Accounting Decision Making Process - Essay Example

Accounting Decision Making Task Introduction This essay comprises three parts. The first part provides the reader’s opinion on what comprise the key concepts presented in the Chapter 4 article on financial statement analysis. In addition, relevant questions regarding some of the issues contained in the article together with subtle ideas, according to the reader’s opinion, are included. The second part (done in excel) is the restatement of Ausdrill’s financial statements (Balance sheet, income statement and statement of changes in equity). The third part includes Ausdrill’s five services, their estimated selling prices, their variable costs and the contribution margin. In addition, an explanation to support the variation in the contribution margin of the five services is provided and possible resource constraints faced by the firm is provided. Part one Firms adopt different dividend policies which are in line with their goals. Dividend payment is preferred by shareholders since that is their source of reward for contributing equity capital. The article states that dividend payment is simply a transfer of value within the firm. That is, the movement of value already owned by the shareholders to shareholders. Therefore, there is no level of dividend payment that contributes to value creation. The statement is true for the reason that dividend payment does not increase the firm’s ability to increase the economic benefits. In other words, a firm cannot increase its cash flow generating ability by paying dividends. However, the payment of cash dividends has a positive impact on the value of a firm (market value). The market value of a firm (market capitalization) is determined by multiplying the outstanding shares of a firm with the current share price. It has been observed that the payment of cash dividends by firms increases the market value of companies. The increase is brought about as follows: when a firm pays cash dividends, more shareholders, who prefer certain payments, are attracted (Frankfurter, Wood & Wansley, 2003, pp. 91). The demand of shares of that company increases, thus increasing the share price. Consequently, the market value of the firm increases. There are two theories of dividend payment which supports the influence of cash dividend on the market value of the firm. That is, the bird-in-hand theory and information signalling dividend payment theory (Hunting & Paulsen 2013). The bird-in-hand, dividend payment theory states that stockholders prefer certainty due to their aversion towards risk. Dividend payments are more assured as compared to the capital gains, which depend on the market forces of demand and supply to influence the share prices. As a result, the bird in hand (the assured dividends) is better than two in the bush (capital gains). Consequently, the value of a firm that pays high dividends is likely to be high. However, Modigliani and Miller provided a contrary argument. They assert that the dividend policy and the required rate of return are independent, thus capital gains, generated from a reinvestment of retained earnings, can be realized by the investors upon selling shares. The investors would be indifferent if the statement is true. As a result, shareholders will scramble for shares of a company that pays cash dividends (Hussainey, Chijoke & Chijoke-Mgbame 2011). Information signalling effect theory states that the underlying concept of the theory states that, the management of a company can use dividend policy to send an important message to the market, which only they know the meaning, in an inefficient market. It is important to note that an inefficient market is characterized by severe cases information asymmetry. For instance, if the management pays high dividend, the message sent to the market is that of a possible high future profits in order to maintain the high dividend payment level (Hunting & Paulsen 2013). Investors who correctly interpret the message would buy more shares of the company. The company’s shares would be in high demand thus increasing the share price. The market value, determined through multiplying the number of shares and the price, would increase. The theory further states that dividend decisions are relevant in an inefficient market and the higher the dividends, the higher the value of the firm. If this is true, is the increase in market value (market capitalization) nothing close to an increase in value referred to in this article? The second concept is the dividend policy. The division of earnings between payment to shareholders and re-investments are determined by the dividend policy implemented in a company. Therefore, dividend policy focuses on the following aspects: how much to pay, when to pay, why dividend payments are made, and how to make the payments. Based on the first aspect (how much to pay), the following are the dividend policies: constant payout ratio, constant amount of each share, constant dividend per share plus a surplus amount, or the residual dividend payment method (Abdelsalam, El-Masry & Elsegini 2008). Constant payout ratio alternative involves the payment of a fixed amount of dividend, usually a fixed portion of the company’s earnings. For instance, a company could decide that 30% of annual earnings is used for dividend payments. Under this method, the amount of dividends paid to the shareholders is directly dependent on the level of the company’s earnings. In addition, if a company makes no profit, the shareholders is paid no dividends. Therefore, this policy creates uncertainty regarding dividend payments, thus has no significant contribution in shareholder value creation (Abdelsalam, El-Masry & Elsegini 2008). A constant amount per share is the second policy used to determine how much to pay. The dividend paid to shareholders is invariable regardless of the earning level of a company. Unlike the above policy, this policy creates a certainty of dividend payments. It, therefore, is the preference of the shareholders with heavy dependence on dividend income. By fixing dividend per share at a lower level, the policy safeguards the company during the seasons of low earnings. In addition, the policy offers the shareholders a preferential treatment by fixing the rate of return. The dividend per share is adjustable and could be increased or reduced depending on the levels and the sustainability of the earnings (Bai, Hunting & Paulsen 2012). Constant dividend per share plus extra involves the payment of a fixed dividend annually. However, shareholders receive occasionally payment of extra dividends when the company makes a supernormal profit. The policy allows for a flexible dividend payment. That is, it allows the company to increase dividend during high profitability seasons. It also gives the shareholders a chance to participate in earning of the supernormal profit. However, the surplus dividends are paid in such a manner that they are not perceived as a constant responsibility of the company. Therefore, the policy is preferable to firms whose earnings are highly volatile (Dhaliwal, Erickson & Trezevant 1999). The residual dividend policy involves the payment of dividends out of the amount of money remaining after investment decisions have been financed. Under this policy, dividends will only