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Dividend policy is concerned with taking a decision regarding paying cash dividend in the

 present or paying an increased dividend at a later stage. The firm could also pay in the form of 

stock dividends which unlike cash dividends do not provide liquidity to the investors, however, itensures capital gains to the stockholders. The expectations of dividends by shareholders helps

them determine the share value, therefore, dividend policy is a significant decision taken by the

financial managers of any company.

Concept

Coming up with a dividend policy is challenging for the directors and financial manager a

company, because different investors have different views on present cash dividends and future

capital gains. Another confusion that pops up is regarding the extent of effect of dividends on theshare price. Due to this controversial nature of a dividend policy it is often called the dividend

 puzzle. 

Various models have been developed to help firms analyse and evaluate the perfect dividend

 policy. There is no agreement between these schools of thought over the relationship betweendividends and the value of the share or the wealth of the shareholders in other words.

One school consists of people like James E. Walter and Myron J. Gordon (see Gordon model),

who believe that current cash dividends are less risky than future capital gains. Thus, they saythat investors prefer those firms which pay regular dividends and such dividends affect themarket price of the share. Another school linked to Modigliani and Miller  holds that investors

don't really choose between future gains and cash dividends.

Gordon's Model

Main article: Gordon model 

Myron J. Gordon

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Myron J. Gordon has also supported dividend relevance and believes in regular dividendsaffecting the share price of the firm.

[2] 

The Assumptions of the Gordon model 

Gordon's assumptions are similar to the ones given by Walter. However, there are two additionalassumptions proposed by him :

1.  The product of retention ratio b and the rate of return r gives us the growth rate of the firm g.

2.  The cost of capital ke, is not only constant but greater than the growth rate i.e. ke>g.

Model description

Investor's are risk averse and believe that incomes from dividends are certain rather than incomesfrom future capital gains, therefore they predict future capital gains to be risky propositions.

They discount the future capital gains at a higher rate than the firm's earnings thereby, evaluating

a higher value of the share. In short, when retention rate increases, they require a higher discounting rate. Gordon has given a model similar to Walter's where he has given a

mathematical formula to determine price of the share.

Mathematical representation

The market price of the share is calculated as follows:

where,

  P = Market price of the share 

  E = Earnings per share 

  b = Retention ratio (1 - payout ratio) 

  r = Rate of return on the firm's investments 

  ke = Cost of equity 

  br = Growth rate of the firm (g) 

Therefore the model shows a relationship between the payout ratio, rate of return, cost of capital

and the market price of the share.

Conclusions on the Walter and Gordon Model 

Gordon's ideas were similar to Walter's and therefore, the criticisms are also similar. Both of 

them clearly state the relationship between dividend policies and market value of the firm.

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Capital structure substitution theory & dividends

The capital structure substitution theory (CSS)[3]

 describes the relationship between earnings,stock price and capital structure of public companies. The theory is based on one simple

hypothesis: company managements manipulate capital structure such that earnings-per-share

(EPS) are maximized. The resulting dynamic debt-equity target explains why some companiesuse dividends and others do not. When redistributing cash to shareholders, company

managements can typically choose between dividends and share repurchases. But as dividends

are in most cases taxed higher than capital gains, investors are expected to prefer capital gains.However, the CSS theory shows that for some companies share repurchases lead to a reduction

in EPS. These companies typically prefer dividends over share repurchases.

Modigliani–Miller theorem

From Wikipedia, the free encyclopedia

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The Modigliani – Miller theorem (of  Franco Modigliani, Merton Miller ) forms the basis for modern thinking on capital structure. The basic theorem states that, under a certain market price process (the classical random walk ), in the absence of  taxes,  bankruptcy costs, agency costs, and

asymmetric information, and in an efficient market, the value of a firm is unaffected by how that

firm is financed.[1]

 It does not matter if the firm's capital is raised by issuing stock  or selling debt.

It does not matter what the firm's dividend policy is. Therefore, the Modigliani – Miller theorem isalso often called the capital structure irrelevance principle.

