APC308 FM Financial Management 1

Dividend payments determine the share price of a company

Dividends play a crucial role in total equity returns and are gaining increasing attention across various companies, countries, and sectors According to Lease et al (2000), dividend policy involves decisions about paying cash dividends now or increasing them in the future, primarily based on a company's unappropriated profits and long-term earning potential When a company has surplus cash that is not needed for operations, management is typically expected to distribute these excess earnings as cash dividends or utilize them for stock repurchase programs.

Miller and Modigliani (1961) proposed that the ex-dividend price of a stock will decrease by the same amount as the dividend increase, indicating that the firm's value remains unaffected during the ex-dividend and post-dividend periods.

Early research on the relationship between dividend yield and stock price volatility, including studies by Harkavy (1953), Friend & Puckett (1964), Litzenberger & Ramaswamy (1982), Fama & French (1988), Baskin (1989), and Ohlson (1995), indicated an inverse relationship in the United States Conversely, Ball et al (1979) demonstrated a positive effect of dividend yield on post-announcement rates of return, while Allen & Rachim (1996) found no evidence of dividend yield influencing stock price volatility in Australia Additionally, Nishat (1992) contributed to this body of research.

Pakistan found that the share price reactions are significant following the earnings announcements

While some studies, such as Conroy et al (2000), indicate that earnings announcements may not significantly affect stock prices, particularly in Japan, it has been concluded that a company's share price is more closely related to its dividend payments.

Dividend relevance theories

Traditional View

Investors generally favor higher dividends over lower ones, as dividends provide a guaranteed return while future capital gains remain uncertain Consequently, the dividend payout significantly influences a firm's share price; firms that offer low dividends may see a decline in their stock value.

Weiss & Weiss (1995) propose a significant modification to the traditional view on earnings distribution, stating that stockholders should receive earnings on their capital unless they choose to reinvest them in the business Management should only retain or reinvest earnings with explicit stockholder approval, as retained earnings necessary for protecting the company’s position do not qualify as true earnings If this principle gained acceptance, the withholding of earnings would require justification similar to that expected for changes in capitalization or stock sales, leading to increased scrutiny and intelligent criticism of dividend policies This would serve as a beneficial check on management’s tendency to expand imprudently and accumulate excessive working capital.

Walter’s Model

Prof James E Walter emphasizes that the dividend payout ratio significantly impacts a firm's value His extensive research highlights the critical relationship between the internal rate of return (R) and the cost of capital (K), which is essential for formulating an optimal dividend policy aimed at maximizing shareholder wealth.

In a stable capital market, a firm finances all its investments solely through retained earnings, maintaining a constant internal rate of return (R) and cost of capital (K) The firm’s earnings are consistently either distributed as dividends or reinvested, with no fluctuations in earnings or dividends over time Additionally, the firm is assumed to have an infinite lifespan, making its dividend policy a relevant factor in its financial strategy.

According to Walter (1963), Walter’s formula for determining MPS is as follows:

Where: o P = market price per share o DPS = dividend per share o EPS = earnings per share o r = firm’s average rate of return o k = firm’s cost of capital

To understand this formula, Walter explains the market value is determined as the present value of two sources of income:

1 PV of constant stream of dividend (DPS/k)

2 PV of infinite stream of capital gains:

Hence the formula can be rewritten as

According to Walter's theory, firms can be categorized into three types, each exhibiting distinct outcomes and effects on their dividend policies, payout strategies, and investment approaches.

A growth firm presents numerous investment opportunities where the return rate (r) exceeds the expected rate of shareholders (k) By reinvesting earnings at this higher rate, the firm can maximize shareholder value per share Therefore, to enhance overall value, it is optimal for the firm to reinvest all its earnings.

 Normal firm: there aren’t any investments available for the firm that are yielding higher rates of return (r = k) thus the dividend policy has no effect on market price

A declining firm faces a lack of profitable investment opportunities, where any potential investments would yield a return lower than its cost of capital (r < k) Consequently, to maximize shareholder value, the firm should distribute all its earnings as dividends.

