Payout Decision and Working Capital Management, Capital Budgeting and Net Present Value - Assignment Example

Payout Decision and Working Capital Management, Capital Budgeting and Net Present Value Task Introduction This essay consists of two parts. Part one contains the analysis of the dividend policies of three companies in the car manufacturing industry. That is, the Daimler automotive, Ford motor company and Jaguar land rover automotive. With reliance on the financial statements of the mentioned companies from 2010 to the end of 2012, the dividend policies are determined. Secondly, there is a critical evaluation of the methods used by the three companies to finance the payouts. Third, a determination of the most effective dividend policy will be included. Last, a critical analysis of the payout policy in relation to the working capital management. Theories on 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. Dividends decisions are essential part of a firm’s financing decision (Firer & Viviers 2011). It is therefore a plan of action adopted by the management. For instance, payment of high dividends means less retained earnings and the firm may have to go to the market to borrow for investment purposes. This will increase its gearing level. The dividend decisions made by a firm have a significant influence on the share value. Managers are, therefore, advised to formulate effective and optimal dividend policy, which creates value and maximizes the shareholder’s wealth. How much to pay: it is a daunting task to determine how much dividend to pay the shareholders. As a result, there are various methods to facilitate the process. Companies can use constant payout ratio, constant amount of each share, constant dividend per share plus a surplus amount, or the residual dividend payment method. Constant payout ratio alternative involves the payment of a fixed amount of dividend, usually a fixed portion of the company’s earnings (Abbott 2001). For instance, a company could decide that 30% of annual earnings are 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 are paid no dividends. Therefore, this policy creates uncertainty regarding dividend payments, thus has no significant contribution in shareholder value creation (Abbott 2001). 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). When to pay Firms can decide to make interim or final dividend payments. Interim payments are made in the middle of a financial period, usually in cash; whereas, final dividends are paid at the end of a financial period, usually through either cash or bonus issue (Setia-Atmaja 2010). Why to pay The following are the theories on dividend payment: the residual dividend theory, the Modigliani and Miller dividend irrelevance theory, the bird-in-hand theory, the information signaling effect theory, the tax differential theory, the clientele effect theory, and the agency theory (Hunting & Paulsen 2013). Under the residual dividend theory, a company pays a dividend from the residual earnings. That is, the amount of earnings remaining after potentially viable projects with positive net present values have been undertaken and financed. The theory asserts that the retained earnings are the best source of finance for long-term projects for the reason that it is cheaply and readily available. The reason for its cheapness is the absence of floatation cost involved in its use. According to the theory, the first claim on earnings after tax is preference dividends and the funds for viable projects (Hunting & Paulsen 2013). The theory considers dividend payment as irrelevant, thus has no significant influence on the value of a company but, investment decisions have direct and significant influence on the value of a company. The following are the advantages of the residual theory: it saves on the floatation cost, prevents the dilution of ownership, and allows the shareholders to avoid tax payment of dividends. First, it saves on floatation cost because the company will avoid debt or equity sources of funds available due to the retained earnings which require no floatation costs. Second, new issuance of shares would dilute the ownership and control of the company (Hunting, M. & Paulsen 2013). A high retention policy may enable financing of firms, thus boosts the growth rate. Third, shareholders earning high income prefer low dividends in order to reduce tax paid on their dividend income. Therefore, they prefer the retention of earnings for the