Топик: Going public and the dividend policy of the company
Топик: Going public and the dividend policy of the company
The theme of the report:
“Going public and the
dividend policy of the company.”
By Timofeeva M. V.
The supervisor: Sidorova
Public’ and the Securities Market3
- Types of
- The Stock
Exchange and the Capital Market
for an Issue of Securities
Share Futures and Options
Policy and Share Valuation
as a Residual Profit Decision
Associated with Dividend Policy
Arguments Supporting the Relevance of Dividend Policy
- Practical Factors Affecting Dividend Policy
Alternatives to Cash Dividends
In this report we focus on the
long-term financing by issuing shares and dividend policy of the company. We
consider the institutional design of capital market, Stock Market Exchange
and Alternative Investment Market; fundamental theories of paying
dividend and factors which influence Dividend Policy of the companies.
The main objective of this report
is to develop a better understanding of the problems faced by start-up firms
seeking capital financing and paying percentage (dividends). In addition, we
try to identify the consequences of shortcoming and overplus of the dividend
payouts for value of corporation (for value of share) and individuals
urgency of this question is obvious, because firms need capital to finance
product-development or growth and must, by a lot of factors (interest rate,
time period and etc), obtain this capital largely in the form of equity rather
than debt. So the issuing of shares and dividend policy is one of the widest
research overseas and I hope Russian economists don’t be backward in that list.
I. ‘Going Public’ and the Securities
Most private companies that experience the rapid growth have reached
the stage when existing shareholders’ private resources are exhausted, retained
profit is insufficient to cope with the rate of expansion, and further
borrowing on top of your current amount of loans will probably be resisted by
lenders until you have a more substantial layer of equity capital. One solution
to this financial problem is to retain the services of a financial intermediary
– usually a merchant bank – to find a few private individuals or financial
institution such as an insurance company or an investment trust that is willing
to subscribe more capital. This is known a private placing. And, of
course, there are some advantages and disadvantages of going public.
access to the capital market and to larger
amounts of finance becomes possible by having shares quoted on the Stock
institutions are more likely to invest on the
public listed company, and additional borrowing becomes possible;
shareholders will find it easier to sell their
shares in the wider market;
the company attains a higher financial standing;
provides an opportunity for public companies to
introduce tax-efficient employee share option scheme.
cost of a public flotation of shares are high –
as much as 4% - 10% of the value of the issue;
because outside shareholders are admitted, some
control may be lost over the business;
publicly quoted companies are subject to more
scrutiny than private;
the risk of being taken over by purchasing of
company’s shares on the Stock Exchange;
as the market tends to be influenced more by the
short- then long-term strategy of listed companies, a company committed to a
long-term plan may find its stock market performance disappointing.
The going public company is required:
minimum issued capital of ₤50.000;
minimum market capitalization of ₤500.000;
25% of your equity shares available to the
sign a Stock Exchange listing agreement,
which binds you to disclose specified information about your company in future.
- Types of
There are two main
classes of shares are ordinary and preference
Ordinary shares (sometimes called ‘equity’
Those are the highest risk-takers shares in the company. This
implies that the holder’s claims upon profit – for dividend, and assets – if
the company is liquidated, are deferred to the prior rights of creditors and
other security holders. However, the capital liability of ordinary shareholders
is limited to the amount they have agreed to subscribe on their shares,
therefore they cannot be called upon to meet any further deficiency that the
company may incur. If the ordinary shares are the voting (controlling
shares) but in some companies the significant proportion is held by the
directors and the remainder are widely held by a large number of shareholders,
so the directors may effectively control the company.
They also are the part of the equity
ownership, attractive to risk-averse investors because of their fixed rate of
dividend, which normally must be at a higher level than the rate of interest
paid to lenders, because of the relatively greater risk of non-payment of
dividend. Whilst they are part of the share capital, the holders are not
normally entitled to a vote, unless the terms of issue specified overwise, and
even then votes are usually only exercisable when dividends are in arrears.
Preference shareholders have prior rights to dividend before ordinary shareholders,
but it may be withheld if the directors consider there are insufficient
resources to meet it. There is an implied right to accumulation of dividends if
they are unpaid, unless the shares are stated to be non-cumulative. Payment of
such arrears has priority over future ordinary dividends. And if the company
goes into liquidation, preference shareholders are not entitled to payment of
dividend arrears or of capital before ordinary shareholders, unless their terms
of issue provide otherwise, which they usually do.
issued three varieties of preferences shares from time to time, to confer
special rights; these are redeemable preferences shares, participating
preferences shares and convertible preferences shares. Redeemable
preferences shares are similar to loan capital in that they are repayable
but they lack the advantage enjoyed by loan interest of being able to
charge dividend against profit for
taxation purposes, participating preferences shares enjoy the right to
further share in the profit beyond their fixed dividend, normally after the
ordinary shareholders have received up to a state percentage on their capital, convertible
preferences shares give the option to holders to convert their shares into
ordinary shares at the specified price over a specified period of time.
