APC308 FM Financial Management 1

Part A Critically evaluate and discuss both the dividend relevance and dividend irrelevance theories, using relevant academic research to develop and support the response Table of contents Part A Table of contents Introduction I Dividend payments determine the share price of a company .6 II Dividend relevance theories II.1 Traditional View .8 II.2 Walter’s Model .9 II.3 Gordon Growth Model 11 III Dividend irrelevance theories 13 Modigliani and Miller (MM theory) 13 Conclusion 14 References 15 Introduction Financial management is a necessary skill for every business enterprise can control their system And a financial manager is a person who has responsibility to lead the company in the best strategy and make the whole system go up by control the process of rising capital, evaluate project Dividend payments always in priority policy of a company and its effect to determining the share price of a company By evaluate and discuss both the dividend relevance and dividend irrelevance theories, the researcher aim to analyse both of these theories and support company determine their share price and which suitable dividend policy for them Main body I Dividend payments determine the share price of a company In summary, we can find out that dividends are important and likely to receive increasing attention Although their contribution and importance differ among companies, countries, and sectors, dividends are a major component of total equity returns over time According to (Lease et al., 2000), dividend policy is concerned with financial policies regarding paying cash dividend in the present or paying an increased dividend at a later stage Whether to issue dividends and what amount, is determined mainly on the basis of the company's unappropriated profit (excess cash) and influenced by the company's long-term earning power When cash surplus exists and is not needed by the firm, then management is expected to pay out some or all of those surplus earnings in the form of cash dividends or to repurchase the company's stock through a share buyback program According to Miller & Modigliani (1961), propositions on dividend the ex-dividend price of the stock at the end of the period would go down by exactly same amount as the increase in the dividend or the value of the firm will remain independent in the ex and post dividend period 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) found an inverse relationship between dividend yield and stock price volatility in United States (Ball et al., 1979) found the positive impact of dividend yield on post announcement rates of return, Allen & Rachim (1996) failed to find any evidence that dividend yield influence the stock price volatility in Australia Nishat (1992), in a study on Pakistan found that the share price reactions are significant following the earnings announcements Although some evidence from other research showed that earnings announcement has no material impact on stock price (Conroy et al., 2000) (case in Japan) The determining the share price of a company was concluded that relevant to dividend payments II Dividend relevance theories If the choice of the dividend policy affects the value of a firm, it is considered as relevant In that case a change in the dividend payout ratio will be followed by a change in the market value of the firm If the dividend is relevant, there must be an optimum payout ratio Optimum payout ratio is that ratio which gives highest market value per share Relevance dividend theory has been empirically tested by a significant number of surveys conducted in the USA, including(Farrelly et al., 1986), (Baker et al., 1985), (Pruitt & Gitman, 1991), Baker and Powell (1999, 2000), (Baker et al., 1985), etc most participants in these surveys indicated that dividend policy affects corporate value II.1 Traditional View In general, follow NASDAQ, there is an argument that, "within reason," investors prefer higher dividends to lower dividends because the dividend is sure but future capital gains are uncertain Dividend payout is important and plays 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 In other research Weiss & Weiss (1995), we should suggest the following principle as a desirable modification of the traditional viewpoint: Principle: Stockholders are entitled to receive the earnings on their capital except to the extent they decide to reinvest them in the business The management should retain or reinvest earnings only with the specific approval of the stockholders Such “earnings” as must be retained to protect the company’s position are not true earnings at all Were this principle to be generally accepted, the withholding of earnings would not be taken as a matter of course and of arbitrary determination by the management, but it would require justification corresponding to that now expected in the case of changes in capitalization and of the sale of additional stock The result would be to subject dividend policies to greater scrutiny and more