Financial Management & M&A

This assignment examines the crucial role of financial management in organizations. It analyzes Walter's relevance theory and its influence on dividend policy and share prices, comparing it with Gordon's growth model and MM's irrelevance theory. The paper also explores mergers and acquisitions (M&A), highlighting their significance in organizational growth and success. Various theories and models are discussed to illustrate the complexities of financial management within a business context.

Financial Management

TABLE OF CONTENTS
INTRODUCTION 1
Part A Dividend relevance and dividend irrelevance theory 1
Part C Explaining mergers and acquisitions, how they are financed and relevant parties involved
in the process 5
Conclusion 8
REFERENCES 9

INTRODUCTION
Financial management refers to planning, organizing, directing and controlling all the
financial activities for procurement of enterprise. With the help of financial management there is
optimum use and allocation of resources for improving operational efficiency of the
organization. It helps in managing sound financial decision of the concern of organisation. In this
report there is a brief understanding of strategic decisions should organizations have to apply.
And how these decisions helps in accounting and finance of the organization. In part A Dividend
relevance theory of Walter and Gordon, Modigliani Miller theory of irrelevance dividend theory
is been explained. In next part importance of merger and acquistions, major parties involved is
elaborated.
Part A Dividend relevance and dividend irrelevance theory
Dividend Relevance theory indicates that company's dividend policy is not a concern for
investors because they have option for selling proportion of equity's portfolio if there is need of
liquidity.
 Walter's model
 Gordon model
Walter model: This model is given by prof. James E. Walter, the firm's share price is
been affected by dividends and policy of investment cannot be separated by policy of dividend as
there is a relationship between them. This model clearly depicts the relationship between the
internal rate of return (r) or return on investments and cost of capital (K). The selection of
dividend policy majorly affects the overall firm's value(Zietlow, and.et.al., 2018). The
relationship between returns and cost shows the efficiency of dividend policy. Walter's dividend
policy can be denoted as:
P = D/k +{r*(E-D)/k}/k
In the above formula P is denoted as market price per share, D represents dividend per
share, E represents earning per share, r represents internal rate of return of firm and k is denoted
as cost of capital of the organization. In short this equation gives an idea that market price of the
company's share is the aggregate of present values of infinite flow of gains on investment from
retained margin and flow of dividends.
If K is smaller than r, earnings should be retained by the company as it possesses the best
opportunities for investment and can get more advantage as compared to shareholders by
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reinvesting. The company which are giving more returns as compare to cost are indicated as
“Growth firms” and there payout ratio is zero. In second case, if r is smaller than K, then all the
earnings should be paid to shareholders in dividend form because all shareholders have better
opportunities for investment than a firm. The payout ratio for the mentioned case is 100%. in last
scenario, where r is equals to K, then there is no effect on value of the company. The firm is
indifferent that how much amount should be retained and to distributed among the shareholders
and for the same the payout ratio is in the range of zero to a hundred percent.
The assumptions related to this model are:
 External financing is not used for the company all funding is done via retained earnings.
 If there is any change in investments but (r) rate of return and (k) cost of capital remains
same.
 All the earnings or margins are distributed among shareholders or they are retained.
 DPS or dividend per share and EPS earning per share remains same.
 Perpetual life of the organization(Titman, Keown, and Martin, 2017).
Criticism of this model:
 If external financing is not used then standard will be low of either dividend policy or
investment policy or both.
 Its applicability is to only equity firms, along with this rate of return is constant so
investments are decreased.
 In real scenario, K cannot be same, in this business risk is avoided which has direct
impact on value of the organization.
Therefore, Cost of Capital (K) is equals to Cost of equity (Ke), because of absence of
external source of funding is used.
Gordon model: This model is given by Myron Gordon who says that dividends are
relevant for the share prices of the organization. The main assumption taken by Gordon that all
investors are risk averse that means no one is willing to take risks and certain returns are being
preferred as compared to uncertain returns(Skogrand and.et.al., 2011). For avoiding risk, current
dividends are preferred and because of risk there are chances for not getting returns on the
investments which are done. But if the earnings are being retained by the company then there are
chances for getting dividends in the future. The future dividends are not certain even time and
amount is also not certain like when and how much the dividends will be received. Future
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dividends should be discounted or less importance should be given as compared to current
dividends. The share's market value is equals to the future dividend's present value of the firm.