In conclusion, several criticisms of the model arise, including the assumption that a firm's investment decisions are solely financed by retained earnings Additionally, the model presumes a constant rate of return and a fixed cost of capital, failing to account for the firm's evolving risk, which leads to fluctuations in the discount rate over time.

Gordon Growth Model

The dividend policy significantly influences a share's value, even when the rate of return matches the cost of capital According to Gordon (1962), the market price of a share equals the present value of all future dividends, highlighting that the growth rate of dividends is determined by retained earnings and their return This perspective aligns with Walter's theory, which asserts the relevance of dividends The model is grounded in key assumptions: the firm operates as an all-equity entity with no debt, relies solely on retained earnings for financing, maintains a constant internal rate of return (R) and cost of capital (K), generates perpetual earnings, and has a fixed retention ratio (b), resulting in a stable growth rate (g=br) Additionally, it assumes the absence of corporate tax and that K exceeds g.

According to (Gordon, 1962), the formula was showed below:

D = the annual dividend g = the projected dividend growth rate, and r = the investor's required rate of return

The traditional model of stock valuation faces challenges, particularly the assumption of a constant growth rate that is lower than the cost of capital, which may be unrealistic For growth stocks that do not currently pay dividends, alternative approaches to the discounted dividend model are necessary One widely used method is based on the Miller-Modigliani hypothesis of dividend irrelevance, which substitutes dividends with earnings per share (EPS) However, this shift necessitates focusing on earnings growth instead of dividend growth, potentially leading to differing outcomes Additionally, the stock price derived from the Gordon model is highly sensitive to the selected growth rate (g), underscoring the importance of careful growth rate estimation in valuation.

Dividend irrelevance theories

Modigliani and Miller (MM theory)

Before Miller & Modigliani's groundbreaking 1961 paper on dividend policy, it was widely believed that higher dividends enhanced a firm's value, primarily due to the "bird-in-the-hand" argument However, M&M showed that, under specific assumptions of perfect capital markets, dividend policy is actually irrelevant to a firm's overall value.

“The sole purpose for the existence of the corporation is to pay dividends” (Graham & Dodd,

In 1951, it was observed that companies offering higher dividends often had to sell their shares at elevated prices However, during the 1960s, a groundbreaking perspective emerged from Modigliani and Miller (M&M), which argued that, under specific assumptions of perfect capital markets, dividend policy does not significantly impact a firm's value.

In a perfect market, a firm's dividend policy does not influence its stock price or cost of capital, leaving shareholders indifferent between receiving dividends or capital gains This indifference arises because shareholder wealth is determined by the income generated from a firm's investment decisions rather than how that income is distributed Consequently, in the framework established by Modigliani and Miller, dividends are deemed irrelevant to shareholder value.

Management must decide on the method of dividend distribution, typically opting for cash dividends or share buybacks Factors influencing this choice include the tax implications for shareholders, which may lead firms to retain earnings or conduct stock buybacks to enhance the value of outstanding shares Additionally, some companies may choose to distribute dividends directly to shareholders.

Dividends can be issued as stock instead of cash, reflecting corporate actions Financial theory posits that a company's dividend policy should align with its type and management's assessment of the optimal use of dividend resources for shareholder benefit Generally, shareholders of growth companies favor share buyback programs, while those of value or secondary stocks prefer cash dividends from surplus earnings.

1 Allen, D.E & Rachim, V.S., 1996 Dividend Policy and Stock Price Volatility: Australian Evidence Applied Financial Economics, 6, pp.175-188

2 Baker, H., Farrelly, G & RB, E., 1985 A survey of management views on dividend policy Financ Manage , 14(3), pp.1007-34

3 Baker, H & Powell, G., 2000 Determinants of corporate dividend policy: a survey of NYSE firms Financ Pract Edu., 10(1), pp.29-40

4 Ball, R., Brown, P., Frank J Finn & Officer, R.R., 1979 Dividend and the Value of the Firm: Evidence from the Australian Equity Market Australian Journal of Management, 4, pp.13-26

