Financial Management

December 2014

1. What are the factors that influence dividend policy?

TYPE OF INDUSTRY: The nature of the industry to which the company belongs has an important effect on
the dividend policy. Industries, where earnings are stable, may adopt a consistent dividend policy as
opposed to the industries where earnings are uncertain and uneven. They are better off in having a
conservative approach to dividend payout.

OWNERSHIP STRUCTURE: The ownership structure of a company also impacts the policy. A company
with a higher promoter’ holdings will prefer a low dividend payout as paying out dividends may cause a
decline in the value of the stock. Whereas, a high institutional ownership will favor a high dividend
payout as it helps them to increase the control over the management.

AGE OF CORPORATION: Newly formed companies will have to retain major part of their earnings for
further growth and expansion. Thus, they have to follow a conservative policy unlike established
companies, which can pay higher dividends from their reserves.

THE EXTENT OF SHARE DISTRIBUTION: A company with a large number of shareholders will have a
difficult time in getting them to agree to a conservative policy. On the other hand, a closely held
company has more chances of succeeding to finalize conservative dividend payouts.

DIFFERENT SHAREHOLDERS’ EXPECTATIONS

Another factor that impacts the policy is the diversity in the type of shareholders a company has. A
different group of shareholders will have different expectations. A retired shareholder will have a
different requirement vis-a-vis a wealthy investor. The company needs to clearly understand the
different expectations and formulate a successful dividend policy. Psychologically, cash dividend will give
more satisfaction to shareholder in comparison to capital appreciation.

LEVERAGE
A company having more leverage in their financial structure and consequently, more interest payments
may to decide for a low dividend payout, so as to increase their net worth and to make sure that it can
make payment of financial charges even in case of earning of the company is falling. Whereas a
company utilizing more of own financing will prefer high dividends.

FUTURE FINANCIAL REQUIREMENTS / REINVESTMENT OPPORTUNITY

Dividend payout will also depend on the future requirements for the additional capital. A company
having profitable investment opportunities is justified in retaining the earnings. However, a company
with no capital requirements should opt for a higher dividend.

BUSINESS CYCLES
When the company experiences a boom, it is prudent to save up and make reserves for dips. Such
reserves will help a company to maintain dividend even in depressing markets to retain and attract
more shareholders.

CHANGES IN GOVERNMENT POLICIES

There could be the change in the dividend policy of a company due to the imposed changes by the
government. The Indian government had put temporary restrictions on companies to pay dividends
during 1974-75.

PROFITABILITY
The profitability of a firm is reflected in net profit ratio and ratio of profit to total assets. A highly
profitable company have a capacity to pays higher dividends and a company with less profits will adopt
a conservative dividend policy.

TAXATION POLICY
The corporate taxes will affect dividend policy, either directly or indirectly. The taxes directly reduce the
residual earnings after tax available for the shareholders. If dividend income is taxable in the hands of
investor and capital gain is exempt, then company may retain its earning so as to increase price per
share, which ultimately gives higher return to investors’ and vice versa. Further if it is possible that
bifurcate all shareholders into high tax bracket or low tax bracket, accordingly dividend policy can be
framed. Finally, objective is to give maximum return to shareholders.

TRENDS OF PROFITS
Even if the company has been profitable over the years, the trend should be properly analyzed to find
the average earnings of the company. This average number should be then studied in relation to the
general economic conditions. This will help in opting for a conservative policy if a depression is
approaching.

LIQUIDITY
Liquidity has a direct relation with the dividend policy. Many a times, company having high profit, may
have majority of profit blocked in working capital or it may acquire assets. In that case its liquidity is
poor. In that case company should pay less dividend. High dividend payment is possible only if company
has good earning and sound liquidity.

LEGAL RULES
There are certain legal restrictions on the companies for dividend payments. It is legal to pay a dividend
only if the capital is not reduced post payment. These rules are in place to protect creditors’ interest.
Most importantly providing depreciation is mandatory before making payment of dividend.
Depreciation is to be provided at minimum rates provided. Providing depreciation is very important
because with that company is able to retain an amount of profit for replacement of fixed assets in
future.

INFLATION
Inflationary environments compel companies to retain major part of their earnings and indulge in lower
dividends. As the prices rise, the companies need to increase their capital reserves for their purchases of
fixed assets. In case of inflationary situation, same quantity of closing stock will have more valuation, so
payment of tax also increases.

