1 What is Finance?

The word finance comes from an old French word 'fine'. It means to pay, settle, or
finish. According to Encyclopaedia of Britannica, "Finance is an act of providing
means of payment". According to the Oxford Dictionary, the word 'finance' means
management of money.
2 Difference between money and finance
Money is any country's currency which is in the hands of a person or an organisation.
But finance may be defined as the provision of money at the time it is needed
3 What is finance function?
According to Osborn R.C., "Finance function is the process of acquiring and utilising
funds by a business".
4 What is Financial management
It is the application of the planning and control functions to the finance function
5 Financial Objectives
Financial objectives include profit maximisation, wealth maximisation and value
maximisation. These may be briefly explained as below:
 A) Profit Maximisation
Maximisation of profit is generally regarded as the main objective of business
enterprises. In the opinion of Milton Friedman, the main objective of a business is to
earn maximum profit According to him, "the business of business is business".
 B) Wealth maximisation
It is an appropriate decision criterion for financial management decisions because it
removes the limitations of profit maximisation criterion. The wealth maximisation
approach aims at maximising the wealth of the shareholders by increasing earnings
per share.
 C) Value Maximisation
Another objective of financial management is to increase the value of the
organisation. The objective is to maximise the long term market value of the
organisation. The total value of an organisation comprises of all the financial assets,
such as equity, debt, preference shares and warrants. When the value of shares of an
organisation increases in the market, its total value will increase.

6 Investment Decision
Investment decision relates to selection of assets in which funds are to be invested
by the firm. Investment opportunities are numerous. But the financial resources are
limited
7 Financing decision
 It is concerned with the selection of the sources of finance. Usually the company
procures its capital through different sources. It has to select the best sources of
finance to meet its investment decision.
8 Dividend decision
Dividend decision is concerned with the amount of profits to be distributed and
retained in the firm. The management has to decide how much to distribute to
shareholders by way of dividend and how much to retain in the business.
9 Liquidity Decision
Liquidity decision is concerned with the management of current assets if the firm
invests less funds in current assets, it loses its liquidity. Then the firm cannot meet
the short term obligations promptly and properly.
10 Role of a Finance manager
 Forecasting and planning
 Determining the capital structure
 Raising sufficient funds
 Managing income
 Managing cash
 Deciding up on borrowing policy
1. Meaning of Financing Decisions
Ans. Financing decisions refer to decisions regarding funding of the business
enterprise. It involves identifying the various sources of finance, evaluating the
sources, selecting the sources and deciding on the amount of funds to be mobilized
from each source. In short, financing decisions are concerned with deciding capital
structure and procuring funds.

2. Process of Financing Decisions

Ans. The process of financing decisions involves the following steps:
1. Estimating the requirement of funds
2. Identifying the various sources of funds
3. Evaluating the various sources of funds
4. Determining the capital structure
5. Selecting the best sources of funds according to the capital structure
6. Procuring or obtaining funds

3. What is Capital structure

Ans. It refers to the kind of securities that make up capitalisation.
In short, capital structure means the proportion of debt and equity in the total
capital of a company. It involves decision with respect to (a) the type of securities
to be issued, and (b) the relative proportion of each type of security.
4. Importance of capital structure
 A good capital structure minimises the financial risk assumed by the company.
 A sound capital structure avoids over or under capitalisation.
 A good capital structure maximises the value of the firm.
 A sound capital structure minimises the cost of capital.
 Capital structure helps to determine the required rate of return from the
investment in projects.
 In the absence of capital structure, the firm may face the problem of raising
funds and financing projects in the long run.
5. What is Finance Structure
Ans. Finance structure refers to the way the company's assets are financed. This
represents all the long term sources of capital and short term sources of capital. In
other words, finance structure is equal to capital structure plus current liabilities.
6. Factors influencing capital structure
Internal factors External Factors
Profitability Conditions in the capital market
Liquidity Attitudes of investors
Flexibility Cost of financing
Size of the business Legal requirements
Nature of the business Taxation policy
Regularity Attitude of management
Period and purpose
Desire to retain control
Asset structure
7. What is Optimum capital structure
Ans. simply refers to the best or most economical capital structure. It is the mix of
debt and equity that maximizes the value of the company and minimizes the cost
of capital.

