DIvidend Policies and Financing Essays

DIvidend Policies and Financing Essays DIvidend Policies and Financing Essay DIvidend Policies and Financing Essay Dividend policy refers to the decision made by the company whether to retain the profits within the company, or they pay out the profits to the owners of the organization in the form of dividends (Garrison 2008). Once the company decides on whether to pay dividends, they may establish a somewhat permanent dividend policy, which may in turn impact on investors and perceptions of the company in the financial markets (Garrison 2008). What they decide depends on the situation of the company now and in the future. It also depends on the preferences of investors and potential investors (Garrison 2008).When deciding on the dividend policy, several factors such as legal constraints, contractual constraints, internal constraints, growth prospect, owners considerations and market considerations have to be taken into account. Considerations taken into account can be incorporated in several dividend theories such as the residual theory of dividends, the clientele theory, the signalling dividend theory, the bird-in-the-hand theory and Modigliani and miller dividend theory.Manufacturing overseas can reduce costs due to its cheap labour costs but there are other considerations that have to be taken into account. There are pros and cons for manufacturing at overseas.Companys capital structure refers to the way a corporation finances its assets through some combination of equity, debt, or hybrid securities (http://en.wikipedia.org/wiki/Capital_structure). Debt financing and equity financing has their own advantages and disadvantages but certain factors have to be considered when choosing between these two financing strategies.2.0 Factors Affecting the Dividend PolicyWhen deciding on the dividend policy, several factors need to be taken into account. The factors needed to taken into account are as follows (sources taken fromhttp://freemba.in/articlesread.php?artcode=488substcode=30stcode=10):Stability of EarningsThe nature of business has an important bea ring on the dividend policy. Industrial units having stability of earnings may formulate a more consistent dividend policy than those having an uneven flow of incomes because they can predict easily their savings and earnings. Usually, enterprises dealing in necessities suffer less from oscillating earnings than those dealing in luxuries or fancy goods.Age of CorporationAge of the corporation counts much in deciding the dividend policy. A newly established company may require much of its earnings for expansion and plant improvement and may adopt a rigid dividend policy while, on the other hand, an older company can formulate a clear cut and more consistent policy regarding dividend.Liquidity of FundsAvailability of cash and sound financial position is also an important factor in dividend decisions. A dividend represents a cash outflow, the greater the funds and the liquidity of the firm the better the ability to pay dividend. The liquidity of a firm depends very much on the investme nt and financial decisions of the firm which in turn determines the rate of expansion and the manner of financing. If cash position is weak, stock dividend will be distributed and if cash position is good, company can distribute the cash dividend.Extent of Share DistributionNature of ownership also affects the dividend decisions. A closely held company is likely to get the assent of the shareholders for the suspension of dividend or for following a conservative dividend policy. On the other hand, a company having a good number of shareholders widely distributed and forming low or medium income group would face a great difficulty in securing such assent because they will emphasize to distribute higher dividend.Needs for Additional CapitalCompanies retain a part of their profits for strengthening their financial position. The income may be conserved for meeting the increased requirements of working capital or of future expansion. Small companies usually find difficulties in raising fi nance for their needs of increased working capital for expansion programs. They having no other alternative, use their ploughed back profits. Thus, such Companies distribute dividend at low rates and retain a big part of profits.Trades CycleBusiness cycles also exercise influence upon dividend Policy. Dividend policy is adjusted according to the business oscillations. During the boom, prudent management creates food reserves for contingencies which follow the inflationary period. Higher rates of dividend can be used as a tool for marketing the securities in an otherwise depressed market. The financial solvency can be proved and maintained by the companies in dull years if the adequate reserves have been built up.Government PoliciesThe earnings capacity of the enterprise is widely affected by the change in fiscal, industrial, labor, control and other government policies. Sometimes government restricts the distribution of dividend