5 Baskin, J., 1989 Dividend Policy and the Volatility of Common Stock Journal of Portfolio Management, 15(3), pp.19-25

6 Conroy, Eades, K.M & Harris, R.S., 2000 A Test of The Relative Pricing Effects of Dividends and Earnings: Evidence from Simultaneous Announcements In Japan Journal of Finance, 55(3), pp.1199-227

7 Fama, E.F & French, K.R., 1988 Dividend Yield and Expected Stock Returns The Journal of Financial Economics, 22, pp.3-25

8 Farrelly, G., Baker, H & Edelman, R., 1986 Corporate dividends: Views of the policymakers Econ Rev., 17(4), pp.62-74

9 Friend, I & Puckett, M., 1964 Dividends and Stock Prices The American Economic Review, 54(5), pp.656-82

10 Gordon, M., 1962 Dividends, Earnings and stock prices In Review of Economics and Statistics pp.99-105

11 Graham, B & Dodd, D., 1951 Security Analysis New York: McGraw-Hill

12 Harkavy, O., 1953 The Relation between Retained Earnings and Common Stock Prices for large Listed Corporations Journal of Finance, 8(3), pp.283-97

13 Lease, R.C K.J., Kalay, A., Loewenstein, U & Sarig, O.H., 2000 Dividend Policy: Its Impact on Firm Value Harvard Business School Press

14 Litzenberger, R.H & Ramaswamy, K., 1982 The Effects of Dividends on Common Stock Prices: Tax Effects of Information Effects The Journal of Finance, 37(2), pp.429-43

15 Miller, M & Modigliani, F., 1961 Dividend policy, growth, and the valuation of shares The Journal of Business, 34(4), pp.411-28

16 Nishat, M., 1992 Share Prices, Dividend and Retained Earnings Behaviour in Pakistan Stock Market The Indian Economic Journal, 40(2), pp.57-65

17 Ohlson, J.A., 1995 Earnings, Book Values, and Dividends in Equity Valuation Contemporary Accounting Research, 11(2), pp 661-687

18 Pruitt, S & Gitman, L., 1991 The interactions between the investment, financing, and dividend decisions of major U.S firms Finance Review, 26(3), p.409–430

19 Walter, J.E., 1963 Dividend Policy: Its' Influence in the Value of the Enterprise Journal of Finance, pp.280-91

20 Weiss, G & Weiss, G., 1995 Dividend Policy and Analysis from Graham to Buffett and Beyond plus Case Studies The Dividend Connection

Explain then critically compare and contrast two investment appraisal techniques that may be utilized by financial managers to assist in the financial management decision making-process

I.2 Internal rate of return (IRR) 24

II Compare and contrast two investment appraisal techniques 27

II.1 Similarities between IRR and NPV 27

II.2 Differences between IRR and NPV 27

II.3 Advantage of two key investment appraisals 29

II.4 Disadvantage of two key investment appraisals 30

III Example of using two key investment appraisals in decision making 31

At the outset of a project, a financial manager evaluates both the sources of capital and the optimal methods for utilizing these funds to ensure project success When a company commits to an investment, it seeks future benefits, making it crucial for the financial manager to identify the most effective investment appraisal techniques Their recommendations to the board of directors are aimed at enhancing investment decision-making, ultimately focused on increasing shareholder wealth.

This paper aims to demonstrate a comprehensive understanding of two investment appraisal techniques and their role in guiding future projects It will explore the limitations of these techniques in informing investment decisions and will focus on the discounted cash flow method, highlighting its preference for company decision-making.

Two key appraisal methods

Net present value (NPV)

Net Present Value (NPV), also known as net present worth (NPW), is a key financial metric that represents the sum of the present values of incoming and outgoing cash flows over a specified period It is calculated as the difference between the present value of cash inflows and the present value of cash outflows, providing insight into the profitability of an investment.

If we know all the cash flow and PVs at time 0, we calculate NPV in this way:

NPV = cash inflows – cash out flows + PV

For an example: Investing in machine A to produce shoes Annually profit is $100,000, starts from the end of the first year

• Maintenance expense is $5000 every time It happens two times at year 0 and the end of year 5.