Gordon's dividend policy can be denoted as:
P = [E (1-b)] /Ke-br
In the above equation P denotes price of a share, E can be represented as earning per
share, b represents retention ratio, 1-b represents the proportion of margin which is distributed in
the form of dividends, Ke as capitalization rate and Br is represented as growth rate. The above
formula denotes that market value of the company's share is aggregate of infinite future
dividend's present value. Generally it is also used for calculating cost of equity, future dividends
can be predicted if market value is known.
If cost of capital is smaller than internal rate of return then it is considered as growth
firm. If dividends are reinvested by company instead of distributing it to shareholders than it will
give advantage to the shareholders. The payout ratio of same is considered as zero. In updated
Gordon model when r is equals to k then, investors preference will be on share where more
current dividends are been paid which will be considered as normal firm and in declining firm
internal rate of return is smaller than cost of capital (Brinckmann, Salomo and Gemuenden,
2011). The shareholders will gain advantage if dividends are distributed instead of reinvested.
The payout ratio is considered as 100% of the organization.
The assumptions related to this model are:
 External financing is not used for funding of the company, only the retained earnings are
used i.e. also considered as equity firm.
 Cost of capital and internal rate of return is same.
 Indefinite life of the organization.
 If retention ratio is once decided then it remains same.
 Growth rate is constant in this model.
 Br is smaller than cost of capital.
 In taxation, corporate taxes are not considered in this model.
Criticism of this model:
 In this scenario, external financing is not used viz. Debt or equity is raised. So the
investment and dividend policy or may be both can be sub optimal.
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 Its applicability is only to equity firm, irr is constant but it leads to fall if the investment
is increased (Titman, Keown, and Martin, 2017).
 In realistic life situations, cost of capital cannot be same as earlier, as it is avoiding
business risk which has direct relationship from the organization's value.
According to Gordon model, dividends play essential role for predicting organization's
share price.
Dividend Irrelevance theory
Modigliani Miller Model: The major proponent of dividend irrelevance is considered as
Modigliani Miller theory given by Franco Modigliani and Merton Miller. This can be also
considered as MM Approach. In this firm's share price is not affected by dividend policy and it is
investment policy which helps in increasing value of the share of organization. Satisfaction level
of investors are until the retained earnings of organization's return are more than compared to Ke
i.e. equity capitalization rate (Chandra, P., 2011). It is the rate on which margins, dividends or
cash flows are converted into value or equity of the firm. Shareholders would like to receive
margins in form of dividends when returns are less than cost of capital. According to this model
market price of shares is not influenced under conditions of perfect capital markets, rational
investors, tax discrimination's absence between the dividend policy. MM's model can be denoted
as:
P0 = 1/(1 + Ke) * (D1 + P1)
In the above equation, P0 represents prevailing market price of a share, Ke represents
cost of equity capital, D1 indicates dividend to be received at the end of period 1 and P1
indicates market price of a share at the period 1's end. This approach is usually for measuring
market price of share at the end period with the condition that original share price, cost of capital
and dividends received is known (Petty and.et.al., 2015). The same discount rate is applicable for
all stock which is important.
The assumptions related to this model are:
 In this model, there is presence of perfect capital market in which rational investors are
there who have access to all information without any costs. Floatation and transaction
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cost is not involved in this scenario. Market price cannot be influenced by any investor
and securities are infinitely divisible.
 In taxation, absence of taxes, capital gains and dividends are taxed at same rate.
 Constant investment policy is followed by organisation which signifies that there is no
change in internal rate of return on investments in project and risk position of business.
 Future profits are certain, future investments, dividends and profit of firms are certain in
the view of investors because of absence of risk (Li and You, 2015).
Criticism of this model:
 There is presence of taxes in capital market as there is no existence of perfect capital
market.
