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Write an essay on the evaluation of the value of a firm based on the dividend policies.
The current study sheds light on the evaluation of the value of a firm based on the dividend policies. This section therefore presents in detail the empirical evidences that support the process of evaluation of the market value of a firm founded on the dividend principles. In addition to this, the present report elucidates in detail the capital structure of a firm, business and financial risk, debt capacity and optimal capital mix with reference to the operations of Easy Jet. Easy Jet is a well known European Airline company that operates in the low cost market segment. The company is serving across 30 nations in Europe in and operating in around 800 routes. The company has a competitive advantage in the market owing to its innovative network design and its ability to effectively utilize its resources.
As rightly put forward by Arnold (2014), the dividend policy refers to the regulations or else guidelines that a corporation employs in order to decide the total amount of the proceeds that can be circulated to all the investors of the firm in the form of dividends. However, in particular, company’s board of directors declare the dividend amount to all the shareholders of the company. However, then dividend policy of a firm depends on several factors such as the availability of various opportunities of business, anticipation of future earning, legal compulsion, liquidity structure of the firm and many other factors (Arnold 2014).
In addition to this, the dividend policy of a corporation can be further categorized into three different classes based on the amount of dividend disbursements and the frequency of dividend payments. The three different categories types of the dividend policies are the stable dividend scheme, constant dividend strategy as well as the residual dividend policy (Brigham and Houston 2012).
The business concern adopting the stable dividend policy makes steady strategies in the company. The stable dividend policy is also known as the regular policy as the company makes payments at fixed rates and maintains the same for a long time period even at the time of fluctuating profit (Brealey et al. 2012). The steady dividend policy also makes payments for dividends regularly every year. The concern making the payments can meet the requirements and at the same time satisfy the shareholders and can augment the credit amount in the market. Again, the level of dividend need to be steady that in turn can help in increasing the long term finance of the corporation. In addition to this, the constant dividend ratio refers to the payment of the fixed percentage of earnings as the dividends each year. Residual dividend policy points out towards the process the management of the company employs to finance different capital expenditures along with the accrued earnings before payments made to the shareholders (Brealey et al. 2012). However, this policy also generates greater volatility in the dividend payments to the financiers of the company each year.
The theory on dividend strategy has generated academic as well as empirical study particularly after the proposal of the dividend irrelevance hypothesis proposed by Miller and Modigliani. In the field of corporate finance, all the finance managers face the two significant operational decisions that include investment as well as the financing decision. Again, as rightly indicated by (Aebi et al. 2012), the matter of the corporate dividend policy is essentially established as a result of the development of the business. The emergence of the different dividend policy principles is very significant to the investors and is primarily driven by the evolving state of different financial markets. The principles on dividend policy are primarily classified into two different types founded on different association between the scheme of dividend and the firm’s value. However, a number of important theories on dividend strategy in the area of financial management include the Walter’s Model, Gordon’s Model and Modigliani and Miller Model/ Hypothesis (Christoffersen 2012).
Walter’s Model:
Arnold (2014) critically discusses the fact that the selection of the dividend plan influences the overall worth of the business concern. However, the model reflects the significance of the association established between the internal rate of return of the corporation denoted by r and the cost of capital represented by (k) in determination of the dividend plan that can maximize the wealth of the shareholders.
Walter’s Model is founded on different suppositions as presented below:
(i) The company funds various investments through retained earnings and do not employ the debt or else new equity (Arnold 2014)
(ii) The internal rate of return of the corporation as well as the cost of capital remains constant
(iii) The earnings generated by the company can be either allocated as dividends or else reinvested with immediate effect.
(iv) The earnings as well as dividends at the beginning of the year do not change. In particular, the values of the earnings per share (EPS) and the dividend per share (DPS) can be altered in this theory so as to find out the outcomes. However, the given worth of earnings per share as well as the dividend per share are supposed to remain constant everlastingly in determination of the agreed value.
(v) The business concern has a very long or unlimited life (Grzegorz 2012)?
