Capital Structure and Dividend Policy Theory - Essay Example

Capital Structure and Dividend Policy Theory Introduction Capital structure of the firm is defined as the manner in which a company would seek to finance its assets by using a combination of equity and debt or/and some hybrid securities. It's a long term effort to keep the company going (www.investorwords.com). A company's capital structure is determined by the manner in which it combines its assets such as between equity capital and debt capital. If the company issues 90% debt and 10% equity by way of ordinary shares then its capital structure is 90% financed by debt and 10% financed by equity. Weighted average cost of capital (WACC) is a measure used to calculate the amount of debt that a firm holds against the amount of equity. However it's much better to put it this way it's a measure of the amount of debt that a firm should hold against the amount of equity. Thus capital structure of the firm is basically determined by the WACC and the formula given below explains how it's calculated. [Rd x D/V x (1-5)] + [Re x E/V] Rd = Bond's yield up to maturity; D = Market Value of Bonds; (1 - t) = 1 - tax rate = Deductible tax shield of interest expenditure; Re = Shareholder's return requirement; and V = Total value of (Debt + Equity). Analysis The capital market structure of the firm can be examined with reference to a number of theories. The Modigliani-Miller Theorem is the earliest of such theories to consider the relevance of capital structure to determine the value of a firm. In recent times these theoretical constructs have been developed in line with an ever increasing tendency to consider the leverage issue of the company. Leveraging by managers to achieve exclusive personal goals is nothing new. In fact it's the conflict of interests between the principals or owners (or shareholders) and the agents (or managers) that has thrust the issue of leverage to the fore. In other words the complex issues revolving around capital structure of the firm are basically influenced by this conflict in which managers tend to have more information about the probable outcomes of future investments than shareholders (Abor, 2005). Thus this information asymmetry leads to a series of other problems. 1. Sainsbury's For instance Sainsbury's being a retailer basically having a huge presence in the UK, has been described as one of the least leveraged firms with 1.6 billion in debt capital and 8.4 billion in equity. Its total capital value has been estimated at 10 billion (www.j-sainsbury.co.uk). The dividend payout for the financial year 2007/08 was 12.0p per share. Sainsbury's retails sales made profits of 543m on sales of 20.4 billion in 2009 (ending May). This shows an 11% rise over the previous year. Dividend cover is calculated by suing the formula (after tax profits/total dividend paid out). For example if a company made an after tax profit of 75 million and paid out 25 million in dividends in the same period, then (75 m/25 m) 3 is a better dividend cover. Any dividend cover less than 1.5 is considered to be a sign of future trouble for shareholders because there is more likely to be a cut in dividends. In fact Sainsbury's dividend cover for the three years - 2006, 2007 and 2008 - was 1.3, 1.5 and 1.63 respectively (Friedrich, 2007). This demonstrates that Sainsbury's is having a difficult time because of its lower leveraged position in the capital/financial markets. Though the company has been making efforts to keep the dividend cover between 1.5 and 1.75, right now its dividend cover is coming down due to the lower leverage. The company has been advised to increase its debt capital by borrowing in financial markets against debentures and bonds rather than issuing ordinary shares. This is where the agency problem plays a pivotal role. Theoretically agency problem arises when managers (agents) have more information about investment related outcomes as against shareholders or owners (principals). This principal agent problem is very strongly seen at Sainsbury's. 2. Easyjet The debt ratio of Easyjet in 2006 was calculated to be 53.72%. This means that its total debt divided by total assets and multiplied by 100 stood at 53.72 percentage points. In other words its equity capital percentage in 2006 stood at 46.28% of the total assets (www.easyjet.com). In comparison to Sainsbury's Easyjet has been performing well in the stock market. However its debt capital ratio has been falling rapidly over the