Shareholder-Wealth Maximization model (SWM)

Table of contents

Introduction

The primary objective of this report is to prepare financial report on Luton Brickworks plc & analysis whether to pay dividends to shareholders or not, the arguments against shareholders wealth maximization. However there is a strong argument against the three directors of the company.

This report clearly discusses about:

  1. What is dividend?
  2. Different dividend policies
  3. Theory of organisational dividend policies
  4. Arguments of directors/analysis
  5. Conclusion
  6. References

What is Dividend

The term dividend refers to the part of divisible profits among its shareholders. In other words, dividend is that portion of company’s profit which is distributed among its shareholders as a percentage of par values of share at a fixed rate per share according to the decision of its board of directors.

The main purpose of any business is to create profits for its owners. When any company earns profit from its business, they reinvest that money in other business, but some companies pay profits to its share holders. However when a company decides to pay dividend to shareholders, the cash available for business will reduce. Dividend in uk are paid on a semi annual basis, net of deduction of tax at the standard personal income tax rate, interim dividends tend to be smaller than final dividends due to cash flow, taxation & financial planning considerations (Sangray, 2010).

Types of Dividends:

1)Cash Dividend

2)Stock Dividend

3)Stock Splits Dividend

Cash dividend:

This method is most common and popular for sharing a company’s profits. A portion of the company’s profits is paid to shareholders as dollar per share. However cash dividends are subject to double taxation in the US, and they are taxed at a maximum rate of 15%. The dividends are distributed after the company has paid income tax.

Stock dividend:

Companies, not having good cash position, generally pay dividend in the form of shares by capitalizing the profits of current and past years. Such shares are issued instead of paying dividend in cash and called ‘Bonus Shares’. Basically there is no change in the equity of shareholders, many companies pay dividends in stock which can avoid paying taxes until the stock is actually sold. In most cases shareholders will receive a specific number of extra shares from the company based on the amount shareholders already own.

Stock splits dividend:

A stock split is a proportionate increase in the number of outstanding shares that does not affect the issuing company’s assets, liabilities, or earnings. A stock split resembles a stock dividend in that an increase occurs in the number of shares issued on a proportionate basis, whereas the assets, liabilities, equity, and earnings remain the same.

Shareholders wealth maximization:

Shareholder Wealth Maximization Model, unlike simple profit-maximization incorporates the time dimension and risk. The Shareholder-Wealth Maximization model (SWM) goal states that the objective of a firm’s management should be to maximize the present value of the expected future cash flows to equity owners (shareholders).

Arguments

Director A:

He argues that cash dividends would be welcome by investors & that a high dividend payout ratio as possible would reflect positively on the market value of the shares.

This argument deals with relevance theory, where the supporting model for this argument is

Walter’s model

According to Walter’s the principles that support dividends are relevant. The investment policy of a company & dividend policy both are inter-related as they cannot be separated by their own. The value of an enterprise will be affected by dividend policy.

Formula for Walter’s model:

p= d/ke-g

where p= price of equity shares

d= initial dividend

ke= cost of equity capital

g= growth rate expected

formula for retained earnings:

p= d/ke-rb where r= expected rate of return on firms investment

b= retention rate (e-d)/e

value of share:

p= d+r/ke (e-d)

Arguments in favour of statement:

1)The dividend should be paid to shareholders only if the company having sufficient liquidity to fulfil their requirements.

2)The dividend acts as a signal to investors about the profits of the company is higher or not.

3)If company pays dividend to investors, it helps to increase confidence & market value in the society.

4)Frequent cash payment makes company more reputed & supports to get finance from other financial institutions, with reasonable interest rates.

Arguments against the statement:

1)In initial stage of the company pays dividend to investors may lead to failure in important investment opportunities. This may happen due to lack of liquidity for investment in new ventures.

2)There may be fall in share value if the company is paying big amount of dividend to the shareholders, because market may think the company is not having any future projects.

3)According to nature of the business the company may suffer loss, as dividend may adversely affect the company.

4) The regular payout of dividends will also be taxed on regular intervals, as they are corporation profits. If this profits are transferred to reserves,(capital gains) in long run, the total impact of tax would be less than the tax paid on regular dividend payments.

Another model which supports this argument is gordon & lintner model

Dividend relevance, as argued by Lintner and Gordon, suggested that investors preferred dividends to capital gains due to their certainty

w The Gordon model can be used to find the theoretical value of a share by summing the share’s discounted future dividend payments to infinity:

P0= Do (1+g)/(y-g)

Where:

P0 =current ex-dividend market price of the share

r=shareholders’ required rate of return

g= expected future growth rate of dividends

D0 = declared dividend at time t0

Dividend relevance was further supported by the argument that dividends were seen by investors as signals of a company’s future profitability

Assumptions of this model:

The firm is an all equity firm. No external financing is used and investment programmes are financed exclusively by retained earnings.
Return on investment(r) and Cost of equity (Ke) are constant.
The firm has perpetual life.
The retention ratio, once decided upon, is constant. Thus, the growth rate, (g = br) is also constant.
Ke > br

Director B

Argues that whether a cash dividend is paid or not is irrelevant in the context of shareholders maximisation.

This argument deals with irrelevance theory, the supporting models for this theory could be miller & modigliani model

Miller and Modigliani argues that dividend payments were irrelevant & should only be offered as a residual after all attractive investment projects has been accepted. Dividend irrelevance implies that the value of a firm is unaffected by the distribution of dividends and is determined solely by the earning power and risk of its assets. Under conditions of perfect capital markets, rational investors, absence of tax discrimination between dividend income and capital appreciation, given the firm’s investment policy, its dividend policy may have no influence on the market price of the shares.

