Analysis Of Dividend Policies In Solna Plc, Rinkeby Plc And Chista Plc

Dividend Policies in Solna Plc, Rinkeby Plc and Chista Plc

The present report is directed to the management of the companies given in the case scenario, that are, Solna Plc, Rinkeby Plc and Chista Plc. The companies operate in the household appliance sector and have fierce competition with each other. The companies are having similar operations with identical capital structure and marketing strategies for over last 10 years. The companies also possess similar debt to equity ratio and thus have identical needs of investment with only slight variance in their dividend policies.

They have also similar number of shares for issuing and the managing director incorporate the use of dividend policy. As such, the companies are seeking for an independent financial expert advice on their dividend policies for maximizing the wealth of shareholders. In this context, the report discusses the benefits and issues in relation to the use of dividend policies with the support of relevant theories. This is followed by presenting an valuation of the foreign currency and interest rate hedging strategies that can be used by the companies to reduce the exposure to foreign currency risks. Lastly, the report provides advice to the treasurer of Chista Plc for investing in the temporary surplus cash within the money market.

Analyses and Discussion on Dividend Polices adopted by all three companies 

This part of the assignment provides information about the dividend policy adopted by the given companies together with benefits and problems of each dividend policies. Graphs have been used to show the trend in dividend distribution. Lastly, dividend theories are being explained for each dividend policy used by all three companies.

Dividend is term used to that part of profit that has been distributed to shareholders of the company. It is referred to as reward distributed for investment made by each shareholder within the company. So it is type of holding period return for shareholders that company pays to them for each period say one year. Dividend paid is not same in case of all companies as management at each company tends to adopt different dividend policy. In this section of the assignment dividend policy adopted by Solna Plc, Rinkeby Plc and Chista Plc has been discussed in detail to provide explanation on problems and benefits for each dividend policy (Glajnaric, 2016).

Dividend policies adopted by each of company have been discussed as below

Solna Plc: Solna Plc has adopted stable dividend policy as it has paid constant dividend payout ratio in last ten years. Stable dividend means there is defined consistency is the dividend payments. It refers to the minimum dividend payments that can be either fixed dividend payout ratio or it can be fixed dividend amount irrespective of earnings. Here, Solna Plc has followed constant dividend payout ratio of 50% every year. In constant dividend payout ratio fixed percentage of net earnings are distributed as dividends each year (Firer, 2012). In case of constant dividend payout ratio dividend payments fluctuates in percentage of earnings of each period. It means dividend payments are not constant but the percentage of dividend payout in proportion to earnings of the company is fixed. It can be better understood through below graphs

Evaluation of Different Dividend Policies

The above graph clearly indicates that company has paid dividend in all the years in proportion of earnings and has paid 50% of earnings every year.

Stable dividend policy has enormous advantages to the investors as well as company as it reflects company following its normal operations and earnings good profits. It helps to stabilizes hat value of company shares in the market. It increases the investors’ morale and confidence to be with the company for long term period. It helps to reflects positive criteria for the potential investors who are looking to company as a best source of investment. Stable dividend policy has certain disadvantages that make it difficult to follow by the companies in real. Each accounting period cannot be same for company and there can be change in management requirement of funds, so it is not easy for the companies to change it. If company fails to pay dividend in any year it creates negative impression in the minds of the investors (Deegan, 2013).

There are number of factors that impacts the dividend policy and also decides which dividend theory best explains the dividend policy adopted by the company. In case of Solna Plc Walter Model supports the dividend policy adopted by the management because Walter Model provides that optimal dividend payout ratio decides the market price per share of the company.

Rinkeby Plc: Rinkeby Plc has been following irregular dividend policy due to irregularity in earnings of the company. This dividend policy is followed by the company when there is lack of liquid resources with the company and there is uncertainty in the income of the company. To better understand the trend in dividend distribution in comparison with earnings of the company, it is important to have look at the below graphs that shows trend line of EPS and DPS as well as dividend payout ratio. From the below graph it is clearly understood that there was irregular trend in dividend distribution over the last 10 years (Baker and Nofsinger, 2010).

Irregular dividend can only be beneficial for the management as they have not worry about maintaining the fixed proportion of dividend every year and can use profits for expansion of business. Irregular dividend policy fails to create confidence among the investors as there is high risk in percentage of return they will generate through making investment in company that makes irregular dividend. The main point of concern is that in irregular dividend policy, dividend neither increases or decreases with span of time.

Both Walter model theory and Gordon dividend theory supports the dividend policy adopted by Rinkeby Plc. It is because both models assume that investors are risk adverse and they are dependent upon the immediate returns in form of dividend as compared to capital gains which is uncertain.

Chista Plc: Chista Plc has adopted no dividend policy as management wants to utilize these funds for the growth of the company and also for the purpose of working capital requirement. There is no trend in dividend payout of company and earnings of the company as no dividend has been paid in last ten years. It means all the earnings has been utilized to fund the new projects or to expand the ongoing projects. This dividend policy is adopted by the company when management believe that reinvesting the retained earnings in the future projects will certainly provides higher return and will also increase the market value of the company.

