APC308 FM financial management 3

TABLE OF CONTENTS PART A I DEFINE DIVIDEND II OPERATIONAL ISSUES III PRACTICAL ISSUES Legal constraints Liquidity IV THE ARUGMENTS BETWEEN DIVIDEND POLICY THEORIES Dividend Irrelevance Dividend Relevance V RECOMMENDATIONS REFERENCES PART B I Advantages, drawbacks and decision rules of Net present value (NPV) Advantages of NPV Drawbacks of NPV Decision rules toward NPV 3.1 Project independence 3.2 Mutually exclusive II Advantages, drawbacks and decision rules of Internal rate of return (IRR) Advantages of IRR Drawbacks of IRR 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 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 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 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 not fit together” (Black (1976) Black,F (1976)) 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 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 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 not exist, investors will have free and public information, but they 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 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 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 (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) 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) 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) Decision rules toward NPV 3.1 Project independence For example an ABC company has projects in the table below: Year Discount Project Project Project factor Cash flow Present value Cash flow Present value Cash flow Present value 1.000 (300,000) (300,000) (280,000) (280,000) (180,000) (180,000) 0.912 110,000 100,320 60,000 54,720 58,000 52,896 0.829 90,000 74,610 50,000 41,450 70,000 58,030 0.755 82,000 61,910 50,000 37,750 74,000 55,870 0.688 80,000 55,040 50,000 34,400 60,500 41,624 0.626 75,000 46,950 65,000 40,690 78,000 48,828 0.570 80,000 45,600 40,000 22,800 78,000 44,460 0.519 85,000 44,115 45,000 23,355 9.81% Interest rate NPV 128,545 (24,835) 121,708 Decision YES NO YES Table 2: NPV and decision in independent projects From the table 2, it shows very clearly that project has negative NPV with -£24,835, while project and project give positive NPV, which are £128,545 and £121,708 Therefore, project and project are accepted and project 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 has highest NPV so that this company should invest in project because of it presents the best shareholders’ wealth II Advantages, drawbacks and decision rules of Internal rate of return (IRR) 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) 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) Furthermore, project can have multiple IRR or even, none of IRR, so it make more difficult in making the computation of IRR (Hazen) Decisions rules of IRR 3.1 Independent projects IRR has three cases to make decision in taking project: IRR < hurdle rate: The project is rejected IRR > hurdle rate: The project is accepted IRR = hurdle rate: The project can be accepted or can be rejected depended on decisions of firms (University of Sunderland, 2007: 81-83) Year Project Project Project Cash flow Cash flow Cash flow (300,000) (280,000) (180,000) 110,000 60,000 58,000 90,000 50,000 70,000 82,000 50,000 74,000 80,000 50,000 60,500 75,000 65,000 78,000 80,000 40,000 78,000 85,000 45,000 IRR 22.68% 6.97% 16% Hurdle rate Decision 29.52% YES NO YES Table 3: Decision is made based on IRR in independent projects From table 3, project is rejected because of it has IRR < hurdle rate Besides that, project and project have IRR higher than hurdle, so these are accepted 3.2 Mutually exclusive projects As well as NPV, companies will selects the project has highest rate IRR, and also exceeds the hurdle rate (Lumby and Jones) According to table 3, project has highest IRR, so this company will choose this project III The complement between NPV and IRR Disadvantages of NPV Complemented by IRR - A project which is invested initially with a large - The percentage of IRR is in comparison with the amount of money will create a higher NPV so it is expected return of company and the shareholders difficult to bring projects into comparison - The result of NPV is not easy to analysis and - Company could assess easily to the result of IRR understands which is presented in terms of percent Disadvantages of IRR Complemented by NPV - The result does not show the value of future cash - The value of future cash flow from projects is shown flow which is created by projects in result - The shareholders does not based on the percentage - The shareholders could decide projects which increase of IRR to access which projects generate the highest their wealth into the peak due to NPV wealth for them Table 4: The comparison and complement between IRR and NPV It is clearly that table above performed the characteristics that IRR complements NPV and vice versa IRR method can overcome the disadvantages of the NPV based on the project’s rate of return They concluded