Financial Mgt Ii.pdf

Microsoft Word FM II HANDOUT 1 CHAPTER ONE DIVIDEND POICY AND THEORY Introduction The term dividend refers to that profit of a company which is distributed by company among its shareholders It is the[.]

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CHAPTER ONE DIVIDEND POICY AND THEORYIntroduction

The term dividend refers to that profit of a company which is distributed by company among its shareholders It is the reward of the shareholders for investments made by them in the shares of the company A company may have preference share capital as well as equity share capital and dividends may be paid on both types of capital The investors are interested in earning the maximum return on their investments and to maximize their wealth on the other hand, a company needs to provide funds to finance its long-term growth If a company pays out as dividend most of what it earns, then for Business requirements and further expansion it will have

to depend upon outside resources such as issue of debt or a new shares Dividend policy of a firm, thus affects both long-term financing and wealth of shareholders

Concept and Significance

The dividend decision is one of the three basic decisions which a financial manager may be required to take, the other two being the investment decisions and the financing decisions In each period any earning that remains after satisfying obligations to the creditors, the government and the preference shareholders can either be retained or paid out as dividends or bifurcated between retained earnings and dividends The retained earnings can then be invested in assets which will help the firm to increase or at least maintain its present rate of growth

In dividend decision, a financial manager is concerned to decide one or more of the following:

o Should the profits be ploughed back to finance the investment decisions?

o Whether any dividend be paid? If yes, how much dividend be paid?

o When these dividend be paid? Interim or final

o In what form the dividend be paid? Cash dividend or Bonus shares

All these decisions are inter-related and have bearing on the future growth plans of firm If a firm pays dividend it affects the cash flow position of the firm but earns the goodwill among investors who therefore may be willing to provide additional funds for financing of investment plans of firm On the other hand, the profits which are not distributed as dividends become an easily available source of funds at no explicit costs

However, in case of ploughing back of profits, the firm may lose the goodwill and confidence of the investors and may also defy the standards set by other firms Therefore, in taking dividend decision, the financial manager has to consider and analyse various factors Every aspects of dividend decision is to be critically evaluated The most important of these considerations is to decide as to what portion of profit should be distributed which is also known as dividend payout ratio

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Meaning of Dividend

Dividend refers to the business concerns net profits distributed among the shareholders It may also be termed as the part of the profit of a business concern, which is distributed among its shareholders

According to the Institute of Chartered Accountant of India, dividend is defined as “a distribution to shareholders out of profits or reserves available for this purpose”

TYPES OF DIVIDEND/FORM OF DIVIDEND

Dividend may be distributed among the shareholders in the form of cash or stock Hence, Dividends are classified into:

Property Dividend

Property dividends are paid in the form of some assets other than cash It will be distributed under the exceptional circumstance

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DIVIDEND DECISION

Dividend decision of the business concern is one of the crucial parts of the financial manager, because it determines the amount of profit to be distributed among shareholders and amount of profit to be treated as retained earnings for financing its long term growth Hence, dividend decision plays very important part in the financial management Dividend decision consists of two important concepts which are based on the relationship between dividend decision and value

1.The Irrelevance Concept of Dividend or Theory of Irrelevance

2.The Relevance Concept of Dividend a Theory of Relevance

The other school of thought on dividend policy and valuation of the firm argues that what a firm pays as dividends to share holders is irrelevant and the shareholders are indifferent about receiving current dividend in future The advocates of this school of thought argue that dividend policy has no effect on market price of share Two theories have been discussed here to focus on irrelevance of dividend policy for valuation of the firm which are as follows:

1 Residual’s Theory of Dividend

According to this theory, dividend decision has no effect on the wealth of shareholders or the prices of the shares and hence it is irrelevant so far as valuation of firm is concerned This theory regards dividend decision merely as a part of financing decision because earnings available may

be retained in the business for re-investment But if the funds are not required in the business they may be distributed as dividends Thus, the decision to pay dividend or retain the earnings may be taken as residual decision This theory assumes that investors do not differentiate

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between dividends and retentions by firm Their basic desire is to earn higher return on their investment In case the firm has profitable opportunities giving higher rate of return than cost of retained earnings, the investors would be content with the firm retaining the earnings to finance the same However, if the firm is not in a position to find profitable investment opportunities, the investors would prefer to receive the earnings in the form of dividends Thus, a firm should retain earnings if it has profitable investment opportunities otherwise it should pay them as dividends

Under the Residuals theory, the firm would treat the dividend decision in three steps:

I Determining the level of capital expenditures which is determined by the investment opportunities

II Using the optimal financing mix, find out the amount of equity financing need to support the capital expenditure in step (i) above

III As the cost of retained earnings kris less than the cost of new equity capital, the retained earnings would be used to meet the equity portions financing in step (ii) above If available profits are more than this need, then the surplus may be distributed as dividends of shareholder As far as the required equity financing is in excess of the amount of profits available, no dividends would be paid to the shareholders

Hence, in residual theory the dividend policy is influenced by (i) the company’s investment opportunities and (ii) the availability of internally generated funds, where dividends are paid only after all acceptable investment proposals have been financed The dividend policy is totally passive in nature and has no direct influence on the market price of the share

2 Modigliani and Miller Approach (MM Model)

Modigliani and Miller have expressed in the most comprehensive manner in support of theory of irrelevance They maintain that dividend policy has no effect on market prices of shares and the value of firm is determined by earning capacity of the firm or its investment policy As observed

by M.M, “Under conditions of perfect capital markets, rational investors, absence of tax discrimination between dividend income and capital appreciation, given the firm’s investment policy, its dividend policy may have no influence on the market price of shares” Even, the splitting of earnings between retentions and dividends does not affect value of firm

Assumptions of MM Hypothesis

(1) There are perfect capital markets

(2) Investors behave rationally

(3) Information about company is available to all without any cost

(4) There are no floatation and transaction costs

(5) The firm has a rigid investment policy

(6) No investor is large enough to affect the market price of shares

(7) There are either no taxes or there are no differences in tax rates applicable to dividends and capital gains

