Week 11: Dividend Policy

Previously, I have discussed about the opportunities for companies to do an investment decision and raising finance decision. Now, I will write about examine the dividend decision in which more or less could influenced by the investment and financing decision. Traditionally, if nothing special for doing the investment, it would be better if increase the dividend and then give it to the shareholders or if it is difficult to get the finance or if it is too expensive, maybe, it would be best if just keep the money to finance the business instead of paying the dividend to the shareholders.

How do the companies pay off the dividends? The UK companies mostly pay the dividend twice a year (interim and final dividend) only from the accumulated distributed profit in order to protect the creditors who were willing to lending money to companies and thus, obviously the companies must have enough cash to pay the dividend to the shareholders. Every company probably need to have the dividend policy before they can pay the dividend (in which dividend policy is the policy that company uses to determine on how much it will pay out to shareholders in dividend) and should intend to maximise the shareholder wealth. And this is also explained in classic study by Porterfield (1965) which he argued that a dividend payment would only do so if the new share price+dividend is equal or higher than previous share price.

Even so, there is an objection from others where according to Modigliani & Millar (1961), the dividend policy is irrelevance to the share price that company is actually valued from future earning potential and not dividends that paid now thus, amount of earnings distributed are not determined the share value but the investment policy does. Additionally, a rational investor is preferred more on dividend rather than the capital gains therefore, the investors are actually indifferent between these two because of the fact that M&M think the investment policy could maximise the company's market value where investing in positive NPV projects in order to increase the positive cash flow might increase the share price thus increase the wealth of shareholders as well.

In other part, Modigliani and Millar also argue that dividends represents a residual payment which investing in all projects that can get a positive NPV and if earnings are left over, they should pay the dividend however, if no surplus after all earnings are invested, no need to pay the dividend while the market value of the company should rise to reflect the future increasing returns. Thus, they believed that dividend decision is merely a financing decision but they did not argue that paying the dividends are irrelevant to company's valuation because the company's valuation is unaffected by the timing of paying the dividend due to the same impact if pay or not paying the dividend however, if dividends are not paid, the shares of the company become not worth at all.

Even so, there are other argument that supported the relevance of dividend before Modigliani & Millar where according to Traditional View; Linter (1956) and Gordon (1959), the investors are more preferable to have the dividends than capital gains because of the uncertainty of future gains in uncertain investments. Thus, as they would prefer on dividends, the market value of the company will influence by the dividend policy for example, if a company pay low dividend to investors, they might swap to other company that pay more dividend to them and this will result on the decrease in share price of the company.

Conceptually, the investors do not have any kind of access to get any internal information of the business so, they see the dividends as the signal to have an idea about the company's performance (high dividends: good performance and low dividends: bad performance). However, the reverse may be true in reality; (where high dividends: lack of attractive investments therefore they get lower future investment returns and low dividend: attractive investments therefore they get better future prospects).

The clientele effect argued that shareholders are not indifferent to dividends versus capital gains due to the need for a regular income to meet their liabilities but however, M&M argue that they could create their own by selling shares but the best if they can consider the control implications, transaction costs, time consuming and tax position. So, investors will be attracted to company's that best suit with their need especially when the company does the best dividend policy. In other problem that might occur in dividend decision is the agency problem which the shareholders may want on high dividend payment to avoid the manager from investing in poor projects but this tend to be burden to managers as their amount of retained profit for them will be lower and they have to raise fund externally and this may be costly thus forces them to justify the spending.

As a conclusion, the dividend decision might have several choices for a company to choose whether to forces promoting a high, low, stable or fluctuating dividend payment where actually in practice, a company may tend to avoid a very low dividend to avoid from lose investor confidence, avoid very high dividend payment to have a backup for long-term future and aim for stable dividends that could give a stable growth. Like the Felda Global Ventures Holding Bhd ( FGV) which this company is situated in Malaysia, its' dividend policy is to pay a high 'good' dividend to their shareholders every year regardless of the presence of uncertain economic condition (Business Times, 2013) as this being their company's pledge which is to distribute at least 50% from its net profit as dividend to the shareholders. This is shows that this company is highly concerned for their shareholders value because they will make sure that all the shareholders will get return on their investments and this might be as the example for other company in order to maintain or create shareholders value while making profitability.

