Role of the Board in Determining

Dividend, Financing, and Investment

Policies

Dr. Demir Yener

Senior Corporate Governance and

Finance Advisor

USAID/BPI Project

Ulaanbaatar, Mongolia

Corporate Governance Development Center

Achieving Shareholder Wealth Maximization

Module 13

22

Outline:

The role of the board in determining dividend, investment

and financing policies

The impact of these decisions on value creation

Beneficiaries of value creation

Lessons learned

Purpose: To explain the role of the board in determining

dividend, investment and financing policies to achieve the

shareholder wealth maximization objective.

33

Learning Objectives:

Understand the role of the boards in determining

dividend, financing and investment policies

How the board set targets and determines the

dividend, investment and financing policies

Board responsibility to ensure value maximization for

the shareholders

44

Strategic Role of the Board of Directors

Revisited

5

Corporate Governance

Is defined as:

“the set of rules by which companies are managed and supervised by its relevant investor bodies such as the boards elected by shareholders.

Practicing good corporate ensures investors a fair rate of return.”

5

6

Key Fundamentals of CG Environment

Four Values of Corporate Governance

Transparency Accountability Responsibility Fairness

Ownership vs. Management

Information Needs

• Stock prices

• Returns on

investment

• Issues of shares

and other securities

• Dividends

• Financing

Different Objectives

• Managers vs.

stockholders

• Top mgmt vs.

operating mgmt

• Stockholders vs.

creditors

7

Financial Markets

Funds

Primary Markets

Secondary

markets

OTC markets

8

Interactions Between Financial Market Participants

Financial Markets

Issuers

Investors

Intermediaries

9

Good Governance Improves Performance

• Disclosure of financial position helps set clear targets

• Holds all employees responsible and accountable for results

Disclosure and Transparency

• Checks on executive management

• Brings market perspective on risk

Audit Committee

• Critical for creating the right incentives to ensure the success of strategies

Management Compensation Committee

• Bring fresh and objective perspective to board decision making process

Independent Directors

1010

11

Competitiveness and Governance

Adopting sound corporate governance practices help

firms compete more efficiently and effectively

Market valuation improves as corporate governance

is improved

Focusing on wealth maximization (not profit

maximization) is an attainable goal for the firm

11

1212

Good Corporate Governance Focuses on

a Model in which…

Shareholders Elect the Board

The Board develops the strategy

S/Hs require that board is transparent

All relevant and material information is disclosed to S/Hs and investors

All actions of the firm are within the law

1313

Strategic Role of the Board of Directors

OECD Principles (2004) on the strategic role of the Board

Reviewing and guiding corporate strategy

Approving major plans of action

Approving risk policy

Approving annual budgets and business plans; setting

performance objectives

Monitoring implementation and corporate performance.

Role of the Board in Finance Function

OECD Principles (2004) on the strategic role of the

Board states that:

“The board should fulfill certain key functions

including:… overseeing major capital expenditures,

acquisitions and divestitures.”

14

15

The Goal of the Firm

To maximize the wealth of shareholders.

15

16

Motivation to Invest

Why invest in a company?

16

17

Rate of Return Expectations

• Key factors in attracting investment:

• Firms must build investor confidence that a rate of

return on invested capital can be assured to the

investors.

• There must be a conducive environment for

corporate governance to protect the rights of

shareholders17

1818

Dividends in Mongolian Regulatory Framework

Mongolian CG Code, Chapter 8 provides for dividend

policy.

8.1 Policy on dividend policy

Mongolian Companies Law, Chapter 6: Dividend

distribution and transfers of a company` s property

provides for:

Article 46 Payment of dividends

Article 47 Conditions Relative to Payment of Dividends

Article 48 Limitations on Disposition of a Company`s

Property

1919

Board’s Role in Wealth Maximization

The Board represents the interests of shareholders

who demand a rate of return for their investment.

Executive management‟s goal is to create value for

stockholders.

This goal is consistent with the wealth maximization

objective.

Directors determine manager‟s compensation or

replace them.

Directors monitor, control and guide the actions of the

executive management.

2020

Dividend, Financing and Investment Policies

Dividend, Investment and Financing Decisions

21

Three Wealth Maximizing Decisions of the Board

Investment

DividendFinancing

The optimal

combination of the three

policy decisions ensure

value maximization.

