Alluri Institute Of Management Sciences For Professionals

UNIT – IV
WORKING CAPITAL DESICION

1. INTRODUCTION:

Working capital refers to the investment by a company in short-term assets such as cash,
marketable securities, accounts receivables and inventories. A study of working capital is of
major importance to internal and external analysis because of its close relationship with
the current day to day operations of business.
Business needs funds for the purpose of its establishment and to carry out its day-to-
day operations. Long-term funds are required to create production facilities through
purchase fixed assets such as plant & machinery, land & buildings, furniture etc. investment
in these assets represents the part of firm's capital, which is blocked on a permanent or
fixed and is called fixed capital, Funds are also needed for short-term purpose for the
purchase of raw materials, payments of wages and other day-to-day expenses etc., these funds
are known as working capital.
Working capital is one of the most important requirements of any business concern.
Working capital can be compared with the -blood of human beings. As human cannot
survive without blood, in the same way on business cannot survive without working capital.
Working capital management deals with maintaining the levels of working capital
to optimum, because if a concern has inadequate opportunities if the working capital is more
than required the concern will loose money in form of interest on the block funds.
Therefore working capital management plays a very vital role in profitability of a
company.

2. DEFINITON AND MEANING:

Working capital is defined as excess of current assets over current liabilities.
Management of working capital includes management of all current-assets and current
liabilities. The interaction between current assets and current liabilities is the main theme of
the theory of working capital management.

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2.1 J.S.Mill: “The Sum of the current assets is the working capital of a business”.

2.2 Bonneviulle and Dewey: “Any acquisition of funds which increases the current
assets, increased working capital, for they are one and the same”.

2.3 C.W. Gerstenberg: “Working capital has ordinarily been defined as the excess of
current assets over current liabilities.”
Working capital is commonly used for the capital required for day to day working in
a business concern, such as purchasing raw material for meeting day to day expenditure
on salaries, wages, rent rates, advertising etc.
Current Working capital measures how much in assets a company has available to build
its business. The number can be positive or negative, depending on how much debt the
company
Cash is the lifeline of a company. If this lifeline deteriorates, so does the company's
ability to fund operations, reinvest and meet capital requirements and payments.
Understanding a company's health is essential to making investment decisions. A good
way to judge a company's cash flow prospects is to look at its Working Capital
Management (WCM).

3. NEED FOR WORKING CAPITAL:

The basic objective of financial management is to maximize the shareholder wealth.
This is possible only when company earns sufficient profits. The amount of such profits
largely depends upon the magnitude of sales. However sales convert into cash
instantaneously. There is always time gap between sale for goods and their actual
realization working capital required in order to sustain the sales activities in this period.
In case adequate working capital is not available for this period the company will not be in a
position to purchase raw material, pay wages and other expenses required for, manufacturing the
goods. Therefore sufficient amount of working capital is to be maintained at nay point time.

4. ADEQUACY OF WORKING CAPITAL:

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A firm must have -adequate working capital is as much as needed by the firm. It should neither
be excessive nor in adequate. Both the situation is harmful to the concern. Excessive working
capital is the firm as ideal funds which earns no profits for the firm inadequate working capital
means the firm does not have funds to perform operations which means ultimately results in
production interruptions and lowering down of the profitability. It will be interesting to understand
the relationship between working capital, risk return in manufacturing concern it is
generally accepted that higher levels of working capital decrees the risk and have the
potential of increasing the profitability also.
ASSUMNPTION:

There is a direct relationship risk and profitability, higher the risk higher the profitability,
while lower the risk lower the profitability. Current assets are less profitable than fixed assets...
Short-term funds are less expensive than long-term funds. On account of above principles, an
increasing in the ratio of current assets to total assets will be result in the decline of the
profitability of the firm, This is because investment in current assets as started above is less
profitable than in the fixed assets, However an increase in the ratio would decrease the risk
of the firm becoming technically insolvent. On the other hand a decrease in the ratio of
current assets to total assets would increase the profitability of the firm because
investment in fixed assets is more profitable then investment in current assets. However
this increases the risk of becoming insolvent on account of its possible inability in meeting its
commitments in time due to shortage of funds.

5. CONCEPT OF WORKING CAPITAL:

There are two concepts of working capital. They are:
 Gross Working Capital
 Net working Capita
5.1 GROSS WORKING CAPITAL:
It is the total of all the current assets, which include inventories, sundry debtors, and cash in
hand, and bank, advances, investments, short term deposits etc.

