Q4. The contention that dividends have an impact on the share price has been characterised as the bird in the hand argument. Explain the essential of this argument. Why this argument is considered fallacious?

Answer:

At the end of each year, every publicly traded company has to decide whether to return cash to its stockholders and, if yes, how much in the form of dividends. The owner of a private company has to make a similar decision about how much cash he plans to withdraw from the business, and how much to reinvest. This is the dividend decision. Dividend influences investor attitudes. Stock holders look negatively on the companies that cut dividend, since they associate such cutbacks with the financial difficulties. In establishing a dividend policy, a financial manager must determine and fulfil the owner’s objectives; otherwise the stockholders may sell their shares in turn driving down the market price of the stock. Stock holder dissatisfaction raises the possibility that control of the company may be seized by an outside group. When a company’s earning increase, management does not automatically raise the dividend. Generally there is a time lag between increased earnings and the payment of a higher dividend. Once dividends are increased, they should continue to be paid at a higher rate. Various types of dividend policies are as below:

1. Stable dividend per share policy: Many companies use a stable dividend per share policy since it is looked upon favourably by investors. Dividend stability implies a low risk company. Even in a year that the company shows a loss rather than profit the dividend should be maintained to avoid negative connotations to current and prospective investors. By continuing to pay the dividend, the shareholders are more apt to view the loss as temporary. Some stockholders rely on the receipt of stable dividends for income. A stable dividend policy is also necessary for a company to be placed on a list of securities in which financial institutions invest. Being on such list provides greater marketability for corporate shares.

2. Constant dividend payout ratio policy: With this policy a constant percentage of earnings are paid out in dividends. Because a net income varies, dividends paid will also vary using this approach. The problem this policy causes is that if a company’s earning drop drastically or there is a loss the dividends paid will be sharply curtailed or nonexistent. This policy will not maximise market price per share since most stockholders do not want variability in their dividend receipts.

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3. A compromise policy: A compromise between the policies of a stable dollar amount and a percentage amount of earning is for a company to pay a low dollar amount per share plus a percentage increment in good years. While this policy affords flexibility, it also creates uncertainty in the minds of the investors as to the amount of dividends they re likely to receive. Stockholders generally do not like such uncertainty. However the policy may be appropriate when earnings vary considerably over the years. The percentage or extra portion of the dividends should not be paid regularly; otherwise it becomes meaningless.

4. Residual Dividend Policy: When a company’s investment opportunities are not stable, management may want to consider a fluctuating dividend policy. With this kind of policy, the amount of earnings retained depends upon the availability of investment opportunities in a particular year. Dividends paid represent the residual amount from earnings after the company’s investment needs are fulfilled.

A stable dividend payout indicates to the stockholders that the firm is successful and worthwhile to invest in. The stock market views the dividend as a source of information about the future prospects of the firm. The announcement of dividends gives a ‘signal’ to the investors about the profitability of the firm.

If the dividend policy was formulated to retain larger share of earnings, plenitude of resources will be available to the firm for its growth and modernisation purposes. This will give rise to business earnings. In view of the improved earnings & financial health of the enterprise, the value of shares will increase and a capital gain will result. Thus share holders earn capital gain in lieu of dividends income, the former in the long run while the latter in the short run.

The reverse holds true if liberal dividend policy is followed to pay out higher dividends to shareholders. Consequently, the shareholders dividend earnings will increase but the possibility of earning capital gains is reduced. Investors desirous of immediate income will value shares with high dividend greatly. The stock market may, therefore, respond to this development and values of shares may zoom. It is thus evident that in retention of earnings lies on capital gains. Distribution of income, on the other hand, increases dividend earnings. Owing to varying notions and attitudes of shareholders due to difference in respect to age, tax bracket, security income, habits, preferences and responsibilities while some are

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primarily concerned with the short run returns, others think in terms of long range returns and still others seek a portfolio which balances their expectations over time. The above analysis leads us to conclude that divided decision materially affects the stockholders wealth and so also the valuation of the firm. However financial scholars have not been unanimous on this issue.

There are 2 schools of thought on dividend policy.

The dividend irrelevance school believes that dividends do not really matter, because they do not affect firm value. This argument is based upon two assumptions. The first is that there is no tax disadvantage to an investor to receiving dividends, and the second is that firms can raise funds in capital markets for new investments without bearing significant issuance costs.

