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FINANCIAL MANAGEMENT

UNIT- I Unit I: Nature of Financial Management: Meaning Nature Objectives Scope- Functions of Financial Management Financial forecasting Financial Planning Time Value of Money (NP) Finance : Finance is defined as the provision of money at the time when it is required The subject of finance has been traditionally classified into two classes public finance and private finance Scope of Financial Management The main objective of financial management is to arrange sufficient finance for meeting short term and long term needs these funds are procured at minimum costs so that profitability of the business is miximised. Estimating financial requirements: The first task of a financial manager is to estimate long term and shorter financial requirements of his business for this purpose, he will prepare a fianancial plan for present as well as future. The amount required for purchasing fixed assets as will as needs of funds for working capital will have to be ascertained. The estimations should be based on sound principles so that neither these are in adequate nor excess funds with the concern. Deciding capital structure: The capital structure refers to the kind and proportion of different securities for raising funds. After deciding about the Quantum of funds required it should be decided which type of securities should be raised. It may be wise to finance fixed assets through long term debts. Even here if gestation period is longer, then share capital may be most suitable. A decision about various sources for funds should be linked to the cost of raising funds. If cost of raising funds is very high then such sources may not be useful for long. A decision about the kind of securities to the employed and the proportion in which these should be used is an important decision which influences the shorter and long term financial planning of an enterprise. Selecting a source of finance: After preparing a capital structure an appropriate source of finance is selected various sources from which finance may be raised. Include share capital debentures financial institutions. Commercial banks public deposits etc If finance are needed for short periods then banks public deposits and financial institutions may be appropriate on the other hand if long term finances are required then share capital and debentures may be useful. If the concern does not want to tie down assets as securities then public deposits may be a suitable source. If management does not want to dilute ownership then debentures should be issued in preference to shares The need purpose, object and cost involved may be the factors influencing the selection of a suitable source of financing. Selecting a pattern of investment: when funds have been procured then a decision about investment pattern is to be taken. The selection of an investment pattern is related to the use of funds. A decision will have to be taken as to which assets are to be purchased the funds will have to be spent first assets and then an appropriate position will be retained for working capital. While selecting a plant and machinery every different categories of them may be available the decision making techniques such as capital budgeting, opportunity cost analysis tec. May be

applied in making decisions about capital expenditures. While spending on various assets, the principles of safety profitability and liquidity should not be ignored. Proper cash management: cash management is also an important task of finance manager he has to assess various cash needs at different times and then make arrangement for cash. Cash may be required to purchase raw material, make payments to creditors. Meet wage bills meet day to day expenses. The usual sources of cash may be cash sales collection of debs short term arrangements with banks etc. The cash management should be such that it is neither there is a shortage of it not it is idle It is better if cash flow statements is regularly prepared so that one is able to find out various sources and applications. Implementing Financial controls: An efficient system of financial management necessitates the use of various control devices. Financial control devices generally use are Return on investment Budgetary control Break even Analysis cost control Ratio Analysis cost and internal audit return on investment is the best control device to evaluate the performance of various financial policies. The higher this percentage better may be the financial performance Proper use of surpluses: The utilization of profits or surpluses is also an important factor in financial management. A judicious use of surpluses is essential for expansion and diversification plans and also in protecting the interests of shareholders. A balance should be struck in using funds for paying dividend and retaining earnings for financing expansion plan etc. The market value of shares will also be influenced by the declaration of dividend and expected profitability in future. A finance manger should consider the influence of various factors such as trend of earning of the enterprise expected earnings in future. Market values of shares need for future for financing expansion etc.

Objectives of financial management: Financial Management is concerned with procurement and use of funds The main objectives is to maximize the owners economic welfare This objective can be achieved by

1) Profit maximization 2) Wealth maximization Profit maximization:


Profit earning is the main aim of every economic activity. A business being an economic Institution must earn profit to cover its costs and provide funds for growth no business can survive without earning profit is a measure of efficiency of a business enterprise profits also serve as a protection against risks which cannot be ensured the accumulated profits enable a business to face risks like fall in prices, competition from other units, adverse government policies etc. When profit earning is the aim of business then profit maximization should be the obvious objective. Profitability is a barometer for measuring efficiency and economic prosperity of a business enterprise, thus, profit maximization is justified on the grounds of rationality.

Economic and Business conditions do no remain same at all the times. A business will be able to survive under unfavorable situation, only if it has some part earnings to rely upon. Therefore a business should try to earn more and more when situation is favorable. Profitability is essential for fulfilling social goals also a firm by pursuing the objective of profit maximization also maximizes socio economic welfare. Profit is the main sources of finance for the growth of a business so a business should aim at maximization of profits for enabling its growth and development. Profit maximization has been rejected because of the following draw backs: Ambiguity: The term profit is vague and it cannot be precisely defined It means different things for different people It is possible that profits may increase but earnings per share decline for ex: If a company has presently 10,000 equity shares issued and earns a profit of 1,00,000 the earnings per share are Rs10 Now if the company further issues 5,000 shares and makes a total profit of 1,20000 the total profits have incrased by 20,000 but the earnings per share will decline to Rs.8. Ignores Time Values of money profit maximization objectives ignores the time value of many and does not consider the magnitude and timing of earnings. The stockholder may prefer a regular return from investment even if it is smaller than the expected higher returns after a long period. Ignores risk factor It does not take into consideration the risk of the prospective earnings stream some projects are more risky than others two firms may have same expected earnings per share, but if the earning stream of one is more risky than the market value of its shares will be comparatively less. Dividend policy the effect of dividend policy on the market prices of shares is also not considered in the objective of profit maximization.

Wealth Maximization:
It is the appropriate objective of an enterprise. Financial theory assets that wealth maximization is the single substitute for a shareholders utility when the firm maximizes the stockholders wealth, the individual stockholder can use this wealth to maximize his individual utility. A stockholders current wealth in the firm is the product of the number of shares owned, multiplied with the current stock price per share. Stock holders current = No of shares owned Wo=NPo Given the number of shares that the stockholders owns the higher the stock price per shares the greater will be the stockholders wealth Thus a firm should aim at maximizing its current stock price this objectives helps in increasing the value of shares in the market The shares market price seems as a performance Index or report card of its p Maximum utility ----------maximum stockholders wealth --------------maximum current stock price per share X current stock price per share

However the maximization of the market price of the shares should be in the long run the longrun implies a period which is long enough to reflect the normal market value of the shares irrespective of short term fluctuations. It seems the interests of owners as well as other stake holders in the firm ie, suppliers of loaned capital, employees, creditors and society. It is commitment with the objective of owners economic welfare The objective of wealth maximization implies long run survival and growth of the firm IT takes into consideration the risk factor and the time value of money as the current present value of any particular course of action is measured. The effect of dividend policy on market price of shares is also considered as the decisions are taken to increase the market value of the shares The goal of wealth maximization leads towards miximising stockholders utility or value maximization of equity shareholders through increase in stock price per share. Criticism of wealth maximization It is a prescriptive idea The objective is not descriptive of what the firm actually do The objective of wealth maximization is not necessarily socially desirable There is some controversy as to whether the objective is to maximize the stockholders weath or the wealth of the firm which includes other financial claisholders such as debenture holders, preferred stockholders ect. The objective of wealth maximization may also face difficulties when ownership and management are separted as is the care in most of the large corporate form of organizations. Functions of Financial Management The functional areas of financial management in modern approach can be divided into two types Executive/managerial finance functions Routine Finance Functions The executive functions deal with decisional areas like planning organizing directing and control of financial resources. Whereas the routine finance functions do not require much managerial ability to perform They are mainly clerical and incidental to the executive functions Managerial or executive finance functions/ decision all areas of financial management Capital budgeting decision, capital structure decision, dividend decision, working capital management, financial analysis planning, acquisitions and amalgamations, profit planning, corporate taxation.