8. What is Leverages
Ans. Generally the term leverage means the relationship between two
Inter-related variables. These variables may be cost, output, sales revenue, EBIT,
EPS etc. Leverage refers to the percentage change in one variable corresponding
to percentage change in the other variable.
Types
1. Financial leverage
2. Operating leverage
3. Combines leverage

9. Financial leverage
Companies use money to make money. They borrow additional funds. The use of
borrowed money (or debt) to make more money is called financial leverage

10.Operating Leverage
In simple words, presence of fixed cost is known as operating leverage. It
measures the extent to which fixed cost is used in operating the firm. If the fixed
costs are more as compared to variable costs, the operating leverage will be high.
11.Combined Leverage
Combined leverage refers to the combination of OL and FL. It is the relationship
between contribution and the taxable income. It is also known as total or overall
leverage.
Computation of Combined Leverage
Combined leverage is the product of OL and FL. It can be computed by multiplying
OL and FL Combined Leverage = OL x FL
12.What is EBIT- EPS Analysis (Earnings Before Interest and Taxes) (Earning per
share)
EBIT-EPS analysis is a tool of financial planning that evaluates various alternatives
of financing a project under varying levels of EBIT and suggests the best
alternative having highest EPS and determines the most profitable level of EBIT.

Thus, EBIT-EPS analysis attempts to examine and to evaluate the effects of EBIT at
varying levels on the EPS under different alternative financial plans. EBIT-EPS
analysis also helps in designing a suitable capital structure and in measuring the
impact of the use of debt capital. The objective of EBIT-EPS analysis is to
determine the effect of using different sources of financing on EPS.
13.Indifference Point
Ans. The indifference point is the amount or level of EBIT at which all financing
plans would bring the same EPS. In other words, there is no difference in the two
alternative financing plans.
14.What is financial risk
Ans. It refers to the possibility of financial loss or unfavourable outcomes arising
from various uncertainties and fluctuations in financial markets.
15.What is Trading in equity
Ans. It involves buying and selling shares of ownership (equity) in publicly traded
companies through stock exchanges.
1. Meaning and Definition (Concept) of Cost of Capital
Ans. Cost of capital simply refers to cost of obtaining funds. Cost of capital is the rate
a firm pays to its investors for the use of their money.
Thus, cost of capital is that rate of return that a firm must pay to the suppliers of
capital for using their funds

Krish Talkz Pvt Ltd Capital

Investors

Equity Share holders Preference Sh. holders Fin Instituition Debenture holders

Divident Divident Interest Interest

Cost of capital
2. Features of Cost of Capital
Cost of capital has the following features:
 It is not a cost. It is a rate of return. Hence, it is a 'hurdle rate'.
 It is the minimum rate of return a firm requires to earn in order to maintain
the market value of its equity shares.
 It is the reward for business risk and financial risk.
 It consists of three elements - (a) riskless cost of the particular source, (b)
business risk premium, and (c) financial risk premium.
3. Types / Classification of Cost of Capital
There are various types of cost of capital. They are as follows:
1. Historical Cost and Future Cost
 Historical cost refers to the cost which has already been incurred for
financing a project. It is calculated on the basis of past data.
 Future cost refers to the expected cost of funds to be raised for financing a
project.
2. Specific Cost and Composite Cost
 Specific cost refers to the cost of a specific source of capital such as equity
share, preference share, debenture etc.
 Composite cost of capital refers to the combined cost of various sources of
capital. It is the weighted average cost of capital. It is also called 'overall
cost of capital.
3. Average Cost and Marginal Cost
 Average cost of capital refers to the weighted average cost of capital
calculated on the basis of cost of each source of capital and weights
assigned to them in the ratio of their share to total capital funds.
 Marginal cost of capital refers to the cost of obtaining an extra 1 of finance.
4. Explicit Cost and Implicit Cost
 Explicit cost of capital refers to the discount rate which equates the present
value of cash inflows with the present value of cash outflows. Thus it is the
internal rate of return which a firm pays for procuring the finance.
 Implicit cost of capital refers to the rate of return which can be earned by
investing the funds in alternative investments. In other words, it is the
opportunity cost of capital.

