Dividend Policy and Importance of Capital Structure - Essay Example

Dividend Policy Introduction Dividend is the amount that a company pays annually or semi-annually to the shareholders out of its profit (Michaely and Roberts, 2012). However, there are certain guidelines which decide the payment of the earning to the shareholders, these set of guidelines is known as dividend policy (Deshmukh et al., 2013). In order to cope up with the competition in the current market as well as add value to the company, the managers go through tough decisions regarding maximization of shareholders’ wealth (Kieschnick et al., 2013). Shareholders’ wealth refers to the increase in the value of stocks that are being held by the shareholders (Hossain et al., 2013). Alternatively, it can also be considered as the payment of dividend so that the shareholders can gain the maximum from their investment. The rise in shareholders’ wealth resembles the increase in the value of company’s common stocks (Carpenter and Yermack, 2013). This study will emphasize on the critical analysis of dividend decision of Tesco Plc. outlining its policy for the last 5 years. It will also demonstrate the effect of dividend payment on the wealth maximization of the shareholders. Any policy is dependent on certain underlying structure of the organisation (Brooks and Mukherjee, 2013). Therefore, the importance of capital structure as well as the risk and return from investing in any company will be highlighted. The concept of risk management will also be focused upon alon with the application of derivatives for mitigating risk. Finally, some of the issues regarding application corporate finance will also be discussed. Discussion Various analysts have examined that the dividend policy could highly affect shareholders’ wealth (Gul et al., 2012). The ability of a firm to distribute cash and increase wealth of shareholders depends on the earnings capability of the firm and its capacity to raise fund from the external sources (Brealey, 2012). There are two ways of raising funds which are debt and equity (Kelly, 2012). Debts are the instrument where the holder gets a fixed payment along with interest (Denis and McKeon, 2012). On the other hand, the equity holders are the owner of the company to the extent of their holding (Hillier et al., 2011). However, as per the Modigiliani and Miller (M&M) model, the dividend policy of an organization has negligible or no effect on the shareholder’s wealth because the firm value is independent of its dividend policy. Moreover, in accounting process the dividend paid or received is calculated in cash flow which is very important for calculating the enterprise value through discounted cash flow method (Brooks and Mukherjee, 2013). Policy Structure of Tesco Plc Tesco Plc is one of the largest retailers globally. It is a British multinational, founded in 1919 and is headquartered in England. The company has paid an interim dividend of 1.16 pence per share in 2015; however, it reflected dividend payment of 14.76p in 2014, 2013, 2012 and 46.46p in 2011. The payment of dividend has been consistent for 5 years. Nevertheless, in recent days, the wealth of shareholders has been weak as the profit generation of Tesco has been low, but it recovered in 2013-14 as the dividend paid is £1,193m in comparison to £1,186m in 2012-13. The company also offers various systems to the shareholders. This includes direct payment to the bank account, sending cheque to the registered address and dividend reinvestment plan where the cash dividend of the investors will be reinvested in the organisation in order to buy more shares. This policy is a well thought plan where the shareholders will invest back the dividend back in the company hence raising the fund for the company (Tesco, 2015). Effects of Dividend and Retained Earnings Dividend refers to the payment made by the company to its shareholders as a return of their money invested and impacts the organization as well as its reputation. On the other hand retained earnings means that profit generated by the company is invested back in the same in order to create more value in the near future (Wolfe and Sauaia, 2014). The organization’s dividend policy affects its share price; the firm which pays dividend, earns the goodwill on basis of which more people will invest; on the other hand, the firm which does not pay a regular dividend may reflect a low stock price as people will be less interested in investing there (Hussainey et al., 2011). However, retained earnings are another aspect, where the company reinvest the earnings (Wolfe and Sauaia, 2014). Here the dividends decreases as most of the amount will be reinvested in the company. Dividend represent the return which will be paid on the present date however, retained earnings increases the future earnings per share (Lin et al., 2014). Modes of Payment of Dividend There are various forms of paying the dividend to the shareholders which includes cash dividend and stock dividend (Wesson et al., 2015). Cash dividend refers to the payment in cash when the company has enough amounts of cash in its accounts (Garcia et al., 2012). However, if the company do not have enough bank balance, it issues bonus share to the existing shareholders as dividend. The investor can sell those and get their money back or keep it for further