Financial Management B.com S3

Transcript

Financial Management III Semester B.Com FINANCIAL MANAGEMENT FINANCEFINANCE- Meaning Finance is defined as the provision of money at the time when it is required. The finance can be basically classified into two: 1. Public finance 2. Private finance Public finance deals with requirements, receipts and disbursements of funds in the government institutions likes states, local self governments and central government. Private finance concerned with requirements, receipts and disbursements of funds in the case of individuals, a profit seeking business organisation and a non- profit business organisation. Private finance can be again classified into business finance, personal finance and finance of non profit organisation. Business Finance Business finance can be defined as an activity of or process which is concerned with acquisition of funds, use of funds and distribution of profits of a business firm. Business finance can be again divided into 3 ie, sole trader finance, partnership finance and corporate finance. FINANCIAL MANAGEMENT Financial management refers to that part of the management activity which is concerned with the planning and controlling of firm’s financial resources. Importance of financial management 1. Helps in financial planning and successful completion of an enterprise. 2. Helps in acquisition of funds as and when required at the minimum possible cost 3. Helps in proper use and allocation of funds 4. Helps in taking sound financial decisions 5. Helps in improving the profitability through financial control 6. Helps in increasing the wealth of the investors and nation 7. Helps in promoting and mobilising individual corporate savings Finance function It is the most important of all business functions, because the need for money is continuous. AIMS OF FINANCE FUNCTION 1. Acquiring Sufficient Funds. The main aim of finance function is to assess the financial needs of enterprise and then finding out suitable sources for raising them. The sources Page then long-term sources like share capital, debentures, term loans may be explored. A 1 should commensurate with the needs of the business. If funds are needed for longer periods St.Berchmans [2010-11] [email protected] Financial Management III Semester B.Com concern with longer gestation period should rely more on owner’s funds instead of interestbearing securities because profits may not be there for some years. 2. Proper Utilisation of Funds. The funds should be used in such a way that maximum benefit is derived from them. The return from their use should be more than their cost. It should be ensured that funds do not remain idle at any point of time. The funds committed to various operations should be effectively utilised. Those projects should preferred which are beneficial to the business. 3. Increasing Profitability. The planning and control of finance function aims at increasing profitability of the concern. It is true that money generates money. To increase profitability, sufficient funds will have be invested. Finance function should be so planned that the concern neither suffers from inadequacy of fund nor wastes more funds than required. A proper control should also be exercised so that scarce resources are r. frittered away on uneconomical operations. The cost of acquiring funds also influences profitability of business. 4. Maximising Firm’s Value. Value Finance function also aims at maximising the value of the firm. A concern’s value is linked with its profitability. Besides profits, the type of sources used for raising funds, the cost of funds, the condition of money market, the demand for products are some other considerations which also influence a firm’s value. SCOPE OF FINANCIAL MANAGEMENT 1. Estimating Fi Financial nancial Requirements. The first task of a financial manager is to estimate short-term and long-term financial requirements of his business. For this purpose, he will prepare a financial plan for present as well as for future. The amount required for purchasing fixed assets as well as needs of funds for working capital will have to be ascertained. The estimations should be based on sound financial principles so that neither there are inadequate nor excess funds with the concern. The inadequacy of funds will adversely affect the day-to-day working of the concern whereas excess funds may tempt a management to indulge in extravagant spending or speculative activities. 2. Deciding Capital Structure Structure. The capital structure refers to the kind and proportion of different securities for raising funds. After deciding about the quantum of funds required it should be decided which type of securities should be raised. It may be wise to finance fixed assets through long-term debts. Even here if gestation period is longer, then share capital may be most suitable. Long- not be suitable. A decision about various sources for funds should be linked to the cost of St.Berchmans [2010-11] [email protected] Page Entirely depending upon overdrafts and cash credits for meeting working capital needs may 2 term funds should be employed to finance working capital also, if not wholly then partially. Financial Management III Semester B.Com raising funds. If cost of raising funds is very high then such sources may not be useful for long. A decision about the kind of securities to be employed and the proportion in which these should be used is an important decision which influences the short-term and longterm financial planning of an enterprise. 3. Selecting a Source of Finance. After preparing a capital structure, an appropriate source of finance is selected. Various sources from which finance may be raised, include : share capital, debentures, financial institutions, commercial banks, public deposits, etc. If finances are needed for short periods then banks, public deposits and financial institutions may be appropriate; on the other hand, if long-term finances are required then share capital and debentures may be useful. If the concern does not want to tie down assets as securities then public deposits maybe a suitable source. If management does not want to dilute ownership then debentures should be issued in preference to shares. The need, purpose, object and cost involved may be the factors influencing the selection of a suitable source of financing. 4. Selecting a Pattern of Investment. When funds have been procured then a decision about investment pattern is to be taken. The selection of an investment pattern is related to the use of funds. A decision will have to be taken as to which assets are to be purchased. The funds will have to be spent first on fixed assets and then an appropriate portion will be retained for working capital. Even in various categories of assets, a decision about the type of fixed or other assets will be essential. While selecting a plant and machinery, even different categories of them may be available. The decision-making techniques such as Capital Budgeting, Opportunity Cost Analysis etc. may be applied in making decisions about capital expenditures. While spending on various assets, the principles of safety, profitability and liquidity should not be ignored. A balance should be struck even in these principles. One may not like to invest on a project which may be risky even though there may be more profits. 5. Proper Cash Management. Cash management is also an important task of finance manager. He has to assess various cash needs at different times and then make arrangements for arranging cash. Cash may be required to (a) purchase raw materials, (b) make payments to creditors, (c) meet wage bills ; (d) meet day- to-day expenses. The usual sources of cash may be: (a) cash sales , (b) collection of debts, (c) short-term arrangements with banks etc. The cash management should be such that neither there is a shortage of it and nor it is idle. Any shortage of cash prepared so that one is able to find out various sources and applications. If cash is spent on St.Berchmans [2010-11] [email protected] Page mean that it is not properly used. It will be better if Cash Flow Statement is regularly 3 will damage the creditworthiness of the enterprise. The idle cash with the business will Financial Management III Semester B.Com avoidable expenses then such spending may be curtailed. A proper idea on sources of cash inflow may also enable to assess the utility of various sources. Some sources may not be providing that much cash which we should have thought. All this information will help in efficient management of cash. 6. Implementing Financial Controls. An efficient system of financial management necessitates the use of various control devices. Financial control devices generally used are, : (a) Return on investment, (b) Budgetary Control, (c) Break Even Analysis., (d) Cost Control, (e) Ratio Analysis (i’) Cost and Internal Audit. Return on investment is the best control device to evaluate the performance of various financial policies. The higher this percentage better may be the financial performance. The use of various control techniques by the finance manager will help him in evaluating the performance in various areas and take corrective measures whenever needed. 7. Proper Use of Surpluses. The utilisation of profits or surpluses is also an important factor in financial management. A judicious use of surpluses is essential for expansion and diversification plans and also in protecting the interests of shareholders. The ploughing back of profits is the best policy of further financing but it clashes with the interests of shareholders. A balance should be struck in using funds for paying dividend and retaining earnings for financing expansion plans, etc. The market value of shares will also be influenced by the declaration of dividend and expected profitability in future. A finance manager should consider the influence of various factors, such as : (a) trend of earnings of the enterprise, (b) expected earnings in future, (c) market value of shares, (d) need for funds for financing expansion, etc. A judicious policy for distributing surpluses will be essential for maintaining proper growth of the unit. OBJECTIVES OF FINANCIAL MANAGEMENT Financial management is concerned with the procurement and use of funds. Its main aim is to use business funds in such a way that the firm’s value is maximised. The main objective of a business is to maximise the owner’s economic welfare and it can be achieved by; 1. Profit maximisation 2. Wealth maximisation Profit maximisation Profit earning is the main aim of every economic activity. Profit is a measure of efficiency of a business enterprise. The accumulated profits enable a firm to face risks like fall in prices, 4 competition from other units, etc. There are so many arguments in favour and against profit St.Berchmans [2010-11] Page maximisation [email protected] Financial Management III Semester B.Com For:
When profit earning is the aim of business then the profit maximisation should be the objective.
Profitability is the barometer of efficiency of a business organisation.
Profits are the main sources of finance for the growth of the business. So it should aim maximising profits
Profitability is essential for fulfilling social goals. Against:
The term profit is vague and it cannot be defined.
It ignores the time value of money and not considers the magnitude and timing of earnings.
It does not consider the prospective earnings stream.
The effect of dividend policy on the market price of share is not considered.
