ACCA F9 Financial Management - 2010 - Study text

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Chapter 12: Sources of equity finance

The theoretical ex-rights price can be calculated as follows.

Marketvalueof5existingshares (5×$3.70) 18.50

Issuepriceof2sharesintherightsissue (2×$3.00) 6.00

Theoreticalvalueof7shares 24.50



Theoreticalex‐rightsprice (=$24.50/7) $3.50

The value of rights

In theory, the holder of five shares in the company in the previous example could

buy two new shares in the rights issue for $3 each, and these two shares will be

expected to rise in value to $3.50, a gain of $0.50 for each new share or $1.00 in total

for the five existing shares.

We can therefore say that the theoretical value of the rights is:

 $0.50 for each new share issued, or

 $0.20 ($1.00/5 shares) for each current share held.

Shareholders are allowed to sell their rights to subscribe for the shares in the rights

issue, and investors who buy the rights are entitled to subscribe for shares in the

rights issue at the rights issue price. The most common way of stating the value of

rights is the value of the rights for each existing share. In the example, the

theoretical value of the shares would normally be stated as $0.20.

3.3 The shareholders’ choices

When a company announces a rights issue, the shareholders have the following

choices:

 They can take up their rights, and buy the new shares that have been offered to

them.

 They can renounce their rights, and sell the rights in the market. By selling

rights, the shareholder is selling to another investor the right to subscribe for the

new shares at the issue price.

 They can take up some rights and renounce the rest. This is a combination of the

two options above.

 They can do nothing. If they do nothing, their existing shares will fall in value

after the rights issue (perhaps from the cum rights price to the theoretical ex-

rights price), and they will suffer a loss in the value of their investment. The

company might try to sell the new shares to which the ‘do-nothing’ shareholders

were entitled, and pay them any surplus receipts above the rights issue price.

However, the ‘do-nothing’ shareholders are still likely to suffer a loss.

If a shareholder takes up his rights, in theory he will be no worse and no better off.

Similarly, if a shareholder renounces his rights and sells them, he will be no better

and no worse off.

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Example

A company announces a 1 for 4 rights issue. The issue price is $5 per share. The

current market price per existing share is $6.25.

The theoretical ex-rights price can be calculated as follows:

Marketvalueof4existingshares (4×$6.25) 25.00

Issuepriceof1shareintherightsissue (1×$5.00) 5.00

Theoreticalvalueof5shares 30.00



Theoreticalex‐rightsprice ($30.00/5) $6.00

 If a shareholder takes up his rights, he will be required to subscribe $5 in cash to

purchase each new share. In theory, the value of his shares will rise from $25 for

every four shares he owns to $30 for every five shares that he owns, but he has

paid an additional $5 to the company. In theory, he will therefore be neither

better off nor worse off. In practice, the gain or loss on his investment will

depend on what the actual share price is after the rights issue (since the actual

share price might be higher or lower than the theoretical ex-rights price).

 If the shareholder renounces his rights and sells them, the theoretical value of his

rights will be $0.25 ($(6 – 5)/4 shares)) for each existing share. If he sells his

rights at this price, he will earn $1 for every four shares that he owns. After the

rights issue, the value of his four shares will fall, in theory, from $6.25 to $6 each,

or from $25 to $24 for every four shares. There will be a theoretical fall in his

investment value by $1 for every four shares held, but this is offset by the sales

value of the rights. In theory, he will therefore be neither better off nor worse off.



$

Cumrightsvalueoffourshares(4×$6.25) 25.00

Theoreticalex‐rightsvalueoffourshares(4×$6.00) 24.00

Expectedfallinvalueoffourshares (1.00)

Salevalueofrights(4×$0.25) 1.00

Netgain/loss 0.00

3.4 Advantages and disadvantages of rights issues

Rights issues give existing shareholders the right to buy the new shares in a share

issue. If an issue did not have to be a rights issue, the company would be able to

offer the shares to all investors.