beyond a certain percentage in a particular industry o r in all spheres of business activity as was done in emergency. The dividend policy has to be modified or formulated accordingly in those enterprises.Need for FundsDividends paid to stockholders use funds that the firm could otherwise invest. Therefore, a company running short of cash or with ample capital investment opportunities may decide to pay little of no dividends. Alternatively, there may be an abundance of cash or a dearth of good capital budgeting projects available. This could lead to very large dividend payments.Management Expectations and Dividend PolicyIf a firms managers perceive the future as relatively bright, on the one hand, they may begin paying large dividends in anticipation of being able to keep them up during the good times ahead. On the other hand, if managers believe that bad times are coming, they may decide to build up the firms reserves for safety instead of paying dividends.Stockholders PreferencesReinvesting earning internally, instead of paying divide nds, would lead to higher stock prices and a greater percentage of the total return common stockholders receive coming from capital gains. Capital gains are profits earned by an investor when the price of a capital asset, such as common stock, increases.Common stockholders may prefer to receive their return from the company in the form of capital gains and some may prefer to receive their return from the company in the form of dividends. Capital gains are not taxed at all unless they are realized. That is, unless the stock is sold. The board of directors should consider stockholder preferences when establishing the firms dividend policy.Restriction on Dividend PaymentsA firm may have dividend payment restrictions in its existing bond indentures or loan agreements. For example, a companys loan contract with a bank may specify that the companys current ratio cannot drop below 2.0 during the life of the loan. Because payment of a cash dividend draws down the companys cash account, the current ratio may fall below the minimum level required. In such a case, the size of a dividend may have to be cut or omitted. In addition, many states prohibit dividend payments if they would create negative retained earnings on the balance sheet. This restriction is a prohibition against raiding the initial capital. Figure 1 summarizes the factors that influence the dividend decision.Figure 1: This figure identifies key elements that make a dividend payment more or less likely.2.1 Leading Dividend TheoriesThe factors that affect the dividend policy can be incorporated in several dividend theories. Dividend theories can be divided into dividend relevance theory and dividend irrelevance theory. Dividend relevance theory refers to the value of a firm is affected by its dividend policy while dividend irrelevance theory refers to a firms dividend policy has no effect on either its value or its cost of capital (studyfinance.com/lessons/dividends/index.mv?page=01).2.1.1 Dividend Relevanc e TheoriesAccording to Gallagher Andrew (2007) dividend relevance theories are as follows:The Clientele Dividend TheoryThe clientele dividend theory is based on the view tat investors are attracted to a particular company in part because of its dividend policy. For example, young investors just starting out may want their portfolios to grow in value from capital gains rather than from dividends, so they seek out companies that retain earnings instead of paying dividends. Stock prices tend to increase as earnings are retained and the resulting capital gain is not taxed until the stock is sold.Older investors, in contrast, may want to live off the income their portfolios provide. They would ten to seek out companies that pay high dividends rather than reinvesting for growth. According to the clientele dividend theory, each company therefore has its own clientele of investors who hold the stock in part because of its dividend policy.If the clientele theory is valid, then it doesnt muc h matter what a companys dividend policy is as long as it has one and sticks to it. If the policy is changed, the clientele that liked the old policy will probably sell their stock. A new clientele will buy the stock based on the firms new policy. When a dividend policy change is contemplated, managers must ask whether the effect of the new clienteles buying will outweigh the effects of the old clienteles selling. The new clientele cannot be sure that the most recent dividend policy implemented will be repeated in the future.The Signaling Dividend TheoryThe signaling dividend theory is based on the premise that the management of a company knows more about the future financial prospects of the firm than do the stockholders. According to this theory, if a company declares a dividend larger than that anticipated by the market, this will be interpreted as a signal that the future financial prospects of the firm are brighter than expected. Investors presume that management would not have raised the dividend if