Burmah Oil
Question 1: Debt Policy Burmah argued that its BP and Shell holdings enabled it to borrow large sums of money on favorable terms. ... Did Burmah’s argument justify a policy of acquisition? ... Because of its large holding in BP and Shell, Burmah is entitled to issue debt at these favorable rates as well. No, overall, Burmah’s argument does not justify a policy of acquisition. ... According to the Trade-off Theory, Firm Value = Vu + PV(tax shields) – PV(bankruptcy costs) – PV(agency costs) If BP and Shell had themselves borrowed as much as they judged appropriate, why did Burmah borrow still more on the strength of those companies’ assets? First, there is unequal information between the managers of BP and Shell and Burmah Oil. And secondly, Burmah was overly optimistic about its abilities and the economy. Question 2: Dividend Policy One disadvantage that Burmah saw in its investment holdings was that “it was denied the full benefit of the cash flows generated by its stakes in the equities of BP and Shell, receiving only dividends. ... However, this statement is incorrect and Burmah’s perceived disadvantage is not real. ... Would Burmah have been any better off if BP and Shell had distributed all of their earnings as dividends? No Burmah would not have been better off. ... Therefore, it is true that Burmah would have more cash in hand because of the higher dividend, but by paying more in dividends, Shell and BP have fewer funds available for internal reinvestment and its capital gains would be lower. ... Question 3: Valuation Burmah claimed that it was better for the company to hold BP and Shell than for the shareholders to do so directly. ... Since the market system is free, each shareholders in Burmah Oil has the opportunity to own BP and Shell in their individual portfolio with all the advantages that come from owning it through Burmah Oil. Allowing Burmah Oil to own shares of BP and Shell introduces additional inefficiencies (such as additional taxation) and dilutes the true return from the BP and Shell assets. Approximately 81% of Burmah Oil’s pretax profit in 1961 came from investing and financing operations and 88% of its assets were tied up in investments. Much of those assets and earnings are not controlled by Burmah Oil and limit the ability of the company to grow. ... If Burmah’s argument is correct, would its shareholders be any better off if, instead of holding Burmah’s shares directly, they formed yet a third company that then held stock in Burmah that then held stock in BP? ... Certainly Burmah had not succeeded in convincing all its shareholders of these benefits, for only a few months earlier, some of them had circulated a letter claiming that the company’s market value would increase by nearly 40 percent if it distributed its BP holding to stockholders. ... However, if Burmah Oil is going to expand the company, the optimal source of cash would be from inside the company. ... Burmah Oil has a source of cash from the dividends to help expand the company and the pecking order theory says that it should be used before additional debt or new equity. ... Burmah oil stockholders were in a similar situation. ... Burmah Oil entered into the tanker industry with two objectives: to reduce their own cost of crude oil to the refinery by providing their own transportation and to generate revenue by hiring out its own tankers on the spot market. In determining the NPV of the project, Burmah Oil did not fully consider that the industry was very competitive with little barriers for entry and that the spot market was highly volatile.