4. Cost of Debt
If capital is the foundation of business, debt is the superstructure. Debts are
liabilities of a firm. Debt capital comprises of debentures, bonds and long term
loans. Cost of debt means the payment of interest on debentures or bonds or
loans from financial institutions.
1. Cost of Irredeemable Debt
Irredeemable debt is also known as perpetual debt. Perpetual or
irredeemable debts are the debts which are not repayable during the life of
the company. These are repayable only on the liquidation of the company.
In this case the time of maturity is not specified.
2. Cost of Redeemable Debt
Usually the debt is issued to be redeemed after a certain period during the
life time of a firm. In the calculation of cost of such debt, the time period of
redemption is very important.

5. Cost of Preference Share Capital

Preference shares carry a fixed rate of dividend. It is paid before equity dividend is
paid. The rate of dividend is determined at the time of issue. The cost of
preference capital is the dividend expected by the preference shareholders. It is
found by dividing annual preference dividend by the net proceeds from the issue
of preference shares.

6. The cost of equity capital

It is the minimum rate of return that the company must earn on its equity share
capital. It is the return which the shareholder expects on his investment. Thus, the
cost of equity capital may be defined as the minimum rate of return that a firm
must earn on the equity investment so that the market value of shares remains
unchanged.

7. Capital Asset Pricing Model or Approach (CAPM)

This approach was developed by William Sharpe (Nobel Prize winner). According
to this approach the return on equity shares depends on the amount of risk
associated with it. If more risk is associated with it, it will provide more return. If it
is associated with less risk, it will provide less return. Thus, this model states that
as the level of risk increases, the investors would expect higher returns to
compensate for the risk that they have taken.
There are two types of risks associated with an equity share. They are: Systematic
risk and Unsystematic risk. The systematic risk is measured by ẞ (beta).

8. Gordon's Dividend Growth Model

This method was developed by M. Gordon to calculate the cost of equity. As per
this model, an investor always prefers less risky investment. Therefore, a company
should pay risk premium only on risky investment. Gordon model also suggests
that an investor would always prefer those investments which provide him
current income.
 9. The cost of retained earnings
It may be defined as the opportunity cost of the dividends foregone by the equity
shareholders. It is the rate at which the shareholder is not receiving the dividend.
It refers to the rate of return which shareholder can obtain by investing the after
tax dividend in other securities.

10.Meaning of Weighted Average Cost of Capital

WACC summarises the after tax cost of the entire capital structure. It simply refers
to the average cost of the various sources of finance. It is an average of the costs
of all sources of funds in the capital structure, properly weighted by the
proportion of each source in the total capital structure. It is also known as
composite cost of capital or overall cost of capital.

