Human Resources/Financial Management
Im doing my MBA in Annamalai University. please help me out
1. "The Profit Maximization is not an operationally feasible criteria" Do you agree? Illustrate your views.
2."The function of Financial Management is to review and control discussion to commit or recommit funds to new or ongoing uses. Thus in addition to raising funds, financial Management is directly concerned with production, marketing and other functions within an enterprise whenever decisions are made about the acquisition of assets". Elucidate.
3. "when the corporate income taxes are assumed to exist Modigilani- Miller ad the traditional theorists agree that capital structure does affect value. So the basic point of disputes disappears". do you agree? why or why not?
4. "The Contention that dividends have an impact on the share price". Explain the essentials of this argument. Why the argument is considered fallacious.
Thanks & Regards,
1.. “The profit maximization is not an operationally feasible criteria” Do you agree? Illustrate your views.
Financial Management Introduction:
Finance is regarded as the lifeblood of a business enterprise. It is the basic foundation of all kinds of economic activities. Finance is the master key that provides access to all the sources for being employed in manufacturing and merchandising activities. The success of an organization largely depends on efficient management of its finances.
Meaning of Financial Function: Objectives of Financial Management:
It is generally agreed that the objective of financial management should be maximization of economic welfare of shareholders. In order to achieve this and to make wise decisions, a clear understanding of the objectives which are sought to be achieved is necessary. The objectives provide a framework for optimum financial decision making. The following are the two widely discusses approaches in financial literature to achieve the above objective.
1. Profit Maximization
2. Wealth Maximization
It is an important concept in economic theory. It simply means that maximizing the rupee income of the firm. According to this approach, actions that increase profits should be undertaken and those that decrease profits are to be avoided. The profit maximization criterion implies that the investment, financing and dividend policy decisions of a firm should be oriented to the maximization of profits.
This objective is justified on the following grounds:
h The very survival of the organization will be depending upon whether it is able to earn profits or not.
h Profit is a test of economic efficiency.
h It indicates the effective utilization of resources.
h It ensures maximum social welfare.
Profit maximization suffers from the following limitations:
1. Profit maximization concept is vague or ambiguous:
The definition of profit itself is ambiguous. Its has no precise connotation. It is amenable to different interpretations by different people. For example, profit may be short-term profit or long-term, it may total profit or rate of profit, it may be before tax or after tax, it may be return on capital employed or return on total assets. Hence, a loose expression like profit cannot form the basis of operational criterion for financial management.
2. It ignores timing of benefits:
The second limitation to the objective of profit maximization is that it ignores the differences in time pattern of the benefits received from investment proposals. The principle of the bigger the better is adopted for decision making.
3. It ignores quality of benefits:
The profit maximization concept ignores consistency or the degree of certainty in getting returns from investment proposals. In view of the above limitations, the profit maximization criterion is considered as inappropriate and unsuitable operational criterion for financial decisions. It is not only vague and ambiguous but it also ignores risk and time value of money. As an alternative to the profit maximization, the other criterion, that is, wealth maximization is developed.
This is also known as value maximization or net present worth maximization. Net present value is the difference between the gross present value of benefits from an investment proposal and the investment required achieving these benefits. The gross present value of a course of action is found out by discounting or capitalizing its benefits at a rate, which reflects their timing or uncertainty. Any financial action with a positive net present worth should be undertaken otherwise it should be rejected.
The objective of wealth maximization resolves two basic limitations of profit maximization.
1. It considers time value of money.
2. It takes care of uncertainty of expected benefits and the benefits are measured in terms of cash flows and not accounting profits.
The wealth maximization objective is consistent with the objective of maximization of economic welfare of shareholders. The wealth of shareholders id reflected by the market value of the company shares. Hence, wealth maximization implies the maximization of the market value of the companys shares, which is the fundamental objective of the firm.
For the above reasons, the wealth maximization criterion is considered to be superior to the profit maximization as an operational objective.
The traditional approach to financial management was popular in the initial stages of its evolution as a separate branch of academic study. Under this approach the role of finance smanager was limited to raising and administering of funds needed by the corporate enterprises to meet their financial needs. It broadly covers the following three aspects:
1.Arrangement of funds from financial institutions.
2.Arrangement of funds through instruments as shares, bonds etc.
3.The legal and accounting relationships between a firm and its sources of funds.
The scope traditional approach to the scope of finance function evolved during the 1920s and 1930s and dominated academic thinking during the fifties and through the early forties. It has now been discarded as it suffers from serious limitations.
