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Financial Management

Q. 9 Discuss the Walter’s and Gordon’s Models of Dividend Relevance.

According to relevance theory dividend decision affects value of a firm. The advocates of this school include Myron Gordon and James Walter. According to them, dividend decision will affect value of a firm as well as stock price. High dividend payout ratio increases value of a firm. Therefore a firm which is interested to maximize shareholders wealth has to declare high divident payout ratio. Two prime theories that say dividends has positive impact on the value of firm are Walter's model, and Gordon's model. Walter Model : James E. Walter proposed a model of share valuation that supports the view that dividend policy of an enterprise has a bearing on value of enterprise. The model is based on: (i) Return on investment or internal rate of return (r) (ii) Cost of Capital or required rate of return (Ko) Optimal dividend policy is determined based on the relationship between interest rate of return (r) and cost of capital (Ko). If r exceeds Ko, the firm should retain earnings. If r is less that Ko, the should distribute the earnings as dividends. The model divides firms into three groups (a) Growth firms (b) Normal firms, and (c) Declining firms.

a)

Growth Firms: Growth firms are those firms which has profitable investment projects,

which provide return that is greater than K. Such firms’ the optimum dividend policy is 100 per cent retention or zero dividend payout ratio

b)

Normal Firms: Normal firms are those firms which has investment projects, whose

rate of return is equals to cost of capital. For such firms the optimal dividend payout ratio ranges between "zero and 100":

c)

Declining Firms: Declining firms are those firms, which does not have profitable

investment projects. In other words, investment projects return is less than cost of capital. For such firms the optimal dividend payout ratio is 100 per cent Assumptions : Walter's Model is based on the following assumptions. (i) (ii) iii) All profitable investments are financed through retained earnings The firm's return on investment and cost of capital are constant. All earnings are either distributed as dividends or reinvested

(iv) (v)

EPS and DPS may be changed in the model to determine its effect on share price. The firm has infinite (perpetual) life

Market Price Per Share Walter has given the following formula for determining the market price or value of share P= D+ (r÷ Ko) (E-D) R /Ko P Price per equity share D Dividends per share; (E-D)  Retained earnings per share Ko  Cost of capital. The formula indicates that the market price per equity share is equals to the present value of an infinite stream of dividends plus the present value of an infinite stream of returns from retained earnings. Gordon Model According to Gordon model, dividends are relevant and dividend decision of a firm affects value. The model uses stock valuation using dividend capitalisation. Assumptions: Gordon's model is based on the following assumptions: (i) The firm is all equity firm and it has no debt (ii) All investment projects are financed by exclusively retained earnings. (iii) The rate of return (r) on firm's investment is constant (iv) The cost of capital of the firm remains constant (v) The firm's stream of earnings are perpetual (vi) The firm has perpetual life (vii) The retention ratio (b), once decided upon is constant. Thus the growth rate (g = b.r) is also constant (viii) There are no corporate taxes. Market price per share: Gordon's Market value per share is determined by the following formula P= E(1- b) Ko - b.r EEarnings per share bRetention ratio (1-b)Proportion of earnings of the firm distributed as dividends; (Ko) Capitalisation rate or cash of capital or required return by equity shareholders rRate of returns earned an investment made by the firm E  E arnings per share r  Rate of return on investment;

gbr = growth rate Thus, the market value of share is equal to the present value of an infinite stream of dividends. Gordon's assumptions are all similar to those of Walter's model. Walter and Gordon models argue that dividends affect a firm's value. But Gordon's model in based on the two main arguments. (i) Investors are risk averse, and (ii) Then put a premium on a certain return for uncertain returns. Investors attach more risk to retained earnings, therefore share price would be adversely affected ______________________________________________________________________

