Dividend Policy

A significant part of a business organisation is capital requirement and capital is deemed to be of five types. They include social capital, human capital, manufactured capital, natural capital and finance capital. Finance capital could be segregated further into debt capital and equity capital. The primary accountability of the management is to establish value for the shareholders and owners of the organisation. Many experts believe that the firm value is depicted in the share price of the organisation. It has been argued further that the share price of the organisation is reliant on the payment of dividend and hence, from the logical point of view, interrelation is observed between organisational value and dividend payment (Michaely and Qian 2017). 

In this section, effort is made to gain an overview of the dividend policy by assessing the current theories on dividend policy along with their empirical findings. Another thing that has been taken into consideration is that the analysts value the firm based on its dividend policy by taking into account dividend irrelevance.

2. Dividend policy:

            Dividend policy is considered as the guidelines used by an organisation in determining the profit amount to be distributed in the form of dividend to the shareholders (Kajola, Adewumi and Oworu 2015). The board of directors announces the quantum of dividend and once it is ascertained, it is considered as the debt of the organisation, which could not be revoked easily. Certain factors affect the dividend policy of an organisation like future earnings expectations, liquidity position, legal obligations and presence of investment opportunity.

            The dividend policy of an organisation could be classified further into three categories based on the dividend paid and frequency of payments and they are summarised as follows:

Stable dividend policy:

In this policy, the organisation pays a stable dividend each year. It is the widely used dividend policy, since it provides the shareholders the lowest possible uncertainty regarding future dividend level (            Jacob and Michaely 2017).

Constant dividend policy:

            Under this policy, a fixed percent of income is announced as dividend each year. The dividend payment is extremely volatile due to its direct association with the company earnings. However, this policy is yet to gain popularity among the shareholders and organisations.

Residual dividend policy:

            In this policy, the organisation pays dividend from fund, which is left after it is used for profitable projects. With the help of this policy, the management could undertake several investment projects; however, in this policy, volatility is high in case of dividend payments, since the firm value might be affected. Hence, it is necessary for the management to take into account that the unexpected change in payment of dividend might affect the perspective of the business performance, which would have impact on the firm value (Caliskan and Doukas 2015).

3. Dividend relevancy theories and their assumptions:

            The dividend policy theories are categorised primarily into two classifications based on the relationship between dividend and firm value. According to few scholars, dividend does not influence the firm value, which is reflected in Modigliani and Miller dividend irrelevance theory. On the other hand, few scholars state that the firm value is affected by the dividend payment, which is supported by dividend relevance theory of Gordon and Walter.

Dividend Relevancy Theories and Their Assumptions

            According to the Walter model, the stock price of an organisation is affected by dividend and the formula for computing it is provided as follows:

P = D/k + {r x (E – D)/k}/k

P = Market value per share

D = Dividend per share                                                                

E = Earnings per share

K = Cost of capital

            For instance, firm A has earnings per share of £15 with an applicable market discount rate of 12.5%. The dividend payment is £5 per share and the internal rate of return is 10%. In this case, the market value per share would be computed as follows:

P = 5/0.125 + {10 x (15 – 5)/0.125}/0.125 = £104

            The Gordon model reflects that dividend influences the share price of the organisation. The formula is depicted as follows:

P = {EPS x (1 – b)}/(k – g)

P = Market value per share

EPS = Earnings per share

b = Firm retention ratio

(1 – b) = Firm payout ratio

k = Firm’s cost of capital

g = Firm growth rate

            For instance, it is assumed that Company X has EPS of £15 with a retention ratio of 70%. The cost of capital is 12% and growth rate of the organisation is 10% respectively. The market value per share in accordance with the Gordon model is reflected as follows:

