Principles Of Finance: Enhancing Shareholder Value - Essay Example

PRINCIPLES OF FINANCE: ENHANCING SHAREHOLDER VALUE TABLE OF CONTENTS Introduction Methodology and Research Route Theory and Practice Recent Developments and Law Summary and Conclusions Introduction This is a wide topic and prompted me to explore a number of issues pertaining to enhancing Shareholder Value. The first query inevitably was whether Share holder wealth is a product of larger dividends paid to investors. The dilemma of whether to return cash to its stockholders and if so how much in the form of dividends haunts every private and public company owner. Many schools of thought have taken conflicting views on this issue. The " dividend irrelevance" group of thought will reveal that dividends have nothing to do with firm value because there is no tax disadvantage to an investor to receiving dividends, and that firms can raise funds in capital markets for new investments without having to go through high issuance costs. Another school of thought believes that dividends are adverse for the average shareholder as they attract taxes and cause fiscal disadvantages. Last but not the least the third group lauds large dividends as a positive signal to shareholders that all is well. So where does the modern shareholder value satisfaction stand in relation to dividend policies This is the one of the main issues which I will review in my paper below. Secondly my research is concerned with whether corporate governance is a mechanism to enhance shareholder wealth The fear of manager stockholder conflicts as being a threat to Shareholder wealth has been expressed by many academics as the quote below demonstrates, "The separation of ownership and control in a modern corporation often requires the delegation of significant decision-making authority to professional managers, which introduces the possibility that managers will have incentives to make decisions that benefit them at the expense of stockholders" (Byrd, Parrino and Pritsch, 1998). As this quote argues from the thesis by Byrd, Parrino and Pritsch, 1998 where the authors have argued that the separation of ownership and control in a modern corporate form will require the transfer of this responsibility to professional managers and this will introduce a stockholder-manager conflict with in the corporate structure. It has even been suggested that like most small investors, they would be likely to depend on free-rider benefits from the efforts of larger shareholders, who may have better expertise in corporate monitoring (Byrd, Parrino, & Pritsch,1998). My paper will defend the Berles and Means thesis and try to assess the truth in the statement given in the question. The modern corporate form finds itself dependant on the efficient allocation of resources by its agents of the funds which have been made available by the shareholders.The creation of new ventures and prudent investment becomes a focal aim of the established companies. This efficient allocation is dependant upon what the investors believe will be the returns as well as the trust that their company will be managed to maximize the investment and that the cash flows promised in exchange for the investment will effectively be returned.This trust will be established through a broad set of factors which will stem from the legal, institutional and regulatory environment that guarantees the investor protection.Accountability is the core concern that runs throughout the governance issues. Whether it is accountability of the management to the board, or the board to the shareholders, or even the employees to the employers, this is one issue that comes to fore whenever the subject is raised. Accountability does not confine itself to financial matters alone. It covers the whole idea of responsibilities placed on a person, a group or even a department and the evaluation thereof to find out how these responsibilities were carried out or delivered. The third issue which I will deal briefly with is how corporate governance can enhance shareholder wealth and the role of the law played in this regard. In this regard I will refer to the Companies Act 2006. Methodology and research route The electronic sources which have been utilised in this paper include the following websites. www.afajof.org www.bloomberg.com www.federalreserve.gov www.investopedia.com accenture.com http://www.yamaha-motor.co.jp/global/ir/dividend/index.html The paper has also utilised peer reviewed journals accessed through Athens and Proquest from Emerald Text, Blackwell Synergy, and Westlaw. Most of these are from prominent financial accountancy journals and allowed me to study the topic in depth. Very few paper sources have however been utilised as most of this information was available online. The Topic is vast and has a wealth of information pertaining to it as I discovered. The essay has been structured to discuss the mechanisms and theories of enhancing shareholder wealth and their importance for a better financial scenario for an economy. More importantly this work is focused on how the managers of a corporation will need to be controlled to ensure shareholders are not deprived of their value arising from their investment. My motivation to study the theory of finance has always been due to the theoretical premises upon which the modern legal systems are modeled and to what extent are the theories of corporate governance enunciated in the 1932 Berle and Means thesis relevant today for shareholder and class rights protection..It is my personal belief that corporate developments cannot be studied in isolation from financial theory and therefore my research was to a large extent focused on the intellectual views of academics who have explored these waters of shareholder and manager conflict and the resultant problems for the minority shareholders and in the creation of shareholder wealth. Theory and Practice The role of dividend policies in enhancing shareholder wealth "The nearly universal policy of paying substantial dividends is the primary puzzle in the economics of corporate finance."