Capital Structure and Dividend Theory and Policy - Term Paper Example

Capital structure and dividend theory and policy Table of Contents Introduction 3 Debenhams Plc 4 Mothercare Plc 8 BROWN (N.) PLC 11 Conclusion 14 Reference 15 Introduction Capital structure composition of an organization is based on a number of factors like industry average, profitability, market-to-book assets ratio etc. Studies have highlighted that firms paying dividends have a low leverage. With the use of debt finance the management reallocates a certain portion of its anticipated cash flows away from the equity holders in lieu of upfront cash. Various empirical studies have been conducted to identify the factors that influence the funding decisions of the firm. Though there are many theories relating to capital structure, however, only a few have gained acceptance (Frank & Goyal, n.d.). The trade-off theory and Pecking order theory complement each other. Trade-off theory gives importance to the benefits of interest tax shield and costs of bankruptcy. Pecking order theory gives preference to retained earnings and debt over the issue of fresh equity. The static trade-off theory advocates that the large firms with a strong market reputation and stable cash flows must use more of debt in their capital base. Market timing theory suggests that the managers assess the conditions prevailing in the equity and debt markets at the time of raising funds. If the current conditions are unfavourable they defer the issue whereas if the conditions are unusually favourable they raise funds even though there is no immediate requirement. The market timing hypothesis states that corporate time their equity issue when their stock price is high (Hovakimian et al., 2004, pp. 524). DEBENHAMS PLC Company background Debenhams Plc is a UK based departmental store dealing in accessories, fashion clothing, household products and cosmetics in domestic as well as international markets (London Stock Exchange plc-a, 2010). Capital structure Ratios The company has maintained significant levels of debt in the capital base as is evident from its capital composition. For the year 2007 the company had a debt to capital ratio of 92.2%. This increased marginally to 93.6% in the following year. But there was a decline in the debt to capital ratio of the company in the year 2009. In this year the equity capital of the company went up to £425.30 million as compared to £125.30 million in the previous year. This was accompanied by an approximate fall of 10% in the debt. It is seen that the fall or rise in the debt to capital ratio is accompanied by a rise or fall in the equity to capital ratio respectively. For the year 2007 the equity capital of the company stood at £163 million with equity to capital ratio of 7.8% but this was followed by the fall in the equity capital to £125.30 million dropping the ratio to 6.3%. In 2009 the equity capital of the company increased by more than three times to £425.30 million increasing this ratio to 20%. A higher amount of debt in the capital base increases the default risk of the company. Often it has been seen that the firms forego lucrative growth opportunities due to the debt servicing burdens. For this reason the firms continuously thrive to achieve the target level of debt. Moreover issue of excessive debt lowers the credit rating of the company which indicates a high default risk and thus raises the cost of debt (Hui, et al., 2006, pp. 1-2). Debenhams Plc too has reduced its debt exposure over the years. This can be due to the above mentioned factors. Relevant theory- The high level of company debt points towards the relevance of Pecking order theory in capital structuring decisions. In line with this theory the company relies heavily on debt and makes limited use of equity. Pecking order theory advocates the offer of equity only as a last resort and emphasises on the use of retained earnings and debt for financing needs. Dividend policy Miller and Modigliani assumed that in a perfect market characterised by the absence of taxes and transactions costs the dividend pay-out policy of the firm has no impact on the shareholders wealth. A higher pay-out ratio amounts to capital gains and lower retained earnings and vice versa without impacting the shareholders wealth. Despite this the corporations maintain a high pay-out ratio (La Porta, et al., 2000, pp. 1-2). It has been seen that the price of the company’s stock rises in anticipation of higher dividend and falls if there is a fall in the rate of dividend. This is because the market participants view dividend fall as a sign of company’s financial uncertainty and factor the same in its share price. Debenhams Plc maintained a varying dividend pay-out for the past three years. It reported a pay-out ratio of 46% in 