The formula of Walter’s Model for the determination of the market price per share is as presented below:
Here, P stands for market price per share, D stands for the dividend per share and E presents the earnings per share. The above mentioned equation plainly discloses the fact that the market price per share of the company is essentially the sum of the present value of two different sources of income. In this case, the (D/K) represents the present value of the unending stream of steady dividends in addition to the present value of the endless stream of gains.
As rightly indicated by Arnold (2014), the Walter’s model can effectively reflect the effects of a particular dividend plan in all the organizations employing equity in diverse suppositions regarding the rate of return. Nevertheless, the easy nature and character of the results of the theory can lead to results that are not correct in nature albeit the fact that it is appropriate under the Walter Model. In addition to this, the method of share valuation under the Walter Model combines the dividend strategy with the investment strategy of the firm. Brigham and Ehrhardt (2013) opines that the Walter’s Model presumes that the investment prospects of an organization are essentially funded by the retained earnings. However, the theory assumes that the financing process does not employ external debts or equity for funding operations. For that reason, the investment policy or else the dividend strategy or both remains sub optimal. Subsequently, the wealth of the owner also do not maximize owing to the sub optimal investment policy of the firm (Lasher 2013).
Furthermore, the Walter’s Model is entirely primarily founded on the supposition that the internal rate of return that is the (r) remains constant in an organization. However, in practice the internal rate of return decreases with increase in the investment. Therefore, this reveals the fact that the most profitable investments are made first and thereafter the lesser profitable investments are carried out. The model indicates the fact that the business concern needs to arrive at a situation where the internal rate of return is equal to the cost of capital that is (r=k) (DRURY 2013). This policy of equalising the r and k is also erroneous as the concerns fail to maximize the wealth of the owner in this manner. In addition to this, the cost of capital of a firm that is the discount rate alters with changes in the risks proposition of the business. Therefore, the present value of the organization changes inversely with respect to the cost of capital of the business concern. Thus, the assumption of constant rate of discount remains nonfigurative about the influence of risk on the total value of the organization.
As rightly put forward by Titman et al. (2015), Myron Gordon proposed a very model that explicitly relates the market value of an organization to the strategy of dividend. This particular model propounded by Gordon is based on certain assumptions as mentioned below:
(i) The business concerns are essentially all equity firms (Titman et al. 2015)
(ii) External financing is not available for investment
(iii) Firm’s internal rate of return remains constant
(iv)The earnings of the organization are continuous
(v) The discount rate of the firm is also considered to remain fixed
(vi)There is no existence of corporate tax
(vii) The ratio for retention (b), once determined, remains constant. Therefore, the rate of growth (g) equals to br and remains fixed forever. Again, the cost of capital needs to greater than br=g in order to get a significant worth of the share.
Therefore, consistent with the dividend capitalization model of Gordon, the market worth of a share equalizes with the present value of the endless flow of dividend that can be acquired from the firm’s share (Titman and Martin 2014). Therefore, in accordance with the Gordon’s theory, the formula for market value of share of a firm is as shown below:
Here, P represents the market price of share, E reflects the current level of earning, b shows the dividend policy, k represents the cost of capital and r reflects the internal rate of return. The above mentioned equation clearly reflects the association between the current earnings represented by (E), strategy of dividend, internal profitability along with the cost of capital of the organization.
As rightly mentioned by Brigham and Ehrhardt (2013) the Modigliani and Miller’s model states that the dividend strategy of an organization bears no relevance as it does not influence the shareholder’s wealth. This theory put forward the argument that the value of an organization is primarily dependent on the earnings of the business that in turn results from the investment strategies. Therefore, given the investment policy of the firm, the segregation between the dividend pay- out ratio and the retention ratio bears no relevance in determination of the overall value of the firm (Weil et al. 2013). This model is based on certain assumption as follows:
(i) The organization functions in a perfectly capital market
(ii) There is no existence of tax (Weil et al. 2013).
(iii) The organization has a pre determined as well as fixed policy of investment
(iv)There is no existence of the risk arising out of uncertainty. This implies that that financiers and investors can forecast the future prices of the shares as well as the dividends of the firm. Furthermore, the assumptions state that only one rate of discount for the securities at different period is appropriate (Weil et al. 2013).
