APC308 FM Financial Management 2

Dividend payments determine the share price of a company The agency cost that results from this overinvestment reduces the value of the firm.. Dividend relevance theories Dividend releva

Part A Critically evaluate and discuss both the dividend relevance and

dividend irrelevance theories

Table of contents

II.2 Walter’s Model

Introduction

The relationship between dividend payouts and stock price volatility was showed in many researchs and discussion of many authors One of them is (Modigliani & Miller, 1958) According to MM firm’s value is irrelevant to dividend policy and firm’s stock price volatility is solely based upon its earning ability

There is a continuing debate on whether dividend payments are relevant in determining the share price of a company This paper aim to critically evaluate and discuss both the dividend relevance and dividend irrelevance theories In details, demonstrate both understanding and knowledge of the dividend relevance and irrelevance theoretical viewpoints and relevant numerical examples

to support the discussion

I Dividend payments determine the share price of a company

The agency cost that results from this overinvestment reduces the value of the firm And

according to Free Cash Flow (FCF) hypothesis, there is a positive relationship among the

dividend policy of a firm and its stock prices

Follow the idea of these authors (Nazir et al., 2010) It means if a firm pays fewer dividends it

would have more funds to invest in projects with less PV and it would cause devaluation of stock

prices of the firm

Different researchers have different views about the relationship among dividend policy and

stock prices The earlier work on dividend-yield and stock price-volatility was conducted by

(Harkavy, 1953); (Friend & Puckett, 1964); (Litzenberger & Ramaswamy, 1982); (Fama &

French, 1988); (Baskin, 1989) and (Ohlson, 1995) in the context of United States (Rozeff, 1982)

1982) found a high correlation between value line CAPM and betas and dividend payout for

1000 US firms (Fama, 1991) and (Fama & French, 1988) focus on dividends and other cash

flow variables such as accounting earnings, investment, industrial production etc to explain stock

returns However, there are some of researchs showed that no significant relationship between

dividend policy and stock prices such as (Allen & Rachim, 1996).

Stock price volatility is generally related with long term debt ratio, earning volatility, asset

growth, size and dividend policy (Nazir et al., 2010)

Therefore dividend policy is one of various factor are relevant in determining the share price of a

company The dividend theories were analyzed in the next part of this research

II Dividend relevance theories

Dividend relevance theory goes back to the early part of the nineteenth century when (Williams, 1938) claimed that share value is determined by the present value of future dividend and the selling price of the share This claim has been supported by (Graham & Dodd, 1951) and (Gordon, 1959) who emphasized that a share price is influenced by dividend and earnings

According to (Naser et al., 2013), investors view dividend payout as a sign of management capabilities and they take dividend policy as an important factor in assessing the certainty

of a company's profit Hence, frequent and high corporate dividend policy indicates that the company is very likely to perform well

Dividend payout involves decisions on how much and when earnings should be paid as dividends (Pruitt & Gitman, 1991) strongly believe that dividend and financing decisions are interrelated and cannot be separated

For example, if a company decides to pay dividends, this means that less earnings are available to invest in profitable projects This move might force the company to raise funds externally

According to (Baker et al., 1985) and (Baker & Powell, 2000) it is not surprising to see some managers viewing dividend policy as a factor that would influence shareholders' wealth and corporate value Thus, dividend policy is relevant to the value of the company

Relevance dividend theory has been empirically tested by a significant number of surveys conducted in the USA, including (Lintner, 1956), (Baker et al., 1985), (Farrelly et al., 1986), most participants in these surveys indicated that dividend policy affects corporate value Dividend relevant theory can be divided into 3 types of views:

II.1 Traditional View

In general, we can understand this view: investors prefer higher dividends to lower dividends because the dividend is sure but future capital gains are uncertain Dividend pay-out is important and play a vital role in the determination of share prices of the firm A firm that pays low dividends may experience a fall in share price

As per this view, share-markets place considerably more weight on dividends, than on retained earnings (Graham & Dodd, 1951) observed “The stock market is overwhelmingly in favour

of liberal dividends.” Shareholders often prefer cash now as dividends rather than a wait for benefits in an uncertain future Value of share is positively correlated with size of dividend The advocates of the theory opine that a bird in hand is better than two in the bushes

II.2 Walter’s Model

The choice of dividend policies almost always affects the value of the firm

(Walter, 1963) argues that the choice of dividend payout ratio almost always affects the value of the firm Prof J E Walter has very scholarly studied the significance of the relationship between internal rate of return (R) and cost of capital (K) in determining optimum dividend policy which maximizes the wealth of shareholders

