Plekhanov Russian Economic Academy The theme of the report: “Going
public and the dividend policy of the company. ” By Timofeeva M. V.
The supervisor: Sidorova E. E. Moscow 2001. Contents Introduction
I. ‘Going Public’ and the Securities Market3 ‘Going Public’ Types
of Shares The Stock Exchange and the Capital Market Procedure for
an Issue of Securities Equity Share Futures and Options II.
Dividend Policy and Share Valuation Dividends as a Residual Profit
Decision Costs Associated with Dividend Policy
Other Arguments Supporting the Relevance of Dividend Policy
Practical Factors Affecting Dividend Policy Alternatives to Cash
Dividends Summary References 3 4 4 5 6 7 7 9 9 10 11 12 12 14 15
Introduction
In this report we focus on the long-term financing by issuing
shares and dividend policy of the company. We consider the
institutional design of capital market, Stock Market Exchange and
Alternative Investment Market; fundamental theories of paying
dividend and factors which influence Dividend Policy of the
companies. The main objective of this report is to develop a better
understanding of the problems faced by start-up firms seeking
capital financing and paying percentage (dividends). In addition,
we try to identify the consequences of shortcoming and overplus of
the dividend payouts for value of corporation (for value of share)
and individuals (shareholders).
The urgency of this question is obvious, because firms need capital
to finance product-development or growth and must, by a lot of
factors (interest rate, time period and etc), obtain this capital
largely in the form of equity rather than debt. So the issuing of
shares and dividend policy is one of the widest research overseas
and I hope Russian economists don’t be backward in that list. I.
‘Going Public’ and the Securities Market ‘Going Public’
Most private companies that experience the rapid growth have
reached the stage when existing shareholders’private resources are
exhausted, retained profit is insufficient to cope with the rate of
expansion, and further borrowing on top of your current amount of
loans will probably be resisted by lenders until you have a more
substantial layer of equity capital. One solution to this financial
problem is to retain the services of a financial intermediary–
usually a merchant bank –to find a few private individuals or
financial institution such as an insurance company or an investment
trust that is willing to subscribe more capital. This is known
aprivate placing. And, of course, there are some advantages and
disadvantages of going public. Advantages
access to the capital market and to larger amounts of finance
becomes possible by having shares quoted on the Stock Exchange;
institutions are more likely to invest on the public listed
company, and additional borrowing becomes possible;
shareholders will find it easier to sell their shares in the wider
market; the company attains a higher financial standing;
provides an opportunity for public companies to introduce
tax-efficient employee share option scheme. Disadvantages
cost of a public flotation of shares are high – as much as 4% - 10%
of the value of the issue; because outside shareholders are
admitted, some control may be lost over the business;
publicly quoted companies are subject to more scrutiny than
private; the risk of being taken over by purchasing of company’s
shares on the Stock Exchange; as the market tends to be influenced
more by the short- then long-term strategy of listed companies, a
company committed to a long-term plan may find its stock market
performance disappointing. The going public company is required:
minimum issued capital of ? 50. 000; minimum market capitalization
of ? 500. 000; 25% of your equity shares available to the
public;
sign a Stock Exchange listingagreement, which binds you to disclose
specified information about your company in future. Types of
Shares
There are two main classes of shares are ordinary and preference
Ordinary shares (sometimes called ‘equity’ shares)
Those are the highest risk-takers shares in the company. This
implies that the holder’s claims upon profit – for dividend, and
assets –if the company is liquidated, are deferred to the prior
rights of creditors and other security holders. However, the
capital liability of ordinary shareholders is limited to the amount
they have agreed to subscribe on their shares, therefore they
cannot be called upon to meet any further deficiency that the
company may incur. If the ordinary shares are thevoting
(controlling shares)but in some companies the significant
proportion is held by the directors and the remainder are widely
held by a large number of shareholders, so the directors may
effectively control the company. Preference shares
They also are the part of the equity ownership, attractive to
risk-averse investors because of their fixed rate of dividend,
which normally must be at a higher level than the rate of interest
paid to lenders, because of the relatively greater risk of
non-payment of dividend. Whilst they are part of the share capital,
the holders are not normally entitled to a vote, unless the terms
of issue specified overwise, and even then votes are usually only
exercisable when dividends are in arrears. Preference shareholders
have prior rights to dividend before ordinary shareholders, but it
may be withheld if the directors consider there are insufficient
resources to meet it. There is an implied right to accumulation of
dividends if they are unpaid, unless the shares are stated to be
non-cumulative. Payment of such arrears has priority over future
ordinary dividends. And if the company goes into liquidation,
preference shareholders are not entitled to payment of dividend
arrears or of capital before ordinary shareholders, unless their
terms of issue provide otherwise, which they usually do.