Chapter 12: Sources of equity finance

Advantages

The advantages of a rights issue are as follows:

 A rights issue gives shareholders the right to retain the same percentage of the

company’s total share capital, and so avoid a ‘dilution’ in the proportion of the

company that he owns.

 A rights issue prevents the company from selling new shares at below the

current market price to other investors.

Disadvantages

The disadvantages of a rights issue are as follows:

 The company might want to raise a large amount of cash for new investment,

but the existing shareholders might be unwilling or unable to invest in the new

shares.

 Shareholders can retain the same proportion of shares in the company by

subscribing for new shares in the issue. There is no reason to give them

preferential treatment.

 If a new share issue is offered to all investors, the issue price might be at or near

the current market price, instead of at a discount to the current ‘cum rights’

price.

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Dividend policy

 The relationship between the dividend decision and the financing decision

 Shareholder preferences

 The nature of dividend policy

 Theories of dividend policy

 Modigliani and Miller’s theory of the irrelevance of dividend policy

 Practical influences on the dividend decision

4 Dividend policy

4.1 The relationship between the dividend decision and the financing

decision

Total earnings are retained or paid out in dividends. Retained earnings are the

surplus profits available to the company for investment after dividend has been

paid. Dividends reduce equity capital.

When a company wants to raise more capital for investment, it could do so by

paying no dividend at all and retaining 100% of earnings. The only external capital

it then needs to raise is the amount by which its capital requirements exceed its

earnings.

In practice, however, not many companies would do this. Instead, they have a

dividend policy that they make known to their shareholders and try to apply in

practice (subject to profits being large enough). Even when they want to raise fresh

capital, they will probably continue to pay dividends.

4.2 Shareholder preferences

Some shareholders prefer to receive dividends from their equity investments.

Others are not concerned about dividends and would prefer the company to

reinvest all its earnings in order to pursue growth strategies that will increase the

market value of the shares. Many shareholders prefer a mixture of dividends and

retaining some profits for share price growth. (For many years, for example,

software giant Microsoft had a policy of retaining its earnings to invest in growth,

with no dividend payouts.)

Shareholders will buy and hold shares of companies that pursue a dividend policy

consistent with their preferences for dividends or share price growth, and

companies might try to pursue a dividend policy consistent with the preferences of

most of their shareholders

Chapter 12: Sources of equity finance

4.3 The nature of dividend policy

In practice dividend policy might be stated in terms of an intention of the board of

directors to increase annual dividends inline with growth in earnings per share.

When dividends increase by the same proportionate amount as the rise in EPS, it is

said to maintain a constant ‘payout ratio’.

Shareholders can monitor the future profit expectations of the company to predict

the amount of dividends they are likely to receive in the future.

4.4 Theories of dividend policy

There are several theories about dividend policy. These theories are intended to

identify the optimal amount of dividends that a company should pay to the

shareholders. Three of these theories are:

 the traditional view of dividend policy

 residual theory

 Modigliani and Miller’s theory of the irrelevance of dividend policy.

Traditional view of dividend policy

The traditional view of dividend policy is that the amount of dividend payments

should be at a level that enables the company to maximise the value of its shares.

Retaining earnings adds to earnings growth in the future, and earnings growth will

enable the company to increase dividends in the future.

For example, suppose that a company pays out 40% of its earnings in dividends and

retains the remaining 60% of earnings which it can reinvest in the business to earn a

return of 10% per year. For every $100 of earnings in the current year, it will pay

dividends of $40 and by reinvesting $60 it will add to future annual earnings by 6%

(= 60% × 10%) each year. Annual earnings next year will be $106.

Similarly if a company retains only 20% of its earnings which it can reinvest at 10%,

for every $100 of earnings in the current year, it will pay dividends of $80 and by

reinvesting $20 it will add to future annual earnings by 2% (= 20% × 10%) each year.

Annual earnings next year will be $102.