CONTROL OBJECTIVES
The firms aiming for more control in the hands of current shareholders prefer a conservative dividend
payout policy. It is imperative to pay fewer dividends to retain more control and the earnings in the
company.
In a nutshell, the management of a company is completely free to frame the required dividend policy.
There are no obligations to be adhered to. So, the company needs to judiciously weight all the above-
mentioned factors and formulate a balanced dividend policy. A dividend policy can also be revised in the
wake of changes in any of the factors.

REPAYMENT OF DEBT
If a substantial amount of debt is required to paid, in that case even though the company has high
amount of earning, it may pay less dividend.

2. Factors influencing the working capital requirements:

a. Nature of business: The requirement of working capital depends on the nature of business. The
nature of business is usually of two types: Manufacturing Business and Trading Business. In the
case of manufacturing business, it takes a lot of time in converting raw material into finished
goods. Therefore, capital remains invested for a long time in raw material, semi-finished goods
and the stocking of the finished goods. Consequently, more working capital is required. On the
contrary, in case of trading business the goods are sold immediately after purchasing or
sometimes the sale is affected even before the purchase itself. Therefore, very little working
capital is required. Moreover, in case of service businesses, the working capital is almost nil
since there is nothing in stock.

b. Scale of Operations: There is a direct link between the working capital and the scale of
operations. In other words, more working capital and the scale of operations. In other words,
more working capital is needed in case of small organisations.

c. Business cycle: The need for the working capital is affected by various stages of the business
cycle. During the boom period, the demand of a product increases and sales also increase.
Therefore, more working capital is needed. On the contrary, during the period of depression,
the demand declines and it affects both the production and sales of goods. Therefore, in such a
situation less working capital is required.
d. Seasonal factors: Some goods are demanded throughout the year while others have seasonal
demand. Goods which have uniform demand the whole year their production and sale are
continuous. Consequently, such enterprises need little working capital.

e. Production cycle: Production cycle means the time involved in converting raw material into
finished product. The longer this period, the more will be the time for which the capital remains
blocked in raw material and semi-manufactured products.

f. Credit Allowed: Those enterprises which sell goods on cash payment basis need little working
capital but those who provide credit facilities to the customers need more working capital.

g. Credit Availed: If raw materials and other inputs are easily available on credit, less working
capital needed. On the contrary, if these things are not available on credit then to make cash
payment quickly large amount of working capital is needed.

h. Operating efficiency: Operating efficiency means efficiently completing the various business
operations. Operating efficiency of every organization happens to be different. Like converting
raw material into finished goods at the earliest, selling finished good quickly. A company which
has a better operating efficiency has to invest less in stock and debtors. Therefore, it requires
less working capital.

i. Availability of raw material: Availability of raw material also influences the amount of working
capital. If the enterprise makes use of such raw material which is available easily throughout the
year, then less working capital will be required, because there will be no need to stock in large
quantity as opposed to a raw material that is available on a seasonal basis i.e., only in some
months of the year but has the production running throughout the year then more money is
invested to buy and stock more of the same raw material.

j. Growth Prospects: Growth means the development of the scale of business operations. The
organizations which have sufficient possibilities of growth require more working capital, while
the case is different in respect of companies of less growth prospects.

k. Level of competition: High level of competition increases the need for more working capital. In
order to face the competition, more stock is required for quick delivery and credit facility for a
long period has to be made available.
 l. Inflation: Inflation means the rise in prices. In such a situation more, capital is required than
before in order to maintain the previous scale of production and sales. Therefore, with the
increasing rate of inflation, there is a corresponding increase in the working capital.

3. Capital Structure theory: Traditional theory approach and Modigani approach.

Traditional Theory Approach: It is accepted by all that the judicious use of debt will increase the value
of the firm and reduce the cost of capital. So, the optimum capital structure is the point at which the
value of the first is highest and the cost of capital structure is the point at which the value of the firm is
the highest and the cost of capital is at its lowest point.

The traditional approach explains that up to a certain point, debt-equity mix will cause the market value
of the firm to rise and the cost of capital to decline. But after attaining the optimum level, any additional
debt will cause to decrease the market value and to increase the cost of capital.

Thus, the basic propositions of this approach are:

a. The cost of debt capital remains constant more or less up to a certain level and thereafter rises.

b. The cost of equity capital remains constant more or less or rises gradually up to a certain level
and thereafter increases rapidly.

c. The average cost of capital decreases up to a certain level and then remains unchanged more or less
and thereafter rises after attaining a certain level.
The graphical representation of traditional theory approach:
It is found from the above that the average cost curve is U shaped. That is, at this stage the cost of
capital would be minimum which is expressed by the letter A in above graph.

