Financial Management: Dividend Policy and Investment Appraisal Techniques

This document discusses the concept of financial management, specifically focusing on dividend policy and investment appraisal techniques. It explains the calculation of fair share price using Gordon's model and explores the use of payback period, accounting rate of return, net present value, and internal rate of return in investment decision making. The document also highlights the challenges and considerations associated with these financial management tools.

Financial Management

INTRODUCTION
FM is defined as planning, controlling, analysing, directing the basic business activities
in the business organisation (Gottschalk, 2016). It helps in dealing investment of a business
entity that help in the business decision making system. Financial management is application of
the fundamental accounting principle of management to financial aspects of a enterprises. It may
includes financial ratio, debts, equity, dividend pay out and investment methods. For the better
understanding of financial management, this report covers dividend policy of planet company
and investment appraisal techniques of a food manufacturing company. This report helps in the
decision making activities of the business that evaluates the dividend pay out policy of equity
share capital and investment tool like pay back period, average rate of return, internal rate of
return to choose the better option in the business that may produces the more profit in the future.
MAIN BODY
Question 01
(A) Dividend policy
It is a financial policy that defined as pay out cash dividend to the shareholders of the
company (Greenbaum, Thakor and Boot, 2015). It is financial decision that concerned with a
certain portion of the net profit after tax of a firm is to be paid out to its real owner or
shareholder. A business firm decides the dividend portion in order to pay the dividend out of the
net generated revenue. There are various model of the Dividend policy like Walter's model,
Gordon's model.
In the given context calculation of the fair price of the planet's shares has been done as
follows:
This year dividend has decided by the company 20p, required rate of the return is 14%.
As per the this question, Gordon's model of the dividend is more appropriate for the calculation
of the growth model. Growth rate is calculated for all of the year
D= 20p
k= 14%
g1 = (14-13) / 13 * 100 = 7.69%
g2 = (17-14) / 14 * 100 = 21.43%
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g3 = (18-17) /17 * 100 = 5.88%
g4 = (20-18) /18 * 100 = 11.11%
here, D = dividend , k = cost of capital, g= growth rate for the years
after calculating the growth rate, dividend formula as follows
= D1 / (k-g)
here, D1 = dividend per share for the next year or expected year
k= required rate of return or cost of equity that is estimated by the dividend growth model
g= expected dividend growth rate
for the first year, share price is calculated as
value of the share price = D1 /(k-g)
= 14 / (0.14- 0.0769)
= 2.22$
for the second year,price of the share is estimated as
value of the share price = D1 /(k-g)
= 17 / 0.14-0.2143)
= 2.28$
for the third year, price of the share is reckoning as
value of the share price = D1 /(k-g)
= 18 / (0.14-.00588)
= 2.22$
for the forth year, price of the share is figuring out as
value of the share price = D1 /(k-g)
= 20 / ( 0.14- 0.1111)
= 6.92$
so here growth is inconsistent but the dividend pay out is average between 13 p to 20 p.
The average is 11.53% that indicates the dividend of the next year will be as follows
Growth in the price of share = (21.87 – 20)/ 20 *100
= 10.69%
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Fair share price is estimated as under:
value of the share price = D1 / ( k – g )
= 20 / ( 1 + 0.1153) / (0.14 – 11.53)
= 9.03 $
(b) company wants to increases its debt level, it may increases the financial risk that is associated
with equity share so here value of the share as follows
for the year 1, value of the share price = D1 / ( k-g )
= 14 / ( 0.154 – 0.0769 )
= 1.81 $
for the year 2, value of the share price = D1 / ( k-g )
= 17 / ( 0.154 – 0.2143)
= 2.81 $
for the year 3, value of the share price = D1 / ( k-g )
= 18 / (0.154 – 0.0588)
= 1.89 $
for the year 4, value of the share price = D1 / ( k-g )
= 20 / ( 15.4 – 0.1111)
= 4.19 $
for this year value of the share price = D1 / ( k-g )
= 20 ( 1+ 0.1153) / 0.154 – 0.1153)
= 22.306 / 0.0387
= 5.80 $
(c)
After observing this question, planet company is paying the dividend on regular basis and it
increases year by year but not on regular growing on yearly basis so here Gordon's model is the
most suitable with this references and data related to this company (Hopkin, 2018). But there are
many problem arises to ascertain the fair price of the shares. By using the dividend growth model
planet company has irregularity in the growth rate of the organisation. The main problem is
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related to uncertainty in the growth rate of the expected year or upcoming year. It may create a
problem in fair valuing the price of the shares. Uncertainty is the situation where the estimates
data may fails and fair share value may not exist in future. The other problem arises in deciding
the share price length of the extra ordinary growth rate period as growth rate is automatically
decline after reaching the maximum level of growth of a share. The fact behind this concepts is
that it is expected a decline after the stability position in the share value. Investment in a
particular share may decreases the return on value that is invested after a stable position. This
model is totally based on the higher growth rate that is always not corrects. This model is
assumed the expected grow in the value of the share but sometimes it may not true. The problem
in using this dividend growth model is arises when firm is not paying the affordable dividend in
the expected year that is happens gradually over the time period. Growth rate is based on the
forecasting the future cash pay out dividend that may be reliable or not to the company. Dividend
model requires an huge number of speculation in order to decide the value of the dividend. It
must be reliable, deep study and plenty of assumptions about the future which may require the
detailed analysis and study and knowledge of past records. The another problem is regarding
dividend discount model about multi stage that take a step closer to the expected result or reality
in the future as it is based on the assumption of the forecasting the growing rate by analysing the
records of the company. But the problem is related to varying the growth phases of an
organisation. Problem in assessing the growing rate of the business in dependent on the past
records and assumption that may not always corrects. And it is not ascertain the earning of the
enterprises (Knights and Tinker, 2016). This model is based on the pay out ratio of dividend but
not related to earnings. The main problem is using the dividend growth model in deciding the
value of the shares is related to figuring out the actual growth rate and the cost of equity. This
model is not applicable on the large or long term shareholders. shareholder buy the share of a
firm on the basis of the degree of control and return on investment but the return is not sufficient
then they sell the holding due to irrelevant dividend.
