Management of Earning

Earnings are the profits of a company. Investors and analysts look to earnings to determine the
attractiveness of a particular stock. Companies with poor earnings prospects will typically
have lower share prices than those with good prospects. Remember that a company's ability to
generate profit in the future plays a very important role in determining a stock's price.
Management of earnings means how these earnings are utilised i.e. how much is paid to the
shareholders in the form of dividends and how much is retained and ploughed back in the
business. The way companies allocate their after tax earnings between dividends and retention
are termed as ‘management of earnings’.

The efficient use of capital is not only dependent upon the acquisition of capital in the proper
amounts at the right time but also upon the careful formulation of internal financial policies and
constant vigilance in their administration. The raising of capital may not entail so much of
foresight and prudence as the effective utilisation of the available resources.

well-established policy regarding management of earnings must be formulated to secure the

maximum benefits for the body corporate and its owners. The prime criterion for every decision-
making in this regard is the expected effect of a decision upon the value of the enterprise. The
decisions relating to management of earnings require proper consideration as to its effect on the
firm’s cost of capital, its growth and its share prices.

All the business concerns are established to earn profits. The foremost duty of an enterprise is
economic performance, which means the preservation and increase in the value of economic
resources entrusted to it. To achieve this object, the enterprise must earn profits at a certain
minimum rate.

In the words of Gerstenberg, “Management of earnings, in its broadest sense, includes the
management of each phase of the company’s business because the minute activity of the
business usually involves income or expenditure.” In fact, proper use of capital and
management of earnings are delicate issues and their success depends upon the internal
administration of the company.

Features of Retained Earnings:

The important features of retained earnings as a source of internal financing have been
summarized below:

1. Cost of Financing:

It is the general belief that retained earnings have no cost to the company.

2. Floatation Cost:

Unlike other sources of financing, the use of retained earnings helps avoid issue- related costs.
3. Control:

Use of retained earnings avoids the possibility of change/dilution of the control of existing
shareholders that results from issue of new issues.

4. Legal Formalities:

Use of retained earnings does not require compliance of any legal formalities. It just requires a
resolution to be passed in the annual general meeting of the company.

Advantages of Retained Earnings:

The advantages or benefits of retained earnings may be stated as under:

i. Cheaper Source of Financing:

The use of retained earnings does not involve any acquisition cost. The company has no
obligation to pay anything in respect of retained earnings.

ii. Financial Stability:

Retained earnings strengthen the financial position of a business and thereby give financial
stability to the business.

iii. Stable Dividend:

Shareholders may get stable dividend even if the company does not earn enough profit.

iv. Market Value:

Retained earnings strengthen the financial position of a company and appreciate the capital
which ultimately increases the market value of shares.

Disadvantages of Retained Earnings

i. Improper Utilization of Funds:

If the purpose for utilization of retained earnings is not clearly stated, it may lead to careless
spending of funds.

ii. Over-capitalization:

Conservative dividend policy leads to huge accumulation of retained earnings leading to over-
capitalization.

iii. Lower Rate of Dividend:

Retained earnings do not allow shareholders to enjoy full benefit of the actual earnings of the
company. This creates not only dissatisfaction among the shareholders but also adversely affect
the market value of shares.

DEFINITION OF DIVIDEND

dividend is a distribution of part of the earnings of the company to its equity shareholders. The
board of directors of the company decides the dividend amount to be paid out to the
shareholders. Mostly, a dividend is stated as an amount each equity share gets. It can also be
stated as a percentage.

TYPES OF DIVIDENDS
There are various forms of dividends that are paid out to the shareholders:

1. CASH DIVIDEND

A Cash dividend is the most common form of the dividend. The shareholders are paid in cash per
share. The board of directors announces the dividend payment on the date of declaration. The
dividends are assigned to the shareholders on the date of record. The dividends are issued on the
date of payment. But for distributing cash dividend, the company needs to have positive retained
earnings and enough cash for the payment of dividends.

2. BONUS SHARE/ STOCK DIVIDEND

Bonus share is also called as the stock dividend. Bonus shares are issued by the company when
they have low operating cash, but still want to keep the investors happy. Each equity shareholder
receives a certain number of additional shares depending on the number of shares originally
owned by the shareholder.

3. SCRIP DIVIDEND

Scrip dividend is a promissory note to pay the shareholders later. This type of dividend is used
when the company does not have sufficient funds for the issuance of dividends.

4. LIQUIDATING DIVIDEND

When the company returns the original capital contributed by the equity shareholders as a
dividend, it is termed as liquidating dividend. It is often seen as a sign of closing down the
company.

5. BOND DIVIDEND

As in scrip dividends, dividends are not paid immediately in bond-dividends; instead company
promises to pay dividends at future date and to that effect issues bonds to stockholders in place
of cash. The purpose of both bond and scrip dividends is alike, i.e. postponement of dividend
payment.

