Part A
1. The Payback Period.
Depreciation of X =
200.000−40.000
4=£40,000
Depreciation of Y =
180.000−4000
4=£44,000
X Y
Initial outlay £200,000 £160,000
Cash Flow 1 £60,000+£40,000=£100,000 £15,000+£44,000=£59,000
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Understanding the Impact of Dividend Policy on Company Value - Prof. Mesuri, Cheat Sheet of Financial Accounting
The role of dividend policy in shaping a company's attractiveness to investors and its market value. It delves into the dividend irrelevance perspective (dip) and the dividend relevance perspective (drp), discussing their implications for a company's stock price and investor base. The document also provides a case study on apple's dividend policy, demonstrating how it has evolved over the years and its impact on shareholder value.
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Part A
1. The Payback Period. Depreciation of X =
Depreciation of Y =
X Y
Initial outlay £ 200 , 000 £ 160 , 000 Cash Flow 1 £ 60 ,000+£ 40 ,000=£ 100 , 000 £ 15 ,000+£ 44 , 000 =£ 59 , 000
Cash Flow 2 £ 30 ,000+40,000=£7 0 , 000 £ 20 ,000+£ 44 , 000 =£ 64 , 000 Cash Flow 3 £ 20 ,000+£ 40 ,000=£ 60 , 000 £ 45 ,000+£ 44 , 000 =£ 89 , 000 Cash Flow 4 £ 10 ,000+£ 40 ,000+£ 40 ,000=£ 90 , 000 £ 60 ,000+£ 4 ,000+£ 44 ,000=£ 108 , 000 Payback period (X) = 2 +^
=2.5 years Payback period (Y) = 2 +^
=2.64 years
2. Return on Capital Employed (ROCE) Project X Initial outlay = £200, Depreciation =
Average annual Accounting profit =
Average investment = Cost + Scrap value 2
ROCE(X)= (Average Annual Accounting profit/average investment) x = ROCE =^
x 100 = 25 % Project Y Initial outlay = £180, Depreciation =
Average annual Accounting profit =
Average investment = Cost + Scrap value 2
ROCE(Y)= (Average Annual Accounting profit/average investment) x 100 = ROCE =^
x 100 =38,04 %
3. The Net Present Value.
a valuable tool for initial screening and rapid assessment of potential returns (Gitman and Zutter, 2021). Furthermore, payback period focuses on real cash inflows, bypassing accounting profits, and is thus less susceptible to manipulation. This transparency provides a more reliable picture of an investment's financial health. In contrast to NPV's consideration of the entire cash flow stream and time value of money, payback period offers a distinct risk perspective. By prioritizing earlier cash flows, payback period acknowledges the inherent lower risk associated with receiving returns sooner rather than later. This focus aligns with the time value of money principle, as earlier cash flows contribute more significantly to the overall NPV (Levy and Alderson, 1989 ). Ultimately, a shorter payback period indicates a faster return on investment, freeing up capital for potential reinvestment and fueling further growth opportunities. The payback period (PP) method is simple to understand, but has several major limitations compared to NPV analysis. Its narrow focus only considers cash flows up to the payback point, ignoring potential profitability beyond that timeframe (Ross et al, 2019 ). Payback period also fails to account for the size and timing of cash flows, which can undervalue projects with large upfront costs but strong long-term cash generation. Most critically, PP neglects the time value of money concept by treating all cash flows equally regardless of when received, contradicting NPV principles. Payback's consideration of risk is inadequate compared to NPV's use of risk-adjusted discount rates (Levy and Alderson, 1989 ). Finally, the arbitrary selection of an acceptable payback period introduces management bias. Due to these shortcomings, payback period should be used in conjunction with NPV, not as a standalone tool, as NPV provides a more comprehensive and theoretically grounded analysis.
