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Saturday, February 02, 2008

Mulling over Microsoft's bid for Yahoo

A lot of people are dazzled when Microsoft is ready to put down $44.6 billion to buy Yahoo. In New York Times, Joe Nocera has written an article A giant bid that shows how tired the giant is that offers an unusually clear-headed interpretation.

In modern thinking, a good financial system is one where investment is based on prospects, not cashflows.

Firms with cashflow but not prospects
Some firms - like Microsoft - are producing a lot of cash, and don't have good prospects. Such firms should be paying out dividends. CEOs and managers derive private benefits from size, and always have a bias in favour of more investment. The critical task of the board of directors, in such companies, is to say to the management team: "Please don't try to use your shareholders money on projects that aren't exciting. Just pay it out to the shareholders, who will buy securities of companies with good prospects." Good corporate governance is about forcing firms with below-median prospects to pay out high dividend rates and not allow their managers to use shareholder's money suboptimally.
I'm puzzled about how the board of directors of Microsoft sees this. Could this purchase be value-destroying, because a Yahoo that's managed by Microsoft might actually be worth less? E.g. many people who like Yahoo finance and yahoo messenger today, owing to their clean software foundations, might stop using them if they are turned into Microsoft-style products. Might it be better for shareholders of Microsoft if they were paid $44.6 billion in a dividend, and then they (i.e. the shareholders) choose how to do their own diversification - which could include buying shares of Yahoo?
Firms with prospects but not cashflow
When a firm has poor cashflow (or lacks tangible assets) but has high NPV projects, a good financial system is one which is able to process information, make forecasts, understand the good projects in the hands of this firm, and get debt and equity capital to this firm.

In a bad financial system, investment follows cashflow or tangible assets, dividend payout ratios are stable across time and across firms. A good financial system is one which breaks this link; investment is also found in firms with bad cashflows (or firms that lack tangible assets), dividend payout ratios are unstable through time and dividend payout ratios are non-uniform across firms.

I have the privilege of serving on the board of directors of one company where the projects aren't good. I have tried hard to persuade the board of directors to pay out bigger dividends. It is hard.


  1. Your analysis of the post acquisition scenario of yahoo by Microsoft seems very relevant. A good forewarning for yahoo shareholders to reject the bid

  2. Hello Ajay Sir,

    During my college days, I have read through materials on dividends or reinvestment. This case in point is a clear case of shareholder wealth destruction as Microsoft could have bought out a hundred companies in the internet space with huge prospects but less cashflows with 10% of the figure ($45bn).

    Appreciate your work and your blog makes really interesting reading.


  3. While a very relevant point raised, this is actually the "beauty" of large corporate firms. Think about still deeper inefficiencies (X- efficiency school) where even at their regular work, resources are used suboptimally. So when you read the big-shots being asked to resign because of some billion $ write-off, it is most likely that such a situation occured as a result of policies followed by their predecessors.
    Now it is always hard to measure the abilities of any management team and here comes the role of perceptions,path dependency, inertia within the system, insufficient information and so on....
    So even if our "science (of accountancy + finance)" can talk of inefficiency, it is the "art (of management)" which often rules.

    Nice point raised though.

  4. Giving out dividend, in India, reduces the payout to investors by nearly 17% (dividend tax + surcharge + cess). This cannot be offset by business or investing losses, so the 17% is gone. Gaayab, chole geche.

    That means the investor gets approx. Rs. 83 for every Rs. 100 paid out. To just get it back to a Rs. 100, they need a 20% return. In fact, assuming that FD interest rates are 9% and the post tax yield is 6% - the Rs. 100 would go to 106 so investors really need to earn Rs. 23 (from the Rs. 83) in a year in order to break even. That's about 27%.

    27% is not easy and definitely not riskless.

    So if a company has a project that beats 6% returns it shouldn't pay dividend. In fact even if it doesn't, it probably should not (27% is very difficult for a broad spectrum of investors).

    This is India, specifically, because of the dividend tax. In the US you can offset dividend income with business losses (I think).


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