Dividends

I have never really put much though into the issue of paying dividends, simply because I have believed it to be pretty straightforward process. An investor buys shares in a company and in return they receive a large pay out (dividends), simple yes? Regrettably not, after this weeks lecture I have once again had my eyes opened to the complex and arduous task companies face when dealing with issues of paying dividends.

Research carried out suggest that investors use dividend signals to assess a companies performance, and that stock returns are positively correlated by dividend fluctuations (Asquith & Mullins 1983 and Aharony & Swary 1980). Having said that it seems to me too presumption to assume that a change in a company’s dividend level means that there has been a change in performance or profitability?

I accept that in certain scenarios a decrease in dividends may lead to a lack of investor confidence, and that investors would argue that dividends are preferable to capital gains because of the fear of uncertainty. However this can be due to a miss-guided feeling that their future investment may get tied up in uncertain projects. Unfortunately we do not live in a ‘perfect world’, and managers are in possession of sensitive operational information that is not always made accessible to investors for fear company investment plans are made public knowledge. Whilst I understand that a degree of secrecy is needed, I do believe that there needs to be a bit of ‘give and take’ on both sides. Whilst investors do get to find out such information in annual reports, as they make a beeline to the page that is most concerning for them, I can’t help but think that there is a lack of trust between the two camps.

One reason for retaining residual income is to reinvest in future investments, investments that in the long-term will create higher returns and maximisation shareholder wealth. However if such projects are not fully communicated to shareholders carefully they can have an adverse affect. Due to this lack of insider information all investors can do is look to dividend levels to access company performance, with the basic assumption being: high dividend = good

                             low dividend = bad

However as discussed above, it’s not all black and which and in reality the reverse many be true: 

high dividend = lack of good investments and thus lower future investment returns.

low dividend = indication of attractive investments made and future prospects.

It could be argued that investors are too short sighted and that managers jeopardise potential long-term profit gains in favour of high dividend returns. Which in return contradicts the concept of shareholder maximisation when it is in fact the very same people who are preventing companies from doing so. It makes me think of the saying ‘all good things come to those who wait’ and questions whether there can ever be a happy medium. In order for companies to give high dividends they need to have made good investments in the first place. I do feel that in this case investors seem to hold the higher ground and can leverage their options to move their stocks to another company where higher dividends are being paid.

One way of dealing with this is for companies to offer a steady dividend return, that way they can attract the right ‘clientele’ to their company. In order for this to work however the dividend policy needs to remain constant, changes would drive the clientele away to companies that were better able to fulfil their needs, and destroy shareholder value. This lack of fluctuation with the dividend level would reduce the problem of communicating with shareholders and give clarification to shareholders that the company was progressing rather than sending them into a fear of uncertainty.

However the view presented by Miller and Modigliani (1961), suggested that the value of the company was created and secured through investment decisions and not dividend decisions. Therefore rationally shareholders wouldn’t care if their return on investment was made through capital gains or dividends and rejects the ‘bird in the hand’ argument that dividends offer certainty rather than uncertainty of capital gains.

What is clear is there doesn’t seem to be a right or wrong dividend policy. It seems to be a very situational opinion and one that is very dependent on each individual company and the needs and expectations of shareholders. I do believe a constant level seems to offer a sense of certainty but we do not live in certain times and companies don’t operate in certain markets, therefore I think fluctuations are both unavoidable and part and parcel of the securing investor finance and investing in future long-term opportunities.

Capital Structure

The discussion of an optimal capital structure has been around for a while, with theorists themselves not being able to agree what is best for companies. On one hand, Myers (1977) would argue that a company financed through debt, looks risky to investors, which may affect their future growth options. Where-as Jensen and Meckling (1976) argue that firms not taking advantage debt finance may be losing a competitive advantage over other companies. Therefore what is the best option?

Debt finance has always been a popular choice as it is cheaper than equity; this is due to lenders requiring a lower rate of return than ordinary shareholders. Plus there are tax benefits to debt finance, but what happens when a company becomes overloaded with debt?? Without a doubt, rarely do we look at a company’s financial statements without seeing they have a substantial amount of long-term loans. Heck one of the most important financial ratios we are taught is gearing, but whilst debt is seen as a reasonable and advantageous way of financing the business there does come a point when enough is enough. Conceptually a company should load up on debt until there comes a time when debt becomes equal to or more than equity. Once this occurs the benefits of debt finance become less sweet as further costs are incurred and the company runs the risk of becoming ‘Financially distressed’.