5.2 NET WORKING CAPITAL:

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It is the excess of current assets over current liabilities; this is as a matter of fact the
most commonly accepted definition. In other words it can also be defined as difference
between current assets and current assets and current liabilities.
It is that portion of a firm's current assets, which is financed with long-term funds.

6. OPERATING CYCLE:
Working capital is required for a business because of the time gap between the sales
and their actual realization in cash. The time gap is technically called an operating cycle
of the Business fig -3 illustrates the operating cycle of a firm working capital
management involves management of different components of working capital such as
account receivable and i9nventories for determining the size and method of financing.
A brief description of various issues involved in the management of each of the
component of working capital is here below. Adequate cash balance have to maintained
so that no fund are blocked in idle cash which involves costs in terms if interest.
Adequate cash is required to meet business obligation as and when they raise. Cash
requirement also arise to meet unforced contingencies such as stake, increase in the price
of raw material, and fall in the collocation of the account receivable. The grater is the
possibilities of contingencies. The greater amount of fund required to maintain by the
firm.
Adequate cash is also required to take the advantages of unexpected Business
opportunities. The management of cash is aimed to meet the obligation as per the
payment schedule and to minimize the amount of idle cash balance. Inventories include
raw material, work in progress and finished good inventories. The maintenance of these
levels of inventories depend upon the nature of business.
Adequate inventories protect the firm from the losses on account of shortage or delay in
production price variations and defer ratio of stock. Accounts receivable constitute a
significant portion of the hotel current assets of a business. Accounts receivable are the
results of goods or credit intended increase the scale volume and thereby increase in the
profits of the business. Management of accounts receivable is aimed to ensure liquidity.
Higher level of accounts receivable to be bad debt and inverse the collection cost.

Working capital can be divided into categories on the basis of time.

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 Permanent working capital / fixed working capital

 Temporary working capital / variable working capita

Cash
Raw material

Work in
progress
Account
receivable

Finished
Sales goods

OPERATING CYCLE

6.1 ESTIMATION OF OPERATING CYCLE:

Since working capital is excess of current assets over current liabilities, the forecast for
working capital requirements can be made only after estimating the amount of different
constituent's working capital.
I. Inventories
 Stock of raw materials
 Work - in – process
 Finished goods
II. Sundry debtors
III. Cash and bank balances
IV. Sundry creditors

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V. Outstanding expenses

6.1.1INVENTORIES:
The terms inventories include stock of raw materials, work - in - process and finished
goods. The estimation of each of them will be made as follows:

 STOCK OF RAW MATERIALS: The average amount of raw materials to be kept in

stock will depends upon the quantity of raw material required for production during a
particular period and the average time taken in obtaining a fresh delivery.
 WORK- IN-PROCESS: The cost of work - in - process includes raw materials, wages
and overheads. In determining the amount of work in process, the time period for which
the good will be in the course of production process, is most important.
 FINISHED GOODS: The finished goods are kept in warehouse and according to the orders of
the customers, goods will be delivered.

6.1.2.SUNDRY DEBTORS: Debtors are those persons who will be purchase goods on credit
basis. The sundry' debtors will-be calculated on the basis of credit sales.
6.1.3. CASH AND BANK BALANCES: The amount of money to be kept as cash in hand or cash at
bank can be estimated on the basis of past experience.
6.1.4. SUNDRY CREDITORS: The lag in payment to suppliers of raw materials, goods, etc.,
and likely credit purchase to be made during the period will be help in estimating the amount of
creditors.
6.1.5 OUTSTANDING EXPENSES: The time lag in payment of wages and other expenses will
be help in estimation of outstanding expenses.

7. SOURCES OF WORKING CAPITAL:

There are mainly two types of sources of working capital, they are as follows:

7.1 PERMANENT OR FIXED OR LONG TERM WORKING CAPITAL:

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 SHARES: Issue of shares is the most important share for raising the permanent or
long-term capital. A company can issue various types of shares, preference share and
deferred share.
 DEBENTURES: A debenture is an instrument issued by the company
acknowledging its debts to its holder it is also an important method of raising long
term permanent working capital
 PUBLIC DEPOSITS: Public deposits are the fixed deposits accepted by a business
enterprise directly popular in the absence of banking facilities.
 LOANS FROM FINANCIAL INSTITUTION : Financial Institutions such as commercial
Banks, industrial finance corporations of India, state financial corporations.