Traditional approach implies that the cost of capital is not independent of the capital structure of
the firm and that there is an optimal structure. At the optimal structure, the marginal real cost of
equity in equilibrium.

Modigliani- Miller Approach:

MM advocated that the relationship between cost of capital, capital structure and the valuation of
the firm should be explained by Net Operating Income approach.

The NOI approach supplies proper justification for the irrelevance of the capital structure. In this
context, MM supports the NOI approach on the principle that cost of capital is not dependent on the
degree of leverage irrespective of the debt equity mix. In other words, according to their thesis the
total market value of the firm and the cost of capital are independent of the capital structure.

They advocated that the weighted average cost of capital does not make any change with a
proportionate change in debt- equity mix in the total capital structure of the firm.

Proposition:

a. The cost of capital and the total value of firm are independent of its capital structure. The cost
of capital is equal to the capitalization rate of equity of operating earnings for its class, and the
market is determined by capitalizing its expected return at an appropriate rate of discount for its
risk class.

b. The second proposition includes that the expected yield on a share is equal to the appropriate
capitalization rate of a pure equity stream for that class, together with a premium for a financial
risk equal to the difference between the pure equity capitalization rate and yield on debt. In
short, increased Cost of Debt is oddest exactly by the use of cheaper debt.

c. The cut off point for investment is always the capitalization rate which is completely
independent and unaffected by the securities that are invested.

Assumptions:
 a. Existence of a perfect capital market: Which include no transaction cost, floatation costs
neglected, no investor can affect the market price of shares, information is available to all
without cost and investors are free to purchase and sales securities.

b. Homogenous risk class: it means the expected yield/return have the identical risk factor i.e.,
business risk is equal among all firms having operational condition.

c. Homogenous expectations: All the investors should have identical estimate about the future
rate of earnings of each firm.

d. The dividend pay-out ratio is 100%: It means the firm must distribute all its earnings in the form
of dividends among the shareholders.

e. Taxes do not exist: i.e., there is no corporate tax effect.

Interpretation of MM Hypothesis:

The MM hypothesis reveals that if more debt is included in the capital structure of a firm, the same will
not increase its value as the benefits of cheaper debt capital are exactly set off by the corresponding
increase in the cost of equity, although debt capital is less expensive than the equity capital. So, the total
value of the firm is completely unaffected by the capital structure.

4. Factors peculiar to multinational firms

a. Character of MNC’s cash flows: An MNC having volatile cash flows can ill afford debt financing
because it is not assured of generating adequate cash to service debt periodically. In refreshing
contrast to this, MNCs having stable cash flows can manage more debt due to regular flow of
earnings. MNCs having diversified operations across the globe usually have relatively more
stable cash flows because the conditions in a country do not exert major influence on their cash
flows. Hence such companies can comfortably have greater financial leverage in their
capitalization.

b. Credit Standing of MNC: MNCs enjoying high reputation and low credit risk find it easy to access
to cheaper debt. Further, those with marketable assets that serve as acceptable collateral can
raise borrowings at reasonable terms. In contrast, MNCs with high credit risk and assets which
are not highly marketable are left with no option but to take recourse to equity financing.
 c. Profitability of MNC: MCs operating profitably are in a position to build retained earnings which
can be employed to finance their expansion programmes economically. Such corporations have
lower degree of leverage as compared to those having small levels of retained earnings. Growth
oriented MNCs usually rely on debt financing because of their limited access to retained
earnings.

d. MNCs guarantees on debt: Where an MNC guarantees borrowings of its subsidiary, the latter is
likely to rely less on equity financing. However, the borrowing capacity of such MNCs will tend
to decline as suppliers are less willing to supply large funds to the parent if those funds are
needed to rescue a parent’s subsidiary.

e. Monitoring of subsidiary by MNC: Where investors of the parent company are finding it difficult
to monitor operations of the subsidiary effectively, the latter will be induced to issue equity
shares in the local market. This will enable the parent company to monitor the managers to
ensure maximization of the firm’s stock price. This strategy can affect the MNC’s capital
structure also. Success of this strategy hinges essentially upon the initiatives taken by the MNC’s
parent to beef up the image of the subsidiary in the host country.

5. Short notes on : a) inventory management b) advantages of cost of capital c) Deed structuring

Inventory Management:

In any business or organization, all functions are interlinked and connected to each other and are often
overlapping. Inventory management is a very important function that determines the health of the
supply chain as well as its impact on the financial health on the balance sheet. Every organization
constantly strives to maintain optimum inventory to be able to meet its requirements and avoid over or
under inventory that can impact the financial figures.

