Questions With Answers on Finance: Dividends - Paper Example

a) Considerations when deciding the size of the annual dividend to return to shareholders

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The free cash flow, the surplus of cash over what a firm needs to fund all its investment needs, should be a major consideration when a listed firm is deciding on the size of the dividend to return to its shareholders. Empirical evidence suggests that free cash flow has a positive relation to a firms payout ratio, which is consistent with the propositions of the agency theory. According to the agency theory, the possession of high free cash flows necessitates the payment of high dividends in order to minimize conflict between the management and shareholders. If a firm with high free cash flow pays low dividends, the managers can opt to, among others, invest in projects whose net value is negative, leading to the erosion of shareholder value in the firm. The size of the annual dividend that a firm returns to its shareholders should be directly proportional to the level of its free cash flow.

Growth should also comprise the set of considerations that guide a firm when deciding on the amount of dividend to pay its shareholders. When a firm has a high rate of growth in turnover, it will have to increase its capital investment, and it must use retained earnings to fund part of the capital investment. If the firm maintains a constant dividend payout rate while it has an increasing rate of turnover growth, it will inevitably have to increase the level of external funding. However, external funding is expensive and can result in high costs of capital, which means increasing the level of retained earnings is more viable compared to increasing the level of external funding. Increasing retained earnings requires a reduction in the size of the dividend paid to shareholders, and, therefore, shareholders of firms with a high turnover growth rate must contend with low dividend payouts. Conversely, firms whose turnover is constant or growing at a declining rate should have a high dividend payout; a decline in the rate of turnover growth means a firm might have a high free cash flow, and having high retained earnings when the free cash flow is high increases the potential for conflict between a firms management and its shareholders.

Managers should also consider a firms leverage when deciding on the size of the dividend to pay the shareholders. Internal financing is not as costly as external financing is. If the leverage is high, the transaction costs will also be high. Therefore, firms with high leverage should cut down on dividend payment and use retained earnings to reduce their transaction costs. Looking at the agency costs of debt, it also becomes apparent that, the dividend payout of the firm should be inversely proportional to its financial leverage. Companies seek to maximize shareholder value, and the managers might try to favor a firms shareholders to the detriment of the bondholders. Bondholders, being aware of the potential opportunistic behavior of a firms management, resort to a raft of measures - such as restrictive covenants - to preempt the erosion of their wealth. With an increase in leverage, a firms risk exposure also increases, which might force a firms bondholders to force more restrictions on dividend payment. Overall, when the firms leverage is growing, the management should reduce the size of the dividend it pays its shareholders, while when the leverage is falling, it can consider increasing the dividend payout.

b) Practical issues to consider when deciding on the size of the annual dividend payment

Company risk also deserves consideration during decisions on the dividend payout. As the risk exposure of a firm increases, the stock price becomes highly volatile, which creates difficulties in planning operations and investment. The uncertainty posed by planning difficulties makes it more appropriate to build a cash reserve from retained earnings than to make high dividend payouts; a substantial cash reserve makes it easy for the company to deal with unforeseen future cash outflows. One might argue that firms can resort to external financing to plug cash deficits occasioned by unforeseen cash outflows. However, firms with a high risk-exposure might not find it easy to obtain funds from the capital and financial markets; lenders charge high interest rates to compensate for the additional risk from lending to firms with uncertain future cash flow. Therefore, managers should reduce dividend payment when a firms risk increases.

Company size is also an important consideration when making decisions on the dividend payout. The separation of ownership from management in large firms creates agency problems. As a firm grows in size, so does the magnitude of the agency problem. In big companies, the shareholder base is large and diverse. Considering that each shareholders relative ownership decreases in a large firm, individual shareholders might not have the incentive to exercise oversight over how the managers are running the firms affairs. The reduced incentive of individual shareholders can increase agency costs, and to reduce these costs, a firm might have to pay large dividends to its shareholders. Thus, as the size of the firm increases, the managers should consider increasing the size of the dividend payout.

c) Wealth effects of the three dividend options

A cash dividend payment of 15p per share means a shareholder owning 1250 shares will receive 1250*15 = 18,500p. With the cash dividend, the investors wealth will increase by 185. If the company pays a 5% scrip dividend, it means existing shareholders will get an additional share for every 20 shares they currently hold. For an investor with 1250 shares, the 5% scrip dividend will result in 1250/20 = 62.5 ~ 62 additional shares. With a share price of 432p, the 5% scrip dividend will increase the investors wealth by 432p*62 = 26,784p ~ 267.84. If we assume that the current shareholders acquired Squeezecos ordinary shares at their par value, it means an investor holding 1250 shares has wealth amounting to 1250*50p = 62500p ~ 625. If the company repurchases 15% of the ordinary shares, we can assume that, one average, each individual investors shareholding will decrease by 15%. Therefore, for the investor holding 1250 shares, we can expect their shareholding to reduce by 1250*0.15 = 187.5 shares. With a reduction in shares by 187.5, the accompanying reduction in wealth is equivalent to 187.5*50p = 9375p ~ 93.75. The company repurchases the shares at the current market price of 432p, which means an investor who loses 187.5 shares is going to receive 187.5*432p = 81000p ~ 810.

