Advanced Financial Management 9789350245040

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Advanced Financial Management

Dr. B.G. Satyaprasad M.Com. M.B.A, Ph.D. Prof. and Head Department of Commerce and Management Abbas Khan College for Women OTC Road, Bangaiore - 2. And

Dr. G.A. Raghu M.Com. Ph.D. Head Dept. of Commerce Sri. Bhagwan Mahavir Jain College J.C. Road, Bangaiore - 37.

l1li GfIimalaya GJlublishing GfIouse MUMBAI • DELHI • NAG PUR • BANGALORE • HYDERABAD • CHENNAI· LUCKNOW • PUNE • AHAMADABAD

© Authors No part of this publication should be reproduced, stored in a retrieval system, or transmitted in any form or any means, electronic, mechanical, photocopying, recording andlor otherwise without the prior written permission of the publisher.

ISBN

:

Revised Edition

Published hy.

978-93-5024-504-0 2010

Mrs. Meena Pandey for HIMALAYA PUBLISHING HOUSE, "Ramdoot", Dr. Bhalerao Marg, Girgaon, Mumbai - 400 004. Phone: 238601 70/23863863 Fax: 022-2387 71 78 Email: [email protected] Website: www.himpub.com

Branch Offices Delhi

"Pooja Apartments", 4-B, Murari Lal Street, Ansari Road, Darya Ganj, New Delhi - 110 002. Phone: 23270392 Fax: 011-2325 62 86 Email: [email protected]

Nagpllr

Kundanlal Chandak Industrial Estate, Ghat Road, Nagpur - 440 018. Phone: 272 12 16, Telefax: 0712-272 12 15

Bangalore

No. 1611 (Old 12/1), First Floor, Next to Hotel Highlands, Madhava Nagar, Race Course Road, Bangalore - 560 001. Phone: 2228 15 41, 2238 54 61 Telefax: 080-2228 66 11 Email: [email protected]

Hyderabad

No. 2-2-1 167/2H, 1st Floor, Near Railway Bridge, Tilak Nagar, Main Road, Hyderabad - 500044. Phone: 5550 17 45 Fax: 040-275600 41

Channai

No.2. Ramakrishna Street, North Usman Road, T.Nagar. Chennai - 600 017. Phone: 044-28144004 I 05

Pune

No.ll, Third Floor, Wing-A, Sahadeo Avenue - II, S.No. 5/9 + 511 0, Someshwarawada, Baner Road, Pune - 411 008. Mob: 94210 53743

Lucknow

C-43, Sector - C, Ali Gunj, Lucknow - 226 024. Phone: 0522-404 75 94

Printed by

Geetanjali Press. Nagpur.

Typeset by

Page Designers, Bangalore

(vii)

CONTENTS

1.

Investment Decision and Risk Analysis

1-38

Cash Flow - Concepts and Measurements - Risk Analysis - Probability Approach - Expected Values - Standard Deviation - Sensitivity Analysis - Decision Tree Analysis (Simple Problems) - Capital Budgeting under Inflation (Theory only)

2.

Capital Structure

39 - 65

Capital Structure Theories - MMS Theory - Tradiational View - Net Income Approach - Net operating Income Approach - Aribrage Process - Simple Problems Only.

3.

Dividend Policy

66 - 88

Dividend Policy - Theory oflrrelavance - M.M. Hypothesis (Only theory) - Theory of Relavance - Walter-Gorden Model (Simple Problems)

4.

Working Capital Management

89 - 214

Planning and Forecasting of Working Capital Management - Funds Statements - Analysis of Working Capital Position - Working Capital Management - Problems on determining the Working Capital- Including Operating Cycle Method - Cash Budget - Cash Management Techniques - Accounts Receivable Management: Meaning - Factors Influencing Accounts Receivable Management - Inventory Management Techniques (Problems) - JIT Analysis - EOQ - Levels

5.