 In this model there are no variations among internal and external financing but if issue of
new floatation cost is considered then it is false.
 Shareholder's wealth is not affected by dividends but the transaction cost is being
associated by selling of shares for cash inflows so dividends are preferred by investors.
Part C Explaining mergers and acquisitions, how they are financed and relevant parties involved
in the process
In the present scenario mergers and acquisitions are very common in this global
marketplace. This is an essential medium for acquiring products and technologies. They are not
allowed for long adjustments periods but it is the best approach is to plan. Organizational plan
must include all the areas which are affecting workforce, communication, customer relationships
etc. The aim of mergers and acquisitions is to improve productivity and profits of the company
and to reduce the expenses of the organization. Though mergers and acquisition are not always
successful, many times processes has been taken place loses the focus. By many factors the
success of mergers and acquisition has been determined. These mergers and acquisitions affects
the workforce of the organization and harms the company's credibility. Even senior executives,
labor forces and shareholders are been impacted by merger and acquisition.
Impact of mergers and acquisitions on employees: Employees and staffing, training
focus, culture shift, motivation during challenging time of company.
 Employees and staffing: Whenever merger takes place between the organizations or
corporations there are huge possibilities of redundancy in which lay offs or the role of
employees may shift. Lay offs cannot be ignored, and the best can be done that
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uncertainty can be reduced among all employees. And whosoever is been laid off should
be intimated prior or immediately with the severance packages and they should be treated
in very respectful manner. The employees who are left in the organizations should be
given proper guidelines with new role in the organizations and plans for development
which will help them for some subsequent changes.
 Training: Proper training should be given regarding new processes, procedures and
policies which are merger's result. In this plan they should be familiar with all new
procedures like submitting purchase order and new technology platforms. Seminar in
which one on one training should be conducted.
 Culture shift: Culture of the organization is going to be impacted. It can also affect the
morale of employees which can be positive or negative. It can lead to face many
challenges by the organization like good employees can be employed by competitors or
workforce can be disrupted. So basic need is communication with vision and mission of
the company and changes should be communicated properly so this will help in reducing
uncertainty and disruptions.
 Motivation during challenging time: To improve productivity and margin, motivation
to employees is basic necessity. If any discussions related to new merger and acquisitions
then they should be not avoided and employees should be rewarded for managing change
in their roles. Not only in form of bonus but can be small gift.
Impact of mergers and acquisitions on top level management: It can be in form of
clash of the egos or it can be explained as variations between the culture of organizations and in
this setup new policies and strategies are implemented which may be not given approval by him.
In this situation company's focus get diverted and top level managers be involved in matters or to
move on. If the manager is been overqualified and with high degree then migration is not
difficult for him.
Impact of mergers and acquisitions on shareholders: Shareholders of both companies
are been affected by merger and acquisition. It may be given different effects of stock prices of
every member in the merger. Merger of two companies may face challenge for dilution of voting
power because of number of shares increment within the merger process. The acquiring
company's shareholders may face marginal loss of voting authority along with this small target
company's shareholder might face the erosion of voting power in big pool of the stakeholders.
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There is a temporary drop in value of shares of the firm which is acquiring and target company's
share value will increase in this period. The newly merged company's stock price is higher as
compared to acquiring and target firms then the merger and acquisition of the company is on
great success and getting benefit from the result of stock price arbitrage. The newly merged
company will have few changes which can be easily noticeable in leadership. These concessions
are usually formed while the negotiations made in the merger process and executives of board
members of newly company will change in some degree.
Mergers can be financed in many ways:
 Cash payment
 Equity share financing
 Debt share financing
 Deferred payment plan
 Leverage buy out
 Tender offer
 Hybrids
Cash payment: The shareholder of the target company are removed from the process
and indirect control of shareholders (bidder) alone with the target company just because of these
transactions are generally termed as acquisition instead of mergers. While, there was downward
trend in the interest rate then cash deal is more sensible and in the same series cash usage for the
acquisition gives fewer chances of earning per share dilution for company which is acquiring.
