Embed Doc
Copy Link
Readcast
Collections

CommentGo Back

Download

Time Value of Money

Time value of money is the value of money figuring in a given amount of interestfor a given amount of time. For example 100 Rupees of todays money held for ayear at 5 percent interest is worth 105 Rupees, therefore 100 Rupees paid now or 105 Rupees paid exactly one year from now is the same amount of payment of money with that given interest at that given amount of time[1]. This notion dates atleast to Martín de Azpilcueta of the School of Salamanca.All of the standard calculations for time value money derive from the most basicalgebraic expression for the present value of a future sum, "discounted" to thepresent by an amount equal to the time value of money. For example, a sum of FV to be received in one year is discounted (at the rate of interest r) to give a sumof PV at present: PV = FV — r·PV = FV/(1+r).Some standard calculations based on the time value of money are:

Present Value

The current worth of a future sum of money or stream of cashflows given a specified rate of return. Future cash flows are discounted at thediscount rate, and the higher the discount rate, the lower the present value of thefuture cash flows. Determining the appropriate discount rate is the key to properlyvaluing future cash flows, whether they be earnings or obligations[2].

Present Value

of a Annuity

An annuity is a series of equal payments or receiptsthat occur at evenly spaced intervals. Leases and rental payments are examples.The payments or receipts occur at the end of each period for an ordinary annuitywhile they occur at the beginning of each period for an annuity due[3].

Present Value

of a Perpetuity

is a constant stream of identical cash flows withno end.

Future Value

is the value of an asset or cash at a specified date in the future thatis equivalent in value to a specified sum today[5].

Future Value of an Annuity

(FVA) is the future value of a stream of payments(annuity), assuming the payments are invested at a given rate of interest.

Compound Value

– We have thus developed a logic for deciding between cashflows that are separated by one period, such as one year. But most investmentdecisions involve more than one period. To solve such complicated investmentdecisions, we simply need to extent the logic developed above.

Present Value

– This process work in the reverse direction of Compound Value –working from future cash flows to their present values. The present value of afuture cash inflow maker, to a specified amount of cash to be received or paid at afuture date. The process of determining present value of a future payment (or receipts) or a series of future payments (or receipts) is called

discounting

. Thecompound interest rate used for discounting cash flows is also called the

discount rate

Annuity Due -

An annuity due requires payments to be made at the beginning of the period. For example, in many lease arrangements, the first payment is dueimmediately and each successive payment must be made at the beginning of themonth. The concepts of compound value and present value of an annuitydiscussed earlier are based on the assumption that series of payments are madeat the end of the year. In practice, payments could be made at the beginning of the year.

Multi period Compounding

– In practice, cash flows can occur more than once ayear. For example, banks may pay interest on savings account quarterly. Onbonds or debentures and public deposits, companies may pay interest on savingsaccount quarterly. On bonds or debentures and public deposits, companies maypay interest semi-annually. Similarly, financial institutions may require borrowersto pay interest quarterly or half-yearly. Its also called as

ContinuousCompounding

Rate of Return

- Rate of return (ROR), also known as Return on Investment(ROI), rate of profit or sometimes just return, is the ratio of money gained or lost(whether realized or unrealized) on an investment relative to the amount of moneyinvested. The amount of money gained or lost may be referred to as interest,profit/loss, gain/loss, or net income/loss. The money invested may be referred toas the asset, capital, principal, or the cost basis of the investment. ROI is usuallyexpressed as a percentage rather than a fraction.

Investment Decisions

–

Investment Decisions / Capital budgeting

(or

investment appraisal

) is the planning process used to determine whether afirm's long term investments such as new machinery, replacement machinery, newplants, new products, and research development projects are worth pursuing. It isbudget for major capital, or investment, expenditures.Many formal methods are used in capital budgeting, including the techniquessuch as - Net present value, Profitability index, Internal rate of return, ModifiedInternal, Rate of Return, Equivalent annuity

Features

– the exchange of current funds for future benefits, the funds areinvested in long-term assets, the future benefits will occur to the firm over a seriesof years.

