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Formulation of

Financial Strategy

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FORMULATION OF FINANCIAL STRATEGY

1.2 Objectives of profit-making entities

The definitions above both indicate that strategy depends on objectives. For a profit- making entity the main strategic objective is to optimise the wealth of the proprietors, which means achieving the maximum profit possible consistent with balancing the needs of the various stakeholders in the entity, including shareholders, fund lenders, customers, suppliers, employees and government (in terms of taxation and legal constraints on opera- tions). The health of the entity also depends on a proper balance being achieved between long-term projects and short-term opportunities, a major constraint against the latter being that they must not be taken where there is a significant risk that they will damage long-term viability. If all these factors can be effectively balanced the result should be the achievement of the overriding strategic financial management objective of maximising shareholder value. The following statement of objectives is taken from the website of Nestle (www.nestle.com) Since Henri Nestlé developed the first milk food for infants in 1867, and saved the life of a neighbour’s child, the Nestlé Company has aimed to build a business based on sound human values and principles. While our Nestlé Corporate Business Principles will continue to evolve and adapt to a changing world, our basic foundation is unchanged from the time of the origins of our Company, and reflects the basic ideas of fairness, honesty and a general concern for people. Nestlé is committed to the following Business Principles in all countries, taking into account local legislation, cultural and religious practices: ● (^) Nestlé’s business objective is to manufacture and market the Company’s products in such a way as to create value that can be sustained over the long term for shareholders, employees, consumers and business partners. ● (^) Nestlé does not favour short-term profit at the expense of successful long-term business development. ● (^) Nestlé recognises that its consumers have a sincere and legitimate interest in the behav- iour, beliefs and actions of the Company behind brands in which they place their trust, and that without its consumers the Company would not exist. ● (^) Nestlé believes that, as a general rule, legislation is the most effective safeguard of respon- sible conduct, although in certain areas, additional guidance to staff in the form of vol- untary business principles is beneficial in order to ensure that the highest standards are met throughout the organisation. ● (^) Nestlé is conscious of the fact that the success of a corporation is a reflection of the professionalism, conduct and the responsible attitude of its management and employees. Therefore, recruitment of the right people and ongoing training and development are crucial. ● (^) Nestlé continues to maintain its commitment to follow and respect all applicable local laws in each of its markets.

1.2.1 Financial objectives

For a profit-making entity the main strategic objective is to optimise the wealth of the proprietors. In other words, the objective is assumed to be to maximise shareholder wealth. Shareholder wealth may be measured by the return that shareholders receive from their investment, represented partly by the dividend received each year and partly by the capital

FINANCIAL STRATEGY 5 FORMULATION OF FINANCIAL STRATEGY gain from the increase in the value of the shares over that period. The value of the shares should increase when the entity is expected to make additional profits that will be paid out as dividends or reinvested for future growth.

1.2.2 Stakeholders

Stakeholders: Those persons and entities that have an interest in the strategy of an entity. Stakeholders normally include shareholders, customers, staff and the local community. (CIMA Offi cial Terminology , 2005)

The various stakeholder groups may have different interests in the activities of an entity, and may seek to influence objectives of the entity. The stakeholders include:

● Shareholders – maximisation of wealth from their investment. ● Fund lenders – receipt of interest and capital repayments by the due date. ● Customers – a continuous trading relationship with suppliers, reflecting product/service quality and price. ● Suppliers – to ensure that they are paid in full by the due date. ● Employees – to maximise rewards paid to them in salaries and benefits, and continuity of employment. ● Government – may have the broad objectives of sustained economic growth and main- taining levels of employment. Faced with such a broad range of stakeholders, managers are likely to fi nd they cannot simultaneously maximise the wealth of their shareholders and keep all the other stakehold- ers content. In practice, the main strategic objective may be interpreted as achieving the maximum profit possible consistent with balancing the needs of the various stakeholders in the entity. Such a policy may imply achieving a satisfactory return for shareholders, whilst establishing competitive terms and conditions of service for the employees, and avoiding polluting the environment. Economists, and many accountants, believe that cash flow is the main criterion to judge an entity’s performance. Cash is a fact, whereas profit can be manipulated by accounting policies. Entities have in fact gone out of business because of a lack of funds, even though they were profitable. In reality, shareholder wealth is based on the present value of future cash flows. Managers in practice may have broader objectives – perhaps undertaking any financing, investment, or dividend decision that will achieve satisfactory returns rather than those that may optimise returns.