The traditional approach outlived its utility due to changed business situations since mid 1950s. The modern approach views the term financial management in a broad sense and provides a conceptual and analytical framework for financial decision making. According to it, the finance function covers both funds as well as their allocations.
The new approach is an analytical way of viewing the financial problems of a firm
. The principle contents of the modern approach to financial management can be said to be:
* How large should an enterprise be, and how fast it should grow
*In what form should it hold assets
*What should be the composition of its liabilities
The questions posed above cover between them the major financial problems of a firm. In other words, financial management, according to the new approach is concerned with the solution of three major problems relating to the financial operations of a firm. They are:
1.The investment decision
2.The dividend policy decision.
Thus,finance is regarded as the lifeblood of a business enterprise.The success of an organization largely depends on efficient management of its finances.
2. “The function of Financial Management is to review and control decisions to commit or recommit funds to new or ongoing uses. Thus in addition to raising funds, financial Management is directly concerned with production, marketing and other functions within an enterprise whenever decisions are made about the acquisition or destruction of assets”. Elucidate.
• Business concern needs finance to meet their requirements in the economic world. Any kind of business activity depends on the finance. Hence, it is called as lifeblood of business organization. Whether the business concerns are big or small, they need finance to fulfill their business activities..In the modern world, all the activities are concerned with the economic activities and very particular to earning profit through any venture or activities.
MEANING OF FINANCE
It includes financial service and financial instruments. The concept of finance includes capital, funds, money, and amount. But each word is having unique meaning
• “Finance is the art and science of managing money”
• word ‘finance’ connotes ‘management of money’
• BUSINESS FINANCE “Business finance is that business activity which concerns with the acquisition and conversation of capital funds in meeting financial needs and overall objectives of a business enterprise”.
“Business finance can broadly be defined as the activity concerned with planning, raising, controlling, administering of the funds used in the business”.
The Four Management Functions:
Planning is the ongoing process of developing the business' mission and objectives and determining how they will be accomplished. Planning includes both the broadest view of the organization, e.g., its mission, and the narrowest, e.g., a tactic for accomplishing a specific goal.
Planning is the first tool of the four functions in the management process. The difference between a successful and unsuccessful manager lies within the planning procedure. Planning is the logical thinking through goals and making the decision as to what needs to be accomplished in order to reach the organizations’ objectives. Managers use this process to plan for the future, like a blueprint to foresee problems, decide on the actions to evade difficult issues and to beat the competition. Planning is the first step in management and is essential as it facilitates control, valuable in decision making and in the avoidance of business ruin.
Quality in the results that are achieved and how the results are reached doing what is right, respect for others, value those that lead and take pride in all they do, and the value of teamwork to reach common goals.
Organizing is establishing the internal organizational structure of the organization. The focus is on division, coordination, and control of tasks and the flow of information within the organization. It is in this function that managers distribute authority to job holders.
Staffing is filling and keeping filled with qualified people all positions in the business. Recruiting, hiring, training, evaluating and compensating are the specific activities included in the function. In the family business, staffing includes all paid and unpaid positions held by family members including the owner/operators.
In order to reach the objective outlined in the planning process, structuring the work of the organization is a vital concern. Organization is a matter of appointing individuals to assignments or responsibilities that blend together to develop one purpose, to accomplish the goals. These goals will be reached in accordance with the company’s values and procedures. A manager must know their subordinates and what they are capable of in order to organize the most valuable resources a company has, its employees . This is achieved through management staffing the work division, setting up the training for the employees, acquiring resources, and organizing the work group into a productive team. The manager must then go over the plans with the team, break the assignments into units that one person can complete, link related jobs together in an understandable well-organized style and appoint the jobs to individuals. .
Directing is influencing people's behavior through motivation, communication, group dynamics, leadership and discipline. The purpose of directing is to channel the behavior of all personnel to accomplish the organization's mission and objectives while simultaneously helping them accomplish their own career objectives.
Organizational success is determined by the quality of leadership that is exhibited. "A leader can be a manager, but a manager is not necessarily a leader," . Leadership is the power of persuasion of one person over others to inspire actions towards achieving the goals of the company. Those in the leadership role must be able to influence/motivate workers to an elevated goal and direct themselves to the duties or responsibilities assigned during the planning process.. Leadership involves the interpersonal characteristic of a manager's position that includes communication and close contact with team members.
Controlling is a four-step process of establishing performance standards based on the firm's objectives, measuring and reporting actual performance, comparing the two, and taking corrective or preventive action as necessary.
