Legally Managing Your Company Tax Bill & Currency Management

The UK’s Tax Avoidance Deficit

To put the discussion of tax avoidance into context we must first look at the figures. The HRMC released figures quoting revenue losses of £6.3billion as a result of tax avoidance, although other sources states figures between £3 billion and £13billion. Either way, at the outset it appears that huge amounts of money are being snatched away from the treasures’ coffers. But let’s put this into context further, the FTSE 100 companies alone have a market capitalisation of £1.8trillion and profits (after tax!!) of over £75billion, and that’s just the top 100 companies. So it seems they pay a fair amount anyway?
 

International Corporations Managing Tax Bills

Who is getting away with this £6.3billion and how? Well, the simple answer is most companies with the ability to hire top accountants. But looking specifically at Diageo, the owner of many brands, for example Guinness, Smirnoff, and Jonnie Walker, has employed a few clever accounting tricks to lower its tax bill. Diageo is listed on the London Stock Exchange and has its headquarters in London and therefore, it should be paying corporation tax of 28%. Between 2005 and 2008, inclusive, Diageo averaged a tax bill of 18%. Over that time frame the corporation tax rate was 30% and Diageo should have paid a total of £2,478million. Diageo only paid £1,454million during this time. This is brilliant news if you’re a shareholder: by reducing the tax bill there is an extra £1billion floating around for either wealth building projects or dividends. Then again, is it not the purpose of a corporation to build as much value for shareholders as possible? The great economist Adam Smith would have taken great delight in such shareholder wealth generation.

So how do they manage their tax bill to save money? It’s fairly simple really; Diageo splits each of its brands into subsidiaries located in different countries, and any profits arise abroad rather than in the UK. This is called transfer pricing. As an example, Guinness is based in Ireland and benefits from a lower tax rate of 12.5% on any profits made from the sales of that brand. This means that Guinness’ tax bill is reduced by over half when compared to the UK. A further way Diageo ensures ensure tax efficiency is by ownership transferring. Diageo has transferred the legal ownership of UK based brands such as Jonnie Walker to a Dutch company called Diageo Brands BV. The Dutch corporation tax for Diageo would normally be 25.5%, however, there is an exemption clause that means Diageo can reduce that to 0% (See link below for details of ownership trading). This means that tax efficiency is achieved as Diageo is not paying any tax on their profits. These two methods ensure sales based in the UK and around the globe are being diverted into countries like Ireland and the Netherlands, so any profits are subject to reduced taxes. Diageo has structured its organisation in a tax advantageous position.

Currency Risk Management

Diageo, as a multinational organisation, has to manage the risks that are associated with any transactions that are between currencies. Diageo recently announced its commissioning of a new brewery is Tanzania at a cost of $55million. Diageo had to consider the financial risk posed by the exchange rate between US dollars and Kshs (Tanzanian Shilling) between committing to purchase the plant and actually paying for it. This time frame creates risk, as any fluctuation in either currency can make the plant either more expensive or cheaper than originally planned. There are several basic techniques that can be used such as leading or lagging payments for reducing transaction exposure. Netting or matching payments is also an option when dealing between subsidiaries and third parties. There is always the option to simply do nothing and hope the currency markets balance out your transaction costs over time. Alternatively, there are some basic hedging techniques used to reduce risk, for example forward market, money market, futures or currency option hedging. All these techniques have their individual benefits that must be assessed by the finance manager and will usually depend on the size of the transaction to the company.

Another currency risk that Diageo has to manage is the translation of its subsidiaries values into UK sterling to form part of its annual report. It is important to differentiate between transaction exposure, which is a pure cash loss, and translation exposure, which is loss of book value and does not involve any loss of cash. Each subsidiary (under the old UKs IAS 27 and current IFRS 3) must be included in the consolidates accounts, meaning Diageo has to convert its North American, European, Asian and International companies results into British Sterling. Again, any negative fluctuations in currency can destroy the value of foreign subsidiaries and thus destroy shareholder value. Therefore, it is important for managers, at least, to consider managing the exposure through hedging, especially when the values of subsidiary companies are relatively large to the company.

How Diageo restructured its company to place brands into Dutch corporations:
http://www.guardian.co.uk/business/2009/feb/02/tax-gap-diageo-johnnie-walker.