Importance

– They have long-term implications for the firm, and can influence itsrisk complexion, They involve commitment of large amount of funds, They areirreversible decisions, They are among the most difficult decisions to make.

Types

– Expansion of existing business, Expansion of new business,Replacement and modernisation.

Investment Evaluation Criteria

– 3 Steps -> Estimation of cash flows, Estimationof the required rate of return

Characteristics

– It should -- consider all cash flows to determine the trueprofitability of the project, provide for an objective and unambiguous way of separating good projects from bad projects, help ranking of projects according totheir true profitability.

DISCOUNTED CASH FLOW - Net Present Value Method

- NPV compares thevalue of a Rupee today to the value of that same Rupee in the future, takinginflation and returns into account. If the NPV of a prospective project is positive, itshould be accepted. However, if NPV is negative, the project should probably berejected because cash flows will also be negative. Each cash inflow/outflow isdiscounted back to its present value (PV). Then they are summed. Therefore NPVis the sum of all terms , where --

- the time of the cash flow

- the discount rate (the rate of return that could be earned on an investment inthe financial markets with similar risk.)

- the net cash flow (the amount of cash, inflow minus outflow) at time t (for educational purposes, R0 is commonly placed to the left of the sum to emphasizeits role as (minus the) investment.

Acceptance Rule –

Accept if NPV > 0 (positive), Reject if NPV < 0 (negative)

Merits

– consider all cash flows, true measure of profitability, based on theconcept of the time value of money, satisfies the value-additivity principle,consistence with wealth maximisation principle

Demerits

– Requires estimates of cash flows which is a tedious task, Requirescomputation of the opportunity cost of capital which poses practical difficulties,sensitive to discount rates

Internal Rate of Return Method (IRR)

- The internal rate of return (IRR) is acapital budgeting metric used by firms to decide whether they should makeinvestments. It is also called discounted cash flow rate of return (DCFROR) or rate of return (ROR).[1] It is an indicator of the efficiency or quality of aninvestment, as opposed to net present value (NPV), which indicates value or magnitude.Instead of converting to the present we can also convertto any other fixed time; the value obtained is zero if and only if the NPV is zero.

Acceptance Rule –

Accept if IRR > k, Reject if IRR < k, Project may be acceptedif IRR = k.

Merits

– considers all cash flows, true measure of profitability, based on theconcept of time value of money, generally consistent with wealth maximisationprinciple.

Demerit

– requires estimates of cash flows which is a tedious task, does not holdthe value-additivity principle, At times fails to indicate correct coice betweenmutually exclusive projects, At times yields multiple rates, Relatively difficult tocompute

Profitability Index -

An index that attempts to identify the relationship betweenthe costs and benefits of a proposed project through the use of a ratio calculatedasA ratio of 1.0 is logically the lowest acceptable measure on the index. Any valuelower than 1.0 would indicate that the project's PV is less than the initialinvestment. As values on the profitability index increase, so does the financialattractiveness of the proposed project.

Acceptance Rule

– Accept if PI > 1.0, Reject if PI < 1.0, Project may be acceptedif PI = 1.0

Merits

– Considers all cash flows, Recognises the time value of money, Relativemeasure of profitability, Generally consistent with the wealth maximisationprinciple.

Demerits

– Requires estimates of the cash flows which is a tedious task, At timesfails to indicate correct choice between mutually exclusive projects.

NON DISCOUNTED CASH FLOWPayback (PB)

- the number of years required to recover the initial outlay of theinvestment is called payback.PB = Initial Investment / Annual cash flow = C

/ C

Acceptance Rule

– Accept if PB < standard payback, Reject if PB > standard…

Merits

– Easy to understand and compute and inexpensive to use, Emphasisliquidity, easy and crude way to cope with risk, Uses cash flows information

Demerits

– Ignores the tome value of money, ignores cash flows occurring after the payback periods, not a measure of profitability, no objective way to determinethe standard payback, no relation with the wealth maximisation principle.

