Corporate Finance .docx

LONDON SCHOOL OF COMMERCE COLOMBO CAMPUS SRI LANKA MBA FOR EXECUTIVES

MODULE ASSIGNMENT: Corporate Finance

Student Name

Rumesh Vishwanatha

Student Registration No.

A0092CBECBE1115

Module Lecturer :

Dr. Robert Suban

Module Tutor

: N.Skandakumar

Date Submitted

03/11/2016

Total Word Count

4452

1

TABLE OF CONTENTS Executive Summary ....................................................................................................... 3 Introduction .................................................................................................................... 3 Importance of the dividend decision. ............................................................................. 5 Review of Bukit Darah’s dividend policy. .................................................................... 6 Discussion of dividend theories and recommendation as to the company’s future policy.............................................................................................................................. 8 1.

Dividends irrelevant theory................................................................................. 8

2.

Dividend relevance theory .................................................................................. 9

3.

Bird-in-the-Hand Theory .................................................................................. 10

4.

Tax Preference Theory (Clientele theory) ........................................................ 10

Types and importance of foreign exchange risk. ......................................................... 11 1.

Transaction Risk ............................................................................................... 12

2.

Translation Risk ................................................................................................ 12

3.

Economic FX Risk ............................................................................................ 13

Four main internal hedging techniques. ....................................................................... 13 1.

Home Currency Invoicing................................................................................. 13

2.

Currency Netting ............................................................................................... 14

3.

Currency Overdraft ........................................................................................... 14

4.

Leading and Lagging ........................................................................................ 15

Two main external hedging technique ......................................................................... 15 1.

Forwards market hedge ..................................................................................... 15

2.

Money Market hedge ........................................................................................ 16

References .................................................................................................................... 17

2

EXECUTIVE SUMMARY The net profit of the Bukit Dahar PLC was continually decreased over the years and this happened because of increasing company expenses over the years without significant increase of the company revenue. Because of the company dividend policy, they have issued the fixed dividend whether company financial performance was good or bad. Therefore, payouts also were increasing with the current financial position. With this situation, company dividend policy needs to be changed to MM Dividends irrelevant theory from Bird in the hand's theory. Foreign Exchange risk is a one of significant risk which can happen to the exporter and importers in the international trading and to companies with the overseas subsidiaries. To reduce FX risk, there are four internal hedging techniques and the two main external hedging techniques.

INTRODUCTION BUKIT DARAH PLC is a publicly quoted company which is incorporated in 1916 is headquartered Colombo, Sri Lanka. The main operation activity is the cultivation of oil palm in Indonesia and Malaysia. The company is engaged in managing and holding the investment portfolio and providing financial services. Other than that, real estate, resorts, airways are also key operational activities of the Bukit Darah. Key financial statistics such as Revenue, Net profit, EBITDA, Operating Cash flows, Net Assets and Net debt were performed within the last three financial years 2014, 2015, 2016 as follows. As shown in figure 1, the highest revenue was represented in 2015 when comparing last consecutive three years. Nearly 12 billion rupees was increased from 2014 to 2015 but it was decreased by nearly 3 billion rupees in 2016. Net profit (figure 2) of the Bukit Dahar PLC was decreased continuously from 2014 to 2016.

3

Net Profit (Rs. '000)

Revenue (Rs. '000 ) 90,000,000

9,000,000

88,000,000

8,000,000

86,000,000

7,000,000

84,000,000

6,000,000

82,000,000

5,000,000

80,000,000

4,000,000

78,000,000

3,000,000

76,000,000 74,000,000

2,000,000

72,000,000

1,000,000 0

70,000,000

2014

2015

1

2016

Figure 1: Revenue

2

3

Figure 2: Net Profit

Lowest EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization) of the Bukit Dahar (figure 3) was received in 2016 and highest was in 2015 among last consecutive three years. Operating Cash flows were varied in the wide-range and a lowest operating cash flow was in 2015.