There are those in another group who argue that dividends are clearly good because stockholders (or at least some of them) like them.

Although dividends have traditionally been considered the primary approach for publicly traded firms to return cash or assets to their stockholders, they comprise only one of many ways available to the firm to accomplish this objective. In particular, firms can return cash to stockholders through equity repurchases, where the cash is used to buy back outstanding stock in the firm and reduce the number of shares outstanding. In addition, firms can return some of their assets to their stockholders in the form of spin offs and split offs.

There are several ways to classify dividends. First, dividends can be paid in cash or as additional stock. Stock dividends increase the number of shares outstanding and generally reduce the price per share. Second, the dividend can be a regular dividend, which is paid at regular intervals (quarterly, semi-annually, or annually), or a special dividend, which is paid in addition to the regular dividend. Most U.S. firms pay regular dividends every quarter; special dividends are paid at irregular intervals. Finally, firms sometimes pay dividends that are in excess of the retained earnings they show on their books. These are called liquidating dividends and are viewed by the Internal Revenue Service as return on capital rather than ordinary income. Consequently, they can have different tax consequences for investors.

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Some Reasons for Paying Dividends that do not measure up

Some firms pay and increase dividends for the wrong reasons. We will consider two of those reasons :

1. The Bird-in-the-Hand Fallacy

One reason given for the view that investors prefer dividends to capital gains is that dividends are certain, whereas capital gains are uncertain. Proponents of this view of dividend policy feel that risk averse investors will therefore prefer the former. This argument is flawed. The simplest counter-response is to point out that the choice is not between certain dividends today and uncertain capital gains at some unspecified point in the future, but between dividends today and an almost equivalent amount in price appreciation today.

Another response to this argument is that a firm’s value is determined by the cash flows from its projects. If a firm increases its dividends but its investment policy remains unchanged, it will have to replace the dividends with new stock issues. The investor who receives the higher dividend will therefore find himself or herself losing, in present value terms, an equivalent amount in price appreciation.

2. Temporary Excess Cash

In some cases, firms are tempted to pay or initiate dividends in years in which their operations generate excess cash. Although it is perfectly legitimate to return excess cash to stockholders, firms should also consider their own long-term investment needs. If the excess cash is a temporary phenomenon, resulting from having an unusually good year or a non-recurring action (such as the sale of an asset), and the firm expects cash shortfalls in future years, it may be better off retaining the cash to cover some or all these shortfalls.

Another option is to pay the excess cash as a dividend in the current year and issue new stock when the cash shortfall occurs. This is not very practical because the substantial expense associated with new security issues makes this a costly strategy in the long term. Since issuance costs increase as the size of the issue decreases and for common stock issues, small firms should be especially cautious about paying out temporary excess cash as dividends. This said, it is important to note that some companies do pay dividends

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and issue stock during the course of the same period, mostly out of a desire to maintain their dividends. While it is not surprising that stocks that pay no dividends are most likely to issue stock, it is surprising that firms in the highest dividend yield class also issue significant proportions of new stock (approximately half of all the firms in this class also make new stock issues). This suggests that many of these firms are paying dividends on the one hand and issuing stock on the other, creating significant issuance costs for their stockholders in the process

Some Good Reasons for Paying Dividends

While the tax disadvantages of dividends are clear, especially for individual investors, there are some good reasons why firms that are paying dividends should not suspend them.

First, there are investors who like to receive dividends, either because they pay no or very low taxes, or because they need the regular cash flows. Firms that have paid dividends over long periods are likely to have accumulated investors with these characteristics, and cutting or eliminating dividends would not be viewed favourably by this group.

Second, changes in dividends allow firms to signal to financial markets how confident they feel about future cash flows. Firms that are more confident about their future are therefore more likely to raise dividends; stock prices often increase in response. Cutting dividends is viewed by markets as a negative signal about future cash flows, and stock prices often decline in response.

Third, firms can use dividends as a tool for altering their financing mix and moving closer to an optimal debt ratio. Finally, the commitmentto pay dividends can help reduce the conflicts between stockholders and managers, by reducing the cash flows available to managers.

