Introduction:
The concern and financial objectives of the old lady can be met on the basis of a sound financial plan. The lady is investing her money in saving bank account but because of really low interest rates, she is now preferring her investment in ABC supermarket which she considers good for her portfolio.
Another consideration that cannot be overlooked is her concern for dividends as the lady relies on regular income. Thus my decision at then end will be based on sound financial considerations and objectives of the old lady where i shall be comapring current situation in supermarket industry with saving deposit interest.
Considering the shares of WesFarmers Limited, operating Chloes Supermarket in Australia against saving deposit rates in Australian Banks, we could possibly build a rational financial plan for her.
Wesfarmers Limited is headquartered in Australia and operates supermarkets and departmental stores in Australia. Currently the company is trading at $41.96/share with expected target price of $42.65 in 1 year. Also the company has a regular dividend history with latest announcement of .50 cents on August 20th , 2013. So the stocks of this supermarket can indeed be good for investing her money as it can both offer her higher returns and regular income in the form of dividends.
Analyzing Bloomberg Finance Report on Wesfarmers Limited, the stock of Wesfarmers Ltd improved by .92% in current day trading while the average one year return was 27.21%.
Now considering the saving deposit rates in Australian Banks, as per world bank database, the deposit rates in Australia during 2012 were 3.9%. This was pretty obvious for a risk free investment.
So it is clear that lady was right that indeed saving deposit rates are low and she should modify her investment towards ABC supermarket. However, since investment in shares involves risk and also the supermarket industry have fluctuating dividends, it is utmost important for the lady to invest some amount of money in saving accounts considering it being a risk free investment.
The Plan: Things to be considered
Our financial plan for the old lady will try to incline more of her investment in shares of ABC Investments probably because these shares will be offering her higher returns. Also a good percentage of dividends in supermarket industry in Australia is another lucrative reason for investing in ABC Supermarket. However, as for dividends the lady should consider that though as of now dividends are high but have been fluctuating. Thus she should understand the factors that affect dividends:
i)External Factors
ii)Internal Factors
External Factors affecting Dividend Policy:
1.State of Economy:
In case of expected uncertain or unfavorable economic business conditions, the management of a company may retain or shell out less percentage of dividends to create reserves to cover up uncertainities. While during the period of inflation, the management of the company shall decide to create reserves to finance replacement of obsolete machinery. During the period of prosperity in the market, some companies may try to hold the profits to reinvest profitable ventures.
.2. State of Capital Market:
During the bullish times in the market, companies may be liberal in their dividend payouts while at times of bearish market, dividend payouts may turn out to be conservative.
3. Legal Restrictions:Companies Act of many countries has lay down restrictions on payment of dividends which are as follows, company can pay dividends only out of:
i)Past or current profits.
ii)Money provided by the government in reference to guarantee given by the government.
iii)Company cannot pay dividends out of capital and if done so it will be violation of companies act.
Also dividends cannot be declared by the company unless a certain percentage of reserves have been created out of net profits of the current year and comapny has provided for present as well as past arrears of depreciation.
4. Contractual Restrictions:Apart from legal and government restrictions, even the lenders of the company(debt issuers) also put restrictions on dividend payments to protect their interests especially when the borrower firms experience liquidity problems. In financial terms these are known as Debt Covenants.
For instance, the debt issuer may include a covenant in agreement that company will not issue dividends unless its liquidity is 2:1 or more.
Internal Factors affecting dividend decisions:
1. Desire of the Shareholders:Though it is the management of the company that decides the dividend payout rate, but the decision is taken considering the interests of the shareholders. Shareholder prefer dividends because:
i)It provides regular income to shareholders as against capital gain which is realized only at the time of sale of shares.
ii)It indicates financial strength of the company.
iii)It reduces uncertainity as capital gains are long term and uncertain.
2. Financial Needs of the Company:
Even if the company has earned huge profits, but if the market scenario makes it difficult for them to raise funds at cost effective rates, it might retain profits for profitable future projects.
3. Nature of earnings:An entity with stable rate of increase in earnings is likely to have high dividend payout ratio.
4. Liquidity position:Payment of dividend involves cash outflow thus though the company may have adequate earning but not enough cash reserves to pay out dividends.
Stability of Dividends:
Since the old lady is desperate to go to a holiday, she would be requiring good returns in the form of dividends as well as capital appreciation of the stock. Thus she should prefer her investment in the company which with stable rate of dividends.
