Afm Theory Notes
Afm Theory Notes
Afm Theory Notes
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Cost of Preference Share Capital
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Cost of Equity Share Capital
Weighted Average Cost of Capital (Book Value and Market Value Weights)
–Problems.
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MEANING OF COST OF CAPITAL
The cost of capital is the expense a company faces when it raises money to fund its
operations. It's like the price the company pays for using money from investors or
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lenders.
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The sources of capital of a firm may be in the form of preference shares, equity
shares, debt, and retained earnings.
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3. Project Expansion
4. Financial Performance Evaluation
5. Financial Decisions
Explaination :
1. Capital Mix Decision: Cost of capital Determines optimal capital structure to
maximize firm value.
2. Capital Budgeting: Cost of capital Guides to accept/reject decisions by comparing
present value of expected returns with cost of investment.
3. Project Expansion: Cost of Capital assists in deciding whether to accept or reject
project expansions based on marginal return on investment compared to cost of
capital.
4. Financial Performance Evaluation: Cost of capital helps to assess firm's financial
performance by comparing actual profitability with projected and actual cost of
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capital.
5. Financial Decisions: Cost of Capital serves as a financial decisions like working
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capital management, dividend policy, leasing, etc., ensuring returns exceed the cost
of capital.
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TYPES OF COST OF CAPITAL
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Explaination :
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COMPUTATION OF COST OF CAPITAL
The computation of the cost of capital of a firm involves:
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1) Computation of the cost of a specific source of finance.
2) Computation of weighted average cost of capital.
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1]. Computation of Specific Source of Finance:- For the computation of overall cost
of capital, calculation of the cost of each source of finance namely cost of debt, cost
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of preferential capital, cost of equity share capital, and cost of retained earnings, etc.
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a]. Cost of Debt:- the term cost of Debt refers to the rate of return or interest
expected by the debenture holders.
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In other words, Cost of debt is a rate of interest payable on debt. Thus, they expect
the cost of that be the rate of interest as per the contract suggested and the cost of
raising the debt.
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DD
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Theory: Says using more debt is good because interest is tax-deductible, so it lowers
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taxes and increases profits.
Explanation: Basically, it's like saying, "Let's borrow more money because we can
save on taxes and make more money."
Explanation: This theory says, "It doesn't matter if we use more debt or equity, as
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long as we make the same amount of money, our value stays the same."
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value.
Explanation: This approach is like saying, "Let's find the right balance of debt and
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4]. MM Hypothesis:
Theory: Believes in a perfect world where capital structure doesn't affect firm value.
Explanation: It's like saying, "In a perfect world without taxes or bankruptcy costs, it
doesn't matter how we finance our company, our value stays the same."
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1. Convention Techniques
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#Risk adjusted Discount Rate Approach
#Certainty Equivalent Approach
2. Statistical Techniques DD
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#Probability Approach
#Standard Deviation and
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#Co-efficient of Variation- Theory and Problems.
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Risk: Risk is the chance of something bad happening. In finance, it means the
possibility of losing money because of uncertain events like market changes or
economic shifts.
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Risk Analysis: Risk analysis is like looking at a situation to see what could go wrong
and how likely it is to happen. It helps us understand and plan for potential problems
so we can make better decisions.
Types of Risks
1. Market Risk
2. Credit Risk
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3. Liquidity Risk
4. Operational Risk
5. Foreign Exchange Risk
Explaination :
1. Market Risk: This is about the risk of losing money due to changes in things like
interest rates or stock prices.
2. Credit Risk: Credit risk is the risk of not getting paid back when you lend money to
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someone.
3. Liquidity Risk: Liquidity risk is when you can't turn your assets into cash quickly
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enough.
4. Operational Risk: Operational risk comes from things going wrong within a
company, like mistakes or accidents.
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5. Foreign Exchange Risk: This is about the risk of losing money because of changes
in currency exchange rates.
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Risk and Uncertainty
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Risk vs. Uncertainty: Risk is when we can guess how likely something is to happen,
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strategies like planning for different scenarios and staying flexible so they can adapt
to unexpected changes.
