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Unit 3 Financial Management EDEXCEL HND Business Management Level 5

Introduction

The main motive of financial management is to arrange the financial requirements of the company for satisfying the short term and long term requirements of funds of the company. The dividend decision is the concept of risk return trade off. It is very important for the company to form a dividend decision in order to form a dividend policy. Dividend policy implies that how much of the net earnings of the company should be retained and how much of it should be distributed among the shareholders (Brigham and Houston, 2012). Mergers and acquisitions has been a very important strategy for the entry and expansion of the firms. Merger takes place when two or more companies combines together where one company loses its existence and the another company survives and expands. Acquisition is the process of acquiring ownership in another company by way of acquiring assets and li

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Part A

Dividend payment decision is the most crucial financial decision that a corporate company has to make, which is why it is the most debating issue in the corporate and financial industry across the globe. The dividend is that portion of the after tax profits of the firm which is being distributed to owners or the shareholders of the company on the basis of the shares acquired by them (Huston, 2010). Dividend payment decisions are a very important decision because it effects the availability and the overall cost of capital. The dividend payment decisions are made by the board of directors of a company and is approved by the shareholders of the company in the annual general meeting held by the company. The shareholders of the company do not have right to ask for a higher rate of dividend and increase in the rate of dividends in comparison to previous years. But it is the duty of the board of directors to set a dividend pay-out ratio that maximises the shareholders’ wealth. The dividend decisions are important and crucial because it influences the capital of the company and it also influences the share prices of the company.

Dividend policies:

Every firm has different dividend policies, the dividend policy of a company divides the total after tax profits made by the company into earnings that are retained and dividends that the company will distribute among its shareholders. Retained earnings are those part of the net earning which company retains for the long term financial growth while dividends are distributed in cash to the shareholders. Dividend policies are governed in major two of the following ways:

Long term financing decisions: When the companies take decisions regarding long term financing, net earnings are viewed as source of financing. When the companies have profitable investment opportunities they retain the earnings and invest the amounts in those investments, the form grows at very fast rate when company accepts such profitable projects. Retained earnings are preferred by the companies because it does not involve floatation cost. Payment of cash dividends reduces the amount of fund that company have for investing on those projects. Hence earnings are retained for investing in profitable projects for long term financing that otherwise would be distributed as cash dividends.

Wealth maximisation dividends: This dividend decision focuses on maximising shareholders’ wealth, because of the imperfections and uncertainties in the market the shareholders prefer annual cash dividends rather than future dividends and capital gains. The annual cash dividends increase the market value of shares, higher dividends lead to increase in the prices of the shares and low dividends decrease it. But there should be a proper balance in both the policies because if the company retains more earnings than it will decrease the market price of shares whereas if it does not retain earnings than it will lose the profitable investment opportunities which will decrease the future prices of the shares. Thus, company should manage an optimum balance between both policies in order to benefit in both the short and long terms (Brusca, Gómez‐villegas and Montesinos, 2016).

Dividend and valuation: There are conflicts in opinions whether there is impact of dividends on the value of the shares and the cost of capital of the company. Some of the theories state that there is relevance of the the dividend in the valuation of the firm, on the other hand some theories state that there is no relevance of dividend in the valuation of the firm.

Relevance theory: This theory implies that dividend policy of the firms has a impact on the valuation of the firm, that means dividend policy is relevant. Which implies that change in dividend policy of the firm will bring a change in the market price of the shares of the firm. If dividend is considered as a relevant factor in the market value of the firm than their must be an optimum pay-out ratio. Optimum ratio is that ratio which maximises the market value of a firm. The following theories shows that there is relevance of dividend:

Walter's Model: Walter model argues that the dividend policy chosen by the firm almost every time affects the market value of the firm. Walter model studies significance of internal rate of return (IRR) and overall cost of capital (Kco) in determining the dividend policy which is optimum and thereby maximising shareholders wealth.

There are several assumptions that are to be considered in Walter's model:

The investments of the firm are financed by the firm's retained earnings.

  • The internal rate of return and cost of capital of the firm remains constant.
  • The firms net earnings are either distributed in the form of cash dividend or retained and reinvested by the firm (Sucuahi, 2013).
  • The firm is operating in a long term basis.
  • Net earnings and dividends of the company remains constant.

Walter's formula to determine the price per share is as follows:

MPS= Market price/share.

EPS= Earnings per share.

