Capital Structure and Dividend Policy Theory - Essay Example

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The 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 and some hybrid securities. It's a long-term effort to keep the company going. …
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Capital Structure and Dividend Policy Theory
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Download file to see previous pages 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.
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The 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 the 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 from 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. ...Download file to see next pagesRead More
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