The process that guarantees plans are being implemented properly is the controlling process. ‘Controlling is the final link in the functional chain of management activities and brings the functions of management cycle full circle.’ This allows for the performance standard within the group to be set and communicated. Control allows for ease of delegating tasks to team members and as managers may be held accountable for the performance of subordinates, they may be wise to extend timely feedback of employee accomplishments.
Importance of Management Planning
The four functions of management planning, organizing, leading and controlling, assume a great worth in the success of any business every day. In all organizations, each employee’s individual contribution to the success of the company is of enormous importance as the company’s goals would not be met and success would not be reached.
Financial management is an integral part of overall management. It is concerned with the duties of the financial managers in the business firm. The term financial management “It is concerned with the efficient use of an important economic resource namely, capital funds”.
SCOPE OF FINANCIALMANAGEMENT Financial management is one of the important parts of overall management, which is directly related with various functional departments like personnel, Marketing and production. Financial Management and Economics Financial Management and Accounting Financial Management and Marketing
Direct, control and administer the financial activities of the organization, and provide the Chief Executive and the Board with financial assessments and information which will ensure planning and budgeting activities meet corporate goals.
In consultation with other senior management, make recommendations and devise financial policy approach, and strategy.
Establish and direct the organisation's financial administrative activities and operational procedures to ensure the organisation's profits are protected.
Plan the financial operations of the organisation.
Provide financial information and interpretations to other management.
Co ordinate the development, implementation and monitoring of financial accounting and related systems.
Direct the collection of financial and accounting information and the preparation of budgets, reports, forecasts, and consolidated profit and loss reports.
Co ordinate the design, implementation and monitoring of up to date or computerised accounting and administrative systems.
Direct and co ordinate economic research, major feasibility studies involving detailed financial analysis, and estimates of future returns on proposed investment.
Evaluate the financial aspects of proposed acquisitions, investments, mergers, or the sale of assets or businesses.
Give assessments of proposals involving financial expenditure and of the financial status of operational projects.
Control activities such as taxation, credit policy, cash flow and investment policy, costing and expense control, preparation of tenders, audits administration of contracts, insurance arrangements and property administration.
Represent the organisation in dealings with the organisation's bankers, legal advisers, major clients and others as required.
Make policy decisions and accept responsibility for operations, performance of staff, achievement of targets and adherence to budgets, standards and procedures.
Control the selection and training of finance staff, establish lines of control and delegate responsibilities to subordinate staff.
OBJECTIVES OF FINANCIALMANGEMENT
PROFIT MAXIMIZATION Main aim of any kind of economic activity is earning profit. A business concern is also functioning mainly for the purpose of earning profit
WEALTH MAXIMIZATION Wealth maximization is one of the modern approaches, which involves latest innovations and improvements in the field of the business concern.
APPROACHES OF FINANCIALMANAGMENT
Financial management approach measures the scope of the financial management fields, which include the essential part of the in various finance. Financial management is not a revolutionary concept but an evolutionary
Traditional Approach Traditional approach is the initial stage of financial management, which was followed, in the early part of during the year 1920 to 1950.
FUNCTION OF FINANCE MANAGER
Finance function is one of the major parts of business organization, which involves the permanent, and continuous process of the business concern. Finance is one of the interrelated functions which deal with personal function, marketing function, production function and research and development activities of the business concern. Forecasting Financial Requirements Investment Decision
IMPORTANCE OF FINANCEMANAGEMENT
Finance is the lifeblood of business organization. It needs to meet the requirement of the business concern. Each and every business concern must maintain adequate amount of finance for their smooth running of the business concern and also maintain the business carefully to achieve the goal of the business concern.
Financial Planning Proper Use of Funds Increase the Value of the Firm
3. “When the corporate income taxes are assumed to exist Modigilani-Miller and the traditional theorists agree that capital structure does affect value. So the basic point of disputes disappears”. Do you agree? Why or why not?
According to many research of corporation finance, the capital structure decision is one of the most fundamental issues facing to the executives and management level. The corporate finance is a specific area of finance dealing with the financial decisions corporations make and the tools as well as analysis used to make these decisions. The discipline as a whole may be divided among long-term and short-term decisions and techniques with the primary goal being maximizing corporate value while managing the firm's financial risks. Capital investment decisions are long-term choices that investment with equity or debt, and the short-term decisions deals with the balance of current assets and current liabilities which is managing cash, inventories, and short-term borrowing and lending. Corporate finance can be defined as the theory, process and techniques that corporations use to make the investing, financing and dividend decisions that ultimately contribute to maximizing corporate value.Thus, a corporation will first decide in which projects to invest, then it will figure out how to finance them, and finally, it will decide how much money, if any, to give back to the owners. All these three dimensions which are investing, financing and distributing dividends are interrelated and mutually dependent.