years. Right now its position is no better than Sainsbury's because its inability to raise debt against equity is so stronger. In 2006 Easyjet made profits equivalent to 94.1 million after tax per seat and it represents an increase by 59.4% in comparison to 2005. The profits after tax have been calculated on the basis of price paid to the seat by passengers after deducting government taxes, i.e. Air Passenger Duty and VAT. In the financial year 2006 Easyjet paid a total tax charge of 35.1 million. In fact it has just begun to review its dividend non-payment policy ever since it was launched in 1995. Thus there is nothing left to discuss about Easyjet's dividend cover. Its founder Stelios has been engaged in discussions with the Board of Directors for dividend payment though there are not yet conclusive agreements over the issue (Frankfurter, 2003). 3. WH Smith WH Smith PLC is listed on the London Stock Exchange (LSE) and is a constituent company in the FTSE 250. As one of the UK's leading retailer chains WH Smith has been operating in high streets, at airports, train stations, on motorways and at hospitals. It has been described as one of the highest leveraged firms with 303 million debt capital and 161 million in equity (www.whsmithplc.co.uk). In 2008 the company incurred a total capital expenditure equal to 39 million. Thus it made a profit before taxation of 76 million in 2008 and this represented an increase by 15% compared to 2007. In 2008 WH Smith's retail sales amounted to 1352 and the company earned profits of 59 million after tax. Its sales rose by 10% in comparison to the previous year especially driven by progress in business developments and acquisitions. The dividend payout for the financial year 2007/08 was 9.7p per share and it is an increase of 20% according to the previous year. WH Smith aims to improve the profitability and cash flow generation through delivery of sustainable returns and also increase dividend payment to shareholders. For example in 2008 WH Smith made an after tax profit of 59 million and paid out 78 million in dividends in the same period. Thus (59 m/78 m) 0.76 is not a better dividend cover. In fact WH Smith's dividend cover for the three years - 2006, 2007 and 2008 - was 2.72, 2.73 and 0.76 respectively. Therefore it's essential now to discuss the various theoretical underpinnings of the optimal capital structure in order to determine how efficiently the capital market would be able to function in the absence of the shortcomings such as bankruptcy costs and information asymmetry. In addition to the Modigliani-Miller Theorem of the optimal capital structure, there are some highly influential theories. With the help of them it's possible to discuss how best an efficient capital market can be brought into existence (or not) thus rendering both capital structure and dividend policy of the firm irrelevant (Abdelsalam, 2008). However the extent to which those capital market imperfections can be overcome would determine the degree of perfection of the capital market in a given situation. 1. Modigliani-Miller Theorem Modigliani-Miller Theorem (M&M) occupies a very important place in the determination of relevance or irrelevance of capital structure in the determination of the value of the firm (Modigliani, & Miller, 1963). Therefore it's equally important in examining the efficiency of capital markets. According to M&M the value of a firm depends on its capacity to earn and distribute profits among its shareholders along with the associated risk of assets. In other words the value of the firm has nothing to do with the way in which it makes its investments and distributes dividends. The firm might adopt one or more of the following methods to finance its assets. After all M&M says that it is irrelevant how the firm finances its assets whether by issuing equity or raising debt. Even the dividend policy does not matter. If there were no dividend policy at all still it would be irrelevant. In short M&M is also known as "capital structure irrelevance theorem". Therefore it's essential to consider the very basis of M&M in the backdrop of an evolving theoretical framework on the subject and delineate the connected arguments on the relative efficiency of the capital market. The following diagram (Figure 1) shows how bankruptcy theory associated with M&M would impact on the capital structure of the firm (Chun, 1993). The firm might borrow and invest, it can issue shares or/and it can reinvest money from its reserves. Whatever