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AC3059 Financial management

Published : 10-Sep,2021  |  Views : 10

Question:

Analysts often value a firm by reviewing its dividends and the firm’s policy on dividend. However, Miller & Modigliani (1963) posit that a firm’s dividend policy is irrelevant in its valuation.

Critically assess the above statements using relevant empirical evidence.  

Download the annual report of British Land plc and examine its capital structure. Your submission should consider:

  1. Business and financial risks facing the firm
  2. Recent financial performance
  3. Debt capacity of the business and sources of financing available to the firm
  4. Recommendation on an optimal capital mix for the firm

Answer:

Task 1:

Introduction:

The main objective of a company is to maximize the value to the shareholders and the owners. This value is often analyzed through the share price of the company. Barman (2008) explained that if dividends are known as the key indicator of share price and it is known as a key indicator of value of firm than it must be in order to enhance the shareholder wealth. When a company earns the profit, it could either retain the profits for further expansion or pay to the shareholders as dividend.

Dividend policies refer to the rules company follow to decide that how much dividends should be pay to the shareholders. Mainly the decision of dividends is taken by the board of directors and once it has been taken than the amount becomes the debt for the company. According to the Eramus (2012) the dividend amount impacts a lot over the investors mind. According to the dividend amount they analyze the worth of the firm.

This report is prepared to analyze that how much dividend policy is important for the investors to take decisions regarding the investment in the company. Further, the relevant and irrelevant, both the theories have been analyzed to reach on a conclusion.  

Dividend theories and policies:

Dividend theories are basically of 2 types. One of the theory explains that the value of the firm get impacted to the dividends and another one explains that dividend don’t make an impact over the firm value. These theories are known as dividend irrelevant theories and dividend relevant theories.

Dividend irrelevant theories:

Miller and Modigliani Model:

Earlier, it was accepted by everyone that the dividend amount decides the value of the organization. Then Miller and Modigliani (1961) came with a publication and explained that firm value does not base upon the dividends, firm pay. Earlier Gorden (1959) and Allen and Michealy (1995) argued that the required rate of return would increase with the increment of retained earnings. The M-M model disagreed with it and figure out the dividend policy framework.

M-M model described about the effect of dividend policy of an organization over its share price. They analyzed that in a perfect capital market, the dividend policy of an organization would not affect. Basically, they said that the firm value is only determined by the current cash flow and future cash flow of firm (DEEPTEE and ROSHAN, 2009). They even said that whenever an investor wants more money, they could sell out the shares to generate the cash.  

The min assumption of this theory is perfect capital market, perfect knowledge about the market to the traders. This theory explains that the value of firm is based upon the financing and investment decision within the finest capital structure, not upon the dividends and its policies. It said that management of a firm must not worry about the policies of dividend when it’s about the value of firm because the dividend value does not make an impact over the value of firm.

Empirical Evidences:

This model is basically believed that the capital market is perfect whereas in reality, the capital market is always imperfect. Believing on this assumption, black and Scholes (1974) conducted a research to analyze that whether the policies of dividend are relevant for value of firm or make an effect over it. They created a portfolio of 25 securities and test the relationship between stock returns and dividend yields. They used the expended CAPM model to test the relationship (STEEN et al., 2012). They said that E(r) on any common stock must be a linear function as follows:

 E(r) = R+ [E (Rm)-(Rf)] Beta

So they used the expanded CAPM model:

 E (?i) = ? 0+ [E (? m) -? 0] β + ? 1(δi -δm)/ δm

They expanded the model to estimate the ? 0 and ? 1 independently. They explained that if ? 1 is considerably different from 0, then dividend policy would matter and if ? 1 is inconsiderably different from 0, than dividend policy would not matter.  Through the portfolio results, Black and Scholes (1974) found that dividend policies don not make an impact over stock prices. The results of this research are reliable with the irrelevant theory that said that policies of dividend do not affect the firm value.  

Relevant theories:

Gordon’s theory:

Gordon’s dividend theories believe that the dividend price make an impact over the value of firm. It is a relevant theory of dividend policies. This theory believes that share’s market value is the continuous flow of future dividends to be rewarded. This theory states that the relation between cost of capital and rate of return and dividend payout policy influences the value of firm.

