Ch6-Capital structure and dividend policy Flashcards
What are the components of a capital structure?
- Equity Capital, short-, medium-, and long-term debt.
What are the parameters needed to maximise the return to owners?
~ Variability of returns (this is regarding the nature of the business)
~ Degree of acceptable risk by owners
~ The desire for immediate profit than future growth
~ The willingness to provide extra capital
~ Reduction in ownership
What are the constraints of changing the capital structure?
- the nature of the business and its assets
- the degree of gearing
- effects of taxation ( taxation affects the relative composition of debt. Debt policy is most sensitive to tax rates in a high-interest rate environment)
What can assets of the business be divided into?
what is the working capital?
1 Current asset - land, equipment, etc
2. Non-current assets - inventory, cash and cash equivalents, etc
~ Working capital = current assets - current liabilities
What is the most accessible source of finance?
and what can limit this source of finance?
~ Retained Profits
~ Shareholders may demand immediate release of profits as dividends
~ Insufficient accumulated funds to finance projects
~some companies require high proportion of debt financing while others rely on equity finance
What is gearing?
What is the purpose of credit rating companies?
Gearing is the ratio of debt to equity - the cost of financial failure to rise.
The greater the debt, the less likely the available assets will be able to pay all debts
- They monitor the financial status of major companies. This is because Lenders will wish to consider the existing debt before providing further funds.
Example the market has on the company
~ The share price reflects the information the market has on the company
- In A medium-sized company with high growth - the value of the shares may be diminished by the market’s expectations that the shareholders will be asked to put up more funds. in a low-growth industry, the converse applies
- Cyclical industry- the most efficient company will have a high gearing when activity is at its peak but will be structured to be able to reduce debt.
- A declining industry- if a company diversifies, it will be capital hungry and will need to adapt its capital structure to that of the industry
- People’s business- selling the skills and abilities
- High growth but high risk industries- loan capital is unlikely to be available but the shareholders will be rewarded for the risks they bear
~the more a company’s capital structure fits the market perception, the higher the shares will be rated.
What are the main features of company taxation?
`~ interest payments are tax-deductible
~ capital allowances on new plant and equipment are deductible
~ Lease of plants and equipment are deductible
~ Property rental payments are tax-deductible
The risk from debt is reduced by company tax
There is a tax incentive to increase gearing and take on more debts.
what are the fundamentals of the Dividend Policy?
~it is a financing decision- money paid out by way of dividends is no longer available for investment.
this is true for unlisted companies because
~the company does not have the option of raising further funds in the stock market
~the borrowing power tends to be more restricted
What are the factors influencing the dividend policy?
D.M.L.L.H.H
- The lower rate of return- the company should not retain profit if the rate of return they achieve on re-investment is less than their investors’ required rate of return
- ANNOUNCEMENT OF DIVIDEND CUTS- there are significant adverse reactions to dividend cuts. This causes businesses to tend to conservatism.
- LARGE CASH RESERVES- to reduce the cash pile, the company offer more dividends(from this cash) to gain more loyalty from the shareholders and also prevent takeover bid.
- NON-TAXPAYING SHAREHOLDERS- company with a large proportion of non-taxpaying shareholders has to distribute more proportion of earnings.
- HIGH-GROWTH INDUSTRIES- companies in high-growth industries may pay fewer dividends in order to maintain a competitive advantage, rather than making a frequent rights issue.
- HIGH/LOW DIVIDEND POLICY AND CHANGING POLICY-companies with high dividends payout tend to attract investors who seek high payouts. Readjusting the portfolio causes market reactions (the business might find it difficult to find investors, it might happen that the investors are not happy with the policy, and the policy portfolio of the business might cause the company not to have retained earnings since they will be trying to gain investors)
- MARKET RATING- a change of dividend policy has significant repercussions for the company’s market rating and its capacity to raise finance.
What are the consequences of changing the dividend policy?
the financial standing of the company in the minds of the investors is damaged and they may like to dispose of their holdings
this is because they may think the company is struggling financially which has the potential of not paying the dividends in n future, hence ruining the image of the business and discouraging the investors from investing.
It adversely affects the market price of shares of the company.
What is a dividend policy?
A dividend policy is the policy a company uses to structure its dividend payout to shareholders.
How do dividends affect a business?
If a company pays stock dividends, the dividends reduce the company’s retained earnings and increase the common stock account.
What are the alternative ways of distributing the profit?
~Income can be distributed in the form of Regular dividends
~an alternative to cash dividends is scrip, stock, or share dividends
- stock/share dividends are paid in the form of extra shares
- scrip dividends retain funds to be used for investment, therefore improving earnings. The capital base also increases
~ if a company has large reserves that it doesn’t need to run the business undertakes a share buyback through
- Purchase of shares in the open market
- Fixed price offer
- A tender offer
- Direct negotiation with a major shareholder
~ Companies may offer non-cash dividends in the form of product samples or discounts on services
~ May offer automatic dividend reinvestment plans- this includes the issue of new shares at a discount to market price.
What is the market value of the company?
~it is the market’s valuation of future dividends
~a consistent dividend policy is important in building the clientele of investors, and unexpected change can have a negative effect on perceptions of the company’s worth.
~ the financial management must therefore consider the likely effect on investor’s perception of any dividend announcement.
~investors have some expectations of a dividend policy. If the expectation is not fulfilled, the investors will move the shares where dividend policy is compatible with the dividend policy