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2]. Statistical Techniques:
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[i]Probability Approach: This is like guessing the chances of different things
happening and then figuring out the average outcome based on those guesses. It
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helps us make decisions by considering the likelihood of different scenarios.
[ii]. Standard Deviation and Coefficient of Variation:
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a). Standard Deviation: This measures how much the outcomes of something can
vary from the average. Higher standard deviation means more variation and more
risk.
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b). Coefficient of Variation: This compares the risk of different things by looking at
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how much risk there is for each unit of return. Lower coefficient of variation means
less risk for the same amount of return.
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Meaning
Sensitivity Analysis is a tool used in financial modeling to analyze how the different
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Explaination :
1]. Identifying Important Factors: First, we figure out which factors are really
important for our decision. These could be things like sales forecasts, interest rates,
or costs.
2]. Testing the Waters: Next, we start changing these factors one by one to see what
happens. For example, if we increase the sales forecast, does our profit go up? If we
lower the interest rate, does our investment look better?
3]. Measuring the Impact: By doing this, we can see how sensitive our decision is to
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each factor. If a small change in sales forecast drastically changes our profit, we
know that sales forecast is a big deal for our decision.
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4]. Making Informed Choices: Sensitivity analysis helps us make smarter decisions
by understanding the risks and uncertainties involved. It shows us where we need to
be careful and where we can be more confident.
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Decision Tree Analysis (5Marks)
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Meaning
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financial decisions.
In other words,
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Decision tree analysis is like mapping out different paths to make better decisions.
Here's how it helps:
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Explaination :
1]. Laying Out Options: We start by listing out all the choices we have. For example,
if we're thinking about investing in a project, our options might be to invest, not
invest, or wait and see.
2]. Predicting Outcomes: Next, we think about what might happen with each choice.
We draw branches to show different scenarios and their outcomes. For example, if
we invest, we might make a profit or a loss. If we don't invest, we might miss out on
potential gains.
3]. Studying the Risks and Rewards: By seeing all the possible outcomes laid out, we
can study the risks and rewards of each choice. This helps us make a more informed
decision based on what's best for us.
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4]. Choosing the Best Path: Decision tree analysis helps us see the big picture and
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choose the path that gives us the best chance of success. It's like having a roadmap
to guide us through uncertain situations and make better choices.
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Meaning and Definition of Receivables Management
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Factors influencing the size of Receivables
Objectives of Receivables Management
Problems on
#Debtors Turnover Ratio, DD
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#Average Collection Period,
#Creditors Turnover Ratio,
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Inventory Management
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2. Smooth Operations
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3. Handling Unexpected Costs
4. Getting Loans
5. Growth Opportunities
6. Keeping Investors Happy
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Explaination :
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1]. Cash Flow: Current assets, like cash and accounts receivable, ensures that
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or emergencies.
4]. Getting Loans: Having enough current assets makes it easier to get loans or
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CASH MANAGEMENT
Meaning of Cash
Cash means Liquid assets that a business owns. Cash includes currency notes,
coins, and cheques.
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investing it wisely.
In other words,
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Cash Management is about making sure that the company's cash is in the right place
at the right time to keep things running smoothly and make the most of rupee.
4. To Speed Things Up
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5. To Stay Safe
6. To Make Money Grow.
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Explaination :
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1]. To Keep Enough Cash: Cash Management objective is to make sure that the
company always has enough money to pay its bills and keep things running
smoothly.
2]. To Avoid Wasting Money: Cash Management objective is to not letting too much
cash sit idle, because that's like losing money. Keeping just the right amount to cover
expenses is one of the objective.
3]. To Keep Cash Moving: Cash Management objective is make sure that the money
flows in and out smoothly by collecting payments from customers quickly and
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Motives of Holding Cash
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Motives of Holding Cash
1. Transaction Motive
2. Precautionary Motive DD
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3. Speculative Motive
4. Compensating Motive
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Explaination :
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Receivables Management
Meaning and Definition of Receivables Management
Receivables management means keeping track of the money customers hsve to pay
to you and making sure that you get paid on time.
