A Report on

How capital structure

and dividend policy affect
value of the firm

University of Dhaka
Department of Finance

Course name: Corporate Finance

Course code: F-408

Prepared For
Prof. Shabbir Ahmed
Professor
Department of Finance
University of Dhaka

Prepared By
Name

Roll

Farhana Rahman

16-004

Farha Farzana

16-006

A.S.M. Kamran

16-040

Md.Rasel Miah

16-068

Sadia Kamal Sanchita

16-070

Marufa Akter

16-132

Date of submission: 20th March, 2014

Letter of Transmittal

March 20, 2014

Prof. Shabbir Ahmed
Professor
Department of Finance
University of Dhaka
Subject: Submission of report.
Dear Sir,
We take the pleasure to inform you that, we are going to submit the report that you had
assigned us as a partial requirement for the course Corporate Finance (F-408).
We sincerely hope that, you will enjoy going through this report, as we have felt great
pleasure to prepare it. If any other information is required for further clarification, we will be
pleased to provide you with that.
We are thanking you heartily. We tried our best to make this report the best one. We think this
report can serve us all as a means of tool for solving business decision problems.
Finally, we would like to thank you for providing us the opportunity to work in such an
interesting and enthusiastic report as we have enjoyed as well as learned a lot in preparing
this report.
Sincerely,
On behalf of the group,
Farha Farzana
BBA 16th Batch, Section-B
ID: 16-006

Table of content

Serial no
1
2
3
4
5
6

Subject

Page no

Executive summary
Literature review
Company Profile
Impact of capital
structure on value of
the firm
Impact of Dividend
Policy on the firm
Bibliography

O5
06
13
14

20
24

Executive Summary
We are assigned to make a report on changes in capital structure and dividend policy. We
have selected Meghna Cement Mills Ltd. for preparing our report. For this purpose we have
collected data from the annual reports of 10 years. The capital structure and dividend policy
varies from company to company based on their financial conditions, economic stability, risk
tolerance etc. Here our main objective is to find out the impact of changes in capital structure
and dividend policy on the value of MCML.
Dividend distribution to the Companys shareholders is recognized as a liability in the
financial statements in the period in which the dividends are approved by the Companys
shareholders. And changes in capital structure means changes of debt-equity ratio according
to the decision of financial leverage.
We have made necessary calculations and analysis considering the financial statements and
given notes.

LITERATURE REVIEW
Capital structure
In finance, capital structure means the manner in which a company finances its assets through
some combination of equity, debt, or hybrid securities. A company's capital structure is then
the make-up or 'structure' of its liabilities.
5

The Modigliani-Miller (M&M) theorem, proposed by Franco Modigliani and Merton Miller,
shapes the basis for modern thinking on capital structure, though it is generally viewed as
purely academic since it assumes away many important factors in the capital structure
decision. The theorem states that, in a perfect market, the value of a company is irrelevant to
how that company is financed. This result provides the base with which to examine real
world reasons why capital structure is relevant. These other reasons include bankruptcy costs,
agency costs, taxes, information asymmetry, to name some. This analysis can then be
extended to look at whether there is in fact an optimal capital structure: the one which
maximizes the value of the company.
Assuming a perfect capital market with no transaction or bankruptcy costs, no taxes and with
perfect information companies and individuals can borrow at the same interest rate, and
investment decisions aren't affected by financing decisions. M&M made two findings under
these conditions. Their first 'proposition' was that the value of a company is independent of
its capital structure. Their second 'proposition' stated that the cost of equity for a leveraged
company is equal to the cost of equity for an unleveraged company, plus an added premium
for financial risk. That is, as leverage increases, while the burden of individual risks is shifted
between different investor classes, total risk is conserved and hence no extra value created.
Their (M&M) analysis was extended to include the effect of taxes and risky debt. Under a
classical tax system, the tax deductibility of interest makes debt financing valuable, that is,
the cost of capital decreases as the proportion of debt in the capital structure increases. The
optimal structure then would be to have virtually no equity at all.
Accordingly, if capital structure is irrelevant in a perfect market, then
imperfections which exist in the real world must be the cause of its
relevance. In the next section we look at how when assumptions in the
M&M model are relaxed, imperfections arise and how they are dealt with.
a. Pecking order theory
The Pecking Order Theory attempts to capture the costs of asymmetric information. It put
forward the notion that companies prioritize their sources of financing starting with internal
financing and ending with equity- this is according to the law of least effort, or of least
resistance, preferring to raise equity as a financing means of last resort. Hence, internal
debt earning is used first, and when that is depleted debt is issued, and when it is not viable to
issue any more debt, equity is issued. This theory maintains that businesses adhere to a
hierarchy of financing sources and prefer internal financing when available, and debt is
preferred over equity if external financing is required. Thus, the form of debt a company
chooses can act as a signal of its need for external finance.

