Marks & Spencers' Choice of Scheme for Returning Cash to Its Investors - Essay Example

I. Part Marks & Spencer A. Introduction This paper aims to critically evaluate Marks & Spencers choice of scheme for returning cash to its investors. In 2002, in an effort to reorganise its capital structure, the company has given back the £2 billion to its shareholders by issuing 17 new ordinary shares per 21 current ordinary shares that an investor holds, as well as an equivalent B share for every ordinary share that an investor of Marks & Spencer holds. The choice of scheme is evaluated as an alternative method of distributing cash to its investors as compared to more traditional methods such as the traditional share repurchase and increasing dividend payout. B. Body i. M&S choice of scheme for returning cash to investors The companys preferred method of returning cash is by using the B shares scheme. Since it does not want to use the traditional share repurchase, it has created a conversion of shares – for every 21 current ordinary shares, investors will receive 17 new ordinary shares along with 1 B share for every current ordinary share (Marks & Spencer Plc 20020). The purpose of the conversion is to decrease the companys share holding without using the traditional repurchase approach, while the use of B shares intends to give back the cash by redeeming it under two choices (Vandermewe 2003). This B share scheme has offered both the company and the investors with regard to payout policy. The scheme addresses both the concerns of investors when cash is distributed by using the traditional shares repurchase, as well as their concerns when funds are distributed by increasing the amount dividend payout – that is, the high amount of income taxes that investors incur when they receive dividends (Hakanson 1982). From the point of view of the company, it also uses this scheme in order to leverage certain payout policy theories. For one, the B share scheme addresses the issues of payout policy such as information asymmetry, residual theory and expectations theory (Keown 2002). When the company has decided to return the £2 billion to its shareholders, it aims to reorganise its capital structure in line with the strategic changes that aims to implement (Marks & Spencer 2002). However, if the company chooses to repurchase its stock, investors will be sceptical about the companys moves and would have a more risky perception of the company, thus affecting the companys price/earning ratio and the value of the stock (Brealey & Myers 2003). As with residual theory, the level of the cash that should be given back to the investors should be its residual earnings, after additional profitable investments have been made (Keown 2002). On the other hand, if the company has preferred to increase the dividend payout, it provides the investors some signals that higher sustainable earnings are coming (Brealey & Myers 2003). If the company fails to deliver and meet this expectation, the companys price/earning ratio and the value of stock will also be affected. Marks & Spencers operations are having troubles during these times, and increasing the dividend payout will only provide a different signal to the investors. This will confuse investors and make them doubt, in which the worst could result in dumping the companys shares because of the high degree of uncertainty, thus riskiness attributed to it. Both share repurchase and dividends send certain signal and covey certain perceptions with regard to information about the companys financial condition (Brealey & Myers 2003). ii. M&S B share scheme versus traditional stock repurchase The use of B share scheme provokes some thoughts as regards the choice of Marks & Spencer for it over some traditional means of returning cash to the companys shareholders. The traditional share buyback is one of these means. In order to assess the firms choice, a comparison between the two ways of returning cash to the shareholders should be conducted. The traditional repurchase of shares has been considered an alternative to the more traditional way of returning cash to the customers – through dividends. Under the traditional share repurchase, the company can opt to buy a certain amount of shares either at the current market price of the share or at a higher price (Brealey & Myers 2003). The companys share holdings is decreased as well as the decrease in cash, as shareholders receive cash through the purchase. The advantages are distributed among the investors who do sell as well as those who do not. For those who sell, because capital gains tax has been less than the income tax on dividends, the advantages come in the form of these savings (Keown 2002). On the other hand, for investors who do not sell, the advantages come in the form of prospect of increase in the future dividends – the reduction of the share holdings decreases the number of shares which the earnings are divided among, which can result in higher future dividends (Berk & DeMarzo 2007). The major concern however, with regard to the use of traditional shares repurchase is from the point of view of the investors who do not sell their shares, as no apparent transfer of wealth has been apparent in contrast to, say increasing dividends (Emery, Finnerty & Stowe 2007). This is where the advantage of using the B scheme comes in. The flexibility of the B scheme, as in the case of Marks & Spencer, allows investors a choice between redeeming their 70 pence per share immediately, or defer it at a later date, in which case, the investors will receive a non-cumulative dividend of 75 percent of 6 months LIBOR (Marks & Spencer 2002). Under this scheme, investors will be able to feel the benefits in the form of cash in either choices – under the first choice where investors will be able to redeem their 70 pence, they still take advantage of the tax savings in the form of lower capital gains tax. While investors who choose the second choice get to experience the companys efforts to return the