7.2 TEMPORARY OR VARIABLE FOR SHORT-TERM WORKING CAPITAL:

 TRADE CREDIT: Trade credit ref ers to the credit extended by the suppliers
of goods in the normal coerce of business. As present day commerce is built
upon credit, the trade credit arrangement of a firm with its suppliers is an
important source of short-term finance.
 I NDIGENOUS BUSINESS: Private money-lenders and other is country banks used
to be the only sources of finance prior to the establishment of commercial
banks. They used to change very higher rates of interest and exploited the
customers to the largest extent possible.
 DEFERRED INCOMES: Deferred incomes are incomes received advances before
supplying goods or services. They represent funds received by a firm for which
it has to supply goods or services in future.
 COMMERCIAL PAPER: Commercial paper represents unsecured promissory notes
issued by firms to raise short-terms funds. It is an important money market
instrument in advanced countries like U.S.A. In India, the reserve bank of India
introduced commercial paper in the Indian Money Market on the
recommendations of the working capital upon money market (Vague -
Committee)
8. FACTORS DETERMINING THE WORKING CAPITAL

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The working capital requirements of a concern depends upon a large number of

factors such as nature and size of the business, scale of it’s operations etc. However the
following are the important factors generally influencing the working capital
requirements.
8.1Nature of the business: The working capital requirements of a firm are basically
influenced by the nature of it’s business. Firms engaged in trading and financing activities
make very heavy investment in current assets as compared to the investment in fixed
assets, whereas in the case of rail and road transport and other public utility services steel,
Aluminum, Automobile industries, working capital forms a relatively low proportion of
total assets.

8.2 Operating Cycle: The operating cycle implies the stages of process through which
the raw materials are processed to get the final product. If the process is lengthy and takes
long time to get the finished products, the requirement of working capital will be much
larger than that of a unit which has a relatively low operating cycle. The shortest
manufacturing process will minimize the investment in the form of work in progress.

8.3 Seasonal Elements: The requirements of working capital to a company is influenced

by the demand for the product. If the firm’s product is seasonal demand oriented, not only
the amount of working capital fluctuates from one season to other, but also the
composition of working capital changes over the time. During the season cash and bank
balances are converted into inventory. The working capital level will increase and cash
balances may reduce.

8.4 Growth and expansion of business: The working capital requirements of the firm
will increase as it grows in terms of sales or fixed assets. Current assets are closely
related with that of sales. The requirements of working capital for a growing firm will be
more. A growing company has to maintain proper balance between fixed and current
assets in order to sustain it’s growing production and sales. This will in turn increase the
investment in current assets to support the increased sale of operations.

8.5 Firm’s credit policy: The Credit policy of the firm affects working capital by
influencing the debtor balances. The credit terms of a company may also depend upon the

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industry credit norms. If a company follows a liberal credit policy, without following
norms of credit, it will result in more credit sales, increased book debts and increased
investment in working capital.

8.6 Turnover of Current Assets: Turnover of current assets refers to the speed at which
the components of current assets can be converted into cash. The greater the turnover is,
greater will be the cash flow and lesser will be the level of working capital. If the
turnover is low, the company can witness heavy pilling up of various components of
current assets and increased level of working capital.

8.7 Availability of Credit: The level of working capital of a company also depends upon
the credit facility available to it. The firm will need less working capital, if liberal credit
terms are available. The availability of credit facility from Commercial Banks also
influences working capital needs of the firm. Generally, if a firm gets credit facility
easily, on favourable conditions, it can operate with less working capital than a firm
without such facility.

8.8 Dividend policy: Dividends are paid to shareholders of the company out of the
profits. The payments of dividend result in cash out flow. Further, a desire to maintain an
established dividend policy may affect the company by reducing the cash balances. It will
cause changes in the level of working capital. Often changes in working capital also bring
an adjustment in the dividend policy. Shortage of working capital therefore, acts as a
powerful reason for reducing or skipping a cash dividend.

8.9 Taxation: Taxation is a short-term liability payable in cash. Advance payment of tax
may have to be paid on the basis of anticipated profits. Higher the tax, greater is the strain
on the working capital of the company.
8.10 Government Regulations and Restrictions: Regulations and restrictions by the
Government and Reserve bank of India through such controls, as credit control, import
regulations, influence the working capital of companies.