increment in price rise (Jiang et al., 2013). Concept of Capital Structure Capital structure refers to the mixtures of various modes of raising funds which could be equity, debt and other financial instrument. An organization while raising its fund can opt for a certain proportions of all the various alternatives. Capital structure is an important topic which is needed to be discussed as it determines the shareholders’ wealth. It refers to use of equity, debt and other leverages in order to raise fund (Fan et al., 2012). The capital structure decision is based on the debt-equity ratio of a company (De Franco et al., 2013). However, raising those funds includes some marginal cost to it. The perfect tool to gauge the cost can be defined as Weighted Average Cost of Capital (WACC), which measures the cost of the debt or equity depended on its proportional weight. WACC is also important in calculation of intrinsic value, which is referred as present value of future cash flow (Barth et al., 2013). It is an analysis done by the equity research analysts which assists the investor to invest in a certain stock. It is done through the method of discounted cash flow where cash flow figures are discounted by WACC (Kaplan and Atkinson, 2015). The WACC recorded for Tesco Plc 10.7% with a risk free rate of 4.61, market premium is 14.36% and cost of debt is 5.31% (Tesco 2015). The capital structure can highly determine the stock price hence has the ability to alter the Earnings per Share (EPS) of a firm which represents the shareholder’s wealth (Young and Yang, 2011). It also determines the return that the investor will get by investing in a stock where the current EPS of Tesco Plc is 9.42 pence (Tesco 2015). As per the traditional hypothesis it is true that one can get a high reward for taking a huge risk (Alloy et al., 2012). There is a relation between risk and return which is determined by the Capital Asset Pricing Model (CAPM) as it identifies the return from the investment. It refers the risk free return which is added to the adjusted market premium (Barberis et al., 2015). Risk free rate is what an investor gets from the bonds but the market premium refers to the return after deducting the risk from it (Brealey, 2012). Recent Issues with Corporate Finance Corporate finance has certain standard and rules which has to be maintained and professionals are mostly needed for that. The professionals generally charges very high fees which the small companies may find difficult to pay (Hillier et al., 2011). The application of corporate finance is an important topic as it deals with the funding part of a company as well as its risk and return from investment and decision policy. However, there are some issues with the application of same. The main task of the company is to decide the structure in such a way which will increase the shareholders’ value (Stulz, 2013). Some recent issues have been identified referring to the NPV valuation, agency problem etc. Agency problem refers to the decision made by the managers which affect the shareholders directly as well as conflicts with the best interest of the investor (Wang et al., 2014). The size of a certain project is very important for any organization but Net Present Value fails to measure that and only calculate the contribution towards the investors who invested in that project. The capital structure of any company takes both debt and equity into consideration. There are some issues related to both the equity as well as debt funding. Equity holders are partly owners of the company and hence, have the power to vote as well as influence the company. On the other hand, debt financing put the pressure on the company for repayment to the lending organization. This may also lead to bankruptcy and has to expose its asset or property. The dividend policy that has been already used cannot be changed without affecting the shareholders which can in turn determine the value of shareholders’ wealth. The various numbers of calculations are done to forecast or to identify the intrinsic value of the firm as well as to reflect the enterprise value of the organisation which stands to a huge amount of £28,415m (Tesco, 2015). Risk Management of Tesco Plc Risk management refers to the identification and well as prioritizing the risk associated with the business in order to minimize its effect and impact (McNeil, Frey and Embrechts, 2015). Investment decision of a company opens it to several types of financial risk such as market volatility, exchange rate fluctuations as well as even bankruptcy. In order to minimize this, various fund managers and investors practice the method of risk management as neglecting it could be very harmful to organization’s financial health (Chance and Brooks, 2015). However, in case of retail business there are certain economical challenges regarding growth prospect which includes negative economic condition, increased competition etc. which is referred as primary risk. Tesco Plc is comprised of five core processes which could be affected by primary risks: Material purchase from suppliers Distributing them among centres Sending them to store from distribution centre Receiving cash Depositing the receipt to the bank According to Tesco Plc (2015), there are certain risk management element that are taken by the company such as: Internal