References:

http://www.hm-treasury.gov.uk/press_46_10.htm

http://www.ftse.com/Indices/UK_Indices/Downloads/FTSE_100_Index_Factsheet.pdf

http://www.guardian.co.uk/business/interactive/2009/feb/02/tax-database

http://www.actionaid.org.uk/doc_lib/addicted_to_tax_havens.pdf

http://www.diageo.com/Lists/Resources/Attachments/640/Diageo_AR10_full_report.pdf

http://www.guardian.co.uk/business/2009/feb/02/tax-gap-avoidance

http://www.telegraph.co.uk/finance/migrationtemp/2802209/FTSE100-companies-see-profits-double.html

http://www.guardian.co.uk/business/tax-gap-blog/2009/feb/13/diageo-taxavoidance

http://www.diageo.com/en-sc/investor/Pages/resource.aspx?resourceid=1135

http://www.eabl.com/inner.asp?pcat=mediacentre&cat=newspressreleases&sid=492

http://www.guardian.co.uk/business/2009/feb/02/tax-gap-diageo-johnnie-walker

We need cash!! – When a loss isn’t a loss.

Cash, money, investment, funds, capital, whatever you want to call it, companies need it to survive and grow. There are three methods by which companies can raise money, retained earnings, equity capital and debt capital. It’s the job of the finance manager to make the decision of which option to choose, and which option is the best for the business.

Firstly we can look at a company that had a long history of using retained profit, Greggs PLC. They were one of very few companies on the FTSE to have no long term debt on their balance sheet at all, that was until 2009, which we will discuss later. Greggs’ growth had always been funded through profit, which to most companies is a dream come true, with retained profit the cost of capital is zero! Any return made on retained earnings is pure profit!

In 2009 Greggs appointed a new chairman, who took over when cash was running low due to dwindling sales figures in light of the recession. With no cash, expansion would grind to a halt. McMeikan was had to raise capital using one of the other methods, and he chose to take a loan from the government, which sits in the long term liabilities as debt. The advantage of taking on debt is obviously it injects cash when it’s otherwise not available, and also there is no dilution of control, the company gets cash and doesn’t release any shares. However the debt will come with interest rates attached, which reduces the rate of return. Greggs needed to ensure the investments were now making higher returns and so when negotiating property leases, they squeezed landlords to retain their margins and significantly slimmed their product range to reduce costs.

An option that Greggs didn’t choose to raise finance was through the issuing of shares. Companies can issue a batch of shares, which have to be offered to current shareholders first, and then to the mass market. Facebook, although it’s an initial public offering  (IPO) rather than a share issuing procedure, are soon to be floating the company to raise money, and it certainly will raise significant amounts of money! The advantage to Facebook is there are no monthly payments or any obligation to pay back the capital raised or even to pay a dividend, which does lower the cost of capital. However it will come at a price to them, they will be losing a significant amount of control of the company and will be under increasing pressure to make returns for the shareholders. To issue shares or float a company is also very costly involving consultants, brokers and underwriters all taking a cut amount to between 10-12% of the finance raised.

Whichever option is chosen, only one thing is important! Return on the investment!! The option chosen should (usually) be the one that eats into the rate of return the least. Companies can calculate the cost of capital for each method and the expected cash flows (usually discounted as well) over the predicted life of the investment. Companies should then look to choose the project that pays the highest return. Seems simple enough, accept or reject projects. So why do companies take on projects that make a loss??

The internet is full of heavily discounted products that are clearly making losses such as airlines offering 99p flights. There are even sites such as Groupon that offer companies a marketing platform for low margin promotions. Surely the finance manager punches the numbers into the calculator and halts the project before a penny is ever invested? So why do they do it?



Sony’s Playstation has been entangled in a console war with Microsoft and Nintendo over the last decade, and has sold over 41 million of its Playstation 3 model (dated 11/05/11) but made a loss of £2bn on these!!  However, making a loss on the consoles was all part of the plan for the Sony bosses. Playstation took the decision to install a blu-ray play in its consoles, which created a point of difference compared to the X-box and Wii, but even if they were sold at cost price they would price themselves out of the market. The decision was made to sell it at a loss to gain market share, which worked exceptionally well and PS3 sales overtook X-box 360 sales early 2011, and as the blu-ray market has continued to grow so has the sales of PS3. The gain in market share was vital to grow sales in the games market as well, margins are smaller on games but customers purchase more frequently and total PS3 games sales recently passed 500 million mark, helping boost Sony’s third quarter net profit to $559.7m. Proving projects that make a loss don’t always make a loss.

 References:

Riley, A & Boome, A., Sex, religion and gossip fuels superbrands. BBC. Available at: http://www.bbc.co.uk/news/business-13416598 [Accessed February 19, 2012].

http://www.guardian.co.uk/technology/gamesblog/2011/apr/05/ps3-overtakes-xbox360

http://www.ft.com/cms/s/0/22ba711e-2f6e-11e0-834f-00144feabdc0.html#axzz1mqTNC5zY



EMH / Random Walk / Behavioural or a Mix Of All Three??