Profit maximisation leads to exploiting workers and consumers
Immoral and leads to malpractices and corruptive actions
It leads to inequalities and lowers human values which are an essential part of an ideal social system. Wealth maximisation When the firm maximises the stockholders wealth, the individual stockholder can use this wealth to maximise his individual utility. In other words by maximising stockholder’s wealth the firm is operating consistently towards maximising stockholder’s utility. There are so many arguments in favour and against wealth maximisation, like; For:
It serves the interest of all stakeholders of the business [shareholders, creditors, employees etc]
Consistent with the objective of owner’s economic welfare
It implies the long term survival and growth of the business
It considers the risk factor and time value of money
The effect of dividend policy on market price of share is also considered
It leads to maximising shareholders utility Against:
It is not socially desirable
It does not give an idea about, what the firm should do to maximise the wealth
It is not clear that whether the wealth of the shareholders or the wealth of the firm is to be increased. The objective faces difficulty when the management is separated from ownership Page 5
St.Berchmans [2010-11] [email protected] Financial Management III Semester B.Com FINANCIAL DECISIONS It refers to the decisions concerning the financial matters of a business firm. They can be broadly classified as under; 1. Investment decisions 2. Financing decisions 3. Dividend decisions Investment decisions It refers to the determination of total amount of assets to be held in the firm, the proportion of the assets and business risk associated with it. In other words it is a decisions related to the investment in fixed assets and current assets and the proportion of these two in the business firm. Investment decisions are broadly classified into; a. Long term investment decisions b. Short term investment decisions Long term investment decisions are known as the capital budgeting and short term investment decisions are known as working capital management. Financing decisions It means the selection of the sources of fund which will make the optimum capital structure. At the time of raising of finance the financial managers has to strike a balance between various sources so that the overall profitability of the business firm and wealth of the shareholders are maximised. Dividend decisions Dividend refers to that part of the profit of the company, which is distributed among its shareholders. A dividend decision includes whether all the profit are to be distributed or retain all the profit in the business or retain a part of the profit and distribute the rest as Page 6 dividend. St.Berchmans [2010-11] [email protected] Financial Management III Semester B.Com TIME VALUE OF MONEY The concept time value of money explains that the value of money received today is more than the value of same amount of money received after a certain period. In other words money received in the future is not as valuable as money received today. As per the time value of money concept, the sooner one receives, the money the better it is. The value of current receipt of money is higher than the future receipt of money after one year. This phenomenon is known as time preference of money. Reasons for time preference of money 1. The future is uncertain and involves risk. Therefore an individual can never be certain of getting cash inflow in future and hence he will like to receive the money today itself, instead of waiting for the future. 2. For people the present needs are more urgent than the future needs. 3. Opportunities available to invest the money received at the earlier days at the some interest or otherwise to enhance the future earnings. Techniques of Time Value of Money There are 2 techniques to adjust time value of money; 1. Compounding technique 2. Discounting technique. 1. COMPOUNDING TECHNIQUE The time preference for money encourages a person to receive money at present instead of waiting for future. But he may like to wait if he duly compensated for the waiting time by way of money at the end of a period. The future value of money at the end of a period can be calculated by using the formula. V1=V0(1+i)n Where; V1= future value of money at the end. V0= value of money at the beginning i = interest rate n= no. of years Doubling Period Doubling period means the length of period within which an amount is going to take double at a certain rate of interest. Doubling period can be calculated be following either Rule 72 or Rule 69 Rule 72 Doubling period = 72/ Rate of interest 7 Rule 69 St.Berchmans [2010-11] Page Doubling period = 0.35+(69/ Rate of interest) [email protected] Financial Management III Semester B.Com Multiple compounding Multiple compounding period means the compounding the interest more than once in a year like, half yearly or quarterly. VO= V1(1+i/m)m x n where; V1= future value of money at the end of a period V0= value of money at the beginning i = rate of interest n= no. of years m= frequency of compounding per year Effective rate of interest Effective rate of interest means the additional growth in the rate of interest due to multiple compounding. It is because the actual rate of interest realised [effective rate of interest] in multiple compounding is more than the normal rate of return. EIR= (1+i/m)m-1 Where; i = the normal rate of interest m= frequency of compounding per year Future value of series of payments Vn= R1(1+i)n-1+ R2(1+i)n-2 + R3(1+i)n-3 Where; Vn=future value of series of payments R1= payment after first period R2= payment after second period R3= Payment after third period i= rate of interest n= no. of years Compounded value of annuity An annuity is a series of equal payments lasting for some specified duration. When cash inflows occur at the end of each period the annuity is called a regular annuity or deferred annuity. Vn= R [( [(1+i)n-1+( 1+i)n-2+( 1+i)n-3] or Vn= R [ACF i,n] Where; 8 Vn= future value of annuity Page R= equal payments n= No .of years St.Berchmans [2010-11] [email protected] Financial Management III Semester B.Com i = rate of interest ACF= annuity compound factor Compounded value of annuity due If the cash inflow occurs at the beginning of each period the annuity is called annuity due. Vn= R [ACF i,n]( 1+i) Where; Vn= future value of annuity R= equal payments n= No .of years i = rate of interest ACF= annuity compound factor 2. DISCOUNTING TECHNIQUE The present value is exact the opposite of compound value or future value. While the future value shows how much sum of money becomes at future period, present value shows what the present value of some future sum of money. The present value of money to be received in future will always be less. The present value of a future sum of money can be calculated as follows; V0= Vn/ (1+i) or V0= Vn X DF i,n Where; V0= present value of money Vn= future value of money i = rate of interest DF= discount factor N= no.of years Present value of series of payments V0= [R1/(1+i)] +[R2/(1+i)2] +[R3/(1+i)3] +[R4/(1+i)4] Where; Vn=future value of series of payments R1= payment after first period R2= payment after second period R3= Payment after third period i= rate of interest n= no. of years V0= R [ADF i,n] St.Berchmans [2010-11] [email protected] Page An annuity is a series of equal payments lasting for some specified duration. 9 Present value of annuity Financial Management III Semester B.Com Where; Vn=future value of series of payments R= series of equal payments i= rate of interest n= no. of years Present value of annuity due If the cash inflow occurs at the beginning of each period the annuity is called annuity due. V0= R [ADF i,n]( 1+i) Where; Vn=future value of series of payments R= series of equal payments i= rate of interest n= no. of years Page 10 ADF= annuity discounting factor St.Berchmans [2010-11] [email protected] Financial Management III Semester B.Com WORKING CAPITAL MANAGEMENT Working capital management is concerned with the problems that arise in attempting to discuss in details various tools and techniques which can be gainfully employed to solve the problem of determining optimum level of working capital. Working capital - Meaning Working capital is defined as the "excess of current assets over current liabilities and provisions". That is, the amount of surplus of current assets which remain after deducting current liabilities from total current assets which is equal to the amount invested in working capital, consisting of work-is-progress, raw materials and stocks, consumable items, amounts owing by customers and cash at the or bank in hand. Shubin defines working capital as “the amount of funds necessary for the cost of operating the enterprise”. Working capital in a going concern is a revolving fund; consist of cash receipts from sales which are used to cover the cost of operation. In accounting working capital is the difference between inflow and out flow of funds. In other words it is the net cash flow. It is also known as circulating capital, fluctuating capital and revolving capital. Need for Working Capital Working Capital is significant because of: a. Adequate working capital is required to continue uninterrupted business operations b. It is essential to run the day to day business activities c. Greater volume of working capital required to invest in current assets for the success of sales activities d. To ensure the maximizing the wealth of the firm e. To enable to increase the rate of return on investment f. To meet the short-term obligations of a business enterprise To increase the operational efficiency of a firm g. To utilize the maximum available resources Concepts of working capital There are two concepts of working capital a. Balance sheet and b. Operating cycle concept Balance sheet concept There are two variations of working capital under this concept: 2. Net working capital Gross Working Capital: The term Gross Working Capital refers to the total of all current St.Berchmans [2010-11] [email protected] Page 11 1. Gross working capital Financial Management III Semester B.Com assets. In other words, the firm's investments in total current or circulating assets. Current assets represent short term securities, sundry debtors, bills receivable, stock (inventories) etc. The Gross concept of working capital is very suited to company organization where ownership is separated from management and control. Advantages of Gross Working Capital: This concept has the following advantages: (1) It provides the amount of working capital at the right time. (2) It enables a firm to realize the greatest return on its investment. (3) It helps in the fixing of various financial responsibilities. (4) It helps to the top executives to make plan and control funds and to maximize the return on investment. (5) It enables a firm to operate its business more efficiently. Net Working Capital : The net concept of working capital is qualitative, indicating the firm’s ability to meet its operating expenses and current liabilities. The term net working capital refers to the difference between current assets and current liabilities. Net working capital = current assets – current liabilities. Current assets are those assets which in the ordinary course of business can be, or will be turned in to cash within one year undergoing a diminution in the value or without disrupting the operations of the firm. Current assets= cash+ marketable securities+ accounting receivables+notes and bills receivables +stock Current liabilities are those liabilities which are intended at their inception to be paid in the ordinary course of business, within a year, out of the current assets or earnings of the concern. Current liability= accounts payable+ bills payable+ outstanding expenses+ shortter loans Positive or negative working capital: the working capital of a firm may be positive or negative working capital. If the value of current liabilities is more than current assets then it is negative working capital. Difference between gross concept and net concept of working capital Net working capital is the concept of
qualitative nature.

It is indicating the firm's ability to quantitative nature.
It is pointing out the total amount meet its operating expenses and available for financing the current current liability. assets. It expressed as current assets minus current liability.
Gross concept of working capital is It is a concept very popular in St.Berchmans [2010-11]
It indicating the total sum of Current assets.
It is a concept very popular in [email protected] 12
Gross Working Capital Page Net Working Capital Financial Management III Semester B.Com accounting system. Net concept suitable for sole Trader
financial management circles.
and partnership firms. It is useful to find out the true
Gross concept suitable for companies
financial position of a company. It can not reveal the true financial position of a company. Operating cycle concept Working capital refers to that part of a firms capital which is required for financing short term or current assets. The operating cycle concept of working capital is based on operating cycle of firm. The term operating cycle otherwise known as "Cash Cycle". In order to earn sufficient profits, a firm has to depend on its sales activities apart from others. Sales are not always converted into cash immediately, i.e., there is a time lag between the sale of a product and the realization of cash. The continuing flow from cash to supplier to investors, to account receivable and back in cash. This time gap is technically termed as operating cycle. In case of a manufacturing firm, firm the duration of time required to complete the following sequence of events is called the operating cycle. (1) Conversion of cash into raw materials (2) Conversion of raw materials into work-in-progress (3) Conversion of work-in-progress into finished goods (4) Conversion of finished goods into accounts receivable and (5) Conversion of accounts receivable into cash. In the case of nonnon-manufacturing firm, firm the operating cycle will include the length of time Cash into inventories; (b) Inventories into accounts receivable; (c) Accounts receivable into cash. St.Berchmans [2010-11] Page (a) 13 required to convert: [email protected] Financial Management III Semester B.Com In the case of service and financial concerns may not have any inventory at all. So the operating cycle include the length of time taken for direct conversion of cash. The following formula is used to express the duration of working capital cycle O =R+W+F+D=R+W+F+D-C [where] O== total period of the operating cycle in number of days R= number of days for holding stock of raw materials and stores W= number of days for holding stock of work in progress with regard to cost of production F= number of days for holding stock of finished goods with regard to cost of production D= debtors collection period C= credit payment period. Kinds of Working Working Capital The Working Capital includes the following broad classifications 1. On the basis of Concept a. Gross Working Capital b. Net Working Capital i. Positive Net Working Capital ii. Negative Net Working Capital 2. On the basis of Time a. Permanent Working Capital i. Regular working capital ii. Reserve working capital b. Temporary Working Capital Permanent Working Capital: The minimum amount of current assets why are kept by a firm over the entire year to ensure uninterrupted course of operation. The minimum level St.Berchmans [2010-11] [email protected] Page ii. Special working capital 14 i. Seasonal working capital Financial Management III Semester B.Com of current asset is referred to as permanent working capital. It is termed as Regular Working Capital or Core Working Capital or Fixed Working Capital. Permanent working capital is classified as regular working capital and reserve working capital. Regular working capital ensures the circulation of current assets from cash to stock, from stock to debtors and debtors to cash and so on. Reserve working capital is the excess amount over the requirement for regular working capital which may be provided for contingencies situations. Permanent Working Capital has following characteristics; a. Continue to exist for a longer period of time in the business. b. Constantly changes in the business from one asset to another. c. Required to meet permanent obligations along with other fixed assets. d. Grows the size or volume of business operations. e. Classified on the basis of the time factor. f. Minimum level of working capital always required to be maintained. Temporary Working Capital: Any amount over and above the permanent level of working is Temporary or Fluctuating or Variable Working Capital. In other worlds, it represents additional current assets required to meet fluctuations during the operating year. As it fluctuates according to the level of operation, it is termed as Fluctuating working Capital. Temporary working capital is classified as Seasonal working capital and special working capital. Seasonal working capital is for meeting the seasonal requirements and special working capital for meeting special situations like, launching new marketing campaigns etc. Temporary working capital has following characteristics; a. It is an extra working capital needed to changing production and sales activities. b. It is created to meet `liquidity requirements. c. Temporary working capital is fluctuating during the operating period. d. It fluctuates according to the level of operations. e. It is needed for shorter period. Reasons for change in working capital. 