Inventory is the idle stock of physical goods that contain economic value and are held in various forms
by an organization in its custody awaiting packing, processing, transformation, use or sale in a future
point of time.

Need to hold inventories:

a. The transactions motive: it expresses the need the maintain inventories to facilitate production and
sales operations smoothly.
b. The precautionary motive: it necessitates holding of inventories to guard against the risk of
unpredictable change in the demand and supply forces.

c. The speculative motive: It influences the decision to increase or reduce inventory levels to take
advantages of price fluctuations. In order to maintain an uninterrupted production it becomes necessary
to hold adequate stock of materials since there is a time lag between the demand for materials and its
supply due to some unavoidable circumstances.

Objectives of inventory management:

Efficient inventory management should result in the maximization of the owner’s wealth. For this
purpose, a firm should neither hold excessive inventory nor inadequate inventories i.e., it should hold
the optimum level of inventory. The optimum level of inventory investment lies between the point of
excessive and inadequate levels.

Hence the objectives are:

a. To ensure a continuous supply of materials to facilitate uninterrupted production,

b. To maintain sufficient stocks of raw material during short supply;

c. To maintain sufficient finished goods for efficient customer service

d. To minimize the carrying cost

e. To maintain optimum level of investment in inventories.

Advantages of Cost of Capital:

An investor provides long-term funds (i.e., equity shares, preference shares, retained earnings,
debentures etc.) to a company and quite naturally he expects a good return on his investment. In order
to satisfy the investor’s expectations, the company should be able to earn enough revenue.
Thus, to the company, the cost of capital is the minimum rate of return that the company must earn on
its investments to fulfill the expectations of the investors.
a. Maximization of the value of the firm: For the purpose of maximisation of value of the firm, a
firm tries to minimise the average cost of capital. There should be judicious mix of debt and
equity in the capital structure of a firm so that the business does not to bear undue financial
risk.

b. Capital budgeting decisions: Proper estimate of cost of capital is important for a firm in taking
capital budgeting decisions. Generally, cost of capital is the discount rate used in evaluating the
desirability of the investment project. In the internal rate of return method, the project will be
accepted if has a rate of return greater than the cost of capital.

c. Decisions regarding leasing: Estimation of cost of capital helps in taking leasing decisions of
business concern.

d. Dividend decisions: Cost of capital is significant factor in taking dividend decisions. The dividend
policy of a firm should be formulated according to the nature of the firm— whether it is a
growth firm, normal firm or declining firm. However, the nature of the firm is determined by
comparing the internal rate of return (r) and the cost of capital (k)

e. A measure for inter-firm comparison: One can compare the WACC of corporations having similar
business risks. This will help to know which corporation is using capital at the minimum costs.

f. Used for valuing a firm: WACC is used to calculate the value of the firm.

g. Criterion to accept or reject a new project: WACC guides the corporate finance team to judge
whether to accept or reject a project. In this process, the internal rate of return is compared to
the cost of capital to decide whether to accept or reject a project. If the internal rate of return is
greater than the cost of capital, accept the project.

h. Used as a hurdle rate: WACC is the minimum rate of return the corporation must generate to
satisfy its shareholders and its creditors. WACC, therefore acts as a hurdle rate which the
corporations have to cross to generate value to all shareholders and stakeholders.
Deed Structuring:

A deed or any other written agreement provides evidence of the transaction it relates to. Deeds
historically had to be executed under seal and prepared on parchment paper and delivered, now they
are simply written documents which must make it clear on their face that they are intended to be a
deed (by stating as much) and are validly executed and delivered as a deed.

Types of Deeds:

A. A deed of indenture: being a deed to which 2 or more persons are party, evidencing some
act/agreement between them other than simply their consent to jointly express a common
intention (ie. a conveyance would be an Indenture – one party wanting to sell and one party to
buy, so two different intentions); and

B. A Deed Poll – being a deed made by and expressing the intention of 1 party only or made by 2 or
more persons joining together to express a common intention (i.e.. a deed declaring a change of
name).

Parts of a Deed:

A deed is generally divided into several distinct parts:

1. The Heading
2. The Parties
3. Recitals
4. Operative Provisions
5. Testimonium
6. Schedules
7. Execution and Attestation

1. The Heading

A deed may be described as a deed in like terms to "This Deed" or "This Indenture". Alternatively it
could be by a name such as a Conveyance, Mortgage (in the Isle of Man a Conditional Bond and Security)
or Lease, according to the nature of the transaction.

