Is tax avoidance a good way to maximise shareholder wealth?

When people are asked about tax avoidance, they often answer: “that’s illegal!! They should be heavily punished!” (not always that polite, but you got the idea). When people are saying that, they are actually thinking about tax evasion.

Indeed, tax evasion is illegal whereas tax avoidance is completely legal! What’s the difference? The results are the same, aren’t they? They both aims at not paying taxes… Well, the answer to that question is what I will try to cover in this week post.

According to McGee (1998), tax evasion is when companies don’t abide by the law and do not respect the tax regulations, edited by the government. It is a felony punished by up to five year of prison and/or a substantial fine. On the other side, tax avoidance is defined by the legal utilisation of the tax policies to one’s own advantage. Using means allow by the law, it is then possible to reduce the amount of tax payable. So the first difference, which I would say is a major one, is a legal matter.

Then, how does “tax avoidance” works? How come one is legal and the other is not when they both aim at the same thing? That’s a harder part! In a basic way of considering it, companies have to pay taxes on their income. The tax rate changes from a country to another. For example, it is around 28% in the UK, 12.5% in Ireland and 0% (!) in places like Cayman Island, also called “heaven tax” countries. When we see these figures, no wonder why companies are trying to avoid paying taxes the best they can! What would you do?

Let’s take the example of Kraft/Cadbury take over. Once Kraft had bought Cadbury, the first thing they did was to move the former English company’s headquarter to Switzerland (17% tax rate instead of 28%!). Several companies have done that in the past, and if nothing changes, it is to bet that several will do that again! I understand why companies are doing that. Honestly, if it was for their own company or their own money, a lot of people will try to do the same and “change of country” if it was possible to do that without literally moving out of the country. No one is glad to pay taxes, but if they exist, they are here for a reason…

In this “ethical matter” two theories confront each other. Some people believe that the only responsibility of a manager is to maximise shareholder value, no matter what. In this concept, manager should try to reduce the tax bill (often a big component in the company growth) by any means necessary. This is understable, isn’t it? If they can do otherwise, why would they pay, right?

Well, let’s take the opposite theory. I think that the moral aspect of this should also be considered. If companies are leaving to “tax heaven” countries, who is going to pay the share of taxes they were paying? The ones staying in the country, and that means… Us! However, I don’t want to condemn companies doing that, but I think they should show a little bit more solidarity, don’t you?

How do companies raise money?

This week in lectures, I was introduced to the concept of “raising finance for multinational enterprises, collaborative ventures and foreign subsidiaries”. This is huge topic which covers several aspects of the way companies raise finance, going from a really technical approach to a more legal way of handling this issue.

In this post, I will try to give an overview of how companies raise money. However, other issues arise when talking about raising money. Where does this money come from in the first place? Is it fair? Are the people from whom the money comes from the one who will benefit for the returns?

According to Savage (2008), there are as many reasons for companies to seek for money that they have ways to raise funds by themselves. Indeed, companies can raise cash like selling assets or division, increasing prices and/or sales… The most used ways to raise money for firm are called “debt finance” and “equity finance”, the last one being the principal way for profit shortfalls, internally generated growth opportunities, investment in immaterial resources and when other solutions are likely to be more expensive in term of cost of capital (Gatchev, Spindt and Tarhan, 2009). But which one is the best way to raise finance for a company?

Both “debt finance” and “equity finance” have their pros and cons, so the best way to choose will depend of the company and the investment it wishes to make. We can’t make a rule dictating when choosing debt finance or equity finance. However, companies have several tools to help them decide.

The most commonly used in these circumstances is the WACC, or Weighted Average Cost of Capital. According to Arnold (2008), the weighted average cost of capital, or discount rate, is “calculated by weighting the cost of debt and equity in proportion to their contributions to the total capital of the firm”. In other words, that means that debt and equity have their own cost in the firm’s capital and the WACC is an overall cost, taking in account the weight of both way of finance. But is it useful? To whom are the benefits for? (If there are benefits…) Is it a good idea to rely only on this indicator? The following video answer these questions.

Let’s now take the example of Kraft. When Kraft Foods bought Cadbury, they had to plan how they will finance the acquisition. As I said before, there is two major ways of raising capital (debt and equity), each with their own advantages and disadvantages. Going back to Savage (2008) description of all these pros and cons, I think that in order to reduce risks linked to debt or equity, companies should have a balance between these two modes. Indeed, when debt shows a major disadvantage, in the same situation, equity seems to offer a solution, and vice versa. Therefore, they did well by borrowing money from banks, thanks to syndicated loans, and creating new shares for other shareholders.

In conclusion, I think that companies should try to maintain a balance between debt and equity, even if that means sometimes that they are not creating the maximum value the shareholders.