DPS= Dividend per shareholder

IRR= Internal rate of return

Kco= cost of capital

Walter's theory states that the optimum dividend policy is dependent on the relationship between the internal rate of return (IRR) and cost of capital (Kco). If the IRR>Kco than the firm should retain the entire earnings whereas if the IRR

Walter's view on dividend payout ratio can be describes as follows:

Growth firms: These are those firms whose internal rate of return are higher than cost of capital. The growth firms has a lot of good investment opportunities. These firms can easily earn a return which is more than the shareholders are capable of earning on their own. So, these firms are not required to distribute dividends among shareholders. They have 0% dividend pay-out ratio.

Normal firms: These firms have an internal rate of return which is equal to the firms cost of capital. In the case of normal firms the dividend pay-out ratio will have no impact on the market value of the shares. So, there is no such thing as optimum pay-out ratio (Sanford, 2011). All the ratios are optimum.

Declining firms: The declining firms internal rate of return is lower than the overall cost of capital (IRR<Kco). This means that returns earned by the company are lower than the shareholders would have earned otherwise in other investments. So, the company has to distribute it complete earnings to its shareholders in cash dividends. And therefore, the dividend pay-out ratio in declining firms are 100%.

Gordon's Model: This model also supports the relevance of dividend pay-out ratio. The Gordon's model states that there is a significant impact of dividend decision in the market value of shares based on following underlying assumptions:

The firm should only have equity component in its capital and no debts.

There should be no outside financing and the firm capital is exclusively financed by retained earnings.

The firm should have a constant internal rate of return.

Cost of capital of the firm should also be constant regardless of the changes in risk levels.

The firms retention ratio and its growth should also be constant.

There should be no corporate tax.

Gordon's model also have the same view on optimum dividend policy for different types of firms:

The pay out ratio should zero for all the growth firms.

There is no optimum pay-out ratio for the normal firms.

The should be 100% pay-out ratio for the declining firms.

Irrelevance theory: The irrelevance theory implies that there is no impact of dividend policy on the valuation of the firm, that means that dividend policy is irrelevant (Jain, Singh and Yadav,  2013). It implies that the dividend policy of the company does not have any impact on the price or values of the shares. The models on irrelevance theory is discussed below:

Modigliani-Miller Model: Modigliani model states that there is no relevance of dividend policy of a firm and that it does not affect the shareholder's wealth. This theory implies that value of the firm is solely dependent on the earnings power and investment policies of the firm and not influenced by the manner in which it is split between the dividends and retained earnings. The following assumptions are taken into consideration in miller model which are as under:

The capital markets are perfect: - Information are easily available in the market, investors are rational, there are no transaction cost, divisible securities, the investors cannot influence the markets.

No taxation: There is no difference in the tax rates of the dividends and the capital gains.

There is no change in the investment policy and it is fixed, so if the retained earnings are reinvested there will not be any change in the risk of the firm. So, cost of capital remains same.

There is no floatation cost.

The arguments stated by the MM model is discussed below:

If the company would have retained the earnings instead of paying out dividends, then shareholders would have enjoyed appreciation in the capital, which is same as the earnings through dividends. If the company would have distributed the earnings by the way of cash dividends, then there would be no appreciation the capital of the shareholders.

Hence, the division of earnings between retained earnings and dividends is irrelevant from the shareholder's point of view.

Part B

Nowadays, corporate world is growing at a faster rate and globalisation has taken a devastated change which ultimately trying to attain a maximum market share possible on both of the market level which is domestic and global market (Siano, Kitchen, and Giovanna Confetto, 2010). Routine business people works to attain a more goal. Some of their manner may embody the competitive throughout the market of their core competency. Henceforth, this protect that they are required to have the best knowledge and skills in order to have fighting likelihood against their rivals in that organisation.

During 21st century business plays a game of growth. Each company want maximum market share over their rivals, henceforth organisations are striving hard to attain the growth by implementing common short cut. Growth is the crucial motive which is financial stability of the organisation and likewise shareholders’ wealth optimisation and key coalition personal aims. M&A renders an organisation along with the potentially higher market share and this opens the organisation in a highly diversified market. Nowadays, this is the most basic method which can be used by organisations for growth of the organisations. M&A helps to form the organisation more. enhance its manufacturing and render it highly financial strength in order to become sound against their contenders on the similar market. M&A have gained quality via the planet throughout the current economic issues attributable to globalisation. M&A normally obtained quality via Merger and takeover are the most crucial tool which can be used by the organisation in order to gain sustainable development in an effective manner (Baker and et al., 2012). Nowadays, this is the combination or consolidation of the organisation which segregate the two terms, Mergers is the consolidation of the two organisations of form one, on the other hand, Acquisitions is one organisation that has been taken over by the other company. M&A is the most effective tool for corporate restructuring. This is the main reason behind M&A normally is that two separate organisations together form higher value compared to being on an individual stand. With the objective of wealth optimization, organisations keep assessing diverse. The classification of acquisitions in the merger are discussed below:

Classification of acquisitions: There are various ways in which a company can be acquired by another company. A merger occurs when the board of directors of the two companies comes at an agreement to combine the two companies. In this decision of mergers, it is important to have a support of at least 50% shareholders initiate the merger process (Hill and et. al., 2012).