2. The Parties

The parties to a deed are usually described immediately after the heading and following the words
"BETWEEN" or "PARTIES".
It makes no difference how parties are described in a deed provided they can be identified satisfactorily.
That said, it is usual for them to be described by their names and addresses, and, if they are not
individuals, or they are party to the deed in a particular capacity, by a description of what they are, or in
what capacity they are party, or both.

3. Recitals

Recitals explain the background of the deed and normally follow a description of the parties to it. It is
unusual to see no recitals at all. Recitals are usually listed as numbered or alphabetical paragraphs (if
they are lettered paragraphs then you would expect the operative provisions to be numbered) and
commonly follow the words "WHEREAS" or "RECITALS".

4. Operative Provisions

Operative provisions set out the rights and obligations of the parties to the deed and are normally found
immediately after the recitals following the testatum which is usually expressed as "NOW WITNESSETH
AS FOLLOWS", or similar words to that effect.

5. Testimonium

This is a clause that is so named as it used to begin formally with the words "In eujus rei testimonium".
It is basically the concluding part of the deed and normally placed after the operative provisions and
before the schedules – it connects the signatures to the document.

6. Schedules

It is usual for any schedules to follow the testimonium but come before the signatures. By doing this the
idea is that nothing else can be added to the body of the deed.

7. Execution and Attestation

This is the signatures and witnesses page. To be validly executed by an individual a deed must be signed
by the individual in the presence of a witness who should sign to acknowledge their witnessing of the
signature and provide their details. If a deed is to be signed at the maker's direction then 2 witnesses are
required. There are other rules which apply where an individual cannot read or write.
July 2014:

1. Importance of Cost of Capital:

a. Maximisation of the Value of the Firm:

For the purpose of maximisation of value of the firm, a firm tries to minimise the average cost of capital.
There should be judicious mix of debt and equity in the capital structure of a firm so that the business
does not to bear undue financial risk.

b. Capital Budgeting Decisions:

Proper estimate of cost of capital is important for a firm in taking capital budgeting decisions. Generally,
cost of capital is the discount rate used in evaluating the desirability of the investment project. In the
internal rate of return method, the project will be accepted if it has a rate of return greater than the cost
of capital.

c. Decisions Regarding Leasing:

Estimation of cost of capital is necessary in taking leasing decisions of business concern.

d. Management of Working Capital:

In management of working capital, the cost of capital may be used to calculate the cost of carrying
investment in receivables and to evaluate alternative policies regarding receivables. It is also used in
inventory management also.

e. Dividend Decisions:
Cost of capital is significant factor in taking dividend decisions. The dividend policy of a firm should be
formulated according to the nature of the firm— whether it is a growth firm, normal firm or declining
firm. However, the nature of the firm is determined by comparing the internal rate of return (r) and the
cost of capital (k) i.e., r > k, r = k, or r < k which indicate growth firm, normal firm and decline firm,
respectively.

f. Determination of Capital Structure:

Cost of capital influences the capital structure of a firm. In designing optimum capital structure that is
the proportion of debt and equity, due importance is given to the overall or weighted average cost of
capital of the firm. The objective of the firm should be to choose such a mix of debt and equity so that
the overall cost of capital is minimised.
g. Evaluation of Financial Performance:
The concept of cost of capital can be used to evaluate the financial performance of top management.
This can be done by comparing the actual profitability of the investment project undertaken by the firm
with the overall cost of capital.

2. Factors affecting dividend policy

TYPE OF INDUSTRY: The nature of the industry to which the company belongs has an important effect on
the dividend policy. Industries, where earnings are stable, may adopt a consistent dividend policy as
opposed to the industries where earnings are uncertain and uneven. They are better off in having a
conservative approach to dividend payout.

OWNERSHIP STRUCTURE: The ownership structure of a company also impacts the policy. A company
with a higher promoter’ holdings will prefer a low dividend payout as paying out dividends may cause a
decline in the value of the stock. Whereas, a high institutional ownership will favor a high dividend
payout as it helps them to increase the control over the management.

AGE OF CORPORATION: Newly formed companies will have to retain major part of their earnings for
further growth and expansion. Thus, they have to follow a conservative policy unlike established
companies, which can pay higher dividends from their reserves.

THE EXTENT OF SHARE DISTRIBUTION: A company with a large number of shareholders will have a
difficult time in getting them to agree to a conservative policy. On the other hand, a closely held
company has more chances of succeeding to finalize conservative dividend payouts.

