Q&A with CMMB Securities

Q: With so many mergers and alliances in the financial sector and banks offering one-stop-shop financial services, is there anything extra to be gained from using an independent investment advisor or broker?

Vishanti, Fyzabad

A: As an investor you may want a profile of investments to suit your specific objectives, time horizon and risk tolerance level. It may be convenient to invest at a “one-stop-shop” that offers a variety of investment products and services. However, one must be mindful that merged institutions tend to cross sell products and services and an investor may not receive a package tailored to his/her individual needs and goals. An independent investment advisor will be able to identify your needs and goals and recommend from a broader spectrum of products and services to create the “best fit.” The importance of structuring a portfolio for yourself that is suitable to your particular needs and circumstances cannot be overemphasised. A lot of investors tend to invest in financial products which are the latest trends, but not necessarily suitable to their investment profile. For example, during the 1990s some investors bought into risky types of investments such as high yield mutual funds, and in some cases hedge funds, without having a full appreciation for the dangers of downside risk. When these investments depreciated in value investors lost sizable amounts. So an independent investment advisor may well give extra value in terms of more objective investment advice.

Q. I run a small family business and we urgently need some new equipment, which costs around $45,000. There’s disagreement about whether to pay for capital equipment cash or get financing. What’s best?

Jeffrey, Tobago

A: While there may be various financing options, which will depend on factors such as the direction and level of interest rates, probably one of the better options would be to partially finance the equipment using debt and the rest by your own funds (ie equity). From this option one can obtain the benefits from leverage in terms of the magnified profits to be derived from the purchase. This will also allow you to share the risk of the purchase with other capital providers. The flip side to this option is the sharing of profits, via interest payments with your creditors. But given the possibility of increased profits at an overall lower level of risk, this option may be the most feasible. However, the most important incentive to using debt financing is the tax break, which is obtained. The servicing of interest on a loan is tax deductible to a business and so acts as a tax shield. In other words, the chargeable income of your business is reduced by the same amount as the interest payments that you make on your equipment loan. However, if you buy the equipment using your own funds this benefit is not obtained and the business would end up paying more in taxes. In fact, financial theory advocates that the business use as much debt as is possible because of the tax deductibility of interest and the effect this has in increasing the value of the firm. This is not to say that debt should be used with impunity as too much of a debt load can result in distress costs and bankruptcy in times of declining business revenues. So the business owner must weigh the effects of the interest tax shield against burdening the firm with too high a debt load.

Q. What is a dividend-reinvestment plan and how does it work?

Asha, Santa Cruz

A: Dividend Reinvestment Plan is a plan offered by a corporation giving investors the option of reinvesting their cash dividends by purchasing additional shares or fractional shares on the dividend payment date. Investors thereby increase the value of their investment by ploughing back their dividends. One of the main benefits of a dividend reinvestment plan is that shares can be purchased commission free. The effect of this is similar to the law of compounding which we discussed in an earlier column. By reinvesting dividends you are effectively augmenting the initial capital invested and so earning “dividends on dividends.” Most times shareholders take their dividends and invest them in cash equivalents or fixed income securities, the returns on which are much lower than the capital appreciation potential of most shares. So by reinvesting dividends into shares the returns on the dividends received are optimised. In fact, some investors like to invest in shares, which pay little or no dividends. They prefer that the company reinvest shareholders’ funds into the firm in order to generate more profits and eventually a higher stock price. Such investors choose firms with high Price/Earnings ratios so that a given increase in the firm’s profits from dividend retention and reinvestment results in a high percentage change in the value of the firm’s stock price.