Sources of Financing and Dividend Policy
Although each of the stated proposals has its own benefits and drawbacks, Echo Co should choose one that would be the most beneficial for the Company and its finances. In this paper we perform the analysis of each of the stated proposals and give recommendation on the most appropriate option for Echo Co.
Dividends are defined as a distribution of a part of company’s earnings to its existing shareholders (Brealey, 2009). There are several dividend theories in corporate finance which have different approach to benefits and disadvantages of dividends. According to the studies of Gordon (1963) and Lintner (1962), equity investors tend to value dividends more than capital gains. They also argue that higher dividends increase stock value of the company and make it more attractive to the equity investors. This is so-called “Bird in Hand” theory, which assumes that higher dividends in the current accounting period are valued more than uncertain capital gains in the future periods. On the other hand, tax-preference theory of Litzenberger and Ramaswamy (1979), suggests that investors are more likely to invest in companies with low dividends for tax reasons. Their main argument is that dividends are taxed at a higher rate than capital gains, therefore, making a high-dividend companies a less attractive investment. Finally, theory of Miller and Modigliani (1963) suggests that dividend policy of a company is totally irrelevant and has no influence on the value of a firm. Their main argument lies under the assumption that capital gains and dividends are taxed equally. Their studies suggest that companies which pay more dividends, offer less price appreciation of their stock and vice versa. As a result, company’s dividend policy only affects capital structure of the company, but has no influence on its total value.
Speaking about our case example, last year Echo Co had 10 million shares outstanding and its dividends equaled $2 million. Thus, the dividend per share was 2/10 = $0.2. Dividend payout ratio (dividends/net income) = 0.33 and dividend yield (dividends per sare/share price) = 0.2/2.3 = 8.6%. If dividends were increased by 20% (to $0.24 per share) this would result in dividends expense of 0.24*10,000,000=$2.4 million. The dividend cover ratio would decrease from 3.0 to 2.5. Dividend coverage ratio proves that Echo Co is capable of paying dividends and providing a return on shareholders’ investment. On the other hand, cash from dividends could be invested in favorable projects which could increase the value of the company and guarantee its future growth. In addition, Echo Co should maintain its cash balance on the reasonable level in order to avoid cash flow crisis. If it distributes too much of earnings in the form of dividends it may face a cash flow crisis in the future.
Overall, Proposal A does not seem to be a good option for Echo Co for several reasons. Firstly, it will result in deterioration of cash in the additional amount of $400,000 dollars. This money could be used for new investments projects or to repay the high amount of debt the company currently has. Although 20% increase in dividends will attract more equity investors and will result in slightly increased market price of shares, there will be no real financial benefit for Echo Co.
Debt financing suggests that a company is raising capital through direct loans or the issue of bonds. Debt financing brings interest liabilities, but it also brings certain tax benefits to a company (interest on debt is tax deductible) and adds more discipline to the management. As explained by Giddy (1983), if a company generates high income and positive cash flows each year, and has no debt, its managers might become complacent. This can lead to inefficiency and investing in low-quality projects. Borrowing money may add more discipline, as managers will be forced to choose investing projects wisely in order to gain a return to cover the interest expenses. On the other hand, if your debt-to-equity ratio becomes very high, the risk of bankruptcy associated with it increases, which may result in increased direct and indirect costs (i.e. increased interest rates, suppliers demanding payments in smaller periods of time etc.). Excessed borrowing might also reduce company’s financial flexibility, as it would be unable to finance its future projects with debt.
A bond issue will attract additional $15 million to debt capital. As a result, Echo Co will have more free funds to invest in favorable projects, however, costs of debt financing shall be considered. $15 million bond issue at the interest rate of 10% will result in 0,1*15= $1.5 million of additional annual interest expense. However, because of increased interest expense, income tax expense will decrease. Assuming that the corporate tax rate is 33%, Echo Co will save 0.33*1.5= $0.495 million in tax expenses. This means that additional net expenses from the bond issue will be 1.5 – 0.495= $1.005 million. The amount of non-current liabilities will increase from $30 million to $45 million. Thus, increase of debt will result in debt-to-equity ratio of 45/20, which is 225%. This is almost three times as large as the industry average of 80%. In addition, company’s interest coverage ratio will also decrease. During the last year it was 12/3= 4 times, compared to 8 times of industry average. Assuming that company’s operating performance will not change in the current year, new interest coverage ratio would be 12/4.5 = 2.6 times.
Clearly, Echo Co’s financial health is under question, as key debt indicators are much worse than the industry average. Company should not consider attracting additional debt for several reasons. Firstly, it will result in increased interest payments of more than $1 million and will reduce company’s profits. Secondly, bond issue will increase company’s debt-to-equity ratio, which is already very high. Finally, Echo Co’s massive debts will deter potential investors and will make it more difficult to raise capital in the future. Echo Co should increase its debt only if it has not enough cash to maintain operational activities or has a favorable investment opportunity. It is clear that company does not need this additional $15 million, as currently there is no suitable investment opportunity. Short-term investments usually do not provide sufficient returns to cover company’s long-term interest payments, therefore, this option shall be forfeited.
Equity financing suggests that a company is raising funds in an exchange for the part of ownership, which means that an investor would be able to receive part of company’s future profits in the form of dividends and influence managing decisions. According to Ross (2002), one of the benefits of equity financing is that it doesn’t damage the credit rating of a company, and company has no financial obligations against new shareholders. However, the sale of the part of the company will result in reduced control and sharing profits with other shareholders. In addition, dividend expense is not tax deductible as in the case with debt financing, therefore there are no tax benefits from this source of financing.
During last year Echo Co had ROE ratio (ROE = net income/shareholder equity) which equaled 6/5= 1.2, which, in my opinion is a very promising figure. Shareholders initially invested $5 million into the company’s equity, while net profits in the last year were $6 million. This means that Echo co has returned its investors’ money within a year of operation. Rights offering will increase Shareholders Equity from $5 million to $9.6 million, and unsurprisingly the ROE coefficient will decrease and will equal 6/9.6 = 0.625, unless Echo Co demonstrates serious growth in the upcoming year. Nonetheless, I believe that Echo Co has enough capacity to conduct rights offering without injuring its financial stability. Therefore, rights offering is the most promising option for Echo Co, because: a) it will attract additional capital without increasing debt and interest expense; b) it will reduce company’s debt to equity ratio and will contribute to the financial stability of the company; c) it will let Echo Co to invest in favorable projects which will result in company’s growth and improved performance.
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