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Evaluating The Effectiveness Of Corporate Payout Policy Finance Essay

The purpose of this Study is to critically evaluate the corporate payout policy. The research will identify the factors that have led to corporate organizations focusing on share repurchases rather than dividends. The research will analyze the theories of corporate payout policy and the associated literature will be reviewed. The study will evaluate the corporate payout policy of IBM and will suggest possible recommendations. The study will gather data and will evaluate the reasons for the importance given to share repurchases by corporate organizations with specific reference to IBM. The paper will gather information through various online resources such as Journals, magazines and finance websites. The study will compare and contrast the paying dividends and buying back stock policies adopted by IBM over the years to evaluate the superior policy and will suggest changes for the future growth.

Introduction

The market system has evolved over the past decade and has highlighted the role of stocks in the capitalist system. Shares and bonds have become the major investment tools in the capital market. Investments on shares and bonds give prospective capital gains and income to the Investors. Shares are appealing investment tools for those who are ready to risk and earn returns less than the investment and it offers dividends and capital income. However, bonds provide limited return on investments and the same principal amount. Organizations payout policy to their shareholders is of the following two types

Dividends: It is the share of the principal that is offered to the investors for their investment in the organization.

Stock repurchases: Organizations, at times, decide to repurchase the issued stock of the organization when the stocks are undervalued. Repurchasing ensures that the remaining outstanding stock prices rises.

In the recent times, stock repurchases have become prominent in the global capital market. Companies such as IBM, Merrill Lynch (Jason Dobosz, 2005) focus on share repurchases rather on dividend payments to shareholders. In this paper, the trend towards stock repurchases will be analyzed and evaluated.

Background

IBM is a Multinational company headquartered at New York, U.S. providing services such as computer, technology and IT consulting and is considered the 4th largest technology organization and 2nd largest brand in the world. IBM is the second most profitable IT services organization and by market capitalization (Forbes, 2000). IBM, in the last decade, decreased the shares from 1.8 bn in 1998 to 1.33 bn in 2008 and achieved a sales revenue increase by 18.4% from $87.5 bn to $103.6 bn. EPS increased by almost 116% as a result of stock repurchases and this also resulted in the increase of net income by 60.4%. Also, the dividend payments increased during this period. Over the last decade, IBM spent $73 bn on stock repurchases, the amount to have been used as dividends to shareholders.

Aim and Objectives

The primary goal of this study is to critically evaluate the shifting trends in the corporate payout policy adopted in IBM, the organization's preference to share repurchases instead of dividends payment. The primary aim will be further classified into objectives

To critically review the literature associated with the corporate payout policy theories

To critically examine the implemented corporate payout policies of IBM and its effectiveness

To do a comparative study on the corporate payout policies - Dividends and Share repurchases and identify the superior policy

To evaluate the existing corporate payout policy and suggest recommendations to IBM to improve their efficiency in the Stocks and Bond Market

To critically review the literature associated with the corporate payout policy theories

The objective focuses on the literature review on the theories of corporate payout policies. The study will analyze the influences of the policies in the financial growth of the organization and the effectiveness of the policies in corporate companies.

To critically examine the implemented corporate payout policies of IBM and its effectiveness

This objective is to critically evaluate IBM’s corporate payout policies and its efficiency in meeting the organizational goals. The study will evaluate the need and the factors driving the implemented corporate payout policies.

To do a comparative study on the corporate payout policies - Dividends and Share repurchases and identify the superior policy

The objective is to conduct a comparative analysis on the payout policies such as dividends and share repurchases and will identify the superior policy based on the research. The study will research the data gathered over the past decade to evaluate the payout policies.

To evaluate the existing corporate payout policy and suggest recommendations to IBM to improve their efficiency in the Stocks and Bond Market

This objective will examine the existing and adopted payout methods adopted by IBM and will provide possible recommendations for enhancing IBM’s efficiency in the capital management markets. The study will highlight the better payout policy for corporate companies to improve their position in the global market.