Executive management

is responsible for

implementing the

wealth maximizing

policies for

shareholders

21

CORPORATE FINANCE FRAMEWORKIN

VE

ST

ME

NT

PO

LIC

Y • Allocating capital

• Ensuring operational efficiencies

• Creating S/H value (Wealth maximization)

FIN

AN

CIN

G P

OL

ICY • Implementing

Investment-Finance-Dividend Policies

• Capital Budgeting (Investment Decisions)

• Cash Budgeting (Operational)

MA

RK

ET

S • Issue securities for LT Funds from investors (Bonds and Stocks)

• Raise ST Funds from banks

12

3 4

5

1=Raise capital in the markets, issue equity/debt2=Allocate (Investing) funds in the firm3=Generate operating profits4=Pay taxes, dividends and Interest5=Reinvest profits after tax (Retained Earnings)

22

ROLE OF THE BOARD IN CORPORATE FINANCE

23

Strategies

Tangible GoalsExternal

Environment

Plan

= Goal?

GOAL:

Maximize value

Minimize riskNO

Reexamine

Assumptions

YES

Initiate Plan

Level of

Operating Assets

FINANCING POLICYCorporate Capital Structure: Leverage

Required

Rate of Return

Risk

Factor

OptionsFinancing Package Plan & Analysis

Trade-offs

Long-Term

Investment

Decisions

Short- Term Liquidity

Structure

Financial

Structure

• Under conditions of certainty:

Present Value

• Under conditions of

uncertainty:

• Expected Present Value

• Expected Utility

• Under conditions of certainty:

No specific measure

• Under conditions of

uncertainty:

• Standard Deviation/Expected

Return

• Coefficient of Variation

• Payback Method

• Average Rate of Return

• Internal Rate of Return

• Net Present Value

• Profitability Index

• Sales Forecast

• Operating Expense

Forecast

• Level of Working Capital

Needed to Support Sales

• Free Cash Flows

INVESTMENT

DECISIONS

INVESTING

In new

Equipment

Develop new

products

(R&D)

Merger with or

Acquisition of

Outside firms

Other

Investments

(environmental)

Risk

Factor

Required

Rate of

Return

Selection of

Investment Project

Selection Of

Best Ranking

Method

Determining

Cash-Flows

Trade-offs

Capital Rationing

Constraint

Proceed to Plan=Goal Diagram

Selection of

Capitalization Rate

24

A STRATEGIC INVESTMENT TOOL: CAPITAL BUDGETING

25

Wealth Maximizing Decision

Choose the investment alternative that offers the highest possible Net Present Value.

NPV > 0

(For a given a required risk adjusted return)

25

VALUATION

26

Role of the Board for Valuation in the Mongolian

Companies Law

Article 55. Determination of the Market Value of

Property and Property Rights

• Provides for the role of the Board in the

determination of the value of property and property

rights, including the value of the shares and

securities.

• The article also provides for the treatment of market

valuation and requires votes of the majority of

members of Board of Directors, who have no conflict

of interest in the transaction to determine the value.

27

The Value of Common Stocks

• How To Value Common Stock

• Capitalization Rates

• Stock Prices and EPS

• Cash Flows and the Value of a Business

• Price Earnings Multiple (P/E)

28

What Is The Purpose Of Value Creation?

29

Focusing on value creation will:

• improve attractiveness of the company to

investors or buyers

• maximize value in joint ventures increasing the

potential value of the firm

• improve the strategic planning process

• provide a framework to reward company

managers

• And above all – maximize the wealth of

shareholders

Scenarios For Uses Of Valuation

30

• By companies to carry out their business:

– Strategic planning, investments, new business launches, benchmarking, capital

budgeting, performance measurement

– Mergers, acquisitions, strategic alliances, joint ventures (JVs) and divestitures

– Pre-acquisition value studies performed on either an entity or operating unit level

– Pre-acquisition purchase price allocations for financial and tax planning and

reporting

• By investment bankers as transaction advisors

– M&A, divestitures, leveraged buy-outs (LBOs)

– Initial public offerings (IPOs)

– Equity offerings

• By investors to decide whether to buy an asset:

– Private equity/LBO players, venture capital funds, hedge funds

– Asset managers, institutional investors

– Investing public

Financial Information: Major Financial Statements

(IFRS)

Balance Sheet

List of assets and liabilities at a moment

in time.

