Реферат: Going public and the dividend policy of the company

Plekhanov RussianEconomic 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 toCash DividendsSummary

References

Introduction

In this report we focus on thelong-term financing by issuing shares and dividend policy of the company. Weconsider the institutional design of capital market, Stock Market Exchangeand Alternative Investment Market; fundamental theories of payingdividend and factors which influence Dividend Policy of the companies.

The main objective of this reportis to develop a better understanding of the problems faced by start-up firmsseeking capital financing and paying percentage (dividends). In addition, wetry to identify the consequences of shortcoming and overplus of the dividendpayouts for value of corporation (for value of share) and individuals(shareholders).

Theurgency of this question is obvious, because firms need capital to financeproduct-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 ratherthan debt. So the issuing of shares and dividend policy is one of the widestresearch overseas and I hope Russian economists don’t be backward in that list.

I. ‘Going Public’ and the SecuritiesMarket‘Going Public’

Most private companies thatexperience the rapid growth have reached the stage when existing shareholders’private resources are exhausted, retained profit is insufficient to cope withthe rate of expansion, and further borrowing on top of your current amount ofloans will probably be resisted by lenders until you have a more substantiallayer of equity capital. One solution to this financial problem is to retainthe services of a financial intermediary – usually a merchant bank – to find afew private individuals or financial institution such as an insurance companyor an investment trust that is willing to subscribe more capital. This is knowna private placing. And, of course, there are some advantages anddisadvantages of going public.

Advantages

·

accessto the capital market and to larger amounts of finance becomes possible byhaving shares quoted on the Stock Exchange;

·

institutionsare more likely to invest on the public listed company, and additionalborrowing becomes possible;

·

shareholderswill find it easier to sell their shares in the wider market;

·

thecompany attains a higher financial standing;

·

providesan opportunity for public companies to introduce tax-efficient employee shareoption scheme.Disadvantages

·

costof a public flotation of shares are high – as much as 4% — 10% of the value ofthe issue;

·

becauseoutside shareholders are admitted, some control may be lost over the business;

·

publiclyquoted companies are subject to more scrutiny than private;

·

therisk of being taken over by purchasingof company’s shares on the Stock Exchange;

·

asthe market tends to be influenced more by the short- then long-term strategy oflisted companies, a company committed to a long-term plan may find its stockmarket performance disappointing.

The going public company is required:

·

minimumissued capital of ₤50.000;

·

minimummarket capitalization of ₤500.000;

·

25%of your equity shares available to the public;

·

signa Stock Exchange listing agreement, which binds you to disclosespecified information about your company in future.Types of Shares

There are two main classes of shares are ordinary andpreference

Ordinary shares (sometimes called ‘equity’shares)

Those are the highest risk-takersshares in the company. This implies that the holder’s claims upon profit – fordividend, and assets – if the company is liquidated, are deferred to the priorrights of creditors and other security holders. However, the capital liabilityof ordinary shareholders is limited to the amount they have agreed to subscribeon their shares, therefore they cannot be called upon to meet any furtherdeficiency that the company may incur. If the ordinary shares are the voting(controlling shares) but in some companies the significant proportion isheld by the directors and the remainder are widely held by a large number ofshareholders, so the directors may effectively control the company.

Preference shares

They also are the part of the equityownership, attractive to risk-averse investors because of their fixed rate ofdividend, which normally must be at a higher level than the rate of interestpaid to lenders, because of the relatively greater risk of non-payment ofdividend. Whilst they are part of the share capital, the holders are notnormally entitled to a vote, unless the terms of issue specified overwise, andeven 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 insufficientresources to meet it. There is an implied right to accumulation of dividends ifthey are unpaid, unless the shares are stated to be non-cumulative. Payment ofsuch arrears has priority over future ordinary dividends. And if the companygoes into liquidation, preference shareholders are not entitled to payment ofdividend arrears or of capital before ordinary shareholders, unless their termsof issue provide otherwise, which they usually do.

Companies haveissued three varieties of preferences shares from time to time, to conferspecial rights; these are redeemable preferences shares, participatingpreferences shares and convertible preferences shares. Redeemablepreferences shares are similar to loan capital in that they are repayablebut they lack the advantage enjoyed by loan interest of being able to

charge dividend against profit fortaxation purposes, participating preferences shares enjoy the right tofurther share in the profit beyond their fixed dividend, normally after theordinary shareholders have received up to a state percentage on their capital, convertiblepreferences shares give the option to holders to convert their shares intoordinary shares at the specified price over a specified period of time.

