APC308 FM financial management 4

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 Modigliani and Miller pointed out that markets are perfect • Perfect capital markets such as investors behave • rationally, were indifferent to the timing of information is freely available to all investors, transaction and floatation M&M argued that shareholders dividends • As future dividends are reflected in costs not exist, there is not an the investor is large enough to influence wanting dividends could sell shares the price of a share (home-made dividends) • share price, shareholders For M&M the investment decision is divorced from the dividend • Taxes not exist; or there is no decision, which is seen as part of difference in the tax rates applicable to the financing decision 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 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 P = (DPS/k) + [r (EPS – DPS)/k]/k investments through retained earnings; debt Where:   or new equity is not issued  P = market price per share Constant return and cost of capital – the  DPS = dividend per share firm’s rate of return, r, and its cost of capital  EPS = earnings per share k are constant  r = firm’s average rate of return 100% payout or retention – all earnings are  k = firm’s cost of capital either distributed as dividends or reinvested if the market value is determined as the internally immediately  present value of two sources of income Constant EPS and DPS – beginning earnings which are PV of constant stream of and dividends never change The values of dividend (DPS/k) and PV of infinite the EPS and DPS may be changed in the stream of capital gains r(EPS-DPS)/k model to determine results but are assumed Hence, the formula can be rewritten as to remain unchanged in determining a given value  P = DPS + (r/k) (EPS – DPS) k Infinite time – the firm has a very long or infinite life 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 The assumptions Relevance dividend made by Miller and Relevance theory is more practical such as: Modigliani are clearly unrealistic such as:  Dividend decisions are taken with  Transaction costs are not zero  Taxation exists in the real world  Issuing securities does incur costs has increased the need for dividend  Information is not necessarily available payments to all investors market expectations in mind   Increased institutional shareholding 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 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 (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) Year Annual Cash Flow Cumulative Cash Balance ($10000) ($10000) $4000 ($6000) $4000 ($2000) years and month $2000 $0 The advantages of payback period The disadvantages of payback period • Simple concept to understand • • Easy to calculate (provided future cash payback period only; says nothing flows have been calculated) about project as a whole Considers cash flows within the • Uses cash, not accounting profit • Ignores size and timing of cash flows • Takes risk into account (in the sense • Ignores time value of money (although that earlier cash flows are more certain) discounted payback can be used) • It does not really take account of risk Net present value One of the advantages of the Net Present Value (NPV) method is that is accounts for the time value of money (i.e., the value of a dollar tomorrow is not the same as a dollar today) The NPV method determines the worth of a project over time, in today’s dollars (K Storesletten, 2003) Unlike the payback method, NPV also accounts for the savings that occur after the payback period The greater the NPV value of a project, the more profitable it is This method can be used to rate and compare the profitability of several competing options NPV is given by C1 Where C2 – I0 + _ + _ + (1+r) C3 _ Cn • + + (1+r)2 (1+r)3 (1+r)n I0 is • > is zero, achieve the same return as the alternative C1, C2, Cn are the > is less than zero, achieve a worse return than the alternative investment and the capital expenditure may not be recovered cash flows occurring in years 1, 2, investment; investment, achieve a capital increase; initial investment project > is greater than zero, in comparison to alternative the n • r is the cost of capital or required rate of return Example: Assume 15% Discount Rate Line Year Initial Investment 12 Annual 10,000 0.00 4,000 Operations 0 0 4,000 2,500 2,000 2000 Cash Flow 13 Total Cash Flow (10,000) 4,000 4,000 2,500 2,000 2,000 14 Present Value Factor 1.0000 0.8696 0.7561 0.6575 0.5718 0.4972 15 Total Present Value 3,024 1,644 1,144 994 (10,000) 3,478 Annual Cash Flow 16 Net Present Value $ 285 In this table the NPV is positive and project is accepted The advantage of NPV • Takes account of time value of money • Uses cash flow, not accounting profit • Takes account of all relevant cash The disadvantage of NPV • Project cash flows may be difficult to estimate (but applies to all methods) • Accepting all projects with positive flows over NPV only possible in a perfect capital • Life of project market • Can take account of conventional and • Cost of capital may be difficult to find non-conventional cash flows, as well as • Cost of capital may change over project changes • In discount rate during project life, rather than being constant Compare Payback method and NPV method These capital budgeting decision rules are applied to the cash flows of any project which comes under consideration Whereas, the Payback Period rule does not involve discounting cash flows, the NPV rule is based on discounting considerations (DS Remer, AP Nieto, 1995) Therefore, the relevant cash flows for the Payback Period rule are different from the relevant cash flows for the NPV rule And it is demonstrated by examples above this report It shows that the NPV rule of capital budgeting and the Payback Period rule of capital budgeting should not be applied to identical sets of cash flows for a given capital budgeting project The cash flows used in the NPV rule of capital budgeting should be different from the cash flows used in the Payback Period rule of capital budgeting This is because the NPV rule involves discounting whereby the cost of debt and equity are accounted for, however the Payback Period rule does not involve discounting and therefore the cost of debt and equity should be accounted for in the cash flows References  AccountingCoach.com, (2015) How you calculate the payback period? | AccountingCoach [online] Available at: http://www.accountingcoach.com/blog/calculatepayback-period  Accountingexplained.com, (2015) Net Present Value (NPV) Formula | Examples | Decision Rule [online] Available at: http://accountingexplained.com/managerial/capitalbudgeting/npv  Financeformulas.net, (2015) Net Present Value [online] Available at: http://www.financeformulas.net/Net_Present_Value.html  Financeformulas.net, (2015) Payback Period [online] Available at: http://www.financeformulas.net/Payback_Period.html  Small Business - Chron.com, (2015) Net Present Value Method Vs Payback Period Method [online] Available at: http://smallbusiness.chron.com/net-present-value-methodvs-payback-period-method-61578.html  Wilkinson, J (2013) NPV vs Payback Method • The Strategic CFO [online] Strategiccfo.com Available at: http://strategiccfo.com/wikicfo/npv-vs-payback-metho/ ... Value Factor 1.0000 0.8696 0.7561 0.6575 0.5718 0 .49 72 15 Total Present Value 3,0 24 1, 644 1, 144 9 94 (10,000) 3 ,47 8 Annual Cash Flow 16 Net Present Value $ 285 In this table the NPV is positive... 10,000 0.00 4, 000 Operations 0 0 4, 000 2,500 2,000 2000 Cash Flow 13 Total Cash Flow (10,000) 4, 000 4, 000 2,500 2,000 2,000 14 Present Value Factor 1.0000 0.8696 0.7561 0.6575 0.5718 0 .49 72 15 Total... operational savings of $4, 6 34 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 $46 34 Annual Savings