Level of Debt and Dividend Policy of Hoad Limited - Case Study Example

 Level of Debt and Dividend Policy of Hoad Limited Introduction: Firm expansion and technological advancement are important aspects for most firms worldwide. Many firms are usually updating themselves with the new technologies to allow them compete favorably in the market. Demand and supply forces are also usually considered making the firms to decide on the expansion of their manufacturing sectors. On the decision for expansion, some firms are usually faced by financial crisis making them to look for external sources of funds (Aghion, Fally & Scarpetta, 2007). Hoad Limited on decision to expansion faced the same challenge. The Company also had been operating in a country with under-developed stock of exchange. There has been therefore the need to carry out research to look into the ways that the firm can maintain its development to a high level. The research is therefore expected to look into an alternative capital sources for the company and analyze the impacts of dividend policy and level of debt on the value of the firm. The firm having been operating under economy with under-developed stock of exchange limited its goals towards adjustments. Risks diversification opportunities were therefore limited for the company. The company’s investment decision was influenced by high diversification costs, making it to avoid financial market use. The technological adjustment is therefore limited as the company end up choosing production technologies that are less capital intensive subject to short-term risk. The company was therefore unable to adjust up to the latest technologies which were more capital intensive. The under-developed stock exchange market prevents the company from structuring their financial packages optimally (Levine, 2002). Conflicts of interest usually exist between the managers of the firms and its suppliers and customers, and also between different firm investors. Hoad Company if having high debt levels had increased its possibility of bankruptcy sufficiently which may put them into risky projects harming their creditors. The company, if highly leveraged, could be unable to get additional credit due to incentives created by debt financing to the taking of greater risks. Availability of well-developed stock of market exchange would allow for equity issuance. This issuance would mitigate problems of incentives providing room for more borrowing to the company. Stock market has always played an important role in the provision of information. A well-developed stock markets gathers information concerning prospects of companies that had their shares traded availing them to creditors and investors. Through the improvement of information flow concerning companies, a developed stock market contributed to control of corporate leading to high managerial competency. Better control of corporate and company management would in turn promote efficiency and investment (Alfaro, Chanda, Kalemli-Ozcan& Sayek, 2004). Alternative methods of finance Most firms usually operate under limited finance preventing them from achieving their dreams of expansion. Hoad Company faces this challenge with its internal finance sources not enough to allow expansion or technological advancements. However, the solution to this is usually to look for external sources of finance. The company should therefore go for long term sources of finance (Ratha, 2005). The expansion and technological advancements will cost the company billions of pounds due to the complexity of the project. One source of finance is from the shares. The company can decide to give out more shares but there is usually the limitations on which the shares can be sold to, as any issue regarding shares must have the full support of the shareholders that existed. The company will need to undergo various legal and administrative procedures, allowing it to be in a position of offering the general public with shares. Shares offering should be accompanied by prospectus which lays out business details (Ofek & Yermack, 2000). These details give information on the company’s structure, what it deals in and management. The details are important as it allows people who want to buy the company’s shares have information about the company before they buy the shares. The company may employ the help of merchant bank to help with the issue of share, which usually specialize in the arrangement of large financial deals. These institutions usually agree to underwrite the issue of share. Therefore, if all the shares are not bought, there will still be the need of the institutions in providing all the money to the company. The share owners will now be able to buy and sell the shares by way of stock exchange. `Another important source of finance for Hoad Company is venture capital. Venture capitalist entails group of individuals or companies who are set up to investing in companies that are developing. They are usually on the look of companies which are having potentials. They are usually ready to offer capitals to help for the growth of the company. Venture capitalists in return gets some shares in the profits compiled by the company and also have some say in the company’s operation (Hellmann & Puri, 2002). These capitalists are always ready to take on risky projects which the banks are never welcoming. The benefits of this might be outweighed through the probability of the probability of the company losing part of its independence in making decisions. Government grant is another source of capital