International Financial Management

215 - 227

International Financial Management - Meaning - Importance - Merits and Demerits

Skill Development

229 - 242

I,

Investment Decision and Risk Analysis Cash Fl~w - Concepts and Measureillents - Risk Analysis - Probability Approach Expected Values - Standard Deviatioli .- Sensitivity Analysis - Decision Tree Analysis (Simple Problems) - Capital Budgetillg under Inflation (Theory only)

CASH FLOW· THE CONCEPT AND MEASUREMENTS Introduction Net cash flow = Net income - non cash revenues + non cash charges The net cash flow differs from accounting profit because of the revenues and expenses listed the income statement were not paid in cash during the year. The examples are depreciation and amortization of expenditures. These items reduces the income but not paid in cash, so it has to be added back to net income when calculating net cash flow. Net cash flow = Net income + Depreciation and amortization Depreciation and amortization are by far the largest non cash items, and in many cases the non other cash items roughly net out to zero. Therefore, many financial experts assume that net cash flow equals net income plus depreciation and amortization.

Operating Cash Flow It arises from normal operation~ and it is the difference between cash revenues and cash costs, including taxes on operatillg income. Operating cash flow differs from net cash flow because, operating income or interest expense, is equal to Net Operating Profit After Taxes (NOPAT).

Net Operating Profit after Taxes It is net operating profit after taxes. It is the after tax profit a company would have if it had no debt and no investments in non operating assets . Because it excludes

1

2

Advanced Financial Management

the effects of financial decisions, it iSd hetter measure of operating performance than net income. Estimating the cash flow is one PI' Ihe most important activity of the finance in general and capital budgeting in parti clilar. Forecasting cash flow is very difficult task because of many variables. These v;lri;i1lles influence individually as well as at the departmental level. Example: The fOI\'casts of unit sale and sale prices are normally made by the marketing group based all their knowledge of price elasticity, advertising effects, the state of the economy, competitors, reaction and trends in consumers tastes . It is also very difficult to foreca~1 Ihe costs and revenues associated with a large complex project. [n the process of I:stimation many forecasting errors may be committed. The financial manager mllst be very careful in estimating the cash flows as it directly affect financial decisiolls both at the beginning as well as after the establishment of business. Therefore he has to forecast the cash flows by using the following processes viz. 1. Obtaining information from variolls departments such as production and marketing

etc. 2. Ensuring that everyone involved with the forecast uses a consistent set of economic assumptions . 3. Making sure that no bias is inhen:nt in the forecasts.

Relevant Cash Flows It is defined as the specific sel or cash flows that should be considered in the decision at hand. The financial analysl Illay commit mistakes in estimating cash flows but two cardinal rules can help in reducing the risk. They are: 1. Capital budgeting decisions muSI he based on cash flows. not accounting income.

2. Only incremental cash flows are rekvant. The relevant cash flow for a project is the free cash flow that the company can expect if it implements project. It is th(' cash flow above and beyond what the company could expect if it does not implement I he project.

1[

c' [ Gross Netfit pro Ioperatin"j a ft er . I Free Cash Flow = taxes + 0 e n. - capIta . [ (NOPA T) P expendIture

. 1

Change In net . operatIng . . workIng capItal

OR

= EBIT (I - T) + Depreciation -

[~:;i~:l

[~i~~~rn:nl

. ]expendIture assets

- Change in operating liabilities

Fixed Assets Purchase of fixed assets n:,crs to the outflow of cash or investments. But accountants do not show the purchase ill" fixed assets as a deduction from accounting

Investment Decision and Risk Analysis

3

income. Instead, they deduct a depreciation expense each year throughout the life of the asset.

Non Cash Charges In calculating net income, accountants usually subtract depreciation from revenues. So, while accountants do Ilot subtract the purchase price of fixed assets when calculating accounting income, they do subtract a charge each year for depreciation. Depreciation shelters income from taxation and this has an impact on cash flow, but depreciation itself is nnt a cash flow. Therefore, depreciation must be added tc5 NOPAT while estimating a pJ'()j~cts cash flow.

Change in Net Operating Working Capital The difference between the reqllirl:d increase in current operating assets and increase in current liabilities is the l'Il:lllge in net operating working capital. If this change is positive, as it generally is fur ~xpansion projects, then additional financing, over and above the cost of the fixed ass~ts, will be needed.

Interest Expenses are not included in project Cash Flows The discounting process reduces the eash flows to account for the project's capital costs. If interest charges were first deducted and then the resulting cash flows were discounted at weighted average cost (If capital, this would double count the cost of debt. Therefore, interest expenses sholiid not be deducted at the time of calculating cash flows. However, to calculate the accounting income, interest expenses is deducted. While calculating the each flows (operating profits) which is available to all the investors, interest expenses will not be deducted.