With the huge availability of information these days, why aren’t we all high flying city traders? Surely if we can follow a company’s progress continuously we can see their profits coming and buy shares with a click of a mouse! Well unfortunately it’s not that easy, and there are several theories on why it’s more difficult than we first thought.

Fama (1970) developed the Efficient Market Hypothesis, which stated that markets react to information instantly and settle at their efficient level until more news becomes available. Specifically in this blog we will be looking into the EMH with respect to share prices, as there is a wealth of information regarding company’s shares and company news.

Efficient Market Hypothesis (EMH) states two fundamental principles. Firstly, nobody can continually beat the market. Secondly, all prices are based on rational information. So if a company reports good news such as increased dividends or profits then surely the price will rise? And if a company releases reduced profits and starts cutting dividends then prices tumble?

Rio Tinto wrote down 8.9 billion dollars worth of its aluminium stock, over 10% of its total market cap, after it cut its losses on its 2007 Alcan project (The FT 2012). This would be considered bad news by most shareholders, however Rio Tinto shares actually finished up 13p on the day!

(Image: Rio Tinto share price 08-02-2012)

Another strange case was Google reporting a 27% rise in profits in its final quarter. When a company can report profits of $2.7bn and shares still fall by a massive 10% then surely this is great news for shareholders? (BBC 2011) Well apparently not! How does this fit with EMH?

When you dig a little deeper into the EMH, three levels of efficiency appear; weak, semi-strong and strong. Weak form efficiency states that current share prices reflect all past movement, which could be true for Rio Tinto. No matter what the bad news is, if Rio Tinto reported very solid share prices over the past ten years then maybe it’s ok to lose $8.9bn this time, because their track record is pretty good. Or semi –strong efficiency might apply to Google, which uses all past movements and all publicly available information to set the share price. Based on Google’s short history on the market and the public information that is available that shows investors expected higher profits than were reported, then maybe this is why share prices fell.

So if we can’t truly rely on information to correctly balance out market efficiencies, then what’s the alternative? Random walk theory (Kendall, 1953) posits that there is no fixed relationship between share price and time. There is no point looking at past information because it has no influence on the future information and therefore future share price. So maybe we would be better throwing our investment pot randomly over several companies and hope to get lucky? Well if you believe random walk theory then maybe you could apply this to the two cases above?

However, personally I would strongly recommend you don’t start throwing your cash around just yet. There is also behavioural finance theory to take into account. This does not rely on past information but has a much more irrational nature. Because the shares are traded by humans, we can’t simply look at the numbers and make a decision, we are affected by other factors such as regret and confidence, amongst other things. This can create a herd mentality amongst traders and drive prices up or down for no reason, look at Black Monday of 1987. There seems to be no reason for these wild swings in the market but they certainly do happen.

It’s not entirely clear how the stock markets work, or we would be the high flying city traders as mentioned previously, but it is clear EMH, Random Walk and Behavioural Finance theories can all be applied to cases in the market.

But if you think you can beat the market then sign up to Yahoo finance Fantasy Trader and then see which theory you believe...

Click here: Yahoo Trader

 References:

http://www.ft.com/cms/s/3/a9596aee-52ff-11e1-8aa1-00144feabdc0.html#axzz1mCXjfJbG

http://www.ft.com/cms/s/2/260cc4d6-9048-11df-ad26-00144feab49a.html#axzz1mCXjfJbG

http://www.bbc.co.uk/news/business-16642925

http://www.ft.com/cms/s/2/260cc4d6-9048-11df-ad26-00144feab49a.html#axzz1mCXjfJbG



Has the "Kodak Moment" Passed?

Kodak’s Rise and Fall – Company overview

The story of Kodak starts with a classic case of science and entrepreneurialism. George Eastman and his partner Henry Strong worked developing photographic technology and in 1891 proudly released their first product, the Brownie. This was a cardboard camera costing $1 and came with the strap-line “You push the button, we do the rest.” It was the world’s first mass market camera.

Kodak Listed in 1930 on the Dow Jones Industrial Average index, and released their most famous product, Kodachrome in 1935 which was the first replaceable cartridge film. Kodak released the instamatic camera in 1963, and in 1975 Steve Sasson invented the first digital camera andwas originally told “that’s cute, but don’t tell anyone about it.” Kodak management were more concerned with maintaining their highly profitable film business than developing the digital camera.