Assumptions of M&M model

Existence of perfect capital markets and all investors in it are rational. there are no transactions costs, securities are infinitely divisible, no investor is large enough to influence the market price of securities and there are no floatation costs.
There are no taxes. Alternatively, there are no differences in tax rates applicable to capital gains and dividends.
A firm has a given investment policy which does not change. It implies that the financing of new investments out of retained earnings will not change the business risk complexion of the firm.

Arguments in favour of statement

1)Paying dividend will not effect on investors, only investment policy will have impact on the shareholders wealth maximization.

2)The investors always want to maximise their wealth from the company as they are less concern about payment of dividend.

3)The shareholders who expect regular income may go for Home-Made Dividend, i.e. selling of a particular plot of shares held by them instead of anticipating dividend.

4)If there is scope for external financing the supply of funds is sufficient the earnings retention is completely irrelevant as the shareholders wealth can be maximised by processing funds externally.

Arguments against the statement

The perfect capital market is unrealistic. Practically, there are taxes, floatation costs and transaction costs.
Paying present cash dividend is far better than capital gains, where whose appearance is definite & more accepted by the shareholders.
Using external source of income is not at all a good option every time, as it increase the gearing ratio & interest payment cost, which can be part of shareholders wealth

Director C

This argument deals with which is similar to relevance theory, there is no specific model that supports this argument, but

Argument for and against that Dividend payment should be avoided since it reduces

Shareholders Wealth

Arguments in favour of the statement

1)Shareholders need to pay tax on the dividend received on the shares which decreases their net income as a result it will decrease wealth.

2) Payment of dividend to the shareholders will reduce the opportunity of the firm to invest in the profitable projects.

So, the firm should try to avoid the dividend payment to its shareholders and try to

Concentrate on its investment opportunities.

Argument against the Statement

1)Watson and Head mention that ‘‘a higher cash dividend payment plays an important role to provide favourable information to the investors higher cash dividend indicates that the company’s financial condition is strong.

2)Reduce Conflict of Interest mention that ‘‘management tries to ensure their personal benefits, whereas owners are concerned about their own interest which cause agency problem. Higher dividend payment rate decreases conflict of interest, because it indicates that agent (management) is doing all things for the wellbeing of the shareholders’’.

3)The higher cash dividend reduces the uncertainty of shareholders income, so it leads to increase the share price of a company.

Factors determine dividend payment:

The dividend decision is difficult decision because of conflicting objectives, because of lack of specific decision-making techniques. It is not easy to lay down an optimum dividend policy which would maximize the long-run wealth of the shareholders. The factors affecting dividend policy are grouped into two broad categories.

Investment Opportunities: Many companies retain earnings to facilitate planned expansion. Companies with low credit ratings may feel that they may not be able to sell their securities for raising necessary finance they would need for future expansion. So, they may adopt a policy for retaining larger portion of earnings.

Similarly, is a company has lucrative opportunities for investing its funds and can earn a rate which is higher than its cost of capital; it may adopt a conservative dividend policy.

Liquidity: This is an important factor. There are companies, which are profitable but cannot generate sufficient cash, since profits are to be reinvested in fixed assets and working capital to boost sales.

Ownership considerations: Where ownership is concentrated in few people, there are no problems in identifying ownership interests. However, if ownership is decentralized on a wide spectrum, the identification of their interests becomes difficult.

Various groups of shareholders may have different desires and objectives. Investors gravitate to those companies which combine the mix of growth and desired dividends.

Firm-oriented considerations: Ownership interests alone may not determine the dividend policy. A firm’s needs are also an important consideration, which include the following:

  • Contractual and legal restrictions
  • Liquidity, credit-standing and working capital
  • Needs of funds for immediate or future expansion
  • Availability of external capital.
  • Risk of losing control of organization
  • Relative cost of external funds
  • Business cycles
  • Post dividend policies and stockholder relationships.

The following factors affect the shaping of a dividend policy:

  1. Nature of Business: Companies with unstable earnings adopt dividend policies which are different from those which have steady earnings.
  2. Composition of Shareholding: In the case of a closely held company, the personal objectives of the directors and of a majority of shareholders may govern the decision. To the contrary, widely held companies may take a dividend decision with a greater sense of responsibility by adopting a more formal and scientific approach.
  3. Restrictions by Concerned Bodies: Sometimes financial institutions which grant long-term loans to a company put a clause restricting dividend payment till the loan or a substantial part of it is repaid.
  4. Inflation: In period of inflation, funds generated from depreciation may not be adequate to replace worn out equipment. Under inflationary situation, the firm has to depend upon retained earnings as a source of funds to make up for the shortfall. Consequently, the dividend payout ratio will tend to be low.
  5. Other factors: Age of the company has some effect on the dividend decision.

The demand for capital expenditure, money supply, etc., undergoes great oscillations during the different stages of a business cycle. As a result, dividend policies may fluctuate from time to time.

Conclusion/recommendations

Concluding that, this report explains the financial status of the company and their decision regarding shareholders wealth maximization.

1)Dividend is paid to shareholders & dividend policy is taken to distribute dividend to shareholders.

2)There are 3 types of dividends cash, stock, stock splits dividend, which plays a key role in paying dividends.

3)Paying dividend to shareholders is an added advantage, which increase the company’s reputation in the market.

4)There is a possible adverse effect to the company depending on the nature of the business.

5)As investors always look forward to maximise their wealth.

6) It is not a good idea to pay dividend to shareholders now, as investors may think that the company is not having any future projects to enhance their business.

7)Recommending that the company should wait for some time to gain good reputation in market and investors as well to get more profits, which help to increase in market share, and overall profits of the company.

8)Concluding that as Luton Bricks Plc is new to company in market, there will have less scope on profit

 

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