1) In equity markets, dividend declaration is generally a very significant event and usually affects the price of the stock in a large manner. However, the relevance and usefulness of declaring dividends has been debated for a very long time.
It is well understood that declaration of dividends is not a legal requirement (ASX). Firms can not declare dividends and choose to reinvest their whole profit into the business. Some of the popular companies which do not pay dividends are Berkshire Hathaway, Amazon, Yahoo, Adobe etc.
Even companies like Google and Apple had stopped paying dividends for long periods recently. As can be noticed, most of these companies are technology companies which may have large capital needs to fund their growth strategy (Ghosh, 2012).
Over the years there have been a lot of theories regarding the relevance and amount of dividend payments. Some of the most popular of these theories are the Gordon Growth model, Walter’s model, Modigliani-Miller hypothesis on dividend irrelevance, bird in hand theory and also artificial dividend theory.
Gordon Growth Model
Gordon growth model states that the stock price of a company is the discounted present value of the future expected dividends. It assumes that the dividends will continue to grow at a steady growth rate and that the discount rate would remain constant. The discount rate which is used is the cost of equity for the firm (Damodar).
The Gordon growth model shows that the value of the firm goes up due to higher dividends. It makes an argument that higher dividends will always result in higher valuation. Further, as the growth rate in dividends would increase, the value of the firm would also increase.
Overall, the model strongly recommends payment of dividends and increasing this dividend payment at a high rate, so as to increase the value of the firm (Damodar).
For Easylife Pty Ltd, as it is now listing its shares on the stock exchange through IPO, the Gordon growth model provides the indication regarding how the company can value its shares under two cases, if it decides to give out dividends, or it does not decide to give dividends.
The model says that the stock price can increase significantly if Easylife Pty Ltd decided to have a dividend policy. The company may decide on specific dividend pay-out ratio later, but the model clearly indicates that the Directors are advised to formulate a dividend policy, so as to increase the value of the company.
Further, Easylife Pty Ltd has to make sure that the dividend growth rate is maintained and there are no sudden declines or changes in the dividends, otherwise the market value of the company will decline.
Walter’s Model
The Walter model argues that the value of the firm is always affected by the dividend payments made. It uses the variables dividend amount, the cost of capital, the internal rate of return for the company and the earnings per share and finds the share price for the company.
The model argues that the value of the firm increases when cost of capital is more than internal rate of return and the dividend payout increases. Conversely, if the dividend payout decreases, the value of the firm decreases (efinancemanagement).
Further, when the cost of capital is less than internal rate of return and the dividend payout increases value of the firm decreases. Conversely, if the dividend payout decreases, the value of the firm increases. There is no change in the value of the firm however, if the internal rate of return is equal to the cost of capital (efinancemanagement).
Modigliani Miller Hypothesis (Dividend Relevance)
The Modigliani Miller Hypothesis (MM hypothesis) argues that dividends are irrelevant and that the share price of a company depends solely on its earnings, which are dependent on the investment policy of the company (Villamil).
The theory however, has been criticised as it does not differentiate between internal financing and external financing. Also, a company may not have a fixed investment policy and the future prospects may change.
The MM hypothesis ignores certain practical issues of investment policy followed by companies, which makes the model difficult to use in the real world (Villamil).
Also another aspect that the theory argues is that it is irrelevant whether a firm raises capital through debt or equity. This however, is not true as the cost of debt and equity can vary widely and affect the valuation of the firm.
For Easylife Pty Ltd, the theory can act as a counter argument regarding the effect that can be seen on the value of the company if it does not pay dividends. As per the irrelevance theory, if Easylife Pty Ltd does not have a dividend policy, then it would not affect its market valuation.
However, even while considering the theory of dividend irrelevance, Easylife Pty Ltd has to take into account that practical considerations such as imperfect markets, taxes etc. can affect valuation of the company specifically and the theory can only be a guiding reference.
Bird In Hand Theory
The theory argues that the main reason why investors put their money in stock of a company is due to the dividends that they will get and place more importance on this than they do on capital gains.
This theory is based on the phrase that a bird in hand is better than two in the bush. Same way, the theory states that when the dividends are certain, investors will prefer that over the uncertainty of getting higher capital gains when dividend is not paid out (Bhattacharya, 1979).
