Cofm6006 Corporate Financial Management Answers Assessment Answers

Introduction:

Capital need is critical to the success of any business organisation and five types of capital are generally found in the same. These are manufactured capital, human capital, finance capital, natural capital and social capital. In this section, emphasis would be placed on finance capital only, which is divided further into debt capital and equity capital. The basic management need is to maximise shareholder value as well as that of the owners (Vernimmen et al. 2014). According to some analysts, the share price of an organisation helps in representing its business value. Further argument has been made that the share price of the firm is dependent on dividend payment and hence, based on logic, relation is present between firm value and payment of dividend (Avanzi, Tu and Wong 2016).

In this segment, attempt is made so that meaningful insight could be obtained regarding the dividend policy by analysis of the theories supported further by empirical findings. Another aspect has been taken into account, which states that the analysts think that the firm value is dependent on its dividend policy, as mentioned in dividend irrelevance theory.

Dividend policy:

Dividend policy is the guidelines that an organisation uses for ascertaining the portion of profit to be provided to its shareholders as dividend. The board of directors of the organisation declares the dividend percentage and after its determination, it is treated as debt that is not easy to be withdrawn (Baker and Weigand 2015). The dividend policy is influenced due to a wide variety of factors that include expectations of future earnings, legal duties, availability of investment alternatives and liquidity position. The payment of dividend and its frequency further categorises the dividend policy of a firm into three types, which are enumerated briefly as follows:

Constant dividend policy:

This policy provides a static percentage of net income to be provided as dividend each year. There is volatility in dividend payments because of direct link with the earnings of the organisation. However, this policy is not much popular among the organisations and their associated shareholders.

Stable dividend policy:

This policy provides a stable rate of dividend to the shareholders per annum and this is immensely popular among the global business organisations. This is because the shareholders do not have the fear of uncertainty about the level of future dividend (Chang, Kang and Li 2016).

Residual dividend policy:

This policy allows a firm to make dividend payments from the remaining funds utilised for profitable ventures. In addition, it helps the management in undertaking various investment proposals; however, increased volatility is deemed to be observed in this policy when it comes to dividend payments due to the probable impact on firm value (Maldajian and El Khoury 2014). Thus, the management needs to consider carefully any unanticipated change in dividend payment, as the impact would be directly on the business performance perspective.

Theories of dividend relevance and their related assumptions:

The categorisation of dividend policy theories is made based on the association between value of the firm and dividend payment. Some scholars have highlighted the fact that there is no impact of dividend on the value of the firm as stated in the dividend irrelevance theory of Miller and Modigliani. However, argument has been put forward by other scholars that the payment of dividend has impact on the value of the firm, as mentioned in the Gordon and Walter theories of dividend relevance.

It is mentioned in the Walter model that the dividend payment has impact on the share price of an organisation, which could be calculated with the help of the following formula:

In the above equation, the market price per share is denoted by P, while D represents dividend per share. Similarly, k signifies cost of capital and E reflects earnings per share. For example, company X has EPS of £15 and the market discount applied is 12.5%. The dividend is paid at £5 per share with an IRR of 10%. The market price per share for the organisation is calculated as follows:

P = 5/0.125 + {10 x (15 – 5)/0.125}/0.13 = £104

According to the Gordon model, there is direct effect of dividend on the stock price of a firm and it mainly rests on the following formula:

In the above equation, P denotes the market value per stock, earnings per share is reflected by E, firm retention ratio is represented by b, k is the cost of capital of the firm, g is the growth rate of the firm and (1 – b) is the payout ratio of the firm. For example, a firm has earnings per share of £15 and its retention ratio is 70%. The firm has growth rate of 10% with 12% cost of capital. The market value per stock could be computed with the help of the above-stated formula:

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

Dividend irrelevance theory of Miller and Modigliani:

Before the establishment of this theory by Miller and Modigliani, there uses to be a common notion that as the dividend payout of an organisation increases, there is an increase in its enterprise value as well. However, this theory has been formulated for contradicting the common notion and it states that the enterprise value does not increase or decrease with rise or fall in dividend payment (Ahmed 2015). This theory states that the enterprise value varies based on the ability of an organisation towards risk acceptance and revenue generating capacity. Thus, this theory assumed certain stuffs, which are highlighted as follows:

• Capital markets are completely perfect
• There is no presence of corporate tax
• There is absence of transaction or floatation cost
• The investment policy is basically fixed in nature

According to this theory, if a company focuses on retained profits instead of distributing net income in the form of dividend, it is possible that the shareholders might be able to enjoy capital appreciation identical to retained earnings. However, if net income is distributed in the form of dividend, the stockholders would obtain dividend identical to the sacrificed capital appreciation (Fairchild, Guney and Thanatawee 2014). Based on this theory, an inference could be drawn that the division of earnings between dividend and retained earnings has no effect on value of the organisation.