Difference between the two is in respect of date of payment and their effect is the same. Both
result in lessening of surplus and in addition to the liability of the firm. The only difference
between bond and scrip dividends is that the former carries longer maturity date than the latter.

6. PROPERTY DIVIDEND

The name itself suggests that payment of dividend takes place in the form of property. This form
of dividends takes place only when a firm has assets that are no longer necessary in the operation
of business and shareholders are ready to accept dividend in the form of assets. This form of
dividend payment is not popular in India.

Factors Affecting Dividend Policy

1. Stability of Earnings

Stability of earnings is one of the important factors influencing the dividend policy. If earnings
are relatively stable, a firm is in a better position to predict what its future earnings will be and
such companies are more likely to pay out a higher percentage of its earnings in dividends than a
concern which has a fluctuating earnings.

2. Financing Policy of the Company:

Dividend policy may be affected and influenced by financing policy of the company. If the
company decides to meet its expenses from its earnings, then it will have to pay less dividend to
shareholders. On the other hand, if the company feels, that outside borrowing is cheaper than
internal financing, then it may decide to pay higher rate of dividend to its shareholder.

3. Liquidity of Funds

The liquidity of funds is an important consideration in dividend decisions. According to

Guthmann and Dougall, although it is customary to speak of paying dividends ‘out of profits’, a
cash dividend only be paid from money in the bank. Payment of dividend means, a cash outflow,
and hence, the greater the cash position and liquidity of the firm is determined by the firm’s
investment and financing decisions.

4. Dividend, Policy of Competitive Concerns:

Another factor which influences, is the dividend policy of other competitive concerns in the
market. If the other competing concerns, are paying higher rate of dividend than this concern, the
shareholders may prefer to invest their money in those concerns rather than in this concern.
Hence, every company will have to decide its dividend policy, by keeping in view the dividend
policy of other competitive concerns in the market.
5. Past Dividend Rates:

If the firm is already existing, the dividend rate may be decided on the basis of dividends
declared in the previous years. It is better for the concern to maintain stability in the rate of
dividend and hence, generally the directors will have to keep in mind the rate of dividend
declared in the past..

6. Debt Obligations

A firm which has incurred heavy indebtedness, is not in a position to pay higher dividends to
shareholders. Earning retention is very important for such concerns which are following a
programme of substantial debt reduction. On the other hand, if the company has no debt
obligations, it can afford to pay higher rate of dividend.

7. Ability to Borrow:

Every company requires finance both for expansion programmes as well as for meeting
unanticipated expenses. Hence, the companies have to borrow from the market, well established
and large firms have better access to the capital market than new and small, firms and hence,
they can pay higher rate of dividend. The new companies generally find it difficult to borrow
from the market and hence they cannot afford to pay higher rate of dividend.

8. Growth Needs of the Company:

Another factor which influences the rate of dividend is the growth needs of the company. In case
the company has already expanded considerably, it does not require funds for further expansions.
On the other hand, if the company has expansion programmes, it would need more money for
growth and development. Thus when money for expansion is not, needed, then it is easy for the
company to declare higher rate of dividend.

9. Profit Rate:

Another important consideration for deciding the dividend is the profit rate of the firm. The
internal profitability rate of the firm provides a basis for comparing the productivity of retained
earnings to the alternative return which could be earned elsewhere. Thus, alternative investment
opportunities also play an important role in dividend decisions.

10. Legal Requirements:

While declaring dividend, the board of directors will have to consider the legal restriction. The
Indian Companies Act, 1956, prescribes certain guidelines in respect of declaration and payment
of dividends and they are to be strictly observed by the company for declaring dividends.

11. Policy of Control:

Policy of control is another important factor which influences dividend policy. If the company
feels that no new shareholders should be added, then it will have to pay less dividends.
Generally, it is felt, that new shareholders, can dilute the existing control of the management
over the concern. Hence, if maintenance of existing 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 without issuing additional shares to the public.

12. Corporate Taxation Policy:

Corporate taxes affect the rate of dividends of the concern. High rates of taxation reduce the
residual profits available for distribution to shareholders. Hence, the rate of dividend is affected.
Further, in some circumstances, government puts dividend tax on distribution of dividends
beyond a certain limit. This may also affect rate of dividend of the concern.

13. Tax Position of Shareholders:

The tax position of shareholders is another influencing factor on dividend decisions. In a

company if a large number of shareholders have already high income from other sources and are
bracketed in high income structure, they will not be interested in high dividends because the
large part of the dividend income will go away by way of income tax. Hence, they prefer capital
gains to cash gains, i.e., dividend capital gains here we mean capital benefit derived by the
capitalisation of the reserves or issue of bonus shares.