it did not think that this higher dividend could be maintained. As a result of this inferred signal of good times ahead, investors buy more stock, causing a jump in the stock price.Conversely, if a company cuts it dividend, the market takes this as a signal that management expects poor earnings and does not believe that the current dividend can be maintained. In other words, a dividend cut signals bad times ahead for the business. The market price of the stock drops when the firm announces a lower dividend because investors sell their stock in anticipation of future financial trouble for the firm. If a firms managers believe in the signaling theory, they will always be wary of the message their dividend decision may send to investors. Even if the firm has some attractive investment opportunities that could be financed with retained earnings, management may seek alternative financing to avoid cutting the dividend that may send an unfavorable signal to the mark et.The Bird-in-the-Hand TheoryThe bird-in-the-hand theory claims that stockholders prefer to receive dividends instead of having earnings reinvested in the firm on their behalf. Although stockholders should expect to receive benefits in the form of higher future stock prices when earnings are retained and reinvested in their company, there is uncertainty about whether the benefits will actually be realized. However, if the stockholders were to receive the earnings now, in the form of dividends, they could invest them now in whatever they desired. In other words, a bird in the hand is worth two in the bush.If the bird-in-the-hand theory is correct then the stocks of companies that pay relatively high dividends will be more popular and therefore will have relatively higher stock prices than stocks of companies that reinvest their earnings.2.1.2 Dividend Irrelevance TheoriesDividend irrelevance theories are as follows (Gallagher ; Andrew 2007):The Residual Theory of DividendsThe residu al theory of dividend is widely known. The theory hypothesize the amount of dividends should not be the focus of the company. Instead, the primary issue should be to determine the amount of earning the firm should retain within the firm for investment. The amount of earnings retained, according to this view, depends on the number and size of acceptable capital budgeting projects and the amount of earnings available to finance the equity portion of the funds needed to pay for these projects. Any earnings left after these projects have been funded are paid out in dividends because dividends arise from residual or leftover earnings, the theory is called the residual theory.The residual theory focuses on the optimal use of earnings generated from the perspective of the firm itself. This may appeal to some, but ignores stockholders preferences about the regularity of and the amount of dividend payments. If a firm follows the residual theory, when earnings are large and the acceptable cap ital budgeting projects small and few, dividends will be large. Conversely, when earnings are small and many large acceptable projects are waiting to be financed, there may be no dividends if the residual theory is applied. The dividend payments will be erratic and the amounts will be unpredictable.Modigliani and Millers Dividend TheoryFranco Modigliani and Merton miller (commonly referred as M;M) theorized in 1961 that dividend policy is irrelevant. Given some simplifying assumptions, M;M showed how the value of a company is determined by the income produced from its assets, not by its dividend policy. According to the M;M dividend theory, the way a firms income is distributed (in the form of future capital gains or current dividends) doesnt affect the overall value of the firm. Stockholders are indifferent as to whether they receive their return on their investment in the firms stock from capital gains or dividends so dividends dont matter.2.2 Advantages and Disadvantages of Overs eas ManufacturingManufacturing at overseas certainly saves cost of production in some degree due to cheap labor and material cost but it has its advantages and disadvantages for overseas manufacturing.2.2.1 Advantages of Overseas ManufacturingEase and Speed of Distribution: Manufacturing in overseas shortening the distance between the original location of manufacturer and its distribution market (if the manufacturer has its markets around the region of the considered location). For example, when Nike manufacturer from United States manufactures in Malaysia, they have greater ease and speed of transportation for goods and people to other Asian markets. Besides that, transportation and shipping cost may be reduced due to a shorter distance for shipping and distribution.Cost Savings: In less-developed countries, labor cost is cheaper than developing and developed countries. It is estimated that a company that manufactures in less-developed country can cut costs by between 30% and 80% d epending on how labor intensive the product is. Besides that, material cost is also cheaper compared