Section B – TWO questions ONLY to be attempted
Bournelorth Co is an IT company which was established by three friends ten years ago. It was listed on a local stock exchange for smaller companies nine months ago.
Bournelorth Co originally provided support to businesses in the financial services sector. It has been able to expand into other sectors over time due to the excellent services it has provided and the high quality staff whom its founders recruited. The founders have been happy with the level of profits which the IT services have generated. Over time they have increasingly left the supervision of the IT services in the hands of experienced managers and focused on developing diagnostic applications (apps). The founders have worked fairly independently of each other on development work. Each has a small team of staff and all three want their teams to work in an informal environment which they believe enhances creativity.
Two apps which Bournelorth Co developed were very successful and generated significant profits. The founders wanted the company to invest much more in developing diagnostic apps. Previously they had preferred to use internal funding, because they were worried that external finance providers would want a lot of information about how Bournelorth Co is performing. However, the amount of finance required meant that funding had to be obtained from external sources and they decided to seek a listing, as two of Bournelorth Co’s principal competitors had recently been successfully listed.
25% of Bournelorth Co’s equity shares were made available on the stock exchange for external investors, which was the minimum allowed by the rules of the exchange. The founders have continued to own the remaining 75% of Bournelorth Co’s equity share capital. Although the listing was fully subscribed, the price which new investors paid was lower than the directors had originally hoped.
The board now consists of the three founders, who are the executive directors, and two independent non-executive directors, who were appointed when the company was listed. The non-executive directors have expressed concerns about the lack of frequency of formal board meetings and the limited time spent by the executive directors overseeing the company’s activities, compared with the time they spend leading development work. The non-executive directors would also like Bournelorth Co’s external auditors to carry out a thorough review of its risk management and control systems.
The funds obtained from the listing have helped Bournelorth Co expand its development activities. Bournelorth Co’s competitors have recently launched some very successful diagnostic apps and its executive directors are now afraid that Bournelorth Co will fall behind its competitors unless there is further investment in development. However, they disagree about how this investment should be funded. One executive director believes that Bournelorth Co should consider selling off its IT support and consultancy services business. The second executive director favours a rights issue and the third executive director would prefer to seek debt finance. At present Bournelorth Co has low gearing and the director who is in favour of debt finance believes that there is too much uncertainty associated with obtaining further equity finance, as investors do not always act rationally.
Required:
Discuss the factors which will determine whether the sources of finance suggested by the executive directors are used to finance further investment in diagnostic applications (apps).
According to traditional finance theory, Bournelorth Co’s directors will wish to strive for long-term shareholder wealth maximisation. The directors may not have been fully committed to long-term wealth maximisation, as they seemed to have focused on the development aspects which interested them most and left the original business mostly to others. However, now they are likely to come under pressure from the new external shareholders to maximise shareholder wealth and pay an acceptable level of dividend. To achieve this, it seems that Bournelorth Co will have to commit further large sums to investment in development of diagnostic applications (apps) in order to keep up with competitors.
Selling off the IT services business
At present the IT services business seems to be a reliable generator of significant profits. Selling it off would very likely produce a significant cash boost now, when needed. However, it would remove the safety net of reasonably certain income and mean that Bournelorth Co followed a much riskier business model. The IT services business also offers a possible gateway to reach customers who may be interested in the apps which Bournelorth Co develops.
Rights issue
If the executive directors wish to maintain their current percentage holdings, they would have to subscribe to 75% of the shares issued under the rights issue. Even though the shares would be issued at a discount, the directors might well not have the personal wealth available to subscribe fully. Previously they had to seek a listing to obtain enough funds for expansion, even though they were reluctant to bring in external investors, and this suggests their personal financial resources are limited.
However, the directors may need to take up the rights issue in order to ensure its success. If they do not, it may send out a message to external investors that the directors are unwilling to make a further commitment themselves because of the risks involved. There are also other factors which indicate that the rights issue may not be successful. The directors did not achieve the initial market price which they originally hoped for when Bournelorth Co was listed and shareholders may question the need for a rights issue soon after listing.
If the executive directors do not take up all of their rights, and the rights issue is still successful, this may have consequences for the operation of the business. The external shareholders would own a greater percentage of Bournelorth Co’s equity share capital and may be in a position to reinforce the wishes of non-executive directors for improved governance and control systems and change of behaviour by the executive directors. Possibly they may also demand additional executive and non-executive directors, which would change the balance of power on the board.
The level of dividend demanded by shareholders may be less predictable than the interest on debt. One of the directors is also concerned whether the stock market is efficient or whether the share price may be subject to behavioural factors (discussed in (c) below).
