Time Value of Money
Time value of money is the value of money figuring in a given amount of interest
for a given amount of time. For example 100 Rupees of todays money held for a
year at 5 percent interest is worth 105 Rupees, therefore 100 Rupees paid now or
105 Rupees paid exactly one year from now is the same amount of payment of
money with that given interest at that given amount of time[1]. This notion dates at
least to Martín de Azpilcueta of the School of Salamanca.
All of the standard calculations for time value money derive from the most basic
algebraic expression for the present value of a future sum, "discounted" to the
present by an amount equal to the time value of money. For example, a sum of
FV to be received in one year is discounted (at the rate of interest r) to give a sum
of PV at present: PV = FV — r·PV = FV/(1+r).
Some standard calculations based on the time value of money are:
Present Value The current worth of a future sum of money or stream of cash
flows given a specified rate of return. Future cash flows are discounted at the
discount rate, and the higher the discount rate, the lower the present value of the
future cash flows. Determining the appropriate discount rate is the key to properly
valuing future cash flows, whether they be earnings or obligations[2].
Present Value of a Annuity An annuity is a series of equal payments or receipts
that occur at evenly spaced intervals. Leases and rental payments are examples.
The payments or receipts occur at the end of each period for an ordinary annuity
while they occur at the beginning of each period for an annuity due[3].
Present Value of a Perpetuity is a constant stream of identical cash flows with
no end.
Future Value is the value of an asset or cash at a specified date in the future that
is equivalent in value to a specified sum today[5].
Future Value of an Annuity (FVA) is the future value of a stream of payments
(annuity), assuming the payments are invested at a given rate of interest.
Compound Value – We have thus developed a logic for deciding between cash
flows that are separated by one period, such as one year. But most investment
decisions involve more than one period. To solve such complicated investment
decisions, we simply need to extent the logic developed above.
Present Value – This process work in the reverse direction of Compound Value –
working from future cash flows to their present values. The present value of a
future cash inflow maker, to a specified amount of cash to be received or paid at a
future date. The process of determining present value of a future payment (or
receipts) or a series of future payments (or receipts) is called discounting. The
compound interest rate used for discounting cash flows is also called the
discount rate.
Annuity Due - An annuity due requires payments to be made at the beginning of
the period. For example, in many lease arrangements, the first payment is due
immediately and each successive payment must be made at the beginning of the
month. The concepts of compound value and present value of an annuity
discussed earlier are based on the assumption that series of payments are made
at the end of the year. In practice, payments could be made at the beginning of
the year.
Multi period Compounding – In practice, cash flows can occur more than once a
year. For example, banks may pay interest on savings account quarterly. On
bonds or debentures and public deposits, companies may pay interest on savings
account quarterly. On bonds or debentures and public deposits, companies may
pay interest semi-annually. Similarly, financial institutions may require borrowers
to pay interest quarterly or half-yearly. Its also called as Continuous
Compounding.
Rate of Return - Rate of return (ROR), also known as Return on Investment
(ROI), rate of profit or sometimes just return, is the ratio of money gained or lost
(whether realized or unrealized) on an investment relative to the amount of money
invested. The amount of money gained or lost may be referred to as interest,
profit/loss, gain/loss, or net income/loss. The money invested may be referred to
as the asset, capital, principal, or the cost basis of the investment. ROI is usually
expressed as a percentage rather than a fraction.
Investment Decisions – Investment Decisions / Capital budgeting (or
investment appraisal) is the planning process used to determine whether a
firm's long term investments such as new machinery, replacement machinery, new
plants, new products, and research development projects are worth pursuing. It is
budget for major capital, or investment, expenditures.
Many formal methods are used in capital budgeting, including the techniques
such as - Net present value, Profitability index, Internal rate of return, Modified
Internal, Rate of Return, Equivalent annuity
Features – the exchange of current funds for future benefits, the funds are
invested in long-term assets, the future benefits will occur to the firm over a series
of years.
Importance – They have long-term implications for the firm, and can influence its
risk complexion, They involve commitment of large amount of funds, They are
irreversible decisions, They are among the most difficult decisions to make.
Types – Expansion of existing business, Expansion of new business,
Replacement and modernisation.
Investment Evaluation Criteria – 3 Steps -> Estimation of cash flows, Estimation
of the required rate of return
Characteristics – It should -- consider all cash flows to determine the true
profitability of the project, provide for an objective and unambiguous way of
separating good projects from bad projects, help ranking of projects according to
their true profitability.