auditor maintains the risk register which is updated regularly and identifies the owner and responses. A board meeting is conducted to review the strategic risk. The internal control system is reviewed by the audit committee. The treasury limits are set by the finance committee The risk management is monitored and facilitated by the internal auditor. The local boards and international CEOs holds the risk registers The board of governance are checked by the CEOs The company maintains the powerful internal culture where they follow two imperative strategies which are caring for customers and caring for staff. Tesco Plc believes that the loyalty of a customer can only be earned through creating the value of the brand in their eyes. They also provide their staff an opportunity to grow. One of the main reasons for the company’s success is because of an effective risk management (Tesco Plc, 2015). Risk Management through Derivatives Risk can be managed using various tools which includes using derivatives, foreign exchange hedging or using options. In finance derivative refers to a deal or contract which derives its value from an underlying asset. It acts as an important tool against risk which can be minimized through hedging. It is a very common way that is used to lower the risk (Bingham and Kiesel, 2013). In this context foreign exchange hedging is concerned with the mitigating the risk associated to the foreign exchange fluctuations. This risk is considered to the adverse impact on the business due to fluctuation of the foreign currency (Chance and Brooks, 2015). Hedging could also be done using the tool of options derivatives. Option in finance can be defined as a contract which gives the buyer the right to purchase or sell but not an obligation to do the same to an underlying asset. Investors with high risk appetite often are witnessed to speculate where they use derivative as their tool to speculate. In options call and put are the words which are commonly used. Call refers to the buying of a contract whereas put refers to the selling of the same (Hull et al., 2013). In this context, a long call generally refers to the buying of a contract about which the investor has optimistic view whereas the long put refers to the selling of the contract if the investor has pessimistic point of view. On the other hand when the investor speculates that the price of the stock will decrease, he will go for the short call where the risk is transferred to the buyers and another is short put which is used if the share price is speculated to increase (Hull, 2006). In case of Tesco plc, the group treasurers generally avoid any kind of engagement in speculations or use of any derivatives to gain profit. However, derivates are used for mitigating risk by controlling cost of the underlying debt or hedging the cost associated to the foreign investment. The interest and exchange rates has been acting as the main issue that the group faces. The credit exposures are generally created with the bank or some credit-worthy institutes (Tesco Plc, 2015). Derivatives including the swaps of interest rates, forward rate agreement and interest rate options are mainly used in Tesco Plc for the desired combination of floating and fixed rate of debt. The company follows a policy where the fixed rate fluctuates between 20% to 50% outstanding debt’s interest costs. The company uses a policy where they use the exchange rate swaps and forward exchange rate transactions for the borrowings from foreign institutes or investors. Their motive for that is to offset the difference created in its balance sheet by the exchange rate fluctuations. The policy also abides the organisation to hedge the currency movement except to that extend where the profit match the interest cost of raising such a fund (Tesco Plc, 2015) Conclusion The study emphasised on the dividend policy of Tesco Plc where the theories of financial management are demonstrated on and the organization’s process of paying the dividend is discussed. According to this study the company either pays the dividend via cheque as well as cash or they generally influence the investors to reinvest it in the company. The effects of the dividend policy of a company on its shareholders have been critically debated upon. One of the most imperative success factor of the company has also been discussed which is its ability of efficient risk management. The concept of derivatives has also been focused as a tool of mitigating risk through hedging the foreign exchange rate and interest rate swaps. As per the company’s policy, it does not engage in derivative for its profit making but to cover up their borrowing cost. The concept of hedging has been highlighted and its application on the reducing the risk of foreign exchange fluctuation has also been emphasised on. Reference List Barth, M. E., Konchitchki, Y. and Landsman, W. R., 2013. Cost of capital and earnings transparency. Journal of Accounting and Economics, 55(2), pp. 206-224. Bingham, N. H. and Kiesel, R., 2013. Risk-neutral valuation: Pricing and hedging of financial derivatives. Berlin: Springer Science & Business Media. Brealey, R. A., 2012. Principles of corporate finance. Noida: Tata McGraw-Hill Education. Brooks, R. and Mukherjee, A. K., 2013. Financial management: core concepts. London: Pearson. Carpenter, J. and