Outlook: The lazy route to enhanced return on capital
Friday 05 December 1997
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.
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