Some investors like dividends

Many in the “dividends are bad” school of thought argue that rational investors should reject dividends due to their tax disadvantage. Whatever might be the merits of that argument; some investors have a strong preference for dividends and view large dividends positively. The most striking empirical evidence for this comes from studies of companies that have two classes of shares: one that pays cash dividends and another that pays an equivalent amount of stock dividends; thus, investors are given a choice between dividends and capital gains.

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John Long studied the price differential on Class A and B shares traded on Citizens Utility. Class B shares paid a cash dividend, while Class A shares paid an equivalent stock dividend. Moreover, Class A shares could be converted at little or no cost to Class A shares at the option of its stockholders. Thus, an investor could choose to buy Class B shares to get cash dividends, or Class A shares to get an equivalent capital gain. During the period of this study, the tax advantage was clearly on the side of capital gains; thus, we would expect to find Class B shares selling at a discount on Class A shares. The study found, surprisingly, that the Class B shares sold at a premium over Class A shares.

While it may be tempting to attribute this phenomenon to the irrational behaviour of investors, such is not the case. Not all investors like dividends –– many feel its tax burden–– but there are also many who view dividends positively. These investors may not be paying much in taxes and consequently do not care about the tax disadvantage associated with dividends. Or they might need and value the cash flow generated by the dividend payment. Why, you might ask, do they not sell stock to raise the cash flow they need? The transactions costs and the difficulty of breaking up small holdings and selling unit shares may make selling small amounts of stock infeasible.

The Clientele Effect

There are companies that pay no dividends, such as Microsoft, and whose stockholders seem perfectly content with that policy. Given the vast diversity of stockholders, it is not surprising that, over time, stockholders tend to invest in firms whose dividend policies match their preferences. Stockholders in high tax brackets who do not need the cash flow from dividend payments tend to invest in companies that pay low or no dividends. By contrast, stockholders in low tax brackets who need the cash from dividend payments, and tax-exempt institutions that need current cash flows, will usually invest in companies with high dividends. This clustering of stockholders in companies with dividend policies that match their preferences is called the clientele effect

Consequences of the Clientele Effect

The existence of a clientele effect has some important implications. First, it suggests that firms get the investors they deserve, since the dividend policy of a firm attracts investors who like it. Second, it means that firms

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will have a difficult time changing an established dividend policy, even if it makes complete sense to do so.

The clientele effect also provides an alternative argument for the irrelevance of dividend policy, at least when it comes to valuation. In summary, if investors migrate to firms that pay the dividends that most closely match their needs, no firm’s value should be affected by its dividend policy. Thus, a firm that pays no or low dividends should not be penalized for doing so, because its investors do not want dividends. Conversely, a firm that pays high dividends should not have a lower value, since its investors like dividends.

This argument assumes that there are enough investors in each dividend clientele to allow firms to be fairly valued, no matter what their dividend policy.

Dividends operate as a information signal

Financial markets examine every action a firm takes for implications for future cash flows and firm value. When firms announce changes in dividend policy, they are conveying information to markets, whether they intend to or not.

Financial markets tend to view announcements made by firms about their future prospects with a great deal of skepticism, since firms routinely make exaggerated claims. At the same time, some firms with good projects are under valued by markets. How do such firms convey information credibly to markets? Signaling theory suggests that these firms need to take actions that cannot be easily imitated by firms without good projects. Increasing dividends is viewed as one such action. By increasing dividends, firms create a cost to themselves, since they commit to paying these dividends in the long term. Their willingness to make this commitment indicates to investors that they believe they have the capacity to generate these cash flows in the long term. This positive signal should therefore lead investors to revaluate the cash flows and firm values and increase the stock price.

Decreasing dividends is a negative signal, largely because firms are reluctant to cut dividends. Thus, when a firm take this action, markets see it as an indication that this firm is in substantial and long-term financial trouble. Consequently, such actions lead to a drop in stock prices.

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We should view this explanation for dividends increases and decreases cautiously, however. Although it is true that firms with good projects may use dividend increases to convey information to financial markets, given the substantial tax liability that increased dividends create for stockholders, is it the most efficient way? For smaller firms, which have relatively few signals available to them, the answer might be yes. For larger firms, which have many ways of conveying information to markets, dividends might not be the least expensive or the most effective signals. For instance, the information may be more effectively and economically conveyed through an analyst report on the company. There is another reason for skepticism. An equally plausible story can be told about how an increase in dividends sends a negative signal to financial markets. Consider a firm that has never paid dividends in the past but has registered extraordinary growth and high returns on its projects. When this firm first starts paying dividends, its stockholders may consider this an indication that the firm’s projects are neither as plentiful nor as lucrative as they used to be.

