Dividend Policy and Firm Value

This assignment delves into the complex relationship between dividend policy and a firm's value. Students are tasked with analyzing various theoretical frameworks surrounding dividend decisions, reviewing empirical evidence that supports or refutes these theories, and discussing real-world examples of companies implementing different dividend policies and their impact on shareholder value. The analysis should consider factors like risk, growth opportunities, and market conditions.

FINANCIAL
MANAGEMENT
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TABLE OF CONTENTS
INTRODUCTION......................................................................................................................1
DIVIDEND POLICY.................................................................................................................1
FINANCIAL MARKET............................................................................................................2
FINANCIAL DERIVATIVES...................................................................................................4
CONCLUSION..........................................................................................................................6
REFERENCES...........................................................................................................................7
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INTRODUCTION
Financial management is the process of effective utilization of monetary resources.
Present project report will explain the role of management of funds in the organization. This
report will discusses dividend policy, financial markets and derivatives for effective and
efficient management of collected funds.
DIVIDEND POLICY
Dividend policy is the combination of certain guidelines which companies have to
follow when they are distributing part of their profits to their shareholders (Deshmukh, Goel.
and Howe, 2013). All the organizations generally do not allocate all their earnings as
dividend to their investors so this policy assists managers to determine the amount of
organizational earnings to be paid to the shareholders. There are various types of dividend
policy which have been described hereunder:
Residual dividend policy
This policy is based on three key elements that are mentioned below:
 Target capital structure.
 Investment opportunity model.
 Cost of external capital.
Initially, residual-dividend model primarily aims at deciding a target dividend payout
ratio. Thereafter, managers determine the equity which will be needed to construct an optimal
capital structure (Renneboog and Szilagyi, 2015). Primarily, equity funds will be collected
through the use of retained earnings. Management decide optimal capital expenditures level
to manage their cost of capital. As per this policy, companies use their total earnings for
meeting business operational as-well-as expansion expenditures and if any surplus is left then
it will be called as residual which will be use for dividend distribution. Henceforth, it seems
to be very useful in capital projects while its disadvantage is fluctuations in business earnings
that contribute to bring instability in dividend.
Stable dividend policy
This policy overcomes with the limitation of residual dividend model because it helps
to maintain stability in dividend. Stability policy says that companies have to provide regular
and stable dividend to the investors (Loudermilk, 2012). Henceforth, it reduces uncertainty in
the shareholders return. It is adopted by the organizations who attempt to share their earnings
with the investors rather than retaining this for future purpose.
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NASDAQ international organizations follow stable dividend policy in which
managers ensure regular and stable dividend distribution to the shareholders. It is because;
managers believe that continuous increase in dividend is not possible because of existing
market uncertainties (Engombe, 2014). Therefore, they strive for maintaining balanced
payment of investors return which ultimately impact on firm's corporate value.
Hybrid dividend policy
It is the combination of both residual and stable dividend policy. As per this model,
companies set a minimum dividend which is relatively a small proportion of total business
earnings so that managers will be able to maintain it easily (Naser, Nuseibeh and Rashed,
2013). Moreover, they can offer extra dividend to the shareholders if actual incomes exceed
the minimum set level. In this policy, companies use and maintain their debt/equity ratio for
long term purpose. In present uncertain market, this is highly used approach of international
organizations. It is because; cyclical fluctuations have a great impact on business incomes
which ultimately affects investors return in the way of dividend (Murto and Terviö, 2014). It
allows flexibility in dividend distribution according to the business performance.
FINANCIAL MARKET
It is the place at which people trade for various securities and commodities. Securities
involve bonds and stocks while commodities include agricultural products and metals (Segal,
Shaliastovich and Yaron, 2015). In this market, large number of buyers and sellers trade their
equities, bonds, currency, derivatives and others at lower cost. There are various types of
financial markets that have been explained hereunder:
Money market
It is a market segment at where financial instruments with high liquidity and short
maturities are traded. Participants use this market for short-term borrowing and lending
purpose (Dieckmann and Plank, 2012). It can vary from many years to a time period of
twelve months. For example, following securities can be traded in money market:
 Negotiable Certificate of Deposits (CDs),
 Treasury bills,
 Commercial Papers (CP)
 bankers acceptance
 Municipal notes
 Repurchase agreements (repos)
 Eurodollars
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Thus, this market provides assistance to generate funds for meeting operational
expenses.
