Introduction: To finance their investments firms use retained earnings, new borrowings or the issue of stock. The financing decision involves i) dividend and ii) the capital structure. Dividend policy involves the decision to pay out earnings versus retaining them for reinvestment in the firm, and dividend policy decisions can have either favorable or unfavorable effects on the price of a firm’s stock. Cash distributions are made to stockholders form the firm’s earnings, whether those earnings were generated in the current period or in previous periods. Origin of the Report:
During this semester of Summer 2010 in MBA program of East West University, we are required to submit a term paper in the course Corporate Finance: “An Appraisal of Dividend Policy and Capital Structure of An Organization”. We have chosen PRAN for our term project. Objectives of the Report: The general objective is to prepare and submit the term project within specified time by having an idea and over viewing the PRAN, their Dividend Policy and their Capital Structure. Scope of the Report: The scope is limited to over viewing PRAN their dividend policy and the Capital Structure they have adopted for their organization.
Limitations of the Study: Secondary data were used in this study as result it may differ from actual data. As a group, we have also faced some difficulties in compiling and discussing it due to unavailability of all members at the same time. The absence of solid and verse knowledge about dividend policy is absent and we have taken it as an addition in our learning curve. Methodology: The report is originated from secondary data sources- 1. The Company’s Annual Report 2. DES website 3. Different Articles from Internet 4. Other related websites
Company Profile PRAN: PRAN stands for Programme for Rural Advancement Nationally. “PRAN” is currently the most well known household name among the millions of people in Bangladesh and abroad also. Since its inception in 1980, PRAN Group has grown up in stature and became the largest fruit and vegetable processor in Bangladesh. It also has the distinction of achieving prestigious certificate like ISO 9001:2000, and being the largest exporter of processed agro products with compliance of HALAL & HACCP to more than 70 countries from Bangladesh.
PRAN is the pioneer in Bangladesh to be involved in contract farming and procures raw material directly from the farmers and processes through state of the art machinery at our several factories into hygienically packed food and drinks products. The brand “PRAN” has established itself in every category of food and beverage industry and can boost a product range from Juices, Carbonated Drinks, Confectionery, Snacks, and Spices to even Dairy products.
Today, our consumers not only value “PRAN” for its authentic refreshing juice drinks products, but also for its mouth watering quality confectionery products with high visual appeal and exciting texture. We intend to expand our presence to every corner of the world and strive to make “PRAN” a truly international brand to be recognized globally. The authorized capital of PRAN is BDT 50,000,000 and paid up capital is BDT 8,000,000. The proportion is given below: |Share Percentage | |Director /Sponsor |Govt. Institute |Foreign |Public | |42. 75% |0% |1. 27% |0% |55. 98% | [pic] Dividends: Dividend is that part of the profits of a company which is distributed amongst its shareholders. According to ICAI, “Dividend is a distribution to shareholders out of profits or reserves available for this purpose. ” In other words we can say that a corporation makes Dividend payments to its shareholder. It is the portion of corporate profits paid out to its stockholders.
When a corporation earns a profit at the end of a financial year, that profit can be uses by two different ways: it can either be re-invested in the business or it can be paid to the shareholders as a dividend. Many corporations retain a portion of their earnings and pay the remainder as a dividend. Dividend Policy and Stock Value: There are various theories that try to explain the relationship of a firm’s dividend policy and common stock value. Dividend policy is the policy a company uses to decide how much it will pay out to shareholders in dividends. A firm has different options to deal with its earnings.
It can give all their earnings as dividend or it can retain all its earnings as retained earnings. The firm can also declare a portion of its earnings as dividend and can retain other portion as retained earnings. Dividends may be in the form of cash or stock. Most secure and stable companies offer dividends to their stockholders. Their share prices might not move much, but the dividend attempts to make up for this. High-growth companies rarely offer dividends because all of their profits are reinvested to help sustain higher-than-average growth. Dividend Relevance Theory:
The value of a firm is affected by its dividend policy – the optimal dividend policy is the one that maximize the firm’s value. Optimal Dividend Policy: Proponents believe that there is a dividend policy that strikes a balance between current dividends and future growth that maximizes the firm’s stock price. Dividend Irrelevance Theory: The theory states that a firm’s dividend policy has no effect on either its value or its cost of capital. Bird-in-the-Hand Theory: It states that dividends are relevant. Remember that total return (k) is equal to dividend yield plus capital gains.
