Topic: The impact of the Covid-19 pandemic on the dividend decision of companies
Blogs: 3 blogs on Value creation, Financial Ethics and Capital Structure decisions
In the contemporary business world, the question as to whether the dividend policy of a firm influences the shareholders wealth remains unresolved. Firstly, proponents of dividend payout follow the theories of dividend relevance that are in line with the bird in hand argument (Priya & Mohanasundari, 2016). As such, dividend relevant theories hypothesize that the current payment of dividends is directly proportional to creation of shareholders wealth. Contrastingly, opposers of the relevance theories believe that dividends are irrelevant in creation of shareholders wealth. As such, dividend irrelevance theorists believe that profits should be reinvested to ensure growth and maximization of shareholders wealth, and dividends should only be paid when there is no viable investment to be pursued (Budagaga, 2017). Recently, the world has significantly been affected by the global Covid-19 pandemic. As such, businesses have suffered financial losses that has impacted on the dividend policy for major companies around the globe. Therefore, it is on this background that this essay seeks to critically evaluate the extant literature on dividends and dividend policy with close reference to real life examples with a special emphasis on the effects of covid-19 pandemic on the dividend decision for companies.
To start with, Ali (2020) accentuates that the bird in hand argument of dividend relevance justifies the relationship between dividends and uncertainty based on two assumptions; stakeholders place a premium on an assured return and penalize an unsure return and stakeholders are risk antagonistic. As such, investors mainly shareholders are logical and reasonable and they will want to evade risks that relate to the likelihood of failing to get a turnover on their venture investment. As such, disbursement of dividends to such investors eliminates the chances of risk but retaining earnings creates uncertainty deeming the investment risky. Therefore, Ali (2020) observes that based on the bird in hand theory reasonable stakeholders or investors are keen to forfeit a higher value for shares with up-to-date dividends. Nonetheless, the usual norm for global companies on their specific dividend policy has been impacted by the Covid- 19 pandemic. According to the financial times (2020), James Murray a retired engineer from Edinburg has been enjoying a fixed pension that is always supplemented by a steady stream of dividend payments From BP. However, BP decided to share out its dividend imbursement to 5.25 cents per share being the first cut from the time of the spill of the Deepwater horizon oil in 2010. Similarly, Information from the financial times (2020) further reveals that dividends which are a fundamental source of income for pension funds, charities and foundations fell by a fifth to $382.2bn in the second quarter of 2020 which is the biggest fall since Janus Henderson investment group commenced its universal share index in 2009. Meanwhile, the financial times (2020) observes that companies for the last three decades have turned out to be progressively shareholder pleasant by reimbursing more of their incomes to stakeholders in dividends and stock buybacks confirming the influence of the bird in hand theory towards investors satisfaction. However, the financial times (2020) indicates that most companies have abruptly curtailed expenditures to preserve cash and reinforce balance sheets to sustain the financial losses triggered by the Covid-19 pandemic. As such, based on the above it is evident enough that the dividend decision of major global companies has been influenced by the Covid-19 pandemic.
Secondly, Lotfi (2018) adduces that based on the signaling theory a higher dividend pay-out announcement gives a strong indication about the bright prospects of a company. Proponents of this theory believe that managers possess more information about the firms’ cash flow more than other stakeholders outside the firm and therefore they have incentives to convey higher dividend pay-outs in order to inform the true value of the firm. Nonetheless, the signaling theory of dividend policy ignites dilemma on the dividend decision making for a firm. For instance, the financial times (2020) indicates that big banks have a dividend dilemma due to the Covid-19 pandemic. According to the financial times (2020), America’s biggest banks have so far staunchly defended their plans to pay dividends. However, Jamie D. in his annual letter to shareholders indicates that JP Morgan is not immune to the Covid-19 crisis and its exposed to billions of dollars of additional credit losses as it lends to individuals and businesses in need. Notably, the financial times (2020) indicates that some analysts argue that dividend cuts show prejudicial signals to investors deeming possessing dividends less alluring as well as harming stakeholders that bank on on a sturdy pay from stocks such as pension funds. As such, based on the above, it is evident enough on the strong influence of the signaling theory on the dividend policy of firms despite the impact of Covid-19.
