APC308 FM financial management 4

Introduction Dividend theories Dividends Irrelevance Assumptions of Modigliani and Miller hypothesis Dividend relevance theory James E.. Introduction Investment appraisal techniques Payb

Part A

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 Critically evaluate and discuss both the dividend relevance and dividend irrelevance theories, using relevant academic research to develop and support the response.

Introduction

Dividend theories

Dividends Irrelevance

Assumptions of Modigliani and Miller hypothesis

Dividend relevance theory

James E Walter and Myron Gordon theory

References

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.

Introduction

Investment appraisal techniques

Payback method

Payback with equal annual savings

Payback with unequal annual savings

Net present value

Compare Payback method and NPV method

References

Part A

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 Critically evaluate and discuss both the dividend relevance and dividend irrelevance theories, using relevant academic research to develop and support the response

Introduction

Dividend is that portion of net profits which is distributed among the shareholders The dividend decision of the firm is of crucial importance for the finance manager since it determines the amount to be distributed among shareholders and the amount of profit to be retained in the business Retained earnings are very important for the growth of the firm Shareholders may also expect the company to pay more dividends So both the growth of company and higher dividend distribution are in conflict So the dividend decision has to

be taken in the light of wealth maximization objective This requires a very good balance between dividends and retention of earnings

Dividend theories

The operational issue of dividend

When dividend is announced the share price goes ‘cum dividend’, meaning the buyer of share also buys right to receive next dividend payment When share price

goes ‘ex dividend’, the buyer no longer gains the right to receive next dividend

There are conflicting opinions as far as the impact of dividend decision on the value of the firm According to one school of thought, dividends are relevant to the valuation of the firm Others opine that dividends does not affect the value of the firm and market price per share of the company (F Bosello, C Carraro, M Galeotti, 2001) In general, there are three main categories advanced which are dividend relevance theory and dividend irrelevance theory

Dividends Irrelevance

France Modigliani and Merton Miller stated that the dividend policy employed by a firm does not affect the value of the firm They argue that the value of the firm is dependent on the firm’s earnings which result from its investment policy, such that when the policy is given the dividend policy is of no consequence (H DeAngelo, L DeAngelo, 2006) However, it must have some condition to satisfy the result as firm operating in a perfect capital market, company has sufficient funds to pay dividend, company does not have sufficient funds to pay dividend therefore it issues stocks in order to finance payment of dividends, and company does not pay dividends but the shareholders need cash

Assumptions of Modigliani and Miller hypothesis

Modigliani and Miller assumed capital

markets are perfect

Modigliani and Miller pointed out that

• Perfect capital markets such as

investors behave rationally,

information is freely available to all

investors, transaction and floatation

costs do not exist, there is not an

investor is large enough to influence

the price of a share

• M&M argued that shareholders were indifferent to the timing of dividends

• As future dividends are reflected in the share price, shareholders wanting dividends could sell shares (home-made dividends)

• For M&M the investment decision

is divorced from the dividend

• Taxes do not exist; or there is no

difference in the tax rates applicable to

both dividends and capital gains

• The firm has a fixed investment policy

• The risk of uncertainty does not exist

such as all investors are able to

forecast future prices and dividends

with certainty and one discount rate is

appropriate for all securities over all

time periods

decision, which is seen as part of the financing decision

Under the assumptions the rate of return, r, will be equal to the discount rate, k As a result the price of each share must adjust so that the rate of return, which is composed of the rate

of dividends and capital gains on every share, will be equal to the discount rate and be identical for all shares

The return is computed as follows:

r = Dividends + Capital gains (loss)

Share price

r = DIV1 + (P1– P0)

P0

As hypothesised, r should be equal for all the shares otherwise the lower yielding securities will be traded for the higher yielding ones thus reducing the price of the low yielding ones and increasing the price of the high yielding ones

This arbitraging or switching continues until the differentials in rates of return are eliminated

Conclusion of Model

A firm which pays dividends will have to raise funds externally in order to finance its investment plans When a firm pays dividend therefore, its advantage is offset by external financing (S Titman, 2002) This means that the terminal value of the share declines when dividends are paid Thus the wealth of the shareholders – dividends plus the terminal share price – remains unchanged Consequently the present value per share after dividends and external financing is equal to the present value per share before the payment of dividends Thus the shareholders are indifferent between the payment of dividends and retention of earnings

Dividend relevance theory

James E Walter and Myron Gordon theory

The relevance theory is demonstrated by James E Walter with Walter’s model and Myron Gordon with Gordon’s model The assumption follow as:

Assumptions Formula

 Internal financing – the firm finances all its

investments through retained earnings; debt

or new equity is not issued

 Constant return and cost of capital – the

firm’s rate of return, r, and its cost of capital

k are constant

 100% payout or retention – all earnings are

either distributed as dividends or reinvested

internally immediately

 Constant EPS and DPS – beginning earnings

and dividends never change The values of

the EPS and DPS may be changed in the

model to determine results but are assumed

to remain unchanged in determining a given

value

 Infinite time – the firm has a very long or

infinite life

P = (DPS/k) + [r (EPS – DPS)/k]/k Where:

 P = market price per share

 DPS = dividend per share

 EPS = earnings per share

 r = firm’s average rate of return

 k = firm’s cost of capital

if the market value is determined as the present value of two sources of income which are PV of constant stream of dividend (DPS/k) and PV of infinite stream of capital gains r(EPS-DPS)/k Hence, the formula can be rewritten as

P = DPS + (r/k) (EPS – DPS)

k

They stated that three types of firms or scenarios of firms the model can be summarized as follows (G Frankfurter, BG Wood, J Wansley, 2003):