Financial targets Subsidiary objectives (or financial targets) may be employed. These include:

● Increasing earnings per share. For example, to increase eps by 5% per annum. ● Borrowing levels. For example, to maintain a gearing ratio below 30%. ● Increasing cash flows and dividends. For example, to increase operating cash flow and dividend per share year-on-year by at least 4%, which is 2.5% above the current rate of inflation. ● Profi t retention. For example, distributable profits must always be two times higher than the annual dividend.

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Investor relations Where ownership is separated from the day-to-day management of an entity, managers may be motivated to behave in ways that are not optimal to the shareholders of the entity:

● (^) Shareholders can spread their risk by investing in a number of entities. Managers have personal and financial capital invested in the entity and so may be averse to investing in a risky investment. ● (^) Shareholder wealth will be maximised by investing in projects with positive net present values. Managers may be more interested in short-term payback than net present value as the investment criterion, in order to help further their own promotion prospects. ● (^) Managers of entities that are subject to a takeover bid often put up a defence to repel the predator. While arguing this action is in the shareholders’ best interests, shareholders of acquired entities often receive large gains in the value of their shares. The managers of the acquired entity often lose their jobs or status. ● (^) Managers may be motivated to award themselves and staff better terms and conditions of service. This will incur costs and reduce profits. If equity investors are losing too much as a consequence, they may sell their shares and the market value of the entity will fall.

Goal congruence

Agency theory : Hypothesis that attempts to explain elements of organisational behaviour through an understanding of the relationships between principals (such as shareholders) and agents (such as company managers and accountants). A conflict may exist between the actions undertaken by agents in furtherance of their own self-interest, and those required to promote the interests of the principals. (CIMA Official Terminology , 2005)

Goal congruence: In a control system, the state which leads the individuals or groups to take actions which are in their self-interest and also in the best inter- est of the entity. (CIMA Offi cial Terminology , 2005)

It is evident that an important element within profit-making entities is the extent to which all members of the management team and their staff work together to achieve the strategic objectives of that entity. An aspect of agency theory aims to demonstrate that while various kinds of contract exist, formal and informal (such as job descriptions, depart- mental responsibilities and office and factory rules), these can only be effective in helping to make an entity successful if there is general acceptance of them in practice, and a con- certed effort by all concerned to strive in the same direction, that is, to achieve genuine goal congruence.

1.2.5 Shareholder value analysis

Traditionally, managers of limited liability entities have used financial measures such as profi t margin and return on assets to assess progress, and have used discounted cash- fl ow measures to assess the viability of projects or investments. Shareholder value analysis

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(SVA) is used to bring these three measurement systems into line, and starts from the view that the main objective of the directors of a profit-making entity is to maximise the wealth of the shareholders. It was developed in the 1980’s largely from the work of Alfred Rappaport (Creating Shareholder Value: The New Standard for Business Performance, MacMillan 1986). SVA is covered in more detail in Chapter 5, but a brief introduction is provided here. An assumption of SVA is that the value of an entity is the net present value of future cash flows, discounted at an appropriate cost of capital. Financing and investment deci- sions should be evaluated on their ability to maximise value for the shareholders. The inference is that the decision made will be reflected in the share price. Seven key value drivers have been identified that have the greatest impact on share price:

1. Revenue growth rate (per cent)
2. Profit margin (per cent)
3. Cash tax rate (per cent)
4. Working capital/revenue (per cent)
5. Capital expenditure/revenue (per cent)
6. Cost of capital (per cent)
7. Value growth duration period (years). The ‘value growth duration period’ represents the future period for which the entity has a foreseeable competitive advantage. SVA is used to indicate the amount of economic value created in a period. It does so by measuring and managing cash flows of the entity that take account of risk and the true value of money. The cash flows used in SVA are the net profits after tax, plus non-cash items, less any investments in working capital and non-current assets. These are known as the ‘free’ cash flows.