(Black 1976 cited by Frankfurter 2002) This section will discuss corporate dividend policy and whether shareholders should be paid sufficient dividends whether or not they are making sizeable profits on the stock market. Over the last half century academics have spoken in great depth over this issue and suggested conflicting theoretical frameworks to explain their point of view.(Frankfurter 2002).The problem is that these assertions often lack empirical depth to the criticism and stumble upon self contradictions in an attempt to explain corporate dividend behaviour.(Frankfurter 2002).Today academic opinion is divided as to whether dividends are attractive to shareholders and will have a positive impact in stock prices.(Frankfurter 2002 )Another school of thought contends that prices are negatively correlated with dividend payout levels.(Frankfurter 2002).The third view is that firm dividend policy is irrelevant in stock price valuation. (Frankfurter 2002). These views are best summed up as being based upon,the tax effect ( Litzenberger and Ramaswamy (1980),)Clientele effects explanations (Elton and Gruber, 1970), Agency theory explanations(Easterbrook 1984), Signaling models(John and Williams (1985), and psychological/sociological explanations ( Frankfurter and Lane 1992). Frankfurter and Wood (2002) have even gone ahead to suggest that none of the dividend theories are unequivocally verified. Academics and theorists like (Adam Smith 1937) have recognised that there will always be agency costs related to taking care of shareholder priorities and controlling unruly management staff.(Corporate Governance issues). Dividend policy has a large bearing on agency costs and many academics have recognised this(Fama and Fama) and they believe that payments of large dividends would potentially compensate for the shareholders are often ignored during decision making in a company and according to John and Kalay 1982 "Debt covenants to minimize dividend payments are necessary to prevent bondholder wealth transfers to shareholders .Although potentially substantial in precipitation of agency costs, its dividend policy is not a major source of bondholder wealth expropriation. In firms where dividend payouts are limited by bondholder covenants, dividend payout levels are still below the maximum level allowed by the constraints" (Frankfurter 2002). However there is a negative aspect to large dividend payments as well as these are known to affect the funds base required to fund the consumption and investment opportunities of a company and this will affect the capital reserve of the company. (Frankfurter 2002).It is worth noting here that the issue of dividend payments relates strongly to the principles enunciated by Berle and Means (1932) that the shareholder should be allowed to invest in all profitable opportunities through the company's managers. Jensen 1986 has even suggested that there be a model which after financing all positive net present value projects cause conflicts of interest between managers and shareholders. (Frankfurter 2002) Case study of the Yamaha Group To take an example of the Yamaha group of Companies it is worth noting that they take their dividend policy seriously by emphasising that the shareholders interests represent one of the highest management priorities of Yamaha Motor1.Their dividend policy is centered on paying cash dividends to accurately reflect on business performance, using the payout ratio as an indicator .Recently they have announces their Basic Policies Regarding Return of Profits to Shareholders (Announced in January, 2005) as including Disclosure and implementation of explicit dividend policy, increase of total amount to be returned to shareholders,payment of cash dividends that accurately reflect business results, Giving priority to capital gains, and aiming to achieve more than 10% in annual EPS growth . 2The company has also announced that it intends to raise the EPS by more than 30% in the next three years and to maintain a payout ratio of at least 10% for the time being, and may aim for 15%, depending on circumstances. If the equity ratio exceeds 50%, or the interest-bearing debt reaches zero in the future, the Company will aim for an even higher payout ratio. The diagram below shows Yamaha's dividend policy aimed at attracting new investors.3 The way ahead for Shareholder Wealth All in all there will always be a tension between the shareholder dividend desires and management need of retained earnings for further investment. (Frankfurter 2002).Many academics have then suggested that this tension can be resolved by making the management take into account all endogenous and exogenous current and expected earnings, dividend payment history, dividend level stability as well as the current position of Cash flows. (Frankfurter 2002). Therefore a coherent dividend policy will take into account all variables like - Sustainability - Current firm profitability, - future cash flow expectations, - Industry norms. (Frankfurter 2002). The research of La Porta et al.