Advanced ane MENETI CTA4+ Ungerstana une impact oF dividend desisio + MM, Walter and Gordon's Approach Determinants of dividend policy. ‘Types of dividend policy, Elfecis end objects of bonus issue, SEBI Guidelines for the issue of bomus shares, Accounting for bonus issue, non valuation of a firm, CE INTRODUCTION ‘The term dividend refets to that part of profits of a eompany which is distributed by the company mong its shareholders. It is the reward of the shareholders for investments made by them in the shares of the company. The investors are interested in earning the maximum return on their investments and to maximise their wealth, A company, on the other hand, needs to provide finds 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 1 depend upon outside resources such as issue of debt or new shares. Dividend policy of a firm, thus affects ‘both the long-term financing and the wealth of shareholders, As a result, the firm's decision to pay dividends I Ist be reached in such a manner so as to equitably apportion the distributed profits and retained carnings. Since dividend is a right of shareholders to participate in the profits and surplis of the company for their investment in the share enpital of the company, they should receive fair amount of the profits. ‘The company should, therefore, distribute a reasonable amount as dividends (which should include a nonnal rate of interest Pls a return for the risks assumed) to its members and retain the rest for its growth and survival, DIVIDEND DECISION AND VALUATION OF FIRMS The value ofthe firm ean be maximised iF'the sharcholders' wealth is maximised. There are conflicting Views regarding, the impact of dividend decision on the valuation of the firm, According tt one school of ‘thought, dividend decision does nat affect the share-holders' wealth and henee the valuation of the firm. Oa the other hand, acconding to the other school af thought, dividend decision matetially affects the shareholders’ Wealth and also the valuatian of the firm. We have discussed below the views of the two schools of thought toler two groups : |. The Irelevance Concept of fend or the Theory of Irrelevance, and 2 ‘The Relevance Concept of Dividend or the Theory of Relevance, | THE IRRELEVANCE CONCEPT OF DIVIDEND OR THE THEORY OF IRRELEVANCE ; _SRESIDUAL APPROACH According t this theory, dividend decision has no effect on the wealth of the shareholders or the a Scanned with CamScannerFe Py a prices of the shares, and hence itis irrelevant so far as the valuation of the fin is eeneimaa ee cl shi ' thea dividend decision merely as a part of financing decision because the earnings available may be rei eg, business for reinvestment. But, if the fimds are not required in the business they may be disse," he dividends. Thus, the decision to pay dividends or retain the earnings may be taken as a residual decjgi "4 a, theory assumes that investors da not differentiate between dividends and retentions by the firm, ‘The desire is to eam higher return an their investment, In ease the firm has profitable investment opportunitjas a higher rate of return than the cost of retained earnings, the investors would be content with the firm so" the camings to finance the same. However, if the firm is not in a position to find profitable ingest ‘opportunities, the investors would prefer to recive the earings in the form of dividends, Thus, a fig y* retain the eamings if it has profitable investment opportunites otherwise it should pay them as dig B. MODIGLIANI AND MILLER APPROACH (MM MODEL} . Modigliani and Miller have expressed in the most comprehensive manner in SUPPOT Of the the irrelevance. They maintain that dividend policy has no effect on the market price of the shares and they of the firm is determined by the earning capacity of the firm or its investment policy. The splitting of car." between retentions and dividends, may be in any manner the firm likes, does not affect the value of ie, As observed by M.M. “Under conditions of perfect capiial markets, rational investors, absence of discrimination between dividend income and capital appreciation, given the firm’ investment policy ts dyge, policy may have no influence on the market price of the shares.”" Assumptions of MM Hypothesis ‘The MM hypothesis of imelevance of dividends is based on the following assumptions (i) There are perfect capital markets. (ii) Investors behave rationally. (iii) eformation about the company is available to all without any cost (ix) There are no floatation and transaction costs, () No investor is large enough to effect the market price of shares. (vi) ‘There