At the heart of every successful corporative is the financing decisions that it adopts to ensure its financial stability. While companies are aiming at maximizing profits, the level of financial risk that they face ought to be minimized. This is usually achieved by making sure that the capital structure of the firm is optimal. In this regard, the dividend policies and decisions of a firm constitute the integral part of firm’s strategic financing decisions as it determines the division of earnings between shareholders and re-investment into the firm. The managers therefore have to formulate an optimal dividend policy that maximizes the wealth of the shareholders.
Option A: Equity financing
The decision of the decision of the board of Echo Company to increase the current dividends by 20% will have both negative and positive impacts. Increase in dividends has a signaling effect of a firm’s anticipated future growth and increased earnings. Investors will use this information as an indicator to measure the value of a firm. Usually, a company which pays high dividends will tend to attract more investors and this will boast the company’s amount of money available for investments in projects that have positive net present value (NPV).
High dividend payments tend to increase the value of a firm hence the value of its shares. If the board of Echo Company decides to increase the dividends, investors will develop an incentive to buy the shares of Echo Company. The increase in demand for its shares will push the prices up and existing shareholders may benefit from high capital gains if they chose to sell their shares. Increase in dividends will also help in solving the agency problem that exists between the management and the shareholders. Shareholders expect high dividends from the company to compensate them for their opportunities forgone by choosing to invest in the company. This is because the board will create a positive image than its activities are constituent with the shareholders objective of wealth maximization.
However, there are negative impacts that will arise by choosing to increase dividends .Increase in dividends tend to reduce earnings retained for reinvestment in projects with positive NPV in the firm. This will reduce the firm’s future growth as it is not able to expand its operations. Increase in dividends may also put the firm in dangerous path of increase in financial risks in which it is exposed to. The firm will have to turn to the financial markets to issue new debt instruments such as debentures and loans in order to raise funds to maintain its operations. This will lead to more exposure of the company to both financial and liquidity risks. Increase in dividends will also attract more equity investors. This will imply increase in number of ordinary shares outstanding and it will have an effect of diluting earnings in subsequent years. Low dividends will be paid out in future since the company’s dividend cover is decreased. The existing shareholders also will have to lose more ownership control.
Option B: Financing using Debt instruments
Financing using debt instruments has several financial implications to the firm. If the board of Echo Company decides to issue a $15 million bond to invest on short term basis, it may increase the company’s earnings based on overall returns from each investment. If the rate of return is higher than the rate at which the debt instruments are paying interest, it will have an overall effect of increasing the returns of the company. Debt instrument will also prevent the company from issuing equity shares which have an effect of diluting earnings per share and ownership. The company will also enjoy from tax advantages that come with paying interests. The company will enjoy more tax benefits payments since its earnings have to be adjusted for interest payments before tax is charged since interest on loan is tax deductable.The firm will also be able to plan early in advance since the interests and principal is known and is certain. However, debt financing has negative implications to the company and it may expose the company to financial and liquidity risks. The company has entered into an obligation and will have to pay the interests and principal at maturity irrespective of whether it takes profits or not. This may lead to liquidation of the company in case it will default in payments due to cash flow problems. The management of Echo co. will have to pay an interest of (10%* $15million= $1.5 million) per annum and this may cause cash flow problems. Investors may also avoid investing in the company as it is deemed to be risk to invest in and this will limit the ability of the company to raise finance in future from financial markets. The high costs of repaying debt may lead to stagnation due to high costs of repaying the debt. The interest coverage ratio increases and this has an implication that more earnings of the company will be directed towards repayments of debts.
Option C: Financing using Rights issue
Rights issues are additional shares issued to existing shareholders at a discount in the proportion of their existing shares in the company. Ex-rights price is the theoretical value of company’s shares after the rights issue. Ex-Rights Price will differ with a margin from the real market price of the shares prevailing after a rights issue due to varying views of market players in relation to the rights issue and stock market variations.
Theoretical Ex-rights price= (market value of shares before rights issue+Proceeds from the rights issue)/number of shares after the rights issue.
Outstanding Shares before the rights issue: 5000000/50=100000
Rights issue: 1:4 thus mew shares outstanding: 4/1*100000 +100000=500000 shares
Proceeds from the issue : 80%*2.30*400000=$ 736,000
Theoretical Ex- rights price = (5000000+736000)/500000 = $ 11.47
Raising finance using rights issue is the most efficient way of a company to finance its operations because it is cheaper than public trading to the general public. The underwriting costs involved are very minimal and the company is able to maximize finance collections from the proceeds to the shareholders. Rights issuing also ensures shareholders benefit from Pre-emptive rights and this is consistent with the objective of maximization of shareholders wealth. The Voting power is not affected if shareholders exercise their rights and this ensures no loss of control of the firm to other shareholders who may have wanted to invest in the firm. This method also ensures the gearing level of the company is reduced since there is no obligation to pay dividends as the case when a debt instrument is issued. This method therefore is the most efficient way of raising capital when debt is not available
However, it has its own limitations in that the underwriting Costs involved are very significant and this may reduce the company’s proceeds from the issue. It also takes a relative longer time as compared to other methods of raising capital using debt instruments. Thus the company’s operations may not be effected promptly. If the existing shareholders do not exercise their rights and decide to sell them to new shareholders, this has an effect of diluting the future earnings per share.