DIFFERENT SHAREHOLDERS’ EXPECTATIONS

Another factor that impacts the policy is the diversity in the type of shareholders a company has. A
different group of shareholders will have different expectations. A retired shareholder will have a
different requirement vis-a-vis a wealthy investor. The company needs to clearly understand the
different expectations and formulate a successful dividend policy. Psychologically, cash dividend will give
more satisfaction to shareholder in comparison to capital appreciation.

LEVERAGE
A company having more leverage in their financial structure and consequently, more interest payments
may to decide for a low dividend payout, so as to increase their net worth and to make sure that it can
make payment of financial charges even in case of earning of the company is falling. Whereas a
company utilizing more of own financing will prefer high dividends.
FUTURE FINANCIAL REQUIREMENTS / REINVESTMENT OPPORTUNITY
Dividend payout will also depend on the future requirements for the additional capital. A company
having profitable investment opportunities is justified in retaining the earnings. However, a company
with no capital requirements should opt for a higher dividend.

BUSINESS CYCLES
When the company experiences a boom, it is prudent to save up and make reserves for dips. Such
reserves will help a company to maintain dividend even in depressing markets to retain and attract
more shareholders.

CHANGES IN GOVERNMENT POLICIES

There could be the change in the dividend policy of a company due to the imposed changes by the
government. The Indian government had put temporary restrictions on companies to pay dividends
during 1974-75.

PROFITABILITY
The profitability of a firm is reflected in net profit ratio and ratio of profit to total assets. A highly
profitable company have a capacity to pays higher dividends and a company with less profits will adopt
a conservative dividend policy.

TAXATION POLICY
The corporate taxes will affect dividend policy, either directly or indirectly. The taxes directly reduce the
residual earnings after tax available for the shareholders. If dividend income is taxable in the hands of
investor and capital gain is exempt, then company may retain its earning so as to increase price per
share, which ultimately gives higher return to investors’ and vice versa. Further if it is possible that
bifurcate all shareholders into high tax bracket or low tax bracket, accordingly dividend policy can be
framed. Finally, objective is to give maximum return to shareholders.

TRENDS OF PROFITS
Even if the company has been profitable over the years, the trend should be properly analyzed to find
the average earnings of the company. This average number should be then studied in relation to the
general economic conditions. This will help in opting for a conservative policy if a depression is
approaching.

LIQUIDITY
Liquidity has a direct relation with the dividend policy. Many a times, company having high profit, may
have majority of profit blocked in working capital or it may acquire assets. In that case its liquidity is
poor. In that case company should pay less dividend. High dividend payment is possible only if company
has good earning and sound liquidity.

LEGAL RULES
There are certain legal restrictions on the companies for dividend payments. It is legal to pay a dividend
only if the capital is not reduced post payment. These rules are in place to protect creditors’ interest.
Most importantly providing depreciation is mandatory before making payment of dividend.
Depreciation is to be provided at minimum rates provided. Providing depreciation is very important
because with that company is able to retain an amount of profit for replacement of fixed assets in future
INFLATION
Inflationary environments compel companies to retain major part of their earnings and indulge in lower
dividends. As the prices rise, the companies need to increase their capital reserves for their purchases of
fixed assets. In case of inflationary situation, same quantity of closing stock will have more valuation, so
payment of tax also increases.

CONTROL OBJECTIVES
The firms aiming for more control in the hands of current shareholders prefer a conservative dividend
payout policy. It is imperative to pay fewer dividends to retain more control and the earnings in the
company.
In a nutshell, the management of a company is completely free to frame the required dividend policy.
There are no obligations to be adhered to. So, the company needs to judiciously weight all the above-
mentioned factors and formulate a balanced dividend policy. A dividend policy can also be revised in the
wake of changes in any of the factors.

REPAYMENT OF DEBT
If a substantial amount of debt is required to paid, in that case even though the company has high
amount of earning, it may pay less dividend.

3. Types of Dividend Policy:

a. Regular Dividend Policy: Payment of dividend at the usual rate is termed as regular dividend.
The investors such as retired persons, widows and other economically weaker persons prefer to
get regular dividends.
Advantages of regular dividend policy:

i. It establishes a profitable record of the company

ii. It creates confidence amongst the shareholders

iii. It aids in long-term financing and renders financing easier.

iv. It stabilizes the market value of shares

v. The ordinary shareholders view dividends as a source of funds to meet their

day-to-day living expenses

vi. If profits are not distributed regularly and are retained the shareholders may
have to pay a higher rate of tax in the year when accumulate profits are
distributed.
 However, it must be remembered that regular dividends can be maintained only by companies
of long standing and stable earnings, A company should establish the regular dividend at a lower
rate as compared to the average earnings of the company.