purpose of reinvestment, which helps create the shareholder value (Hunting & Paulsen 2013). The Modigliani and Miller dividend irrelevance theory- the theory claims on the absence of influence on the market value, thus the cost of capital by the dividend policy of a company. The theory argues that the value of a firm is primarily influenced by the ability to generate earnings from an investment and the level of both business and financial risk. The theory states that it is the company’s needs for investment funds that determine the dividend policy. The division of earning between the dividend payment and the shareholders is not a major factor in this case (Chawla 2008). Therefore, there is no existence of such thing as the optimal dividend policy. The theory has heavy reliance on the following assumptions: there is the absence of corporate or personal kites, there is no transaction cost associated with the floatation of new shares, the company’s dividend policy is not depended upon by the investment decision, the market is efficient, thus there is free flow of information, and there is no uncertainty because all investors make decisions using similar discounting rate (Chawla 2008). Bird -in - hand theory - this theory argues 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 (Hunting & Paulsen 2013). Information signaling effect theory - 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 in an inefficient market is characterized by information asymmetry. For instance, if the management pays high dividend, the message sent to the market is that of a possible high future profits to maintain the high dividend level. Investors who correctly interpret the message would buy more shares of the company (Hussainey, Chijoke & Chijoke-Mgbame 2011). 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. Modigliani and Miller presented a contrary argument that the change in share price prompted by the change in dividend amount is due to the content of the dividend policy information rather than the dividend policy itself. Consequently, dividends are of no relevance if important information can be made available to all market players. Dividend decisions are relevant in an inefficient market and the higher the dividends, the higher the value of the firm. The theory is based on the following assumptions: first, the sending of signals by the management should be cost effective. Second, the signals should be correlated to observable events (common market trends). Third, no company can imitate its competitor in sending the signals. Fourth, the managers can only send true signals if they are bad signals. False messages negatively affect the survival of firms (Hussainey, Chijoke & Chijoke-Mgbame 2011). Tax differential theory- the theory states that dividends have a higher rate of tax than capital gains. Therefore, a company that pays high dividends has a lower value due to high tax on dividends paid by the shareholders. Under this theory, dividend decisions are relevant and the lower the dividend the higher the value of a firm. The reverse of the statement is true in this case (Chawla 2008). The Clientele effect theory – the theory states that different groups of shareholders (clientele) have dissimilar first choices for dividends based on the level of their income from other sources. Shareholders earning low level of income prefer high dividends in order to meet their daily consumption needs while shareholders whose level of income is higher, prefers low dividends in order to reduce the level of tax on dividend paid. Therefore, the change on dividend policy prompts the shift of investors into and out of the firm until equilibrium is achieved. At equilibrium, the dividend policy is consistent with a clientele of shareholders a firm has. Dividend decisions at equilibrium are irrelevant since they cannot cause any shifting of investors (Chawla 2008). Agency theory – one method of solving the agency problem between the shareholders and managers is through the payment of high dividends. If retention is low, managers are required to raise additional equity capital to finance investments. Each fresh equity issue will expose the managers financing decision to providers of capital such as bankers, investors, and suppliers. Managers will thus engage in activities that are consistent with maximization of shareholder wealth by making full disclosure of their activities (La Porta, Lopez-de-Silanes, Shleifer & Vishny 2011). The reason is managers