1. What is Investment decisions

It refer to decisions relating to utilization of funds or capital deciding upon where to invest,
for how long to invest etc. is known as investment decision.
Types of Investment decisions
Investment decisions are of two types
Long term investment decision - Long term investment decision is known as capital
budgeting.
Short term investment decision - Short term investment decision is called working
capital management decision
2. Techniques of Capital Budgeting
Thus capital budgeting decisions are taken by using various techniques or methods. All
techniques of capital budgeting may be classified into two, namely traditional techniques
and modern techniques.
Traditional Techniques (Non-Discounted Cash Flow Techniques)
These are techniques which do not consider time value of cash flows. Traditional
techniques are also known as non-discounted cash flow techniques. Important traditional
techniques are:
(a) Pay Back Method
(b) Post Pay Back Profitability Method
(c) Average Rate of Return Method
Modern Techniques (Discounted Cash Flow Techniques)
(a) Discounted Pay Back Method
(b) Net Present Value Method
(c) Benefit Cost Ratio
(d) Internal Rate of Return
1. Payback period method
It is one of the commonly used techniques of evaluating capital expenditure proposals. It is
a cash based technique. Payback period is the length of time or period required to recover
the initial cost (investment) of the project. It is the expected number of years during which
the original investment is recovered. It is the breakeven point of the project, where the
accumulated returns (cash inflows) equal investment (cash outflow). Pay back method is
also called 'pay-out' or 'pay-off period' or 'recoupment period' or 'replacement period.
2. Post Payback Profitability Method
A serious limitation payback period is that it ignores the cash inflows after the payback
period. As a result, the true profitability of the project cannot be judged. The post payback
method has been developed to overcome this limitation. Under post payback method, the
entire cash inflows generated from a project during its working life are taken into account.
3. Average Rate of Return Method/Accounting Rate of Return Method (ARR)
Under this method, the profits earned (average profits) on the amount of investment
proposal is expressed in terms of percentage. Hence this method is also known as return on
investment method. Thus this method takes into account the earnings expected from the
investment over its whole life. It is based on accounting profits and not cash flows. This
method is also known as Accounting Rate of Return method. This method is also known as
unadjusted rate of return method. ARR is found out by dividing average income by the
average investment.

1. Discounted Payback Period

A major shortcoming of the conventional payback period method is that it does not take
into account the time value of money. To overcome this limitation, the discounted pay back
period method is suggested. In this modified method, cash flows are first converted into
their present values (by applying suitable discounting factors) and then added to ascertain
the period of time required to recover the initial outlay on the project.
2. Net Present Value Method (NPV)
Under this method, all future cash inflows (benefits) and cash outflows (cost) are
discounted to present values. Then the present value of cash outflows is deducted from the
sum of the present value of cash inflows. The balance amount is the NPV. The NPV may be
either positive or negative. If the NPV is positive, it means that the actual rate of return is
more than the discount rate. A negative NPV indicates that the project is not even covering
the cost of capital. It means that the actual rate of return is less than the discount rate.
3. Profitability Index Method (or Discounted Benefit Cost Ratio)
It is the ratio of present value of cash inflows to the present value of cash outflows. Thus, it
measures the present value of returns. Profitability index method is also called discounted
benefit cost ratio (or simply benefit cost ratio) or present value index. It is particularly
useful to compare the projects having different investment outlays.
4. Internal Rate of Return (IRR)
Net present value method indicates the net present value of the cash flows of a project at a
pre-determined interest rate. In order to find out the rate of return of a project, estimated
net cash inflows of each year are discounted at various rates till a rate is obtained at which
the present value of cash inflow is equal to the initial investment or the net present value
comes to zero. Such a rate is called internal rate of return or marginal rate of return. It is
also called time adjusted rate of return. It is called so because it gives due importance to
the time value of money. IRR was first introduced by Joel Dean.
1. What is Working capital?

Working capital is the capital required for the day-to-day working of an enterprise. It
is required for the purchase of raw materials and for meeting the day-to-day
expenditure on salaries, wages, rents, advertising etc. working capital is also called
circulating capital or revolving capital or floating capital or liquid capital. It is also
known as operating capital.

2. Components of Working Capital

A. Current assets: Current assets are those assets which can be converted into
cash in the normal course of activity of a firm usually one year. Examples of
current assets include ca short term investment, bank balance, B/R, stock of
raw material, stock of stock of finished goods, sundry debtors, prepaid
expenses, advance payment of tax etc.
B. Current liabilities: Current liabilities are those liabilities which are repayable
during short period usually within a year. Examples of current liabilities include
short term borrowings, sundry creditors, B/P, advance payments from
customers, outstanding expenses, provision for taxation dividends payable etc.