The Stock Exchange and the Capital Market

The Capital Market embracesall the activities of financial institution engaged in:

·

theraising of finance for private and public bodies whether situated in UK oroverseas (the primary market);

·

tradingthe securities and other financial instruments created by the activity above(the secondary market).

The Stock Exchange playsa central role in this international market. It provides the primary facilityfir marketing new issues of shares and other securities, and also awell-regulated secondary market in shares, British government and localauthority stocks, industrial and commercial loan stocks and many overseasstocks that are included in its Official List. Nowadays it called the LondonStock Exchange Ltd is an independent company with the Board of Directors drawnfrom the Exchange’s executive, and from the customer and user base.

The main participants onthe Stock Exchange are Retail Service Providers (RSPs) and the stockbrokers.The function of RSPs is to provide a market in securities, which theyhave nominated, and to maintain two-way prices, i.e. lower price at which theyare prepared to buy and a higher price at which thy will sell. And stockbrokerscan act for client as agent only, when purchasing or sell securities ontheir 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 bothagent and principal in carrying out clients ‘buy’ and ‘sell’ instruction.Unfortunately the integration of the broking and dealing functions within thesame financial grouping can give rise to conflict of interest, and this hasmade it essential to create a protective regulatory framework both within andbetween financial institutions.

But some companies are not suitablefor a full Stock Exchange listing and the Alternative Investment Market(AIM), setting up by the Stock Market Exchange in 1995, is a more suitablefor unknown and risky companies.

Its main features are:

·

noformal limit on company size;

·

₤500.000capitalization (full listing ₤3-₤5 million);

·

nominimum trading record (full listing five years);

·

10%of the equity capital must be in public hands (full listing 25%)

·

noentry 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 thiswork. The procedure would be probably as follows:

·

anevaluation by the Issuing House of the company’s financial standing and futureprospects;

·

anassessment if the finance required, and advise regarding the most appropriatepackage to finance to meet the need;

·

adviceof the timing of the issue;

·

agreementwith the Stock Exchange on the method of issue (sale by tender, SE placingetc);

·

completionof an underighting agreement;

·

preparationof the prospectus and other documents required by the Stock Exchange in theinitial application for the quotation;

·

advertisingthe offer for sell and the publication of the prospectus;

·

arrangementswith the bankers to receive the amounts payable;

·

theissue price of the share to be agreed at a level to ensure a success of theissue;

·

finalapplication for the Stock Exchange quotation, and signing of the listingagreement, which binds the company to maintain a regular supply of informationto the Stock Exchange and shareholders.Equity Share Futures and Options

These are traded at the LondonInternational Futures and Options Exchange (LIFFE), which was established in1982.

Both futures and options are usedby investors for:

·

hedging i.e. protecting against future capital loss in their investments;

·

speculation i.e. gambling on forecasts of favorable movements in future StockMarket prices.

Themain differences between futures and options is that futures contracts are bindingobligation to buy or sell assets, whereas options convey rights tobuy or sell assets, but not obligations. Futures are agreed, whereas optionsare purchase.

Equity Share Futures

The only equity futures dealt in on LIFFEare those based on the FTSE 100 and MID 250 Stock Indices.

Futurescontracts may b used to protect an expected rise in the market before funds areavailable to an investor. For example, an investor expecting a large cash sumin three months’ time could protect his position by buying FTSE 100 Indexfutures contract now, and selling futures for a higher sum when the marketrises. The profit made on the futures position would then compensate him forthe higher price he has pay for his investments when the expected cash sumarrives.

Equity Share Options

An option is the right to buy or sellsomething at an agreed price (the exercise price) within a stated period oftime. As applied to shares, a payment (a premium) is made through or to astockbroker for a call option, which gives the right to buyshares by a future date; or for a put option, which gives the rightto sell shares by future date. And the holder may exercise the option, orlate it lapse. However the giver (the ‘writer’) of the option, i. e. the dealerto whom the premium has been paid, is obliged to deliver or buy the sharesrespectively, if the option holder exercises his rights.

Traditionaloptionshave been dealt in for over 200 years, andare usually written for a date three month’ hence, when either the shares areexchanged, or the option lapses. The disadvantage of the traditional option isthat it cannot be traded before the exercise date, and it was because of thisinflexibility that the traded options market was created in the UK in1978.

