Going public and the dividend policy of the company
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
5. Alternatives
to Cash Dividends
Summary
References
3
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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 a private 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 listing agreement, 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 the voting (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 by loan 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 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 of RSPs is 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. And stockbrokers can act for client as agent only, when
purchasing or sell securities on their behalf, in which case they deal with
RSPs. And dual capacity stockbrokers/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 rights to 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 a call
option, which gives the right to buy shares by a future date; or for
a put option, which gives the right to sell shares 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 options have
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 the traded
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
1.
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.
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.
2. 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.
3. Other
Arguments Supporting the Relevance of Dividend Policy.
Activity:
As a potential investor, how
would you react to the following questions?
a. Would
you prefer cash dividends now, against the promise of future, perhaps
uncertain, dividends?
b. Would
you prefer a stable, growing dividend to one that fluctuates in sympathy with
company’s investment needs?
c. 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.
4. 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 accumulated realized 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, any realized
profit 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.
5. 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
1.
Anjolein Schmeits, ‘Essay on Corporate Finance and Financial
Intermediation’, Thesis publishers, 1999, 225-246.
2.
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.