The capital structure of a company refers to a combination of debt, preferred stock, and common stock of finance that it uses to fund its long-term financing. Equity and debt capital are the two major sources of long-term funds for a firm. The theory of capital structure is closely related to the firm's cost of capital. As the enterprises to obtain funds need to pay some costs, the cost of capital in the investment activities is also the main consideration of rate of return. The weighted average cost of capital (WACC) is the expected rate of return on the market value of all of the firm's securities. WACC depends on the mix of different securities in the capital structure; a change in the mix of different securities in the capital structure will cause a change in the WACC. Thus, there will be a mix of different securities in the capital structure at which WACC will be the least. The decision regarding the capital structure is based on the objective of achieving the maximization of shareholders wealth.
With regard to the capital structure of the theoretical basis, most well-known theory is Modigliani-Miller theorem of Franco Modigliani and Merton H.Miller (1958 and 1963). Yet the seeming simple question as to how firms should best finance their fixed assets remains a contentious issue.
2. Modigliani-Miller Proposition I
The Modigliani-Miller Proposition I Theory (MM I) states that under a certain market price process, in the absence of taxes, no transaction costs, no asymmetric information and in an perfect market, the cost of capital and the value of the firm are not affected by the changed in capital structure. The firm's value is determined by its real assets, not by the securities it issues. In other words, capital structure decisions are irrelevant as long as the firm's investment decisions are taken as given.
The Modigliani and Miller (1958) explained the theorem was originally proven under the assumption of no taxes. It is made up of two propositions that are (i) the overall cost of capital and the value of the firm are independent of the capital structure. The total market value of the firm is given by capitalizing the expected net operating income by the rate appropriate for that risk class. (ii) The financial risk increase with more debt content in the capital structure. As a result, cost of equity increases in a manner to offset exactly the low cost advantage of debt. Hence, overall cost of capital remains the same.
The assumptions of the MM theory are:
1. There is a perfect capital market. Capital markets are perfect when
l investors are free to buy and sell securities
l investors can trade without restrictions and can borrow or lend funds on the same terms as the firms do
l investors behave rationally
l investors have an equal access to all relevant information
l capital markets are efficient
l no costs of financial distress and liquidation
l there are no taxes
2. Firms can be classified into homogeneous business risk classes. All the firms in the same risk class will have the same degree of financial risk.
3. All investors have the same view for the investment, profits and dividends in the future; they have the same expectation of a firm's net operating income.
4. The dividend payout ration is 100%, which means there are no retained earnings.
In the absence of tax world, base on MM Proposition I, the value of the firm is unaffected by its capital structure. In other words, regardless of whether a company has liabilities, the total risk of its securities holders will not change even the capital structure is changed. As the weighted average cost of capital unchanged, so must the same as the total value of the company. That is VL = VU = EBIT/ requity where VL is the value of a levered firm = price of buying a firm that is composed of some mix of debt and equity, VU is the value of an unlevered firm = price of buying a firm composed only of equity and EBIT is earnings before interest and tax. Whether or not the company has loans or the loans for high or low, investors are all accessible through the following two kinds of investment on their own to create the desired type of earning.
1. direct invested in the company's stock borrowing
2. if shares of levered firms are priced too high, investors will try to take advantage of borrowing on their own and use the money to buy shares in unlevered firms. The use of debt by the investors is known as homemade leverage.
The investors of homemade leverage can obtain the same return as the levered firms, therefore, for investors; the value of the firm is not affected by debt-equity mix.
The MM Proposition I assumptions are quite unrealistic, there have some implications, (i) Capital structure is irrelevant to shareholder wealth maximization. (ii) The value of the firm is determined by the firm's capital budgeting decisions. (iii) Increasing the extent to which a firm relies on debt increases both the risk and the expected return to equity - but not the price per share. (iv) Milton Harris and Artur Raviv (1991) illustrated the asymmetric information that firm managers or insiders are assumed to possess private information about the characteristics of the firm's return stream or investment opportunities. They will know more about their companies' prospects, risks and values than do outside investors. Then it cannot fulfill the assumption of perfect market.