Thirdly, the dividend relevance theories of Walter and Gordon held some assumptions that have some underlying limitations in the real-world scenario. According to Panchal (2018) the Walter and Gordon theories on dividend relevance assume that a firm only source of capital is retained earnings without any outside finances. However, this is impractical as many firms also rely on debt and government financing (Golmohammadi, Pourheidari and Baharmoghaddam, 2017). Consequently, extant literature and real-life examples emphasize on the influence of the stakeholder theory on the dividend decision of a firm. Golmohammadi, Pourheidari and Baharmoghaddam (2017) explicate that the dividend decision of a firm goes beyond the satisfaction of the shareholders but rather to satisfy the need of various stakeholders to the firm such as employees, creditors and the government. Based on this, the financial times (2020) pinpoints that industries are pressurized by both the investors and governments to cut dividends. Particularly, many governments are attaching strings to bailout packages for companies affected financially by the Corona virus requiring them to suspend investor payouts. According to the financial times (2020) some realistic stakeholders are calling for certain kinds of changes in response to Covid-19. For instance, the center on corporate responsibility in New York has gathered 322 institutional investors with a combined $9.2tn in assets under management to sign a letter calling on firms to prioritize health and safety, maintain employment, provide paid leave, maintain supplier/customer relations and exercise financial prudence over paying dividends. Further, the financial times (2020) indicates that the new corporate Zeitgeist and popularity of environmental, social and governance (ESG) investing model may mean that dividend cuts may extend beyond the downturn of Covid-19 with analysts arguing that fair wages for employees may take precedence over returning cash to shareholders. On this basis, despite the support of the relevance theorists of dividend payout, Covid-19 has precipitated the importance of the stakeholder’s theory in determining the dividend decision for most firms.
Finally, Husain & Sunardi (2020) indicate that the dividend decision of a firm is highly driven by the profitability rate for the year. As such, the internal profitability of a firm provides a platform for comparison of the productivity of retained earnings to the alternative return that can be earned elsewhere. Similarly, in addition to the profitability of a firm, major companies consider the corporate taxation policy of their jurisdiction in determining their dividend policy. Higher rates of taxation reduce the residual amount available for distribution as dividends to shareholders. On this basis, Bloomberg (2020) indicates that Tesco has every single right to reimburse a share to its shareholders. According to Bloomberg (2020), Britain’s main vendor has a right to award its stakeholders as it is doing well unlike other companies crippled by the Virus lockdown. Tesco announced an operational turnover of below 3 billion pounds for the year ending 29th February 2020. Additionally, the company reveals that it made more than 2 billion pounds of free cash flow with net debt including lease liabilities decreasing from 22 billion pounds as at February 2015 to 12.1 billion pounds as at 29th February 2020 meaning that the retailer has no instant necessity for additional cash or liquidity (Bloomberg, 2020). Nonetheless, Bloomberg (2020) observes that Tesco is allowing in a coronavirus reprieve from the government, which includes a 12-month day off from property-based tax translating to 585 million pounds. Despite this, Bloomberg (2020) indicates that Tesco outplays the savings from the property tax by indicating that extra costs will be incurred to have the stores open and treat the workers fairly during the pandemic. Based on this, some companies are still paying dividends despite the effects of covid-19 given their healthy profitability ratios coupled with government tax holidays.
Overall, the essay concludes that the dividend policy of a firm is determined by a pool of factors ranging from satisfaction of shareholders wealth and other stakeholders party to the affairs of the firm. Extant literature has portrayed the relevance and irrelevance of paying dividends towards the creation of shareholders wealth. Meanwhile, most companies have foregone payouts to shareholders in the year 2020 as a reactionary measure to the negative effects of covid-19. However, some companies have continued to pay dividends during the pandemic period enabled by their profitability levels, government bailouts and shareholder satisfaction. Nonetheless, the essay concludes that share policy has a considerable effect in the formation or demolition of stakeholder wealth.
