BUS020N532A Financial Management Level 4 Mont Rose College

Part A. Explain Dividend relevance theory and dividend irrelevance theory?

Dividend policy which affects the value of firm can be considered as relevant. If there is positive relationship between a dividend and market value and preference of current dividend is been suggested by Walter and Gordon (Linawati and Halim, 2017). Majorly investors are risk averse and they usually prefer a current dividend which is giving less importance to capital gain and dividends of future. So in this series- Walter Model and Gordon Model

Walter Model : James E. Walter says that value of enterprise is always affected by type of dividend policy. Relationship between cost of capital and internal rate of return plays major key role while determining dividend policy which helps in maximizing shareholders wealth (Vogiatzi, 2015). Assumptions of Walter model are,

• Internal financing has been practised in the context of firm's investments, which are usually with retained earning, external financing is not used i.e. new debt or equity are not issued for same (Mattli and Dietz, 2014).
• For all investment decisions business risk remains constant and technically internal rate of return and cost of capital of the firm are same (never change).

• Earnings and dividend of the firm in the beginning never change. EPS and DPS are used in the model but the assumption is that they remain constant while value is been determined.
• Margin or earning which is made by company is reinvested internally or may be distributed as dividends.
• The company has long and infinite life (Mellor and Shilling, 2016).

Formula for determining market price per share can be denoted as:

P=D/K+r(E-D)/K/K

P is market price per share, D is dividend per share, E is earning per share, r is internal rate of return and K is cost of capital. This equation gives indication that MPS of firm's share is aggregate of present values of infinite flow of gains from retained earning on investments and dividends.

As it is stated above that optimum dividend policy depending on the relationship between IRR and Cost of capital. If R is greater than K, entire earnings should be retained and if K is greater than R then all earnings should be distributed to the shareholders. The main thinking about the Walter model when R is greater than K, then organization is able to make more return as compared to shareholders from retained earnings (Masubuchi 2013). Growth firms have K smaller than R. The main assumption is to have enough profitable opportunities. These firms can earn returns very easily which is always more than what shareholders can do on their own. Normal firms have R and K equal. Usually these firms gain same return as compared to shareholders. The price per share is not been influenced by dividend policy, so there is absence of payout ratio for a normal organization (Baker and Riddick, 2013). Declining firms have lower R as compared to K, Firm's return is less than compared to shareholder's investment. There is no sense for retaining the earning. So for maximizing the price per share entire earnings should be distributed among shareholders.

Gordon Model: It states that current dividend plays major role in determining firm's value. The most famous model for calculating the company's market value by using the dividend policy. Assumptions of Gordon model can be,

• In the capital structure there is no proportion of debt, the company should be form of equity only i.e. it should be considered as an equity firm (Brigham and Ehrhardt, 2013).
• All the investments of the company should be funded by internal financing i.e. retained earnings, external financing is not required.
• Internal rate of return (r) should be constant and diminishing marginal efficiency of the investment should be ignored.
• Cost of capital (K) must be constant which implies that investments related to business risk be same (Cao and Han, 2016).
• Gordon model says that a firm should have perpetual earning or repetitively ernings.
• In taxation corporate taxes are not existed in this model.
• In this model retention ratio is constant, if it is decision taken by the company. Growth rate (g) = b*r, by this logic growth rate should be constant.
• K is greater than G which replicates cost of capital is greater than growth rate and this is essential for getting the value of company's share (Kale and Singh, 2017).

Formula for determining market price per share can be denoted as:

P = {EPS*(1-b)} / (k-g)

            P is market price per share, EPS is earning per share, b is retention ratio of the company, (1-b) is payout ratio of company and g is denoted as growth rate i.e. b*r. This equation indicates that company's market value share is aggregate of present values of infinite future dividends. When R is greater than K, dividend payout ratio decreases as the price per share increases, but when R is smaller than K it is vice versa relationship between price per share and dividend payout which increases and decreases respectively (Masoumi, Yu and Nagurney, 2017). In the case when K and R are equal then the payout ratio is changed but price per share remains unchanged. The internal rate of return of the growth firm is greater than cost of capital (k). If the company reinvest the dividends instead of distributing it to shareholders, then shareholders will be gaining more advantage in monetary terms. The growth firms have a zero optimum payout ratio. When the internal rate of return (r) is equal to cost of capital (k) then it denotes that firm as normal firm (Chang and Cho, 2017). Whether the dividends are distributed or reinvested, it does not affect shareholders so there is absence of dividend payout ratio in normal firms.

