dividend theories financial mgment.pptx

Based on ktu sylabus

1. DIVIDEND THEORIES

2. DIVIDEND THEORIES

3. Relevant Theory If the choice of the dividend policy affects the value of a firm, it is considered as relevant. According to on school of thought, dividends decisions are relevant to the value of the firm measured in terms of the market price of the shares. This is called Relevance Theory . In that case a change in the dividend payout ratio will be followed by a change in the market value of the firm. If the dividend is relevant, there must be an optimum payout ratio. Optimum payout ratio is that ratio which gives highest market value per share.

4. Irrelevance of Dividend As per Irrelevance Theory of Dividend, the market price of shares/value of the firm is not affected by dividend policy. Dividend Irrelevance Theory is a financial theory that claims that the issuing of dividends does not increase a company’s potential profitability or its stock price. To investors, whether a company issues shares or not does not mathematically affect personal wealth; only the form of the wealth is changed. According to professors Soloman, Modigliani and Miller, dividend policy has no effect on the share price of the company. There is no relation between the dividend rate and value of the firm. Dividend decision is irrelevant of the value of the firm. Modigliani and Miller contributed a major approach to prove the irrelevance dividend concept.

5. MODIGLIANI AND MILLER’S APPROACH( IRRELEVANCE THEORY) According to MM, under a perfect market condition, the dividend policy of the company is irrelevant and it does not affect the value of the firm. “ Under conditions of perfect market, rational investors, absence of tax discrimination its dividend policy may have no influence on the market price of shares”. It suggest that a shareholder can earn as much money as in the case of dividend by selling the shares in the market. MM approach is based on the following important assumptions: 1. Perfect capital market. 2. Investors are rational. 3. There are no tax. 4. The firm has fixed investment policy. 5. No risk or uncertainty.

6. MM approach can be proved with the help of the following formula:= Where, Po = market price of the share at the beginning of period Ke = Cost of equity capital. D1 = Dividend to be received at the end of period one. P1 = Market price of the share at the end of period one.

7. CRITICISM: MM approach assumes that tax does not exist. It is not applicable in the practical life of the firm. MM approach assumes that, there is no risk and uncertain of the investment. It is also not applicable in present day business life. MM approach does not consider floatation cost and transaction cost. It leads to affect the value of the firm. MM approach assumes that, investor behaves rationally. But we cannot give assurance that all the investors will behave rationally.

8. RELEVANCE OF DIVIDEND WALTER’S MODEL: Its developed by Prof. James E. Walter According to this concept, dividend policy is considered to affect the value of the firm Walter model argues that the dividend policy almost always affects the value of the firm. ASSUMPTIONS Of Walter Model The firm uses only internal finance. (retained earning) The firm does not use debt or equity finance. The firm has constant return and cost of capital. The firm has 100 % payout. The firm has constant EPS and dividend. The firm has a very long life.

9. Walter model is based in the relationship between the following important factors: Rate of return - I Cost of capital (k) According to the Walter’s model, If Irr > k – Growth firms , 100% retained and 0% as dividend payout. If Irr < k – Declining firms , then 0% as retained earnings and 100% as dividend payout If the firm has r = k – Normal firms – Unchanged

10. Where, P = Market price of an equity share D = Dividend per share r = Internal rate of return E = Earning per share Ke = Cost of equity capital

11. Criticism Of Walter’s Model : Walter model assumes that there is no extracted finance used by the firm. It is not practically applicable. There is no possibility of constant return. Return may increase or decrease, depending upon the business situation. Hence, it is not applicable. According to Walter model, it is based on constant cost of capital. But it is not applicable in the real life of the business.

12. GORDON’S MODEL Myron Gorden suggest one of the popular model which assume that dividend policy of a firm affects its value, A ssumptions : The firm is an all equity firm. The firm has no external finance. Cost of capital and return are constant. The firm has perpectual life. There are no taxes. Cost of capital is greater than growth rate (Ke>br).

13. Gordon approach gives the relationship of r (rate of return ) and cost of capital ) Accor ding to this model, If r> k- 100 % retain and 0% as dividend payout ratio. If r< k – 0% as reatined earnings and 100% as dividend payout ratio. If r = k , then unchanged.

14. Criticism Of Gordon’s Model: Gordon model assumes that there is no debt and equity finance used by the firm. It is not applicable to present day business. Ke and r cannot be constant in the real practice. According to Gordon’s model, there are no tax paid by the firm. It is not practically applicable.

15. GORDAN’S REVISED MODEL Gordon revised his basic model to consider risk &uncertainty. He suggested that even r=k, dividend policy affects the value of shares on account of uncertainty of future. Investors are rational &they want to avoid risk They prefer near dividend than future dividend “Bird in the hand is better than in bush” It is based on the belief that investors place a high preference for the receipt of dividends .