are either no taxes or there are no differences in the tax rates applicable to dividends sg capital gains. (vit) The firm has a rigid investment policy. (vit) There is no risk or uncertainty in regard to the future of the firm. (MM dropped this asumpie: later), ‘The Argument of MM The argument given by MM in support of their hypothesis is that whatever inerease in the vale &f ‘the firm results from the payment of dividend, will be exactly off set by the decline in the market price of bus because of extemal financing and there will be no change in the total wealth of the shareholders, For exanml if'a company, having investment opportunities, distributes all its earnings among the shareholders, it will to raise additional funds from externat sources. This will result in the increase in number of shares or pay of interest charges, resulting in fall in tlie carnings per share in the future. Thus whatever a shareholder sss ‘on account of dividend payment is neutralised completely by the fallin the market price of shares due to desl=t in expected future eamings per share, To be more specific, the market price of a share in the beginning of! period is equal to the present value of dividends paid at the end of the period plus the market price ofthe sha=* at the end of the period. This can be put in the form of the following, formula is +R Where = P= eee price per share at the beginning of the period, or prevailing market pA ie a share ividend to be received at the end of the period. 1 Miller, M ‘and F,Modigtiani, “ Dividend Policy, Growth ad Valuation of Journal of Business, October 1961 Scanned with CamScanneraoa aww wow be w ma fans eee SLIM = Vepeapmamy 203050 Md pe anc mpunmgy © Say 300 208 Ch 1 iy "WHE wo oS SHY GON pei se Gl? I “amadondds 2p sap aos YH! © 0 uoqag Pe] OSV "T WOWEREMHL iy yo EI ening ex wopezanyy Sauoqas tem 3B HPT ‘an 2yJ0 ome, = 48 uid oxy J pus og. 8 prod 2908 pop jpousd ap go Sueutog axe w TapaRD seams jo sem ‘pede i 40188 pound ayo peo out oe ans ad aed EL “pou op SUP UY op Jo Bune FeO “panto cn sa pospigp Jo sowexzeaur yo somedS HIN Scanned with CamScanner_—— ‘cates of MIM. Approach, MM hypothesis has been criticised on acount of various unrealistic assumptions as given below 1. Prefect capital market does not exist in reality 7 ing securities. 4, Taxes do exit and there treatment far dividends and capital gains. 5, The firms do not folk ‘6 The investors have to pay brokerage, fees, etc. while doi transaction. jes, ete. while doing any 5 7, Shareholders may prefer current income as compared to further gains 2, THE RELEVANCE CONCEPT OF DIVIDEND OR THE THEORY OF RELEVANCE idend decisions pea greaiet value as compared to those which do not pay dividends or have a lower dividend pay out fuve examined below two theories representing thts notion () Walter's Approach, and (i) Gordon's Approach () WALTER'S APPROACH roach supports the doctrine that dividend decisions are relevant and affect the value ‘ermal rate of retum eamed by the firm and its cost of capital is very he dividend ‘to subserve the ultimate goal of maximising the wealth of the share a model is based on the relationship between the firm's (i) return on investment, Le. T, and (ii). the cost of capital or the required rate of return, J-e.k. According to Prof, Walter, Ifr> kie., ifthe firm earns a higher rate of rem on its investment than the required rate of return, the firm should retain the eernings. Such finns aé termed as growth firen's and the ‘optimam pay-out would be zero in their ease. This would maximise the valué of shares. In case of declining firms which do:not have profitable investments, ie., where r ) ‘The cost of capital for the firm remains constant and it is greater than the growth rate, i.e. k > br. (1) ‘The firm has perpetual life. (il) Corporate taxes do not exist. rene to Gordon, the market value of a share is equal to the present value of future strcam of . Thus, SU@HINMeU WIL Galimcannerred rte of ret, Le. hen T= ky pee i i notated by dividend poly, Thus, fo a nontal fim aa ie reuied rate of return, fe. when F< Ke the pee pre lecrasies. Thao, the shordiolders of declining fm ts: = fir. the opcisum pay oat woul bela Scanned with CamScannerFredertand the meaning, concept and kinds of wa oraree of adequate working capital + Pors determining the working capital requirements " Jpnagement of working cay - * FareasvEstimate of Working capital requirements \ Methods of estimating working capital requirements, + Percentage of sales method, regression analysis method, cash forecasting mcthad, operatingcycle method ‘nd projected balance sheet