Financial Management Assignment Solution

PART A

Explain dividend  irrelevant and relevant theory:

Dividend is a part of profit which is given by the company to their shareholder. It is fixed  by the company the shareholder received the dividend if the company not earn profit but  the firm give the dividend to their share holders. Dividend policy is the distribution of  the company earnings between the reinvestment and net profit payments (Asimakopoulos,and Athanasoglou,2013. ). Retained earnings is related to internal finance and it is the main source of it. Dividend policy is affect the value of the firm, and this policy is also help to maximise the profit. Company board of director take the decision regarding dividend . Dividend policy will help the company shareholders to earn maximum profit and to increase shareholder wealth. Dividend policy can be divided into two parts which are dividend relevance theory and dividend irrelevant theory.

The Irrelevant theory of dividend: This theory says that the company will only pay dividend from retained earnings.  These are dividends are to be paid only if the rest of the funds after all suitable investment have been financed or paid(Brigham,and Houston,2012.).  The value of the firm is directly related with investment decision which is makes the dividend policy relevant (Dividend theories 2018). The irrelevance theory refers to  that policy has been not effect the company cost of capital. Miller and Modigliani gives the irrelevance theory of dividend.

Modigliani and Miller model

According to Modigliani and Miller says that the situation where the total value of the company is not depends on its capital structure (Deshmukh,and et.al  2013.). They argued on some points which are market participants have more possibilities for effective investment. According to this model perfect markets  for capital investment is exists and its includes zero fees , taxes and legal proceeding.  A in constant rate companies and investors and share holder can borrow or lend  the money. In this model there is unlimited opportunity for credit . Modigliani and Miller model says it does not affect the share price because the value of the firm is a main components of its earnings. Modigliani and Miller model is related to following assumption these are:

• In this model the perfect capital market should be exists so there is no personal or corporate taxes and no transactions costs.
• The company investment policy is free form the firm dividend policy.
• Risk is not exist in the firm if it is applicable.
• Investor behaviour is god or rational towards the firm and information is freely given to them.
• It suggests there is no information imbalance between company's investor ,shareholders, actual data for future cash flows and profits for the company.

Investor of the firm are able to forecast dividends and future cost from which one discount rate is suitable for all securities in all time periods (Ferris, Jayaraman,and Sabherwal, 2013.).  Rate of return of the company is calculating by using this formula which is given by Modigliani and Miller

P0=D1+P1/(1/Ke)

where P0 is prevailing market price of the share, Ke is cost of equity capital,D1 refers to dividend is to be received at the end of period, P1 is market price of a share at the end of the year. According to this model market value of a share before the company should announce the dividend which is equal to current value of dividends paid and add the market value of the share after dividend is declared.

Relevance theory of dividend:

The dividend policy which is affect the value of the firm or a company  is a relevant . In this theory suggest that directly relationship between firms policy and its market price  (Halkos,  and Tzeremes, 2013). Dividend policy may affect the share price of the company, because this theory is focuses on frims behaviour on daily basis. There are two types of relevance theory :

• Walter's approach
• Gordon's approach

Walter's approach: This project is given by Prof James E Walter. According to Walter dividend policy affects the  market value of the shares . This theory is used for maximising the value of the firm and wealth maximisation of the shareholder. Walter gives the following assumption which is followed by the firm , by using this model of dividend policy:

• All the investment which is proposed by the firm and it can be financed by through only retained earnings. In this model there is finance is not sourced by external resources which is like new equity capital and debt .
• There is no change in firm risk , if funds are invested in new projects .
• Dividend per share and the value of the earning per share should be constant.
• The firm has very long life.

According to this model dividend policy of the firm is effected by the investment opportunities available to the firm . If the investment is not available then the firm should pay the dividend to their shareholders. Shareholders invested in the firm and they earn returns in term of dividend which is given by company. When the shareholders earn dividend so its known as the opportunity cost of the firm or cost of capital (Ke) of the firm. If any firm does not pay dividend to their shareholder so then the firm will invest this earning and earn return on this investment and this is called rate of return(r). according to this model , the dividend policy of the firm is relationship between rate of return (r) and cost of capital(Ke).  If r is greater than k (r>Ke) so the firm is earned more by investing the retained earnings. Which is compared  to shareholder earned through investment. If r is less than Ke(r<ke)  so in this situation shareholders earn more compared to return earned by the firm on investment of earnings(Higgins, 2012.). If r is equal to ke (r=Ke)so there is both are in equal situations. Walter's give the formula for calculating market price of equity share

P=D/Ke+r(E-D)Ke/ke

Where P is market price of equity share , D is dividend per share , E is earning per share ,R is the internal rate of return and Ke is the cost of equity share capital. The Walter's model has the fundamental model of dividend policy and it explain the relationship between both value of the firm and dividend policy . This model main disadvantage is  conventions are not realistic. According to Walter's model  assumption  is based on external sources of finance is not convincing . And in practical life retained earning is rarely found in the firm. In this model researcher says that rate of return and cost of capital being constant so it is unreasonable. Rate of return and cost capital fluctuate with changes in the firm risk.