1. Change in the level of sales activities 2. Change in the level of operating activities 3. Policy change initiated by management 4. Technological changes 5. Cyclical change in the economy 6. Changes in the operating cycle Dangers of Excess Working Capital The success and otherwise of a business depends on the adequacy of the said capital St.Berchmans [2010-11] [email protected] Page 15 7. Sources of change is seasonally in sales activity. Financial Management III Semester B.Com maintaining a desired level. Both excessive or inadequate working capital poses a serious problem to a company which may even lead to its doom. Excessive working capital means idle fund which earn no profits for the firm. Inadequate working capital impairs firm's profitability and liquidity . When working capital is excessive, a firm faces the following 1) It leads to unnecessary purchase and accumulation of inventories. (2) Excessive working capital results in imbalance between liquidity and profitability (3) It is an indication of defective credit policy (4) A company may not be tempted to overtrade and lose heavily. (5) Excessive working capital leads to operational inefficiency because large volume of funds not being used productively. (6) This makes management complacent which degenerates into managerial inefficiency. (7) High liquidity may induce a firm to undertake great production which may not have a matching demand. Dangers of Inadequate Working Capital When working capital is inadequate, a firm faces the following problems. (1) Inadequate working capital causes stagnates growth and expansion (2) It may not able to utilize production facilities fully (3) It becomes difficult to take advantages of profitable business opportunities (4) It may not able to efficiently utilized fixed assets. This leads to low profitability (5) A firm may not able to take advantages of cash discount facilities. (6) Inadequate working capital causes paucity of funds. This leads to damage creditworthiness of the firm (7) It may not able to meet short term obligation (8) Inadequate working capital causes unable to pay its dividends and interest (9) A firm may not able to meet its day to day commitments. This leads to firm, loses its reputation. Factors determining determining the Working Capital Capital The total working capital requirement is determined by a wide variety of factors. It should be however, noted that these factors affect different enterprises differently. The following is the description of the factors which generally influence the working capital requirements of the firms. Internal factors. 1. Nature of Enterprise. 2. Size of business 16 3. Manufacturing cycle Page 4. Firm’s credit policy 5. Access to money market St.Berchmans [2010-11] [email protected] Financial Management III Semester B.Com 6. Expansion and growth of business 7. Profit margin and dividend policy 8. Depreciation policy 9. Operating efficiency of the firm 10. Co-ordination activities of the firm External factors 1. Business cycle fluctuations 2. Technological developments 3. Seasonal fluctuations 4. Environmental factors 5. Taxation policy Internal Factors (1) Nature of Enterprise: The working capital requirements of a firm basically influenced by the nature of its firm. For example, trading and financial firms require a large amount of investment in working capital but a significantly smaller amount of investment in fixed assets. But in the case of manufacturing concern have to invest substantially in working capital and a normal amount in fixed assets. In contrast public utilities have a very limited need for working capital, while a merchandising department depends generally on inventory and receivable need a large amount of working capital. Needs for working capital are thus determined by the nature of an enterprise or business. (2) Size of Business. The size of the firm is also an important factor to requirements of working capital. Because a smaller firm needs smaller amount of working, capital on the basis of its production activities and vise versa in the opposite case. (3) Manufacturing Cycle: Time span required for conversion of raw materials into finished goods is to block period. The period in reality extends a little before and after the work-in-progress. This cycle determine the need of working capital. (4) Firm's Credit Policy: The level of working capital is also determined by credit policy which relates to sales and purchases. The credit policy influences the requirement of working capital in two ways (a) Through credit terms granted by the firm to customers/ buyers of goods; (b) Credit terms available to the firm from its creditors. Access to Money Market: Working capital requirements of a firms are condition--- by the firm’s access to different sources of money market. Thus, firm with readily available credit (5) from banks and trade credit facilities at liberal terms will be able to get by W-= less Expansion Expansion and Growth of Business: It is obvious that, as business expands it will require more working capital in terms of sales or fixed assets. In the case of growth and expansion, there will be an increase in investment. With the increase in fixed assets for St.Berchmans [2010-11] [email protected] Page (6) 17 working capital than a firm without such facilities. Financial Management III Semester B.Com increasing sales the requirement of working capital will be expanded not only for financing increased volume of raw materials but also to finance maintenance of inventory stock and grant credit to customers. (7) Profit Margin and Dividend Policy: Magnitude of working capital in a firm depend upon its profit margin and dividend policy. As a matter of fact, a high net profit margin reduces the working capital requirements of the firm because it contribute towards working capital pool. Similarly, distribution of high proportion of profits in the form of dividend result in a drain on cash resources and thus reduces company's working capital to that extend. Where the management follows constructive dividend policy and retain larger portion of the net profits, the company's working capital position is strong. (8) Depreciation Policy: The depreciation policy influences the level of working capital by affecting the tax liability and retained earnings of the enterprise. Since depreciation is tax deductible expense item, this will affect the firm's tax liability and retained earnings and thus strengthen the firm's working capital position. (9) Operating Efficiency of Firm: The operating efficiency of management is also an important determinant of the level of working capital management can contribute to a sound working capital position through operating efficiency. Efficiency of operations accelerates the pace of the cash cycle and improves the working capital turnover. (10) CoCo -ordination Activities of Firm: In addition, absence of co-ordination in action and distribution policies in a company results in a high demand for working capital. Where production and distribution activities are co-ordinate, pressure on working capital will be minimized. External Factors Business Cycle Fluctuations: Fluctuations: This is another factor which determines the need level. Barring exceptional cases, there are variations in the demand for goods/services handled by (1) any organization. Economic boom/recession have their influence on the transactions and consequently on the quantum of working capital required. (2) Technological Development: Changes in technologies may lead to improvements in processing raw materials, minimizing wastages, greater productivity, more speed of production. All these improvements may enable the firm to reduce investments in inventory. Thus changes in technology affect the requirements of working capital. If the firm decides to go for automation, thus world reduce the requirements for working capital. If the firm adopts a labour intensive process, the requirement for working capital will be larger Seasonal Fluctuations: Seasonal fluctuations in sales affect the level of variable working capital. Often the demand for products may be of a seasonal nature. Yet capital in one period may therefore, be bigger than that in another. St.Berchmans [2010-11] [email protected] Page inventories have got to be purchased during certain seasons only. The size of working 18 (3) Financial Management (4) III Semester B.Com Environment Factors: Political stability in its wake bring in stability in money market and trade world. Risk ventures are possible with enhanced need for working capital finance. (5) Taxation Policy: Taxes must be paid out of profits. Tax liability is unavoidable and adequate provision should be made for it in working capital planning. If the tax liability increases, it will impose an additional strain on working capital. The finance manager must do tax planning in order to avail the benefits of all sorts of tax concessions and incentives. Working Capital Financing Mix There are three basic approaches for determining the working capital financing mix. They are; 1. Hedging or matching approach 2. Conservative approach 3. Aggressive approach 1. Hedging Approach This approach suggests that the permanent working capital requirement should be financed with funds from long term sources while the temporary working capital should be financed with short term funds. 2. Conservative approach As per this approach, the entire estimated investments in current assets should be financed from long term sources and the short term sources should be used only for emergency requirements. In this finance mix liquidity is greater, risk is minimum and cost is relatively high. 3. Aggressive approach This approach suggests that, the entire estimated requirements of current assets should be financed from short term sources and even a part of fixed assets requirements be financed from short term sources. This finance mix is more risky, less costly and more profitable. Principles of working capital management policy The following are the sound principles of a sound working capital management policy; 1. Principle of risk variation 2. Principles of cost of capital 3. Principle of equity position 4. Principle of maturity of payment. Principle of risk variation: There is inverse relationship between risk and profitability. A firm can prefer to minimize the management should keep a suitable balance between profitability and risk. Principles Principles of cost of capital: capital: St.Berchmans [2010-11] [email protected] Page reducing working capital. As per the risk varies according to the level of working capital, 19 risk by maintaining a higher level of current assets or working capital or maximize risk by Financial Management III Semester B.Com Different sources of working capital have different cost of capital and different degree of risk. The higher the risk, lower the cost and lower the risk, higher the cost. A sound working capital management policy should maintain a proper balance between cost and risk associated with it. Principle of equity position As per this principle, the amount of working capital invested in each component should be adequately justified by a firm’s equity position. Every rupee invested in current assets should contribute to the net worth of the firm. Principle of maturity of payment. A firm should make effort to relate maturities of payment to its flow of internally generated funds. Maturity patterns of various current obligations is an important factor in risk. Estimation of Working Capital Requirements The term working capital as already point out, usually means the excess of current assets over current liabilities. In reality such excess of current assets over current liability may be either more or less than the working capital requirement of the company. Assessing the requirements of working capital to be employed during the immediate future period of operations. The working capital requirements can be determined by the following three techniques (1) Percentage of Sales Method. (2) Estimation of Components of Working Capital Method. (3) Operating Cycle Approach (or) Cash Working Capital Method. 