Capital budgeting decision/ Investment decision: Capital budgeting decision deals with allocation of capital to acquire fixed assets for the enterprise. These assets need to spend funds at present and receive benefits in future hence is why such decision involves long term implications and futurity. Future benefits are uncertain and difficult to measure. Since it involves investing companys funds, it is also known as investment decision. It is the oldest area of modern approach. These decisions can be taken during promotion expansion reorganization and replacement. Modern approach, capital budgeting decisions are very crucial as they relate to judicious allocation of capital. Capital budgeting forecasts returns on proposed long term investments and compares profitability of different investments and their cost of capital. The various proposed assets ranked on the basis of such criteria as urgency, liquidity profitability and risk sensitivity. The financial manager should be familiar with financial techniques as pay back, internal rate of return and net present value among others. Risk increases when investment is stretched over a long period of time. The financial manager should be able to blend risk with returns so as to get current evaluation of potential projects. Capital structure financing Decision After the requirement of funds are ascertained through capital budgeting decision, the capital is to be acquired through the various long term sources of finance. The financial manager must decide when where and how to acquire funds to meet the investment requirements of enterprise The various sources of long term finance can be divided in to two groups Equity capital-shares Debt capital-debentures preference shares and long term loans, etc The financial manager has to maintain optimum capital structure and ensure the maximum rate of return on investment. The ratio between equity and liabilities carrying fixed charges has to be decided he has to consider the operating and financial leverages of his enterprise. The operating leverage exists because of operating expenses, while financial leverage exists because of the amount of debt involved in a firms capital structure. Manager has to decide the what extent he can apply leverage to the advantage of the enterprise

Dividend decision The financial manager must decide whether the company must distribute all profits or retain them or distribute a part and retain the balance. The dividend policy should be decided in terms of its effect on the shareholders wealth the dividend policy must maximize the market value per share. If the shareholders are indifferent to the firms dividend policy, the financial manager must determine the optimum dividend payout ratio. He should also consider the aspects like dividend stability, stock dividends and cash dividends. Working capital management: any organization contains two types of assets namely fixed assets and current assets. The financial manager must look after current assets to safeguard the profitability liquidity and solvency of the company if current assets are not maintained at the required level liquidity suffers and solvency is threatened. Working capital is an adjunct of fixed capital investment It is a financial lubricants which keeps business operations going cash bills receivables inventory are the important components of working capital which is rotating by nature cash is the central reservoir of a firm and ensures liquidity receivables and inventory form the principal factors of production and sales They also represent liquid funds. The financial manager must match inventory with level of sales several risks are there in inventory management they should not be inadequate or in excess of requirements. Financial Analysis and planning: After the decisions regarding the fixed assets and current assets are taken and implemented the results can be secured. So the next job of the financial manager is to analyze the financial position of the enterprise and to plan accordingly It involves the evaluation and interpretation of companys

financial position and operations. And also involves a comparison and interpretation of accounting data in order analyze cash flow analysis break even analysis and CVP analysis funds flow analysis are to be used. Acquisitions and amalgamations: Enterprises may expand by acquiring other concerns or by entering into mergers. Acquisitions consist of either the purchase or lease of a smaller firm by a bigger organization mergers may be accomplished with a minimum cash outlay through these involve major problems of valuation and control. The process of valuation of a firm and its securities is difficult complex and subject to errors. So the financial manager should go through the valuation process carefully Profit planning: profit is the surplus which occurs to a firm after its total expenses are deducted from revenue It is necessary to determine profits properly to measure the economic viability of a business. The first element in profit is revenue or income This revenue may be from sales or operating revenue. Investment income or income from other sources. The second item in profit calculation of expenditure this expenditure may include manufacturing costs, selling costs, administrative costs and finance costs etc. Corporate taxation: includes tax planning it is able to determine the profitability and EPS of the company substantially. As a result highly specialized departments and professional are engaged for this purpose. A company is subject to several types of direct and indirect taxes the financial manager must possess sufficient knowledge about the nature. Routine Finance Functions In order to carry out managerial finance functions effectively certain routine or clerical functions are performed by manager Supervision of cash receipts and payments safe guarding of cash balances Taking care of the mechanical details of new outside financing. Custody and safeguarding of securities, insurance policies Record keeping and reporting Maintaining appropriate accounts and other details.

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Unit II: Financing Decisions: Sources of Finance - Cost of Different Sources of Finance - Cost of Debt Cost of Preference Capital - Cost of Equity Share - Cost of Retained Earnings - Weighted Average Cost of Capital Capital structure financial and operational Leverage (NP)

Unit II CAPITAL STRUCTURE


INTRODUTION
Every organization requires funds to run and maintained its business the required funds may be raised from short term sources or long term sources or a combination both the sources of funds, so as to equip it self with an appropriate combination of fixed assets and current assets. Current assets to a considerable extent are financed with the help of short term sources. Normally, firms are expected to follow a prudent financial policy, as revealed in the maintenance of net current assets. These net positive current assets must be financed by long term sources. Hence long term sources of funds are required to finance for both. Long term assets (fixed assets) Net working capital (Positive Current assets).

A firm can easily estimate the required funds by a detailed study of the investment decision. In other words, anticipation of the require funds may be estimated analyzing the investments decision. Once anticipation of require funds is completed then the next step is financial for the manager to make decisions related to the finance or the selected investment decisions. Generally capital is raised from the prime source are Equity, Debt

Then the questions are what should be the proportion of equity and debt in the capital structure of a company. As the objective of a firm should be directed towards the maximization of the valve of the firm, the capital structure decision should be examined from the point of its impact on the firm. If the value of the firm

can be affected by capital structure, a firm would like to have a capital structure, which maximizes the market valve of the firm. There exist conflicting theories on the relationship between capital structure and the valve of the firm. Capital structure decisions are significant finance of the corporate firm in that they influence the return as the risk of equity shareholders. That there exist Nexus between optimum judicious debt and the market valve/valuation of the firm is well recognized in literature of finance. While the excessive use of debt may endanger the every survival of the corporate firms, the conservative policy may deprive its equity-holders the advantage of debt as a cheaper source of finance to magnify their rate of return. Following such an overconservative policy runs counter the basic objective of financial decision making to maximize the wealth of equity holder. Apart from financial risk return consideration, non-financial factors are also likely to be very decisive in designing capital structure of the corporate famous for instance use of debt, unlike equity doesnt dilute the controlling power of existing owners in brief, debt is not an unmixed blessing and, hence a dilemma for the corporate finance manager. Determinants of Capital Structure 1. Cost of borrowings (CB): When the cost of borrowing increases, the dependence on borrowed funds is likely to decline. As a result, the leverage ratio is expected to have a negative relationship with the cost of borrowing. The cost of borrowing can be measured as total interest payment as percentage of total borrowings of total borrowings of the firm.

