Finance and Growth Strategies - Assignment Example

? Finance and growth strategies Introduction Dividends are returns which are paid to the shareholders from thefirm’s earnings for their investment in the company regardless of whether the earnings are generated in previous period or the current period (Copeland and Weston 1988). Dividends will influence the capital structure of the firm since retained earnings increase the value of the common stock than debt capital. A firm cannot assume the dividend policy to be irrelevant. In determining the amount to be paid as dividends, the firm should analyze the effect of the dividend policy on the operations of the firm (Copeland and Weston 1988). However, some financial analysts are of the opinion that dividend policy is irrelevant since it does not change the value of the firm. Investors can adjust the investment portfolios when if their preference is a steady source of income hence they can invest in bonds where the interest payments are certain rather than investing in common stocks where the dividend payments fluctuate (Copeland and Weston 1988). Another argument of the opponents of dividend payment is that taxation of dividends is higher hence capital gains are more preferable by investors (Damodaran 1997). They propose that the firm should reinvest the earnings which will ultimately increase the value of the firm hence increasing the share value. The firm should utilize its earnings in undertaking more investment projects, repurchasing the common stock and acquiring more profitable companies thus increasing the market value of the common stock (Damodaran 1997). Question one: Practical considerations which are likely to influence a firm’s Dividend policy Dividend decisions are important in the corporate financial policy since they determine the availability and the cost of capital. In making the dividend policy, the firm is faced by the question of how much to pay as dividends. Dividends can be paid from previous or the current earnings of the firm. The amount which is not paid as dividends is referred as retained earnings hence it can be used for other investment opportunities (Copeland and Weston 1988). The board of directors of the firm also determines the method of payment of the dividends hence they can be paid as either cash dividends or bonus shares. The firm is also supposed to make a decision on the timing of the payment of the dividends whereby interim and final dividends can be paid from the earnings of the firm (Khan 2004). The board of directors is supposed to make a decision on the amount to pay where a constant dividend pay out ratio or fluctuating dividend pay out ratio may be implemented by the firm. The firm may also adopt a residual policy on the payment of dividends. The dividend policy has to take in to account several practical considerations which include the following (Khan 2004). Long term financing decision The dividend policy can be termed as a financing decision when retained earnings are considered as cheap source of finance. The dividend policy should consider the investment opportunities which are available (Khan 2004). If the firm ahs viable investment opportunities which exist, the dividend policy which is adopted should be residual dividend decision where dividends are paid only after enough funds have been allocated to the viable investment opportunities (Khan 2004). Retained earnings are a cheaper source of funds since they do not involve the floatation costs. Payment of cash dividends would reduce the funds available for the long term financing decisions when the firm may not have other sources of finance (Harold 2009). In this case, the firm may decide to pay bonus shares as dividends to the stockholders and invest the retained earnings in other profitable opportunities since the share value of the stocks increase with the increase in the value of the firm (Harold 2009). Financial needs of the firm Retained earnings of the firm are cheaper source of finance for reinvestment purposes. If the internal rate of return of the firm is greater than the return required by the stockholders, it is more prudent for the management to reinvest the earnings of the firm than acquire debt finance (Harold 2009). The financial risk and debt obligation will increase if the firm issues additional debt capital to fiance its operations (Brigham and Gapenski 1990). Growth stage of the firm Mature companies will have been in operation for while may have enough retained earnings to finance their investment opportunities (Harold 2009). Such companies have stable profitability hence can afford to pay high dividends. Companies at the maturity stage have few investment opportunities hence the management can decide to implement a constant dividend pay out ratio which is high (Khan 2004). The share prices of such profitable and mature firms are sensitive to fluctuating dividend policy. If the firm is at the growth stage, a high proportion of the earnings should be retained for emergency financial needs and reinvestment (Brigham and Gapenski 1990). The companies at the growth stage should retain their earnings and declare bonus issues as dividends. Access to capital markets The dividend policy should consider the ability of the firms to access the capital markets for future financing (Harold 2009). Large and profitable firms have more access to the capital markets hence can afford to pay high cash dividends. If the firm has limited access to the capital markets, it should withhold the payment of cash dividends and use the retained earnings for investment purposes (Harold 2009). Legal constrains on dividend payments According to the companies act, the payment of dividends is made from the previous or the current earnings of the firm. If the firm is insolvent, some jurisdictions prohibit the payment of cash dividends by the firm. Some countries also prohibit the payment of dividends from capital profits (Harold 2009). Liquidity position of the firm Payment of cash dividends involves the outflow of cash which may not be available (Harold 2009). The ability to pay cash dividends will depend on the cash position