In other words,
Receivables Management involves things like deciding who can buy on credit, &
sending out invoices, and following up to make sure payments come in smoothly.
The goal is to keep cash flowing in and minimize the risk of not getting paid.
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Factors influencing the size of Receivables
Meaning
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Factors Influence the Size of Receivables means that certain things affect how much
money a company is having obligation to be received by its customers.
1. Credit Policy
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2. Sales Volume
3. Customer Base
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4. Economic Conditions
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5. Collection Policies
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6. Payment Terms
7. Seasonality
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8. Inventory Turnover
9. Competitive Pressure
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10. Technology
11. Regulations
Explaination :
1. Credit Policy: How easy or strict it is for customers to buy on credit.
2. Sales Volume: More sales mean more customers buying on credit, leading to
larger receivables.
3. Customer Base: The type of customers and how good they are at paying on time.
4. Economic Conditions: When the economy is struggling, customers may take
longer to pay, leading to larger receivables.
5. Collection Policies: How well the company follows up on overdue payments.
6. Payment Terms: How long customers have to pay and whether there are
discounts for paying early.
7. Seasonality: Sales may vary throughout the year, affecting the size of receivables.
8. Inventory Turnover: How quickly goods are sold can affect receivables.
9. Competitive Pressure: Companies may offer more credit to compete, leading to
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larger receivables.
10. Technology: New tech tools can make it easier to manage receivables and get
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paid faster.
11. Regulations: Laws about credit and collections can affect how receivables are
managed.
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Objectives of Receivables Management
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Explaination :
1. Get Paid On Time: The objective of Receivables Management is to make sure
customers pay what they have to repay when they're supposed to, so the company
has enough money to keep running smoothly.
2. Avoid Bad Debts: The objective of Receivables Management is to make sure the
company doesn't lose money from customers who don't pay their bills.
3. Use Money Wisely: The objective of Receivables Management is to manage the
money received by customers to balance having enough cash on hand for expenses
while not letting too much money sit idle.
4. Make More Profit: The objective of Receivables Management is to reduce costs
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related to collecting money from customers and minimize losses from unpaid bills,
so the company can make more money.
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5. Keep Customers Happy: The objective of Receivables Management is to find
ways to collect money without upsetting customers, so they keep coming back to
buy more.
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6. Make Things Easier: The objective of Receivables Management is to find ways to
make the process of invoicing, collecting payments, and managing receivables
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simpler and cheaper.
7. Watch How Things Are Going: The objective of Receivables Management is to
keep an eye on how well the company is doing at collecting money from customers
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8. Follow the Rules: The objective of Receivables Management is to make sure the
company follows all the laws and rules about collecting money from customers, so it
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process of turning sales into cash, so the company has money available when it's
needed most.
INVENTORY MANAGEMENT
Definition of Inventory
Inventory refers to the stock that a company keeps on hand to sell or use in its
business. Inventory includes things like raw materials, goods, or products being
made, and finished goods ready to be sold.
Elements of Inventory
1. Raw Materials
2. Work-in-Progress (WIP)
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3. Finished Goods
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4. Maintenance, Repair, and Operations (MRO) Inventory
5. Safety Stock
6. Finished Goods for Resale
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Explaination :
1. Raw Materials: These are the basic materials that a company uses to
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manufacture its products. Raw Materials are in their most basic form and are used in
the production process.
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completed and are ready to be sold to customers. These are the final products that
have passed through the entire production process.
4. Maintenance, Repair, and Operations (MRO) Inventory: MRO inventory consists of
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supplies and materials used for maintaining equipment, repairing machinery, and
supporting ongoing operations.
5. Safety Stock: Safety stock refers to additional inventory held by a company as a
safe guard against unexpected fluctuations in demand or supply chain confusions. It
serves as a contingency measure to prevent stockouts and ensure continuity of
operations.
