Dividend Policy & Working Capital Management

Dividend Policy Models for Price Evaluation

Walter Model Gordon Model

Walter Model
It proposes that dividend policy of the firm has a bearing on share valuation. P = D + (E-D)*(r/k) k P is price of equity share, D is dividend per share, E is EPS, r is rate of return on investment & k is cost of capital. Refer page 546- 547 in Prasanna Chandra.

Gordon Model
It is a model of stock valuation using dividend capitalization approach. Po = E1 (1-b) (k-br) Po is price per share at end of year 0, E1 is eps at end of year 1, b is the fraction of earning the firm retains, k is the rate of return required by shareholders, r is the rate of return earned on investments. Refer Page no 548-549 in Prasanna Chandra

WORKING CAPITAL MANAGEMENT

OUTLINE Characteristics of Current Assets Factors Influencing Working Capital Requirements Level of Current Assets Current Assets Financing Policy Profit Criterion for Current Assets Operating Cycle Analysis Cash Requirement for Working Capital

CHARACTERISTICS OF CURRENT ASSETS

Short life span Swift transformation into other asset forms Current Assets Cycle

Finished goods

Accounts receivable Wages, salaries, factory overheads

Work-inprocess

Raw materials

Cash

Suppliers

FACTORS INFLUENCING WORKING CAPITAL REQUIREMENTS Nature of Business:

Hotel and Restaurants,

Electricity generation and Distribution, Aluminum, Shipping, Iron and steel, Tea Plantation, Cotton Textiles, Sugar, Trading.

Seasonality of Operations

Production Policy Market Conditions

WORKING CAPITAL POLICY Two important issues in working capital policy are: What should be the level of investment in current assets? What mix of long-term and short-term financing should the firm employ to support current

LEVEL OF CURRENT ASSETS

Flexible (Conservative) Policy High Large High Restrictive (Aggressive) Policy Low Small Low

Liquidity Inventories Debtors

A flexible policy results in fewer production stoppages, ensures quicker deliveries to customers, and stimulates sales .. but HIGHER INVESTMENT IN CURRENT ASSETS A restrictive policy leads to more production stoppages, delayed deliveries to customers, and lost sales but LOWER INVESTMENT IN CURRENT ASSETS

CAPITAL REQUIREMENTS AND THEIR FINANCING

Fluctuating current asset requirement

Capital requirements

A B

CPermanent curren asset-requiremen

Fixed asset requirement

Time

CURRENT ASSETS FINANCING POLICY According to the matching principle, fixed assets and permanent current assets should be supported by long-term sources of

finance whereas fluctuating current assets must be supported by short-term sources of finance.

PROFIT CRITERION FOR WORKING CAPITAL Investment in current assets is easily reversible. For reversible investments, the criterion of net profit per period (which here means residual income) is equivalent to the criterion of net present value

OPERATING CYCLE AND CASH CYCLE

Order placed Cash received Stock arrives Inventory period receivable period Accounts payable period Firm receives invoice Cash paid for materials Operating cycle Cash cycle Average inventory Inventory period = Average COGS / 365 Average accounts receivable Accounts receivable period = Annual sales / 365 Average accounts payable Average payable period = Average COGS / 365 Goods sold Accounts

ILLUSTRATION
Financial Information for Horizon Limited
Balance Sheet Data Profit and Loss Beginning of End of Account Data 20X0 Sales 96 Cost of goods 86 90 Sold 56 60 800 102 720 Accounts receivable Accounts payable Inventory

20X0

(96 + 102) / 2 Inventory period = = 50.1 days

(86 + 90) / 2 Accounts receivable period = 800 / 365 (56 + 60) / 2 Accounts payable period Operating cycle = 720 / 365 = 50.1 Inventory period 90.3 Operating cycle + 40.2 = 90.3 days Accounts receivable period = 29.4 days = 40.2 days

Cash cycle

29.4 = 60.9 days Accounts payable period

CASH REQUIREMENT FOR WORKING CAPITAL Step 1 : Estimate the cash cost of various current assets required by the firm. Step 2 : Deduct the spontaneous current liabilities from the cash cost of current assets