Module: Corporate Finance: Module Leader: S A Palan
Module: Corporate Finance: Module Leader: S A Palan
Module: Corporate Finance: Module Leader: S A Palan
Table of Contents
EXECUTIVE SUMMARY ..................................................................................................................................... 3 INTRODUCTION ............................................................................................................................................... 4 ANSWER TO THE QUESTION NO. 1 ................................................................................................................... 5 ANSWER TO THE QUESTION NO. 2 ................................................................................................................... 8 REFERENCE .................................................................................................................................................... 12 APPENDIX ...................................................................................................................................................... 13
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Executive Summary
The price of shares of a company changes due to many factors. The most direct factor is the information announced by the company itself. This information has positive or negative impacts on the market price of shares of a company. Whenever any representative of a company announces any new information to the market, the market gives a reaction to that announcement. It is because the market makes the valuation of the shares on the basis of some key information. In case of valuation of shares there are different methods and techniques available in the market. All the methods and techniques have a common variable and that is the expected flow of benefit from and to the company and the growth of such benefit. Any change in these variables can change the entire valuation outcome in relation with the company. It is only the company source, from where the market can get the information in the most reliable manner. Therefore, whenever there is any announcement by a company director about new information, there is a subsequent change in the share price of the company. A companys dividend policy determines whether the firm will offer dividend or not; if it offers dividend to the shareholders, what will be the manner of such dividend payment. For a short term investor, who has an objective of maximizing gain through trading of shares, the dividend policy of the invested company is very much important. But in case of an investor who invests for a long period of time, the subject of dividend policy has no importance to him. His objective is to maximize his wealth. So, the discussion of dividend policy to him is nothing but just waste of time.
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Introduction
Modern age is the age of information. Information is the most important element of any kind of decision making. In case of making any investment decision, the decision makers need appropriate information regarding the profitability and the characteristics of the securities of the market. The companies make different announcements regularly to the market and make a flow of information regarding their current position and prospects. These companies are positively treated by the investors as all the information, both positive and negative, is discussed by the company. On the other hand, if any company remains silent and give no information to the investors in the market, the company is treated as a company having some bad news. Therefore, companies have to make some announcements on a regular basis. In the market, all the information does not have the same importance to the investors. As the announcement by the company is one of the raw sources of information, the information generated from this source obviously has some value. This information is used as the basis of valuation of the company and its shares. So, whenever the director of a company makes an announcement of new information, the flow of information to the market causes a change in the share price accordingly. If the information is favourable, the market price of the companys stock will increase. On the other hand, some information may cause a decline in the share price. Therefore it can be said that the announcement of new information by a company director has direct relationship with the price of the stock of the company. Another important discussion in the field of finance and investment is dividend policy. A firms dividend policy is its strategies and procedures regarding the declaration and payment of dividends to the shareholders. This issue has an impact on the investment decision making. But in the long run, it has no effect on the wealth of the shareholders. A true investor invests in the shares of a company for a long period of time. His objective of investment is to maximize wealth by maximizing the value of his investment. So, regardless of payment of dividend by the company, the investor can do it. If the company does not pay out dividend, it is using the money to invest in a new business and earning an increased amount of profit. On the other hand, if the firm pays dividend, the investor, with the money of dividend can go for a new investment, keeping his original investment intact. So, in either dividend policy the
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wealth of the shareholders experiences no effect by the nature of the dividend policy adopted by the company. In the following two sections, there are discussions in detail regarding two critical issues effect of information provided by a company to the market, and the usefulness of the discussions on dividend policy on the wealth of the shareholders.
