Dividend Policy
Considerations
Risk is not only a source of randomness on the return of investment but also a measure of this variability because the probabilities of various outcomes are known ( & 1997 ; 2001 ). Contrary to uncertainty, risk is more predictable and measurable because outcome probabilities need not to be estimated rather given. The probability of having tail or head (i.e. 50/50) in a toss coin is an example of risk while the probability of winning or loosing in a legal trial is an example of uncertainty. In addition, there are three fallacies about risks; namely, risk is always bad, risk should be eliminated at all costs and playing it safe is the safest thing to do ( 2001 ). Risks are either threat or opportunity depending on the stance of entities involved. For example, a hurricane is a disaster for homeowners in a certain community but some people like sellers of lumber, weather radios and other emergency equipments/ tools may view the disaster as earning opportunity.
Elimination of risks to avoid untoward results should address initially two questions; namely, is it complete elimination and what is the cost of any reduction? For example, there is a chance that an asteroid could hit the earth according to some experts but would the probability of the event (i.e. 1 in 1 billion) can be substantial enough to create the need to create homes in caves and underground which have monetary and non-monetary costs ( 2001 ). Lastly, preferring zero risk is equated to a risk-averse person. For example, even though the probability of wining a ,400 raffles ticket at a cost 0 is 50%, a risk-averse person will not bet his 0 due to the adversity on having nothing. This despite the expected value of buying the raffle ticket and betting is 0 (i.e. ½ () + ½ (,400) = 0) which means there is an equal probability of doubling his money ( 2001 ).
I. Total Risks
Consistent with a rational market, individuals and other entities expect and are promised with higher (lower) returns if they engaged in investments with higher (lower) risks. Shareholders are concern with total risk because it is a measure of the risk of an exposure of business portfolio that is comprised by the sum of market and firm-specific risks. Due to this, investors can reduce their total risk through diversification without altering their expected return ( 1993 ). However, this incentive is less attractive to contemporary investors because firm-specific risks are automatically considered when they hold a certain number of securities. As a result, firm specific risk becomes irrelevant to investment motivation because investors do not have to bear the firm-specific risk and therefore do not have to be compensated ( 1993 ).
II. Unsystematic Risk
Business risk is related to operating features of a firm while financial risk is related to the strategies behind the capital structure of a firm ( 1999). The former is a type of risk that is outside the control of firms and hardly affected by certain tactics and strategies because business risk is very dynamic and uncertain. On the other hand, the latter involves factors within the scope of managerial control because it arises from borrowed funds the company is bound to pay unlike equity funds. However, they are both under the definition of systematic risk or inherent risks of companies that cannot be reduced by diversification strategies. Business risks includes example such as the sensitivity of competitive structure of an industry to changes in macroeconomic variables such as inflation and interest rates. On the other hand, the more debt a firm has a greater level of financial risk or inability to meet such obligation.
III. Systematic Risk
For example, every stock in London Stock Exchange is uncorrelated with every stock; the beta coefficient is zero ( 2006). In this case, it will be possible to hold a portfolio in LSE that has risk-free. Investors would be acting like a casino owner having to only wait at the end of the day to receive fees from the players. The owner will accumulate earnings without any risks in playing rather only responsible for maintaining the venue. With zero betas, game theory will not hold and stock markets will never exist as correlated risk is the source of all risk in the diversified portfolio. On individual assets, beta represents volatility and liquidity of the market place while on portfolio perspective it refers to investor’s level of risk adversity. Beta is estimated through times series analysis and linear regression models ( 2006) like estimating ninety trading days of simple returns used as estimators for covariance and variance. Negative betas can be derived by holding securities that move against the market, shorting stocks and putting on options.
IV. Agency Problem
Problems of agency relationship focus on the conflict between principal (i.e. shareholders/ clients) and agent (i.e. the managers/ consultants). It states that as much as principals would like to maximize their investments and minimizing costs, agents have a conflicting goal of maximizing compensation and providing less-effort service ( & 1976). The former can only speculate about the tendency of the latter to exemplify such agent behavior because agents can misinterpret skills and knowledge to the attention of the principals. Due to speculation, principals implement monitoring systems and reduction in asymmetrical information to prevent any possible opportunistic behaviors from the agents. In effect, the relationship implies that highly-preferred agents are those who can minimize such agency costs leaking from the pockets of principals.
Managers can work for shareholders yet they themselves are significant shareholders. This happens when managers exercise their rights for employee stock options. Due to lack of transparency, managers may have conflict interest in the onset especially if their shares have significant voting rights to direct the corporate strategy in the future. Agency and principal compact should be guarded by corporations to prevent adverse scenarios of diluting agent’s (e.g. managers) responsibilities by giving them the probability to be principals (e.g. stockholders). When this happens, managers can have sub-optimal effort in managing the company because part of his time, strategic contribution and money are diverted to being a stockholder. As a general rule, stockholders are the risk-takers while managers are the agents that will assure the former from being under success.