2007 when it declared a dividend per share (DPS) of £4.9 against an Earning per share (EPS) of £10.74. This ratio increased by more than 50 percent to £73% in the following year when the company paid a higher dividend of £6.3 despite the lower EPS of £8.64. However this trend was reversed in 2009 when the company retained a majority of its earnings declaring a dividend of £0.5 against an EPS of £10.02 lowering the dividend pay-out ratio to merely 5%. MM model- The dividend decisions of the company seem to be influenced by the Miller and Modigliani model that propagates the irrelevance of dividend pay-outs. The recent low dividend pay-out ratio of Debenhams Plc may be because the company has profitable investment opportunities and thus has retained a considerable portion of its income for financing the same. The dividend policy of the company is in accordance with the MM model that considers the investment policy to be the sole determinant of the stockholders wealth. This theory considers that the pay-out is not relevant as long as the company is able to offer good reinvestment rates on the amount retained in the business (DeAngelo, et al., 2006, pp. 294). The dividend cover of the company that is expressed as EPS/DPS. This ratio is the reciprocal of the dividend pay-out ratio. Debenhams Plc had a dividend cover of 2.19 times in 2007 which fell to 1.37 times in 2008. In 2009 the low dividend declared as a percentage of EPS increased the dividend cover to 20.04 times. A ratio of 2 more than that is considered to be safe as it indicates that the company is capable of paying the dividends. But a dividend cover of less than 1.5 is risky. Except for 2008 the company’s dividend cover has been fairly good. The dividend yield is expressed as DPS/ Market Price per share (MPS). This ratio measures the cash flow earned on every pound that is invested in the equity. The dividend yield of Debenhams Plc is 4.07%, 12.66% and 0.63% for the years 2007, 2008 and 2009 respectively (Yahoo Finance-a, 2010; Yahoo Finance-b, 2010).This ratio improved significantly in 2008 when there was a fall in the share price of the company but it deteriorated sharply in the following year as the company lowered its dividend pay-out ratio (Yahoo Finance-c, 2010). Through payment of dividends the corporate insiders return the earnings of the investors and cannot use these earnings for their personal benefits. Thus the dividends play an important role in mitigating agency problems. If the management wants to make use of the funds for funding growth opportunities it can provide information for the same to the shareholders. If the shareholders are convinced of higher reinvestment rates that guarantee good future returns the low pay-out ratio is taken positively by them. This is especially true in countries that encourage shareholder protection and for the companies that have good investment opportunities (La Porta, et al., 2000, pp. 4-6). Profitability The profitability position of the company has remained more or less stable over the last three years. It reported a gross profit margin of 15%, 14.5% and 14% respectively for the years 2007, 2008 and 2009 respectively. Similarly the net profit margin of the company remained within the range of 4 to 5 percent over the past three years reporting a margin of 4.5% in 2007, 4.2% in 2008 and 5% in 2009. Despite a 50bp fall in the gross profit margin of the company the net profit margin went up by 80bp as compared to 2008. This is indicative of efficient cost management of the company. MOTHERCARE PLC This is a company engaged in the designing and retail of products for children, babies and mothers-to-be (London Stock Exchange plc-b, 2010). Capital Structure The company has maintained insignificant level of debt in the capital base as is evident from the debt to capital ratio. In the year 2007 the company reported a debt to capital ratio of 33.5%. This has increased over the last two years with the rise in the level of debt employed by the company to 43.4% in 2008 and 47.8% in 2009. In the year 2008 the company doubled its debt from £76 million to £152.10 million along with a rise in the equity capital by nearly 30 percent. This was further increased to £181.70 million in the following year. The low debt and high equity has raised the equity to capital ratio of the company. This ratio was 66.5% in 2007 but with the gradual rise in debt it reduced to 56.6% and 52.2% in the years 2008 and 2009 respectively. Relevant theory- The leverage ratio of the company indicates that the company has gradually increased its debt exposure. This is in line with the trade-off theory which states that the firms aim towards achieving an ideal level of debt in the capital mix by balancing the marginal benefits of debt with the marginal costs of debt such as