Looking at the investors gains and losses following the repurchase of 187.5 shares, the net gain stands at 810 - 93.75 = 716.25. Therefore, the repurchase of 15% of Squeezecos shares will increase the investors wealth by 716.25. The opportunity to invest 70 million in a project with positive net present value might make the company revert its consideration of a dividend payment to its shareholders; this is especially so if the rate of return from the project exceeds the wealth increase that the investors stand to earn from dividend payment. However, in one of the dividend payment options the company is considering - the repurchase of 15% of ordinary shares, the current shareholders - particularly those who bought the companys shares at its inception stand to gain more than a 100% increase in wealth. Therefore, it is highly likely that the investment opportunity will not make the firms shareholders forgo the annual dividend so that funds can instead go the investment project. A look at the firms reserves shows that the company can fund the investment opportunity without retaining all of its current distributable earnings. The reserves stand at 108 million, an amount of money that is enough to fund the investment opportunity and buy back 15% of ordinary shares at the prevailing market rate. Overall, it is in the shareholders interests that the opportunity to invest 70 million in a project with net present value does not change the decision to pay dividends.

Question 2

a) Price/earnings ratio

The share price of Trojan Plc. currently stands at 2.05. The firms ordinary shares have a value of 147 million, and with each share having a par value of 1, it means the firm has 147 million shares outstanding. The distributable earnings stand at 40.4 million, which implies that the earnings per share amount to 40.4/147 = 0.275. Therefore, Trojan Plcs price/earnings multiple amounts to 2.05/0.275 = 7.45 times.

b) Dividend valuation method

The following formula gives the intrinsic value of Trojan Plc.s stock:

Intrinsic value = D1/ (k g) (Watson and Head, 2010)

In the preceding formula, D1 is the expected dividend in the coming year, k is the discount rate, and g is the dividend growth rate. We can estimate D1 using the following formula:

D1 = (1 + g) D0, where D0 is the dividend in the current year

Using past dividends, we can estimate the dividend growth rate as follows:

g = (Dt Dt-n) 1/n 1, where:

Dt is the most recent dividend, and Dt-n is the dividend paid n years ago (Watson and Head, 2010)

Looking at Trojan plc.s dividend history, it paid a dividend of 12p one year ago, while the most recent dividend is 13p. Thus, the growth rate of Trojans dividends is:

(13p 12p) 1

= 0

We can use the CAPM to estimate k, the discount rate, which is also the rate of return that investors require. The following is the CAPM formula:

R1 = Rf + bi (Rm Rf) (Watson and Head, 2010)

For Trojan, the Rf = 5%, bi = 1.1%, and Rm= 11%. Therefore, Trojans discount rate becomes:

0.05 + 0.011(0.11 0.05)

= 0.051

With the estimated dividend growth rate of 0, and a current dividend of 13p, the expected dividend in the coming year is:

= (1)*13p

= 13p

With a discount rate of 0.051, the intrinsic value of Trojan Plcs shares is:

13p/0.051

= 254p ~ 2.54

Trojan has 147 million shares outstanding, and the intrinsic value of its shares is 140*2.54 = 373.38 million.

c) Discounted cash flow method

The annual after tax synergy benefits resulting from the takeover will be 4.35 million. Considering that Trojan plc is a going concern, we can assume that the synergy benefit will be perpetuity. To find the present value of a perpetuity, we use the following formula:

A/r, where A is the annual payment, and r is the discount rate

We earlier saw that the discount rate for Trojan is 0.051. Applying the formula for the present value of a perpetuity:

4.35/0.051

= 85.29 million

The managers expect that Trojans distributable earnings will grow at an annual rate of 2%. Assuming that Trojan is a going concern, the distributable earnings will accrue indefinitely. Therefore, the distributable earnings are a growing perpetuity. The present value of a growing perpetuity is given by the following formula:

C1/(r-g),

In the preceding formula, C1 is the cash flow in the first period, r is the discount rate, and g is the rate at which the perpetuity is growing. Applying the formula:

Trojans distributable earnings currently stand at 40.4 million. With an annual growth rate of 2%, the distributable earnings will grow to 40.4*1.02 = 41.208 million one year after the merger. With a growth rate of 0.02, and a discount rate of 0.051, we calculate the present value of Trojans distributable earnings as follows:

41.208/ (0.051 0.02)

= 1329.29 million

Duplication will allow the sale of 21 million of assets, net of a 20% corporate tax. The sale will yield a cash flow of 21*0.8 = 16.8 million. The following formula gives the present value of a cash flow due one year:

C1/(1+r), where C1 is the cash flow and r is the discount rate

Trojans r is 0.051, and applying the preceding formula, we...