Apc308 Financial Management

Part A Dividend relevance and dividend irrelevance theory

Dividend Relevance theory indicates that company's dividend policy is not a concern for investors because they have option for selling proportion of equity's portfolio if there is need of liquidity.

• Walter's model
• Gordon model

Walter model:

This model is given by prof. James E. Walter, the firm's share price is been affected by dividends and policy of investment cannot be separated by policy of dividend as there is a relationship between them. This model clearly depicts the relationship between the internal rate of return (r) or return on investments and cost of capital (K). The selection of dividend policy majorly affects the overall firm's value(Zietlow, and.et.al., 2018). The relationship between returns and cost shows the efficiency of dividend policy. Walter's dividend policy can be denoted as:

P = D/k +{r*(E-D)/k}/k

In the above formula P is denoted as market price per share, D represents dividend per share, E represents earning per share, r represents internal rate of return of firm and k is denoted as cost of capital of the organization. In short this equation gives an idea that market price of the company's share is the aggregate of present values of infinite flow of gains on investment from retained margin and flow of dividends.

If K is smaller than r, earnings should be retained by the company as it possesses the best opportunities for investment and can get more advantage as compared to shareholders by reinvesting. The company which are giving more returns as compare to cost are indicated as “Growth firms” and there payout ratio is zero. In second case, if r is smaller than K, then all the earnings should be paid to shareholders in dividend form because all shareholders have better opportunities for investment than a firm. The payout ratio for the mentioned case is 100%. in last scenario, where r is equals to K, then there is no effect on value of the company. The firm is indifferent that how much amount should be retained and to distributed among the shareholders and for the same the payout ratio is in the range of zero to a hundred percent.

The assumptions related to this model are:

• External financing is not used for the company all funding is done via retained earnings.
• If there is any change in investments but (r) rate of return and (k) cost of capital remains same.
• All the earnings or margins are distributed among shareholders or they are retained.
• DPS or dividend per share and EPS earning per share remains same.
• Perpetual life of the organization(Titman, Keown, and Martin, 2017).

Criticism of this model:

• If external financing is not used then standard will be low of either dividend policy or investment policy or both.
• Its applicability is to only equity firms, along with this rate of return is constant so investments are decreased.
• In real scenario, K cannot be same, in this business risk is avoided which has direct impact on value of the organization.

Therefore, Cost of Capital (K) is equals to Cost of equity (Ke), because of absence of external source of funding is used.

Gordon model: This model is given by Myron Gordon who says that dividends are relevant for the share prices of the organization. The main assumption taken by Gordon that all investors are risk averse that means no one is willing to take risks and certain returns are being preferred as compared to uncertain returns(Skogrand and.et.al., 2011). For avoiding risk, current dividends are preferred and because of risk there are chances for not getting returns on the investments which are done. But if the earnings are being retained by the company then there are chances for getting dividends in the future. The future dividends are not certain even time and amount is also not certain like when and how much the dividends will be received. Future dividends should be discounted or less importance should be given as compared to current dividends. The share's market value is equals to the future dividend's present value of the firm. Gordon's dividend policy can be denoted as:

P = [E (1-b)] /Ke-br

In the above equation P denotes price of a share, E can be represented as earning per share, b represents retention ratio in assignment online, 1-b represents the proportion of margin which is distributed in the form of dividends, Ke as capitalization rate and Br is represented as growth rate. The above formula denotes that market value of the company's share is aggregate of infinite future dividend's present value. Generally it is also used for calculating cost of equity, future dividends can be predicted if market value is known.

If cost of capital is smaller than internal rate of return then it is considered as growth firm. If dividends are reinvested by company instead of distributing it to shareholders than it will give advantage to the shareholders. The payout ratio of same is considered as zero. In updated Gordon model when r is equals to k then, investors preference will be on share where more current dividends are been paid which will be considered as normal firm and in declining firm internal rate of return is smaller than cost of capital (Brinckmann, Salomo and Gemuenden, 2011). The shareholders will gain advantage if dividends are distributed instead of reinvested. The payout ratio is considered as 100% of the organization.

The assumptions related to this model are:

• External financing is not used for funding of the company, only the retained earnings are used i.e. also considered as equity firm.
• Cost of capital and internal rate of return is same.
• Indefinite life of the organization.
• If retention ratio is once decided then it remains same.
• Growth rate is constant in this model.
• Br is smaller than cost of capital.
• In taxation, corporate taxes are not considered in this model.