This theory assumes that company don’t raise any funds through debt, the only source company use is equity stocks to raise the funds, the IRR and cost of capital is constant, corporate taxes are not considered, retention rate is constant, cost of capital is always greater than growth rate and perpetual earning theory is taking care off.

The valuation formula of this theory is as follow:

 P = {EPS * (1-b)} / (k-g)

Empirical Evidences:

Gordon (1959) explained that behind investing in a company, an investor could have the following reasons:

  • Obtain the earnings and dividends
  • Obtain earnings
  • Obtain dividends

Gordon (1959) conducted a study on hypothesis by measuring the different models of regression using the data of steel, chemical, food and machine tool industry data of 2 years. Through this study, he found that dividends influence the value of firm on a great level. Further, he stated that required rate of return get increased with the increment in retained earnings. Fisher (1961) also stated that dividend makes a great impact over the value of firm. This model is widely accepted by the analyst to determine the value of firm and dividend policies.

Conclusion:

This paper is analyzed to examine the dividend policies and its empirical evidences. Further, the paper examined about the impact of dividend over the value of firm. It has been reviewed through the relevant and irrelevant theories that dividend is important for managers to manage the value of their firm, market value of shares and retained earnings. It could be concluded through this study that dividend theories have distinct importance between the shareholder and management from contrasting interest.

The empirical evidences studied in this paper conclude that dividend payout and value of firm have a positive relationship. The investors make a decision about investment through analyzing the dividend price of the company. Thus the analyst reviews the value of firm by conducting a research upon the dividend policies and dividend payout ratio. Thus it could ee said that a manger must take care about the dividend payout ratio to attract the investors and M-M approach is not much relevant in the practical life.

Task 2:

Introduction:

British land plc is engaging in developing, financing and managing the commercial properties in UK. Its portfolio contains the super stores, retail warehouses, department stores, retail pranks, high street shops and supermarkets. This company is qualifies as REIT (real estate investment trust) for the purpose of federal income tax (British Land, 2017). It has been founded in 1856 in London, UK. This company is among the largest property development companies in UK. It is listed in FTSE 100 index on London Stock Exchange. This company is a founding member of Estate Association and European Public real also.

Capital Structure:

Capital structure depicts about the firm capacity and method to finance the overall operations and expansion by taking the help of many sources. Capital structure of British Land Plc is studied to analyze the overall capability of the company. This report is mainly prepared to analyze the situation of thee company in industry (Investors, 2017). For analyzing the capital structure of the company following points has been studied:

Business risk:

This risk is related with the possibilities an organization would have lower than expected profits or loss rather than making profits. It is influenced by input cost, competition, per unit price, sales volume and government regulations. This risk is related with the variances of income in the British land plc.

British Land Plc’s financial report depicts that the operating leverage of the company is 3.45, contribution of the company is .93, financial leverage of the company is 1.04 and total leverage effect is 3.61. These ratios are lower than the 2015 ratios. the financial leverage of the company has been decreased from 1.58 to 1.49 (Annual Reports, 2015).  The operating income of the company has been decreased from 1941 to 1406. The reason behind these decrement is some business risk such as economy breakdown in UK, high currency volatility, less industry share etc.

Finance Risk:

This risk is associated with financing risk which includes financial transaction such as risk of default. It is often include to understand the downside risk which means that financial loss potential and uncertainties about its extent.

It has been found through the final financial report of the company that long term debt of the company has been decreased in 2016 from 29.59 to 26.57 whereas the assets f the company has been decreased from 96.45 to 95.91 (Annual Reports, 2016). The EBT of the company has been decreased from 1789 to 1331. The interest expenses of the company have been decreased by 112 to 111. Thus it could be said that company is facing a high risk in the market. All the income and assets of the company is getting decreased.

The reason behind the finance risk of the company is economic breakdown in UK, less investment in real estate industry, currency volatility etc. British Land Plc is still doing better than other companies in the market (morning star, 2017). But due to the analysis and external and internal environment company could bear a high financial risk in near future.  

Recent Financial Performance:

Financial performance is a measurement of subjects. It measures about the firm’s capability to use the assets for generating and expanding the profits and business. Financial performance is analyzed on the basis of financial statements. The main purpose of financial performance analysis is to understand the financial aspect of a firm.

Recently, company has expanded its market and invested in new projects. Still, due to some issues in the industry and country company has made less profit than last year. The investment of the company has been decreased from .83 to .82 (Aviva Investors, 2017), the long term asset of the company has been decreased from 96.45 to 95.91. the current liabilities and long term liabilities of the company has been decreased. This shows that company is still waiting for the market condition to be good to expand the market and invest into new project.