DISCOUNTED CASH FLOW - Net Present Value Method - NPV compares the
value of a Rupee today to the value of that same Rupee in the future, taking
inflation and returns into account. If the NPV of a prospective project is positive, it
should be accepted. However, if NPV is negative, the project should probably be
rejected because cash flows will also be negative. Each cash inflow/outflow is
discounted back to its present value (PV). Then they are summed. Therefore NPV
is the sum of all terms , where -- t - the time of the cash flow
i - the discount rate (the rate of return that could be earned on an investment in
the financial markets with similar risk.)
Rt - the net cash flow (the amount of cash, inflow minus outflow) at time t (for
educational purposes, R0 is commonly placed to the left of the sum to emphasize
its role as (minus the) investment.
Acceptance Rule – Accept if NPV > 0 (positive), Reject if NPV < 0 (negative)
Merits – consider all cash flows, true measure of profitability, based on the
concept of the time value of money, satisfies the value-additivity principle,
consistence with wealth maximisation principle
Demerits – Requires estimates of cash flows which is a tedious task, Requires
computation of the opportunity cost of capital which poses practical difficulties,
sensitive to discount rates
Internal Rate of Return Method (IRR) - The internal rate of return (IRR) is a
capital budgeting metric used by firms to decide whether they should make
investments. It is also called discounted cash flow rate of return (DCFROR) or
rate of return (ROR).[1] It is an indicator of the efficiency or quality of an
investment, as opposed to net present value (NPV), which indicates value or
magnitude.
Instead of converting to the present we can also convert
to any other fixed time; the value obtained is zero if and only if the NPV is zero.
Acceptance Rule – Accept if IRR > k, Reject if IRR < k, Project may be accepted
if IRR = k.
Merits – considers all cash flows, true measure of profitability, based on the
concept of time value of money, generally consistent with wealth maximisation
principle.
Demerit – requires estimates of cash flows which is a tedious task, does not hold
the value-additivity principle, At times fails to indicate correct coice between
mutually exclusive projects, At times yields multiple rates, Relatively difficult to
compute
Profitability Index - An index that attempts to identify the relationship between
the costs and benefits of a proposed project through the use of a ratio calculated
as
A ratio of 1.0 is logically the lowest acceptable measure on the index. Any value
lower than 1.0 would indicate that the project's PV is less than the initial
investment. As values on the profitability index increase, so does the financial
attractiveness of the proposed project.
Acceptance Rule – Accept if PI > 1.0, Reject if PI < 1.0, Project may be accepted
if PI = 1.0
Merits – Considers all cash flows, Recognises the time value of money, Relative
measure of profitability, Generally consistent with the wealth maximisation
principle.
Demerits – Requires estimates of the cash flows which is a tedious task, At times
fails to indicate correct choice between mutually exclusive projects.
NON DISCOUNTED CASH FLOW
Payback (PB) - the number of years required to recover the initial outlay of the
investment is called payback.
PB = Initial Investment / Annual cash flow = Co / C
Acceptance Rule – Accept if PB < standard payback, Reject if PB > standard…
Merits – Easy to understand and compute and inexpensive to use, Emphasis
liquidity, easy and crude way to cope with risk, Uses cash flows information
Demerits – Ignores the tome value of money, ignores cash flows occurring after
the payback periods, not a measure of profitability, no objective way to determine
the standard payback, no relation with the wealth maximisation principle.
Discount Payback – The number of years required in recovering the cash outlay
on the present value basis is the discounted payable period. Except using
discounted cash flows in calculating payback, this method has all the demerits of
payback method.
Accounting rate of return (ARR) – An average rate of return found by dividing
the average profit [EBIT (1 – T)] by the average investment.
ARR = Average profit / Average investment
Acceptance Rule – Accept if ARR > minimum rate, Reject if ARR < minimum rate
Merits – Uses accounting data with which executives are familiar, Easy to
understand and calculate – Demerits – Ignores the time value of money, Does
not use cash flows, Gives more weightage to future receipts, No objective way to
determine the minimum acceptable rate of return.
Cash Flow Vs Profit – The estimation of cash flows, though difficult, is the most
crucial step in investment analysis. Cash flows are different from profits. Profit is
not necessarily cash flow; it is the difference between revenue earned and
expenses incurred rather than cash received and cash paid. Also, in the
calculation of profits, an arbitrary distinction between revenue expenditure and
capital expenditure is made.
Cash flows should be estimated on incremental basis. Incremental cash flows are
found out by comparing alternative investment projects. The comparision may
simply be between cash flows with and without the investment proposal under
consideration when real alternatives do not exist.