At first, we Calculate PV of the profit in the next 10 years:

Secondly, calculate cash out flow

=>NPV =PV - cash out flows = 772,173.4929 – 8,917.63 = 763,255.8629

In general, we have a formula to calculate NPV:

Given the (period, cash flow) pairs (t, Rt) where N is the total number of periods

When evaluating projects, it is essential to reject those with a negative Net Present Value (NPV) and only accept projects that have a positive or zero NPV Among multiple exclusive projects with positive NPVs, the project with the highest NPV should be selected for acceptance.

I.1.4 Example of decision depend on NPV

Three projects, each initiated with a $100,000 investment, progress through five distinct stages over five fiscal years, yet they allocate cash flow differently At the end of the five-year period, the projects yield varying Net Present Values (NPV), highlighting the impact of cash flow management on overall financial performance.

 Project B has negative NPV so it should be rejected

 Project C will be chosen because this project has the highest NPV.

Internal rate of return (IRR)

The internal rate of return (IRR), also known as the economic rate of return (ERR) or discounted cash flow rate of return (DCFROR), is a key metric in capital budgeting that assesses and compares the profitability of various investments.

The Internal Rate of Return (IRR) is defined as the interest rate at which an investment's net present value equals zero, indicating the rate of return on that investment (Watters & Hoare, 2009).

The IRR is the discounted rate that make NPV = 0 We use Microsoft Excel to calculate the IRR of a project

A car company is poised to invest $100 million in developing a new vehicle, projected to yield after-tax cash flows of $20 million annually for the next 15 years.

=>IRR = 18.4% (Using Microsoft Excel software)

When evaluating a project, a company will accept it if the internal rate of return (IRR) exceeds the required rate of return or the cost of capital Additionally, when faced with multiple projects, financial managers will prioritize selecting the project with the highest IRR to maximize potential returns.

I.2.4 Example of decision depend on IRR

To find the internal rate of return of the above investment we find the value(s) of r that satisfies the following equation:

The company wants Internal Rate of Return (IRR) given a required return of 15 % (k), therefore

- IRR> k => the project is accepted

- IRRthe project should be rejected.

Compare and contrast two investment appraisal techniques

Similarities between IRR and NPV

IRR and NPV are essential investment appraisal techniques that highlight the time value of money, making them valuable for capital budgeting and investment valuation Both methods emphasize the significance of a project's cash flow timing and amount, allowing for adjustments based on varying risk levels by modifying the required rate of return For independent projects, IRR and NPV consistently provide the same accept-reject decision, reinforcing their reliability in investment analysis.

Differences between IRR and NPV

As NPV is calculated on capital cost and IRR is determined on calculated IRR rate

The Internal Rate of Return (IRR) is a key metric for investors to assess which investment offers a better rate of return, often expressed as a percentage However, many investors find the Net Present Value (NPV) method more intuitive, as it evaluates the total cash flows relative to the initial investment Unlike IRR, which can complicate return evaluations, NPV provides a clearer picture by discounting all cash flows to their present value, allowing investors to determine whether a project will yield a profit or a loss.

In some researches, the differences between IRR and NPV were showed:

- First, NPV assumes that cash inflows are reinvested at required rate of return, whereas IRR assumes that cash inflows are reinvested at computed IRR

- Second NPV measures profitability in absolute manner and IRR measures in relative manner (Heitger et al., 2007)

Arshad (2012) notes that while the Internal Rate of Return (IRR) is primarily used to assess individual projects, the Net Present Value (NPV) is often favored for mutually exclusive projects Investors may choose NPV for its straightforward calculation and the ability to reinvest cash flows at the cost of capital Conversely, IRR is preferred for its percentage-based results, which are easier to comprehend, although it assumes reinvestment at the calculated IRR.

Advantage of two key investment appraisals

 It is a direct measure of the dollar contribution to the stockholders

 Tell whether the investment will increase the firm’s value.

 Considers all the cash flow

 Considers the time value of money

 Considers the risk of future cash flows (through the cost of capital)

 It shows the return on the original money invested

The Internal Rate of Return (IRR) method is straightforward and easy to grasp, determining that an investment is deemed acceptable when its IRR exceeds a predetermined minimum acceptable rate of return or cost of capital.

