Dividend Policy, Mergers, and Takeovers - Literature review Example

Part A

Determining whether dividend payments are relevant in determining the share price of a company

Introduction

Dividend payment decisions shape the financing resolutions of an organization. The views and expectations of the shareholders are important components of financing as well the dividend decisions (Wei and Xiao, 2009). Managers consider dividend payment as the simplified ways of determining shareholding and financial wellbeing. The cash distribution paid out to shareholders from the accumulated net realized profits indicates the capacity of a firm to exploit future prospects and sustain performance hence dividends matter. Conversely, other researchers argue that corporate earnings determine the share value but only when a company generates distributable profits. Any investment decision determines share value so that dividend and financing decision becomes irrelevant (Barclay, Holderness, and Sheehan, 2008). Hence, divergent views exist regarding the relevance of dividend payments in determining share prices. The following paper provides a critical evaluation of the divergent theoretical viewpoints of dividend relevance and irrelevance.

Dividend Irrelevance Viewpoints

Modigliani and Miller (1963) presented principal theoretical standpoints about the irrelevance of dividend irrelevance in the determination of share. The theory presents a varied approach to valuation of shares by suggesting irrelevance of dividends. However, the methodology has significant flaws that cannot exist in the real world. Modigliani & Miller believe in the irrelevance of dividends based on a perfect capital market. The theorists assume that firms operate without tax and transactions costs, which is not true in the reality. Taxes exist in capital markets considering the diversified tax treatment of dividends and capital gains. Al-Kuwari (2009) focused on listed firms in Gulf Cooperation Council Countries between 1999 and 2003 and affirmed that taxes are among factors that shape dividend payout policies and payments in extension. The findings of the qualitative study showed that indeed investors focus on after-tax returns, which means taxes has a significant effect on the demand for dividends. Admittedly, refuting the relevance of dividends from the perspective of a perfect capital market is unrealistic. Additionally, the homogeneity of investors cements the use dividends and capital gains, but many shareholders focus on after-tax returns, which may cause preference of dividends to capital gains (Stowe, 2007). A clientele effect signals the existence of investors in low and high tax brackets who may perceive stable dividend payouts as lucrative sources of income.

Modigliani & Miller assume that company investors have perfect information about the firm and future cash flows. The theory claims that shareholders expect that companies will pay dividends without affecting their market value. The standpoint ignores the existence of asymmetric information between companies and the shareholders. The ability of investors to have instant and free access to information is limited for firms that publish false financial disclosure. The misinformation between investors and the firms may impair the intrinsic value of a share hence becoming difficult to determine the true price of shares. Cormier et al. (2010) consider that firms have the discretion for voluntary disclosure particularly in markets where there are no legal regulations. The constitution of financial reporting principles in both developing and developing markets prevents asymmetric information from misguiding investors in determining the true value of shares from dividend payouts. Cormier et al. (2010) observed Canadian markets and found that dividend announcements provide the relevant signals for defining prospects, share value, and performance of firms. The credibility of dividend as signaling effects shows the extent symmetric and asymmetric information determines dividend policies as well as decisions.

Correspondingly, basing dividend irrelevance theory on capital markets implies that managers and shareholders do not show conflict of interests. Cormier et al. (2010) focuses in Canadian context of corporate governance and shows that managers may adopt questionable dividends or financing decisions. Furthermore, owners and shareholders are distinct entities in the management of firms, which may bring a conflict of interests with shareholders. Shareholders incur agency costs when they monitor the actions of the managers. Dividend payments may mitigate the conflicts, which imply that they are determinants of a firm's’ intrinsic value.

Modigliani assumed that firms use equity or ordinary shares as sources of finances. Determining the value of shares from the perspective equity shares may not provide true information of shares (Stowe, 2007). Dividend payouts come in handy alongside other sources of external financing such as debentures, trade credit, and loans. No empirical support exists to support the logic of ordinary shares as the only sources of financing for firms. In effect, investors do not limit their focus on retained earnings because they do not shape investments decisions exclusively in practice. Brown, Fazzari, and Petersen (2009) acknowledged the connection between cash flow and share issues when they studied external financing for U.S technology firms in the 1990s.