BASIC PRINCIPLES OF CASH FLOW ESTIMATION The financial analyst must adopt the following principles to estimate the cashflows. They are: 1. Separation Principle 2. Incremental Principle 3. Post Tax Principle 4. Consistency Principle Separation Principle: A business project will be viewed according to two individual principle viz. Investment :-.ide and financing side principle. The cash flow linked with these sides must be deall independently. In financing side principle. the cost of financing play an important role, it may be cost of equity or cost of dl'ht capital. In investment side principle, (he rate of return or expected rate of return i~ considered. Profit before interest and tax (l - tax rate) = Profit after tax + Interest (l - tax rate) Incremental Principle: Under this principle, cash flows are estimated purely on the basis incremental terms. The rash flow generated with the project and without the project will be taken as the base f( II' estimation.

ot

4

Advanced Financial Management

PrOject] cashflow [ for the year

flow for] = [caSh the fifIJ~ with

__

the pn '.lCCI for the year

[caSh flow for the] fi~ without the project for the year

Post-Tax Principle : Cash flo"" s are measured on post tax basis. Many firms ignore tax payments and discounts the cush flows with the higher rate to compensate the lapse. It is the general practice 10 lise after tax cash flows along with after-tax discount rate. The impact of taxes arc assessed by three elements viz., (a) Tax Rate (b) Treatment of losses (c) Effect of non cash charges Consistency Principle: Cash flows and discount rate used to find the present value of cash flows must be consistenl with respect to the inventors and inflation. The cash flows are estimated for both to the entire investor or to the equity investors. The cash flow relating to -all the investors is calculated as under: Cash flows to all the investors

= PH rr (1 -

Tax rate) + Depreciation and non cash charges - ('apital expenditure - Change in working capital

Cash flow to equity inventors is l':llculated as under: = Prolil after tax + Depreciation and other non cash charges - Preference dividend - Capital expenditure - Change in working capital - Repayment of debt + Proceeds from debt issues - Redemption from of preference capital

+ Proceeds from preference issue Cash flow to all inventors = Weighted average cost of capital Cash flow to equity = Cost of equity Three components of the cash flow stream of a replacement project are: Initial Investment

=

Cost of the New assets

After tax salvage value realised from the old asses

-I-

+ Net working capital required for the old asset

Net working capital requin'd for the new asset

Investment Decision and Risk Analysis

Operating cash inflows

=

Operating cash inflows from the new asset

Terminal cash flow

=

After tax salvage value o/" thc new asset

5

)-

Operating cash inflows from the old asset, had it not been replaced. After tax salvage value of the old asset, had it not been replaced

+

t Recovl~ry

of net workillg c :::J (')

CD

3

.909

.826

20000

22130

a. "T1

5'

II>

3

10000

60000

.909

.826

9090

49560

58650

20000 Total

38650

=

128,960

:::J (')

~

:!:

II> :::J

II>

co CD 3

CD :::J

Investment Decision and Risk Analysis

33

CAPITAL BUDGETING UNDER INFLATION The business decision are made by taking all the economic factors into consideration, viz., supply of money, inflation, deflation, interest rate, productivity, consumption level etc. These factors will have direct influence on the performance of business firms. Inflation is one such factor which has the direct bearing on the capital budgeting decisions. Since India is a developing nation, inflation is a constant and permanent feature of the country. The fluctuation in the real value of Rupee or purchasing power of currency, availability of goods and services are the symptoms of inflation. The Finance Manager must have to consider this factor at the time of allocating the resources to various activities. But in a real life situation, adjustment of inflation towards the allocation of funds are hardly done. But to get the accurate results of the investment decision, inflation has to be adjusted both to the cost as well as revenue of the company. Generally impact of inflation is found both as revenue and expenditure equally (similar fashion). But in certain situation the inflation is overloaded. They are (a) Depreciation is based on historical costs, therefore the tax benefits enjoyed on the depreciation does not keep pace with inflation. (b) The cost of capital used for project appraisal contains a premium for anticipated inflation.