One of the assumptions of this theory is that there are perfect capital markets in the global economy. However, this assumption does not hold true in reality. Moreover, the assumption that no tax is needed to be paid by the business organisations is purely unrealistic. However, it would not be feasible, if this theory is rejected due to these assumptions (Belousova et al. 2016). In order to examine the validity of this theory, a research was conducted on 25 stocks listed on New York Stock Exchange by Black and Scholes in 1974 so that an insight could be formed between dividend yield and share return. After the completion of the research, it has been gathered that there is absence of any association between dividend yield and share return (Bo?oc and Pirtea 2014). Hence, it could be found that the outcome of the research has been in tandem with this theory, which validates the fact that there is no effect of dividend policy on the stock price of a firm.

Comparison between dividend relevant and dividend irrelevant theories:

Dividend irrelevance theory denotes that dividend fails to influence enterprise value, while dividend relevance theory states that the enterprise value is affected directly by the dividend policy of a firm. According to dividend irrelevance theory, the external financing payment would set off the increase in enterprise value because of dividend payment and therefore, no impact could be observed on the wealth of the shareholders. In opposition to this statement, Gordon model lays emphasis on the fact that the investors value present dividend more than the capital appreciation expected to take place in future. Thus, the dividend payment would help in increasing the enterprise value (Sáez and Gutiérrez 2015).

For example, dividend irrelevance theory cites that a dividend payment of £1.50 per share does not influence the enterprise value of an organisation. As funds are distributed as dividend, there is need to raise additional funds from external sources, which might increase the interest payments. Taking the same instance as mentioned above, dividend relevance theory cites that the shareholders like dividend payments, as there would be eventual appreciation of enterprise value (Kajola, Adewumi and Oworu 2015).

Conclusion:

After careful analysis of dividend irrelevance theory supported by empirical evidence, it is clear that the theory is not entirely accurate; however, an argument is laid out in this theory regarding the absence of relationship between stock price and dividend policy. Therefore, based on the theory coupled with empirical evidence, dividend policy should not be taken into account for valuation purpose. Along with this, it is crucial for the analysts to consider dividend policy for valuing the exact enterprise value. However, it is suggested that the analysts should not avoid this practice by considering dividend irrelevance theory.

Sainsbury Plc is the second biggest chain in the UK supermarket having 16.9% of the market share. The organisation is involved mainly in general merchandise, food, clothing and financial service activities. It operates in different store formats like supermarkets and convenience stores. It currently has 815 convenience stores and 608 supermarkets, while it makes investments in real estate properties as well (About.sainsburys.co.uk 2018).

Current financial performance of Sainsbury Plc:

In this section, the financial analysis of Sainsbury Plc is carried out for the years starting from 2014 to 2018. After analysing the financial statements of the organisation, it has been found that the revenue has increased by 18.82% from 2014 to 2017; however, the profit level has fallen over the years due to rise in cost (About.sainsburys.co.uk 2018).

The major indicators of profitability include gross margin, ROCE and net margin, which are valuable to determine the operating efficiency and performance of a firm (O'Hare 2016). An increase in gross margin could be observed over the years; the only exception could be observed in 2015, when it has declined compared to 2014. In addition, decline in net margin could be observed during the years due to increasing cost to manage business operations. The decline in net margin signifies that Sainsbury Plc is struggling in handling its operations in an effective fashion. Moreover, it is important to note that the net margin for the organisation has declined, while there is an increase in gross margin due to higher selling, general and administrative expense. This highlights the weakness of Sainsbury Plc in relation to its strategy of cost management (Adewuyi 2016).

ROCE is a fundamental ratio, which is valuable in measuring the financial performance of a firm (Maynard 2017). From another perspective, it highlights the efficacy with which the firm has utilised its invested capital. In case of Sainsbury Plc, the ratio has fallen from 10.32% in 2014 to 4.43% in 2018 because it has generated lower income even though the asset base has increased.

Liquidity analysis:

Current ratio provides a deep understanding of the capability of a firm to settle its short-term obligations like accounts payable with current assets such as marketable securities, cash and other assets (Trinh, Karki and Ghimire 2016). Thus, it helps in providing a rough overview of the financial health of a firm. For Sainsbury Plc, there is an increase in current ratio from 0.64 in 2014 to 0.76 in 2018; however, the industry average 2. This signifies that the organisation is struggling to settle its short-term obligations with its current assets.

Quick ratio is considered for liquidity analysis as well, which is often preferred to current ratio by the analysts. The reason is that inventories and prepaid expenses are not included in this ratio for assessing the liquidity position of the firm (Rahman 2016). The ideal or industrial benchmark of this ratio is 1. For Sainsbury Plc, even though it has increased from 0.49 in 2014 to 0.57 in 2018, it is well behind the industrial benchmark. The reason is that it has incurred sufficient amount of money on inventory and thus, it has minimised the cash availability over the years. Therefore, it could be stated that Sainsbury Plc is not efficient at all to settle its short-term dues with its available short-term asset base.