Conclusion

In summary, there is some truth to all these viewpoints, and it may be possible to develop a consensus around the points on which they agree. The reality is that dividend policy requires a trade-off between the additional tax liability it may create for firms and the potential signaling and free cash flow benefits of making the additional commitment to their stockholders. In some cases, the firm may choose not to increase or initiate dividends, because its stockholders are in high tax brackets and are particularly averse to dividends. In other cases, dividend increases may result.

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Q3. Merely increasing the level of current asset holding does not necessarily reduce the risk ness of the firm. Rather the composition of current assets, whether highly liquid or highly illiquid , is the important factor to consider. Explain your position.

Answer:

Current assets are assets that are cash or are expected to become cash “currently” that is, within the next 12 months. These are the assets that produce most of the liquidity in a company and they are the main sources of working capital for the business. Here are the most typical examples of current assets.

Cash and cash Equivalents

Cash itself is the most liquid asset of all and always the first item listed on any balance sheet. Cash reserves might be kept in the form of savings accounts, bank certificates, money market accounts, short term investments, and similar cash like assets.

Accounts Receivables

Amounts due from customers and others are usually next in the current assets section of the balance sheet. The largest of these is usually called accounts receivables; it typically means trade accounts or amounts due from customers as a result of sales made on credit. When a company makes a sale, it usually does so on credit, normally expecting payment within 30 days. When the sale is made, cash is yet to flow into the company, the obligation is carried as a receivable from the buyer. When the cash is received, it is placed in the cash account and the equivalent amount is deleted from the accounts receivable account.

To maintain the integrity of accounts receivables as a current asset, there is a limit on the length of time for which an asset may be carried as an account receivable. Usually if payment is not received within 90 days, the asset has to be netted out of accounts receivable. It is generally out in a reserve for bad debts account, which is simply netted out of accounts receivable.

The two most readily convertible current asset, cash and receivables are often referred to as Liquid or Quick assets.

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Allowances on bad debts

Closely related to accounts receivables, but not always shown separately on the balance sheet, is an account called “allowance for bad debts”. This is a reserve, an estimated amount the company provides for the possibility that some customer balances will not be paid at all and will have to be written off. Any company that sells on credit has these kinds of issues to deal with-granting credit and managing customer relationships so that collection losses are as small as possible, consistent with good business practice.

Inventory

Next balance sheet item is inventory; a item used for production materials or products purchases or products manufactured and then held by the company for sale.

Raw materials: Whatever the company uses in the manufacturing process. It might be whole logs for a sawmill or it might be lumber for a company that makes furniture.

Work in Process: Products in the midst of the manufacturing process, no longer raw materials but not yet finished goods.

Finished Goods. Fully manufactured product ready for sale to customers.

Liquidity is the ability to meet current obligations with cash or other assets that can be quickly converted to cash, to pay the bills as they come due. In other words, the company has enough cash or enough assets that will become cash so that it is able to write checks without running out of money. Illiquid is the assets that cannot easily be sold or exchanged for cash without a substantial loss in value. Illiquid assets also cannot be sold quickly because of a lack of ready and willing investors or speculators to purchase the asset. The lack of ready buyers also leads to larger discrepancies between the asking price (from the seller) and the bidding price (from a buyer) than would be found in an orderly market with daily trading activity.

The management of current assets is an essential part of the business' short-term planning process. It is necessary for management to decide how much of each element should be held, because there are costs

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associated with holding either too much or too little of each element . Management must be aware of these costs in order to manage effectively the business processes. Management must also be aware that there may be other, more profitable, uses for the funds of the business. Hence, the potential benefits must be weighted against the likely costs in order to achieve the optimum investment. Obviously, the shorter current assets cycle, the more efficient a business is. If cash comes faster back into company and can be invested in a new cycle of procurement, production, and sale of goods, it generates greater return to initial cash investment. If cash does not come fast enough back into company, the company has to borrow more cash, for example from a bank, to be able to carry on with its business process.

