Sources of Long Term Finance

and dividend decision

Study Unit Seven

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Management Objectives
• Prime objective of managers
– Maximise shareholder wealth through increased
dividends and share price.
– Majority of shareholder wealth is through increases in
share price which should reflect the value of the
future cash flows to be gained by holding the share

• Therefore managers’ objectives are to maximise

future cash flows of the company, by investing
in all available profitable projects

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Company’s value
• Market Capitalization = share price x number of shares
outstanding
• The stock price is a relative and proportional value of a
company's worth.
• Prices in the stock market are driven by supply and demand.
This makes the stock market similar to any other economic
markets. When a stock is sold, a buyer and seller exchange
money for share ownership. The price for which the stock is
purchased becomes the new market price.
• Various dividend policies are developed based on the concept
that a stock's current price equals the sum of all its
future dividend payments
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Dividend Decision
• Retained earnings are the most important source
of finance, rather than paying dividends.
– Do not have to involve shareholders or other
outside investors
– Avoid issue costs
– Avoid loss of control for existing shareholders
• Shareholders are usually obliged to accept the
dividend payment. If they need cash they
usually sell their shares.

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Dividend policy related theories

• Modigliani & Miller (1961): (MM theory)

– dividend policy is irrelevant
– Shareholder’s return is dividends plus capital
growth.
– Firms not paying a dividend will invest in
profitable projects and there will be capital
growth equal to the dividend foregone
– Shareholders wanting cash by selling the
shares for a higher value

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The case against MM

• Dividend retention preferred in a period of

capital rationing (no new projects)
• Imperfect markets and transaction costs mean
shareholders cannot easily sell shares as an
alternative to a cash dividend
• Shareholders prefer a certain dividend to
uncertain future capital gains (Bird in the hand
theory)

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MM Theory

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Bird in the hand theory
• Dividend policy affects the value of the company
• Higher dividends paid currently would reduce the
uncertainty about the future cash flows which
would in return result a higher payout ratio
reducing the cost of capital.
• More stable pay out – less perceived risk (Cash
in hand now better than uncertain future
earnings)

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Bird in the hand theory

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Clientele effect
• Different tax rates in dividends and capital gains
create a preference for either high dividend or
high earnings retention (Clientele effect) based
on investors’ own interest on investment
portfolio.
• Income tax on dividends – exempt, 14%
• Capital gains (gain on sale of shares) tax on
capital gains – 10%
• Higher rate income tax payers would prefer high
growth companies that do not pay a dividend.

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Clientele effect

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 Signalling Effect
• Share prices can fluctuate if investors have access to information about
a company’s future earnings via the indications from dividend
announcements. In says that these announcements could be an
indication of future prospects and this may impact the investment
decisions of potential investors.
• Due to asymmetric information, the dividend declared can be
interpreted as a signal from directors about the strength of underlying
project cash flows
• A cut in dividends signals to the market that future prospects are weak
• Directors like to show a steady growth in dividends which gives a
steady increase in share price even when there is fluctuating profit
• An increased dividend can be used when there is a threat of takeover to
drive up the share price

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Signalling Effect

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Other theories of dividend policy

• Residual theory – Dividend only paid when

no new profitable projects can be
identified and residual paid as dividend
• So paying a dividend is a bad signal to the
market – conflicting theory?

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Sources of Finance
• Internal – Retained Earnings (not profits)
– No issue costs but opportunity cost of not paying a
dividend
• External -Bank Debt
-Money Market Debt (ST /High liquid
instruments)
Covenants may be imposed and risk of servicing fixed
interest debt
• External – Equity (capital market)
– Dilution of control (Pecking Order Theory)

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Bank debt
• Overdraft – used to finance day to day trading
– Only pay interest when overdrawn
– Does not affect gearing (if temporary only)
– Repayable on demand
• Loan – repayment of interest and principal set in
advance
– Makes planning simpler
– Restrictive covenants may be imposed and
period review of financial statements by bank
– Not as onerous as ‘due diligence’ for public
issue
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Government bills/bonds
• Risk free securities. The government has never
defaulted on the payments so they have no
default risk. They are said to be riskless
securities and give a ‘risk free’ rate of return

• The pay back is certain

• Less risk : Less return

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Market debt
• Bonds – each bond issued in SL offering to pay a fixed rate of interest
(coupon).