Difference between the

two is “shareholder’

s equity”

Income Statement

Shows revenues and costs during a specified

period

Cash Flow Statement

Shows cash payments

and receipts over a

specified period

Other Disclosures

Statement of changes in

equity

Notes

Financial Controls, Auditing and

Disclosure

31

Methods Of Business Valuation

• Adjusted Book Value

• Net Asset Value

• Replacement Value

• Liquidation Value (break-up value)

Asset Based Valuation

• The Earnings Multiplier Method (P/E)• Payback Method• Discounted Cash Flow Method (DCF): a.k.a. the “income

capitalization method

Going Concern Value

32

Stocks & Stock Market

• Common Stock - Ownership shares in a publicly

held corporation.

• Secondary Market - market in which already issued

securities are traded by investors.

• Dividend - Periodic cash distribution from the firm to

the shareholders.

• P/E Ratio - Price per share divided by earnings per

share.

33

Stocks & Stock Market

• Book Value - Net worth of the firm according to the

balance sheet.

• Liquidation Value - Net proceeds that would be

realized by selling the firm‟s assets and paying off its

creditors.

• Market Value Balance Sheet – Financial statement

that uses market value of assets and liabilities.

34

Investment Criteria for Valuation

Criteria

Cash flow:

Liquidity

Yield: Expected Return

Safety: Level of

Risk

35

What Do Different Investors Seek from an

Investment?

Type of Investors

BOD of company

Management

Entrepreneurs

Venture Capital

Fund Mgrs

What they Seek

Expand market share

Cash flow, partners

New markets, undervalued assets

Strong mgmt, growth & value

Diversified Portfolio

Expected Outcomes

Business Growth

Liquidity & Job Security

Diversification & growth

Capital gains

Risk diversification

36

Investor Risk Return Preferences

• The valuation of an asset reflects the risk-return preferences of an investor

• Risk and return criteria are largely a personal phenomenon, and is explained by the “Behavioral Finance” theory.

• This may explain why some investors prefer safety or liquidity over return for riskier investments.

• In the end, these preferences will have an impact on the required rate of return criteria, based on a level of perceived risk from an investment.

37

Valuing Common Stocks

• Expected Return –

• The percentage yield that an investor forecasts from

a specific investment over a set period of time.

Sometimes called the market capitalization rate.

• This is the key concept in valuation

38

Asset Valuation

• Function of both return and risk

– At the center of security analysis

• How should realized return and risk be measured?

– The realized risk-return tradeoff is based on the past

– The expected risk-return tradeoff is uncertain and may not

occur

6-39

Measuring Returns

• For comparing performance over time or across

different securities

• Total Return is a percentage relating all dividend

cash flows received during a given time period,

denoted expected Dividends at time t + (Expected

Price of stock „Pe‟ less Beginning price of stock Pb at

b), divided by the start of period price, Pb

P

)P(PDividendsturn Total

b

bet Re

6-40

41

Fundamental Analysis

• Present value approach

– Capitalization of expected income

– Intrinsic value based on the discounted value of the

expected stream of cash flows

• Multiple of earnings approach

– Valuation relative to a financial performance measure

– Justified P/E ratio

42

• Intrinsic value of a security is

• Estimated intrinsic value compared to the current

market price

– What if market price is different than estimated intrinsic value?

n

tt k) (

Cash Flows urity secValue of

1 1

Present Value Approach

43

Required Inputs

• Discount rate or the Required Rate of Return

– Required rate of return: minimum expected rate to induce

purchase

– The opportunity cost of dollars used for investment

• Expected cash flows

– Stream of dividends or other cash payouts over the life of the

investment

44

• Assume a constant growth in dividends

– Dividends expected to grow at a constant rate, g, over time

Where:

– D1 is the expected dividend at end of the first period

– D1 =D0 (1+g)

gk

D P

1

0

Dividend Discount Model

45

P/E Ratio or Earnings Multiplier Approach

• Alternative approach often used by security analysts

• P/E ratio is the strength with which investors value

earnings as expressed in stock price

– Divide the current market price of the stock by the latest 12-

month earnings

– Price paid for each $1 of earnings

46

• To estimate share value

11/E

o P E

oP

or

o P/E rati justifiedearnings estimated o

P

P/E Ratio Approach

P/E Ratio

• P/E ratio can be derived from

or

Indicating the factors that affect the estimated P/E ratio47

k - g

D Po

1

k - g

/ED/EPo

111

Important Variables in Valuation

1- Discount Rate

K = Risk adjusted discount rate (cost of capital)

k= Risk Free Rate + Risk Premium

2- Growth Rate

g= Growth rate in earnings

g= ROE * (1 – dividend payout ratio)

49

Which Approach Is Best?