Discount Payback

– The number of years required in recovering the cash outlayon the present value basis is the discounted payable period. Except usingdiscounted cash flows in calculating payback, this method has all the demerits of payback method.

Accounting rate of return (ARR)

– An average rate of return found by dividingthe average profit [EBIT (1 –

)] by the average investment.ARR = Average profit / Average investment

Acceptance Rule

– Accept if ARR > minimum rate, Reject if ARR < minimum rate

Merits

– Uses accounting data with which executives are familiar, Easy tounderstand and calculate –

Demerits

– Ignores the time value of money, Doesnot use cash flows, Gives more weightage to future receipts, No objective way todetermine the minimum acceptable rate of return.

Cash Flow Vs Profit

– The estimation of cash flows, though difficult, is the mostcrucial step in investment analysis. Cash flows are different from profits. Profit isnot necessarily cash flow; it is the difference between revenue earned andexpenses incurred rather than cash received and cash paid. Also, in thecalculation of profits, an arbitrary distinction between revenue expenditure andcapital expenditure is made.Cash flows should be estimated on incremental basis. Incremental cash flows arefound out by comparing alternative investment projects. The comparision maysimply be between cash flows with and without the investment proposal under consideration when real alternatives do not exist.Three components of cash flow can be identified – (1) Initial investment withcomprise the original cost (including freight and installation charges) of theproject, plus an increase in working capital. (2) Annual net cash flow is thedifference between cash inflows and cash outflows including taxes. Taxcomputations are based on accounting profits. Care should be taken in properlyadjusting depreciation while computing net cash flows. Depreciation is a noncashitem, but it affects cash flows through tax shield (3) terminal cash flows are thosewhich occur in the project’s last year in addition to annual cash flows. They wouldconsist of the salvage value of the project and working capital released (if any). Incase of replacement decision, the foregone salvage value of old asset should alsobe taken into account.

COST OF CAPITAL

- The cost of capital is an expected return that the provider of capital plans to earn on their investment. Capital (money) used for funding abusiness should earn returns for the capital providers who risk their capital. For aninvestment to be worthwhile, the expected return on capital must be greater thanthe cost of capital. In other words, the risk-adjusted return on capital (that is,incorporating not just the projected returns, but the probabilities of thoseprojections) must be higher than the cost of capital. The cost of debt is relativelysimple to calculate, as it is composed of the rate of interest paid. In practice, theinterest-rate paid by the company will include the risk-free rate plus a riskcomponent, which itself incorporates a probable rate of default (and amount of recovery given default). For companies with similar risk or credit ratings, theinterest rate is largely exogenous.

Components

Cost of debt -

The cost of debt is computed by taking the rate ona risk free bond whose duration matches the term structure of the corporate debt,then adding a default premium. This default premium will rise as the amount of debt increases (since the risk rises as the amount of debt rises). Since in mostcases debt expense is a deductible expense, the cost of debt is computed as anafter tax cost to make it comparable with the cost of equity (earnings are after-taxas well). Thus, for profitable firms, debt is discounted by the tax rate. Basically thisis used for large corporations only.The formula can be written as (Rf + credit risk rate)(1-T), where T is the corporatetax rate and Rf is the risk free rate.

Cost of equity -

Cost of equity = Risk free rate of return + Premium expected for risk.

Expected return -

The expected return (or required rate of return for investors) can be calculated with the "dividend capitalization model", which isThat equation is also seen as, Expected Return = dividend yield + growth rate of dividends.

Capital asset pricing model -

The capital asset pricing model (CAPM)is used in finance to determine a theoretically appropriate price of an asset suchas a security. The expected return on equity according to the capital asset pricingmodel. The market risk is normally characterized by the β parameter. Thus, theinvestors would expect (or demand) to receive:Where: E

- The expected return for a securityR

- The expected risk-free return in that market (government bond yield)β

- The sensitivity to market risk for the securityR

- The historical return of the stock market/ equity market(R

-R

) - The risk premium of market assets over risk free assets.