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The Argument of MM

The argument given by MM in support of their hypothesis is that whatever increase in value of the firm results from payment of dividend, will be exactly off set by achieve in market price of shares because of external financing and there will be no change in total wealth of the shareholders For example, if a company, having investment opportunities distributes all its earnings among the shareholders, it will have to raise additional funds from external sources This will result in increase in number of shares or payment of interest charges, resulting in fall in earnings per share in future Thus whatever a shareholder gains on account of dividend payment

is neutralized completely by the fall in the market price of shares due to decline in expected future earnings per share To be more specific, the market price of share in beginning of period is equal to present value of dividends paid at end of period plus the market price of shares at end of period plus the market price of shares at end of the period This can be put in form of following formula:-

P0 = D1 + P1

1 + Ke

where

PO = Market price per share at beginning of period

D1 = Dividend to be received at end of period

P1 = Market price per share at end of period

Ke = Cost of equity capital

P1 can be calculated with the help of the following formula

P1 = Po (1+Ke) – D1

Example:

A company whose capitalization rate is 10% has outstanding shares of 25,000 selling at $100 each The firm is expecting to pay a dividend of $5 per share at the end of the current financial year The company's expected net earnings are $250,000 and the new proposed investment requires $500,000 Prove that using MM model, the payment of dividend does not affect the value of the firm

Solution:

1 Value of the firm when dividends are paid:

2 Value of the firm when dividends are not paid:

i Price per share at the end of year 1:

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The MM Hypothesis can be explained in another form also presuming that investment required

by the firm on account of payment of dividends is financed out of the new issue of equity shares

In such a case, the number of new shares to be issued can be computed with the help of the following equation

M × P1 = I – (X – nD1)

Where, M = Number of new share to be issued

P1 = Price at which new issue is to be made

I = Amount of investment required

X = Total net profit of the firm during the period

nD1= Total dividend paid during the period

Example 2

ABC Ltd has a capital of Br 1,000,000 in equity shares of Br 100 each The shares are currently quoted at par The company proposes to declare a dividend of Br 10 per share at the end of the current financial year The capitalization rate for the risk class to which the company belongs is 12%

What will be the Market price of the share at the end of the year, if

i A dividend is not declared

ii A dividend is declared

iii Assuming that the company pays the dividend and has net profits of Br 500,000 and makes new investments of Br 1,000,000 during the period, how many new shares must

be issued? Use the MM Model

Solution

As per MM Model, the current MP of the share is

(i) If the dividend is not declared

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P1 = Market price per share at the end of the period

Ke = Cost of equity capital

n = number of shares outstanding at the beginning of the period

D1 = Dividend to be paid at the end of the period

nPO = Value of the firm

This equation shows that dividends have no effect on the value of the firm when external financing is used Given the firm’s investment decision, the firm has two alternatives, it can retain its earnings to finance the investments or it can distribute the earnings to the shareholders

as dividends and can arise an equal amount externally If the second alternative is preferred, it would involve arbitrage process Arbitrage refers to entering simultaneously into two transactions which exactly balance or completely offset each other Payment of dividends is associated with raising funds through other means of financing The effect of dividend payment

on shareholder’s wealth will be exactly offset by the effect of raising additional share capital When dividends are paid to the shareholder, the market price of the shares will increase But the issue of additional block of shares will cause a decline in the terminal value of shares The market price before and after the payment of the dividend would be identical This theory thus signifies that investors are indifferent about dividends and capital gains Their principal aim is to earn higher on investment If a firm has investment opportunities at hand promising higher rate

of return than cost of capital, investor will be inclined more towards retention However, if the expected return is likely to be less than what it would cost, they would be least interested in reinvestment of income Modigiliani and Miller are of the opinion that value of a firm is determined by earning potentiality and investment policy and never by dividend decision

Criticism of MM Approach

MM Hypothesis has been criticized on account of various unrealistic assumptions as given below

1 Perfect capital markets does not exist in reality

2 Information about company is not available to all persons

3 The firms have to incur floatation costs which issuing securities

4 Taxes do exit and there is normally different tax treatment for dividends and capital gains

5 The firms do not follow rigid investment policy

6 The investors have to pay brokerage, fees etc which doing any transaction

7 Shareholders may prefer current income as compared to further gains

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The advocates of this school of thought include Myron Gordon, James Walter and Richardson According to them dividends communicate information to the investors about the firm’s profitability and hence dividend decision becomes relevant Those firms which pay higher dividends will have greater value as compared to those which do not pay dividends or have a lower dividend payout ratio It holds that dividend decisions affect value of the firm

We have examined below two theories representing this notion:

(i) Walter’s Approach and (ii) Gordon’s Approach

(i) Walter’s Approach:Prof Walter’s model is based on the relationship between the firms (a) return on investment i.e r and (b) the cost of capital or required rate of return i.e k According to Prof Walter, If r>k i.e if the firm earns a higher rate of return on its investment than the required rate of return, the firm should retain the earnings Such firms are termed as growth firm’s and the optimum pay-out would be zero which would maximize value of shares

In case of declining firms which do not have profitable investments i.e where r<k, the shareholder would stand to gain if the firm distributes it earnings For such firms, the optimum payout would be 100% and the firms should distribute the entire earnings as dividend

In case of normal firms where r = k the dividend policy will not affect the market value of shares

as the shareholders will get the same return from the firm as expected by them For such firms, there is no optimum dividend payout and value of firm would not change with the change in dividend rate

Assumptions of Walter’s model

1 The firm has a very long life

2 Earnings and dividends do not change while determining the value

3 The Internal rate of return (r) and the cost of capital (k) of the firm are constant

4 The investments of the firm are financed through retained earnings only and the firm does not use external sources of funds

Walter’s formula for determining the value of share

P = D + r/ke (E - D)

ke

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Where P = Market price per share

D = Dividend per share

r = internal rate of return

E = earnings per share

ke = Cost of equity capital

Example 3:The following information is available in respect of Axis Ltd

Earnings per share (EPS or E) $ 10

Cost of Capital, ke, 10%

Find out the market price of the share under different rate of return, r, of 8%, 10%, and 15% for different payouts of 0%, 40%, 80% and 100%

Answer:

The market price of the share as per Walter’s Model may be calculated for different combinations of rates and dividend payout ratios (the earnings per share, E, and the cost of capital, ke, taken as constant) as follows:

If the rate of return, r= 15% and the dividend payout ratio is 40%, then

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= 96

The expected market price of the share under different combinations of ‘r’ and ke have been calculated and presented in the table below: r = 15% 10% 8%