Operating Current Assets Cycle:

Cash is used to pay for raw materials and spent also on labor and other aspects that turn raw materials into work in progress and, finally, into finished goods. The finished goods are sold either for cash or on credit. In the case of credit customers, there will be a delay before the cash is received from the sales. While the company is waiting for the cash payment to be received, it will record the amount of sales as accounts receivable. When the cash is received, the cycle is completed.

The size and composition of current assets can vary between industries. For some types of business, the investment in current assets can be substantial. For example, a manufacturing business will typically invest heavily in raw material, work in progress and finished goods, and will often sell its goods on credit, thereby generating trade debtors. A retailer,

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RAW MATERIALS

CASH

WORK IN PROGRESS

FINISHED GOODS

ACCOUNTS RECIEVABLES

on the other hand, will hold only one form of inventory (finished goods), and will usually sell goods for cash. Most businesses buy goods and service on credit, giving rise to accounts payable (a.k.a. trade creditors). Accounts payable are not an asset, but a liability of a company and are recorded in the balanced sheet as one of the elements of current liabilities.The amount of investment in raw materials depends on the conditions in the supply market and the organization and efficiency of procurement department. The amount of cash held in the form of work in progress depends on the technology used in the production process and the organization and management of the process itself. The amount of cash held in the form of inventories of finished goods depends on the conditions in the demand market and the organization and efficiency of the sales department. The amount of cash held in the form of accounts receivable depend on the conditions in the demand market, payment policy of the company, cash collecting practices and payment discipline of customers.The current ratio is a measure of entity’s liquidity. The formula is as follows:

Current Ratio = Current Assets Current Liabilities

Although high current ratios would appear to be good (If you are a creditor of a company , a high current ratio indicate that you are more likely to be paid), a ratio that is very high may indicate that a company holds too much cash, accounts receivables or inventory. Historically, a current ratio of 2.0 was considered good. However many companies strive to maintain current ratios that are close to 1.0. Managers need to look closely at the current ratio and its composition so as to have better control levels of current asset.

Acid test Ratio (Quick Ratio)

The quick ratio is a stricter test of a company’s ability to pay its current debts with highly liquid current assets. The quick ratio removes inventories and prepaid assets from the current assets amount used in the calculation of the current ratio. These current assets are considered the least liquid.

Quick Ratio = Quick Assets Current Liabilities

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A quick ratio less than 1 should be of concern to both creditors and internal managers, as it indicates that liquid current assets are not sufficient to meet current obligations.

The current ratio and quick ratio have two major weakness. The first is that all debt payments are made with cash, whereas current assets include non cash assets. The second is that both ratio focus on liquid and current assets at one point in time (The balance sheet date)

In order to monitor the efficiency of current assets management, managers often calculate the current operating assets turnover ratio. This ratio shows how many cycles happen in a certain period, typically one year. It can be calculated only for the past periods, but when planning it is frequently assumed that it will be the same in the future periods or it can be set based on experience. When the ratio is based on past data, it is calculated as follows:

The term in the numerator (operating expenses less depreciation) measures the level of business activity. Alternatively, the level of business activity can be measured also by sales. Sometimes it is reasonable to calculate the ratio also for periods shorter than one year (for example, if there is a strong seasonal effect) or for individual elements of current assets (accounts receivable turnover, inventory of raw materials turnover, inventory of finished goods turnover etc.).

The current operating assets turnover ratio tells how many times current operating assets turn over in a period (how many cycles). It is used when planning the necessary investment of cash in the business process for the next period. The necessary investment of cash in current operating assets is calculated as follows:

From this last equation, we can observe two important relationships:

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1. The higher planned level of business activity (i.e. planned operating expenses less depreciation is higher) at a certain level of current operating assets turnover, the higher investment of cash in current operating assets is needed and the higher average amount of current operating assets is held.

2. The faster current operating assets turnover (i.e. higher ratio) at certain level of business activity, the smaller investment of cash in current operating assets is needed and the smaller average amount of current operating assets is held.

Instead of calculating the turnover ratio, the same information about the speed of converting current operating assets into cash, can be obtained by calculating the current operating assets turnover period. This is calculated as follows:

The turnover period tells how long the current operating assets cycle is on average, or equivalently how many days cash is on average held in the form of other current operating assets.

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