1. Percentage of Sales Method: This is simple and traditional method. According to percentage of sales method, the requirement of working capital can be determined or the basis of sales, amount of working capital required and prior year's experiences. In this method, the working capital is calculated and expressed it as a percentage to sales This method is much useful in planning short term working capital requirements However, the basic criticism of this method is that it assumes a linear relationship between sales and working capital. Therefore, this method is not universally accepted 2. Estimation of Components of Working Capital Method: The second method is useful in estimating working capital requirements on the basis of the components current assets and current liabilities. These components include inventories, Account: receivables, Accounts payables, Marketable investments, Short Term Obligations etc This method is widely discussed in the chapter of cash management of this book. It practically suitable for long term forecasting. Symbolically, it can be expressed as: known as 'cash working capital method'. In estimating the working capital cycle require for a business, the volume of cash needed to finance the entire process the cycle is to be taken in St.Berchmans [2010-11] [email protected] Page 3. Operating Cycle (or) Cash Working Capital Method. Operating cycle method otherwise 20 Working Capital = Current Assets - Current Liabilities Financial Management III Semester B.Com to consideration. Accordingly, this method suggests that actual level of working capital requirement of a firm in a period can be appropriately determined with reference to the length of net operating cycle and the volume of cash needed to meet the operation expenses for the period. In other words, the operating cycle refers u the period The following formula is used to express the duration of working capital cycle O =R+W+F+D=R+W+F+D-C where O== total period of the operating cycle in number of days R= number of days for holding stock of raw materials and stores W= number of days for holding stock of work in progress with regard to cost of production F= number of days for holding stock of finished goods with regard to cost of production D= debtors collection period C= credit payment period. PLANNING OF WORKING CAPITAL Objectives of Working Capital The following are the main objectives of adequate working capital management (1) Availability of adequate funds (2) Minimum cost (3) Matching (balance) between profitability and liquidity (4) Flexibility (5) Optimum use of funds (1) Availability of Adequate Funds: A sound working capital financial plan must ensure the supply of adequate amount of working capital needed by the business enterprises, both for current and future needs. (2) Minimum Cost: The fund required by the firm should be made available at the lowest cost. It is made possible through planning, considering in advance various cost factors and trends of capital market and suggesting the best course of action. (3) Matching (Balance) Between Profitability and Liquidity: Liquidity A judicious balance between profitability and liquidity is one of the fundamental principles of successful finance planning. Profitability and liquidity are inversely related. The working capital financial plan must ensure sufficient amount of investment in those assets which are liquid cash and near-cash assets. (4) Flexibility: The working capital financial plan should be dynamic in nature. In other structure. Such changes become necessary due to changes in business conditions in future. Page SOURCE OF WORKING CAPITAL Source of working capital can be basically classified into following; St.Berchmans [2010-11] 21 words, it should provide sufficient scope for change and re-adjustment in the financial [email protected] Financial Management III Semester B.Com 1. Long term source a. Issue of share b. Floating of debentures c. Long term loans d. Public deposits e. Private loans f. leasing 2. Medium and short term a. Internal i. Depreciation ii. Taxation provision iii. Accrued expanses iv. Private loans v. Reserves and provisions b. External i. Bank credit ii. Trade credit iii. Customers credit iv. Hire purchase and sale v. Government assistance vi. Accounts receivables. Long Term Source of Working Capital 1. Issue of Shares: This is the most common method of raising the permanent working capital. Every company generally uses this method. “Shares” may be defined as “the share in the capital of a company and des stock expect where a distinction between stock and share is expressed or implied.” Shares are of two types. Equity shares and preference shares. 2. Floating of Debentures: It is also an important source of long term working capital. A debenture is a document issued by a company as an evidence of a debt due from the company with or without a charge on the asset of the company. Debenture includes debenture stock, bonds and any other ties of a company whether constituting a charge on the assets of the company or not. 3. Long Term Loans: Long term loans are one of the important sources of permanent working capital. Financial institutions and commercial banks provide loans for augmenting long term working capital needs and for meeting additional margin money requirements 4. Public Deposits/Loans : The issue of public deposits is directly related to the image of the company seeking to invite deposits. Many companies accept deposits as permanent working St.Berchmans [2010-11] [email protected] Page diversifications etc. 22 for working capital arising out of increase in volume of operations, expansion, Financial Management III Semester B.Com capital from members, directors and the general public. This mode of raising funds is becoming popular these days on account of bank credit becoming quiet costlier. 5. Sale of Unwanted Assets:. Considerable amount of working capital can be raised by the sale of unwanted or unutilized assets of land, building, machinery, furniture, scrap and loose tools etc. 6. Private Loans: Lending private institutions and private banks are granting permanent working capital at a fixed rate of interest against securities to meet the operational expenses. 7. Equipment Leasing: Companies can get the permanent working capital assistance by offering equipment leasing facilities. Financial institutions and commercial banks provides facilities for leases indigenously procured imported machinery and equipment for a period of 5 to 8 years with a 90% principal amortization through lease rentals over the period Medium and and Short Term Sources of Working Capital Internal sources 1. Depreciation: Depreciation means decrease in the value of asset due to wear lapse of time, obsolescence, exhaustion and accident. Depreciation reserves a good source of funds for working capital. It is as a non-cash expense, and it represent any cash outlay with the result that part of the profits adjusted for depreciation can be used by management to increase any of the current assets or pay dividend etc. 2. Taxation Provision: Provision for taxation is one of the internal sources of medium and short-term working capital. According to Income Tax Act, firms are liable to pay income tax on the assessable net profit as per rate prescribed for the same by Finance Act from time to time. Normally, there is a time lag between the creation of the provision for taxes and their actual payment. And in the period the resources as against this provision which remain within the enterprise may be used as a source of working capital 3. Accrued Expenses: Accrued expenses otherwise known as outstanding expenses The firm can postpone the payment of expenses for shorter periods. This constitute as an internal source of medium and short-term working capital. 4. Private loans: Lending private institutions and private banks are granting medium and short-term working capital at a fixed rate of interest against securities to meet the operational expenses. 5. Reserves and Provisions: It is provided for meeting prospective losses or liabilities. creation of reserve and provision to increase the working capital in the business and as additional working capital but is invested in purchase of outside securities, then it Page is called reserve fund. External Sources St.Berchmans [2010-11] 23 strengthen its financial position. Sometimes, the amount is not kept in the business [email protected] Financial Management III Semester B.Com 1. Bank Credit: Credit Bank credit is one of the important external sources of medium and shortterm sources of working capital. It is arranged by which a banker allow his customer to borrow money up to a certain limit. Cash credit arrangements are usually made against the security of commodities hypothecated or pledged with the bank. 2. Trade Credit: Trade credit is a form of medium and short-term financing common to all type of business firm. It is the largest source of temporary working capital. Most buyers are not required to pay for goods on delivery. Trade credit is also granted by the seller of raw materials and goods to manufactures and/ or wholesaler. It generally takes the form of discount for cash payment on delivery and net for future payment. This credit may take the form of (a) Open account credit arrangement (b) Acceptance credit arrangement. In the case of an open account credit arrangement, the buyer does not sign a formal debt instrument as an evidence of the amount due by him to the seller while in the case of acceptance. 3. Discounting Bills: Companies can get the medium and short-term working capital assistance by discounting their bill of exchange, promissory notes from banks. These documents are discounted by the banks at a price lower than their face value. 4. Accounts Receivable Financing: Under this arrangement, the account receivable of a business concern are bought by a financing company or money may be advanced on securing of accounts receivable. Normally, 60% of the value of accounts receivable pledged is advanced by the finance companies. If there are any bad debts, it is to be borne by the business concern itself. 5. Government Assistance: Government undertakes a variety of promotional activities including provides subsidies and short-term working capital assistance for the acquisition and installation of energy conversion equipment. It extends the facility of granting loans, tax concessions for projects involving the development and use of indigenous technology and for adopting and development of imported technology, as well as high risk, high return ventures. 6. Customer Credit: This is also known as installment credit as it is usually allowed by retailers for selling consumer durable goods. Some portion of the cost price of the asset is paid at the time of delivery and the balance is paid in number of installments along with the interest. Sometimes, installment credit is granted by financial companies or banks which have special arrangements with the suppliers. 7. Loans from Directors: A business firm may resort to miscellaneous source of finance in periods of pressing working capital needs. Specialized financial institutions also provide medium and short-term working capital to companies engaged in leasing and financing or industrial plant and machinery or durable customer goods. St.Berchmans [2010-11] [email protected] Page 8. Hire Purchase and Sale: Financial institutions and commercial banks grant loans as 24 finance to their client units in times of need. The cost of these funds is nominal. Financial Management III Semester B.Com COST OF CAPITAL Cost of capital is the rate of return the firm requires from investment in order to increase the value of the firm in the market place. In economic sense, it is the cost of raising funds required to finance the proposed project, the borrowing rate of the firm. Thus under economic terms, the cost of capital may be defined as the weighted average cost of each type of capital. There are three basic aspects about the concept of cost 1. It is not a cost as such: The cost of capital of a firm is the rate of return which it requires on the projects. That is why; it is a ‘hurdle’ rate. 2. It is the minimum rate of return: A firm’s cost of capital represents the minimum rate of return which is required to maintain at least the market value of equity shares. 3. It consists of three components. A firm’s cost of capital includes three components a. Return at Zero Risk Level: It relates to the expected rate of return when a project involves no financial or business risks. b. Business Risk Premium: Business risk relates to the variability in operating profit (earnings before interest and taxes) by virtue of changes in sales. Business risk premium is determined by the capital budgeting decisions for investment proposals. c. Financial Risk Premium: Financial risk relates to the pattern of capital structure (i.e., debt-equity mix) of the firm, In general, a firm which has higher debt content in its capital structure should have more risk than a firm which has comparatively low debt content. This is because the former should have a greater operating profit with a view to covering the periodic interest payment and repayment of principal at the time of maturity than the latter. Significance of Cost of Capital rate for selecting the capital expenditure projects. The capital budgeting decision St.Berchmans [2010-11] [email protected] Page 1. Capital Budgeting Decisions: The concept of cost of capital can serve as a discount 25 The cost of capital is significant because of the following cases; Financial Management III Semester B.Com after all is the matching of the costs of the use of funds with the returns of the employment of funds. Thus the financial manager can arrive at the break-even point in the capital structure the point at which the rate of return of a given project equals the cost of procuring funds for that project. 2. Capital Structure Decisions: The concept of cost of capital is an important consideration in capital structure decisions. It helps to devise an optimal capital structure with an ideal debt-equity mix based on minimum costs Classification of cost of capital Cost of capital can be brought as under:
Explicit Cost and Implicit Cost
Future Cost and Historical Cost
Specific Cost and Combined Cost
Average Cost and Marginal Cost 1. Explicit Cost and Implicit Cost The explicit cost of any source of finance may be defined as the discount rate that equates the present value of the cash inflows (that are incremental to the taking of the financing opportunity) with the present value of its expected cash outflows. In other words, the explicit cost is the internal rate of return the firm pays for financing. The implicit cost may be defined as the rate of return associated with the best investment opportunity for the firm and its shareholders that will be forgone if the projects presently under consideration by the firm were accepted. When the earnings are retained by a firm, the implicit cost is the income which the shareholders could have earned if such earnings would have been distributed and invested by them. In short, the explicit cost arises when the capital is raised and implicit cost of capital arises whenever funds are used. 2. Future Cost Cost and Historical Cost If future cost is the expected cost of funds for financing a project, historical cost is the cost which has already been incurred for financing a particular project. In financial decision making process, the relevant cost is future cost. 3. Specific Cost and Combined Cost The cost of each component of capital, i.e., equity shares, preference shares, debentures, loan, etc., is called the specific cost of capital. The firm should consider the specific cost, while determining the average cost of capital. When specific costs are combined to find out the overall cost of capital, it is called shares, debentures and other loans). This concept of capital is used as a basis for accepting St.Berchmans [2010-11] [email protected] Page capital is inclusive of all costs of capital from all sources (i.e., equity shares, preference 26 the combined cost or composite cost. In other words, the combined or composite cost of Financial Management III Semester B.Com or rejecting the proposal in capital investment decisions although various proposals are financed through various sources. 4. Average Average Cost and Marginal Cost Average cost of capital is the weighted average of the cost of each component of funds invested by the concern. But the weights are in proportion of the shares of each component of capital in the total investment. Marginal cost of capital is the cost of additional amount of capital which is raised by a firm Approaches of cost of capital 1. Traditional Approach As per this approach, the cost of capital of a firm relates to its capital structure. In other words, the cost of capital of the firm is the weighted average cost of debt and the cost of equity. However, the raising of funds by way of debentures is cheaper. This is mainly due to the following facts: a. Usually, interest rate is less than dividend rates. b. Interest is allowed as an expense while taxable profit of the company is computed. But dividend is not allowed as an expense. The main argument in favour of this approach is that the weighted average cost of capital will go up with every increase in the debt content in the total capital employed. However, the debt content in the total capital employed must be maintained at a proper level as the cost of debt is a fixed burden. Moreover, when the debt content goes up beyond a certain level, the investors consider the company too risky and their expectations from equity shares will go up. 2. Modigliani and Miller Approach Under this approach, the total cost of capital of a company is constant and independent of its capital structure. In other words, a change in the debt-equity ratio does not affect the total cost of capital. The main arguments of MM approach are:
The total market value of the firm and its cost of capital are independent of its capital structure. The total market value of the firm can be calculated by capitalising the expected stream of operating earnings at a discount rate considered appropriate for its risk class.