D/P Ratio 0% $150 $100 $80

40% 130 100 88

80% 110 100 96

100% 100 100 100

It may be seen from the table that for a growth firm (r= 15% and r>ke), the market price is highest at $ 150 when the firm adopts a zero payout and retains the entire earnings As the payout increases gradually from 0% to 100%, the market price tends to decrease from $ 150 to $

100 and the firm retains no profit However if r=ke= 10%, then the price is constant at $ 100 for different payouts ratios Such a firm does not have any optimum ratio and every payout ratio is good as any other

Criticism of Walter’s Model

Walter’s model has been criticized on account of various assumptions made by Prof Walter in formulating his hypothesis

1 The basic assumption that investments are financed through retained earnings only is seldom true in real world Firms do raise fund by external financing

2 The internal rate of return i.e r also does not remain constant As a matter of fact, with increased investment the rate of return also changes

3 The assumption that cost of capital (k) will remain constant also does not hold good As a firm’s risk pattern does not remain constant, it is not proper to assume that (k) will always remain constant

(ii)Gordon’s Approach

Another theory which contends that dividends are relevant is Gordon’s model This model which opinions that dividend policy of a firm affects its value are based on following assumptions:-

1 The firm is an all equity firm No external financing is used and investment programs are financed exclusively by retained earnings

2 r and ke are constant

3 The firm has perpetual life

4 The retention ratio, once decided upon, is constant Thus, the growth rate, (g=br) is also constant

capital gains implies a higher required rate of return for discounting the capital gains than for discounting the current dividends In other words, an investor values current dividends more highly than an expected future capital gain

Hence, the “bird-in-hand” argument

investors prefer current dividends as against the future uncertain capital gains When investors are certain about their returns they discount the firm’s earnings at lower rate and therefore placing a higher value for share and that of firm So, the investors require a higher rate of return

as retention rate increases and this would adversely affect share price.Symbolically:

where P = Market price of equity share

E = Earnings per share of firm

b = Retention Ratio (1 – payout ratio)

r = Rate of Return on Investment of the firm

Ke = Cost of equity share capital

br = g i.e growth rate of firm

Example 4:

The following information is available in

Earning per share (EPS or E)

Cost of Capital, ke,

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ecided upon, is constant Thus, the growth rate, (g=br) is also

Gordon argues that the investors do have a preference for current dividends and there is a direct relationship between the dividend policy and the market value of share He has

on basic premise that investors are basically risk averse and they evaluate the future dividend/capital gains as a risky and uncertain proposition Investors are certain of receiving incomes from dividend than from future capital gains The incremental risk associated with capital gains implies a higher required rate of return for discounting the capital gains than for discounting the current dividends In other words, an investor values current dividends more

capital gain

argument of this model suggests that dividend policy is relevant, as investors prefer current dividends as against the future uncertain capital gains When investors are certain about their returns they discount the firm’s earnings at lower rate and therefore ing a higher value for share and that of firm So, the investors require a higher rate of return

as retention rate increases and this would adversely affect share price.Symbolically:

where P = Market price of equity share

gs per share of firm

payout ratio)

r = Rate of Return on Investment of the firm

= Cost of equity share capital

The following information is available in respect of Axis Ltd

$ 10 10%

ecided upon, is constant Thus, the growth rate, (g=br) is also

Gordon argues that the investors do have a preference for current dividends and there is a direct relationship between the dividend policy and the market value of share He has built the model

on basic premise that investors are basically risk averse and they evaluate the future dividend/capital gains as a risky and uncertain proposition Investors are certain of receiving

e incremental risk associated with capital gains implies a higher required rate of return for discounting the capital gains than for discounting the current dividends In other words, an investor values current dividends more

of this model suggests that dividend policy is relevant, as investors prefer current dividends as against the future uncertain capital gains When investors are certain about their returns they discount the firm’s earnings at lower rate and therefore ing a higher value for share and that of firm So, the investors require a higher rate of return

as retention rate increases and this would adversely affect share price.Symbolically: -

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Find out the market price of the share under different rate of return, r, of 8%, 10%, and 15% for different payouts of 0%, 40%, 80% and 100%

ANSWER:

The market price of the share as per Gorden’s model may be calculated as follows:

If r=15% and payout ratio is 40%, then the retention ratio, b, is 0.6 (i.e 1-.4) and the growth rate, g= br= 09 (i.e.,0 6*0.15) and the market price of the share is

P = E (1-b)

ke-br

P = 10(1-.6)/0.10-.09

P = $ 400

If r= 8% and payout ratio is 80%, then the retention ratio, b, 0.2 (i.e., 1-.8) and the growth rate, g=br=.016 (i.e., 0.2*0.08) and the market price of the share is

P = 10(1-.2)//10-.016

P = $ 95

Similarly the expected market price under different combinations of ‘r’ and dividend payout ratio have been calculated and shown below:

r = 15% 10% 8%

D/P Ratio 0% 0 0 0

40% $400 $100 $77

80% 114.3 100 95

100% 100 100 100

On the basis of figures given in the table above, it can be seen that if the firm adopts a zero payout then the investor may not be willing to offer any price For a growth firm (i.e., r>ke>br), the market price decreases when the payout is increased For a firm having r<ke, the market price increases when the payout is increased

If r=ke, the dividend policy is irrelevant and the market price remains constant at $100 only Gordon had also argued that even if r=ke, the dividend payout ratio matters and the investors being risk averse prefer current dividends which are certain to future capital gains which are uncertain The investors will apply a higher capitalization rate i.e., ke to discount the future

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capital gains This will compensate them for the future uncertain capital gain and thus, the market price of the share of a firm which retains profit will be adversely affected

DIVIDEND POLICY: DETERMINANTS AND CONSTRAINTS

Determinants of Dividend Policy

The payment of dividend involves some legal as well as financial considerations It is difficult to determine a general dividend policy which can be followed by different firms at different times because dividend decision has to be taken considering the special circumstances of an individual case The following are important factors which determine dividend policy of a firm:

1 Legal Restrictions: Legal Provisions relating to dividends as laid down in section, 205, 205A,

206 and 207 of companies Act, 1956 are significant because they lay down a framework within which dividend policy is formulated These provisions require that dividend can be paid only out

of current profit or past profits after providing for depreciation The companies (Transfer of Profits to Reserves) Rules, 1975 require a company providing more than 10% dividend to transfer certain percentage of current year’s profit to Reserves

not be less than Exceeds 10% but not 12.5% of paid up

Exceeds 12.5% but not 15% of paid up

Exceeds 15% but not 20% of paid up

Companies Act, further provides that dividend cannot be paid out of capital, because it will amount to reduction of capital adversely affecting the security of creditors

2 Desire and Type of Shareholders: Although, legally, the direction as to whether to declare dividend or not has been left with BOD, the directors should give importance to desires of shareholders in declaration of dividends as they are representatives of shareholders Investors such as retired persons, widows, and other economically weaker persons view dividends as source of funds to meet their day-to-day living expenses To benefit such investors, the companies should pay regular dividends On other hand, a wealthy investor in a high income tax bracket may not benefit by high current dividend incomes Such an investor may be interested in lower current dividend and high capital gains

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3 Nature of Industry: Nature of Industry to which company is engaged also considerably affects dividend policy Certain industries have comparatively steady and stable demand irrespective of prevailing economic conditions For example, people used to drink liquor both in boom as well as in recession Such firms expect regular earnings and hence follow consistent dividend policy On the other hand, if earnings are uncertain, as in the case of luxury goods conservative policy should be followed Such firms should retain a substantial part of their current earnings during boom period in order to provide funds to pay adequate dividends in the recession periods Thus, industries with steady demand of their products can follow a higher dividend payout ratio while cyclical industries should follow a lower payout ratio

4 Age of Company: It also influences dividend decision of company A nearly established concern has to limit payment of dividend and retain substantial part of earnings for financing its future growth while older companies which have established sufficient reserves can afford to pay liberal dividends

5 Future Financial Requirements: If a company has highly profitable investment opportunities

it can convince the shareholders of need for limitation of dividend to increase future earnings and stabilise its financial position But when profitable investment appointments do not exist then company may not be justified in retaining substantial part of its current earnings Thus, a concern having few internal investment opportunities should follow high payout ratio as compared to one having more profitable investment opportunities

6 Liquid Resources: The dividend policy of a firm is also influenced by availability of liquid resources Although, a firm may have sufficient available profit to declare dividends, yet it may not be desirable to pay dividend if it does not have sufficient liquid resources Hence liquidity position of company is an important consideration in paying dividends If company does not have liquid resources, it is better to declare stock dividend i.e issue of bonus shares to existing shareholders

7 Requirements of Institutional Investors: Dividend policy of a company can be affected by requirements of institutional investors such as financial institutions, banks, insurance corporations etc These investors usually favour a policy of regular payment of cash dividends and stipulate there own terms with regard to payment of dividend on equity shares

8 Stability of Dividends: Stability of dividend refers to payment of dividend regularly and shareholders generally, prefer payment of such regular dividends Some companies follow a policy of constant dividend per share while others follow a policy of constant payout ratio and while there are some other who follow a policy of constant low dividend per share plus an extra dividend in years of high profits A policy of constant dividend per share is most suitable to concerns whose earnings are expected to remain stable over a number of years or those who have built up sufficient reserves to pay dividends in years of low profits The policy of constant

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payout ratio i.e paying a fixed percentage of net earnings every year may be supported by firm because it is related to firms ability to pay dividends The policy of constant low dividend per share plus some extra dividend in years of high profits is suitable to firms having fluctuating earnings from year to year

9 Magnitude and Trend of Earnings: The amount and trend of earnings is an important aspect

of dividend policy It is rather the starting point of the dividend policy As dividends can be paid only out of present or past’s years profits, earnings of a company fix the upper limits on dividends The dividends should nearly be paid out of current years earnings only as retained earnings of the previous years become more or less a part of permanent investment in the business to earn current profits The past trend of the company’s earnings should also be kept in consideration while making dividend decision

10 Control objectives: When a company pays high dividends out of its earnings, it may result

in dilution of both control and earnings for existing shareholders As in case of high dividend pay out ratio the retained earnings are insignificant and company will have to issue new shares to raise funds to finance its future requirements The control of the existing shareholders will be diluted if they cannot buy additional shares issued by the company Similarly issue of new shares shall cause increase in number of equity shares and ultimately cause a lower earnings per share and their price in the market Thus under these circumstances to maintain control of the existing shareholders, it may be desirable to declare lower dividends and retain earnings to finance the firm’s future requirements

Types of Dividend Policy

The various types of dividend policies are discussed as follows:

(a) Regular Dividend Policy: Payment of dividend at usual rate is termed as regular Dividend The investors such as retired persons, widows, and other economically weaker persons prefer to get regular dividends A regular dividend offer following Advantages

 It establishes profitable record of company

 It creates confidence among shareholder

 It stabilises market value of shares

 It aids in long term financing and renders financing easier

 The ordinary shareholders view dividends as a source of founds to meet their day-to-day living expenses

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Regular dividend can be maintained only by companies of long standing and stable earnings (b) Stable Dividend Policy: The term ‘Stability of Dividend’ means consistency or lack of variability in stream of dividend payments A stable dividend policy may be established in any of following three forms

(i) Constant Dividend Per Share: Some companies follow a policy of paying fixed dividend per share irrespective of level of earnings year after year Such firms usually create a ‘Reserve for Dividend Equalisation’ to enable them pay fixed dividend even in year when earnings are not sufficient or when there are losses A policy of constant dividend per share is most suitable to concerns whose earnings are expected to remain stable over number of years

(ii) Constant Pay out ratio: It means payment of fixed percentage of net earnings as dividends every year The amount of dividend in such a policy fluctuates in direct proportion to earnings of company The policy of constant pay out is preferred by the firms because it is related to their ability to pay dividends

(iii) Stable dollar Dividend plus extra dividend: Some companies follow a policy of paying constant low dividend per share plus an extra dividend in the years of high profit Such a policy

is most suitable to the firm having fluctuating earnings from year to year

Advantages of Stable Dividend Policy: A Stable dividend policy is advantageous to both investors and company on account of the following:

a It is sign of continued normal operations of company

b It stabilises market value of shares

c It creates confidence among investors

d It improves credit standing and making financing easier

e It meets requirements of institutional investors who prefer companies with stable dividends