method. + Agproathes wo estimation of working capita; total approach and cash cost approach. Financing of working eapital. + Dateanining, the working capital financing mix. * Heroworking capital approach, + Newntends in financing working capital by banks. TT HANING OF WORKING CAPITAL Capital required for a business can be classified under two main eategories viz. (i) Fixed Capital, and (i) Working Capital. Every business needs funds for two purposes-for its establishment and to carry out its day-to-day [Ess Long-term funds are required to create production facilities through purchase of fixed assets stich ‘fet ang machinery, land, building, furniture, ete. Investments in these assets represent that part of firm's 8 hich is blocked on a permanent or fixed hasis and is called fixed capital. Funds are also needed H Purposes for the purchase of raw materials, payment of wages and other day-to-day expenses, SNS? finds are known as working capital. In simple words, working capital refers to that pert of tg tag, ull which is required fr financing. short term or eufrent assets such as cash, marketable sceuritics, Segal inventories. Funds, thus, invested in current assets keep revolving fast and are being constantly: Smggit® 5h and this cash flows out again in exchange for other current assets. Hence, itis also known “IRS OF circulating: capital or short-term capital, righ wonds of Shubin, “Working capital is the amount of funds necessary to cover the cost off Emterprise,” . ‘te feeding to Genestenberg, “Circulating eapital means current assets of a coi Sofa) course of buss hema tao fora Wave, ac Boy num ‘© feceivables, reecivables into ¢ash.” pany that are changed from cash to inventories, Scanned with CamScannerThre are no erect of ekg cpl te aie tet ene (i) Om Wading Copa (i) Nec Working Cai Ine ed some, be om marking cpl ref te OR Wer AP cnt of fh ot cree he rs ering epi he pa ge (riot tof the verge, Cine ats anes wach EOE coe crv Ue cashed Heh win short prod af acral ae acoomting ye. Fup of cate yo = ‘CONSTITUENTS OF CURRENT ASSETS Tas Fad ard bak alot Till Rese ae Sundry Debiors (es rowan iv bad Ga Thor-tem lane sof aces a] na naow see the rs woking capital refers the eet weking call. Net working pa | mets Over erent Hable, oe #4): 7 Provision Tor wnation, 1 W ds no oat 1 Scanned with CamScannerWorking Capital Aton ‘Fatal of Current Liabilities ~ 1,50,00030,00020,000 +50,000 +20,000"30,000 WE. (Net) = Rs. 3,80,000-3,00,000-= Rs. 80,000 Positive or Negative Working Capital The net working capital of firm may be positive oF i the negative workin the current liabilities, the working capital is positive and Tiabilities are more than the ewrrent assets. The position of mepative working; capital Joes not alloy 4 (A pac eeently the fixed assets due to non-availability of Liquid funds and it averse aTect rent or the rate of retum, In fact, no firm can continue business for a long-term with a negative working eine lity a1, business of the firm may have to be closed duc to technical insolvency (B) Operating Cycle or ‘Circular Flow Concept "hs digcussod earlier, working capital refers to thot part of firm's capital which is required far shoretera pr curren asets such as eash, marketable securities, debtors and inventories. Tunds, thus, incuren asses. Keep evolving fast and are bsing constantly conver ato cash and this eas Tol ‘again in exchange for other current assets. Hence, it is also known as revolving or circulating ca na retla ov enocept of working capital is based upon this operating or working. capital cyele of a fee ‘Sale sans with ibe purchase of raw material and ether resources and ends with the realisation of cay the saleof finished goods. t involves purchase of raw material and stores, its conversion into stock, oan goods ‘hough work-in-progress wih progressive hicrement of labour and service cost, conversion of in’ eek ess, ers desirable nd intel asain of eas and ths ple comin ne cnt pc of ew mtr edo on The seine eration rq in complete one Gycle dearest requirements of working eaptal-longer the petiod of eyele, larger isthe requirement of Working eng ni Cash reecived Fim debtors ane paidio suppliers ‘ora mineral Sale of finished The gross operating cycle is periods, Thus, wz cycle of a firm is equal to the length of the inventories and receivables couversat MCP + WIPCP + FGCP+ RCP ‘aw Material Conversio 4 n Period are” ~ Wotk-in recess Conversion Period nd = ‘inished Goods Conversion Period as met eae Receivables Conversion Period .. me : In that case, net operating eyéle period can be akiiel ‘au ial ol low : Where, Sade Wil Galiocanner‘LASSIFICATION OR KINDS OF WORKING CAPITAL ~ Working capital may be classified in two ways = fa) On the basis of concept (6) On the basis of time, On the basis of concept, working capital is classified as gross working capital and ney capital as discussed earlier. ‘This classification is important from the point of view of the financig range? Gn the basis of time, working capital may be classified as : ™ 1. Permanent or fixed working capital. 