intelligent criticism than they now receive, thus imposing a salutary check upon the tendency of managements to expand unwisely and to accumulate excessive working capital II.2 Walter’s Model According to Prof James E Walter 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 capital market in the assumption of these conditions: The firm finances its entire investments by means of retained earnings only; Internal rate of return (R) and cost of capital (K) of the firm remains constant; The firms’ earnings are either distributed as dividends or reinvested internally; The earnings and dividends of the firm will never change; The firm has a very long or infinite life The dividend policy is relevant According to Walter (1963), Walter’s formula for determining MPS is as follows: P = (DPS/k) + [r (EPS – DPS)/k]/k Where: o P = market price per share o DPS = dividend per share o EPS = earnings per share o r = firm’s average rate of return o k = firm’s cost of capital To understand this formula, Walter explains the market value is determined as the present value of two sources of income: PV of constant stream of dividend (DPS/k) 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 And there are three kinds of firms can follow this theory of Walter, with each type of rim, the dividend policy has different result and effect to the pay-out policy ad investment strategy of the company  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 will 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 (rg According to (Gordon, 1962), the formula was showed below: Stock Price = D (1+g) / (r-g) Where: D = the annual dividend g = the projected dividend growth rate, and r = the investor's required rate of return But in this model has existed some problems: The presumption of a steady and perpetual growth rate less than the cost of capital may not be reasonable If the stock does not currently pay a dividend, like many growth stocks, more general versions of the discounted dividend model must be used to value the stock One common technique is to assume that the Miller-Modigliani hypothesis of dividend irrelevance is true, and therefore replace the stocks’ dividend D with E earnings per share However, this requires the use of earnings growth rather than dividend growth, which might be different The stock price resulting from the Gordon model is hypersensitive to the growth rate g chosen PV = 100,000 / 5% * (1 – 1/(1+5%) ^ 10) = 772,173.4929 Secondly, calculate cash out flow COF = 5,000 + 5,000/ (1+r) ^ n’ = 5,000 + 5,000/ (1+5%) ^5 = = 8,917.63 =>NPV =PV - cash out flows = 772,173.4929 – 8,917.63 = 763,255.8629 In general, we have a formula to calculate NPV: Given the (period, cash flow) pairs (t, Rt) where N is the total number of periods I.1.3 Decision Rule Reject the project having negative NPV and accept the project only if the NPV is positive or zero Comparing two or more exclusive projects having positive NPVs, we accept the project the highest NPV I.1.4 Example of decision depend on NPV Three Projects start at the same time with investment $100,000 and divided stages, each stage is one fiscal year But each project allocates cash flow in different way After year, projects have different NPV: NPV of Project A equal 7,000; NPV of Project B equal 2,500; NPV of Project C equal 12,000  Project B has negative NPV so it should be rejected  Project C will be chosen because this project has the highest NPV I.2 Internal rate of return (IRR) I.2.1 Definition The internal rate of return (IRR) or economic rate of return (ERR) is a rate of return used in capital budgeting to measure and compare the profitability of investments It is also called the discounted cash flow rate of return (DCFROR) (M.A.Main, n.d.) Other definition notice IRR is a rate of return on an investment The IRR of an investment is the interest rate that will give it a net present value of zero (Watters & Hoare, 2009) I.2.2 Calculation The IRR is the discounted rate that make NPV = We use Microsoft Excel to calculate the IRR of a project An example: The car company that has the opportunity to invest $100 million in the development of a new car that will generate after-tax cash flows of $20 million per year for the next 15 years The IRR makes NPV = =>IRR = 18.4% (Using Microsoft Excel software) I.2.3 Decision Rule If the company required rate of return is lower than IRR (or IRR > Cost of capital) when considering a project, it will accept this project Or when two or more projects need financial manager to make decision, they will choose the project has the highest IRR I.2.4 Example of decision depend on IRR To find the internal rate of return of the above investment we find the value(s) of r that satisfies the following equation: Solution: IRR = r, IRR = 17.09% Thus using r = IRR = 17.09% The company wants Internal Rate of Return (IRR) given a required return of 15 % (k), therefore - IRR> k => the project is accepted - IRRthe project should be rejected II Compare and contrast two investment appraisal techniques II.1 