Dividend policies are crucial to a company and the relations with their shareholders and investors. Investors and shareholders have a great interest in these policies as they relate directly to the returns on the capital they have invested in a company. In terms of what policy the company will use they must decide on the value they will pay out to shareholders; this decision must be taken with caution because a policy set too high and the company may not have the finances to satisfy the payments, too low and shareholders may recognise they are not being appropriately rewarded.
Residual Dividend Policy
This policy is concerned with debt and equity; a company using this method will have a strict debt to equity ratio that it must maintain and therefore will use internally generated equity to finance any new projects. The dividend amount in this case is decided by the leftover value of equity after the project's financial requirements have been met, the downside of this policy is that if there is no spare capital post project completion there will not be any dividend value to pay and therefore a company's ability to generate its own internal equity is extremely important to keeping good relations with investors and having a hopeful future in taking on new investors. This policy does however help a business with its long term dividend policy.
Constant Growth Dividend
This policy is popular with shareholders due to agreement of growth year on year hence a boost in returns for the shareholders. On the other hand, the company must be careful what they promise shareholders in terms of their capability to grow. A company may use this method which keeps shareholders happy, the problem arises if the company does not earn as much money as it hoped to in order to pay out the increasing dividends. Two problems arise from this lack of success in its own policy: firstly they can suffer financial problems as they pay out dividends which in reality they cannot afford and secondly, the shareholders may lose confidence in the company as they witness the problem of paying out an increasing rate of dividend, which may only worsen as the years go on. On the positive side of this agreement is the benefits it can have with shareholder satisfaction assuming the company can match the increasing payout.
Constant Payout Dividend
Similar to a constant growth in that it should guarantee a payout for the shareholders but this policy agrees a constant amount that will be paid to shareholders each year without having any arrangement of growth in dividends. This has the advantages of keeping shareholders happy with their payouts on investments and also does not put too much pressure on the company to keep growing their revenue in order to increase their dividends each year.
Consequences of changing a policy
Shareholders enjoy a consistent policy when it comes to dividends which creates certainty when it comes to receiving payouts on their investments, a successful dividend policy will create a confidence amongst new investors who will be interested in the company for the future. This is a delicate position though; if a company has promised an increase in dividends each year as part of a policy change and suddenly realise the funds are not there for that rate of payout it creates tension and uncertainty within the business. On the other side of this, if the new dividend payout rate is not high enough and not in line with earnings then the rate is too low and greater dividends could and arguably should be paid to shareholders. The recent financial crisis has caused some companies to hold back on dividend payouts and this trend can also be seen in companies engaged in a merger or takeover.
Sunday, 16 November 2014
Sunday, 2 November 2014
Financing decisions: Equity Vs Debt
As a business grows it must decide what method to use in order to access more capital, usually to fund an expansion in one way or another. Ultimately there are two options that most managers would consider: Equity, in the form of an investor, or debt, in the form of a bank loan. I will weigh up the advantages and disadvantages of both compared to each other which will outline which method is more appropriate.
Equity
Whilst capital in the form of equity may seem attractive due to there not being any issue over repayments or the overhanging problem of a raise in interest rates causing your repayment to increase over time; there are still factors to consider when using an investor. As the investor will be putting their own money into the business they will usually want to have some control of the company as investors will be much more at ease with some reassurance of the activities that are being funded by their capital and perhaps more importantly they will want a hand in decision making and the direction of the business who must decide if they are willing to give up some of their control and ownership of the business for the benefit of their expansion. In terms of the advantages of equity finance the business has less pressure in relation to their performance and return on the capital. Whilst a loan requires the business to make a return in order to pay it back (with interest) capital from investors does not require a return, although investors will be expecting one, and even so they will be more willing to take a long-term view on the investment thus being less demanding on a quick return from the business.
Another benefit which can be coupled with the desire for expansion is that the business can use the networks of the investor for new information and to increase their credibility and reputation in the market, therefore making expansion and further investment possible. Generally, with an investor the business will have more cash in hands and the finance is more easily accessible for the business. There are of course some disadvantages to this method: as mentioned before the loss of ownership can be very crucial to the efficiency of the business due to time lost of decision making; a business will be keen to invest this new capital in pre-made plans and with the investor reviewing these decisions their will be a delay and possibly and re-think to the strategy. Disagreements can lead to stressful relationships and even in extreme cases the investor making the decision; the business will need to consider the type of investor they have gone with and decide if they are the best to take the company forward. In relation to selecting an investor the process takes a long time to ensure all the right factors have been considered; this is a very time consuming process and is another example of a time constraint possibly adversely affecting the company.