Weighted average cost of capital

- The Weighted Average Cost of Capital(WACC) is used in finance to measure a firm's cost of capital.The total capital for a firm is the value of its equity (for a firm without outstandingwarrants and options, this is the same as the company's market capitalization)plus the cost of its debt (the cost of debt should be continually updated as the costof debt changes as a result of interest rate changes). Notice that the "equity" inthe debt to equity ratio is the market value of all equity, not the shareholders'equity on the balance sheet. To calculate the firm’s weighted cost of capital, wemust first calculate the costs of the individual financing sources: Cost of Debt Costof Preference Capital Cost of Equity Capital.

Capital structure

- Because of tax advantages on debt issuance, it will becheaper to issue debt rather than new equity (this is only true for profitable firms,tax breaks are available only to profitable firms). At some point, however, the costof issuing new debt will be greater than the cost of issuing new equity. This isbecause adding debt increases the default risk - and thus the interest rate that thecompany must pay in order to borrow money. By utilizing too much debt in itscapital structure, this increased default risk can also drive up the costs for other sources (such as retained earnings and preferred stock) as well. Managementmust identify the "optimal mix" of financing – the capital structure where the costof capital is minimized so that the firm's value can be maximized.

Modigliani-Miller theorem

- If there were no tax advantages for issuing debt, andequity could be freely issued, Miller and Modigliani showed that, under certainassumptions, the value of a leveraged firm and the value of an unleveraged firmshould be the same. Their paper is foundational in modern corporate finance.

RISK

- A fundamental idea in finance is the relationship between risk and return.The greater the amount of risk that an investor is willing to take on, the greater thepotential return. The reason for this is that investors need to be compensated for taking on additional risk.For example, a U.S. Treasury bond is considered to be one of the safestinvestments and, when compared to a corporate bond, provides a lower rate of return. The reason for this is that a corporation is much more likely to go bankruptthan the U.S. government. Because the risk of investing in a corporate bond ishigher, investors are offered a higher rate of return.

Techniques

–

Payback

– It is one of the oldest and commonly used methods for explicitly recognising risk associated with an investment project.The merit of payback is its simplicity. Also payback makes an allowance for risk by(i) focusing attention on the near term future and thereby emphasising the liquidityof the firm through recovery of capital and (ii) by favouring short term projects over what may be riskier, longer term projects.

Risk-Adjusted Discount Rate

- In Portfolio Theory and Capital Budget analysis,the rate necessary to determine the Present Value of an uncertain or risky streamof income; it is the risk-free rate (generally the return on short-term U.S. Treasurysecurities) plus a risk premium that is based on an analysis of the riskcharacteristics of the particular investment or project.

Evaluation

– It is simpleand can be easily understood, It has a great deal of intuitive appeal for risk-aversebusinessman, It incorporates an attitude (risk-aversion) towards uncertainty.

Certainty Equivalent -

This is useful in determining what return investors willrequire from your company. In other words, at what return would an investor in acertain (risk-free) investment be enticed to invest in your higher paying, yet morerisky, investment.

Evaluation

– The certainty equivalent approach explicitlyrecognises risk, but the procedure for reducing the forecasts of cash flows isimplicit and likely to be inconsistent from one investment to another. Further, thismethod suffers from many dangers in a large enterprise. First, the forecaster,expecting the reduction that will be made in his forecasts, may inflate them inanticipation. Second, if forecasts have to pass through several layers of management, the effect may be greatly exaggerate the original forecast or tomake it ultra conservative. Third, by focussing explicit attention only on thegloomy outcomes, changes are increased for passing by some good investments.

Sensitivity analysis -

A technique used to determine how different values of anindependent variable will impact a particular dependent variable under a given setof assumptions. This technique is used within specific boundaries that will dependon one or more input variables, such as the effect that changes in interest rateswill have on a bond's price.Sensitivity analysis is a way to predict the outcome of a decision if a situationturns out to be different compared to the key prediction(s).