EBITDA (Rs. '000)

Operating Cashflows (Rs. '000)

18,000,000 16,000,000

16,000,000

14,000,000

14,000,000

12,000,000

12,000,000

10,000,000

10,000,000

8,000,000

8,000,000

6,000,000

6,000,000

4,000,000

4,000,000

2,000,000

2,000,000

0

0 2014

Figure 3: EBITDA

2015

2016

1

2

3

Figure 4: Operating Cash flows

4

In 2016, Net Asset was increased to highest level comparing other two years and it was nearly 5 billion rupees from 2015 to 2016. Net Debt was increased continuously within consecutive last three years.

Net Debt ('000)

Net Assets (Rs. '000) 69,000,000

80,000,000

68,000,000

70,000,000

67,000,000

60,000,000

66,000,000

50,000,000

65,000,000 40,000,000 64,000,000 30,000,000

63,000,000

20,000,000

62,000,000

10,000,000

61,000,000

0

60,000,000 2014

Figure 5: Net Assets

2015

2016

1

2

3

Figure 6: Net Debt

IMPORTANCE OF THE DIVIDEND DECISION. Bukit Dahar PLC annual report 2015/16 mentioned that “Dividends on ordinary shares are recognised as liability” (Bukit Dahar PLC, 2016), it means they think the dividends are crucially important. According to the oxford dictionary dividend is the amount of money which is paid by a company among their profits for its shareholders regularly (Oxford Dictonaries, 2016). Investopedia Stated that “A dividend is a distribution of a portion of a company's earnings, decided by the board of directors, to a class of its shareholders. Dividends can be issued as cash payments, as shares of stock, or other property” (Investopedia, 2016). Actually, the dividend is the portion of the profit which is distributed to shareholders. Shareholders are the investors of the company, on the other hand, they are the owners of the company. Because of that, the owner portion of the reserves is very important for healthy future of the company. As defined in the Investopedia (2016), dividend policy is the set of instruction to decide how much pay to shareholders from their profit. Moreover, Investopedia said

5

dividend policy may change company to company based on the various factors and some of them view the dividend policy as an integral part of the corporate strategy of the company (Investopedia, 2016). Buki Dahar PLC paid a fixed dividend rate over the last 4 year period. They had not changed the dividend according to their financial performance. They are always trying to improve the shareholder's value and yield a better return to both companies and the shareholders in a long-term perspective (Bukit Dahar PLC, 2016). Dividend decision is important mainly because of three reasons. 1. The effect on the internal finance that is available to the company. The dividend is paid after tax profit and it is divided into two portions one is a dividend and another one is reserved. Reserves are internal financial and if it’s paid the more divided amount of reserves are reduced. 2. The effect on return on investment of the investors on their share. If it is received more dividend, dividend yield of the share is increased. When it is calculated with the capital gain, the return on investment of the investors is increased. Because dividend rate is directly affected to the investors return. 3. It is maximising the shareholder’s wealth. With the dividend decision the return on investment and the value of a share are increased and then their wealth of the shareholders will be increased. As mention above, the dividend decision may directly affect to not only shareholders but as the company.

REVIEW OF BUKIT DARAH’S DIVIDEND POLICY. Bukit Dahar PLC paid their dividend over last four years as fixed extent of the company profit and also the Dividend on ordinary shares are recognised as a liability and subtracted from equity when they are permitted by company’s shareholders. Interim dividends are subtracted from equity when they are declared and are not at the discretion of the corporation (Bukit Dahar PLC, 2016). But in this point of scenario, the directors do not recommend a dividend. When considering main investor relation ratios such as DPS, EPS and Payout trend following fluctuations are obtained. 6

Dividend per share (LKR) 3.1

According to the figure 7, a fixed dividend

3

ratio was declared by Bukit Dahar PLC

2.9

within last four years period. It was LKR 3

2.8

per share. But before 4 years at 2012, they

2.7

were declared only LKR 2.5. This is a

2.6

certain dividend rate and it was low risk

2.5

for the shareholders and them always

2.4

prefer it.

