The Dignity’s Brilliant Strategy, good for investors and financial managers?!

This week, we focus on the decision tool for managers. The WACC (Weighted Average Cost of Capital) should be treated as a common tool to help managers to decide whether to operate a project or not. In simple, the WACC is the capital return rate of running a business, including debt interest and equity return rate. And the rates could be formed as the following formula:

WACC=kE*WE + kD*WD. (kE is equity return rate, and kD is debt return rate. WE is the proportion of the equity in the whole capital, and WD is the proportion of debt). Besides, the enterprise value is the result of it that the expect cash flow is divided by WACC, so the enterprise value has directly relationship with WACC.

In December of 2010, according to London Stock Exchange news, compared with the other companies in the same area, the Dignity plc stock price increased much more greatly. The reason is the company published special dividends, which encouraged the investors in the depression market. And I read about their annual report and find their brilliant strategy. Dignity had been readjusting their capital in the recent year to exchange their equity to debt, and the company explained that they did that because they thought the cost of debt was much cheaper than the equity cost. It is true a method to reduce their WACC in their business. However, it was not only for that reason.

When they reduce their liability account, they increased the return rate every year, which could be attributed to their decrease liability, not for their development on their business. Because the cost of debt is cheaper than that of equity, when they increase the proportion of the debt and decrease the percentage of equity, the WACC would be reduced a lot. Then, they increased a little their equity return rate gradually, and the WACC could be decreased at the same time, which could be used to show great management achievement of the managers in Dignity plc and the market would put positive opinion on the company. Most important, the investors would benefit for the increasing dividends, and they would praise the managers in the company.Apart from that, as the WACC decreased, the enterprise value could be increased at the same time. Thus, the strategy of Dignity is so brilliant to obtain three goals together.  It seem to be win-win action for managers. However, it could not be so bright as we imagined.

Since the financial crisis, the whole British market became depression. The pressure of the management team was increased greatly. The adjustment of capital could provide a method for them to improve their achievement, but it could release more problems for the company. For example, the debt account could reduce their cash ability in the future, and it could put the company on an increasing risk gradually. Especially, in financial crisis, the cash ability could give the company opportunity to survival, when they is in trouble. So is it a brilliant method for managers? Mangers should use it after they thought twice.