(2000) suggests that firms operating in the same field or area of study can surprisingly offer different offer different degrees of investor protection and of these features are dividend policies which are a result of the specific operational characteristics and to particular interests. Infact La Porta et al. (2000). goes on to state that firms in common law countries where investor protection is stronger will have a tendency to make higher dividend payouts when the firms' investment opportunities are poor than do firms in countries with weak legal protection. All this will also be a result of board composition, managerial compensation, takeover defences, and audit. However other academics have concluded that even in the absence of endogenous and exogenous regulation the agency costs will be toned and routed by the pressures of the takeover market. In essence Dividend policy is better viewed as " a corporate tradition" and indeed it does matter that how much money is being paid to investors.This is because even in tight times the managers will want to signal good news but will be careful not to offer too high dividends which they are not able to maintain in the future.So dividend payments become the invisible handshake of ownership and control.Current theories have been criticised to ignore other social influences of investor and managerial response and that is why they have been rendered faulty. It has to be understood that like stock prices dividend policy is a slave to similar psychological influences. (Frankfurter 2002). Recent developments and Legislation Role and the need for corporate governance: The Companies Act 2006 The concept of corporate governance pertains to the notions of the "agency". or the "principal-agent" relationship which is a consequence of the Berle and Means thesis that the who owns the firm does not necessarily control it.In the modern corporate entity the investors or financiers (principals) hire managers (agents) to run the firm on their behalf. This means that the finance and management of the firm will be separate.see Berle and Means (1932).In this vein the query whether the Companies Act 2006 has actually gone ahead to promote corporate governance and allowed the shareholder to have sufficient reasons to invest in the economy has already made many politicians nervous and burned the curiosity of academics post Companies Act 2006. The Companies Act White Paper clearly stated that one of the main aims of this new Act would be to codify the notions of Enlightened Shareholder Value through clarifying the duties of directors to promote the success of the company for the benefit of its shareholders.(White Paper 2002).This was aimed to be achieved through the all the long term and short term economic factors as well as other stakeholders like the employees and creditors. As far as the regulatory burden is concerned it seems that this Act has transferred it to the directors and for the first time non executive and shadow directors have been expressly made liable for their actions to make sure the companies are better governed and more successful. However the Act has not gone with out criticism and in its defence and it is often feared that this could lead to a rather compliance driven approach to the performance of these duties rather than a matter of good faith.This is a line taken strongly by the Law Society which believes that it will often become a matter of red tape and extra legal fees for compliance advice rather than a proper trend.There is more than an ounce of truth to this view mainly because good faith and honesty are a part of culture and can not be achieved solely through strict laws. The pith and substance of the concept of enlightened shareholder value is contained with in section 172 of the Companies Act which is an important section for the ensuring corporate governance, providing thus the requirement of good faith onto directors ,where they have to make decisions with regard to "the likely consequences of any decision in the long term, the interests of the company's employees, the need to foster the company's business relationships with suppliers, customers and others, the impact of the company's operations on the community and the environment, the desirability of the company maintaining a reputation for high standards of business conduct; and,the need to act fairly as between members of the company."(Section 172 Companies Act 2006). Summary and Conclusions The basic aim of this paper has been to explore the significance of dividend policies upon shareholder payments and whether this has a bearing upon shareholder loyalty and positive behaviour. Here I have presented the basic goals of dividend policy and the results of empirical research showing the corporate practice. Black (1976) called the love of dividends by shareholders a puzzle, because of taxes such sentiment is economically not rational however empirical evidence has disproved his view and further models to explain this behaviour have also subsequently failed. Secondly in my discussion of the concept of corporate governance and legislation I have reached the conclusion that The Companies Act 2006 needs its time to absorb into the veins of Corporate Britain and only then will there be a culture of corporate governance instead of mere regulation for the protection of the minority shareholder and the class rights pertaining to voting and dividend policies. 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