2.3 2.2 1

2

3

4

5

Figure 7: Dividend per share

60

As shown in figure 8, Earning per share

50

was continually decreased over the years. In 2012, EPS was approximately LKR 50, but

40

it was reduced by more than 300% within 5 30

years period and in 2016, it was nearly LKR 14. EPS is clearly shown the negative

20

gradient for the last five years. 10

Dividend payout (%) 0 25 1

2

3

4

5

20

Figure 8: Earning per share 15

10

5

7

0 1

2

3

4

5

With the effect of fixed dividend rate and the decreasing earning per share, dividend payout represents the regular increasing payout. It was increased 5% to 22% within 5 years of the period. When comparing the 2014 and 2016, it was more than doubled. Shareholders are most preferred this kind of the low-risk dividend scenario. And it was encouraged the people to invest.

Figure 9: Dividend payout This happened because of the dividend policy of the Bukit Dahr PLC. They were offered a certain dividend and it was preferred by the investors and low-risk dividend policy of shareholders. This type of dividend theory called as Bird-in-the-Hand Theory.

DISCUSSION

OF

DIVIDEND

THEORIES

AND

RECOMMENDATION AS TO THE COMPANY’S FUTURE POLICY. There four main dividend payout theories. And those theories effect on the various level for the company and the shareholders. Those four theories are, 1. MM- Dividends are irrelevant 2. MM- Dividend relevance theory 3. Bird in the hand 4. Tax preference (Clientele effect theory)

1. Dividends are irrelevant Dividends irrelevant theory was introduced by Modigaliani-Miller in 1961. As explained in this concept, buyers don't pay any value to the dividend historical past of an enterprise and for this reason, dividends are beside the point in calculating the valuation of a manufacturer. This conception is in direct distinction to the ‘Dividend Relevance’ conception which beliefs dividends to be predominant within the valuation of a corporation. In keeping with this idea, investors do not pay any 8

significance to the dividend historical past of a corporation and thus, dividends are beside the point in calculating the valuation of a manufacturer. This concept is in direct contrast to the ‘Dividend Relevance’ concept which beliefs dividends to be fundamental in the evaluation of an organisation. If investors need cash, they have the opportunity to sell shares and take money, if they do not need cash, dividends can be used by new shares and increased their ownership (Anon., 2015). If there is a too big company’s dividend, more shares can be bought by the investors and it will be over satisfy them. If it is too small, share can be sold by the investors. However, the dividends irrelevant theory is not based on taxes or brokerage costs. 2. Dividend relevance theory Myron J. Gordon and John Lintner have introduced the Dividend relevance theory and it suggested that investors are generally risk averse and would rather have dividends today than possible share appreciation and dividends tomorrow. According to Dividend relevance theory, dividend policy affects the stock price. Therefore, this theory explained that optimal dividend policy should be determined which will ensure maximisation of the shareholder's wealth. For dividend relevance theory, there is not helped by the empirical studies. Although, there is some relation among stock price and the dividend policy (Firmsconsulting, 2016). In 1961, Modigliani and Miller have introduced the relevant theory and

its

investment policy was driven off the Company value. Companies should re-invest incomes as long as they have valuable investment chances and should pay out dividends only when they have no more investment value undertaking. If incomes lesser than the required amount the finance was raised from outside. If the investor prevents the valuable investment that dividend payment are essential. That is a cost of opportunity may be imposed (Anon., 2015). There are some assumptions for MM dividend relevant theory. Such as, 

