Dividend Policy Theory and Practice - Literature review Example

Financial Strategy Name Class Unit Introduction Excelsior is a private owned toy manufacturer in Europe. The company shareholders are content with its current financial situation and have no intention of going public. The company shareholders are averse in taking huge risks. According to the case, the treasurer is looking for opportunities and consequences of refinancing. The company main objective has been increasing their dividends each year. While it’s non financial objective have been to treat all stakeholders equal. Review of objectives is very sensitive issue which requires collaboration of all stakeholders. An objective should be able to specify what the decision maker is trying to achieve and the measures that can help in deciding between objectives. If an appropriate objective is not chosen in a business, it becomes hard to make business decisions. The cost of making the wrong objective is very high in a business (James & John, 2005). This is why it is vital for all directors to agree on the best objectives for Excelsior. This essay will look at the appropriateness of excelsior’s current objectives and the Finance Director suggestion. The essay will then look at issues that needs to be considered when coming up with new corporate objective and give recommendations. In addition, the essay will discuss factors that Treasury manager is supposed to consider when coming up with financing and refinancing strategies based on Excelsior context and how it affects determination of corporate objectives. Appropriateness of Excelsior's current objectives Current Excelsior financial objective is based increasing dividends each year while non financial objective is based on treating all stakeholders with fairness and equality. Increasing dividends each year are a great objective. This is due to fact that the increasing dividends offer a great earning to the shareholders (Frankfurter & Wood, 2003). An increase in dividend implies that the firm does not suffer from depressed prices. The power of the dividend is determined by the company history of dividends. Powerful dividends occur when the company has a history of dividends which increase over time (Peirson et al., 2014). This makes the company more rewarding to the investors. Despite this, dividend policy that is used by Excelsior matters a lot. This is based on determining how much the organisation is willing to give back to the shareholders. The organisation can use one of the two types of dividend policies available. The two types are; managed and residual policies. The residual policies give dividends in form of the cash that is left after making investments (Frankfurter & Wood, 2003). This makes dividends variable and in some cases zero. Managed divided policy enables the company to value their investors (Peirson et al., 2014). The best dividend policy should maximise shareholder’s wealth. The non financial objective is very vital in this context. All stakeholders should be treated equitably and fairly. The financial success of the firm depends on the stakeholders and the way in which they are handled. The current financial objective is only appropriate if it suits the organisation lifecycle. If the organisation is experiencing high growth, they can pay more of their earnings as dividends. It is important to note that dividends lag behind the earnings. When earnings increases, dividend increases. In some cases, firms fail to cut dividends when the earnings drop. This makes it prudent to look at the growth of Excelsior. At the moment, the company is experiencing steady growth in an environment where there is low inflation. The company have high revenue and steady growth which makes their financial objective viable (Frankfurter & Wood, 2003). Shareholders wealth is a function of company investments, financing and their dividend decisions. For an organisation to attain efficient perfoamcne, dividend decisions are very important (Peirson et al., 2014). This is due to the role that finances plays in firm growth. The Finance Director has a role in coming up with a dividend policy that is able to enhance firm value (Frankfurter & Wood, 2003). For the shareholders, dividends are not only a source of income but also act as form of firm valuation. Lenders are also more concerned on the amount of dividend a firm gives. When a firm gives a lot of dividend, the amount available to service their claims reduces. In this case, the stakeholders are risk averse. Risk averse shareholders prefers investing in firms that are able to give high returns on their shares (Peirson et al., 2014). Being an organisation with risk averse shareholders, their current dividend based objective suits them. Appropriateness Finance Director’s suggestion The finance director suggestion is based on maximisation of shareholders wealth. Shareholders own the firm and maximisation of their wealth is a very important goal in firm (Peirson et al., 2014). To maximise shareholders value, the organisation have to work in increasing the stock price. When stock price increases, the firm value is able to increase. The Finance Director suggestion is thus very appropriate in a capitalist society (James & John, 2005). According to the shareholder wealth maximisation principle, the immediate goal of a firm is maximising the return on equity capital. The main goal of the investors is maximisation of their financial returns. Despite this, maximisation of the shareholders wealth should not be the only goal. Maximisation of shareholders wealth should serve as a primary goal, but not a singular goal. There is need to have other objectives as suggested