Based on the inadequate of MM Proposition I, Franco Modigliani and Merton H.Miller revised their theory in 1963, which is MM Proposition II.
3. Modigliani-Miller Proposition II
The Modigliani-Miller Proposition II Theory (MM II) defines cost of equity is a linear function of the firm's debt/equity-ratio. According to them, for any firm in a given risk class, the cost of equity is equal to the constant average cost of capital plus a premium for the financial risk, which is equal to debt/equity ratio times the spread between average cost and cost of debt. Also Modigliani and Miller (1963) recognized the importance of the existence of corporate taxes. Accordingly, they agreed that the value of the firm will increase or the cost of capital will decrease with the use of debt due to tax deductibility of interest charges. Thus, the value of corporation can be achieved by maximizing debt component in the capital structure. This theory of capital structure for the study provided an important and analytical framework. According to this approach, value of a firm is VL = VU = EBIT (1-T) / requity + TD where TD is tax savings. MM Proposition II is assuming that the tax shield effect of each is the same, and continued in sight. Leverage firms are increased in interest expense due to reduced tax liability, has also increased the allocation to the shareholders and creditors of the cash flow. The above formula can be deduced from the company debt the more the greater the tax saving benefits, the greater the value of the company. The revised capital structure of the MM Proposition II, pointed out that the existence of tax shield in a perfect capital market conditions cannot be reached, in an imperfect financial market, the capital structure changes will affect the company's value. Therefore, the value and cost of capital of corporation with the capital structure changes in different leverage, the value of the levered firm will exceed the value of the unlevered firm.
MM Proposition theory suggests that the higher the debt ratio is more favorable to corporate, but though borrowing adds an interest tax shield it may lead to costs of financial distress. Financial distress occurs when promises to creditors are broken or honored with difficulty. Financial distress may lead to bankruptcy. The trade-off theory of capital structure theory in MM based on the added risk of bankruptcy and further improves the capital structure theory, to make it more practical significance.
3.1 Trade-off Theory of capital structure
According to Myers (1984), a firm that follows the trade-off theory sets a target debt to value ratio and then gradually moves towards the target. The target is determined by balancing the tax benefits of using debt against costs of financial distress that rise at an increasing rate with the use of leverage. It so predicts moderate amount of debt as optimal. But there is evidence that the most profitable firm in an industry tend to borrow the least, while their probability of entering in financial distress seems to be very low. This fact contradicts the theory because if the distress risk is low, an increase of debt has a favorable tax effect. Under the trade-off theory, high profits should mean more debt-servicing capacity and more taxable income to shield and therefore should result in a higher debt ratio.
3.2 Pecking Order Theory of capital structure
The pecking order theory stems from Myers (1984) argues that adverse selection implies that retained earnings are better than debt and debt is better than equity. Firms prefer internal finance and if external finance is required, firms issue debt first and issue equity only as a last resort. The pecking order explains why the most profitable firms generally borrow less because they have low target debt ratios but they don't need outside money. As in Baskin (1989), asymmetric information affects capital structure by limiting access to outside finance. Managers know more than outside investors about the profitability and prospects of the firm. Information problems are particularly acute with common stock, announcement of stock issue can drive down the stock price.
The capital structure decision is one of the most fundamental issues in corporate finance. Regardless of which kind of capital structure, to achieve one of the most optimal capital structures, the company should be mixture of equity and debt and it cannot only focus on equity or debt. Equity is a cushion and debt is a sword, debt is always cheaper than equity, partly because lenders bear less risk and partly because of the tax advantage associated with debt. In general, there are differences in the capital structures of different industries; they are having their own characteristic. The most important thing is the company's liquidity is sufficient or not. In making the decision of how to allocate the fund in which type of assets, the company has to consider and compare the different factors such as NPV, IRR and payback period. In evaluating the NPV, IRR and payback period, cash inflow is fund of the vital element. Therefore the company should know how to obtain the financing and how to invest it. They should carefully to allocate their resources to maximize the firm value.
4. “The contention that dividends have an impact on the share price”. Explain the essentials of this argument. Why the argument is considered fallacious.
At the end of each year, every publicly traded company has to decidewhether to return cash to its stockholders and, if yes, how much in the form of dividends. The owner of a private company has to make a similar decision about how much cash he plans to withdraw from the business, and how much to reinvest. This is the dividend decision.