The cut-off rate for investment purposes is completely independent of the way in This indicates that: a. Investors have full-fledged freedom to buy and sell securities. St.Berchmans [2010-11] [email protected] Page Assumptions of MM Approach 1. Perfect Capital Ma Market: rket: Trading of securities takes place in perfect capital market. 27 which investment is financed. Financial Management III Semester B.Com b. As investors are completely knowledgeable and rational persons, they can know at once all information and changes. c. The buying and selling of securities does not involve costs such as broker’s commission, transfer fees, etc. d. The investors can borrow against securities on the same basis as the firms can do so. 2. Homogeneous Risk Classes: In case the firms expected earnings have identical risk features, they should be considered to belong to a homogeneous class. 3. Same Expectations: Expectations All investors have the same expectations of the net operating income (EBIT) of firm which is used for its evaluation. There is 100 per cent dividend payout, i.e., all the net earnings of the firm are distributed to the shareholders, 4. No Corporate Taxes: At the formulation stage of hypothesis, Modigliani and Miller assume that there are no corporate taxes, However, they have removed this assumption later on. Computation of Cost Of Capital Computation of the cost of capital involves: (i) computation of specific costs and (ii) computation of composite cost. I. Computation of Specific Costs: It is the computation of the cost of each specific source of finance such as debt, preference capital and equity capital. 1. Cost of Debt: It is the rate of return which is expected by lenders. This is actually the interest rate specified at the time of issue. Debt may be issued at par, at premium or discount. It may be perpetual or redeemable. Debt Issued at Par: The cost of debt issued at par is the explicit interest rate adjusted further for the tax liability. It is computed in accordance with the following formula: Debt Issued at Premium or Discount: When the debentures are issued at a premium (more than the face value) or at a discount (less than the face value) the cost of debt should be Cost of St.Berchmans [2010-11] Redeemable Debt: When debentures [email protected] Page 28 computed on the basis of net proceeds realised on account of issue of such debentures. Financial Management III Semester B.Com are redeemed after the expiry of a fixed period, the cost of debt before tax can be computed with the help of the following Formula 2. Cost of Preference Share Capital Even though it is not legally binding on the part of the company to pay preference dividend, it is generally paid as and when the company earns enough profits. The failure to pay preference dividend is a matter of serious concern on the part of the equity shareholders. They may even lose control of the company as the preference shareholders will enjoy the right to take part in the general meeting with equity shareholders under certain conditions if the company fails to pay preference dividend. The accumulation of arrears of preference dividend may adversely affect the right to equity shareholders. Cost of Redeemable Preference Shares: The cost of redeemable preference shares is the discount rate which equates the net proceeds of sale of preference shares with the present value of future dividend and repayment of principal. But the cost of preference share capital is not adjusted for taxes as it Page 29 is not a charge against profit but an appropriation of profit. St.Berchmans [2010-11] [email protected] Financial Management III Semester B.Com 3. Cost of Equity Capital Cost of equity capital may be defined as the minimum rate of return that a firm must earn on the equity financed portion of an investment project in order to leave unchanged the market price of its stock. a. Dividend Price (DIP) Method According to this approach, the cost of equity capital is computed against a required rate of return in terms of future dividends. Thus cost of capital is defined as “the discount rate that equates the present value of all expected future dividends per share with the net proceeds of the sale (or the current market price) of a share”. In other words, the cost of equity capital will be that rate of expected dividends which will maintain the present market price of equity shares b. Dividend Price Plus Growth Method In this approach, the cost of equity capital is calculated on the basis of the expected dividend rate plus the rate of growth in dividend. But the rate of growth is ascertained on the basis of the amount of dividends paid by the company for the last few years. c. Earning Price Approach percentage which can keep the market price of the equity shares constant. This approach recognises both dividend and retained earnings. St.Berchmans [2010-11] [email protected] Page earnings for evaluating their shareholdings. Thus the cost of capital relates to that earning 30 This method is based on the assumption that the shareholders capitalise a stream of future Financial Management III Semester B.Com d. Realised Yield Approach Under this approach, the cost of equity capital should be ascertained on the basis of return actually realised by the investors on their investment (i.e., on equity shares). Thus in this approach, the past records in a given period regarding dividends and the actual capital appreciation in the value of the equity shares held by the shareholders should be taken to calculate the cost of equity capital. 4. Cost of Retained Earnings Generally, the companies do not distribute the whole of the profits earned by them by way of dividend among their shareholders. A part of such profits is retained by them for future expansion of the business. This portion of profit is known as retained earnings or ploughing back of profit. The cost of retained earnings is the earnings foregone by the shareholders. In other words, the opportunity cost of retained earnings may be taken as the cost of retained earnings. It is equal to the income what a shareholder could have earned otherwise by investing the same in alternative investment. The following adjustments are required for determining the cost of retained earnings. a. Income Tax Adjustment: The dividends receivable by the shareholders are subject to income tax. Thus the dividends actually received by them are the amount of net dividend (i.e., gross dividends less income tax). b. Brokerage Cost Adjustment: The shareholders cannot utilise the whole amount of dividend received from the company for the purpose of investment as they have to incur some expenses by way of brokerage, commission, etc. for purchasing new weighted average of the cost of each specific type of funds i.e., weighted average cost. In other words, the composite or weighted average cost of capital is the combined specific St.Berchmans [2010-11] [email protected] Page II. Composite or Weighted Average Cost of Capital The term cost of capital is used to denote the overall composite cost of capital or 31 shares against the dividend. Financial Management III Semester B.Com costs used to find out the overall cost of capital. The computation of weighted average cost of capital involves the following steps: a. Calculate the cost of each specific source of funds. b. Assign proper weights to specific costs. c. Multiply the cost of each source by the appropriate weight. d. Divide the total weighted cost by the total weights to get the overall cost of capital. Assignment of Weights This involves the determination of the proportion of each source of funds in the total capital structure of the company. For this purpose, the following three possible weights may be used.
Book Value Weights used for actual or historical weights.
Market Value Weights used for current weights.
Marginal Value Weights used for proposed future financing. Book Value Weights Under this method, the relative proportions of various sources to the existing capital structure are used to assign weights. The advantages of these weights are as follows: 1. Book values are easily available from the published annual report of a company. 2. All companies set their targets of capital structure in terms of book values rather than market value, 3. The analysis of capital structure on the basis of debt equity ratio also depends on book value. Market Value Weights Theoretically, the use of market value weights for computing the cost of capital is more appealing due to the following facts: 1. The market values of the securities are approximate to the actual amount to be obtained from the sale of such securities. 2. The cost of each specific source of finance is computed in accordance with the prevailing market price. However, there are some practical difficulties for using market value weights. They are as 1. Frequent fluctuation in the market value of securities is a common phenomenon. 2. Market values of securities are not readily available like book values. But book values are available from the published records of the company. 3. The book value and not the market value is the base for analysing the capital structure of the company in terms of debt-equity ratio. Page 32 Marginal Value Weights St.Berchmans [2010-11] [email protected] Financial Management III Semester B.Com Under this method, weights are assigned to each source of funds in proportions of financing inputs the firm intends to employ. This method is based on a logic that the firm is with the Page 33 new or incremental capital and not with capital raised in the past. St.Berchmans [2010-11] [email protected] Financial Management III Semester B.Com SOURCES OF FINANCE Every business needs funds for two purposes, for its establishment and to carry out its day-to-day operations. Long-term funds are required to create production facilities through purchases of fixed assets such as plant, machinery, land, building, furniture, etc. Investments in these assets represent that part of firm’s capital which is blocked on a permanent or fixed basis and is called fixed capital. Funds are also needed for short-term purposes for the purchase of raw materials, payment of wages and other day-to-day expenses, etc. These funds are known as working capital. The various sources of raising long-term funds include issue of shares, debentures, ploughing back of profits and loans from financial institutions, etc. The short-term requirements of funds can be met from commercial banks, trade credit, instalment credit, advances, factoring or receivable credit, accruals, deferred incomes, and commercial paper, etc. The various sources of finance have been classified in many ways, such as Period Basis a. Short-term sources-bank credit, customer advances, trade credit, factoring, accruals, commercial paper, etc. b. Medium-term sources -issue of preference shares, fixed deposits, etc. c. Long term sources- issue of shares, debentures, specialised financial institutions. etc. Debentures, bank loans, public deposits, ploughing back of profits, loans from Ownership Basis a. Owned capital- share capital, retained earnings, profits and surpluses, etc. b. Borrowed capital - debentures, bonds, public deposits, loans, etc. Source of Finance Finance a. Internal sources- ploughing back of profits, retained earnings, profits, depreciation funds, etc. b. External sources- shares, debentures, public deposits, loans, etc. surpluses and Mode of Financing a. Security financing or external financing-financing through raising of corporate securities such as shares, debentures, etc. b. Internal financing- financing through retained earnings, capitalisation of profits and depreciation of funds, etc c. Loan financing through raising of long-term and short term loans. SECURITY FINANCING Ownership securities or capital stock.