are aware that the firm will be exposed to external parties through external borrowing. Consequently, agency costs will be reduced since the firm becomes self-regulating. Dividend policy will have a beneficial effect on the value of the firm because the dividend policy can be used to reduce agency problems by reducing agency costs. The implies that companies adopting the higher dividend payout ratio will have a higher value due to reduced agency costs (La Porta, Lopez-de-Silanes, Shleifer & Vishny 2011). Corporate payout policy to shareholders of the Landrover, Ford and Daimler motors Ltd According to the financial statements of the Jaguar Land rover motors, the company’s dividend payment has been as follows: during the year ended 31 March 2013, the company paid dividend worth £ 150.1 million. No payment was made in 2012, 2011 and 2010 due to reinvestment plans the company had. Part of the earnings for the three financial periods was channeled to finance a research and development activities in order to improve the quality of the products. During the year ended 31 March 2013, the Land rover jaguar motors Ltd made cash payment of dividend worth £ 14.0 million on preference shares. £ 11.4 million of the amount were accrued during the financial year 2012. No payments were made during the financial year 2011 and 2010 for the same reasons stated in the case of ordinary shares (Annual report – Jaguar Land rover 2012). According to the financial statement of Daimler, the dividend payment activities have been as follows: for the period ended December 31, 2012, the management of the company announced a proposed dividend payment of € 2,349 million or € 2.20 per no-par-value share that earns dividend. In the financial year 2011 and 2010, € 2,346 and € 2,340 million respectively, was paid. No payment proposal was made for the year 2013 (Annual report – Daimler 2012). According to Ford’s annual report, dividend payment activities are as follows: on December 8, 2011, dividend was declared on common and class B stock of $ 0.05 per share to be paid on March 1 2012. The total amount spent on dividend payment was $ 190 million. No record of any payment for 2010 and 2013 (Annual report – Ford 2012). Analysis of the strategies applied for financing the payouts Jaguar Land rover finances the dividend payment through retained earnings. The following are the advantages of the method: first, it is a cheaper source of finance as compared to equity and debt because no floatation cost is involved as in the case of equity. In addition, the cost of retained earnings is considerably lower as compared to that of the debt. Second, it is readily available. The disadvantage of using retained earnings is the opportunity cost of making a viable investment (Annual report – Jaguar Land rover 2012). Daimler finances the dividend payment through excess cash (profit). The method is cheaper compared to equity, debt and retained earnings. It also puts idle cash to work. An effective management of working capital requires companies to maintain a reasonable amount of cash. Excess cash is costly because of the investment opportunities foregone. Daimler’s strategy does not influence the capital structure, thus it is effective (Annual report – Daimler 2012). Last, Ford motor company uses a similar strategy as Jaguar Land rover to finance dividend payment. Therefore, a similar analysis applies in the case of Ford Motors (Annual report – Ford 2012). The most effective dividend policy Both the Jaguar Land Rover Company and Ford Motor Company have implemented effective dividend policy. Among the dividend policies listed above, the two companies have implemented the residual dividend policy. As has been mentioned, under this policy, a company pays a dividend from the remaining earnings. That is, the portion of a company’s earnings left untouched after viable projects with positive net present values have been undertaken and financed (Hunting & Paulsen 2013). First, the policy is effective because it gives first priority to the investment activities of a company. Investment decisions such as the purchase of capital assets and investments made in projects with high growth potential help boost the value of a company as measured by the discounted cash flow methods. In addition, such decisions, increase the cash flow generated by companies, thus help maximize the shareholder’s wealth. Second, retained earnings are the best source of finance for long-term projects for