9. INVENTORY MANAGEMENT

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Management of inventories means an optimum investment in inventories, it should

neither be too low to effect the production adversely nor too high to block the funds.
Unnecessary investment in inventories is unprofitable for business. Inventories are one of the
major elements, which help the firm in obtaining the desired level of sales. Inventories mean
the stock of the product of a company and components of the products, which include raw
materials, work - in - process and finished goods. Inventories constitute about 60 percent of
current assets of public limited companies in India.
The term inventory refers to the stockpile of the product, a firm is offering for sale
and the components that make up the product. In other words, inventory is composed of
assets that will be sold future in the normal course of business operations.
The manufacturing companies hold inventories in the form of
1) Raw materials inventory(pre-production)
2) Work in process inventory(in process) and
3) Finished goods inventory.
Raw material inventory consists of those basic inputs that are converted into
finished products through the manufacturing process. Raw material inventories are those
units which are have been purchased and stored for future production.
Work in process inventories are semi-manufactured products. They represent
products that need more work before they become finished products for sales.
Finished goods inventories and those completely manufactured products which
are ready for sale.

10. NEED TO HOLD INVENTORIES:-

There are three general motives for holding inventories.

1) Transaction motive:- emphasizes the need to maintain inventories to facilitate

smooth production and sales operation.
2) Precautionary:- motive necessitates holding of inventories to guard against the
risk of unpredictable changes in demand and supply forces and other factors.

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3) Speculative motive:- influences the decision to increase or reduce inventory

levels to take a advantage of price fluctuations.
11. OBJECTIVES OF INVENTORY MANAGEMENT:-
In the context of inventory management, the firm is faced with the problem of meeting
two conflicting needs:-
1) To maintain a large size of inventory for efficient and smooth production and
sales operations.
2) To maintain a minimum investment in inventories to maximize profitably.
3) To ensure continuous supply of materials, spares and finished goods so that
production should not suffer of any time and the customers demand should also
be met.
4) To avoid both over-stocking and under-stocking of inventory.
5) To maintain investments in inventories at the optimum level as required by the
operational and sales activities.
6) To minimize losses through deterioration, pilferage wastage and damages.
Inventories represent the investment of a firm’s funds. Thus a firm should always avoid a
situation of over investment or under investment in inventories.
11.1 Problems of over investment.
1) Unnecessary tie ups of the firm’s funds and loss of profits
2) Excessive carrying costs
3) Risk of liquidity
11.2 Consequences of under investment.
1) Production hold-ups
2) Failure of meet delivery commitments.
Thus an effective inventory manager should
 Ensure a continuous supply of raw material to facilitate uninterrupted production.
 Maintain sufficient finished goods inventory for smooth sales operation and efficient
customer service.
 Maintain sufficient stock of raw material in periods of short supply and anticipate
price changes.
 Control investment in inventories and keep it at an optimum level.

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12. RECEIVABLES MANAGEMENT

The term receivable is defined as “debt owned to the firm by customer arising from
sale of goods or services in the ordinary course of business.” When a firm makes an
ordinary sale of goods or services and does not receive payment, the firm grants trade
credit and creates accounts, receivables which would be collected in the future.
Receivable management is also called trade credit management. Thus accounts
receivable represent an extension of credit to customers, allowing them a reasonable
period of them in which to pay for the goods which they have received.
A firm’s investment in account receivables depends upon
a) Volume of credit sales, and
b) The collection period.
The volume of credit sales is a function of the firm’s total sales and the percentage of
credit sales to total sales. Total sales depend on market size, firm’s market share product
quality, intensity of competition, economic conditions, etc.
The financial manager hardly has any control over these variables. The percentage of
credit sales to total sales is mostly influenced by the nature of business and industry
norms.
The term credit policy is used to denote a combination of these decision variables.
1) Credit standard
2) Credit terms, and
3) Collection efforts on which the financial manager had influence.
Credit standards are criteria to decide the types of customers to whom goods could be
sold on credit.
Credit terms specify duration of credit and terms of payment by customers.
Credit efforts determine the actual collection period.
The average collection period ratio represents the average number of days for which
firm has to wait before its receivables are converted in to cash. It measures the quality of
debtors generally, the shorter the average collection period the better is the quality of
debtors as a short collection period implies quick payment of debtors similarly a higher
collection period implies as inefficient collection performance which in turn adversely
affects the liquidity or short-term paying capacity of a firm out of its current liabilities

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moreover longer the average collection period larger are the chances of bad debtors. But a
precaution i.e., needed while interpreting a very short collection period because a very
low collection period may imply a firm’s conservative policy to sell on credit or its
inability to allow credit to its customer and thereby losing sales and profits. If possible
stock figures at the beginning and at the end of every month should be taken and added
up and thus should be divided by 13 to get a proper average. In questions the stock
figures are not given for different months. Rather inventory in the beginning and at the
end of the year is given; so the average of these two figures should be taken.

13. OPTIMUM COLLECTION POLICY

Optimum collection policy is one which maximizes the firm’s value. The value of the
firm is maximized when the incremental rate of return or marginal rate of return of an
investment is equal to the incremental cost of funds used to finance the investment. The
incremental rate of return can be calculated as incremental profit divided by the
incremental investment in receivables.

