Wednesday, March 24, 2010

A common form of corporate ownership – Capital Structure

When raising investment capital for a corporation, it is all based on the cost of money. If you raise capital by issuing a corporate bond, the ‘rent’ you are paying is the interest rate of the bond.  So what would be more expensive, borrowing money at 6% or...

Issuing shares, i.e. selling part of the company’s ownership, and paying a dividend on those shares of 3.6%? At first sight, you may say the dividends, but dividends are paid on after tax profits and are not tax deductible. The interest on a bond is tax deductable as a business expense. On an after-tax basis and a corporate tax rate of 40%, the real cost of money would be 60% of the interest rate or 0.6x6% =3.6% after tax. So from the corporate perspective there is no difference.

However, the investor who buys those dividend paying shares can claim the dividend tax credit and makes on an after-personal-income-tax basis 3.2% . The 6% interest rate would be taxed at the top margin rate of say 50% and he/she makes only 3% after-tax. Thus the investor prefers the dividends and the company will likely sell the shares easier than the corporate debt.

It is these kinds of number games and all those ratios we discussed in the previous segment that determine a corporation’s capital structure. Often shareholder rights and ownership are just pipedreams, with management only acting in its own interest. Either way through share equity or lending, the corporation will raise capital when needed for its operations or yet another acquisition.

This is why many investors feel so frustrated and powerless when investing in the stock market. In theory they own the company, in real life they only provide a different form of capital than lenders. Real Estate investors feel they have more control over their investments and that is true to some degree. But they forget two essential factors:

1: They are only in control if they run the real estate operation. Single property owners and true partnerships are indeed in control. But this, in my books is not investing but the running of a business. So basically they are the management and employees of this real estate investment company.

2: Typical joint venture (JV) investors have little or no say in the operation of a real estate investment. They just collect a monthly cheque for 10 to 15% return per year, while the rest of the profits remain with the partner(s) in charge of the real estate purchase and operations, sometimes called the finder(s). What other than risk is the difference with a mortgage or debt? None! The finders are similar to the management of a share trading corporation.

Basically, whether you run a corporation or a real estate joint venture, you are management and typically you are in control. While when you are the corporate share holder or the financing partner of a JV you are the source of rented capital.

Having made these important distinctions, you as an investor should now be able to look at your investments being it real estate or stock market investments in a much different light. Either way, you are not executing the business and you are not the board of directors. You are just supplying money in the hope of making more money without getting really involved with running the business – this is true investing.

Whether you are corporate management (including the board) or whether you are the ‘finder’ of a JV, you are not an investor. You are trying to increase the value of an investment for others (sometimes including your own equity) through your work and expertise. Your compensation is exactly that, compensation for your work and expertise. Of course this compensation can be in all kinds of forms ranging from share options to dividends or bonuses or plain salary.

When investing in real estate, the suppliers of capital
are ordered in priority of repayment. At the top of the list of repayment of owed funds are Municipal Taxes, followed by Condominium Fees. Next comes the First Mortgage with the right to foreclose, followed by subsequent mortgages also called equity mortgages because they get what’s left of the property’s equity after the previous creditors have been paid out. Finally at the bottom is the owner's equity, which has the largest upside potential for profits but which also incurs the highest level of risk and liability.

Compare this with corporations. Again at the top of the heap is taxation, followed by the most senior of secured forms of debt, next unsecured forms of debt and then the equity holders. First preferred (equity) shareholders who get a fixed proportion of the profits paid out in dividends but who do not share in the remaining profit potential regardless of the upside. They are like the equity mortgage holders – they get what’s left of the business’ equity after all lenders have been paid out. Finally at the bottom are the common share holders, who carry the highest risk but also have the chance of making the largest profits.

“So what is a better investment real estate or stock market?” is often asked. The answer by now should be clear. It depends, whether you are in control as manager or finder (in a JV) or whether you are just the provider of capital. One is no better investment class than the other; we’re just dealing with assets - corporate versus real estate assets. The asset performance is a function of the state of the economy and the stage of the economic cycle. How you are awarded depends strictly on the soundness of the investment including the skills of those who are in control and the way the asset is financed.

Since we’re talking in this segment about corporate financial structure, I would like to conclude by discussing preferred shares versus common shares. In my opinion, preferred shares are a form of fixed income – the dividend rate is set upon issuance and is not a function of the corporation’s profits. However, in case of default it is now called the ‘suspension of dividend payment’.

Because, preferred shares are the highest risk source of capital after common share it is paid out of after tax profits. It is a hybrid investment valuated based on interest rates paid on competing, more traditional, forms of lending while it is considered share holder equity rather than debt. It is tax-advantaged over conventional interest and dividend rates are typically higher than that of common shares.

In poor economic times, preferred shares can be bought at very low prices while paying out incredible high dividend yields. If you are convinced the underlying company is healthy enough to survive the current troubles, preferred shares provide excellent cash flow while you wait for an even more profitable return in the form of appreciation when the corporation recovers to its normal level of profitability. In the mean time, if the corporation goes broke after all, you still have a better chance to recover some of your investments than common share holders do. It were these investment aspects that made preferred shares so popular during the 2008-2009 Great Recession with sophisticated investors such as Warren Buffett, especially when linked with warrants (the right to purchase shares at a pre-set price).

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