P = {15 x (1 – 0.70)}/(12 – 10) = £225

4. Dividend irrelevance theory of Miller and Modigliani and its assumptions:

            Before the proposition of this theory, it was believed that the firm value increases with rise in dividend. However, this theory challenged the accepted opinion and it proposed a suggestion that dividend does not affect the firm value (Koo, Ramalingegowda and Yu 2017). Instead, it depends on the capability of the organisation to accept risks along with earning money. This theory is dependent on a group of assumptions, which are depicted as follows:

• Perfect capital markets
• Absence of taxes
• Absence of floatation or transactions cost
• Fixed investment policy

In this theory, if an organisation concentrates on retained earnings rather than distributing the same as dividend, the shareholders would enjoy capital appreciation equivalent to retained profits. On the contrary, if it distributes profit in the form of dividend, the shareholders would enjoy dividend equivalent to foregone capital appreciation (Jacob, Michaely and Alstadsæter 2015). Thus, this theory infers that earning division between retained profit and dividend has no impact on firm value.

            Dividend irrelevant theory states that there is existence of perfect capital markets; however, in reality, the capital markets are not perfect. In addition, the company is not needed to pay tax under this theory is not realistic. However, rejecting this theory based on these unrealistic assumptions might not be correct (Baker and Weigand 2015). For verifying this theory, Black and Scholes carried out a study on 25 companies listed on the New York Stock Exchange in 1974 for deciding the association between stock return and dividend yield. After the study was completed, it was found that no relationship is inherent between stock returns and dividend yield (Al-Najjar and Kilincarslan 2016). Therefore, it could be inferred that the study outcome was unswerving with this theory, which implies that dividend policy does not influence share price of the organisation.

Dividend Irrelevance Theory of Miller and Modigliani and its Assumptions

5. Differences between dividend relevant and irrelevant theories:

            According to dividend relevance theory, dividend policy influences firm value, while dividend irrelevance theory states that the firm value is not affected by dividend (Renneboog and Szilagyi 2015). In addition, dividend irrelevance theory states that rise in firm value due to dividend payment would be set off because of the external financing payment; thus, there would be no change in shareholder wealth. However, the Gordon dividend model states that investors prefer current dividend more compared to future capital appreciation and hence, the firm value would be increased to dividend payment (Florackis, Kanas and Kostakis 2015).

For instance, if an organisation intends to make dividend payment of £2 per share, it would have no impact on the firm value, as per dividend irrelevance theory. Since the organisation distributes fund in the form of dividend, additional funds need to be obtained from outside sources for funding the project leading to rise in interest payment. By considering the same example, dividend relevance theory states that the shareholders of the organisation would value the dividend payments more, which would appreciate the firm value eventually.

6. Conclusion:

            After evaluating dividend irrelevance theory along with empirical evidences, it could be inferred that the theory is not correct fully; however, the theory argues that dividend policy and share price is not related to each other. Hence, depending on the theory and empirical evidences, the valuation need not be reliant on dividend policy. Moreover, the analysts use dividend policy to value the correct firm value; however, it is recommended to the analysts that such practice need not be avoided by taking into consideration the dividend irrelevance theory.

Task B:  Introduction:

            Easy Jet is one of the leading low cost European airlines headquartered in London, UK. The airline operates in above 800 routes covering 30 nations throughout Europe. The airline has enjoyed competitive advantage over the years due to its network design linking various cities, capability of maximising asset utilisation, cost advantage and its financial strength (Easyjet.com 2018).

a. Recent financial performance of Easy Jet Airline:

            In this section, the financial analysis of Easy Jet is performed for the years 2013-2017 based on its annual reports. On assessing the financial statements of the organisation, it could be found that the revenue has increased by 8.10% in 2017; however, it has not managed to increase its profit in the year due to increase in cost (Corporate.easyjet.com 2018).

