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Going public and the dividend policy of the company

                     Plekhanov Russian Economic Academy



                          The theme of the report:
           “Going public and the dividend policy of the company.”



                                                          By Timofeeva M. V.
                                              The supervisor: Sidorova E. E.



                                Moscow 2001.



                                  Contents



      Introduction

I. ‘Going Public’ and the Securities Market3
   1. ‘Going Public’
   2. Types of Shares
   3. The Stock Exchange and the Capital Market
   4. Procedure for an Issue of Securities
   5. Equity Share Futures and Options
II. Dividend Policy and Share Valuation
   1. Dividends as a Residual Profit Decision
   2. Costs Associated with Dividend Policy
   3. Other Arguments Supporting the Relevance of Dividend Policy
   4. Practical Factors Affecting Dividend Policy
   5. Alternatives to Cash Dividends

      Summary

      References



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                                Introduction


       In this report we focus on the long-term financing by issuing shares
and dividend policy of the company. We consider the institutional design  of
capital market, Stock Market Exchange  and  Alternative  Investment  Market;
fundamental  theories  of  paying  dividend  and  factors  which   influence
Dividend Policy of the companies.
       The  main  objective  of  this  report  is  to  develop   a   better
understanding of the  problems  faced  by  start-up  firms  seeking  capital
financing  and  paying  percentage  (dividends).  In  addition,  we  try  to
identify the consequences  of  shortcoming  and  overplus  of  the  dividend
payouts for value of  corporation  (for  value  of  share)  and  individuals
(shareholders).
      The urgency of this question is obvious, because firms need capital to
finance product-development  or  growth  and  must,  by  a  lot  of  factors
(interest rate, time period and etc), obtain this  capital  largely  in  the
form of equity rather than debt. So  the  issuing  of  shares  and  dividend
policy is one of the widest research overseas and I hope Russian  economists
don’t be backward in that list.

                 I. ‘Going Public’ and the Securities Market


   1. ‘Going Public’
Most private companies that experience the rapid  growth  have  reached  the
stage when existing shareholders’ private resources are exhausted,  retained
profit is insufficient to cope with  the  rate  of  expansion,  and  further
borrowing on top of your current amount of loans will probably  be  resisted
by lenders until you have a more substantial layer of  equity  capital.  One
solution to this financial problem is to retain the services of a  financial
intermediary – usually a merchant bank – to find a few  private  individuals
or financial institution such as  an  insurance  company  or  an  investment
trust that is willing to subscribe more capital. This  is  known  a  private
placing. And, of course, there are  some  advantages  and  disadvantages  of
going public.

       Advantages

 . access to the capital market and to larger amounts of finance becomes
   possible by having shares quoted on the Stock Exchange;
 . institutions are more likely to invest on the public listed company, and
   additional borrowing becomes possible;
 . shareholders will find it easier to sell their shares in the wider
   market;
 . the company attains a higher financial standing;
 . provides an opportunity for public companies to introduce tax-efficient
   employee share option scheme.

       Disadvantages

 . cost of a public flotation of shares are high – as much as 4% - 10% of
   the value of the issue;
 . because outside shareholders are admitted, some control may be lost over
   the business;
 . publicly quoted companies are subject to more scrutiny than private;
 . the risk of  being taken over by purchasing of company’s shares on the
   Stock Exchange;
 . as the market tends to be influenced more by the  short-  then  long-term
   strategy of listed companies, a company committed to a long-term plan may
   find its stock market performance disappointing.
The going public company is required:
 . minimum issued capital of ?50.000;
 . minimum market capitalization of ?500.000;
 . 25% of your equity shares available to the public;
 . sign a Stock Exchange listing agreement,  which  binds  you  to  disclose
   specified information about your company in future.

   2. Types of Shares
There are two main classes of shares are ordinary and preference


Ordinary shares (sometimes called ‘equity’ shares)

Those are the highest risk-takers shares in the company. This  implies  that
the holder’s claims upon profit – for dividend, and assets – if the  company
is liquidated, are deferred to the  prior  rights  of  creditors  and  other
security holders. However, the capital liability  of  ordinary  shareholders
is limited to the amount they have agreed  to  subscribe  on  their  shares,
therefore they cannot be called upon to meet  any  further  deficiency  that
the company may incur. If the ordinary shares are  the  voting  (controlling
shares) but in some companies the significant  proportion  is  held  by  the
directors  and  the  remainder  are  widely  held  by  a  large  number   of
shareholders, so the directors may effectively control the company.