The incremental cost of fund is the rate of return required by the supplies of fund,
given the risk of investment rate. Higher the risk of investment, higher the required rate
of return. The firm looses its credit policy, its investment in accounts receivable become
more risky because of increase in slow paying and defaulting accounts.
14. CASH MANAGEMENT:
Cash is the most important current asset for the operation 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 realized 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.
Thus a major function of the financial manager is to maintain a sound cash
position.
14.1 Cash management is concerned with managing of
1. Cash flows into and out of the firm.

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2. Cash flows within the firm, and

3. Cash balances held by the firm at a point time by financing deficit of investing surplus
cash.
15. FACTS OF CASH MANAGEMENT:
In order to resolve the uncertainty about flow prediction and lack of
Synchronization between cash receipts and payments the firm should develop appropriate
for cash management. The firm should evolve strategies regarding the following four
facets of cash management.

1) Cash planning: Cash inflows and out flows should be planned to project cash
surplus or deficit for each period of the planning period. Cash budget should be
prepared for this purpose.

2) Optimum cash level: The firm should decide about the appropriate level of cash
balances. The cost of excess cash and danger of cash deficiency should be
matched to determine the optimum level of cash balances.

3) Managing the cash flows: The flow of cash should be properly managed. The
cash inflows should be accelerated while, as far as possible, decelerating the cash
outflows.

4) Investing surplus cash: The surplus cash balances should be properly invested to
cash profits. The firm should decide about the division of such cash balances
between bank deposits, marketable securities and inter corporate lending.

16. MOTIVES FOR HOLDING CASH

1) The transaction Motives:
The transaction motive requires a firm to hold cash to conduct its business in the
ordinary course. The firm needs cash primarily to make payments for purchases, wages
and salaries other operating expenses, taxes, dividends, etc. Profitability will be
increased only when the operating needs are met promptly.

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2) The Precautionary Motives:

The precautionary motive is the need to hold cash to meet contingencies in future.
The precautionary motive provides a cushion or buffer to withstand some unexpected
emergency.
Stronger the ability of the firm to borrow at short notice, less the need of
precautionary balances. These balances may be kept in cash and marketable securities.
3) The speculative Motive:
The speculative motive relates to the holding of cash for investing in profit
making opportunities as and when they arise. Changes in security price may provide such
opportunities to make profits.
The firm will hold cash when it is expected that interest rates will rise and
security prices change.

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UNIT - V
DIVIDEND DECISIONS
1. INTRODUCTION
A business organization always aims at earning profits. The utilization of profits
earned is a significant financial decision. The main issue here is whether the profits
should be used by the owners or retained and reinvested in the business itself. This
decision does not involve any problem so far as the sole proprietary business is
concerned. In case of a partnership the agreement often provides for the basis of
distribution of profits among partners. The decision-making is somewhat complex in the
case of joint stock companies only. The decisions regarding dividend is taken by their
Board of directors and is meeting of the company. Disposal of profits in the form of
dividends can become a controversial-issue because of conflicting interests if various
parties like the directors, employees, shareholders, debenture holders, lending
institutions, etc. even among the shareholders there may be conflicts as they may belong
to different income groups. While some may be interested in regular income, others may
be interested in capital appreciation and capital gains. Hence, formulation of dividend
policy is a complex decision. It needs careful consideration of various factors, one thing,
however, standout. Instead of an ad hoc approach, it is more desirable to follows a
reasonably long term policy regarding dividends.

2. DIVIDEND POLICY
The objective of corporate management usually is the maximization of the market
value of the enterprise i.e., its wealth. The market value of common stock of a company
is influenced by its policy regarding allocation of net earnings into plough back and
payout while maximizing the market value of shares, the dividend policy should be so
oriented as to satisfy the interests of the existing shareholders as well as to attract the
potential investors and the appreciation in the market price of share.

