Torstar Inc.

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As the Torstar board meeting in April of 1998 was approaching, a memorandum on Torstar’s dividend policy, their repurchases and their strategy with regards to strategic acquisitions within their three business areas was composed. The memorandum included pros and cons as well as recommendations with regards to the issues to be discussed when the board gathered for their meeting. The dividend policy and the share repurchase strategy are the main issues since the institutional shareholders preferred Torstar’s historical share repurchases and historical dividend pay outs. Management has during the last years focused on acquisitions, especially in order to diversify their business through the children’s supplementary education products (CSEP) segment. Management plans to pursue aggressively with this strategy. These strategies will affect the payout policies, hence Torstar is moving away from their historical dividend and repurchase policy. Torstar‘s institutional shareholders prefer to diversify by themselves, using dividends and repurchases to invest in other public “pure plays”. Two important considerations regarding the key issues are Torstar’s ability to acquire strategic investments and their ability to maintain a certain capital expenditure level. Are the current strategic acquisitions valid? CSEP is definitely a way of diversifying Torstar’s business since it is not part of their two core business areas, Newspaper and Book publishing. Hence, they are directly violating the owner’s desires. When reviewing the gross margin percentage of the three business areas, it is clear that the investments in the supplementary education segment are initially very profitable. However, the margins have been decreasing vastly and by year end 1997 it is down to 0.09%. More investments in the CSEP segment are planned, even though the margins are bad. By the end of first quarter 1998 margins decreased even more to a negative 4.62%, thus the acquisition strategy can definitely be questioned. This is evidence of an empire building where management focuses on growth and size rather than increasing shareholder value. Furthermore, it could also be evidence of overinvestment in “pet projects”, where managers invest in projects they like, such as supplementary education. With regards to adverse selection, one can discuss if managers have overconfidence. Investments starts generating good margins but due to it riskiness, margins are slumping over time, which is exactly what we see with the investments in the CSEP segment. According to Hackbarth (2009) irrational managers tend to over lever and are overconfident and therefore underestimate risk. Torstar has been financing their acquisitions with debt and are planning to increase their leverage ratio to at least 30%. The increased leverage ratio will be well above the printing and publishing industry average of 16.53% (Pinkowitz & Williamson, 2007). According to Fama and French (2001) a way to mitigate agency problems, and hence mitigate the empire building, is to use stock options. Torstar management holds a lot of stock options which aligns the incentives of the stockholders and the management. Thus, this is in favor of the theory of irrational managers at Torstar rather than empire building. Another aspect to account for is management’s optimism with regards to their acquisition in the CSEP segment. They believe very strongly in the CSEP segment, but as we can see CSEP has not been performing that strong so far.

The other important consideration is Torstar’s ability to maintain its capital expenditure levels. Torstar’s management believes that their debt can be substantially increased, from their current debt-to-total-assets ratio of 18 per cent up to 30 per cent. They even suggest that a 50 per cent debt-to-total-assets ratio is possible if suitable strategic acquisitions appear which will create a greater tax benefit due to the tax deductibility of interest payments. Their interest expense...
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