Myron Gordon and John Linter took this equation and assumed that k would decrease as a company’s payout increased. As such, as a company increases its payout ratio, investors become concerned that the company’s future capital gains will dissipate since the retained earnings that the company reinvests into the business will be less. Gordon and Linter argued that investors value dividends more than capital gains when making decisions related to stocks. In this theory “the bird in the hand’ is referring to dividends and “the bush” is referring to capital gains.
The traditional argument in favour of dividend is the idea that dividends reduce risk because they bring shareholders’ cash inflows forward. Although shareholders can create their own dividends by selling part of their holdings, this entails trading costs, which are saved when the firm pays dividends. The risk reduction or bird in the hand argument is associated with Graham and Dodd (1951) and with Gordon (1959) and it is often defended as follows. By paying dividends the firm brings forward cash inflows to shareholders, thereby reducing the uncertainty associated with future cash flows.
In terms of the discounted dividend equation of firm value, the idea is that the required rate of return demanded by investors (the discount rate) increases with the plough-back ratio. Although the increased earnings retention brings about higher expected future dividend, this additional dividend stream is more than offset by the increase in the discount rate. This argument overlooks the fact that the risk of the firm is determined by its investment decisions and not by how these are financed.
The required rate of return is influenced by the risk of the investments and should not change if these are financed from retained earnings rather than from the proceeds of new equity issues. As noted by Easterbrook (1984), in spite of paying dividends the firm does not withdraw from risky investments, thus the risk is merely transferred to new investors. Reasons for Paying Dividends: 1. Clientele Effect: The investors in your company like dividends. 2. The Signaling Story: Dividends can be signals to the market that you believe that you have good cash flow prospects in the future. 3.
The Wealth Appropriation Story: Dividends are one way of transferring wealth from lenders to equity investors (this is good for equity investors but bad for lenders) Types of Dividend Policies: 1. Constant-Payout-Ratio: Constant-Payout-Ratio is a dividend policy based on the payment of a certain percentage of earnings to owners in each dividend period. The problem with this policy is that if the firm’s earnings drop or if a loss occur, the dividend may low or nonexistent. 2. Regular Dividend Policy: Regular Dividend Policy is a dividend policy based on the payment of fixed amount of dividend in each period.
It provides the owners with positive information, thereby minimizing their uncertainty. 3. Low Regular and Extra Dividend Policy: Low regular and Extra Dividend Policy refers to a dividend policy based on paying low regular dividend, supplemented by additional dividend when earnings are higher than normal in a given period. Nature of Dividend Decision The dividend decision of the firm is crucial for the finance manager because it determines: 1. The amount of profit to be distributed among the shareholders, and 2. The amount of profit to be retained in the firm. There is a reciprocal relationship between cash dividends and retained earnings.
While taking the dividend decision the management take into account the effect of the decision on the maximization of shareholders’ wealth. Maximizing the market value of shares is the objective. Dividend pay out or retention is guided by this objective. Factors Affecting Dividend Policy: A. External Factors B. Internal Factors A. External Factors Affecting Dividend Policy 1. General State of Economy: In case of uncertain economic and business conditions, the management may like to retain whole or large part of earnings to build up reserves to absorb future shocks.