Therefore, as per the assumptions of the Modigliani and Miller’s Model, the internal rate of return that is the (r) remains equal to the rate of discount and is alike for every share. Therefore, the market price of each and every share needs to adjust to the rate of return that is chiefly composed of the rate of dividends as well as capital gains. Therefore, the rate of return on a share can be calculated by using the following formula:
Here, P0 is the market price of each share at the time period 0. Again, P1 is the market or else the purchase price per share at the time period 1. Here, D represents the dividend per share during the time period 1. As per the assumptions of this model, the rate of return needs to be equal for each and every share. This assumption reflects the fact that the shares yielding lower rate of return can be put up for sale by the investors who intends to buy the shares that yields higher rate of return. However, this course can tend to decrease the price of the shares that yield lower rate of return and increase the prices of the shares that yield higher rate of return (Healy and Palepu 2012). Consequently, this process of switching can continue till the time the differentials in the rate of return can be eliminated. Again, the rate of discount shall also remain equal for all businesses under the assumptions of the model as this model eliminates the risk differentials. Therefore, according the principle of the M-M hypotheses, the valuation model can represented by the following equation as presented below:
We can arrive at the value of the firm by multiplying values in either sides of the above mentioned equation by the total quantity of stocks that is outstanding (represented by n), given the fact that there exists no external source of financing (Healy and Palepu 2012).
Now, in case if the firm markets new shares during the time period 1 at price P1, the value of the firm during the time period 1 can be represented as shown by the equation mentioned below:
Therefore, the above mentioned equation shows that the valuation process under the M-M hypotheses permits for the issuance of the new shares. Therefore, the organization can make dividend payments and at the same time raise funds in order to optimise the investment strategy.
As agued by Healy and Palepu (2012), the M-M hypotheses lacks relevance owing to the underlying unrealistic assumptions. For instance, the non-existence of tax is unreal and inappropriate. Again, this model states that the shareholder’s wealth remains same irrespective of dividend payment policy of the firm. However, owing to transaction cost as well as other inconveniences related to the process of acquiring capital gains from the the share sale, the shareholders tend to prefer dividends more than the capital. Again, Davis, J.A., Marino and Vecchiarini (2013) argues that the assumption of equal discount rate for both internal as well as external financing is also not appropriate. The rate of discounts generally becomes different at the time when the investors tend to diversify the portfolio.
Evaluation of the financial performance and the overall business operation of Easy Jet
The present section analyses the financial performance of the company Easy Jet by taking into consideration the annual report published by the company during the year 2015. The current segment focuses on the analysis of the financial statements of the firm by using different key financial ratio.
As rightly put forward by Weil et al. (2013) gross profit refers to the operational efficiency of the firm and the company to generate profits out of the available resources. The assessment of the financial declaration can help in investigation of the profitability of the firm using the key profitability ratio that includes the return on equity, return on capital invested and the interest coverage. Return on equity refers to the potential of the firm to generate earnings out of the equity investments of the firm. The percentage of return on equity during the year 2015 has increased to 24.79% from 21.48% recorded during the year 2014. This shows a favourable financial condition as the increase in return on equity greater effectiveness of operations that in turn has generated better returns on the equity investments. Again, the return on capital refers to the ability to the firm to generate income out of the capital employed. The calculations show that the percentage rate of return on capital employment has also increased during the year 2015 to 20.2 as compared to 16.73 recorded during the year 2014.
As rightly put forward by Weil et al. (2013), the liquidity ratio reflects the ability of the company easy Jet to make payments for its debt compulsions. However, the liquidity ratio primarily includes the current ratio as well as the quick ratio among many others. The current ratio essentially refers to the capacity to pay off its debt obligations during the short term and is enumerated by dividing the current assets by the current liabilities. The current ratio of Easy Jet is recorded to be 0.72 during 2015 and has marked a decrease from 0.89 registered during the year 2014. This indicates an unfavourable condition as the current assets have decreased in comparison to the current liabilities. Again, the quick ratio also signifies the capacity and competence of the firm to repay the obligations with the liquid assets that includes the cash and cash equivalents during the short term (Weil et al. 2013). The quick ratio during the year 2015 is registered to be 0.66. This ratio has decreased from 0.66 during the year 2015 from 0.79. The decrease in the quick ratio reflects an undesirable financial condition of Easy Jet as it indicates decrease in the potential of the firm to meet up requirement of debt repayments with its liquid assets during the short term.