There is a model for the valuation of shares based on expectations of future

dividend growth, known as Gordon’s growth model or the dividend growth model.

This model is described in a later chapter on valuation.

According to traditional theory of dividend policy, the optimal dividend policy is

the dividends and retentions policy that maximises the share price using the

dividend growth model to obtain a share price valuation.

Residual theory of dividend policy

The residual theory of dividend policy is that the optimal amount of dividends

should be decided as follows.

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 If a company has capital investment opportunities that will have a positive NPV,

it should invest in them because they will add to the value of the company and

its shares.

 The capital to invest in these projects should be obtained internally (from

earnings) if possible.

 The amount of dividends paid by a company should be the residual amount of

earnings remaining after all these available capital projects have been funded by

retained earnings.

 In this way, the company will maximise its total value and the market price of its

shares.

A practical problem with residual theory is that annual dividends will fluctuate,

depending on the availability of worthwhile capital projects. Shareholders will

therefore be unable to predict what their dividends will be.

4.5 Modigliani and Miller’s theory of the irrelevance of dividend policy

Modigliani and Miller (MM) developed a theory to suggest that dividend policy is

irrelevant, and the level of dividends paid out by a company does not matter. The

total market value of a company will be the same regardless of whether the

dividend payout ratio is 0%, 100% or any ratio in between.

Their theory was based on certain assumptions. One of these was that taxation (and

the differing tax position of shareholders and companies) can be ignored. Their

theory assumes a tax-free situation.

MM argued that the value of a company’s shares depends on the rate of return it

can earn from its business. ‘Earning power’ matters, but dividends do not. They

argued that if a company has opportunities for investing in capital projects with a

positive NPV, they can either:

 use retained earnings to finance the investment, or

 pay out earnings and dividends and obtain the equity that it needs for capital

investment from the stock market.

For example if a company has earnings of $100 million and investment

opportunities costing $100 million that have a positive NPV, it does not matter

whether it pays no dividend and invests all its earnings on the capital projects, or

whether it pays dividends of $100 million and raises new equity capital of $100

million for the capital project investments.

If the company pays out dividends and raises new equity capital, the existing shares

will fall in value by the amount of the dividend payments. However this loss of

value will be replaced by the new equity raised in the market, so the total value of

the company’s equity will be unaffected.

 Loss in value of existing shares = Amount of dividends paid

 Total value of equity before the dividend payment and equity issue = Total

value of equity after the dividend payment and equity issue

Chapter 12: Sources of equity finance

Whenever shareholders want cash, it does not matter whether they obtain it in the

form of dividends or by selling their shares in the market.

One initial criticism of this theory of dividend irrelevance was that some

shareholders have a preference for high dividends, so dividend policy does matter.

MM responded by arguing that companies often have a consistent dividend policy

with a constant payout ratio. Shareholders will be attracted to holding shares in the

companies whose dividend policy is consistent with their own dividend preference.

Criticisms of irrelevance theory

However, there are other criticisms of MM’s theory of dividend irrelevance.

 The theory assumes that there are no costs involved in raising new equity

capital, so that there is no cost difference between retaining earnings and raising

new equity.

 Similarly, MM assumed that there are no costs involved in selling shares, so that

shareholders should be indifferent between getting cash in the form of dividends

or getting it by selling some shares.

 MM assumed that shareholders possess perfect information about the returns

that will be obtained by companies from their new capital investments. Since

future earnings can be predicted with confidence, MM argued that share prices

would remain close to their real value. In practice, however, this is not the case.

Shareholders cannot always assess the real value of their shares with confidence:

this is one reason why many shareholders prefer high cash dividends instead of

the prospect of bigger capital gains in the future.

4.6 Practical influences on the dividend decision

There are several practical limitations and influences on the amount of dividends

paid by companies.

