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Corporate
Finance FIN 622
VU
Lesson
23
DIVIDEND
POLICY & FINANCIAL PLANNING PROCESS AND
CONTROL
The
following topics will be
discussed in this lecture.
Dividend
and value of firm
Dividend
relevance
Residual
dividend policy
Financial
planning process and
control
Dividend
and Value of Firm
Dividend
A
taxable payment declared by a
company's board of directors and given to
its shareholders out of
the
company's
current or retained earnings, usually quarterly.
Dividends are usually given as
cash (cash
dividend),
but they can also take the
form of stock (stock
dividend) or other property.
Dividends provide an
incentive to
own stock in stable
companies even if they are
not experiencing much
growth. Companies are
not
required to pay dividends. The companies
that offer dividends are
most often companies that
have
progressed
beyond the growth phase, and no longer
benefit sufficiently by reinvesting their
profits, so they
usually
choose to pay them out to
their shareholders also
called payout.
Value
of firm
The
term `valuation' implies the task of estimating the
worth / value of an asset, a
security or a business /
firm.
The price an investor or a firm is
willing to pay to purchase a
specific asset/security would be
related
to this
value. Obviously, two
different buyers may not
have the same valuation for
an asset/ security as
their
perception
regarding its worth/value
may vary; one may
perceive the asset/business to be the higher
worth
(for
whatever reason) and hence
may be willing to pay a higher
price than the other. A
seller would consider
the negotiated
selling price of the asset/business to be
greater than the value of
the
Asset
/ business/firm he is selling.
1. Dividend
relevance
A. Preference
for Dividends
· Uncertainty
surrounding future company profitability
leads certain investors to prefer the
certainty
of current
dividends.
· Investors
prefer "large" dividends.
· Investors do
not like to manufacture
"homemade" dividends, but prefer the
company to distribute
them
directly.
· As a
mean of resolving the uncertainty early,
investors prefer dividend
paying stock rather
than
non-dividend
paying.
· taxation:
individual bracket, on capital
gains vs. dividends
· liquidity
preference
· Financial
signaling: Dividends have
impact on share prices
because it indicates the
firm's
profitability
as well. Accounting earnings may
not be a influencing factor as
compared to
increase
in dividend.
B. Taxes
on the Investor
· Capital
gains taxes are deferred
until the actual sale of
stock. This creates a timing
option.
· Capital
gains are preferred to dividends, everything
else equal. Thus, high
dividend-yielding
stocks
should sell at a discount to generate a higher
before-tax rate of return.
· Certain
institutional investors pay no
tax.
· Corporations
can typically exclude 70% of
dividend income from
taxation. Thus, corporations
generally
prefer to receive dividends rather than capital
gains.
· The
result is clienteles of investors
with different dividend
preferences. In equilibrium,
there
will
be the proper distribution of firms with
differing dividend policies to
exactly meet the
needs
of investors.
· Thus,
dividend-payout decisions are
irrelevant.
75
Corporate
Finance FIN 622
VU
Residual
Dividend Policy
If a
company does not pay
all the profit to shareholders in the
form of dividend then the
debt equity ratio
will
change. In this section we will
assume that company do have
some potential opportunities
and will
finance
these opportunities first
and any remainder profit
will be paid as dividend and the
debt equity ratio
will
be held constant.
An
approach that suggests that
a firm pay dividends only if
there are no potential
opportunities for
expansion
or there's some profit left
after financing the potential
opportunities, represents residual
dividend
policy.
Sr
#
After
Tax
New
Additional
Retained
Additional
Dividends
D/E
Earning
Investment
Debt
Earning
Stock
1
2,000.00
6,000.00
2,000.00
2,000.00
2,000.00
-
0.50
2
2,000.00
5,000.00
1,500.00
2,000.00
1,000.00
-
0.50
3
2,000.00
4,000.00
1,250.00
2,000.00
500.00
-
0.50
4
2,000.00
3,000.00
1,000.00
2,000.00
-
-
0.50
5
2,000.00
2,000.00
666.67
1,333.33
-
666.67
0.50
6
2,000.00
1,000.00
333.33
666.67
-
1,333.33
0.50
7
2,000.00
-
2,000.00
The
main objective to present this table is
to aid your understanding that
how debt equity ratio is held
constant
under residual dividend policy.
This table complies with the
definition of the policy
presented
above,
which state that first
acceptable opportunities will be financed
and if there's any profit
left that will
be
distributed as dividend.