company based on the future dividend payments by the company and its expected growth rate. The formula given by the dividend discount model to calculate the value of a share is:
Where,
cost of capital and g is the expected growth rate of dividend. In the dividend discount model it is stated that the value of a share today is the present value of all the expected dividend payments by the company. As the announcement of the director may have any association with the expected dividend payments by the company in the future and the expected growth of it, the announcement by the director will directly have an impact on the share price of the company. For example, currently all the investors know that a company will pay dividend of $4 in the next year and it will have an annual growth of 2%. The director of the company now announces that next year the company will declare a dividend of $10 per share and it will increase every year at a rate of 5%. This announcement will radically change the market scenario. After the announcement the investors will consider the companys share as more valuable. They will offer an increased amount of money to buy the companys share. In this way the announcement by the director puts an impact on the share price of the company. Another technique for share valuation is the Discounted Cash Flow Model (DCF). In this model the expected operating free cash flow to the equity holders of the company is discounted to present value and on the basis of this value the share price is determined. The technique used in this method is:
Where,
represents the value of the share today, PV(OFCFE) is the present value of
operating free cash flow to the equity holders of the company and it is divided by the total number of shares outstanding and then the present value of operating free cash flow to each of the share is derived which indicates the intrinsic value of that share. 6|Page
So, if the market applies the discounted cash flow model to have a valuation of the shares of the company, and then a director of a company announces any information regarding the future cash flow of the company like the planned sectors of investments, or any expected change in the capital structure of the company, there will be a direct effect on the value of the expected free cash flow to the equity holders of the company. As a result the value of the stock of the company will change. Therefore we can say that any announcement by the company director bearing any new information will have an impact on the price of the shares of the company. Some other methods comprise the comparable method where different performances of the company are compared with the other companies of the industry or stock market. Some of the well known and widely used performance measures are the profit margin (PM), operating income (OI), price-earnings multiples (P/E multiples), return on investment (ROI), return on equity (ROE), cash flow performance etc. Any announcement by the company director will obviously bear some information in relation to any of the measures or comparables used by the investors and the market. So, if a company director announces any information, there will be a change in the price of the shares of the company accordingly. On the basis of above discussion we can say that when a director of a company announces any new information, the companys share price will change accordin gly. Some information may cause an increase of the share price; again some information may cause a fall in the share price.
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asset management of the corporation and decision related with the finance will help to increase the wealth of the shareholders (Bernheim, & Wantz, 1994). Dividend policy may affect the value of the company in a low level of the degree. But in the company, if the dividend is not paid regularly the market perception of the company will fall (Bernheim, & Wantz, 1994). A standard set of dividend policy may reduce the gap of the agency problem. In a regular interval if the dividend is paid in cash, it will create a good image of the company. If all the assets are used efficiently in the company, the operation will be efficient and the performance of the will be good (James et al, 2001). This will ensure the higher net profit of the company. It is also seen that, there is no penalty for giving no dividend or low dividend of the company. This is all the shareholders do not expect dividends always. On the other hand, companies paying higher dividends must not have a lower value. But is happens. This is applicable when there are available investors in the market to invest. It is not considered what the dividend policy of the company is (Dann et al, 2001). According to the Miller & Modigliani, it is suggested that the value of the company is relevant with the earnings of the company (Dann et al, 2001). The earnings of the company are come from the investment policy of the company. This can be applied in the world where there is no taxes and imperfect market. Although it is said that dividend policy motivate shareholder to buy more share and to make more profit in regular basis but there have some negative impact of dividend policy (Bernheim, & Wantz, 1994). In case of providing dividend there have two methods by which companies can give dividend (Timmer& Jan, 2011). Cash dividend is obviously loss project for the company because by the cash dividend companies cannot make profit they have to paid those money to the shareholders on the other hand by the share dividend by bonus is somehow important because by that company can finance themselves (Bernheim, & Wantz, 1994). By that their money will increase for operational use of the business. Financing policy is an important for the company, in case of operating the business there needs a lot of working capital by that company can meet their working capital very much because by the working capital company can run their business and by the time they can make profit and increase their sales and revenue (Timmer& Jan, 2011). By using the 9|Page
financing policy, company can buy much more equipment for the company and by that Equipment Company can earn more profit and company can grow up their sales growth (Bernheim, & Wantz, 1994). In case of dividend paying company cannot earn those profits because of misuse of that money. Investment is very much important for company, because by the proper investment Process Company can earn more profit and by this time company can invest in valuable sector in case of providing money to the shareholders company cannot earn those profit because by that company cannot pay attention to the investment process (Timmer& Jan, 2011). In case of investment process company can invest money to the profitable sector and can increase shareholder wealth but in the short term dividend paying is a wise decision because by the dividend paying company has an effective impact on the share market and the money market. Working capital management is an important factor for every company because by the money company can use their regular business but by the dividend Policy Company cannot use their money for different purpose (Fama & French, 2008). Company can give dividend from the retained earnings, on the other hand shareholder also expect dividend from the company but in the long run dividend do not effective for the company because by the dividend money company can use those money for the working capital purpose (Bernheim, & Wantz, 1994). In case of providing Dividend Company have to use money for the purpose of investment or financing. Finally, dividend policy needs a lot of discussion because by providing dividend there have to consult with the higher authority of the company, by that company have to use lots of money, company have to hire a lot of consultant so that company have to waste a lot of money and time but by those money company can meet their working capital management, financing different project and investing in different project so that their wealth maximize and they will have long term benefit (Bernheim, & Wantz, 1994).
