Financial Ethics: OLYMPUS, The $1.7 Billion Fraud

In today’s world, we can found a lot of scandals and fraud on the news. What causes all this scandals and fraud occurred in the market? Is it because of greed of money or gain of the company value? When come to the ethical decision, I have always wondered how many decision maker will think ethically instead of its own gain. Today, I will talk about the topic of Olympus, $1.7 billion accounting fraud which is related to the financial ethics.

As you all know, Olympus is a large multinational corporation around the world. However, this scandal had made the Japanese people feel embarrassed about it. This scandal is found out by the first foreign leader, Michael Woodford during 2011. Woodford find suspicious that the money of 1.2 billion has disappeared in the account and he got fired after questioning this to Kikukawa. So, he started to investigate this mysterious payment. In this case, Tsuyoshi Kikukawa, Mori and Yamada are involved in this fraud by doing illegal practice of moving loss- making investments off shore. It sounds foolish that Kikukawa hide up 1.2 billion losses since he started working as CEO of Olympus instead of announce it to the public.  The total losses of 1.2 billion is cleared by acquired three defunct companies at a minimal valuation cost and sell them to Olympus at an inflated price of $550 million and Kikukawa contrives a new scheme paying on inflated fee to the financial advisers for Gyrus acquisition that cost $67 million. With all the losses that are cleared, Kikukawa thought he had buries this secret and Olympus could start again with a clean slate. Why Kikukawa decided to do that? Is it because the gain of the company in which the 1.2 billion losses will cause a decrease in share price or he is trying to protect the reputation of the company? However, what he did is an illegal practice and he had cause a bad reputation to the company. In 12 February 2012, Kikukawa and the members that participate in this fraud are arrested and punished.

After all, I doubt about how many people will act like a professional instead of employee when they come to the point of making decision for the company. How many of you will think of whether it is fair to the investors and how many of you will consider of what you might gain for making the decision? Please share your opinion with me.

 Much appreciated. 

Volkswagen's scandal: A grey November

After all the topics about M&A, dividend, CAPM, and stock efficiency, I decided to talk about business ethics which I think it is the most important topic in the financial market. There are a lot of successful smart leaders like Bill Gates, Mark Zuckerberg, Steve Jobs and more in the world, but they would not be so successful if they do not have business ethics in their mind. Business ethics is very important to a company because it will affect the reputation of the company which how the image is form in the public. It also builds trust with shareholder and stakeholders. If the reputation of the company is bad, it will definitely affect the value of the company and the shareholder and stakeholders will choose to bail out or sell off the shares because they do not trust the company.

I believe that everyone have heard of the recent news which talk about the Volkswagen’s scandal in the market. Since the beginning of November 2015, the bad news about Volkswagen does not stop. It is a grey November to Volkswagen due to the decrease of sales in Volkswagen. First, the company is found cheating by installing the software that was used to cheat on emissions tests. Volkswagen has also admitted that 11 million of its vehicles were equipped with software that was used to cheat on emissions tests which is kind of disappointed when I heard the news. After the scandal has been announced, Martin Winterkorn said that his company had broken the trust of their customers and the public. He decided to resign from the company and was replaced by Matthias Muller, the former boss of Porsche. However, it does not make any big changes to the company because the public does not trust the brand of Volkswagen anymore. As what I have mentioned, the reputation of a company is very important in the market. According to BBC news, the scandal has caused the Volkswagen sales fall 20% in the UK market. It may took a long time to build the trust between the customer and the company but the trust can be destroy in just a second if the company is found out doing illegal practice in the market. In addition, the Volkswagen scandal has affected the company’s debt downgraded as well.

 

After the scandal was found out in US, it has spread to countries like UK, Italy, France, South Korea, Canada and, of course, Germany, have opened investigations. Throughout the world, politicians, regulators and environmental groups are questioning the legitimacy of Volkswagen's emissions testing. Volkswagen respond that they will recall 8.5 million cars in Europe, including 2.4 million in Germany and 1.2 million in the UK, and 500,000 in the US as a result of the emissions scandal. Moreover, Volkswagen is one of the largest car maker in Germany and due to that it has also affect the car maker's shares fallen by about a third since the scandal broke.

After all, do you think it is worth to do illegal practice because the company wanted to earn more profit? This is the punishment that Volkswagen got after they were found cheating to pass the emission test. I am not sure how long will Volkswagen take to overcome this problem and to rebuild the trust of their customers. Do you agree with me that business ethics is so important to a company? Please leave some comment and share your opinion with me. 

Merger and Acquisition

In this day and age, mergers and acquisitions play an important role in corporate finance. For many companies, mergers and acquisitions are a source of external growth when primary growth is not possible, whereas to other companies they represent a constant threat to their continuing independent existence. Merge can be explained as a friendly negotiated deals between 2 organization into a new organization while acquisition means that a takeover of one company’s ordinary share capital by another company, financed by cash or issue shares. Why mergers and acquisition will occur in the financial world? It is because of synergy which the executives believe that the combined organization will have a greater value than the sum of its parts.