3. Concepts of Working Capital

1. Gross Concept: According to gross concept working capital refers to the amount of
funds invested in current assets. Thus working capital is equal to total current assets.
The working capital as per gross concept is called gross working capital. This concept
is used by the management to evaluate the current working capital position and to
ensure the optimum investment in individual current assets. Gross concept is a
quantitative concept.

2. Net Concept: According to net concept, working capital refers to excess of current
assets over current liabilities.
To be more clearly, working capital is equal to total current assets minus total current
liabilities. Thus working capital refers to net current asset. The working capital as per
net concept is called net working capital the net concept is a qualitative concept
because it establishes a relationship between current assets and current liabilities.
4. Types of Working Capital
1. Permanent Working Capital
There is always a minimum amount of working capital which is continuously
required by the enterprise to carry out its normal business operations. This is
usually called as permanent or fixed working capital. Permanent working capital is
again divided into three - initial working capital, regular working capital and
cushion working capital.

(a) Initial Working Capital: The working capital which is needed in the initial stage
of business is called initial working capital. It is the capital with which the project
is commenced.

(b) Regular Working Capital: It is the amount needed for continuous operation of
the business. It is the amount of working capital required after the project has
been established as a going concern. It is the minimum amount of the liquid
capital to keep up the capital circulating from cash to inventories, to receivables
and back again to cash.

(c) Reserve Margin or Cushion Working Capital: It is the excess working capital
over the regular working capital that should be kept in reserve for contingencies
that may arise at any time. These contingencies may be rising prices, business
depression, strikes, special operations such as experiments with new products etc.

2. Variable Working Capital

This is the additional capital needed to meet seasonal and special needs. Variable
working capital is again divided into two - seasonal working capital and special
working capital.

(a) Seasonal working capital: It is the working capital which is needed to meet the
seasonal needs of the firm. It refers to the additional working capital required
during busy seasons.
(b) Special working capital: This refers to the extra working capital to be
maintained to finance special operations. It may be required to carry on a special
sales campaign or financing slow moving stock or financing a period of strike or
lockout etc.
5. Operating Cycle Concept
Operating cycle refers to the average time elapses between the purchase of raw
materials and the final cash realisation. According to Hunt, William and Donaldson,
"The working capital is required because of the time gap between the sale and their
actual realisation in cash. This time gap is technically termed as "Operating Cycle' of
the business".

6. Hard Core Working Capital (Core Current Assets)

It represents the minimum amount of investment in raw materials, work-in progress,
finished goods, stores and spares, accounts receivable and cash balance which an
industrial enterprise is required to carry on a certain level of activity. It is the
irreducible minimum amount of current assets required throughout the year for
maintaining the circulation of current assets.
7. Management of Working Capital
Working capital management simply refers to management of working capital. In
other words, it is the management of current assets and current liabilities. According
to Smith, Working capital management is concerned with the problems that arise in
attempting to manage the current assets, current liabilities and the interrelationships
that exist between them".
8. Cash
In a narrow sense "cash" means currency and equivalents of cash such as cheques,
drafts, money orders etc. In a broad sense, "cash" includes cash assets such as
marketable securities and demand deposits in banks.
9. Meaning of Cash Management
Cash management simply refers to management of cash. It refers to systematic way
of handling cash inflows and cash outflows. It is the process of forecasting, collecting,
disbursing, investing and planning for the cash a company needs to operate its
business smoothly.

10. Functions of Cash Management

1. Planning cash inflows and outflows.

2. Controlling cash inflows and outflows.
3. Investing surplus cash.
4. Improving investment image.
5. Maintaining relationship with banks.
11. Meaning of Inventories

The dictionary meaning of inventory is stock of goods or list of goods (The term
inventory simply refers to stock. In accounting language, inventory means stock of
finished goods.