Profitability ratios:

            Gross margin, net margin and ROCE are the profitability indicators useful in ascertaining the operational efficacy and performance of an organisation (Shah 2015). A fall in gross margin could be observed from 37.40% in 2016 to 37.15% in 2017 and similar trend is observed in case of net margin as well, in which it has declined from 9.15% in 2016 to 6.04% in 2017. The fall in gross margin and net margin during the year implies that Easy Jet is struggling to manage its operations efficiently. Along with this, it is noteworthy to mention that the fall in net margin is more compared to gross margin, which signifies that the organisation has to incur greater administrative and other costs. This signals weakness of the airline in terms of cost management strategy (Jordan 2014).

Capital Structure of Non-Financial Company listed on London Stock Exchange

            ROCE is a significant financial ratio that helps in gauging the financial performance of an organisation (Evans and Mathur 2014). In other words, it denotes the efficiency with which the organisation has used the capital invested. For Easy Jet, the ratio has fallen from 12.67% in 2016 to 9.39% in 2017 due to the fact that it has generated lower income despite the increase in asset base.

Liquidity ratios:

            With the help of current ratio, it is possible to gain an insight of the ability of an organisation to repay its liabilities like trade payables with its assets like cash, marketable securities and others (Robb and Robinson 2014). Thus, current ratio provides a rough estimate of the financial health of an organisation. In case of Easy Jet, the current ratio has increased from 0.92 in 2016 to 1.04 in 2017; however, the ideal benchmark is considered as 2. This implies the inability of the airline to meet its short-term debt with the short-term asset base available.

However, quick ratio is taken into consideration, which is superior over current ratio. This is because this ratio excludes inventories and prepaid expenses while analysing the liquidity position of an organisation. The ideal quick ratio is considered as 1 (Zeitun and Tian 2014). For Easy Jet, the ratio has increased from 0.86 in 2016 to 0.97 in 2017, which is near to 1. This is because it has not maintained any inventory level, which has helped in increasing its cash base over the year. Hence, it signifies that Easy Jet has been quite successful in clearing its short-term dues with the current asset base available.

Efficiency ratios:

            In the words of Graham, Leary and Roberts (2015), receivables period is used in assessing the time taken by the customers to make payments to the organisation. A low number is always favourable, which denotes that the organisation is locking up lower funds as accounts receivable and they could be used for other business purposes. In case of Easy Jet, the ratio has increased from 16.07 days in 2016 to 17.36 days in 2017, which signifies that the airline has extended its credit period to the customers or the customers are making delays in clearing their dues. Hence, this has restricted the cash availability of Easy Jet to additional 1.35 days in 2017.

            The payables period denotes the time taken by an organisation in making payments to its suppliers (Faccio and Xu 2015). In this respect, a lower payment period indicates prompt payment to the suppliers. However, a very short payment might indicate that the organisation is not seeking advantage of the credit terms allowed on the part of the creditors. On the other hand, short payments are often made in order to obtain discounts for bulk purchases from the suppliers. In case of Easy Jet, the figure has increased from 14.17 days in 2016 to 18.81 days in 2017, as the suppliers are not providing adequate discount on bulk purchases of raw materials. As a result, Easy Jet has decided to seek advantage of the credit terms by using its positive brand image in the global market.

Empirical Evidence

Cash flow statement analysis:

            After assessing the cash flow statement of Easy Jet based on its annual report in 2017, in which positive operating cash flows are observed in both 2016 and 2017. The net cash flows from operations have risen from £387 million in 2016 to £663 million in 2017, which is a positive signal. The net cash used in investing activities has been negative in both the years, since it has heavy investment for purchasing 20 aircrafts. This is a positive is signal, since it denotes that the airline has increased the overall operational capability. The cash flows used in financing activities has increased in 2017 and it is positive in both the years because of the fall in money market deposits (Raviv et al. 2017). The deposits in money market signify the unearned revenue of the tickets sold on the part of Easy Jet, which signifies positive cash flow position of the airline.

b. Debt capacity (gearing level) of Easy Jet Airline:

            For analysing the debt capacity or gearing level, the following ratios are considered in the context of Easy Jet:

            The debt-to-equity ratio highlights the way the capital structure of an organisation is titled either toward equity or debt financing (Öztekin 2015). Based on the above table, it could be stated that the debt-to-equity ratio of Easy Jet has increased from 1.03 in 2016 to 1.13 in 2017. This implies that the organisation has increased its proportion of debt in capital structure rather than obtaining funds from the equity stockholders. A high debt-to-equity ratio could be favourable, when it is possible for an organisation to service its debt obligations with the help of cash flow and it is utilising the leverage to raise equity returns.