Kodak’s share price was at its highest point in 1997, reaching an impressive $92.3 with a company value of $25bn. However 1997 was the tipping point for Kodak, their shares would never reach the same levels again. Competitors had reaslised the potential of digital photography and had started developing their own products, but Kodak was focused on protecting their core film business and although they were developing digital photography, it wasn’t receiving the funding it needed to compete.

As Kodak entered the 2000’s it realised it needed to diversify after revenues plummeted for its core film business. Kodak invested in the pharmaceutical industry, purchasing Algotec Systems. Kodak had also started to invest in domestic printers and ink supplies. However these decisions weren’t enough to save Kodak and in 2004 Kodak were delisted from the Dow Jones and they responded over the next few years selling off divisions and cutting staff.  Kodak announced it would stop selling its Kodachrome in 2009, which was a clear concession to the digital age, after sales film had practically dried up.

2012 Kodak were warned if they did not raise their share price above $1 they would be delisted from the NYSE. Finally on 19^th January 2012 Kodak filed for chapter 11 bankruptcy protection, and their share price stood at $0.36 and a company value of just $132m. Shareholder wealth destruction of 99.6%

Kodak’s Shareholder Value & Managerialism

Although Kodak’s demise has been over a long period of time there are still clear elements of theory that relate to this case. There has been a clear destruction of shareholder value, which can be seen in the current value of the company and the non-existent dividend payments these days. The elements that contribute to shareholder value are; strategy, organisational capabilities and finance. Kodak clearly had the finances and organisational capabilities to maintain shareholder value, being one of the largest companies in the US. The strategy however has been found dramatically lacking. Kodak’s strategy to defend their film market rather than developing the digital camera market was their single largest error. Kodak invented the digital camera and still failed to develop it, the strategy was too narrow minded to take into account their promising R&D, and has seen competitors come in and dominate the market. This shows if one element of shareholder value is incomplete how it leads to a destruction of shareholder value. The reasons why the strategy were missing are slightly less clear, but it is possible to link it to managerialism, this is where managers act in their self interests. The executives at Kodak had one of the most successful companies in the world and they had a regular income from the film market. They became focused on making as much money out of their current business and generating shareholder wealth, but ignored the future prospects of the market and the company, which inevitably lead to shareholder wealth destruction.

Value Maximisation as an Objective

Value maximisation has two main points, firstly, purposeful behaviour requires the existence of a single-valued objective function. The value maximisation theory clearly doesn’t work here because if you are trying to create as much value as you can but your being outperformed by competitors then you simply can’t create value. In this case it leads not to social welfare maximisation but a decrease in the social welfare, as Kodak employees pension funds are currently under threat, after Kodak filed for bankruptcy protection. The second theory that social welfare issues and externalities occur because governments fail to set rules and boundaries, again doesn’t apply to Kodak. In a free market Kodak have been out manoeuvred strategically and are paying the price for not adapting soon enough, competitors have acted within the rules and there has been no foul play. It has not been the governments fault, it was Kodak’s.

Looking Past Kodak’s Figures

There have been many investors looking at their portfolios over the past five years wondering how that giant hole has been created where the value of Kodak once stood, and it’s the classic case of how investors fail to look at anything other than the numbers. Kodak looked for many years to be a stable investment, but if they had taken the time to stop and question how Kodak can invent the digital camera and not control this market as well as their traditional film market, then maybe they would have seen the corporate failure sooner. If investors had looked behind the numbers and seen the static strategy of the company and realised the market would change sooner or later, rather than being drawn in by the impressive EPS, profit and ROCE figures, then it would have saved a lot of investor embarrassment.

Kodak’s Value Destruction Pentagon

By flipping the value creation pentagon around you can create a value destruction pentagon. This works by failing to use an element of the value creation pentagon correctly.

Kodak clearly failed to correctly engage some of the elements of the value creation pentagon. Firstly Kodak sold off several divisions of its company raising over £2billion, however this was not used to create value for the shareholders, it was used to fill the cash flow gap that had been created from the reduced revenues from the core film business. This shows that if divesting monies are not correctly used it leads to greater destruction of value.

Kodak also seems to have tried to extend the planning horizon of its central film business, to create or maintain value. Kodak believed it could continue selling its film so made projections based on this belief. When sales weren’t being matched, it caused Kodak to make huge losses and destroy value. Kodak had over-extended its planning horizon and based it on incorrect figures.

Again we come back to Kodak failing to invest within the digital market, and one section of the pentagon is raise investment in positive business units. Kodak failed to invest the funds in a rapidly growing market that had the ability to create more value. Failing to invest in this positive business unit caused the 99.6% shareholder wealth destruction.