Payout Decision and Working Capital Management

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Question 1

Payout Decision and Working Capital Management

Introduction

One of the most popular investment tools in the capital market are shares and bonds since they give income and prospective capital gains to the Investors. Shares are attractive investment tools for investors who are ready to take risk and it offers dividends and capital income, bonds provide limited return on and almost the same principal amount.

Dividend policy is one of the most important polices in the corporate finance. This idea has been considered from shareholder perspective, worker and regulatory bodies, consumers, and the government perspective as well as from the company point of view. The payout policy for a certain a company determines how this company will distribute cash to its shareholders, it can either pay a cash dividend or it can do share repurchases. Dividends are the share of the principal that the investors are offered for their investment. Stock repurchases is an activity that occurs when an organization decides to repurchase the issued stock when the stocks are undervalued.

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In this assignment, a study of the payout policy was conducted for three companies in the food sector: Associated British Foods (ABF), Compass Group (CPG) and Tate & Lyle (TATE). The study will give us an opportunity to get some hands-on experience on analyzing and evaluating the payout policies and models in real firms.

Literature Review

Payout Policy

Most companies are paying dividends in regular and quarterly basis. Sometimes there are some special dividends that are announced one time. Share repurchasing can be done using a tender offer, an open market repurchase, a repurchase Dutch auction, or a targeted repurchase. Cash return using issuing dividends is more flexible for the shareholder while share purchases are more flexible for the company.

Miller and Modigliani (1961) challenged the concept that the payout of high dividends increases the organization's value (UKEssays. 2014). Miller and Modigliani is a theory states that the investors are not concerned with the dividend policy of the company. Modigliani-Miller payout irrelevance policy states that “In perfect capital markets, if a firm invests excess cash flows in financial securities, the firm’s choice of payout versus retention is irrelevant and does not affect the value of the firm”.

According to the theory, the value of a firm is unaffected by how that firm is financed under a certain market price process in the absence of agency costs, taxes, bankruptcy costs. It does not matter what the firm's dividend policy and whether the firm's capital is raised by issuing stock or selling debt. (Berk et al. 2012).

The payout policy for an organization is affected by certain factors which can be identified as the valuation of shares, cash flows, taxation, and Tax benefits. Organization's payout policy doesn't impact the organization's value since rational decisions of investors have minimum effect in a smooth economy. The high payout policy can be considered as an offer to the shareholders to sustain the organization's financial value (UKEssays. 2014).

Valuation of Shares

The valuation of the organization shares is important for the payout policy. If there was a shares undervaluation then organizations' repurchase the stock to enhance the share price by utilizing the undervalued price and in turn this helps the investors to buy more shares of the organization. During Mergers and acquisitions stock repurchases are common. The stock of the undervalued firm can be bought by another organization which would help in increasing the share price of both the firms.

In certain cases, the undervalued shares of a certain firm are bought by the firm itself in order to increase the share price. Normally, other competitors would delay the purchasing of the shares of undervalued company as it would need additional increase in value to buy that stock. The success of the stock repurchases is related to the buying shares price and can be measured from the number of investors who are willing to sell their shares. (Berk et al. 2012).

Taxation

Taxation has major effect on the corporate payout policies of most organizations. Adoption of different policies is the target of different firms due to the change of tax regulations and the shareholders are looking for modifying and balancing their investments to align them to the tax regulations changes (Kalay, 1982; Stiglitz, 1983).

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If tax liabilities are low, Investors may participate in buyouts and this will help the investors to defer tax payments. As compared to stock repurchases, Dividends have less favorable tax regime but some firms prefer paying dividends due to tax exemptions regulations which allow the firm to get some benefits.

Analysis of the corporate payout policy

Associated British Foods PLC (ABF)

In 2011 Associated British Foods plc. (ABF) opened 233 store chains which resulted in 15% increase in revenue, assisted by 2% rise in sales. This increase in profitable investment resulted in change in the dividend policy of ABF. A considerable growth of ABF occurred in 2012 and 2013 which resulted in increase in operating profit and earnings per share.