Criticism of this model:

• In this scenario, external financing is not used viz. Debt or equity is raised. So the investment and dividend policy or may be both can be sub optimal.
• Its applicability is only to equity firm, irr is constant but it leads to fall if the investment is increased (Titman, Keown, and Martin, 2017).
• In realistic life situations, cost of capital cannot be same as earlier, as it is avoiding business risk which has direct relationship from the organization's value.

According to Gordon model, dividends play essential role for predicting organization's share price.

Dividend Irrelevance theory

Modigliani Miller Model:

The major proponent of dividend irrelevance is considered as Modigliani Miller theory given by Franco Modigliani and Merton Miller. This can be also considered as MM Approach. In this firm's share price is not affected by dividend policy and it is investment policy which helps in increasing value of the share of organization. Satisfaction level of investors are until the retained earnings of organization's return are more than compared to Ke i.e. equity capitalization rate (Chandra, P., 2011). It is the rate on which margins, dividends or cash flows are converted into value or equity of the firm. Shareholders would like to receive margins in form of dividends when returns are less than cost of capital.  According to this model market price of shares is not influenced under conditions of perfect capital markets, rational investors, tax discrimination's absence between the dividend policy. MM's model can be denoted as:

P0 = 1/(1 + Ke) * (D1 + P1)

In the above equation, P0 represents prevailing market price of a share, Ke represents cost of equity capital, D1 indicates dividend to be received at the end of period 1 and P1 indicates market price of a share at the period 1's end. This approach is usually for measuring market price of share at the end period with the condition that original share price, cost of capital and dividends received is known (Petty and.et.al., 2015). The same discount rate is applicable for all stock which is important.

The assumptions related to this model are:

• In this model, there is presence of perfect capital market in which rational investors are there who have access to all information without any costs. Floatation and transaction cost is not involved in this scenario. Market price cannot be influenced by any investor and securities are infinitely divisible.
• In taxation, absence of taxes, capital gains and dividends are taxed at same rate.
• Constant investment policy is followed by organisation which signifies that there is no change in internal rate of return on investments in project and risk position of business.
• Future profits are certain, future investments, dividends and profit of firms are certain in the view of investors because of absence of risk (Li and You, 2015).

Criticism of this model:

• There is presence of taxes in capital market as there is no existence of perfect capital market.
• In this model there are no variations among internal and external financing but if issue of new floatation cost is considered then it is false.
• Shareholder's wealth is not affected by dividends but the transaction cost is being associated by selling of shares for cash inflows so dividends are preferred by investors.

Part C Explaining mergers and acquisitions, how they are financed and relevant parties involved in the process

In the present scenario mergers and acquisitions are very common in this global marketplace. This is an essential medium for acquiring products and technologies. They are not allowed for long adjustments periods but it is the best approach is to plan. Organizational plan must include all the areas which are affecting workforce, communication, customer relationships etc. The aim of mergers and acquisitions is to improve productivity and profits of the company and to reduce the expenses of the organization. Though mergers and acquisition are not always successful, many times processes has been taken place loses the focus. By many factors the success of mergers and acquisition has been determined. These mergers and acquisitions affects the workforce of the organization and harms the company's credibility. Even senior executives, labor forces and shareholders are been impacted by merger and acquisition.

Impact of mergers and acquisitions on employees: Employees and staffing, training focus, culture shift, motivation during challenging time of company.

• Employees and staffing: Whenever merger takes place between the organizations or corporations there are huge possibilities of redundancy in which lay offs or the role of employees may shift. Lay offs cannot be ignored, and the best can be done that uncertainty can be reduced among all employees. And whosoever is been laid off should be intimated prior or immediately with the severance packages and they should be treated in very respectful manner. The employees who are left in the organizations should be given proper guidelines with new role in the organizations and plans for development which will help them for some subsequent changes.
• Training: Proper training should be given regarding new processes, procedures and policies which are merger's result. In this plan they should be familiar with all new procedures like submitting purchase order and new technology platforms. Seminar in which one on one training should be conducted.
• Culture shift: Culture of the organization is going to be impacted. It can also affect the morale of employees which can be positive or negative. It can lead to face many challenges by the organization like good employees can be employed by competitors or workforce can be disrupted. So basic need is communication with vision and mission of the company and changes should be communicated properly so this will help in reducing uncertainty and disruptions.
• Motivation during challenging time: To improve productivity and margin, motivation to employees is basic necessity. If any discussions related to new merger and acquisitions then they should be not avoided and employees should be rewarded for managing change in their roles. Not only in form of bonus but can be small gift.

Impact of mergers and acquisitions on top level management: It can be in form of clash of the egos or it can be explained as variations between the culture of organizations and in this setup new policies and strategies are implemented which may be not given approval by him. In this situation company's focus get diverted and top level managers be involved in matters or to move on. If the manager is been overqualified and with high degree then migration is not difficult for him.