3. FACTORS AFFECTING THE SHAPING OF DIVIDEND POLICY

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Normally dividend policy of any organization is influenced by many factors,

namely known as Nature of business, management policy and philosophy and other
factors. Those factors are discussed in detail in the following lines
3.1 Nature of Business
This is an important determinant of the dividend policy of a company. Companies
with unstable earnings adopt dividend policies, which are different from those which
have steady earnings. Consumer good industries usually suffer less from uncertainties of
income and therefore, pay dividends with greater regularity than the capital goods
industries. Industries with stable income are in a position to formulate consistent dividend
rate. Mining companies on the other hand, with long gestation period and multiplicity of
hazards, may not be able to declare dividends payments. If earnings fluctuate and losses
are caused during depression, the continued payment of dividends may become a risky
proposition.
A company with ‘wasting assets such as timber, oil or mines-which get depleted over
time may well pursue a policy of gradually returning capital to its owners because its
resources are going to be exhausted. Such a company may offer dividends, which
include, in part a return of the owner investment.
Generally speaking large and mature companies pay a reasonable good but not a
excessive rate of dividend. Excessive dividends may be paid only by mushroom
companies. A healthy company with an eye on future follows a somewhat cautious policy
and build up reserves. A company which believes in publicity gimmicks may follow a
more liberal; dividend policy to its future detriment. A firm with a heavy programme of
investments in research and development would see to it that adequate reserves are built
up for the purpose.

3.2 Attitude and Objectives of Management

While some organization may be niggardly in dividend payments. Some others may
be liberal. A large number of firms may be found within these two extremes. Niggardly
organizations prefer to conserve cash. Though such an approach may easily meet their
future needs for funds, it deprives the stockholders of a legitimate return on their
investment. Liberal organizations on the other hand feel that stockholders are entitles to

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an established rate of dividend as long as their financial condition is reasonably sound.

Within these two extremes, a number of corporations adopt several variations.
The attitude of the management affects the dividend policies of a corporation in
another way. The stockholders who control the management of the company may be
interested in empire building they may consider ploughing back earnings as the most
effective technique for achieving their objectives of building up the corporation is
perhaps the largest in the field.
3.3 Composition of shareholdings
There may be marked variations in dividend policies on account of the variations in
the composition of the shareholding. In the case of a closely held company, the personal
objectives of the directors and of a majority of shareholders may govern the decision.
Widely held companies have scattered shareholders. Such companies may take the
dividend decision with a greater sense of responsibility by adopting a more formal and
scientific approach.
The tax burden on business corporations is a determining factor in formulation of
their dividend policies. The director’s of a closely held company may take into
considerations the effect of dividends upon the tax position of their important
shareholders. Those in the high-income brackets may be willing to sacrifice additional
income in the form of dividends in favour of appreciation in the value of shares and
capital gains. However when the stock is widely held, stockholders are enthusiastic about
collecting their dividends regularly and do not attach much importance to tax
considerations.
Thus a company, which is closely held by a few shareholders in the high income-tax
brackets, is likely to payout a relatively low dividend. The shareholders in such a
company are interested in taking their income in the form of capital gains rather than in
the form of dividends, which are subject to higher personal income taxes. On the other
hand, the shareholders of a large and widely held company may be interested in high
dividend payout.
3.4 Investment Opportunities
Many companies retain the earnings to facilitate planned expansion. Companies with
low credit ratings may feel that they may not be able to sell their securities for raising

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necessary finance they would need for future expansion. So, they may adopt a policy for
retaining larger portion of earnings.
In the context of opportunities for expansion and growth, it is wise to adopt a
conservative dividend policy if the cost of capital involved in external financing is greater
than the cost of internally generated funds.
Similarly, if a company has lucrative opportunities for investing its funds and can
earn a rate, which is higher than its cost of capital, it may adopt a conservative
3.5 Desire for financial solvency and liquidity.
Companies may desire to build up reserves by retaining their earnings which would
enable them to weather deficit years of the downswings of business cycle. They may,
therefore, consider it necessary to conserve their cash resources to face future
emergencies. Cash credit limits, working capital needs, capital expenditure commitments,
repayments of long term debt etc. influence the dividend decision. Companies sometimes
prune dividends when their liquidity declines.
3.6 Regularity
A company may decide about dividends on the basis of its current earnings which
according to its thinking may provide the best index of what a company can pay, even
though large variations in earnings and consequently in dividends may be observed from
year to year. Other companies may consider regularity in payment of dividends as more
important that anything else they may use past profits to pay dividends regularly,
irrespective of whether they have enough current profits or not. The past record of
company in payment of dividends regularly builds up the morale of the stockholders who
may adopt a helpful attitude towards it in periods of emergency of financial crisis.
Regularity in dividends cultivates an investment attitude rather than speculative one
towards the share of the company.
3.7 Restrictions By Financial Institutions:
Sometimes financial institutions which grant long term loans to corporations put a
clause restricting dividend payment till the loan or a substantial part of it is repaid.
3.8 Inflation
Inflation is also a factor, which may affect a firm’s dividend decision. In period of
inflation, funds generated from depreciation may not be adequate to replace worn out