Value of Research

The Study is to identify the importance of the corporate payout policies and the elements that drive the preference to stock repurchases as compared to the payment of dividends by organization. The research will suggest recommendations to enhance the implementation of IBM's corporate payout policy and improve its financial growth.

Literature Review

Payout Policy

The concept of high dividends payout increases the organization's value was challenged by Miller and Modigliani (1961). Organization's payout policy doesn't impact the organization's value as investors rational decisions have minimum effect in a frictionless economy. The issue of dividends could affect the investment options available to the organization and it could result in lesser cash flows in the future. However, at the same time, had the organization retained the earnings, it could be seen as over-investment and the return on investment for the investors as compared to the market average will be lower. The high payout policy can be considered as an offering to the shareholders so as to sustain the organization's financial value (Trojanowski, 2004). The factors that determine the payout policy of an organization can be identified as Organization's valuation, Taxation, cash flows and Tax benefits.

Valuation of Shares

The valuation of the organization is important for the payout policy and if the shares are undervalued, organizations' repurchase the stock so as to improve the share price by utilizing the undervalued price and in turn this helps the investors to buy more shares of the organization. Stock repurchases are common during Mergers and acquisitions. A firm will buy the stock of the undervalued firm and this would help the increase in share price of both the firms. In certain cases, a firm buys its own undervalued shares to increase the share price in the market. Normally, competitors would hesitate to buy the shares of undervalued company as it would need additional premium to buy that stock. The success of the Stock repurchases can be measured directly from the number of investors who are willing to sell their shares as it is related to the buying shares price. At times, during the fall of stock price, the repurchase option might not cover the investment loss. and Stock repurchases can be used as an effective strategy when the fall in share price is moderate and this will trigger many investors to sell their stock.

Taxation

Taxation affects the corporate payout policies of most firms globally and this is based on the following aspects. Firms tend to adopt different policies when the tax regulations are changed and the Shareholders tend to modify and balance their investments aligning them to the changes in tax regulations (Kalay, 1982; Stiglitz, 1983). i.e., Investors hedge the risk of their investments. Stock buyouts are attractive payout options as it could be done at anytime of the year and investors might tend to force the firm to select a time perfect for the shareholders and this option provides flexibility for the investors and investors might participate in buyouts when the tax liabilities are lower. This helps the investors to defer tax payments. Dividends have less favourable tax regime as compared to stock repurchases. However, some firms prefer paying dividends due to regulations regarding tax exemptions.

Financial Structure

Firms transform their financial structure during share repurchases and this ensures the firm has a good debt/equity ratio. Share repurchases reduces equity and increases the debt and hence the leverage ratio increases after the repurchase. Hence, the financial structure has a major influence on the payout policies. 'Block Holders' are the investors with majority shares of the firm and are very few in number. The performance of the firm is actively reviewed by the block holders as they have huge interest in growing their investments. During repurchases, minor investors tend to sell their stock and this will result in block holders taking control of the firm's performance. Hence, it is increasingly essential to change the financial structure of the organization.

Cash Flow

Public companies have shares that could be traded in the stock market and the shareholders expect dividends for their investments and when organizations fail to meet the shareholders' needs, the price of the shares fall. Share repurchases normally occurs when the organization has excess cash and it is better to pay the shareholders in the form of share repurchases. Organizations with excess cash flows issue dividends and organizations with limited cash flows opt for share repurchases (Jaganathan et al, 2000). Also, organizations with cash flow in excess temporarily adopt share repurchase policy to distribute the excess cash to the investors.

Agency Issues

Management and shareholders of a firm are always under consistent tension. The management is assumed to work for the interests of the investors, however, the management often tries to maximise the firm's wealth and benefits at the expense of the investors. The relationship between them is competitive in real life. Management might use the investments to increase the salary and other benefits instead of offering payout. The relationship of trust between the management and Investors increases when the organization purchases the shares of the investors using the excess fund as it is seen as a maintenance to the shareholder's resources. Economists suggest that share repurchases has to be done along with selling of the management shares so to have a better management in the organization (Siu and Wetson, 2002). Share repurchases might cause conflict of interests as the timing of stock buying will be known only to the inside investors and this could lead to negative impact on the organization.