What does financially distressed mean for a company? Well, due to the company becoming increasingly risky because they are highly geared, lenders expect high interest for the loans they are proving and Banks etc. start raising interest on current debt due to their fear of defaulting on the payments. All in all to me it sounds like a very tricky and messy situation, a situation whereby companies get sucked into a vicious circle of borrowing to pay off debts whilst sustaining further debt. Certainly doesn’t sound like an ideal situation to me!

It is important to remember that companies are trying to create and maintain shareholder maximisation but I think extreme debt finance is a sure way of destroying value, as companies look less and less likely to offer good strong future prospects. It doesn’t matter if profits are high or low, interest has to be paid regardless. If we think back to a time when we have ever been in debt, even if it’s to our parents, it still hangs around like a dark cloud and doesn’t disappear until it is paid. . . and that is without interest.

So maybe being financed solely through equity doesn’t sound like such a bad idea. For a start it has the huge advantage of releasing the ball and chain and having the freedom to choose whether or not to pay dividends or retain and reinvest the money.

Those companies that were financed predominately/ fully through equity would have been rejoicing that they had when the economic crisis hit. The good years had seen companies load up on cheap debt to finance their business activities, but when 2008 hit these companies were left with the bad years, when all they could do was stand back and watch interest rates rocket and scratch their hands thinking of a strategy to get them out this mess.

Unfortunately thought, equity finance isn’t all its cracked up to be. Just like debt finance, equity comes at a cost. Instead of using loans to finance business activities a company uses shares instead, the catch being that shareholders can demand higher rates of return the more risky the project looks. Whilst bondholders have a built in level of security, shareholders don’t therefore they have to take precautionary actions to protect their investments.

It is understandable why companies try and chase the ideal of an ‘optimal capital structure’, surely the benefits of a mixed financed approach will be in the company’s best interest? But surely is theorist can’t decide whether there is such a thing as an ‘optimal capital structure’ then companies shouldn’t waste their time and resources trying to achieve the impossible? There are industry norms set, so investors can determine and set aside those companies with the most potential and less risk.

I think there is the issue of companies becoming too reliant on debt, with the worse case scenario of being insolvency. If the 2008 economic crash taught us anything, it is that loading up solely on high levels of debt finance is not the way forward. I agree that strategically debt finance can offer a competitive advantage and create shareholder value, but its whether companies can stop themselves from becoming too greedy and tipping the scales in the wrong direction. Maybe what is meant by optimal capital structure is a company keeping within the boundaries of finance and avoiding extremes therefore taking the advantages offering from debt finance but not becoming too highly geared and incurring financial distress costs.

SRI - Taking Back Control

The main focus of each blog has been around the creation and maximisation of shareholder wealth. I can honestly say that so far it has opened my eyes to the unscrupulous world of multi-national corporations. Their immoral and sometimes arguably corrupt methods of creating wealth, in my view knows no bounds and has left me exasperated that shareholder maximisation takes precedence over all other factors.

However I believe that there may be a shinning light at the end of tunnel and that is the theory of ‘Socially Responsible Investment’ (SRI). The viewpoint that investors take an interest in the companies they are investing their money into and can influence a company’s decision to act in a social responsible way. I believe this, somewhat redeems the fundamental desire for creating shareholder wealth as together both investors and companies can work together to attain a socially responsible status.

Ultimately companies need investment for sustainable long-term growth and development; in return shareholders expect high returns for their investment. Therefore I understand that a company’s ultimate aim is to create shareholder wealth. If by taking an interest in SRI, investors are able to wield some form of power over companies to take a leading role in acting in a socially responsible manner. This therefore will have a positive impact on surrounding economies, environment and the people.

So what does it mean to be socially responsible and why in today’s world have we seen an increase in demand for more socially responsible businesses? Hellsten & Mallin (2006), argue that being socially responsible relates to our ethical behaviour and how our moral agency assumes that we should take responsibility for our actions. In recent years SRI has gathered momentum through the increasing control businesses have on our day-to-day lives. The promotions of public-private partnerships have lead to Governments progressively diminishing their control and handing the reigns to the private sectors. This has lead to investors being at the mercy of businesses and relying more and more on them to commit to being socially responsible. This has lead to more politically aware investors’ demanding clearer codes for business’ (Hellsten & Mallin, 2006).