Similarities between IRR and NPV In general, IRR and NPV are both of investment appraisal techniques; they explain the time value of money and both useful in capital budgeting and investment valuation They both focus on the amount and timing of a project’s cash flows; both can accommodate differences in risk by adjusting the project’s required rate of return and both give the same accept-reject decision for independent projects II.2 Differences between IRR and NPV As NPV is calculated on capital cost and IRR is determined on calculated IRR rate IRR is used to evaluate that which one investment is providing comparatively better rate of return Some investors prefer to use IRR as to take decision on the basis of required rate of return calculated in percentage They tend to find NPV less intuitive because it does not measure the amount relative to the amount invested (Gitman & Lawrence., 2008) It is because the IRR gives answer in percentage which in many cases become difficult for investors to evaluate return NPV project evaluation is superior to that of IRR NPV discounts all the cash flows to present to see whether the investment project will cause benefit or loss to the investor (Don et al., 2002) In some researches, the differences between IRR and NPV were showed: - First, NPV assumes that cash inflows are reinvested at required rate of return, whereas IRR assumes that cash inflows are reinvested at computed IRR - Second NPV measures profitability in absolute manner and IRR measures in relative manner (Heitger et al., 2007) According to Arshad (2012), for individual projects IRR is used mostly to evaluate the project and NPV is preferable when the projects are mutually exclusive But sometimes investors prefer to use NPV because it is easy to calculate and reinvest the cash flows at the cost of capital And sometimes IRR is preferable because it gives answer in percentage and it is easy to understand But IRR reinvest at calculated IRR II.3 Advantage of two key investment appraisals NPV  It is a direct measure of the dollar IRR  contribution to the stockholders  Tell whether the investment will It shows the return on the original money invested  The IRR method is very clear and easy to increase the firm’s value understand  Considers all the cash flow acceptable if its internal rate of return is greater  Considers the time value of money than an established minimum acceptable rate of  Considers the risk of future cash return or cost of capital An investment is considered flows (through the cost of capital)  Estimate the initial costs easily According to (Peterson-Drake, n.d.)  The IRR method only concerns itself with the projected cash flows generated by a capital injection and ignores the potential future costs that may affect profit  IRR allows you to calculate the value of future cash flows  There is no base for selecting any particular rate in internal rate of return  Maximum profitability of Shareholder According to (Rudolf, 2008) Table 1: Advantage of two key investment appraisals II.4 Disadvantage of two key investment appraisals NPV IRR  The project size is not measured  Requires an estimate of the cost of capital compared to NPV for mutually exclusive in order to calculate the net present value projects   Express in terms of dollars, not as a calculation to use when you're comparing Hard to estimate accurately, does not fully mutually exclusive projects give a complete picture of an investment's  It does not account for the project size when comparing projects  It makes an implicit assumption that those gain or loss It requires that the investor know the exact cash flows can be reinvested at the same discount rate, the size of each cash flow, rate as the IRR and when each cash flow will occur   The IRR method is usually not the best percentage account for opportunity cost, and does not   It can give conflicting answers when  It is difficult to understand it why are The NPV is only useful for comparing calculating different rate in it and it projects at the same time; it does not fully becomes more difficult when real value of build in opportunity cost IRR will be two experimental rate because According to (Peterson-Drake, n.d.) of not equalize present value of cash inflow with present value of cash outflow Table 2: Disadvantage of two key investment appraisals III Example of using two key investment appraisals in decision making A specific example: Using Microsoft Excel software, the financial manager can calculate exactly the NPV and IRR for each project Detail was shown in the table below: Table 3: Investment appraisal using NPV and IRR Discount rate equal to 10% In conclusion, the company should reject Project B because of negative NPV Between project A and C, we recognized that NPV and IRR for Project C were higher than for Project A => Project C will be chosen Conclusion By critically compare and contrast two investment appraisal techniques that may be utilized by financial managers to assist in the financial management decision making-process