Benefits and Problems Associated with the Dividend Policies

No dividend policy is helpful only when there is certainty the reinvesting of profits will provide higher capital returns to the shareholders otherwise this policy will lead to complete failure of the company. Therefore, this policy is difficult to adopt as it requires definite management judgments and valuation of projects (Zimmerman and Yahya-Zadeh, 2011).

Modigliani and Miller (M & M) dividend theory supports the no dividend policy as this theory provides that retained earnings are used by the company to finance the new investment plans. M&M theory assumes that company uses either retained earnings or use issue of new equity shares to finance the new business opportunities. This policy is followed by Chista Plc through not paying dividends and using the retained earnings for financing the new projects.  

Part B: Evaluation of three foreign Currency hedging strategies and three interest rate hedging strategies

Three Foreign Currency Hedging strategies

Use of ETFs: ETFs refers to the exchange traded funds and it focuses on providing long and short exposures in various different currencies. It is type of marketable security that has ability to track the stock, index, bonds, and any other assets. They are very similar to mutual fund but they are not as they are traded on stock just like common and their prices changes on regular bass as they are bought and sold on daily basis. In case of currency hedging ETFs is specialized in long or short currency exposure so that it matches actual performance of currencies risks that it has been focusing on. But the actual performance diverges as it is originally expected due to tendencies of mechanics of the funds. It means all types of currency risks cannot be eliminated but most of them can be eliminated (Schlichting, 2013).

Use of Forward Contracts: This option is most widely and frequently used method to eliminate or mitigate the currency risk. This method of mitigating currency risk is very old and requires financial knowledge. In forward contract there is contract between two or more parties to buy or sell the desired assets on particular date as set out in contract. Price of a contract is also fixed if contract is executed. On exercise date, if there is need to hedge the forward contract, it can be done through executing the contract. In this way any change in currency price in respect to other currency can be easily hedged.

Use of options for hedging the currency risk: In this currency hedging method, investor is given right to buy or sell the contract of currency on defined date and price. Investors have no obligation to settle the contract made as in case of forward contracts (Schlichting, 2013).

Interest rate hedging strategies

Interest rate options

            This use of options will largely help the company to gain a protection over negative fluctuations within the interest rate and gaining benefit from its positive movements. They are also known as interest rate guarantees (Macrae, 2015). It can be regarded as similar to an equity option that can be either put or a call. Interest rate call provides the right to gain benefit from the increase in interest rates while put option provides the holder the right to benefit from decreasing interest rates.

Dividend Theories Supporting the Dividend Policies

Interest Rate Swaps

            It is a major type of hedging strategy that is used for managing the impact of fluctuations occurring within the interest rate environment. It can be described as a contract where the prices involved possess the obligation to exchange the cash flow as per the pre-determined terms. The swaps are arranged by a financial intermediary such as bank that allows companies to hedge the inertest rate risk over longer period of time.

Sale of Long-term Bonds

            This involves hedging against the rising interest rates by sale of bonds that have particularly long maturity period and coupon rates. In addition to this, the investors can also transit the bond portfolios from long-term to short-term bonds such as high yield or floating rate bonds (Jha, 2011).

 Risk and return trade off and explanation of four money market investment instruments

The treasurer of Chista Plc is planning to invest its temporary excessive cash within the money market for realizing returns from them that are currently of no use but will be required for capital investment project within six months time. However, it is essential for the company to consider the return and risk related to investment within the money market so that it is able to take accurate investment decisions. The money market can be described as a financial market where the financial instruments with high liquidity for a very short term are traded. In this context, the company need to undertake a risk and return trade off before taking the final investment decision within the money market as followed:

Risk Related to Investment in Money Market

• Investment Risk: The major risk that is related with investing in money market is associated with the financial instrument risks. The risk occurs when a money market instrument does not perform as expected due to adverse events within the market. This could occur due to default of the counterparty to meet its commitments or rise in the credit risk of the instrument. The major type of financial instrument present within the money market includes fixed deposits, tradable certificate, treasury bills and commercial paper. In this context, it is essential for the company to consider the nature of these instruments before investing the short-term cash within this market (Wilde, 2015).
• Liquidity Risk: It is the risk associated with the money market when there occurs a large cash outflow and the instruments are forced to sell due to insufficient liquidity for meeting the unexpected outflow of cash. The sale of illiquid instruments before the maturity can result in incurring an additional cost to the fund that can result in declining the income to be realized from it (Treasury Today, 2016).

Returns Associated with Money Market

The investment in money market can also prove to be profitable option for the company to realize return on the investment that is currently of no use. The financial instruments of money markets are associated lock-in period that provides the facility to investors to redeem and also the money can be transferred via electronic means. These can provide the highest source of short-term income in comparison to investing the same amount of money within savings bank account. It will help the company to invest its short-term surplus cash or borrow funds on a short-term basis as these instruments carry less risk in comparison to long-term debt.