History has taught us just how influential SRI can be. Going all the way back to the 1950’s Montgomery Bus Boycott, where a segregated seating system was in place on public transport. The boycott, lasting 382 days, was organised by Rosa Parks (an elderly black woman, who refused to give up her seat to a white man). This collective action helped people realise just how powerful groups could be once they worked together and how their influence and actions could help bring about change. In this instance the bus company changed its regulations, and the Supreme Court declared such segregation unconstitutional (BBC, 2012).

A further example of SRI came in the 1960’s by the company Dow Chemical who made Napalm Bombs for the American war in Vietnam. Such propaganda as the seen in the picture lead to huge protests across America, as many people saw the barbaric and cruel way Napalm bombs were effecting innocent civilians. As a result investors turned against Dow Chemicals, as they didn’t want outsiders to they think they were supporting such a destructive cause.

Too much of the time I think we are made to believe that the power lies solely with multinational corporations. But both of these examples show that investors can have just as much influence and if motivated their involvement in ethical investing can be hugely beneficial in promoting socially responsible businesses.

However is there such a thing as being ‘fully ethical’ and is it even possible? I think it’s important to understand that everyone has different thresholds and one person’s view of being ethical may be opposite to another person’s viewpoint. Individually we express different attitudes and preferences, as well as accepting a continual social change in opinions; therefore I think there is a clear argument of ambiguity.

I think the defence sector is a good example of ambiguity and controversy. Currently with the war in Iraq those who are opposed would not deem investing in BAE Systems as SRI, however those in support would disagree with this opinion. Therefore this represents a current day issue with SRI, furthermore I think this supports the view that people can’t be ‘fully ethical’ because no one can define a meaning for it. Ultimately investing in the likes of BAE will be influenced by ones own beliefs in what they deem to be right and wrong. Personally I believe that it is a necessity to have the provisions to be able to defend and offer aid to others. I also think it is ignorant to think that as a country we don’t need companies like BAE, therefore I think investing in BAE is being socially responsible.

Many companies have taken on board this theory of SRI, and adapted their strategy around being seen as a highly ethical company to encourage investors. The Body Shop for example prides itself on being one of the first companies to make a stand against animal testing (The Body Shop, 2012). Other companies like Gap try to promote their belief of equal rights for their workers in factories, taking an avid interest in working conditions, hours and pay to ensure the company retains their ethical image. 

Whilst some companies are creating their strategy around being socially responsible, Governments’ are also getting involved in the action. The UK was the first country to initiate regulatory disclosure of social, environment and ethical investment policies of pension funds and listed charities. This action has helped encourage all companies to become socially responsible.  Furthermore I believe this action will help drive the growth of this market.

I acknowledge that SRI cannot be distinguished and individuality plays a key role in investment decision-making. But I think that multinational companies have grown so large over the years that their uncontrollable behaviour has escalated into something that is beyond our reach. Therefore if SRI is a way of raining in the behaviours of companies colluding in unethical behaviour then I am very much in favour of its development. Furthermore I think that SRI helps give the people a voice that would otherwise be drowned out in the arrogant magnitude of multinational businesses. 

The Economic Crisis - Should We Blame The Banking Sector??

                                                             

In 2007, panic flooded the financial market as banks were verging on collapse. This called for huge Government bailouts for banks such as Northern Rock, to protect the country and economy from financial ruin. I don’t think anyone could have predicted the enormous knock-on effect this would have on all sectors within the UK. Even at present day I can’t walk around Newcastle or my hometown without seeing how this ‘domino effect’ has badly hit our country. Derelict shops and offices, continuous promotions and sales and high levels of unemployment are just some of the negative effects to have impacted on our economy.

Up until now I don’t feel like I have been affected but, as a final year student the prospect of finding a suitable graduate job looks pretty bleak. Every day new reports and statistics highlight how directly graduates are being hit, with the BBC (2012) recognising that graduates are more likely to work in lower skilled jobs than 10 years ago.

So whom should we blame for this financial fiasco? Since 2007 bankers and the banking industry has seemed to pick up the majority of bad press, with scathing attacks on the extravagant culture and arrogant attitudes of those working within the sector. But are they really to blame or have the press set about using them as a scapegoat? 

During the periods of 2002-2007 the economy was financed through cheap debt.  There was an explosion of ‘Mega Deals’ particularly by Private Equity Firms as many businesses decided to fund their activities through loans. Furthermore the availability of low interest rates in many developed countries (particularly within the US and UK) encouraged confidence within the market. It doesn’t take a genius to work out that sooner or later flaws would begin to appear and these good times just couldn’t last.