Question 02
Investment appraisal techniques
(a) Pay back period: It is tool of capital budgeting that concerned with the capital investment
requirement to make a capital expenditure and how much it will take to return its cost of capital.
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It refers to basic time period to recover the cost of capital that is invested in the capital
expenditure (McKinney, 2015). It is also known as break even point. In the given question pay
back period is calculated as:
pay back period = cost of investment / Annual cash inflow
computation of economic feasibility of project that is using following investment appraisal
techniques:
Recommendation:
Here, Payback Period is 3.79 as invested amount is recovered in the almost forth years.
So it is really beneficial for the Lovewell Limited. So the new machine must be installed in the
business organisation as its cost recovery in forth year. it is feasible and economical to the
company to investment in it.
(b) Accounting rate of return: It is a financial ratio that is used in the capital budgeting to define
the ratio between net profit generated by the capital expenditure and the average investment. It
does not take time value of money in account. But calculated the generated income by the
investment in percentage (Otley, 2016). It is also known as average rate of return. The formula of
the accounting rate of return is as under:
Average rate of return = average net profit / average investment *100
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ARR for Lovewell Limited
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Particular Amount
Initial Investment 275000
Particular Y 1 Y 2 Y 3 Y 4 Y 5 Y 6
Annual Cash Inflows 85000 85000 85000 85000 85000 85000
Less: Annual Cash Outflows 12500 12500 12500 12500 12500 12500
Net annual Cash Inflows 72500 72500 72500 72500 72500 72500
Less: Depreciation @ 15% 38958.3
333
38958
.3333
38958.
3333
38958.
3333
38958.
3333
38958.3
333
Net annual Cash Inflows after
providing depreciation
33541.6
7
33541
.67
33541.
67
33541.
67
33541.
67
33541.6
7
Initial Investment 275000
Accounting Rate of return 12.19%
Here, calculation of the
depreciation by straight line method = cost of investment – salvage value / No. of year
={(275000 - ( 275000*0.15)}/6 = 38958.3333
Average net accounting profit = (72500 – 38958.3333) = 33541.67
Average rate of return = average net profit / average investment *100
= 33541.67 / 275000 *100
= 12.19 %
Recommendation:
As per above calculation of ARR is 12.19% for buying the machine, it is economical for
lovewell limited to invest in it. Machine should be purchased by the lovewell limited.
(c) Net present value: It is capital budgeting techniques that planning about the future
investment and analysing the profitability of the projects (Renz and Herman, 2016). It is
calculated as difference between present value of cash inflow and outflow for a specific time
period. It is also depends on the discounting factor.
NPV = Net cash inflow – cash outflow
Computation of the net present value for the Lovewell limited
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Net Cash inflow PV factor @ 12% Disc. Cash Flow
72500 0.892 64670
72500 0.797 57782
72500 0.711 51547
72500 0.635 46037
72500 0.567 41107
72500 0.506 36685
Discounted Cash inflow 297828
Less – cost of project/ cash outflow 275000
Net Present Value 22828
Recommendation:
As per the above computation of NPV, it has been determined that NPV is positive at
cost of capital of 12% taken as discount rate, So it is recommended to lovewell limited should
buy the machine.
(d) Internal rate of return: It is a interest rate where net present value of cash inflow and cash
outflow equal zero. The internal rate of return measures the efficiency of the project and rate of
return. It may calculates the other internal factor of the particular project such as risk free rate of
return, financial risk, cost of capital, inflation rate etc (Skoglund and Chen, 2015). it is also
called as discounted cash flow rate of return. The calculation of the IRR is as follows.