Companies have issued three varieties of preferences shares from
time to time, to confer special rights; these are redeemable
preferences shares, participating preferences shares and
convertible preferences shares. Redeemable preferences shares are
similar to loan capital in that they are repayable but they lack
the advantage enjoyed byloan interest of being able to
charge dividend against profit for taxation purposes, participating
preferences shares enjoy the right to further share in the profit
beyond their fixed dividend, normally after the ordinary
shareholders have received up to a state percentage on their
capital, convertible preferences shares give the option to holders
to convert their shares into ordinary shares at the specified price
over a specified period of time. The Stock Exchange and the Capital
Market
The Capital Market embraces all the activities of financial
institution engaged in: the raising of finance for private and
public bodies whether situated in UK or overseas (the primary
market);
trading the securities and other financial instruments created by
the activity above (the secondary market).
The Stock Exchange plays a central role in this international
market. It provides the primary facility fir marketing new issues
of shares and other securities, and also a well-regulated secondary
market in shares, British government and local authority stocks,
industrial and commercial loan stocks and many overseas stocks that
are included in its Official List. Nowadays it called the London
Stock Exchange Ltd is an independent company with the Board of
Directors drawn from the Exchange’s executive, and from the
customer and user base. The main participants on the Stock Exchange
are Retail Service Providers (RSPs) and the stockbrokers. The
function ofRSPsis to provide a market in securities, which they
have nominated, and to maintain two-way prices, i. e. lower price
at which they are prepared to buy and a higher price at which thy
will sell. Andstockbrokers can act for client as agent only, when
purchasing or sell securities on their behalf, in which case they
deal with RSPs. And dual capacitystockbrokers/dealers, however they
will buy and sell shares on their own account, and may act as both
agent and principal in carrying out clients‘buy’ and
‘sell’instruction. Unfortunately the integration of the broking and
dealing functions within the same financial grouping can give rise
to conflict of interest, and this has made it essential to create a
protective regulatory framework both within and between financial
institutions.
But some companies are not suitable for a full Stock Exchange
listing and the Alternative Investment Market (AIM), setting up by
the Stock Market Exchange in 1995, is a more suitable for unknown
and risky companies. Its main features are: no formal limit on
company size; ? 500. 000 capitalization (full listing ? 3-? 5
million); no minimum trading record (full listing five years);
10% of the equity capital must be in public hands (full listing
25%) no entry fee is required, but a annual listing fee of ? 2. 500
in year 1, rising to ? 4. 000 in year three is payable. Procedure
for an Issue of Securities
All arrangements made by an Issuing House, which specialized in
this work. The procedure would be probably as follows:
an evaluation by the Issuing House of the company’s financial
standing and future prospects; an assessment if the finance
required, and advise regarding the most appropriate package to
finance to meet the need; advice of the timing of the issue;
agreement with the Stock Exchange on the method of issue (sale by
tender, SE placing etc); completion of an underighting
agreement;
preparation of the prospectus and other documents required by the
Stock Exchange in the initial application for the quotation;
advertising the offer for sell and the publication of the
prospectus; arrangements with the bankers to receive the amounts
payable; the issue price of the share to be agreed at a level to
ensure a success of the issue;
final application for the Stock Exchange quotation, and signing of
the listing agreement, which binds the company to maintain a
regular supply of information to the Stock Exchange and
shareholders. Equity Share Futures and Options
These are traded at the London International Futures and Options
Exchange (LIFFE), which was established in 1982. Both futures and
options are used by investors for:
hedging i. e. protecting against future capital loss in their
investments; speculation i. e. gambling on forecasts of favorable
movements in future Stock Market prices.
The main differences between futures and options is that futures
contracts are binding obligation to buy or sell assets, whereas
options convey rightsto buy or sell assets, but not obligations.
Futures are agreed, whereas options are purchase. Equity Share
Futures
The only equity futures dealt in on LIFFE are those based on the
FTSE 100 and MID 250 Stock Indices.
Futures contracts may b used to protect an expected rise in the
market before funds are available to an investor. For example, an
investor expecting a large cash sum in three months’time could
protect his position by buying FTSE 100 Index futures contract now,
and selling futures for a higher sum when the market rises. The
profit made on the futures position would then compensate him for
the higher price he has pay for his investments when the expected
cash sum arrives. Equity Share Options
An option is the right to buy or sell something at an agreed price
(the exercise price) within a stated period of time. As applied to
shares, a payment (a premium) is made through or to a stockbroker
for acall option, which gives the right to buy shares by a future
date; or for a put option, which gives the right to sellshares by
future date. And the holder may exercise the option, or late it
lapse. However the giver (the‘writer’) of the option, i. e.
the
dealer to whom the premium has been paid, is obliged to deliver or
buy the shares respectively, if the option holder exercises his
rights.