- Return on Capital Employed (ROCE ) The Return on Capital Employed (ROCE) boasts several advantages for evaluating investments. Firstly, its user-friendly percentage format makes it easy to grasp, even for those without financial expertise. This clarity fosters communication and stakeholder buy-in (Hilton et al, 2019). Moreover, ROCE connects to the crucial Return on Equity (ROE) metric, revealing a company's capital utilization efficiency for profit generation. This link provides a holistic view of the investment's impact on overall financial health. Additionally, ROCE offers a simpler alternative to complex discounted cash flow (DCF) methods like NPV and IRR, making it more accessible within an organization. Furthermore, ROCE facilitates comparisons between mutually exclusive projects, pinpointing the one that promises the most
efficient capital use and highest return. Finally, unlike the Payback Period's focus on short- term cash flows, ROCE considers the entire project, ensuring long-term profitability is factored into the evaluation (Gitman and Zutter, 2021). Despite its usefulness in investment analysis, Return on Capital Employed has several limitations. Firstly, it relies on accounting profit, which can be manipulated through accounting practices, potentially masking the project's true financial performance. Secondly, ROCE focuses on profit, which doesn't directly align with the long-term goal of maximizing shareholder wealth. Furthermore, by using average profits, ROCE overlooks the timing of cash flows, potentially undervaluing investments with later but larger returns (Ross et al, 2019 ). Perhaps most significantly, ROCE doesn't consider the time value of money, potentially favoring projects with immediate but smaller returns over those offering larger returns in the future. Finally, as a relative measure, ROCE doesn't account for the initial investment size or project duration, potentially misrepresenting the attractiveness of larger projects with higher initial investments but ultimately greater profitability. Therefore, while ROCE offers valuable insights, its limitations necessitate its use alongside other methods for a more comprehensive investment analysis (Drury, 2013).
3. Net Present Value (NPV): The Net Present Value (NPV) methodology offers a robust analytical framework for evaluating potential investment opportunities by incorporating several key advantages. Firstly, it acknowledges the fundamental principle of the time value of money, recognizing that a dollar received today possesses greater value than a dollar received in the future. Unlike traditional accounting measures of profit, net present value focuses on actual cash inflows and outflows, thereby providing a more accurate depiction of an investment's financial performance and viability (Brigham & Ehrhardt, 2017). Furthermore, the NPV approach considers the totality of relevant cash flows throughout the project's lifespan, rather than merely the initial capital outlay. This flexibility extends to the inclusion of both conventional and non-conventional cash flow streams, as well as accommodating adjustments for changes in the discount rate over time (Levy and Alderson, 1989 ). Ultimately, NPV delivers a single, absolute measure of a project's net value, thereby facilitating straightforward comparison between different investment alternatives. However, it is imperative to recognize that the NPV methodology is predicated on the assumption of perfect capital markets with no limitations on the availability of funds. In practical reality, capital is
Dividend in 2022: 35. A constant growth rate (g) from 2017 to 2022: Dividend in 2018 = 26.2 x (1 + g) Dividend in 2019 = 26.2 x (^) ( 1 + g )^2 Dividend in 2020 = 26.2 x (^) ( 1 + g )^3 Dividend in 2021 = 26.2 x ( 1 + g ) 4 Dividend in 2022 = 26.2 x ( 1 + g ) 5 = 35. Solving for g: 26.2 x ( 1 + g ) 5 = 35. => g ≈ 0. Therefore, the estimated dividend growth rate (g) is approximately 0.0596 or 5.96%. P = Dividend X ( 1 + g ) r − g
35 x ( 1 +5.96 % ) 15 %−5.96 %
Case 2: Fixed Payout Ratio (Using 2022 Data) Payout ratio (2022) = Dividend per Share Earnings Per Share x 100 =
x100 = 58.3% Lot of the pay-out rate
- Estimate Next Year's Dividend Payout Ratio (2022) * EPS (2023) = 58.3% * 65p = 37.92p (approximately 38p)
- Apply Dividend Growth Model (DGM)
Share Price (Po) = Dividend per Share ( r − g )
(This assumes a constant payout ratio, which might not be realistic) Next year dividend of the company maintain the pay-out rate Therefore, under the scenario of changing the dividend policy as proposed, the estimated share price of RR Plc. Is 419. b. Change in Dividend Policy The scenario now describes a change in Clear Plc's dividend policy, proposing a 6 5% payout ratio for retained earnings. The dividend payout ratio for 2023: Dividend Payout Ratio = 1 - Retention Ratio = 1 - 0.65 = 0. The dividend per share for 2023: Dividend per Share 2023 = Earnings per Share 2023 x Dividend Payout Ratio = 65p x 0.35 = 22.75p Apply the Dividend Discount Model (DDM) formula to find the share price: D1 = Next year's dividend (£22.75) r = Cost of capital (15%) g = New dividend growth rate (10.5%) Share Price = Dividend per Share r − g
Therefore, under the scenario of changing the dividend policy as proposed, the estimated share price of RR Plc. is £505.