2. Temporary or variable working capital. cINDS OF WORKING CAPITAL ON THE BASIS OF CONCEPT = 7 ‘ FIXED WORKING VARIABLE SARTAL SOS Aa CAPITAL WORKING CAPITAL | REGULAR RESERVE SEASONAL ] WORKING Garital.| | woRKING CAPITAL ‘WORKING -CAPITAL 1. Permanent or Fixed Working Capital, Permanent or fixed working capital fs the minima ama! whieh Is required to ensure effective utilisation of fixed facilities and for maintaining the circulation of ure assets. There is always a minimum level of current assets which i continuously required by the enterts¢® carry out its normal business operations, For example, every firm has to maintain a minimum level of" materials, work-in-process, finished goads and cash balance. This minimum level of current assets is ct permanent or fixed working capital as this part of capital is permanently blocked in current assets Ast business grows, the requirements of permanent working capital also increase due to the increase in cir assets, The permanent working capital ean further be classified as regular working capital and reserve Wai al Scanned with CamScannerjagenent and Analysis 0 al requited toc clip receivabRs (0 cash and 40 OM. Reserve. m of current assets from cash ta inventories, from inventories to receivables orking capital is the execss amount over the requirement be provi fac ¥y be provided for contingencies that at unstated periods suck oof Wifjar working capital which ise in prices, depression, ete, a arises. 1 2. Temporary or Variable Working Cay ; 1. Temporary or variable working capital is the amount sta wth etd oe fe Seen dma Le eke Vertoile ig coi * ne = ee Senet ats seasonal working capital and spectal working capital. Most ore entrpings Mave pro ional working capital to meet the seasonal and special needs. The ital oe ances ie seasonal needs of the enterprise is called seasonal working eapital. Special sparking Pil = hat part of working capital which is required to meet special exigencies such as launching wmarnsive marketing, campaigns for conducting research, et : eS, capital differs from permanent working capital in the sense that itis required for short periog permanently employed gainfully in the business. Figures given below Illustrate ihe difference between permanent and temporary working capital. _—_Inig. be Permmpen wae Capital is stable or fixed over time while the temporary or variable working capital uetwates. In Fig. 2, permanent working eapital is also increasing with the passage of time due fr expansion of business but even then it does not Muctuate a§ variable working capital which sometimes jngreases and sometimes decreases, af working TEMPORARY OR VARIABLE TEMPORARY O ‘VARIABLE WORKING CAPITAL CAREEAL PERMANENT O% FIXED WORKING CAPITAL + AMOUNT OF WORKING +— ‘PERMANENT OF FINED WORKING CAPITAL <= — Fig. 2 a1 Fig. 1 IMPORTANCE OR ADVANTAGES OF ADEQUATE WORKING CAPITAL lood and nerve centre of a business. Just as circulation af blood is ccseatial te man body’ for maintaining life, working capital is very essential fo maintain the smoofh running ofa business, No business can run svccescfilly. wiihout an adequate amount of working capital, The main advantages of maintaining adequate amount of working capital are as follows i isolvency of the business. Adequate working capital helps in maintaining solvency of the osinese by providing uninterrupted flow of production. 2, isingss Po fefent working capital enables a business concer to make prompt payments and henge helps in creating and raintsining goodwill, 3. Bnsy loans, A concer having adequate working capital, high solvency and good credit st Easy toan® ioane from banks. and ofhers on easy and favourable terms 4, Cash discounts. Adequate ‘working capital also enables a concern to avail cash discounts on the purehases and hence it reduces cos — 5 Regular supply of raw materials. Sufficient working capital ensures regular supply of raw ‘als and continuous production. 