             This theory was revised by Gordon that market value will be impacted by dividend policy when k is equals to r and investors will always prefer shares which are giving more current dividend are been paid. But when internal rate of return is smaller than cost of capital then it will be indicating as declining firms (Fernald and et.al., 2017). Shareholders will be given advantage if dividends are distributed instead of reinvested. So in this case dividend payout ratio will be 100%.

Irrelevance Theory

Dividend policy does not impact the market price of shares. The wealth of all existing shareholders does not change because the dividend's payment has decreased the cash balance and with that specific amount their share price falls (Review of the Efficient Market Theory and Evidence. 2017).

Modigliani Miller model

The dividend policy of company is irrelevant because it does not affect the shareholder's wealth because of certain assumptions:

• In this theory capital markets are perfect, the rational information is available easily, no transaction cost as market price of the share is not influenced by any of the investors.
• In taxation, there is not any single difference between tax rate on capital gains and tax rate on dividends (Linawati and Halim, 2017).
• Fixed investment policy of the company will never change, the risk of firm will never change if retained earnings are reinvested so K is constant.
• There is absence of any flotation cost.
• The EBIT of the firms will be not affected by debt financing.

This theory indicates the leveraged firm's value is same as the unleveragd firm's value if future prospects are similar to operating profit. If the shares of leveraged firm are purchased then it will be same cost as the leveraged firm's share.

The arguments of MM model are stated as, if the earnings are retained in the medium of dividends, capital appreciation has been enjoyed by shareholders which is equal to earnings (Vogiatzi, 2015). If the earnings are distributed in the form of dividends instead of retention, the dividends are enjoye d by shareholders which is equal to the capital appreciation which is selected by company for retaining the margin. Dividend and retained earning's division is no relevant from the context of shareholders.

There are some propositions which are without taxes, firstly the valuation of firm is not been influenced by capital structure or in other words the market value of the company is not increased by the leveraging the company. The equity holders and debt holders are given same priority or we can say that earnings are distributed equally. Second proposition says that cost of equity is in direct proportion of financial leverage. If the debt component is increased the equity shareholders are facing more risk for the company. Contrary the shareholders expect more return if the cost of equity is increased. In this proposition upper hand is with debt shareholders against the claim on margins is concerned so in this series cost of debt is reduced. Proposition with tax says that tax advantage is been accrued by the payment of interests. The tax on interest on borrowed funds is deductible (Mattli and Dietz, 2014). In other words it can be elaborated as actual debt cost is less than nominal debt cost because of the tax advantage. The company can capitalize the requirement with debt as cost of distress is been advocated by trade off theory which also includes bankruptcy  cost which exceeds the value of tax benefit.

PART C

Merger and acquisition:

Merger is a financial tool which is used for expansion of business and long term profitability of the two companies which going to be merge. Merger is a two companies who agree to join together for a common goal. The merger helps to diversify the products and service which the company offered. It increases the plant capacity, and it also reduces the financial risk. If the merger should fail its main reason is lack of human integration, mismanagement of cultural issues, lack of communication (Mellor and Shilling, 2016). In merger all liabilities of the companies. Merger includes the mutual decision of two companies, the combination of two companies or business by structural and operational advantages which is secured in merger and it cut the cost and increase the both company profit. Merger is occurred when there is no such flow in the business.

Acquisition is to purchase a smaller company by a larger company,  This combination is also had the same profit like merger. In this both company doesn't take mutual decision and it should be regarded as a series of transaction where acquired control over the assets of the company. Acquisition is occurred when if a company purchase the assets and net assets of another company. Merger and acquisitions classified into three categories that are: Horizontal, Vertical and conglomerate (Masubuchi 2013). Horizontal merger and acquisitions is a market extension of the two companies  and both companies have sold the same products in different markets. Vertical mergers and acquisitions refers to product extension of the two companies , in this both companies sell different product but related products in the same markets. Conglomerate mergers and acquisitions refers to that two companies who have no common business areas. Hostile takeover attempt that is strongly resisted by the target firm, and friendly takeover is the target company management and board of directors agree to merge or acquire by another company (Baker and Riddick, 2013). This type of merger occur between companies that sell the same product but compete in different markets. Mergers and acquisitions are a most important aspect of modern strategy. In present time there are many acquisitions is expanded rapidly. Company like google, apple, amazon, Microsoft are acquiring new technology companies for their business expansion.