This theory is in direct contradiction to the dividend irrelevance theory by Modigliani and Miller and was formulated by Gordon and Lintner. (Bhattacharya, 1979).
Artificial Dividend Theory
The artificial dividend theory was formulated using the Modigliani Miller hypothesis of dividend irrelevance. This theory postulates that if investors want dividends, they can artificially create such cash flows by selling from their existing portfolio of stocks.
The theory argues that every investor has separate goals and the value of the firm is not impacted by individual goals and investing objectives. For investors who do not want dividends can wait for capital gains on their stocks.
On the other hand, investors who invest in a stock primarily for dividend gains can artificially get those gains by selling their positions. The quantum of stocks sold can depend on the cash needs for individual investor.
Company specific factors
So as it can be seen above, the theories are divided regarding the usefulness and need of dividends. However, the decision to declare or not to declare dividends is taken by the senior management of a company and is then approved by the Board of Directors.
This dividend decision is based on a lot of company specific factors such as the stability and projections for earnings, future capital requirements, capital needs for inorganic growth, current cash position, taxation on dividends, macroeconomic projection etc.
Easylife Pty Ltd will have to estimate the stability of strong earnings in the future, it can declare dividends. However, when the earnings are declining, or the management is unsure about the sustainability of the earnings, it may refrain from declaring dividends.
The current cash position too can play an important role in the dividend decision for a company. If Easylife Pty Ltd has large cash piles, it could be comfortable with declaring dividends in the future, however if it does not have a huge stock of cash, it would be reluctant to give out dividends.
The management also has to take into account future capital requirements for various investment decisions, while declaring dividends. If Easylife Pty Ltd has planned a lot of new projects or expansions, it would require large amount of cash. So for the company, preserving cheaper internally generated equity would make sense rather than giving out dividends and then raising more equity for market at a higher price.
Not only does organic growth needs play an important role in determining the dividend decision, plans for inorganic growth too can influence the dividend policy. If Easylife Pty Ltd has plans for growing through mergers and acquisitions in the near future, the management would not like to declare large dividends and preserve capital for the inorganic growth events.
Current macroeconomic conditions and future estimates can also influence the dividend decision apart from company specific factors. When a market or economy is doing well, and the future forecast shows expansion in the economy, Easylife Pty Ltd can predict higher revenues and earnings, and would be more comfortable with declaring dividends as compared to a situation when the economic downturn has set in or is predicted.
Taxation on dividends in some countries can also influence the dividend policy of companies. So Easylife Pty Ltd will have to decide upon the dividend policy after taking taxation into consideration.
Need for a stable dividend policy
Even the market values a stable policy with logical rationale, much more than it values adhoc increase in dividends. It has been empirically proven that market reacts negatively to management decision to step down dividends per share.
Further, it has been proven that dividend termination is taken very negatively by the market, which can result in large decline in the stock value. So any dividend policy, which starts or increases dividends, should take into account future sustainability of such dividends and should not be focussed only on the short term gains which would be derived from declaring dividends (Accounting Management).
This may be the reason that although several large companies do not declare dividends and may not have ever declared dividends in their history, are still taken more positively by investors as compared to companies which increase or decrease or stop and start their dividends regularly.
So while formulating the dividend policy for the company Easylife Pty Ltd, the management and the Directors should take the above factors into consideration, and realise the importance of dividends. The company must formulate the dividend policy after taking various factors such as future earnings, capital needs etc. into consideration, and have a clear cut dividend policy.
2) Capital markets play a very important role in financing the short term and long term needs of companies. Every company requires capital to fund its operations and grow. This capital can either come from the promoters, from banks or from external financing.
There is a limit to which promoters can put their own funds and companies that are growing year after year, require much more money than what a group of promoters can put in. Further, bank loan comes under the category of debt and directly hits the profit and loss statement of a company through interest costs.
The other option available to companies to raise capital is through the market. They can raise both debt as well as equity through the capital markets. Further, to fund their working capital and short term fund requirements, they can raise money through money markets, which is nothing but short term version of capital markets.
Equity Market
Companies can raise equity through the capital market. The first time a company issues fresh shares in the market is known as an Initial Public Offer (IPO). IPO allows companies to access a large pool of investors who are willing to put in money into the company (Hendricks, 2012).