Free cash fl ow: Cash flow from operations after deducting interest, tax, prefer- ence dividends and ongoing capital expenditure, but excluding capital expend- iture associated with strategic acquisitions and/or disposals and ordinary dividends. (CIMA Offi cial Terminology , 2005)

1.3 Objectives of not-for-profit entities

As a general rule, books on financial management, and modern corporate finance theories, are written in the context of the profit-seeking segment of the private sector. Note that the very survival of such entities depends on their being able to identify and satisfy needs and to offer the prospect of an adequate financial return. Those which can hold out such a prospect are able to attract the funds necessary to grow their businesses, while those which cannot must inevitably shrink. Financial management involves not only heeding that discipline but also translating it into a criterion for the allocation of resources within the entity. In this context, the expression ‘an adequate return’ describes a situation in which the value of outputs (to customers or, in more upmarket situations, ‘clients’ ) exceeds the value of inputs of all kinds: not just bought-in goods and services and labour, but also capital.

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● (^) In some cases, the clients (e.g. the passengers travelling on some railway routes in the United Kingdom) will contribute towards the cost but the taxpayer meets the balance in the form of a subsidy. ● (^) In other cases, the primary function is a regulatory one, and fees are charged to those being regulated. To various degrees, however, managers in such entities see their role in terms of ration- ing their limited resources. Specifically, many are uncomfortable with the concept of value, and retreat into choosing between costs. Resources are assumed to be finite, and the task is seen as trading-off within one time-frame, for example the current fiscal year. On a small scale, for example a church council’s decisions could include choosing between a toilet for the disabled or paying for a missionary to go to a far-off land. On a large scale, governments make a political assessment of what it can raise in taxation and borrowings, and this becomes the total that it can ‘afford’ to spend. Choices have to be made and confrontation (in this case between spending ministries: Health/Education/ Defence, etc.) is inevitable. Lower down the scale, departments use the term virement ( significantly, a term which is unknown in the private sector) to refer to the need to get permission to offset an overspend on one account against an underspend in another.

1.3.1 Value for money

Value for money may be defined as ‘achieving the best possible combination of services from the least resources’. This means maximising benefits for the lowest cost and has three constituent elements: ● (^) economy , which is concerned with the cost of inputs required to deliver a defined level of outputs (i.e. inputs/money); ● (^) effi ciency , which is the ratio of outputs to inputs (i.e. outputs/inputs) and is a measure of productivity; ● (^) effectiveness , which measures the value of outcomes from a defined level of outputs (i.e. value/outputs). Value for money can then be expressed as:

Inputs Money

Outputs Inputs

Value Outputs

Value Money

In practice, value for money is difficult to measure, and it is a relative rather than an absolute measure. There will often be different views of what the objectives of a not-for- profi t entity should be, and therefore, whether appropriate objectives have been achieved. What value does one put on curing an illness, or saving a life? Should the success of a hos- pital be measured by shorter waiting list? These are societal matters, the discomfort being one of the reasons they are placed firmly in the public sector, rather than being left to the ‘survival of the fittest’ philosophy associated with the competitive markets. A public sector college will measure the number of students, the number of courses, the ratio of lecturers to students, and so on. It will also seek its customers’ assessments of the standard of, for example its lecturing and catering, and compare them with preset targets. In the language of strategic financial management, these are answers to the ques- tion ‘ How well did we do what we chose to do? ’. You should also be aware, by now, of the

FINANCIAL STRATEGY 11 FORMULATION OF FINANCIAL STRATEGY dangers of concentrating on what can be measured. Note, for example that it is possible to measure crime detection, but it is not possible to measure crime prevention; it is possible to measure the extent to which the sick are cured, but not the extent to which sickness is prevented. People can be rewarded on the basis of measurables , but it should come as no surprise if they then skimp on the immeasurables : you get what you measure. Measuring performance is but a part of monitoring progress: assessing potential and changes therein are at least as important.