• Best estimate is probably the present value of the

(estimated) dividends

– Can future dividends be estimated with accuracy?

– Investors like to focus on capital gains not dividends

• P/E multiplier remains popular for its ease in use and

the objections to the dividend discount model

50

Which Approach Is Best?

• Complementary approaches?

– P/E ratio can be derived from the constant-growth version of

the dividend discount model

– Dividends are paid out of earnings

– Using both increases the likelihood of obtaining reasonable

results

• Dealing with uncertain future is always subject to

error

51

Other Multiples

• Price-to-book value ratio– Ratio of share price to stockholder equity as measured on

the balance sheet

– Price paid for each $1 of equity

• Price-to-sales ratio– Ratio of a company‟s total market value (price times number

of shares) divided by sales

– Market valuation of a firm‟s revenues

DIVIDEND DECISIONS

52

TREATMENT OF DIVIDENDS IN COMPANIES LAW

CHAPTER SIX: DIVIDENDS

Article 46. Payment of Dividends• Stipulates that the Board of Directors or in its absence, the

shareholders meeting, shall decide the matter of paying dividends and

the amount of the dividend to be paid per share, the date for issuing the

list of shareholders entitled to receive dividend, and the dividend

payment date.

Article 47. Conditions With Respect to Payment of

Dividends • Stipulates that a company shall pay dividends with respect to its

common shares so long as the company remains solvent after payment

of the dividend.

Factors Affecting Dividend Decisions

Constraints on Dividend Payments

Investment Opportunities

Availability and cost of alternative sources

of capital

Effects of dividend policy on cost of

capital

Dividend Decisions

54

A Five-stage Life-Cycle Model

55

1. Development Stage

2. Market Introduction

3. Growth Stage

– High earnings growth

– Low dividend payout ratio

– Transition Stage• Slower earning growth

• Increasing dividend payout ratio

4. Maturity Stage

– Stable earnings growth

– Stable dividend payout ratio

5. Decline

The challenge is not only to accurately forecast the earnings

growth and payout ratio values for each segment, but also to

estimate the duration of each of the first two stages.

5656

Constraints on Dividend Payments

1. Bond Indentures

2. Preferred Stock Restrictions

3. Impairment of capital rule

4. Availability of cash

5. Penalty tax on improperly accumulated

earnings

5757

Investment Opportunities

1. Number of available profitable

investment opportunities

2. Possibility of accelerating or delaying

projects

5858

Financing: Alternative Sources of Capital

1. Cost of selling new stock

2. Ability to substitute debt for equity

3. Control issues

5959

Effect of Dividend Policy on Cost of Capital

1. Stockholders‟ desire for current versus future

income

2. Perceived riskiness of dividends over capital

gains

3. The tax advantage of capital gains over

dividends

4. The information content of dividends

(signaling effect)

6060

Break Out Session

Participants are divided into two groups (45 minutes)

Group One: (1) Please discuss the four broad sets of

factors that that affect dividend policy in Mongolian

firms. (2) What constraints affect dividend policies?

Group Two: (1) How do investment opportunities affect

dividend policy in Mongolian firms? (2) How does the

availability and cost of outside capital affect dividend

policy?

61

Summary and Conclusion The ultimate goal of the firm is SH wealth maximization. Board is charged

with the strategy formulation and management oversight towards reaching this goal.

Good governance is rewarded with a higher market valuation.

Corporate governance can be improved by pursuing the goal of wealth maximization.

Attaining the competitive viability of the firm is an essential element of governance.

The firm‟s dividend payout is largely affected by its investment and financing decisions.

A number of factors affect dividend decisions, including the corporate capital structure, the cost of capital and cash flows.

Implementing globally accepted best practices of corporate governance will result in achieving better access to finance.

The active cooperation between firms and stakeholders will create wealth, jobs and sustain the financially viable enterprises.

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The End