Relevance of Dividend and Irrelevance of Dividend

Dividend and market price of shares are interrelated. However, there are two schools of thought:
while one school of thought opines that dividend has an impact on the value of the firm, another
school argues that the amount of dividend paid has no effect on the valuation of firm.

The first school of thought refers to the Relevance of dividend while the other one relates to the
Irrelevance of dividend.

Relevance of Dividend:

Walter and Gordon suggested that shareholders prefer current dividends and hence a positive

relationship exists between dividend and market value. The logic put behind this argument is that

investors are generally risk-averse and that they prefer current dividend, attaching lesser
importance to future dividends or capital gains.

:
Walter Valuation Model:

Prof James E. Walter developed the model on the assumption that divi
dividend
dend policy has significant
impact on the value of the firm.

As per Walter, the value of the share is determined by two sources of income:

Assumptions of the Walter Model:

The Walter Model is based on the following assumptions:

(a) All investment is financed through retained earnings and external sources of finance are not
used.

(b) The firm has an indefinite life.

(c) All earnings are either distributed or internally invested.

(d) The business risk of the firm remains constant, i.e. r and k remain constant.
Criticism of the Walter Model:

The Walter Model explains the relationship between dividend and value of the firm. However,
some of the a
Gordon’s Dividend Model

Gordon’s theory on dividend policy is one of the theories believing in the ‘relevance of
dividends’ concept. It is also called as ‘Bird-in-the-hand’ theory that states that the current
dividends are important in determining the value of the firm. Gordon’s model is one of the most
popular mathematical models to calculate the market value of the company using its dividend
policy.

Relation on Dividend decision an Value of the Firm

The Gordon’s theory on dividend policy states that the company’s dividend payout policy and
the relationship between its rate of return (r) and the cost of capital (k) influence the market price
per share of the company.

Relationship between r and k Increase in Dividend Payout

r>k Price per share decreases

r<k Price per share increases

r=k No change in the price per share

Assumptions of Gordon Model

Gordon’s model is based on the following assumptions:

1. No debt

The model assumes that the company is an all equity company, with no proportion of debt in
the capital structure.

2. No external Financing

The model assumes that all investment of the company is financed by retained earnings and no
external financing is required.

3. Constant IRR

The model assumes a constant Internal Rate of Return (r), ignoring the diminishing marginal
efficiency of the investment.
4. Constant Cost of Capital

The model is based on the assumption of a constant cost of capital (k), implying the business risk
of all the investments to be the same.

5. Perpetual Earnings

Gordon’s model believes in the theory of perpetual earnings for the company.

6. Corporate taxes

Corporate taxes are not accounted for in this model.

7. Constant Retention ratio

The model assumes a constant retention ratio (b) once it is decided by the company. Since the
growth rate (g) = b*r, the growth rate is also constant by this logic.

8. K>G

Gordon’s model assumes that the cost of capital (k) > growth rate (g). This is important for
obtaining the meaningful value of the company’s share.

According to the Gordon’s Model, the market value of the share is equal to the present value of
future dividends. It is represented as:

P0= D0(1+g) = D1
Ke - g Ke -g

where, P0 = Current ex-dividend market price of a share

D0 = Current year’s dividend

D1 = Expected dividend

Ke = Cost of equity capital

g = Expected future growth rate of dividends

The Gordon’s Growth Model using dividend capitalisation can also be used as follows

P0 = [E (1-b)] / Ke-br

Where, P = price of a share

E = Earnings per share

b = retention ratio

1-b = proportion of earnings distributed as dividends

Ke = capitalization rate

br = growth rate

Q.1 The EPS of the company is Rs. 15. The market rate of discount applicable to the company is
12%. The dividends are expected to grow at 10% annually. The company retains 70% of its
earnings. Calculate the market value of the share using Gordon’s model.

Solution

Here, E = 15

b = 70%

k = 12%

g = 10%

Market price of the share = P = {15 * (1-.70)} / (.12-.10) = 15*.30 / .02 = 225
Dividend Irrelevance Theory

The dividend irrelevance theory is the theory that investors do not need to concern themselves
with a company's dividend policy since they have the option to sell a portion of their portfolio
of equities if they want cash.

Modigliani- Miller Theory on Dividend Policy

Modigliani – Miller theory is a major proponent of ‘Dividend Irrelevance’ notion. According to

this concept, investors do not pay any importance to the dividend history of a company and thus,
dividends are irrelevant in calculating the valuation of a company. According to them Dividend
Policy has no effect on the Share Price of the Company. In their opinion investors do not
differentiate dividend with the capital gains. Their basic desire is to earn higher return on their
investment. The Company has adequate investment opportunities giving a higher rate of return
than the cost of retained earnings, the investors would be contented with the firm retains the
earnings. Dividend Decision is a financial decision whether to finance company’s fund
requirements by retained earnings or not. In case a Company has profitable investment
opportunities, it will retain the earnings to finance them otherwise distribute there. The interest of
shareholders is income whether it is in the form of Dividend or in the capital gains.