It has also been analyzed through the reports that the worth of the company has been deceased from last year. This is impacting over the total financial performance of the company. Company has raised the funds through external sources to meet the needs of the company and run the operations (Brealey, Myers and Marcus, 2007). The current ratio is increased to 1.58, quick ratio to .45 and financial leverage has been decreased to 1.49 and debt/equity to .39. This shows that company has decreased the total debts and the EBIT of the company has been decreased.

 The operations of the company are still running smoothly. The operating margin of the company has been decreased from 349.1 to 238.3. The payout ratio of the company has been increased from 16.9 to 19.2 (Davies and Crawford, 2011). The reason behind such decrement in the financial performance is global financial risk, volatility in currency, capital fluctuation, capital fight, weaker economic growth, yield, high guild etc.

Debt capacity of British Land Plc:

It refers to an estimation of amount owned by the company which it needs to pay after a certain period of time. Normally, it is calculated to know the ability of the company to borrow. This helps analysts to analyze the borrowing condition of the company.

Debt capacity of company has been decreased from last year due to global financial risk, volatility in currency, capital fluctuation, capital fight, weaker economic growth, yield, high guild etc. as now the financial condition of the company is not that much strong. Company is not in a condition to pay interest on debentures. So company has even reduced the debt capital from 29.59 to 26.57 (CORREIA et al.2013). The debt equity ratio of the company is also decreased from .47 to .39. Short term debt of the company has also been decreased from .78 to .53.

The debt capacity of the business is not that much strong because company is already facing many financial risks, if the debt liability would also increased than the profitability of the company would be lesser (Sherman, 2005). And it would directly make an affect over the investors. The dividend rate would be less and investors would get demotivated due to it. So it is suggested to the company to not raise the funds through debts for now.

Sources of financing:

There are many sources of raising the funds such as debentures, equity, debt, long term loans, short term loans, retained earnings, venture funding etc (Hillier, Grinblatt and Titman, 2011). each source has different pros and cons and used by the companies in different situation.

British Land Plc uses many sources to raise the funds. Some of them are as follows:

  • Share Capital:

This is the main source of finance in every limited company. British land plc uses this source of fiancé the most. Currently the share capital of the company is 67.33 which has been increased from 2015 i.e. 63.32 (Tucker, 2011). Cost of share capital is less than any other source in the company, so company uses this source the most for raising thee funds.

  • Debt:

Debt is also used by the company on a great level to raise the funds. The cost of debt is higher than the cost of equity. Earlier the debt of the company was 29.59 but in 2016 company has reduced it to 26.57 (Atrill and McLaney, 2006). the cost of debt is quite higher than cost of equity. So company has decreased the Debt amount and increases the Equity amount.  

  • Short term Debt:

Short term debt is used by the company to meet the short term requirement. Earlier, company had .78 of short term debt but in 2016, it has reduced by .53. Company has reduced the operations and that’s why the requirement of fund has also been less for a while (Glynn, 1993).

  • Banks:

This is the great source of finance for every company. British land plc also uses this source to raise the funds now and then. It is less risky than any other source.  

  • Financial Institute:

This is the great source of finance for every new or established company. British land plc also uses this source to raise the funds. It is less risky due to some policies and contracts between the company and institutes (FIRER et al. 2012).  

  • Bank Overdraft:

Bank Overdraft is used by the company to meet the short term requirement. Company has reduced the operations and that’s why the requirement of fund has also been less for a while.

  • Commercial Paper:

This source is also used by the company to fulfill the short term requirement. This helps the company t reduce the business and financial risk and help the company to meet the objectives.  

Recommendation and Conclusion:

Optimal capital mix explains the relation between debt and equity ratio for a firm that enhances the value of a firm. In the above study, it has been found that the condition of British Land plc is not good enough. The capital mix of British land plc was in such a condition that the financial risk of the company was quite high. And the return to the investors was quite low. The issues was faced by the company due to many external factors which were reducing the market for the company.

Though it could be recommended to the company that company must focus over the different markets to expand the business and it must maintain the financial stability by raising the funds through equity capital. Company was operating its business on a very smooth level but due to some external issues, company has not been able to manage the performance of the operations in 2015. The investors has found that if they would invest in the British land plc than the risk level would be quite high and the return level would be quite low. So the company has taken some strong decisions to reduce the losses such as reduction in debt capital, decrement in the investments.