Modigliani was awarded the 1985 Nobel Prize in Economics for this and other contributions.

Miller was a professor at the University of Chicago when he was awarded the 1990 Nobel Prizein Economics, along with Harry Markowitz and William Sharpe, for their "work in the theory of 

financial economics," with Miller specifically cited for "fundamental contributions to the theory

of corporate finance."

Historical background

Miller and Modigliani derived the theorem and wrote their groundbreaking article when they

were both professors at the Graduate School of Industrial Administration (GSIA) of  Carnegie

Mellon University. The story goes that Miller and Modigliani were set to teach corporate financefor business students despite the fact that they had no prior experience in corporate finance.

When they read the material that existed they found it inconsistent so they sat down together to

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try to figure it out. The result of this was the article in the American Economic Review and what

has later been known as the M&M theorem.

The theorem

Consider two firms which are identical except for their financial structures. The first (Firm U) isunlevered: that is, it is financed by equity only. The other (Firm L) is levered: it is financed

 partly by equity, and partly by debt. The Modigliani – Miller theorem states that the value of the

two firms is the same.

Without taxes

Proposition I: where is the value of an unlevered firm = price of buying a firm

composed only of equity, and is the value of a levered firm = price of buying a firm that iscomposed of some mix of debt and equity. Another word for levered is  geared , which has the

same meaning.[2]

 

To see why this should be true, suppose an investor is considering buying one of the two firms U

or L. Instead of purchasing the shares of the levered firm L, he could purchase the shares of firmU and borrow the same amount of money B that firm L does. The eventual returns to either of 

these investments would be the same. Therefore the price of L must be the same as the price of U

minus the money borrowed B, which is the value of L's debt.

This discussion also clarifies the role of some of the theorem's assumptions. We have implicitly

assumed that the investor 's cost of borrowing money is the same as that of the firm, which neednot be true in the presence of asymmetric information, in the absence of efficient markets, or if 

the investor has a different risk profile than the firm.

Proposition II:.

Proposition II with risky debt. As leverage (D/E) increases, the WACC (k0) stays constant.

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  is the required rate of return on equity, or  cost of equity . 

  is the company unlevered cost of capital (ie assume no leverage). 

  is the required rate of return on borrowings, or  cost of debt . 

  is the debt-to-equity ratio. 

A higher debt-to-equity ratio leads to a higher required return on equity, because of the higher 

risk involved for equity-holders in a company with debt. The formula is derived from the theoryof  weighted average cost of capital (WACC).

These propositions are true assuming the following assumptions:

 no transaction costs exist, and

  individuals and corporations borrow at the same rates.

These results might seem irrelevant (after all, none of the conditions are met in the real world),

 but the theorem is still taught and studied because it tells something very important. That is,

capital structure matters precisely because one or more of these assumptions is violated. It tells

where to look for determinants of optimal capital structure and how those factors might affectoptimal capital structure.

Capital asset pricing model

An estimation of the CAPM and the Security Market Line (purple) for the Dow Jones Industrial Average 

over 3 years for monthly data.

In finance, the capital asset pricing model (CAPM) is used to determine a theoreticallyappropriate required rate of return of an asset, if that asset is to be added to an already well-

diversified  portfolio, given that asset's non-diversifiable risk. The model takes into account the

asset's sensitivity to non-diversifiable risk  (also known as systematic risk  or  market risk ), oftenrepresented by the quantity  beta (β) in the financial industry, as well as the expected return of themarket and the expected return of a theoretical risk-free asset.

The model was introduced by Jack Treynor  (1961, 1962),[1]

 William Sharpe (1964), John Lintner  (1965a,b) and Jan Mossin (1966) independently, building on the earlier work of  Harry

Markowitz on diversification and modern portfolio theory. Sharpe, Markowitz and Merton

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Miller   jointly received the  Nobel Memorial Prize in Economics for this contribution to the field

of  financial economics. 