Investors are rational wealth maximizers



No distorting effects of taxation



No transactions cost in market dealing



All corporate investment programmes are known and understood by investors



Dividend payments are not used to signal information

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

Firms have no access to external finance

3. Bird-in-the-Hand Theory Bird in Hand theory introduced by the Myron Gordon and John Lintner as a development of the dividend irrelevance theory of the Modigliani-Miller. Which continues that investors are unresponsive as to whether their returns from preserving shares ascend from dividends or positive factors for capital investment (Investopedia, 2016). Bird in Hand theory says that despite taxes and operational expenses, and also all investor likes to the dividend with a certain amount receiving now relatively to an uncertain dividend with the better amount for a future dividend. In a lower tax paying situation. Most of the investors search the low-risk investment method and they think the dividend is less risky than future capital gain. But in another way dividend tax is higher than the capital gain tax. Because of that firms must pay out as much as possible from profit after tax as dividend and retain is very little. High-performing firms are doing high payout as a result of the high profit. But this is not a principle of the universal truth. Bukit Dahar PLC is also using this policy which is “Bird in Hand theory” is as their dividend policy. 4. Tax Preference Theory (Clientele theory) Taxes are most vital concerns for investors. But Capital beneficial properties are taxed at a decreasing rate than dividends. As such, buyers may decide upon capital good points to dividends. That is referred to as the "tax alternative idea". Additionally, capital gains usually are not paid until an investment is definitely sold. Investors can manage when capital beneficial properties are realised, however, they cannot control dividend payments, over which the related enterprise has managed. Capital features are also not realised in an estate obstacle. For example, suppose an investor bought an inventory in an organisation 50 years in the past. The investor held the stock unless his or her death when it is passed on to an heir. That inheritor does now not must pay taxes on that stock's appreciation (Investopedia, 2016). Long-term capital gains are lead to reserved earnings. Those capital gains are taxed at lower rates than dividends. Personal tax situation are depending on investors. Some of the shareholders more liked to capital gains over dividends and vice versa as capital 10

gains are taxed at a lower rate than dividends. The clientele effect is simply different stockholders' preference on receiving dividends compared to capital gains. For example, a shareholder in a high rate of tax support may favour shares with a low rate of dividend payouts compared to a shareholder in a low tax support who may favour shares with a higher rate of dividend payouts. In my point of view, the most suitable and the correct dividend theory to applicable for any kind of situation is Dividends irrelevant theory because it has a manageable risk for both parties investor and the company. In this situation, the stocks have high liquidity and the company have not a liable responsibility to pay a dividend at a fixed rate. Some of the firms have continuously increasing payouts over the period of time. This situation happens causing various kinds of factors. Such as revenue, profit, capital requirement etc. And also management decisions, dividend policy, investment policies etc. According to the Bukit Dahr PLC, there was decreased the profit after tax continuously, the main reason behind this profit reduction, the level of expense was increased over the years without a significant change of the company income. And also share price also continuously decreased but they offered fix rate of dividend. When analysing this situation the current dividend policy of the company is not suitable for the company and need to change current dividend policy. Among main four dividend theories, according to my concern, the most viable dividend policy for the Bukit Dahr PLC is Dividend Irrelevance Theory which is “Investors are indifferent between dividends and retention-generated capital gains. If they want cash, they can sell stock. If they don’t want cash, they can use dividends to buy stock”. Because currently, the company was giving fixed dividend whether their profit increased or not. But the firm's profit was decreased over years in last five years period.

TYPES AND IMPORTANCE OF FOREIGN EXCHANGE RISK. Foreign exchange risk which is called as FX risk, currency risk, and exchange risk is a financial risk that can happen because of the financial transaction is denominated in exchanges other than that of the bottom foreign money of the organisation (Wikipedia, 2016). In Investopedia stated that foreign exchange risk is the financial 11

risk of the change of the investment value due to the currency exchange rate (Investopedia, 2016). The risk of foreign currency exchange is severely affected to the anyone who involved to the import and export business such as product, services and supplies. It's also important to recognise values uncovered to the gigantic hazard of loss and thereby decide whether foreign exchange charges can also be forecast and thus devise a compatible hedging strategy or not. There are mainly three types of FX risk. Those are, 1. Transaction risk 2. Translation risk 3. Economic FX risk