            Merger and acquisition is occurred because of some reason behind this, these are competition, efficiency, product, resources, marketing and tax issues. Merger and acquisition occurs because the greedy corporation want to acquire everything. The primary concern of the firm is to earn more profit and to maximize share holders wealth. When evaluating a new company, it is very important to identify why merger is done (Brigham and Ehrhardt, 2013). And investor needs to know  the new industry would take them to the highest capital markets. Main motives of merger is synergy, growth, market power, tax savings, market business, and to acquire needed resources and the last diversification. One  the main motives of a merger is to increase the share of a firm in the market. It means to increase the size of the firm and also leading to the monopoly power, hence the firm gets an opportunity to set prices at levels that are not sustainable in a more competitive market. There are three sources by which market power can be achieved (Cao and Han, 2016). They are product differentiation, overcoming entry barriers and improving market share. The largest mergers in the history have total $100billion each where Vodafone acquired Mannesmann for $181 billion to create the world's largest mobile telecommunication. Diversification is another frequently cited reason for mergers. Actually, it was the reason during the conglomerate merger wave. The idea was to regulatory restrictions on horizontal and vertical mergers by going outside a company's industry into new markets and to achieve growth there.

            In a business environment mergers and acquisition may solve the many problems of the business, there are some importance of merger and acquisition are: Economics of productions, large scale production, marketing, finance. Merger and acquisition assists in building an empire, it brings diversification of products, it's also increases market power, Claim in promotion profit. There are some demerits of merger and acquisition, loss of trade identity, problem with integration, remoteness in personnel relation. Merger results is stated that one company lose their identity and goodwill. In acquisition acquired company goodwill bring the other company goodwill may not lost their identity (Kale and Singh, 2017). It is a well established projects but it differentiates the opinion. In acquisition large organization is to be very impersonal, they regulate the small organization by their rules and regulation

            Corporate finance is the sources of funding and capital structure of a company, it is associated with investment banking. Although tax savings may not be a primary motivation for a combination, it can sweeten the deal. When a purchase of either the assets or common stock of a company takes place, the tender offer less the stock's purchase price represents a gain to the target company's shareholders (Masoumi, Yu and Nagurney, 2017). Merger and acquisition gives a external growth to the business which increase more profits. There are some points which helps for external growth of a  corporate, these are :

            Market screening: It identifies that the companies is fit or not in the development program. Company market analysis should be identify all suitable targets . In this screening process include reviewing the objectives, these are : Define the strategy and target selection criteria, and the next to examine and analyse the target, and analyse the market competition and their trends. Monitoring of the past acquisition is related to the buyers interest.

            Network creation: merger and acquisition is also given external growth by creating network direct contact provide total confidentiality of targets, leading the preliminary discussions.

            Expansion of whole business: by merger and acquisition  both the company should expand their business and earn more profit , and this the best deal to satisfy your development strategy.

Source funding: this also support in sourcing of funds by other companies.

            Internal growth of the business depends on the both of the companies hierarchical structures may increase communication problems and then decision making may be slow. When business want to be grows, it need to be restructure and communication will need to be  more care. Specialist managers will need to hired a new employee for work expansion (Chang and Cho, 2017). Increasing a company's growth is the most common reason behind merger. Growth can be achieved through investing in capital projects internally or externally by buying out the assets of outside companies. The  studies show that the faster growth rates are achieved through external growth by means of mergers and acquisitions. Merging internationally provides an immediate growth opportunity to a firm which was once operating within a single country. There are various factors which  a firm to merge internationally for growth are , A firm has a surplus with cash flows operating in a slow-growing economy can invest its cash in fast-growing economy (Fernald and et.al., 2017). The domestic markets if they  are too small to accommodate the corporate with  or if the domestic markets have already reached saturation point can go for international markets.

Benefit to the shareholders of the acquiring company

Takeover defence is the shareholder plan which help to take potential acquiring announcement. Under these shareholders should purchase additional company stock at discounted price. A merger can affects the shareholders of both companies there are several factors which influence the economic environment, size of the companies and management of the merger process. Stock price of the merged company is higher than the both of the acquiring firms , in this share holder benefits is stock price arbitrage. Share holders merged the company usually experience to improve the long term performance and dividends. After a takeover completed the new company have changes in leadership, the company who is acquired by the big company  so the acquiring company regulates or take the decision of both the companies. Merger and acquisition is benefit to the share holder of the acquiring company. The business opportunities lead firms to search for a new product and markets. Share holders in the acquiring company which is extracted a small or a proportion of the overall profit. The voting power of the share holder is dilute to increase more shares, when the new company offering its shares in exchange market  for the share of the targeted company at an agreed conversion rate. And the shareholder of an acquiring company have loss the voting power, while the target company share holders have relatively power to vote in a smaller target company (Linawati and Halim, 2017). The shareholder has to dilute to earn per share on share stock. Cost of the company is also given the benefit to the shareholders. In a takeover the company issue a ordinary shares and the effective control of the company.