Yermack, D., 2013. Executive compensation and shareholder value: theory and evidence. Germany: Springer Science & Business Media. Chance, D. and Brooks, R., 2015. Introduction to derivatives and risk management. Boston: Cengage Learning De Franco, G., Vasvari, F. P., Vyas, D. and Wittenberg-Moerman, R., 2013. Debt analysts' views of debt-equity conflicts of interest. The Accounting Review, 89(2), pp. 571-604. Denis, D. J. and McKeon, S. B., 2012. Debt financing and financial flexibility evidence from proactive leverage increases. Review of Financial Studies, 25(6), pp. 1897-1929. Deshmukh, S., Goel, A. M. and Howe, K. M., 2013. CEO overconfidence and dividend policy. Journal of Financial Intermediation, 22(3), pp. 440-463. Fan, J. P., Titman, S. and Twite, G., 2012. An international comparison of capital structure and debt maturity choices. Journal of Financial and quantitative Analysis, 47(1), pp. 23-56. Garcia, M., Moore, C. G. and Moore, C. M., 2012. The cash dividend: the rise of cash transfer programs in sub-Saharan Africa. Washington D C: World Bank Publications. Gul, S., Sajid, M., Razzaq, N., Iqbal, M. F. and Khan, M. B., 2012. The Relationship between Dividend Policy and Shareholder’s Wealth. Economics and Finance Review, 2(2), pp. 55-59. Hillier, D., Grinblatt, M. and Titman, S., 2011. Financial markets and corporate strategy. USA: McGraw-Hill. Hossain, M., Mitra, S. and Rezaee, Z., 2013. Auditing regulations and bank shareholders’ wealth: An international analysis. Research in Accounting Regulation, 25(2), pp. 252-257. Hull, J. C. 2006. Options, futures, and other derivatives. New Delhi: Pearson Education India. Hull, J. Treepongkaruna, S. Colwell, D. Heaney, R. and Pitt, D., 2013. Fundamentals of futures and options markets. Australia: Pearson Higher Education AU Hussainey, K. Oscar Mgbame, C. and Chijoke-Mgbame, A. M., 2011. Dividend policy and share price volatility: UK evidence. The journal of risk finance, 12(1), pp. 57-68. Jiang, Z., Kim, K. A., Lie, E. and Yang, S., 2013. Share repurchases, catering, and dividend substitution. Journal of Corporate Finance, 21, pp. 36-50. Kaplan, R. S. and Atkinson, A. A., 2015. Advanced management accounting. Delhi: PHI Learning. Kelly, K. S., 2012. Effective fund-raising management. London: Routledge. Kieschnick, R., Laplante, M. and Moussawi, R., 2013. Working capital management and shareholders’ wealth. Review of Finance, 17(5), pp. 1827-1852. Lin, S. H. Lin L. H., Lai H. H. and Tu, C. C., 2014. expected dividend and earnings management: evidence from taiwan. The international journal of organizational innovation, pp. 202-220. McNeil, A. J. Frey, R. and Embrechts, P., 2015. Quantitative Risk Management: Concepts, Techniques and Tools: Concepts, Techniques and Tools. New Jersey: Princeton university press. Michaely, R. and Roberts, M. R., 2012. Corporate dividend policies: Lessons from private firms. Review of Financial Studies, 25(3), pp. 711-746. Stulz, R., 2013. How Companies Can Use Hedging to Create Shareholder Value. Journal of Applied Corporate Finance, 25(4), pp. 21-29. Tesco, 2015. Annual Report and Financial Statements. [pdf] Tesco Plc. Available at: [Accessed 23 November 2015] Wang, S. F. Jou, Y. J., Chang, K. C. and Wu, K. W., 2014. Industry Competition, Agency Problem, and Firm Performance. Journal for Economic Forecasting, (4), pp. 76-93. Wesson, N. Bruwer, B. W. and Hamman, W. D., 2015. Share repurchase and dividend payout behaviour: the South African experience. South African Journal of Business Management, 46(3), pp. 43-54. Wolfe, J. and Sauaia, A. C. A., 2014. The Tobin q as a company performance indicator. Developments in Business Simulation and Experiential Learning. pp. 30-45. Bibliography Alloy, L. B. Bender, R. E. Whitehouse W. G., Wagner C. A., Liu, R. T., Grant D. A. and Abramson, L. Y., 2012. High Behavioral Approach System (BAS) sensitivity, reward responsiveness, and goal-striving predict first onset of bipolar spectrum disorders: A prospective behavioral high-risk design. Journal of Abnormal Psychology, 121(2), p. 339. Arnold, G. 2012. Modern Financial Markets and Institutions: A Practical Perspective. London: Pearson. Ballwieser, W., Bamberg, G., Beckmann, M. J., Bester, H., Blickle, M., Ewert, R. and Wilhelm, J. E. B., 2012. Agency theory, information, and incentives. G. Bamberg, and K. Spremann. Germany: Springer Science & Business Media. Barberis, N., Greenwood R., Jin, L. and Shleifer, A., 2015. X-CAPM: An extrapolative capital asset pricing model. Journal of Financial Economics, 115(1), pp. 1-24. D'Erasmo, P. N. and Boedo, H. J. M., 2012. Financial structure, informality and development. Journal of Monetary Economics, 59(3), pp. 286-302. Hargreaves Lansdown. 2015. Tesco plc (TSCO) Ordinary 5p. [online] Available at: [Accessed 23 November 2015] Mukherji, S., 2011. The capital asset pricing model’s risk-free rate. The International Journal of Business and Finance Research, 5(2), pp. 75-83. van der Laan, E. and Teunter, R., 2012. Average Costs versus Net Present Value: A Comparison for Multi-source Inventory. Quantitative Approaches to Distribution Logistics and Supply Chain Management. pp. 519-359. Young, S. and Yang, J., 2011. Stock repurchases and executive compensation contract design: The role of earnings per share performance conditions. The Accounting Review, 86(2), pp. 703-733. Read More