Impact of mergers and acquisitions on shareholders: Shareholders of both companies are been affected by merger and acquisition. It may be given different effects of stock prices of every member in the merger. Merger of two companies may face challenge for dilution of voting power because of number of shares increment within the merger process. The acquiring company's shareholders may face marginal loss of voting authority along with this small target company's shareholder might face the erosion of voting power in big pool of the stakeholders. There is a temporary drop in value of shares of the firm which is acquiring and target company's  share value will increase in this period. The newly merged company's stock price is higher as compared to acquiring and target firms then the merger and acquisition of the company is on great success and getting benefit from the result of stock price arbitrage. The newly merged company will have few changes which can be easily noticeable in leadership. These concessions are usually formed while the negotiations made in the merger process and executives of board members of newly company will change in some degree.

Mergers can be financed in many ways:

• Cash payment
• Equity share financing
• Debt share financing
• Deferred payment plan
• Leverage buy out
• Tender offer
• Hybrids

Cash payment: The shareholder of the target company are removed from the process and indirect control of shareholders (bidder) alone with the target company just because of these transactions are generally termed as acquisition instead of mergers. While, there was downward trend in the interest rate then cash deal is more sensible and in the same series cash usage for the acquisition gives fewer chances of earning per share dilution for company which is acquiring. But there are some constraints on the organization's cash flow (Titma, Keown and Martin, 2017).

Equity share financing: Most common method for financing merger. The acquired company's shareholder are provided shares of the company. This will lead to benefits and margins of merger among acquired company's shareholders and the acquiring company. The most important factor for determination of exchange ratio can be in financing merger form. Both the companies usually depends upon price earning ratio and exchange ratio of the organization. The most common method is in case that price earning ratio should be high as compared to acquired company.

Debt share financing: A company's merger should be financed by issuing fixed convertible debentures and convertible preference share along with fixed rate of dividend. The acquired company's shareholder prefer medium of payment because of income security within the period. So this acquired company also get benefited on dilution of earning per share as well as controlling authority to the shareholders which are existing.

Deferred payment plan: It can be also referred as earn out plan for making payments to target company which can be also acquired in a manner that partial payment is made in form of cash or securities. This helps in while negotiating successfully with target company abd helps in increment of earning per share because of fewer shares which are issued in prior years. For achieving success, the acquiring firm should be able to co-operate along with success and growth of target company (Graham and Harvey, 2010).

Leverage buy out: A company which is mostly financed through debt is referred as leveraged buy out. Debt which is generally formed by more than 70% of purchase price. Shares which are not generally traded in stock exchange are known as leveraged buy out.

Tender Offer: The acquired company approaches shareholders of target company and offers price which is mostly more than market price for encouraging them to sell shares. This method is used in forced or hostile takeover.

Hybrids: It is a combination of debt and cash or stock of the purchasing firm and cash.

Parties involved in merger and acquisition

There are two main parties which are involved in merger and acquisition that is buyer : acquiring party and seller : party being acquired. There are more parties which are involved in merger and acquisition which are accountant, financial planner, M & A consultants and attorney. Every body has their own role in the process.

Conclusion

From the above report it has been concluded that financial management is very vital for every organizations. Though Walter's model of relevance theory has many unrealistic assumptions but there is concept of dividend policy has an effect on the market price of the share of organizations. Further it is assisting impact in mathematical valuations for finding value of share. In Gordon theory the market price of share is determined for predicting the dividends and MM approach is very interesting and unique approach for the valuation. It is an irrelevance theory of dividends but it also has major limitations. It has been proved from above report that mergers and acquisition plays very important role in the organization.

References

• Zietlow, J. and.et.al., 2018. Financial management for nonprofit organizations: Policies and practices. John Wiley & Sons.
• Titman, S., Keown, A. J. and Martin, J. D., 2017. Financial management: Principles and applications. Pearson.
• Skogrand, L., and.et.al., 2011. Financial management practices of couples with great marriages. Journal of Family and Economic Issues, 32(1). pp. 27-35.
• Brinckmann, J., Salomo, S. and Gemuenden, H. G., 2011. Financial Management Competence of Founding Teams and Growth of New Technology‐Based Firms. Entrepreneurship Theory and Practice. 35(2). pp. 217-243.
• Titman, S., Keown, A. J. and Martin, J. D., 2017. Financial management: Principles and applications. Pearson.
• Chandra, P., 2011. Financial management. Tata McGraw-Hill Education.