Dangers of Stable dividend policy

Inspite of many advantages, the stable dividend policy suffers from certain limitations Once a stable dividend policy is followed by a company, it is not easier to change it If stable dividends are not paid to shareholders on any account including insufficient profits, the financial standing

of company in minds of investors is damaged and they may like to dispose of their holdings It adversely affects the market price of shares of the company And if a company pays stable dividends inspite of its incapacity it will be suicidal in long run

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(c) Irregular Dividend Policy: Some companies follow irregular dividend payments on account of following:

a) Uncertainty of Business

b) Unsuccessful Business operations

c) Lack of liquid resources

d) Fear of adverse effects of regular dividend on financial standing of company

(d) No Dividend Policy: A company may follow a policy of paying no dividends presently because of its unfavourable working capital position or on account of requirements of funds for future expansion and growth

A Compromise Dividend Policy

Many firms seem to follow a compromise dividend policy based on the following goals:

1 Do not reject positive NPV projects to pay a dividend

2 Avoid reducing the dividend

3 Avoid issuing new equity

4 Maintain a target debt-equity ratio

5 Maintain a target dividend payout ratio

For this kind of compromise policy, both the target debt-equity ratio and the target dividend payout ratio are regarded as long-term goals In general, management is reluctant to increase dividends to a level that cannot be sustained, or to decrease dividends since that would suggest

an expectation of adverse future events

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CHAPTER TWO PRINCIPLES OF WORKING CAPITAL MANAGEMENT Working capital management is concerned with the problems that arise in attempting to manage the current assets, the current liabilities and the interrelationship that exists between them The term Current Assets refer to those assets which in the ordinary course of business can be, or will

be, converted into cash within one year without undergoing a reduction in value and without disrupting the operations of the firm 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 AssetsCurrent Liabilities

Cash and Bank BalancesShort term Borrowings

Marketable Securities Accounts Payables

Accounts Receivables Notes Payables

Notes Receivables Trade Advances

Inventories: RMs, WIP, FGs

In the management of working capital two characteristics of current assets must be borne in mind: (i) Short life span, and (ii) swift transformation into other asset form Current assets have a short life span Cash balance may be held idle for a week or two, account receivables may have a life span of 30 to 60 days, and inventories may be held for 30 to 100 days The life span of current assets depends upon the time required in the activities of procurement, production, sales and collection and degree of coincide (synchronization) among them

Each current asset is swiftly transformed into another asset forms: cash is used for acquiring raw material; raw materials are transformed into finished goods ( this transformation may involve several stages of work-in-progress); finished goods, generally sold on credit, are converted into accounts receivables; and finally accounts receivables, on realization generate cash The following figure 1.1 shows the cycle of transformation

The goal of the working capital management is to manage the firm’s current assets and liabilities

in such a way that a satisfactory level of working capital is maintained This is so because if the firm cannot maintain a satisfactory level of working capital it is likely to become insolvent and may even be forced into bankruptcy The current assets should be large enough to cover its current liabilities in order to ensure a reasonably margin of safety Each of the current assets

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must be managed efficiently in order to maintain the liquidity of the firm while not keeping too high level of any one of them Each of the short term sources of financing must be continuously managed to ensure that they are obtained and used in the best possible way The interaction between current assets and current liabilities is, therefore, the main theme of the theory of working capital management

2.1 Concepts and Definitions of Working Capital

The term Gross Working Capital also referred to as working capital means a firm’s investment

in assets that are expected to be converted to cash within one year (i.e current assets)

When a firm is originally established there is a need for two types of investment, fixed asset investments (land, building, machinery, vehicles, office equipment etc.)and working capital investment The working capital investment is meant for payments for raw material purchases, payment for labor and to meet other expenditures in an attempt to produce goods (services) for sale

The term Net Working Capital(NWC) can be defined in two ways (i) the most common

definition of NWC is the difference between current assets and current liabilities; and (ii)

alternative definition of NWC is that portion of current assets which is financed with long-term funds

NWC is commonly defined as the difference b/n CAs and CLs Efficient working capital requires that firms should operate with some amount of NWC, the exact amount varying from firm to firm and depending, among other things, on the nature of industry The theoretical justification for the use of NWC to measure liquidity is based on the basis that the greater the margin by which the current assets cover the short term obligations, the more is the ability to pay obligations when they become due for payment The NWC is necessary because the cash outflows and inflows do not coincide In other words, it is the non-synchronous nature of cash flows that makes NWC necessary The cash inflows are,however, difficult to predict, therefore, NWC is necessary The more predictable the cash inflows are, the less NWC will be required and vise-versa

NWC can alternatively be defined as that part of the current assets which are financed with term funds Since current liabilities represent sources of short term funds, as long as current assets exceed the current liabilities, the excess must be finance with long-term funds

long-NWC = Current Assets – Current Liabilities

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Importance or Advantages of Adequate Working Capital:

Working capital is the life blood and nerve centre of a business Hence, it is very essential to maintain smooth running of a business No business can run successfully without an adequate amount of working capital The main advantages of maintaining adequate amount of working capital are as follows:

1) Solvency of the Business: Adequate working capital helps in maintaining solvency of business by providing uninterrupted flow of production

2) Goodwill: Sufficient working capital enables a business concern to make prompt payments and hence helps in creating and maintaining goodwill

3) Easy Loans: A concern having adequate working capital, high solvency and good credit standing can arrange loans from banks and others on easy and favourable terms

4) Cash Discounts: Adequate working capital also enables a concern to avail cash discounts on purchases and hence it reduces cost

5) Regular Supply of Raw Material: Sufficient working capital ensure regular supply of raw materials and continuous production

6) Regular payment of salaries, wages and other day to daycommitments: A company which has ample working capital can make regular payment of salaries, wages and other day to day commitments which raises morale of its employees, increases their efficiency, reduces costs and wastages

7) Ability to face crisis: Adequate working capital enables a concern to face business crisis in emergencies such as depression

8) Quick and regular return on investments: Every investor wants a quick and regular return

on his investments.Sufficiency of working capital enables a concern to pay quick and regular dividends to is investor as there may not be much pressure to plough back profits which gains the confidence of investors and creates a favourable market to raise additional funds in future