Write-off applied to stock option-related expenses that loosen the pressure of costs being deducted to revenues. As a result, the profit of the company especially the whole income statement has the incentive to mitigate any losses or even look as profitable. Due to this, Dunlap’s previous use of writing-off option-related costs enables its losses to be minimized in terms of revenue reduction. The argument of Dunlap against Sun Beam also gained ground because writing-off mitigated the loss.
The hiring of auditors and bond companies to evaluate corporation’s financial statements can have negative and positive effects for the public. The former can induce collusion in which other auditing functions can be affected by the profit being derived from the additional work. As a result, corporations can collude to minimize reporting standards or favor few misapplications of required disclosures. Also, this situation can give corporations unnecessary incentive to model their financial statements according to the liking of auditors and bond companies. In effect, they can lead to getting their positive thinking of the corporation and then submit the real intention of getting funds or colluding to by-pass financial statement requirements. On the contrary, such situation is positive when the relationship blooms in minimizing transaction costs of auditing because at the planning stage of designing the reports intervention is already applied. Financial markets can have efficiency in managing resources and capital.
In view of the positive and negative side of this ideal, it is suggested that potential clients should be applied with restrictions regarding the extent of opinions that auditing offices and bond agencies can apply. Those accounts that relating to additional income of the contractors should not be communicated and the design or content per se of the statements should be focused. Auditors should not also have relatives in the client’s company to avoid personal biases in evaluating the financial statements. Government standards may also include additional disclosures in the financial statements about the extent of preview and opinion that auditing and bond agencies have been made. In these recommendations, the public may be assured that negative collusion will ensue and their best interests are protected in both investing and evaluation areas.
On extreme cases, agency problem leads to more problematic scenario in which publicly-listed companies are grounded. Auditing services which when degraded can impact the reputation of stock exchanges and listed companies. This is usually the case in some countries. Non-audit services create economic benefits which are complemented by direct payment of clients to auditing firms ( 2001). The lucrative effects of the transaction are eminent like evasion of corporate/ income taxes, productivity demands from top-level management of the auditing company (e.g. in case of individual employee) and relative ease (perhaps comfort) of performing profession and public responsibilities. Connivance is often used to speed-up economic and regulated dealings in the absence of relevant authorities and other stakeholders.
Importance
For the stock price, an increase in expected dollar earnings of a firm with unchanged risk will increase its value while an increase in expected dollar earnings with lower risks will “significantly” increase its value ( 2000 ). Due to this scenario, higher-ranked common stocks are more preferred than lower-ranked stocks and the latter tends to be sold in favor of the former. The former is defined as those stocks with highest expected rate of return for the risk or the lowest risk for an expected rate of return. As earnings per share (EPS) indicates the dollar return for every stock an investor purchased, it is one of the most items in the firm’s financial information that receives highest interests. For its part, the firm should solidify its claim of having high-ranked stocks to be able to compete for the limited available capital in the economy. As debt financing is more risky than equity financing (since the firm is obligated to pay debts even minimal or no profits is obtained), this task of the firm should be convincing.
Although corporate earnings have positive relationship with stock price ( 2000 ) such as the greater earnings the higher stock price will be, external forces both political and economic in nature would barred the firm from optimal realization of such relationship. In effect, being inclined or parallel with economic indicators is as crucial as internally generated earnings. One indication of this is that expected earnings should exceed interest rate of government bond to be able to be competitive. Another is that it should flow consistently with changes in interest rate, inflation and economic activity. This will make the firm’s investors to avoid unguided speculation when making investment decisions. It is a well-known dogma that no participant in a stock exchange can control the entire trend of stocks and so the consensus counts. And where will a rational firm/ investor/ government base their decisions? Of course, on what is really happening to the economy with small number of them speculating for short-term gains, that is, a mere buy and sell strategy.
Too much inflation (e.g. hyperinflation) has negative effect on stock price which can either be stimulated by pull and/or push consumer/ producer effects. To dispute this, common stocks are viewed as inflation hedgers ( 2000 ) as they can easily maneuver the cost of firm’s goods to follow inflation in the cost of production. Generally, the adverse inflationary effects on stock price is rather of short-term basis while the long-run inflationary functions of common stocks can be derived by an investor who is willing to place his investment longer in the hands of the firm.
There are at least three types of traders/ investors in the stock market ( 1964). This will serve as a guide for every trading/ investment strategy. For portfolio managers, one profitable trading strategy especially for portfolio managers is top-down stock strategy wherein the economic and market environments are analyzed before making a decision. Bottom-up approach emphasizes financial analysis of a firm’s data including comparison of stock performance against its competitors. For technical traders, there is also a technique to forecasts stock price movements by using previous charts to identify trends and there signals of actually happening including their impact. Hedging and arbitraging strategies are also used to aid in analysis. For sales traders, another is the strategy that aims to determine the best price by having knowledge of trading partners and relative prices to identify who is liquid in the market and exploit such identification.