Capital market
It deals with long term financial instruments such as long term debt and equity-backed
securities. In this market, funds are provided for longer duration of more than one year
(Carey and et.al., 2012). It has been classified into two types that are primary and secondary
market, explained as below:
Primary market:
It deals with new and fresh securities which provide huge assistance to large
companies and government to obtain required funds. They can sale their new issued equity
shares and bonds in this market and collect large amount of funds. Sale of fresh issue of
equity and bond stock is termed as Initial Public Offering (IPO). It facilitates capital
formation in the economy.
Secondary market:
This market segment trades for existing financial securities. After issuing fresh stock
in primary market, it will be traded in secondary market (Horowitz, 2014). Various securities
such as bonds, options, stock and futures are bought and sold in this market. Here, it is also
uses for trading goods and assets. Greater number of investors and speculators transfer their
securities to another. It is highly liquid market thus; prefer by investors who do not want to
stick their money for longer time period.
Difference between money and capital market
Basis of difference Money market Capital market
Collection of funds Money market helps to gather
funds for shorter duration
through dealing with highly
liquid securities (Money and
Capital Market, 2012).
Capital market deals with
long term securities
henceforth; funds can be
generated for longer time
period.
Financing It assists companies for
funding their routine
activities. Thus, it can be used
to meet out operational
expenses.
Its purpose is to finance
capital expenses such as
business expansion.
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Difference between primary and secondary market
Basis of difference Primary market Secondary market
Securities It trades with new and fresh
securities.
It deals with existed securities
which are currently trading in
the market (Handtke, 2012).
Purchases Investors purchase shares and
bonds through issuing
companies.
Investors purchase securities
from other investors rather
than issuing organizations.
Dealing It deals through registering
securities in the stock
exchange.
Securities are dealing at
Over-the-Counter market
(OTC). It refers to the
securities that are not traded
at stock exchanges.
FINANCIAL DERIVATIVES
Derivative is the contract of various assets which will be settled between two or more
parties in the future period to manage associated risk. Assets comprise bonds, stocks,
commodities, currencies and interest rates. Financial derivatives are the instrument or
indicators through which financial risks can be minimized (Hirsa and Neftci, 2013). It can be
traded at Over-The-Counter (OTC) market and any stock exchange. It enables parties to trade
various financial risks such as currency, equity, price risks, credit risk and interest rate risk.
There are number of available financial derivatives which can be used by
organizations for controlling and eliminating their financial risk, given as below:
 Options
 Futures
 Swaps Credit derivatives
Options
It is an agreement which gives right and opportunity but not the obligation to the
option holder to buy or sell any financial security at a specified future date at prevailing strike
price (Chellaboina, Bhat and Shikha, 2014). These rights can be purchased by paying its
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charges, called premium. There are two types of options that are call and put option,
described underneath:
Call option
It gives the holder right to purchase a security at a specified price for a fixed time
interval. It is often used by investors if they assume that in future period, share prices may
raise.
Put option
Put option is the selling right of option holder to sell an underlying assets at a
specified strike price before the expiration date or maturity period. When investors feel that
share prices may be fall in future years, then they buy put option to sell their stock at high
prices.
Futures
It is the most significant type of derivatives which is generally used in the market.
Future contract is an agreement that can be exercised between two parties for sale of assets
(Sullivan, 2013). The contract will be settle down at agreed prices and on predetermined date
in future. It is highly used by corporations to mitigate or hedge their financial risk at a
particular point of time.