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equipment. Under these circumstances, the firm has to depend upon retained earnings as
a source of funds to make up for the shortfall. This is of particular relevance if the assets
have to be replaced in near future. Consequently, the dividend payout ratio will tend to be
low.
On account of inflation often the profits of most of the companies are inflated. A
higher payout ratio based on overstated profits may eventually lead to the liquidation of
the company. You are aware that inflation has become an integral part of the present
financial climate while shareholders may delight in immediate income; they will feel
sorry lithe company has to suffer in a few years on account of not retaining sufficient
earnings to support future growth or not being able to maintain its position in the market
place.
Inflation has another dimension. In an inflationary situation, current income becomes
more important and shareholders in general attach more value to current yield than to
distant capital appreciation. They would thus expect a higher payout ratio.
3.9 Other Factors:
Age of company has some effect on the dividend decision. Established companies
often find it easier to distribute higher earnings without causing an adverse effect on the
financial position of the company than a comparatively younger corporation which has
yet to establish itself.
The demand for capital expenditure, money supply, etc. undergoes great oscillations
during the different stages of a business cycle. As a result, dividend policies may
fluctuate from time to time.
In many instances, dividend policies result from tradition, ignorance and indifference
rather than from considered judgment. An industry or a company may have established
some satisfactory standard for the payment of dividends and this standard becomes a
convention of custom for that industry or company.

4. DIVIDEND THEORIES

4.1 THE RELEVANCE CONCEPT

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Alluri Institute Of Management Sciences For Professionals

Another school of thought represents relevance concept which considers dividend

decision to be an active variable influencing the value of the firm. Gordon, Richardson,
Lintner and James E Walter are of the opinion that dividend decision is very important.
According to them, a Firms position in the stock market i.e. dividends communicate
information to the investors about the firms profitability Prof Walter strongly supports
doctrine that dividend policy almost always affects the value of the enterprise.
4.1.1 Walters Approach
Prof Walter recognizes that dividend policy cannot be separated from investment
policy of a company. He opines that the choice of dividend policies almost always affects
the value of the firm.
Professor James E Walter has been a proponent of relevance of dividends concept. He
argues that the choice of dividend policies almost always affects the value of enterprise.
His model is one of the earlier theoretical models on this concept and it is clearly shows
the importance of dividend policy in maximization of wealth of shareholders. Walters’
model is based on the following assumptions.
 The firm finances all its investments retained earnings and debt or new
equity is not issued.
 The firm’s internal rate of return, r and its cost of capital k are
constant.
 All earnings are either distributed as dividends or reinvested internally
immediately.
 Beginning earnings and dividends never change. The value of the
earnings per share E and the dividend per share D may be changed in
the model to determine results, but any given values of E and D are
assumed to remain constant forever in determining a given value.
 The firm has a very long or infinite life.
Walter’s formula for determining the market price per share is as follows.
D r (E-D)/K
P= --- + ------------------
K K
Where:

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Alluri Institute Of Management Sciences For Professionals

P = Market price per share.

D = Dividend per share.
E = Earnings per share
r = Internal rate of return
K = Cost of Capitalization or (cost of capital)
The equation shows that the market price per share is the sum of the present value of
two sources of income i) the present value of an infinite stream of constant dividends,
D/K and all the present value of infinite stream of capital gains, [r(E-D)/K]/K
According to Walter’s model, the optimum dividend policy depends on the
relationship between the firm’s internal rate of return, and its cost of capital k. the
relationship works in different circumstances a follows.
A) Growth firms where r > K; firm having r > K may be referred to as growth
firms. The growth firms are assumed to have ample profitable investment
opportunities. These firms would reinvest retained earnings\s at a higher r than
K. hence, these firms will maximize the value per share if they follows a
continuous policy of retaining all earnings for internal investment,
B) Normal Firms where r =K: the firms having the rate of r equal to K are said to
be normal firms. After having exhausted such profitable opportunities these
firms earn on their investment a rate of return equal to the cost of capital only.
Hence, for such normal of average firms, the dividend policy has no effect on
the market value per share
C) Declining firms where r < K declining firms are these firms which do not
have any profitable investment opportunity, hence they earn less than the cost
of capital (the expectation of share holders in case of the earnings are retained
and reinvested in the business ) for such firms 100% payment ratio will e an
optimum ratio. The shareholders will be better if its 100% earnings are
distributed among them so that they may spend or invest it in alternative
investments.
Thus in Walters model, the dividend policy of the firm depends on the availability of
investment opportunities and the relationship between the firms internal rate of return r
and its cost of capital, K . the firm should use earnings to finance investments if r < K and

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Alluri Institute Of Management Sciences For Professionals

would remain indifferent when r = K this dividend policy becomes a financing decision
also. When dividend policy is treated as a financing decision, the payment of cash
dividends is a passive residual.