Week 10: Capital Structure

Before I start to write on this week’s blog, I just want to revise back regarding the topic ‘raising corporate finance’ where this topic has some connection with this week’s blog (related to capital structure).

A company could raise its’ finance by applying the two main ways; by equity finance or debt finance. As a revision, raising finance via equity financing by having investors to issuing shares seems like the best way especially for those who want to expand their business without paying back to the investors but they just need to share the profits or deliver an appropriate return to the investors. However, equity financing may need returns that are higher than the rate that you probably need to pay for a bank loan, plus the cost is more expensive than debt financing and more risky for the investors. In addition, the investors also might want some ownership from the company and this may occur the agency problem where some people in the company might not agree with the investors since they need to discuss first before making any decision with investors.

On the other hand, debt financing (a loan from bank or any lending institution) is cheaper than issuing shares as the issuing and transaction costs is lower and less of debt interest that need to pay due to tax reduction. Applying this form of raising finance also do not have to give up a part of company profit as a return to the investors and they have no right in the company. Apart from this, debt financing is less risky for the lenders as the borrowers are obliged to make repayment of the loan including the interest. Therefore, after all, in order to obtain the optimal capital structure (capital structure= the way a firm finances its’ assets through the equity or debt or combination of both), since debt finance is cheaper, all company may need to do is to increase the gearing level (with the consideration if this changes could increase the shareholder wealth) in order to reduce its’ cost of capital (as a wise firm will use the right way to keep their true cost of capital low as possible).

But, a company has to bear in mind where higher debt or gearing may cause the risk of financial distress costs. Furthermore, the various components of cost of capital is depending on the market values (which change on a daily basis), where then the market values are depending on the firm’s prospects (which it is depends on the investors belief on the success of this activity). A firm prospects are influenced by capital structure, thus, if a firm has too much debt, in which they still need to pay the interest regardless with high or low profits in good or bad years, could result s on interference in creating the shareholder wealth. Overall, increasing the gearing level could give an advantage to the decreasing of WACC, but also may cause the increasing of shareholders’ risks (that thus, they will demand a higher return for the risks they are taking).

Based on the traditional view, decreasing the WACC (merely changing the company’s capital structure) by increasing the gearing level indeed will affect on the increased of the share price, returns per share, value of the company and shareholders’ wealth thus, can attain an optimal capital structure but then, this also tend to increased the risks if the gearing level always rising.

However, Modigliani and Miller stressed that the company’s capital structure has no impact on WACC so, there is no optimal structure exists and that the company’s value is merely depending on the business risks. In addition, their assumptions that there is no taxation (while in real world, individuals and companies need to pay taxes, therefore the introducing of taxation give them additional advantage to using the debt capital-as mentioned before, there is tax reduction by using this form of raising finance), there are perfect capital markets with perfect information available to all people with no financial distress and liquidation costs thus make individuals can borrow as cheaply as corporation. Even so, people cannot rely on their assumptions, as perfect markets do not really exist in the real practice until they have corrected their assumptions in 1963.

Lets have an idea of the importance of the capital structure. In real world, according to the recent news in Bloomberg (April, 2013) where Fiat SpA(F), the Italian car-maker wants to buy the remaining stake in Chrysler Group LLC by cash (considering the disposal of some assets to control its debt) and no issuing new shares. Fiat is also planning to raise its finance via loan from banks. This means that Fiat is structuring its’ capital in the form of debt financing. This is perhaps by raising its finance through debt finance, they would get better benefits from it to their business rather than use the equity finance. However, the management may affect on some factors on borrowing decisions such as, capacity to borrow, managerial preferences, pecking order, financial slack, signalling, control, industry group gearing, motivation, reinvestment risks, operating and strategic efficiency as their business sales was slightly worse last year. In addition, the CEO of this company believes that to close with the deal (buy remaining stake in Chrysler Group LLC), its capital structure has to be looked at for the long term in order to survive the business in a long run.

Therefore, considering the company’s capital structure carefully is important for those who want to success and sustain their business in the long lifetime..