In the period of depression the management may also retain a large part of its earnings to preserve the firm’s liquidity position. In periods of prosperity the management may not be liberal in dividend payments because of availability of larger profitable investment opportunities. In periods of inflation, the management may retain large portion of earnings to finance replacement of obsolete machines. 2. State of Capital Market: Favorable Market: liberal dividend policy. Unfavorable market: Conservative dividend policy. 3. Legal Restrictions: Companies Act has laid down various restrictions regarding the declaration of dividend:
Dividends can only be paid out of: Current or past profits of the company. A company cannot declare dividends unless: It has provided for present as well as all arrears of depreciation. Certain percentage of net profits has been transferred to the reserve of the company. Past-accumulated profits can be used for declaration of dividends only as per the rules framed by the Central Government 4. Contractual Restrictions: Lenders sometimes may put restrictions on the dividend payments to protect their interests (especially when the firm is experiencing liquidity problems) B.
Internal Factors affecting dividend decisions 1. Desire of the Shareholders: Though the directors decide the rate of dividend, it is always at the interest of the shareholders. Shareholders expect two types of returns: [i] Capital Gains: i. e. , an increase in the market value of shares. [ii] Dividends: regular return on their investment. Cautious investors look for dividends because, [i] It reduces uncertainty (capital gains are uncertain). [ii] Indication of financial strength of the company. [iii] Need for income: Some invest in shares so as to get regular income to meet their living expenses. . Financial Needs of the Company: If the company has profitable projects and it is costly to raise funds, it may decide to retain the earnings. 3. Nature of earnings: A company, which has stable earnings, can afford to have a higher divided payout ratio 4. Desire to retain the control of management: Additional public issue of share will dilute the control of management. 5. Liquidity position: Payment of dividend results in cash outflow. A company may have adequate earning but it may not have sufficient funds to pay dividends. Apprising Dividend Policy of PRAN: Year |NI |EPS |Dividend Per |Dividend Payout Ratio | | |(in Millions) | |Share | | |2000 |33. 76 |42. 20% |20. 00% |47. 39% | |2001 |41. 99 |52. 49% |20. 00% |38. 10% | |2002 |43. 41 |54. 26% |25. 00% |46. 07% | |2003 |44. 39 |55. 49% |24. 00% |43. 25% | |2004 |40. 31 |50. 39% |24. 00% |47. 3% | |2005 |40. 77 |50. 96% |26. 00% |51. 02% | |2006 |28. 95 |36. 19% |26. 00% |71. 84% | |2007 |29. 33 |36. 66% |26. 00% |70. 92% | |2008 |35. 95 |44. 94% |28. 00% |62. 31% | |2009 |39. 97 |49. 96% |29. 00% |58. 05% | Table: 1 From the table 1 we see that in 2000 and 2001 PRAN have paid a cash dividend of BDT 20 per share in 2000 and 2001; in 2002 the dividend payment was BDT 25 per share.
In 2003 to 2004 and 2005 to 2007 they have paid a cash dividend of BDT 24 and BDT 26 per share respectively. In the year 2008 and 2009 the cash dividend per share was BDT 28 and 29 respectively. Here we see that the dividend has increased in last two year, although the Net Income of the company decreased. However the EPS has also increased during the last two years and the same pattern can be seen in the Market Price of the share. [pic] Figure: 1 From figure 1 we can say that the dividend payment of the PRAN is certain and stable, regardless with earnings.
As we see that despite of a drop in the earning in the year 2006 and 2007 the company maintained a constant cash dividend payment which is BDT 26 per Share and when the earnings increased in the year 2008 and 2009 the Dividend payment also increased. [pic] Figure: 2 The Dividend payout ratio indicates the percentage of each unit earned that a firm distributes to the owners in form of cash |Dividend Payout Ratio |= |Dividend Per Share | | | |Earnings Per Share |
If we look at the figure 2 we see that to maintain a steady dividend payment per share each year they had to make a huge payment out of the Net Income. In 2006 and 2007 the dividend payout ratio was above 70% and in 2008 and 2009 it was above 58%. According to the Regular Dividend Policy the payment of the dividend is a fixed amount in each period. The Regular Dividend Policy also tries to establish to pay out a certain percentage of earnings, however it tries to stabilize the dividend by pay out a certain amount of dividend and it adjusts the dividend towards the target payout as proven earnings increases.