Three components of cash flow can be identified – (1) Initial investment with
comprise the original cost (including freight and installation charges) of the
project, plus an increase in working capital. (2) Annual net cash flow is the
difference between cash inflows and cash outflows including taxes. Tax
computations are based on accounting profits. Care should be taken in properly
adjusting depreciation while computing net cash flows. Depreciation is a noncash
item, but it affects cash flows through tax shield (3) terminal cash flows are those
which occur in the project’s last year in addition to annual cash flows. They would
consist of the salvage value of the project and working capital released (if any). In
case of replacement decision, the foregone salvage value of old asset should also
be taken into account.
COST OF CAPITAL - The cost of capital is an expected return that the provider of
capital plans to earn on their investment. Capital (money) used for funding a
business should earn returns for the capital providers who risk their capital. For an
investment to be worthwhile, the expected return on capital must be greater than
the cost of capital. In other words, the risk-adjusted return on capital (that is,
incorporating not just the projected returns, but the probabilities of those
projections) must be higher than the cost of capital. The cost of debt is relatively
simple to calculate, as it is composed of the rate of interest paid. In practice, the
interest-rate paid by the company will include the risk-free rate plus a risk
component, which itself incorporates a probable rate of default (and amount of
recovery given default). For companies with similar risk or credit ratings, the
interest rate is largely exogenous.
Components - Cost of debt - The cost of debt is computed by taking the rate on
a risk free bond whose duration matches the term structure of the corporate debt,
then adding a default premium. This default premium will rise as the amount of
debt increases (since the risk rises as the amount of debt rises). Since in most
cases debt expense is a deductible expense, the cost of debt is computed as an
after tax cost to make it comparable with the cost of equity (earnings are after-tax
as well). Thus, for profitable firms, debt is discounted by the tax rate. Basically this
is used for large corporations only.
The formula can be written as (Rf + credit risk rate)(1-T), where T is the corporate
tax rate and Rf is the risk free rate.
Cost of equity - Cost of equity = Risk free rate of return + Premium expected for
risk. Expected return - The expected return (or required rate of return for
investors) can be calculated with the "dividend capitalization model", which is
That equation is also seen as, Expected Return = dividend yield + growth rate of
dividends. Capital asset pricing model - The capital asset pricing model (CAPM)
is used in finance to determine a theoretically appropriate price of an asset such
as a security. The expected return on equity according to the capital asset pricing
model. The market risk is normally characterized by the β parameter. Thus, the
investors would expect (or demand) to receive:
Where: Es - The expected return for a security
Rf - The expected risk-free return in that market (government bond yield)
βs - The sensitivity to market risk for the security
RM - The historical return of the stock market/ equity market
(RM-Rf) - The risk premium of market assets over risk free assets.
Weighted average cost of capital - The Weighted Average Cost of Capital
(WACC) is used in finance to measure a firm's cost of capital.
The total capital for a firm is the value of its equity (for a firm without outstanding
warrants and options, this is the same as the company's market capitalization)
plus the cost of its debt (the cost of debt should be continually updated as the cost
of debt changes as a result of interest rate changes). Notice that the "equity" in
the debt to equity ratio is the market value of all equity, not the shareholders'
equity on the balance sheet. To calculate the firm’s weighted cost of capital, we
must first calculate the costs of the individual financing sources: Cost of Debt Cost
of Preference Capital Cost of Equity Capital.
Capital structure - Because of tax advantages on debt issuance, it will be
cheaper to issue debt rather than new equity (this is only true for profitable firms,
tax breaks are available only to profitable firms). At some point, however, the cost
of issuing new debt will be greater than the cost of issuing new equity. This is
because adding debt increases the default risk - and thus the interest rate that the
company must pay in order to borrow money. By utilizing too much debt in its
capital structure, this increased default risk can also drive up the costs for other
sources (such as retained earnings and preferred stock) as well. Management
must identify the "optimal mix" of financing – the capital structure where the cost
of capital is minimized so that the firm's value can be maximized.
Modigliani-Miller theorem - If there were no tax advantages for issuing debt, and
equity could be freely issued, Miller and Modigliani showed that, under certain
assumptions, the value of a leveraged firm and the value of an unleveraged firm
should be the same. Their paper is foundational in modern corporate finance.
RISK - A fundamental idea in finance is the relationship between risk and return.
The greater the amount of risk that an investor is willing to take on, the greater the
potential return. The reason for this is that investors need to be compensated for
taking on additional risk.
For example, a U.S. Treasury bond is considered to be one of the safest
investments and, when compared to a corporate bond, provides a lower rate of
return. The reason for this is that a corporation is much more likely to go bankrupt
than the U.S. government. Because the risk of investing in a corporate bond is
higher, investors are offered a higher rate of return.