9) Exploitation of Favourable market conditions: Only concerns with adequate working capital can exploit favourable market conditions such as purchasing its requirements in bulk when the prices are lower and by holding its inventories for higher prices

10) High Morale: Adequacy of working capital creates an environment of security, confidence, high morale and creates overall efficiency in a business

The Need or Objects or Working Capital

The need for working capital arises due to time gap between production and realisation of cash from sales There is an operating cycle involved in sales and realisation of cash There are time

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gaps in purchase of raw materials and production, production and sales, and sales and realization

of cash Thus, working capital is needed for following purposes

1 For purchase of raw materials, components and spares

2 To pay wages and salaries

3 To incur day-to-day expenses and overhead costs such as fuel, power etc

4 To meet selling costs as packing, advertisement

5 To provide credit facilities to customers

6 To maintain inventories of raw materials, work in progress, stores and spares and finished stock

Greater size of business unit large will be requirements of working capital The amount of working capital needed goes on increasing with growth and expansion of business till it attains maturity At maturity the amount of working capital needed is called normal working capital 2.2 operating and cash conversion Cycle

The need for working capital or current assets cannot be overemphasized Given the objective of financial decision making which is to maximize the shareholders’ wealth, it is necessary to generate sufficient profits The extent to which profits can be earned will naturally depend, among other things, upon the magnitude (size) of the sales A successful sales program is, in other words, necessary for earning profits by any business enterprise However, sales do not convert into cash instantly; there is invariably a time-lag b/n the sales of goods and the receipt of cash There is, therefore, a need for working capital in the form of CAs to deal with the problem arising out of the lack of immediate realization of cash against good sold Therefore, sufficient working capital is necessary to sustain sales activity Technically, this is referred to as the

“Operating Cycle”

The Operating Cycle can be said to be at the heart of the need for working capital The continuing flow from cash to suppliers, to inventory, to accounts receivable and back into cash is

Figure 1- Operating Cycle

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The Operating cycle consists of three phases In the phase – 1, cash gets converted into inventory This includes purchase of raw materials, conversion of raw material into WIP, finished goods and finally the transfer of goods to stock at the end of the manufacturing process

In the case of trading organizations, this phase is shorter as there would be no manufacturing activity and cash is directly converted into inventory The phase is, of course, totally absent in the case of service organizations

In phase – 2 of the cycle the inventory is converted into receivables as credit sales are made to customers Firms which do not sell on credit obviously not have phase – 2 of the operating cycle The last, phase, phase – 3, represents the stage of when receivables are collected This is phase completes the operating cycle This, the firm has moved from the cash toinventory, to receivables and to cash again

2.3 Characteristics of Working Capital

A) Circulating Capital

Working capital, once invested, is constantly circulating from one component to other component of working capital Cash is used to buy RMs, pay labor and overhead costs Then the result of production becomes outputs and hence changed to finished goods inventories The finished goods will be sold either for cash or on account The A/R is then changed back to cash This circulation goes on until the life of a project (see figure) Note that the working capital changes with the stage of life cycle of product or condition of operation Stable operation necessitates constant working capital

The cycle is shown in the following figure

Figure 2: Working Capital as a Circulating Capital

WIP

Finished goods (or service)

Input (Raw Material)

Cash sales

Sales on account

Cash A/R

b) Liquidity

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Each component of working capital has different degrees of liquidity Cash is the most liquid asset Next is the marketable security (it is sometimes called near cash asset) A/R is more liquid than inventories in the sense that inventories may first be converted to receivables before it is converted to cash

c) Risk

Each component of working capital has its own risk For example, accounts receivable may be uncollectible or becomes bad debt The raw materials may be damaged, finished goods may be unsalable

Types of working capital :Permanent and Temporary Working Capital

The operating cycle creates the need for the current assets (working capital) However, the need does not come to an end after the cycle is completed It continues to exist To explain this continuing need of current assets (working capital) a distinction should be drawn b/n

“Permanent and Temporary WC”

To carry on business, a certain minimum level of working capital is necessary on a continuous and uninterrupted basis For all practical purposes, this requirement has to be met permanently as with other fixed assets This requirement is referred to as “Permanent or Fixed WC”

Any amount over and above the permanent level of working capital is “temporary, fluctuating

or variable WC” This is related to cyclical WC that does not have long term impact, changing

2.4 Determinants of Working Capital Management

A firm should plan its operations in such a way that it should have neither too much nor too little working capital The total working capital requirement is determined by a wide variety of factors These factors, however, affect different enterprise differently

a) Nature of Business

The working capital requirement of a firm is closely related to the nature of its business A service firm, like electricity undertaking or a transport corporation, which has a short operating cycle and which sells predominantly on cash basis, has modest (low) working capital requirement On the other hand, a manufacturing concern likes a machine tools unit, which has long operating cycle and which sells largely on credit, has a very substantial working capital requirement

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b) Length of Operating Cycle

The longer the operating cycle the more the working capital requirement will be Hence, more working capital is needed:

 The more time the inventories (RMs or FGs) are stocked

 The more the manufacturing cycle (i.e the more the time it takes to convert the raw materials to final output)

 The more time it takes to collect receivables (liberal credit policy)

c) Seasonality of Operations

Firms which have marked seasonality in their operations usually have highly fluctuating working capital requirements To illustrate, consider a firm manufacturing rain coats The sale of rain coats reaches a peak during the rainy season and drops sharply during the winter period, and almost no sales in summer season The working capital need of such a firm is likely to increase considerably in rainy months and decrease significantly during winter period On the other hand, afirm manufacturing a product like lamps, which have fairly even sales round the year, tends to have stable working capital needs

d) Production Policy

A marked by pronounced seasonal fluctuation in its sales may pursue a production policy which may reduce the sharp variations in working capital requirements For example, a manufacturer of rain coats may maintain a steady production throughout the year rather than intensify the production activity during the peak business Such a production policy may dampen the fluctuations in working capital requirements

e) Market Conditions

The degree of competition prevailing in the market place has an important bearing on working capitalneeds When competition is keen, a large inventory of finished goods is required to promptly serve customers who may not inclined to wait because other manufacturer are ready to meet their needs Further, generous(liberal) credit terms may have to be offered to attract customers in a highly competitive market Thus, working capital needs tend to be high because

of greater investment in finished goods inventory and A/R

g) Credit Policy

The credit policy related to sales and purchases also affect the working capital The credit policy

