APC308 FM financial management 3

The buyer can receive next dividend payment when dividend is announced, so the share price goes 'cum dividend'.. In addition, when the share price goes 'ex dividend', the buyer do not re

TABLE OF CONTENTS

PART A

I DEFINE DIVIDEND

II OPERATIONAL ISSUES

III PRACTICAL ISSUES

1 Legal constraints

2 Liquidity

IV THE ARUGMENTS BETWEEN DIVIDEND POLICY THEORIES

1 Dividend Irrelevance

2 Dividend Relevance

V RECOMMENDATIONS

REFERENCES

PART B

I Advantages, drawbacks and decision rules of Net present value (NPV)

1 Advantages of NPV

2 Drawbacks of NPV

3 Decision rules toward NPV

3.1 Project independence

3.2 Mutually exclusive

II Advantages, drawbacks and decision rules of Internal rate of return (IRR)

1 Advantages of IRR

2 Drawbacks of IRR

3 Decisions rules of IRR

3.1 Independent projects

3.2 Mutually exclusive projects

III The complement between NPV and IRR

IV Recommendation

REFERENCES

PART A

DIVIDEND RELEVANCE AND IRRELEVANCE THEORETICAL

I DEFINE DIVIDEND

A dividend is proportional to the amount of shares, which is paid for shareholder The value of companies has determined relevant in the dividend Managers determine an optimal dividend policy to maximize the value of companies, and attract investors

II OPERATIONAL ISSUES

After a taxable payment declared of the firm, the dividend is a distribution made on a cash basis, but they can also take the stock dividend or other property, and shareholders have to accept the final dividend The buyer can receive next dividend payment when dividend is announced, so the share price goes 'cum dividend' In addition, when the share price goes 'ex dividend', the buyer do not receive next dividend payment

Figure1 Cum dividend and share prices

(Denzil Watson and Antony Head)

Reliability of dividends

Payout ratio is important indicator, which indicates shareholder can receive how much profit It is calculated by dividing the company's dividend by the earnings per share:

Dividend payout ratio = Dividend per share ÷ Earnings per share Dividend payout ratios vary among companies, the higher the dividend payout ratio will attract more shareholders

(Dividend Policy, Simon S P Lee, The Chinese University of Hong Kong)

In the U.K there is a similar ratio, which is known as dividend cover Investors use this ratio define the level of risk about their investment through the receipt of dividends

Dividend cover may be calculated as:

(accounting-simplified.com) Corporations pay out the profits for shareholder through dividends A low dividend cover means that that the firms may not able to sustain the current dividends of firm's profitability in downward trend case in the future, which could impact the share price

III PRACTICAL ISSUES

1 Legal constraints

Governments can impose the limitations about dividend payments, which may be applied

by loan agreements or covenants Dividend can only be paid from distributable profits, and which can be defined by regulations such as accounting standards

2 Liquidity

Liquidity underscores why many investors prefer cash-rich companies For example, assume a company has $1 billion in cash, an annual dividend obligation of $50 million and just

$10 million in debt The cash on hand is more than enough to pay its dividend for a long time and eliminate its debt This is a company with a strong liquidity position (finance.zacks.com)

IV THE ARUGMENTS BETWEEN DIVIDEND POLICY THEORIES

There is a continuing debate on whether dividend payments are relevant in determining the share price of a company, with empirical research within this area producing conflicting results, that at least there is consensus with Black (1976)’s: “the harder we look at the dividends picture, the more it seems like a puzzle, with pieces that just do not fit together” (Black (1976) Black,F (1976))

1 Dividend Irrelevance

Franco Modigliani and Merton Miller (1958, 1961) are the people proposed of this view The main of this case is investors, who can sell their share if they need cash, so the payment of dividends is irrelevant Thus, although two firms has the same of scale and industry that one of them do not pay dividends and other one do, so they should have same values

According to the M&M theorem, investors see that dividends and capital gains are same

as returns The company's earning get from investment policy and the profit of its industry, so it will decide the value of company Therefore, investors just need the information about a firm's investment policy to make decision

By theory, investors can base on amount of their stocks to generate cash flows from their stocks depending on their needs regardless of whether dividend is paid or not Particularly, if investors buy a stock which has dividend, but they do not need amount of money from entitled dividend or receive a much more dividend than their need they will continuous to reinvest in other stock Similarly, if investors need more amount of cash, but they invest on a non-dividend paying stock, they will sell their part of stock to meet their demand