Techniques – Payback – It is one of the oldest and commonly used methods for
explicitly recognising risk associated with an investment project.
The merit of payback is its simplicity. Also payback makes an allowance for risk by
(i) focusing attention on the near term future and thereby emphasising the liquidity
of the firm through recovery of capital and (ii) by favouring short term projects over
what may be riskier, longer term projects.
Risk-Adjusted Discount Rate - In Portfolio Theory and Capital Budget analysis,
the rate necessary to determine the Present Value of an uncertain or risky stream
of income; it is the risk-free rate (generally the return on short-term U.S. Treasury
securities) plus a risk premium that is based on an analysis of the risk
characteristics of the particular investment or project. Evaluation – It is simple
and can be easily understood, It has a great deal of intuitive appeal for risk-averse
businessman, It incorporates an attitude (risk-aversion) towards uncertainty.
Certainty Equivalent - This is useful in determining what return investors will
require from your company. In other words, at what return would an investor in a
certain (risk-free) investment be enticed to invest in your higher paying, yet more
risky, investment. Evaluation – The certainty equivalent approach explicitly
recognises risk, but the procedure for reducing the forecasts of cash flows is
implicit and likely to be inconsistent from one investment to another. Further, this
method suffers from many dangers in a large enterprise. First, the forecaster,
expecting the reduction that will be made in his forecasts, may inflate them in
anticipation. Second, if forecasts have to pass through several layers of
management, the effect may be greatly exaggerate the original forecast or to
make it ultra conservative. Third, by focussing explicit attention only on the
gloomy outcomes, changes are increased for passing by some good investments.
Sensitivity analysis - A technique used to determine how different values of an
independent variable will impact a particular dependent variable under a given set
of assumptions. This technique is used within specific boundaries that will depend
on one or more input variables, such as the effect that changes in interest rates
will have on a bond's price.
Sensitivity analysis is a way to predict the outcome of a decision if a situation
turns out to be different compared to the key prediction(s).
Pros – It compels the decision maker to identify the variables which affect the
cash flow forecasts. This helps him in understanding the investment project in
totality. – It indicates the critical variables for which additional information may be
obtained. The decision maker can consider actions which may help in
strengthening the ‘weak spots’ in the project.
Cons – It does not provide clear cut results. The terms ‘optimistic’ and
‘pessimistic’ could mean different things to different persons in an organisation.
- It fails to focus on the interrelationship between variables.
FINANCIAL LEVERAGE - Financial leverage (FL) takes the form of a loan or
other borrowings (debt), the proceeds of which are (re)invested with the intent to
earn a greater rate of return than the cost of interest. If the firm's rate of return on
assets (ROA) is higher than the rate of interest on the loan, then its return on
equity (ROE) will be higher than if it did not borrow because assets = equity +
debt (see accounting equation). On the other hand, if the firm's ROA is lower than
the interest rate, then its ROE will be lower than if it did not borrow. Leverage
allows greater potential returns to the investor that otherwise would have been
unavailable but the potential for loss is also greater because if the investment
becomes worthless, the loan principal and all accrued interest on the loan still
need to be repaid.
Margin buying is a common way of utilizing the concept of leverage in investing.
An unleveraged firm can be seen as an all-equity firm, whereas a leveraged firm
is made up of ownership equity and debt. A firm's debt to equity ratio is therefore
an indication of its leverage.
Measures of financial leverage – The Ratio of debt to total capital – i.e.,
L1 = (D / D+S) = D/V, where D is value of debt, S is value of equity and V is value
of total capital. D and S may be measured in terms of book value or market value.
The book value of equity is called net worth.
The ratio of debt to equity i.e., L2 = D/S
The ratio of net operating income (or EBIT) to interest charges, i.e.,
L3 = EBIT / Interest
OPERATING LEVERAGE - The operating leverage is a measure of how revenue
growth translates into growth in operating income. It is a measure of leverage,
and of how risky (volatile) a company's operating income is. There are various
measures of operating leverage,[1] which can be interpreted analogously to
financial leverage. Costs - One analogy is "fixed costs + variable costs = total
costs ..similar to.. debt + equity = assets". This analogy is partly motivated
because (for a given amount of debt), debt servicing is a fixed cost. This leads to
two measures of operating leverage: One measure is fixed costs to total costs:
(FC/TC) = FC / (FC+VC).
Compare to debt to value, which is (Debt/Assets) = Debt / (Debt + Equity)
Another measure is fixed costs to variable costs: FC/VC.
