Strategic Corporate Finance

Strategic Corporate Finance

Part B

2018 Earnings per share = 68%

2019 Earnings per share = 72%

Average dividend growth =  1.49

Cost of capital = 5%

Stock value = Dividend per share / (Required Rate of Return – Dividend Growth Rate)

Arithmetic Average = (1.32% + 0.52% + 1.55%+1.02% +3.03%)/5 = 1.49%

Company historical DGR can be used to compute the annual growth rate (CAGR).

                   CAGR = (40.8/37.9)^1/6 -1 = .0124 OR 1.24%

Stock price = 40.8/ (5%-1.25%) =1,088

The company decides to change the dividend policy

The proposed changes include

70% percent of earnings in 2018 and subsequent years should be retained for investment in new product development.

Dividend growth rate =3.50 per cent

Dividend per share 2018= 68p x (100% -70%) = 20.4

Dividend per share 2018= 72p x (100% -70%) = 21.6

Average dividend per share = (20.4 + 21.6)/2 = 21

Primrose’s cost of capital =5%

Sustainable growth rate = 5% x (1-30%) =3.50%

Stock value = Dividend per share / (Required Rate of Return – Dividend Growth Rate)

Stock value = 21/ (5% -3.5%) = 1,400

The effect of dividends on share prices

Dividends refer to payments per-per share distributable to the shareholder of a company. Dividend per share varies from one company to another. Dividends are considered to be relevant as they have informational value. According to the financial signaling theory, it is argued that the dividend policy adopted by the company is applied to convey information. Information conveyed by the dividend policy affect the stock price. The dividend policy adopted by the firm plays an important role as it determines the amount of profit to be distributed to the company shareholders as the amount of profit retained in the business. The retained earnings are very essential in firm growth. In most cases shareholders expect the company to pay higher dividends hence there exists conflict between the higher distribution of dividends and growth of the company. Hence dividend policy affects the value of the stock. It is therefore important to strike a balance between dividend payment and retention of earnings. According to schools of thought, the dividend can be either relevant or irrelevant in stock valuation. Therefore dividends will not always affect company value and the market price per stock of the firm.

Relevant Theory

If the company dividend policy affects company value, the dividend policy is considered to be relevant. Hence the change in dividend payout ratio will affect changes in the market value of the company.  In case the dividend is relevant then there is a maximum payout ratio. The optimum payout ratio is the ratio which provides the maximum market value per stock. A higher dividend has a positive effect on the company value in the security market.  A higher dividend will raise the stock value and the lower dividend reduces the stock value. More dividends indicate that the company is more profitable. According to Gordon (1963) increase in dividend result in making the shares of the company becoming more attractive to the investors hence increasing their demand which results to increase in their prices.

In general, investors consider an increase in dividend per share as a sign of improved performance in the company. In case a firm with a history of paying higher dividends suddenly reduce its dividend payout ratio, investor assume the company is facing some financial challenges, in this case, stock price drop as investor interest in the company stocks reduces.

Besides according to bird in hand theory, there is direct nexus between the dividend policy of the firm and its market value. The bird in hand theory argues that investors are interested in the current dividends since they are considered to be less risky as compared to the future capital gains or dividends. The theory suggests that shareholders value dividends more as compared to capital gain and hence companies with a high dividend payout ratio will attract more investors.

The study by Akbar and Baig (2010) on the role of dividend payout ratio on the share prices for listed companies indicated that dividend announcement either on stock dividend and cash dividend has a positive effect on share prices.  The empirical study by Habib, Kiani, and Khan (2012) on the effect of the dividend policy on the stock price movement in the Pakistan stock market it was discovered that the dividend payout ratio resulted in the company share prices.

Irrelevant theory

To Modigliani and Miller (1961) argues that investor is not concerned with the dividend policy of the company as they can sell their equity any time they want cash.  Irrelevant dividend theory suggests that company dividend policy affects the company cost of capital neither does it affect its share price. The theory argues that the value of the firm is only determined by its earning power and its business risk. The value of the company is dependent on the income produced by its asset and the income is dividends and the retained earnings.

In the improvement of the theory, Modigliani and Miller assumed that taxes do not exist and there exists no difference between tax rates on capital gain and dividend. There is also an assumption that uncertainty does not about the company’s prospect and hence investors can predict the future and prices with certainty.  The theory has been criticized because it is highly dependent on the two critical assumptions transaction costs and taxes. Transaction costs and taxes are not applicable in today’s real-world business environment. A study by Muigai (2012) on the impact of dividend announcement on value commercial banks listed in Nairobi Security concluded that during the event window there was no pattern observed.

According to Brennan, 1971 suggested that any rejection of irrelevancy theory by Miller and Modigliani must be founded by ignoring the principle of irrelevant information independence and assumption of symmetric market rationality. The assumption must be rejected based on the following condition: firstly; investors are irrational in their behavior. Second, the stock price should and must be subordinate to historical events as well as expected prospects.  Irrelevant theory allude that dividend is irrelevant to the value of the company when the market is fully efficient, investors have time additive utility and homogeneous belief.