that there is at least one project will show the same suggestion Besides, Osborne announced that the significant number of large companies used the result of NPV to make decision and the percentage of IRR to adjust their decision in the most proper way (Osborne,2010) On the other hand, Godinho, Afonso and Costa insisted that NPV is the best techniques for companies, which own available capital, to appraise investments If the available source of capital is limited and not identified to use in the future, IRR method will be a better replacement for NPV (Godinho, Afonso and Costa, 2004) IV Recommendation ABC Company is suggested to use both NPV and IRR to evaluate the projects Year Discount Project Project Project factor Cash flow Present value Cash flow Present value Cash flow Present value 1.000 (300,000) (300,000) (280,000) (280,000) (180,000) (180,000) 0.912 110,000 100,320 60,000 54,720 58,000 52,896 0.829 90,000 74,610 50,000 41,450 70,000 58,030 0.755 82,000 61,910 50,000 37,750 74,000 55,870 0.688 80,000 55,040 50,000 34,400 60,500 41,624 0.626 75,000 46,950 65,000 40,690 78,000 48,828 0.570 80,000 45,600 40,000 22,800 78,000 44,460 0.519 85,000 44,115 45,000 23,355 9.81% Interest rate NPV 128,545 (24,835) 121,708 IRR 22.68% 6.97% 29.52% 16% Hurdle rate Decision NO NO YES Table 5: The consolidated result of three projects in IRR and NPV technique Based on table 5, project has the highest NPV (128,545), but project has IRR higher than project 1's IRR In addition, project has NPV (121,708) approximated with NPV of project 1, and it also has small amount of initial investment Therefore, ABC Company should invest to in project in this circumstance Project will help company saved more money, and it can make more profits with maximize more shareholders’ wealth Thus, ABC Company should use both of the techniques, and compare them because NPV and IRR can bring more right decision for firm REFERENCES Boundless “Advantages of the NPV method.” Boundless Finance Boundless, 03 Jul 2014 Available: https://www.boundless.com/finance/textbooks/boundless-finance-textbook/capital- budgeting-11/net-present-value-94/advantages-of-the-npv-method-410-3863/ Sangster, A (1993) 'capital investment appraisal techniques: a survey of current usage', Journal of Business finance and accounting, vol 20, no 3, April Pamela Peterson-Drake (Unknown) Capital budgeting techniques unknown (unknown) Advantages of the NPV method Available: https://www.boundless.com/finance/textbooks/boundless-financeQafqaz University, Economics and Administrative Sciences, Finance Department Available: http://fi.qu.edu.az/~faliyev Peterson, P.P and Fabozzi, F.J (2002) Capital Budgeting: Theory and practice, 1st edition, New York: John Wiley& Sons Inc Khan, M.Y and Jain, P.K (2007) Financial Management: Text, problems and cases, 7th edition, New Delhi: Tata McGraw- Hill ltd Periasamy, P (2009) Financial Management, 2nd edition, New Delhi: Tata McGraw Hill Education Private Ltd Lumby, S and Jones, C (2007) Corporate finance: theory and practice, 7th edition, London: Thomson Learning Lasher, W.R (2010) Practical financial management, 7th edition, Mason: Cengage Learning Megginson, W.L., Smart, S.B and Lucey, B.M (2008) Introduction to corporate finance, 1st edition, London: South Cengage Learning Akalu, M.M (2001) 'Re- examining project appraisal and control: developing a focus on wealth creation', International Journal of Project Management, vol 19, pp 375-383 Gallagher, T and Andrew, J.D (2007) Financial Management: Prinicples and Practice, 4th edition, Freeloud Press Fabozzi, F and Drake, P.P (2009) Finance: Capital market, Financial Management and Investment Management, 1st edition, Hoboken: John Wiley and Sons Inc Hazen, G (2009) 'An extension of internal rate of return to stochastic cash flow', Management Science, vol 55, no 6, June, pp 1030-1034 University of Sunderland (2007) 'Internal rate of return (IRR)', in Sunderland, U.o Financial Management, Sunderland: University of Sunderland Lumby, S and Jones, C (2003) Corporate finance: theory and practice, 7th edition, London: Thomson Learning Osborne, M.J (2010) 'A resolution to the NPV–IRR debate?', The Quarterly Review of Economics and Finance, vol 50 , no 2, p 234–239 Godinho, P.C., Afonso, A.R and Costa, J.P (2004) 'On the use of multiple financial methods in the evaluation and selection of investment projects', Investigacao Operacional, vol 24, pp 1-20  ... focus on wealth creation', International Journal of Project Management, vol 19, pp 37 5 -38 3 Gallagher, T and Andrew, J.D (2007) Financial Management: Prinicples and Practice, 4th edition, Freeloud... 1.000 (30 0,000) (30 0,000) (280,000) (280,000) (180,000) (180,000) 0.912 110,000 100 ,32 0 60,000 54,720 58,000 52,896 0.829 90,000 74,610 50,000 41,450 70,000 58, 030 0.755 82,000 61,910 50,000 37 ,750... 1.000 (30 0,000) (30 0,000) (280,000) (280,000) (180,000) (180,000) 0.912 110,000 100 ,32 0 60,000 54,720 58,000 52,896 0.829 90,000 74,610 50,000 41,450 70,000 58, 030 0.755 82,000 61,910 50,000 37 ,750