it does, its freedom to choose between choices is limited by the very structure of capital. In other words the leverage decisions might interfere with its freedom to have more of one and less of the other even if it were desirable. Despite this limitation according to M&M there is no need for the firm to have a dividend policy (Modigliani, & Miller, 1958). Above all M&M seeks to prove its validity through an example of two firms, one adopting a leverage policy in which the firm borrows money partially (debt) and finances its assets and another adopting an unlevered approach in which it finances its assets only through equity. M&M comes to the conclusion that the value of both the firms would remain the same. Jensen and Meckling (1976) however question the credibility of M&M's assumption that individual firms make their investment decisions with no regard to capital structure. They cite the asset substitution effect as the basis on which such conclusions cannot be warranted. In other words equity-holders of levered firms can benefit at the expense of debt-holders through manipulating risk when investments have been made. As the above diagram illustrates the actual value of the firm declines as the optimal amount of debt is surpassed at D1. The value of the firm without leverage (Vu) is shown by the flat horizontal arrow. Value of the firm with leverage (VL) is shown by the extended blue arrow and its total value is depicted by taxes, debt and a residual value. For example if an individual investor considers buying shares of the unlevered firm, Vu and thus matches his borrowings to the borrowings of the levered firm, VL, then the returns of both the firms must be the same. As a result the value of the levered firm must be the same as the value of the unlevered firm minus the debt that the levered firm borrows in order to finance its assets. However in this example there are no taxes (Harris, & Raviv, 1991). In the real world, taxes do exist. Therefore it's better to consider an example with taxes. This is illustrated by the above diagram with present value of a tax shield on debt. Thus according to theoretical and conceptual underpinnings Sainsbury's actual firm value is on the left side of the curve because it has been increasing its capital equity while debt equity has been scaled down. Thus actual firm value of Easyjet is on the middle of the curve while the WH Smith is on the right side of the actual firm value curve (Miller, & Rock, 1985). The levered firm stands to gain by way of tax deductions, i.e. it is entitled to compensation of interest related expenses. This means leveraging would help the firm to pay less taxes than those unlevered firms (Lightner, 2008). However looking at Sainsbury's capital structure and dividend policy it's clear that the company has failed to optimize its debt/equity ratio while having a positive link between gearing and cost of capital. Sainsbury's performance related drawbacks in previous years have increased its debt level up to a considerable amount. However debt has been raised to finance operations and not to buy assets. Sainsbury has been making good efforts to consolidate its debt position in the coming years though to ensure stability in the capital structure of the company. On the other hand Easyjet is functioning well in comparison to the Sainsbury's drawback of the business. However when the dividend policy of Easyjet is looked at it's clear that a dividend non-payment policy has been in existence ever since the company was launched in 1995. Now it has been proposed to pay dividends to shareholders form 2011 though. Finally WH Smith is a highly cash-flow generating business and according to the latest news the company is announcing the payment of returns up to 35million to its shareholders. In addition there will be a proposed final dividend increase of 16%. Further the company continues to invest in the business where it will add value to shareholders' equity. 