The efficiency ratio points out towards the ability of the firm to critically analyse the ability of the company to effectively utilize both the assets as well as liabilities (DRURY 2013). The efficiency ratio therefore enumerates different turnover of receivables, quantity and at the same time use of the inventory and equipment. Receivable turnover ratio refers to the number of times a concern acquires average receivable each year (DRURY 2013). The accounts receivable turnover is registered to be 80.79 during the year 2015 as compared to 60.36 recorded during the year 2014. The asset turnover ratio indicates the potential of the organization to generate sales out of the assets possessed by the company by comparing the total sales of the business with the average assets. The asset turnover ratio of Easy Jet is registered to be 1.01 during the year 2015 as compared to 1.01 recorded during the year 2014. This reflects a decrease in the efficiency of the firm to utilize the assets possessed by the company to generate sales. However, the decrease in asset turnover is quite insignificant during the year 2015.
The capital structure theory refers to the methodical process of financing business operations by using a combination of different of equities as well as liabilities. The capital structure principles establish the associations between different ways of financing business activities using debt and equity, with the market value of the organization. The shareholders’ equity of the firm was registered to be £2249 m during the year 2015 as compared to £2172 m. The process of raising of funds through equity is a positive sign as it implies positive elements in the cash flows under the section financing activities and at the same time an increase in the common stock calculated at par value. The borrowings of the company Easy Jet are recorded to be £283million during the year 2015 as compared to £114million recorded in 2014. The significant increase in the borrowings indicates an increase in debt in comparison to the equity of the firm. Therefore, the figures on debt and equity reflect the capital structure of the company Easy Jet. The management of the company can reduce the proportion of the debt in the capital structure of the firm with the aim of reducing the risk of business operation and to increase the overall efficiency of the financing decision.
The current section also presents a detailed analysis of the business and financial risks of the firm Easy Jet. The business risk refers to the chances of loss that is inherent in the process of operation and the business environment of the organization. The business risk essentially impairs the potential of the business to deliver returns on investment. The business and the financial risk arising out of the debt obligations of the firm lead to the corporate risk. The business risk of the company can be analyzed by undertaking a SWOT analysis.
Assessment of the Debt capacity and the financing resource available to Easy Jet
Debt capacity of a company refers to the capability to pay off debts. The debt capacity of the company can be analysed by taking into consideration different factors. The factors are as mentioned below:
Rate of return- the rate of return helps in analysing the capacity of the firm to generate income. The financiers will sanction less debt to a company with lower rate of return and consequently lesser amount of income.
Fluctuation Rate- The high rate of return is associated to the higher capacity of the company to generate greater income. Therefore, this leads to the low fluctuation rate where the risks of acquiring return become low. The financiers can provide huge debt to corporations at such a situation.
The Debt capacity of the firm can also be calculated by the debt equity ratio that can be calculated by dividing the debt figure by the equity. During the year 2015, the debt equity ratio is recorded to be (2249/283) =7.9. However, during the year 2014, the debt equity ratio is recorded to be (2172/114) =19.05. The decrease in the debt equity shows a favourable financial position of the firm as compared to the previous year as the equity of the firm has considerably increased during the year 2015. However, the debt obligations of the company too have increased during the year 2015.
The best possible capital structure refers to the finest combination of the debt-equity ratio that in turn can maximize the value of the corporation Easy Jet. The optimal framework of the capital structure can deliver a balance between the perfect debt equity proportion and at the same time minimize the overall cost of capital of the firm. The debt equity ratio can help in analyzing the optimal capital structure. The debt equity ratio of the firm has decreased during the year 2015 as the amount of equity has also increased simultaneously. The company has increased the borrowed funds for financing the operations during the year 2015. Therefore, the management of the company can explore different alternatives for reducing the debt with the intention and purpose of lessening the financial risk of the firm. ?
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