signal of a company's financial health, stability, and commitment to shareholder value. Consistent dividend payouts can boost investor confidence, potentially leading to a higher valuation. Moreover, Dividend Relevance incorporates the Bird-in-the-Hand Theory, which suggests that some investors prefer the guaranteed income from dividends over the potential for future capital gains (Lintner, 1956). Apply special Case Apple dividend from 1995 to 2017 Apple's dividend policy has undergone a significant transformation over the years, reflecting the company's evolving financial strategy and investor base. From its initial years of non- payment to the establishment of a consistent dividend program, Apple's approach to capital allocation has mirrored its growth trajectory and changing investor preferences. Source: YCHARTS.com Table 1: The change in Apple's dividend payment strategy from 1995 to 2017 Declared Record Payable Amount Type Jan 25, 1995 Feb 17, 1995 Mar 10, 1995 N/A Regular Cash Apr 19, 2000 May 19, 2000 Jun 21, 2000 N/A 2-for-1 Stock Split Feb 11, 2005 Feb 18, 2005 Feb 28, 2005 N/A 2-for-1 Stock Split
Jul 24, 2012 Aug 13, 2012 Aug 16, 2012 $2.65 Regular Cash Apr 23, 2013 May 13, 2013 May 16, 2013 $3.05 Regular Cash Apr 23, 2014 May 12, 2014 May 15, 2014 $3.29 Regular Cash Jan 27, 2015 Feb 9, 2015 Feb 12, 2015 $.47 Regular Cash Jan 26, 2016 Feb 8, 2016 Feb 11, 2016 $.52 Regular Cash Jan 31, 2017 Feb 13, 2017 Feb 16, 2017 $.57 Regular Cash Source: investor.apple.com Throughout the period from 1995 to 2012, Apple's decision to forgo dividend payments was driven by a strategic focus on maximizing shareholder value through reinvestment and growth. This approach aligned with the Dividend Irrelevance Theory (DIP), which suggests that dividends have minimal impact on stock prices for companies focused on long-term growth. Despite the absence of regular dividends, Apple's stock price experienced significant growth during this time frame. The price per share climbed from approximately $0.32 in 2003 to over $2.56 in 2006 (Yahoo Finance). During this period, Apple prioritized reinvesting its earnings into research and development, product innovation, and expansion. This growth-oriented strategy aimed to generate future earnings that would ultimately increase the value of each share of stock held by investors. By reinvesting internally, Apple could potentially create greater value for shareholders than by distributing dividends. Moreover, for Apple, paying dividends would have resulted in a significant tax liability, reducing the amount of capital available for reinvestment and potentially diminishing shareholder value. By not distributing dividends, Apple saved on transaction costs associated with payouts and record-keeping. Consequently, Apple's decision to forgo regular dividends demonstrably did not impede shareholders' willingness to invest in the company (Apple Inc, 2020). Apple's dividend policy serves as a compelling illustration of the Dividend Relevance Perspective. After a 17-year period of no dividend payouts, Apple's decision to resume dividends in 2012 was met with a positive market reaction. According to Atlanta press research documents, the announcement of a $2.65 per share quarterly dividend coincided with an immediate stock price increase of nearly 3%, pushing it above $600 for the first time (Atlanta Press Research, 2012). This instant response aligns with the Dividend Relevance
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