12. Costs of Inventory

The following costs are associated with inventory:

1. Ordering costs: These are costs of placing orders. These costs depend upon the
number of orders and not on quantity of inventory ordered. Ordering costs include
cost of preparation of purchase order, cost of receiving goods, transport costs,
documentation processing costs, etc. These are also known as acquisition or setup
costs.

2 Carrying costs: These are the costs incurred in keeping or holding inventory. These
include storage costs (rent, lighting etc.), handling cost, insurance, security costs, cost
of pilferage and damage, depreciation, opportunity cost of money tied up in
inventory (interest) etc.

3. Stock-out costs: A stock-out is a situation when the firm is not having items in store
but there is a demand for the same. If the firm runs out of stock of finished goods, it
may lose sales. It may lose goodwill also. Thus stock-out costs include loss of profit
due to loss of sale, loss of future sale, loss of goodwill etc. These are also known as
shortage costs.

13. Techniques of Inventory Management

1. Economic order quantity.
2. Classification and codification of inventories.
3. Stock levels.
4. Safety stock.
5. Inventory turnover ratio.
6. ABC analysis.
7. VED analysis.
14. EOQ
It stands for Economic Order Quantity. The quantity of materials to be ordered at one
time is known as EOQ. It is a formula used in inventory management to determine
the optimal order quantity that minimizes total inventory costs. The Economic Order
Quantity is designed to balance the costs associated with holding inventory (holding
costs) and the costs of ordering or replenishing inventory (ordering costs).

15. Classification and Codification of Materials

For efficient storage, proper classification and codification of materials is necessary.
Classification of materials refers to grouping of materials according to their nature in
suitable categories.

16. Stock Levels

Carrying too much or too less of inventories is harmful for an enterprise. In order to
avoid overstocking and understocking of materials or to minimise the total cost of
inventory, management may fix certain stock levels like maximum level, minimum
level, reorder level, average level and danger level.

17. safety stock

It is an additional supply of inventory that is carried all the time to be used when
normal stocks run out. It is the minimum additional inventory to serve as a safety
margin or buffer or cushion to meet an unanticipated increase in usage. If an order is
placed when the inventory reaches 250 units instead of 200 units, the additional 50
units constitute the safety stock. The safety stock protects the firm from stock- outs
due to unanticipated demand for an item or slow deliveries.

18. Inventory Turnover Ratio

Material turnover ratio is the ratio of cost of material consumed during a given
period to the average stock during that period. It indicates the speed with which the
raw materials have been consumed in production it gives the number of times in a
year stock is used up and replenished. In short, it shows the rate of consumption of
materials. Stock turnover ratio is called stock velocity.
 19. ABC Analysis (Always Better Control or Alphabetic Control)
ABC analysis is used with a view to exercise better control over materials. It is one of
the best and popular techniques of inventory control.
Under ABC analysis all materials are classified into three categories - A, B and C
according to value.
1. Category A includes high value materials (costlier materials).
2. Category B includes medium or moderate value of materials (less costly
materials).
3. Category C includes lower value materials (least costly materials).
According to this technique a greater or strict control is exercised over category A
materials, a moderate control is exercised over category B materials and relatively
lesser degree of control over category C materials Thus ABC analysis is an analytical
technique of material control that divides materials into three categories and uses
different degrees of control over each category. It aims at concentrating efforts in
those items where attention is needed most. Thus it is the 'management by
exception' system of inventory management. The following example helps to
understand the concept:

20. VED Analysis

Under this technique, inventories are classified into three categories in the
decreasing order of their criticality. Accordingly, inventories are classified into
Vital, Essential, and Desirable
1. Vital items are those which are very critical for production. If these are out of stock, it
will lead to immediate production stoppage and heavy production loss.
2. Essential items are those which are very important. They are essential, but their
absence (for few days) would not do much harm in production.
3. Desirable items are those which are required for production but factory can manage
without them for some time, say, a week or even more because they have some
substitutes. While exercising control, greater attention should be paid on vital items.
VED analysis is used for control of spare parts, oil, lubricants etc.
1. Meaning of Dividend
Thus, dividends are a sum of money distributed by a company to its shareholders. It is the
share of profit (after-tax profit) distributed among the shareholders of the company. It is
the reward paid to the shareholders for investments made by them in the shares of the
company. In short, dividend is the part of profits distributed among the shareholders.
2. Types/Forms of Dividend
1 Cash dividend: This is the most popular form of dividend. It is the dividend paid to
shareholders in cash. The cash dividend may be of the following two types:
(a) Regular or final dividend: It is the dividend declared and paid at the end of trading
period after final accounts have been prepared.
(b) Interim dividend: It is the dividend declared before the declaration of the final dividend.
This is declared at any time between the two annual general meetings.
2. Stock dividend: Companies not having sufficient cash generally pay dividend in the form
of shares by capitalising the past reserves and profits. Such shares are called bonus shares.
3. Scrip dividend: In case a company does not have sufficient funds to pay dividend in cash,
it may issue transferable promissory notes for a shorter maturity period for amounts due to
shareholders. This is called scrip dividend.
4. Bond dividend: In rare cases, dividends are paid in the form of debentures or bonds or
notes for a long term period bearing interest at fixed rate. A company issues bonds by way
of dividend when it does not have enough funds to pay cash dividend.
5. Property dividend: Sometimes dividend is paid in the form of asset instead of paying
dividend in cash.
3. What is Dividend Policy?
It refers to the policy which determines the allocation of earnings into retained earnings
and dividend. A company's dividend policy influences the divisions of its net earnings into
two parts - dividend and retained earnings.

Profit
50,000

Dividend Retain
30,000 20,000

4. Objectives of Dividend Policy

 Wealth maximization
 Provide sufficient finance
 Achieve a trade-off among the financial decisions
 Avoid undesirable variations in dividend
 Communicate to shareholders

5. Factors of dividend policy

Internal Factors External Factors
Stability and size of earnings Trade cycle
Liquidity of funds Legal requirements
Investment opportunities and Corporate tax
shareholders preference
Attitude of management towards General state of economy
control
Pat dividend rates Conditions in the capital market
Ability to borrow Government policy
Need to repay debt
6. Types of Dividend Policies
1. Stable Dividend Policy
Stability of dividend means consistency in dividend payment. Thus stable dividend
policy is one that maintains regularity in paying some dividend even though the
earnings fluctuate from year to year. In short, stable dividend means payment of
certain minimum amount of dividend regularly
(a) Constant dividend per share: This is the policy of paying a fixed amount of
dividend per share every year irrespective of the fluctuations in the earnings.
(b) Constant percentage of earnings: This is the policy of paying a fixed percentage of
net profit as dividend every year. This is the policy of constant pay-out ratio.
(c) Constant dividend per share plus extra dividend: This is the policy of paying a
Fixed minimum rate of dividend per share plus extra dividend in the years of good
profits.
2. Regular and Extra Dividend Policy
Under this policy shareholders are paid a constant rupee dividend as a fixed
percentage (called regular dividend) along with extra dividends, if earnings are higher
than normal earnings in any year, the company may pay an additional or extra
dividend in addition to regular dividend. By giving extra dividends, the company
avoids giving shareholders false hopes of increased dividends in coming years.
3. Regular Stock Dividend Policy
This is the policy of distributing shares (bonus shares) in lieu of (or in addition to)
cash dividend to the existing shareholders. Such a policy results in increase in the
number of outstanding shares of the company. This policy is justified when: (a) There
are retained earnings but cash is insufficient, and (b) Company has modernisation
and extension programmes and the need is to finance them immediately.
4. Regular Dividends plus Stock Dividend Policy
This is the policy of giving regular (stable) dividend in cash and extra dividend in stock
(shares). This policy is adopted when a company: (a) wants to continue its record of
regular cash payment, (b) has reinvested earnings that it wants to capitalise, and (c)
wants to give shareholders a share in the additional earnings but cannot afford to pay
in cash.
5. Irregular Dividend Policy
This policy is adopted by companies having highly unstable earnings. Under this
policy, higher rates of dividends shall be paid in the years of higher profits and lower
rates of dividends in the years of lesser profits.
6. Residual Dividend Policy
In residual dividend policy, a company will pay dividends only after undertaking all
investment opportunities. In this policy the dividend is distributed from the profits
remaining after meeting the capital expenditure proposals.
7. Optimal Dividend Policy
An optimal dividend policy is one that maximizes the firm's value or its share price. The
optimal dividend policy can be studied with the help of the following graph