Q. 1 What is financial Management? Explain the Financial Manager’s role in fund raising, allocation and profit planning. Ans. Finance deals with the financial problems of corporate enterprises. Problems include financial aspects of the promotion of new enterprises and their administration during early development. Financial management mainly involves raising of funds and their effective utilization with the objective of maximizing shareholders' wealth. Definitions: According to Joseph and Massie, "financial management is the operational activity of a business that is responsible for obtaining and effectively utilizing the funds necessary for efficient operations". According to Van Horne, "Financial Management is concerned with the acquisition, financing and management of assets with some overall goal in mind. Thus, Financial Management is concerned with three activities: (i) anticipating financial needs, which means estimation of funds required for investment in fixed and current assets .or long-term and short-term assets. (ii) acquiring financial resources-once the required amount of capital is anticipated the next task is acquiring financial resources i.e., where and how to obtain the funds to finance the anticipated financial needs and (iii) allocating funds in business - means allocation of available funds among best plans of assets, which are able to maximize shareholders' wealth. Financial Manager’s role in fund raising, allocation and profit planning: Efficient management of finance helps in maximizing the shareholders wealth. Financial manager plays key role in maximization of owner's wealth. 1. Profit Planning Profit planning is most important decision. It begins with a determination of the totals amount

of assets needed to be held by the firm. In other words, decision relates to the selection of assets, on which a firm will invest funds. The required assets fall into two groups:(i) Long-term Assets which involve huge investment and yield a return over a period of time in future. Investment in long-term .assets is known as "capital budgeting". (ii) Short-term Assets that can be converted into cash within a financial year without loss of in value. Investment in current assets is popularly termed as "working capital management'. It relates to the management of current assets. It is an important decision of a firm, as short survival is the prerequisite for long-term success. 2. Financing Decision After estimation of the amount required and the selection of assets required to be purchased then the next financing decision comes into the picture. Here the financial manager is concerned with make up of the right hand side of balance sheet. It is related to the financing mix or capital structure or leverage. Financial manager has to determine the proportion of debt and equity in capital structure. It should be optimum finance mix, which maximizes shareholders' wealth. A proper balance will have to be struck between risk and return. 3. Dividend Decision (Fund allocation) This is the third financial decision, which relates to dividend policy. Dividend is a part of profits, which are available for distribution to equity shareholders. Payment of dividends' should be analyzed in relation to the financial decision of a firm. There are two options. available in dealing with net profits of a firm, viz., distribution of profits as dividends to the ordinary shareholders or retention of earnings. Dividends or retaining should be determined in terms of its impact on the shareholders' wealth. Financial manager should determine optimum dividend policy, which maximizes market value of the share there by market value of the firm. _____________________________________________________________________________

Q. 3 What is dividend policy? Explain Ans Dividend policy refers to the policy chalked out by companies regarding the amount it would pay to their shareholders as dividend The profits of a company when made available for the distribution among its shareholders are called dividend. The dividend may be as a fixed annual percentage of paid up capital or it may vary according to the prosperity of the company. The decision for distributing or paying a dividend is taken in the meeting of Board of Directors and in confirmed by the annual general meeting of the shareholders. The dividend are declared out of divisible profits, remained after setting of all the expenses for the year. It means if in any year,

there is not profits, no dividend shall be distributed that year. Dividend may be of different types. It can be classified according to the mode of its distribution as follows: (1) Regular Dividend It means mean regular dividend are paid annually. It is also known as final dividend because it is usually paid after the finalization of accounts. (2) Interim Dividend If Articles so permit, the directors may decide to pay dividend at any time between the two Annual General Meeting before finalizing the accounts. It is generally declared and paid when company has earned heavy profits or abnormal profits during the year (3) Stock-Dividend Companies not having good cash position, generally pay dividend in the form of shares by capitalizing the profits of current year and of past years. (4) Scrip Dividend Scrip dividends are used when earnings justify a dividend, but the cash position of the company is temporarily weak. Factors involved in Determining the Sound Dividend Policy 1. Cost of Capital Cost of capital is one of the considerations for taking a decision whether to distribute dividend or not. As decision making tool, the Board calculates the ratio of rupee profits that the business expects to earn to the rupee, profits that the shareholders can expect to earn outside. If the ratio is less than one, it is a signal to distribute dividend and if it is more than one, the distribution of dividend will be discontinued. 2. Realization of Objectives The main objectives of the firm i.e., maximization of wealth for shareholders including the current rate of dividend-should also be aimed at in formulating the dividend policy. 3. Shareholders' Group Dividend policy affects the shareholders group. It means a company with low pay-out an heavy reinvestment attracts shareholders interested in capital gains rather than n current income whereas a company with high dividend pay-out attracts those who are interested in current income. 4. Release of Corporate Earnings Dividend distribution is a means of distributing unused funds. Dividend policy affects the shareholders wealth by varying its dividend pay- out ratio. In Dividend policy, the financial manager decides whether to release corporate earnings or not. Dividend policy to a large extent affects the financial structure, the flow of funds, liquidity, stock prices and in the last shareholders' satisfaction. That is why management exercises a high degree of judgment establishing a sound dividend pattern. 5. Stability of Earnings The nature of business has an important bearing on the dividend policy. Industrial units having stability of earnings may formulate a more consistent dividend policy than those having an uneven flow of incomes because they can predict easily their savings and earnings. 6. Age of Company Age of the corporation counts much in deciding the dividend policy. A newly established company may require much of its earnings for expansion and plant improvement and