The ABF overall sales increase to 11% in 2012 with net debt of £1.5 billion and £326 million of net capital investment. Based on this ABF has increased its dividend with 8%.

The current dividend policy of ABF is based on the formation of the optimal dividend policy. This policy was chosen by ABF since in order to increase the demand of the product and the market share as well. Also, ABF has chosen this strategy due to the fact that many opportunities in the investment which govern growth are based on the investment decision. It also identified that the sources of financing by ABF is largely occupied by the money invested by the shareholders. This funding decision will determine the funding allocation between debt and equity. (Associated British Foods Plc Interim Results 2012).

(( 2012 , 6) .Corporate Finance Researchomatic .Retrieved 6 , 2012, from http://www.researchomatic.com/Corporate-Finance-134794.html)

Associated British Foods plc normally declares two dividends per year. The interim dividend is usually paid in July and the final dividend is recommended to shareholders for approval at the Annual General Meeting and is normally paid in January. (http://www.abf.co.uk/investorrelations/shareholder_services/dividend_history)

The board’s policy is to maintain a strong capital base so as to maintain investor, creditor and market confidence and to enable successful future development of the business. The board monitors return on capital by division and determines the overall level of dividends payable to shareholders.

(http://www.abf.co.uk/documents/pdfs/2013/2013_abf_annual_report_and_accounts.pdf)

Tate and Lyle (TATE)

Tate & Lyle operates a DRIP whichprovides shareholders with the opportunity to reinvest their dividends in Tate & Lyle PLC shares. The terms and conditions of the DRIP are contained in theexplanatory booklet. Shareholders wishing to participate in the DRIP for all future dividends may print, complete and return theDRIP mandate formto our registrars, Equiniti.

Tate and Lyle consider high standards of corporate governance as central to maximizing shareholder value. The allocation of excess capital has for many years been through dividends and Tate & Lyle has historically had a stable dividend payout.. (http://studenttheses.cbs.dk/bitstream/handle/10417/1548/jonas_skovsted-andersen.pdf?sequence=1)

Tate & Lyle has for many years had two share-classes; preference and common shares, but the preference shares were cancelled during 2007.

Compass Group (CPG)

The company makes distributions from its profits to shareholders through payment of dividends twice a year. A dividend is paid for each share and the level of each dividend is decided by the company’s directors. It can be paid in cash or used to buy more shares. (http://www.compass-group.com/dividends.htm)

The Company pays a dividend twice in each year. Dividends are recognized in the Company’s financial statements in the year in which they are approved in general meeting by the Company’s Shareholders. Interim dividends are recognised when paid.

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http://www.compass-group.com/images/CompassAnnualReport2013.pdf

Dividend Reinvestment Plan (DRIP)

A DRIP service is provided by Capita IRG Trustees Limited. The DRIP allows eligible Shareholders to use the whole of their cash dividend to buy additional shares in the Company, thereby increasing their shareholding. Additional information, including details of how to sign up, can be obtained from the Company’s website at www.compass-group.com and from Capita IRG Trustees Limited, telephone within the UK: Freephone 0800 280 2545 and from overseas: +44 20 7763 0041; email: shares@capitaregistrars.com.

http://www.compass-group.com/images/CompassAnnualReport2013.pdf

In November 2011Compass Group plcreturned £500 million to shareholders, after reporting pre-tax profits are up 5 per cent to £958 million for the year ending 30 September. The total revenues jumped by 9.4 per cent to £15.8 billion. Richard Cousins, Chief Executive, said: "The strength of our cash flow has enabled us to invest in organic growth and to reward our shareholders.

Evaluation of strategy applied for financing the payout for each company

ABF

Looking at the above Dividend per Shareand Earnings per Share Growth which are the bases for the deciding the dividend policy for a company it is clear that company has be performing well through four years. Moreover, they have been changing their policy according to their earnings which has been increasing due to their investment in other countries which now giving Associated British Foods plc a good return. (( 2012 , 6) .Corporate Finance Researchomatic .Retrieved 6 , 2012, from http://www.researchomatic.com/Corporate-Finance-134794.html)

The Company with the most effective and efficient payout policy?