Here is the formula for synergy:

                 PV_AB = PV_A + PV_B + Gains

Today I will talk about the largest merger between Chrysler, a car industry from America and Daimler, another car industry from Germany which is happened in 1998. Chrysler is one of the car industries that have the 3^rd ranking in the United States car-maker. Besides, it is known for “block-buster” products because their best-selling vehicles are Minivan and Chrysler Jeep Grand Cherokee. Chrysler are risk takers in term of design, finance and manufacturing, it is quick and nimble where it can produce 2.2 million cars per year.  Meanwhile, Daimler- Benz is a car industry that produce high-end car in Germany which was very different from Chrysler. It has a strong historic roots and powerful heritage in the market. Daimler- Benz is a complex company structure with a holding company, a much diversified group including train; airline and car production and they are all run as autonomous business units which each have its own chairman and management board. Mercedes is one of the famous and profitable products around the world. Can this two large company that have big different succeed in the merging process? Well, not everyone will agree with merge and acquisition because they will afraid of losing their jobs and takeover by the stronger company. In this case, Daimler Benz is the powerhouse behind of the merger negotiation. Indeed, the board member of Chrysler will definitely worry about this merger process because it sounds like an acquisition instead of merge.

 However, the merge between these two companies was announced in 7 May 1998. In my point of view, I would say this merger as a vertical merger because the combination of two companies operates at different stages of production within same industry. It is because Jurgen Schrempp, CEO of Daimler Benz said no to platform sharing because this would be a merger without dilution of brands. After the merge, Daimler Chrysler started to face problems because there was confusion between merger management and operational management. Daimler Chrysler is excluded from the Standard & Poor 500 because the head-quartered is located in Germany. In this case, would Daimler Chrysler be a German company or American company? What about the conflicts of taxation and national pride for this company? Eventually, Daimler Chrysler did not perform well in the market where it did not make any profit for their first year and the new productions of Minivan from Chrysler were remaining unsold. At this point, Schrempp started to lose confident with Chrysler because he realized that Chrysler was losing control in the U.S market and the German management made a mistake of not taking this problem serious in the early time. However, Schremmp decided to take a drastic action by restructuring, downsizing and refocusing on Daimler Chrysler.

After all, I personally think that merger and acquisition between two companies may help them to expand their value of the organization. However, there are also a lot of limitations like culture, communication between employees, senior management were inaccessible that will cause the failure of M&A. Please drop some comment and tell me what you all think about merge and acquisition.

Cheers

Wall Street: Money Never Sleep

                It is a meaningful week for me because I have spent two and half hours to watch this interesting financial movie called “Wall Street: Money Never Sleep” which basically talk about greed. Today I am going to talk about some interesting topic which is related to finance. As a finance student, I assumed that everyone know about Wall Street. It is a place where investors experienced gain and loss through trading shares. Before I start, I would like to ask everyone a question. Do you think greed is a good thing? Well, I think that greed can be a kind of motivation because a person with a greedy mindset is willing to do anything to achieve what they want. However, this also means that a person will do something that is illegal to achieve their aim. Who does not have a greedy mindset? I believe all investors are greedy but everyone has different level of greediness. In this movie, Gordon Gekko was sent into the prison because he was caught doing insider trading and fraud. It is greed that causes him lost his family and spends his life in the prison.

                There is another scenario talk about Louis Zabel, the chief executive of the KZI commit suicide because he cannot accept the fact that his company collapsed. The rumors in the market caused the share price of KZI decreases rapidly and he is forced to sell his share to the FED for £2 per share.  After all, Jacob found out that the reason of KZI’s share price decrease is because that Bretton James spread rumors in the market and trying to hunt down KZI. After that, there is carnage on Wall Street which all sectors in the market are going down. The indicator of DJIA, S&P and NASDAQ turned red and the market was in a chaos condition. At the end of 2008, Bretton James is caught for doing fraud and sent into the prison.

                After watching this movie, I realized that how bad a person can be because of the greed for money. Gekko did not change the greediness of himself even after he is out from the prison instead. He just came back in a different form to cheat and betray to the people that have trusted him. He asked Jacob to tell lie to his daughter, Winnie Gekko to get back his 100million from the bank in Switzerland.

                After all, do you all still think greed is good? I believe that everyone wish to have gains instead of losses. But can everyone stop himself from being greedy because of the gain of value in the investment they made? To be honest, who hates money? In this movie, I really learned a lot about why a person will fail and cause the company collapse. For example, Bretton James greed for money was his ruin. If he did not do fraud and betray Louis, he might not end up his life in the prison. Lastly, I would recommend to people who have not watched this movie before to spend your time to watch it because it is really worth to watch. 