Dividend influences investor attitudes. Stock holders look negatively on thecompanies that cut dividend, since they associate such cutbacks with the financial difficulties
. In establishing a dividend policy, a financialmanager must determine and fulfil the owner’s objectives; otherwise thestockholders may sell their shares in turn driving down the market priceof the stock. Stock holder dissatisfaction raises the possibility that controlof the company may be seized by an outside group. When a company’s earning increase, management does not automatically raise the dividend.Generally there is a time lag between increased earnings and the payment of a higher dividend. Once dividends are increased, they should continueto be paid at a higher rate. Various types of dividend policies are as below:
1.Stable dividend per share policy
: Many companies use a stabledividend per share policy since it is looked upon favourably byinvestors. Dividend stability implies a low risk company. Even in ayear that the company shows a loss rather than profit the dividendshould be maintained to avoid negative connotations to current and prospective investors. By continuing to pay the dividend, theshareholders are more apt to view the loss as temporary. Somestockholders rely on the receipt of stable dividends for income. Astable dividend policy is also necessary for a company to be placedon a list of securities in which financial institutions invest. Beingon such list provides greater marketability for corporate shares.
2.Constant dividend payout ratio policy
: With this policy a constant percentage of earnings are paid out in dividends. Because a netincome varies, dividends paid will also vary using this approach.The problem this policy causes is that if a company’s earning dropdrastically or there is a loss the dividends paid will be sharplycurtailed or nonexistent. This policy will not maximise market price per share since most stockholders do not want variability intheir dividend receipts.
3. A compromise policy
: A compromise between the policies of astable dollar amount and a percentage amount of earning is for acompany to pay a low dollar amount per share plus a percentageincrement in good years. While this policy affords flexibility, italso creates uncertainty in the minds of the investors as to theamount of dividends they re likely to receive. Stockholdersgenerally do not like such uncertainty. However the policy may beappropriate when earnings vary considerably over the years. The percentage or extra portion of the dividends should not be paidregularly; otherwise it becomes meaningless.
4. Residual Dividend Policy
: When a company’s investmentopportunities are not stable, management may want to consider afluctuating dividend policy. With this kind of policy, the amount of earnings retained depends upon the availability of investmentopportunities in a particular year. Dividends paid represent theresidual amount from earnings after the company’s investmentneeds are fulfilled.
A stable dividend payout indicates to the stockholders that the firm is successful and worthwhile to invest in
. The stock market views thedividend as a source of information about the future prospects of the firm.The announcement of dividends gives a ‘signal’ to the investors about the profitability of the firm.If the dividend policy was formulated to retain larger share of earnings, plenitude of resources will be available to the firm for its growth andmodernisation purposes. This will give rise to business earnings. In viewof the improved earnings & financial health of the enterprise, the value of shares will increase and a capital gain will result.
share holdersearn capital gain in lieu of dividends income, the former in the long runwhile the latter in the short run
.The reverse holds true if
liberal dividend policy is followed
to pay outhigher dividends to shareholders. Consequently, the shareholdersdividend earnings will increase but the possibility of earning capital gainsis reduced. Investors desirous of immediate income will value shares withhigh dividend greatly. The stock market may, therefore, respond to thisdevelopment and values of shares may zoom. It is thus evident that inretention of earnings lies on capital gains. Distribution of income, on theother hand, increases dividend earnings. Owing to varying notions andattitudes of shareholders due to difference in respect to age, tax bracket,security income, habits, preferences and responsibilities while some are
primarily concerned with the short run returns, others think in terms of long range returns and still others seek a portfolio which balances their expectations over time.
The above analysis leads us
to conclude that divided decision materially affects the stockholders wealth and so also the valuation of the firm
However financial scholars have not beenunanimous on this issue.There are
2 schools of thought on dividend policy.
•The dividend irrelevance school
believes that dividends do notreally matter, because they do not affect firm value. This argumentis based upon two assumptions. The first is that there is no taxdisadvantage to an investor to receiving dividends, and the secondis that firms can raise funds in capital markets for new investmentswithout bearing significant issuance costs.
•There are those in another group
who argue that
dividends areclearly good
because stockholders (or at least some of them)like them.
Although dividends have traditionally been considered the primaryapproach for publicly traded firms to return cash or assets to their stockholders, they comprise only one of many ways available to the firmto accomplish this objective. In particular, firms can return cash tostockholders through equity repurchases, where the cash is used to buy back outstanding stock in the firm and reduce the number of sharesoutstanding. In addition, firms can return some of their assets to their stockholders in the form of spin offs and split offs.
