Outlook: The lazy route to enhanced return on capital

There is nothing particularly new in share buy-backs, special dividends, capital reconstructions and the like, but they do seem to be sweeping corporate Britain right now as never before; the business of handing out large amounts of cash to shareholders has very definitely become a phenomenon.

Reuters and GEC yesterday became the latest to catch the bug - the former with a pounds 1.5bn distribution, the latter with a pounds 300m buy-back and the promise of more to come. It was tempting to think that Kenneth Clarke, the former chancellor, effectively killed these things off when he cracked down on dividend tax credits just ahead of his last budget. Remove the tax incentive, and capital distribution schemes would lose much of their appeal, was the general view. Not a bit of it. Since then, pounds 9.5bn has been returned to shareholders over and above ordinary dividends and there are now more of these things in the pipeline than ever before.

What's causing companies to hare down this route? Are these handouts just another fee earning devise for investment bankers, a temporary and possibly financially quite dangerous corporate fad, or are there good reasons for companies to be doing this? Like most things commercial, the fashion comes from the United States, where capital distributions of the type launched by Reuters yesterday are now so common that they often go unreported.

Reuters and its advisers, SBC Warburg, have come up with a clever new way of performing the trick, even if it amounts to just a variant of the same thing; the company is bidding for itself. The effect is to structure the transaction as an exercise in capital rather than an income distribution, and thus allow Reuters to avoid paying advance corporation tax on the whole thing. This is particularly important for Reuters, since most of its earnings are overseas and it would therefore be unable to offset the ACT against its main UK tax bill.

Most companies are not in this position, and in any case would probably find the Reuters approach just too complicated and expensive to try. All the same, virtually every company runs up against some sort of ACT problem when it attempts a distribution of this sort, even though most can eventually offset the extra ACT liability against their main stream tax. All impediments will cease in April 1999, when ACT is abolished, and it will then be no holds barred. If you think there are already far too many capital distributions, just wait till then. According to one estimate, there is pounds 100bn of potential for handouts in the UK stock market.

In business there are two ways of improving return on capital and thus shareholder value. One way is the self evident and wholly commendable one of striving for improved efficiency and general business success. But if this seems too much like hard work, there may be another. Plainly the rate of return also goes up if the cost of capital is reduced. Since debt is always a good deal cheaper than equity, because it is generally considered a less risky form of capital, it can obviously make sense to replace the equity with debt.

Some companies can halve the cost of their capital in this way, and produce a corresponding rise in the rate of return. This is very much the lazy route to improved return on capital, so it is not hard to see why it appeals to so many executives.

However, there are obvious dangers. If companies load themselves up with too much debt they may become unable to fund their interest costs when the economy turns nasty. That's probably not going to happen with a company as large and financially robust as Reuters, but it is possible with smaller more cyclical companies which have perhaps been forced too far down this road by a hostile takeover bid.

Furthermore, the phenomenon may have some adverse effect on direct investment in the economy. Logically it shouldn't, since reducing the cost of capital in a company should improve the expected rate of return on new investment and therefore make managements even keener to invest in new projects. However, this is very much theoretical, business school mindset which though it might strike a cord among some FTSE 100 companies, doesn't belong to the real world of ordinary business. For most companies, having cash in the bank makes the difference between making do with the old machinery and buying the new.

The argument for buy-backs also suffers from a fatal flaw. By loading up with debt, the company increases the cost of its equity, since by definition the remaining equity must become more risky. In very highly geared companies, the cost of the debt may also become excessive, simply because no one will lend on any other terms. In other words, there may be no net benefit to the cost of capital.

To assess the real effect of all these capital repayments on the fabric of our companies, we are going to have to await the next recession and cyclical peak in interest rates. Some companies are going to regret they ever listened to the investment bankers. In the meantime, everyone makes hay.