1.4 Public and private – similarities and

differences

Financial management is, on the whole, equally applicable to the not-for-profit sector gener- ally and the public sector in particular. It is worth stressing perhaps, that – in common with the private sector – it is never possible to say whether or not value has been maximised. We do not know what we do not know: specifically, we do not know what opportunities have been missed. This is not a problem for those familiar with devolved authority, as it is the only approach compatible with empowerment: you cannot tell an explorer what to find, or identify what he/she has not found! Some bridge is usually required, from the known to the unknown, for example to relate the value of a unit to the costs of its tangible assets, and to consider what ‘intangibles’ explain the difference. This will often act as a very good attention-directing tool, but recognise it as holding up a mirror: in reality, value is not a function of cost. The health sector provides other examples. Investments in medical equipment represent decisions to trade in purchasing power now in the expectation of benefits later. These bene- fi ts may take the form of increased throughput (and hence reduced waiting lists) or the meeting of needs which would otherwise go unsatisfied. These benefits are not measur- able, because it is not possible to measure something which has not yet happened; they are judgemental. But this does not mean that they are not quantifiable and hence capable of evaluation. The main obstacle is usually an unwillingness on the part of those in authority (e.g. politicians) to express value judgements, perhaps because they fear such judgements ‘ being taken down and used in evidence against them’. For the avoidance of doubt, it is worth stressing that values are equally subjective in the private sector. No one pretends that they can measure the effectiveness of a proposed investment in advertising: they forecast the improvement after assessing the likely reactions of competitors, direct customers and ultimate consumers. The management accountant fulfi ls a vital role in being able to synthesise these judgements together with others (e.g. the volume–cost relationship and the cost of capital) to identify the optimum level of invest- ment they imply. The forecast outcome is logged, so as to provide a benchmark by which to monitor progress.

1.5 Assessing attainment of financial objectives

Traditionally, managers have focused on financial measures of performance and progress. Increasingly, entities in both the private and public sectors are using non-financial indica- tors to assess success across a range of criteria, which need to be chosen to help an entity meet its objectives. We discuss a number of common financial and non-financial indicators below.

FINANCIAL STRATEGY 13 FORMULATION OF FINANCIAL STRATEGY reason, would overstate an entity’s performance. In the public sector, the concept of profi t is absent, but it is still not unrealistic to expect entities to use donated assets with maximum efficiency. If depreciation on such assets were to be charged against income, this would depress the amount of surplus income over expenditure. Other points which may affect interpretation of RoA in the public sector are:

• diffi culty in determining value;
• there may be no resale value;
• are for use by community at large;
• charge for depreciation may have the effect of ‘double taxation’ on the taxpayer.

1.5.2 Non-financial performance indicators

● (^) Market share. A performance indicator that could conceivably be included in the list of fi nancial measures, market share is often seen as an objective for an entity in its own right. However, it must be judged in the context of other measures such as profitability and shareholder value. Market share, unlike many other measures, can take quality into account – it must be assumed that if customers do not get the quality they want or expect, then the entity will lose market share. Gaining market share must be seen as a long-term goal of entities to ensure outlets for their products and services, and to minimise competition. However, market share can be acquired only within limits if a monopoly situation is to be avoided. It is a measure that is becoming increasingly relevant to the public sector – for example universities and health provision. Health providers must now ‘sell’ their services to trusts established to ‘ buy’ from them. Those providers which are seen to fail their customers will lose market share as the trusts will buy from elsewhere (within certain limits). ● (^) Customer satisfaction. This can be linked to market share. If customers are not satisfied they will take their business elsewhere and the entity will lose market share and go into liquidation. Measuring customer satisfaction is difficult to do formally, as the inputs and outputs are not readily defined or measurable. Surveys and questionnaires may be used but these methods have known flaws, mainly as a result of respondent bias. It can of course be measured indirectly by the level of sales and increase in market share. ● (^) Competitive position. The performance of an entity must be compared with that of its com- petitors to establish a strategic perspective. A number of models and frameworks have been suggested by organisational theorists as to how competitive position may be determined and improved. A manager needing to make decisions must know by whom, by how much, and why he is gaining ground or being beaten by competitors. Conventional measures, such as accounting data, are useful but no one measure is sufficient. Instead, an array of measures is needed to establish competitive position. The most difficult problem to overcome in using competitive position as a success factor is in collecting and acquiring data from competitors. The public sector is increasingly in competition with other providers of a similar serv- ice both in the private and public sectors. For example hospitals now have to compete for the funds of health trusts. Their advantage is that it is easier to gain access to data from such competitors than it is in the private sector. ● (^) Risk exposure. Risk can be measured according to finance theory. Some risks – for exam- ple exchange-rate risk and interest-rate risk – can be managed by the use of hedging mechanisms. Shareholders and entities can therefore choose how much risk they wish to be exposed to for a given level of return. However, risk can take many forms, and the theory does not deal with risk exposure to matters such as recruitment of senior person- nel or competitor activity.