Blog 1: Value Creation
Traditionally, the main aim of the firm was to create a return to the shareholder through retained profitability levels. Top executives of corporations had the sole responsibility of ensuring a profit at any cost for the benefit of the owners. Nonetheless, the contemporary business world has evolved over the years deeming the role of a firm to go beyond profitability but rather creation of value for a pool of stakeholders. As a result, conflicts have risen in various corporations regarding shareholders’ wealth creation and value creation of a firm. Critiques of the shareholders theory have pushed for firms to include a broader set of stakeholders in their decision making. Further, short-termism measures by CEOs and CFOs too often fixate on short-term metrics particularly earnings per share rather than value creation over a long term which has ignited debates from various scholars. Majority of scholars argue that companies that conflate short-termism with value creation often put at risk the shareholder value and the stakeholder’s interests at large. For instance, the 2009 financial recession was precipitated by banks that were driven by short term goals of recording high profitability numbers. Similarly, firms whose short-term needs lead to environmental disasters also impede the shareholders value not just directly through fines but through lingering reputational damage. As such, value creation is inclusive as shareholders value in the long-term cannot be maximized by ignoring the need of your employees, customers and suppliers. Further, investment in sustainable growth has been fronted by the UN in its 5Ps of sustainable development namely; people, planet, prosperity peace and partnership.
According to the international federation of Accountants (IFAC), this is the right time for businesses to reconsider value formation amid substantial monetary losses and impending downturns in 2020 caused by the Covid-19 outbreak. Covid-19 has enhanced technological transformations which coupled with a wider responsibility in lasting value formation delivers a platform for shifting from short-termism. The role of corporate boards of management has evolved as they are now tasked with balancing on the fortification, usage and circulation of cash with guaranteeing long-standing value formation and making a positive effect for all investors. Notably, major companies in the world are forfeiting pay-outs to shareholders in dividends and share buy-backs to conserve cash for sustainability of all the stakeholders needs in the future. According to Bloomberg (2020) companies across Europe are coming under immense pressure to defer dividend payments to preserve cash. Regulators such as the European central bank have already pressed banks to hold off payouts to shareholders to increase their resilience. For instance, Germany’s Commerzbank Ag, which the German Government holds a 15.6% stake indicated that it will not pay a dividend to obey the ECB’S recommendation. Meanwhile, Sam Witherow who works for JPMorgan Asset Management stated that the Corona crisis has really showcased the benefits of long termism for both corporates and shareholders that have invested in them (Bloomberg 2020). This statement can be backed by dividend cuts by FTSE 100 members such as Shell, HSBC and BP in the year 2020 driven by a focus of preserving cash for future stability.
Conclusively, value creation for firms is an inclusive notion that eliminates the short-termism nature of firms of generating a profit at any cost and paying shareholders a return after a certain financial period. As such, value creation refers to the success of the firm in long-term driven by the satisfaction of all stakeholders’ party to a company beyond their owners (shareholders)
Blog 2: Financial ethics
Generally, ethics have to do with human conduct that is agreeable (tolerable). As such, over-all ethic customs include uprightness, honesty, fairness, truthfulness, veneration for others. Basically, ethics relate to all aspect of our life. Hence, financial ethics can be defined as a subclass of overall ethics. The success of any business is influenced by the degree of its financial ethics. Moral predicaments and desecrations in finance may lead to the demise of an entity and they are attributable to a discrepancy in the theoretical framework of modern financial-economic theory and the widespread use of a principal-agent approach in financial transactions. Notably, in the modern capitalist system, the financial-economic theory is based on the rational-maximizer paradigm, which embraces that people are egoistic or self-centered and that they act reasonably while pursuing to make the most of their personal welfares. Meanwhile, the principal-agent model is a prearrangement where a party acts as a go-between for another thereby conducting particular roles in the best interests of the principal. As such, principal-agent preparations are an essential part of modern economic and financial systems. Conceptually, the principal-agent relationship exists between the management of a company (agent) and the shareholders of a company (owners). The management of any corporate is tasked with the role of maximizing the shareholders wealth. However, the management in their own self interest may breach financial ethics by committing frauds and ethical dilemmas in their line of work.