2. Trade-off theory Trade-off theory is not against the existence of bankruptcy costs. The theory supports debt-financing of assets rather than equity-financing because of the associated tax benefits. The theory goes onto add the disadvantages also. Its origin of the existence of bankruptcy costs entails more of a burden in times of failure because bankruptcy would further encumber the firm with debt. Further there are non-bankruptcy costs also such as trained staff leaving the company and demanding favorable settlement packages (Kraus, & Litzenberger, 1973). Above all such costs would compel the firm to increase its debt. Thus the marginal benefit associated with original debt-financing would diminish and turn into a marginal cost. So the theory essentially focuses on the trade-off between equity and debt. However according to the Trade-Off Theory of capital structure Sainsbury has been chosen debt financing option rather than equity financing thus lower leveraging its operations. This in turn has decreased risk but has had a negative impact on the company's long term profitability. Similarly ass the above cited figures show Easyjet's debt capital ratio has been falling rapidly over the years and its performance is no better than Sainsbury's because of its inability to raise debt against equity has obviously hampered moves to reposition itself on the air travel market in Europe. There is an advantage in debt financing for Easyjet Company because of the tax benefits of debt (Jones, 2007). However there is a cost of financing with debt, including bankruptcy costs of debt and non-bankruptcy costs such as staff leaving and suppliers demanding disadvantageous payment terms and so on. On the other hand WH Smith can be considered to be more leveraged. Despite the advantages of debt, it carries a high risk. But the interest rates will rise with the economic changes which mean better times for the WH Smith (Marks, 2005). 3. Pecking order theory Pecking order theory was developed in response to the relatively weaker arguments of Trade-off theory by Myers and Majluf (1984) and simply states that managers choose their financing sources according to the inherent rule of least effort in which equity-financing is carried out only as a last resort, i.e. after exhausting every possibility of raising debt. Thus according to Myers and Majluf the firm goes by priorities - first, it uses internal reserves, then debt and finally equity capital (Damodaran, 1997). Thus debt financing is a major issue at Easyjet compared to the Sainsbury because cash flow related constraints on deposits for the purchase of aircraft and long-term bank loans may indicate financing problems. However it all depends on an examination of the deal in terms of impact on the company's capital structure (gearing) and cash flow projections. Given the fact that banks are increasingly reluctant to lend for long term projects against the backdrop of the current economic downturn, Easyjet would have problems. In contrast to Trade-off theory, Pecking order theory has a clear advantage in that it adequately captures the negative relationship between the firm's profitability and debt. According to Pecking order theory this proposition has a number of other advantages. In the first instance, firms attempt to match their ratios of target dividend payment with their investment plans (Nissam, & Ziv, 2001). Secondly such sticky dividend pay-out policies would ensure a constant positive cash flow despite unpredictable profit margins and erratic changes in investment opportunities. Conclusion Capital structure of the firm refers o the ratio of debt to equity and therefore it's relevant to know how the dividend policy of the firm is influenced by the theoretical underpinnings of the firm's capital structure determination process. For example Sainsbury's as retailer in the UK has been seeking to raise more equity as against debt. Next its inability to increase dividend cover in the recent years to match with its expectations between 1.50 to 1.75 shows that the company has depended on the less risky way of equity financing its capital rather than adopting the riskier way of debt financing. Thus the dividend policy at Sainsbury has run into difficulty. On the other hand Easyjet has adopted a policy of non-payment of dividends to its ordinary shareholders since its launch in 1995. Just now under pressure from its principal shareholder, Stelios, the Board has agreed to pay dividends form next year. Currently the company has a debt ratio of 53.72% thus achieving a marginally higher debt financing ratio. However its position is no better than that of Sainsbury though the company has made good profits. Its long term commitments to purchase aircraft have been increasing despite the fact that there is an excess capacity even on its short haul flights. Thus its capital structure needs to be more debt-financed than equity-financed. Finally currently WH Smith is the highest leveraged company out of the three. Almost 70% of its capital is debt-financed. This shows that the company has taken on more risk but probably with a view to increasing the value of the firm. Thus M&M theorem has better promise for WH Smith. Number of words: 3000 REFERENCES 1. Abdelsalam, O 2008, 'Board composition, ownership structure and dividend policies in an emerging market: Further evidence from CASE 50, Managerial Finance, vol.34, no.12, pp. 953-964. 