6. Finished Goods for Resale: Some businesses may also hold inventory that they
have purchased from suppliers for the purpose of resale. This inventory consists of
products that are ready for sale to customers without undergoing any further
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processing or manufacturing.
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6. Uncertainty
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Explaination :
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1. Meet Customer Demand: Having inventory on hand ensures that a company can
fulfill customer orders promptly and avoid stockouts, thereby maintaining customer
satisfaction and loyalty.
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2. Smooth Production: Inventory allows for smooth production processes by
ensuring that raw materials and components are readily available when needed,
reducing production delays and confusions.
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demand, ensuring that they have sufficient stock to capitalize on peak selling
periods.
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7. Storage Costs
8. Inventory Valuation Costs
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Explaination :
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1. Ordering Costs: Money spent when ordering new inventory.
2. Carrying Costs: Money spent to store and maintain inventory, like rent for
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warehouse space and insurance.
3. Stockout Costs: Costs incurred when demand exceeds available inventory, leading
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4. Handling Costs: Money spent to move and manage inventory within the
warehouse.
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7. Storage Costs: Expenses related to storing inventory, including rent, utilities, and
maintenance.
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8. Inventory Valuation Costs: Money spent to determine the value of inventory for
financial reporting purposes.
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Explaination :
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1. First-In, First-Out (FIFO): This method assumes that the oldest inventory items are
sold or used first, It is commonly used to value inventory and calculate cost of goods
sold.
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2. Last-In, First-Out (LIFO): LIFO assumes that the most recently acquired inventory
items are sold or used first, It is also used for inventory valuation and cost of goods
sold calculations.
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3. Weighted Average Cost: This method calculates the average cost of inventory
items by dividing the total cost of goods available for sale by the total number of
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units available for sale. It provides a blended cost for inventory valuation.
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5. ABC Analysis: ABC analysis categorizes inventory items into three groups based
on their value and importance: A items (high-value, low-quantity), B items (moderate-
value, moderate-quantity), and C items (low-value, high-quantity). It helps prioritize
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minimizes total inventory costs, including ordering costs and holding costs. It helps
determine how much to order to balance ordering and holding costs effectively.
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Determinants of Dividend Policy
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Dividend Theories:
Theories of Relevance
#Walter's Model and DD
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#Gordon's Model and
Theory of Irrelevance
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Dividend decisions are choices made by a company about how much of its profits it
will share with its shareholders as dividends, and how much it will keep for itself to
reinvest in the business.
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In other words,
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Dividend decision refers to deciding how much allowance to give out and how much
to save for future needs.
Types of Dividends
1. Cash Dividends
2. Stock Dividends
3. Property Dividends
4. Regular Dividends
5. Special Dividends
6. Interim Dividends
7. Liquidating Dividends
Explaination :
1. Cash Dividends: This is when a company pays its shareholders in cash from its
profits. It's like getting money as a reward for owning shares.
2. Stock Dividends: Instead of cash, companies sometimes give out additional
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shares of stock to their shareholders. It's like getting more pieces of the company.
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3. Property Dividends: Sometimes, companies give out assets other than cash or
stock, like products or equipment. It's like receiving something useful from the
company instead of money.
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4. Regular Dividends: These are dividends paid out periodically, usually quarterly or
annually, based on the company's profits and dividend policy. It's like a regular
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paycheck for shareholders.
5. Special Dividends: These are one-time payments made by a company to its
shareholders, often when the company has excess cash or has had an exceptionally
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6. Interim Dividends: Sometimes, companies pay out dividends before the end of
their financial year, known as interim dividends. It's like getting a partial payout while
waiting for the full dividend at the end of the year.
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It's like getting a share of whatever's left when the company shuts down.
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Explaination :
1. Stable Dividend Policy:
- Keeps giving the same amount of dividend regularly.
- Makes shareholders feel secure and happy.
- Shows the company is doing well consistently.
2. Residual Dividend Policy:
- Pays dividends only if there's extra profit after covering all expenses and
investments.
