Corporate Financial Management: Dividend and Hedging Strategies Report

This report provides a comprehensive analysis of corporate financial management, focusing on the dividend policies of three companies: Solna Plc, Rinkeby Plc, and Chista Plc. It examines the benefits, problems, and theoretical underpinnings of each company's dividend approach, including stable, irregular, and no-dividend policies, respectively. The report also evaluates various foreign currency and interest rate hedging strategies, such as ETFs, forward contracts, options, interest rate options, swaps, and bond sales, to mitigate financial risks. Furthermore, it advises the treasurer of Chista Plc on money market investments, considering the risk-return trade-off and explaining various money market instruments to optimize the use of temporary surplus cash. The report concludes with a discussion on risk management and financial instrument selection.

COFM6006
Corporate Financial Management
Autumn 2018
1

Contents
Introduction......................................................................................................................................3
Part A: Analyses and Discussion on Dividend Polices adopted by all three companies.................3
Part B: Evaluation of three foreign Currency hedging strategies and three interest rate hedging
strategies..........................................................................................................................................8
Part C: Risk and return trade off and explanation of four money market investment instruments
.......................................................................................................................................................10
Conclusion.....................................................................................................................................13
References......................................................................................................................................14
Appendix........................................................................................................................................15
2

Introduction
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.
Part A: 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:
3

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:
2008 2009 2010 2011 2012 2013 2014 2015 2016 2017
£-
£0.05
£0.10
£0.15
£0.20
£0.25
£0.30
£0.35
£0.40
EPS and DPS of Solna Plc
Amount
4

2008 2009 2010 2011 2012 2013 2014 2015 2016 2017
0.00%
10.00%
20.00%
30.00%
40.00%
50.00%
60.00%
Dividend Payout Ratio of Solna Plc
Percentage
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
5

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).
2008 2009 2010 2011 2012 2013 2014 2015 2016 2017
£-
£0.05
£0.10
£0.15
£0.20
£0.25
£0.30
£0.35
£0.40
EPS and DPS of Rinkeby Plc
Amount
2008 2009 2010 2011 2012 2013 2014 2015 2016 2017
0.00%
10.00%
20.00%
30.00%
40.00%
50.00%
60.00%
70.00%
80.00%
Dividend Payout Ratio of Rinkeby Plc
Percentage
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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.
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).
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2008 2009 2010 2011 2012 2013 2014 2015 2016 2017
£-
£0.05
£0.10
£0.15
£0.20
£0.25
£0.30
£0.35
£0.40
EPS and DPS of Chista
Amount
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).
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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.
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
9

transit the bond portfolios from long-term to short-term bonds such as high yield or floating rate
bonds (Jha, 2011).
Part C: 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
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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
Limitations
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 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.
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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.
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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:
http://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.
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Appendix
year Solna Plc Rinkeby Plc Chista Plc
Earnings
per share
Dividend
per share
Earnings
per share
Dividend
per share
Earnings
per share
Dividend
per share
2008 13p 6.5P 13p 6.5p 13p 0
2009 19p 9.5p 20p 7.3p 19p 0
2010 14p 7p 12p 8.2p 22p 0
2011 22p 11p 23p 9.1p 23p 0
2012 12p 6p 10p 10.2p 24p 0
2013 0 0 0 11.5p 0 0
2014 17p 8.5p 19p 12.8p 18p 0
2015 26p 13p 25p 14.4p 26p 0
2016 33p 16.5p 32p 16.1p 33p 0
2017 36p 18p 36p 18.0p 36p 0
Dividend Payout Ratio for each company for each year
year Solna Plc Rinkeby Plc Chista Plc
Earnings
per
share
Dividend
per
share
Dividend
Payout
Ratio
Earnings
per
share
Dividend
per
share
Dividend
Payout
Ratio
Earnings
per
share
Dividend
per
share
Dividend
Payout
Ratio
200
8
£
0.13
£
0.07 50.00%
£
0.13
£
0.065 50.00%
£
0.13 £ -
No
Dividend
200
9
£
0.19
£
0.10 50.00%
£
0.20
£
0.073 36.50%
£
0.19 £ -
No
Dividend
201
0
£
0.14
£
0.07 50.00%
£
0.12
£
0.082 68.33%
£
0.22 £ -
No
Dividend
201
1
£
0.22
£
0.11 50.00%
£
0.23
£
0.091 39.57%
£
0.23 £ -
No
Dividend
201
2
£
0.12
£
0.06 50.00%
£
0.10
£
0.102 102.00%
£
0.24 £ -
No
Dividend
201
3 £ - £ - 0 £ -
£
0.115 0 £ - £ -
No
Dividend
201
4
£
0.17
£
0.09 50.00%
£
0.19
£
0.128 67.37%
£
0.18 £ -
No
Dividend
201
5
£
0.26
£
0.13 50.00%
£
0.25
£
0.144 57.60%
£
0.26 £ -
No
Dividend
201
6
£
0.33
£
0.17 50.00%
£
0.32
£
0.161 50.31%
£
0.33 £ -
No
Dividend
15

201
7
£
0.36
£
0.18 50.00%
£
0.36
£
0.180 50.00%
£
0.36 £ -
No
Dividend
16