There are different types of methods for the merger of two companies which are discussed as following:

Tender offer: In a tender offer a firm buys the outstanding shares of the another firm at a specific price through advertising and mailings to the shareholders of the firms. The tender offers are used for the hostile takeover of the firm. The firm which is acquired through the tender offer continue to exist as long as all the stockholders do not sell their shares to the company. Generally, tender offers become successful mergers if the acquirer successfully gains control over the acquired company (Molina and Preve, 2012).

Acquisition of assets: In this acquisition all the assets of the company are taken over by the another company, though formal voting by the shareholders of the company are still required for the acquisition of the firm.

Buyouts: The buyouts are usually assisted by the tender offers. In this the firm is generally acquired by the own management of the firm or by the group of investors. After the buyout the firm cease to exist as a publicly traded firm and becomes a private business. These type of acquisitions are called management buyouts. And the leveraged buyouts are those in which the funds acquired for the acquisition is financed through debt (Chandra, 2011).

Mergers and acquisitions are considered as the capital investment projects through which the company expands externally by acquiring another related or unrelated firm. It is having an impact on the shareholding of the company as well because various kinds of issues are raised regarding separation of ownership and control of the company. According to S. Cartwright (2014), It is also considered that through takeovers company tries to remove their inefficient management teams and replace it with the efficient ones so that activities can be carried out in an effective manner. It also helps in facilitating repayment of capital to more effective users of the company.

Therefore, it is said that if the company which is doing merger and acquisitions are following the policy of maximising shareholders’ wealth then the shareholders of that company will not face any issue when the acquisition process will be carried on. But there are many times when the company which have come for bidding raises the premium which is paid to the target shareholders so that they can earn good amount of money in short period of time. As per the views of LA Stout (2012), If these consequences are being seen then it can be said that merger and acquisition is the zero net present value investment decision for the company (Brigham and Houston, 2012).  

So, it can be said that mergers and acquisitions not only affect the value of the merging firm but also have a positive as well as negative effect on the shareholders of firms involved. According to The Hubris theory, it is described that mergers and acquisitions is having an effect on the value of firm as well as shareholder's wealth. This theory predicts that after the merger, the value of the target firm rises and bidding firm's value diminishes. Accordingly, the shareholders of the targeted firm get the opportunity to increase their wealth but at the same time the shareholders of bidding firm see a negative impact on their wealth. But there are also situations when shareholders of bidding firm get the opportunity to earn a marginal gain but the target company shareholders obtain a large gain. However, it has also been argued that shareholders’ wealth creation and destruction in the acquisition process is dependent on the economic condition that is prevailing at that time. So, it can be said that impact of mergers and acquisitions on the economy can be both positive or negative and thus wealth of the shareholders are sometimes in danger as well.

As per the reports of Johnson (2017), it was known that there are various types of mergers and acquisition that is happening around the world. Some are like Amazon buys Home food and Michael Kors acquires Jimmy Choo etc. There were some more high end acquisitions that happened around the world and are considered as successful as well since their shareholders supported them in doing these kinds of changes in the company. So, the management is required to make sure that the shareholders are not at loss while doing these kinds of activities in the company.

Conclusion

From the above mentioned report, this can be observed that this report consists of dividend payments which helps to determine the share price of the organisation. In this report, dividend relevance and dividend irrelevance theory are mentioned. Merger and Acquisition are also being identified and analysed in this report.

References

  • Brigham, E.F. and Houston, J.F., 2012. Fundamentals of financial management. Cengage Learning.
  • Chandra, P., 2011. Financial management. Tata McGraw-Hill Education.
  • Molina, C.A. and Preve, L.A., 2012. An empirical analysis of the effect of financial distress on trade credit. Financial Management. 41(1). pp.187-205.
  • Hill, M.D., Kelly, G.W. and Lockhart, G.B., 2012. Shareholder returns from supplying trade credit. Financial Management, 41(1), pp.255-280.
  • Baker and et. al., 2012. Are good performers bad acquirers?. Financial management. 41(1). pp.95-118.
  • Siano, A., Kitchen, P.J. and Giovanna Confetto, M., 2010. Financial resources and corporate reputation: Toward common management principles for managing corporate reputation. Corporate Communications: An International Journal. 15(1). pp.68-82.
  • Jain, P.K., Singh, S. and Yadav, S.S., 2013. Financial management practices. India Studies in Business and Economics ReDIF-Book.
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