• Will have a market value above (below) their par value depending on
whether current market interest rates are below (above) the coupon
rate.

• Company bonds carry some default risk and therefore should give a
higher rate of return. There are credit rating agencies such as
Standard and Poor , Moody’s . Nationally recognized statistical rating
organizations designated by the U.S. Securities and Exchange
Commission in 1975

• Fitch ratings is a credit rating agency that rates the viability of

investments relative to the likelihood of default. ... Fitch uses a letter
system; for example, a company rated AAA is very high quality with
reliable cash flows, while a company rated D has already defaulted.

• The next slide shows Countries by Standard and Poor’s rating (March
2019) 18
AAA AA A BBB BB B CCC CC/D
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Convertible Bonds
• Debt giving the holder the right to convert into
ordinary shares.
• Assumed to be ‘cheap debt’ as coupon rate is
usually lower due to option to convert. Investors
will accept a lower interest rate for the potential
for a capital gain when converting into shares
when the market price is high.
• Assumed to be deferred equity as will convert
from debt to equity
• Self liquidating debt as conversion reduces
gearing and enables entity to issue further debt
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Convertible bond – example
You buy a convertible bond with a low coupon rate
for £100 but convertible into 20 shares.

The current market price is £4 per share. Would you

convert? No-as the value of the shares would only
be 20 x £4 = £80.

In the future the market price rises to £6. You may

convert as the value of the shares would be 20 x £6
= £120, but you would be swapping fixed interest
for an uncertain dividend.
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Costs of Share Issues

• Underwriting costs
• Stock market listing fee
• Issuing house fee, solicitors, auditors and public
relations consultant
• Cost of producing the prospectus
• Advertising in national newspapers
• Last in the pecking order so usually a new issue
results in a fall in the existing share price

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Rights Issues
• Existing shareholders given the right to subscribe
to new shares in proportion to current holdings.
Expensive as issued at a discount and have
underwriting fees, but less administration and no
prospectus.
• No change of control if all rights taken up
• Amount of finance raised is limited to existing
shareholder’s funds
• But existing shareholdes need to take up the right
to buy if they do not want dilution of control

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Capital structure theories
• Pecking Order Theory
• Static Trade off Theory

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Cost of debt and equity – pecking order
theory

Pecking Order theory shows that the risk to the

investor is higher for equity.
Return to debt = Interest + principal (usually
guaranteed, only default risk).
Return to equity = Dividend (at the discretion of
the directors)
Initial investment – have to sell in the secondary
market.
Higher risk = higher expected return = higher cost
to the company 25
weighted average cost of capital (WACC)
Let’s assume: (for a company that does not pay
corporation tax)
Cost of debt (kd) = 10%
Cost of equity (ke) = 20%
So why not finance with all debt as it is cheaper?
What would the weighted average cost of capital be if
it was 50% debt, 50% equity?
50% x 10 (kd) = 5
50% x 20 (ke) = 10
WACC = 15% ? Could we do similar
calculations for different proportions?
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WACC and high gearing

In the example before, an all equity financed

company would have a WACC of 20% (ke). Adding
debt to the capital structure, which has a lower
cost, should reduce WACC. However only to a
certain extent. At high levels of interest payment
there is the risk to equity of no profits remaining
for them. Increasing risk means higher expected
return and higher cost of equity.
Also asking for more debt will probably mean only
obtaining this at a higher interest rate.
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Static Trade-off theory

STOT says that combining lower cost debt in the

capital will lower WACC to a point but then the
FINANCIAL DISTRESS costs of too much debt
means that WACC starts to increase.

The optimal capital structure should be when

WACC is at its lowest.

This will vary for organisations depending on their

borrowing capacity.
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• An optimal mix of debt and equity arises when
the decreasing weighted average cost of capital
(WACC) offsets the increasing financial risk
creating a tradeoff between cost of capital and
company’s market value.
• Due to debt payments being tax-deductible and
less risky over equity, debt financing is identified
as cheaper than equity.
• A company shall lower its WACC through a
capital structure with higher debt, however
increased debt could increase company’s risk of
bankruptcy
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Thank You

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