Investors will invest in the equity of a firm so as to earn a return on that investment. Essay Example

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Investment in a Firm’s Equity

Private equity in financial terms refers to the privately owned equity securities by a company which are not traded publically. Investment in the private equity has really gone high due to high expectation of returns by the investors. According to Markowitz et al (2002, p.745) private equity close to 75% is under the ownership of the households themselves, which is more than half of the company’s net worth. The authors further note that those households that have entrepreneurial equity tend to put in more resources in their private holdings. This results to low level of diversification which often affects investment returns. Investing in the company’s equity is challenging to investors and sometimes they may not get the expected returns due to risk associated with this type of investment.

It is riskier to invest in the equity of a single firm than to invest in the public equity. Research has it that private companies have a low survival rate which is estimated to at 34% within the first ten years of the company’s life cycle, and there is a wider spread of investment returns across the investors which reduce the amount of returns allocated to individual investors. Given the risky nature of private equity for a single private company, the implication is that the total returns on investment is more likely to be an overestimation of the total investment returns to be received by individual entrepreneur (Moskowitz et al(2002, p.746). Most investors are overoptimistic about the returns on their investments in equity, and become disappointed when they do not achieve this expectation.

Shareholders’ value or earnings is the amount or returns given to shareholders by the company as a result of growth in the earnings, price of the share and dividends. Shareholders’ value affects the decision making process of the company in terms of increasing its cash flow over a given time. Shareholders earn dividends from their investments in the company. Dividends are referred to as earnings distributions made to the shareholders of the company in relation to the number of share they hold to the company (Kapoor, 2009 p.5). Managers use the payout policy to decide on the pattern and size of dividends to distribute to the shareholders. This is based on their major goal of maximizing the shareholders’ wealth. It therefore means that a company cannot at any given time pay 100% of its earnings to the shareholders in form of dividends. The company can only attain its objective by giving its shareholders what is worth to them as a return to their investment.

Firms are supposed to use dividend policies that are in line with their current development life cycle. It is practical for instance, for a mature firm with big volume of cash flows and less ongoing projects to pay a bigger percentage of its earnings to the shareholders in form of dividends. In the same perspective, it is not sensible for a company which is at its development stage with minimum cash flows to pay an extremely high percentage of its earnings to shareholders in form of dividends. It is important to understand the following facts about dividends: First, dividends come after an earning has been made implying that when earnings are high dividends will be high, and when there is a reduction in earnings, the dividends paid will definitely be low. Second, unlike the earnings, dividends usually assume a smoother path. Third, the rate at which dividends are paid to shareholders is normally constant since many companies are not willing to make changes to the dividends. Lastly, there is a big different in the kind of dividend policies used by firms relative to their various life cycles, and this is normally due to changes in the rate of cash flows, growth and the ongoing project investments (Kapoor, 2009: p.5-6).

Decisions related to the distribution of dividend are deemed important because they have a direct effect on the finances of the company, which are the cornerstone for the implementation of the growth strategy. It is significant for the company to use an optimum dividend policy in order to create value in the company. Research indicates that a decrease in the dividend payments leads to a reduction in the price per share of a firm due to the signaling effect of the dividends. This allows management to use the confidential information about the future predictions to use a dividend payout ratio that is constant (Kapoor, 2009: p.6).

References

Kapoor, Sujata. «Impact of dividend policy on shareholders’ value: a study of Indian firms.» (2011).

Moskowitz, Tobias J., and Annette Vissing-Jorgensen. The returns to entrepreneurial investment: A private equity premium puzzle?. No. w8876. National Bureau of Economic Research, 2002.

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