Traditional optionshave been dealt in for over 200 years, and are
usually written for a date three month’hence, when either the
shares are exchanged, or the option lapses. The disadvantage of the
traditional option is that it cannot be traded before the exercise
date, and it was because of this inflexibility that thetraded
options market was created in the UK in 1978. Equity options were
first traded on LIFFE in 1992, and currently (1997), options are
available on 73 large companies’shares. Because traded options cost
much less then the underlying shares, an investor is able to back
an investment opinion without risking too much money. II. Dividend
Policy and Share Valuation Dividends as a Residual Profit
Decision
It would seem sensible for a company to continue to reinvest profit
as long as projects can be found that yield returns higher than its
cost of capital. In this way, the company can earn a higher return
for shareholders than they can earn for themselves by reinvesting
dividends. Such a policy can be optimal, however, only if the
company maintains its target-gearing ratio by adding an appropriate
proportion of borrowed funds to the retained earnings. If not, the
company’s coast of capital would increase because of its
disproportionate volume of higher-cost equity capital; this would
be reflected share price. Activity:
The LTD Company has the chance to invest in the five projects
listed below: Projects Capital outlay, ? Yield rate, % A 70. 000 18
B 100. 000 17 C 130. 000 16 D 50. 000 15 E 100. 000 14
The company cost of capital is 16% its optimal debt to net assets
ratio is 30% and the current year’s profit available to equity
shareholders is ? 350. 000. Required:
State which projects would be accepted, and what is the total
finance requires for those projects.
Assuming that the company wishes to maintain its gearing ratio, how
much of the required finance will be borrowed? How much of this
year’s profit can be distributed? The answers:
A, B and C, with yield greater than or equal to the company’s cost
of capital; total finance required ? 300. 000. Amount to be
borrowed: 30% of ? 300. 000=? 90. 000. This year’s profit: ? 350.
000
less amount to be reinvested ? 300. 000-? 90. 000: 210. 000 Profit
for distribution: 140. 000
Company’s shareholders obtain the best of both words. They can
invest the ? 140. 000 received as dividends to earn a higher rate
of return than the company could earn for them; and the? 210. 000
retained by the company is reinvested to shareholders’ advantage.
Shareholders’wealth is optimized, and the dividend paid is simply
the residual profit after investment policy has been approved.
If companies look upon dividend policy as what remains after
investments are decided then the search for an optimum dividend
policy is pointless. Shareholders wanting dividends can always make
them for themselves by selling some of their shares.
Further support for the ‘residual’theory of dividends, and the
argument that the change in dividend policy does not affect share
values, was advanced by Modigliani and Miller in 1961. They
contended that in a perfect market the increase in total value of a
company after it has accepted an investment projects is the same,
whether internal or external finance is used.
One deficiency in the Modigliani and Miller hypothesis, however, is
that they ignore costs associated with an issue of shares, which
can be quite considerable. Costs Associated with Dividend
Policy
Capital floatation costs are a deterrent substituting external
finance for retained earnings but there are other costs affected by
the dividend decision. If shareholders are left to make their own
dividends by selling some shares, this involves brokerage and other
selling costs that, on a small number of shares, can be extremely
an economic. In addition, if they have to be sold during a period
of low share price, capital losses may be suffered. Another
important factor is taxation. First, when the company distributes
dividend it has to pay an advance installment of corporation tax
(ACT), currently one quarter of the amount paid. But the offset
against mainstream liability to pay corporation tax will be delayed
by at least one year. Indeed, if the company does not currently pay
this type of tax, the delay in setting off ACT will be even longer,
and this will tend to restrain extravagant dividend
distributions.
Second, from the investors’viewpoint profitability invested
retained earnings should increase share values, enabling
shareholders to create their own dividends. Selling shares creates
a liability to capital gains tax, currently 20%, 23% or 40%, but
subject to a fairly generous exemption limit. By comparison,
dividends in the hands of shareholders attract
higher rate of income tax (up to 40%). Thus higher-rate taxpayers
may prefer comparatively low dividend payouts to minimize their tax
burden. Third, financial institutions confuse the taxation picture
even more, through their major holdings in the shares of quoted
companies. They are able to set off dividends received against
dividends paid for tax purpose but some may be liable to capital
gains tax if they sell shares to make dividends. The effect of
taxation on dividend decision is difficult to analyse. It may be
argued that companies attract investors who can match their
personal taxation regimes to company’s dividend policy, and that
those who don’t join a particular ‘taxation club’ will invest
elsewhere. If this were true, however, a change in company’s
dividend policy would probably not find favour with its
shareholders clientele. And would consequently affect share values,
which seem to support the argument that dividend policy
matters.
Other Arguments Supporting the Relevance of Dividend Policy.