Preference shares

They also are the part of the equity ownership,  attractive  to  risk-averse
investors because of their fixed rate of dividend, which  normally  must  be
at a higher level than the rate of interest paid to lenders, because of  the
relatively greater risk of non-payment of dividend. Whilst they are part  of
the share capital, the holders are not normally entitled to a  vote,  unless
the terms of issue specified overwise, and even then votes are usually  only
exercisable when dividends are  in  arrears.  Preference  shareholders  have
prior rights to  dividend  before  ordinary  shareholders,  but  it  may  be
withheld if the directors consider there are insufficient resources to  meet
it. There is an implied right to  accumulation  of  dividends  if  they  are
unpaid, unless the shares are stated to be non-cumulative. Payment  of  such
arrears has priority over future ordinary  dividends.  And  if  the  company
goes into liquidation, preference shareholders are not entitled  to  payment
of dividend arrears or  of  capital  before  ordinary  shareholders,  unless
their terms of issue provide otherwise, which they usually do.
       Companies have issued three varieties  of  preferences  shares  from
time to time, to confer special rights;  these  are  redeemable  preferences
shares,  participating  preferences  shares  and   convertible   preferences
shares. Redeemable preferences shares are similar to loan  capital  in  that
they are repayable but they lack the advantage enjoyed by loan  interest  of
being able to
charge  dividend  against  profit  for  taxation   purposes,   participating
preferences shares enjoy the right to further share  in  the  profit  beyond
their  fixed  dividend,  normally  after  the  ordinary  shareholders   have
received up to a state percentage on their capital, convertible  preferences
shares give the option to holders to  convert  their  shares  into  ordinary
shares at the specified price over a specified period of time.

   3. The Stock Exchange and the Capital Market
The Capital Market embraces all  the  activities  of  financial  institution
engaged in:
 . the raising of finance for private and public bodies whether situated  in
   UK or overseas (the primary market);
 . trading the securities and other financial  instruments  created  by  the
   activity above (the secondary market).
       The Stock Exchange  plays  a  central  role  in  this  international
market. It provides the primary facility fir marketing new issues of  shares
and other securities, and also a well-regulated secondary market in  shares,
British government and local authority  stocks,  industrial  and  commercial
loan stocks and many overseas stocks  that  are  included  in  its  Official
List. Nowadays it called the London Stock Exchange  Ltd  is  an  independent
company with the Board of Directors drawn  from  the  Exchange’s  executive,
and from the customer and user base.
       The main participants on  the  Stock  Exchange  are  Retail  Service
Providers (RSPs) and the stockbrokers. The function of RSPs is to provide  a
market in securities, which they have nominated,  and  to  maintain  two-way
prices, i.e. lower price at which they are prepared  to  buy  and  a  higher
price at which thy will sell. And stockbrokers can act for client  as  agent
only, when purchasing or sell securities on  their  behalf,  in  which  case
they deal with RSPs. And dual capacity  stockbrokers/dealers,  however  they
will buy and sell shares on their own account, and may  act  as  both  agent
and  principal  in  carrying  out  clients  ‘buy’  and  ‘sell’  instruction.
Unfortunately the integration of the broking and  dealing  functions  within
the same financial grouping can give rise to conflict of interest, and  this
has made it essential to  create  a  protective  regulatory  framework  both
within and between financial institutions.
       But some companies are not suitable for a full Stock Exchange
listing and the Alternative Investment Market (AIM), setting up by the
Stock Market Exchange in 1995, is a more suitable for unknown and risky
companies.
       Its main features are:
 . no formal limit on company size;
 . ?500.000 capitalization (full listing ?3-?5 million);
 . no minimum trading record (full listing five years);
 . 10% of the equity capital must be in public hands (full listing 25%)
 . no entry fee is required, but a annual listing fee of ?2.500 in  year  1,
   rising to ?4.000 in year three is payable.