Start your day with The Independent, sign up for daily news emails
A boy holds a chick during the Russian National Agricultural Exhibition Golden Autumn 2014 in Moscow on October 9, 2014.
Life and Style
love + sex
Arts and Entertainment
Victoria Wood, Kayvan Novak, Alexa Chung, Chris Moyles
tvReview: No soggy bottoms, but plenty of other baking disasters on The Great Comic Relief Bake Off
Ashley Young celebrates the winner for Manchester United against Newcastle
footballNewcastle 0 Man United 1: Last minute strike seals precious victory
Life and Style
Tikka Masala has been overtaken by Jalfrezi as the nation's most popular curry
food + drink
Arts and Entertainment
Seth Rogan is one of America’s most famous pot smokers
filmAmy Pascal resigned after her personal emails were leaked following a cyber-attack sparked by the actor's film The Interview
Benjamin Netanyahu and his cartoon bomb – the Israeli PM shows his ‘evidence’
ebooksA special investigation by Andy McSmith
Arts and Entertainment
80s trailblazer: comedian Tracey Ullman
Life and Style
A statue of the Flemish geographer Gerard Kremer, Geradus Mercator (1512 - 1594) which was unveiled at the Geographical Congree at Anvers. He was the first person to use the word atlas to describe a book of maps.
techThe 16th century cartographer created the atlas
Arts and Entertainment
Stephen Tompkinson is back as DCI Banks
tvReview: Episode one of the new series played it safe, but at least this drama has a winning formula
Latest stories from i100
Have you tried new the Independent Digital Edition apps?
Independent Dating

By clicking 'Search' you
are agreeing to our
Terms of Use.

iJobs Job Widget
iJobs Money & Business

Ashdown Group: Graduate Application Support Analyst

£25000 - £30000 per annum + benefits: Ashdown Group: A global leader operating...

Reach Volunteering: External Finance Trustee Needed!

Voluntary post, reasonable expenses reimbursed: Reach Volunteering: Would you ...

Christine McCleave: FP&A Analyst

£36,000 - £40,000: Christine McCleave: Are you looking for a new opportunity a...

Recruitment Genius: Sales Executive - OTE £40,000

£15000 - £18000 per annum: Recruitment Genius: This is a great opportunity for...

Day In a Page

War with Isis: Iraq's government fights to win back Tikrit from militants - but then what?

Baghdad fights to win back Tikrit from Isis – but then what?

Patrick Cockburn reports from Kirkuk on a conflict which sectarianism has made intractable
Living with Alzheimer's: What is it really like to be diagnosed with early-onset dementia?

What is it like to live with Alzheimer's?

Depicting early-onset Alzheimer's, the film 'Still Alice' had a profound effect on Joy Watson, who lives with the illness. She tells Kate Hilpern how she's coped with the diagnosis
The Internet of Things: Meet the British salesman who gave real-world items a virtual life

Setting in motion the Internet of Things

British salesman Kevin Ashton gave real-world items a virtual life
Election 2015: Latest polling reveals Tories and Labour on course to win the same number of seats - with the SNP holding the balance of power

Election 2015: A dead heat between Mr Bean and Dick Dastardly!

Lord Ashcroft reveals latest polling – and which character voters associate with each leader
Audiences queue up for 'true stories told live' as cult competition The Moth goes global

Cult competition The Moth goes global

The non-profit 'slam storytelling' competition was founded in 1997 by the novelist George Dawes Green and has seen Malcolm Gladwell, Salman Rushdie and Molly Ringwald all take their turn at the mic
Pakistani women come out fighting: A hard-hitting play focuses on female Muslim boxers

Pakistani women come out fighting

Hard-hitting new play 'No Guts, No Heart, No Glory' focuses on female Muslim boxers
Leonora Carrington transcended her stolid background to become an avant garde star

Surreal deal: Leonora Carrington

The artist transcended her stolid background to become an avant garde star
LGBT History Month: Pupils discuss topics from Sappho to same-sex marriage

Education: LGBT History Month

Pupils have been discussing topics from Sappho to same-sex marriage
11 best gel eyeliners

Go bold this season: 11 best gel eyeliners

Use an ink pot eyeliner to go bold on the eyes with this season's feline flicked winged liner
Cricket World Cup 2015: Tournament runs riot to make the event more hit than miss...

Cricket World Cup runs riot to make the event more hit than miss...

The tournament has reached its halfway mark and scores of 300 and amazing catches abound. One thing never changes, though – everyone loves beating England
Katarina Johnson-Thompson: Heptathlete ready to jump at first major title

Katarina Johnson-Thompson: Ready to jump at first major title

After her 2014 was ruined by injury, 21-year-old Briton is leading pentathlete going into this week’s European Indoors. Now she intends to turn form into gold
Syrian conflict is the world's first 'climate change war', say scientists, but it won't be the last one

Climate change key in Syrian conflict

And it will trigger more war in future
How I outwitted the Gestapo

How I outwitted the Gestapo

My life as a Jew in wartime Berlin
The nation's favourite animal revealed

The nation's favourite animal revealed

Women like cuddly creatures whilst men like creepy-crawlies
Is this the way to get young people to vote?

Getting young people to vote

From #VOTESELFISH to Bite the Ballot