 Growth firm: there are several investment opportunities (r > k) and the firm can reinvest earnings at a higher rate r than that which is expected by shareholders k thus they wil maximize value per share if they reinvest all earnings

 Normal firm: there aren’t any investments available for the firm that are yielding higher rates of return (r = k) thus the dividend policy has no effect on market price

 Declining firm: there aren’t any profitable investments for the firm to reinvest its earnings, i.e any investments would earn the firm a rate less than its cost of capital (r < k) The firm will therefore maximize its value per share if it pays out all its earnings as dividend

Gordon’s assumptions to conform slightly to reality, he concludes that even when r = k, the dividend policy does affect the value of the share based on the view that: under conditions of uncertainty, investors tend to discount distant dividends (capital gains) at a higher rate than they discount near dividends It is called Bird-in-hand argument

Kirshman (1969) stated that “Of two stocks with identical earnings record and prospects but the one paying higher dividend than the other, the former will undoubtedly command higher dividend than the latter merely because stockholders prefer present to future values….stockholders normally act on the premise that a bird in the hand is worth two in the bush and for this reason are willing to pay a premium price for the stock with the higher dividend rate just as they discount the one with the lower rate” It means shares of companies paying higher dividends can be more valuable than shares of companies paying lower dividends Therefore, dividend policy is seen as a key factor in determining the share price

Irrelevance dividend Relevance dividend

The assumptions made by Miller and

Modigliani are clearly unrealistic such as:

 Transaction costs are not zero

 Taxation exists in the real world

 Issuing securities does incur costs

 Information is not necessarily available

to all investors

Relevance theory is more practical such as:

 Dividend decisions are taken with market expectations in mind

 Increased institutional shareholding has increased the need for dividend payments

 Listed companies maintain dividends if possible, even if profits are low

 Both managers and investors behave as

if dividend policy is important

This means that which do not pay dividends might actually end up paying nothing to their shareholders This uncertainty should not be compared with the return on investment actualized by a periodic dividend The subsidiary theories supporting the dividend relevance hypothesis are all based on observed phenomena across different domains Hence, it’s likely that indeed in the real world, dividends policy is relevant in determining the value of a firm’s stock and by extension its market value

References

 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

 Black (1976) Black,F (1976) The Dividend Puzzle Journal of Portfolio Management 2, 5-8

 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

 Walter, J,E., (1963) Dividend Policy: Its Influence on the Value of the Enterprise, Journal

of Finance 18, 280-291

 Rozeff, M, S (1982) Growth, Beta and Agency Costs as Determinants of Dividend payout Ratios, The Journal of Financial Research 5, 249-259

 Baskin, J, B (1988) The Development of Corporate Financial Markets in Britain and the United States, 1600-1914: Overcoming Asymmetric Information, The Business History Review 62, 199-237

 Koch, P,D & Shenoy,C (1999), The Information Content of Dividend and Capital Structure Policies, Financial Management 28, 16-35

 Lintner, J (1956) Distribution of Incomes of Corporations Among Dividends, Retained Earnings, and Taxes, American Economic Review 46, 97-113

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

Introduction

This section demonstrates how the relevant cash flows for the Payback Period rule of capital budgeting are different from the relevant cash flows for the NPV rule of capital budgeting It illustrates this argument by way of a numerical example

Capital budgeting is the process of evaluating specific investment decisions It is the whole process

of analyzing projects and deciding which ones to include in the capital budget It involves large expenditures The results of capital budgeting decisions continue for many years Capital budgeting decisions define the firm’s strategic directions, which is very important to firm’s future

Investment appraisal techniques

Payback method

Payback considers the initial investment costs and the resulting annual cash flow The payback period is the amount of time (usually measured in years) to recover the initial investment in an opportunity Unfortunately, the payback method doesn’t account for savings that may continue from a project after the initial investment is paid back from the profits of the project, but this method is helpful for a “first cut” analysis of a project (F Lefley, 1996) The payback rule is often used by: large and sophisticated companies when making relatively small decisions, or firms with very good investment opportunities but no available cash (small, privately held firms with good growth prospects but limited access to the capital markets)

There are two ways calculate in payback method which are Payback with equal annual savings and Payback with unequal annual savings

Payback with equal annual savings

If annual cash flows are equal, the payback period is found by dividing the initial investment by the annual savings (ST Anderson, RG Newell, 2004)

The formula is Payback Period (in years) = Initial Investment Cost

Annual Operating Savings

Consider the example of a shop evaluating the purchase of a still to recycle its waste solvent The shop manager analyzes both his current operation and the option of using a still He sees that installation of a still will cost $7,700, but provide a net annual operational savings of $4,634 When the net annual savings is divided into the initial cost, the manager finds that the still will pay for itself in 1.7 years:

$7700 Investment Costs

$4634 Annual Savings

 Payback Period = $4634 Annual Savings = 1.7 yrs

Payback with unequal annual savings

The previous example assumes that the annual cash flow is the same each year In reality, there are significant costs such as depreciation and taxes that will cause cash flows to vary each year If the annual cash flow differs from year to year, the payback period is determined when the accrued cash savings equal the initial investment costs (ST Anderson, RG Newell, 2004)

The advantages of payback period The disadvantages of payback period

• Simple concept to understand

• Easy to calculate (provided future cash

flows have been calculated)

• Uses cash, not accounting profit

• Takes risk into account (in the sense

that earlier cash flows are more

certain)

• Considers cash flows within the payback period only; says nothing about project as a whole

• Ignores size and timing of cash flows

• Ignores time value of money (although discounted payback can be used)

• It does not really take account of risk