   4. Procedure for an Issue of Securities
All arrangements made by an Issuing House, which specialized in this work.
The procedure would be probably as follows:
 . an evaluation by the Issuing House of the  company’s  financial  standing
   and future prospects;
 . an assessment if the finance required,  and  advise  regarding  the  most
   appropriate package to finance to meet the need;
 . advice of the timing of the issue;
 . agreement with the Stock Exchange on the method  of  issue  (sale  by
   tender, SE placing etc);
 . completion of an underighting agreement;
 . preparation of the prospectus and other documents required by  the  Stock
   Exchange in the initial application for the quotation;
 . advertising the offer for sell and the publication of the prospectus;
 . arrangements with the bankers to receive the amounts payable;
 . the issue price of the share to be agreed at a level to ensure a  success
   of the issue;
 . final application for the Stock Exchange quotation, and  signing  of  the
   listing agreement, which binds the company to maintain a  regular  supply
   of information to the Stock Exchange and shareholders.

   5. Equity Share Futures and Options
       These are traded at the London International Futures and Options
Exchange (LIFFE), which was established in 1982.
       Both futures and options are used by investors for:
 . hedging i.e. protecting against future capital loss in their investments;
 . speculation i.e. gambling on forecasts of favorable movements  in  future
   Stock Market prices.
       The main differences between futures and  options  is  that  futures
contracts are binding obligation to buy  or  sell  assets,  whereas  options
convey rights to buy or  sell  assets,  but  not  obligations.  Futures  are
agreed, whereas options are purchase.

Equity Share Futures
The only equity futures dealt in on LIFFE are those based on  the  FTSE  100
and MID 250 Stock Indices.
       Futures contracts may b used to protect  an  expected  rise  in  the
market before funds are available to an investor. For example,  an  investor
expecting a large cash sum in three months’ time could protect his  position
by buying FTSE 100 Index futures contract now, and  selling  futures  for  a
higher sum when the market rises. The profit made on  the  futures  position
would then  compensate  him  for  the  higher  price  he  has  pay  for  his
investments when the expected cash sum arrives.

Equity Share Options
An option is the right to buy or sell something  at  an  agreed  price  (the
exercise price) within a stated period of time.  As  applied  to  shares,  a
payment (a premium) is made through or to a stockbroker for a  call  option,
which gives the right to buy shares by a future date; or for a  put  option,
which gives the right to sell shares by future  date.  And  the  holder  may
exercise the option, or late it lapse. However the giver (the  ‘writer’)  of
the option, i. e. the dealer to whom the premium has been paid,  is  obliged
to deliver or buy the shares respectively, if the  option  holder  exercises
his rights.
       Traditional options have been dealt in for over 200 years,  and  are
usually written for a date three month’ hence, when either  the  shares  are
exchanged, or the option lapses. The disadvantage of the traditional  option
is that it cannot be traded before the exercise date, and it was because  of
this inflexibility that the traded options market was created in the  UK  in
1978.
       Equity options were first traded on LIFFE  in  1992,  and  currently
(1997), options are available on 73 large companies’ shares. Because  traded
options cost much less then the underlying shares, an investor  is  able  to
back an investment opinion without risking too much money.
                   II. Dividend Policy and Share Valuation


      Dividends as a Residual Profit Decision

       It would seem sensible for a company to continue to reinvest  profit
as long as projects can be found that yield returns higher than its cost  of
capital. In this way, the company can earn a higher return for  shareholders
than they can earn for themselves by reinvesting dividends.  Such  a  policy
can be optimal, however, only if the company  maintains  its  target-gearing
ratio by adding an appropriate proportion of borrowed funds to the  retained
earnings. If not, the company’s coast of capital would increase  because  of
its disproportionate volume of higher-cost equity  capital;  this  would  be
reflected share price.
       Activity:
The LTD Company has the chance to invest in the five projects listed below:
|Projects               |Capital outlay, ?     |Yield rate, %         |
|A                      |70.000                |18                    |
|B                      |100.000               |17                    |
|C                      |130.000               |16                    |
|D                      |50.000                |15                    |
|E                      |100.000               |14                    |