16. Bird in the hand is better than in bush ” The saying means that it is better to hold onto something you have now, or can count on receiving soon. Versus the risk of losing whatever “it” is by trying to get something bigger and better down the road. A dividend from a high-quality dividend stock is something you can count on. It is the bird in hand, In contrast to the potential for large increases in the share price of a stock. That may or may not come in the future.

17. OTHER SOURCES OF FINANCE

18. LEASING Lease is a contract under which a lessor, the owner of the assets, gives right to use the asset to a lessee, the user of the assets, for an agreed period of time for a consideration called the lease rentals. Leasing is the process by which a firm can obtain the use of certain fixed assets for which it must make a series of contractual, periodic, tax-deductible payments. A lease is a contract that enables a lessee to secure the use of the tangible property for a specified period by making payments to the owner.

19. The Contract:  There are essentially two parties to a contract of lease financing, namely the owner and the user. Assets:  The assets, property to be leased are the subject matter lease financing contract. Lease Period:  The basic lease period during which the lease is non-cancelable. Rental Payments:  The lessee pays to the lessor for the lease transaction is the lease rental. Maintain:  Provision for the payment of the costs of maintenance and repair, taxes, insurance, and other expenses appertaining to the asset leased.

20. Term of Lease:  The term of the lease is the period for which the agreement of lease remains in operation. Ownership:  During the lease period, ownership of the assets is being kept with the lessor, and its use is allowed to the lessee. Terminating:  At the end of the period, the contract may be terminated. Renew or Purchase:  An option to renew the lease or to purchase the assets at the end of the basic period. Default:  The lessee may be liable for all future payments at once, receiving title to the asset in exchange.

21. OPERATING LEASE An operating lease is a cancellable contractual agreement whereby the lessee agrees to make periodic payments to the lessor, often for 5 or fewer years, to obtain an asset set’s services. Short-term, cancelable lease agreements are called operating lease. Tourist renting a car, lease contracts for computers, office equipments and hotel rooms. The Lessor is generally responsible for maintenance and insurance. Risk of obsolescence remains with the lessor.

22. FINANCIAL LEASE   A financial (or capital) lease is a longer-term lease than an operating lease that is non-cancelable and obligates the lessee to make payments for the use of an asset over a predetermined Period of time. Long-term, non-cancelable lease contracts are known as financial lease. Examples are plant, machinery, land, building, ships and aircrafts.

23. Direct Lease :  Under direct leasing, a firm acquires the right to use an asset from the manufacture directly. The ownership of the asset leased out remains with the manufacture itself. Sale & Leaseback :  Under the sale & leaseback arrangement, the firm sells an asset that it owns and then leases to the same asset back from the buyer. This way, the lessee gets the assets for use, and at the same time, it gets cash. Leveraged Lease :  Leveraged lease is the same as the direct lease, except that a third party, the lender, is involved in addition to the lessee & lessor. The lender partly finances the purchase of the asset to be leased; the lessor turns to be a borrower.

24. HIRE PURCHASE Hire purchase is an arrangement for buying expensive consumer goods, where the buyer makes an initial down payment and pays the balance plus interest in installments. In a hire purchase agreement, ownership is not transferred to the purchaser until all payments are made. Hire purchase agreements usually prove to be more expensive in the long run than purchasing an item outright.

25. VENTURE CAPITAL Venture capital (VC) is a form of private equity and a type of financing that investors provide to start-up companies and small businesses that are believed to have long-term growth potential. Venture capital generally comes from well-off investors, investment banks, and any other financial institutions. However, it does not always take a monetary form; it can also be provided in the form of technical or managerial expertise. Venture capital is typically allocated to small companies with exceptional growth potential, or to companies that have grown quickly and appear poised to continue to expand.

26. FEATURES Equity Participation. Long-term Investments. Participation in Management. High Risk Long term horizon Venture capital investments are made in innovative projects METHODS OF VENTURE CAPITAL FINANCING Equity participating debentures conditional loan

27. STAGES OF FINANCING

28. THE FUNDING PROCESS:  Approaching a Venture Capital for funding as a Company

29. Financial engineering Financial engineering encompasses a broad, multidisciplinary field of study and practice that, essentially, applies an engineering approach and methodology to the world of finance. It integrates and utilizes information obtained from different fields, such as economics, mathematics, computer science, and financial theory. Much of financial engineering consists of converting financial theories into practical applications in the financial world. An example of financial engineering in practice is the work of quantitative analysts – usually referred to as “quants” – who develop things such as algorithmic or artificial intelligence trading programs that are used in the financial markets.