(1) through credit terms granted by the firm to its customers; (2) credit terms available to the firm from its suppliers The credit terms granted to customers have a bearing on the magnitude of

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working capital by determining the level of receivables The credit sales results in higher receivables; higher receivables mean more working capital On the other hand, if liberal credit terms are available from the supplier of goods, the need for working capital is high The working capital requirements of a business are thus, affected by the terms of purchase and sale, and the role given to credit by a company in itsdealing with suppliers and customers

h) Inflation

Inflation affects the value of cash and other elements of cash More WC is required during high inflation rate affecting price of inputs

Excess or Inadequate Working Capital

Every business concern should have adequate working capital to run its business operations It should have neither excess working capital nor inadequate working capital Both excess as well

as short working capital positions are bad for any business

Disadvantages of Excessive Working Capital

1 Excessive working capital means idle funds which earn no profits for business and hence business cannot earn a proper rate of return

2 When there is a redundant working capital it may lead to unnecessary purchasing and accumulation of inventories causing more chances of theft, waste and losses

3 It may result into overall inefficiency in organization

4 Due to low rate of return on investments, the value of shares may also fall

5 The redundant working capital gives rise to speculative transaction

6 When there is excessive working capital, relations with banks and other financial institutions may not be maintained

Disadvantages of Inadequate working capital

1 A concern which has inadequate working capital cannot pay its short-term liabilities in time Thus, it will lose its reputation and shall not be able to get good credit facilities

2 It cannot buy its requirements in bulk and cannot avail of discounts

3 It becomes difficult for firm to exploit favourable market conditions and undertake profitable projects due to lack of working capital

4 The rate of return on investments also falls with shortage of working capital

5 The firm cannot pay day-to-day expenses of its operations and it created inefficiencies, increases costs and reduces the profits of business

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Management of Working Capital

Working capital refers to excess of current assets over current liabilities Management of working capital therefore is concerned with the problems that arise in attempting to manage current assets, current liabilities and inter relationship that exists between them The basic goal of working capital management is to manage the current assets and current of a firm in such a way that satisfactory level of working capital is maintained i.e it is neither inadequate nor excessive This is so because both inadequate as well as excessive working capital positions are bad for any business Inadequacy of working capital may lead the firm to insolvency and excessive working capital implies idle funds which earns no profits for the business Working capital Management policies of a firm have a great effect on its profitability, liquidity and structural health of organization In this context, evolving capital management is three dimensional in nature

1 Dimension I is concerned with formulation of policies with regard to profitability, risk and liquidity

2 Dimension II is concerned with decisions about composition and level of current assets

3 Dimension III is concerned with decisions about composition and level of current liabilities Principles of Working Capital Management

a) Principle of Risk Variation

b) Principle of Cost of Capital

c) Principle of Equity position

d) Principle ofMaturity ofPayment

1 Principle of Risk Variation: Risk refers to inability of firm to meet its obligation as and when they become due for payment Larger investment in current assets with less dependence on short-term borrowings increases liquidity, reduces risk and thereby decreases opportunity for gain or loss On other hand less investment in current assets with greater dependence on short-term borrowings increases risk, reduces liquidity and increases profitability

There is definite direct relationship between degree of risk and profitability A conservative management prefers to minimize risk by maintaining higher level of current assets while liberal management assumes greater risk by reducing working capital However, the goal of management should be to establish suitable trade off between profitability and risk The various working capital policies indicating relationship between current assets and sales are depicted below:-

2 Principle of Cost of Capital: The various sources of raising working capital finance have different cost of capital and degree of risk involved Generally, higher the risk lower is cost and lower the risk higher is the cost A sound working capital management should always try

to achieve proper balance between these two

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3 Principle of Equity Position: This principle is concerned with planning the total investment

in current assets According to this principle, the amount of working capital invested in each component should be adequately justified by firm’s equity position Every rupee invested in current assets should contribute to the net worth of firm The level of current assets may be measured with help of two ratios

(i) Current assets as a percentage of total assets and

(ii) Current assets as a percentage of total sales

4 Principle of Maturity of Payment: This principle is concerned with planning the sources of finance for working capital According to this principle, a firm should make every effort to relate maturities of payment to its flow of internally generated funds Generally, shorter the maturity schedule of current liabilities in relation to expected cash inflows, the greater inability to meet its obligations in time

2.5 Alternative Current Assets Investment Policy

An investment working capital policy decision is concerned with the level of investment in current assets Under a relaxed/flexible policy, the investment in current assets is high This means that the firm maintains huge balance of cash and marketable securities, carries large amount of inventories, and grants generous terms of credit to customers which leads to high level

of receivables

Under a restricted/aggressive policy, the investment in current assets is high This means that firm keeps a small balance of cash marketable securities, manages with small amount of inventories, and offers terms of credit which leads to a low level of receivables A restricted currents asset investment policy generally provides the highest expected return on investment (ROI) But, it entails the greatest risk The reverse is true under a relaxed policy

Moderate policyisa policy that is b/n the relaxed and restricted policy.Itfalls in between the two extremes in terms of expected risk and return

CAsRelaxed

Moderate

Restricted

Sales

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Fig 1.5 Alternative current assets investment policies

Determining the optimal level of current assets involves a trade-off between costs that rise with currents assets and costs that fall with current assets The former are referred to as “carrying cost” and later as “shortage costs”.Carrying costs are mainly in the form of the cost of financing

a higher level of current assets Shortage costs are mainly in the form of disruption in production schedule, loss of sales, and loss of customer goodwill

2.6 Sources of Financing Working Capital

Working capital can be financed from different sources:

a) Spontaneous current liabilities: this source of working capital financing mainly emanated from operational activities between a credit customer and a supplier The customer finances his purchases through a credit that he obtains from the supplier Other spontaneous liabilities include accrued wages, accrued taxes, etc

b) Short – term financing sources: the sources include bankloans, private loans, and commercial papers

c) Long – termloans: this usually involves bank loans on long term basis

d) Equity Capital: this is usually the major source of initial WC investment It is the money put

in the firm by the owner or investor

In assessing the suitability of the above sources one needs to evaluate the risk and the costs involved, in relation to the returns from each of the sources Spontaneous liabilities usually

do not involve costs The short and long term sources have explicit cost (interest) while equity capital has implicit costs (opportunity costs)