b. Agency Costs
6

The other imperfection is the presence of agency costs. Three types of agency costs, that is:
asset substitution effect; underinvestment problem and free cash flow could help explain the
relevance of capital structure, in this instance.
Firstly, in terms of the asset substitution effect as gearing increases, management has an
increased incentive to undertake risky projects (even negative NPV projects). This is because
if the project is successful, shareholders get all the upside, whereas if it is unsuccessful, debt
holders get all the downside. If the projects are undertaken, there is a chance of company
value decreasing and a wealth transfer from debt holders to shareholders.
Secondly, the underinvestment problem view is that if debt is risky (for example, in a growth
company), the gain from the project will accrue to debt holders rather than shareholders.
Thus, management have an incentive to reject positive NPV projects, even though they have
the potential to increase company value.
Thirdly, there is the free cash flow view that unless free cash flow is given back to investors,
management has an incentive to destroy company value through empire building and perks.
On the flip side, increasing leverage imposes financial discipline on management.

c. Dividend policy
The view of Miller & Modigliani (1961) is that dividend payment is irrelevant. According to
the duo, the investor is indifferent between dividend payment and capital gains. In line with
this argument, Black (1976) poses the question, "Why do corporations pay dividends?" As a
follow up, he poses a second question, "Why do investors pay attention to dividends?" Even
though, the solutions to these questions may appear obvious, he concludes that they are not.
The harder we try to rationalize the phenomenon, the more it seems like a puzzle, with pieces
that just do not fit together. After over two decades since Black's paper, the dividend puzzle
persists.
There are some scholars who emphasize the informational content of dividends. Miller &
Rock (1985), for instance, developed a model in which dividend announcement effects
emerge from the asymmetry of information between owners and managers. It is argued that
dividend announcement provides shareholders and the marketplace the missing piece of
information about current earnings upon which their estimation of the company's future
earnings is based. These expected future earnings have been found to determine the current
market value of a company. The dividend announcement, therefore, provides the missing
piece of information and allows the market to ascertain the company's current earnings. These
earnings are then used in predicting future earnings. In a study by John & Williams (1985) a
signaling model was constructed in which the source of the dividend information is liquidity
driven.
7

The Dividend Policy is a decision made by the directors of a company. It relates to the
amount and timing of any cash payments made to the company's stockholders. The decision
is an important one for the company as it may influence its capital structure and stock price.
In addition, the decision may determine the amount of taxation that stockholders pay. There
are three main factors which are thought to influence a company's dividend decision: Freecash flow; Dividend clienteles and Information signalling.
The free cash flow theory of dividends
Under this theory, the dividend decision involves the company paying out, as dividends, any
cash that is surplus after it has invested in all available positive net present value projects. A
major criticism of this theory is that it does not explain the observed dividend policies of realworld companies. Most companies pay relatively consistent dividends from one year to the
next and managers tend to prefer to pay a steadily increasing dividend rather than paying a
dividend that fluctuates dramatically from one year to the next.
Dividend clienteles
A certain model of dividend payments may appeal to one type of share holder more than
another. A retiree may prefer to invest in a company that offers a consistently high dividend
yield, whereas a person with a high income from employment may prefer to avoid dividends
due to their high marginal tax rate on income. If clienteles subsist for particular patterns of
dividend payments, a company may be able to maximise its stock price and minimise its cost
of capital by catering to a particular clientele. This model may help to explain the relatively
consistent dividend policies followed by most listed companies.
A key criticism of the idea of dividend clienteles is that investors do not need to depend upon
the company to provide the pattern of cash flows that they desire. An investor who would like
to receive some cash from their investment always has the option of selling a portion of their
holding. This argument is even stronger in recent times, with the advent of very low-cost
discount stockbrokers. It remains possible that there are taxation-based clienteles for certain
types of dividend policies.