The
first column refers to various
situations and we will
discuss couple of such
scenarios.
Taking
the 2nd scenario, if the
profit is Rs. 2000 and a
potential opportunity exists
which needs Rs 6000.
This
6000 shall be financed by three
items: 2000 from loan, 2000
from additional equity and
2000 profit.
This
is because we need to keep the
debt equity ratio at 0.50.
You can see in this case we
don't have
anything
left to pay as dividend to
shareholders. Now coming to case # 6
where we have 2000 profit
and
investment
1000 is needed for a
potential project. So we have 1000
remaining profit but we are
not going to
distribute
1000 as dividend.
Why?
The
answer to the question is pretty simple:
if we pay out 1000 as
dividend then the debt equity
ratio of 0.50
is no longer
there. (Try it yourself by changing the
above table).
The
company needs to seek an amount of loan
that could ensure desired D/E
ratio. In this case, this can
be
ensured
by taking a loan of 1/3rd* of the remainder
profit of 1000 Rs.333/-. Now
consider here the after
financing
the potential opportunity of Rs 1000,
and obtaining loan of Rs 333, we
have now Rs. 1,333/-
left
which
can be paid as dividend and this
will ensure that debt equity
ratio is same.
(* D/E
ratio of 0.50 means that
debt is 1/3rd and equity is
2/3rd)
Dividend
payments may increase or
reduce shareholder wealth.
The dividend policy adopted should
be
aimed
at maximizing shareholder wealth in line
with corporate objectives, and we
need to examine whether
there
is any particular dividend policy
which maximizes shareholder
wealth. Is a high dividend
payment
policy
better than a low payment
policy?
Dividend
policy research is being done in the
world for a long time, but
practical issues in dividend
policy is
poorly
investigated in a company. The
purpose of this paper is to investigate
dividend policy in
few
76
Corporate
Finance FIN 622
VU
companies
and to estimate its impact
on share market price.
Dividend policy in practice in
foreign
countries,
its necessities and
shortcomings are investigated in the
paper. During the research
dividend policy
in
practice is determined in Lithuanian
companies; the impact of net profit
changes on dividends is
investigated;
the correlation between dividends
payments and share market
price is determined.
There
are four kinds of dividend
policy in practice:
· residual
dividend policy;
· stable
or dividend growth
policy;
· stable
net profit/dividend payment ratio
dividend policy;
· Premium
dividend policy.
The
investigation which has been
carried out in few companies
reveals the impact of dividends payments
on
share
market price. However, it is
necessary not to forget that
capital market is at the forming
stage and
most
companies put into practice
residual dividend policy in
order to strengthen their
position in the
market.
To
wrap up this topic we need to
consider the following factors when we
are confronted with
dividend
policy:
· A
firm must endeavor to
establish a dividend policy
that maximizes shareholders
wealth.
· Mostly
it is believed that if a firm does
not have investment opportunities on
its plate, it should
return
/ distribute funds to
shareholders.
· It is
not necessary to pay out
everything but firm may wish
to stabilize the dividends.
· There
must be preference for
dividend.
· It
appears realistic to have
some value associated with
modest dividend as compared to
nothing.
· The
value of firm's stock is
unchanged. Whatever the pattern of
dividend payout, the value of
stock
will
be the same. the reason is
simple:
· The
increase in dividend in one
year is exactly offset by the
decrease in later year, so the net
effect
is
nil.
· Dividends
are relevant because investors
like to have higher dividends. if there's
one higher
dividend
and other dividends are
constant, the stock price
will rise.
Financial
Planning Process and Control
Financial
planning is often thought of as a
way to manage debt, but a
good financial plan really is a way
to
make
certain that you have
financial security throughout
your life. Many small
business owners
consider
their
business as their investment in their
future, but that is a huge
risk to take. As any economist
will tell
you,
diversification is the only sure
way to create security in the
long run. Your business is
one stream of
income.
Putting together a financial plan that
allows for multiple streams
of income is what provides you
security
in the longer term.
The
essential components of a good financial
plan are investing, retirement planning,
insurance, borrowing
and
using credit, tax planning, having a
will, and ensuring the right
people receive your assets.
Financial
planning
is the process of meeting your
life goals through the
proper management of your
finances. Life
goals
can include buying a home,
saving for your child's
education or planning for
retirement.
The
financial planning process involves gathering relevant
financial information, setting
life goals,
examining
your current financial status and coming
up with a plan for how you
can meet your goals
given
your
current situation and future
plans.