6 Regular payment of salaries, waged and other day-to-day commitments, A.company which has ample working capital ean make regular payment of salaries, wages and other day-to-day Working capital is the life bl Scanned with CamScannerorale. Adeseacyof working ere ena overall eceny «uses WORKING CAPITAL EXCESS OR INADEQUATE ee ‘er infin inthe npaiston. oe ing epi relvios wit sks and ott Francia nites ty eum on investment, th wa of stares may al fil ying opal ives re 1 speculative Waiions. fdequae wanking capa cannot pat sbort-term_ abies nti. reputation 20 shall not be able to get good ceed fii, mpivenent a bulk sed cannot avail discounts, ee. market conditions and undertake posh igi fond. 1 ing lcm ei. Bray bain ase aa ing copitl arses doe 10 the time gap berween production and ceaitit® i= ig ee td we wl awash Ta ot chs of aie tin oi an se; nd tein of th Scanned with CamScannera For the purchase of raw materials, comy To pay wages and Salaries renee md spare \ i di 3 pe incur day-to-day expenses and overhead costs such as fuel, power and office expenses 4, To meet the selling costs as packing, advertising, e $ Te provide credit facilities to the customers, ‘eee the inventories of raw material, work-in-progress, stares and spares and finished stock. for studying the need of working capital in a business, one has to study the business under varyine ane OOP BSN Soncem; a growing concem and as one fh has attained: maturity. A new ! ane requires & lot of liquid funds to meet initial expenses like promotion, formation, etc. ‘These expenses aie preliminary expenses and are capitalised. ‘The amin! needed as working capital it 8 concern erode primarily upon Its size and the ambitions of its promoters. Greater the sie of the business unit, eel Targer Will be the requirements of working capital. ‘The amount of working eapital needed gocs on sEeasing withthe growth and expansion of business til itattains maturity, At maturity the amount of working a needed is called normal working capital, ‘There are many other factors which influence the need of jorking capital in a business and these are discussed in the next pages. facTORS DETERMINING THE WORKING CAPITAL REQUIREMENTS ‘The working capital requirements of a concern depend upon a large number of factors such as nati andsize of business, the character of thelr operations, the length of production cycles, the rate of stock tumover site state of economic situation, It isnot possible to rank them because all such factors are of different fepocunce and the influence of individual factors changes for a firm overtime, However, the following sre important factors generally influencing the working capital requirements. Nature or Character of Business, ‘The working copital requirements of a firm basically depend upon the nature of its business. Public utility undertakings like Electricity, Water ‘Supply and Railways need ‘ay’ limited working capital because they offer cash sales only and supply services, not products, and as ‘echno fimds are tied up in inventories and receivables. On the other hand trading and financi firms require ks investment in fixed assets but have to invest large amounts in current assets like inventories, receivables death; as. such they need large amount of working capital, The manufacturing undertakings also require sible working eapital alongwith fixed investments. Generally speaking it may be said that public utility undertakings require small arnount of working capital, t and financial firms require relatively very large amount, whereas manufacturing undertakings require sizable working capital between these two extremes. 2. Size of Business/Seale of Operations. The working capital requirements of a concern are directly influenced by the size of its business which may be measured in terms of scale of operations. Greater the size tfabasiness unit, generally larger will be the requirements of working capital. However, in some cases even smaller concern may need more ‘working capital duc to high overhead charges, inefficient use of available reiurces and other economic disadvantages of small size. 3. Production Poliey. Incertain industries the demand is subject to wide fluctuations due to seasonal ‘waons, ‘The requirements of working capital, in such eases, depend upon the production policy. The Production could be kept either steady by accumulating inventories during slack periods with a view to meet high demand during the peak season or the production could be curtailed during the slack season and increased ring the peak season. Ifthe policy is to keep production steady by accumulating inventories it will require Nigher working capital. 