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Corporate
Finance FIN 622
VU
Lesson
22
PROBLEMS
ASSOCIATED WITH HIGH GEARING
& DIVIDEND
POLICIES
The
following topics will be
discussed in this lecture.
Problems
associated with high
gearing
Bankruptcy
costs
Optimal
capital structure
Dividend
policy
Types
of dividends and important
dates
Dividend
policies
Factors
influencing dividend
policy
Irrelevance of
dividend policy
1. Problems
associated with high
gearing
A
general term describing a financial ratio
that compares some form of
owner's equity (or capital)
to
borrowed
funds. Gearing is a measure of financial
leverage, demonstrating the degree to
which a firm's
activities
are funded by owner's funds
versus creditor's funds.
The
higher a company's degree of leverage,
the more the company is considered
risky. As for most
ratios,
an
acceptable level is determined by its
comparison to ratios of companies in the
same industry. The
best
known
examples of gearing ratios include the
debt-to-equity ratio (total debt /
total equity), times
interest
earned
(EBIT / total interest),
equity ratio (equity / assets),
and debt ratio (total
debt / total assets).
A
company with high gearing
(high leverage) is more vulnerable to
downturns in the business
cycle
because
the company must continue to
service its debt regardless
of how bad sales are. A
greater proportion
of equity provides
a cushion and is seen as a
measure of financial strength.
M & M model
says that debt financing
increases the value of firm
due to tax shield. However,
there are
certain
aspects of high gearing that
discourage borrowing. These
aspects are:
Bankruptcy
Costs:
As debt
increases, a chance of default of
repayment of principal and
interest increases. Investors dislike
this
and
will result in fall in value
of firm's securities. The
interest tax shield should overweigh the
bankruptcy
cost.
Direct
bankruptcy costs: in case of liquidation
disposal of assets will fetch
less than going concern
value of
assets.
And there are other
costs like liquidation and
redundancy costs. The loss
in value is normally
borne
by the
debt holders and that's
why they demand higher returns
for their investment for higher
gearing and
eventually this
will drive down the firm's
security value.
Indirect
Bankruptcy Costs:
When a
firm goes into liquidation
or approaches near bankruptcy because
under sever financial distress.
Employees
leaving, supplier refusing to provide
goods on credit, and customers
even leaving fearing firm
will
not be able to honors its warranty
and after sales services
commitments. This will
reduce future cash
flow
and therefore, value of
firm.
2.
Bankruptcy Costs
Bankruptcy is a
legal proceeding whereby an
individual or a business can
declare an inability to pay
back
debts.
Bankruptcy allows individuals or
businesses to either restructure their
debt and pays it back
within a
payment
plan , or have most of their
debts absolved
completely.
The
argument that expected
indirect and direct bankruptcy costs
offset the other benefits from
leverage so
that
the optimal amount of leverage is less
than 100% debt financing.
3.
Optimal capital
structure
Capital
structure with a minimum
weighted-average cost of capital
and thereby maximizes the value of
the
firm's
stock, but it does not
maximize earnings per share
(Eps). Greater leverage maximizes
EPS but also
increases
risk. Thus, the highest
stock price is not reached
by maximizing EPS. The optimal
capital structure
usually
involves some debt, but not
100% debt. Ordinarily, some firms cannot
identify this optimal
point
precisely,
but they should attempt to find an
optimal range for the
capital structure. The required
rate of
72
Corporate
Finance FIN 622
VU
return
on equity capital (R) can be
estimated in various ways,
for example, by adding a percentage to
the
firm's
long-term cost of debt. Another
method is the Capital Asset Pricing Model
(CAPM)
Capital
structure is a business finance term
that describes the proportion of a
company's capital, or
operating
money, that is obtained through debt
and equity. Debt includes
loans and other types of
credit
that
must be repaid in the future,
usually with interest.
Equity involves selling a
partial interest in the
company
to investors, usually in the form of
stock. In contrast to debt financing,
equity financing does
not
involve
a direct obligation to repay the funds. Instead,
equity investors become
part-owners and partners
in
the
business, and thus are
able to exercise some degree
of control over how it is
run.
4. Dividend
Policy
The
policy a company uses to
decide how much it will
pay out to shareholders in
dividends.
Distribution
of a portion of a company's earnings,
decided by the board of directors, to a
class of its
shareholders
is called dividend. The
dividend is most often quoted in
terms of the dollar amount each
share
receives
(i.e. dividends per share or
DPS). It can also be quoted in
terms of a percent of the current
market
price,
referred to as dividend yield.
Lots
of research and economic logic
suggests that dividend
policy is irrelevant (in
theory).
5. Types of
Dividends and Important Dates:
TYPES
OF DIVIDEND
1. Cash
(most
common) are those paid out in
form of "real
cash". It is a
form of investment
interest/income
and is taxable to the recipient in the
year they are paid. It is the most
common
method of
sharing corporate profits.
