Financial Management

Equity source and dividend policy

Synopsis-03

Presented by:
Sk. Md. Tarikul Islam
FCA (ICAB), ACA (Eng. & Wales), MBA (UK)
Partner
Hoda Vasi Chowdhury & Co

15 May 2020
 Session Focuses On:

Equity Source and Dividend Policy

 The M & M view

 They argued that cost of equity finance is same

irrespective of whether the equity is new shares, a
rights issue or retained profit.
For example, ke= D0 / P0

 If returns to investors fall, i.e. dividend falls, then

the value of share price will fall as well. This
results in the required rate of returns being
maintained at the required level.
 The M & M view
 Example
Zeus Plc is an equity-financed company. It has in issue 5,000,000 shares.
These are currently quoted at $5.50 each cum-div. The dividend
proposed for the current year is 50p per share. No increase in this
dividend is anticipated unless new projects are accepted. There is no
long-term debt.
The company’s cost equity is 10%.
One such project is currently under consideration. This project would
involve investing $500,000 immediately. It would generate a cash surplus
of $100,000 in one year’s time and annually thereafter in perpetuity. The
project cash flows are known to the market, and do not after the
company’s risk. All of the project cash flows would be paid as dividends.
 The M & M view
The NPV of the project is ($500,000) + $100,000/0.1 = $500,000

You are asked to evaluate three alternative sources of finance

form the point of view of the existing shareholders:
a) A reduction in the current year’s dividend to 40p per share, so
as to release $500,000 of internally generated funds.
b) A rights issue on a one-for-ten basis at $1 per share.
c) A new issue of shares. These would be identical to existing
ordinary shares and would first rank for dividend in one year’s
time.
Ignore taxation and issue costs.
 Pecking order

 The order in which equity funds may be used is as under:

• Retained earnings as they involve no issue costs;
• Right issues because of relatively low issue costs; and
• New issues might be the most expensive source as it involves
high issue costs.
 M & M and Dividend Policy
The Theory
M & M proposed that the pattern of dividends over time is irrelevant
in determining shareholder wealth. M & M are not saying that
dividends themselves are irrelevant but they are saying that pattern
of payments is irrelevant.
Relevance of dividend policy:
a. Traditional theory
Traditionalist argued that dividend income received now is more
certain than future’s capital gain. This implies that cost of equity
increases over time, i.e. later cash flows should be discounted at a
higher rate than earlier cash flows.
Criticism: The resolution of uncertainty is fallacious as risk is related
to nature of projects rather than timing of cash flows.
 M & M and Dividend Policy
b. Dividend signalling
Many authorities claim that, the pattern of dividend is key consideration
and therefore, a sudden dividend cut would usually have a serious effect
upon equity value. This argument implies that dividend policy is relevant.
Criticism: It is against strong form of market efficiency.
c. Clientele
Investors may be attracted to firms by their dividend policy. This might be
because high pay-outs attract those who prefer current income or low
payment attract those with high marginal income tax rates. On contrary,
new clientele may find new policy attractive.
 M & M and Dividend Policy
• Preference for current income: Many investors require cash to
finance consumption.
• Taxation: Dividend and capital gain are taxed differently on
different hands.
d. Cash
If cash is unavailable to pay dividend, either the planned investment
should be cut back or money borrowed to avoid adverse signaling
effects.
e. Agency theory: So called battle between managers and
shareholders
* Share buy back and scrip dividend
• Conclusion:
M & M are probably right, despite their assumptions. But evidence
also points to a clientele effect. Perhaps the best a firm can do is
establish a dividend policy and stick with it.
 Business Planning and Restructuring
 Organic growth:
This involves the retention of profit and/or raising of new finance to
fund internally generated projects.
Advantages
- Cost spread over time
- Better Control
- Slower rate of change and therefore avoids disruption
Disadvantages
- Risk of failure
- Too slow
-Barriers to entry in new market
 Business Planning and Restructuring

 Acquisition: Here the bidder company acquires the target

company either in its entirely or by buying sufficient shares in the
target to exercise control. Some of the reasons why business
combine are as under:
• Synergy;
• Risk reduction;
• Reduced competition;
• Vertical integration.