Activity:
As a potential investor, how would you react to the following
questions? Would you prefer cash dividends now, against the promise
of future, perhaps uncertain, dividends?
Would you prefer a stable, growing dividend to one that fluctuates
in sympathy with company’s investment needs?
If a company, in whose shares you invest, increases or decreases
its dividend, would it change your personal investment policy?
In answer in question (a) you probably opted for cash now rather
than cash you may never see. The future is uncertain and most
people take much convincing that it is in their interests to
postpone income. Although the equity shareholder by definition is
the risk-bearer, he is also entitled to a reasonable resolution of
dividend prospects to compensate for the additional risk he
carries. An investor will almost certainty pay higher price for
earlier rather than later dividends.
In question (b), in definition, a fluctuating dividend is more
risky than a stable dividend. Investors will pay more for
stability, especially if it is linked with steady growth. Research
has shown that, in general, dividends follow a pattern of stability
with growth. Maintenance
of the previous year’s dividend is the first consideration, with
growth added when directors feel that a higher plateau of
profitability has been consolidated. As regards question (c), you
would no doubt be very happy about an increase, and might even be
prompted to buy more shares–thus helping to put the market price
up. Conversely a decreased dividend would cause to review your
investment, perhaps even to sell your shares to take advantage of
better investment opportunities elsewhere. Investors tend to
believe that dividend changes provide information regarding a
company’s futures prospects, and they react accordingly. Practical
Factors Affecting Dividend Policy
Whatever dividend policy is thought to be best for a company in
theory, certain practical factors influence the decision.
Availability of profit The Companies Act 1985 provides that
dividends can only be paid out of accumulatedrealized profit less
realized losses, whether these are capital of revenue. Previous or
current years’losses must be made good before a distribution can be
made. If an asset is sold, anyrealizedprofit or loss arising can be
distributed; but any profit or loss arising from revaluation of an
asset cannot be distributed– unless and until the asset is sold.
Availability of cash Profit may be earned during a year and yet it
may hot be possible to pay a dividend because of lack of cash. This
can arise for different reasons. It may already have been expected
or be needed to replace fixed and working assets, perhaps at
inflated prices. Large customers may not yet have paid their
accounts or cash may be needed to repay a loan.
Other restrictions The company’s articles association may limit the
payment of dividends or a lender by insert into a loan agreement to
restrict the level of dividends. A company’s dividend policy cannot
be so outrageously different from policies followed by similar
companies in the same industry; otherwise the market price of its
shares could fall. Dividends may be restricted by government prices
and incomes polices. Alternatives to Cash Dividends
In recent years companies have introduced more flexibility into
their dividend policy by either:
issuing shares in place of cash dividends (‘scrip’ dividend);
repurchasing their shares.
Script dividends Companies may give their shareholders the option
to receive shares rather than cash. This has the effect of
maintaining company liquidity, and enabling the company to increase
earnings by investing the retained cash. However company has to pay
ACT on the distribution, and the shareholders have to pay income
tax.
Thus, the shareholders can increase his investment in the company,
without expense associated with the public issue or a purchase on a
stock market, but the same time retain the option to convert his
shares into cash at a future date.
Repurchasing shares Since 1981 companies have been allowed to
purchase their own shares subject to certain restrictions, and the
prior authorization of their shareholders. This is normally done by
utilizing distributable profits, and the shares must be cancelled
after purchasing.
Repurchasing of shares may be carried out for any of the following
reasons: to repay surplus cash to shareholders; to increase gearing
by reducing equity capital;
to increase EPS by reducing the number of shares related to an
unchanging level of profit, and hopefully, therefore, the value of
each remaining share; to purchase the shares of a large
shareholders. Summary
In this report we have explored an important and long-standing
issue in financial research: how do corporations finance
themselves, the shares issuing in the Stock Market Exchange and
dividend policy of the companies.
And the situation is that the rapidly expanding companies suffer
from the retained profit insufficiency and one of the solutions of
this financial problem is going public.
But it is not surprising that existing shareholders dig more deeply
into company’s pocket by claiming dividends. And of course the
public company is subject to more scrutiny than a private one.
Thus I think only when all other sources are exhausted your can
dilute already existing shareholders’control over the company.
However corporations willingly make issues of shares and pay
dividends. So how are their dividend, financial and investment
policy reconciled? This question has exercised the minds of
academics and financial managers in recent years without any
completely satisfactory answer being produced. References
Anjolein Schmeits, ‘Essay on Corporate Finance and Financial
Intermediation’, Thesis publishers, 1999, 225-246.
Geoffrey Knott, ‘Financial Management’, Creative Print and Design,
Third edition, 1998, 300-337.
3. Kovtun L. G. , ‘English for Bankers and Brokers, Managers and
Market Specialists’, Moscow NIP“2”, 1994, 340-350.
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