In the above graph, the horizontal axis shows the pay-out ratio and the vertical axis, the
firm's value. We get the horizontal line if changes in the dividend pay-out ratio do not affect
the firm's value, i.e., dividend policy is irrelevant. If dividend policy is relevant, we get curve
cde. Optimum pay-out occurs at point p because maximum firms’ value (d) occurs at this
pay-out. Each firm may have a curve with a different shape. But as long as its line is not
horizontal, we can identify an optimal dividend policy.
8. Dividend Pay-out Ratio
Dividend pay-out ratio is one of the important factors determining the dividend policy, Out
of the earnings, a company pays only a certain percentage or proportion as dividend to the
shareholders. The balance of profit will be retained. Dividend pay-out ratio is the
percentage or ratio of dividend to the earnings. In other words, it is the percentage share of
net earning distributed to the shareholders as dividends. In short, it is the ratio between
dividend and earnings.
9. Modigliani and Miller- Irrelevancy Theory
This theory states that a firm's dividend policy has no effect on value of the firm or
shareholders' wealth. Modigliani and Miller state that when a company pays dividend,
(retention of earnings decreases) the market price of its share increases. Hence the value of
firm increases. But due to payment of dividend, the cash balance decreases. Consequently
funds to finance the projects decrease. Now the company would issue new equity shares.
As a result of this, supply of shares increases in the market. Consequently the price of the
shares decreases. Value of firm also decreases. In short, the market value of the shares is
not affected by the dividend payment.
10.Relevance concept of Dividend ( Relevance Theories)
(a) Walter's Dividend Model (Walter's Dividend Theory)
Prof. Jame E. Walter has developed a dividend model. In this theory Walter argues that
dividend decision (dividend policy) of a firm is relevant. Hence this is a theory of relevance.
This means that dividend policy has an impact on market price of the share. Thus dividend
policy affects the value of the firm. According to Walter, the investment policy (investment
decision) of a firm cannot be separated from its dividend policy. That is, the investment
decision and dividend decision of a firm are interrelated. The company will pay dividend or
not depends upon whether it has suitable investment opportunities to invest the retained
earnings or not. This means that if the company has investment opportunities to invest its
earnings, it does not pay dividend. That is, it will invest earnings. If the company has no
investment opportunities, it will pay dividend. Thus the dividend decision (i.e., to pay
dividend or not) affects the market price of the shares and this in return affects value of the
firm or shareholders' wealth.
(b) Gordon's Model
M. Gordon has also given a model on the line of Walter. He suggested that dividends are
Relevant and it will affect the value of the firm. He argued that the value of a rupee of
dividend income is more than the value of a rupee of capital gain. This is on account of
uncertainty of future and discounting future dividends by shareholders at a higher rate.
According to Gordon the market value of a share is equal to the present value of future
infinite stream of dividends. Gordon argues that investors prefer current dividends rather
than capital gains. Dividends are more predictable than capital gains. Investors value
current dividends more highly than an expected future capital gain. Gordon's model is also
known as bird in hand argument. It is called so because this model is based on the
assumption that shareholders prefer to receive current dividend rather than distant capital
gain.