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Public sector entities tend to be risk-averse because of the political repercussions of failure and the fact that taxpayers, unlike shareholders, do not have the option to invest their money in less (or more) risky ventures.

1.6 The three key decisions of financial

management

The practical applications of financial management can be grouped into three main areas of decisions – investment decisions, financing decisions and dividend decisions – which reflect the responsibilities of acquiring financial resources and managing those resources.

1.6.1 Investment decisions

Investment decisions are those which determine how scarce resources in terms of funds available are committed to projects, which can range from acquisition of plant to the acquisition of another entity. Investing in non-current assets usually carries the need for supporting investment in working capital, for example inventories and receivables, less payables, an aspect often not properly taken into account by management. Investment to enhance internal growth is often called ‘ internal investment’ as compared with acquisi- tions, which represent ‘external investment’. The other side of the investment coin is disinvestment , which means the preparedness to withdraw from unsuccessful projects, and the disposal of parts of an entity which no longer fit with the parent entity’s strategy. Such decisions usually involve one very special element – the right timing for the action to be taken. Disinvestment decisions can also be involved in reconstructions, where an entity has to alter its capital structure, possibly to survive as a result of heavy losses.

1.6.2 Financing decisions

Financing decisions relate to acquiring the optimum finance to meet financial objectives and seeing that non-current assets and working capital are effectively managed. The finan- cial manager must possess a good knowledge of the sources of available funds and their respective costs, and should ensure that the entity has a sound capital structure, that is, a proper balance between equity capital and borrowings. Such managers also need to have a very clear understanding of the difference between profit and cash flow, bearing in mind that profit is of little avail unless the entity is adequately supported by cash to pay for assets and sustain the working capital cycle. Financing decisions also call for a good knowledge of evaluation of risk: excessive borrowing carries high risk for an entity’s equity because of the priority rights of the lenders. A major area for risk-related decisions is in overseas trading, where an entity is vulnerable to currency fluctuations, and the manager must be well aware of the various protective procedures – such as hedging – which are available.

Hedge : Transaction to reduce or eliminate an exposure to risk. (CIMA Official Terminology , 2005)

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Using internally generated funds is often thought to be a ‘free’ form of finance. This is of course not the case, and it is important to remember that these funds do have a cost, that is, an opportunity cost, normally taken as the cost of equity. In deciding an entity’s dividend policy the following factors should be considered: ● (^) Liquidity. In order to pay dividends, an entity will require access to cash. Even very prof- itable entities might sometimes have difficulty paying dividends if resources are tied up in other forms of assets, especially if bank overdraft facilities are not available. ● (^) Repayment of borrowings. Dividend payout may be made difficult if borrowings are scheduled for repayment and this is not financed by a further issue of funds. ● (^) Restrictive covenants. The Articles of Association may contain agreed restrictions on divi- dends. In addition, some forms of borrowing may have restrictive covenants limiting the amount of dividend payments or the rate of growth which applies to them. ● (^) Rate of expansion. The funds may be needed to avoid overtrading. ● (^) Stability of profits. Other things being equal, an entity with stable profits is more likely to be able to pay out a higher percentage of earnings than an entity with fluctuating profits. ● (^) Control. The use of internally generated funds to finance new projects preserves the enti- ty’s ownership and control. This can be advantageous in entities where the present dis- position of shareholdings is of importance. ● (^) Policy of competitors. Dividend policies of competitors may influence corporate divi- dend policy. It may be difficult, for example to reduce a dividend for the sake of further investment, when competitors follow a policy of higher distributions. ● (^) Signalling effect. This is the information content of dividends. Dividends are seen as signals from the entity to the financial markets and shareholders. Investors perceive dividend announcements as signals of future prospects for the entity. This aspect of divi- dend policy is assuming increasing importance, and there have been numerous instances reported in the press where entities have paid an increased dividend when financial pru- dence suggests that they should be paying no dividend at all. Having taken into account the above factors, entities will formulate standard dividend policies, three of which are discussed below.