The US Sub-Prime Mortgage Market was hugely irresponsible and accused of ‘predatory lending’, without any regard to their clients ability to repay the loans. They used brokers who earned a percentage of every loan they sold, therefore the incentive was to sell rather than consider whom they were selling to. Whilst viewed as hugely unethical, I have wonder over the stupidity of those customers willingly accepting loans that surely they knew they would not be able to repay. Also if banks new that they could get away with it why would they stop, their aim was to make money whether that be through ruthless means or not. Therefore I think that the US Government should accept some responsibility. They should have intervened to protect those who didn’t have the financial knowledge or experience to understand the true consequences of repaying the loan.

After learning about ‘Collateralised Debt Obligations’ (CDO) in the lecture I think this had a huge impact on the financial crisis. Once again the greed and total disregard for consumers shone through as bankers ‘stuffed CDO’s with riskier assets like subprime mortgage securities, rather than traditional bonds’ (The New York Times, 2012).  So what was the process and how did it go so wrong?

Sub-rime loans were repackaged and resold, and to spread the risk 30-40 different loans were repackaged together. The thinking behind that was, not every one within that package would default at the same time, and therefore there would be a constant inflow of payments. These packages were then classified with different credit ratings. But like anything everyone wants the best, so the primary were snatched up first and so on and so on. What wasn’t thought through was when it was decided that to sell on those packages still left, they would create a secondary pool. Initially viewed as an excellent idea, soon became a disaster when the repackaged loans were given the same credit ratings as those in the primary pool.

             PRIMARY CDO’s                                                                  

                                                                                                                               SECONDARY CDO’s

The market was flooded with CDOs, and what was meant as a strategy to diversify away from risk actually created it. The pooling of risk should have signified that even in a bad year an AAA investor would have been assured some kind of return. However the lack of transparency within the CDO market meant that investors were lured into buying what they thought to be AAA credit rated loans but were in fact AAA secondary, offering little security.

I have primarily looked at the role of bankers within the credit crisis, but arguably there are many contributing factors and numerous events that have caused a knock on effect. Economists have tried to identify what the major cause of the economic crash was but have found it difficult to identify the pinnacle point.

  

I personally believe that the banking sector have a lot to answer for. I can understand why media has targeted them; they have caused public outrage and distrust. Their refusal to acknowledge any harm, and disrespectful attitude has infuriated people. Have they damaged their reputation beyond repair? Only time will tell. But what I think is important to take from this is, whilst banks might have been acting unethically Governments stood back and permitted such behaviour to carry on and go unpunished. 

Pepsi's Acquisition Disaster

The overall aim of companies’ implementing and investing in mergers and acquisitions (M&A) is to create shareholder maximisation. However, it is important that companies consider all the eventualities before ploughing headlong into often expensive and sometimes very costly business strategies.

It is imperative that when M&A’s occur, managers are able to integrate the two companies creating synergies. Ultimately though, keeping their promise to shareholders that the right decision was made is key to their success. So what happens when things don’t work?

This was the case for PepsiCo (Pepsi), when the company decided to diversify into the fast-food industry, acquiring Pizza Hut in 1977, Taco Bell a year later and Kentucky Fried Chicken (KFC) in 1986 (The Independent, 2012). Pepsi is a clear example as to why companies tend focus on ‘sector concentrated’ acquisitions rather than diversifying into unknown markets. Furthermore the concept of diversifying is extremely expensive to implement and from a shareholder perspective it is not viewed as advantageous or viable. Shareholders themselves can diversify, by broadening their portfolio of investments, which are both cheaper and a less risky strategy, than companies diversifying.

So what drove Pepsi to diversify? I think it is clear from their mission statement what the answer is, ‘Beat Coke’.  For as long as I can remember, there has always been a long-standing rivalry between the two soft drink companies, both willing themselves to ‘out do’ one another in order to gain more market share. I believe that Pepsi thought they had gained a competitive advantage when they acquired the three fast food companies and initially the acquisitions seemed lucrative, with the share price rising by 5% after they attained KFC.

Unfortunately for Pepsi they were unable to retain or recoup the expected benefits they believed they would achieve through the acquisitions. This is because they managed to alienate themselves, from their customers (other fast food chains), who had now become their competitor. Whilst the acquisitions guaranteed that Pizza Hut, Taco Bell and KFC were using Pepsi fountains, it drove potential customers to choose Coke. Furthermore Pepsi were suffering in the soft drinks industry, allowing Coke to consistently gain market share throughout the world.  What was meant to propel Pepsi into the fast-food industry as a major player was in fact costing them in the successful soft-drinks market, and playing straight into the hands of Coke (The Independent, 2012).