Pros

– It compels the decision maker to identify the variables which affect thecash flow forecasts. This helps him in understanding the investment project intotality. – It indicates the critical variables for which additional information may beobtained. The decision maker can consider actions which may help instrengthening the ‘weak spots’ in the project.

Cons

– It does not provide clear cut results. The terms ‘optimistic’ and‘pessimistic’ could mean different things to different persons in an organisation.- It fails to focus on the interrelationship between variables.

FINANCIAL LEVERAGE

- Financial leverage (FL) takes the form of a loan or other borrowings (debt), the proceeds of which are (re)invested with the intent toearn a greater rate of return than the cost of interest. If the firm's rate of return onassets (ROA) is higher than the rate of interest on the loan, then its return onequity (ROE) will be higher than if it did not borrow because assets = equity +debt (see accounting equation). On the other hand, if the firm's ROA is lower thanthe interest rate, then its ROE will be lower than if it did not borrow. Leverageallows greater potential returns to the investor that otherwise would have beenunavailable but the potential for loss is also greater because if the investmentbecomes worthless, the loan principal and all accrued interest on the loan stillneed to be repaid.Margin buying is a common way of utilizing the concept of leverage in investing.An unleveraged firm can be seen as an all-equity firm, whereas a leveraged firmis made up of ownership equity and debt. A firm's debt to equity ratio is thereforean indication of its leverage.

Measures of financial leverage

–

The Ratio of debt to total capital

– i.e.,L

= (D / D+S) = D/V, where D is value of debt, S is value of equity and V is valueof total capital. D and S may be measured in terms of book value or market value.The book value of equity is called net worth.

The ratio of debt to equity

i.e., L

= D/S

The ratio of net operating income (or EBIT) to interest charges,

i.e.,L

= EBIT / Interest

OPERATING LEVERAGE

- The operating leverage is a measure of how revenuegrowth translates into growth in operating income. It is a measure of leverage,and of how risky (volatile) a company's operating income is. There are variousmeasures of operating leverage,[1] which can be interpreted analogously tofinancial leverage.

Costs

- One analogy is "fixed costs + variable costs = totalcosts ..similar to.. debt + equity = assets". This analogy is partly motivatedbecause (for a given amount of debt), debt servicing is a fixed cost. This leads totwo measures of operating leverage: One measure is fixed costs to total costs:(FC/TC) = FC / (FC+VC).Compare to debt to value, which is (Debt/Assets) = Debt / (Debt + Equity)Another measure is fixed costs to variable costs: FC/VC.Compare to debit to equity ratio: Debt/Equity

Contribution

: Contribution margin is a measure of operating leverage: the higher the contribution margin is (the lower variable costs are as a percentage of price),the faster profits increase with sales. Note that unlike other measures of operatingleverage, in the linear Cost-Volume-Profit Analysis Model, contribution margin is afixed quantity, and does not change with Sales.

CAPITAL STRUCTURE

- A mix of a company's long-term debt, specific short-term debt, common equity and preferred equity. The capital structure is how a firmfinances its overall operations and growth by using different sources of funds.Debt comes in the form of bond issues or long-term notes payable, while equity isclassified as common stock, preferred stock or retained earnings. Short-term debtsuch as working capital requirements is also considered to be part of the capitalstructure.A company's proportion of short and long-term debt is considered when analyzingcapital structure. When people refer to capital structure they are most likelyreferring to a firm's debt-to-equity ratio, which provides insight into how risky acompany is. Usually a company more heavily financed by debt poses greater risk,as this firm is relatively highly levered.The management of a company should seek answers to the following questionswhile making the financing decisions:- How should the investment project by financed, - Does the way in which theinvestment projects are financed matter, - How does financing affect theshareholders’ risk, return and value, - Does there exist an optimum financing mixin terms of the maximum value to share-holders of a company, - Can the optimumfinancing mix be determined in practice for a company, - What factors in practiceshould a company consider in designing its financing policy.