Dividend Relevance Theoretical Viewpoints

Lintner and Gordon forwarded the Bird-in-Hand theory to support their dividend relevance standpoints (Lee and Lee, 2006). The framework of dividend relevance by Lintner and Gordon provides a simple explanation regarding the relationship between the value of a share of the market and the dividend policy of a firm. Nonetheless, the viewpoints contain unrealistic viewpoints. By arguing that firms should not have any external financing for the dividend relevance to hold true, they propose that companies should utilize retained earnings to finance prospects of expansion. According to Ali and Chowdhury (2010), a firm in the real world survives through external financing. Furthermore, companies cannot sustain internal operations using retained earnings as the only source of finance hence other external financing sources come in handy. The Bird-in-Hand argument shows that companies prefer dividends to capital gains. The argument is true due to the lower risks and high certainty of dividends (Barclay, Holderness, and Sheehan, 2008). Companies should achieve high share value when they pay higher dividends and generate low value when they pay low dividends. The approach renders dividend policy as an essential factor in the determination of share prices.

Additionally, the dividend relevance model ignores the fact that capital markets are not perfect. Al- Hasan (2013) argues that the imperfection of capital market gives rise to information asymmetry. Companies should base their dividend decisions on the asymmetry of information because dividends contain signaling properties. Shareholders may or may not get new information about shares because firms must determine the direction of dividend changes. Similarly, exploiting the signaling effect of dividends requires firms to determine the actual and expected dividends.

The clientele effect perspective helps firms to establish payout patterns to shareholders hence the relevance of dividends policy in the determination of share prices (Abor and Bokpin, 2010). The mainstay of clientele effect approach is acknowledging the heterogeneity of shareholders who have varied needs and preferences. Abor and Bokpin (2010) analyzed clientele effect from the perspective of emerging markets and argue that the model understands the reality of dividend policy in attracting the diverse groups of shareholders who seek long-term or long-term capital gains. A study by Wei and Xiao (2009) on Chinese firms affirmed that some shareholders focus on generating regular income hence the preference of dividends to capital gains. Other shareholders will consider diverse dividend and capital gain preferences based on the prevailing tax situations. Evidently, Companies must identify clienteles whose preferences align with the dividend policies and share prices ultimately.

Share valuation is a difficult process for firms, but dividend growth model helps to overcome the challenge. Firms cannot determine the intrinsic value of a share without using dividend growth model (Lee and Lee, 2006). The approach suggests that the dividends are essential determines of share prices. The mainstay of Gordon’s dividend growth model is allowing investors to understand and establish the specific value of a share. The investors and companies concentrate on the value factors that drive the shares. While the model suggests dividend payments as effective means of determining share price, it ignores different valuation figures may arise due to small changes. According to Stowe (2007, p.61), the dividend growth model is limited to the companies that operate in stable and mature industries because it assumes that dividends grow in perpetuity and constant rate. The constancy of the rate of investment is rare in the real world due to dynamic business risks.

Conclusion

Dividend relevance is more tenable than dividend irrelevance approach, which shows that dividend payments can determine the price of shares. Behaviors of managers and investors imply that dividend policy is an important component of valuation. While Lintner and Gordon provide defensible arguments, Modigliani and Miller use unrealistic assumptions. The essence of discrediting perfect capital markets, zero tax effects, and free access to information is because the assumptions do not have any practicality in the current market. Signaling effects, agency, dividend growth, and clientele models provide sufficient support to dividend relevance theory. Investors require practical approaches rather than the theory that dividend irrelevance theory presents. Nonetheless, firms or investors should not focus on dividend decisions because it may elicit injurious influence on the shareholding value.