be paid if there are no profitable investment opportunities available. Therefore, the policy is said to be in line with the shareholders’ wealth maximization objective (Abdelsalam, El-Masry & Elsegini 2008). Therefore, I agree with the statement in the article mentioning that the amount of dividends paid to equity investors by a firm can be affected by a firm’s dividend policy, which influences the amount of value transferred to shareholders. As a firm invests more in operating assets, it uses more of either the retained earnings or the free cash flow. I concur with the article that the value of the company as determined by the discounted cash flow, in the short-run, will be low. From another point of view, if the firm uses the retained earnings to invest in projects with positive net present value, the dividend policy becomes interrupted in the sense that the firm ceases to pay cash dividends. Based on the two theories of dividend payment discussed above, the strategy to pursue projects with a positive NPV at the expense of paying cash dividend will reduce the market demand of the company’s shares thus, leading to a decline in the share prices. Consequently, the market value of the firm declines (Pratt 2004, pp. 87-92). The third concept is the economic profit. It is true as is asserted in the article that free cash flow is not a good way of measuring a firms value. Based on the illustration from the article (page 3), companies that allocate a small portion of free cash flow for investments end up experiencing higher free cash flow than those companies that heavily invest. That is, the amount free cash flow is easily changed by the level of investments made by a firm. Consequently, the only realistic method of measuring a firm’s economic profit is by determining the earnings above the cost of capital. Based on the formula, (the economic profit should be return on net assets – the cost of capital). However, it is incomprehensible why the formula for economic profit provided by the article is (RNOA – the cost of capital) * NOA. Part two When restating the balance sheet items, I encountered some difficulties. First, I was not sure of whether to categorize the intangible assets as operating or financial assets. Second, the property, plant and equipments presented the same problem. Last, I was indecisive when it came to classifying the long-term deferred tax liability under operating or financial asset. From several discussion meetings I held, most students were of the idea that intangible assets are financial since they significantly influence the firm’s value. However, others suggested that intangible assets are created by the firms operations and thus, should be considered as operating assets. Concerning property, plant and equipment, most students agreed that they fall under operating assets while others objected, stating that they are financial assets since they are traded in the financial markets. Last, long-term deferred tax liability can be used as a source of finance. It is for that reason many students classified it as a financial asset. Others argued that it is for the purpose of the firm’s operations, thus, should be classified under operating assets. Part three Ausdrill is a mining company that offers various services. For the purpose of this essay, the following are five chosen services: exploration drilling, Mineral analysis, Water well drilling, mining supplies and logistics and drill rigs. Under exploration drilling, the company does the following: rotary air blast drilling, air core drilling, reverse circulation, and diamond drilling. Under mineral analysis, the company analyses precious metals and geochemical. Under water well drilling, the company monitors borehole drilling, depressurization and drainage. Under mining supplies and logistics, the company procures and delivers equipments, consumables and parts for exploration. Under drill rigs, the company designs, produces and provide maintenance services for drill rigs made of diamond (Ausdrill 2013). Variable costs are costs that change with the rate of production, whereas, fixed costs are costs that are constant regardless of the level of production. Contribution margin, on the other hand is determined by subtracting the variable costs from the selling price. The estimated selling price of exploration drilling, mineral analysis, water well drilling, mining supplies and logistics and drill rigs in Australian dollar are 800, 200, 650, 3,000,000, and 300 respectively. The estimated variable costs in Australian dollar are 550, 120, 450, 1,800,000, and 190. Therefore, based on the formula for finding the contribution margin, 250, 80, 200, 1,200,000, and 110 respectively, are the values for the services. From the above estimates, it is clear that the contribution margin for each product is different. The difference is due to the following reasons: the difference in the nature of the services, the difference in the cost of equipment used, the difference in the level of skills required to facilitate the delivery of each service, and the amount of resources needed (the amount of energy and time). Therefore, the total cost of offering each service would differ and so will the selling price. Consequently, since the contribution margin is a function of selling price, it will vary with the service. The firm might offer services with varying contribution margin in order to maintain the total contribution margin at a high level when lower contribution margins are offset by high contribution margins. Being a mining company, the following resources are needed in abundance: manpower, equipment, soil structure and finance. However, the company’s operation could be slowed down by lack of enough manpower to operate the mining equipment. Second, there could be lack of equipments to facilitate sophisticated excavation activities. Third, soil structure could be unsupportive of constructing shafts in a mine field. Last, the company could be faced with insufficient funds to facilitate the acquisition of sophisticated equipments. List of References Abdelsalam, O., El-Masry, A. & Elsegini, S. 2008, "Board composition, ownership structure and dividend policies in an emerging market", Managerial Finance, vol. 34, no. 12, pp. 953-964. Ausdrill 2013, Viewed 30 December 2014, http://www.ausdrill.com.au/find-services.html Bai, L., Hunting, M. & Paulsen, J. 2012, "Optimal dividend policies for a class of growth-restricted diffusion processes under transaction costs and solvency constraints", Finance and Stochastics, vol. 16, no. 3, pp. 477-511. Dhaliwal, D.S., Erickson, M. & Trezevant, R. 1999, "A test of the theory of tax clienteles for dividend policies", National Tax Journal, vol. 52, no. 2, pp. 179-194. Frankfurter, G, M., Wood, B, G., & Wansley, J, W 2003, Dividend policy theory and practice, Academic Press San Diego, CA. Hunting, M. & Paulsen, J. 2013, "Optimal dividend policies with transaction costs for a class of jump-diffusion processes", Finance and Stochastics, vol. 17, no. 1, pp. 73-106. Hussainey, K., Chijoke, O.M. & Chijoke-Mgbame, A. 2011, "Dividend policy and share price volatility: UK evidence", The Journal of Risk Finance, vol. 12, no. 1, pp. 57-68. Pratt, S. P 2004, Business Valuation Body of Knowledge Exam Review and Professional Reference, John Wiley & Sons, Hoboken. Read More