Disadvantages could be risky, pay too much, cultural unfit, integration issue etc.
 Valuation
 Reasons for valuation:
- To establish merger/takeover terms
- Share purchase/sale decision
- Listing in the stock exchange
- To value shares sold in a private company
- Tax purpose
- Divorce settlement
- To value subsidiaries for disposal, MBO etc.
 Valuation

Asset-based approaches
A. Historical cost (Book value)
i. Balance sheet value
ii. Meaningless as it is not market value
B. Net realisable value
i. NRV of asset less liabilities
ii. Minimum acceptable value
iii. Problems:
- Estimating NRV is difficult for specialized assets
- Redundancy costs, liquidator’s cost, tax
- Ignores goodwill
- Particularly useful for controlling interest
 Valuation

Asset-based approaches
C. Replacement cost
i. Cost of setting up business from scratch
ii. Maximum price for buyer
iii. Problems:
- Estimating replacement costs
- Ignores goodwill
- Particularly useful for controlling interests
D. General
- Asset are more certain than income
- Useful for asset strippers
- Service businesses often have few tangible assets
 Valuation

Income-based approaches
A. General
- Forecasting problems
- Type of business- more appropriate than assets for service
business

B. PV of future cash flows

Theoretically superior model. FCFF Vs FCFE

C. Problems
- Estimating future cash flows
- Estimating discounting rate
- Time horizon
 Valuation
Price of the acquisition: The maximum price a bidder should
pay for a target is:
Market value of combined business less market value of
bidder before bid is made.
Page 325, IQ 2

Income-based approaches
D. PE Ratio
A company having great deal of potential will have high
PE ratio.
Page 326-327, IQ 3-4
 Valuation

Income-based approaches
E. Dividend valuation
Useful for non-controlling interest.
Problems:
- Estimating future dividend and growth
- Estimating Ke (risk)
- Adjustments for non-marketability
- It is not useful for valuating controlling interest
Page 327, IQ 5
 Valuation

SVA Valuation
i. Two relevant periods to consider
- Competitive advantage period
- After the competitive advantage period
ii. Estimate future cash flows and discount at
current WACC
iii. Short-term investment, if any shall be added
iv. Market value of debt should be deducted to
value equity
Page 328, worked example
 Valuation

Other factors in valuation:

i. Quoted companies
- Minimum value
- Premium for bulk buying
ii. Income valuation
- Surplus asset should be added
- Trade investment and non-trade investment
- Freehold properties
- Directors’ Remuneration
- Preference shares and debenture
 Valuation

Other factors in valuation:

iii. General
- HRM
- Service contracts
- Restrictive covenants
- Other bidders will push up the price
ii. Methods of payment
- Cash
- Share for share exchange
- Loan for share
 Business Planning and Restructuring

Reasons for divestment:

•Lack of fit;
•Size of the investment;
•Conglomerate discount;
•It is trading poorly;
•A better offer.
 Business Planning and Restructuring
 Management buy-outs (MBOs): The part of the business
being sold is bought by its existing management from the
parent company. Funding:
Junk bond
Mezzanine

 Management buy-ins (MBIs): Same as an MBO but the

business is bought buy an external group of managers who
have not previously been connected with running the
business.
 Business Planning and Restructuring
 Sell-offs: The sale, normally for cash, of part of the operations
of a business to another established business.

 Spin-offs or demerger: The shareholders are given shares in

the new equity pro-rata to their shareholding in the original
parent. Effects are:
• No change in ownership occurs;
• It gives separate corporate identities;
• May avoid the problem of conglomerate discount;
• To avoid the takeover of the whole business.
 Business Plan
Standard format:
Front sheet: Title page, foreword or disclaimer
Contents page
1. Executive summary
2. History and background
3. Mission statement and objectives
4. Products or services
5. Market information
6. Resource employed, management and operations
7. Financial information, risks and returns
8. Summary action plan containing milestones
9. Appendices – past accounts, CVs, market research, brochures,
technical data etc.
Sensitivity analysis and financing decision