In 1997 statistics showed that although restaurants were Pepsis largest business with an estimated ‘36% of the group’s £19.6bn sales, they accounted for only about 22% of its £1.9bn profit’ (The Independent, 2012). It was these poor results that worried shareholders, as they called for Pepsi to sell off the underperforming restaurants. Pepsi started to consider the possibilities of a ‘demerger’, as the believed the way forward was to concentrate their efforts in the soft-drinks industry and the cut-throat competition with Coke.  Pepsi decided to ‘spin off’ its fast food business and in 1997 Yum Brands Inc. (formerly known as Tricon Global Restaurants Inc.) was created. This enabled Pepsi to assigning over its current £4.6 billion debt to the spinoff company (The New York Times, 2012). 

It’s quite ironic to think that back when Pepsi started their acquisitions into the fast-food industry the company hoped to create synergies, gain a competitive advantage over Coke and ultimately create shareholder wealth. In reality however all they did was lose focus of their core business strategies, help give Coke a competitive edge over them by isolating themselves in the fast-food industry and devaluing the companies reputation amongst their shareholders.

Obviously every company that chooses to diversify will not have to deal with the same problems Pepsi faced, but it does beg the question ‘Are companies creating shareholder wealth’? Furthermore there needs to be a distinction as to whether ‘diversification’ or ‘M&As’ or a mix of both can lead to a destruction in shareholder wealth?

In Pepsis case, their shares rose by 12% on The New York Stock Exchange a day after The Wall Street Journal announced that a spinoff was expected (The New York Times, 2012). This alone shows the confidence within Pepsi to create shareholder wealth as long as they are acting with in their ‘concentrated market sector’.  

I think it is clear what drove Pepsi to diversify, the arrogance of the management and their desire to ‘Beat Coke’. This left little or no regard for shareholder maximisation and resulted in their decisions being clouded.  Their longing to gain a competitive advantage over their biggest rivals, resulted in them losing concentration and allowing Coke to take advantage in the soft drinks industry. 

Foreign Direct Investment - Long-Term Strategy?

Foreign Direct Investment (FDI) is:

‘The purchase of physical assets or a significant amount of the ownership (stock) of a company in a another country to gain a measure of management control’

(Wild, Wild & Hans, 2004)

What makes multinational companies chose FDI over other options like, Exporting, Franchising and Licensing. Like anything there is advantages and disadvantages to each of the above approaches, so what makes FDI the popular choice?

Dunning (1988) designed the ‘Electric Paradigm’ framework, as he believed that there was multiple reasons why companies might chose FDI as a way to locate abroad. His ideas involved:

·      Location Advantage – Companies moving to a particular advantageous economic location because of the characteristics e.g. Shell moving to oil rich countries

·      Ownership Advantage – Keeping control of the brand, knowledge and management ability in order to retain the over all high quality expected of the company.

·      Internationalisation Advantage – Integration e.g. vertical of certain business activities are better kept inside the company rather than laving it to relatively inefficient markets.

Whilst FDI is deemed advantageous for multinational companies there can be complications involved for the ‘host country’. Some people may argue that these cost are overridden by the boost that will be injected into the host country’s economy. I believe however that this is a more serious consideration and that once again the reign and superiority of multinational companies prevail over all others.

The biggest concern is the adverse affects FDI can have on the local competition. For example the state agricultural marketing board in India are trying to oppose FDI into multi-brand retail, as they fear the negative impact this will have on local farmers. The arguments for FDI are strong; if this is given the go ahead there will be a creation of jobs along with other benefits such as the transfer of knowledge and expertise as well as management, capital and technological skills.

There seems to be a misconception that FDI is all about companies going abroad to set up ‘sweat shops’ for the availability of cheap labour. However it is more to do with the natural or acquired economic resources offered within that country. The majority of FDI flowing into Africa is to specific countries that have mineral wealth, which is then exploited by multinational companies concerned with high profit margins and shareholder maximisation. However what happens when natural resources dry-up, many of these African countries never initially had the infrastructure or economic stability and do not have the pulling power to entice the companies to stay.  Just as easily as the money flowed it, it will flow straight back out leaving these severally unbalanced economies further unstable. Therefore is this really a long-term solution?