Features

Profitability

: The capital structure of the company should be mostadvantageous. With the constraints, maximum use of leverage at a minimum costshould be made.

Solvency

: The use of excessive debt threatens the solvency of the company. To the point debt does not add significant risk it should be used,otherwise its use should be avoided.

Flexibility

: The capital structure should notbe inflexible to meet the changing conditions. It should be possible for a companyto adapt its capital structure with a minimum cost and delay.

Capacity

The capitalstructure should be determined within the debt capacity of the company, and thiscapacity should not be exceeded. The debt capacity of a company depends on itsability to generate future cash flows. It should have enough cash to pay creditors’fixed charges and principal sum.

Control

The capital structure should involveminimum risk of loss of control of the company. The owners of closely-heldcompanies are particularly concerned about dilution of control.

Three common approaches

–

EBIT-EPS Analysis

– The use of fixed costsources of finance, such as debt and preference share capital to finance theassets of the company is known as financial leverage or trading on equity. If theassets financed with the use of debt yield a return greater than the cost of debt,the earnings per share increases when the preference share capital is used toacquire assets.

Limitations

–

EPS variability

– The EPS variability resulting fromthe use of leverage is called financial risk. Financial risk is added with the use of debt because of (a) the increase variability in the shareholders’ earnings and (b)the threat of insolvency. A firm can avoid financial risk altogether if it does notemploy and debt in its capital increases in EPS. Therefore, a company mayemploy debt to the extent the financial risk perceived by shareholders does notexceed the benefit of increased EPS. The EPS criterion does not consider thelong-term perspectives of financing decisions. It fails to deal with the risk-returntrade-off.

Operating Conditions

– One very important factor on which thevariability of EPS depends is the growth and stability of sales. EPS will fluctuatewith fluctuations in sales. The magnitude of the EPS variability with sales willdepend on the degrees of operating and financial leverages employed by thecompany. The firms with stable earnings and cash flows and thus, can employ ahigh degree of leverage as they will not face difficult in meeting their fixedcommitments. Sale of the consumer goods industries show wide fluctuations,therefore, they do not employ a large amount of debt. On the other hand, thesales of public utilities are quite stable and predictable.

Trade-off Theory -

The Trade-Off Theory of Capital Structure refers to the ideathat a company chooses how much debt finance and how much equity finance touse by balancing the costs and benefits. The classical version of the hypothesisgoes back to Kraus and Litzenberger who considered a balance between thedead-weight costs of bankruptcy and the tax saving benefits of debt. Oftenagency costs are also included in the balance. This theory is often set up as acompetitor theory to the Pecking Order Theory of Capital Structure.An important purpose of the theory is to explain the fact that corporations usuallyare financed partly with debt and partly with equity. It states that there is anadvantage to financing with debt, the tax benefits of debt and there is a cost of financing with debt, the costs of financial distress including bankruptcy costs of debt and non-bankruptcy costs (e.g. staff leaving, suppliers demandingdisadvantageous payment terms, bondholder/stockholder infighting, etc). Themarginal benefit of further increases in debt declines as debt increases, while themarginal cost increases, so that a firm that is optimizing its overall value will focuson this trade-off when choosing how much debt and equity to use for financing.Despite certain criticisms, the Trade-Off Theory remains the dominant theory of corporate capital structure as taught in the main corporate finance textbooks.Dynamic version of the model generally seem to offer enough flexibility inmatching the data so, contrary to Miller's verbal argument, dynamic trade-off models are very hard to reject empirically.