The Walter’s formula: P = [D + (E - D) x ROI / K] / K

Where: P= Market price per share

E= Earnings per share

D = Dividend per share

K= Cost of Capital

ROI = Return on Investment

This formula explains why market prices of shares of growth companies are high even though the dividend paid out is low It also explains why the market price of shares of certain companies which pay higher dividends and retain very low profits is also high

The effect of the optimum dividend policy on the relationship between the firm’s internal rate of return (r) and its cost of capital (k) according to him is a growth function of the firm:

- In growing firm where r > k, all earnings can be reinvested, hence, the firm is assumed to have sample profitable opportunities so as to maximize the value per share over and above the rate expected by shareholders

- In a normal firm where r = k, dividend policy have no effect on the market value per share since the rate of return is equal to the cost of capital

- In a declining firm where the optimum payout ratio should be 100% to enable increase

in the market value per share

But other author has different ideas with Walter and show that This Walter theory has been criticized because r and k are not constant in real life situation Moreover, the non-existence of external financing makes it weak The firm’s r decreases as more investment occurs and k changes directly with the firm’s risk It should be understood here that Walter’s model though weak, recognizes the fact that dividend policy is relevant, according to (Samuels & Wilkes, 1975)

III.3 Gordon Growth Model

The dividend policy does affect the value of a share even when rate of return equal to cost of capital

According to (Gordon, 1959), market price of share is equal to present value of all future dividends His main contention is that rate of growth of dividend is a function of retained earnings and rate of return on retained earnings (g = b.r, where g = rate of growth, b = proportion of retained earnings, r = rate of return of retained earnings

His conclusions are similar to those of Walter

- If r > K, lower payout ratio is in interest of shareholders as lower dividend ratio would be more than compensated by higher growth rate of dividend Hence lower payout ratio will result in higher market price

- If r < K, higher dividends would be preferred by shareholders as retained earnings would be invested by the company at rate lower than the rate expected by them, so they won’t like to leave the earnings with the company Hence higher dividend rates would result in higher market price

- If r = K, growth rate will exactly compensate for loss of dividend, i.e., for the profits retained by the company Hence, the shareholders would be indifferent between dividend and retained earnings Correlation between dividend and market price of the share would be nil Gordon argues that what is available at present is preferable to what may be available in the future As investors are rational, they want to avoid risk and uncertainty They would prefer to

pay a higher price for shares on which current dividends are paid They would discount the value

of shares of a firm which postpones dividends

The Gordon growth model is mainly applied to value mature companies that are expected to grow at the same rate forever The Gordon growth model, like other types of dividend discount models, begins with the assumption that the value of a stock is equal to the sum of its future stream of discounted dividends The Gordon growth model formula is shown below:

Stock Price = D (1+g) / (r-g)

Where,

D = the annual dividend

g = the projected dividend growth rate

r = the investor's required rate of return (cost of equity capital)

This formula shows that when the rate of return is greater than the discount rate, the price per share increases as the dividend ratio decreases and if the return is less than discount rate it is vice-versa The price per share remains unchanged where the rate of return and discount rate are equal

From these analyses, we can recognize that The Gordon growth model is appropriate for a firm with stable growth rates, pay out dividends that are high and a firm with stable leverage such as: regulated companies, utilities, large financial services companies, real estate investment trusts… with these assumptions:

o The firm is an all equity firm, i.e no debt

o No external financing is available; consequently retained earnings would be used to finance any expansion of the firm Similar argument as Walter’s for the dividend and investment policies

o Constant return which ignores diminishing marginal efficiency of investment as represented in the diagram on Walter’s model

o Constant cost of capital; model also ignores the risk-effect as did Walter’s

o Perpetual stream of earnings for the firm

o Corporate taxes do not exist

III Dividend irrelevance theories

III.1 Summary

According to (Miller & Modigliani, 1961), investors should be indifferent as to whether or not they receive dividends now or capital appreciation in the future, an idea known as the Dividend Irrelevance Theory According to these authors, an increase in current dividends must lead to a reduction in the terminal value of the existing shares because the dividend stream on the existing shares must be diverted to attract outside capital from which higher future dividends are paid Although this theory is one of the most central theories of finance, their theory assumed that markets are frictionless and that there would be no direct or indirect costs of trading (Banerjee et al., 2007)

III.2 Modigliani and Miller (MM theory)