2. Cost of Equity (CE): If the cost of equity increases, the firm is likely to depend more on debt than equity capital. Therefore, the leverage ratio can be accepted to be an increasing function of the cost of equity. This variable can be measured as the ratio of dividend payment to share capital of the company.

3. Size of the Firm (SF): It has been suggested by a number of authors that the size of the firm is likely to be positively related to the leverage ratio. The rational behind this view is provided by Warner (1977), and Angchua and McConnell (1982). They have argued that the ratio of direct bankruptcy costs to have firms valve decreases as the valve of firm is said to be negligible is also argued that the larger firms are more diversified and they have easily access to the Capital Markets, and borrow more favorable interest rates. Also Chung (1993) argued that the larger firms have lower agency costs associated with the assets substitution and under investment problems which mostly arise from the conflicting interests of shareholders? Further, the similar firms are more likely to be liquidated when they are in financial distress. All, such considerations suggest a positive relationship between the firm size is measured as the volume of total assets of firm and the leverage ratio. 4. Probability (PR): Myers (1977) suggested that the firms prefer retained earnings as their main source of financing. Their second preference is for debt financing followed by new equity issues, which might be due to the significant transaction cost of issuing new equity. It is suggested that the observed capital structure of the firm would reflect the cumulative requirements for external financing. An unusually profitable firm with a slow growth rate will end up with an unusually low leverage low ratio compared with the industry average in which it operatives. On the other hand, an unprofitable firm in theSame industry will end up with a relatively high leverage ratio. The profitability of the firm enables it to use retained earnings over external finance and therefore, one should accept a negative. Association between the profitability of the firm and its debt ratio. Barton and Gordon (1988) have also argued that a firm with high rates would maintain a relatively lower debt level because of its ability to finance itself with internally generated funds. This is consistent with the proportion that the management of firm desire flexible and freedom from the profitability of the firm. Which can be measured as the ratio of operating income to total assets, will be negatively related to the debt level of the firm.

5. Growth Rate (GR): The growing firms need more funds. The greater the future need for the funds, the more likely that the firm will retain earnings or issue debt. A firm is except to rarely on debt financially to rely on debt financing to maintain its debt ratio as its equity increases due to the large retention of earnings. Thus the firms debt level and growth rate are expected to have a positive relationship. This variable can be measured as the annual growth rates are expected to have a positive relationship. This variable can be measured as the annual growth rate of total assets of the company. 6. Collateral Valve of Assets (CVA): Some capital structure theories have argued that the type of assets owned by the firm affects its capital structure choice. Scott (1977) ahs suggested that by selling the secured debt, the firms can increase the valve of their equity by taking away the wealth without payment, from their existing unsecured debtors. By issuing debt secured by assets, the firm can avoid higher interest costs and high issuing cost. For these reasons the firms with assets that can be used as collateral may be expected to issue more debt. Therefore, the collateral valve attribute can be one of the determinants of capital structure of the firm. This variable can be measured as the ratio of accounts receivable plus net fixed assets to total assets, and itcan be expected to be positively related with the leverage ration. 7. Liquidity (LQ): Liquidity ratios are mostly used to judge a firms ability to meet its short term obligations. The liquidity ratio may have conflicting affects on the capital structure decisions of the firm. First, the firm with higher liquidity rations might have relatively higher debt rations. This is due to greater ability to meet short-term obligations. Form this viewpoint one should accept a positive relationship between the firm liquidity position and its debt ratio. However, the firms with greater liquid assets may use these assets to finance their investments. If this happens there will be a negative relationship between the firms liquidity ratio and debt ratio. We include the liquidity as the argument in our capital structure determination model. It is measured as the ratio of current assets to current liabilities and the direction of its effect on capital structure is allowed to be empirically determined.

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THEORIES OF CAPITAL STRUCTURE 1. Net Income Approach(NI)

Different kinds of theories are have been

2. Net Operating Income Approach(NOI) 3. The Traditional Approach 4. Modigliani and Millar Approach(MM) 1. Net Income Approach (NI): This approach introduced by Durand. A firm can minimize weighted average cost of capital and increase the valve of the firm and share valve in the market. This approach is based upon the following assumptions: (i) The cost of debt is less than the equity. (ii) There are no taxes. (iii) The risk percentages of inversion are not changed by the use of the debt. Degree of leverage: The reasons for assuming cost of debt is less then cost of equity are that interest rates are lower then divided rates due to element of risk and the benefit of tax as the interest is a deductible expenses. The total market valve of a firm on the basis of NI is: V=S+D V=Total market valve of firm. S=Total market valve of equity shares (or) NI/Equity capitalization rate. D=market valve of debt.

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Weighted Average Cost of Capital can be calculated as: KO=EBIT

0.1 Ke

st of Capital 0.05 Degree of leverage:

Ko

The reasons for assuming cost of debt is less than the cost of equity are the interest rates are lower than dividend rates due to elements of risk and benefit of tax as the interest is a deductible expenses. The total market value of firm on the basis of NI is

V = S+D V = Total market value of firm S=Total market value of equity share (or) NI/Equity capitalization Rate D=Market value of debt. Weighted average cost of capital can be calculated as KO = EBIT/V 2.Net Operating Income Approach: This theory suggested by

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Durand. It is opposite to the NI approach .Here Change in the capital structure of a company does not effect in the market valve of the firm and the weighted cost of capital remains constant whether the debtequity mix is 50:50 or 20:80 or 0:100. This theory presumes that: (i) (ii) (iii) The market capitalizes the valve of the firm as a whole The business risk remains constant. There are no corporate taxes.

The valve of the firm can be determined as: V=EBIT/KO KO=Overall cost of capital Y Ke(0/0)

Ko(0/0)

OX

Ki(0/0)

Leverage and cost of capital (NOI) The market valve of equity is: S=V-D S=Market value of equity shares V=Total market value of firm D=Total market value of debt.

3. The Traditional Approach The traditional approach also known, as Intermediate Approach is a compromise between the two extremes of income approach and net operating Income approach. According to this theory, the valve of the firm can increase initially or the cost of capital can be decreased by use more debt is a cheaper sources of funds than equity. Thus, a proper debt-equity mix can reach the capital structure.

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When the increased cost of equity cant be offset by the advantage of low cost debt. Thus the overall cost of capital according to this theory, decrease up to a certain point, remains more are less unhinged for moderate increase in debt thereafter, and increase or rise beyond a certain point.

Ke Ko

Kd 4. Traditional Approach Modigliani -Miller (MM) Approach:

The MM thesis relating to the relationship between capital structures, cost structures, cost of capital and valuation is a kin to the NOT approach, in other words, does not provide operational justification for the irrelevance of the Capital Structures. The MM proportion supports the NOT approach relating to the independence of the independence of the capital of the degree of leverage level of debt-equity ratio. Capital Structure Planning and Policy Introduction: Capital structures refer to the mix of long-term of sources of the funds, such as debentures, long-term debt and preference shares. Some companies do not plan there capital structure they may face considerable difficulties in raising funds to finance there activities. May also fail to economize the use of their funds.