Compare to debit to equity ratio: Debt/Equity
Contribution: Contribution margin is a measure of operating leverage: the higher
the contribution margin is (the lower variable costs are as a percentage of price),
the faster profits increase with sales. Note that unlike other measures of operating
leverage, in the linear Cost-Volume-Profit Analysis Model, contribution margin is a
fixed quantity, and does not change with Sales.
CAPITAL STRUCTURE - A mix of a company's long-term debt, specific short-
term debt, common equity and preferred equity. The capital structure is how a firm
finances its overall operations and growth by using different sources of funds.
Debt comes in the form of bond issues or long-term notes payable, while equity is
classified as common stock, preferred stock or retained earnings. Short-term debt
such as working capital requirements is also considered to be part of the capital
structure.
A company's proportion of short and long-term debt is considered when analyzing
capital structure. When people refer to capital structure they are most likely
referring to a firm's debt-to-equity ratio, which provides insight into how risky a
company is. Usually a company more heavily financed by debt poses greater risk,
as this firm is relatively highly levered.
The management of a company should seek answers to the following questions
while making the financing decisions:
- How should the investment project by financed, - Does the way in which the
investment projects are financed matter, - How does financing affect the
shareholders’ risk, return and value, - Does there exist an optimum financing mix
in terms of the maximum value to share-holders of a company, - Can the optimum
financing mix be determined in practice for a company, - What factors in practice
should a company consider in designing its financing policy.
Features: Profitability: The capital structure of the company should be most
advantageous. With the constraints, maximum use of leverage at a minimum cost
should be made. Solvency: The use of excessive debt threatens the solvency of
the company. To the point debt does not add significant risk it should be used,
otherwise its use should be avoided. Flexibility: The capital structure should not
be inflexible to meet the changing conditions. It should be possible for a company
to adapt its capital structure with a minimum cost and delay. Capacity The capital
structure should be determined within the debt capacity of the company, and this
capacity should not be exceeded. The debt capacity of a company depends on its
ability to generate future cash flows. It should have enough cash to pay creditors’
fixed charges and principal sum. Control The capital structure should involve
minimum risk of loss of control of the company. The owners of closely-held
companies are particularly concerned about dilution of control.
Three common approaches – EBIT-EPS Analysis – The use of fixed cost
sources of finance, such as debt and preference share capital to finance the
assets of the company is known as financial leverage or trading on equity. If the
assets financed with the use of debt yield a return greater than the cost of debt,
the earnings per share increases when the preference share capital is used to
acquire assets. Limitations – EPS variability – The EPS variability resulting from
the use of leverage is called financial risk. Financial risk is added with the use of
debt because of (a) the increase variability in the shareholders’ earnings and (b)
the threat of insolvency. A firm can avoid financial risk altogether if it does not
employ and debt in its capital increases in EPS. Therefore, a company may
employ debt to the extent the financial risk perceived by shareholders does not
exceed the benefit of increased EPS. The EPS criterion does not consider the
long-term perspectives of financing decisions. It fails to deal with the risk-return
trade-off. Operating Conditions – One very important factor on which the
variability of EPS depends is the growth and stability of sales. EPS will fluctuate
with fluctuations in sales. The magnitude of the EPS variability with sales will
depend on the degrees of operating and financial leverages employed by the
company. The firms with stable earnings and cash flows and thus, can employ a
high degree of leverage as they will not face difficult in meeting their fixed
commitments. Sale of the consumer goods industries show wide fluctuations,
therefore, they do not employ a large amount of debt. On the other hand, the
sales of public utilities are quite stable and predictable.
Trade-off Theory - The Trade-Off Theory of Capital Structure refers to the idea
that a company chooses how much debt finance and how much equity finance to
use by balancing the costs and benefits. The classical version of the hypothesis
goes back to Kraus and Litzenberger who considered a balance between the
dead-weight costs of bankruptcy and the tax saving benefits of debt. Often
agency costs are also included in the balance. This theory is often set up as a
competitor theory to the Pecking Order Theory of Capital Structure.
An important purpose of the theory is to explain the fact that corporations usually
are financed partly with debt and partly with equity. It states that there is an
advantage to financing with debt, the tax benefits of debt and there is a cost of
financing with debt, the costs of financial distress including bankruptcy costs of
debt and non-bankruptcy costs (e.g. staff leaving, suppliers demanding
disadvantageous payment terms, bondholder/stockholder infighting, etc). The
marginal benefit of further increases in debt declines as debt increases, while the
marginal cost increases, so that a firm that is optimizing its overall value will focus
on this trade-off when choosing how much debt and equity to use for financing.
Despite certain criticisms, the Trade-Off Theory remains the dominant theory of
corporate capital structure as taught in the main corporate finance textbooks.