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- Adjusts dividends based on what's left over.
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- Gives flexibility but may result in varying payouts.
3. Hybrid Dividend Policy:
- Mixes stable and residual policies.
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- Tries to offer regular dividends while also saving for future needs.
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- Balances consistency with flexibility.
4. No Dividend Policy (Zero Dividend Policy):
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payouts.
5. Low Dividend Policy:
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7. Smart Money Management
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8. Less Risky Image
9. Supports Future Plans
10. Keeps Everyone Happy
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Explaination :
1. Shareholders satisfaction : Regular dividends make shareholders feel secure and
satisfied.
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doing well financially and can be trusted for the long term.
3. Attracts Long-Term Investors: Stable dividends attracts investors looking for
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6. Stands Out from Competition: Offering stable dividends sets a company apart
from competitors, making it more appealing to investors.
7. Smart Money Management: Maintaining stable dividends encourages responsible
financial decisions by company management, ensuring money is used wisely.
8. Less Risky Image: Companies with stable dividends are seen as safer
investments, attracting more investors and lowering borrowing costs.
9. Supports Future Plans: Stable dividends provide a reliable source of funds for
future growth and expansion, helping the company plan ahead.
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4. Legal and Regulatory Constraints
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5. Tax Considerations
6. Financial Leverage
7. Ownership Structure
8. Industry Norms DD
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9. Market Conditions
10. Company's Growth Stage
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Explaination :
1. Earnings Stability: Companies with stable and predictable earnings are more likely
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to adopt a regular dividend policy as they can consistently generate sufficient profits
to pay dividends.
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2. Cash Flow Position: A company's ability to generate positive cash flows is crucial
for dividend payments. A strong cash flow position enables the company to sustain
dividend payouts even during periods of economic downturns.
3. Investment Opportunities: Companies with attractive investment opportunities
may retain earnings for reinvestment in growth projects rather than distributing them
as dividends. The availability of profitable investment avenues influences dividend
policy decisions.
4. Legal and Regulatory Constraints: Legal requirements and regulatory guidelines
may impose restrictions on dividend payments, such as minimum capital
requirements or limitations on dividend distributions in certain industries.
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5. Tax Considerations: Tax implications for both the company and shareholders play
a significant role in determining dividend policy. Tax rates on dividends, corporate
tax laws, and shareholder preferences for tax-efficient income impact dividend
decisions.
6. Financial Leverage: Companies with high levels of debt may adopt a conservative
dividend policy to ensure sufficient cash flows for debt servicing and to maintain
financial stability. High financial leverage can constrain dividend payouts.
7. Ownership Structure: The ownership composition of the company, including the
presence of controlling shareholders or institutional investors, may influence
dividend policy. Shareholder preferences and expectations regarding dividends can
shape the company's dividend decisions.
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8. Industry Norms: Dividend policies may vary across industries based on industry
norms and practices. For example, mature industries with stable cash flows may
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have higher dividend payout ratios compared to growth-oriented industries.
9. Market Conditions: Economic conditions, interest rates, and market sentiment can
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impact dividend policy decisions. Companies may adjust dividend payments in
response to changes in market dynamics and investor preferences.
10. Company's Growth Stage: The growth stage of the company, whether it is in the
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early growth phase, mature stage, or declining phase, can influence dividend policy.
Growth-oriented companies may prioritize reinvestment of earnings for expansion,
while mature companies may focus on distributing dividends to shareholders.
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Dividend Theories
1. Theories of Relevance:
Walter's Model:
Walter says companies should keep profits if they earn more than they need.
Critics say it's too basic and doesn't fit real situations well.
Gordon's Model:
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Assumes no borrowing, constant profits and growth, and no taxes.
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Critics say it's too simple and doesn't consider real-world complexities.
2. Theory of Irrelevance:
The Miller-Modigliani (MM) Hypothesis:
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Modigliani and Miller say dividends don't affect share prices in a perfect world.
investment plans.
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Critics say it's unrealistic and doesn't match how markets really work.
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