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Conclusion
The main source of all the information about the company is the director of the company. The company director, as a representative of the company, announces different information regarding the companys future plans, decisions of different meetings, decisions regarding the dividend policy etc. All the information shared by the director has some effect on the share price of the company. Some information may have positive impact on the share price. Some information may have negative impact on the share price. Again, the same information may cause different reactions from different investors of the market. Therefore, it can be said that if the market is efficient, information announced by the company will obviously have some effect on the share price of the company. In more precise words, any information flow from a company causes an according change in the share price of the company. One of the important factors of an investors investment decisions in a companys share is the companys dividend policy. But dividend policy has no major impact on the wealth of the shareholders of the company. A dividend policy by a company is the policy of payment of dividends from the profit of the company to the shareholders. It does not affect the wealth of the shareholders of the company. The objective of the investors while investing in the shares of a company is to maximize wealth or the value of investment. If a company pays no dividend, it can capitalize the undistributed profit and invest in a new business from where it may generate more profit. In this way the capital as well as the return from the investment is invested by the company and a huge return is ensured. On the other hand, if the company pays out dividends to its shareholders, it can be of two manners. If the dividend is a stock dividend, the value of investment will rise as the share of the investor rises. On the other hand if the dividend is a cash dividend, the investor will make a new investment with the money of dividend and go for wealth maximization. So, in either policy, there is no major impact on the wealth of the shareholders. Therefore, it can be said that if we consider the issue of wealth of the shareholders, the discussion on the dividend policy is just a waste of time.
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Reference
1. Aharony, J., and Swary I. 1999. Quarterly dividend and earnings announcements and stockholders' returns: An empirical analysis. Journal of Finance. 2. Asquith, P., and Mullins, D., 2003. The impact of initiating dividend payments on shareholders' wealth. Journal of Business. 3. Bernartzi, S.; Michaely, R.; and Thaler, R. 2005. Do changes in dividends signal the future or the past? Journal of Finance. 4. Bernheim, D., and Wantz, A. 1994. A tax-based test of the dividend signaling hypothesis. W orking paper, Stanford U niversity. 5. Dann, L.; Masulis, R.; and Mayers, D. 2001. Repurchase tender offers and earnings information. Journal of Accounting and Economics. 6. DeAngelo H.; DeAngelo L.; and Skinner, D., 2003, Dividends and losses. Journal of Finance 47: 1837-1863. 7. Denis, D.; Denis, D.; and Sarin, A., 2001, The information content of dividend changes: Cash flow signalling, overinvestment, and dividend clienteles. Journal of Financial and Quantitative Analysis. 8. Fama& French, 2008, "Disappearing Dividends: Changing Firm Characteristics or Lower Propensity to Pay". Journal of Financial Economics. 9. Fama, R.; Fisher, L.; Jensen, M.; and Roll R. 1969. The adjustment of stock prices to new information. International Economic Review. 10. James .C Van Horne & John M. Wachowicz, Jr., 2001, Financial Management, Pearson Inc, USA. 11. Mageshwari.S.N, 1992, Financial Management: Principles and Practice, Pearson Inc, USA 12. Timmer& Jan, 2011, Understanding the Fed Model, Capital Structure, and then Some.
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Appendix
Formulas used in the report: 1. ; Where, represents the value of the share today, is the dividend of
next year, k is the cost of capital and g is the expected growth rate of dividend. 2. ; Where, represents the value of the share today,
PV (OFCFE) is the present value of operating free cash flow to the equity holders of the company and it is divided by the total number of shares outstanding and then the present value of operating free cash flow to each of the share is derived which indicates the intrinsic value of that share.
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