cash in the form of non-cumulative dividends for the B-scheme, they get to pay the price in the form of higher income tax on dividends. Still, they have the option to redeem their 70 pence at a future date, subject to a capital gains tax. iii. M&S B share scheme versus increased dividend payout When a company has surplus earnings, the company has a choice of either to retain the funds and invest it in capital expenditure projects, or to distribute the funds to its shareholders (Arnold 2008). Another way of returning cash to the companys shareholders is by paying dividends; or when there is an existing dividend already, to increase the dividend payout (Arnold 2008). Dividend policy has long been a very controversial topic in the subject of finance because of conflicting views with regard to its effect on a companys stock value. The choice of distributing cash to the companys shareholders through dividend payments has advantages such as the revenue stream to the shareholders in order to capture returns with regard to the investors investments, it also has it share of advantages. One of these include the high income taxes that investors incur when they receive the dividends (Keown 2002). Many proponents suggest that the high income taxes affects the after-tax returns of investments to the investors, thus paying high dividends is not a good thing. Also, after the increase in dividends have been declared, these amounts that the company pay to the investors are relatively stable over time; however, the earnings of the company, which determines its ability to pay dividends is not – it fluctuates (Emery, Finnerty, & Stowe 2007). In the case of Marks & Spencer, during the past there has been an instance when it was forced to announce a cut in dividends because of the changes within the company in order to make the operations better. This has significantly affected the stock price of the company. Therefore, in practice more companies are reluctant to increase dividend payouts in order to avoid such situations where the amount of dividends need to be cut because of significant decreases in the companies earnings (Brealey & Myers). The B share scheme of Marks & Spencer aims to address these concerns. Under the B share scheme, the company distributes cash to investors without having to incur high income taxes on dividends; they get tax savings because the tax that is applicable to redeeming the the 70 pence is capital gains tax, which is significantly lower than the income tax on dividends. The flexibility of the B share scheme also enables investors to enjoy the benefits of receiving cash in the form of dividends if they happen to prefer the second choice, without putting strains on the companys treasury if higher dividend payout scheme has been used to return the cash (Strebulaev 2007). C. Conclusion In an effort of Marks & Spencer to reclaim its strategic position, the company has analysed its options with regard to its resources and strategic direction. In order to re-position the company as a strong contender in the high street retail industry in the United Kingdom, the first thing the company has done is to change its capital structure from having too much equity from property ownership in its balance sheet. In its efforts to raise cash, Marks & Spencer has sold, leased and securitised some of its properties in order to raise £2 billion which is aimed to return the cash to the investors in its effort to increase the shareholder value of the company. In line with this, the company has raised an equivalent amount of debt in order to include a 30% gearing in its financial statement. When deciding on a companys payout policy, the management has to include certain considerations in its analysis. These include the role of dividends in the companys share price, as well as theories like information asymmetry, expectations theory and residual theory as all these provide the consequences for a companys choice of payout policy. In the case of Marks & Spencer, it has lowered its share holdings in order to avoid the consequences of using the traditional repurchase method, by substituting the number of current ordinary shares by a lower number of new ordinary shares. In order to distribute cash to its shareholders, it has utilised B share schemes in order to address the issues that are related to using traditional ways of returning cash to shareholders such as the shares repurchase method and increasing dividend payout. II. Part 2: Vodafone A. Introduction This paper aims to analyse the executive compensation that Vodafone provides its directors, in an effort to evaluate the incentive schemes with relation to the agency problems that are likely to be faced by the company, as well as the relation of these incentives with the impact of that recent write-offs of assets and heavy indebtedness can have on the valuation of Vodafone. B. Body i. Evaluation of incentives in light of the agency problems that are likely to be faced by the company One of the problems that may arise from the incentive scheme of Vodafone to its directors is the companys lack of incentive compensation to its non-executive directors, such as the remuneration committee (Baker, Jensen & Murphy 1988). Due to this lack of incentive, there is a little reward for the committee to craft compensation scheme that provides value to the company. As noted in the companys annual report, there is a bit of involvement of the Chief Executive Officer, Group Human Resource Director and remuneration consultants. The agency conflict that arises from the participation of these individuals due to the lax regulations of the remuneration committee include the conflict of interest between the remuneration set for the CEO, which the Group Human Resource Director and remuneration consultants answer and report to. Since the companys incentive scheme is mostly equity-based, one of the agency problems the company may experience wasting of capital through the issue of options by the companys directors (Bebchuk & Fried 2003). As the company issues more fixed-price options to executives as part of the compensation scheme, the directors assume that the cost of these options to the company is zero, and virtually free that they can give more as incentives (Hall & Murphy 2002). The companys cost of capital is not zero, and this has to be included in the decision of providing incentives (Hall & Murphy 2002). Therefore, directors should only provide options that are indexed to the companys cost of capital, which would be less valuable to the company but would provide higher incentives to executives if their strategy increases the share price over the any period (Bodie, Kaplan, Merton 2003). Options that are indexed to the companys cost of capital will only provide incentives to executives if they provide real value to the shareholders in the form of increase in share prices (Jensen 2001). Another agency problem that Vodafone may face in line with its incentives scheme include the issues in cashing in of incentives and possibility of insider trading (Baker, Jensen & Murphy 1988). Insiders, such as the directors and managers have more access to information than the general public, which they use to obtain substantial profits (Baker, Jensen & Murphy 1988). If the directors, as well as the executives do this, they violate the fiduciary responsibility to the rest of the shareholders of the company. One way in order to address this is to “require pre-trading disclosure to trade for all insiders as part of the employment contract (Jensen 2001).” This way, the transfer of vast wealth due to the information that these insiders have can be better regulated. With the incentive scheme, risks are higher because it is tied-up to the companys equity. However, there is a possibility that the directors will hedge these risks to their benefits (Baker, Jensen & Murphy 1988). However, this defeats the additional risk premium that the company is willing to pay the directors in order to compensate for an equity-based riskier compensation plan (Baker, Jensen & Murphy 1988). This is another agency problem that can arise. In order to address this, the remuneration committee must not allow the directors to trade derivatives in order to hedge the risks of the companys shares (Baker, Jensen & Murphy 1988). ii. Evaluation of incentives in light of the impact that recent write-offs of assets and heavy indebtedness can have on the valuation of the company (500) The composition of incentives for Vodafones executive directors include salary, short-term incentives and long-term incentives which are subject to certain targets, restricted shares, executive share options, and global market-related remuneration. When these incentives are looked at more closely, it is apparent that salary only comprises a small percentage of the total compensation of the directors (Vodafone 2000). The large share of the directors of Vodafone is comprised of equity-based incentives such as in the form of stock options (Vodafone 2000). During the year 2000, the company has decided to acquire Mannesmann AG. In doing this, the company aims to offer Vodafone AirTouch Shares in exchange for Mannesmann AG shares (Vodafone 2000). According to the company, in order to ensure that the offer will be tax-free for US shareholders, the company has to write off its 0.45% stake in Mannesmann. Along with the acquisition, the acquisition of debt from Mannesmanns convertible bonds has substantially increased the companys indebtedness (Vodafone 2000). These activities provoke some thoughts as regards the motivation of the top management and directors with regard to pursuing such activities. On one hand, it can be evaluated as an act to increase the companys firm value by entering joint venture agreements as well as acquiring a valuable player in the pan-European area which is vital to the companys operations. However, since the acquisition has included activities such as write-offs of assets and heavy indebtedness, certain light has been brought by looking at the incentive schemes as motivating factors to the decision-makers. The directors are rewarded for increasing the value of the firm by acquiring a new company that is vital to the companys operations. When looked at the perspective of the public, these activities are meant to increase the value of the firm in the form of higher cash flows, thus higher earnings to the company. The directors must have also aimed for higher market valuation of stocks due to the increase in value that the activities have provided. This is most true in the use of a huge amount of debt (or acceptance of the high amount of new issue of bonds for Mannesmann AG). As the public sees the high amount of debt, this shows the commitment of the company to increasing the cash flows in order to service the debt. The reward for the directors by pursuing these activities come in the higher stock prices for the subsequent years when they can cash in their incentives, after they meet certain targets in order to receive those incentives. Thus, the incentive scheme in this case serve to motivate the decision-makers to pursue activities that are value-adding to the company; the interests of the agents and the principals are aligned. C. Conclusion Compensation schemes play a huge role when in comes to resolving agency conflicts as well as mitigating issues on corporate control and governance. However, in some instances, compensation schemes become the source of the agency costs. While the agency conflict between the managers and shareholders is usually addressed by providing the managers a form of ownership in the company, the agency conflict between the shareholders and the board of directors as representatives of the shareholders sometimes become a problem to the company. Compensation schemes, therefore are for managers as corporate governance is for the board of directors when it comes to reducing and mitigating problems that arise from agency conflicts. 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