Creditor ship securities or Debt Capital. Page
34 Corporate securities can be classified under two categories St.Berchmans [2010-11] [email protected] Financial Management III Semester B.Com Ownership securities Ownership securities, also known as capital stock represents shares. The capital of a company is divided into a number of equal as shares. Section 2[46] of the Companies act, 1956 defines it as “a share in the share capital of a company, and includes stock except where difference between stock and shares is expressed or implied” The following are the different ownership security 1. Equity Shares Equity shares, also known as ordinary shares or common shares represent the owners’ capital in company. The holders of these shares are the real owners of the company. Equity capital is paid after meeting all other claims including that of preference shareholders. They take risk both regarding dividend dud return of capital. Equity share capital cannot be redeemed during the life time of the company. Characteristics of Equity Shares The following are the most significant features of equity shares 1. Maturity. Equity shares provide permanent capital to the company and cannot be redeemed during the life time of the company. Equity shareholders can demand refund of their capital only at the time of liquidation of a company. Even at the time of liquidation, equity capital is paid back after meeting all other prior claims including that of preference shareholders. 2. Claims/Right to Income. Equity shareholders have a residual claim on the income of a company. They have a claim on income left after paying dividend to preference shareholders. The rate of dividend on these shares is not fixed, that is why, and equity shares are also known as ‘variable income security’. 3. Claim on Assets. Equity shareholders have a residual claim on ownership of company’s assets. In the event of liquidation of a company, the assets are utilised 4. Voting Voting Rights. Equity shareholders are the real owners of the company. They have voting rights in the meeting of the company and have a control over the working of St.Berchmans [2010-11] [email protected] Page thereafter, belongs to the equity shareholders. 35 first to meet the liabilities of creditors, preference shareholders but everything left, Financial Management III Semester B.Com the company. Directors are appointed in the Annual General Meeting by majority votes. Each equity shareholders has votes equal to the number of equity share held by him. Hence, equity share holders exercise an indirect control over the working of the company. 5. PrePre-emptive Right. To safeguard the interest of equity shareholders and enable them to maintain their proportional ownership, section 81 of the Companies Act, 1956 provides that whenever a public limited company proposes to increase its subscribed capital by the allotment of further shares, such shares must be offered to holders of existing equity shares in proportion to the paid up capital on these shares. Shares so offered to shareholders are called Right Shares and their prior right to such is known as pre-emptive right. 6. Limited Liability. Although equity shareholders are the real owners of the company, their liability is limited to the value of share they had purchased. If a shareholder has already fully paid the share price, he cannot be held liable further for any losses of the company even at the time of liquidation. Advantages of Equity Shares
Equity shares do not create any obligation to pay a fixed rate of dividend.
Equity shares can be issued without creating any charge over the assets of the company.
It is a permanent source of capital and the company has not to repay it except under liquidation
Equity shareholders are the real owners of the company who have the voting rights.
In case of profits, equity shareholders are the real gainers by way of increased dividends and appreciation in the value of shares. Disadvantages of Equity Shares Shares
If only equity share are issued, the company cannot take the advantage of trading on equity.
As equity capital cannot be redeemed, there is a danger of over capitalisation.
Equity shareholders can put obstacles in management by manipulation and organising themselves.
During prosperous periods higher dividends have to be paid leading to increase in the value of shares in the market and speculation.
Investors who desire to invest in safe securities with a fixed income have no are given two preferences. There is a preference for payment of dividend. Whenever the St.Berchmans [2010-11] [email protected] Page 2. Pref Preference erence Shares These shares have certain preferences as compared to other types of shares. These shares 36 attraction for such shares Financial Management III Semester B.Com company has distributable profits, the dividend is first paid on preference share capital. Other shareholders are paid Types of Preference Shares Preference shares are of the following types 1. Cumulative Preference Shares. These shares have a right to claim dividend for those years also for which there are no profits. Whenever there are divisible profits, cumulative preference shares are paid dividend for all the previous years in which dividend could not be declared. The dividend goes on cumulating unless otherwise it is paid. 2. Non-Cumulative Preference Shares. The holders of these shares have no claim for the arrears of dividend. They are paid a dividend if there are sufficient profits. They cannot claim arrears of dividend in subsequent years. 3. Redeemable Preference Shares. The company has right to return redeemable preference share capital after a certain period. The Companies Act has provided certain restrictions on the return of this capital. 4. Irredeemable Preference Shares. Those shares which cannot be redeemed unless the company is liquidated are known as irredeemable preference shares. 5. Participating Preference Shares. The holders of these shares participate in the surplus profits of the company. They are firstly paid a fixed rate of dividend and then a reasonable rate of dividend is paid on equity shares. If some profits remain after paying both these dividends, then preference shareholders participate in the surplus profits. 6. Non-Participating Preference Shares. The shares on which only a fixed rate of dividend is paid are known as non-participating preference shares. These shares do not carry the additional right of sharing of profits of the company. 7. Convertible Preference Shares. The holders of these shares may be given a right to convert their holdings into equity shares after a specific period. These are called convertible preference shares. The right of conversion must be authorised by the Articles of Association. 8. Non-Convertible Preference Shares. The shares which cannot be converted into equity shares are known as non-convertible preference shares. Features of Preference Preference Shares The following are the most significant features of preference shares 1. Maturity. Generally, preference shares resemble equity shares in respect of maturity. repay the preference shareholder after meeting the claim of creditors but before paying back the equity shareholders. However, a company may issue redeemable St.Berchmans [2010-11] [email protected] Page amount during its life time. It is only at the time of liquidation that a company has to 37 These are perpetual irredeemable and the company is not required to repay the Financial Management III Semester B.Com 2. Claims on Income. A fixed rate of dividend is payable on preference shares. Preference shareholders have prior claim on income (dividend) over equity shareholders. Whenever the company have distributable profits, the dividend is first paid on preference share capital. 3. Claims Claims on Assets. Preference shares have a preference in the repayment of capital at the time of liquidation of a company. Their claims on assets are superior to those of equity shareholder. In the event of winding up of the company, their claim is to be settled first before making any payment to the equity shareholders. 4. Control. Ordinarily, preference shareholders do not have any voting rights; so they do not have any say in the management or control of the company. However, shareholders can vote on a resolution which directly affects the rights to be attached to their preference shares. 5. Hybrid Form of Security. Preference share capital, in the real sense, represents a hybrid form of security as it includes some features of equity and other of debt financing. Preference shares provide a number of advantages both to the company as well as investors r shareholders. Advantages or Merits of Preference Shares a. There is no legal obligation to pay dividend on preference shares. b. Preference shares provide a long-term capital for the company. c. There is no liability of the company to redeem preference shares during the life time of the company. d. Redeemable preference shares have the added advantage of repayment of capital whenever there are surplus funds with the company. e. As a fixed rate of dividend is payable on preference shares, these enable a company to adopt trading on equity f. As preference share capital is generally regarded as part of company’s net worth, it enhances the credit worthiness of a firm. g. Preference shares do not carry voting rights under normal circumstances and hence there is no dilution of control. h. As no specific assets are pledged against preferred stock, the mortgage able assets of the company are conserved. i. It earns a fixed rate of dividend to investors j. It is a superior security over equity shares. k. It provides preferential rights in regard to payment of dividends and repayment of Page 38 capital at the time of liquidation of the company. St.Berchmans [2010-11] [email protected] Financial Management III Semester B.Com Disadvantages of Preference Shares a. It is an expensive source of finance as compared to debt because generally the investor’s expect a higher rate of dividend on preference shares as compared to the rate of interest on debentures. b. Cumulative preference shares become a permanent burden so far as the payment of dividend is concerned. c. Although there is no legal obligation of a company to pay dividend on preference shares, but frequent delays or non-payment adversely affect the creditworthiness of the firm. d. Preference share dividend is not a deductible expense while calculating tax while interest is a deductible expense. e. In some cases, preference shares carry even the voting right and hence the control and management of the company may be diluted. f. As the preference shareholders ordinarily do not have any voting rights, they remain at the mercy of the management for the payment of dividend and redemption of their capital. g. The rate of dividend on preference shares is usually lower as comported to the equity shares. h. Preference shareholders do not have any charge on the assets of the company while debentures, usually, provide a charge on all the assets of the company. i. The market prices of preference shares fluctuate much more than that of debentures. 3. Deferred shares. These shares were earlier issued to promoters or founders for services rendered to the company. These shares were known as Founders Shares because they were normally issued to founders. These shares rank last so far as payment of dividend and return of capital is concerned. These shares were generally of a small denomination and the management of the company remained in their hands by virtue of their voting rights. 4. No Par Stock/Shares No par stock means shares having no face value. The capital of a company issuing such shares is divided into a number of specified shares without any specific denomination. The share certificate of the company simply states the number of shares held by its owner without mentioning any face value. The value of a share can be determined by dividing the real net worth of the company with the total number of shares of the company. Dividend on The term ‘sweat equity’ means equity shares issued by a company to its employees or directors at a discount or for consideration other than cash for providing know-how or St.Berchmans [2010-11] [email protected] Page 5. Sweat Equity 39 such shares is paid per share and not as a percentage of fixed nominal value of shares. Financial Management III Semester B.Com making available rights in the nature of intellectual property rights (say, patents or copyright) or value additions, by whatever name called. The idea behind the issue of sweat equity is that an employee or director works best when he has ‘sense of belongingness’ and is amply rewarded. One of the ways of rewarding him is by offering him shares of the company at low prices, where he is working. It is termed as ‘sweat equity’ as it is earned by hard work (sweat) of employees and it is also referred to as ‘sweet equity’ as employees become happy on the issue of such shares. The purpose of sweat equity is to ensure more loyalty and participation of employees. CREDITORSHIP SECURITIES The term ‘creditor ship securities’, also known as ‘debt capital’, represents debentures and bonds. A debentures or a bond is acknowledgement of a debt. It is a certificate issued by a company under its seal acknowledging a debt by it to its holders. According to the Companies Act, 1956, the term debenture includes, “debentures stock, bonds and many other securities of a company whether contributing a charge the assets of the company or not”. Debentures or Bond A company may raise long-term finance through public borrowings. These loans are raised by the issue of debentures. A debenture is an acknowledgement of a debt. A debenture holder is a creditor of the company. A fixed rate of interest is paid debentures. The interest on debentures is a charge on the profit and loss account of the company. debentures are generally given a floating charge over the assets of the company. When the debentures secured, they are paid on priority in comparison to all other creditors. Types of Debentures 1. Simple, Naked or Unsecured Debentures, Debentures, These debentures are not given any security on They have no priority as compared to other creditors. They are treated along with unsecured creditors at the time of: winding up of the company. So, they are just unsecured creditors. 2. Secured or Mortgaged Debentures, Debentures, These debentures are given security on assets or company. In case of default in the payment of interest or principal amount, debenture holders can sell the assets in order to satisfy their claims. 