In general we can understand that: Given that in a perfect market dividend policy has no effect

on either the price of a firm’s stock or its cost of capital, shareholders wealth is not affected by the dividend decision and therefore they would be indifferent between dividends and capital gains This is an idea of (Al-Malkawi et al., 2010) And conclusion is M&M demonstrated that under certain assumptions about perfect capital markets, dividend policy would be irrelevant (Miller & Modigliani, 1961) argued that regardless of how the firm distributes its income, its value is determined by its basic earning power and its investment decisions They stated that

“…given a firm’s investment policy, the dividend payout policy it chooses to follow will affect neither the current price of its shares nor the total returns to shareholders” In other words, investors calculate the value of companies based on the capitalized value of their

future earnings, and this is not affected by whether firms pay dividends or not and how firms set their dividend policies

The M&M dividend irrelevance proposition has provided the foundation for much subsequent research on dividend policy However, as stated by (Ball et al., 1979) empirical tests of M&M’s

“dividend irrelevance theorem have proven difficult to design and to conduct” Recall that M&M built their conclusions on a certain set of assumptions of perfect capital markets

Another research from (Naser et al., 2013) proved that (Modigliani & Miller, 1958) contended that dividends policy has no effect on corporate value They believe that firm’s value is dependent on the income produced from its assets rather than from the income distribution between dividends and retained earnings They showed that investors can affect the return on their shares regardless of the share’s dividend

For example, if an investor expects high dividend payout, he/ she could buy more shares from the dividends received above his/ her expectation If the investor expects the company to have small dividend payout, the investor could sell some of the company's shares

to compensate for the shortage in cash he/ she expects to receive Consequently, dividend is irrelevant to investors, since they can formulate their own

Conclusion

After collecting various data and information, the writer of this report had provided many knowlegde about dividend policy paying particular attention to both the dividend relevance theory and the dividend growth model

Both dividend relevance theory and dividend irrelevance theories proved that dividend payments are relevant in determining the share price of a company The dividend policy does affect the value of a share even when rate of return equal to cost of capital Value of share is positively correlated with size of dividend

References

Applied Financial Economics

EuroJournals

Financ Manage

Financ Pract Edu.

Australian Journal of Management

Journal of Financial and Quantitative Analysis

Journal of Portfolio Management

Journal of Finance

The Journal of Financial Economics

Econ Rev.

The American Economic Review Review of Economics and Statistics Security Analysis

Journal of Finance

Am Econ.Rev

The Journal of Finance

The Journal of Business

American Economic Review –

Am Econ Rev.

Business Management and Economics

International Research Journal of Finance and Economics

Contemporary Accounting Research

Finance Review –

Journal of Financial Research

Management of \Company Finance Ply Mouth Clarke

Journal of Finance

The Theory of Investment Value.

Part B Explain then critically compare and contrast two investment appraisal techniques that may be utilized by financial managers to assist in the financial management decision

making-process

Table of contents

Introduction

There are four commonly used techniques for appraising capital investment projects: Payback, Accounting rate of return (ARR), Net present value (NPV) and Internal rate of return (IRR) (University of Sunderland, 2007) Any investment decision involves risk, because it deals with the future so firms are likely to have a number of alternatives to choose from and investment appraisal techniques can help them to do choose the best option Each technique has different merits and limitations, but in this report, the financial manager chose two key methods: NPV and IRR with analysis and compare the distinctions of each technique

From the beginning of a project, a financial manager considers not only about the sources of capital but also methods of using these sources in the most appropriate way which lead to successful projects

Main body

I Two key appraisal methods

Net present value and internal rate of return do deal with the change in value of money over time and solve the big problems of Payback and ARR method Therefore NPV and IRR are chosen like two key methods

I.1 Net present value (NPV)

I.1.1 Definition

In finance, the net present value (NPV) or net present worth (NPW) of a time series of cash flows, both incoming and outgoing, is defined as the sum of the present values (PVs) of the individual cash flows of the same entity (Lin & Nagalingam, 2000)

- The time of the cash flow

- The discount rate (the rate of return that could be earned on an investment in the financial markets with similar risk.); the opportunity cost of capital

- The net cash flow i.e cash inflow – cash outflow, at time t

For educational purposes, R0 commonly placed to the left of the sum to emphasize its role as (minus) the investment.1

Given the (period, cash flow) pairs ( , ) where N is the total number of periods, the net present value is given by:

I.1.3 Decision Rule

Accept the project only if the NPV is positive or zero Reject the project having negative NPV While comparing two or more exclusive projects having positive NPVs, accept the one with highest NPV

I.1.4 Example