Notably, the contemporary business world has designed mechanisms to deal with ethical dilemmas in finance through regulations and corporate governance structures. For instance, since 1992 when the UK published its first code of corporate governance, the code has been improved over the years leading to the formulation of the 2018 UK code of governance by the financial reporting council. This code guides the running of a company based on five main principles; renumeration, board leadership, audit, succession, division of responsibilities, board leadership and company purpose, succession and evaluation, composition, audit, risk and internal control. Nonetheless, businesses have by-passed these regulations to commit ethical dilemmas that have resulted in detrimental financial implications. For instance, Ted Baker a leading fashion retailer in the UK has had its share prices falling due to accounting frauds committed by its management. According to the Guardian (2020) Ted baker had suggested that from its preliminary investigations, the value of its stock held as at 26th January 2019 had been overestimated by between £20m and £25m. However, Ted Baker’s banks appointed an adviser to conduct a business review amid concerns that the company’s weak financial position would plunge it into seeking for a cash injection. As such, the review revealed that the company had overstated its inventory position by £58m which was larger than the annual profits listed on the London stock exchange of £50.9m. According to the Guardian (2020), the accounting fraud was committed by the company’s top management that wanted to report profits despite the dwindling operations of the retailer. Similarly, KPMG who were the external auditors of ted baker failed to note this material misstatement of inventories in the books of their clients. Consequently, the company has suffered financial losses and non-financial losses. Notably, the shares prices have plummeted indicating the low level of confidence by investors in the market coupled with the company making various profit warnings in the year.
Overall, ethical dilemmas such as financial frauds or accounting frauds are detrimental to the success of any entity. Notably, as per the case example, accounting frauds resulted in the change of management, loss of jobs, decline in share prices and a plunge in profitability levels.
Blog 3: Core concepts of Corporate Finance with a special emphasis on capital structure decisions
Basically, corporate finance is mainly concerned with three concepts to a corporate namely; working capital management, capital budgeting and capital structure. Ideally, corporate finance is concerned with maximizing the shareholders wealth through an integration of long- and short-time financial planning and through the implementation of various strategies. Notably, one of pertinent principles of corporate finance is the capital structure decision that refers to the approach to which an entity finances its operation through the combination of debt, equity and hybrid securities. As such, the choice of capital structure is pertinent to the long-term success of an entity. Generally, an idyllic investment structure should help a firm to lessen its capital cost, diminish business-related perils, offer flexibility, offer power to the proprietors and make the most of the worth of a business. Notably, debt is expensive but possess certain advantages such as tax exemptions and ensuring liquidity of a firm. On the other hand, equity is cheaper as compared to debt but may plunge a firm into short-term liquidity problems. Nonetheless companies have struggled in maintaining a right mixture of debt and equity in their capital structure.
According to the financial times (2020) in the year 1973 an oil embargo was threatening the foundations of the US economy. Petrol stations were running dry and Hertz a car rental company realized that transport companies would inevitably be among the first casualties. As such, Hertz turned to debt and borrowed heavily to finance the replacement of fuel guzzlers with smaller and efficient cars. The next year there was an oil price shock that ravaged competitors of Hertz and triggered a bout of stagflation coupled with low growth leading to Hertz announcing profit records in the year. Fast forward to 2020, Hertz is now bankrupt being a victim of the corona virus pandemic. According to the financial times (2020) the company which employed over 38,000 staff and operated from about 12,000 locations was unable to escape the effects of a piled debt of $17bn. Similarly, the demise of Hertz has drawn attention to the relentless build-up in corporate debt in the US where companies now owe a record of $10tn equivalent to 49% of the economic output. Meanwhile, the financial times (2020) notes that even before the pandemic the level of corporate leverage was alarming with IMF issuing a warning with as much as $19tn of business debt in eight countries led by the US that held 40% of this amount. As such, companies are vulnerable currently due to a material slowdown in the global economy.
Overall, the capital structure of a company is pertinent to the long-term success of any entity. Too much debt may expose a company in times of crisis such as currently where the world is experiencing a financial recession triggered by the Covid-19 Pandemic.