3. Bearer Debentures. These debentures are easily transferable; they are just like negotiable instruments. The debentures are handed over to the purchaser without any registration deed. Anybody purchasing them with a consideration and in good voucher. The form is sent to the company along with the registration fees. St.Berchmans [2010-11] [email protected] Page 4. Registered Debentures, Debentures, registered debentures require a procedure to be followed for their transfer. Both the transfer and the transferee are expected to sign a transfer 40 faith becomes the lawful owner of the debentures. Financial Management III Semester B.Com 5. Redeemable Debentures. Debentures These debentures are to be redeemed on the expiry of certain period. The interest on the debentures is paid periodically but the principal amount is returned after a fixed period 6. Irredeemable Debentures. Such debentures are not redeemable during the life time of the country. 7. Convertible Debentures. Debentures Sometimes convertible debentures are issued by a company and the shareholders are given an option to exchange the debentures into equity shares after the lapse of a fixed d period. Convertible debentures may be either ‘Fully Convertible Debentures’ (FCD’s) or ‘Partly Convertible ntures’ (PCD’s) with or without buy back facilities. 8. Zero Interest Bonds / Debentures. Zero interest bonds is an instrument recently introduced in lndia by some companies. It is usually a convertible debenture which yields no interest. The company does not pay any interest on such debentures. But the investor in a zero interest bond is compensated for the loss of through conversion of such bond into equity shares at a specified future date. 9. Zero Coupon Bonds. Zero coupon bonds do not carry any interest but it is sold by the issuing company at deep discount from its eventual maturity value. The difference between the issue price and the maturity represents the gain or interest earned by its investor. 10. First Debentures and Second Debentures. Debentures From the view of priority in the payment of interest and repayment of the principal amount, the debentures may be either first debentures or second debentures, etc debentures which have to be paid back first or who have preference over other debentures in payment rest or called first debentures and the debentures who rank after these are known as second debentures, 11. Guaranteed Debentures. These are debentures or bonds on which the payment of interest and principal is guaranteed by third parties, generally, banks and Government, etc. 12. Collateral Debentures. A company may Issue debentures in favour of a lender of money, generally the banks and financial institutions, as a collateral, subsidiary or secondary, security for a loan raised by it. These debentures are called collateral debentures and these become effective only when the company‘s a default in the repayment of the loan against which these have been issued. 13. Secured Premium Notes (SPNs). The secured premium note is a tradable instrument 14. Callable Bond. A callable bond is a bond that can be called in and paid off by the issuer at a price, called the ‘call price’, stipulated in the bond contract. It gives the St.Berchmans [2010-11] [email protected] Page of time. 41 detachable warrant against which the holder gets equity shares after a fixed period Financial Management III Semester B.Com advantage to Issuer Company to the existing bonds if the interest rates fall in the market below the bond’s coupon rate. 15. Floating / Variable or Adjustable Rate Bonds. The rate of interest payable on these bonds periodically depending upon the market rate of interest payable on the gilt edged securities. 16. Deep. Discount Bonds (DDBs). The deep discount bond does not carry any interest but it is sold by the issuer company at a deep discount from its eventual maturity (nominal) value. 17. Inflation Adjusted Bonds (lABs). These are the bonds on which both interest as well as principal is adjusted in line with the price level changes or the inflation rate. Features of Debentures or Bond: The salient characteristics of debenture as below. 1. Maturity. Although debentures provide long term funds to a company, they mature after a specific period. Generally, the debentures are to be repaid at a definite time as stipulated in the issue. The company must pay back the principal amount on these debentures on the given date otherwise the debenture holders to force winding up of the company as creditors. 2. Claims on Income. A fixed rate of interest is payable on debentures. Even if a company makes no earnings or incurs loss, it is under an obligation to pay interest to its debenture holders. The default in payment of interest may cause winding up of company because the debenture holders may take recourse to law for the same. 3. Claims on Assets. Even in respect of claim on assets, debenture holders have priority of claim on assets of the company. They have to be paid first before making any payment to the preference or equity shareholders in the event of liquidation of the company. However, they have a claim for the principal amount and Interest due only and do not have any share in the surplus assets of the company, 4. Control. Since, debenture holders are creditors of the company and not its owners; they do not have any control over the management of the company. They do not have any voting rights to elect the directors of the company or on any other matters. 5. Call Feature. Issue of debentures sometimes provides a call feature which entitles the company to redeem its debentures at a certain price before the maturity date. Since, the call feature provides advantages to the company at the expense of its debenture Page 42 holders, the call price is usually more than the issue price. St.Berchmans [2010-11] [email protected] Financial Management III Semester B.Com Advantages of Debentures 1. Debentures provide long-term funds to a company. 2. The rate of interest payable on debentures is, usually, lower than the rate of dividend paid on shares. 3. The interest on debentures is a tax deductible expense and hence the effective cost of debentures (debt-capital) is lower as compared to ownership securities where dividend is not a tax deductible expense. 4. Debt financing does not result into dilution of control because debenture holders do not have any voting rights. 5. A company can trade on equity by mixing debentures in its capital structure and thereby increase its earnings per share, 6. Debentures provide flexibility in the capital structure of a company as the same can be redeemable as and when the company has surplus funds and desires to do so. 7. Debentures provide a fixed, regular and stable source of income to its investors. 8. It is comparatively a safer investment because debenture holders have either a specific or a floating charge on all the assets of the company and enjoy the status of a superior creditor in the event of liquidation of the company. 9. Many investors prefer debentures because of a definite maturity period. 10. A debenture is usually more liquid investment and an investor can sell or mortgage his instrument to obtain loans from financial institutions. Disadvantages of Debenture Finance 1. The fixed interest charges and repayment of principal amount on maturity are legal Hence, it is a permanent burden on the company. Default in these payments. Page Adversely affects the credit-worthiness of the firm and even may lead to winding up of the company. St.Berchmans [2010-11] 43 obligations of the company. These have to be paid even when there are no profits. [email protected] Financial Management III Semester B.Com 2. Charge on the assets of the company and other protective measures provided to investors by the issue of debentures usually restrict a company from using this source of finance. 3. The use of debt financing usually increases the risk perception of investors in the firm. This enhanced financial risk increases the cost of equity capital. 4. Cost of raising finance through debentures is also high because of high stamp duty. 5. A company whose expected future earnings are not stable or who deals in products with highly elastic demand or who does not have sufficient fixed assets to offer as security to debenture holders cannot use this source of raising funds to its benefit. 6. Debentures do not carry any voting rights and hence its holders do not have any controlling power over the management of the company. 7. Debenture holders are merely creditors and not the owners of the company. They do not have an claim on the surplus assets and profit of the company beyond the fixed interest and their principal amount. 8. Interest on debentures is fully taxable while shareholders may avoid tax by way of stock dividend (bonus shares) in place of cash dividend. 9. The prices of debentures in the market fluctuate with the changes in the interest Page 44 rates. St.Berchmans [2010-11] [email protected] Financial Management III Semester B.Com DIVIDEND POLICY AND DECISIONS Dividend refers that part of profit of a company which is distributed by the company among its shareholders. Dividends may be brought into different categories in accordance with the forms in which they are paid. The following are the various forms of dividends. 1. Cash Dividend Dividend is usually paid in cash. When dividend is paid in cash, it is known as cash dividend, But the payment of dividends in cash involves outflow of funds from the firm. Thus a firm should have enough cash in its bank account when cash dividends are declared. When cash dividend is paid, both the cash account and the reserves account of the firm will be curtailed. Hence, both the net worth and the total assets of the firm are reduced when the cash dividend is distributed. Moreover, the market price of the share comes down in most cases by the amount of the cash dividend distributed. 2. Stock Dividend [Bonus Shares] When a firm issues its own shares to the existing shareholders in lieu of or in addition to cash dividend, it is called stock dividend or scrip dividend. In India, the payment of stock dividend is popularly termed as “issue of bonus shares”. The issue of bonus shares has the effect of increasing the number of outstanding shares of the firm. The shares are distributed proportionately. Hence, a shareholder retains his proportionate ownership of the firm. The declaration of the bonus shares will enhance the paid-up share capital and curtail the reserve and surplus (retained earnings) of the firm. Bonus issue is merely an accounting transfer from reserves and surplus to paid-up capital. Advantages of bonus shares a. It conserves the company’s liquidity as no cash leaves the company. b. The shareholder who receives a dividend can be converted into cash as and when he wants through selling the additional shares, c. It broadens the capital base and enhances image of the company. – d. It helps to decline the market price of the shares, rendering the shares more marketable. e. It is an indication to the prospective investors about the financial soundness of the company. f. It is one of the best ways of bringing the paid up capital of the company in line with actual capital employed in the business, g. It is an inexpensive method of raising capital by which the cash resources of the company are preserved. 45 h. It absolves the liability of the shareholders when bonus is applied for converting Page partly paid up shares into fully paid-up. St.Berchmans [2010-11] [email protected] Financial Management III Semester B.Com Disadvantages of bonus shares a. After bonus issue, there is a sharp fall in the future market price of the share. b. The rate of dividend in future will come down. c. Lengthy legal procedures and approvals are involved in the issue of bonus shares. d. When the conversion of partly paid-up shares into fully paid-up shares is made the company foregoes cash equivalent to the amount of bonus applied for this purpose. SEBI Guidelines on Bonus Issues The company shall, while issuing bonus shares ensure the following guidelines issued by the Securities Exchange Board of India (SEBI) on 11th June, 1992. 1. The bonus issue is made out of free reserves built out of the genuine profits or share premium collected in cash only. 2. Reserves created by revaluation of fixed assets are not capitalised. 3. The development rebate reserve or the investment allowance reserve is considered as free reserve in order to calculate residual reserve test. – 4. The residual reserves after the proposed capitalisation shall not be less than 40 % of the increased paid-up capital. 5. All contingent liabilities disclosed in the audited accounts which have the bearing on the net profits shall be considered for computing residual reserves. 6. The declaration of bonus issue, in lieu of dividend, is not made. 7. The bonus issue is not made unless the partly-paid sh4es, if any existing, are made fully paid-up. 8. No bonus issue shall be made within 12 months of any public/right issue. 9. No bonus issue shall be made which will dilute the value or rights of the holders of debentures, convertible fully or partly. 10. Consequent to the issue of bonus shares if the subscribed and paid-up capital exceeds the authorised share capital, a resolution shall be passed by the company at its general body meeting for enhancing the authorised capital. 11. There should be a provision in the Articles of Association of the company for capitalisation of reserves, etc., and if not, the company shall pass a resolution at its general body meeting making provisions in the Articles for capitalisation. 12. A company which announces its issue after the approval of the Board of directors should implement the proposals within a period of six months from the date of such approval and shall not have option of changing the decision. 3. Bond Dividend the postponement of payment of immediate dividend in cash. Here the bondholders get St.Berchmans [2010-11] [email protected] Page does not have enough funds to pay dividend in cash. The purpose behind such an issue is 46 A firm may issue bonds for the amounts due to shareholders by way of dividends if it Financial Management III Semester B.Com regular interest on their bonds in addition to the bond money on the due date. In India, bond dividend is not popular. 