Debt
Debt finance is the alternative method which is obtaining finance through loans. This type of capital does not require the company to give up control of their operations however there is more of an emphasis on return on investment. Unlike an investor putting their own money into the company and therefore wanting some say in how the business spends its new funds and may try too have a hand in other decisions. With loan funding from banks this will not occur as the bank will not be interested in trying to run the business and therefore the company can retain the control they wish over investment activities and obtain the finance they feel they need. However, with that comes added pressure and a greater need for the business to perform. The bank will set a length of time in which the money must be paid back to them and this will include interest on the loan (increasing the amount to pay back) and penalties to the business if they do not return the investment in the form of financial fines; these will not only cause damage to the company's finances due to poor performance and fines but will also create a poor credit rating for the company which makes it much more difficult to obtain future loans. Furthermore, relying on loans to finance the company can result in a poor cash flow record causing problems when paying back the loan and perhaps even worse this can put off potential investors due to worries over the high risk of investing in the company. Perhaps the biggest risk taken with debt financing is putting up company assets as 'collateral' for the bank; these assets will be used as a security against the loan if the company fails to re-pay what is owed. This is a huge disadvantage to the company and potentially the owner as their personal belongings may also have to be put up for security if the company assets cannot cover the loan.
As there is such a huge cost involved with repaying the loan debt finance can limit a business' ability to grow which contradicts the aim of the company to expand their operations. The company will need to consider these limitations against the potential for growth and further re-investment that comes with an investor and equity finance.
The graph below shows the equity to debt ratings of small businesses from 2000 to 2010. It shows that debt financing is much more popular with small businesses due to their smaller capacity for self raised capital. Therefore choosing between debt or equity finance heavily depends on the size of the company.
In my personal opinion I believe that the choice between equity and debt finance should meet the company needs and situation. If a company is looking for long-term growth and willing to make internal changes and have decisions influenced by investors then equity finance provides an excellent source of capital without the pressure of repaying a loan. However, loans have always been a reliable source when investors consider a business to be high risk due to poor cash flow and as long as the company can repay the loan then it is a very good method for a business.
Equity
Whilst capital in the form of equity may seem attractive due to there not being any issue over repayments or the overhanging problem of a raise in interest rates causing your repayment to increase over time; there are still factors to consider when using an investor. As the investor will be putting their own money into the business they will usually want to have some control of the company as investors will be much more at ease with some reassurance of the activities that are being funded by their capital and perhaps more importantly they will want a hand in decision making and the direction of the business who must decide if they are willing to give up some of their control and ownership of the business for the benefit of their expansion. In terms of the advantages of equity finance the business has less pressure in relation to their performance and return on the capital. Whilst a loan requires the business to make a return in order to pay it back (with interest) capital from investors does not require a return, although investors will be expecting one, and even so they will be more willing to take a long-term view on the investment thus being less demanding on a quick return from the business.
Another benefit which can be coupled with the desire for expansion is that the business can use the networks of the investor for new information and to increase their credibility and reputation in the market, therefore making expansion and further investment possible. Generally, with an investor the business will have more cash in hands and the finance is more easily accessible for the business. There are of course some disadvantages to this method: as mentioned before the loss of ownership can be very crucial to the efficiency of the business due to time lost of decision making; a business will be keen to invest this new capital in pre-made plans and with the investor reviewing these decisions their will be a delay and possibly and re-think to the strategy. Disagreements can lead to stressful relationships and even in extreme cases the investor making the decision; the business will need to consider the type of investor they have gone with and decide if they are the best to take the company forward. In relation to selecting an investor the process takes a long time to ensure all the right factors have been considered; this is a very time consuming process and is another example of a time constraint possibly adversely affecting the company.
Debt
Debt finance is the alternative method which is obtaining finance through loans. This type of capital does not require the company to give up control of their operations however there is more of an emphasis on return on investment. Unlike an investor putting their own money into the company and therefore wanting some say in how the business spends its new funds and may try too have a hand in other decisions. With loan funding from banks this will not occur as the bank will not be interested in trying to run the business and therefore the company can retain the control they wish over investment activities and obtain the finance they feel they need. However, with that comes added pressure and a greater need for the business to perform. The bank will set a length of time in which the money must be paid back to them and this will include interest on the loan (increasing the amount to pay back) and penalties to the business if they do not return the investment in the form of financial fines; these will not only cause damage to the company's finances due to poor performance and fines but will also create a poor credit rating for the company which makes it much more difficult to obtain future loans. Furthermore, relying on loans to finance the company can result in a poor cash flow record causing problems when paying back the loan and perhaps even worse this can put off potential investors due to worries over the high risk of investing in the company. Perhaps the biggest risk taken with debt financing is putting up company assets as 'collateral' for the bank; these assets will be used as a security against the loan if the company fails to re-pay what is owed. This is a huge disadvantage to the company and potentially the owner as their personal belongings may also have to be put up for security if the company assets cannot cover the loan.
As there is such a huge cost involved with repaying the loan debt finance can limit a business' ability to grow which contradicts the aim of the company to expand their operations. The company will need to consider these limitations against the potential for growth and further re-investment that comes with an investor and equity finance.
The graph below shows the equity to debt ratings of small businesses from 2000 to 2010. It shows that debt financing is much more popular with small businesses due to their smaller capacity for self raised capital. Therefore choosing between debt or equity finance heavily depends on the size of the company.
In my personal opinion I believe that the choice between equity and debt finance should meet the company needs and situation. If a company is looking for long-term growth and willing to make internal changes and have decisions influenced by investors then equity finance provides an excellent source of capital without the pressure of repaying a loan. However, loans have always been a reliable source when investors consider a business to be high risk due to poor cash flow and as long as the company can repay the loan then it is a very good method for a business.
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