Information signalling
A model constructed by Merton & Rock (1985) suggests that dividend announcements
convey information to investors regarding the company's future prospects. Many earlier
studies had shown that stock prices tend to increase when an increase in dividends is
announced and tend to decrease when a decrease or omission is announced. Miller & Rock
(1985) pointed out that this is likely due to the information content of dividends.
8

When investors have incomplete information about the company (perhaps due to opaque
accounting practices) they will look for other information that may provide a clue as to the
company's future prospects. Managers have more information than investors about the
company, and such information may inform their dividend decisions. When managers lack
confidence in the company's ability to generate cash flows in the future they may keep
dividends constant, or possibly even reduce the amount of dividends paid out. Conversely,
managers that have access to information that indicates very good future prospects for the
company, for instance a full order book, are more likely to increase dividends.
Investors can use this knowledge about managers' actions to enlighten their decision to buy or
sell the company's stock, bidding the price up in the case of a positive dividend surprise, or
selling it down when dividends do not meet expectations. This, in turn, may influence the
dividend decision as managers know that shareholders closely watch dividend
announcements looking for good or bad news. As managers tend to avoid sending a negative
signal to the market about the future prospects of their company, this also tends to lead to a
dividend policy of a steady, gradually increasing payment.

Company Profile

MCML is one of the biggest companies in the manufacturing sector. This enterprise produces
World-class cement and, as a testimony to this, stands the fact that the concern has been
awarded the ISO-9001 certification for sustained quality control effort. The Company
markets its cement under the registered trademark of King Brand Cement. The factory of this
Company is located in the southwestern part of Bangladesh at Mongla Port Industrial Area, in
Mongla, Bagerhat under the Khulna Division. MCML is the 1 st unit of Bashundhara Group
producing nearly 1 million metric tons a year.

It was incorporated on March 1992 as private ltd. Co. under the co. act 1913 and on 1996
started producing. The co. was enlisted with DSE in 1995 and with CSE in 1996 under
trading code mechanism. The face value was 100 during enlistment and during 2010 the co.
executed stock split option and followed the change of the denomination of shares and market
lot, the new face value became 10 instead of 100. The co. has 22500400 O/S and it has paid
up capital of 225 million and authorized capital of 5000 million. It is an A category share. It
gives minimum 10% dividend each year and follows regular dividend policy from the past
10years.
During the year 2010 the board of director is pleased and recommended for payment of 25%
cash dividend. The span of control of MCML is almost tall. In office high officials control the
subordinates and subordinates are liable for their work to their authorized superior boss. In
this organization all the people works in relaxation. As per job character job threatening is
very low here. Very naturally job satisfaction is very high for all working people. On the
other hand job-switching tendency for the mid-level, high-level officers and expert peoples is
very low here. Working environment is all over satisfactory here.

Impact of capital structure on value of the firm

10

We use EPS and P/E as the representative of firm value

Earnings per share of Meghna Cement Mills Limited:
Year
EPS

2003
1.157

2004
1.525

2005
3.338

2006
4.671

2007
6.586

2008
1.028

2009
5.87

2010
2.23

2011
2.96

2012
6.28

2010
155.16

2011
47.16

2012
16.69

EPS
8
6
EPS

4
2
0

Price Earnings Ratio of Meghna Cement Mills Limited:

Year
P/E

2003
24.21

2004
20.61

2005
7.64

2006
5.92

2007
5.35

11

2008
37.55

2009
22.23

P/E
200
150
100
50
0
2003 2004 2005 2006 2007 2008 2009 2010 2011 2012

P/E

Debt ratio and equity ratio represents capital structure of a firm.