the reason that it is cheaply and readily available. The reason for its cheapness is the absence lack of floatation cost involved in its use. Therefore, the policy prompts the exploitation of a cheaper source of finance (Abdelsalam, El-Masry & Elsegini 2008). The outcome and substitution model As mentioned by La Porta, Lopez-de-Silanes, Shleifer & Vishny (2011), the agency problems can be solved by the payment of dividends to shareholders. Shareholders are against the withholding of excess cash by the management of a company only to channel them to projects with low growth potential. Some managers use the extra earnings from companies for their self benefit. Payment of dividends to the shareholders enable the managers to distribute the company’s earnings thus minimizes the misuse of funds by the insiders. As mentioned in one of the dividend theories above, bird-in-hand theory, investors prefer certainty (bird in hand), which is the retained earnings. The view that the dividend is an outcome of legal protection of shareholders is effective only in countries with strong legal protection of the minority shareholders like the United States and the United Kingdom. Under such this kind of system, the minority shareholders have strong voting right powers, rather than right to dividend. They, therefore, rely on the voting rights to pressure companies to pay dividends. This, in turn, reduces the availability of excess cash, thus prevents the insiders from possible funds mismanagement. On the other hand, the view that dividend is a substitute for legal protection is effective only in countries where the minority shareholders have no strong legal protection, thus companies use the opportunity to develop a good reputation by ensuring the payment of dividends to the shareholders (La Porta, Lopez-de-Silanes, Shleifer & Vishny 2011). The reputation is built primarily to ease the process of raising funds from the capital markets. Therefore, the three companies considered for this essay (Jaguar-Land rover, Daimler and Ford) are situated both in the U.K and the U.S., where the minority shareholders enjoy strong legal protection. Therefore, it is appropriate to conclude that their payout policy is an “outcome” of an efficient working capital management (La Porta, Lopez-de-Silanes, Shleifer & Vishny 2011). Base case NPV analysis For the base case NPV analysis, the initial cost of the project is $ 10 million, the operating cost is $ 900,000 ($ 500,000 as fixed costs and $ 400,000 as variable cost), the quantity of transcendental zirconium is 340 tons annually, quantity for zircon gemstone is 150 pounds annually, the price of transcendental zirconium is $ 10,000 per ton and that for zircon gemstone is $ 3,300 per pound. The nominal rate of return of 14% must be adjusted for inflation, which is at 3.5% to determine the real rate of return. Therefore, the real rate of return is (14*1.035) = 14.49%. The tax rate is at 35% and the annual depreciation cost is (10,000,000/7) = $ 1,428,572. Prices and operating costs would increase by the inflation rate every year. Consequently, the cash flows from the project are expected to be as follows given the above information (Zoric & Bræk 2011). Years 1 2 3 4 5 6 7 Revenue: Transcendental 3,519,000 3,642,165 3,769,641 3,901,578 4,038,133 4,179,468 4,325,749 Gemstone 512,325 530,256 548,815 568,024 587,905 608,481 629,778 Total revenue 4,031,325 4,172,421 4,318,456 4,469,602 4,626,038 4,787,949 4,955,527 Less operating cost 931,500 964,103 997,846 1,032,771 1,068,918 1,106,330 1,145,051 EBIDT 3,099,825 3,208,318 3,320,610 3,436,831 3,557,120 3,681,619 3,810,476 less depreciation 1,478,572 1,530,322 1,583,883 1,639,319 1,696,695 1,756,080 1,817,543 EBT 1,621,253 1,677,996 1,736,727 1,797,512 1,860,425 1,925,539 1,992,933 less tax (35%) 567438.55 587298.6 607854.45 629129.2 651148.75 673938.65 697526.55 Cash flow 1,053,814 1,090,697 1,128,873 1,168,383 1,209,276 1,251,600 1,295,406 Add depreciation 1,478,572 1,530,322 1,583,883 1,639,319 1,696,695 1,756,080 1,817,543 Net cash flow 2,532,386 2,621,019 2,712,756 2,807,702 2,905,971 3,007,680 3,112,949 Using the required rate of return (14.49%) as the discounting factor, below is the present value of the cash flows. Year DF (14.49) Cash flow PV 1 0.8734 2,532,386 2211785.9 2 0.763 2,621,019 1999837.5 3 0.6663 2,712,756 1807509.3 4 0.582 2,807,702 1634082.6 5 0.5083 2,905,971 1477105.1 6 0.444 3,007,680 1335409.9 7 0.3878 3,112,949 1207201.6 Total 11672932 The