to developed countries too.Gain in Efficiencies and Economies of Scale: Besides that, in the long run, manufacturing overseas can gain efficiencies and economies of scale which will assist in reducing unit cost as output increases. Moreover, the initial investment of capital may be spread over an increasing number of units of output and therefore the marginal cost of producing a good or services decreases as production increases.Low Capital Costs: Low capital cost is one of the advantages that encourages manufacturing overseas. The cost of capital in developing or developed countries is higher than the cost of capital in less-developed countries.Incentives for Manufacturing: Some of the less developed countries encourage overseas manufacturers to invest or manufacture in their country. In order to attract manufacturers, these less-developed countries do offer incentives for the manuf acturers. For example, Penang has offered incentive to Motorola from USA in order to attract them to manufacture at Penang.2.2.2 Disadvantages of Overseas ManufacturingQuality of Production Suffers: Cheap labor is an advantage for cost savings. Inversely, it reduces the quality of the products as cheap labors usually produce less quality productions. Therefore, the products will suffer in quality as most of the cheap labors are unskilled or semi-skilled. Indirectly, the manufacturer may lose its customers due to the production of less quality products.Time Consuming: When an organization wants to manufacture in overseas, the organization has to analyze and comprehend the considered location and also the facilities available around the setting up area. The analysis and comprehension takes considerable time to complete in order to have a perfect set up in overseas. Therefore it spends considerable time and energy to understand the considered location (Sweeney N.D.).Complexity: To oper ate oversea is not as easy as locally. Most of the manufacturers have adapted to their own manufacturing culture and therefore adapting to another manufacturing environment would be difficult for them to familiarize with it. First of all, language may be a barrier, for example, it is difficult to communicate with the South Americans labors if we are not familiar with Latin (Sweeney N.D.). Besides that, finance, tax, and labor laws will be different and must be understood (Sweeney N.D.). Sweeney (N.D.) stated that, understanding national cultures and subcultures are important for any activity as manufacturers have to deal with government and private sector people and especially selling into the market.Brand Risks: Nowadays, consumers are perceived where the product is made from. The production location is a factor that will affect the brand image and reputation. For example, consumers would prefer a product made in USA rather than made in China. If the manufacturer produces in Bangla desh it may more or less affect their images as some of the consumers believe that products from developed countries are much better than less-developed countries and therefore the image and reputation of the brand may suffer.Availability of Expertise: The availability of expertise is one of the factors that should be considered when organization seeks to manufacture overseas. Less developed countries may not provide the expertise in the fields required.Long Start Up Time: It is not easy for manufacturer to start up their manufacturing process. To manufacture in a smooth way requires time. It usually requires a considerable of long time start up and familiarize.3.0 Debt ; Equity Financing3.1 Equity FinancingEquity financing is a method to acquire capital that involves selling a partial interest in the company to investors (Brian 1990). In return of the money paid, shareholders receive ownership interests in the corporation (Brian 1990).3.1.1 Pros and Cons of Equity Financing3.1.2 Pr os of Equity FinancingThe advantages of equity finance are:Commitment of Funds: The funding is committed to the business and intended projects. Investors only realize their investment if the business is doing well (eg. through flotation or a sale to new investors).Vested Interest: Investors have the same interest that is to keep the business going on well and generate maximum profits which leads to an increase in the value of the business.Follow-up Funding: When business grows, investors are often prepared to provide follow-up funding.(Source of reference:businesslink.gov.uk/bdotg/action/detail?type=RESOURCES;itemId=1073789573)Wider Pool of Finance: When company is listed in stock exchanged, the company has the access to wider pool of finance.Quality Products: The owners will pay proper attention for improving the quality of products. The reason is the appropriate of quality product goes to them.No Interest Cost: No payment of interest for the funds provided by the shareholders. The cost of production remains low as there is no burden of interest.Earning Remains with the Firm: When funds provided by shareholders for improvement in the business are making profits, the earnings are remained with the owners. Earnings are not shared by the creditors.To Tide over Emergencies: Firm is in a better position to tide over recession period and other emergencies due to no burden of rate of interest.Ability to borrow: Borrowing ability is improved if the equity capital is financed well.