Investment opportunities

The amount of earnings a company wishes to retain might be affected by the

number of suitable investment opportunities available to the company. If there are

few investment projects available which can generate sufficient return then surplus

cash should be returned to shareholders. Companies might payout as dividends any

surplus cash for which they have no long-term need

Legal constraints

There might be legal restrictions on the maximum dividend payments. Companies

can only pay dividends out of accumulated net realised profits. There may also be

restrictions imposed by loan agreements to protect lenders.

Liquidity

Retained profit is not the same as retained cash. A company might be highly

profitable but still have low levels of surplus cash. The dividends paid must not

threaten a company’s liquidity and dividends might be limited by the availability of

cash.

Paper F9: Financial management

Dividends as a signal to investors and shareholder expectations

A dividend which differs from shareholders expectations about dividends might

send signals to the market and affect share price.

 A higher than expected dividend may signal that the board of directors are

confident about the future and may lead to an increase in share price

 A lower than expected dividend may signal that the company is in financial

difficulties and lead to a fall in share price.

Investors usually expect a consistent dividend policy from year to year or steady

dividend growth. This can lead to pay-out ratios fluctuating as companies seek to

hold a steady dividend as earnings fluctuate.

A company might also use dividend policy to send signals to the stock market about

its future prospects and intentions.

4.7 Alternatives to cash dividends

There are alternatives to paying cash dividends.

Scrip dividends

A company that wants to retain cash for reinvestment but does not want to reduce

its dividends might offer its shareholders a scrip dividend. A scrip dividend is a

dividend paid in the form of new shares. Instead of receiving cash, the shareholder

receives new shares.

The rules of the stock exchange might require that when a company wants to make

a scrip dividend, it must offer a cash dividend alternative, so that shareholders can

choose between new shares and cash.

In practice, scrip dividend shave not proved popular and they are fairly uncommon.

Share repurchases

Share repurchases were mentioned in a previous section of this chapter. If a

company has surplus cash and is over-capitalised, it might decide to repurchase

some shares as an alternative to paying out the cash in the form of a higher

dividend.

If a company chooses to pay a higher dividend, this might act as a signal to

shareholders who then expect high dividends in future years too. If the cash is used

for share repurchases instead of higher dividends, future dividend expectations will

not be affected.

Paper F9

Financial management

CHAPTER

Sources of finance:

debt capital

Contents

1 Usingdebtcapital

2 Convertiblebondsandbondswithwarrants

attached

3 Preferenceshares

Paper F9: Financial management

Using debt capital

 The nature of debt finance

 Long-term, medium-term and short-term debt finance

 Interest payments

 Tax relief on interest

 Straight debt

 Access to the bond markets for companies

 Debt finance and risk for the borrower

 Advantages and disadvantages of debt finance to the investor

 Finance leases

1 Using debt capital

1.1 The nature of debt finance

The term ‘debt finance’ is used to describe finance where:

 the borrower receives capital, either for a specific period of time (redeemable

debt) or possibly in perpetuity (irredeemable debt)

 the borrower acknowledges an obligation to pay interest on the debt for as long

as the debt remains outstanding, and

 the borrower agrees to repay the amount borrowed when the debt matures

(reaches the end of the borrowing period).

For companies, the most common forms of debt finance are:

 borrowing from banks

 issuing debt securities.

Debt finance might be secured against assets of the borrower. When a debt is

secured, the lender has the right to seek repayment of the outstanding debt out of

the secured asset or assets, in the event that the borrower fails to make payments of

interest and repayments of capital on schedule. The secured assets provide a second

source of repayment if the first source fails.

When a debt is unsecured, the lender does not have this second source of

repayment in an event of default by the borrower.

For both secured and unsecured debt, the borrower is usually required to give

certain undertakings or ‘covenants’ to the lender, including an undertaking to make

interest payments in full and on time. The borrower will be in default for any breach

of covenant, and the lenders will then have the right to take legal action against the

borrower to recover the debt.

ACCA F9 Financial Management - 2010 - Study text - Emile Woolf Publishing

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