Dynamic version of the model generally seem to offer enough flexibility in
matching the data so, contrary to Miller's verbal argument, dynamic trade-off
models are very hard to reject empirically.
Cash flow approach – One of the features of a sound capital structure is
conservatism. Conservatism does not mean employing no debt or small amount
of debt. Conservatism is related to the fixed charges created by the use of debt or
preference capital in the capital structure and the firm’s ability to generate cash to
meet these fixed charges. In practice, the question of the optimum (rather
appropriate) debt-equity mix boils down to the firm’s ability to service debt without
any threat and operating inflexibility. A firm is considered prudently financed if it is
able to service its fixed charged under any reasonably predictable adverse
conditions.
The fixed charges of a company include payment of interest, preference dividends
and principal, and they depend on both the amount of senior securities and the
terms of payment. The amount of fixed charges will be high if the company
employs a large amount of debt or preference capital with short-term maturity.
Whenever a company thinks of raising additional debt, it should analyse its
expected future cash flows to meet the fixed charges. It is mandatory to pay
interest and return the principal amount of debt.
Components – Operating cash flows relate to the operations of the firm and
can be determined from the projected profit and loss statements. Nonoperating
cash flows generally include capital expenditures and working capital changes.
During a recessionary period, the firm may have to specially spend for the
promotion of the product. Such expenditures should be included in the non-
operating cash flows. Financial flows includes interest, dividends, lease rentals,
repayment of debt etc.
DIVIDENDS - 1. A distribution of a portion of a company's earnings, decided by
the board of directors, to a class of its shareholders. The dividend is most often
quoted in terms of the dollar amount each share receives (dividends per share). It
can also be quoted in terms of a percent of the current market price, referred to as
dividend yield.
Also referred to as "Dividend Per Share (DPS)."
2. Mandatory distributions of income and realized capital gains made to mutual
fund investors.
3. Dividends may be in the form of cash, stock or property. Most secure and
stable companies offer dividends to their stockholders. Their share prices might
not move much, but the dividend attempts to make up for this.
High-growth companies rarely offer dividends because all of their profits are
reinvested to help sustain higher-than-average growth.
4. Mutual funds pay out interest and dividend income received from their portfolio
holdings as dividends to fund shareholders. In addition, realized capital gains from
the portfolio's trading activities are generally paid out (capital gains distribution) as
a year-end dividend.
Types - Cash dividends (most common) are those paid out in the form of a
cheque. Such dividends are a form of investment income and are usually taxable
to the recipient in the year they are paid. This is the most common method of
sharing corporate profits with the shareholders of the company. For each share
owned, a declared amount of money is distributed.
Stock or scrip dividends are those paid out in form of additional stock shares of
the issuing corporation, or other corporation (such as its subsidiary corporation).
They are usually issued in proportion to shares owned (for example, for every 100
shares of stock owned, 5% stock dividend will yield 5 extra shares).
Property dividends or dividends in specie (Latin for "in kind") are those paid out
in the form of assets from the issuing corporation or another corporation, such as
a subsidiary corporation. They are relatively rare and most frequently are
securities of other companies owned by the issuer, however they can take other
forms, such as products and services.
Other dividends can be used in structured finance. Financial assets with a
known market value can be distributed as dividends; warrants are sometimes
distributed in this way. For large companies with subsidiaries, dividends can take
the form of shares in a subsidiary company. A common technique for "spinning
off" a company from its parent is to distribute shares in the new company to the
old company's shareholders.
Constraints – Legal Constraints - Most state securities regulations prevent firms
from paying out dividends from any portion of the company’s “legal capital” which
is measured by the par value of common stock—or par value plus paid-in-
capital.--- Dividends are also sometimes limited to the sum of the firm’s most
recent and past retained earnings— although payments in excess of current
earnings is usually permitted. Contractual Constraints - In many cases,
companies are constrained in the extent to which they can pay dividends by
restrictive provisions in loan agreements and bond indentures. -- Generally, these
constraints prohibit the payment of cash dividends until a certain level of earnings
are achieved or to a certain dollar amount or percentage of earnings. Internal
Constraints - A company’s ability to pay dividends is usually constrained by the
amount of available cash rather than the level of retained earnings against which
to charge them. Growth Prospects - Newer, rapidly-growing firms generally pay
little or no dividends. -- Because these firms are growing so quickly, they must use
most of their internally generated funds to support operations or finance
expansion. Owner Considerations - As mentioned earlier, empirical evidence
supports the notion that investors tend to belong to “clienteles” - where some
prefer high dividends, while others prefer capital gains.
