| Managing capital in the euro environment |
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| Many companies are generating significant cash surpluses, but according to Dave Gribben, companies need to work harder in the low interest rate environment of the euro to improve net returns. |
Capital Management in this new post-Euro climate needs to take account of some fundamental changes in the environment for investment of capital. Our membership of the Euro economy has brought about a level of domestic economic management since the early 1990€s that has the admiration of our competitors. The strong domestic economy coupled with low inflation has given rise to more profitable companies, often creating surplus capital, as well as a general increase in wealth all round. Venture capital, long absent from the market, is now more widely available and borrowing rates are at an unprecedented low level. These factors along with low rates of corporate tax have given rise to a market where access to capital was never easier. As a result new issues and choices arise for working capital management as much as for the capital deployed in the fixed assets of the business.
A Large Company Perspective
Within large companies and in particular plcs, capital is most often viewed from a liability perspective. In a typical large bank, for example, capital is seen in terms of share capital, retained earnings and revenue reserves. This capital is expensive as shareholders expect to see increasing dividend payments (not tax deductible to the company) on an annual basis. Invariably in a large organisation such as a bank there are more investment opportunities than available capital, which means that it is vital for the organisation to have a rigorous method of determining how to deploy that capital. Frequently the sorts of criteria which are used to determine whether an investment should be made in a particular project include the payback period and, with acquisitions, PE ratios. A more rigorous tool, however, is return on equity (ROE). In the context of capital deployment then, this involves, in the first instance, measuring the overall cost of equity in the organisation. A decision then needs to be made regarding the target return on equity for capital deployed and only considering projects that deliver that minimum return. Engaging in this type of exercise requires the preparation of complex projections, which is a challenging exercise, but an excellent discipline. All things being equal it is then down to strategic arguments determining the choices that are made for capital deployment. Obviously, in this economic environment, using as much debt as is prudent in capital expenditure also makes sense as it is inexpensive and tax deductible.
For non-quoted and high-tech companies who don€t pay dividends, it is also a good discipline to impute the cost of equity when managing capital within the business. It is interesting to note that you will not typically see these types of companies returning capital because of the risk that they may not get it back at the same price when they need it in the future. On the other hand, there is a growing trend amongst quoted companies to undertake share buy-backs which, as part of an overall capital management strategy, improves the return on capital to shareholders.
By way of example, one of Britain€s largest financial services providers €‘ uses a measurement of profit called Economic Profit, which in its simplest terms is a profit measure which takes into account the equity charge. This means that when such a measurement system is used throughout all businesses within their Group it allows for rational comparison of those businesses as well as truly signalling where value is being created within the Group. Economic Value Added (EVA) is another such measure, which is in essence the difference between the cost of capital and the return on capital. Many organisations, including Lloyds TSB, Coca Cola and Lucas Varity, using these types of measurement systems see them as the only financial measures that take account of all resources, including equity. These profit measures also reflect a greater emphasis towards the shareholder€s interest over other stakeholder€s interests in the business.
Managing Surplus Capital €‘ A Backdrop
Capital can also be viewed from an asset perspective in terms of managing surplus capital. Following the recent ECB 0.5% rate cut, interest rates are now firmly at a historically low level of 2.5%. As a result, many companies currently investing in cash deposits are dissatisfied with their returns. Low inflation and low interest rates continue to fuel the equity markets, particularly in Europe and the US, and over the medium to long term investing in the right equities is likely to deliver a very positive real rate of return.
Why Invest in Equities? The case for owning equities has always been very strong, but never stronger than it is today. Equities have consistently outperformed investments in bonds and cash. For example: -
· The average performance over the past 5 years of a ¹Managed Fund was 76%, whilst the best performance from a Deposit Account was 17%.
· ²£1 invested in equities 30 years ago would now be worth £170 as against £32 if invested in bonds or £24 if invested in a deposit. Typically, equities outperform bonds by around 6% per annum, providing real protection against inflation.
