APC308 FM financial management 5

During time, dividend policy has impact in stock price in some cases Al-Malkawi, et al., 2010.. Until now, many dividend theories have investigated to study how impact of dividend policy

Part A

DIVIDEND RELEVANCE AND DIVIDEND IRRELEVANT THEORIES

TABLE OF CONTENTS

INTRODUCTION 5

1 Background of dividend policy 5

2 Understanding of dividend theories 5

2.1 Irrelevant theories 5

2.2 Relevant theories 6

3 Empirical evidences 7

CONCLUSION AND RECOMMENDATION 8

REFERENCES 9

INTRODUCTION Dividend payment has been issue that attract concern of stakeholder In the present time, dividend theories have been developing in different ways without certain conclusion for dividend policy decision This essay focuses discussing about dividend payment theories in order to show how complicated in distributing earning for investors It includes 3 main part (1) background of dividend policy (2) dividend theories and (3) empirical evidences of dividend theories

1 Background of dividend policy

Return of company maybe divided into dividend for shareholders or retain earning which is used to keep investing Both ways have impact on shareholder wealth directly and indirectly If shareholders receipt dividend, they directly receipt benefit meanwhile, when return are kept, shareholders have chance to receipt more in future During time, dividend policy has impact in stock price in some cases (Al-Malkawi, et al., 2010) Investors pay attention on dividend payment as an important information which relate directly on investors’ wealth at the beginning of the nineteenth century However, dividend policy is becoming complicated issue when dividend which is pay

at the present can have negative effect to wealth of shareholders in the future Dividend policy need to be appropriate and suitable for shareholder expected DP is one of factor that manager should pay attention Until now, many dividend theories have investigated to study how impact of dividend policy to share price or firm market value

2 Understanding of dividend theories

Dividend theories are developed to explain the relationship between dividend policies with share price There are two schools trying to explain how impact of dividend policies on wealth of shares Dividend irrelevant theories show unrelated between share price and dividend policies Meanwhile, relevant theories impress share’s prices are affected by dividend payment (Bishop, et al., 2000) There many empirical studies support for both of schools However, each school is developed basing on some assumptions which are unreality Until now, this relationship still wonders the decision of managers

2.1.Irrelevant theories

In 1961, Miller and Modiliani (M&M) demonstrated reason of irrelevant of dividend policy on the wealth of shareholders From his view, investors prefer firm’s income which reflects finance, value and growth of company rather than its distribution For long-term, investment policy is the key reflecting wealth of firms (Bishop, et al., 2000) because it reflects the cash flow in the future However, this approach was developed base on unreal assumption including (1) perfect capital market, (2) there are no taxes, (3) the constant of cost of equity and (4) no asymmetric information (Al-Malkawi, et al., 2010)

2.2.Relevant theories

Relevant theories mention more about reality interest of investors such as fees, taxes and other uncertain factors This school is divided in two belief including higher dividend high share value and lower dividend high share value

2.2.1 High dividends increase stock value

“Bird-in-the hand” theory is the represent for this perspective It impresses that the higher dividend payout, the higher firm value It can be explained that the future is uncertain and investors care more about the present The higher current dividend payment reflects strength of current share value

Gordon (1959) was known as the first suggestion of relevant between dividend policy and firm market value He mentions that shareholders prefer the current dividend to avoid market uncertain He impresses dividend payout depending on rate of return on firm’s investment and cost of equity capital From that, each type of firm would give different distinguish amount of dividend For example, growing firm normally have rate of return higher than cost of equity, hence, when dividend payout ratio increase,

MV of share decrease However, this model ignores external financing Rate of return and cost of capital do not always remain constant

2.2.2 High dividends decrease stock value

This theory mentions about taxes in the real world and it has significant influence to dividend payment and the firm value This theory is named “tax-effect hypothesis” and suggest that lower dividends payment leading to higher stock value It can be explained that dividend payout are normally taxed If companies keep dividend as retain earning, investor can reduce amount of money for tax which is considered as cost of equity, and hence, shareholder’s wealth is considered increasing This theory is

strongly applied in many countries that taxed with high rate on dividend Brennan (1970) prove that perception when finding relationship between tax risk adjusted return and dividend yield by using the model the capital asset pricing model