may adopt a rigid dividend policy while, on the other hand, an older company can formulate a clear cut and more consistent policy regarding dividend. 7. Liquidity of Fund Availability of cash and sound financial position is also an important factor in dividend decisions. The liquidity of a firm depends very much on the investment and financial decisions of the firm which in turn determines the rate of expansion and the manner of financing. If cash position is weak, stock dividend will be distributed and if cash position is good, company can distribute the cash dividend. 8. Extent of share Distribution Nature of ownership also affects the dividend decisions. A closely held company is likely to get the assent of the shareholders for the suspension of dividend or for following a conservative dividend policy. 9. Needs for Additional Capital Companies retain a part of their profits for strengthening their financial position. The income may be conserved for meeting the increased requirements of working capital or of future expansion. Small companies usually find difficulties in raising finance for their needs of increased working capital for expansion programmes. 10. Trade Cycles Business cycles also exercise influence upon dividend Policy. Dividend policy is adjusted according to the business oscillations. During the boom, prudent management creates reserves for contingencies 11.Government Policies: Sometimes government restricts the distribution of dividend beyond a certain percentage in a particular industry or in all spheres of business activity as was done in emergency. 12. Taxation Policy: . Sometimes government levies dividend-tax of distribution of dividend beyond a certain limit. It also affects the capital formation and reduces the earnings of the companies and consequently the rate of dividend is lowered down. 13. Legal Requirements: In deciding on the dividend, the directors take the legal requirements too into consideration. For example, a company is required to provide for depreciation on its fixed and tangible assets before declaring dividend on shares. 14. Past dividend Rates:. The current rate should be around the average past rate. If it has been abnormally increased the shares will be subjected to speculation. 15. Ability to Borrow: Well established and large firms have better access to the capital market but smaller firms have to depend on their internal sources and therefore they will have to built up good reserves by reducing the dividend pay out ratio for meeting any obligation requiring heavy funds. 16. Policy of Control: Adding new shareholders may dilute control. If the directors do not bother about the control of affairs they will follow a liberal dividend policy. Thus control is an influencing factor in framing the dividend policy. 17. Repayments of Loan: A company having loan indebtedness are vowed to a high rate of retention earnings and limit the rate of dividend payout.