The next times a company issues fresh shares in the market, the process is called Follow-on Public Offer (FPO). The whole process is similar to that of IPO and further allows a company to raise equity (Hendricks, 2012).
Apart from issue of fresh shares in the market, a company can sell its existing shares. These can be the shares that are already issued and held by the promoters. This process is called Offer for Sale.
Further, a company can issue rights. A rights issue gives the existing shareholders a right to buy additional shares. This process results in creation of additional equity capital for the company.
Debt Market
Similar to equity market, companies can raise debt from the capital markets by issuing bonds. A bond is an instrument which pays regular interest rates in the form of coupons to the buyer or the holder of the bond and then pays the face value at the time of maturity (Hendricks, 2012).
Raising capital by issuing bonds is cheaper than both issuing equity as well as raising money through bank loans. This is the reason why most companies prefer to raise a lot of money through bond markets, as compared to the other two avenues.
A very important factor that companies need to take into account while issuing a bond, is the maturity of the bond. Unlike shares which are perpetual in nature, bonds have a fixed maturity (Hendricks, 2012).
A company needs to estimate its capital requirements at different points in time in future and thus need to decide on the maturity of the bond they issue. Maturity which is either higher or lower than the required maturity, can result in cash flow mismatches for the company. This can be detrimental to the earning capacity.
Money Market
While the debt and equity markets help a company raise capital for long term needs, the short term working funds requirements are fulfilled through the money market instruments.
Several money market instruments are commercial paper, repurchase agreements and certificate of deposits. While commercial paper is issued almost exclusively by corporations, certificate of deposits are issued by banks. Repurchase agreements can be by any of the market participants (Hendricks, 2012).
Overall, money market instruments are nothing but short term financing instruments with maturity less than one year.
Implications of capital markets
The capital markets have immense implications for companies, managers and shareholders. The impact and usefulness of capital markets for companies has already been discussed above.
Financial managers make most of their decisions by factoring in the usefulness of capital markets. As discussed above, for every business decision, capital is key. And financial managers are aware that any fresh capital needs can be fulfilled through raising money from capital markets (Shanken and Smith, 1996).
All the business decisions, like investment decision, financing decision etc. are taken on the basis that they would be able to raise the necessary finance through capital markets at any time (Shanken and Smith, 1996).
The shareholders also gain from capital markets through increased information access. Market disseminates and factors in new information much more quickly than what an individual can. This reduces the information asymmetry that may exist and enables the shareholders and investors to make an informed decision.
So when Easylife Pty Ltd decides to give out 40% to 50% of its earnings as dividends, it must take into consideration its future capital needs. If the company mentions elsewhere that it has significant capital needs in coming years, but plans 40% to 50% dividends, the market is likely to view it negatively.
So rather than planning to give 40% to 50% dividends, the company should rather evaluate its capital needs, and explain clearly in the dividend policy that dividend payout ratio will depend on future earnings estimate and capital requirement estimate.
Such a well defined and forward looking dividend policy is likely to be viewed by the market in a more positive way, rather than paying 40% to 50% dividends initially, but raising more expensive equity later from capital markets.
Reference List
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Damodar, A. The Stable Growth DDM: Gordon Growth Model. NYU Stern. [online] Available at: <http://people.stern.nyu.edu/adamodar/pdfiles/ddm.pdf> [Accessed 04 March 2016].
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Villamil, A. P. The Modigliani-Miller Theorem. The New Palgrave Dictionary of Economics. [online] Available at: <http://www.econ.uiuc.edu/~avillami/course-files/PalgraveRev_ModiglianiMiller_Villamil.pdf> [Accessed 04 March 2016].
Bhattacharya, S., 1979. Imperfect Information, Dividend Policy, and “the Bird in the Hand” Fallacy. Bell Journal of Economics, 10(1), pp.259-270.
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Hendricks, M., 2012. Debt and Equity Markets. University of Chicago. [online] Available at: <http://www-finmath.uchicago.edu/docs/finm_intro_2012_part1.pdf> [Accessed 05 March 2016].
Shanken, J. and Smith, C. W., 1996. Implications of Capital Markets Research for Corporate Finance. Financial Management, 25(1), pp.98-104.