of the firm hence where available funds are not enough to finance working capital needs the firm may result to issue of bonus stocks as dividends (Harold 2009). Preferences of stockholders Stock holders preference for dividends is determined by their tax position. A dividend distribution tax which is levied on the companies must be borne by the shareholders receiving the dividends (Harold 2009). Wealthy individuals and institutional shareholders prefer capital gains since they seek to avoid the payment of taxes on the cash dividends. Small shareholders on the other hand prefer regular cash dividends since they use them as their source of income (Harold 2009). Wealthy shareholders also prefer bonus issues than cash dividends hence the dividend policy should consider the composition of the shareholders and their preferences for dividends (Harold 2009). Stability of dividends The management should consider the stability of dividends in their dividend policy. The firm may choose a constant dividend per share policy irrespective of the fluctuations of the earnings of the firm (Harold 2009). Companies may follow a policy of paying a fixed amount of dividend per share as dividends every period. Such companies should create a dividend equalization reserve fund by keeping marketable securities which can be liquidated for paying dividends when the earnings of the firm dip. This policy would be preferred by shareholders who depend on dividend income for consumption purposes (Harold 2009). Constant dividend pay out ratio Some firms may establish a constant percentage of the net earnings of the firm which is dedicated to the payment of dividends (Harold 2009). According to this policy, the amount of dividends fluctuates in proportion with the changes in earnings of the firm. If the firm makes losses, no dividends would be paid according to the policy. The policy is conservative since it avoids underpayment or overpayment of dividends (Harold 2009). Constant dividend per share plus extra dividends In this policy, a constant dividend per share is set out irrespective of the earnings level of the firm. An extra dividend per share is usually paid in times of prosperity hence creating a flexibility of receiving higher dividends when the earnings of the firm are high (Brealey and Myers 2003). Method of dividend payment Dividends can be paid in different forms. Cash dividends are usually paid when the firm has enough liquid assets though the working capital and net worth of the firm is reduced when cash dividends are distributed (Harold 2009). The firm may also decide to distribute stock dividends (bonus shares) which are done proportionately to the respective shareholding of the firm thus retaining the ownership of the company (Harold 2009). By issuing stock dividends, the firm will increase the share capital but reduce the retained earnings hence the net worth of the firm remains constant. Shareholders benefit from the tax advantages of the firm while the firm will conserve cash (Brealey and Myers 2003). The dividend decision of the firm is relevant. According to the Gordon growth model, the market value of the firm is determined by the dividend policy. The model assumes a constant internal rate of return (r), a constant discount rate (k), constant dividend growth rate and absence of debt finance. The discount rate is also assumed to be greater than the growth rate (ke>br). The firm is assumed to have perpetual life where rational investors seek certain returns. Investors would pay higher prices for shares if dividends are paid and would discount the share prices if the dividends are not paid. The discount rate depends on the retention ratio. The formula is outlined as follows: Ve = do (1 + g) Ke – g Where Ve = market price of share (ex-dividend) do = current dividend g = constant annual dividend growth rate Ke = cost of equity (expected rate of return) Suppose that Lexus ltd which listed in the stock exchange have an expected rate of return of capital of 15 %. Annual dividend growth rate is 2% while the shares current market price after dividends of 20% per annum is $ 10. Assume retained earnings are $ 1,000,000. The dividends distributed would be (20% * 1,000,000) which is $ 200,000. The value of the firm would be; 200,000 (1+ 0.02) 0.15 – 0.02 The value of the firm is $ 1,569,230.77 while the value per share would be (1,569,230.77/ 100,000) which is $ 15.69. From the above example, the dividend policy of the firm is relevant since when the internal rate of return is greater than discount rate the price of the share increases. Question two: main practical considerations which are likely to influence a Firm’s capital structure The capital structure of the firm refers to the sources of funds which the firm uses to finance its assets. It includes the combination of equity, debt and other marketable securities. The capital structure of the firm would be irrelevant in perfect markets but imperfections which exist in the modern capital markets make the capital structure decision relevant (Harold 2009). An optimum capital structure is achieved when the market value of the share is maximized and the cost of capital minimized. An appropriate capital structure should consider the profitability of the firm, the flexibility of the financing and the control of the firm (Brealey and Myers 2003). The capital structure should consider the solvency of the firm and the gearing level. The capital structure should also consider the tax benefits of debt capital, the legal requirements and the agency costs involved in raising the required capital (Brealey and Myers 2003). Unlike the financial structure which includes short term debts, the capital structure of the firm is long term and includes long term debt, common stock and preferred stock and the retained earnings (Brealey and Myers 2003). Management attitude The management attitude towards the control of the firm and risk may influence the decision on whether to acquire debt capital or not. Every addition of equity capital presents the management with an opportunity to increase their control of the firm (Brealey and Myers 2003). Asset structure