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Features of an appropriate capital structure: The capital should be planned generally keeping in view the interest of the equity shareholders, being the owners of the owners of the company. An appropriate capital structures should have the following features: Leverages Financial leverage, operating leverage Financial leverage: it is used to increase EPS it is also called as trading on equity means the employment of funds which are secured at a fixed cost for the benefit of equity stock holders it is considered favorable when the firm is ableto earn more on the assets purchased with the funds than the fixed cost of their used financial leverage is the ratio of total debt to taltal assets of a firm Degree of financial leverage : EBIT/EBIT-I it is important to consider the effect of leverage on the value of the firm rather than the EPS If more debt is employed it will reduce the share price and also the return to stock holders even though the earning of the firm may increase Degree of Financial Leverage = %change in EPS / %change in EBIT Return,Risk ,Flexibility,Capacity,Control

Operating leverage the cost structure of any firm consists of two variable like fixed cost and variable cost The operating leverage has got a bearing on fixed costs higher the fixed costs in the production process greater will be the operating leverage fixed costs give more returns when production is high and become burden at low production levels operating leverage = contribution / operating profit

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Unit III: Investment Decision: Basics of Capital Budgeting - Appraisal and Evaluation of Long Term Investment Proposals - Pay Back Method - Accounting Rate of Return - Internal Rate of Return - Net Present Value Profitability Index. (NP) UNIT III

CAPITAL BUDGETING

Capital budgeting (long term Investment, Investments against fixed assets) is the process of identifying, evaluating, and selecting investments in long-lived assets. These outlays involve capital investments, which are outlays expected to result in future benefits. Examples of such outlays include Projects plant expansion, research and development, advertising, and a training program for managers. Good capital budgeting decisions enable firms to acquire the long-lived fixed assets that generate a firms future cash flows and determine its overall profitability. Capital budgeting decisions are important to a firms success because they often involve a sizeable outlay, affect a firms future direction, and are difficult and costly to reverse. In addition, proper capital budgeting decisions can improve cash flows and lead to higher stock prices. Making appropriate capital budgeting decisions is vital to achieving the goal of maximizing shareholders wealth. These decisions are especially important to small businesses and their success because of the size and magnitude of capital budgeting decisions.

The six stages of the capital budgeting process are:

Stage 1: Identify project proposals. This step involves identifying projects consist with the firms business strategy and conducting a preliminary evaluation and screening of these proposals. Stage 2: Estimate project cash flows. Proposals surviving the initial screening undergo further refinement. This step requires gathering additional data from various sources such as accounting, engineering, marketing, production, purchasing, and finance needed to estimate a projects inflows and outflows. Estimating future cash flows for capital projects is perhaps the most difficult part of the capital budgeting process. Stage 3: Evaluate projects. This step involves determining the financial viability of projects. Firms typically use both quantitative and qualitative methods to evaluate projects according to specified selection criteria. Stage 4: Select projects. This step concerns selecting the projects that make up the final capital budget. This is the stage where final budgeting approval and authorization occurs. Stage 5: Implement projects. This stage entails initiating and tracking projects. During the tracking phase, managers compare the estimated costs to the actual costs as a way of identifying variances such as cost overruns. Such monitoring helps to avoid delays and enables managers to make appropriate decisions if problems arise. Stage 6: Perform a post-completion audit. This final stage usually applies to selected projects 16

and occurs after project completion. Post-completion audits provide a way of providing valuable feedback about the project and identifying errors or biases in the capital budgeting process. The capital budgeting process should use cash flows instead of accounting profits because cash flows directly affect a firms ability to pay bills and buy assets. That is, firms can only spend or reinvest cash. Accounting profits do not represent cash. Accounting profits include some cash flows but excludes others. For example, accrual accounting allows a firm to recognize profit when no cash changes hands. Adhering to this procedure would make a firm look better, but it would not have the cash flow available to fund a new project. Only incremental, after-tax cash flows are relevant in capital budgeting. Using incremental after-tax cash flow enables a manager to identify the changes in cash flow that are directly attributable to a specific project. A firm will eventually use these cash flows to invest in other projects, reduce liabilities, or pay them out to shareholders.

Analysts and managers should not consider financing costs when measuring a projects cash flows. For example, interest expense is a form of claim by suppliers of capital and is part of the cost of capital used to determine the discount rate when computing net present value. Considering financing costs in measuring a projects cash flows would result in double counting these costs by deducting financing costs from the cash flows and discounting the cash flows by the required rate of return. Although depreciation is a non-cash expense, managers should not ignore depreciation when estimating a projects relevant cash flows. While depreciation itself is not a cash flow, it does affect a projects relevant cash flow by reducing a firms taxable income. Since depreciation reduces the tax outflow, it amounts to a cash inflow.

When a firm buys an income-producing asset, the tax laws permit the firm to depreciate the asset. Depreciation lowers a firms taxable income and provides that firm with a depreciation tax shield. This tax shield reduces the firms tax outflow and effectively results in a cash inflow. Sunk costs, which are expenditures that occurred before making a decision, should not be included when estimating a projects cash flows. Sunk costs are unrecoverable. Future costs and benefits form the basis for making project decisions. Therefore, past or historical costs are irrelevant and have no bearing on current or future decisions. No matter what actions the decision maker may take, the firm has already incurred the cost. (1) operating cash flows: A format for calculating the operating cash flows is: 17

Format for Calculating Operating Cash Flows Operating revenues Operating expenses Depreciation Taxable income Income taxes Net income + Depreciation Increase in net operating working capital (NOWC) Operating cash flows

This section discusses the important evaluation techniques for capital budgeting. Included in the methods of appraising an investment proposal are those which are objective, quantified and based on economic cost and benefits. The methods of appraising capital expenditure proposals can be classified into two broad categories:

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(i) (ii)

traditional and Time-adjusted: more popularly known as discounted cash flow (DCF) techniques as they take the time factor into account. The first category includes

Traditional: Payback period method, Average rate of return method The second category includes : Net Present Value method , Internal rate of return method, Profitability index.

TRADITIONAL TECHNIQUES Pay-back method:-(within how many years we get back our investment) (Cash flows =before tax and before depreciation) The pay-back period method is a traditional method of capital budgeting. It is the simples and, perhaps, the most widely employed, quantitative method for appraising capital expenditure decisions. How many years will it take for the cash benefits to pay the

original cost of an investment, Cash benefits here represent CFAT ignoring interest payment- Thus, the pay back method measure the number of years required for the CFAT to pay track the original outlay required in an investment proposal 19

This method is also known as the payout period, is one of the most important and traditional techniques used for evaluating the general projects requiring small amounts. Simply stated, the payback refers to the time period within which the cost of investment can be covered by the revenues, it is the length of time required for the stream of cash proceeds produced by an investment to equal the initial expenditure incurred. There are two ways of calculating the Payback period. The first method can be applied when the cash flows stream is in the nature of annuity for each year of the project's life, flat is, cash flows after tax are uniform. In such situation, the initial cost of the investment is divided by the constant annual cash flow: Pay-Back period = Investment/ Constant annual cash flow. The second method is used when a project's cash flows are not uniform but vary from year to year. In such situation, payback period is calculated by the process of cumulating cash flows till the time when cumulative cash flows become equal to the original investment outlay. Accept-Reject Criterion: The pay back period can be used as a decision criterion to accept or reject investment proposals. One application of this technique is to compare the actual pay back with a predetermined pay back that is the pay back set up by the management in terms of the maximum period which the initial investment must be recovered. If the actual pay back period is less than the predetermined pay back, the project would be accepted; if not, it would be rejected. Evaluation:

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A widely used appraisal criterion the pay back period seems to offer the following advantages. It is simple, both in concept and application. It does not use involved concepts and tedious calculations and has few hidden assumptions. 1) It is rough and ready method for dealing with risk. It favors projects, which generate substantial cash inflows in earlier years, and discriminates against projects, which bring substantial cash inflows in later years but not in earlier years. Now, if the risk tends to increase with futurity in general, this may be true the payback period criterion may be helpful in weeding out risky projects. Similarly, it serves well for projects characterized by a high degree of cataclysmic risks, 3) Since it emphasizes earlier cash flows, it may be sensible criterion when the firm pressed with problems of liquidity or during is

periods when financing costs are very

high. It weighs all returns equally, ignoring even distant returns, this method has an inherent hedge against economic depression. 4) It enables a firm to choose an investment which yields quick return of funds. 5) This is a sensible criterion which emphasizes early cash when the project is hard pressed with the problem of liquidity. 6) This method reduces the possibility floss on account of prefers investment in relatively shorter projects. Dis-advantages of Pay Back Period: 1) Ignores the returns after the payback period. 2) Ignores time value of money where cash flows are simply added without is counting them at a suitable, cut-off rate. It completely ignores the magnitude and timing of cash 21 obsolesce because it inflows especially

inflows. 3) Ignores the total life of the project. period of investment 4) Measures project's capital recovery, not profitability. Pay back emphasizes Pay back method considers only the recovery

earlier capital recovery and ignores totally the profitability of the project. 5) Inconsistent with the firms objective. As James Porterfield contends it would be

consistent with the firm's objective of share values were a function of pay back periods of investment projects. 6) This is suitable only to small projects consuming less investment and time 7) The results are not purely reliable as it does not cover all aspects inflationary (rends, profitability etc. AVERAGE depreciation) The average rate of return method of evaluating proposed capital expenditure is also known as the accounting rate of return method. It is based upon accounting information rather than cash flows. There is no unanimity regarding the definition of the rate of return. The most common usage of the average rate of return ARR= project X100 Average annual profits after taxes/ Average investment over the life of the RATE OF RETURN (Cash flows =after tax and after time value,

The average profits after taxes are determined by adding up the after-tax profits expected for each year of the project's life and dividing the result by the number of years, in the case of annuity, the average after-tax profits are equal to any year's profits. 22

The average investment is determined by dividing the net investment by two. This averaging process assumes that the firm is using straight tine method of depreciation, in which case the book value of the asset declines at a constant rate from its purchase price to zero at the end of its depreciable life. This means that, on the average, firms will have one-half of their initial purchase prices in the books. Consequently, if the machine should be divided by two in order to ascertain the average net investment, as the salvage money will be recovered only at the end of the life of the project. Therefore, an amount equivalent to the salvage value remains tied up in the project throughout its lifetime. Hence, no adjustment is required to the sum of salvage value to determine the average investment. Accept - Reject Rule: with the help of the ARR, the financial decision maker can decide whether to accept or reject the investment proposal. As an accept-reject criterion, the actual ARR would be compared with a predetermined or a minimum required rate of return or cut-off rate. A project would qualify to be accepted if the actual ARR is higher than the minimum desired ARR. Otherwise; it is liable to be rejected. Evaluation of ARR: In evaluating the ARR, as a criterion to select/reject investment projects, its merits and drawbacks need to be considered. The most favorable attribute of the ARR method is its easy calculation. What is required is only the figure of accounting profits after taxes which should be easily obtainable. Moreover, it is simple to understand and use. In contrast to this, the discounted flow techniques i nvolve tedious calculations and are 23

difficult to understand. Finally, the total benefits .associated with the project are taken into account while calculating the ARR. Some methods, pay back for instance, do not use the entire stream of incomes. Discounted Cash Flow (DCF}/Time-Adjusted (TA) Techniques: (Cash flows =before tax and before depreciation) The distinguishing characteristics of the DCF capital budgeting techniques is that they take into consideration the time value of money while valuating the costs and benefits of a project. In one form or another, all these methods requires cash flows to be discounted at a certain rate, that is, the cost of capital. The cost of capital (KJ is the minimum discount rate earned on a project that leaves the market value unchanged. The second commendable feature of these techniques is that they take into account all benefits and costs occurring during the entire life of the project. Present Value (PV)/Discounted Cash Flow(DCF) General Procedure: The present value or the discounted cash flow procedure recognizes that cash flow streams at different time periods differ in value and can be compared only when they are expressed in terms of a common denominator, that is, present values, it, thus takes into account the time value of money. In this method, all cash flows are expressed in terms of their present values. NET PRESENT VALUE METHOD (NPV) Net Present Value is described as the summation of the present values of cash proceeds in each year minus the summation of present values of the net cash outflows In each year. Rationale for the NPV method: 24

The NPV method has a straightforward rationale. An NPV of zero signifies that the benefits of the project are just enough to recoup the capital invested and (b) earn the required return on the capital invested, A positive NPV implies that the project earns an excess return. Since the return to the providers of debt capital is fixed, the excess return accrues solely to equity shareholders, thereby augmenting their wealth. Features of the Net Present Value Method: Two features of the net present value method may be emphasized: 1. The net present value method is based on the assum ption that the intermediate cash inflows of the project are re-invested at a rate of return equal to the cost of capital. 2. The net present value; of a simple project steadily decreases as the discount rate increases. The decrease in net present value, however, is At a decreasing rate. Evaluation: Conceptually sound, the net present value criterion has considerable merits 1) It takes into account the time value of money. 2) It considers the cash flow stream in its entirety. 3) It squares neatly with the financial objective of maximization of the wealth of the shareholders. The net present value represents the contribution to the wealth of shareholders. 4) The net present value of various projects, measured as they are in today's rupees, can be added. The additively property of net present value ensures that a poor project will not be accepted just because it is combined with a good project.