Assumptions of the Modigliani and Miller mode

According to M&M, the capital market is perfect, which means that transaction and floatation costs do not exist, investors will have free and public information, but they do not ability influence the price of share though they is large About the both of dividends and capital gains that these are not applied taxes or tax rates do not have differences

The company needs to have a fixed investment policy, and their future prospects are certainty Therefore, all the investor can see the future prices and dividends and the discount rate

is reasonable for securities in during periods

In conclusion, the Modigliani and Miller theory is strongly influence on two critical assumptions, which are transaction costs and taxes are absent, but there is not have an economy that both of them are absent in real case Therefore, these two assumptions are not tenable in the real world

2 Dividend Relevance

Lintner and Gordon insisted that the capital could be increased easily through dividend based on the lower level of risk and the high certainty of dividend

Following the bird-in-the-hand theory, Gordon (1963) and by Lintner (1962) indicated that dividends are one of the factors to determine the value of enterprise Besides, Gordon also concluded that the perpetuity dividends of firm, the current stock price and the expected annual growth rate of dividends are the determinants which estimate the value of cost of equity of financing firm

The total return of the equity investor includes the dividend's growth rate in the future and the dividend yield In a while, the dividend yield is more effective method to measure total return than the forward looking growth rate of dividend (where the capital gains and the net earnings’ growing is in the future) Hence, it will be difficult to assess and guarantee capital gains accurately if the firm's market value can be loosen and bankrupted in the stock exchange

Therefore, investors only focus on capitals and uncertain to ensure the firm's future market value when a firm does not pay for them dividends

Assumptions of the Bird-in-the-Hand theory

The firm which does not create any debt in structure of capital is an equity firm There is

no available external financing and preserved earnings to spend on increasing in economic expansion The investment's diminishing marginal efficiency will be ignored if the returns are unchanged However, firms suffer a remained cost of capital

V RECOMMENDATIONS

It is clearly that theory about dividend is used more popular because of its logic and empirical support The assumptions in this hypothesis is more feasible than M&M theory so it is remained in a realistic economic The assumption is that there is a challenge when shareholders seem to neglect the current dividends and prospective capital in the future As a result, there are a few firms which are certain about its sustainability and almost firms concern its dropping of market value, bankrupt and financial crisis in the future

The shareholder might not receive anything when the dividends are not paid for them Besides, the periodic dividend generates an amount of return on investment Based on the realistic phenomena in the different fields, there are the various subsidiary theories relating to dividend hypothesis Therefore, it brings real meaning on determining the extension and the value its market value of firm's stock through dividends policy

REFERENCES

Denzil Watson and Antony Head (2010) Corporate Finance: Principles and Practice

Simon S P Lee (Unknown) Dividend Policy The Chinese University of Hong Kong

Unknown (2010) Dividend Coverage Ratio Available: http://accounting-simplified.com/financial/ratio-analysis/dividend-coverage.html

Todd Shriber (Unknown) What Is a Liquidity Dividend Available: http://finance.zacks.com/liquidity-dividend-8536.html

Black (1976) Black,F (1976) The Dividend Puzzle Journal of Portfolio Management 2, 5-8 M,H.Miller & Modigliani,F (1958) The Cost of Capital, Corporation Finance and the Theory

of Investment The American Economic Review, Vol 48, No 3 (Jun., 1958), pp 261-297 Miller, M H., and Modigliani, F (1961) Dividend Policy, Growth, and the Valuation of Shares, Journal of Business 34, 411-433

Gordon, M, J (1963) Optimal Investment and Financing Policy, Journal of Finance 18, 264-272 Lintner,J (1962) Dividends, Earnings, Leverage, Stock Prices and Supply of Capital to Corporations, The Review of Economics and Statistics 64, 243-269

PART B

INVESTMENT APPRAISAL TECHNIQUES

To have the best decisions in making process, financial managers used investment appraisal techniques It plays an important role in gathering information which is related to the investing selection of corporations From that, financial managers can have the right decision in investment to bring the best advantages for their Company, and more benefits for shareholders There are four basic techniques, including:

- Payback

- Accounting Rate of Return (ARR)

- Net Present Value (NPV)

- Internal Rate of Return (IRR)