18. Time for Payment of Dividend: When should the dividend be paid is another consideration. Wise management plans the payment of dividend in such a manner that there is no cash outflow at a time when the undertaking is already in need of urgent finances. 19. Regularity and stability in Dividend Payment: Dividends should be paid regularly because each investor is interested in the regular payment of dividend. __________________________________________________________________________ Q.7 What is capital budgeting ? Discuss the importance Ans : Capital Budgeting : Capital budgeting is the planning process used to determine whether a firm's long term investments such as new machinery, replacement machinery, new plants, new products, and research development projects are worth pursuing. All types of capital budgeting decisions are exposed to risk and uncertainty. Capital budgeting refers to long-term panning for proposed capital outlays and their financing. Thus, it includes both raising of long-term funds as well as their utilization. It may, thus, be defines the “firm’s formal process for acquisition and investment of capital”. Capital budgeting decision may be defined as “the firms’ decision to invest its current find more efficiently in long-term activities in anticipation of an expected flow of future benefit over a series of years.” The long-term activities are those activities which affect firms operation beyond the one year period. Capital budgeting contains searching for new and more profitable investment proposals to predict the consequences of accepting the investment and making economic analysis to determine the profit potential of investment proposal. Basic features of capital budgeting decisions 1. Current funds are exchanged for future benefits; 2. There is an investment in long-term activities 3. The future benefits will occur to the firm over series of years 4. It requires considerable investment of funds. 5. These assessments are irrevocable. 6. These assessments decide and influence the future development of the organization Steps of Capital Budgeting 1. 2. 3. Evaluation of costs and profit of a proposal or of each option. Evaluation of the cost of capital Choice and implementing the decision criterion.

Importance of Capital Budgeting In modern times, the efficient allocation of capital resources is a most crucial function of financial management. This function involves organization’s decision to invest its resources in long-term assets like land, building facilities, equipment, vehicles, etc. All these assets are extremely important to the firm because all the organizational profits are derived from the use of its capital in investment in assets. The future development of a firm depends on the capital investment projects, the replacement of existing capital assets, and the decision to abandon previously accepted undertakings For new projects such as investment decisions of a firm fall within the definition of capital budgeting or capital expenditure decisions. The key function of the financial management is the selection of the most profitable assortment of capital investment and it is the most important area of decision-making of the financial manger because any action taken by the manger in this area affects the working and the profitability of the firm for many years to come. Its importance can be on the following other grounds:(1) Indirect Forecast of Sales: The investment in fixed assets is related to future sales of the firm during the life time of the assets purchased. It shows the possibility of expanding the production facilities to cover additional sales shown in the sales budget. Any failure to make the sales forecast accurately would result in over investment or under investment in fixed assets and serious economic results. (2) Comparative Study of Alternative Projects: Capital budgeting makes a comparative study of the alternative projects for the replacement of assets which are wearing out or are in danger of becoming obsolete so as to make the best possible investment in the replacement of assets. For this purpose, the profitability of each projects is estimated. (3) Timing of Assets-Acquisition. Proper capital budgeting leads to proper timing of assetsacquisition and improvement in quality of assets purchased. (4) Cash Forecast. Capital investment requires substantial funds which can only be arranged by making determined efforts to ensure their availability at the right time. Thus it facilitates cash forecast. (5) Worth-Maximization of Shareholders. The impact of long-term capital investment decisions is far reaching. It protects the interests of the shareholders. it avoids over-investment and underinvestment in fixed assets. By selecting the most profitable projects, the management facilitates the wealth maximization of equity share-holders.

(6) Other Factors. The following other factors can also be considered for its significance:(a) It assist in formulating a sound depreciation and assets replacement policy. (b) It may be useful in considering methods of cost reduction. (c) It facilitates the management in making of the long-term plans an assists in the formulation of general policy. ____________________________________________________________________________

Q.2 Explain determinants of working capital and the sources of working capital Adequate working capital is required for the efficient conduct of a business. But, there is no criterion or formula to determine the amount of working capital needs that may be applied to all the firms. The amount of working capital required depends upon a large number of factors and each factor has its own importance. Following are to be considered carefully: 1. Nature of Business: The amount of working capital is basically related to the nature and volume of business. Firms engaged in public utility services such as railways, transport and electricity supply companies require moderate amount of working capital. Firms producing luxury goods, construction firms, basic steel industry, engineering industries etc. require large amount of working capital since they have to invest substantial amount in current assets such as inventories, receivables and cash. 2. Size of Business : The size may be measured either in terms of scale of operations or in assets or sales. Large firms require more amount of working capital for investment in current assets and to pay current liabilities than smaller firms. 3. Changes in Technology: Changes in technology may lead to improvement in processing of raw material, savings in wastage, higher productivity and more speedy production. All these improvements enable the firm to reduce investment in inventories. Thus, technological changes affect the requirements for working capital. 4. Length of Operating or Working Capital Cycle: Amount of working capital depends upon the length or duration of operating cycle. The larger is the period of operating cycle, the more is the investment in inventories and wage bills. 5. Seasonal Nature of the Business: In certain industries, demand is subject to wide fluctuations due to seasonal characteristics or production policies. The working capital requirements of such industries vary with seasonal 6. Firm's Credit Policy: A firm following liberal credit policy and thus granting credit facilities to all customers without evaluating the credit worthiness, will require more working capital to carry book debts.