3 Empirical evidences

There are many empirical studies on dividend and stock price behaviour However, there is no one can decide which theory is the most practical M&M (1961) blames Gordon theory bypass risks of business which should be concern in long-term operation of the firms Actually, even M&M theory is built basing on a range of unreal assumption, there are many research prove that relationship between dividend payment and the firm’s value is true such as Black and Scholes (1974), Hess (1981), Miller and Scholes (1978, 1982) Black and Scholes’s research (1974) prove that supposed share price is no different from low or high yield shares from 25 portfolio of common stock which listed on the New York Exchange as the evidence for M&M conclusion Hess (1981) also provided evidence in support of M&M approach when

he did not find any relationship between dividend yield and the monthly share returns for the period of 1926 to 1980 Especially, these researches did not mention about the assumptions in this theory The research of Adefila & Adeoti finds there no correlation of dividend payout and share price in Nigerian Nigerian firms do have a dividend policy that is dependent on earnings Share prices or Nigerian firms are fixed and regulated by the Securities and Exchange Commission (SEC) for quoted companies only

However, there are many researches against this M&M theory Ball et al (1979) test M&M approach from Australian statistics from 1960 to 1969, however, the conclusion had to build on unreal assumptions Many other studies focus on psychology of investors for the sake of find out how their action from dividend policy From 318 responses who are financial managers, Baker, et al., (1985) showed that share prices are influenced by dividend payment Partington (1985) also find the pleasure from shareholders on share price basing on dividend payout Baker & Powell (1999) surveyed 603 CFOs and 90 percent of them believed that there is relationship between dividend payment and the value of firm

Moreover, there is debate between “Bird-in-the hand” theory and “tax-effect hypothesis” theory Two theories with the opposite suggestion create conflict for

financial managers and shareholders From survey of Baker, et al (2002), show that only 17 percent from nearly 186 responses that they favour dividend payment rather than keep money in the company Meanwhile, Litzenberger & Ramaswamy (1979) gives conclusion that shareholder require higher return before tax for every dollar increase in the form of dividends Both theories have evidence for their reasonable

In conclude the relationship between dividend and the value of the share is not clear cut There is still a considerable controversy concerning the relation between dividend and stock price The financial manager must understand the various conflicting factors which influence the dividend policy before deciding the allocation of its company’s earnings into dividends and retain earnings

CONCLUSION AND RECOMMENDATION The essay discusses about two sides of dividend theories including relevant theory and irrelevant theories Each theory has its own reasonable and the facts prove that each theory is true in different cases

Moreover, as the important issue in corporate finance, many researchers develop some others dividend theories such as agency costs and free cash flow hypothesis of dividend policy and the information content of dividends hypothesis Which theory is appropriate for the company should be considered

In addition, financial managers have to pay attention on many distinguish factors to have decision on dividend payment such as macroeconomic, national regulation and taxes law, preference of investors Each factor in each investment market would give the different perspective in making dividend payment decision

REFERENCES Adefila, D J J & Adeoti, D J A O a J., n.d THE EFFECT OF DIVIDEND POLICY ON THE MARKET PRICE OF SHARES IN NIGERIA: CASE STUDY OF FIFTEEN QUOTED COMPANIES, s.l.: s.n

Al-Malkawi, H.-A N., Rafferty, M & Pillai, R., 2010 Dividend Policy: A Review of Theories and Empirical Evidence International Bulletin of Business Administration, Issue 9, pp 171-200

Baker, H K & Powell, G E., 1999 How Corporate Managers View Dividend Policy Quarterly Journal of Business and Economics, Volume 38, pp 17-35

Baker, H K., Powell, G E & Veit, E T., 2002 Revisiting Managerial Perspectives

on Dividend Policy Journal of Economics and Finance, Volume 26, pp 267-283 Baker, Kent, H., Farrelly, G E & Edelman, R B., 1985 A Survey of Management Views on Dividend Policy Financial Management, Volume 14, pp 78-84

Ball, et al., 1979 Dividend and the Value of the Firm: Evidence from the Australian Equity Market Australian Journal of Management, Volume 4, pp 13-26

Bishop, et al., 2000 Corporate Finance Sydney: Prentice Hall Inc

Black, F & Scholes, M S., 1974 The Effects of Dividend Yield and Dividend Policy

on Common Stock Prices and Returns Journal of Financial Economics, Volume 1,

pp 1-22

Brennan, M J., 1970 Taxes, Market Valuation and Corporate Financial Policy National Tax Journal, Volume 23, pp 417-427