probability of bankruptcy. With the rise in the debt component the company has been able to increase its profitability over the previous years. With the increase in debt the earning before interest and tax (EBIT) of the company has increased 10 times from £4.60 million in 2008 to £43.70 million in 2009 (London Stock Exchange plc-c, 2010). Dividend policy The dividend pay-out ratio of the company indicates the percentage of earnings that is distributed by the company among its equity investors. Mothercare Plc maintained a high pay-out ratio of 42% in 2007 but this has been reduced over the following years to 27% in 2008 and 31% in 2009. In both these years the company reported a rise in its earnings and even declared a higher dividend amount but the proportion of the DPS in terms of EPS was reduced. A firm usually reduces the pay-out ratio for financing the growth opportunities or for share repurchase. The constant rise in the dividend over the years points towards the efficacy of signalling theory. Even though the EPS of the company in 2009 increased by nearly £2.56, the company increased its DPS by nearly the same amount, as a fall in dividend may signal negative information about its future cash flows among the investors. This shows the relevance of signalling model in the dividend policy decisions of the company. The dividend cover of the company has remained stable at above 2 for the last three years indicating that the earnings of the company are sufficient of discharging dividend payments to the equity investors. It reported a dividend cover of 2.4 times, 3.7 times and 3.2 times respectively for the years 2007, 2008 and 2009 The dividend yield of the company for the last three years is 2.32%, 2.60% and 3.34% for the years 2007, 2008 and 2009 respectively (Yahoo Finance-d, 2010; Yahoo Finance-e, 2010). This has improved over the years with the rise in the dividend amount. (Yahoo Finance-f. 2010) It has been observed that high pay-out ratios help to remove the asymmetry in the information and reduces the agency costs. Low dividend yielding stocks are preferred by the institutional investors as they have better monitoring capabilities. This is the reverse for the non-institutional investors who desire high dividend yield stocks and prefer higher cash pay-outs. For this reason the institutional investors choose firms engaged in higher share repurchases whereas the opposite holds true for the individual investors (Jain, 2007. pp. 407). Profitability The profit margins of the company have improved significantly in 2009. The gross profit margin has remained stable within the range of 9.5% to 12% in the last three years indicating the improvement in the operating efficiency of the business. This was 9.6%, 9.5% and 12% in the years 2007, 2008 and 2009 respectively. Similarly the net profit margin which indicates the administrative efficiency of the business was 2.9% in 2007 and dropped to 0.015% in the following year. This went up to 4.2% in 2009 fuelled by the rise in the group turnover from £676.80 million in 2008 to £723.6 million in 2009 and the cut down in the administrative expenses of the company from £43.40 million in 2008 to £41.20 million in the immediately following year (London Stock Exchange plc-d, 2010). BROWN (N.) PLC This company is engaged in home shopping and other financial services (London Stock Exchange plc-e, 2010). Capital Structure The company reported a debt to capital ratio of 64.2% in 2007. With the rise in the equity component this ratio fell marginally to 60.8% in the following year. This reduced to 59% in the year 2009 with the rise in equity being more than the rise in the debt. The equity to capital ratio of the company was 35.8% in 2007. This increased to 39.2% in the following year due to a rise in the equity from £202.50 million in 2007 to £248.5 million in 2008 marking an increase of nearly 25 percent. For 2009 the company reported equity to capital ratio of 41%. Relevant theory- The above ratios indicate that the company has gradually increased its reliance on equity. This means that the company’s capital structure decisions are in accordance with the trade-off theory that advocates the optimum use of debt in the capital base to take advantage of the interest tax shield. Besides, this theory strikes a balance between the two sources of capital by matching the gains arising out of the debt use with the costs pertaining to it. It has been seen that the firms with a high leverage face revenue downturn during distressed times making it difficult to honour the interest expenses. In contrast the conservatively leveraged companies do not face this situation. They do not have to bear the burden of financial expenses when there is a fall in the revenue in times of crisis. This helps in maintaining the stability