Gordon's model : This model is given by Myron Gordon's and he suggested that dividend policy may influence the value of the firm. Assumption is related to this model

• The retention ratio of the firm remain fixed .
• Cost of the capital of the firm is more than the growth rate of the firm.
• Corporate tax is does not exists.
• Rate of returns and discount rate of the firms its remain constant.

This model is preferred current dividend which is compare to future dividend . They discount on future dividends . According to  this model market value of the share is equal to present value of dividend for a very long period . Formula for calculating price of equity share :

P0=E(1-b)/Ke-br

Where, P0 refers to price of equity share , E is related to earning per share, b refers to retention ratio, 1-b is dividend payout ratio , Ke refers to cost of equity capital , br is growth rate of the the firm. In this model R is greater than k so the share price of the firm increases and pay out ratio decreases. If r is equal to k (r=k )Price per share and payout ratio remains unchanged. If r is less than k (r<k) per share price increases  and payout ratio is also increases.

According to this model it is concluded that relevant theory of dividend is more reliable and its affect the value of the firm. Both the theories relevant and irrelevance theory explain the relationship between shareholder and the value of the firms. Dividends is the income of the share holders . Dividend payout ratio focusing on  share which create the value of the shareholders. Dividend policies results are equivocal . So a good model that include dividends with retained earnings is a good compromise due to its advantage of flexibility . Reinvestment of shares leads to better tax treatment rather than dividends of the shareholders. Relevance theory of dividend is mostly used in the many organisation to maximising the firm's value.

PART B

Explain Merger and takeover activity fundamental role  in corporate finance :

Merger is the process where two companies or even more companies are come together with a common interest and control. After merging the new company can be formed because the companies who has been merged  it lose their identities (Krishnan, and Masulis, 2013).  Takeover or acquisition refers to overall controls of the company is acquire by the other company, in this a person can purchase the company without any combination of the company . In this a person can control over the assets and control on management.  If merger and takeover has been taken place companies may achieve as follows by holding a company, Arrangement scheme. In a merger where two companies are merged it creates a new company . So it acquired  the share of merging companies. For example “A” limited company and  “C” limited company are merging their companies with a common objectives (Mehta,2012). So it creates a new holding company AC (holding) limited company. And the another situation is where one existing big company hold the another small company and its bids its share.

Importance of merger and takeover in business:

• Economics of large scale production: After merging and acquisition companies have a large number of production space, and it creates the expansion of the firm .Merger and acquisition taken place so supply of material is increases , bulk purchase discount  or negotiating in dealing of products and services.
• Economies of productions: Merging of two companies obtained to improve the technological aspects of the company and it could bring the  good quality of product , and it improves after sales service.
• Marketing: after merging and takeover  company obtaining a new product  line for diversify their business through marketing.
• Finance: A company loans may increases their production and also increase in company earnings per share and the market price of share.

There are two types Merger and takeovers these are, horizontal merger and acquisition and vertical acquisition. In horizontal type of merger and acquisition both companies have been manufacturing same type of products (Rees, and Valentincic, 2013). And vertical merger and acquisition both companies having  relationship between them which a buyer or seller of the products. Both the companies operate at different stages of the same production  chain.

Main points which shows the external growth of the firm by merger and acquisition:

• This avoid the limited competition, after merging and acquisition both companies have different identity and it creates the rivalry towards the other company.
• Both companies may utilize the resources like employee, managerial skills to increasing the growth of the company. It is  used  in the market power
• Main motive of the company is to repurchasing their own shares and investments and to decrease tax liability of the companies.
• Merger and acquisition activity  is used by company or an organisation for expansion of their businesses . When two company can merge , both companies have same objectives towards their businesses, they should merged their employee, they share their view point and take decision jointly and for enhancing their business.
• When two company have been merged, it is possible to reduce overlapping functions. It includes some managerial functions that are, marketing, purchasing etc. and they also help in expand the volume of the operation to invest in assets.
• If a company not going to grow internally  because of their resources and management restrictions. So the company can grow externally by the another company owned their company to expand their businesses . For example in a company growth may take place so the firm will expand their business by to develop the products, increase the manufacturing facilities in the organisation (Zhang,and et.al, 2015.). In acquisition company may earn desire growth by expanding their business entities.
• Financing by external growth is easy in operational function of the other company, they exchange their stock and its helps in cash requirement of the company. It is restricted in internal growth of the company.