Swaps
It is a contract or agreement in which two parties are agreeing for trade loan terms and
exchange their associated cash flows to each other. It is greatly used to manage financial risk
which can be arising due to fluctuation in interest rates. It is because; high interest rate
imposes high financial obligations to the company and vice versa. Under the interest rate
swaps, counter-parties will be agreeing to exchange their variable interest rate loan with the
fixed interest rate loan (Chance and Brooks, 2015). Thereafter, both the parties will pay
towards other person obligations upon mutually agreed rate. Lastly, on the maturity date,
principle amount will be again transferred to the original party. It is very risky method
because; if one party may fail or goes default of bankruptcy then it will force other party to
get back to their original loan (Subrahmanyam, Tang and Wang, 2016).
Credit derivatives
Credit derivatives are the contract between counter-parties allowing them to manage
their credit risk. For example; if bank feels that customers are unable to repay their
borrowings then bank may use credit derivatives to transfer credit risk to another party. It will
provide huge assistance to financial institutions to protect towards foreseen credit risk.
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CONCLUSION
Presented report concluded that dividend policy greatly assist management to manage
regular dividend. Financial market helps to collect required funds for different time duration
whereas derivatives are the effective tools to hedge financial risk. Thus, it can be concluded
that all the techniques help to ensure effective management of funds in the businesses.
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REFERENCES
Books and Journals
Carey, M. and et.al., 2012. Market institutions, financial market risks, and the financial crisis.
Journal of Financial Economics. 104(3). pp. 421-424.
Chance, D. and Brooks, R., 2015. Introduction to derivatives and risk management. Cengage
Learning.
Chellaboina, V., Bhat, S. P. and Shikha, D., 2014. On pricing and optimal hedging of path-
dependent financial derivatives. Nonlinear Studies. 21(2).
Deshmukh, S., Goel, A. M. and Howe, K. M., 2013. CEO overconfidence and dividend
policy. Journal of Financial Intermediation. 22(3). pp. 440-463.
Dieckmann, S. and Plank, T., 2012. Default risk of advanced economies: An empirical
analysis of credit default swaps during the financial crisis. Review of Finance. 16(4).
pp. 903-934.
Hirsa, A. and Neftci, S. N., 2013. An introduction to the mathematics of financial derivatives.
Academic Press.
Horowitz, N., 2014. Art of the deal: Contemporary art in a global financial market. Princeton
University Press.
Loudermilk, M. S., 2012. Estimation of fractional dependent variables in dynamic panel data
models with an application to firm dividend policy. Journal of Business & Economic
Statistics.
Murto, P. and Terviö, M., 2014. Exit options and dividend policy under liquidity constraints.
International Economic Review. 55(1). pp. 197-221.
Naser, K., Nuseibeh, R. and Rashed, W., 2013. Managers' perception of dividend policy:
Evidence from companies listed on Abu Dhabi Securities Exchange. Issues in
Business Management and Economics. 1(1). pp. 1-12.
Renneboog, L. and Szilagyi, P. G., 2015. How relevant is dividend policy under low
shareholder protection?. Journal of International Financial Markets, Institutions and
Money.
Segal, G., Shaliastovich, I. and Yaron, A., 2015. Good and bad uncertainty: Macroeconomic
and financial market implications. Journal of Financial Economics. 117(2). pp. 369-
397.
Subrahmanyam, M. G., Tang, D. Y. and Wang, S. Q., 2016. Does the tail wag the dog? The
effect of credit default swaps on credit risk. In Development in India. Springer India.
pp. 199-236
Sullivan, S., 2013. Banking nature? The spectacular financialisation of environmental
conservation. Antipode. 45(1). pp. 198-217.
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Online
Engombe, M. T., 2014. Dividend policy and its impact on firms value: A review of theories
and Empiricalm Evidence. [PDF]. Available through:
<http://www.academia.edu/8447440/Dividend_policy_and_its_impact_on_firm_valu
e_A_Review_of_Theories_and_Empirical_Evidence>. [Accessed on 3rd March,
2016].
Handtke, K. E., 2012. Primary and secondary market. [PDF]. Available through:
<http://www.levyinstitute.org/pubs/wp_741.pdf>. [Accessed on 3rd March, 2016].
Money and Capital Market. 2012. [PDF]. Available through:
<https://www.dst.dk/Site/Dst/Udgivelser/GetPubFile.aspx?id=16251&sid=18mon>.
[Accessed on 3rd March, 2016].
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