· For the really, really long term investor, had you invested ³£100 in 1918, virtually as far as records go back, in UK equities, that £100 would now be worth £1,000,351 as against £13,315 in bonds and £7,038 on a cash deposit.
The bottom line for equities from an investment perspective is that the investor should take a 5 year view and is likely to get a return well in excess of deposit interest rates, which are low and falling. This is not likely to change for the foreseeable future.
Managing Surplus Capital €‘ For Companies: There are many issues involved for companies managing surplus capital. Obviously, shareholders want returns on capital and don€t like the idea of surplus cash in a company. Companies tend to have a variety of options beyond fully investing in business assets, including, share buy-backs or business acquisitions and expansions. Nonetheless businesses do have cash build-ups from normal trading activities or from the disposal of a business or property. Many companies do not want to take cash out of the business. Margins are often tightening and competition has meant that many companies today charge less for their products than they did 5 years ago. When this backdrop is combined with the falling return on deposits because of lower interest rates, the return on surplus capital is therefore even more important. There are therefore more and more companies prepared to consider the notion of capital management through investments, rather than just deposits, to improve their overall income.
A comparison of the likely returns from investing in a traditional cash deposit with those from investing in a Unit Fund is interesting€€€
Tax Treatment of an Investment in a Deposit
A limited company that has five or less board directors is known as a €Close Company€. Interest income earned by such a company is liable for corporation tax and an additional €Close Company Surcharge Tax€ of 20%. Example 1 demonstrates the tax treatment of a company€s investment in a cash deposit that earns a gross rate of 4% gross p.a. This provides a net annual return of 2.44% p.a., which only just keeps the deposit growing ahead of inflation.
The following summarises the treatment of deposits.
¨ Interest income suffers corporation tax at 25%/28%.
¨ Tax is payable at the end of each tax year.
¨ Indexation relief is not available.
¨ In addition, Close Company Surcharge Tax is applied at a rate of 20%.
Tax Treatment of an Investment in a Unit Fund
Under current tax legislation, when a company invests in a unit fund the following rules apply:
¨ The gains on the investment are liable to capital gains tax at a rate of 20%. Tax applies only on the encashment of some or all of the investment.
¨ As your investment is treated as capital in nature, it qualifies for indexation relief: the value of your original investment is increased in line with inflation when calculating gains.
¨ The investment gain is also free from Close Company Surcharge Tax.
¨ Standard rate of income tax is deducted at source at 24% from gains in the fund; therefore a tax rebate/offset is made to the company of 4%.
Example 2 demonstrates the tax treatment of an investment of £250,000 in a *Guaranteed Unit Fund (Capital Guarantee on the fifth anniversary). On the assumption of a net annual growth rate of 6% p.a., after 5 years the net annualised return would be 6.22%.
To summarise, in the current economic climate, many companies are generating significant cash surpluses. Interest rates are low and are unlikely to rise for the foreseeable future. With low returns and the unfavourable tax treatment of deposits, companies need to assess alternative investment solutions that will provide improved net returns.
Through investing in a unit fund such, a company has the opportunity to achieve significantly higher returns in a low risk manner. A company can access some or all of its funds at any time - such flexibility is necessary to allow ease of response to changing cashflow requirements. The tax advantages of such an investment are also considerable.
In summary then, measuring return on equity, which might well be very difficult, is a powerful tool when making strategic decisions concerning capital deployment. Bringing the cost of capital into the profit equation has proved very useful in terms of discovering where real value is created. The changing economic background globally has begun to force many companies to reconsider how they manage surplus capital and a trend is emerging towards deploying surplus capital into investment products linked to equity markets. Many companies are seeing very positive benefits in doing this. The world of capital management, from all perspectives, is changing in many respects, and will demand a continuous change in thinking by all those responsible. |
Dave Gribben is head of investment & insurance services at Ulster Bamk
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| Article appeared in the June 1999 issue.
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