Examples of recently merger and acquisitions:

Merger and acquisition lead  to create shareholder wealth, Shareholder wealth effect the company diversification compared to non diversifying acquisitions. The share holder wealth will maximise the company profit. It increased the return, strategic consistency, common concern.

There are many mergers and acquisition is held in the world in the whole year. Merger and acquisition gives strength to the weak company (Vogiatzi, 2015). They mutually take the decision in merger for earning more profits. In the present time many mergers and acquisition is based on new technology which gives the great expansion to the company. Other notable acquisitions include forays into education software, music discovery, video streaming, big data analytics, data protection, and mobile communications (Brigham and Ehrhardt, 2013). An organization with acquisitions ranging from software storage and management, streaming video, cyber security, sales force systems, mobile APIs, healthcare, cloud security and capabilities, behavioural marketing, cognitive computing, and an incredibly wide range of other technical abilities. In the race of new technology advantage of acquisition is dynamic .

Sainsbury's -Asda merger lead to monopoly towns in United kingdom. The purposed merger of the two supermarkets in towns, so its opening the possibility of a local monopoly . In this the competition and markets authority is expected carefully select Sainsbury's planned £7.3bn takeover of Asda under which the latter's US parent,b walmart and it will become a major shareholder in this combined group. Asda profitability has grown during in two decades . Walmart's buying power as the world's biggest retailer (Kale and Singh, 2017). The number of retail sector mergers and acquisition has grown by  15 percent in the last year as companies try earn profit. This is the one example of merger and acquisition  there are many more example of merger and acquisition in united kingdom.

Conclusion

In this report we concluded that dividend policy which affects the value of firm can be considered as relevant. If there is positive relationship between a dividend and market value. In this we explain the different dividend policy theories these are Walter model, Gordon model.  Merger is a two company come together for same motive or objectives and for expansion of their business. And acquisitions is a one big company purchase or acquire a small one  to earn or maximise the business. Merger and acquisitions is the aspect of corporate strategy, corporate finance and management and that gives the rapidly growth to the company. In the report we also concluded that merger and acquisitions are helps to maximise the shareholder wealth  . now time merger and acquisitions is mostly based on new technology.

References

• Baker, H.K. and Riddick, L.A., 2013. International finance: a survey. Oxford University Press.
• Brigham, E.F. and Ehrhardt, M.C., 2013. Financial management: Theory & practice. Cengage Learning.
• Cao, J. and Han, B., 2016. Idiosyncratic risk, costly arbitrage, and the cross-section of stock returns. Journal of Banking & Finance. 73(11). pp.1-15.
• Chang, Y. B. and Cho, W., 2017. The Risk Implications of Mergers and Acquisitions with Information Technology Firms. Journal of Management Information Systems. 34(1). pp.232-267.
• Fernald, K. D. S. and et.al., 2017. The moderating role of absorptive capacity and the differential effects of acquisitions and alliances on Big Pharma firms' innovation performance. PloS one. 12(2). p.e0172488.
• Kale, P. and Singh, H., 2017. Management of overseas acquisitions by developing country multinationals and its performance implications: the Indian example. Thunderbird International Business Review. 59(2). pp.153-172.
• Linawati, N. and Halim, R., 2017. THE EFFECT OF FINANCIAL PERFORMANCE AND MACRO ECONOMIC FACTOR TO PROFITABILITY OF BIDDER COMPANIES. Jurnal Manajemen dan Kewirausahaan. 19(2). pp.99-105.
• Masoumi, A. H., Yu, M. and Nagurney, A., 2017. Mergers and acquisitions in blood banking systems: A supply chain network approach. International Journal of Production Economics. 193. pp.406-421.
• Masubuchi, K., 2013. Analysis of welded structures: Residual stresses, distortion, and their consequences. Elsevier.
• Mattli, W. and Dietz, T., 2014. International Arbitration and Global Governance: Contending Theories and Evidence. Oxford University Press, USA.
• Mellor, P.A. and Shilling, C., 2016. Arbitrage, uncertainty and the new ethos of capitalism. The Sociological Review.
• Vogiatzi, S., 2015. Credit risk management and bank profitability.

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