4.1.2 Gordon’s approach:

J. Gordon has also put forth a model arguing for relevance of dividend decision to
valuation of firm. The model is founded on the following assumptions.
 The firm is an all-equity firm. i.e., the firm only uses retained earnings for
financing its investments programmes.
 ‘r' and K remain unchanged for all times to come.
 The firm has perpetual life.
 There are no corporate taxes.
 The retention ratio, b once decided upon, is constant. Thus the growth rate
g = br is constant.
Gordon is of the view that the investors always prefer dividend as current income to
dividend to be obtained in future because they are rational and would be non-chalant to
take risk. The payment of current dividends completely removes any possibility of risk.
They would lay less emphasis on future dividends as compared to the current dividend.
That is why when a firm retains its earnings; its share values receive set back. Investors’
preference for current dividend exists even in situation where r = K. this sharply contrasts
with Walter’s approach which holds that investors are indifferent between and retention,
when r = K.
Gordon has proved the following formula (which is a simplified version of the original
formula to determine the market value of a share.
E (1-b)
P= ---------
K-br
Where:
P = Price of shares.
E = Earnings per share
b = retention ratio

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Alluri Institute Of Management Sciences For Professionals

1-b= percentage of earnings distribution as dividends

K = Capitalization rate or cost of capital.
br = Growth rate in r, i.e., rate of return on investment of an all equity firm.

4.2 IRRELEVANT CONCEPT OF DIVIDEND

The school of thought is associated with Solomon and Modigliani and miller. The
basic theme of irrelevance approach of dividend is that the dividend policy is a passive
variable which does not in any way influence share values.

4.2.1 Modigliani and millers approach of irrelevance of dividend

Modigliani - Miller’s thoughts for irrelevance of dividends are most comprehensive
and logical. According to them, dividend policy does not affect value of a firm and is
therefore, of no consequence. They are of the view that the sum of the discounted value
per share after dividend payments is equal to the market value per share before dividend
is paid. It is earning potentially and investment policy of a firm rather than its pattern of
distribution of remainings that affects value of the firm.
The basic assumptions of M-M approach are:
1) There exists perfect capital market where all investors are rational-information is
available to all at no cost, there are no transaction costs and floatation costs, there
is no such investor as could alone influence market value of shares.
2) There does not exist taxes. Alternatively, there is no tax differential between
income on dividend and capital gains
3) Firm’s investment policy is well planned and is fixed for all the time to come.
4) There is no uncertainty as to future investments and profits of the firm. Thus,
investors are able to predict future prices and dividends with certainty. This
assumption was dropped by M-M later.
M-M’s argument of irrelevance of dividend remains unchanged whether external
funds are obtained by means of share capital borrowings. This is for the fact that
investors are indifferent between debts and equity with respect to leverage and the real
cost of debt is the same as the real cost of equity. Besides, even under conditions of
uncertainty, dividend decision will be of no relevance because of operation of arbitrage.

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Alluri Institute Of Management Sciences For Professionals

According to MM hypothesis the market value of a share in the beginning of the period is
equal to the present value of dividends paid at the end of the period plus the market price
of the share at the end of the period. This can be expressed by the following formulas:

D1+P1
Po = ----------
1+Ke
Where:
Po = existing price of a share
Ke = cost of capital
D1 = Dividend to be received at the end of the period
P1 = Market price of a share at the year end.
From the above equation the following equation can be derived to
determine the value of P1
P1 = P0 (1+Ke) –D1
A firm can finance its investment programme either by ploughing back its
earnings or by issue of new shares or by both. The number of new share to be
issued can be determined as follows.
M x P1 = I - (X-nD1)
Where
M = number of new issue is to be made
P = price at which new issue is to be made
I = investment amount required
X = total net profit of the firm during the period.
nD1 = total dividends paid during the period.

Criticism of M-M’s Hypothesis:

M-M Hypothesis if dividend irrelevance is based on some simplifying
assumptions, the most critical of which were:
 No floatation costs
 No taxes, and

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Alluri Institute Of Management Sciences For Professionals

 No uncertainty
All the assumptions in the model are very far from reality. Fluctuations
costs do exists in real circumstances, tax differentials wok in actual life,
uncertainty is also there shareholders very much desire current dividends and
afford to ignore capital gains.

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