  1. Is the payout policy observed by all the three firms is an “Outcome” of an efficient working capital management?

Question 2

Capital Budgeting and Net Present Value

Sensitivity Analysis

The two big cost and price uncertainties are the mine construction costs and the price of the transcendental zirconium (TZ). The expected cost of the mine construction is $10m. Cost overruns for the initial cost of 10% or 15% are common in the mining industry. For a pessimistic estimate for the investment, a further $1.5m in cost ($10mx0.15) will be added to the expected $10m cost.

An additional $1.5 million will be added to the pessimistic due to environmental regulations, so the total pessimistic estimate of the initial cost will be $13m. It is not applicable to have an optimistic cost figure since it is not expected for the new mine to cost less than $10m so since we know that net present value will be positive and greater than $1.13m.

As per Ms. Peru expectations, the transcendental zirconium price which will increase in line with inflation is $10000. The optimistic price which was predicted by experts is $14000, while the pessimists’ price is: $7500.

The expected price of the transcendental zirconium of $10000 gives expected net present values for this design of $1.13m. The optimistic net present value is approximately $4.05m. The transcendental zirconium of pessimistic price of $7500 gives net present values of approximately -$2.11m.

Range

Net Present Value

Variable

Pessimistic

Expected

Optimistic

Pessimistic

Expected

Optimistic

Initial cost

$13,000,000

$10,000,000

N/a

-$1,225,523

$1,131,232

N/a

Transcendental zirconium Price

$7500

$10000

$14000

-$2,106,854

$1,131,232

$4,053,296

What was discussed above is the more expensive model of the design. Cheaper design will reduce the cost by $1.7m, so the expected mine cost is $8.3m. In this design, most of the uncertainty occurred because of cost overruns will be eliminated, pessimists will account only for the environmental regulation which will add $1.5m to the expected cost so the pessimistic estimate of the initial cost will be $9.8m.

It is not expected that the new mine cost would be less than $8.3m. Because of that, It is not applicable to have an optimistic cost figure since we know that the net present value will be a positive and greater than $1.10m.

The transcendental zirconium of pessimistic price of $7500 gives net present values of approximately -$2.14m for the cheaper design. Price would not go ahead. A net present value of -$0.81m is given for the cheaper design using the pessimistic initial cost which gives -$1.23m for the more expensive one.

The expected net present values for the cheaper design is about $1.10m. The optimistic net present values for the cheaper design is about $4.02m. The transcendental zirconium of pessimistic price of $7500 gives net present values of approximately -$2.11m and -$2.14m for the more expensive and cheaper design respectively

Range

Net Present Value

Variable

Pessimistic

Expected

Optimistic

Pessimistic

Expected

Optimistic

Initial cost

$9,800,000

$8,300,000

N/a

-$809,685

$1,097,409

N/a

transcendental zirconium Price

$7500

$10000

$14000

-$2,140,677

$1,097,409

$4,019,473

The net present values for both more expensive and cheaper designs are close in value and since are negative, the investment for either the cheaper or more expensive design with a pessimistic

The expected and optimistic net present values for the both designs with respect to initial cost and price are close in values, so the factor here in a decision is the pessimistic net present values. The pessimistic initial cost will give A negative net present value of the investment for the more expensive design which is much higher than the cheaper one. The positive net present values for the more expensive design are also not significantly higher than those of the cheaper design to take this risk.

The pessimists forecast that say that the prices could be $7500/ ton is the only forecast that should worry Ms. Peru. Absolutly, this is the worst scenario that could occur which gives the cheaper design a negative net present value. Although Ms. Peru did not have a strong view about the price and the effect of inflation, any additional information would be helpful on the future prices of transcendental zirconium.

The direction of the price of transcendental zirconium which will move in is the only reason for delaying construction of the new mine. Since Ms. Peru doesn’t know that the price will fall or not then he should keep delaying construction.

With respect to cost overruns and weather the expected new environmental regulations will be put in place or not, there is not a case for any delay in construction and even with the environmental regulations the investment net present value of would be positive.