Evaluate the merger and acquisition are helps in maximisation of share holder wealth:

When two companies have merger and takeover so it helps the shareholder's to maximising their wealth by different factors. These factors are:

1. Stock price: When a big company acquire the another company so the acquiring company stock prices may be fluctuated . The news is out of acquisition of companies  so the small company or acquiring company  share price may rises . So it is profit for the share holder of that company.
2. Shares: If shareholder hold their share after merging of both the companies  after that the shareholder purchase this by share to share in the exchange  markets. Before merging the shareholder should not sell their share because its a lost for share holder.
3. Purchase opportunities: in merger and acquisition has been held between the two companies. So in this situation the shareholders should purchase their share at discounted price and to earn more profit on this . Its helps in maximising the shareholder wealth.
4. Growth:  Shareholder have been hold their shares after merger and acquisition done and then using the retain earnings they invest for a long term for earn much more profits from this, its helps in increase resources for both the companies , And it also increases entity of production of the products.
5. Control: The effective control of the company can change by one company to another company but its not effect the shareholder growth.
6. Increase in borrowing limit: A shareholder have increases the borrowing limit of share.

Recent merger and acquisition example:

Morrison is UK based largest supermarket company.  Morrison acquire the safeway company. Safeway is also supermarket brand in UK.  Morrison takeover Safeway at £3bn . Morrisons has been cut their prices to create the customers but its not help the company and its results is profit reduction. But sales analysis shows the different results it shows the Morrison can grow after the acquisition has done.  After the Morrisons good and effective performance may increase their growth and they have been successfully converted four stores with some changes.  In this acquisition Safeway  have much more time to absorb this changes and to face them is difficult. Safeway try to decline their sales in the years (Merger and Acquisition 2018) And Safeway had been choose to sale the product for having some loss and to create customer. According to the data of market research  Safeway market share has been down from 9.1% to 7.8% . if together we saw the results of sales is dropped down from 14.8% to 14.1%.  Morrisons also said the performance of Safeway stores is convert into their market and to achieve their targets by increasing sell and profits. And Safeway also convert the format of their company and adopt the Morrisons format. Morrisons is now the second position in UK supermarket. This acquisition is horizontal type . Both the companies having same product line, they both are deal in supermarkets stores.  The earn short term profitability and but it is consider integration progress for both the company. Merger and acquisition is both the financial activities of the business. They both help in increasing the profit and to expand their business efficiently and effectively. And it also helps in to maximise the shareholder's wealth. Merger and acquisition is a wide term for increase the business by having some loss . Its helps in to growth in the market and to create new customer.

Conclusion

Financial management refers to a process where how to manage a finance  and how to allocate the resources is done . In this report I am concluding that the dividend  policy of relevant theory  is more accurate then irrelevance theory , because relevance  theory of dividend policy is affect the value of the firm . In this report I am elaborate the Walter's model, Gordon's model and Modigliani and Miller's models. And in this report I am concluding that the merger and acquisition is helps in external growth of the business . Merger and acquisition is a financial activity of the business for expansion and to creating more profit and it gives the rapidly growth to the business. I am also explaining that merger and acquisition are also gives growth to shareholder's for maximising their wealth.  It helps in increasing stock prices of the firm,  it gives the purchase opportunities to the share holders, Share benefits  of acquiring companies. And it also helps in financing the funds, and merger and acquisition is free from taxation liabilities.

References

• Asimakopoulos,  I. and Athanasoglou, P. P., 2013. Revisiting the merger and acquisition performance of European banks. International review of financial analysis.29. pp.237-249.
• Brigham, E. F. and Houston, J. F., 2012. Fundamentals of financial management. Cengage Learning.
• Deshmukh, S., and et.al  2013. CEO overconfidence and dividend policy. Journal of Financial Intermediation.22(3). pp.440-463.
• Ferris, S. P., Jayaraman, N. and Sabherwal, S., 2013. CEO overconfidence and international merger and acquisition activity. Journal of Financial and Quantitative Analysis.48(1). pp.137-164.
• Halkos, G. E. and Tzeremes, N. G., 2013. Estimating the degree of operating efficiency gains from a potential bank merger and acquisition: A DEA bootstrapped approach. Journal of Banking & Finance.37(5). pp.1658-1668.
• Higgins, R .C., 2012. Analysis for financial management. McGraw-Hill/Irwin.
• Krishnan, C.N.V. and Masulis, R. W., 2013. Law firm expertise and merger and acquisition outcomes. The Journal of Law and Economics.56(1). pp.189-226.
• Mehta, A., 2012. An empirical analysis of determinants of dividend policy-evidence from the UAE companies. Global Review of Accounting and Finance.3(1). pp.18-31.
• Rees, W. and Valentincic, A., 2013. Dividend irrelevance and accounting models of value. Journal of Business Finance & Accounting.40(5-6). pp.646-672.

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