WORKING CAPITAL – 2 concepts – Gross concept and net concept – Gross –
simply called as working capital, refers to the firm’s investment in current assets.
Current assets are the assets which can be converted into cash within an
accounting year (or operating cycle) and include cash, short-term securities,
debtors, bills receivables and stock (inventory). Net refers to the difference
between current assets and current liabilities. Current liabilities are those claims
of outsiders which are expected to mature for payment within an accounting year
and include creditors, bills payable, and outstanding expenses. Net working
capital can be positive or negative. A positive net working capital will arise when
current assets exceed current liabilities. A negative net working capital occurs
when current liabilities are in excess of current assets.
The two concepts of working capital – gross and net – are not exclusive, rather
they have equal significance from management viewpoint. The gross working
capital concept focuses attention on two aspects of current assets management
(a) optimum investment in current assets and (b) financing of current assets.
Decisions relating to working capital and short term financing are referred to as
working capital management. These involve managing the relationship between a
firm's short-term assets and its short-term liabilities. The goal of working capital
management is to ensure that the firm is able to continue its operations and that it
has sufficient cash flow to satisfy both maturing short-term debt and upcoming
operational expenses. Decision Criteria - By definition, working capital
management entails short term decisions - generally, relating to the next one year
period - which are "reversible". These decisions are therefore not taken on the
same basis as Capital Investment Decisions (NPV or related, as above) rather
they will be based on cash flows and / or profitability. Management of working
capital - Guided by the above criteria, management will use a combination of
policies and techniques for the management of working capital. These policies
aim at managing the current assets (generally cash and cash equivalents,
inventories and debtors) and the short term financing, such that cash flows and
returns are acceptable.
Requirement – (1) Fixed assets alone cannot generate sales and profit. The
managerial activities required to operate this assets in order to generate sales
and profit are referred to as the firm’s operating activities. These activities require
investments in the form of inventories and trade receivables that are generated by
the firm’s operating cycle. (2) Operating cycle starts with procurement, the act of
acquiring raw materials. It is followed by production, during which raw materials
are transformed into finished goods. The cycle continuous with the sales of these
goods, ending when cash is collected from customers. The cycle repeats itself as
long as the firm’s production activity continuous. (3) Working capital is of two
types; viz. Gross working capital and Net working capital. Gross working capital
refers to the firm’s investment in current assets. Deducting current liabilities from
Gross working capital results in Net working capital. (4) There are two primary
sources of capital available to firms: the equity capital provided by owners
(shareholders) and the debt capital provided by debt holders (lenders). Debt can
be of short term, due to be repaid within a fiscal & of long term, due to be repaid
after that fiscal. Thus, the firm’s total capital employed can be classified either as
equity and debt capital or as Long-term financing and Short-term financing.
CASH MANAGEMENT – Cash is the important current asset for the operations of
the business. Cash is the basic input needed to keep the business running on a
continuous basis; it is also the ultimate output expected to be realised by selling
the service or product manufactured by the firm. The firm should keep sufficient
cash, neither more nor less. Cash shortage will disrupt the firm’s manufacturing
operations while excessive cash will simply remain idle, without contributing
anything towards the firm’s profitability.
Cash management is concerned with the managing of – (i) cash flows into and
out of the firm, (ii) cash flows within the firm, (iii) cash balances held by the firm at
a point of time by financing deficit or investing surplus cash. It can be represented
by a cash management cycle. Sales generate cash which has to be disbursed
out. The surplus cash has to be invested while deficit has to be borrowed. Cash
management seeks to accomplish this cycle at a minimum cost. At the same, it
also seeks to achieve liquidity and control.
4 facets of cash management – Cash planning, Managing the cash flows,
Optimum cash level, Investing surplus cash.
Why Hold Cash – transactions motive, precautionary motive, speculative motive.
ACCURED EXPENSES - Accrual, in accounting, describes the accounting
method known as accrual basis, whereby revenues and expenses are recognized
when they are accrued, i.e. accumulated (earned or incurred), regardless when
the actual cash is received or paid out.
Accrued expense, in contrast, is a liability with an uncertain timing or amount,
but where the uncertainty is not significant enough to qualify it as a provision. An
example is an unpaid obligation to pay for goods or services received FROM a
counterpart, while cash for them is to be paid out in a latter accounting period
when its amount is deducted from accrued expenses.
DEFERRED INCOME - Deferred income, in accrual accounting, (e.g. advance
payment received from a client) is, according to revenue recognition, revenue not
earned until the delivery of goods or services, which until then, is still owed to the
payer, hence remaining a liability.