In four techniques above, IR and NPV are two techniques that use discounted cash flow (DCF), which shows clearly and directly the shareholders’ wealth

Table1 Result of survey (1993) about investment appraisal techniques’ usage

(Sangster, 1993)

I Advantages, drawbacks and decision rules of Net present value (NPV)

1 Advantages of NPV

NPV tells whether investment will raise corporation's value, which considers all the cash flows, the time value of money, and the risk of future cash flows through the cost of capital (Pamela Peterson-Drake) The formula to calculate present value is:

C0: Initial investment r: discount rate t: time

Calculating the NPV is a way investors determine how attractive a potential investment

is Since it essentially determines the present value of the gain or loss of an investment, it is easy

to understand and is a great decision making tool (Boundless)

NPV is a direct measure of how well the investment meets the goal of financial management—to increase owners’ wealth

- If NPV > 0, an investment should be accepted because it adds the value for companies

- If NPV < 0, an investment should be reject because it damages to firm’s value

- If NPV = 0, the shareholders’ wealth is not affected

(Qafqaz University) The cash flow in NPV is discounted at opportunity costs of capital over the life of the project, so company can identify the risk of each project The project has negative NPV which is riskier than project having positive NPV Finally, NPV shows the time value of money according

to discount factor The higher in discount factor, the longer the time of the project (Peterson and Fabozzi)

2 Drawbacks of NPV

NPV will show different result for project, depending on the number of initial

investment If a larger number of initial investment, so projects will have the higher NPV Thus,

it is very difficult to compare among projects (Pasqual, Padilla and Jadotte)

Moreover, the rate to make decision in choosing project is not safe and correct because

the life of each project is different, which can lead not meet requirement results when calculating

NPV (Khan and Jain)

The interest rate can be change year by year, so it is not realistic in NPV's assumption,

which is the discount rate is unchanged throughout the period of project (Periasamy)

3 Decision rules toward NPV

3.1 Project independence

For example an ABC company has 3 projects in the table below:

Year Discount

factor

Project 1 Project 2 Project 3 Cash flow Present value Cash flow Present value Cash flow Present value

0 1.000 (300,000) (300,000) (280,000) (280,000) (180,000) (180,000)

1 0.912 110,000 100,320 60,000 54,720 58,000 52,896

2 0.829 90,000 74,610 50,000 41,450 70,000 58,030

3 0.755 82,000 61,910 50,000 37,750 74,000 55,870

4 0.688 80,000 55,040 50,000 34,400 60,500 41,624

5 0.626 75,000 46,950 65,000 40,690 78,000 48,828

6 0.570 80,000 45,600 40,000 22,800 78,000 44,460

7 0.519 85,000 44,115 45,000 23,355

NPV 128,545 (24,835) 121,708

Table 2: NPV and decision in independent projects

From the table 2, it shows very clearly that project 2 has negative NPV with -£24,835, while project 1 and project 3 give positive NPV, which are £128,545 and £121,708 Therefore, project 1 and project 3 are accepted and project 2 is rejected

3.2 Mutually exclusive

When NPV is highest, the project will be selected for investment In addition, the higher NPV make the higher shareholders’ wealth in corporation's investment (Lumby and Jones) Therefore, according to table 2, Project 1 has highest NPV so that this company should invest in project 1 because of it presents the best shareholders’ wealth

II Advantages, drawbacks and decision rules of Internal rate of return (IRR)

1 Advantages of IRR

The meaning of IRR is finding the rate of return earned on invested funds (Lasher, 2010)

The time value of money and cash flows is presented through the results of IRR which is the same NPV's meaning In addition, if hurdle rate is smaller than IRR, the shareholder's wealth will be maximized then the company will make decision in investing a best project (Megginson, Smart and Lucey, 2008) On the other side, IRR is also different with NPV in some aspects Akalu analyzed that it is convenient for companies to compare the proportion of benefits and identifying discount rate among projects based on IRR (Akalu, 2001)

2 Drawbacks of IRR

IRR has some limitation that the company is hard to specify project brings how much profit for them, and maximize the shareholders’ wealth because IRR's result is the form of percent (Gallagher and Andrew)

In addition, IRR does not present which project make the maximizing value to compare

to each other IRR can be highest, but it is not sure that this project can bring the highest profit for shareholder and company (Fabozzi and Drake)