4. Property Dividend Dividend Property dividend is also not popular in India. When a firm pays dividend in the form of assets other than cash, it is called property dividend. The payment of such a dividend may be in the form of a firm’s product or in the form of certain assets which are not required by the firm. 5. Interim Dividend A dividend which is declared before the declaration of the final dividend is called the interim dividend. In other words, interim dividend is a dividend which is declared between two annual general meetings. If the profits of the company appear to be justified for the payment of interim dividend, the Board of directors may from time to time pay to the members such dividends. While deciding to declare an interim dividend, the directors should take into consideration the future prospects of the profits, cash resources etc., of the company. DIVIDEND POLICY Dividend policy is the policy concerning the amount of profits to be distributed as dividend. Usually companies through their Board of Directors evolve a pattern of dividend payment which has a bearing on future action. The power to recommend/declare dividends vests completely in the board of directors of the company. Factors Affecting Dividend Policy The factors affecting dividend policy are divided into: I. External External Factors The following are the various external factors affecting dividend policy of the company: 1. General State of Economy: The management’s decision to retain or distribute earnings of the firm mainly relates to the general state of economy. However, the management may prefer to retain the whole or part of the earnings with a view to building up reserves during Uncertain economic and business conditions, depression, prosperity and inflation 2. State of Capital Market: Market A firm can follow a liberal dividend policy if it has an easy access to the capital market on account of its financial strength or favourable conditions prevailing in the capital market. However, a firm is likely to adopt a more conservative dividend policy if it has no easy access to capital market because of its weak financial position or unfavorable conditions in the capital market. 3. Legal Restrictions: A firm may also be legally restricted from declaring and paying of The following are some of the legal restrictions imposed on dividend declaration of companies. St.Berchmans [2010-11] [email protected] Page declaration and payments of dividends. 47 dividends. The Companies Act of 1956 contains several restrictions relating to the Financial Management III Semester B.Com a. A company is entitled to pay dividend only out of its a. current profits, b. past accumulated profits c. money provided by the Central or State Governments for the dividend payments in pursuance of the guarantee given by the Government. However, the dividend payment out of capital is illegal. b. A company is not entitled to pay dividend unless it has provided for current and all arrears of depreciation, and a certain percentage of net profits of that year has been transferred to the reserves of the company. c. A company can use the past accumulated profits for the declaration of dividends only in accordance with the rules framed by the Central Government in this behalf. d. The Income tax Act also prescribes certain restrictions about the payment of dividend. The management should consider all the legal restrictions before taking the dividend decision. 4. Contractual Restrictions: Restrictions: Restrictions which are imposed by the lenders of the firm are called contractual restrictions. The lenders of the firm lay down restrictions on dividend payment to protect their interest particularly during the period when the firm is experiencing liquidity or profitability crisis. 5. Tax Policy: The tax policy followed by the Central Government also affects the dividend policy of the firm. Sometimes the government provides tax incentives to those companies which retain most of their earnings. In such a situation, the management is inclined to retain a larger amount of the firm’s earnings. Internal Factors Various internal factors which affect the dividend policies of the firm are as follows: 1. Desire of the Shareholders: Shareholders expect returns from their investment in a firm in the form of both capital gains and dividends. Capital gain relates to the profit as a result of the sale of capital investment, i.e., equity shares in the case of shareholders. Dividends are the regular return expected by the shareholders on their investment in a firm. The desire of the shareholders to get dividends takes priority over the desire to earn capital gains on account of the following reasons. 2. Future requirements: The prudent management should give more weightage to the financial needs of the company than the desire of the shareholders. While retained earnings help for the further growth of the firm, the payment of dividend will adversely affect both the owner’s wealth and long term growth of the firm. Thus a firm requires an optimum 3. Nature of Earnings: A firm whose income is stable can afford to have a higher dividend payout ratio than a firm which does not have such stability in its earnings. St.Berchmans [2010-11] [email protected] Page growth in future. 48 dividend policy which should maximise the firm’s wealth and provide enough funds for the Financial Management 4. III Semester B.Com Liquidity Position: The payment of dividends usually involves cash outflow. Thus sometimes, a firm which has adequate earnings may not have sufficient cash to pay dividends. It is, therefore, the duty of the management to see the liquidity aspect of the firm before and after payment of dividends wh1’e taking the dividend decision. The management should keep in mind that, in no case can the liquidity ratio be less than 1:1 after the payment of dividends. 5. Desire of Control: Control: The desires of the shareholders or management should also influence the dividend policy of the firm. If a firm issues additional equity shares for raising funds, it will dilute control which is detrimental to the existing equity shareholders. Thus in the case of strong desire for control, the management prefers a smaller dividend payout ratio and hence low rate of dividend. 6. Age of the company: a newly established concern has to limit payment of dividend and retain substantial part of earnings for financing its future growth and development, while older companies can afford to pay liberal dividends because of sufficient reserves. Types of dividend policy 1. Regular dividend policy Payment of dividend at the usual rate is termed as regular dividend. Regular dividends can be maintained by companies of long standing and stable earnings. The main advantage of regular dividend policy is; a. Establishes a profitable record of the company b. Creates confidence among shareholders c. Stabilizes market price of shares d. Meets the day to day living expenses of the ordinary shareholders e. Aids long term financing. 2. Irregular dividend policy Some companies follow irregular dividend policy on account of uncertainty of earnings, unsuccessful business operations, lack of liquid resources, etc 3. No dividend policy A company may follow a policy of paying no dividends presently because of unfavourable working capital position or requirement of funds for future expansion and growth. 4. Stable dividend policy Stable dividends relate to the consistency or lack of variability in the streams of dividends payments. It means a regular payment of a certain minimum amount as dividend or earnings/profits may fluctuate from year to year but not the dividend. The stability of Under this policy, the firm pays a certain fixed amount per share by way of dividends. This fixed sum per share is paid year after year irrespective of the level of St.Berchmans [2010-11] [email protected] Page a. Constant Dividend per Share 49 dividends can be in any of the following three forms: Financial Management III Semester B.Com earnings of the firm. When the earning increases, the amount of dividend also increases if the firm can maintain the new level in future. Moreover, there will not be any change in the payment of dividend in the cast of temporary increase in earnings. b. Constant Percentage Under this policy, a certain percentage of net earnings/profits is paid year after year as dividend to the shareholders, In the case of constant payout ratio policy the amount of dividend fluctuates in direct proportion to the earnings of the firm. As per this policy when the earnings of a firm decrease, the dividend will naturally be low. c. Constant Dividend per Share plus Extra Dividend Under this policy, fixed dividend per share is paid to the shareholders. But during market prosperity, additional or extra dividend is paid over and above the regular dividend. This extra dividend is waived immediately on the return of normal conditions. The most appropriate policy is the constant dividend per share. This is due to the fact that most investors expect a fixed rate of return from their investment which should gradually go up over a period of time. But in the case of the constant percentage of net earnings policy, the return to the shareholders varies in accordance with the earnings. The management may be in favour of constant percentage policy as it correlates the amount of dividend to the firm’s ability to pay dividend. However, the shareholders are against it as it involves uncertainties. But the constant dividend per share plus extra dividend policy is not preferred by the shareholders because of its general uncertainty about the extra dividend. Advantages of Stability of Dividend A stable dividend policy is advantageous from the point of view of shareholders and the firm on account of the following reasons. 1. Expectation of Current Current Income: Many investors such as retired persons, widows, etc., consider dividend as a source of income to meet their current living expenses. Such expenses are almost fixed in nature and hence a stable dividend policy should have least inconvenience to these investors. 2. Perception of Stability: When a firm declares regular dividend, the shareholders usually accept it as a sign of normal operation. But, a decline in the rate of dividend will be considered as a token of expected trouble in the future. Thus most of the shareholders would like to dispose their shares without further checking. As a result, the market value of the firm’s shares will come down. Such uncertainties can be avoided if the firm follows a Requirements of Institutional Institutional Investors: Usually, the shares of the companies are acquired both by individuals and institutions. But every firm would like to sell its shares to financial institutions as they are the largest buyers of shares in the corporate sector in our St.Berchmans [2010-11] [email protected] Page 3. 50 stable dividend policy. Financial Management III Semester B.Com country. As such, a stable dividend policy is a prerequisite to attract the investible funds of these institutions. 4. Raising Additional Finance: For raising additional funds from external sources, a stable dividend policy is beneficial to the firm. The investors develop confidence in such a firm for further issue of shares. DIVIDEND THEORIES Dividend decision is one of the unique areas of financial management as the firm is to choose one between the two alternatives, viz, (i) distribute the profits to the shareholders as dividend, and (ii) retain profits in the business (i.e., ploughing back of profit). Thus it is required to consider which alternative use is consistent with the object of wealth maximization or there is a relationship between dividends and value of the firm which should be carefully considered before any dividend decision. There are conflicting theories regarding impact of dividend decision on the valuation of a firm. However, the view points of these two schools of thought may be brought under the following two groups: 1. Relevance Concept of Dividend 2. Irrelevance Concept of Dividend 1. Relevance Concept of Dividend Myron Gordon, James Walter and others are associated with the relevance concepts of dividend. According to them, dividend policy of a firm has a direct effect on the position of a firm in a stock market. This is mainly due to the fact that dividends actually communicate information relating to the profit earning capacity of a firm to the investors. There are two notable theories, viz, (a) Gordon’s Model, and (b) Walter’s Model explaining this concept. GORDON’S MODEL (DIVIDEND GROWTH VALUATION MODEL) Myron Gordon assumes a constant level of growth in dividends in perpetuity. According to him, the dividends of most companies are expected to grow and evaluation of value of shares based on dividend growth is often used in valuation. Assumptions of Gordon’s model 1. Retained earnings represent the only source of financing. 2. Rate of return is constant. 3. The firm has perpetual or long life. 4. Cost of capital remains constant and is greater than growth rate. 5. Growth rate of the firm is the product of retention ratio and its rate of return. 6. Tax does not exist. This model implies that when the rate of return is more than the cost of capital, the cost of capital it is vice versa. However, the price per share remains constant in case the rate St.Berchmans [2010-11] Page of return and discount rate are equal. 51 price per share goes up as the dividend ratio comes down and in case the return is less than [email protected] Financial Management III Semester B.Com WALTER’S VALUATION MODEL Prof. James E. Walter suggests that dividend policy and investment policy of a firm are interlinked and hence the dividend decision always affects the value of a firm. His proposition clearly states the relationship between the firm’s internal rate of return[r] and its cost of capital[k]. In short, in case the firm’s return on investment is more than the cost of capital, it must retain its earnings and otherwise it should distribute its earnings to the shareholders. Thus Walter’s model implies that:
The optimal payout payout ratio for a growth firm [r >k] is nil. nil A firm is said to be a growth firm when it has adequate profitable investment opportunities and its rate of return[r] is more than cost of capital[k].
The optimal payout ratio for a normal firm [r=k]is irrelevant irrelevant. A firm is said to be normal when its dividend policy does not affect the market price of a share and rate of return is equal to cost of capital.
The optimal payout ratio for a declining firm [r