b. Stable dividend policy: The term stability of dividends’ mean consistency or lack of variability in
the stream of dividend payments. In more precise terms, it means payment of certain minimum
amount of dividend regularly.
Three forms:

i. Constant dividend per share: Some companies follow a policy of paying fixed
dividend per share irrespective of the level of earnings year after year. Such
firms, usually, create a ‘Reserve for Dividend Equalisation’ to enable them to
pay the fixed dividend even in the year when the earnings are not sufficient or
when there are losses.

ii. Constant payout ratio: Constant pay-out ratio means payment of a fixed
percentage of net earnings as dividends every year. The amount of dividend in
such a policy fluctuates in direct proportion to the earnings of the company. The
policy of constant pay-out is preferred by the firms because it is related to their
ability to pay dividends.

iii. Stable rupee dividend plus extra dividend: Some companies follow a policy of
paying constant low dividend per share plus an extra dividend in the years of
high profits. Such a policy is most suitable to the firm having fluctuating earnings
from year to year.

c. Irregular Dividend Policy: When companies are facing constraints of earnings and unsuccessful
business operations, they may follow irregular dividend policy. It is one of the temporary
arrangements to meet the financial problems.

d. No dividend policy: Sometimes the company may follow no dividend policy because of its
unfavorable working capital position of the amount required for future growth concerns.
 4. Assumptions of MM approach under the dividend theory.

The Modigliani and Miller approach to capital theory, devised in the 1950s, advocates the capital
structure irrelevancy theory. This suggests that the valuation of a firm is irrelevant to the capital
structure of a company. Whether a firm is highly leveraged or has a lower debt component has no
bearing on its market value. Rather, the market value of a firm is solely dependent on the operating
profits of the company.

The capital structure of a company is the way a company finances its assets. A company can finance its
operations by either equity or different combinations of debt and equity. The capital structure of a
company can have a majority of the debt component or a majority of equity, or an even mix of both
debt and equity.

The fundamentals of the Modigliani and Miller Approach resemble that of the Net Operating
Income Approach. Modigliani and Miller advocate capital structure irrelevancy theory, which suggests
that the valuation of a firm is irrelevant to the capital structure of a company. Whether a firm is highly
leveraged or has a lower debt component in the financing mix has no bearing on the value of a firm.

The Modigliani and Miller Approach further states that the market value of a firm is affected by its
operating income, apart from the risk involved in the investment. The theory stated that the value of the
firm is not dependent on the choice of capital structure or financing decisions of the firm.

Following are the assumptions under which this approach can work:

 There are no taxes.

 Transaction cost for buying and selling securities, as well as the bankruptcy cost, is nil.
 There is a symmetry of information. This means that an investor will have access to the same
information that a corporation would, and investors will thus behave rationally.
 The cost of borrowing is the same for investors and companies.
 There is no floatation cost, such as an underwriting commission, payment to merchant bankers,
advertisement expenses, etc.
 There is no corporate dividend tax.

The Modigliani and Miller Approach indicates that the value of a leveraged firm (a firm that has a mix of
debt and equity) is the same as the value of an unleveraged firm (a firm that is wholly financed by
equity) if the operating profits and future prospects are same. That is, if an investor purchases shares of
a leveraged firm, I t would cost him the same as buying the shares of an unleveraged firm.
 5. What is working capital management? Explain the types of working capital and its significance.

Meaning:

In ordinary parlance, working capital denotes a ready amount of fund available for carrying out the day-
to-day activities of a business enterprise. It is considered to be the life-blood of the business and its
effective and efficient management is necessary for the very survival of the business.

There are two concepts: a) Gross Concept b) Net concept

a) Gross Concept of working capital: The gross working capital refers to the total fund invested in
current assets. Current assets are those assets which are easily converted into cash within a
time period of one year. It includes cash in hand and at bank, short term securities, debtors, bills
receivable, prepaid expenses, accrued expenses and inventories like raw materials, work-in-
progress, stores and spare parts, finished goods. The gross concept of working capital refers to
the firm’s investment in above current assets.
Useful for the following purposes:
i) It is the total investment in current assets which earns profits.
ii) management can give attention to manage very efficiently and carefully each item of the
current assets in order to minimise bad debt, slow-moving and non-moving items, idle cash etc.
iii) it takes into consideration of the fact that, if other things remains constant, infusion of fund
in the business increases its working capital
iv) it enables management to compute the rate of return on total investment in current assets.

b) Net Concept of Working Capital: The term net working capital refers to the excess of current
assets over current liabilities. In other words, the amount of current assets that would remain in
a firm after all its current liabilities are paid.
Current liabilities are those claims of outsiders to the business ness enterprise which are payable
in within one year and include sundry creditors, bills payable, outstanding expenses, short term
loans, advances and deposits, bank overdraft, proposed dividend, provision for taxation etc.
Use for the following purposes:
i) It indicates the liquidity position of the firm i.e., ability of the firm to meet its short- term
obligations.
ii) It helps creditors and other potential investors to judge the financial health of the firm.
iii) Gross concept of working capital may lead to incorrect conclusion regarding financial stability
of firms having the same amount of current assets.
 iv) It indicates the extent of long-term sources of fund used in financing current assets of a
business enterprise.