Do markets always need to be efficient?

What is market efficiency? What is it about? How does it work? Is it possible for markets to be efficient at all time? If, yes, would it be a good thing?...

These are all the questions commonly asked in finance lectures. However, there is no “clear” answer and different theories clash. But, when looking deeper in all those theories, we can see that they are not necessarily exclusive to one another. When dealing with a subject like this one, different aspects of the problem have to be taken into account.

Literature doesn’t have a one definition for market efficiency. For Hou and Zhao (2011), the market efficiency is "the absence of arbitrage opportunity in the market". However, for this post, I’ll use a more precise definition. According to Statman (1999), market efficiency is the centre of three dimensions: standard finance, behavioural finance and investment professionals. For him, market efficiency means two things: 

• Investors cannot systematically beat the market 
• Security prices are rational

However, when according to consumers/investors behaviour studies we know that 70% of choices we make when we buy products are made by impulsion and therefore lead by sentiments, is it possible to maintain that prices are rational?

Of course not! Whether it is share prices on the stock market or goods prices in the supermarket, prices are based on demand and customer habit. Let’s take an example. Porridge. You can find some at a relatively fair price in the United Kingdome. However, in France for example, if you succeed in finding some, it would probably be much more expensive. Another example would be if a successful company had to sell a large amount of its share, for random reason, then the share price would certainly be cheaper than its “real” value (because of the large number of share in the market).

Since Statman’s definition was referring to two different points, let’s now consider the fact that some investor actually beat the market and this almost systematically. I think notably about Warren Buffet. He said to the Financial Times that “Observing correctly that the market was frequently efficient; they [academics, investment professionals and corporate managers] went on to conclude incorrectly that it was always efficient. The difference between the propositions is night and day.” 

In this case, the difference between the two models is huge. Indeed, as Warren Buffet proves it for 50 years, we don’t need the market to be always efficient. He made his money from the part of the market that is infrequently inefficient! He keeps beating the markets every time he invests… Therefore, I don’t think that having a market always efficient would be a good thing. Indeed, if markets were always efficient, it would mean that no one can gain from it, or at least not a lot. And if people, like Warren Buffet weren’t gaining more than the average, they wouldn’t be able to invest what they gained in a new market, and therefore keep the markets growing…

However, according to Fama (1970), an efficient market is market in which “prices always fully reflect all available information”. He then defines three forms of market efficiency: the weak form (where historical prices are discussed), the semi-strong form (where the main objective is to see if prices efficiency reflect the publicly available information), and the strong form (where all information are available). Today, we are in the semi-strong form: investors use all the information they have to make decision. However, the strong form remains a utopic form, at least nowadays. Indeed, in our modern societies, having information that others don’t have, gives some kind of power. Information nowadays, especially in a business environment, is a huge source of power.

In conclusion, I don’t think markets can nor should be efficient at all times, since it is their “infrequently inefficiency” that allows investors to gain more than average money.

How does strategy create value?

A clear, precise and defined strategy is vital for companies nowadays. Indeed, according to Arnold (2011), several decisions are made every day in companies. This is why it is primordial that management teams are aware of, respect and contribute to the main objective of the firm (Arnold, 2008).

For Johnson, Whittington and Scholes (2010), setting goals is a major issue in organisations. It has to be the right objective, at the right time. For the Boston Consulting Group (BCG), clearly establishing a suitable shareholder value target is the basis to generate long term sustainable shareholder value. To achieve a competitive advantage, and reach the shareholder value target, investor, business and financial strategies must go in the same direction.

Apple is a good example to explain the importance of the strategy in the creation of shareholder value. Everybody considered Steve Jobs, the ex CEO of Apple, as responsible for setting the stratey of the company. Between 1985 and 1995, when Steve Jobs was away from Apple, the company encountered several financial difficulties (The Economist, 2011). However, when he returned to the company, and set the company’s objective clearly and explained them to the manager of the organisation, shareholder value was suddenly created… Could it be a coincidence?

I don’t think so. To illustrate that fact, we can study another example.

In august 2011, Steve Jobs had to resign from his position as CEO of Apple, due to medical reason. The fact that Apple shares fall of 3% the day Steve Jobs gave his resignation, going from $376.18 to $365.01. This element shows that shareholders believed is his way to create shareholder value: setting a clear strategy.

Strategy decision are about choosing which product to launch, which market to enter/exit, how it is possible to ensure a good competitive advantage in those markets/products... once the strategy is in place, then it is possible to create shareholder value.

It all comes down to saying that strategy creates shareholder value by fixing clear objectives, and explaining managers how to achieve them.

As I said in the first post of this blog, any constructive feedback is welcome. And if you have any suggestions, notes or comments, please feel free to comment under this post.