Debt ratio of Meghna Cement Mills Limited:
Year
Debt
ratio

2003
0.600

2004
0.563

2005
0.517

2006
0.451

2007
0.468

2008
0.524

2009
0.543

2010
0.540

2011
0.536

2012
0.489

2008
0.476

2009
0.457

2010
0.460

2011
0.464

2012
0.511

2009
0.457

2010
0.460

2011
0.464

2012
0.511

Equity ratio of Meghna Cement Mills Limited:

Year
Equity
ratio

2003
0.400

2004
0.437

2005
0.483

2006
0.549

2007
0.532

Debt Equity Ratio of Meghna Cement Mills Limited:

Year
Equity
ratio

2003
0.400

2004
0.437

2005
0.483

2006
0.549

2007
0.532

2008
0.476

0.8
0.6
0.4

Debt ratio

0.2

Equity ratio

0
2003200420052006200720082009201020112012

12

Correlation Analysis
Correlation is concern describing the strength of relationship between two variables. In this
report the correlation co-efficient analysis is undertaken to find out the relationship between
capital structure and Firm Value. It can be said that what relationship exist among variables.

Debt
ratio
Equity
ratio
EPS

Debt
ratio
1

Equity
ratio

-1

-0.68756

0.687563

EPS

The above table presents a correlations matrix of the relationship between dependent variable
and independent variable. Here EPS is dependent variable equity ratio, debt ratio are
independent variables. The correlation between Debt Ratio and EPS is -68.75%.This exhibits
the strong inverse relationship and also statistically significant at 0.05 level. At the same time
Equity ratio also indicate the value of 68.75%. That indicates that strong optimistic
relationship between EPS and Equity Ratio correlation.
Now we bring P/E ratio in place of EPS. The Excel output shows the following result.

Debt
ratio
Equity
ratio
P/E

Debt
ratio
1

Equity
ratio

-1

0.285966

-0.28597

P/E

The above table presents a correlations matrix of the relationship between dependent variable
and independent variable. Here Price Earnings Ratio is dependent variable equity ratio; debt
ratio are independent variables. The correlation of Debt ratio is 28.59%. That means weak
optimistic relationship between PER and Debt ratio. This exhibits the weak inverse
relationship between P/E and Equity ratio and statistically significant at 0.05 level.
So from the correlation analysis we can see that Capital structure has some influence in
the value of the firm because there is correlation between the two factor..

13

Regression Summary Output

Coefficient of determination R2 is the measure of proportion of the variance of dependent
variables about its mean that is explained by the independents or predictor variables. The
adjusted R square value indicates how well the independent variables influence the
dependent one. (Benjamin 1999).
We run the regression analysis where Debt equity ratio is independent variable and EPS
is dependent variable.
Regression Statistics
Multiple R
R Square
Adjusted R Square
Standard Error
Observations

0.684120221
0.468020477
0.401523037
1.663820158
10

ANOVA
df

SS

MS

Regression

1
8

19.4837
6
2.76829
8

7.03817
3

Residual
Total

19.4837
6
22.1463
8
41.6301
4

Significan
ce F
0.029122

The specification of the two independent variables that the ability to predict the capital
structure and value of the firm. Adjusted R 2 value of 0.401523037 which is in the model
denotes that 40.15 % of observed variability of value of firm can be explained by the
differences in the independent variables. Remaining 59.85 % variance of the value of the firm
attributed to other variables
Again, we run the regression analysis where Debt equity ratio is independent variable
and P/E is dependent variable.
Regression Statistics
Multiple R
0.24745
4
R Square
0.06123
4
Adjusted R Square
0.05611
Standard
45.8085
14

Error
Observation
s

1
10

ANOVA
df

SS

MS

Regressi
on
Residual

1095.0
02
2098.4
2

0.5218
22

Total

1095.0
02
16787.
36
17882.
36

Significa
nce F
0.49064

The specification of the two independent variables that the ability to predict the capital
structure and value of the firm. Adjusted R2 value of -0.05611 which is in the model denotes
that -5.61 % of observed variability of value of firm can be explained by the differences in
the independent variables.
So, we can say capital structure has an impact on the value of the firm, and this is more
evident in case of firm value represented by EPS.