 Estimate the initial costs easily

 The IRR method only concerns itself with the projected cash flows generated by a capital injection and ignores the potential future costs that may affect profit

 IRR allows you to calculate the value of future cash flows

 There is no base for selecting any particular rate in internal rate of return

According to (Rudolf, 2008) Table 1: Advantage of two key investment appraisals

Disadvantage of two key investment appraisals

 The project size is not measured

 Requires an estimate of the cost of capital in order to calculate the net present value

 Express in terms of dollars, not as a percentage

 Hard to estimate accurately, does not fully account for opportunity cost, and does not give a complete picture of an investment's gain or loss

 It requires that the investor know the exact discount rate, the size of each cash flow, and when each cash flow will occur

 The NPV is only useful for comparing projects at the same time; it does not fully build in opportunity cost

 It can give conflicting answers when compared to NPV for mutually exclusive projects

 The IRR method is usually not the best calculation to use when you're comparing mutually exclusive projects

 It does not account for the project size when comparing projects

 It makes an implicit assumption that those cash flows can be reinvested at the same rate as the IRR

Understanding the discrepancies in calculating different rates can be challenging, particularly when the internal rate of return (IRR) is influenced by two experimental rates This complexity arises from the failure to equate the present value of cash inflows with the present value of cash outflows.

Example of using two key investment appraisals in decision making

Using Microsoft Excel software, the financial manager can calculate exactly the NPV and IRR for each project Detail was shown in the table below:

Table 3: Investment appraisal using NPV and IRR Discount rate equal to 10%

In conclusion, the company should reject Project B because of negative NPV Between project A and C, we recognized that NPV and IRR for Project C were higher than for Project A => Project

Financial managers often rely on investment appraisal techniques to enhance their decision-making process Among the four primary methods—Payback, Average Rate of Return (ARR), Internal Rate of Return (IRR), and Net Present Value (NPV)—IRR and NPV stand out as the most critical for effective financial management While Payback focuses on the time required to recoup an investment, ARR evaluates profitability as a percentage of investment In contrast, IRR and NPV provide a more comprehensive analysis by considering the time value of money, making them essential tools for assessing the potential profitability and feasibility of investment projects.

NPV and IRR share several advantages, including their focus on the timing and amount of a project's cash flows, the ability to adjust for varying risk levels through the required rate of return, and consistent accept-reject decisions for independent projects However, their differences can influence financial managers and investors in making distinct investment choices.

1 Arcon Professional Tutors, 2012 PERFORMANCE OPERATIONS In CIMA Operational Level 1st ed Arcon Professional Tutors pp.39-43

2 Arshad, A., 2012 Net Present Value is better than Internal Rate of Return

3 BAFS, 2008 Professional Development Programme on Enriching Knowledge of the Business, Accounting and Financial Studies (BAFS) Curriculum Course 1 : Contemporary Perspectives on Accounting/ Unit 10 : Capital Investment Appraisal

5 Don et al., 2002 Capital Budgeting: Financial Appraisal of Investment Projects United Kingdom: Cambridge University Press

6 Gitman & Lawrence., 2008 Principles Of Managerial Finance India: Pearson Education Inc

7 Heitger, Mowen & Hansen, 2007 Fundamental Cornerstones of Managerial Accounting USA: Cengage Learning

8 Lefley, F., 1996 The payback method of investment appraisal: A review and synthesis Int J Production Economics , (44), pp.207-24

9 Lin, G.C.I & Nagalingam, S.V., 2000 CIM justification and optimisation London: Taylor & Francis

10 M.A.Main, n.d Project Economics and Decision Analysis In Volume I: Deterministic Models p.269

11 Peterson-Drake, P., n.d Advantages and disadvantages of the different capital budgeting techniques Florida: Florida Atlantic University

12 Rudolf, S., 2008 The Net Present Value Rule in Comparison to the Payback and Internal Rate of Return Methods

13 University of Sunderland, 2007 APC 308 In Financial Management 7th ed Sunderland: University of Sunderland p.64

14 Watters, A & Hoare, J., 2009 Internal Rate of Return