Types of Net Working capital:

a. Positive NWC: Positive working capital refers to excess of current assets over current liabilities. It
indicates the extent of long-term sources of funds such as equity share, preference share, retained
earnings, long-term loans and debentures etc. used to finance the current assets of a business
concern.
b. Negative NWC: If current liabilities of a firm exceed current assets it is called negative working
capital. In other words, working capital is said to be negative when the current assets fall short of
the current liabilities. The excess of current liabilities over current assets is supposed to have been
used in procuring fixed assets of the firm.
c. Zero Working capital: If the current assets are equal to current liabilities, it is called zero or nil
working capital.

Importance of Working capital

a. Smooth flow of production: to maintain a smooth flow of production, it is necessary that

adequate working capital is available for paying trade suppliers, hiring labour and
incurring other operational expenses.

b. Increase in liquidity and solvency position: In enhances the liquidity and solvency
position of the business concern.

c. Goodwill: A firm with a sound working capital position can make timely payment of its
outstanding bills. This keeps the reputation of the firm intact.

d. Advantages of cash discount: it enables the firm to avail itself of the facilities like cash
discount by making prompt payments.

e. Easy loan: adequate amount of working capital builds a sound credit-worthiness of the
firm. As a result, it becomes easier for the firm to obtain additional loans in favourable
terms and conditions.

f. Regular payment of wages and salaries: The firm can make regular and timely payment
of wages and salaries to its employees. This increases the morale and efficiency of
employees.
 g. Security and confidence: it creates a sense of security and confidence in the mind of the
management or officials of the firm.

h. Efficient use of fixed assets: Adequate amount of working capital enables the firm to use
its fixed assets more efficiently and extensively. If the fixed assets remain idle due to
paucity of working capital, depreciation of fixed assets and interest on borrowed capital
invested in fixed assets will to incurred unnecessarily.

i. Meeting of contingencies: It can meet unforeseen contingencies of the firm. Unforeseen

contingencies like business depression, financial crisis due to huge losses etc. can easily
be overcome, if adequate working capital is maintained by a firm.

j. Completing operating cycle: A sound management of working capital helps in

completing the operating cycle quickly. This enables a firm to increase its profitability.

k. Timely payment of dividend: Adequate working capital ensures regular payment of

dividends to the shareholders.

6. Inventory management:

In any business or organization, all functions are interlinked and connected to each other and are often
overlapping. Inventory management is a very important function that determines the health of the
supply chain as well as its impact on the financial health on the balance sheet. Every organization
constantly strives to maintain optimum inventory to be able to meet its requirements and avoid over or
under inventory that can impact the financial figures.

Inventory is the idle stock of physical goods that contain economic value and are held in various forms
by an organization in its custody awaiting packing, processing, transformation, use or sale in a future
point of time.

Need to hold inventories:

a. The transactions motive: it expresses the need the maintain inventories to facilitate production and
sales operations smoothly.

b. The precautionary motive: it necessitates holding of inventories to guard against the risk of
unpredictable change in the demand and supply forces.
c. The speculative motive: It influences the decision to increase or reduce inventory levels to take
advantages of price fluctuations. In order to maintain an uninterrupted production it becomes necessary
to hold adequate stock of materials since there is a time lag between the demand for materials and its
supply due to some unavoidable circumstances.

Objectives of inventory management:

Efficient inventory management should result in the maximization of the owner’s wealth. For this
purpose, a firm should neither hold excessive inventory nor inadequate inventories i.e., it should hold
the optimum level of inventory. The optimum level of inventory investment lies between the point of
excessive and inadequate levels.

Hence the objectives are:

a. To ensure a continuous supply of materials to facilitate uninterrupted production,

b. To maintain sufficient stocks of raw material during short supply;

c. To maintain sufficient finished goods for efficient customer service

d. To minimize the carrying cost

e. To maintain optimum level of investment in inventories.

7. Financial Management of MNCs