Debt finance
Debt providers will demand Bournelorth Co commits to paying interest and ultimately repaying debt. This may worry the directors because of the significant uncertainties surrounding returns from new apps. Significant debt may have restrictive covenants built in, particularly if Bournelorth Co cannot provide much security. The directors may be faced with restrictions on dividends, for example, which may upset external shareholders.
Uncertainties surrounding funding may also influence directors’ decisions. Loan finance may be difficult to obtain, but the amount and repayments would be fixed and could be budgeted, whereas the success of a rights issue is uncertain.
(i) Identify the risks associated with investing in the development of apps and describe the controls which Bournelorth Co should have over its investment in development. (6 marks)
(ii) Discuss the issues which determine the information Bournelorth Co communicates to external finance providers. (3 marks)
(i) The main risks connected with development work are that time and resources are wasted on projects which do not generate sales or are not in line with corporate strategy. Directors may choose apps which interest them rather than apps which are best for the business. There is also the risk that projects do not deliver benefits, take too long or are too costly.
Bournelorth Co’s directors’ heavy involvement in development activities may have made it easier to monitor them. However, the dangers with this are that the directors focus too much on their own individual projects, do not consider their projects objectively and do not step back to consider the overall picture.
The board must decide on a clear strategy for investment in development and needs to approve major initiatives before they are undertaken. There must be proper planning and budgeting of all initiatives and a structured approach to development. The board must regularly review projects, comparing planned and actual expenditure and resource usage. The board must be prepared to halt projects which are unlikely to deliver benefits. One director should be given responsibility for monitoring overall development activity without being directly involved in any of the work. Post-completion reviews should be carried out when development projects have been completed.
(ii) Communication with shareholders and other important stakeholders, such as potential customers, may be problematic. Bournelorth Co faces the general corporate governance requirement of transparency and has to comply with the specific disclosure requirements of its local stock market.
However, governance best practice also acknowledges that companies need to be allowed to preserve commercial confidentiality if appropriate, and clearly it will be relevant for Bournelorth Co. However, the less that it discloses, the less information finance providers will have on which to base their decisions.
Another issue with disclosure is that product failures may be more visible now that Bournelorth Co has obtained a listing and may have to include a business review in its accounts.
(i) Explain the insights which behavioural finance provides about investor behaviour. (3 marks)
(ii) Assess how behavioural factors may affect the share price of Bournelorth Co. (5 marks)
(i) Sewell defines behavioural finance as the influence of psychology on the behaviour of financial practitioners and the subsequent effect on markets. Behavioural finance suggests that individual decision-making is complex and will deviate from rational decision-making. Under rational decision-making, individual preferences will be clear and remain stable. Individuals will make choices with the aim of maximising utility, and adopt a rational approach for assessing outcomes.
Under behavioural finance, individuals may be more optimistic or conservative than appears to be warranted by rational analysis. They will try to simplify complex decisions and may make different decisions based on the same facts at different times.
(ii) Bournelorth Co’s share price may be significantly influenced by the impact of behavioural factors, as it is a newly listed company operating in a sector where returns have traditionally been variable and unpredictable. The impact of behavioural factors may be complex, and they may exert both upward and downward pressures on Bournelorth Co’s share price. Investors may, for example, compensate for not knowing much about Bournelorth Co by anchoring, which means using information which is irrelevant, but which they do have, to judge investment in Bournelorth Co.
The possibility of very high returns may add to the appeal of Bournelorth Co’s shares. Some investors may want the opportunity of obtaining high returns even if it is not very likely that they will. The IT sector has also been subject to herd behaviour, notably in the dotcom boom. The herd effect is when a large number of investors have taken the same decision, for example to invest in a particular sector, and this influences others to conform and take the same decision.
However, even if Bournelorth Co produces high returns for some time, the fact that it is in a volatile sector may lead to investors selling shares before it appears to be warranted on the evidence, on the grounds that by the laws of chance Bournelorth Co will make a loss eventually (known as the gambler’s fallacy).
Under behavioural finance, the possible volatility of Bournelorth Co’s results may lead to downward pressure on its share price for various reasons. First some investors have regret aversion, a general bias against making a loss anyway. This, it is claimed, means that the level of returns on equity is rather higher than the returns on debt than is warranted by a rational view of the risk of equity.
Similarly under prospect theory, investors are more likely to choose a net outcome which consists entirely of small gains, rather than an identical net outcome which consists of a combination of larger gains and some losses. At present also, Bournelorth Co does not have much of a history of results for the market to analyse. Even when it has been listed for some time, however, another aspect of behavioural finance is investors placing excessive weight on the most recent results.
If the market reacts very well or badly to news about Bournelorth Co, the large rise or fall in the share price which results may also not be sustainable, but may revert back over time.