Dividend policy

                This week I will talked about how a company make decision between dividends or reinvest the retained earnings to some positive NPV projects. This topic is related to the previous topic that I posted last week. Every company will have their own ways to make profit. Some companies will prefer more debt than equity or vice versa. But in order to make sure that shareholders will not stop investing your company and  a company can increase its value each year, it has to give some return back to the shareholders as well. At this point, companies will come into a tough decision of either giving dividends to its shareholders or reinvest into some other positive NPV projects. Well, either way the company will also bring benefits to the shareholders in long term. Some shareholders will look at the dividend payout ratio before they invest into that company while some will look at the retained earnings of the company and what recent projects that the company plans to invest in.

                According to Modigliani& Miller (1961) theory, it says that the share prices are determined by the future earning potential not the dividends that will be paid now. Therefore, the share value is determined by investment policy and not the amount of earnings distributed. M&M also argue that he dividend decision is mainly financing and investment decision with any money that is leftover after a company invests in all positive NPV projects. Thus, the timing of dividend is not really important and investors should look at the long term of the investment instead. In my opinion, I think that dividend will not be the main concern for me to invest my money. It is because if a company chooses to reinvest the money into some NPV projects, then the share prices will increase. By that time, if investors prefer to get return back from the company, they can just sell some of their shares away. For example, Google Inc. is a big company that does not pay dividend to its shareholders. Google choose reinvest its retained earning into different type of project which has positive NPV where it may be good to shareholders because it might have a large capital gain in long term. However, by doing so, there are disadvantages to the shareholders because the risks of reinvesting money to other projects are uncertainty. Therefore, shareholders might not feel safe and confident in investing company like Google. Besides that, a company might not choose to reinvest the profit into other projects but to do share re-purchase schemes as ways of returning cash to shareholders instead. This is also a good way for the company to increase gearing without taking more debt and incurring interest cost. By doing so, it can increase the share price due to the lesser shares in the market and it can prevent someone to take over the company.  

                On the other hand, some shareholders will prefer company that pay dividend to shareholders like Apple Inc. It is because they can know whether the company is doing well or not. If a company is doing well, it could give a better dividend back to their investors and investors can use the money to invest in other positive NPV project that they prefer. Despite that, investors will have to pay taxes when they collect dividends. In company’s perspective, paying dividends will restrict the company from having lesser opportunity in investing positive NPV projects.

                As you can see, Google Inc. and Apple Inc. are large company in the world and both companies have used different method to create shareholder’s value. Thus, there is no best way of creating value for the company as well as to the shareholder’s wealth. If you are an investor, will you prefer a company that helps you reinvest your money into other positive NPV projects or give dividends? I believe most of the investors who are not willing to take high risk will prefer a company that gives dividend regularly. Please leave a comment and let me know what you think about the dividend policy for different companies.      

Debt and Equity in capital structure

                Today I will talk about debt and equity in capital structure which is taught in Week 6 lecture. In the business world, many companies are facing tough decision between debt and equity. However, both debt and equity have different ways in raising company’s capital with different costs. Many companies prefer debts more than equity. Why? One of the reasons is that the issuing and transaction costs for debt are lesser than ordinary shares. Besides that, lenders require a lower rate of return than ordinary shares because debt is less risky than ordinary shares and it has tax advantages as well. Since debts has a lot of advantage to a company, why company do not go for a 100% debt instead. Well, this is because that if a company choose to go for full debt will cause financial distress risk to the company. A higher level of debt will leads to an increase in gearing level and a decrease in the overall cost of finance that will cause the risk of the company increase at the same time. This will cause the company become financially distressed as its WACC increased and shareholders will start to demand for a higher return to compensate the higher risk of the debts. Meanwhile, too much debt is not a good thing to a company because a company still has to pay the interest even if the profits are low or high. Therefore, a company has to balance the percentage between debt and equity.  

The diagram above shows the changes of WACC between debt and equity. The WACC will falls initially because debts has tax advantage but if it go beyond the optimal debt-equity ratio, it begins to rise because of the financial distress cost.

                I have found an article which talk about European Central Bank that has recently launched its quantitative easing programme. Unfortunately, this programme failed to stimulate lending due to lack of investment from many firms. In Europe, many blue-chip companies have recently issued debt at a lower rate. However, with the cheap credit and low interest rates, many companies in Europe are still reluctant to take on more debt (Financial Times, 2015). According to Marc Zenner, the co-head of corporate advisory at JPMorgan say that a debt with low cost does not mean that its hurdle rate is low as well. It is just a slow process from QE and cheap money to get more companies to invest more. It is quite true that corporate boards seldom adjust the hurdle rate and so the impact of borrowing costs will not pass on immediately. Companies have to bear in mind that they have to repay all these debts to lenders on its maturity. So, even if the interest rate is low or cheap credit, it is not necessarily to take more debt because it may cause higher risk to the company.   