Equity optionswere first traded on LIFFE in 1992, and currently (1997), options are availableon 73 large companies’ shares. Because traded options cost much less then theunderlying shares, an investor is able to back an investment opinion withoutrisking too much money.

II. Dividend Policy and Share Valuation

1. Dividends as a ResidualProfit Decision

It would seem sensible for acompany to continue to reinvest profit as long as projects can be found thatyield returns higher than its cost of capital. In this way, the company canearn a higher return for shareholders than they can earn for themselves byreinvesting dividends. Such a policy can be optimal, however, only if thecompany maintains its target-gearing ratio by adding an appropriate proportionof borrowed funds to the retained earnings. If not, the company’s coast ofcapital would increase because of its disproportionate volume of higher-costequity capital; this would be reflected share price.

Activity:

The LTDCompany has the chance to invest in the five projects listed below:

Projects

Capital outlay, ₤

Yield rate, %

70.000

100.000

130.000

50.000

100.000

The company cost of capital is 16%its optimal debt to net assets ratio is 30% and the current year’s profitavailable to equity shareholders is ₤350.000.

Required:

·

State which projects would beaccepted, and what is the total finance requires for those projects.

·

Assuming that the companywishes to maintain its gearing ratio, how much of the required finance will beborrowed?

·

How much of this year’s profitcan be distributed?

The answers:

·

A, B and C, with yield greater than or equal to thecompany’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 caninvest the ₤140.000 received as dividends to earn a higher rate of returnthan the company could earn for them; and the ₤210.000 retained by thecompany is reinvested to shareholders’ advantage. Shareholders’ wealth isoptimized, and the dividend paid is simply the residual profit after investmentpolicy has been approved.

If companieslook upon dividend policy as what remains after investments are decided thenthe search for an optimum dividend policy is pointless. Shareholders wantingdividends can always make them for themselves by selling some of their shares.

Furthersupport for the ‘residual’ theory of dividends, and the argument that thechange in dividend policy does not affect share values, was advanced byModigliani and Miller in 1961. They contended that in a perfect market theincrease in total value of a company after it has accepted an investmentprojects is the same, whether internal or external finance is used.

Onedeficiency in the Modigliani and Miller hypothesis, however, is that theyignore costs associated with an issue of shares, which can be quite considerable.

2.

Costs Associatedwith Dividend Policy

Capitalfloatation costs are a deterrent substituting external finance for retainedearnings but there are other costs affected by the dividend decision.

Ifshareholders are left to make their own dividends by selling some shares, thisinvolves 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 aperiod of low share price, capital losses may be suffered.

Anotherimportant factor is taxation. First, when the company distributes dividend ithas to pay an advance installment of corporation tax (ACT), currently onequarter of the amount paid. But the offset against mainstream liability to paycorporation tax will be delayed by at least one year. Indeed, if the companydoes not currently pay this type of tax, the delay in setting off ACT will beeven longer, and this will tend to restrain extravagant dividend distributions.

Second, fromthe investors’ viewpoint profitability invested retained earnings shouldincrease share values, enabling shareholders to create their own dividends.Selling shares creates a liability to capital gains tax, currently 20%, 23% or40%, but subject to a fairly generous exemption limit. By comparison, dividendsin the hands of shareholders attract

higher rate of income tax (up to 40%). Thushigher-rate taxpayers may prefer comparatively low dividend payouts to minimizetheir tax burden.

Third,financial institutions confuse the taxation picture even more, through theirmajor holdings in the shares of quoted companies. They are able to set offdividends received against dividends paid for tax purpose but some may beliable to capital gains tax if they sell shares to make dividends.

The effect oftaxation on dividend decision is difficult to analyse. It may be argued thatcompanies attract investors who can match their personal taxation regimes tocompany’s dividend policy, and that those who don’t join a particular ‘taxationclub’ will invest elsewhere. If this were true, however, a change in company’sdividend policy would probably not find favour with its shareholders clientele.And would consequently affect share values, which seem to support the argumentthat dividend policy matters.

3.

Other ArgumentsSupporting the Relevance of Dividend Policy.

Activity:

As a potential investor, how would you react to the followingquestions?

a.

Would you prefer cash dividendsnow, 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 investmentneeds?

c.

If a company, in whose sharesyou invest, increases or decreases its dividend, would it change your personalinvestment policy?