1. Transaction Risk Transaction risk is the rises out of the transactions of import and export. It is a risk which happened in between credit period over the exchange rate. If it happened within a short period of time, it will be directly impacted the cash flow of the company. This transaction risk happens because of the receivable and the payables. Contracts between two one-of-a-kind businesses with specific local currencies set contracts with selected principles. This contract offers particular prices for services and particular transfer dates. But, this contract faces the risk of exchange rates among the involved exchange varying before the services are distributed or before the deal is settled (Investopedia, 2016). 2. Translation Risk The translation risk happens because of the non-current assets and/or liabilities of the company. This risk is detected at end of each year when translating the company assets and liabilities to company own domestic currency, and they included the annual statement of the financial position. In another way, when translating the financial statements of the overseas subsidiaries in to the domestic currency also can be happened this translation risk of the foreign exchange. Actual this is the risk happening when translating the real money from one currency to another currency. However, translation exposed would possibly not have an impact on a corporation's cash flow; it could possibly exchange the total pronounced gains of the company, 12

which affects its stock cost (Investopedia, 2016). The reported performance of a foreign subsidiary in home-based exchange terms can be highly distorted if there has been a significant foreign exchange movement. 3. Economic FX Risk Economic FX risk is the risk happening to the company long term cash flows because of the economical exposure (Investopedia, 2016). Currency fluctuations can be caused by the company position it’s compared the competitors of the company. For example, if a UK company’s, US factory investment is generating a stream of US dollar cash flows then, Economic Risk is the risk that the value of that $ cash flow –in £s – will become worth less and less over time, caused by a longer-term, adverse movement in the $/£ exchange rate. According to the above example, economic FX risk is the long-term version of the short-term transaction. And, it is an impact to the company cash flows.

FOUR MAIN INTERNAL HEDGING TECHNIQUES. To reduce the transaction risk, there are using various kinds of techniques for financial reporting. Among those techniques, there are four main different actions that can be taken to companies. Those actions are, 1. Home currency invoicing. 2. Currency netting. 3. Currency loan. 4. Leading and lagging.

1. Home Currency Invoicing Home currency invoicing means invoice the international sale for home currency without using buys currency (Webber, & Freedman, 2015). As an example, if the German car manufacturer sold a car for €100,000 for the UK, it’s worth for UK customer is £84,746. But German manufacturer invoices them for their currency as €100,000. This is the home currency invoicing which international trading invoiced as German currency. Because that German manufacturer does not face to uncertainty with the three-month credit period, UK buys will pay from German currency. But UK buyer has to face uncertainty because he has to pay from foreign currency, in three month periods. UK buyer does not know exact amount need to after the three months’ 13

periods. In the case of this scenario, exporters received a sufficient monopoly power and importers automatically push into FX risk. If not, they will risk losing the deal to a competitor who will invoice in British pounds. 2. Currency Netting Currency Netting is an internal hedging technique which is used if there are both receipts and the payments, in the same foreign currency with the same credit period. There are instances where an organization has associates in a couple of countries that actively exchange with each other. If so, they must have bills receivable and payable with every different, which would give rise to a flurry of foreign exchange transactions in multiple currencies that could trigger any quantity of hedging hobbies. (Accounting Tools, n.d.). In this method, reduce FX risk offsetting one against the other. As an example, if the firm has a payment of $500,000 with the 3 months’ credit period and the receipt of the $450,000 with the 3 months’ credit period. According to this technique, the firm needs to settle only the balance of payment $50,000. Because of that only $50,000 is exposed to foreign exchange risk. 3. Currency Overdraft Another main method which reduces the foreign exchange risk is the currency overdraft. Currency Overdraft is used where fairs have a large amount of small scale customers invoicing in one foreign currency. The low-value nature of each invoice makes it administratively inconvenient to deal with each one separately. Instead, they are dealt with collectively. As an illustration, A UK corporation sale their goods to a massive quantity of small consumers in the Europe who are invoiced in euros. The enterprise bet that, over the next three hundred and sixty-five days, they will export valued at €500,000 in complete, to those clients. To hedge their revelation to FX transaction risk, their earnings was once €500,000 12month overdraft and immediately translate the whole amount into pounds at the spot price of, say, €/£ 1.2600, to present €500,000 ÷ 1.2600 = £396,825 now. The result is that the firm has no uncertainty concerning the cost, in pounds, of their Europe exports remodeled the following three hundred and sixty-five days they have £396,825 now. Then, over the following one year, as each of the small