in the profits (Istaitieh, et al., 2006, pp. 52-53). Dividend Policy Despite the increase in the DPS of the company from £6.64 in 2007 to £9.19 in 2009 the dividend pay-out ratio of the company has reduced over the years. For 2007 the company reported a pay-out ratio of 42.1% followed by 39% in the following year. In 2008 the EPS of the company rose by more than 25 percent but the increase in the DPS was only 18 percent. Similarly in 2009 the pay-out ratio of the company was 38% despite a rise of nearly 25 percent in EPS. In this year the rise in the DPS was even less than the previous year. Signaling model- Higher amount of retained earnings over the years signifies that the company may have good investment opportunities that it wants to finance through its earnings. In perfect markets with information symmetry this is taken positively by the market participants. As per Miller and Modigliani, dividend policy does not have an impact on the share value in efficient markets. But in reality it has been seen that the share price rises in response to a rise in the dividend. The signalling model assumes that there is a positive relationship between the dividend policy and information asymmetry. This suggests that the firms with higher asymmetric information actively pay dividend. For this reason the managers are reluctant to reduce the dividend even when there is a fall in the earnings of the company. This is because the market participants view it as an adverse sign of company’s performance. Lintner (1956) highlights that dividend being sticky few firms are willing to omit it. It has been seen that the share price of the company falls if the actual dividend is less than the anticipated market figures (Li, et al., 2008, pp. 673-675). Though the dividend pay-out ratio of Brown Plc has reduced over the years but the company has successively increased it’s DPS over the same period. This is in line with the signaling model which suggests that there is an inverse relation between the information quality and large dividend increase. (Li, et al., 2008, pp. 673-675). The company seems to be lacking an efficient information transmission which can be the main reason for the management’s reluctance in reducing the dividend as is evident from the continuous increase in the DPS over the last three years. If the management is able to effectively convey the reasons for the fall in the dividends to the shareholders i.e. there is perfect transmission of information between the company management and the market participants the shareholders are able to understand the need of the dividend cut. In the presence of market imperfections a fall in the DPS is not taken positively by the equity investors. The dividend cover of the company is 2.4 times in 2007 and has remained more or less stable over the years. For 2008 and 2009 the company reported a dividend cover of 2.6 times and 2.7 times respectively. A rise in the EPS of the company is accompanied by a rise in the DPS which has ensured a stable dividend cover for all the years. As this ratio is more than 2 it means that the company’s earnings are sufficient for meeting the dividend charges. The dividend yield of the company is 1.99%, 3.04% and 4.60% for the years 2007, 2008 and 2009 respectively (Yahoo Finance-g, 2010; Yahoo Finance-h, 2010). This has steadily increased over the years mainly due to a rise in the DPS from £6.64 in 2007 to £9.19 in 2009 and fall in the share price of the company from £318.75 in 2007 to £199.75 in 2009 (Yahoo Finance-i, 2010). This explains the co-relation between the size of the dividend and dividend yield. Therefore a large dividend leads to high dividend yield. The reason for this co-relation is that the firms want to keep their stock prices within a range (Jakob, et al., 2007. pp. 719). The high dividend yield of Brown (N) Group suggests that the policy decisions of the company are aimed towards the objective of keeping the stock price within a desired range. Profitability- The gross profit margin of the company has reduced over the last three years. The company reported a gross profit margin of 55.6% in 2007 which fell to 52.3% in the following year. This increased to 53.2% in 2009 indicating a marginal improvement in the operating efficiency of the company. The net profit margin of the company has moved up continuously over the years from 8.9% in 2007 to 9.1% in 2008. This further increased to 9.4% in 2009. The rise in the net profit margin of the company indicates efficient cost management by the company. Conclusion The capital structure decisions form an important part of the management function. The debt mode of financing is preferred over equity due to its low cost and the interest tax shield. For this reason the static trade-off theory states that the marginal benefit