Terms of Purchase and Sale : The terms of purchase and sale followed by the firm also affect the quantum of working capital. A firm buying raw materials and other services on credit and selling the finished goods on cash basis will require less investment in current assets Business Cycles: In a period of boom when the business is prosperous, there is need for larger amount of working capital due to increase in sales and rise in prices of raw materials. The expansion of business units caused by the inflationary conditions creates demand for more working capital. Rate of Growth of Business: In case of existing businesses, the rate of growth of business directly affects the working capital. If the rate of growth is slow, the working capital requirements can be meet out from ploughing back of profits. But, if the business is expanded at large scale, additional funds will be required to acquire fixed assets alongwith current assets. Working Capital Turnover: It implies the speed with which the working capital circulates in the business. The faster is the sales, the larger is the turnover, consequently lesser will be the need for working capital and vice-versa. Profit Margin and Dividend Policy : The amount of working capital required in a firm also depends upon its profit margin and dividend policy. A high rate of profit margin due. to quality products or good marketing management or monopoly power in the market, reduces-the working capital requirements of the firm. Other Factors: In addition to the above; there are a number of other factors which affect the requirements of working capital like rate of industrial development; means of transport and communication, co-ordination of activities of the firm, political stability etc. Sources of Working capital After determining the level of working capital, there is procurement of funds from various sources to meet its working capital requirement from time to time. Sources of working capital may be classified under the two heads :a) Sources of long term working capital. (b) Sources of short term or seasonal working capital

a) Sources of Long-term Working Capital (1)Issue of Shares. It is the most important source of long term regular working capital. . As far as possible, efforts should be made to procure the maximum amount of regular working capital out of the proceeds of issue of shares. (2) Issue of Debentures. Regular working capital can also be procured by issue of debentures or bonds. The cost of capital is lower in this case. By Issuingdebentures; company may trade on equity (3) Retained profits. Accumulated large profits is considered to be a coed source of financing long term working capital requirements. It is the best and the cheapest source of finance. It creates no charge on future profits. Sources of Short term Working Capital The sources of short-term working capital or seasonal working capital may be classified into two heads- (i) Internal and (ii) External Internal Sources, Under this category, the sources of working capital are tapped from within, The main internal sources are

1)

Depreciation Funds: Depreciation' funds created out of profits of the company provide

a good source of working capital provided they are not invested in or represented by an asset. 2) Provisio for Taxation: There remains a lag between making the provision for and n

payment of taxation. A company , may utilize such provision. 3) Accrued Expenses. The company sometimes postpones tbe payment of certain

expenditures due on the date of finalization of the accounts. These accrued (due but not paid) expenses o constitute an important source of working capital. External Sources: 4) Normal Trade Credit Trade .creditors provide short term finance to the company by

selling the goods, inventories and equipments on the basis of deferred payment. It becomes a very common source of short term finance and normally every concern use this source as a normal trade practice. 5) Customers' Credit Advances may also be obtained from customers against the contracts entered into by the company. Such advances can be used for purchasing raw materials and paying wages etc.

(6)

Bank Credit: The greater part of the working capital is supplied by commercial. banks to their customers though direct advances in the shape of loans, cash credit or overdraft and through discounting the credit papers. 7. Public Deposits: It had been most common in cot ton textile mills in Bombay and Ahmedabad but now almost every public limited company raises finances from this source Uneder the companies (Acceptance of Deposits) rules, a company is authorized to raise funds equal to 25 per cent of paid up capital and free Reserves by this source. -------------------------------------------------------------------------------------------------------------------