Capital Structure
Considerations
I. Modigliani and Miller (Without Tax)
This argument is opposite of the traditional view. It argues that the value of the firm is independent of its capital structure that can be proved by simply capitalizing the expected return appropriate to each risk class ( 1999). For example, two different firms have a capital structure or debt-to-equity ratio of 90:10 and 10:90 respectively. With this argument, the value of the firm is reflected by its earnings before interest and taxes (EBIT) and the variability or risk of the EBIT while the average cost of capital serves as the discount rate that will capitalize EBIT. As a result, the cost of capital of the un-geared firm will also be equal to the geared firm because the cost of debt capital is eliminated. In this proposition, cost of equity capital is a linear function of capital structure that cancels the yield in equity due to capitalization rate and financial risk premiums. As a result, increases in gearing also increases the risk of equity capital that will positively push the required rate of return upwards. In addition, the use of cheaper debt is trade-off by increasing the cost of equity
II. Modigliani and Miller (With Tax)
This argument is a refined version of “without taxes” because it adapts to real corporate situations. It posits that tax shields that benefit a highly geared firm is misleading and with questionable effects ( 1999). The benefits are initially apparent because the highly geared firm has tax allowable interest payments to creditors that will make their earnings after interest and taxes (EAIT) greater than un-geared firm. When capitalizing method in “without tax” version is applied, appropriate discount rate will be applicable to interest payments on debt which produces the tax shield making interest and tax shield on the same class of risk. In this regard, the value of the geared company and the un-geared company plus the present value of the tax shield will be equal. Finally, as debt-equity ratio increase, the firm’s financial risk is also increased which cause its cost of equity to rise. In contrast, the impact of corporate taxes cancels the cost of debt and therefore cost of equity where trade-off is the obvious situation.
III. The Traditional View
Weighted average cost of capital (WACC) aids the firm to select the most efficient combination of capital structure by reflecting in the computation both equity and debt financing options. It is posted that high equity capital structure is less risky than debt financing because the firm should pay banks even though there is no profits. However, too much equity financing can destruct the ownership structure of the firm which can be harmful for major stakeholders. Therefore, capital structure must be managed by combining financing alternatives in order to optimize a firm’s cost of capital that can contribute to increase in firm’s value.
Traditional model believes that capital structure is related to the value of the company wherein it is possible to reduce WACC ( 1999). The model held by following assumptions; namely, all earnings are distributed as dividends, earnings are expected to remain constant indefinitely, all investors have identical expectations about future earnings, taxation is ignored, business risk remains constant, capital structure can be altered immediately by exchanging debt for equity or vice versa and there is no transaction cost. The traditional model theorizes that the WACC of the firm is a source of useful information or signal to achieve an optimal capital structure.
IV. Capital Structure Analysis
Using the gearing ratio, the level of a firm’s financial risk is assessable which means that the firm can identify if financial resources are able to pay planned or on-going financial commitments or not ( 1999). In this way, the firm can make decisions and implement strategies according to its financing ability. This upper hand is worthy not only because it places the firm in a safer stance but more importantly it is able to control one side of the general risk confronting a business (financial side) which relaxes problems emerging from the uncontrollable business/ environmental risks.
With this, the survival of the firm is protected by capital structure (CS) as internal consequences of a firm’s strategy are detected. Questions such as “Do we have enough money for the project?”, “Is there a need to borrow or issue shares?” and “What is the gearing ratio to be adopted to maximize the potential of the project?” This facility has also its implications on corporate ability to forecast, exploit and mitigate environmental changes and even apply influence over its gradual evolution. This can achieve merit by using the resource-based model of above average returns wherein core competencies are matched against the changing environment (, & 2003 ).
Using CS as the basis for project planning and implementation, the firm can enjoy the computed future earnings without interference from pending obligations to creditors or shareholders. This is important for project cash flows to be obtained all throughout its life span because creditors can sue a company when debt contract or shareholders’ expectation are not met. As an example, in the early years of US operations of News Corporation (the owner of Twentieth Century Fox), its CEO and financial officers faced difficulty to calm its creditors and defer lawsuit that can substantially disrupt its corporate life in the US (, & 2004 ).
The company’s debt came from its huge acquisition costs on most American-owned media companies where some are unsuccessful to meet their expected earnings. This case shows how lack of financial planning can provide a big headache for (expanding) firms. However, through CS, this highly-owned family company may have give-up some of its control in favor of equity financing. Thus, it may have prevented the last minute plead and risky confrontations to its creditors.
In general, debt financing is cheaper than equity financing because it is a tax allowable expense ( 1999 ). However, it is also more committed (thus, risky) because repaying includes the principal and interest and it is mandatory even if the company results to a loss. In addition, too much debt can discourage shareholder and their funds from entering the firm’s coffers because ordinary shareholder is only awarded with the profit residual after the creditors are paid (). In the contrary, focus on equity financing can be unacceptable (in the case of News Corporation) or not strategic because the firm can loose its identity as it also looses control to major corporate decisions. When company’s shares are concentrated to one entity on the market, it may also face hostile takeover. This literally is one way to say that the original company has already perished.
Bibliography
Books
Electronic Sources
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