       The company cost of capital is 16% its optimal debt  to  net  assets
ratio is 30% and the current year’s profit available to equity  shareholders
is ?350.000.
       Required:
 . State which projects would be accepted, and what  is  the  total  finance
   requires for those projects.
 . Assuming that the company wishes to maintain its gearing ratio, how  much
   of the required finance will be borrowed?
 . How much of this year’s profit can be distributed?
       The answers:
 . A, B and C, with yield greater than or equal to  the  company’s  cost  of
   capital; total finance required ?300.000.
 . Amount to be borrowed: 30% of ?300.000=?90.000.
 . This year’s profit:                                        ?350.000
   less      amount     to     be     reinvested           ?300.000-?90.000:
210.000
   Profit for distribution:                                     140.000
   Company’s shareholders obtain the best of both words. They can invest the
?140.000 received as dividends to earn a higher  rate  of  return  than  the
company could earn for them; and the ?210.000 retained  by  the  company  is
reinvested to shareholders’ advantage. Shareholders’  wealth  is  optimized,
and the dividend paid is simply the residual profit after investment  policy
has been approved.
       If companies  look  upon  dividend  policy  as  what  remains  after
investments are decided then the search for an optimum  dividend  policy  is
pointless.  Shareholders  wanting  dividends  can  always  make   them   for
themselves by selling some of their shares.
       Further support for the ‘residual’  theory  of  dividends,  and  the
argument that the change in dividend policy does not  affect  share  values,
was advanced by Modigliani and Miller in 1961.  They  contended  that  in  a
perfect market the increase in  total  value  of  a  company  after  it  has
accepted an investment projects is the same, whether  internal  or  external
finance is used.
       One deficiency in the Modigliani and Miller hypothesis, however,  is
that they ignore costs associated with an issue  of  shares,  which  can  be
quite considerable.

   1. Costs Associated with Dividend Policy
       Capital floatation  costs  are  a  deterrent  substituting  external
finance for retained earnings but there are  other  costs  affected  by  the
dividend decision.
       If shareholders are left to make their own dividends by selling some
shares, this involves brokerage and other selling costs  that,  on  a  small
number of shares, can be extremely an economic. In addition,  if  they  have
to be sold during a period  of  low  share  price,  capital  losses  may  be
suffered.
       Another important  factor  is  taxation.  First,  when  the  company
distributes dividend it has to pay an  advance  installment  of  corporation
tax (ACT), currently one quarter of the amount paid. But the offset  against
mainstream liability to pay corporation tax will be delayed by at least  one
year. Indeed, if the company does not currently pay this type  of  tax,  the
delay in setting off ACT  will  be  even  longer,  and  this  will  tend  to
restrain extravagant dividend distributions.
       Second,  from  the  investors’  viewpoint   profitability   invested
retained earnings should increase share  values,  enabling  shareholders  to
create their own dividends. Selling shares creates a  liability  to  capital
gains tax, currently 20%, 23% or 40%,  but  subject  to  a  fairly  generous
exemption limit. By comparison,  dividends  in  the  hands  of  shareholders
attract
higher rate of income tax (up to 40%). Thus higher-rate taxpayers may
prefer comparatively low dividend payouts to minimize their tax burden.
       Third, financial institutions  confuse  the  taxation  picture  even
more, through their major holdings in the shares of quoted  companies.  They
are able to set off  dividends  received  against  dividends  paid  for  tax
purpose but some may be liable to capital gains tax if they sell  shares  to
make dividends.
       The effect of taxation on dividend decision is difficult to analyse.
It may be argued that  companies  attract  investors  who  can  match  their
personal taxation regimes to company’s dividend policy, and that  those  who
don’t join a particular ‘taxation club’ will invest elsewhere. If this  were
true, however, a change in company’s  dividend  policy  would  probably  not
find favour with its shareholders clientele. And would  consequently  affect
share values, which seem  to  support  the  argument  that  dividend  policy
matters.

   2. Other Arguments Supporting the Relevance of Dividend Policy.
       Activity:
As a potential investor, how would you react to the following questions?
a. Would you prefer cash dividends  now,  against  the  promise  of  future,
   perhaps uncertain, dividends?
b. Would you prefer a stable, growing dividend to  one  that  fluctuates  in
   sympathy with company’s investment needs?
c. If a company, in whose shares you  invest,  increases  or  decreases  its
   dividend, would it change your personal investment policy?
   In answer in question (a) you probably opted for  cash  now  rather  than
cash you may never see. The future is uncertain and most  people  take  much
convincing that it is in their interests to postpone  income.  Although  the
equity shareholder by definition is the risk-bearer, he is also entitled  to
a  reasonable  resolution  of  dividend  prospects  to  compensate  for  the
additional risk he carries. An investor will  almost  certainty  pay  higher
price for earlier rather than later dividends.
   In question (b), in definition, a fluctuating dividend is more risky than
a stable dividend. Investors will pay more for stability, especially  if  it
is  linked  with  steady  growth.  Research  has  shown  that,  in  general,
dividends follow a pattern of stability with growth. Maintenance

of the previous year’s dividend is  the  first  consideration,  with  growth
added when directors feel that a higher plateau of  profitability  has  been
consolidated.
   As regards question (c), you would  no  doubt  be  very  happy  about  an
increase, and might even be prompted to buy more shares –  thus  helping  to
put the market price up. Conversely a  decreased  dividend  would  cause  to
review your investment, perhaps even to sell your shares to  take  advantage
of better investment opportunities  elsewhere.  Investors  tend  to  believe
that dividend changes provide  information  regarding  a  company’s  futures
prospects, and they react accordingly.