Gordon, M J., 1959 Dividends, Earnings, and Stock Prices Review of Economics and Statistics, Volume 41, pp 99-105

Hess, P J., 1981 The Dividend Debate: 20 Years of Discussion The Revolution in Corporate Finance

Litzenberger, R H & Ramaswamy, K., 1979 The Effect of Personal Taxes and Dividends on Capital Asset Prices Journal of Financial Economics, Volume 7, pp 163-195

Miller, M H & Modigliani, F., 1961 Dividend Policy, Growth, and the Valuation of Shares Journal of Business, Volume 34, pp 411-433

Partington, G H., 1985 Dividend policy and its Relationship to Investment and Financing Policies: Empirical Evidence Journal of Business Finance and Accounting, Volume 12, pp 531-542

PART B TWO INVESTMENT APPRAISAL TECHNIQUES

TABLE OF CONTENTS

INTRODUCTION……… 13

1 The introduction of investment appraisal techniques……… 13

2 The introduction of two techniques………14

3 Critically analyse investment appraisal techniques………16

CONCLUSION AND RECOMMENDATION……….17

REFERENCES……… 18

INTRODUCTION Financial managers always focus on investment appraisal for the seeking of make decision Investment appraisal techniques have developed in many types Each type of business has its own methods to manage decision making This essay will compare and contrast two popular techniques The content of this essay including (1) the introduction of investment appraisal techniques, (2) the introduction of two techniques, and (3) critically analyse investment appraisal techniques

1 The introduction of investment appraisal techniques

In business, financial administrators always have to make investment decisions for the project These decisions will be directly related to the existence and development of the company The decision will have to balance between investment and income after rent collected To ensure that maximize return for investments, financial managers must observe and analyze many factors objectively and subjectively, micro and macro, and then make investment decisions

However, the final outcome of the project can only be known in the future and the current investment decisions based on the estimated and expectation To predict the future, managers often use the financial investment appraisal techniques which are used to apply are the relevant information and data of the project to measure and analyse (Sangster, 1993)

There are a range of techniques that from the simple on as payback period to the complicated one as Net Present Value Overall, there are two types of techniques It includes (1) non-discounting methods which mention useful economic life expectancy (Röhrich, 2007) These techniques normally deal with an average value of a representative period instead Payback period and the accounting average rate of return are known as non-discount method The main advantage of these methods is simple to understand However, they ignore (1) the time value of money and (2) cash flow of projects (Afonso & Cunha, 2009) (2) Discounting methods are the second type of investment appraisal technique (Röhrich, 2007) The valuation of the investment will be based on estimated cash flow of the project at defined time This type of method normally mentions to Net Present Value and Interest Rate of Return According to Afonso & Cunha (2009), non-discounting methods are normally used for small, less complicated and short-term project because its simplicity Meanwhile,

discount cash flow technique is known as superior valuation tools Until now, it is mentioned as popular techniques to analyse the practical of the investment projects (Afonso & Cunha, 2009) Thus, Net Present Value and Interest Rate of Return are two techniques will be discuss and analyse in this essay

2 The introduction of two techniques

Net present value (NPV)

Net present value is a technique used to present the present value of after-tax cash flow in the future on a project investment The formula of calculation of NPV following:

Where = after-tax cash flow at time t

r = required rate of return for the investment

= investment cash flow at time zero

NPV will need estimated cash flow in the future and reflect it at the present value NPV should illustrate (1) the opportunity cost of capital and (2) the risk of the project (Damodaran, 2001) NPV can give negative value It means that this project can give negative cash flow in the future Generally, the project NPV below 0 will not be selected Some exceptions such as non-profit projects or public projects which do not require positive return may continue to be considered (Afonso & Cunha, 2009) Advantages of NPV method is effective economic assessment taking into account the time value of money It also allows direct measurement value added generated by the investment, since it enables the evaluation and selection projects consistent with the goal of maximizing the profitability of the business (Akalu, 2003) However, this method is based on the anticipated cash flow, therefore, will include the risks during the operation In case of fluctuations in the economy unexpectedly, the results of the NPV method will suffer serious and affect expected return (Sangster, 1993)