(Source of Reference: blurtit.com/q303144.html)Sources of Skills and Experiences: Good investors can bring resources for the business. They can help one to get skilled people, right contacts to build the business. They might also help out with their own experience in the formation of the strategy or with decision making.No Obligation for Repayment: No obligation for the repayment of the finances in the initial phase of the business when the cash flow is quite slow. Whereas, in bank loans the re are severe obligations and penalties in case a business fails to generate monthly interests and make the monthly payments to the bank.(Sources of Reference:freewarefiles.com/techfi/Advantages_of_Equity_Financing.html)Pledge No Assets: Corporation does not have to pledge their assets as collateral to obtain equity investments.Availability of Cash: Business will have more cash available due to no debt payments have to be made.(Source of reference:http://forums.forbes.com/forbes/board/message?board.id=entreforum;message.id=399)3.1.3 Cons of Equity FinancingThe disadvantages of equity finance are:Costly and Time Consuming: Raising equity finance is costly and time-consuming. Business may suffer as times are devoted to the deal. Potential investors will seek background information on owner and his business and they will closely scrutinize past results and forecasts and will delve the management team.Interference in Management: The equity investors can interfere in the management of th e company and in addition they also have the voting rights which could influent the making of major decisions.Extra Effort to Provide Information: Founder will have to invest management time to provide regular information for the investor to monitor the situation of the business.Share Dilution: Founders share in the business will be diluted which means lessen in strength. Besides that, businesss profits will be shared by other equity investors.Legal and Regulatory Compliance: There can be legal and regulatory issues to comply with when raising finance (eg. when promoting investments).(Source of Reference;businesslink.gov.uk/bdotg/action/detail?type=RESOURCES;itemId=1073789573)Limitation of Control: Founders must give up some control of the business. If investors have different perceptions and ideas about the companys strategic direction or day-to-day operations, they can pose problems for the entrepreneur.(Source of Reference: answers.com/equity+Financing?cat=biz-fin)No Tax Deductio n: Dividend payments are not tax deductible.(Source of Reference:http://forums.forbes.com/forbes/board/message?board.id=entreforummessage.id=399)3.2 Debt FinancingAccording to (answers.com/debt+financing?cat=biz-fin) debt financing is a strategy that involves borrowing money from a lender or investor which the full amount will be repaid in the future usually with interest within a certain period. It asserted that it does not include any provision for ownership of the company. Debt financing has a prior claim on the company irrespective of the profits earned despite the company goes into liquidation (Joseph 2008).3.2.1 Pros and Cons of Debt Financing3.2.2 Pros of Debt FinancingMaintain ownership: The debt holder cannot interfere in the management of the company and they do not have the voting rights. Therefore, business can be run without outside interferenceTax deductions: Principal and interest payments on a business loan are classified as business expenses and thus tax deductible. It also lowers the actual cost of the loan to the company.Lower interest rate: There is a lower interest rate of debt financing when interest rate is lower than tax rate (where the business can take a loan and have a deduction on tax rather than high interest rate).(Source of Reference: http://entrepreneurs.about.com/od/financing/a/debtfinancing.htm)No Complex Procedures Required: Debt financing is easier to obtain than equity financing. Raising debt capital is less complicated because the company is not required to comply with state and federal securities laws and regulations.No Profits Sharing: Profits of company are not shared with the lenders who require capital appreciation and dividends on their investments.Forecasting: Interest and principal payments are typically a know amount that can be forecast.(Source of Reference: job-employment-guide.com/business-financing.html)No Extra Rewards: Debt holders are entitled only to repayment of the agreed-upon principal of the loan plus interest and have no direct claim on future profits of the business if the company has made extra profits.Saving Management Time: Company does not have to send periodic mailings to large numbers of investors, hold periodic meetings with shareholders and seek the vote of shareholders before taking certain actions.