In short we can say that PRAN is following the Regular Dividend Policy Constrains of Regular Dividend Policy: If we have a look at the figure 1 we see that the earnings of PRAN fluctuates year to year for this Regular dividend policy may sometimes prove dangerous. Once a company adopts the regular dividend policy, any adverse change in the dividend payment may result in serious damage regarding the financial standing of the company in the mind of the investors. The same problem is been experienced by PRAN despite of a drop in the earnings that they had to maintain the same amount of dividend.
Appropriate type of Dividend Policy: A Stock market tends to be very efficient in the allocation of capital to its highest-value users. That market also helps increase savings and investment, which are essential for economic development. An equity market, by allowing diversification across a variety of assets, helps reduce the risk the investors must bear, thus reducing the cost of capital, which in turn spurs investment and economic growth. However, volatility and market efficiency are two important features which will ultimately determine the effectiveness of the stock market in economic development.
In contrast to that the stock market of Bangladesh which is informationally inefficient, investors face difficulty in choosing the optimal investment as information on corporate performance is slow or less available. The resulting uncertainty induce investors either to withdraw from the market until this uncertainty is resolved or discourage them to invest funds for long term. Moreover, most of the time it is seen that investors are not rewarded for taking on higher risk by investing in the stock market, or excess volatility weakens investor’s confidence as a result they people avoid investing their savings in the stock market.
Due to the imperfect market and the uncertainty of return the investors always aim for short term investment as a result they prefer dividend rather maximizing the firm’s wealth. The regular dividend policy, which ensures a fixed amount of dividend to be paid to the investor regardless to the company’s income during the period, helps to reduce the uncertainly for the investors. For this the Regular Dividend Policy is the appropriate for PRAN. Year |Net Asset Value Per |EPS |Dividend Per Share |Bonus Share |Market Price Per | | |Share | | | |Share | |2000 |258. 39 |42. 20% |20. 00% |- |416. 50 | |2001 |284. 60 |52. 49% |20. 00% |- |370. 00 | |2002 |312. 82 |54. 26% |25. 00% |- |366. 00 | |2003 |343. 9 |55. 49% |24. 00% |- |412. 00 | |2004 |362. 27 |50. 39% |24. 00% |- |523. 50 | |2005 |386. 55 |50. 96% |26. 00% |- |519. 25 | |2006 |396. 11 |36. 19% |26. 00% |- |386. 00 | |2007 |383. 91 |36. 66% |26. 00% |- |382. 63 | |2008 |428. 9 |44. 94% |28. 00% |- |1142. 00 | |2009 |449. 96 |49. 96% |29. 00% |- |1363. 00 | Net Asset Per Share Vs. Market Value Per Share: Table: 2 From the table 2 we can say that PRAN has never issued any Bonus shares from 2000 to 2009. However they have maintained a steady dividend payment that shows a positive slope. The market price is very fluctuating in 2005 the MV was 519. 25 but in 2006 it went down to 386. 00, in 2007 it was 382. 63 but in 2008 the MV was 1142. 00. [pic]
Figure: 2 From the figure 2 we see that till 2007 the Share Market Price and the Net Asset Value Per share is very close however from 2008 the difference between the Market Price and Net Asset value per Share increased despite of a drop in the Net Income. In the year 2008 and 2009 the corporation has paid a cash dividend of BDT 28 and 29 per share respectively and the EPS in 2008 was 44. 94% and in 2009 was 49. 96. From the above mentioned information we can say that there is a high possibility that the reason behind the increase in the market price of the share imperfect market condition in the Capital Market in Bangladesh.
The imperfect market situation might be the result of Syndication or by spreading rumor in the market, which caused the Share Price of PRAN to go up. Capital Structure: In finance, capital structure refers to the way a corporation finances its assets through some combination of equity, debt, or hybrid securities. In other words we can say that Capital Structure is the mix of a company’s long-term debt, specific short-term debt, common equity and preferred equity. The capital structure is how a firm finances its overall operations and growth by using different sources of funds.
