Corporate Finance – Semester 2


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

  1. 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.
  2. 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.
  3. 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 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.

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.

  1. 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.

  1. 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.