The term stability of dividends means consistency in the payment of dividends. It means that even if the earnings of the company tends to fluctuate, its dividend will not. In other words, company pays out regular amount of dividend every year as its shareholders value stable dividends valuable than non-stable fluctuating ones. Significance of Stability of Dividend1. Desire for current income 2. Sign of financial stability of the company 3. Requirement of institutional investors 4. Investors confidence in the company
Recommendation:
Considering the concerns over dividends and also the risk involved in share investment my recommendation for her would be to create a portfolio of both investments i.e Shares in ABC Supermarket and also some deposits in Saving Bank Account. The decision will provide the lady with diversification benefits as it will mitigate her risk of investing in shares of ABC Supermarket and can also relief her from concerns over dividend payments to some extent.
The very core definition of equity investments defines it as Risk Capital Investment where investor assumes the risk of losing their funds if the business fails. Thus, if the stock of ABC supermarket fails, the lady loses all her investment. Also if the company does not perform as per market expectations and loses out profit margins, it is likely that company will announce lower dividend payout. Thus, investing some amount in her saving account will be a risk free investment where she can be sure of atleast a fixed percentage of investment returns in the form of interest income.
Now since we have decided that the lady should invest both in shares of ABC Supermarket and Saving Account Deposits, it is important to decide the amount she should invest in each asset so her objectives are met at minimum risk. Our decision should equally weight her objectives of higher returns and regular income.
For instance, if the old lady had $100000 and at present she has invested all her amount in saving deposit accounts, then as per world Bank Deposit Rates in Australia of 3.9%, she would be earning $3900 from her investment with no capital appreciation factor as Saving Deposit Accounts do not attract any capital appreciation. Now if she modifies her investment towards ABC Supermarket, then considering shares of Wesfarmers Limited, annual return of 27.9% would appreciate her capital to $127900 and dividend of $.50/share will earn her 2396(100000/41.73)*.50 = $1198.
Thus the total return that she will earn will amount to $129098. Thus comparing her investment to saving bank account, she will be earning more returns in her investment for supermarket share as saving bank account will earn her only $3900 in an year.
However, since shares of the supermarket company are expected to reduce their dividend payment by 0.72% on an average of 5 years and considering risk factor involved in share investments, she should invest some percentage of total funds in saving deposit account.
Many analysts consider 30% allocation to risk free asset as optimum allocation. By investing 30% of her investment in saving account, she would be earning $1170 from her investment. While on the other hand, the remaining 70% investment in Supermarket Shares will make her buy 1677 shares of the company. On this amount of shares she will be earning $838 from dividend payments.
Thus the total amount that she will earn from her portfolio’s interest and dividend income will amount to $2008 of which $1170 will be risk free. This is really important for her as if she invests all the amount in Supermarket Share and if the company in future decides to curtail the dividend payout or even if it decides not to pay dividends, she would end up earning nothing from her portfolio and would just have to wait for capital appreciation to be part of total return.
Thus, by following asset allocation decision of choosing the optimum ratio of 70:30 among Risky and Risk Free Assets respectively, the lady will have following advantages:
i)She would end up earning $1170 even in worst economic scenario when company decides not to pay dividends.
ii)The asset allocation will mitigate her risk of investing shares by providing her diversification benefit.
iii)Even if economy is in prosperity, she would earn $838 from dividends, $1170 from her saving interests and a capital appreciation of 27.9% every year(as per current market expectations).
Thus, in every state of economy investment in both shares of Supermarket and Saving Deposit accounts would make her achieve her objectives of higher returns and regular income.
Conclusion:
Our financial plan will help the old lady to meet her objectives of both higher return and also her need of regular income. Though her investment in shares of ABC Supermarket will expose her to risk which she is not exposed as of now, but following our recommednationof mainating a portfolio of risk free and risky asset class she can earn higher return along with some assured some of interest from her saving bank deposit account.
Works Cited
Australia Stock Exchange. (2013, October 11). Wesfarmers Ltd. Retrieved October 11, 2013, from Australia Stock Exchange: http://www.asx.com.au/asx/research/companyInfo.do?by=asxCode&asxCode=wes#dividends
Bloomberg Finance. (2013, October 11). Wesfarmers Ltd. Retrieved October 11, 2013, from Bloomberg: http://www.bloomberg.com/quote/WES:AU
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Kaplan Schweser. (2013). Equity Valuation. In Schweser Notes for CFA Exam- Equity Investments (pp. 221-246). USA: Kaplan Inc.
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The World bank. (n.d.). Deposit Interest Rates. Retrieved October 9, 2013, from http://data.worldbank.org/indicator/FR.INR.DPST