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Given the above merits, the net present value criterion is conceptually unassailable. Its practical application, however, seems to be marred by the following: a) The ranking of projects on the net present value dimension is influenced by the discount rate. b) It is difficult to calculate as we as understand and use in comparison with the pay back method or even the ARR method. This, of course, is a minor flaw. c) A more serious problem associated with the present value method involves the calculation of the required rate of return to discount the cash flows. d) Another shortcoming of the present value method is that It is an absolute measure. Prima facie between two projects, this method will favor the project, which has higher present value. But is likely that project may also involve a larger initial outlay, Thus, in case of projects involving different outlays, the present value method may not give dependable results. INTERNAL RATE OF RETURN The second discounted cash flow or time adjusted method for appraising capital investment decisions is the internal rate of return (IRR) method. This technique is also known as yield on investment, marginal efficiency Capital, marginal productivity of capital, rate of return, time-adjusted rate of return and so on. Like the present value method, the IRR method also considers the time value of money by discounting the cash streams. The basis of the discount factor, however, is different in both the cases. In the case of the net present value method, the discount rate is the required rate of return and being a predetermined 26

rale, usually the cost of capital, its determinants are external to the proposal under consideration. The IRR, on the other hand, is based on facts, which are internal to the proposal. In other words, while arriving at the required rate of return for finding out present values the cash flows-inflows as well as outflows are not considered. But IRR depends entirely on the initial outlay and the cash proceeds of the project, which is being evaluated for acceptance or rejection. It is, therefore, appropriately referred to as internal rate of return. Accept-Reject Decision: the use of IRR, as a criterion to accept capital investment decisions, involves a comparison of the actual IRR with the required rate of return also known as the cut -off rate or hurdle rate. The project would qualify to be accepted it the IRR exceeds the cut-off rate. If the IRR and the required rate of return are equal, the firm is indifferent as to whether to accept or reject the project Evaluation: The IRR method is a theoretically correct technique to evaluate capital expenditure decisions. It has the advantages which are offered by the NPV criterion such as; (i) (ii) It considers the time value of money and It takes into account the total cash inflows and outflows,

Merits: The IRR method is easy to understand. Business executives and non-technical people understand the concept of IRR much more readily than the concept of NPV. They may not be following the definition in terms of the equation but they are well aware of its usual meaning in terms of the rate of 27

return of investment. It does not use the concept of the required rate of return. It itself provides a rate of return

which is indicative of the profitability of the proposal. The cost of capital, of course, enters the calculations later on. Finally, it is consistent with the overall objective of maximizing

shareholders wealth. Limitations: It involves tedious calculations. It produces multiple rates which can be confusing. In evaluating mutually exclusive proposals, the project with the highest RR would be picked up to the exclusion of all others. However, in practice, it may not turn out to be the one which is the most profitable and consistent with the objectives of the firm, that is maximization of the shareholder's wealth. PROFITABILITY INDEX OR BENEFIT-COST RATIO Yet another time-adjusted capital budgeting technique is profitability index or benefit-cost ratio. It is similar to the NPV approach. The profitability index approach measures the present value of returns per rupee invested, while the NPV is based on the difference between the present value of future cash inflows and the present value of the cash outlays. A major shortcoming of the NPV method is that, being an absolute measure it is not reliable method to evaluate projects requiring different initial investments. The Profitability Index method provides a solution 28

to this kind of problem. It is in other words, a relative measure. It may be defined as the ratio, which is obtained by dividing the present value of future cash inflows by the present value of cash outlays. This method is also known as the B/C ratio because the numerator measures benefits and the denominator costs. A more appropriate description would be present value index. Accept-Reject Rule: Using the B/C ratio or the PI, a project will qualify for acceptance if its PI exceeds one. When PI equals 1. the firm is indifferent to the project. Evaluation: like the other discounted cash flow techniques, the PI satisfies almost all the requirements of a sound investment criterion. It considers all the elements of capital budgeting, such as the time value of money, totality of benefits and so on. Conceptually, it is a sound method of capital budgeting. Although based on the NPV, it is a better evaluation technique than NPV in a situation of capital rationing. This method however is more difficult to understand. Also, it involves more computation than the traditional methods but less than IRR.

Unit IV WORKING CAPITAL MANAGEMENT Unit IV: Working Capital Management: Concept of Working Capital - Determinants of Working Capital Operating Cycle Computation of Working Capital Requirements (NP) Working capital (Funds (current assets) required by a firm to finance day-to-day operations) it contains short term to meet day to day dealings of the firm The two concepts of working capital are 1. gross working capital 2. net working capital

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Gross working capital means the total of all current assets It is the sum of all current assets appear in balance sheet Net working capital: Excess of current assets over current liabilities. Net working capital refers out of current assets when current liabilitites are deducted we can get net Current assets means which can be converted into cash within a year ex: cash, bank, bills receivable, stock, debtors, short term securities, prepaid expenses etc. Current liabilities are those which will be payable with in one year ex: outstanding expenses creditors bills payable bank overdraft etc.

A positive net working capital will arise when current assets are more than current liabilities a negative net working capital occurs when current liabilities are more than current assets.. Working capital is necessary to run the day do day business activities. It is very difficult to find a business firm which does not require any amount of working capital. However, firms differe in their requirements of the working capital Companies aim at maxixisng the wealth of shareholders. In their efforts to maximize shareholders weath they should earn sufficient return from their operations.The firm has to invest enough funds in current assets for the

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efficient sales activity sales do ono convert into cash immediately there is always an operating cycle involved in the conversion of sales into cash Objectives of Working Capital To ensure optimum investment in current assets To strike a balance between the twin objectives of liquidity and profitability in the use of funds To ensure adequate flow of funds for current operations To speed up the flow of funds or to minimize the stagnation of funds.

Operating Cycle:
The time that elapses in conversion of raw materials into cash

Conversion of raw material into work in process conversion of work in process into finished goods. Conversion of finished goods into debtors and bills receivables thorough sales Conversion of debtors and bills receivable into cash. Cash Conversion Cycle Cash cycle = Operating Cycle - Time take to pay Suppliers

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Factors Affecting Working Capital * Nature of Business * Production cycle * Production policy * Terms of purchase and sales * Growth opportunity * Profit level * Dividend policy * Size of business *Business fluctuations * Availability of credit * Business cycle * Scarce availability of RMs * Operating efficiency * Price level changes

Nature and size of business: The working capital requirements of a firm are fundamentally influenced by the nature of its business. Trading and financial firms have lesser investment in fixed assets but require a large amount of money to be invested in working capital ex: a retail shop must have large stocks of a variety of goods to satisfy the varied and continuous demand of their customers some manufacturers and construction firms may also have to invest substantially in working capital and a small amount in the fixed assets Some manufactures do not require working capital because they have cash sales and supply servicers only but not products. no funds will be tied up in debtors and inventories. The size of business also has an important influence on its working capital needs size may be measured in terms of the scale of operation. A firm with larger scale of operation will need more working capital than a small firm. Production cycle: production cycle starts with the purchase and use of materials and completes with the production of finished goods longer the manufacturing cycle larger will be the firms working capital needs a long production time span means a larger tie-up of funds in inventories. Shorter manufacturing cycle should be selected. After a manufacturing process has been selected, it should be ensured that manufacturing cycle is completed within the specified time this needs proper planning and coordination at all levels of production activity. Any delay in manufacturing process will result in accumulation of work in process and waste of time. In