   3. Practical Factors Affecting Dividend Policy
       Whatever dividend policy is thought to be  best  for  a  company  in
theory, certain practical factors influence the decision.
      Availability of profit The Companies Act 1985 provides that  dividends
can only be paid out of accumulated realized profit  less  realized  losses,
whether these are capital of revenue.  Previous  or  current  years’  losses
must be made good before a distribution can be made. If an  asset  is  sold,
any realized profit or loss arising can be distributed; but  any  profit  or
loss arising from revaluation of an asset cannot  be  distributed  –  unless
and until the asset is sold.
      Availability of cash Profit may be earned during a year and yet it may
hot be possible to pay a dividend because of lack of cash.  This  can  arise
for different reasons. It may already have been expected  or  be  needed  to
replace  fixed  and  working  assets,  perhaps  at  inflated  prices.  Large
customers may not yet have paid their accounts or  cash  may  be  needed  to
repay a loan.
      Other restrictions The company’s articles association  may  limit  the
payment of dividends or  a  lender  by  insert  into  a  loan  agreement  to
restrict the level of dividends. A company’s dividend policy  cannot  be  so
outrageously different from policies followed by similar  companies  in  the
same industry;  otherwise  the  market  price  of  its  shares  could  fall.
Dividends may be restricted by government prices and incomes polices.

   4. Alternatives to Cash Dividends
In recent years companies have introduced  more  flexibility  into  their
dividend policy by either:
    . issuing shares in place of cash dividends (‘scrip’ dividend);
    . repurchasing their shares.
       Script dividends Companies may give their shareholders the option to
receive shares rather than cash. This has the effect of maintaining  company
liquidity, and enabling the company to increase earnings  by  investing  the
retained cash. However company has to pay ACT on the distribution,  and  the
shareholders have to pay income tax.
       Thus, the shareholders can increase his investment in  the  company,
without expense associated with the public issue or a purchase  on  a  stock
market, but the same time retain the option to convert his shares into  cash
at a future date.
       Repurchasing shares  Since  1981  companies  have  been  allowed  to
purchase their own shares subject to certain  restrictions,  and  the  prior
authorization of their shareholders. This  is  normally  done  by  utilizing
distributable profits, and the shares must be cancelled after purchasing.
       Repurchasing of shares may be carried out for any of  the  following
reasons:
  . to repay surplus cash to shareholders;
  . to increase gearing by reducing equity capital;
 . to increase EPS by reducing the number of shares related to an unchanging
   level of profit, and hopefully, therefore, the value  of  each  remaining
   share;
 . to purchase the shares of a large shareholders.

                                   Summary


       In this report we have explored an important and long-standing issue
in financial research: how do corporations finance  themselves,  the  shares
issuing in the Stock Market Exchange and dividend policy of the companies.
       And the situation is that the  rapidly  expanding  companies  suffer
from the retained profit insufficiency and one  of  the  solutions  of  this
financial problem is going public.
But it is not surprising that existing shareholders  dig  more  deeply  into
company’s pocket by claiming dividends. And of course the public company  is
subject to more scrutiny than a private one.
   Thus I think only when all other sources are exhausted  your  can  dilute
already  existing  shareholders’   control   over   the   company.   However
corporations willingly make issues of shares and pay dividends. So  how  are
their dividend, financial and investment policy  reconciled?  This  question
has exercised the minds of academics and financial managers in recent  years
without any completely satisfactory answer being produced.


                                 References



1.  Anjolein  Schmeits,  ‘Essay   on   Corporate   Finance   and   Financial
   Intermediation’, Thesis publishers, 1999, 225-246.

2. Geoffrey Knott, ‘Financial Management’, Creative Print and Design,  Third
   edition, 1998,
   300-337.

3.    Kovtun L.G., ‘English for Bankers and  Brokers,  Managers  and  Market
   Specialists’, Moscow NIP“2”, 1994, 340-350.



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