There
are personal finance
software packages, magazines
and self-help books to help you do
your own
financial
planning. However, you may
decide to seek help from a
professional financial planner
if:
· You
need expertise you don't
possess in certain areas of
your finances. For example,
a planner can
help
you evaluate the level of risk in your
investment portfolio or adjust your
retirement plan due
to
changing family
circumstances.
· You
want to get a professional opinion
about the financial plan you
developed for yourself.
· You
don't feel you have the time to
spare to do your own financial
planning.
· You
have an immediate need or
unexpected life event such
as a birth, inheritance or major
illness.
· You
feel that a professional adviser could
help you improve on how
you are currently
managing
your
finances.
· You
know that you need to
improve your current financial situation
but don't know where to
start.
77
Corporate
Finance FIN 622
VU
A financial planner
is someone who uses the financial
planning process to help you
figure out how to
meet
your
life goals. The planner can
take a "big picture" view of
your financial situation and
make financial
planning
recommendations that are
right for you. The planner
can look at all of your
needs including
budgeting
and saving, taxes,
investments, insurance and retirement
planning.
In
addition to providing you
with general financial planning
services, many financial planners
are also
registered
as investment advisers or hold insurance
or securities licenses that
allow them to buy or
sell
products.
Other planners may have
you use more specialized
financial advisers to help you implement
their
recommendations.
With the right education and
experience, each of the following
advisers could take
you
through
the financial planning process. Ethical
financial planners will refer
you to one of these
professionals
for
services that they cannot provide
and disclose any referral
fees they may receive in the
process. Similarly,
these
advisers should refer you to a planner if they cannot
meet your financial planning
needs.
The
Financial Planning Process
consists of the Following
five Steps
1. Establishing
and defining the client-planner
relationship.
The
financial planner should clearly explain or document the
services to be provided to you
and define
both
his and your
responsibilities. The planner should explain
fully how he will be paid
and by whom.
You
and the planner should agree on how
long the professional relationship should
last and on how
decisions
will be made.
2. Gathering
client data, including goals.
The
financial planner should ask for
information about your financial situation.
You and the planner
should
mutually define your personal
and financial goals,
understand your time frame
for results and
discuss,
if relevant, how you feel about risk.
The financial planner should gather
all the necessary
documents
before giving you the advice
you need.
3. Analyzing
and evaluating your financial
status.
The
financial planner should analyze your
information to assess your current
situation and determine
what
you must do to meet your
goals. Depending on what services
you have asked for, this
could
include
analyzing your assets,
liabilities and cash flow,
current insurance coverage, investments
or tax
strategies.
4. Developing
and presenting financial planning
recommendations and/or
alternatives.
The
financial planner should offer financial planning
recommendations that address
your goals, based
on the
information you provide. The
planner should go over the recommendations
with you to help
you
understand them so that you
can make informed decisions.
The planner should also listen to
your
concerns
and revise the recommendations as
appropriate.
5. Implementing
the financial planning
recommendations.
You
and the planner should agree on how the
recommendations will be carried
out. The planner may
carry
out the recommendations or serve as
your "coach," coordinating the whole
process with you
and
other
professionals such as attorneys or
stockbrokers.
The Control
Process:
When
plans are finalized and
put to action or implemented, then the
actual performance is compared
with
the
budgeted numbers. The difference
between the actual and
budgeted numbers is called
variance. This
variance
is investigated as to know the real
causes of the difference. The investigation
leads to initiate the
corrective action
and to adjust the budget of future
periods. The investigation result is
known as feedback.
There
are three types of feedback
emerging from investigation of
variance.
1. Change
The Strategy or Course of Action
If
something went wrong with
strategy, the course
of action is
fine tuned or changed to
ensure future actual results
conform to original plan.
For
example,
if sales was less than the
budgeted and variance investigation
revealed that sales
force
could
not be motivated then some
incentives and bonuses can
be offered to motivate the
sales
force.
The future period budgets
will be adjusted for the
proposed incentive expenses.
2. Do
Nothing if the
results are in line with the
planned, no action is required.
3. Change
The Plan
Targets or plan itself is revised rather
than changing strategy. For
example the
targeted
profit is scaled
down.
For
example we continue the example in 1
above, if sales were less
than budgeted and investigation
revealed
that
the sales target was not
realistic, then the sales
targets will be adjusted for
future period.
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