1.7.1 Practical dividend policies

Constant payout ratio There are important links between dividends and profits. In United Kingdom company law, for instance, the prohibition of paying dividends other than out of profits is seen as an important protection for creditors (including lenders, who may well specify a maximum proportion of profits which can be declared as dividends while their loans remain in force). This is reinforced by the accounting concept which defines profit as what you could afford to distribute, and still be as well off as you were. Such links encourage an approach to dividend policy, based on his- toric trends with some boards of directors publishing an objective to maintain a certain divi- dend cover, that is, to declare dividends which represent a constant percentage of profits after tax. In a stable state, one would expect some symmetry in the figures, for example an entity whose profits after tax represented a 10% per annum return might choose to plough half back into the business, and look forward to a 5% per annum growth in its profits (and earn- ings per share) and hence dividends. This forms the basis of the idea that the value of a profit- making entity is a multiple of its past profits. The reality, however, is not one of a stable state. One very specific shock to the system has been the instability of the unit of measure (money). Should dividends be related to the profits calculated under the historical cost

FINANCIAL STRATEGY 17 FORMULATION OF FINANCIAL STRATEGY convention, or after making an adjustment to exclude the inflationary element? Ought they to be based on the underlying profit of the entity after adjusting for the gains or losses on the revaluation of financial instruments that are included within profit under IAS 39? Bear in mind that ‘well-offness’ is measured by reference to the cost of unconsumed tangible assets. No allow- ance is made for the intangible assets (such as quality, reputation and pace of innovation) which are so crucial to survival in a rapidly changing environment. Intriguingly, what the accountant calls an asset, for example, an old-fashioned piece of plant, can actually be a strategic liability.

Stable policy – signalling Some boards of directors think not in terms of maintaining dividend cover, but in terms of maintaining a trend in the absolute level of payout. Their starting point for deciding this year’s dividend is what was paid last year, what rate of increase it represented on the previous year, and whether they feel that this rate can be repeated, taking into account considerations of liquidity. Rightly or wrongly, the dividend decision is seen as a powerful signal to the market of the directors’ confidence in the future of the entity, and this does appear to be supported by evidence that unexpected dividend cuts have been followed by a reduction in share prices. The danger, of course, is that this can become a game, in which directors seek to give the signal they think will have the most favourable effect on the share price. Some even argue that the aim must not be to surprise the market, which leads to the suggestion that the dividend should be what the analysts are predicting. In pure economic terms, entities should pay zero dividends when they have sufficient positive net present value projects to utilise all their after tax profits and pay out 100% of after tax profits when they have no such investment possibilities. Whatever the theoretical rationale, boards would not normally countenance such potentially huge variation in divi- dends payouts that such a policy would imply. In the United Kingdom, the practice of maintaining a particular rate (sometimes real, sometimes nominal) of growth of dividends has been very popular, and seemed to work well as long as things were stable, cyclical or at least predictable. As the rate of change has speeded up, however, its limitations have become more obvious and more serious. In particular, the unexpectedly severe downturn in the United Kingdom in the early 1990s presented boards with a dilemma: given sharply reduced profits, what should be preserved – dividend growth or dividend cover? Some fund managers made it clear that they preferred dividends to retentions. Some boards responded, to the point of declaring dividends in excess of their profits after tax. One chairman talked about the need to ‘ reward shareholders for their loyalty’. As a general rule, however, financial journalists took the opposite view, based on their perception of dividends as just another outlay, like wages or advertising or plant and machinery. Entities in fi nancial difficulties, they argued, should cut dividends and increase investment. Such comments give the impression that their authors mistakenly see financial management as being about trade-offs within one time-frame (i.e. the short term). The reality is that it is about trade-offs between different time-frames.

Residual dividend policy The residual approach to dividends argues that if an entity has opportunities to invest for a return in excess of the cost of capital, it should retain funds within the entity. If, on the other hand, it has funds in excess of its identifiable viable investment opportunities, it should return them to its shareholders for investment elsewhere. This would mean much more volatile lev- els of dividend, of course, but that was what equity capital was originally meant to be about.