(Source of Reference: http://smallbusiness.findlaw.com/banking_financing/be1_5debtvsequity.html) David H. Schwartz3.2.3 Cons of Debt FinancingRepayment: Sole obligation to the lender is to make payments on time. If the business fails, the company still has to make payments. If business goes into bankruptcy, lenders will have claim to repayment before any equity investors.Impacts Credit Rating: It seems to be attractive to keep bringing on debt when company needs money, a practice known as levering up, but each loan will be noted on your credit rating. The more borrowings, the higher the risk to the lender and the higher interest rate the company will have to pay.Cash and Col lateral: The company is usually required to pledge assets of the company to the lender as collateral, and owners of the company are in some cases required to personally guarantee repayment of the loan.(Source of Reference:http://entrepreneurs.about.com/od/financing/a/debtfinancing.htm)Difficulty in Business Growth: Interest is a fixed cost which raises the companys break-even point. High interest costs during difficult financial periods can increase the risk of insolvency. Companies that have large amounts of debt as compared to equity often find it difficult to grow because of the high cost of servicing the debt.Restrictions on Activities: Debt instruments often contain restrictions on the companys activities, preventing management from pursuing alternative financing options and non-core business opportunities which results in losing of other investment opportunities.(Source of Reference:http://smallbusiness.findlaw.com/banking_financing/be1_5debtvsequity.html)3.3 Consideration Fac tors for Sources of FinanceEquity financing and debt financing is the option for a company that needs financing. Each company is unique and they have their own financing requirements and therefore, it is inappropriate to determine any one of the financing methods is the best option for companies. There are certain factors that a company needs to consider before choosing the right financing method:The size of the company: Larger companies may obtain financing by equity financing due to the needs of wider pool of finance for company growth (Joseph 2008). However for smaller companies, debt financing is much easier to obtain because its not easy to reach the status of public limited company and the issuance cost of equity finance is unaffordable by smaller companies (Joseph 2008).The ability to generate cash flow: This relies upon the operations of the company (Joseph 2008). If the company is able to generate enough cash flow, the company may seek debt financing because debt financing requires cash make frequent repayment of interest and principal (Joseph 2008).Any Restrictive Covenants: If the company is restricted by the lender from subsequent borrowings, equity financing is more appropriate due to the bindings against the company.The Cost of Financing: The cost of financing for debt financing is cheaper than equity financing due to the debt financer is exposed to lesser risk and he is entitled for prior claim in the companys profits and interest payable are tax deductible (which means actual cost of debt is lesser) (Joseph 2008).The Duration of Borrowing: The longer the duration, the interest rate charged on the borrower will be higher (Joseph 2008).The Current Gearing Level: If a company has a high gearing level, it is the best to go for equity financing whilst if a company has a low gearing level, they can go for debt financing (Joseph 2008).4.0 ConclusionNot every dividend policy suits a company. When deciding on how much dividend should be distributed to t heir investors, factors such as legal constraints, contractual constraints and etcetera have to considered to obtain the most suitable and appropriate dividend policy for better financing.Factors that affect dividend policy can be incorporated in several dividend theories such as residual dividends theory, clientele theory, signalling dividend theory, bird-in-the-hand theory and Modigliani Miller dividend theory. These theories can be classified into dividend relevance theory where its dividend policy will affect on companys value and cost of capital and dividend irrelevance theory where its dividend will not affect on companys value and cost of capital.Overseas manufacturing gains advantages such as cost savings and economies of scale. Inversely, it also has other effects such as no expertise available and also time consuming for starting a new factory.Companys capital structure can be financed through debt financing and equity financing. These are the strategies that a company ca n get its fund. However, these two strategies have their own advantages and disadvantages. When implementing any of those strategies, factors such as size of the company, ability to generate cash flow, current gearing level and other factors have to be considered in order to have the most suitable strategy to finance the organization.