Example

For example: If a Company having investment opportunities distribute its earning among
shareholders it will have to raise the capital required from outside. This will increase the number
of shares, result fall in future earning of shares.

Thus, whatever a shareholder gets as a result of increased Dividend will be neutralized

completely on account of fall in the value of shares due to the decline in expected earnings per
share.

Assumptions of M.M. Hypothesis

The M.M. Hypothesis approach is based on the following assumptions:

 Personal or corporate income taxes do not exist,

 There are no stock flotation or transaction costs,
 Financial leverage does not affect the cost of capital,
 Both managers and investors have access to the same information concerning firm's
future prospects,
 Firm's cost of equity is not affected in any way by distribution of income between
dividend and retained earnings,
 Dividend policy has no impact on firm's capital budgeting.
Price of share can be known by the following formula:

P1 = P0 (1 + ke) – D1

AS PER M & M APPROACH ( VALUE OF ENTIRE FIRM)

1. Retained Earning = E – n D1

E = Earning

n = Number of Outstanding Equity shares at the beginning of the year

D1= Dividend Paid to existing shareholders at the end of year

2. New Issue of Equity Share Capital (Rs.) = I – Retained earning

= I – {E – n D1}

= I – E + nD1

I = Investment to be made at the end of the year

3. New Issue of Equity shares at the end of the year (∆n)

Value of New Issue of Equity Shares at the end of year = ∆n × P 1

So, we can say that

∆n × P1 = New Issue of Equity Share Capital (Rs.)

∆n × P1 = I – E + nD1

For one equity share :-

P1 = P0 * (1 + ke) – D1

P0 = D1 + P1 / (1 + ke)

Now, in above equation, n is multiplied on both sides, so instead of one share, it will become
value of firm:-

nP0 = (n + ∆n) × P1 – I + E / (1 + ke)

I = Investment to be made at the end of the year

E = Earning
n = Number of Outstanding Equity shares at the beginning of the year

∆n= New Issue of Equity shares at the end of the year

Example 1

Z Ltd. has 1000 Share of Rs. 100 each. The Company is contemplating Rs. 10 Per Share
Dividend at the end of the earned year. The Co. expects a Net Income of Rs.25000. The cost of
equity capitalization is 10%.

What will be the price of Shake if (i) Dividend is not declared. (ii) a Dividend is declared.
Presume Company pays dividend and has to make new Investment of Rs. 48,000 in the coming
Period. how many new shares be issued to Finance Investment Programme as per M.M.
approach .

Example 2

Share price at the beginning of the year is Rs. 150. The discount rate applicable to the company
is 10%. The company declares Rs. 10 as dividends at the end of a year. Market price of the share
at the end of one year using the Modigliani – Miller’s model can be found as under.

Example 3

The capitalization rate of A Ltd. is 12%. The company has outstanding shares to

the extent of 25,000 shares selling @ 100 each. Assume, the net income anticipated for the
current financial year of 3,50,000. A Ltd. plans to declare a dividend of 3 per share. The
company has investment plans for new project of 500,000. Find out the value of firm that under
the MM Model, the dividend payment does not affect the value of the firm.

Solution 1

Price of share can be known by the following formula:

P1 = PO (1 + k) – D1
When dividend is not paid:
P1 = $100 (1 + 10) – 0
= 100 x 1.10

=$110

When dividend is paid:

P1 = 100 (1 + .10) – 10
= $100
New Shares:
M x P1 = i – (X – ND1)
M x 100 = 48,000 – (25,000 – 10,000)

110M = 33,000

M = 33,000 / 100

M = 330 shares

Solution 2

Here, P0 = 150
ke = 10%

D1 = 10
Market price of the stock = P1 = 150 * (1 + .10) – 10 = 150 *1.1 – 10 = 155.

Solution 3

To prove that MM model holds good, we have to show that the value of the firm Notes
remains the same whether dividends are paid or not.

1. The value of the firm, when dividends are paid:

Step 1: Price per share at the end of year I

P1 = P0 (1 + ke) – D1

P1 = 109

Example 4:

X Ltd., belongs to a risk class having cost of capital 12%. It has 25,000 shares outstanding
selling at Rs 10 each. The company is planning to declare a dividend of Rs 2 per share at the end
of the current year.

What will be the market price of share if dividend is declared and dividend is not declared,
assuming the M-M Hypothesis.

Solution:

We know,
P0 = D1 + P1 / 1 + k

Where, P0 = Current market price = Rs 10

D1 = Dividend at the endd of the year

k = Cost of capital