Inanswer in question (a) you probably opted for cash now rather than cash you maynever see. The future is uncertain and most people take much convincing that itis in their interests to postpone income. Although the equity shareholder bydefinition is the risk-bearer, he is also entitled to a reasonable resolutionof dividend prospects to compensate for the additional risk he carries. Aninvestor will almost certainty pay higher price for earlier rather than laterdividends.

Inquestion (b), in definition, a fluctuating dividend is more risky than a stabledividend. Investors will pay more for stability, especially if it is linkedwith steady growth. Research has shown that, in general, dividends follow apattern of stability with growth. Maintenance

of theprevious year’s dividend is the first consideration, with growth added whendirectors feel that a higher plateau of profitability has been consolidated.

Asregards question (c), you would no doubt be very happy about an increase, andmight even be prompted to buy more shares – thus helping to put the marketprice up. Conversely a decreased dividend would cause to review yourinvestment, perhaps even to sell your shares to take advantage of betterinvestment opportunities elsewhere. Investors tend to believe that dividendchanges provide information regarding a company’s futures prospects, and theyreact accordingly.

4.

Practical FactorsAffecting Dividend Policy

Whatever dividend policy is thoughtto be best for a company in theory, certain practical factors influence thedecision.

Availabilityof profit The Companies Act 1985 provides thatdividends can only be paid out of accumulated realized profit less realizedlosses, whether these are capital of revenue. Previous or current years’ lossesmust be made good before a distribution can be made. If an asset is sold, any realizedprofit or loss arising can be distributed; but any profit or loss arising fromrevaluation of an asset cannot be distributed – unless and until the asset issold.

Availabilityof cash Profit may be earned during a year andyet it may hot be possible to pay a dividend because of lack of cash. This canarise for different reasons. It may already have been expected or be needed toreplace fixed and working assets, perhaps at inflated prices. Large customersmay not yet have paid their accounts or cash may be needed to repay a loan.

Otherrestrictions The company’s articles associationmay limit the payment of dividends or a lender by insert into a loan agreementto restrict the level of dividends. A company’s dividend policy cannot be so outrageouslydifferent from policies followed by similar companies in the same industry;otherwise the market price of its shares could fall. Dividends may berestricted by government prices and incomes polices.

5.

Alternatives toCash Dividends

In recent years companies have introduced more flexibility intotheir dividend policy by either:

·

issuing shares in place of cashdividends (‘scrip’ dividend);

·

repurchasing their shares.

Scriptdividends Companies may give their shareholdersthe option to receive shares rather than cash. This has the effect ofmaintaining company liquidity, and enabling the company to increase earnings byinvesting the retained cash. However company has to pay ACT on thedistribution, and the shareholders have to pay income tax.

Thus, theshareholders can increase his investment in the company, without expenseassociated with the public issue or a purchase on a stock market, but the sametime retain the option to convert his shares into cash at a future date.

Repurchasingshares Since 1981 companies have been allowedto purchase their own shares subject to certain restrictions, and the priorauthorization of their shareholders. This is normally done by utilizingdistributable profits, and the shares must be cancelled after purchasing.

Repurchasingof shares may be carried out for any of the following reasons:

·

to repay surplus cash toshareholders;

·

to increase gearing by reducingequity capital;

·

to increase EPS by reducing thenumber of shares related to an unchanging level of profit, and hopefully,therefore, the value of each remaining share;

·

to purchase the shares of alarge shareholders.
Summary

In this report we have explored animportant and long-standing issue in financial research: how do corporationsfinance themselves, the shares issuing in the Stock Market Exchange anddividend policy of the companies.

And the situation is that therapidly expanding companies suffer from the retained profit insufficiency andone of the solutions of this financial problem is going public.

But it isnot surprising that existing shareholders dig more deeply into company’s pocketby claiming dividends. And of course the public company is subject to morescrutiny than a private one.

Thus Ithink only when all other sources are exhausted your can dilute alreadyexisting shareholders’ control over the company. However corporations willinglymake issues of shares and pay dividends. So how are their dividend, financialand investment policy reconciled? This question has exercised the minds ofacademics and financial managers in recent years without any completelysatisfactory answer being produced.

References

1.

Anjolein Schmeits, ‘Essay onCorporate 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 andBrokers, Managers and Market Specialists’, Moscow NIP“2”, 1994, 340-350.

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