However, if the company suffers serious losses, a high debt-to-equity ratio could increase the overall debt burden. In case of Easy Jet, the organisation is highly reliant on debt funding and fall in profit margin could be observed in the year as well. Thus, Easy Jet is highly leveraged and additional debt burden might crop up in future.

            On the other hand, the debt ratio shows the ability of an organisation to discharge its liabilities with its assets. A debt ratio of 0.5 is less risky for the organisation, as it has twice as many assets in contrast to liabilities (Asquith and Weiss 2016). For Easy Jet, the ratio has increased slightly to 0.53 in 2017 from 0.51 in 2016, which denotes that the organisation is increasing its dependence on debt funding. Equity ratio denotes the portion of assets of an organisation that is financed by assets. An increase in equity ratio denotes the equivalent fall in debt ratio and vice-versa. In case of Easy Jet, the equity ratio has fallen from 0.49 in 2016 to 0.47 in 2017, which indicates that the organisation is highly leveraged. However, it needs to be borne in mind that rise in debt funding has helped Easy Jet in lowering its cost of capital, even though the solvency position is not sound.

Conclusion

c. Financial and business risks facing Easy Jet Airline:

            Certain financial and business risks confront the business operations of Easy Jet, which are enumerated briefly as follows:

Market risk:

            The market risk that Easy Jet faces is due to the fall in the prices of fuel, rate of exchange and rate of interest. Hence, it is recommended to the organisation to hedge funds appropriately for minimising its overall exposure to risk.

Counterparty risk:

            This type of risk arises because of the non-accomplishment of contractual obligations by either contract party (Dokas, Giokas and Tsamis 2014). For Easy Jet, the counterparty risk takes place due to non-performance of the deposited additional funds.

Liquidity risk:

            When an organisation is unable to fulfil its existing obligations, it results in liquidity risk. It might occur due to unsuitable cash planning. Thus, it is essential to prepare and follow cash budget for the organisation (Almamy, Aston and Ngwa 2016). Easy Jet has enforced various strict policies for mitigating its financial risk. Out of them, the most significant is that the airline has established a financial committee for monitoring its overall financial activities.

d. Recommendation and justification of optimal capital mix of Easy Jet Airline:

            Based on the above assessment, it could be identified that Easy Jet has placed more emphasis on debt, instead of raising funds through equity. The capital structure of the airline consists of funds from the shareholders, deposits in money market and long-term borrowings. The strategy that the organisation uses in maintaining its capital structure is to raise funds from debts for investing in capital projects. However, this strategy minimises the dividend payment to the shareholders. Hence, it needs to focus on maintaining debt ratio of 0.5 and equity ratio of 0.5 for maintaining optimal capital mix, since it would maximise the wealth of the shareholders as well.

Conclusion:

            In this section, after evaluating all the factors, it could be stated that Easy Jet has a slightly high leveraged position in its capital structure. The organisation focuses more on debt funding than equity financing, which is evident from high debt-to-equity ratio. In conclusion, it could be stated that the overall financial condition of Easy Jet is not extremely sound and difficulties might occur in its future prospects. Therefore, it is recommended to issue new equity shares so that funds could be raised more from equity as well.

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Appendices:

Appendix 1: Income statement of Easy Jet for the years 2013-2017

Appendix 2: Balance sheet statement of Easy Jet for the years 2015, 2016 and 2017 

Appendix 3: Cash flow statement of Easy Jet for the years 2013-2017