Signalling

Share repurchases are used as signalling methods to forecast the operating cash flows of the firm. Management must convey the actual value of the stock when it increases above the market value. Share repurchases impact the overvalued organization's cost. Share repurchases of overvalued firms results in reduction of share prices. Share repurchases signal the shareholders that organization will invest in certain few projects and the cash flow will be lower due to payment to the investors. Share repurchases can be an indicator of the organization's financial situation.

Convertible bonds execution

Convertible bonds are bonds that pay the investors a regular premium and the bond price is based on interest rates and credit history of the issuer. Convertible bonds possess the attributes of bonds and shares. Organizations provide shareholders the option to convert bonds to shares whenever needed so as to get the investors attracted, however, shares and bonds offer different income choices. Lower interest rate makes shares attractive and high interest rates makes the bonds attractive. Organizations, buy shares from market to ensure that the investor's needs of convertible bonds are met. Options are related to increased payouts and decreased retaining of the income (Lambert et al, 1989). There exists a negative relationship between dividends and the managerial stock (Fenn and Liang, 2000). The executive compensation impacts the decision of the payout in the organization and it emphasizes that the dividend reductions due to options improve the management's option value and is often used for income retention.

Share repurchases vs. Dividends

Dividends help the firm's performance as the investors monitor the organizational management and work and the investors hold the management accountable for the decisions and performance of the organization and during share repurchases, the firm will have lesser investors monitoring the organizational operations. Dividends usually attract long-term investors and it is essential for organization to have long-term shareholders as it will help the organization to restructure. Critics argue that dividends help in retaining long term investors as it ensures the money reaches the investors directly. Share repurchases are often considered better investments by short-term investors. The cost associated with share repurchases might outweigh the tax disadvantage of dividend payout, according to the article, 'corporate payout policy' (Barclay and Smith, 1988). Share repurchases are considered better investment by economists as the shareholders don't get the negative feel towards the firm. Share repurchases benefit the shareholders in terms of tax exemptions and benefits. In most firms, the managers are provided share options and at times the directors are unwilling to repurchase the firm's shares as it increases the share price. Share repurchase can be used by the directors to dilute the control of the other investors.

Market Response to Share repurchases

The market response to the stock buyback depends on the management's motivation and reason for the repurchases. The stock prices will increase, if the repurchases are performed with the aim to improve the interests of the investors and the position of the firm. Organization payout policy of share repurchases with an intention to increase the earning per share might help in increasing the value of the shares, however the effectiveness will be lost as the total earning will reduce based on the number of outstanding shares. this will result in constant EPS and hence the organization's objective of increasing the EPS will not be achieved. The organization will use the earnings to buy the liabilities and the relative position will remain constant. In this case, the market will not actively pursue to buy the shares.

Hypotheses

Hypothesis 1: The Stock repurchases are driven by Taxation and Cash flow

Hypothesis 2: There is an increase in trend towards migration from dividends to stock repurchases

Hypothesis 3: Stock repurchases provides multiple and more benefits as compared to dividends payment

Methodology

Research Approach

The Research will use a mixture of Inductive and Deductive approach (Mixed Approach) and hence the research will include both qualitative and quantitative analysis. The approach is used to identify the superior payout policy based on the data collected. Sources of data will be gathered from various online resources such as journals, case studies and the published financial statements issued by IBM. The study will suggest recommendations based on the research as an Inductive approach and the online resources will be used to compare the two tools of corporate payout. The research will explore the nature of stock buyouts by IBM and the ways of using it as temporary income.

Qualitative Research

The exploratory nature of the discussed objectives will be achieved through qualitative research. The theories related to the corporate payout policy will be discussed and the associated literature will be reviewed and the effectiveness of the implemented policy will be deducted based on the various studies conducted. The study will focus on measuring the efficiency of the policies and their implementation in IBM.

Purpose

The aim of this study is to analyze the policies of corporate payout and their various influences on the financial growth of the organizations. The study will use a case study analysis on IBM and the financial statement analysis to deduce the outcomes for the following questions

What made IBM prefer Stock repurchases to Dividends payment?