2. Stock
or Scrip dividends (common)
are those paid out in form
of additional
stock shares of
the
issuing
corporation, or other corporation
(e.g., its subsidiary
corporation). They are usually
issued in
proportion
to shares owned (e.g., for
every 100 shares of stock
owned, 5% stock dividend will
yield
5
extra shares). This is very
similar to a stock split in
that it increases the total number of
shares
while
lowering the price of each
share and does not
change the market capitalization
3. Property
or dividends in specie are
those paid out in form of assets
from
the issuing
corporation,
or other corporation (e.g.,
its subsidiary corporation). Property
dividends are usually
paid in the
form of products or services provided by
the corporation. When paying
property
dividends, the
corporation will often use
securities of other companies owned by
the issuer.
Important
Dates:
Dividends
must be declared (i.e., approved) by a
company's Board of Directors each time they
are paid.
There
are four important dates to
remember regarding dividends.
Declaration
date: The
declaration date is the day the Board of
Director's announces their
intention to pay
a
dividend. On this day, the company
creates a liability on its books; it
now owes the money to
the
stockholders.
On the declaration date, the Board will
also announce a date of
record and a payment
date.
Date
of record:
Shareholders who properly
registered their ownership on or before this
date will receive
the
dividend. Shareholders who
are not registered as of this
date will not receive the
dividend. Registration
in
most countries is essentially
automatic for shares
purchased before the ex-dividend
date.
Ex
dividend date: Is
set by the exchange where the
stock is traded, several
days (usually two) before
the
date
of record, so that all
trades made on previous dates
can be properly settled and
the shareholder list on
the
date of record will
accurately reflect the current owners.
Purchasers buying before the ex-dividend
date
will
receive the dividend. The
stock is said to trade cum
dividend on these dates.
Purchasers buying on or
after the
ex-dividend date will not
receive the dividend. The
stock trades ex-dividend on
these dates.
Payment
date: The
date when the dividend cheques
will actually be mailed to the
shareholders of a
company.
6. Dividend
Policies
Stable
dividend per share: look
favorably by investors and
implies low risk firm. it
increases the
marketability
of firm's share. Cash flow
can be planned as dividend amount can be
ascertained with
accuracy
(aid in financial planning)
73
Corporate
Finance FIN 622
VU
Constant
dividend payout (div per
share/Eps)
A
fixed %age is paid out as
dividend. Under this policy the
dividend amount will vary because
the
net
income is not constant. Thus
results in variability of return to
investors. the dividends may drop to
nil in
case
of loss. market price of
share will lower.
Hybrid
dividend policy:
This
contains feature of both the
above mentioned policies. Dividend
consists of stable base amount
and
%age
of increment in fat income years.
This is more flexible policy
but increases uncertainty of future
cash
flow
or return to investors. The
extra slice of %age is only
paid when there is high jump
in income. So it is
not
regularly paid.
Fluctuating
dividends:
When
the firm is having investment opportunities on
its plate or unstable
capital expenditure,
then
dividends are of residual amount i.e.,
amount left after meeting capital
expenditure.
7.
Factors Influencing Dividend
Policy
A-Capital
Impairment Rule -- many
states prohibit the payment of dividends
if these dividends
impair
"capital" (usually either par
value of common stock or par
plus additional paid-in
capital).
Incorporation
in some states (notably
Delaware) allows a firm to
use the "fair value," rather
than "book
value,"
of its assets when judging
whether a dividend impairs
"capital."
B-Insolvency
Rule --
some states prohibit the
payment of cash dividends if the company
is insolvent
under either a
"fair market valuation" or
"equitable" sense.
C-Undue
Retention of Earnings Rule --
prohibits
the undue retention of earnings in excess
of the
present
and future investment needs of the
firm
Other
Issues to Consider
1.
Funding Needs of the
Firm
2.
Liquidity
3.
Ability to Borrow
4.
Restrictions in Debt Contracts
(protective covenants)
5.
Control
8.
Irrelevance of Dividend
Policy
A.
Current dividends versus
retention of earnings
M&M contend
that the effect of dividend payments on
shareholder wealth is exactly offset by
other
means
of financing.
The
dividend plus the "new"
stock price after dilution
exactly equals the stock
price prior to the
dividend
distribution.
B.
Conservation of value
M&M
and the total-value principle ensures
that the sum of market value
plus current dividends of two
firms identical in
all respects other than
dividend-payout ratios will be the
same.
Investors
can "create" any dividend
policy they desire by selling
shares when the dividend payout is
too
low or
buying shares when the dividend payout is
excessive.
According
to M&M, in an ideal market, dividend
policy is irrelevant as long as the
firm's capital
investments
and debt policy are
fixed. Dividend payments are
simply financed over time by a
combination
of excess retained earnings
and as necessary new equity
financing.
In
other words value of firm is
only determined by increase in earning
and investment policy.
Accordingly
to M&M, dividend policy does
not matter.
M&M
assumes perfect capital markets
with no transaction cost, no
floatation cost to companies
and no
taxes.
Also, future profits are
known with certainty.
We did
cover in our earlier studies
that valuation of share is
dependent upon dividends, then
why this
contradiction?
The
dividend irrelevance simply states the PV
of dividends remains unchanged even
though dividend
policy
may change the amount and
timing of dividends.
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