net present value of the base case is (11,672,932 – 10,000,000) = $ 1,672,932. The project is viable because the NPV is greater than one. Sensitivity analysis In this type of analysis, only one variable is altered and the influence thereof, determined. Assuming that enactment of the new environmental law, the presumed project’s initial cost of $ 10 million would be increased by $ 1.5 million. In that case, the total initial cost for the project would be $ 11.5 million. The new net present value after incorporating the variable is (11,672,932 – 11,500,000) = $ 172,932, which is lower, but still proves the viability of the project (Dennis & Smith 2014). Scenario analysis In this analysis, it is assumed that the following variables are considered: the enactment of the new environmental law, the implementation of the cheaper design for the mine, and the increase in the price of transcendental zirconium to $ 14,000. The total initial cost of the project would, therefore be (10,000,000 + 1,500,000 – 1,700,000) = $ 9,800,000. Other variables are assumed to be constant. The cash flow would change as shown below. Years 1 2 3 4 5 6 7 Revenue: Transcendental 4,926,600 5,099,031 5,277,497 5,462,209 5,653,387 5,851,255 6,056,049 Gemstone 512,325 530,256 548,815 568,024 587,905 608,481 629,778 Total revenue 5,438,925 5,629,287 5,826,312 6,030,233 6,241,292 6,459,736 6,685,827 Less operating cost 1,397,250 1,446,154 1,496,769 1,549,156 1,603,377 1,659,495 1,717,577 EBIDT 4,041,675 4,183,133 4,329,543 4,481,077 4,637,915 4,800,241 4,968,250 less depreciation 1,478,572 1,530,322 1,583,883 1,639,319 1,696,695 1,756,080 1,817,543 EBT 2,563,103 2,652,811 2,745,660 2,841,758 2,941,220 3,044,161 3,150,707 less tax (35%) 897086.05 928483.85 960981 994615.3 1029427 1065456.4 1102747.5 Cash flow 1,666,017 1,724,327 1,784,679 1,847,143 1,911,793 1,978,705 2,047,960 Add depreciation 1,478,572 1,530,322 1,583,883 1,639,319 1,696,695 1,756,080 1,817,543 Net cash flow 3,144,589 3,254,649 3,368,562 3,486,462 3,608,488 3,734,785 3,865,503 Using the required rate of return (14.49%) as the discounting factor, below is the present value of the cash flows. Year DF (14.49) Cash flow PV 1 0.8734 3,144,589 2746484 2 0.763 3,254,649 2483297.2 3 0.6663 3,368,562 2244472.9 4 0.582 3,486,462 2029120.9 5 0.5083 3,608,488 1834194.5 6 0.444 3,734,785 1658244.5 7 0.3878 3,865,503 1499042.1 Total 14494856 The net present value would be (14,494,856 - 9,800,000) = $ 4,694,856 (Dennis & Smith 2014). Mrs. Peru would probably be worried about the decrease in the prices of transcendental zirconium to $ 7,500 per ton. This forecast means that the revenue generated from the mine would decrease by $ 2,500 per ton. The second scenario is the sharp increase in the fixed cost if the new design of the mine is implemented. The implementation would increase the total annual operating cost to $ 1,350,000 from $ 900,000. Since there is no clear determination of the project’s initial cost, more information concerning that would be very useful. Secondly, the inflation rate should be obtained reliably rather than using a guessed value. Consequently, the project should be delayed in order to allow sufficient time to determine, with a high degree of reliability, some critical variables such as the projects initial cost and the inflation rate (Dennis & Smith 2014). List of References Abbott, L.J. 2001, "Financing, dividend and compensation policies subsequent to a shift in the investment opportunity set", Managerial Finance, vol. 27, no. 3, pp. 31-47. 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. 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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. Firer, C. & Viviers, S. 2011, “Dividend policies of JSE-listed companies: 1989-2010”, Management Dynamics, Vol. 20, No. 4, pp. 2-22. Viewed 13 November 2014, http://search.proquest.com/docview/1434982030?accountid=45049 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. La Porta, R, Lopez-de-Silanes, F, Shleifer, A, & Vishny, R, W 2011, “Agency problems and Dividend Policies around the world”, The journal of finance, Vol. 55, No. 1, pp 1-33. Setia-Atmaja, L. 2010, "Dividend and debt policies of family controlled firms", International Journal of Managerial Finance, vol. 6, no. 2, pp. 128-142. Zoric, J. & Bræk, R. 2011, "Scenario based techno-business analysis of service platforms and their service portfolios", Telecommunication Systems, vol. 46, no. 2, pp. 95-116. Read More