- The Stock
Exchange and the Capital Market
The Capital Market embraces all the activities of financial
institution engaged in:
the raising of finance for private and public
bodies whether situated in UK or overseas (the primary market);
trading the securities and other financial
instruments created by the activity above (the secondary market).
The Stock Exchange plays a central role in this
international market. It provides the primary facility fir marketing new issues
of shares and other securities, and also a well-regulated secondary market in
shares, British government and local authority stocks, industrial and
commercial loan stocks and many overseas stocks that are included in its
Official List. Nowadays it called the London Stock Exchange Ltd is an
independent company with the Board of Directors drawn from the Exchange’s
executive, and from the customer and user base.
The main participants on the Stock Exchange are Retail
Service Providers (RSPs) and the stockbrokers. The function of RSPs is
to provide a market in securities, which they have nominated, and to maintain
two-way prices, i.e. lower price at which they are prepared to buy and a higher
price at which thy will sell. And stockbrokers can act for client as agent
only, when purchasing or sell securities on their behalf, in which case they
deal with RSPs. And dual capacity stockbrokers/dealers, however they
will buy and sell shares on their own account, and may act as both agent and
principal in carrying out clients ‘buy’ and ‘sell’ instruction. Unfortunately
the integration of the broking and dealing functions within the same financial
grouping can give rise to conflict of interest, and this has made it essential
to create a protective regulatory framework both within and between financial
But some companies are not suitable for a full Stock Exchange
listing and the Alternative Investment Market (AIM), setting up by the
Stock Market Exchange in 1995, is a more suitable for unknown and risky
Its main features are:
no formal limit on company size;
₤500.000 capitalization (full listing
no minimum trading record (full listing five
10% of the equity capital must be in public
hands (full listing 25%)
no entry fee is required, but a annual listing
fee of ₤2.500 in year 1, rising to ₤4.000 in year three is payable.
for an Issue of Securities
made by an Issuing House, which specialized in this work. The procedure would
be probably as follows:
an evaluation by the Issuing House of the
company’s financial standing and future prospects;
an assessment if the finance required, and
advise regarding the most appropriate package to finance to meet the need;
advice of the timing of the issue;
agreement with the Stock Exchange on the method
of issue (sale by tender, SE placing etc);
completion of an underighting agreement;
preparation of the prospectus and other
documents required by the Stock Exchange in the initial application for the
advertising the offer for sell and the
publication of the prospectus;
arrangements with the bankers to receive the
the issue price of the share to be agreed at a
level to ensure a success of the issue;
final application for the Stock Exchange
quotation, and signing of the listing agreement, which binds the company to
maintain a regular supply of information to the Stock Exchange and
Share Futures and Options
These are traded at the London
International Futures and Options Exchange (LIFFE), which was established in
Both futures and options are used
by investors for:
protecting against future capital loss in their investments;
gambling on forecasts of favorable movements in future Stock Market prices.
main differences between futures and options is that futures contracts are binding
obligation to buy or sell assets, whereas options convey rights to
buy or sell assets, but not obligations. Futures are agreed, whereas options
The only equity futures dealt in on LIFFE
are those based on the FTSE 100 and MID 250 Stock Indices.
contracts may b used to protect an expected rise in the market before funds are
available to an investor. For example, an investor expecting a large cash sum
in three months’ time could protect his position by buying FTSE 100 Index
futures contract now, and selling futures for a higher sum when the market
rises. The profit made on the futures position would then compensate him for
the higher price he has pay for his investments when the expected cash sum
Equity Share Options
An option is the right to buy or sell
something at an agreed price (the exercise price) within a stated period of
time. As applied to shares, a payment (a premium) is made through or to a
stockbroker for a call option, which gives the right to buy
shares by a future date; or for a put option, which gives the right
to sell shares by future date. And the holder may exercise the option, or
late it lapse. However the giver (the ‘writer’) of the option, i. e. the dealer
to whom the premium has been paid, is obliged to deliver or buy the shares
respectively, if the option holder exercises his rights.
options have been dealt in for over 200 years, and
are usually written for a date three month’ hence, when either the shares are
exchanged, or the option lapses. The disadvantage of the traditional option is
that it cannot be traded before the exercise date, and it was because of this
inflexibility that the traded options market was created in the UK in
were first traded on LIFFE in 1992, and currently (1997), options are available
on 73 large companies’ shares. Because traded options cost much less then the
underlying shares, an investor is able to back an investment opinion without
risking too much money.