for Hoad Company expansion. These grants are always available to companies to set up within areas that need economic development. Bank loans can also provide a good source of capital. Banks may decide to lend sums for a longer period of time. These loans usually consist of rates of interest attached to them, which varies according to the ways in which interest rates are set by the banks. For the expansion of the company, using bank loans is an easy way; however, the cost for paying 8interest on top of the money might be high. Rise of interest rates can add to costs of business and this must be considered during in the planning stage before taking out the loan (Cetorelli & Strahan, 2006). Mortgage, a loan specifically for property purchase, can also be used to finance the expansion of the company. The company may decide to buy manufacturing equipments through mortgage. Mortgage is usually used as security for loan in most cases (Duchin, Ozbas & Sensoy, 2010). The company can use its own property as security for loan. If the technological advancement details to work well for the company and the borrowed capital not returned at the right time, the bank would have the right to take away worthy equipment from the company and sell it to recover the loan. The selling of assets is also another way of getting capital for expansion. These assets are usually in form of machinery, other companies, logo, and equipments. In other cases, it may be right for the company to sell some of its assets to finance the upcoming more productive projects. The company may also decide to lease the equipment and payments made under the agreed terms and conditions. Leasing will allow the company to use the equipment and paid the agreed capital from the profits realized from the production. The manufacturing equipment may be leased from the company that carried out the innovation. Leasing also have advantages on the tax system of the country (Beck & Demirguc-Kunt, 2006). The company may also retain the advanced manufacturing equipment on higher purchase. The company will therefore be in a position to posses the equipment on completion of the final credit installment. The company would decide on the best alternative sources of finance on comparing the requirements and conditions of the sources. The company should be certain that the expansion and new technology once achieved would allow them to return the borrowed capital at the agreed time. Impacts of level of debt and dividend policy Dividend policy allows the company to decide the amount of capital it will give out to shareholders in dividends. Dividend policy has formed the issue of interest in financial literature from the time Joint Stock Companies existed. Dividends are referred to as earning distribution among shareholders in real assets to their ownership proportions. Policy of dividend connotes to the policy of payout, which managers look for when coming up with decision on cash distribution size and pattern to shareholders over time (Fan & Sundaresan, 2000). The primary goal of management is to maximize the wealth of the shareholders, which brings the need of maximizing the company value measured by the common stock price of the company. The achievement of this goal is usually through provision of fair payments to the shareholders. Dividend policy appears in the top ten finance puzzles. Two types of dividend policy known to economist are residual and managed dividend policy. Residual policy results from the amount of cash left after investment by the firms using NPV rule (Smith, 2009). The managers of the Hoad Company will have to adopt managed dividend policy if they believe that dividend policy influences positively share price valuation and important to the investors. Companies usually adhere to dividend policies that match with their lifecycle stage. Therefore, Hoad Company having experienced low growths with low cash flows should restrict paying more of the company’s earnings out as dividends. Company’s dividend policy has several impacts on the investors, lenders, managers and stakeholders (Short, Zhang & Keasey, 2002). For the company’s investors, dividends not only form a regular income but also important input for firm valuation. Manager’s project investment flexibility depends on amount of dividends offered to shareholders and offering more dividends limits the amount of funds available for more investments. Interest also forms among lenders on the amount of dividend declared by the firm. Paying more dividends would avail less capital for redemptions and servicing of lenders claims. Dividend policy can provide mechanism to decrease the cost of agency. Dividends payment reduces funds for perquisite consumption and opportunities for investments available to managers (Chen, Cheung, Stouraitis & Wong, 2005). Managers therefore look for financing in market’s capital. The monitoring provided by the outside capital markets encourages managers to become more disciplined and acts in best interest of the owners. There is therefore the need of the company to prefer dividend payout ratio that is stable since shareholders needs it and prefers it. Shareholders therefore aim at investing in companies that gives high returns on shares. The Hoad Company should therefore strive to aim high dividend return through increased investment so as not to send away shareholders. The industry type of the firm also influences dividend policy. A factor irrelevant to one company may be relevant to another but all this depends upon the characteristics of industries like