An empirical study by Uddin & Chowdhury, 2005 selected 139 listed companies on the Dhaka Stock Exchange (DSE) to study the nexus between the dividend payout and share price. The findings demonstrated that the announcement of dividend does not offer value to shareholders and investors’ wealth. The findings confirm that irrelevant theory of dividend policy. Though several empirical studies support the irrelevant dividend theory, many studies challenge the dividend irrelevance hypothesis.

A study on the relationship between the dividend payout and share price in the Australian security exchange market found by Ball, Brown, Finn, & Officer, 1979 found a significant correlation between stock return and dividend yield as well as a dividend payment. These findings do not support the irrelevance dividend hypothesis.

The empirical study by Travlos, Trigeorgis, & Vafeas, 2001 on the effect of dividend announcement and dividend increase in the stock price of companies listed in the Cyprus Stock Exchange for a period between 1985 to 1995. The results indicated that the stock price is affected by the dividend policy adopted by the management of the company.

Several empirical studies show that there is a direct link between dividend policy and stock return as well as their price volatility.  Besides Nazir et al., 2010 selected 73 companies listed in Karachi Stock Exchange the relationship between dividend policy and share price volatility for the period starting from 2003 to 2008. The results demonstrated a significant nexus between the dividend payout and dividend yield. It was also observed the leverage and firm size has a negative but non-significant influence on the share price movement.  Besides, the study by Suleman et al., 2011 on the relationship between dividend policy ad share prices of companies showed that the share price of the company is influenced by the dividend policy.

Companies that have high dividend yield are considered to be well-performing hence increasing their attractiveness to the investors. The company share price goes high due to higher demand for shares from the investors.

Part C

Acquirer = Hazard PLC

Target =Bale PLC

Current Hazard PLC’s share price =£3.68

Company’s earnings per share = 21p

Hazard’s weighted average cost of capital = 8%

Annual after-tax synergy benefits = £2m

Distributable earnings annual growth rate =3%

Sale of asset = £4.5m

Net of corporate tax =25%

The value of Bale PLC using the following valuation methods:

Price / Earnings Ratio. (using Hazard’s P/E ratio)

Share price = P/E ratio x earning per share

P/E = Stock price per share / Earning per share

Hazard’s P/E ratio = 3.68/21 =0.175

Bale PLC Earning per share = 21.3p

Share price = 21.3 x 0.175 =£ 3.7275

1. Dividend valuation method.

Stock value = Dividend per share / (Required Rate of Return – Dividend Growth Rate)

Value of equity = company rate of dividend /market nominal dividend x Nominal value of the share

Weighted average dividend growth rate = 2.63%

Required Rate of Return = Rf​+βi​(Rm​−Rf​)

Bale’s Equity Beta (βi​)) = 1.46

Treasury bill yield (Rf​) = 2%

Return of the market (Rm) = 7%

Required Rate of Return =2% + 1.46(7%-2%) = 9.3%

Stock value = 21.3 /(9.3%-2.63%) = 319.34

Mergers and acquisitions and shareholder wealth maximization

Merger refers to a situation where two or more companies are combined to form a single company while others are dissolved. On the other hand, the acquisition is a situation where one company acquires another one. Acquisition occurs when one firm takes control of the company’s interest either as legal subsidiary or minority interest.

Mergers and acquisitions are one of the most attractive business strategies applied by the company to create wealth for its shareholders.  Shareholder wealth maximization is defined as maximizing the company’s net present value. The objective of mergers and acquisitions activity is to create value for shareholders. The success of merger and acquisition is measured through the value it generates to the shareholders.  It is measured using parameters that include competitiveness position and market attractiveness which result from product differentiation and cost leadership strategy. This results in shareholders’ wealth creation and long-term profit sustainability.

According to value creation theory companies enter into merger and acquisition deal to generate synergies between the target and predator firm which in return enhance the value of the company.  Merger and acquisition are dominated by company strategies followed by corporates with the objective of value creation. Corporates apply inorganic strategies to promote the growth of the businesses. In the current global competitive business environment organization prefer to use mergers and acquisitions to achieve their strategic plan.

According to the shareholder wealth maximization perspective, all decisions adopted by companies including mergers and acquisitions are taken with the sole objective of shareholder wealth maximization. Most corporate managers enter into mergers and acquisition deals for shareholder best interest.