Debt used by the company in its capital structure

year
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012

Debt
923377280
802296636
718168213
594207439
450256304
300708080
500708080
225775034
175550623
330256985

15

1000000000
800000000
600000000

year

400000000

Debt

200000000
0
1

10

Firm value over the year

year

Month
(Dec)

2003
2004
2005
2006
2007
2008
2009
2010
2011
2012

end
553.75
347.75
544.25
647.25
276.75
386
1304
346
139.60
104.8

price #
of
share Firm value
outstanding
2250040
1245959650
2250040
782451410
2250040
1224584270
2250040
1456338390
2250040
622698570
2250040
868515440
2250040
2934052160
2250040
778513840
2250040
314105584
2250040
235804192

3000000000
2500000000
2000000000
year

1500000000

Firm value
1000000000
500000000
0
1

16

9 10

As we can see, company attempts to redeem its debt over the year. As a result, debt
used in its capital structure decreases. According to MM proposition we know that more
debt will result in higher firm value for tax gain. But this is not the case always as firm
value fall sharply in the year 2009. So we can say more use of debt in capital structure
increases firm value but other factor may influence it.

Analysis of dividend and dividend payout ratio

Year

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

Dividend
30
payout ratio

65

216

164

75

54

46

146

60

112

Dividend
Rate

25

25

25

25

25

30

15

35

25

25

Dividend payout ratio is continuously fluctuating but dividend rate is constant up to

year 2008 and after then there is fluctuation in year 2009-2011 and again in year 2012
the dividend is 25%. Higher dividend payout ratio indicates higher dividend payment
than EPS on the other hand dividend payout ratio less than 100% indicates some
portion of EPS were kept as retain earnings to meet financing requirements.
So we can say the company gives regular dividend.
The average EPS for the last 10 years is 3.53 and average dividend per share is 2.55.
From this data we can say that the firm follows regular dividend policy and its
decision is based on dividend irrelevance theory as the firm retains (3.53-2.55) =.98
per share every year for internal financing and expansion of the company to increase
future earning power.
Whether or not to pay dividend is a dividend policy of a company. From our text book we
came to know that dividend policy is irrelevant. But dividends itself are relevant. We can say
divided policy irrelevant investors can create homemade dividend-the tailored dividend
policy created by individual investors who undo corporate dividend policy by reinvesting
dividends or selling shares of stock.
17

Year
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012

Dividend per share

2.5
2.5
2.5
2.5
2.5
2.5
3
1.5
3.5
2.5

Dividend yield
4.5%
7.1%
4.5%
3.8%
8.9%
6.4%
2.3%
4.3%
25%
23%

Now we want to regress price volatility with the above two variables, DPS and Dividend
yield.
The model we used, Price Volatility = a + b1DPS + b2Dividend yield
We used yearly price volatility data for our analysis purpose.
The price volatility is showed below,

Year
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012

Volatility of Share Price

-.3720
.5651
.1893
.5724
.3948
2.3782
-.7347
-.5966
-.2493
-.3492

The regression output is shown below,

Regression Statistics
0.264
Multiple R
432
0.064
R Square
644
18

Adjusted R Square
Standard Error
Observations

0.004
298
0.729
011
10

Intercept
DPS
Dividend Yield

Coefficients
0.647497
-0.13424
-6.22146

Standard
Error
2.299299
1.459012
10.16908

P-value
0.785353
0.943216
0.088664

Here we can see a significant negative association is seen between dividend yields but the
negative association between DPS and share price volatility is not significant So, we can say
that dividend policy is not irrelevant.

19

Bibliography
1. DSE website
2. Annual reports of Meghna Cement Mills Limited
3. Does Capital Structure Cause high Firm Value? Evidence from Selected
Companies in Colombo Stock Exchange Sri Lanka by Velnampy.T &
Pratheepkanth.
4. www.dsebd.org
5. Monthly review of DSE
6. www.boshundhoragroup.com

20

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