14

euro’s receipts is bought, the money is used to ceaselessly repay the company’s €500,000 overdraft. That is the currency Overdraft hedge. 4. Leading and Lagging Leads and lags are the alterations of traditional fee or receipts in a currency trading transaction since of an anticipated trade in exchange rates. An anticipated expand in alternate rates is likely to pace up repayments, even as an expected lessen in exchange premiums will ordinarily sluggish them down (Investopedia, 2016). In another word, payment is paid earlier or later in this method to reduce the bad changes of currency rate. The main problem of this technique is FX risk can be reduced only if it is doing successful forecasting the future currency rate. Otherwise, it is not reliable to reduce FX risk and it may be created the high risk in the future than present. As an example, Therefore, our German Toy producer, who is about to invoice their UK client for £84,746 on 3 months’ credit, might try to convince the client to pay instantly. In other words, to lead the payment, if they fear that the €/£ exchange rate will move harmfully over the next 3 months. To take strong currency involvement, need to be followed the following sequence for payments. 

payables in soft currency – delay payment



payables in strong currency – pay up quickly



receivables in soft currency – force early payment



receivables in strong currency – delay collection

TWO MAIN EXTERNAL HEDGING TECHNIQUE To reduce the foreign exchange risk, there two main external hedging techniques. Those are, 1. Forwards market hedge 2. Money Market hedge 1. Forwards market hedge The gaining market is where that you can purchase and promote a currency, at a constant future date for a predetermined price, that is, the forward expense of 15

exchange. This conveniently fixes the longer-term fee (Kaplan Financial Knowledge Bank, 2016). In this method, foreign currency received from the forward rate in the future. At the receiving point, the forward rate may be two types. One is minus the premium and another one is a plus from a discount. In another word, it can be said as Supply the purchaser the proper, however now not the duty, to buy (“name”) or promote (“put”) a specific amount of foreign money at a specified price on a specific date. Contracts entered into the ahead market are binding on the events concerned. Forward markets are used for trading a range of devices including currencies and interest charges. As an example, BMW is the one of German car producer and has sold a car to a US customer for $100,000 in 3 months’ credit period. $/€ spot is $1.3560 and after 3 months it is $1.3720. Annual interest rate for loans and deposits of USD respectively is 6% and the 3% and for the euro, it is 4% and 2%. BMW is due to receive $100,000 in 3 months’ time to undertake a forward market hedge, the company goes to its bank today and enters into a contract to sell the $100,000 three months forward to give a certain receipt of €72,886 receipt in 3 months. Thus, the German exporter has no doubt as to the outcome in euros of their export transaction. They will receive €72,886 after 3 months’ time, for certain. 2. Money Market hedge The money markets are markets for wholesale lending and borrowing, or trading briefly-period of time financial devices. Many companies are capable of borrowing or depositing money through their monetary organization within the money markets (Bank, 2016). On the other hand, to hedge payments in an overseas currency, one would borrow at home, which would then be transformed into the required overseas currency and capitalized until the payment is due. To undertake a money market hedge, companies should take 3 steps, Step 1: Borrow $x for 3 months. Step 2: Exchange the $x now, at the spot, for euros. Step 3: At the end of 3 months, use the $y receipt from the customer to repay the $x loan, plus interest.

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at:

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/Wiki%20Pages/Forward%20Contracts.aspx?mode=none[Accessed

29

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