Companies apply mergers and acquisitions with the motive of improving their financial position. Large companies have better access to finance in the capital market as compared to smaller companies. Expansion of business through mergers and acquisitions enables them to access equity and debt financing used in investment.  Merger and acquisition play an important role in improving business liquidity. As a result, the company can strengthen the value of its assets. According to Masulis and Simsir, 2018 mergers and acquisition helps the organization to dispose of the surplus and outdated assets for cash which is invested in profitable business operations. Absent of adequate financial company is one of the motives of merger and acquisition. Increasing the business’s financial capacity promotes the implementation of projects that are profitable to the company hence increasing the value of the shareholder’s wealth. A study by Selvam, Babu, Indhumathi, and Ebenezer (2009) on the role of M&A corporate performance of acquirer and target companies in India indicated that the liquidity of shareholders in acquiring company is enhanced.

Corporate enters into merger and acquisition deal to neutralize competition hence protecting them from the existing market. Through mergers and acquisition companies can acquire new markets using the acquired resources hence increasing the value of shareholders. According to market power theory, corporates enter into mergers and acquisitions to increase their competitive advantage in the market. Merger and acquisition enable the organization in getting monopoly position, therefore, increasing the profitability of the company. in the long-run, this helps the companies in achieving their shareholder wealth maximization fundamental objective.

Companies also merge with foreign corporations to enter profitable foreign markets. Merger and acquisition are one of the best strategy applied by International Corporation to reduce the risk associated with business expansion.  Companies can reduce local recessions and foreign exchange risks by entering into the foreign market.

In additional mergers and acquisition offers several tax benefits to the company. in case one of the company either targets or the acquired firm suffered losses, such losses are offset against the profit of the other company being merged. This reduces the tax liability of the merged company hence increasing the profits distributable to the shareholders of the company.

To create the value of shareholders today, companies are recommended to invest in risk reduction and diversification. Most of the companies, therefore, apply mergers and acquisitions as a strategy for risk reduction and diversification. Mergers and acquisitions help the company to invest in products that are more profitable and also reduce the risk associated with the investment. According to Maranga (2010), mergers and acquisitions also have a positive impact on scale production as well as the cost of carrying out joined businesses in the financial sector.

An empirical study by Loderer and Martin (1992) on analysis of 304 mergers and 155 acquisitions relieved a negative though insignificant statistical abnormal return after the completion of the merger and positive insignificant abnormal returns for the takeover.  Result by Jean-Francois (2004) found a negative and significant return after mergers and acquisitions.

The study conducted by Diz and Silva,2005 on the effect of merger and acquisition on performance of the Portuguese banking industry indicated that the wealth of target shareholders increased while that of the acquiring shareholders was lost significantly. A significant wealth gain for target firm shareholders was achieved through diversification of products and services through mergers and acquisitions. It has also been found that acquiring companies experienced significant negative abnormal returns as a result of a horizontal deal while no effect is observed as a result of diversifying deals. An empirical study conducted by Anand and Sigh,2008 that mergers and acquisitions affect shareholder wealth maximization the fundamental objective of the banking industry. The study demonstrated a significant wealth increase for both the targets and acquiring banks.

Factors like financial leverage, cash positions, liquidity, and event market volatility were identified factors that impact the abnormal magnitude of return. Other empirical researches indicate that the wealth of shareholders affects both international and domestic deals, however, the local mergers and acquisition deals are perceived to give more gains as compared to cross borders. From different empirical studies, it can be demonstrated that mergers and acquisitions have both positive and negative effects on shareholder wealth.

According to the efficiency theory merger between two companies generate sufficient synergies that offer mutual benefits to both parties. According to the efficient theory merger and acquisition deals should be sealed for mutual benefits. If the deal does not benefit the parties then there is a likelihood of merger and acquisition not taking place.

According to Klein (2001), companies enter mergers and acquisitions to create the value of creating wealth for shareholders. before entering into merger and acquisition it is therefore important to measure the contribution of merger and acquisition deal for shareholder wealth maximization.

Mergers and acquisitions promote cost efficiency via increased economy of scale, scope efficiency, and managerial efficiency.  Maranga (2010) empirical review on role M&A on shareholders’ wealth maximization found that firms that enter into the merger of the firm being acquired have no significant impact on cost efficiency during post-merger event. Some of the firms that engage in mergers and acquisitions indicate a decrease in cost efficiency hence affecting the shareholder’s wealth. Empirical research by Sufian’s (2004) effect of merger and acquisition of Malaysia banking sectors demonstrate that post-merger efficiency was higher. The investment strategies implemented by the management are expected to offer the maximum returns to the shareholders. The ability of an organization to engage in strategic merger and acquisition is based on the ability of the company the generate cash and the ability to maximize shareholder wealth.

Many firms adopt merger and acquisition as it helps in increasing the firm profit, efficiency, and boosting the shareholder’s wealth. An empirical study on the market efficiency through the application of merger and acquisition by the United State companies, the finding demonstrated a positive relationship as it proved to be more beneficial to the company shareholders. Merger and acquisition bring new skills in the company which helps in promoting efficiency hence increasing the profitability of the company. Merger and acquisition also help promote market power and hence increasing the competitive advantage of the company. In long-run merger and acquisition helps in achieving the fundamental objective of wealth maximization.