APC308 FM financial management 5

Part A DIVIDEND RELEVANCE AND DIVIDEND IRRELEVANT THEORIES TABLE OF CONTENTS INTRODUCTION Background of dividend policy Understanding of dividend theories 2.1 Irrelevant theories 2.2 Relevant theories Empirical evidences CONCLUSION AND RECOMMENDATION REFERENCES 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 main part (1) background of dividend policy (2) dividend theories and (3) empirical evidences of dividend theories 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 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 (AlMalkawi, 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 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 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 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 10 PART B TWO INVESTMENT APPRAISAL TECHNIQUES 11 TABLE OF CONTENTS INTRODUCTION………………………………………………………………… 13 The introduction of investment appraisal techniques……………………… 13 The introduction of two techniques…………………………………………14 Critically analyse investment appraisal techniques…………………………16 CONCLUSION AND RECOMMENDATION…………………………………….17 REFERENCES…………………………………………………………………… 18 12 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 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, 13 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 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 will not be selected Some exceptions such as non-profit projects or public projects which 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) 14 NPV is usually calculated with interest rate of return which is used to estimate discount rate At IRR, manager can estimate where future cash flow equal investment outlay Interest rate of return (IRR) Internal Rate of return is the discount rate at which the interest rate balances the present value of net cash flows generated expectations with the always original In other words, the internal rate of return is the rate at which the discount rate that makes the net present value of investments equal (Akalu, 2001) Formula of IRR flowing: Where: = ( + = after-tax cash flow at time t ) − = IRR = rate of return for the investment = investment cash flow at time zero IRR is an important reflection of the quantity of projected profitability paste from It is the discount rate used future net cash flows from to for the same price as at the value of original amount of outflow (Akalu, 2001) IRR is usually determined by, the IRR would be anticipated and included in the test and rate at which NPV equal to 0, the IRR is determined However, today, Excel was introduced to determine the IRR quickly By using the formula in Excel, IRR is defined immediately (Table 1.2) The advantage of the method is the internal rate allows to assess project profitability into account the time value of money It also allows easy comparisons to be profitable project with the cost of capital in the implementation of investment projects (Afonso & Cunha, 2009) However, the drawback of this approach is not focused on the scale of the project Because these projects are often small proportion of higher interest rates lead to higher IRR than large projects (Sangster, 1993) But in reality, the cash flow of each project is evaluated differently In particular, the project may not have or have multiple IRR (CFA, 2013) In such cases, the evaluation and selection project will encounter some difficulties 15 The table 1.1 below describes NPV and IRR of project A, B, and C The table 1.2 describes the formulas of calculation NPV and IRR of project A, B, and C by using Excel Table 1.1: NPV and IRR of project A, B, and C A B C Project Outflow ($200,000) ($230,000) ($180,000) End year 80,000 100,000 55,000 End year 70,000 70,000 65,000 End year 65,000 50,000 95,000 End year 60,000 50,000 108,000 End year 65,000 65,000 18% Cost of capital (rate) NPV $14,398.27 ($8,769.70) $22,726.52 IRR 21.886% 15.754% 24.580% Source: Calculation of author Table 1.2: Formulas of calculation NPV and IRR of project A, B, and C A B C Project Outflow -200000 -230000 -180000 End year 80000 100000 55000 End year 70000 70000 65000 End year 65000 50000 95000 End year 60000 50000 108000 End year 65000 65000 Cost of 0.18 capital (rate) NPV =NPV($B$9,B3,B4:B8) =NPV($B$9,D3,D4:D8) =NPV($B$9,F3,F4:F8) IRR =IRR(B3:B8) =IRR(D3:D8) =IRR(F3:F8) Source: Calculation of author Critically analyse investment appraisal techniques Typically, the NPV and IRR of the investment projects often result in investors alike However, sometimes there will be cases occurred between NPV and IRR conflict For example, in a project, the NPV of the project a higher NPV of Project B of the project but IRR is higher than project B A In that case, if financial managers had to choose one of two projects, which should company According to the CFA (2013), NPV will always be the first choice for selection of investment projects For projects with a positive NPV is higher, the project should be considered first This could explain that, 16 NPV shows "the amount of gain or wealth increase" (CFA, 2013) Meanwhile, just give the IRR rate of return for a short period of time CONCLUSION AND RECOMMENDATION The essay compares and contrasts two popular investment appraisal techniques for financial managers consisting of Net Present Value and Interest Rate of Return Even both techniques are quite complicated; they are preferred because of their accuracy Moreover, net present value is strongly preferred than interest rate of return because it reflects the amount of gain of the project meanwhile interest rate of return lack of accuracy for scale of investment However, financial manager should consider which techniques are suitable for which projects basing on many factors such as macroeconomic, scale of the project, the purpose of project to make the best decision with maximize benefit 17 REFERENCES Afonso, P & Cunha, J., 2009 DETERMINANTS OF THE USE OF CAPITAL INVESTMENT APPRAISAL METHODS: EVIDENCE FROM THE FIELD, Prague, Czech Republic: European Applied Business Research Conference Akalu, M., 2001 Re-examining project appraisal and control: developing a focus on wealth creation International Journal of Project Management, Volume 19, pp 375383 Akalu, M., 2003 The process of investment appraisal: the experience of 10 large British and Dutch companies International Journal of Project Management, Volume 21, pp 355-362 CFA, 2013 Corporate finance and portfolio management 8th ed USA: Jonh Wiley & Son, Inc Damodaran, 2001 Corporate Finance: Theory and Practice 2nd ed s.l.:Corporate Finance: Theory and Practice Röhrich, M., 2007 Fundamentals of Investment Appraisal: An Illustration Based on a Case Study Deutschen: Oldenbourg Sangster, A., 1993 Capital investment appraisal techniques: a survey of current usage Journal of Business Finance & Accounting, 20(3), pp 307-332 18 ... 100,000 55 ,000 End year 70,000 70,000 65, 000 End year 65, 000 50 ,000 95, 000 End year 60,000 50 ,000 108,000 End year 65, 000 65, 000 18% Cost of capital (rate) NPV $14,398.27 ($8,769.70) $22,726 .52 IRR... -180000 End year 80000 100000 55 000 End year 70000 70000 650 00 End year 650 00 50 000 950 00 End year 60000 50 000 108000 End year 650 00 650 00 Cost of 0.18 capital (rate) NPV =NPV($B$9,B3,B4:B8) =NPV($B$9,D3,D4:D8)... 21.886% 15. 754 % 24 .58 0% Source: Calculation of author Table 1.2: Formulas of calculation NPV and IRR of project A, B, and C A B C Project Outflow -200000 -230000 -180000 End year 80000 100000 55 000