Debt comes in the form of bond issues or long-term notes payable, while equity is classified as common stock, preferred stock or retained earnings. Short-term debt such as working capital requirements is also considered to be part of the capital structure. For example, a firm that sells BDT 20 billion in equity and BDT 80 billion in debt is said to be 20% equity-financed and 80% debt-financed. The firm’s ratio of debt to total financing, 80% in this example is referred to as the firm’s leverage. In reality, capital structure may be highly complex and include dozens of sources.
Gearing Ratio is the proportion of the capital employed of the firm which come from outside of the business finance, e. g. by taking a short term loan etc. A company’s proportion of short and long-term debt is considered when analyzing capital structure. When people refer to capital structure they are most likely referring to a firm’s debt-to-equity ratio, which provides insight into how risky a company is. Usually a company more heavily financed by debt poses greater risk, as this firm is relatively highly levered.
The Modigliani-Miller theorem, proposed by Franco Modigliani and Merton Miller, forms the basis for modern thinking on capital structure, though it is generally viewed as a purely theoretical result since it assumes away many important factors in the capital structure decision. The theorem states that, in a perfect market, how a firm is financed is irrelevant to its value. This result provides the base with which to examine real world reasons why capital structure is relevant, that is, a company’s value is affected by the capital structure it employs.
Some other reasons include bankruptcy costs, agency costs, taxes, and information asymmetry. This analysis can then be extended to look at whether there is in fact an optimal capital structure: the one which maximizes the value of the firm. Capital structure in the real world if capital structure is irrelevant in a perfect market, then imperfections which exist in the real world must be the cause of its relevance. The theories below try to address some of these imperfections, by relaxing assumptions made in the M model.
Capital Structure Theory: Trade-off theory of capital structure Trade-off theory allows the bankruptcy cost to exist. It states that there is an advantage to financing with debt (namely, the tax benefit of debts) and that there is a cost of financing with debt (the bankruptcy costs of debt). The marginal benefit of further increases in debt declines as debt increases, while the marginal cost increases, so that a firm that is optimizing its overall value will focus on this trade-off when choosing how much debt and equity to use for financing.
Empirically, this theory may explain differences in D/E ratios between industries, but it doesn’t explain differences within the same industry. Pecking order theory Pecking Order theory tries to capture the costs of asymmetric information. It states that companies prioritize their sources of financing (from internal financing to equity) according to the law of least effort, or of least resistance, preferring to raise equity as a financing means “of last resort”.
Hence: internal debt is used first; when that is depleted, then debt is issued; and when it is no longer sensible to issue any more debt, equity is issued. This theory maintains that businesses adhere to a hierarchy of financing sources and prefer internal financing when available, and debt is preferred over equity if external financing is required (equity would mean issuing shares which meant ‘bringing external ownership’ into the company. Thus, the form of debt a firm chooses can act as a signal of its need for external finance.
The pecking order theory is popularized by Myers (1984) when he argues that equity is a less preferred means to raise capital because when managers (who are assumed to know better about true condition of the firm than investors) issue new equity, investors believe that managers think that the firm is overvalued and managers are taking advantage of this over-valuation. As a result, investors will place a lower value to the new equity issuance.. Agency Costs: There are three types of agency costs which can help explain the relevance of capital structure.
Asset substitution effect: As D/E increases, management has an increased incentive to undertake risky (even negative NPV) projects. This is because if the project is successful, share holders get all the upside, whereas if it is unsuccessful, debt holders get all the downside. If the projects are undertaken, there is a chance of firm value decreasing and a wealth transfer from debt holders to share holders. Underinvestment problem: If debt is risky (e. g. , in a growth company), the gain from the project will accrue to debt holders rather than shareholders.