Deferred income, sometimes referred to as deferred revenue or unearned
revenue, shares characteristics with accrued expense with the difference that a
liability to be covered later is cash received FROM a counterpart, while goods or
services are to be delivered in a latter period, when such income item is earned,
the related revenue item is recognized, and the same amount is deducted from
deferred revenues.
INVENTORY - Possessing a high amount of inventory for long periods of time is
not usually good for a business because of inventory storage, obsolescence and
spoilage costs. However, possessing too little inventory isn't good either, because
the business runs the risk of losing out on potential sales and potential market
share as well.
Inventory management forecasts and strategies, such as a just-in-time inventory
system, can help minimize inventory costs because goods are created or received
as inventory only when needed.
Time – (1) The time lags present in the supply chain, from supplier to user at
every stage, requires that you maintain certain amount of inventory to use in this
"lead time". (2) Uncertainty - Inventories are maintained as buffers to meet
uncertainties in demand, supply and movements of goods. (3) Economies of scale
- Ideal condition of "one unit at a time at a place where user needs it, when he
needs it" principle tends to incur lots of costs in terms of logistics. So bulk buying,
movement and storing brings in economies of scale, thus inventory.
All these stock reasons can apply to any owner or product stage.
Buffer stock is held in individual workstations against the possibility that the
upstream workstation may be a little delayed in long setup or change-over time.
This stock is then used while that change-over is happening. This stock can be
eliminated by tools like SMED.
These classifications apply along the whole Supply chain not just within a facility
or plant.
TECHNIQUES - Economic order quantity is the level of inventory that minimizes
the total inventory holding costs and ordering costs. The framework used to
determine this order quantity is also known as Wilson EOQ Model. The model
was developed by F. W. Harris in 1913. But still R. H. Wilson is given credit for his
early in-depth analysis of the model. Assumptions - The ordering cost is
constant., The rate of demand is constant., The lead time is fixed., The purchase
price of the item is constant i.e no discount is available., The replenishment is
made instantaneously, the whole batch is delivered at once., EOQ is the quantity
to order, so that ordering cost + carrying cost finds its minimum. (A common
misunderstanding is that formula tries to find when these are equal.)
Ordering Costs - All costs associated with preparing a purchase order. These
include the cost of preparing a purchase invoice, telephone, salaries of
purchasing clerks, and stationery.
Carrying Costs - Cost incurred for maintaining a given level of inventory are
called carrying costs. They include storage, insurance, taxes, deteriorations and
obsolescence. The storage costs comprise cost of storage space, clerical and
staff service costs incurred in recording and providing special facilities such as
fencing, lines, racks etc.
ABC Analysis - ABC analysis is a business term used to define an inventory
categorization technique often used in materials management.
ABC analysis provides a mechanism for identifying items which will have a
significant impact on overall inventory cost [1] whilst also providing a mechanism
for identifying different categories of stock that will require different management
and controls. When carrying out an ABC analysis, inventory items are valued
(item cost multiplied by quantity issued/consumed in period) with the results then
ranked. The results are then grouped typically into three bands[3]. These bands
are called ABC codes. ABC codes "A class" inventory will typically contain items
that account for 80% of total value, or 20% of total items. "B class" inventory will
have around 15% of total value, or 30% of total items. "C class" inventory will
account for the remaining 5%, or 50% of total items.
ABC Analysis is similar to Pareto in that the "A class" group will typically account
for a large proportion of the overall value but a small percentage of the overall
volume of inventory.
TRADE CREDIT - Trade credit exists when one firm provides goods or services to
a customer with an agreement to bill them later, or receive a shipment or service
from a supplier under an agreement to pay them later. It can be viewed as an
essential element of capitalization in an operating business because it can reduce
the required capital investment to operate the business if it is managed properly.
Trade credit is the largest use of capital for a majority of business to business
(B2B) sellers in the United States and is a critical source of capital for a majority
of all businesses. For many borrowers in the developing world, trade credit serves
as a valuable source of alternative data for personal and small business loans.
For example, Wal-Mart, the largest retailer in the world, has used trade credit as a
larger source of capital than bank borrowings; trade credit for Wal-Mart is 8 times
the amount of capital invested by shareholders.
There are many forms of trade credit in common use. Various industries use
various specialized forms. They all have, in common, the collaboration of
businesses to make efficient use of capital to accomplish various business
objectives.
CREDIT TERMS - Standard or negotiated terms (offered by a seller to a buyer)
that control (1) the monthly and total credit amount, (2) maximum time allowed for
repayment, (3) discount for cash or early payment, and (4) the amount or rate of
late payment penalty.
The conditions under which credit will be extended to a customer. The
components of credit terms are: cash discount, credit period, net period.