The combination and liquidity of the assets of the firms may influence the capital structure decisions of the firm. Firms with adequate long term assets especially highly marketable assets can pledge the assets as security for debt capital (Brealey and Myers 2003). If the assets of the firm are not liquid enough, the firm may not be able to access debt financing from the capital markets (Brealey and Myers 2003). Debt tax shield According to Modigliani and Miller, interest tax shield from the use of debt capital creates strong incentives for firms to increase their leverage. On the other hand, the non-debt related corporate tax shields like capital deductions for depreciation and other investment tax shields can also affect the leverage of the firm (Harold 2009). It may be argued that non-debt related tax shields can be substitutes for tax shields of debt financing but firms still have the incentive to increase debt capital in order to benefit from the interest tax shields (Harold 2009). Profitability of the firm According to the Pecking order theory, firms display a pecking-order in their capital structure decisions. This theory postulates that firms prefer to use internal financing than external financing (Brealey and Myers 2003). If external finance is to be used, the firm will issue debt capital first then a hybrid security like convertible bonds then any extra financing will be sourced from equity as the last option (Harold 2009). This pecking-order can be explained by the transaction costs involved in the issue of equity hence more profitable firms will use lower leverage since they have enough reserves of retained earnings (Harold 2009). Projected growth rate of the firm The growth prospects of the firm can determine the capital structure decisions of the firm. If the firm is certain of high future growth, it can increase the leverage since it will be able to generate enough profits to cater for the interest repayments (Harold 2009). If the firm is uncertain about the future growth rate, the management will prefer to use internal financing like the retained earnings or issue equity capital where dividend payment is not a legal obligation (Khan 2004). The size of the firm The relationship between the capital structure and the size of the firm may not be quite clear but large firms are able to access debt financing in the capital markets at a lower cost than small companies (Khan 2004). Small firms face a high probability of bankruptcy since they are not well diversified in their investment portfolios. Large firms also provide more information to outside investors hence can easily access debt financing at cheaper costs than the small firms (Khan 2004). Inflation and general economic conditions The existing economic climate may determine the ability of the firm to use different sources of capital. Under conditions of high inflation, the firm will avoid using debt capital since inflation creates uncertainty in planning and projecting the future profitability of the firm (Brealey and Myers 2003). Under conditions of boom, the firm may increase the leverage since it is guaranteed of higher returns which can be able to repay the interest charges. Other external factors like the level of capital markets activity and state regulations may impact on the capital structure decisions of the firm (Weston and Copeland 1989). If the interest rates are expected to decline, the management of the firm may postpone acquisition of debt in order to take advantage of cheaper source of debt in future at the reduced interest rates (Brealey and Myers 2003). Control In deciding on the optimal capital structure of the firm, the management should consider the desire of the shareholders to maintain the ownership and control of the firm. Some shareholders may not want to lose ownership of the firm hence the firm may not be able to access further equity financing without altering the shareholders ownership in the firm. Such companies prefer debt capital than equity finance (Weston and Copeland 1989). Business risk The income variability of the firm may determine the capital structure of the company. Firms with high income variability have a higher risk of bankruptcy hence have lower leverage since they may not be able to access debt financing from the capital markets due to their high business risk (Brealey and Myers 2003). Conclusion Due to market uncertainty, stockholders prefer dividends than capital gains. Payment of high dividends increases the value of the firm. When the firm decides to increase the retention ratio to undertake investment opportunities, the dividend payments declines as so is the value of the firm hence a balance between dividend payment and retention should be established. Reinvestment of the retained earnings will increase the future earnings per share. The management of the firm should establish optimum dividend policy so as to ensure the achievement of the wealth maximization objective of the stockholders. In deciding the optimal capital structure, the management should consider the business risk and the desire by the shareholders to maintain ownership and control of the firm. The firm should also consider the general economic conditions prevailing in the market since they impact on the profitability of the firm. Debt tax shield increases the incentive of management to acquire more debt capital. The asset structure can also determine the optimal capital structure since debt financiers require liquid assets as collateral for their debt. Bibliography: Brealey, R and Myers, S. 2003. Principles of corporate finance. New York. McGraw- Hill. Brigham, E and Gapenski, L. 1990. Intermediate financial management. Chicago. Dryden Press. Copeland, T and Weston, J. 1988. Financial theory and corporate policy. New York. Addison-Wesley Publishing. Damodaran, A. 1997. Corporate finance: theory and practice. New Jersey. Cengage Learning. Harold, K.B. 2009. Dividends and dividend policy. New York. Routledge. Khan, M.Y. 2004. Financial management: text, problems and cases. New York. Routledge. Weston, F and Copeland, T. 1989. Managerial finance. Chicago. Dryden Press. Read More