We define types of investment appraisal techniques like Payback, ARR, IRR and NPV But IRR and NPV are two key investment appraisal techniques which prefer use in decision making process Both NPV and IRR have the same advantages and some similarity like both focus on the amount and timing of a project’s cash flows; both can accommodate differences in risk by adjusting the project’s required rate of return and both give the same accept-reject decision for independent projects However, they have different things which lead the financial manager, the investor have different choice in investment project References Arcon Professional Tutors, 2012 PERFORMANCE OPERATIONS In CIMA Operational Level 1st ed Arcon Professional Tutors pp.39-43 Arshad, A., 2012 Net Present Value is better than Internal Rate of Return BAFS, 2008 Professional Development Programme on Enriching Knowledge of the Business, Accounting and Financial Studies (BAFS) Curriculum Course : Contemporary Perspectives on Accounting/ Unit 10 : Capital Investment Appraisal Blas, P.B.d., 2006 Net Present Value Don et al., 2002 Capital Budgeting: Financial Appraisal of Investment Projects United Kingdom: Cambridge University Press Gitman & Lawrence., 2008 Principles Of Managerial Finance India: Pearson Education Inc Heitger, Mowen & Hansen, 2007 Fundamental Cornerstones of Managerial Accounting USA: Cengage Learning Lefley, F., 1996 The payback method of investment appraisal: A review and synthesis Int J Production Economics , (44), pp.207-24 Lin, G.C.I & Nagalingam, S.V., 2000 CIM justification and optimisation London: Taylor & Francis 10 M.A.Main, n.d Project Economics and Decision Analysis In Volume I: Deterministic Models p.269 11 Peterson-Drake, P., n.d Advantages and disadvantages of the different capital budgeting techniques Florida: Florida Atlantic University 12 Rudolf, S., 2008 The Net Present Value Rule in Comparison to the Payback and Internal Rate of Return Methods 13 University of Sunderland, 2007 APC 308 In Financial Management 7th ed Sunderland: University of Sunderland p.64 14 Watters, A & Hoare, J., 2009 Internal Rate of Return Appendices  It is a direct measure of the dollar  contribution to the stockholders  Tell whether the investment will It shows the return on the original money invested  The IRR method is very clear and easy to increase the firm’s value understand  Considers all the cash flow acceptable if its internal rate of return is greater  Considers the time value of money than an established minimum acceptable rate of  Considers the risk of future cash return or cost of capital flows (through the cost of capital) (Peterson-Drake, n.d.) An investment is considered  Estimate the initial costs easily  The IRR method only concerns itself with the projected cash flows generated by a capital injection and ignores the potential future costs that may affect profit  IRR allows you to calculate the value of future cash flows  There is no base for selecting any particular rate in internal rate of return  Maximum profitability of Shareholder Table 1: Advantage of two key investment appraisals  The project size is not measured  Requires an estimate of the cost of capital compared to NPV for mutually exclusive in order to calculate the net present value projects   Express in terms of dollars, not as a calculation to use when you're comparing Hard to estimate accurately, does not fully mutually exclusive projects give a complete picture of an investment's  It does not account for the project size when comparing projects  It makes an implicit assumption that those gain or loss It requires that the investor know the exact cash flows can be reinvested at the same discount rate, the size of each cash flow, rate as the IRR and when each cash flow will occur   The IRR method is usually not the best percentage account for opportunity cost, and does not   It can give conflicting answers when  It is difficult to understand it why are The NPV is only useful for comparing calculating different rate in it and it projects at the same time; it does not fully becomes more difficult when real value of build in opportunity cost IRR will be two experimental rate because According to (Peterson-Drake, n.d.) of not equalize present value of cash inflow with present value of cash outflow Table 2: Disadvantage of two key investment appraisals Table 3: Investment appraisal using NPV and IRR ... profit in the next 10 years: PV = 10 0,000 / 5% * (1 – 1/ (1+ 5%) ^ 10 ) = 772 ,17 3.4929 Secondly, calculate cash out flow COF = 5,000 + 5,000/ (1+ r) ^ n’ = 5,000 + 5,000/ (1+ 5%) ^5 = = 8, 917 .63 =>NPV =PV... 40(2), pp.57-65 17 Ohlson, J.A., 19 95 Earnings, Book Values, and Dividends in Equity Valuation Contemporary Accounting Research, 11 (2), pp 6 61- 687 18 Pruitt, S & Gitman, L., 19 91 The interactions... Finance, 37(2), pp.429-43 15 Miller, M & Modigliani, F., 19 61 Dividend policy, growth, and the valuation of shares The Journal of Business, 34(4), pp. 411 -28 16 Nishat, M., 19 92 Share Prices, Dividend