APC308 FM Financial Management 2

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 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 not exist III Example of using two key investment appraisals in decision making IRR and NPV methods tend to give the same accept or reject recommendations for independent investments  The two methods will always agree when the projects are independent and the projects’ cash flows are conventional  After the initial investment is made (cash outflow), all the cash flows in each future year are positive (inflows) For example: Figure 1: NPV Profile for a project In the NPV Profile for this project, the NPV value is on the vertical (y) axis and the discount rate is on the horizontal (x) axis When the discount rate increases, the NPV profile curve declines smoothly and intersects the x-axis at precisely the point, where the NPV = and the IRR = 13.7%, at which the NPV changes from a positive to a negative value  NPV and IRR methods lead to identical accept/ reject decisions for this type of project A IRR and NPV methods can produce different accept/reject decisions if a project either has unconventional cash flows or the projects are mutually exclusive  Unconventional Cash Flows9 In these situations, if we use IRR method, it leads more than one solution This makes the result unreliable and should not be used in deciding about accepting or rejecting a project For example: Figure 2: NPV profile showing multiple IRR solutions This project has unconventional cash flows Because there are two cash flow sign reversals, we end up with two IRR (16.05% & 55.65%) – neither of them correct In this case, the IRR provides a solution that is suspect  The results should not be used for capital budgeting decisions  Mutually Exclusive Projects When you are comparing two mutually exclusive projects, the NPVs of the two projects will equal each other at a certain discount rate Depending on whether the required rate of return is above or below this crossover point 10, the ranking of the projects will be different When comparing projects with different costs, IRR gives a return based on the cash invested; it does not recognize the difference in the size of the investments while NPV can express this For example: Figure 3: NPV Profiles for two mutually exclusive Projects Two projects A and B has the crossover point is at 14.3% For any cost of capital > 14.3% but below 20.7%, project A has positive NPV and higher than project B => Project A will be chosen For any cost of capital below the crossover point, project B has a higher NPV => Project B will be chosen (Although IRR for project A > IRR for project B) 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 4: Investment appraisal using NPV and IRR Thus, the opportunity cost of capital is simply a weighted average of the costs of debt and equity and is equivalent to the WACC Hence, WACC is the appropriate discount rate (Anon., n.d.) Discount rate equal to 9.23919% 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 According to (The Institute of Chartered Accountants of India, 2012), using NPV or IRR lead to different conclusion in the following scenarios: Large initial investment: IRR is more appropriate Difference in the timing and amount of net cash inflows: NPV is better choice Projects with long useful life: Both NPV & IRR suitable Varying cost of capital: NPV is a better method Multiple investments: NPV is a better method Some of empirical evidences come from (Arshad, 2012) mentioned in his study that The 40 copy righted Google books were selected randomly, to categorize the data ordinal scale was used and then analyze the data by sum, mean and graphical presentation These views were analyzed on individual basis and by categorizing under 10 different disciplines Then found that 52.50% authors had the view that NPV is better Than IRR References MFIN INTERDISCIPLINARY JOURNAL OF CONTEMPORARY RESEARCH IN BUSINESS Intermediate Financial Management Investing Answers Financial Management: Principles And Applications Financial Management Appendices Example of NPV PROJECT A Year PROJECT B PROJECT C Cash flow PV11 Cash flow PV Cash flow PV (100,000) (100,000) (100,000) (100,000) (100,000) 100,000) 10,000 9,091 40,000 36,364 30,000 27,273 20,000 16,529 30,000 24,793 30,000 24,793 30,000 22,539 30,000 22,539 30,000 22,539 30,000 20,490 20,000 13,660 30,000 20,490 30,000 18,628 20,000 12,418 35,000 19,757 10,000 5,645 NPV 7,034 (2,643) 13,159 Table 1: Calculation of NPV (Interest rate = 10%)  Project C will be chosen because this project has the highest NPV n Example of IRR Compute the Internal Rate of Return (IRR) given a required return of 12 % (k) and the following cash flows: Year CF t ($20,000) $6,000 $7,000 $8,000 $5,000 $4,000 Set the NPV equation equal to zero and solve for the IRR: NPV    20,000 6,000 7,000 8,000 5,000 4,000      (1  IRR) (1  IRR) (1  IRR) (1  IRR) (1  IRR) (1  IRR)5 At this point, unless you are using a financial calculator or spreadsheet, solving for the IRR is a trial and error process That is, we would “plug” in different estimates for the IRR, work through the calculations, and determine if we have found the rate