But there are some constraints on the organization's cash flow (Titma, Keown and Martin, 2017).
Equity share financing: Most common method for financing merger. The acquired
company's shareholder are provided shares of the company. This will lead to benefits and
margins of merger among acquired company's shareholders and the acquiring company. The
most important factor for determination of exchange ratio can be in financing merger form. Both
the companies usually depends upon price earning ratio and exchange ratio of the organization.
The most common method is in case that price earning ratio should be high as compared to
acquired company.
Debt share financing: A company's merger should be financed by issuing fixed
convertible debentures and convertible preference share along with fixed rate of dividend. The
acquired company's shareholder prefer medium of payment because of income security within
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the period. So this acquired company also get benefited on dilution of earning per share as well
as controlling authority to the shareholders which are existing.
Deferred payment plan: It can be also referred as earn out plan for making payments to
target company which can be also acquired in a manner that partial payment is made in form of
cash or securities. This helps in while negotiating successfully with target company abd helps in
increment of earning per share because of fewer shares which are issued in prior years. For
achieving success, the acquiring firm should be able to co-operate along with success and growth
of target company (Graham and Harvey, 2010).
Leverage buy out: A company which is mostly financed through debt is referred as
leveraged buy out. Debt which is generally formed by more than 70% of purchase price. Shares
which are not generally traded in stock exchange are known as leveraged buy out.
Tender Offer: The acquired company approaches shareholders of target company and
offers price which is mostly more than market price for encouraging them to sell shares. This
method is used in forced or hostile takeover.
Hybrids: It is a combination of debt and cash or stock of the purchasing firm and cash.
Parties involved in merger and acquisition
There are two main parties which are involved in merger and acquisition that is buyer : acquiring
party and seller : party being acquired. There are more parties which are involved in merger and
acquisition which are accountant, financial planner, M & A consultants and attorney. Every body
has their own role in the process.
Conclusion
From the above report it has been concluded that financial management is very vital for
every organizations. Though Walter's model of relevance theory has many unrealistic
assumptions but there is concept of dividend policy has an effect on the market price of the share
of organizations. Further it is assisting impact in mathematical valuations for finding value of
share. In Gordon theory the market price of share is determined for predicting the dividends and
MM approach is very interesting and unique approach for the valuation. It is an irrelevance
theory of dividends but it also has major limitations. It has been proved from above report that
mergers and acquisition plays very important role in the organization.
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REFERENCES
Books and Journals
Zietlow, J. and.et.al., 2018. Financial management for nonprofit organizations: Policies and
practices. John Wiley & Sons.
Titman, S., Keown, A. J. and Martin, J. D., 2017. Financial management: Principles and
applications. Pearson.
Skogrand, L., and.et.al., 2011. Financial management practices of couples with great
marriages. Journal of Family and Economic Issues, 32(1). pp. 27-35.
Brinckmann, J., Salomo, S. and Gemuenden, H. G., 2011. Financial Management Competence of
Founding Teams and Growth of New Technology‐Based Firms. Entrepreneurship Theory
and Practice. 35(2). pp. 217-243.
Titman, S., Keown, A. J. and Martin, J. D., 2017. Financial management: Principles and
applications. Pearson.
Chandra, P., 2011. Financial management. Tata McGraw-Hill Education.
Graham, J. R. and Harvey, C.R., 2010. The theory and practice of corporate finance: Evidence
from the field. Journal of financial economics, 60(2-3). pp. 187-243.
Petty, J. W., and.et.al., 2015. Financial management: Principles and applications. Pearson
Higher Education AU.
Li, X. and You, Y., 2015. Permutation monotone functions of random vectors with applications
in financial and actuarial risk management. Advances in Applied Probability. 47(1).
pp.270-291.
ONLINE
Mergers & Acquisitions, 2018. [Online]. Available through:
<http://www.americasjobexchange.com/employer/employer-articles/business-mergers-
and-employees>.
Benefits of M&A to Shareholders, 2018. [Online]. Available through:
<http://www.lexuniverse.com/merger-acquisitions/US/Benefits-of-M-&-A-to-
Shareholders.html>
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