II. Dividend Policy and Share Valuation
1. Dividends as a Residual Profit Decision
It would seem sensible for a
company to continue to reinvest profit as long as projects can be found that
yield returns higher than its cost of capital. In this way, the company can
earn a higher return for shareholders than they can earn for themselves by
reinvesting dividends. Such a policy can be optimal, however, only if the
company maintains its target-gearing ratio by adding an appropriate proportion
of borrowed funds to the retained earnings. If not, the company’s coast of
capital would increase because of its disproportionate volume of higher-cost
equity capital; this would be reflected share price.
Company has the chance to invest in the five projects listed below:
Capital outlay, ₤
Yield rate, %
The company cost of capital is 16%
its optimal debt to net assets ratio is 30% and the current year’s profit
available to equity shareholders is ₤350.000.
State which projects would be accepted, and what
is the total finance requires for those projects.
Assuming that the company wishes to maintain its
gearing ratio, how much of the required finance will be borrowed?
How much of this year’s profit can be
A, B and C,
with yield greater than or equal to the company’s cost of capital; total
finance required ₤300.000.
Amount to be borrowed: 30% of
This year’s profit: ₤350.000
less amount to be reinvested ₤300.000-₤90.000:
shareholders obtain the best of both words. They can invest the ₤140.000
received as dividends to earn a higher rate of return than the company could
earn for them; and the ₤210.000 retained by the company is reinvested to
shareholders’ advantage. Shareholders’ wealth is optimized, and the dividend
paid is simply the residual profit after investment policy has been approved.
If companies look upon dividend
policy as what remains after investments are decided then the search for an
optimum dividend policy is pointless. Shareholders wanting dividends can always
make them for themselves by selling some of their shares.
Further support for the ‘residual’
theory of dividends, and the argument that the change in dividend policy does
not affect share values, was advanced by Modigliani and Miller in 1961. They
contended that in a perfect market the increase in total value of a company after
it has accepted an investment projects is the same, whether internal or
external finance is used.
One deficiency in the Modigliani
and Miller hypothesis, however, is that they ignore costs associated with an
issue of shares, which can be quite considerable.
Costs Associated with Dividend
Capital floatation costs are a
deterrent substituting external finance for retained earnings but there are
other costs affected by the dividend decision.
If shareholders are left to make
their own dividends by selling some shares, this involves brokerage and other
selling costs that, on a small number of shares, can be extremely an economic.
In addition, if they have to be sold during a period of low share price,
capital losses may be suffered.
Another important factor is
taxation. First, when the company distributes dividend it has to pay an advance
installment of corporation tax (ACT), currently one quarter of the amount paid.
But the offset against mainstream liability to pay corporation tax will be
delayed by at least one year. Indeed, if the company does not currently pay
this type of tax, the delay in setting off ACT will be even longer, and this
will tend to restrain extravagant dividend distributions.
Second, from the investors’
viewpoint profitability invested retained earnings should increase share
values, enabling shareholders to create their own dividends. Selling shares
creates a liability to capital gains tax, currently 20%, 23% or 40%, but
subject to a fairly generous exemption limit. By comparison, dividends in the
hands of shareholders attract
higher rate of income tax (up to 40%). Thus higher-rate taxpayers
may prefer comparatively low dividend payouts to minimize their tax burden.
Third, financial institutions
confuse the taxation picture even more, through their major holdings in the
shares of quoted companies. They are able to set off dividends received against
dividends paid for tax purpose but some may be liable to capital gains tax if
they sell shares to make dividends.
The effect of taxation on dividend
decision is difficult to analyse. It may be argued that companies attract
investors who can match their personal taxation regimes to company’s dividend
policy, and that those who don’t join a particular ‘taxation club’ will invest
elsewhere. If this were true, however, a change in company’s dividend policy
would probably not find favour with its shareholders clientele. And would
consequently affect share values, which seem to support the argument that
dividend policy matters.
Other Arguments Supporting the
Relevance of Dividend Policy.
potential investor, how would you react to the following questions?
Would you prefer cash dividends now, against the
promise of future, perhaps uncertain, dividends?