The cost of  capital is a term used in the field of financial investment to refer to the cost of a

company's funds (both debt and equity), or, from an investor's point of view "the shareholder'srequired return on a portfolio company's existing securities".

[1] It is used to evaluate new projects

of a company as it is the minimum return that investors expect for providing capital to thecompany, thus setting a benchmark that a new project has to meet.

In statistics, the coefficient of multiple correlation is a measure of how well a given variablecan be predicted using a linear function of a set of other variables. It is measured by the

coefficient of determination, but under the particular assumptions that an intercept is included

and that the best possible linear predictors are used, whereas the coefficient of determination is

defined for more general cases, including those of nonlinear prediction and those in which the predicted values have not been derived from a model-fitting procedure. The coefficient of 

multiple correlation takes values between zero and one; a higher value indicates a better 

 predictability of the dependent variable from the independent variables, with a value of oneindicating that the predictions are exactly correct and a value of zero indicating that no linear 

combination of the independent variables is a better predictor than is the fixed mean of the

dependent variable.

Capital budgeting

From Wikipedia, the free encyclopedia

Capital budgeting (or investment appraisal) is the planning process used to determine whether 

an organization's long term investments such as new machinery, replacement machinery, new plants, new products, and research development projects are worth pursuing. It is budget for 

major  capital, or investment, expenditures.[1]

 

Many formal methods are used in capital budgeting, including the techniques such as

  Accounting rate of return 

  Payback period 

  Net present value 

  Profitability index 

  Internal rate of return 

  Modified internal rate of return 

  Equivalent annuity 

  Real options valuation 

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These methods use the incremental cash flows from each potential investment, or  project .

Techniques based on accounting earnings and accounting rules are sometimes used - though

economists consider this to be improper - such as the accounting rate of return, and "return oninvestment." Simplified and hybrid methods are used as well, such as  payback period  and

discounted payback period .

Contents

  1 Net present value 

  2 Capital Budgeting Definition 

  3 Internal rate of return 

  4 Equivalent annuity method 

  5 Real options 

  6 Ranked Projects 

  7 Funding Sources 

  8 Need For Capital Budgeting 

  9 External links and references 

Net present value

Main article: Net present value 

Capital Budgeting Definition

Capital budgeting is a long-term economics decision making. Each potential project's value

should be estimated using a discounted cash flow (DCF) valuation, to find its net present value 

(NPV). (First applied to Corporate Finance  by Joel Dean in 1951; see also Fisher separationtheorem, John Burr Williams: Theory.) This valuation requires estimating the size and timing of 

all the incremental cash flows from the project. (These future cash highest NPV(GE).) The NPV

is greatly affected by the discount rate, so selecting the proper rate — sometimes called the hurdle

rate — is critical to making the right decision. The hurdle rate is the Minimum acceptable rate of return on an investment. This should reflect the riskiness of the investment, typically measured

 by the volatility of cash flows, and must take into account the financing mix. Managers may use

models such as the CAPM or the APT to estimate a discount rate appropriate for each particular  project, and use the weighted average cost of capital (WACC ) to reflect the financing mix

selected. A common practice in choosing a discount rate for a project is to apply a WACC that

applies to the entire firm, but a higher discount rate may be more appropriate when a project's

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risk is higher than the risk of the firm as a whole.

Internal rate of return

Main article: Internal rate of return 

The internal rate of return (IRR) is defined as the discount rate that gives a net present value (NPV) of zero. It is a commonly used measure of investment efficiency.

The IRR method will result in the same decision as the NPV method for (non-mutually

exclusive) projects in an unconstrained environment, in the usual cases where a negative cash

flow occurs at the start of the project, followed by all positive cash flows. In most realistic cases,

all independent projects that have an IRR higher than the hurdle rate should be accepted. Nevertheless, for mutually exclusive projects, the decision rule of taking the project with the

highest IRR - which is often used - may select a project with a lower NPV.

In some cases, several zero NPV discount rates may exist, so there is no unique IRR. The IRR 

exists and is unique if one or more years of net investment (negative cash flow) are followed by

years of net revenues. But if the signs of the cash flows change more than once, there may beseveral IRRs. The IRR equation generally cannot be solved analytically but only via iterations.