Arguably FDI is harder to reverse but ultimately multinational companies would not stay in a specific country if there were not long-term benefits of shareholder maximisation. So regardless as to how easy or hard it would be for a company to leave a country, if there was no strategic or competitive advantage they would move out and onto their next victim, exploiting their resources.  Put into perspective oil companies such as BP and Shell invest in oil rich countries but once the resources finish what is realistically keeping them there?

Are Multinational Corporations Tax Dodgers??

Tax, it’s that dreaded sum taken out of each months wage slip, but as individuals we accept that its part and parcel of earning a wage and being part of society. From a company perspective however ‘tax avoidance’ can and is viewed as a strategic implement to minimize tax and increase shareholder maximisation. However does this make it right? Do companies not have a duty of corporate social responsibility? I think it is very much a personal opinion and companies should consider the ethics of dodging the taxman.

Some may argue that it’s a vicious circle, high corporate tax within the UK forces multinational companies to look elsewhere to become more ‘tax efficient’. Whilst at the same time these taxes contribute towards recourse benefiting society like the NHS, public transport etc. etc and therefore lowering corporate tax will detrimentally affect theses public services.

Many companies that operate within the UK rely on customer expenditure to keep them strategically competitive and prospering within the market. Therefore do they not have an obligation to give something back, by contributing to their ‘fair share’ of tax responsibility?

Lets face it; companies like Tesco would not be as successful as they are without customers spending ‘£1 in every seven’ (Guardian, 2012) within their store.  Yet The Times (2008) reported that they transferred ownership of over 80 UK stores to joint ventures in the Cayman Islands. Whilst totally legal the company managed to shirk responsibility of £500m in tax and justified their decision by arguing they were trying to become ‘tax efficient’.  

Tax and taxation regimes can have major impacts on: long-term strategic planning, long and short-term cashflow and investment/ project portfolios. The above most probably contributes to the ultimate strategic decision of creating and maintaining shareholder maximisation. Does this mean that shareholder maximisation takes precedence over a fairer tax regime?

Within the FTSE 100, 98 companies base their operations in territories where there is low or no tax (Sky News, 2012). Furthermore the four biggest British banks have 1,649 ‘tax haven’  (e.g. Bahamas, Switzerland, Monaco) companies between them (Sky News, 2012).  Whilst there is a lot of opposition from foreign governments towards these ‘tax havens’, unless home governments reduce their tax rate this legal abuse is not going to end.

The topic of tax is certainly controversial and ethically disputed. However I believe that as long as tax avoidance is a legal strategy nothing is going to persuade multinational companies otherwise. Unfortunately this means that when multinationals avoid paying their fair share, it is the ordinary people who are left to pick up the deficit.

Loss or Top Leader??

In order for companies to become listed they have to go through rigorous checks, have a substantial mount of capital and maintain and endure demanding rules at the time of flotation and in subsequent years. However once listed the options and networks available for companies become endless. The London Stock Exchange for example in 2010 had around 3,000 companies from over 70 countries, with £20.8 billion being raised and traded on their market (London Stock Exchange, 2012). Whilst the decision to ‘go public’ should not be taken lightly the reasons for a company becoming listed are clear.

The hard work however doesn’t end there; many companies are then faced with issues of ‘How are we going to finance our operations’?

A primary source is through external sources: Equity finance, issue of new ordinary shares and Debt finance, variety of loans and debt securities. Both of these sources are risky, debt finance is much cheaper but can become a burden whereas in financial difficulties companies are under no obligation to pay dividends but equity finance means a dilution of company control.

In order to entice investment, companies need to offer returns to shareholders; equivalent to the risk they are undertaking. Therefore many companies have adopted a mix of both equity and debt to finance their activities, this is known as the ‘Weighted average cost of capital’ (WACC).

This begs the question ‘why do companies sometimes have projects, offers, products or services which are referred to as ‘loss leader’, with a return below that of the WACC’??

For example the Bugatti Veyron is one of the world’s most rare, expensive and fastest cars.  With a two-year waiting list and a UK price of £850,000 it is Volkswagen pivotal product. However incredibly, development of the supercar is rumored to be in excess of £2million per car and sold at a loss.

I ask myself why make it then, especially when I wouldn’t otherwise associate Volkswagen as a premium brand?

However Volkswagen argues that thanks to the supremeness and status of the Veyron, it has helped raise the group’s profile. Whilst this may seem like a drastic and expensive corporate strategy, if it is positively impacting and stimulating profitable sales in the Volkswagen group then it is an effective and seemingly feasible strategy.

Therefore I believe that sometimes companies need to adopt the strategy of ‘loss leaders’ in order to raise their profile and increase their external finance options.