Computation of Internal Rate of Return :
Particulars
Initial investment 275000
Discount Rate : Lower (a) 12.00%
Discount Rate : Higher (b) 18.00%
NPV @ 12% discount rate 22528
NPV @ 18% discount rate -21423
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Difference in discount rates [(b)-(a)] 6.00%
Internal Rate of Return 15.07%
IRR = Ra + { NPV a / NPV a – NPV b } * Rb – Ra
here,
Ra = lower discount rate
Rb = higher discount rate
NPV a = NPV at Ra
NPV b = NPV at Rb
Recommendation:
From above calculation of IRR is positive in case cost of capital of 12% is considered as
discount rate and another rate that taken into account is 18% that may gibe negative result. so it
is recommended to lovewell limited to buy the machine as it is economical and viable to use in
the organisation (Finkler, Smith and Calabrese, 2018).
Working Notes:
Computation of Discounted Cash Flows @ 12% to calculate the IRR :
Net Cash inflow PV factor @ 12% Disc. Cash Flow
72500 0.892 64670
72500 0.797 57782
72500 0.711 51547
72500 0.635 46037
72500 0.567 41107
72500 0.506 36685
Discounted Cash inflow 297828
Less – cost of project/ cash outflow 275000
Net Present Value 22828
Computation of Discounted Cash Flows @ 18 % to calculate the IRR:
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Net Cash inflow PV factor @ 18% Disc. Cash Flow
72500 0.847 61440
72500 0.718 52068
72500 0.608 44125
72500 0.515 37394
72500 0.437 31690
72500 0.370 26856
Discounted Cash inflow 253576
Less – cost of project/ cash outflow 275000
Net Present Value -21423
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Benefits and Limitations of Different Investment Appraisal Techniques
Pay Back Period – Pay back period is an investment appraisal technique in capital budgeting
which helps to calculate the time period to recover the initial investment in the project
(Wreathall, 2017).
Benefits of Pay Back Period
 It is an easy and simplest method to compare the different projects of Lovewell
Limited.
 Pay back period is a very good signal of liquidity for every food manufactured by
company.
 In addition, this method is useful for companies in the case of uncertainty. This is so
because companies can resolve the issue of computing of payback period under this
method.
Limitations of Pay Back Period
 Pay back period do not consider the return on investment but capital investment is
required by Lovewell Limited to exceed the barrier of rate of return.
 This technique ignore the profitability as short payback period does not mean that it
is profitable for Lovewell because project might never return a profit throughout its
life.
 Payback period does not consider the time value of money which means that it does
not provide clear understanding about which project is to be selected by Lovewell
Limited.
2. Accounting rate of return – Accounting rate of return is also known as average rate of
return which is used in capital budgeting to estimate whether a company can go beyond
with an investment or not (Bartram, Brown and Waller, 2015). It gives an estimate of
annual earnings that Lovewell Limited can make on their investment in any new food
manufacturing.
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Benefits of Accounting Rate of Return
 Accounting Rate of Return gives a clear understanding of profitability to all food projects
to Lovewell limited.
 Lovewell can easily make a decision about the suitable manufacturing process. Process
with higher ARR can directly selected and lower ARR of process can be ignored.
 This method is based on accounting methods which can easily be analysed by managers
of Lovewell which enables the comparison of different products effectively (Campbell,
Jardine and McGlynn 2016).
 In this, value of projects to its economical life is assigned that creates outcomes more
reliable.
Limitations of Accounting Rate of Return
 The results from Accounting Rate of return and Return on investment is different which
creates confusion in effective decision making.
 A fair rate of return can not be calculated on the basis of ARR by mangers of Lovewell
Limited which is a discretion of the management.
 ARR cannot be applicable in situations when Lovewell has to made investment in several
parts.
3. Net Present value : Net Present Value is used by companies in capital budgeting and
investment planning to analyse the profitability of a business, investment security, capital
project, new venture, cost reduction program and anything that involves cash flow (Eniola and
Entebang, 2015).
NPV = Present value of inflows – Present value of outflows. If NPV is positive then the
investment can be done but not the vice versa.
Advantages
 It takes into account the present value of the cash flow.
 Stakeholders of Lovewell Limited can easily see if the investment will be profitable or
not in the future.
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 It takes into account each and every cash flow that can be taken into account of Lovewell
Limited.
 The risk belongs to any undertaking of Lovewell Limited project's gets factored in this
method (Erel, Jang and Weisbach, 2015).
 Along with this method focus on both factors including time and size of cash flows.
Disadvantages
 Estimation of opportunity cost may be difficult.
 Sunk costs like R&D costs of Lovewell Limited are ignored.
 Short term projects of Lovewell Limited might not boost EPS & ROE.
 The rate of discounting the companies projects may be difficult.
CONCLUSION
By inclusive all the method of financial management that may help in making the
investment decision, provide the actual profitability to business instantiation. Financial
management is important to the company in order to making the financial decision making
capabilities, financial statement and provide the financial strategies to apply in the business to
sustain in the long run. In this report, the computation of the dividend pay out strategies through
the discount dividend method that provides the clarification in the long term to adopt the method
regarding paying the dividend to shareholder. The capital budgeting tool provides the deep
knowledge regarding to adopting the project that provides the more profit in future.
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REFERENCES
Books and Journals:
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