One shortcoming of the IRR method is that it is commonly misunderstood to convey the actualannual profitability of an investment. However, this is not the case because intermediate cash

flows are almost never reinvested at the project's IRR; and, therefore, the actual rate of return is

almost certainly going to be lower. Accordingly, a measure called Modified Internal Rate of 

Return (MIRR) is often used.

Despite a strong academic preference for NPV, surveys indicate that executives prefer IRR over 

 NPV[citation needed ]

, although they should be used in concert. In a budget-constrained environment,efficiency measures should be used to maximize the overall NPV of the firm. Some managers

find it intuitively more appealing to evaluate investments in terms of percentage rates of return

than dollars of NPV.

Equivalent annuity method

Main article: Equivalent annual cost 

The equivalent annuity method expresses the NPV as an annualized cash flow by dividing it bythe present value of the annuity factor. It is often used when assessing only the costs of specific

 projects that have the same cash inflows. In this form it is known as the equivalent annual cost  (EAC) method and is the cost per year of owning and operating an asset over its entire lifespan.

It is often used when comparing investment projects of unequal lifespans. For example if project

A has an expected lifetime of 7 years, and project B has an expected lifetime of 11 years it would

 be improper to simply compare the net present values (NPVs) of the two projects, unless the

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 projects could not be repeated.

The use of the EAC method implies that the project will be replaced by an identical project.

Alternatively the chain method can be used with the  NPV method under the assumption that the

 projects will be replaced with the same cash flows each time. To compare projects of unequallength, say 3 years and 4 years, the projects are chained together , i.e. four repetitions of the 3

year project are compare to three repetitions of the 4 year project. The chain method and theEAC method give mathematically equivalent answers.

The assumption of the same cash flows for each link in the chain is essentially an assumption of zero inflation, so a real interest rate rather than a nominal interest rate is commonly used in the

calculations.

Real options

Main article: Real options analysis 

Real options analysis has become important since the 1970s as option pricing models have gottenmore sophisticated. The discounted cash flow methods essentially value projects as if they were

risky bonds, with the promised cash flows known. But managers will have many choices of how

to increase future cash inflows, or to decrease future cash outflows. In other words, managers getto manage the projects - not simply accept or reject them. Real options analysis try to value the

choices - the option value - that the managers will have in the future and adds these values to the

 NPV. 

Ranked ProjectsThe real value of capital budgeting is to rank projects. Most organizations have many projectsthat could potentially be financially rewarding. Once it has been determined that a particular 

 project has exceeded its hurdle, then it should be ranked against peer projects (e.g. - highest

Profitability index to lowest Profitability index). The highest ranking projects should beimplemented until the budgeted capital has been expended.

Funding Sources

When a corporation determines its capital budget, it must acquire said funds. Three methods are

ge stock have no financial risk but dividends, including all in arrears, must be paid to the

 preferred stockholders before any cash disbursements can be made to common stockholders;

they generally have interest rates higher than those of corporate bonds. Finally, common stocksentail no financial risk but are the most expensive way to finance capital projects.The Internal

Rate of Return is very important.

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Need For Capital Budgeting

1.  As large sum of money is involved which influences the profitability of the firm making capital

budgeting an important task.

2.  Long term investment once made can not be reversed without significance loss of invested

capital. The investment becomes sunk and mistakes, rather than being readily rectified,mustoften be borne until the firm can be withdrawn through depreciation charges or liquidation. It

influences the whole conduct of the business for the years to come.

3.  Investment decision are the base on which the profit will be earned and probably measured

through the return on the capital. A proper mix of capital investment is quite important to

ensure adequate rate of return on investment, calling for the need of capital budgeting.

4.  The implication of long term investment decisions are more extensive than those of short run

decisions because of time factor involved, capital budgeting decisions are subject to the higher

degree of risk and uncertainty than short run decision.[2]