Discuss the factors that should be considered by the senior managers
of a listed company in making a decision on the size of the annual dividend to pay its shareholders.
The decision regarding the paying of dividends to the shareholders is an important aspect of any particular company. It is important to note that the main objective of the company should be to maximize the shareholder value. For this, shareholders receive dividends. This would reduce a portion of cash available to the company for investment purposes and it would have to fall into the trap of debt for increasing companys capital (Stern, 2011). The factors are as under:
i. The dividend payout ratio reveals the portion of earnings distributed to the stockholders of company. As mentioned above, the dividends reduce the total cash available to the company (Finance, 2012). This ratio should be considered for the decision regarding the paying of dividends by keeping a balance between two main objectives that are to maximize shareholders value and to keep sufficient funds for investment purposes (Ratios, 2011). For this purpose, the managers refer an industry average.
i. The newly established firm would require much of its earnings for its expansion and growth (Fontinelle, 2012). Therefore, when the firm has just started its business then it would have to follow a rigid dividend policy.
ii. The liquidity of any particular company should be concerned first before paying dividends to the shareholders. If the liquidity position is strong, then the managers should not worry of distributing the cash dividends to them (Star, 2012). Otherwise, stock dividends are distributed.
iii. The working capital is definitely the most important factor. This is because it decides if the firm is in a dire need for an additional capital. If that is so, the firm should continue paying dividends at low rates and shareholders can cooperate on the fact that the company is trying to expand itself further.
iv. Government policies also shape the dividend policies. Such policies restrict dividend rates beyond a particular percentage in any particular industry (FreeMBA, 2011).
v. The taxation policy also affects the decision if the taxation is determined to be high for the complete business activity and even if the government levies tax of distribution of dividend beyond a certain limit.
vi. Established Companies have an easy access to the capital market. Therefore, they can borrow funds when needed and their dividend policy is not disturbed. However, smaller and developing companies have to vary the dividend rates, as they cannot easily access the capital market for borrowing purposes.
vii. The company is bound to vary the dividend rates if it restricted to do so due to the repayment of loans (Rafique, 2012). If the amount of loan is high then the company is bound to keep a good portion of retained earnings for such purpose. Hence, this lowers the dividend rates distributed to the shareholders.
viii. If the expected rate of return is high for any particular investment then the company should retain the earnings for further growth purposes. The dividends rates should be set low then (Moradi, et al., 2010).
ix. The desire for control factor is important when there is a need for further financing. Therefore, the firms management would not decide to issue common stock further as there could be a chance of dilution in control on management. Hence, that firm is obliged to retain the earnings to satisfy their financing need.
2. GLC plc. has just announced an ordinary dividend of 20p per share. The past four years dividends per share have been 15p, 17p, 19p and 20p, with the most recent dividend last. Shareholders require a return of 15 per cent. GLC decides to increase its debt level, thereby increasing the financial risk associated with its equity shares. Because of this, the companys shareholders require an increased rate of return to 16.5 per cent.
A. Identify what is a fair price for GLCs shares prior to the increased debt level?
The most appropriate method in this particular scenario is the absolute valuation. This method has the ability to compute the absolute fair value of GLC shares. The Gordon growth model suits the scenario well. This method is based on the future payment of dividends at a rate that is constant. The method helps in computing the present value of infinite series of future dividends. The formula is as under:
Stock Value (P) = D / (k G) (Analyst, 2013)
Where D is the expected dividend per share one year from now. K is the return required by an investor In addition, G is growth rate of dividends. We assume that dividend per share to be paid next year is 22p per share. Therefore, the growth G is 10%. The fair value is:
Stock Value (P) = D / (k G) Stock Value (P) = 22/ (15 10) Stock Value (P) = 22 / 5 = 4.4p per share
B. Calculate what is a fair price for GLCs shares after the increase in debt?
Using the same formula,
Stock Value (P) = D / (k G) Stock Value (P) = 22 / (16.5 10) Stock Value (P) = 3.14p per share
It can be said that the fair price of GLC shares declined to some extent because the company opted for further debt, which increased the shareholders rate of return. The rate of return required increases because of the fact that the company faces an increased risk due to its decision of issuing debt and the second reason could be that the shareholders expect further dividend payments. The share prices declined because of the increased rate of return.
C. Discuss any problems with using the dividend growth model as a way of valuing shares and suggest alternative models, which could be used to value companies and shares. In this discussion you should also identify any merits and disadvantages of each method.
The dividend growth model states that the price of a stock should be equal to the sum of current and future cash flows respectively after the consideration of time value of money. The above statement clearly explains us two different concepts. 1. Estimating Current and Future Cash flows The shareholders invest the cash in the desired companies where they expect some return as dividends. This is the only way to determine the future cash one can expect to get. More importantly, if a company is not in a state to pay dividend to its shareholders then the price of stock is determined by assuming that the company will pay it later. Therefore, if there were no way a company could pay dividends then investors would never be interested in buying the stocks of such company.
2. The time value of money It is important to note that investing is just like saving. When there is, an additional money left after ones expenses are paid then that people set it for future use. Through saving, one can achieve this purpose. Most importantly, investing can help you to invest today and receive more money in future.
THE DDM FORMULA The DDM is a basic valuation tool that is well suited for investing purposes. This principle combines the time value of money factor and future cash flows through the following formula:
Stock Price = the Sum of the Present Value of All Future Dividends Stock Price = (D t / (1 + r) t ) Where t is time or year, D t is the dividend during year t and r is the rate required on the stock.
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Buy and Hold The following formula would allow us to determine if an investor can purchase the stock. If the calculated value is higher than the state price then the shareholder can wait for price to decline. The formula is as under: Stock Price = Dividend / required rate of return
Dividend Growth If the company ABC has the ability to grow its dividend through enhanced earnings, then the formula for computing the stock price is an under:
Stock Price = D 1 / (r - g) D 1 = Dividend declared during year 1 g = dividend growth rate
Issues in this model The model is best for those companies that pay dividends. However, two third of the companies retain a portion of their earnings for further investment purposes. Therefore, analysts would need to make assumption on how much the company would pay later (Springer, 2011). Therefore, a misassumption about company can result in either overvaluing or undervaluing of stock.
The other drawback tells us that if the dividend of any particular company grows faster, the denominator becomes a negative value. For example, suppose ABC pays a $3 dividend and has a dividend growth rate of 15%. The required rate of return is 10%. The value of ABCs stock become ($3 x 1.15) / (0.10-0.15) = -$69.
I would suggest the following models: 1. Earnings per share which is the net income divided by the number of shares outstanding. The main advantage of this method is that it gives an outlook of companys earning power. Therefore, it is a good measure of profitability. The disadvantages of this method is that it does not tell us about the future of company as when any asset like building is sold, then it will result a sudden fluctuation in EPS. 2. Price to earnings ratio reflects the confidence of investors in the company in the future. It is a straightforward method of valuing a stock but it has an inability to consider the growth of company as P/E has a limited meaning. 3. Return on assets tells us the profit earned on the resources or assets altogether. This technique measures the use of effective use of assets in the companys operation. It also entails the productivity of business (Leskov, 2007). However, it gives no indication as to how to assets were financed. 4. Market Capitalization measures the size of a business by multiplying the share price by the number of shares outstanding. The most important benefit of using this model is its simplicity and lets the investors know if the fund invests in either large or small cap stocks. Therefore, A high M cap helps improve a companys credit rating, lowers borrowing costs and makes raising funds for expansion via a rights issue easier (Abdolmohammadi, 2005).
References
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