Who was instrumental in the financial decision making of the organization?

What are the concerns to be addressed when shifting policies?

Which is greater – Share repurchases vs. Dividends payment?

How do the corporate policies affect the cash flows?

What are the benefits of implementing the stock repurchases policy?

How does reducing dividends payment affect the shareholders?

What is the policy predominantly adopted in the nations where IBM operates?

How do Government rules and regulations affect the corporate policy?

What corporate payout policies do the competitors adopt?

Population and Sampling

The theoretical sampling method will be employed to deduce the outcome of this research. The research will analyze the various online resources and deduce the objectives and sample the results to suggest recommendations

Procedure

The study will use case study approach to deduce the superior corporate payout policy. The research will use the data gathered online and the financial statements of IBM over the past few years and the analysis of economists of the policies.

Quantitative Research

The study will try to analyze, compare and contrast the policies based on the financial statements.

Purpose

To identify the better policy in terms of financial growth of the organization and to suggest recommendations for companies to adopt a policy that yields maximum benefits.

Population and Sampling

The study will be conducted using the financial statements published by IBM.

Procedure

In this research, the following questions related to corporate choices of payout will be answered. There will be classification of policies on the following basis

1. Policy with no distributions to the shareholders

2. Policy with dividend payments alone

3. Policy with Stock buyouts; and

4. Policy which pays both dividends and repurchases stock.

Based on the classification, the stability of the policy will be compared.

The probability of IBM using the first Policy instead of second policy can be identified using the following formula.

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The difference in coefficient vectors can be used to calculate the probability of the policy adopted using multivariate logic regression method.

Sources and acquisition of Data

The research will be mainly focused using the major secondary data and a little of primary data. The data will be used to analyze the research objectives discussed in this study and will be collected through extensive online research.

Primary Data

The primary data will be collected through the published financial statements. Interviews and articles published online regarding IBM’s corporate policy would be used as the primary source of data. The study will extensively research on the corporate policies in practice and gather information and researches conducted previously on this theory.

Secondary Data

Secondary source of data will be gathered online through Journals, articles and researched conducted by others. A case study on IBM will be analyzed and the literature on corporate payout policies will be reviewed. The following source ‘International Evidence on Corporate Payout Policy: Dividends vs. Share Repurchases by Bong Soo Lee and Jungwon Suh’ will be used as the major secondary source of data

Form of Presentation

The comparative study will be submitted as a report. The analysis will be provided in the form of charts, graphs and illustrative figures. The research information will be presented and the recommendations based on the case study analysis will be provided. The report will use tables to compare and contrast the two policies.

Timetable

Week

Tasks

I

Basic Research

II

Research Data gathering

II-III

Qualitative Study

III-IV

Qualitative Report Submission

V-VI

Quantitative Research

VI-VII

Calculations and Information Processing

VII

Presentation and References

VIII

Recommendations and Report

Scope of the Research

The research scope will be limited due to unavailability of access and authorization to internal data of IBM. The assumptions will be based on the available online research materials and the data collected will be considered to be true. The scope is limited to the corporate payout policies adopted by IBM

Limitations of the Research

The research limitations are confined to cost and travel. The access to information available within IBM is hard to gather and hence the research may not be an exact picturization of the economic situation and the analysis will be majorly limited and restricted to the data gathered through secondary sources.

Ethics

The study will be carried out in an ethical way. The financial statements, case study and research data used will be referenced and quoted whenever used and the information will be collected in ethical means. The gathered information will be provided on request.

Observation and Recommendations

The research will submit the observations and will present the report findings. The research will critically evaluate the effectiveness of the corporate payout policies and the differences between dividend payments and stock repurchases and their efficiency in terms of financial growth will be identified. Furthermore, the research will propose possible recommendations for the improvement of adopting the Stock repurchases policy by IBM.

Summary and Conclusion

The study will highlight the various factors such as signalling, cash flow, tax benefits, stocks drive stock repurchases by organizations and the most important elements that attribute the movement from dividends to stock repurchases are Tax, valuation of shares, Stock options and Cash flows.

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