by the board of directors. This is due to fact that the organisations have to follow business ethics, corporate social responsibility and the stakeholders’ theory. When the organisation have only maximisation of shareholders wealth, they are very likely to clash with ethics. The firm is supposed to have diverse goals which also look at the social aspect. There is a need to satisfy the shareholders and CSR while at the same time following ethics (Peirson et al., 2014). There is also need to look at areas suggested by the board of directors such as profits after tax, return on investment and aiming to improve on different operational areas. Issues that the Board should consider when determining the new corporate objectives When coming up with new objectives, the board have to look at several issues. Maximisation of the shareholders value should always be based on the cash flow in the firm. The management also have to consider that they have a fiduciary duty to the shareholders as they come up with new objectives. This should guide the board in coming up with goals that are able to maximise shareholders value rather than managerial goals (Peirson et al., 2014). Due to fact that the company’s shareholders are risk averse, it is vital for the objectives, to consider maximising dividends (James & John, 2005). As the directors maximise the shareholder’s value, it is very vital for them to be socially responsible. The welfare of the society should be looked at as the shareholders value is being maximised. The directors should also look at profit maximisation as a short term goal. This is due to fact that it does not take into account the risk and reward as it is with the shareholders value maximisation. The objectives suggested by the board are also vital as the firm will be able to determine its efficiency on resource allocation (Peirson et al., 2014). They will be able to determine how the organisation is using its resources to generate returns. This will help in determining the firm profit. Recommendation From the discussion, it is evident that there is need for the Finance Director has to come into a common ground with objectives that fits excelsior context. The objectives should take shareholders wealth maximisation as the primary goal, but not the only goal. There is need to incorporate other goals such as maximisation of dividends, maximisation of profit after tax and return on investment and perfoamcne improvement in all areas. The new financial objectives must be complimented with social objectives such as corporate social responsibilities, ethics and looking at all stakeholders interests. A balance has to be achieved between shareholders and the rest of stakeholders in the new Excelsior objectives. There is the need to align the financial interests of the shareholders, directors and employees. The Finance Director must realise that business ethics, CSR and stakeholder theory need to be addressed when coming up with new objectives. Ethics will help the management from wrong doing (Peirson et al., 2014). CSR will help in ensuring that the business is doing social good while according to stakeholder theory, a firm is a multiple constituent as well as a social entity. Factors that the Treasury Manager should consider when determining financing, or refinancing strategies in the context of the economic environment For the firm to continuously run its business, it requires adequate capital. In this case, the shareholders are not willing to go public, but are ready to buy smaller investors. The investors are risk averse hence not ready to expand more overseas. Currently, Excelsior is financed 70% equity and 30% debt. The company debt is made up of a mixture of secured and unsecured debts with interest rates varying between 7 and 8.5%. The repayment time is between 5 to 10 years hence long term debts. The company is operating in a country with minimal inflation. The treasurer is looking for means of financing and refinancing and associated consequences for the company to achieve its objectives. When a firm requires additional finances, the treasurer has to take a financial structure decision. Financial structure refers to the means in which a firm finances its assets. The Treasury Manager has to consider several factors when making financial structure decision. The most important factors to look at are; trading on equity, capital gearing, cost of capital, maximum control, cash flow in the company and flexibility. Treasury Manager has also to base decision on the market conditions and economic conditions. According to the context of the firm, the country economic condition is stable with low inflation. There is a conducive business environment. The economic conditions are the main determinant of the cash flow (Peirson et al., 2014). They determine the risk rate of the returns. Trading on equity When making a capital structure decision, it is important to look at firm financial leverage. This is due to fact that leverage affects earning per share. Use of debt and preference capital as a source of finance is known as financial leverage. Leverage use lead to higher earnings on company share capital (Erel et al., 2012). If the company uses borrowed capital to finance assets, it must be able to maximise earnings on it. Trading on equity is measured through fixed charge ratio. Capital gearing The policy decision on capital gearing determines the form and proportion of the security issued. Capital gearing is the ratio on equity is calculated as the ratio of the equity share capital and the preference share capital (Erel et al., 2012). Capital gearing is very important to investors and company. The Treasury Manager has to