Therefore, it is important for the company to outweigh both the risks and returns associated with investing the funds for a short duration within the money market. In this context, it is essential for the company to develop a well-diversified portfolio consisting of different types of financial instrument that helps in reducing the risks and maximizing the returns from investing within the money market. Also, the company needs to re-invest the funds in a capital project after 6 months of time and therefore it is essential that the company selects the financial instruments that can yield maximum returns within this period of time (Kidwell, 2016).

Description of Four Potential Investment Instruments and their advantages and disadvantages

Certificate of Deposit

The certificate of deposit enables the company to invest the money for a specific period of time in return for a guaranteed return. The major benefits associated with investing the money within this financial market instruments are as follows:

• It is a secured type of financial instrument that will provide guaranteed return without having any impact of the interest rates
• The terms and amounts that can be deposited within the CD are highly flexible and thus the company can easily invest for a short-period of time
• There are variety of commercial deposits instruments present that provides the options to select the most appropriate one as per the  company needs and requirements

Hedging Strategies for Reducing Foreign Currency and Interest Rate Risk

Limitations

• The most significant limitation associated with the use of CD is that if the money is to be withdrawn before realizing maturity then it is required that investor need to pay penalty for meeting the lost interest (Parameswaran, 2011).

Shares in Money Market Instruments

Money market mutual funds enable the investor to invest in low-risk securities such as US treasury bills and commercial paper. The funds are regarded as safe and yielding higher returns due to investing the money in liquid instruments such as treasury bills, commercial paper, certificates of deposits and repurchase agreements. Its significant advantages and limitations can be stated as follows:

Advantages

It enables the investors to invest within highly liquid and safe financial instruments that have relatively lower risk and also have short-term maturity. Thus, it will enable the company to realize higher funds in comparison to the other cash equivalents as fund managers can diversify the money market instruments for gaining higher returns.

Disadvantages

It can also result in losing the money of the company in the situation where the interest rates are lower than the mutual funds can provide less money in comparison to the rate of inflation (Fabozzi, 2015).

Commercial Paper

CP is the promises provided by the companies to provide the short-term working capital directly from the market in place of borrowing it from the bank. Thus, the company through the use of commercial paper can provide loans to other companies for gaining interest over it for a specified period of time.

Advantages

It provides the companies a better way to raise the working capital as it is cheaper source of fund in comparison with the bank loan.

Disadvantage

The issue of commercial paper has to be done as per the RBI guidelines that can make it a rather complex process

Promissory Note

This is a written type of promise that is provided by a company to another for repaying the borrowed amount of money on a specified future date. The promissory note is required to be repaid within a period of 90 days and thus can also be used by the company effectively to realize interest on its idle amount of cash.

Advantage

It is written type of contract between the lenders and buyers and there clearly outlines the rights and obligation of both the parties

Disadvantage

It is long-written contract that can lead to hiding unfavorable terms and therefore it is highly necessary to understand all the critical terms before making a final decision (Fabozzi, 2003).

Conclusion

To conclude it can be said that dividend policies is the management decisions and choice of dividend policies impacts the market performance of the company. Every dividend policy is based on any of dividend theories and application dividend theories helps to judge the market value of the company. Solna Plc has suffering with foreign currency and interest rate risk that can be sorted through application of hedging strategies provided in part B of this assignment. Lastly, investment strategies have been explained to treasurer of Chista Plc together with meaning of return and risk trade off.

References

Baker, H.K. and Nofsinger, J.R. 2010. Behavioral Finance: Investors, Corporations, and Markets. John Wiley & Sons.

Deegan, C., 2013. Financial accounting theory. McGraw-Hill Education Australia.

Fabozzi, F. 2003. The Global Money Markets. John Wiley & Sons.

Fabozzi, F. 2015. Capital Markets: Institutions, Instruments, and Risk Management. MIT Press.

Firer, C. 2012. Fundamentals of Corporate Finance. Berkshire.McGraw-Hill.

Glajnaric, M., 2016. The importance of dividend paying stocks. Equity, 30(2), p.6.

Jha, S. 2011. Interest Rate Markets: A Practical Approach to Fixed Income. John Wiley & Sons.

Kidwell, D. 2016. Financial Institutions, Markets, and Money. John Wiley & Sons.

Macrae, V. 2015. Mastering Interest Rate Risk Strategy: A practical guide to managing corporate financial risk. Pearson UK.

Parameswaran, S. 2011. Fundamentals of Financial Instruments: An Introduction to Stocks, Bonds, Foreign Exchange, and Derivatives. John Wiley & Sons.

Schlichting, T. 2013. Fundamental Analysis, Behavioral Finance and Technical Analysis on the Stock Market. GRIN Verlag.

Treasury Today. 2016. Introduction to short-term investment instruments. [Online]. Available at: https://treasurytoday.com/handbook/mmf-2016/section-02 [Accessed on: 20 November 2018].

Wilde, S. 2015. The Risks Associated with Money Market Investing. [Online]. Available at: https://www.recm.co.za/uploads/newsletterdocument/the_risks_associated_with_money_market_investing.pdf [Accessed on: 20 November 2018].

Zimmerman, J.L. and Yahya-Zadeh, M., 2011. Accounting for decision making and control. Issues in Accounting Education, 26(1), pp.258-259.