2. Abor, J 2005, 'The effect of capital structure on profitability: an empirical analysis of listed firms in Ghana,' The Journal of Risk Finance, vol.6, no.5, pp. 438-445. 3. Capital Structure Definition, Retrieved from www.investorwords.com on February 08, 2010. 4. Chun, C 1993, 'Payout Policy, Capital Structure, and Compensation Contracts When Managers Value Control', Review of Financial Studies, vol.6, no.4, pp.911-933. 5. Damodaran, A 1997, Corporate Finance: Theory and Practice, John Wiley & Sons, Inc, New York. 6. Easy jet Financial Report 2006, Retrieved from www.easyjet.com on February 08, 2010. 7. Friedrich, B 2007, The Theory of Capital Structure: How theory meets practice in the German market, Book Surge Publishing, South Carolina. 8. Frankfurter, G 2003, Dividend Policy: Theory and Practice Academic, Press, California. 9. Harris, M & Raviv, A 1991, 'The theory of capital structure', Journal of Finance, vol. 46, pp.297-355. 10. 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Modigliani, F & Miller, MH 1963, Corporate income taxes and the cost of capital: a correction, American Economic Review, Vol. 53, pp. 433-443. 17. Miller, M & Rock, K 1985, 'Dividend Policy under Asymmetric Information,' Journal of Finance, vol. 40, pp.1031-1051. 18. Myers, S & Majluf, N 1984, Corporate financing and investment decisions when firms have information that investors do not have, Journal of Financial Economics, vol.13, pp.187-222. 19. Nissam, D & Ziv, A 2001, 'Dividend Changes and Future Profitability', Journal of Finance, vol.56, pp.2111-2133. 20. Sainsbury Financial Report 2009, Retrieved From, www.j-sainsbury.co.uk on February 08, 2010. 21. WH Smith Annual Report 2009, Retrieved from, www.whsmithplc.co.uk on February 08, 2010. APPENDICES 1. EASY JET Easy Jet PLC Year ended 30 September 2007/2008 Income Statement Year ended Year ended 30 September 2008 30 September 2007 million million Notes Passenger revenue 1,995.7 1,626.0 Ancillary revenue 367.1 171.2 Total revenue 2,362.8 1,797.2 Ground handling charges (212.2) (156.1) Airport charges (397.2) (305.8) Fuel (708.7) (425.5) Navigation charges (195.7) (141.8) Crew costs (263.2) (204.1) Maintenance (147.5) (98.1) Advertising (46.5) (38.0) Merchant fees and commissions (33.7) (20.6) Aircraft and passenger insurance (9.1) (12.1) Other costs (87.5) (96.9) GB Airways integration costs (12.9) _ EBITDAR 248.6 298.2 Depreciation (44.4) (33.3) Amortisation of other intangible assets (2.5) (0.9) Aircraft dry lease costs (110.7) (91.0) Aircraft long-term wet lease costs - (1.0) Operating profit 91.0 172.0 Interest receivable and other 53.2 54.6 Financing income Reversal of prior year impairment - 10.6 losses on financial assets Interest payable and (34.0) (35.4) other financing charges Net finance income 19.2 29.8 Share of profit of associate - 0.1 Profit before tax 110.2 201.9 Tax (27.0) (49.6) Profit for the year 83.2 152.3 Earnings per share, pence Basic 19.8 36.6 Diluted 19.4 35.6 Source: www.easyjet.com Easy Jet PLC As At 30 September 2007/2008 Balance Sheet 30 September 2008 30 September 2007 million million Non-current assets Goodwill 359.8 309.6 Other intangible assets 80.6 1.8 Property, plant and equipment 1,102.6 935.8 Derivative financial instruments 21.3 - Loan notes - The Airline 12.0 11.1 Group Limited Restricted cash 42.9 32.9 Other non-current assets 61.1 58.1 Investments in associates - 0.3 Deferred tax assets 0.5 0.4 1,680.8 1,350.0 Current assets Assets held for sale 195.8 - Trade and other receivables 236.9 223.6 Derivative financial 96.5 14.4 instruments Restricted cash 23.3 15.9 Money market deposits 230.3 193.4 Cash and cash equivalents 632.2 719.1 1,415.0 1,166.4 Current liabilities Trade and other payables (653.0) (461.7) Borrowings (56.7) (40.5) Derivative financial instruments (76.0) (26.6) Current tax liabilities (75.1) (89.7) Maintenance provisions (49.0) (2.8) (909.8) (621.3) Net current assets 505.2 545.1 Non-current liabilities Borrowings (570.2) (478.6) Derivative financial (0.3) (6.3) Instruments Other non-current liabilities (68.8) (86.8) Maintenance provisions (160.4) (136.0) Deferred