that causes NPV to equal $0 We have already computed the NPV of this project at a 12% discount rate and found the NPV to be positive In addition, we computed the NPV of the project at a discount rate of 17% and found NPV to be negative Therefore, we know that the IRR lies somewhere between 12% and 17% (in fact, we can see that the IRR is much closer to 17%) o Using a financial calculator12, we find the IRR = 16.3757%.13 o Since the IRR > k (16.38% > 12%), the project should be accepted The calculation of the project’s IRR does not depend upon the required rate of return The IRR is compared to the required rate of return to determine whether to accept or reject the project Also, if a project’s NPV is positive, IRR will exceed the required rate of return If a project’s NPV is negative, its IRR will be below the required rate  Takes account of time value of money  Tells whether an investment increases the  Uses cash flow, not accounting profit  Takes account of all relevant cash flows  Consider all cash flows of the project firm’s value (the whole stream of cash flow is  Consider the time value of money  Consider the risk of cash flows (through the considered)  Can take account of conventional and non- cost of capital in the decision rule) conventional cash flows, as well as  Direct comparison to projects with different changes in discount rate during project  values Gives absolute measure of project value  Inflation is taken into account (tell whether the investment will increase  Looks at cash flows not accounting profits firm’s value)  Consider the risk of future cash flows (through the cost of capital) Table 2: Advantage of two key investment appraisals  Project cash flows may be difficult to  estimate  Requires an estimate of the cost of capital in order to make a decision Accepting all projects with positive NPV  only possible in a perfect capital market  Cost of capital may be difficult to find  Cost of capital may change over project  life, rather than being constant May not give the value-maximizing decision when used to compare mutually exclusive projects May not give the value- maximizing decision when used to choose projects when there is capital rationing  Cannot be used in situations in which the sign of cash flows of a project change more than once during the project’s life  IRR is a relative measure of the return It does not reflect the size of the project and the timing of cash flows Table 3: Disadvantage of two key investment appraisals Table 4: Investment appraisal using NPV and IRR Figure 1: NPV Profile for a project Figure 2: NPV profile showing multiple IRR solutions Figure 3: NPV Profiles for two mutually exclusive Projects Graphically NPV = IRR 2% 4% 6% 8% 10% 12% 14% 16% 18% 20% Figure The required IRR can also be found from the graph, at the point where the line crosses the x-axis where the NPV = The graph shows an IRR of 17% The concept of future value and the compounding technique Future value (FV) refers to an amount to which current saving will increase based on a certain interest rate and a certain time period; the process of growth is known as compounding Compounding is a process of accumulating value over time, from a single money amount (deposit/payment) or a series of equal deposits/payments (annuity) Example: What is the future value of $1,000 put in a one-year time deposit at an annual interest rate of 5%?  Future value = $1,000 + ($1,000 x 5%) = $1,050 Present value and discounting technique Present value (PV) refers to the current value of a future amount based on a certain interest rate and a certain period Discounting is a process of reducing future value to present value It is used to determine the current value of a desired amount for the future The technique for calculating PV in capital investment appraisal is generally referred to as the discounted cash flow (DCF) method Example: A person will have a 10% return per annum for money deposited with a financial institution What is the amount required to be deposited now in order to receive $10,000 at the end of one year? Let z be the money deposited at present: z x (1+10%) = $10,000 z = $10,000 / (1 + 10%) z = $9,090.9 In the above calculation, / (1 + 10%) is a discount factor to convert $10,000 into a present value of $9,090.9 Calculation of crossover point Expected after-tax net cash flows (NCFt) Cash flow Year (t) differential Project A Project B ($100) ($100) 50 20 30 40 30 10 30 50 (20) 30 65 (35) IRR = Crossover rate = Table IRR was calculated by Microsoft Excel (Broker, 2011) 14.3% ... 40,000 36,364 30,000 27 ,27 3 20 ,000 16, 529 30,000 24 ,793 30,000 24 ,793 30,000 22 ,539 30,000 22 ,539 30,000 22 ,539 30,000 20 ,490 20 ,000 13,660 30,000 20 ,490 30,000 18, 628 20 ,000 12, 418 35,000 19,757... 30,000 24 ,793 30,000 22 ,539 30,000 22 ,539 30,000 22 ,539 30,000 20 ,490 20 ,000 13,660 30,000 20 ,490 30,000 18, 628 20 ,000 12, 418 35,000 19,757 10,000 5,645 NPV 7,034 (2, 643) 13,159 Table 1: Calculation... flow PV2 Cash flow PV Cash flow PV (100,000) (100,000) (100,000) (100,000) (100,000) 100,000) 10,000 9,091 40,000 36,364 30,000 27 ,27 3 20 ,000 16, 529 30,000 24 ,793 30,000 24 ,793 30,000 22 ,539 30,000