consider gearing ratio as it affects the company distribution policy especially during difficult training periods. Cost of capital This is the maximum return that the suppliers can expect. This is based on the degree of risk which the investors have assumed. In this case, the shareholders are risk averse. When the risk is ignored, debt becomes a cheap source of financing as opposed to equity (Erel et al., 2012). The Treasury Manager must come up with a way in which total cost of the capital is minimised. This is through looking at the interest, dividends and costs incurred. Maximum control It is important to note that shareholders always tries to haves maximum control. It’s also important to note that certain securities involve voting rights (Erel et al., 2012). This is where control is exercised. It is important for the Treasury Manager to ensure that proper balance is maintained between voting and nonvoting capital. Voting capital involves equity capital while nonvoting capital involves debentures, loans and retained earnings. Cash flow ability of the firm Sound capital structure is based on conservatism. This is based on the use of fixed charges through using debt of preference capital and the ability of the company to generate cash, which will enable it meet the fixed charges (Erel et al., 2012). Fixed charges are determined by the interest rates, dividends on preference and capital. As the company makes a decision to increase their debt, it is very important to look future cash flow which will help in meeting fixed charges. Flexibility A company must be able to change based on the environment. The company capital structure is supposed to be present. Flexibility is determined by the flexibility of the service charges, debt capacity and redemption process (Erel et al., 2012). The decision made by treasurer must consider flexibility. How these factors might impact on the determination of corporate objectives. The corporate objectives being determined will be impacted by the financing strategies used by the firm. The financial source selected will determine the financial perfoamcne for the firm in the long run. As the company seeks to maximise the shareholders’ value, the means in which they have obtained their extra capital will determine the attainment of the objective. If the company used borrowed capital, it has to earn more money from it in order to achieve the objective. The debt equity ratio, which will be determined by the new debt will enable the manager and board of directors to come up with sound financial objectives. This is due to the fact the intensity of trading will be based on this ratio (Peirson et al., 2014). The equity share will also determine the objectives. This is due to fact that long term objectives will be affected based on whether the capital structure is high or low geared. The cost of capital will determine the returns, hence the dividends. This will help in coming with objectives which consider the source of fund. The shareholders control is also vital in making objectives since they have the voting rights. Their opinions will determine the capital structure as well as the set objectives. Corporate objectives are based on the expected flow of cash in the company. Also the level of flexibility in capital structure will determine the ability of the firm to take the finance source with the best rates. This will affect the firm growth, hence the determination of the objectives (Peirson et al., 2014). It is important to note that financial objectives are based on firm finances and projected growth. Conclusion Excelsior current objectives are appropriate based on the context. Looking at financial objective, increasing dividends offers a great earning to the shareholders. An increase in dividend implies that the firm does not suffer from depressed prices. Excelsior financial success of the firm depends on the stakeholders and the way in which they are handled. Being a company with risk averse shareholders, their current dividend based objective suits them. This is due to fact that Risk averse shareholders prefer investing in firms that are able to give high returns on their shares. Shareholders own the firm and maximisation of their wealth is a very important goal in firm as suggested by finance manager. Despite this, maximisation of shareholders wealth should serve as a primary goal but not a singular goal. There is need to have other objectives as suggested by the board of director. Its recommendable to incorporate other objectives such as maximisation of dividends, maximisation of profit after tax and return on investment and performance improvement in all areas. The firm should also look at CSR, ethics and stakeholders in their non financial objectives. Based on the context, Treasury Manager has to consider several factors when making financial structure decision. The most important factors to look at are; trading on equity, capital gearing, cost of capital, maximum control, cash flow in the company and flexibility. There is also need to base decisions on the market conditions and economic conditions. The company corporate objectives will be affected by these factors since financial objectives are based on the company financial performance and growth as explained. References Erel, I., Julio, B., Kim, K & Weisbach, M 2012, “Macroeconomic Conditions and Capital Raising,” Review of Financial Studies, Vol.25, no.1, p.341-376. Frankfurter, M. G. & Wood, B. G 2003, Dividend Policy Theory and Practice, Academic Press. James C. H. & John M. W 2005, Fundamentals of Financial Management, Pearson Education, Singapore. Peirson, et al, 2014, Business finance. Mcgraw-Hill,Australia. Read More