It is recommended to the company to make a perfect optimal capital structure by reducing the some borrowings and company is suggested to make some strong policies to bear all the risk and expand the business. Company could reduce the debt and enhance the funds through equity to reduce the risk. The growth rate of the company could be increased by diversifying the market to cover all the risk. The management of the company is very strong and the vision of the company helps the company to maintain the performance and operations very well.

Although, it is suggested to the company to decrease the debt level and enhance the equity level to reduce the risk and enhance the operations of the company. The financial manager of the company must look over the proportions of equity and debt in such a manner that the financial risk could be lower. Company must set the debt equity proportion according to the company so that the share price could be at maximum and the cost of capital could be at minimum. 

Through the following study it could be concluded that British land plc is among the biggest real estate companies of the country. Still due to global financial crisis the financial performance of the company has been decreased. It has also found through this study that company has taken many strong steps to manage the financial performance.

Company has managed to save itself from losses. The decisions made by the management of the company are really appreciable. The capital structure of the company is still strong. Company has taken some bold steps to manage the capital structure. Reducing the capital from debt is one of them. It has also been concluded that company would definitely recover itself from all the risk and losses soon.   

References:

Miller, M. and Modigliani, F. 1961. Dividend policy, growth and the valuation of shares. Chcago Journals, Vol 4.p.p. 411-433

Black, F. and Scholes, M. 1974. The effects of dividend and dividend policy on common stock price and returns. Journal of financial economics.

DEEPTEE, P. and ROSHAN, B. 2009. Signaling Power of Dividends on firms futureProfits A Literature Review. Evergreen Energy- Interdisciplinary Journal, pp.1-9.

CORREIA, C. et al. 2013. Financial Management. 7th Edition. Cape Town: Juta andCompany Ltd.2.

FIRER, C. et al. 2012. Fundamentals of Corporate Finance. 5th Edition.Berkshire.McGraw-Hill Companies, Inc.

Fisher. 1961. Fundamentals of Corporate Finance. 5th Edition.Berkshire.McGraw-Hill Companies, Inc.

STEEN, E. et al. 2012. stakeholder conflicts and dividend policy. Journal of Banking & Finance, 36 pp. 2852-2864

Davies, T. and Crawford, I., 2011. Business accounting and finance. Pearson.

Glynn, J.J., 1993. Public sector financial control and accounting.

Atrill, P. and McLaney, E.J., 2006. Accounting and Finance for Non-specialists. Pearson Education.

Hillier, D., Grinblatt, M. and Titman, S., 2011. Financial markets and corporate strategy. McGraw Hill.

Sherman, S., 2005. Finance and fictionality in the early eighteenth century: Accounting for Defoe. Cambridge University Press.

Brealey, R., Myers, S.C. and Marcus, A.J., 2007. FundamentalsofCorporate Finance. Mc Graw Hill, New York.

Tucker, J.W., 2011. Selection bias and econometric remedies in accounting and finance research.

Investors. 2017. Retrieved as on 19 March 2017 from http://www.britishland.com/investors

Annual Reports. 2015. Retrieved as on 19 March 2017 from http://www.britishland.com/~/media/Files/B/British-Land-V2/documents/ar-2015/pdf/annual-report-and-accounts-2015.pdf

Annual Reports (2016). Retrieved as on 19 March 2017 from http://www.britishland.com/investors/reports/reporting-centre

Morning star. 2017. Retrieved as on 19 March 2017 from http://financials.morningstar.com/income-statement/is.html?t=BTLCY&region=usa&culture=en-US

Morning star. 2017. Retrieved as on 19 March 2017 from http://financials.morningstar.com/ratios/r.html?t=BLND&region=gbr&culture=en-US

Aviva Investors. 2017. Retrieved as on 19 March 2017 from https://www.avivainvestors.com/en-gb/media/insights/real-estate/key-risks-for-uk-real-estate-in-2016.html

The Actuary. 2017. Retrieved as on 19 March 2017 from http://www.theactuary.com/archive/old-articles/part-3/risk-analysis-in-the-property-industry/

British Land. 2017. Retrieved as on 19 March 2017 from http://www.britishland.com/

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