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order to minimize their investment in working capital some companies have a policy of asking for advance payments from their customers. Business fluctuations: many co. have seasonal and cyclical fluctuations in the demand for their products. These business variations influence the w.c. especially the temporary working capital requirements of the company. Where there is a boom in the economy sales will increase. Accordingly the firms investment in inventories and book debts will also increase such activities will require further additions of working capital also increase. Such activities will require further additions of working capital this meets their requirements of funds for fixed assets and current assets if there is a decling in the economy sales will fall so, the levels of inventories and book debts will also fall as a result the need for working capital also decreases. Production policy: constant production will maintain in order to resolve the working capital problems

they may arise due to seasonal changes in the demand for the companys production. A steady production policy will cause inventories to accumulate during the off season periods. Those firms whose productive capacities can be utilizes for manufacturing a variety products, can have the advantage of diversified activities. So that they can solve their working capital problems.
Availability of credit: The working capital requirements of a co. are also affected by credit terms granted by its creditors A co. will need less working capital if liberal credit is available the availability of credit from bank also influences the working capital needs of the company if it is able to get bank credit easily on favourable conditions it will operated with less w.c. Growth activities : The working capital needs of the company increase as it grows in terms of sales. It is difficult to determine the relationship between volume of sales and the w. c. needs . the that need for increased working capital funds does not follow growth but preceeds it. Therefore, necessary advance planning of working capital for a growing frim is to be made on a continuous basis. A growing firm may need to invest funds in fixed assets in order to sustain its growth. This will increased investment in current assets to support enlarged its growth. This will increased investment in current assets to support enlarged scale of operation. It should be realized that growing firm needs funds continuously Profit margin/profit level:. A high profit margin contributes more towards the working capital pool. In fact the net profit is source of working capital if it has been earned in cash the cash profit can be found by adjusting non cash items, such as depreciation. Outstanding expenses and losses written off etc, in the net profit when the companys operations are in progress, cash is used up for increasing stock, book debts or fixed assets the financial manager must see whether or not the cash generated has been used for right purposes. The application of cash should be well planned. If the net profits are earned in cash at the end of the period, total cash is not available for working capital purposes. The contribution towards working capital would be affected by the ,ammer om wjojc [rpfots are a[[rppriated. The availability of cash generated from operations depends upon taxation, retention policy and depreciation policy The firm policy to retain or distribute profits also influences working capital payment of dividend consumes mor cash resources and thus reduces firms working capital. If the profits are retained in the business the firms working capital position will be improved.

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Price level changes: The increasing changes in price levels make the functions of financial manger difficult. He should anticipate the effect of price level changes on working capital requirements of the firm. Generally rising price level will require a firm to maintain higher amount of working capital. The same levels of current assets will need increased investment when prices are increasing. The effects of rising price will de different for different companies.

Statement of Working Capital Estimation

Particulars A. Estimation of Current Assets: i) Raw materials ii) Work-in-process Raw materials (full cost) XX Direct labour (to the extent of completed stage) XX Overheads (to the extent of completed stage) XX iii) Finished goods inventory iv) Debtors v). Cash balance required Total Current Assets B. Estimation of Current Liabilities: i) Creditors ii) Expenses Overheads Labour Total Current Liabilities C. Working Capital (A-B) Add: Contingency (Percentage on working capital i.e. C) D. Working Capital Required

Amount (Rs.) XXX XXX XXX XXX XXX

XXX XXX XXX XX XX XXX XXX

XXX

Utilization of resources at minimum costs. The used of working capital is improved and the pace of the cash cycle is accelerated with operating efficiency better utilization of resources improves profitability and thus helps in releasing the pressure on working capital ******************************************************************************************* Financial Management Unit V

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Financial Management Unit V: Dividend Policy: Stable Dividend Dividend Theories - Factors Influencing Dividend Policy Issues in Dividend Policy - Bonus Shares 1)What do you mean by Dividend? Explain the factors influencing dividend policy? Dividend is the amount of earnings to be distributed to share in other words Dividend means profits of the firm which is distributed to the equity share holders. Dividend policy determines the division of earnings between shareholders and the amount to be retained in the business Retained earnings are the most important source of internal funds for the financial needs of the company Dividend distributed to the share holders involve the outflow of cash A higher dividend rate means less retained earnings leads to slower growth and lower market value per share in future. Factors influencing of dividend policy : while determining the dividend policy, the financial manager of a company consider the following factors Stability of earnings: It is one of the important factors influencing the dividend policy. If the earnings are stable a firm is in a better position to predict what its future earnings will be hence, such companies are likely to pay more dividends that a concern which has a fluctuating earnings firms which are producing necessaries have stable profits when compared to cosmetics and luxurious goods. Financing policy of the company: Dividend policy is effected by financing policy if the company decides to meet its expenses from its earnings, then it will have to pay less dividend to share holder if company is borrowing from the outside then it will pay higher dividend. Liquidity position : cash dividend is to be paid from money in the bank The presence of profits is an accounting phenomenon and common legal requirement, with the cash and working capital position is also necessary in order to judge the ability of the company to pay dividend because payment leads to outflow. The greater the cash position the greater is its ability to pay dividend liquidity of the firm is determined the firms investment financing decision and credit policies Dividend policy of competitors: If the competitors are paying higher rate of dividend than this concern, the share holders may prefer to invest their money in those companies rather than in this company. So every company decides it dividend policy by keeping in view the dividend policy of other competitors. Dividend practices of the company: For the existing firms the dividend rate may be decided on the basis of dividends in the previous years. It is also better for the company to maintain stability in the rate of dividend Ability to borrow: A co requires finances both for expansion programmes as well as for meeting unexpected expenses. So the companies have to borrow from the market. Large firms have better access to the capital market than new and small firms and hence the large firms company higher rate of dividend but new companies cannot obtain money from outside so they cannot pay more dividends. Growth needs of the company: A very important factor which influences the dividend policy is the growth needs of the company if the company has already grown it does not need funds for further expansions only for

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expansion it would need more money for growth and development if expansion is not required then it is easy for the company to declare heger dividends. Profitability : The internal profitability rate of the firm provides the basis for comparing the productivity of retained earnings to the alternative investment if the profitability is higher, the dividends are more liberal. Legal restrictions: board of directors will have to consider legal restrictions while declaring dividend and they are to be strictly observed by the company for declaring dividends dividend payment out of capital is prohibited. Control policy: If the company feels that no new shareholder should be added then it will have to pay less dividend if maintenance of control is an important consideration, the rate of dividend may be lower so that the company can meet its financial requirements from its retained earnings. Corporate taxation policy: Corporate taxes influence the rate of dividends of company. Heavy rates of taxation reduce the residual profits available for distribution to shareholders the Government puts dividend tax on distribution of dividends beyond a certain limit and tax on retained earnings may be lesser that on dividends in such cases the company prefers more retained earning than dividends. Tax position of shareholders in a company if large group of shareholders have already high income from other sources and they fall in high tax rates they will not be interested in high dividends. Because large part of the dividend will go away as income tax. They will prefer receovomg the dovodem om the fpr, pf casj the sjare jp;ders wpi;d ;ole tp get npis sjares they get money by selling extra shared received in they have to pay tax on this capital gain it is less when compared to income tax on cash dividend. Effect of trade cycles: During the period of inflation funds generated from depreciation may not be adequate to replace the assets. As a result there is a need for more retained earnings in order to preserve the earning power of the firm, so dividends fall. Vice versa. Desires of the shareholders: The shareholders 4 types Risk shareholders they fall in higher tax brackets and prefer more retained earnings by the co. Small shareholders they hold lesser number of shares they do not a definite investment policy sometimes they prefer more dividends and in other times capital gains Retired persons they invest out of their retirement benefits They need regular income for their survival so they prefer such company with have stable dividend Institutional investors: This is another dominant group in many companies. They purchase large quantities of share to hold then for relatively longer period of time because they invest out of public funds and they have the obligation to pay interest regularly to their investors so they prefer regular dividends. Company must understand the various factors and apply a dividend policy that is suitable to its market value.