               According to Modigliani& Millar (1958) theory, it says that a company’s capital structure has no impact on the WACC. Thus, there is no optimal structure exists and a company’s value are purely depends on business risk where it can perfectly measurable by shareholders. In Modigliani & Millar(M&M) theory, it has make few assumptions like there is no taxation, no transaction costs, a perfect capital markets with perfect information available to all and there are no costs of financial distress and liquidation. In real world, this theory can be easily debate because all these assumptions are not possibly happen. Thus, M&M revised their theory to take tax into account. However, you might feel that M&M theory does not really make sense in the real world but it does help some manager to make decision on capital structure.  

Royal Bank of Scotland:Inside the Bank that ran out of money

The Royal Bank of Scotland (RBS) is one of the biggest banks in the world. In the 90’s, Sir Fred Goodwin is the chief executive officer of RBS and he lead RBS to became one of the bank that has rapid growth among other banks. How did Sir Fred Goodwin do it? Under the lead of Fred Goodwin, he started by merge and acquisition. In order to make the financial growth of RBS increase, Fred Goodwin plans to takeover other banks in the market. First, Fred Goodwin plans to takeover NatWest which is a bank that is located at United Kingdom. The reason why Fred makes that decision is because that NatWest Bank has a big building but with a very poor finance growth and the share price is low as well. After Fred takeover NatWest, RBS make a large profit over the year and Fred decided to reinvest those profits into different assets.  Well, some people think that Fred Goodwin is a megalomaniac because he pursues the size more than shareholder value. Do you agree with that? In my point of view, Sir Fred Goodwin is overconfidence with the decision that he made. Is taking over other bank a good way to build up the name of the bank? If yes, why do Sir Fred Goodwin almost cause RBS collapsed in the end?

                In the early 2006, USA has a property booming where Fred Goodwin thinks that there is a big money could be made. RBS has merged with a bank in USA which is known as Charter One. By that time, banks started to make loans like prime and subprime loan to borrowers. By making loans like subprime lending, the bank can make a lot of money as long as borrowers repay their loan. However, it is a high risk high return investment because the bank lend loans to people who might not have enough of ability to repay back their loan and so the interest rate are high as well. Unfortunately, the property bubble burst in the late 2006. Many borrowers cannot afford to pay back their loan and so they stop paying it and declare themselves to bankruptcy. Banks that do a lot of subprime loan are facing heavy losses as well and the market is in recession. In this case, RBS is also affected by the subprime crisis due to the merge with Charter One in USA. I personally think that merge and acquisition with other banks is benefit to the company. However, if a bank takeover too many banks, it will cause a burden to itself because it needs a lot of capital to takeover a bank each time. By that time, RBS had a press conference to assure to the city that the subprime amount that they do is very small which will not affect the bank. But, how could a bank manage to grow well if the economy is in recession condition?

                In 2007, RBS plan to takeover a Dutch Bank known as ABN AMRO. Sir Fred Goodwin thinks that this bank has a good potential in future because it has many good business, good attractive and good views. At that time, many risk analyst and investors are disagree with what Fred plan to do because that think that his decision is insane even after ABN AMRO announced that they sold off LA SALLE in USA. In my opinion, the reason why I think Fred Goodwin is overconfidence is because he thought he could make profit after takeover ABN AMRO like how he takeover NatWest in the past. In addition of that, I think that Fred Goodwin did not do enough of background research of ABN AMRO where he should go through the due diligence process before he decide to take over the bank. Besides that, I think Fred Goodwin had made a very serious mistake by taking the bank reserves to purchase ABN AMRO. If a bank runs out of money, it is because that it does not have enough of bank reserves in the bank. But why Fred Goodwin wanted to make this decision even he knows the risk of it? In September, subprime crisis is fully spread and the market went into turmoil. By this time, RBS realised that it is a wrong move to purchase ABN AMRO because it contained exposure of £100mil of subprime related investment. In December 2007, RBS announced that they have suffered deep losses of £1.5 billion. The RBS core equity 1 ratio is getting dangerously low and RBS force to ask for more cash from shareholders. However, shareholders are angry with what Fred Goodwin’s decision and they do not trust RBS anymore. RBS started to run out of option and the cash reserve drained on ABN AMRO followed by the decrease of share price. By that time, no banks are willing to lend money to RBS. Lastly, RBS ran out of money and the government has to help RBS from the deep losses. Therefore, do you think that Sir Fred Goodwin is a smart CEO? If he could be a bit more careful and concern more about shareholder’s value then RBS might not have to face such deep losses.