more cautious approach to accepting new credit risk. Bernanke and Lown concluded that the evaluation of the capital charges was difficult to execute and thus did not found it to be an explicit reason for a lending slowdown. A data on allowances for loan losses and charges to capital proved that neither of these experienced a discontinuous jump. Thus Bernanke and Lown saw no clear connection between overzealous regulation and lending slowdown. Although the securitization had an effect to bank lending, the fundamental factor of lending slowdown, was a fall in the bank capital. Accounting to Bernanke and Loan, as a result of regulatory capital standards, banks had to  sell assets and reduce lending. This situation was called the capital crunch.

To understand more about the credit crunch in 2007-2008, it is important to comprehend the concepts of market and funding liquidity. The credit crunch in 2007-2008 is a fine example of an event where market illiquidity turns into funding illiquidity. According to Brunnemeier and Pedersen (2008) market liquidity is the ease with which an asset is traded and funding liquidity is the ease with which traders can obtain funding. A trader cannot use the entire value of the security as collateral because she must pay a margin which is financed with the trader's own capital. A margin is a difference between security 's price and collateral.

The rationale of Brunnermeier and Pedersen (2009) is explained that when traders' are having difficulties in acquiring funding, that is , the funding liquidity is tight, the traders' are not willing to invest in high-margin securities which would require a lot of capital. This reduces market liquidity and increases volatility because asset is not traded as smoothly. When the market liquidity is low, it might increase the risk of financing a trade, meaning that higher margins are demanded which worsens traders' funding constraint even more. The phenomenon described above is called a margin spiral. A loss spiral is formed when speculators have a large initial capital position that is negatively correlated with the customer's demand shock. That increases market illiquidity and induce higher speculator losses on their positions. Speculators are finally forced to sell more of their assets which cause a further drop on the price of an asset.

In short, funding problems of investors forces the leveraged investors to reduce their positions, which causes more losses and higher margins, which in turn worsens the funding problems and so on.

Week 7 --- Mergers and acquisitions

Mergers and acquisitions play signigicant roles for helping companies achieve certain objectives and financial strategies. Even though different companies have diverse reasons for engaging in mergers and acquisitions, the main purpose is to create shareholders' value and competitive advantages. Both the terms merger and acquisition indicate that a corporate combination of two separate companies to form one company and they are often used synonymously in practice, but there are slightly different meanings between them.(Harrison et al, 2001)

In a merger activity, it usually takes place  when two separate firms which have similar size agree to form a new single company. Then both companies' stocks will cease to exist and the newly created company's stock will be issued in its place (Harrison, et al,2001). This kind of activity is often referred as a merger of equals. While in the case of an acquisition, one company is purchased by another one and then no new company is formed subsequently. From a legal point of view, the target company ceases to exist, the acquirer occupies the business of the target firm and the acquirer's stock continues to be traded (Sudarsanam, 2003). In addition, the acquiring firm collects all asset and gains of the target company as well as the liability (Sudarsanam, 2003).

The synergy motive is regarded as the most popular motive for M&A. It refers to acquire or to merge with the resources of two separate firms and thus it contributes to the value of the newly combined firm greater than that of two separate unities (Seth et al., 2000). One important source of synergy is from the transfer of some valuable intangible assets, such as know-how, between targets and acquirers (Seth et al., 2000) Evaluating synergy effects from M&A deals has become one of major tasks of managers. From the perspective of the relationship between targets and total gains, they are positively correlated in synergy motivated M&A. This means that the higher the synergy, the higher the target gains as well as the acquiring firm's shareholders' benefits.

The Lightbox Photos app developed by the 500 Startups company automatically created personal photo blogs from a user's uploads. But now it will be shut down, has already been stripped from Google's Play marketplace. One problem with Instagram was that its content was siloed. Users could only engage with its photos through its apps or on other social networks. There was no mobile site or website where you could comment or Like Instagrams. But Lightbox auto-generates full-featured photo blogs with their own vanity URLs from a user's uploads, so your friends and followers could interact with your photos from any interface. This understanding of the need for wide-accessibility will serve Facebook well. While this acquisition should bolster confidence in Facebook's mobile product, it doesn't answer the question of how it going to turn mobile into a massive revenue stream. Those two go together, though. The better the mobile product, the more mobile ads Facebook can get away with.

Similar to Instagram, Lightbox wasn't just a photosharing app, but also a community where people browsed each other's mini-masterpieces. However, Facebook won't be adding that community to its 500+ million mobile population. Just Lightbox's talent is joining the big blue social network.