Efficiency analysis:

As commented by Metzger (2014), inventory turnover ratio helps in measuring the number of times an organisation has sold and replaced its inventory in a particular financial year. A lower number in terms of days indicates strong sales or bulk discounts and a higher number in terms of days indicates weaker sales and excessive inventory. For Sainsbury Plc, the ratio has increased from 16.11 days in 2014 to 24.62 days in 2018, which denotes that the organisation is experiencing declining demand in the UK supermarket. As a result, it has minimised the availability of working capital for the organisation and the scope for new investment projects to be undertaken in future.

In the words of Davies (2017), payables turnover ratio denotes the time that an organisation usually takes for settling its supplier payments. A lower time limit highlights quick supplier payment; however, it is not enjoying advantage of the credit terms that the suppliers often allow to the organisation. On the contrary, an organisation makes early payment with the intent to seek discount for bulk buying from the suppliers.

Evaluation of the cash flow statement:

After careful evaluation of the cash flow statement of Sainsbury Plc for the five years, it has been found that operating cash flows have been positive in all the years. There is significant increase in operating cash flows from £392 million in 2016 to £1,365 million in 2018, which is a favourable sign. The investing cash flows have been negative all the years except 2014 because of huge investment in buying new properties. This is a favourable sign as well, as it implies that the organisation has enhanced its operating capacity. The financing cash flows have decreased over the years due to decline of deposits in the money market. The money market deposits denote the unearned income of the products sold and thus, in terms of cash flows, Sainsbury Plc is placed in a favourable position in the UK supermarket.

Debt capacity (gearing level) of Sainsbury Plc:

For evaluating the gearing level of Sainsbury Plc, certain gearing ratios are taken into consideration, which are demonstrated briefly as follows:

The debt-to-equity ratio signifies how the capital structure of a firm is titled towards either debt funding or equity funding (Sebora, Rubach and Cantril 2014). According to the above table, it could be cited that this ratio has varied between 1.67 and 1.99 over the years. which signifies that Sainsbury Plc has raised its debt percentage in capital structure, instead of accumulating funds from the shareholders. A high ratio could be favourable at the time an organisation could service debt obligations by using cash flow and leverage for obtaining equity returns. However, if the organisation incurs heavy losses, a greater ratio could raise the total debt burden. In case of Sainsbury Plc, this ratio is found to be above 1 in all the years coupled with decline in net margin. This implies high leverage position of Sainsbury Plc and its debt burden might increase in future.

On the contrary, the debt ratio signifies the capability of a firm to clear debt obligations with asset base. A debt ratio of 0.5 or below contains lower risk for a firm, since it has twice or more than twice assets compared to its liabilities (Vickerstaff and Johal 2014). In case of Sainsbury Plc, constancy could be observed in this ratio over the years; however, it is highly dependent on debt financing. On the other hand, equity ratio signifies the percentage of assets funded on the part of equity. For Sainsbury Plc, the ratio has remained constant like that of debt ratio indicating higher leverage. However, this increased debt funding has enabled Sainsbury in minimising its cost of capital despite the risky solvency position.

Financial and business risks confronting Sainsbury Plc:

The main financial and business risks inherent in Sainsbury Plc constitute of the following:

Counterparty risk:

This kind of risk occurs due to non-achievement of contractual obligations by any party of the contract (Lovreta and Silaghi 2017). In case of Sainsbury Plc, this risk occurs because of not performing the deposited excess funds.

Liquidity risk:

Liquidity risk occurs at the time of non-fulfilment of current obligations because of ineffective cash planning. Hence, cash budget needs to be followed for every organisation (Wood and McCarthy 2014). Sainsbury has adopted stringent polices so that the financial risk could be minimised. Thus, a financial committee has been formed so that its financial activities could be monitored.

Market risk:

The main market risks confronting Sainsbury are increasing fuel price, exchange rate and interest rate. Thus, funds need to be hedged suitably for reducing the risk exposure of the organisation.

Recommendation of optimum capital mix for Sainsbury Plc:

As Sainsbury Plc has raised more funds through debt, it has minimised the dividend payment to the shareholders. The capital structure of Sainsbury comprise of shareholders’ funds, money market deposits and borrowings. The capital structure is used to accumulate funds from the debtors so that investments could be made in capital projects. Therefore, it is required to maintain debt ratio and equity ratio of 0.5 to maintain optimum capital structure for increasing shareholder wealth.

Conclusion:

After assessing all influential dynamics, it could be cited that Sainsbury Plc has high leverage position in its capital structure due to additional reliance on debt funding. The other financial ratios evaluated state that the organisation is not enjoying a healthy financial condition in the UK supermarket and it might experience difficulties in conducting its future business operations. Thus, issuing new equity shares for the organisation would help in minimising its overall debt burden.

References:

About.sainsburys.co.uk., 2018. Investors. [online] Available at: https://www.about.sainsburys.co.uk/investors [Accessed 3 Jul. 2018].

About.sainsburys.co.uk., 2018. Welcome to Sainsburys Home. [online] Available at: https://www.about.sainsburys.co.uk/ [Accessed 3 Jul. 2018].

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