Would you prefer a stable, growing dividend to
one that fluctuates in sympathy with company’s investment needs?
If a company, in whose shares you invest,
increases or decreases its dividend, would it change your personal investment
answer in question (a) you probably opted for cash now rather than cash you may
never see. The future is uncertain and most people take much convincing that it
is in their interests to postpone income. Although the equity shareholder by
definition is the risk-bearer, he is also entitled to a reasonable resolution
of dividend prospects to compensate for the additional risk he carries. An
investor will almost certainty pay higher price for earlier rather than later
question (b), in definition, a fluctuating dividend is more risky than a stable
dividend. Investors will pay more for stability, especially if it is linked
with steady growth. Research has shown that, in general, dividends follow a
pattern of stability with growth. Maintenance
previous year’s dividend is the first consideration, with growth added when
directors feel that a higher plateau of profitability has been consolidated.
regards question (c), you would no doubt be very happy about an increase, and
might even be prompted to buy more shares – thus helping to put the market
price up. Conversely a decreased dividend would cause to review your
investment, perhaps even to sell your shares to take advantage of better
investment opportunities elsewhere. Investors tend to believe that dividend
changes provide information regarding a company’s futures prospects, and they
Practical Factors Affecting
Whatever dividend policy is thought
to be best for a company in theory, certain practical factors influence the
of profit The Companies Act 1985 provides that
dividends can only be paid out of accumulated realized profit less realized
losses, whether these are capital of revenue. Previous or current years’ losses
must be made good before a distribution can be made. If an asset is sold, any realized
profit or loss arising can be distributed; but any profit or loss arising from
revaluation of an asset cannot be distributed – unless and until the asset is
of cash Profit may be earned during a year and
yet it may hot be possible to pay a dividend because of lack of cash. This can
arise for different reasons. It may already have been expected or be needed to
replace fixed and working assets, perhaps at inflated prices. Large customers
may not yet have paid their accounts or cash may be needed to repay a loan.
restrictions The company’s articles association
may limit the payment of dividends or a lender by insert into a loan agreement
to restrict the level of dividends. A company’s dividend policy cannot be so outrageously
different from policies followed by similar companies in the same industry;
otherwise the market price of its shares could fall. Dividends may be
restricted by government prices and incomes polices.
Alternatives to Cash Dividends
In recent years companies have introduced more flexibility into
their dividend policy by either:
issuing shares in place of cash dividends
repurchasing their shares.
Script dividends Companies may give their shareholders the option to receive shares
rather than cash. This has the effect of maintaining company liquidity, and
enabling the company to increase earnings by investing the retained cash.
However company has to pay ACT on the distribution, and the shareholders have
to pay income tax.
Thus, the shareholders can increase
his investment in the company, without expense associated with the public issue
or a purchase on a stock market, but the same time retain the option to convert
his shares into cash at a future date.
Repurchasing shares Since 1981 companies have been allowed to purchase their own shares
subject to certain restrictions, and the prior authorization of their
shareholders. This is normally done by utilizing distributable profits, and the
shares must be cancelled after purchasing.
Repurchasing of shares may be
carried out for any of the following reasons:
to repay surplus cash to shareholders;
to increase gearing by reducing equity capital;
to increase EPS by reducing the number of shares
related to an unchanging level of profit, and hopefully, therefore, the value
of each remaining share;
to purchase the shares of a large shareholders.
In this report we have explored an
important and long-standing issue in financial research: how do corporations
finance themselves, the shares issuing in the Stock Market Exchange and
dividend policy of the companies.
And the situation is that the
rapidly expanding companies suffer from the retained profit insufficiency and
one of the solutions of this financial problem is going public.
But it is
not surprising that existing shareholders dig more deeply into company’s pocket
by claiming dividends. And of course the public company is subject to more
scrutiny than a private one.
think only when all other sources are exhausted your can dilute already
existing shareholders’ control over the company. However corporations willingly
make issues of shares and pay dividends. So how are their dividend, financial
and investment policy reconciled? This question has exercised the minds of
academics and financial managers in recent years without any completely
satisfactory answer being produced.
Anjolein Schmeits, ‘Essay on Corporate Finance
and Financial Intermediation’, Thesis publishers, 1999, 225-246.
Geoffrey Knott, ‘Financial Management’, Creative
Print and Design, Third edition, 1998,
3. Kovtun L.G., ‘English for Bankers and Brokers,
Managers and Market Specialists’, Moscow NIP“2”, 1994, 340-350.