There are several ways to classify dividends
. First, dividends can be paidin cash or as additional stock.
increase the number of shares outstanding and generally reduce the price per share. Second, thedividend can be a
, which is paid at regular intervals(quarterly, semi-annually, or annually), or a
, which is paid in addition to the regular dividend. Most U.S. firms pay regular dividends every quarter; special dividends are paid at irregular intervals.Finally, firms sometimes pay dividends that are in excess of the retainedearnings they show on their books. These are called
and are viewed by the Internal Revenue Service as return oncapital rather than ordinary income. Consequently, they can havedifferent tax consequences for investors.
Some Reasons for Paying Dividends that do not measure up
Some firms pay and increase dividends for the wrong reasons. We willconsider two of those reasons :
1.The Bird-in-the-Hand Fallacy
One reason given for the view that investors prefer dividends to capitalgains is that dividends are certain, whereas capital gains are uncertain.Proponents of this view of dividend policy feel that risk averse investorswill therefore prefer the former. This argument is flawed. The simplestcounter-response is to point out that the choice is not between certaindividends today and uncertain capital gains at some unspecified point inthe future, but between dividends today and an almost equivalent amountin price appreciation today.Another response to this argument is that a firm’s value is determined bythe cash flows from its projects. If a firm increases its dividends but itsinvestment policy remains unchanged, it will have to replace thedividends with new stock issues. The investor who receives the higher dividend will therefore find himself or herself losing, in present valueterms, an equivalent amount in price appreciation.
2.Temporary Excess Cash
In some cases, firms are tempted to pay or initiate dividends in years inwhich their operations generate excess cash. Although it is perfectlylegitimate to return excess cash to stockholders, firms should alsoconsider their own long-term investment needs.
If the excess cash is atemporary phenomenon, resulting from having an unusually good year or a non-recurring action (such as the sale of an asset), and the firm expectscash shortfalls in future years, it may be better off retaining the cash tocover some or all these shortfalls.
Another option is to pay the
excess cash as a dividend in the current year and issue new stock when the cash shortfall occurs
. This is not very practical because the substantial expense associated with new securityissues makes this a costly strategy in the long term. Since issuance costsincrease as the size of the issue decreases and for common stock issues,small firms should be especially cautious about paying out temporaryexcess cash as dividends. This said, it is important to note that somecompanies do pay dividends
and issue stock during the course of the same period, mostly out of adesire to maintain their dividends. While it is not surprising that stocksthat pay no dividends are most likely to issue stock, it is surprising thatfirms in the highest dividend yield class also issue significant proportionsof new stock (approximately half of all the firms in this class also makenew stock issues). This suggests that many of these firms are payingdividends on the one hand and issuing stock on the other, creatingsignificant issuance costs for their stockholders in the process
Some Good Reasons for Paying Dividends
While the tax disadvantages of dividends are clear, especially for individual investors, there are some good reasons why firms that are paying dividends should not suspend them.
First, there are investors who like to receive dividends, either becausethey pay no or very low taxes, or because they need the regular cash flows
. Firms that have paid dividends over long periods are likely to haveaccumulated investors with these characteristics, and cutting or eliminating dividends would not be viewed favourably by this group.
Second, changes in dividends allow firms to signal to financial marketshow confident they feel about future cash flows
. Firms that are moreconfident about their future are therefore more likely to raise dividends;stock prices often increase in response. Cutting dividends is viewed bymarkets as a negative signal about future cash flows, and stock pricesoften decline in response.
Third, firms can use dividends as a tool for altering their financing mixand moving closer to an optimal debt ratio
. Finally, the commitmentto pay dividends can help reduce the conflicts between stockholders andmanagers, by reducing the cash flows available to managers.
Some investors like dividends
Many in the “dividends are bad” school of thought argue that rationalinvestors should reject dividends due to their tax disadvantage. Whatever might be the merits of that argument; some investors have a strong preference for dividends and view large dividends positively. The moststriking empirical evidence for this comes from studies of companies thathave two classes of shares: one that pays cash dividends and another that pays an equivalent amount of stock dividends; thus, investors are given achoice between dividends and capital gains.