Types of dividend policies:

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Stability of dividends shareholders prefer stable dividends because all other things being the same stable dividends have a positive impact on the market price of the share stability of dividends means amounts paid out regularly dividend declared may or may not be related with earnings there are four types of dividend practices Constant dividend according to this fixed amount per share as dividend every year. Without considering the fluctuation in the earning of the company but dividend per share may increase if the profits are increase there are periodical increases or decreases in dividends it is shown

Company will follow when its earnings are stable Constant percentage of of net earnings: this policy implies the amount of dividend will fluctuate in direct proportion to earnings of the company ex. If a company adopts 50% payout ratio if the company incurs losses no dividend shall be paid.

Small constant dividend per share plus extra dividend constant dividend per share is paid the policy to pay a minimum dividend per share with a step up feature is quite popular the small amount of dividend is fixed with the purpose of maintaining regularity in payment of dividend and extra dividend is paid in periods of higher profits. Scrip dividend if the company cash position is weak it may declare dividend in the form of scrips in this method the shareholders are issued transferable promissory notes which may or may not be interest bearing only when company has really earned profit.

Property dividend payment with assets other than cash Cash dividend which is distributed to the shareholders in cash

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Stock dividend or Bonus shares Stock dividend is the dividend which is paid to the shareholders in kind when stock dividends are paid a portion of the surplus is transferred to the capital account and shareholders are issued additional share certificates such share are known as bonus shares. Stock split increase the number of outstanding through a proportional reduction in the par value of the share. A stock split does not give any monetary advantage to the share holders. for ex:10face value share into 10 shares of 1 each divided into 10face value into 2 shares of 5 each.

Dividend Theories
Dividend decision determines the amount of earnings to be distributed to share holders and the amount to be retained in the firm There are two theories regarding dividend Relevant theories Irrelevant theories

Walters Model
Walters Model supports the view of dividend policy of an enterprise has bearing on value of firm. The Model is based on r and K o.it states that dividend policy affets the value of the firm according to him firm is calssified into three Model divides firms into: Growth firms: r>K o Normal firms: r=K o Declining firms: r<K o Growth firms: r>K

The growth firm should retain the earnings as much as possible


Normal firms: r=K o Not matter whether the firm retains or distributes its earnings. in their case the value of the firms share would not fluctuate with change in the dividend rates. Declining firms: r<K o
The optimum dividend policy for them would be to distribute the entire earnings as dividends. The shareholders will gain because they can invest the divided in channels which can give them higher return. thus 100% dividend payout ratio in their case would result in maximizing the value of the company

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D ( r K 0 )( E D) D ( E D) r K or K0 K0 K0
P = Price per equity share; D = Dividends per share; E = Earnings per share; (ED)= Retained earnings per share; r = Rate of return on investment; K0 = Cost of capital.

Where:

Assumptions:

Only internal source of funds used r and K o constant All earnings are paid as dividends or completely reinvested EPS; and DPS never change Perpetual life Altd R=15% K=10% E=Rs8 Bltd R=5% K=10% E=Rs8 Cltd R=10% K=10% E=Rs8

Calculate the value of an equity share of each of these companiew applying walters formula when dividend payment ratio is 1)50% 2)75% 3)25%. And draw conclusions. Interpretation:

r>K o=optimum DP Ratio is zero r=K o=No optimum DP Ratio r<K o=Optimum DP Ratio 100% Criticism * No external financing * Constant rate of return as investment * Constant cost of capital

Gordons dividend model

Gordons dividend model (Gordon Model says that firms share price is dependent on dividend payout ratio.)

Gordon supported the relevant approach on dividend determination i. e. dividend policy of a company will influence its market value according him dividend policy the market value of the companys equity share is

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equal to the present valued of an infinite stream of dividend dividends are infinite because equity shares are not bound for time

Assumptions: All equity firm; Properties financed by retained earnings; r is constant; K o remains constant; K o>b. r; Perpetual stream of earnings; Perpetual life; Retention ratio constant; No corporate taxes

E (1 b) K o b. r

Where:

P = Price per share E = Earnings per share b = Retention ratio (1- b) = Proportion of earnings of the firm distributed as dividends; Ko = Capitalization rate or cash of capital or required return by equity shareholders r = Rate of returns earned an investment made by the firm g = b. r = growth rate Gordons argument: Investors are risk averse, need premium on uncertain return divides firms into: Growth firms: r>K o Normal firms: r=K o Declining firms: r<K o Growth firms: r>K o In this case the returns r are greater than their costs k. when return are greater investors expectation it is more preferable for them to retain as much earnings as possible in the firm because they cannot earn more than that rate so the market value of the share is maximum when retained earnings are higher and vice versa Normal firms: r=K o for a normal firm the earnings( r) are just equal to its costs (k). The investor is indifferent between retained earnings and dividends his opportunity cost is also similar to the firms earnings so the market value of the share is the same at any amount of dividend or retained earnings. Declining firms: r<K o because of lesser returns their costs are known as declining firms there will be lesser returns than earnings so it cannot retain any earnings. If their retain more the earnings to the share holders are lesser. So the market value of t he share is maximum when retained are lesser and minimum when retained earnings are maximum. Ex: the earings Xltd Yltd Zltd R=15% R=10% R=7%

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K=10% K=10% E=Rs10 E=Rs10 Find out the market values when pay out ratio is 40% ,60%,90%.

K=10% E=Rs10

MM THEORY(Irrelevant theory)

MM Theory: Value of Firm is determined by its basic earning power and its business risk. It states that the dividend decision does not influence the market value of the equity shares/ Modigliani and Millers approach: They stated that the price of shares of a firm is determined by its earnings potentialituy and investment policy and never ny the pattern of income distribution they argued that what ever increase in shareholders wealth results from dividend paymnt, will be exactly offset by the effect of raising additional captial Assumptions: Existence of perfect capital markets No taxes Firm has fixed investment policy There is no risk Arbitrage involving simultaneously into two transactions which exactly balance each other. Here two transactions are: (i) Payment of dividends (ii) Raising funds externally 1. Market Price of Share at the end of Period 1: The market price per share (Po) in the beginning of the period is equal to the present value of dividends paid at the end of the period plus market price of share at the end of the period. Where: D1 = P1 = k = capital) P1 = Po (1 + Ke) D1 The total capitalization value of outstanding equity shares of the firm at period 0 is obtained by the use of following formula. Po = Market price per share at period o Dividends per share at end of period 1 Market price per share at the end of period 1 Discount rate applicable to the risk less to which the firm belongs to (cost of equity

1 ( nD1 nP1 ) nPo = (1 k )


3. Amount needed to be raised by the Issue of New Shares nP1 = I (E nD1) Where: nP1 = Amount raised by sale of new shares I = Total funds required for investment E = Total earnings of the firm during the period

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4. 5.

nD1 = Total dividends period (E nD1)= Retained earnings. No. of additional Shares to be Issued; n = nP1 P1 Value of the Firm:
( n n) P I E 1 (1 K e )

nPo

Criticisms on MM Theory

Tax deferential Existence of flotation cash Existence of transaction costs Information asymmetry Institutional restrictions Resolution of uncertainty Near vs. Distant dividend Desire for current income Under pricing

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