FINANCIAL STRATEGY 19 FORMULATION OF FINANCIAL STRATEGY ● (^) From these arguments it seems reasonable to assume that if an entity does not have suffi cient worthwhile projects to use up retentions, it should distribute these surplus funds to its shareholders, who will then be able to invest in other entities which do have satisfactory investments to which these extra funds can be applied. Within the considerable limitations of the assumptions made, which are discussed below, MM do present some interesting, if contentious, arguments as to why dividends are irrelevant to the value of any particular entity. Has MM’s theory any practical relevance today? Arguably we can answer positively in that:

● (^) it sets out a number of issues which provide useful background in developing an approach to dividend policy, for example concerning ‘informational content’ of dividends; ● (^) since legalisation of share buy-backs in the United Kingdom, a number of entities have shown interest in, and a number have acted upon, the concept of returning surplus funds to shareholders, signifying that this may prove to be the better way of ensuring their more profitable use. In a perfect world, which in the interests of clarity MM explicitly assumed, their the- ory would seem unexceptional. In the real world, however, we need to recognise some imperfections:

● (^) Use of the accounting model for purposes beyond its design specification. As mentioned above, retention of profits is likely to result in the entity reporting earnings per share growth. Paying dividends and raising capital would not. If that earnings per share figure is seen as a measure of performance, or is used for determining rewards, this could have consider- able significance. ● (^) Transaction costs. It costs money to pay a dividend, and it costs money to raise capital. To eliminate one transaction by reducing the size of the other would clearly avoid wasteful administration costs. ● (^) Taxation is never neutral, and the declaration of a dividend can affect the attribution of value as between shareholders and the tax-gatherers. Whether entities need be concerned about the tax ultimately borne by their shareholders – in respect of dividends and/or the buying and selling of shares – is a moot point. Some are adopting policies which appeal to a particular clientele, that is, category of investor; others are passively watch- ing the steady decline of the individual shareholder, and the growth of the tax-exempt fund. ● (^) The inefficiency of the market. A dividend is certain, being tangible cash-in-hand and dis- cretionary income, whereas the market price is subject to all sorts of extraneous influ- ences and therefore more uncertain. Note, accordingly, how increasing the dividend is a predictable response to a threat of a takeover, the presumption being that it will have the effect of increasing the share price. ● (^) Supporters of the efficient market hypothesis would like to think that prices equate with the net present value of projected cash fl ows and are therefore fair as between buyers and sell- ers, but it would be perverse to argue that directors have a responsibility for the bargains struck between consenting shareholders, that is for ensuring that reality fits the hypoth- esis! It would be more rational to argue that they should concentrate on creating wealth, and recognise that the question of its distribution as between stakeholders is far from being within their control.

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1.7.3 Scrip dividends

Entities sometimes offer shareholders a choice between a cash dividend and additional shares worth the same, or approximately the same amount. The dividend paid in shares is referred to as a scrip dividend and is often offered when the directors feel they must pay a dividend but would prefer to retain cash funds within the entity. The presumption is that the retained funds will be invested in projects which can reasonably be expected to earn an adequate return. As with bonus or scrip issues directors rarely highlight the fact that once the reserves are capitalised in this way, they become undistributable. To see how scrip dividends work, imagine an entity with 100m shares in issue, the directors of which decided to declare a dividend of 12p per share. In the ‘normal’ course of events this would mean a cash outflow of £ 12m to the shareholders. Assuming, for the sake of illustration, that the entity’s shares had been trading at around 360p ex-div., the board might offer an alternative of one new share for every 30 held. There would be rules as to fractional entitlements, of course, but in simple terms someone who held, say, 3,000 shares could receive a dividend of £ 360, or 100 shares’ worth – at the contemporary share price – £ 360. From the point of view of the individual shareholder: ● if he (or she) had been thinking of buying some more shares, and felt that the price was unlikely to fall below 360p in the near future, he would welcome the opportunity of obtaining some without having to pay the usual commissions, etc. ● if he had no wish to increase his holding, he could simply take the dividend as originally declared. ● if he had no firm views, he could take part dividend and part shares.

1.7.4 Share repurchases

The decline in scrip dividend offers in recent years has coincided with an increase in the number of entities returning capital to investors through share repurchase schemes, or in some cases by making a special dividend payment. The repurchase of an entity’s shares may be carried out for a number of reasons: ● return of surplus cash to investors; ● to reduce the entity’s cost of capital; ● to enhance earnings per share in the hope of also increasing market price per share; ● to prevent, or reduce the likelihood of, unwelcome takeover bids; ● to adjust the gearing of the entity to a higher level, closer to the entity’s optimal capital structure; ● to reduce the amount of cash needed to pay future dividends. Shares may be repurchased by: ● purchase on the open market; ● individual arrangement with institutional investors; ● a tender offer to all shareholders. An individual arrangement with institutional investors tends to be the most popular approach as it is the quickest, most efficient means of returning surplus cash. Often therefore,