2.7 Alternative CA Financing Policies/Strategies

There are three basic option of financing WC, i.e., options of matching-expected cash inflows from assets with outflows from their respective sources of financing

a) Perfect Hedge (Maturity matching) Policy

It is a strategy of financing temporary current assets from short term sources and permanent current assets and fixed assets from long term sources of funds This strategy is considered sound because temporary obligations are paid from the sale of temporary current assets i.e the temporary obligations are used to finance the acquisition of current assets (a self-liquidating

principle)

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b) Conservative Hedge Policy

This strategy finances all the fixed assets, all permanent current assets and significant portion of temporary current assets with a long term sources The short term source of finance is used to finance just little of temporary CAS.This policy is conservative becauseit makes sure that most of its current assets are acquired from a stable long term source The advantage is that such long term sources may be obtained when credit terms are favorable and at times of credit restraint the firm will have already enough funds and will have less risk Excess funds at firms may be invested in marketable securities

The distinct features of this approach are:

 Liquidity is greater

 Risk is minimized

 The cost of financing is relatively more as interest has to be paid even on seasonal requirements for entire period

Trade offbetween the Hedging and Conservative Approaches

The hedging approach implies low cost, high profit and high risk while the conservative approach leads to high cost, low profits and low risk Both the approaches are the two extremes and neither of them serves the purpose of efficient working capital management A trade off between the two will then be an acceptable approach The level of trade off may differ from case

to case depending upon the perception of risk by the persons involved in financial decision making However, one way of determining the trade off is by finding the average of maximum and the minimum requirements of current assets The average requirements so calculated may be financed out of long-term funds and excess over the average from short-term funds

Hedging Vs Conservative Approach

1 The cost of financing is reduced 1 The cost of financing is higher

2 The investment in net working capital is

3 Frequent efforts are required to arrange

4 The risk is increased as firm is

vulnerable to sudden shocks 4 It is less risky and firm is able to absorb shocks

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In aggressive hedge policy, all fixed assets and portion of permanent assets are financed from long term sources All temporary current assets and a portion of permanent current assets are financed from the short term sources It is a dangerous strategy in the sense that it may create a problem of liquidity crisis and sometimes it may lead to a bankruptcy

Which policy is better?

This depends on how individuals view risks in relation to return on equity Basically, higher returns involve higher risk or conversely, for taking higher risk, there should be compensating higher return In the same manner, lower risksareassociatedwith lower returns Relating this to the hedging policy, one should realize that conservative hedge policy has less risk and less return

on equity and aggressive hedge policy has higher risk and higher return

The following illustration shows that the risk of conservative policy as measured in current ratio

is less than that of aggressive policy But, aggressive policy has higher return on equity

The Effect of Conservative and Aggressive Financing

Assets Current Assets 1,000

Fixed Assets 1,000

Total Assets 2,000

Financing Options Conservative Aggressive

Short term loan (12%) 200 1000

Long term loan (15%) 900 100

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Financial Indicators:

Risk: current ratio 5 times 1 times

Return: ROE 46.7% 48.06%

Estimate of Working Capital Requirements

“Working Capital is the life blood and controlling nerve centre of a business.”No business can be successfully run without an adequate amount of working capital To avoid the shortage of working capital at once, an estimate of working capital requirements should be made in advance

so that arrangements can be made to procure adequate working capital But estimation of working capital requirements is not an easy task and large numbers of factors have to be considered before starting this exercise There are different approaches available to estimate the working capital requirements of a firm which are as follows:

(1)Working Capital as a Percentage of Net Sales:This approach to estimate the working capital requirement is based on the fact that the working capital for any firm is directly related to the sales volume of that firm So, the working capital requirement is expressed as a percentage of expected sales for a particular period This approach is based on the assumption that higher the sales level, the greater would be the need for working capital There are three steps involved in the estimation of working capital

a To estimate total current assets as a % of estimated net sales

b To estimate current liabilities as a % of estimated net sales, and

c The difference between the two above is the net working capital as a % of net sales

(2) Working Capital as a Percentage of Total Assets or Fixed Asset:

This approach of estimation of working capital requirement is based on the fact that the total assets of the firm are consisting of fixed assets and current assets On the basis of past experience, a relationship between (i) total current assets i.e., gross working capital; or net working capital i.e Current assets – Current liabilities; and (ii) total fixed assets or total assets of the firm is established The estimation of working capital therefore, depends upon the estimation

of fixed capital which depends upon the capital budgeting decisions

Both the above approaches to the estimation of working capital requirement are simple in approach but difficult in calculation

(3) Working Capital based on Operating Cycle:In this approach, the working capital estimate depends upon the operating cycle of the firm A detailed analysis is made for each component of working capital and estimation is made for each of these components The different components

of working capital may be enumerable as follows:

Current Assets Current Liabilities

Cash and Bank Balance Creditors for Purchases

Inventory of Raw Material Creditors for Expenses

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Inventory of Work-in-Progress

Inventory of Finished Goods

For manufacturing organization, the following factors have to be taken into consideration while making an estimate of working capital requirements

Factors Requiring Consideration While Estimating Working Capital

1 Total costs incurred on material, wages and overheads

2 The length of time for which raw material are to remain in stores before they are issued for production

3 The length of production cycle or work in process i.e the time taken for conversion of raw material into finished goods

4 The length of sales cycle during which finished goods are to be kept waiting for sales

5 The average period of credit allowed to customers

6 The amount of cash required to pay day to day expenses of the business

7 The average amount of cash required to make advance payments, if any

8 The average credit period expected to be allowed by suppliers

9 Time lag in the payment of wages and other expenses

From the total amount blocked in current assets estimated on the basis of the first seven items given above, the total of the current liabilities i.e the last two item, is deducted to find out the requirements of working capital In case of purely trading concern, points 1, 2, 3 would not arise but all other factors from points 4 to 9 are to be taken into consideration In order to provide for contingencies, some extras amount generally calculated as a fixed percentage of the working capital may be added as margin of safety

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Suggested Pro-forma for estimation of working capital requirements under operating cycle is given below:

Estimation of Working Capital Requirements