tax liabilities (108.1) (35.0) (907.8) (742.7) Net assets 1,278.2 1,152.4 Shareholders' funds Share capital 105.7 104.8 Share premium 640.2 633.9 Hedging reserve 27.6 (13.7) Translation reserve 0.1 - Retained earnings 504.6 427.4 1,278.2 1,152.4 Source: www.easyjet.com 2. WH Smith PLC WH Smith PLC For the Year ended 31st August 2007/2008 Group income Statement 2008 2007 m m Continuing operations Revenue 1,352 1,299 Operating profit 74 77 Investment income 5 5 Finance costs (3) (6) Profit before tax 76 76 Income tax expense (17) (16) Profit after tax from continuing operations 59 60 Profit for the year 59 60 Earnings per share1 36.4p 34.3p Basic Diluted 35.3p 33.1p Non GAAP measures Underlying earnings per share2 Basic 36.4p 30.3 Diluted 35.3p 29.3 Equity dividends per share3 14.3p 11.8p Fixed charges cover 1.4x 1.4x Source: www.hsmithplc.co.uk WH Smith PLC As At 31st August 2007/2008 Group Balance sheet Group Balance sheet 2008 2007 m m Non-current assets Goodwill 32 15 Other intangible assets 23 20 Property, plant and equipment 177 176 Deferred tax assets 11 15 Trade and other receivables 4 5 247 231 Current assets Inventories 147 141 Trade and other receivables 70 59 Available for sale investments - 4 Derivative financial assets 2 - Cash and cash equivalents 22 82 241 286 Total assets 488 517 Current liabilities Trade and other payables (239) (217) Current tax liabilities (31) (25) Obligations under finance leases (4) (3) Bank overdrafts and other borrowings (25) (9) Short-term provisions (4) (6) Derivative financial liabilities - (1) (303) (261) Non-current liabilities Retirement benefit obligation - - Deferred tax liabilities (10) (12) Long-term provisions (4) (4) Obligations under finance leases (2) (6) Other non-current liabilities (8) (7) (24) (29) Total liabilities (327) (290) Total net assets 161 227 Total equity 161 227 2008 2007 m m Shareholders' equity Called up share capital 35 37 Capital redemption reserve 2 - Revaluation reserve 2 4 ESOP reserve (28) (29) Hedging reserve 2 (1) Translation reserve (2) (2) Other reserve (179) (165) Retained earnings 329 383 Total equity 161 227 Source: www.hsmithplc.co.uk 3. J SAINSBURY PLC J Sainsbury Plc For the Year ended 22 March 2008/2007 Group Income Statement 2008 2007 m m Continuing operations Revenue 17,837 17,151 Cost of sales (16,835) (15,979) Gross profit 1,002 1,172 Administrative expenses (502) (669) Other income 30 17 Operating profit 530 520 Finance income 83 64 Finance costs (132) (107) Share of post-tax loss from joint ventures (2) - Profit before taxation 479 477 Analysed as: Underlying profit before tax 488 380 Profit on sale of properties 7 7 Financing fair value movements (4) 8 One-off items (12) 82 479 477 Income tax expense (150) (153) Profit for the financial year 329 324 Attributable to: Equity holders of the parent 329 325 Minority interests - (1) 329 324 pence pence Earnings per share Basic 19.1 19.2 Diluted 18.6 18.9 Underlying basic 19.6 14.7 Underlying diluted 19.1 14.5 Dividends per share pence pence Interim 3.00 2.40 Proposed final 9.00 7.35 (not recognised as a liability at balance sheet date) Source: www.j-sainsbury.co.uk J Sainsbury Plc As At 22nd March 2008 and 24th March 2007 Balance Sheet Group Group 2008 2007 m m Non-current assets Property, plant and equipment 7,424 7,176 Intangible assets 165 175 Investments in subsidiaries _ _ Investments in joint ventures 148 98 Available-for-sale financial assets 106 137 Other receivables 55 50 Deferred income tax asset - - Retirement benefit asset 495 - 8,393 7,636 Current assets Inventories 681 590 Trade and other receivables 206 197 Derivative financial instruments 30 4 Cash and cash equivalents 719 1,128 1,610 1,915 Non-current assets held for sale 112 25 1,722 1,940 Total assets 10,115 9,576 Current liabilities Trade and other payables (2,280) (2,267) Short-term borrowings (118) (373) Derivative financial instruments (6) (2) Taxes payable (191) (65) Provisions (10) (14) (2,605) (2,721) Net current liabilities (883) (781) Non-current liabilities Other payables (89) (33) Long-term borrowings (2,084) (2,090) Derivative financial instruments (18) (43) Deferred income tax liability (321) (168) Provisions (63) (69) Retirement benefit obligations - (103) (2,575) (2,506) Net assets 4,935 4,349 Equity Called up share capital 499 495 Share premium account 896 857 Capital redemption reserve 680 670 Other reserves 494 143 Retained earnings 2,366 2,184 Total equity 4,935 4,349 Source: www.j-sainsbury.co.uk Read More