Thus, management has an incentive to reject positive NPV projects, even though they have the potential to increase firm value. Free cash flow: unless free cash flow is given back to investors, management has an incentive to destroy firm value through empire building and perks etc. Increasing leverage imposes financial discipline on management. Other The neutral mutation hypothesis—firms fall into various habits of financing, which do not impact on value. Market timing hypothesis—capital structure is the outcome of the historical cumulative timing of the market by managers.
Accelerated investment effect—even in absence of agency costs, levered firms use to invest faster because of the existence of default risk. Primary Factors influencing the Capital Structure: 1. Business Risk: It is the risk associated with the unique circumstances of a particular company, as they might affect the price of that company’s securities. If the business risk is higher than the optimal debt amount will be lower. 2. Tax Position: It is the second key factor.
The major reason for using debt is that the interest is tax deductable which helps to lower the effective cost of debt. However, if much of a firm’s income is already sheltered from taxes by accelerated depreciation or tax loss carried forward from previous years, its rate will be low, as a result debt will not be advantageous as it would be to a firm with higher effective tax rate. 3. Financial Flexibility: It indicates a firm’s ability raise capital on reasonable terms under adverse conditions. 4. Managerial Attitude: It is the firm’s attitude to borrowing fund.
Some of the firms are more aggressive than others; hence, some firms are more inclined to use debt in an effort to boost profit. This factor does not affect the optimal capital structure or value-maximizing, however it does influence the firm’s target capital structure. Evaluating the Capital Structure of PRAN: The debt-to-equity ratio (D/E) is a financial ratio indicating the relative proportion of shareholders’ equity and debt used to finance a company’s assets. Closely related to leveraging, the ratio is also known as Risk, Gearing or Leverage. Year |Equity |Debt |Debt to Equity Ratio|NI |EPS | | | | | |(in Millions) | | |2005 |330. 04 |165. 94 |33. 46% |40. 77 |50. 96% | |2006 |337. 69 |152. 59 |31. 12% |28. 95 |36. 19% | |2007 |327. 93 |114. 00 |25. 80% |29. 33 |36. 66% | |2008 |342. 71 |92. 9 |21. 25% |35. 95 |44. 94% | |2009 |359. 97 |138. 99 |27. 86% |39. 97 |49. 96% | Table: 3 From the table: 3 we can say that that in 2005 when the D/E ratio was 50. 96% the company experienced the highest EPS. If we compare the D/E ratio and the EPS of 2008 and 2009 we see that in 2009 the debt ratio has increased by 6. 61% which had a positive effect on the EPS as a result the EPS increased by 5. 02%. It shows that when the D/E ration increases the EPS also increases.
If we look at the graphical presentation it will be easier for us to understand which is given below. [pic] Figure: 4 If we take the average of the D/E ratio from 2005 to 2009 we see that on average PRAN is maintaining a D/E ratio of 27. 90%. In short we can say that 27. 90% of the total equity is financed by Debt. It means that the PRAN is moderately aggressive towards the debt financing. As a result they have a lower Financial Risk and higher Business risk. Conclusion: PRAN is one of the reputed companies in the Dhaka Stock Exchange and they fall under the Category “A”.
From year 2000 to 2009 PRAN has always have paid cash dividend however they have never paid stock dividend. PRAN is maintaining a reserve capacity Dividends can be used to budge assets out of the company and consequently from the potential allege of creditors which can be injurious to creditor wealth, and creditors will beyond a shadow of a doubt take pricing or contractual actions to offset these latent uses of dividends. The contemplations of signaling, agency and the effects of market imperfections upon optimal dividends are imperative dimensions about which financial managers must be sentient. Recommendations:
Cash and stock dividend, both should be paid without fail. Our stock market is not an efficient market. The available information most of the times do not lead to the desired reality. Many investors believe on the rumors and invest in the share market. Security Exchange Commission should take proper steps to minimize this condition. Disclosure of the overall market price in the annual report is desirable. The company can ideas from its investors to improve the situation and thereby engaging them in the part of the decision making process. Issuing of bonus shares can be a good option to attract the potential investors.