4, Manufacturing Process/Length of Production Cycle. In manufacturing, business, the requirements St working capital increase in direct proportion to length of manufacturing process, Longer the process period Sfomufoctre, larger isthe aout of working captlreqited. The longer the manufacturing time, dhe ray terials and other supplies have to be carried for a longer period in the process with progressive increment Scanned with CamScannerly obtained, Therefore, i there finished product is : Bole oF ahour an serves cots before the finished ti peri shouldbe chosen, Processes of produstio, the proest wil Ie St cavalo throughout _ 5, Seasonal Variations. In certain ind crrupted flow and process ty i gthe season 10 6 | hae to uy rasy mateo is ole darn * ston ie fn of material inveniores daring see the entire year, A huge amount és, thus, bla shich ts king capital requirements, Generally, during, the busy season, a firm Fequires iy Which gives rise to more working & me working capital than in the slack seasos 6. Working Capital Cyele. isation of cash fo! ase OF raw material and ends with the realisation af cash diego te, Involves purchne af manera aed steve is conversion in stocks of Fished goods Cro i sion of finished stock id service casts, conversion pity Progress with progressive increment of labour an m5 ‘ i debtors and receivables and ultimately realisation af cash and this eycle continues again from cash to py, of raw material and so an. ‘ em, the z capital cycle gt anufueturing concern, the working capital cycle sant yi Te at fam ihe satecof fined giodiss nth This gp ih DEBTORS (RECEIVABLES) 1 RAW MATERIALS Pop aN ROCESS [WORKING CAPITALIOPERATING CYCLE OF A MANUFACTURING CONCERN) ‘The speed with which the working capital completes one cycle determines the fequirements of workin ‘apital-longer the period of the cycle lager is the requirement of working capital 7. Rate of Stock Turnover. There is a high degree o| shall be higher than that of a provision store. 8. Credit Policy. The eredit policy ofa concem in its dealin, tors i | 8S with debtors and creditors influsst considerably the requirements of ‘working capital. A concem that Purchases its requirements on credit sells its products/services on cash requires lesser amount of working capital. On the ather hand a conte! buying its requirements for cash and allowing credit to iis Customers, shall need larger amount of work? capital as very huge amount of funds are bound to be tied up in debtors or bills receivables. q neta Coston Business cycle refers to altsmnate expansion and contraction in general busi ital bs bs ereeae ‘naa, rine ay (tsi is prosperous, there i a feed for larger amount of wort les, tise ade: Optimistic expansion of business, ete. On the contrary in aben swing of the eyele, the busingss contracts, sales decline, siffievli a large 10. Rate of Growth of Business, The Working aa ee pom and xpansion of is business activities. Although 4 is difficult to. determi ationship be"? the growth in the volume of business and the gree ft re ie elena a concluded that for normal rate of expansion i ae YOrRIME capital of a business, yet it mY f ss, We may have retained profs © Fy Fequite larger amount of working. © d Scanned with CamScannerinostration TL. ABC Ltd. sells its products on a gross profit of 20% on sales The following, jon 18 extracted from its annual accounts for the year ended 31st March 2008 + Re it 49,00,000 ses aoa credit) 12,00,000 a ays by areas) ‘9,60,000 tjacturing expenses (one month in arrears) er re Manistatfon expenses (one month in arrears) Scot ‘ifs promotion expenses (payable half yearly in advance) “Tae company enfoys one month's eredit from supplier of raw materials and maintains 2 months stock poaterials and one and a half months finished goods. Cash balance is maintained at Rs, 1,00,000 as ; onary balance, Assuming a 10% margin, find out the working capital requirements of ABC Lid. ce Fras fr computation of debtors and stock of finished goods may be taken at sales minus gross PrOle 2S pends of gross profit given. ‘anton ewe Statement of Working Capital Requirements Careent Assets Re, 2) 2,00,000 Sock of aw materials, (12,0,000% 80 3 Sinck of finished goods at cast (4oon.000%-8 x2 [as grass profit is 20% on sales, so cest is 80% of sales) Dehiors at cost (s1.00.000«5 4,00,000 3) 8,00,000 ‘Advance payment of sales promotion expenses (2.on.000 “) 1,00,000 Cubbalance 100,000 16,00,000 Less : Current Liabilities: Re, 1 ‘Creditors for raw materials (12.00.0005 1,00,000 40,000 1 ‘ 100,000 1 ‘Mevinistration expenses outstanding (120.000. 4) 40,000 ‘Wages outstanding (15 days taken for 1/2 months in arrears, 9.60.00: Mnatcringexpenses outstanding (1402.000x Na Working Capital {it lov Margin for contingencies Srking Capital Resi Scanned with CamScanner