Part C

Critical evaluation on whether mergers and takeovers are actually aligned with the core financial objective of maximizing shareholders’ wealth

Introduction

Mergers and takeovers are significant corporate events, which require efficient execution to protect the interests of the shareholders and the companies. Managers have different goals but one of the principal purpose is to maximize shareholders wealth (Gaughan, 2011). On the other hand, existing research studies have established that managers can focus on non-value maximizing motives particularly when the prospects of expanding assets are high. Some managers focus on eliminating inefficient management and diversifying business prospects at the expense of the share prices. The aim of the following critical evaluation is to determine whether mergers and takeovers benefit shareholders’ wealth. The papers will focus on motives and financing perspectives to establish value maximizing and non- value maximizing motives.

Value Maximizing Motives for Mergers and Takeovers

Varied motives inspire firms to consider mergers and takeovers, but shareholders may generate substantial wealth gains when companies focus on target returns. Megginson and Smart (2008, p.575) argues that the increase in shareholder wealth only when firms accept premiums offer. The period between the acquisition and the announcement date may determine the number of returns that shareholders will generate. The success of merger or takeover determines target returns coming from multiple bidders. The role of managerial resistance comes in handy in negotiating higher offers. Alexandridis, Petmezas, and Travlos (2010) studied the most expensive takeovers from United States, UK, and Canada and found varied target returns in each region. However, the study established that ordinary shareholders receive premiums of 29.1% in an average takeover and 15.9% in any successful mergers. The evidence shows different target gains, but the amount that shareholders generate depends on the methods that managers utilize and the availability of bidders from diverse economies. Evidently, target and bidding of firms’ benefit shareholder wealth by a huge margin, but the results may vary from company to company.

The rationale for investment and financing decision increases the shareholder wealth maximization. Firms invest when they expect the present value to exceed the project outlay (Megginson and Smart, 2008). Achieving high-value cash flow requires firms that perceive mergers and takeovers as the means for aligning shareholding wealth maximization and business strategy. However, the cost of merger or takeover must exceed transaction costs or any other premium from the bidders’ perspectives. The motive of any manager is to increase the value of the target shareholders alongside their present value. Some firms focus on economies of scale to achieve operating synergy, but it may limit to certain aspects such as production, marketing, and distribution. Consequently, a large operation may result in a decrease in average unit cost, which implies that the shareholding value might decrease. Haleblian et al. (2009) acknowledges the trends in shareholder wealth maximization across the globe but argues that mergers and takeovers do not have a uniform standard for generating returns. The study predicts potential problems in operational synergies, particularly when managers consider internal as well as external expansion.

Another focus of mergers and takeovers is the achievement of financial synergies where managers anticipate low cash flow volatility, default risk, and cost of capital. The principal focus is to lower the cost of debts and expand the size of the firms, which leads to financing scale of economies (Megginson and Smart, 2008). However, the motive of financial synergies depends on the extent the financial structures of the new structures may reduce financial burdens. Two separate companies may exhibit low tax advantages when compared to the when they have merged. AT&T and Bell South achieved a high financial synergy of $2billion for making proper forecasting and concentrating on achieving the economies of scale (Sung and Gort, 2006). Financial excellence is not a guarantee for firms that fail to project their financial synergies properly. The benefit of mergers and acquisitions depends on the performance of the acquiring. Marfo, Amoako, and Gyau (2013) focused on the case of ChevronTexaco and found poor results of the mergers. The performance of the merger dwindled considerably between 2001 and 2002. While the performance of merger was subject to market circumstances, it depicts possibility of dismal results when firms focus on financial synergies alone. The following graph shows the poor financial performance of ChevronTexaco:

Figure 1: Pre and Post Merger financial ratios of ChevronTexaco (Marfo, Amoako, and Gyau, 2013)

Contrastingly, a review of Facebook-Whatsapp acquisition by MacMillan, Albergotti, and Stahl (2014) showed that financial synergies have positive performance outcomes. Facebook shares dropped by 3.4% after the $19billion deal, which implied that the Wall Street analysts that shareholders would lose holding by 8%. However, the same week the shares increase by 2.3% to depict one of the successful cases of mergers and acquisitions that focus on increasing financial power. According to MacMillan, Albergotti and Stahl (2014) the value of the deal was more promising for the founders and employees of Whatsapp, who were entitled to restricted stock units for four years after the announcement. Firms attract higher financial power depending on the methods they use to achieve synergy.

