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Putting theory into practice: why is a cash-rich firm such as Apple using the bond markets?

In crude terms, financial theories claim to emphasise key ideas that recur in different situations while ignoring the contextual details. In fact, this separation rarely happens--traces of the time and place in which the theories are developed are embedded in the way they are stated. Also, since theory testing involves data drawn from a specific time and place, more contextual information inevitably gets mixed in with key ideas during testing. As a result, the theories on offer to financial managers combine ideas and contexts in an ad-hoc way.

Financial managers who want to put financial theories to use therefore have a tricky task. They must strip out the remnants of the contexts in which these concepts were developed and tested to get back to the underlying ideas. Only then can the theories be put to work in the particular situations the managers are facing. The effective use of financial theory is based on the recognition that the same core ideas can lead to different conclusions in different settings.

Let's consider a problem that's currently bothering Apple's management team. Over the past couple of years the computing giant has faced pressure to find cash to increase dividend payments to shareholders. Pecking-order theory seems to offer Apple, and many other companies facing a similar need to bridge a funding gap, clear guidance on how to proceed (1).

The theory that is usually presented describes the sequence in which funding sources should be accessed. Cutting dividends (which is not relevant in Apple's case anyway) is ignored as a potential source of finance. This means that squeezing cash out of the company's existing assets and operations comes first in the sequence, with new debt next, followed by additional hybrid securities and, lastly, new equity.

Apple has a cash balance of about $140bn. So, according to pecking-order theory, its best course of action is obvious: run down this balance before even considering any other measure. Yet the firm has gone to the bond markets, raising substantial amounts of cash, which have been passed on to shareholders through dividend payments and stock repurchases. The cash balance remains untouched. This example doesn't seem to support pecking-order theory as either a predictive mechanism or a source of advice. If Apple's managers are aware of the theory--and they probably are--then why aren't they acting as the theory says they should?

This apparent conflict between theory and practice disappears once pecking-order theory is stripped back to its key underlying concept: use the cheapest funding source first. The sequence built into the typical statement of pecking-order theory arose because it was introduced and developed during a period when transactions costs, information asymmetries and the tax-deductibility of interest all pointed to it as being the best approach for a typical company. But times change--and not every company is typical, of course.

Unready money

For Apple, the cash balance isn't the cheapest funding source available. Its problem is that much of this money is trapped outside the US in its organisational structure, which has been described as "a double Irish with a Dutch sandwich". Apple has two subsidiaries in the Republic of Ireland, one holding all patent rights and the other looking after all international operations. There is a third subsidiary in the Netherlands. Some payments from the operations subsidiary in Ireland pass through the Dutch subsidiary on their way to the patent-owning subsidiary back in Ireland. This has had the effect of lowering Apple's worldwide tax bill, but has left its cash largely outside the US. Unfortunately for the company, the tax bill would come to about $30bn if it were to bring this money back to the US.

Once taxation is taken into account, Apple's cash balance isn't its cheapest source of finance. Given the low interest rates and the continuing tax-deductibility of interest payments, new debt is cheaper. So the key idea in pecking-order theory go for the cheapest source of cash first--is at the root of Apple's actions, even though the theory's usual sequence of funding sources hasn't been followed.

Apple is not unique in having cash trapped overseas. Several other US corporations have cash-rich foreign subsidiaries as a result of transfer-pricing systems that shift profits to operations based in low-tax jurisdictions. These companies would also face substantial US tax bills if they were to repatriate the money. But tax isn't the only reason cash gets trapped. Whenever a company is organised into divisions, each with its own banking arrangements, a similar situation can arise.

Some time ago I supervised an MBA student's summer project looking at cash flow management in company A a large, divisionalised organisation. Its head office had the task of granting divisional requests for cash. Requests were sometimes made with little warning, so were often resolved by hastily raised short-term debt. More recently, a business analytics project in another firm, company B, discovered a worrying pattern concerning the increasing use of short-term debt. Once again, divisional requests for cash at short notice proved to be the underlying cause. In both organisations it became apparent that, even as some divisions were asking for cash, others were sitting on healthy balances. It seemed that a more expensive cash source than necessary was being accessed, contradicting not only the sequence but also the key underlying concept of pecking-order theory.

Investigations indicated that senior managers in both businesses believed that accessing divisional cash balances would be a costly option. Company B's management team rated developing a model for forecasting the timing and level of funding requests, aimed at lowering financing costs through planning well in advance, as easier than getting hold of divisional cash.

The MBA student's report to company A highlighted the fact that centralised banking was a potential solution to the problem. It suggested that a centralised bank account could pay interest on divisional deposits using savings from the reduced use of short-term borrowing. Subsequent work by the company determined that such a system would be acceptable to the divisions. This was then introduced. Over time the system was developed to include an element of stick as well as carrot: divisions continued to be permitted to hold cash, but these balances were counted, with a mark-up, in the asset base when the divisional ROI figures were calculated. Bonus systems at that time had an ROI element. As a result of the (perhaps rediscovered) cheapness of internal funds, short-term borrowing ceased to be the first option when head office received requests for cash.

Company B is holding an investigation into the costs of accessing divisional cash balances. The perceived costs seem to be linked to a possible disruption of the organisation's ethos of decentralised resource control and decision-making. But the amount and source of these costs do not appear to be well understood yet. There is an increasing acceptance in the firm of the possibility that subjective estimates of costs are too large.

If it does turn out to be a case of cost overestimation, then managers have tried to use the key idea of pecking-order theory, but on the basis of an incorrect view of relative costs. Of course, to an outside observer all that's apparent is yet another case highlighting a gap between theory and practice.


(1) R Brealey, S Myers and F Allen, Principles of Corporate Finance (11th edition), McGraw Hill, 2014.

By Robert Berry, Boots professor of accounting and finance at Nottingham University Business School
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Author:Berry, Robert
Publication:Financial Management (UK)
Date:Feb 1, 2015
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