of debt must be same as the marginal cost like agency costs, probability of bankruptcy and default risk. This is necessary to ensure that the financial obligations arising from the debt do not threaten the financial solvency of the business. Dividend policy too forms a crucial part of management decisions as in the absence of market efficiency a change in the dividend may prove to be unfavourable for the company’s share price. Reference DeAngelo, H. DEAngelo, L. 2006. The irrelevance of the MM dividend irrelevance theorem. Journal of Financial Economics. Elsevier. Frank, Z.M. Goyal, K.V. No Date. Capital Structure Decisions: Which Factors Are Reliably important?. Hovakimian, A. Hovakimian, G. Tehranian, H. 2004. The market timing hypothesis. Determinants of target capital structure: The case of dual debt and equity issues. Journal of Financial Economics. Elsevier. Hui, H.C. Lo, F.C. Huang, X.M. 2006. Are corporates’ target leverage ratios time-dependent?. International Review of Financial Analysis 15. Istaitieh, A. Rodrı´guez-Ferna´ndez, M.J. 2006. Factor-product markets and firm’s capital structure: A literature review. Review of Financial Economics. Elsevier. Jain, R. 2007. Institutional and individual investor preferences for dividends and share repurchases. Journal of Economics and Business. Elsevier. Jakob, J.K. Ma, T. 2007. Are ex‐day dividend clientele effects dead? Dividend yield versus dividend size. Journal of Empirical Finance. Elsevier. La Porta, R. Lopez-de-Silanes, F. Shleifer, A. Vishny, W.R. 2000. Agency problems and dividend policies around the world. The Journal of Finance. VOL. LV, NO.1. Li, K. Zhao, X. 2008. Asymmetric Information and Dividend Policy. London Stock Exchange plc-a. 2010. Summary. DEBENHAMS PLC. Available at: http://www.londonstockexchange.com/exchange/prices-and-news/stocks/summary/company-summary.html?fourWayKey=GB00B126KH97GBGBXSTMM [Accessed on February 23, 2010]. London Stock Exchange plc-b. 2010. Summary. Mothercare Plc. Available at: http://www.londonstockexchange.com/exchange/prices-and-news/stocks/summary/company-summary.html?fourWayKey=GB0009067447GBGBXSTMM [Accessed on February 23, 2010]. London Stock Exchange plc-c. 2010. Fundamentals. MOTHERCARE PLC. Available at: http://www.londonstockexchange.com/exchange/prices-and-news/stocks/exchange-insight/company-fundamentals.html?fourWayKey=GB0009067447GBGBXSTMM [Accessed on February 23, 2010]. London Stock Exchange plc-d. 2010. Fundamentals. MOTHERCARE PLC. Available at: http://www.londonstockexchange.com/exchange/prices-and-news/stocks/exchange-insight/company-fundamentals.html?fourWayKey=GB0009067447GBGBXSTMM [Accessed on February 23, 2010]. London Stock Exchange plc-e. 2010. Summary. BROWN(N.)GROUP PLC. Available at http://www.londonstockexchange.com/exchange/prices-and-news/stocks/summary/company-summary.html?fourWayKey=GB00B1P6ZR11GBGBXSTMM [Accessed on February 23, 2010]. Yahoo Finance-a, 2010. Historical Price. DEBENHAMS. Available at: http://finance.yahoo.com/q/hp?s=DEB.L&a=07&b=15&c=2007&d=08&e=10&f=2007&g=d [Accessed on February 23, 2010]. Yahoo Finance-b. 2010. Historical Price. DEBENHAMS. Available at: http://finance.yahoo.com/q/hp?s=DEB.L&a=07&b=15&c=2008&d=08&e=10&f=2008&g=d [Accessed on February 23, 2010]. Yahoo Finance-c. 2010. Historical Price. DEBENHAMS. Available at: http://finance.yahoo.com/q/hp?s=DEB.L&a=07&b=15&c=2009&d=08&e=10&f=2009&g=d [Accessed on February 23, 2010]. Yahoo Finance-d. 2010. Historical Price. MOTHERCARE PLC. Available at: http://finance.yahoo.com/q/hp?s=MTC.L&a=02&b=15&c=2007&d=02&e=31&f=2007&g=d [Accessed on February 23, 2010]. Yahoo Finance-e. 2010. Historical Price. MOTHERCARE PLC. Available at: http://finance.yahoo.com/q/hp?s=MTC.L&a=02&b=15&c=2008&d=02&e=31&f=2008&g=d [Accessed on February 23, 2010]. Yahoo Finance-f. 2010. Historical Price. MOTHERCARE PLC. Available at: http://finance.yahoo.com/q/hp?s=MTC.L&a=02&b=15&c=2009&d=02&e=31&f=2009&g=d [Accessed on February 23, 2010]. Yahoo Finance-g. 2010. Historical Price. N BROWN GROUP. Available at: http://finance.yahoo.com/q/hp?s=BWNG.L&a=01&b=15&c=2007&d=01&e=28&f=2007&g=d [Accessed on February 23, 2010]. Yahoo Finance-h. 2010. Historical Price. N BROWN GROUP. Available at: http://finance.yahoo.com/q/hp?s=BWNG.L&a=01&b=15&c=2008&d=01&e=28&f=2008&g=d [Accessed on February 23, 2010]. Yahoo Finance-i. 2010. Historical Price. N BROWN GROUP. Available at: http://finance.yahoo.com/q/hp?s=BWNG.L&a=01&b=15&c=2009&d=01&e=28&f=2009&g=d [Accessed on February 23, 2010]. Annexure-     Debenhams Plc   Mothercare Plc   Brown(N) Group Plc       2009 2008 2007 2009 2008 2007 2009 2008 2007 DPS (£) 0.5 6.3 4.9 12.9 10.4 9.45 9.19 7.86 6.64 MPS (£) 79.5 49.75 120.5 386.5 400 407 199.75 258.25 334.5 Dividend Yield(%) 0.63 12.66 4.07 3.34 2.60 2.32 4.60 3.04 1.99 Read More