Cash flow approach

– One of the features of a sound capital structure isconservatism. Conservatism does not mean employing no debt or small amountof debt. Conservatism is related to the fixed charges created by the use of debt or preference capital in the capital structure and the firm’s ability to generate cash tomeet these fixed charges. In practice, the question of the optimum (rather appropriate) debt-equity mix boils down to the firm’s ability to service debt withoutany threat and operating inflexibility. A firm is considered prudently financed if it isable to service its fixed charged under any reasonably predictable adverseconditions.The fixed charges of a company include payment of interest, preference dividendsand principal, and they depend on both the amount of senior securities and theterms of payment. The amount of fixed charges will be high if the companyemploys a large amount of debt or preference capital with short-term maturity.Whenever a company thinks of raising additional debt, it should analyse itsexpected future cash flows to meet the fixed charges. It is mandatory to payinterest and return the principal amount of debt.

Components

–

Operating cash flows

relate to the operations of the firm andcan be determined from the projected profit and loss statements.

Nonoperatingcash flows

generally include capital expenditures and working capital changes.During a recessionary period, the firm may have to specially spend for thepromotion of the product. Such expenditures should be included in the non-operating cash flows.

Financial flows

includes interest, dividends, lease rentals,repayment of debt etc.

DIVIDENDS

- 1. A distribution of a portion of a company's earnings, decided bythe board of directors, to a class of its shareholders. The dividend is most oftenquoted in terms of the dollar amount each share receives (dividends per share). Itcan also be quoted in terms of a percent of the current market price, referred to asdividend yield.Also referred to as "Dividend Per Share (DPS)."2. Mandatory distributions of income and realized capital gains made to mutualfund investors.3. Dividends may be in the form of cash, stock or property. Most secure andstable companies offer dividends to their stockholders. Their share prices mightnot move much, but the dividend attempts to make up for this.High-growth companies rarely offer dividends because all of their profits arereinvested to help sustain higher-than-average growth.4. Mutual funds pay out interest and dividend income received from their portfolioholdings as dividends to fund shareholders. In addition, realized capital gains fromthe portfolio's trading activities are generally paid out (capital gains distribution) asa year-end dividend.

Types - Cash dividends

(most common) are those paid out in the form of acheque. Such dividends are a form of investment income and are usually taxableto the recipient in the year they are paid. This is the most common method of sharing corporate profits with the shareholders of the company. For each shareowned, a declared amount of money is distributed.

Stock or scrip dividends

are those paid out in form of additional stock shares of the issuing corporation, or other corporation (such as its subsidiary corporation).They are usually issued in proportion to shares owned (for example, for every 100shares of stock owned, 5% stock dividend will yield 5 extra shares).

Property dividends

or dividends in specie (Latin for "in kind") are those paid outin the form of assets from the issuing corporation or another corporation, such asa subsidiary corporation. They are relatively rare and most frequently aresecurities of other companies owned by the issuer, however they can take other forms, such as products and services.

Other dividends

can be used in structured finance. Financial assets with aknown market value can be distributed as dividends; warrants are sometimesdistributed in this way. For large companies with subsidiaries, dividends can takethe form of shares in a subsidiary company. A common technique for "spinningoff" a company from its parent is to distribute shares in the new company to theold company's shareholders.

Constraints

–

Legal Constraints

- Most state securities regulations prevent firmsfrom paying out dividends from any portion of the company’s “legal capital” whichis measured by the par value of common stock—or par value plus paid-in-capital.--- Dividends are also sometimes limited to the sum of the firm’s mostrecent and past retained earnings— although payments in excess of currentearnings is usually permitted.

Contractual Constraints

- In many cases,companies are constrained in the extent to which they can pay dividends byrestrictive provisions in loan agreements and bond indentures. -- Generally, theseconstraints prohibit the payment of cash dividends until a certain level of earningsare achieved or to a certain dollar amount or percentage of earnings.

InternalConstraints

- A company’s ability to pay dividends is usually constrained by theamount of available cash rather than the level of retained earnings against whichto charge them.

Growth Prospects

- Newer, rapidly-growing firms generally paylittle or no dividends. -- Because these firms are growing so quickly, they must usemost of their internally generated funds to support operations or financeexpansion.

Owner Considerations

- As mentioned earlier, empirical evidencesupports the notion that investors tend to belong to “clienteles” - where someprefer high dividends, while others prefer capital gains.