Non-Value Maximizing Intents

Sometimes companies and individual managers purpose on eliminating agency problems rather maximizing shareholder wealth. The motive of the merger or takeover may bring conflicts between the shareholders and the companies, which is why some large corporations disguise the true objectives (Cartwright and Schoenberg, 2006). Agency issues arise when managers focus on personal benefits such as growth in sales and assets rather than working in expanding profit margins as well as share profits. DePamphilis (2013, p.729) presents Managerialism theory of mergers that explains that managers maximize the assets of the corporation or managerial remuneration without taking into account the likelihood of the motives creating value for shareholders. According to Megginson and Smart (2008, p.580), cash flow theory of mergers reveals that managers consider investing in projects with negative net present values (NPV). NPV does not enhance the value of the shareholders because the unmonitored managers concentrate on establishing corporate empires at the expense of the shareholders.

The intent of the management may be incongruent with the interests of the shareholders, who hope that the company creates value by overbidding the target. Decreasing the value of the shareholders may result in conflicts. The record of litigation cases in the U.S in 2009-2012 indicates that shareholders have legitimate concerns over the companies that pursue mergers and acquisition without wealth maximization in mind (Corpgov.law.harvard.edu, 2016). The reviews of the lawsuit filed by Security Exchange Commissions shows an increase in litigations valued $100million and a shareholding population that understands the misconduct of managers during acquisitions or mergers.

Sources of Finance

Sources of finance that companies use determine the degree of shareholders’ wealth maximization. Share for Share offers increases the maximizing value for target company shareholders due to the fixed number of shares that they gain in exchange for their shares. Corporates focus on retaining equity interest of the company, which increases the gains of the target and bidders (Gaughan, 2011). The advantage of using target company shareholders is reducing the overall costs of the transactions. Firms cannot extend the costs to the shareholders because share-for-share eliminates brokerage costs from the reinvested cash. Additionally, shareholding value increases tax advantages considering the capital gains does not attract liabilities. Altunbaş and Marqués (2008) established the economic impact of share-for-share when they examined the post-merger performance of European Banks. The improvement in the performances through reduction of costs would make sense for shareholders and affirms the essence of mergers and takeovers a financial standpoint. Hijzen, Görg, and Manchin (2008) analysis of trade costs of cross-border mergers and takeovers affirms the essence of increasing the value of the shareholders. However, companies must be ready to adopt an optimum capital structure to eliminate costs for the best interest of the shareholders.

Correspondingly, firms that have value maximizing in mind use mixed bids. The attractiveness of mixed bids reinforces the economic standpoint of maximizing shareholders’ value (Hijzen, Görg, and Manchin, 2008). Firms incorporate cash and share-for-share offers in the financing decision of mergers as well as takeovers. Target company’s shareholders accept the financial approach because they understand the amount on offer and the zero effect on the number of shares issued. Martynova and Renneboog (2009, p.293) found that companies underperform when they use debt to finance takeovers when compared to cash payments. The study used the assumption of bidder’s strategic preference towards cash as the means of payment. Conversely, Tuch and O'Sullivan (2007) found that the underperformance experienced in the post-bid periods is due to the wrong choice of financing decisions. However, the research acknowledged mixed benefits of mergers and takeovers from financing decision perspective.

Conclusion

The existence of maximizing and non-maximizing motives in academic research affirms that mergers and takeovers cannot guarantee shareholders’ wealth maximization. Companies maximize shareholders’ wealth when they focus on financial synergies, and investment. Target returns because motives are acceptable to shareholders. Research on non-maximizing value motives shows that shareholding value decreases when firms concentrate on eliminating agency problems and diversification. In addition, financing decisions such as mixed bids and share-for-share offers increase generate cash flow for the bidders, which shape the gains for the shareholders. Apparently, the mixed results from the empirical studies show that mergers and takeovers benefit shareholders wealth only when the motive of the firms is value maximization.