growth stage, size, and pattern of ownership, earnings variability and systematic risks. There is also heterogeneous influence on dividend pay out by the ownership pattern. Sectoral differences exist in influence and impact on dividend payout on ownership groups (Baker, Veit & Powell, 2001). Companies will always provide several reasons for the use of debt. The issuance of new stock to reach financial need sometimes become costly. Therefore, this dilutes the future existing shareholders earnings. It may also minimize management’s control. Firms always believe in financing first with combination of earnings retained and debt and with newly-issued equity under some conditions. Equity financing usually sends a signal that is negative to the market. The theory of optimal capital structure has the assumptions of firms cherished in a world of parties with the same information (Titman & Tsyplakov, 2007). Hoad Company Managers should be in a position to get to know the companies under their management well and competition in their environment better. There is therefore the need for Hoad Company investors to find out information about the competing companies to bring them to managerial level of knowledge. Managers who are usually after maximizing current stockholders’ values together with for themselves usually have the drive to issue additional stock as long as the firm’s prospects are good. These managers usually prefer debt finance and future benefits are reserved for current stockholders. Tax-deductibility of the debt paid interest increases the flow of cash making debt a valuable financial tool (Hendershott & Pryce, 2006). However, there is a level where debt will reach at which tax benefits outweighed by the cost of financial distress and decrease in firm value if more debt are added. Financial distress includes all costs associated with debt and bankruptcy. Furthermore, the financial distress costs are not easy to determine and hence difficulty in determining optimal debt level (Donaldson, 2000). The value of the firm in relation to debt can be analyzed. Total value of the firm with more debt in relation to their size for a desirable debt should be higher. Firms with more liabilities in relation to their size usually have low market values, liquidity, cash flows and lower ownership fraction. These results are shown when measuring indebtedness using current debt and current debts correlating negatively with earnings. When using long-term debt in measuring indebtedness, firm value shows negative correlation at a level that is statistically-significance (Blanco, Brennan & Marsh, 2005). However, earnings are usually correlated positively to a long term debt. Using of debt to assist managers retain control requires a positive relation between higher debt level and higher managerial ownership level. Preference of debt by knowledgeable investors would drive investors towards firms having debts of higher level. Furthermore, if taxes are lowered by debts, then there are the expectations of higher after-tax income in firms having more debts. Higher debt levels bring about lower valuation of free cash flows in the market (Zingales, 2009). Free cash flows are usually the main components for valuing company. Therefore, managers of wealth-maximizing always avoid any actions that reduce market place value for them. Firms with higher levels of debt always have decreased levels of liquidity. Long-term debts are always used for the financing of long-term assets. However, current liabilities form the required sinking fund payments and the payable interest. The decrease in liquidity resulting from the added current obligations forms a debt cost. From the above analysis of the firm performance correlation with debt, it would be good for managers of the Hoad Company to avoid debt if the company can operate effectively without debt. The current analysis shows debt premium being closer to its historic. However, there is a premium for the firm with less debt. Therefore, for Hoad Company to maximize the value of the firm there would be the need to minimize debt. Debt may lead to several problems which usually affects the value of the company negatively. When a company has more debts, the managers will have the fear to incur liquidity constraints or causing violation to debt agreements, making them trim strategic expenditure (Ozkan, 2000). They also became less aggressive in market exploitation and investment opportunities and operating policies are based on sales forecasts range low ends. This creates rooms for the competitors to attack the firm, for the company is rendered incapable of responding faster to market conditions in aggressive financial strategy. There is also the problem of hidden agency costs for loan agreements monitoring, indenture agreements, performance guarantees and property mortgages that accompany financing of debt. Conclusion In my conclusion, the Hoad Company can still achieve its dreams of expansion. It therefore needs combined efforts by all the managers, shareholders, lenders and the government. Expansion in the company is a way of an improvement in economic development. The government revenue will increase and more employment opportunities will be created as more employees will be required to occupy the added sectors. The company should always try to minimize operating on debts, as they lower the company’s value. Under debts, the company face difficulties in competing favorably in the market and this may lead to end of its operation. 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