John Long studied the price differential on Class A and B shares tradedon Citizens Utility. Class B shares paid a cash dividend, while Class Ashares paid an equivalent stock dividend. Moreover, Class A shares could be converted at little or no cost to Class A shares at the option of itsstockholders. Thus, an investor could choose to buy Class B shares to getcash dividends, or Class A shares to get an equivalent capital gain.During the period of this study, the tax advantage was clearly on the sideof capital gains; thus, we would expect to find Class B shares selling at adiscount on Class A shares. The study found, surprisingly, that the ClassB shares sold at a premium over Class A shares.While it may be tempting to attribute this phenomenon to the irrational behaviour of investors, such is not the case. Not all investors likedividends –– many feel its tax burden–– but there are also many whoview dividends positively. These investors may not be paying much intaxes and consequently do not care about the tax disadvantage associatedwith dividends. Or they might need and value the cash flow generated bythe dividend payment. Why, you might ask, do they not sell stock to raisethe cash flow they need? The transactions costs and the difficulty of breaking up small holdings and selling unit shares may make sellingsmall amounts of stock infeasible.
The Clientele Effect
There are companies that pay no dividends, such as Microsoft, and whosestockholders seem perfectly content with that policy. Given the vastdiversity of stockholders, it is not surprising that, over time, stockholderstend to invest in firms whose dividend policies match their preferences.Stockholders in high tax brackets who do not need the cash flow fromdividend payments tend to invest in companies that pay low or nodividends. By contrast, stockholders in low tax brackets who need thecash from dividend payments, and tax-exempt institutions that needcurrent cash flows, will usually invest in companies with high dividends.This clustering of stockholders in companies with dividend policies thatmatch their preferences is called the clientele effect
Consequences of the Clientele Effect
The existence of a clientele effect has some important implications. First,it suggests that firms get the investors they deserve, since the dividend policy of a firm attracts investors who like it. Second, it means that firm
will have a difficult time changing an established dividend policy, even if it makes complete sense to do so.The clientele effect also provides an alternative argument for theirrelevance of dividend policy, at least when it comes to valuation.
In summary, if investors migrate to firms that pay the dividends that mostclosely match their needs, no firm’s value should be affected by itsdividend policy. Thus, a firm that pays no or low dividends should not be penalized for doing so, because its investors
do not want
dividends.Conversely, a firm that pays high dividends should not have a lower value, since its investors like dividends.This argument assumes that there are enough investors in each dividendclientele to allow firms to be fairly valued, no matter what their dividend policy.
Dividends operate as a information signal
Financial markets examine every action a firm takes for implications for future cash flows and firm value. When firms announce changes individend policy, they are conveying information to markets, whether theyintend to or not.Financial markets tend to view announcements made by firms about their future prospects with a great deal of skepticism, since firms routinelymake exaggerated claims. At the same time, some firms with good projects are under valued by markets. How do such firms conveyinformation credibly to markets? Signaling theory suggests that thesefirms need to take actions that cannot be easily imitated by firms withoutgood projects.
Increasing dividends is viewed as one such action. Byincreasing dividends, firms create a cost to themselves, since they commit to paying these dividends in the long term.
Their willingness to make thiscommitment indicates to investors that they believe they have thecapacity to generate these cash flows in the long term. This positive signal should therefore lead investors to revaluate the cash flows and firm values and increase the stock price. Decreasing dividends is a negative signal
, largely because firms arereluctant to cut dividends. Thus, when a firm take this action, markets seeit as an indication that this firm is in substantial and long-term financialtrouble. Consequently, such actions lead to a drop in stock prices.
We should view this explanation for dividends increases and decreasescautiously, however. Although it is true that firms with good projects mayuse dividend increases to convey information to financial markets, giventhe substantial tax liability that increased dividends create for stockholders, is it the most efficient way? For smaller firms, which haverelatively few signals available to them, the answer might be yes. For larger firms, which have many ways of conveying information tomarkets, dividends might not be the least expensive or the most effectivesignals. For instance, the information may be more effectively andeconomically conveyed through an analyst report on the company. Thereis another reason for skepticism. An equally plausible story can be toldabout how an increase in dividends sends a negative signal to financialmarkets. Consider a firm that has never paid dividends in the past but hasregistered extraordinary growth and high returns on its projects. Whenthis firm first starts paying dividends, its stockholders may consider thisan indication that the firm’s projects are neither as plentiful nor aslucrative as they used to be.
In summary, there is some truth to all these viewpoints, and it may be possible to develop a consensus around the points on which they agree.The reality is that dividend policy requires a trade-off between theadditional tax liability it may create for firms and the potential signalingand free cash flow benefits of making the additional commitment to their stockholders. In some cases, the firm may choose not to increase or initiate dividends, because its stockholders are in high tax brackets andare particularly averse to dividends. In other cases, dividend increasesmay result.