Depreciation and Historical Cost The cost inflows are calculated by taking into account the significant impact of inflation since both cost and the revenue both are influenced by inflation. But the depreciation charges and tax concersions are not influenced by inflation because the depreciation charged is on the basis of historical cost. Therefore the project manager has to reduce the real rate of return. The annual after tax cash inflow of the project is equal to: Rs. Sales revenue of the project - Total cost of the project Gross revenue of the project - Depreciation Gross revenue after depreciation - Income tax - Profit after tax

+ Depreciation Net cash inflow

*** *** *** *** *** *** *** *** ***

OR Sales revenue - Cost of the project Gross revenue

*** *** ***

•

34

Advanced Financial Management

*** *** *** ***

-Tax Gross revenue after tax

+ Benefits enjoyed on depreciation Net cash inflow

Problem 1: If the cost project is Rs. 6000, the revenue expected is Rs. 10,000, the amount of depreciation is Rs. 10,000, the amount of depreciation is Rs. 1000, the increase tax rate is 50%. Show the concept of cash flow by using both depreciation as well as income tax. Version A Version B Rs. Rs. Sale revenue

10,000

Sales revenue

10,000

- ..cost

6,000

-Cost

6,000

Gross revenue

4,000

Gross revenue

4,000

- Depreciation

1,000

- Tax (50%)

2,000

Net revenue after tax

2,000

Gross revenue after depreciation

3,000

+ Tax benefits enjoyed an depreciation 1000 (1 - .50)

- Income tax

1,500

+ Add back represent

1,500

Gross revenue after tax

1000

Cash inflow

2,500

500 2,500

EXERCISE 1. An investment project will cost Rs. 60,000 initially and it is expected to generate cashflows in years are Year

Cash flows Rs.

2

10,000 20,000

3

30,000

4

40,000

The risk free rate of return is 10% and the risk associated with the project is 4%. Calculate risk adjusted rate of return. 2. A company has the proposal of buying two machine viz., Machine A and Machine B. Each costing Rs. 300,000. The expected cashflows are: Year Cash inflows for project A Expected cash flow for project B

1

2

3

Rs.200,000

.Rs. 220,000

Rs. 300,000

Rs.250,000 Rs. 225,000 Rs. 350,000 If the risk adjusted rate of return is 14%. Calculate NPV of the two proposal and offer your comments.

Investment Decision and Risk Analysis

35

3. Calculate the NPV of the two project by using risk adjusted rate of return from the following data. The cost of both the projects A and B is 75,000. The cash inflows of both the projects are: Year

A

B

Cashflows

Cashflows

Rs. 10,000

Rs. 15,000

2

20,000

20,000

3

30,000

25,000

4

40,000

30,000

5

50,000

35,000

The risk free rate of return is 10% for both the project. Project A has 4% and project B has 6% quantified risk. 4. There are two projects X and Y each involves investment ofRs. 50,000. The expected cashflows and the Certainty Equivalent Coefficient are as under: Project X Project Y Year

Cashflow

Certainty

Cashflow

Certainty

Rs.

Equivalent Coefficient

Rs.

Equivalent Coefficient

1 2.

20,000 30,000

.8 .7

20,000 24,000

.9 .8

3.

35,000

14,000 .7 .9 Risk free cut-off rate is 10%. Suggest which of the two projects should be preferred. 5. A company is examining two mutually exclusive investment proposals. The management of the company uses certainty equivalents to evaluate new investment proposals. From the following information pertaining to these projects advise the company as to which project should be taken up by it. Year

Project A Cashflow Certainty Rs. Equivalent

Project B Certainty Cashflow Equivalent Rs.

Coefficient

Coefficient

10,000

0.8

10,000

0.9

2

20,000

0.7

20,000

0.8

3

25,000

15,000

0.7

4

30,000

0.6 0.5

20,000

0.5

The total cash outlay is Rs. 25,000. The risk free rate of return is 7%. Estimate the proposals. 6. A company is considering a new investment proposal. The net cashflows of the equipment have been estimated as given below. The equipments life is estimated to be 2 years.

36

Advanced Financial Management

Year 1

Probability

Year 2

Rs. Cashflow

10,000

Cashtlow

Probability

Rs.

12,000

0.40 0.60

8,000

0.5

12,000

0.5

16,000

0.4

20,000

0.6

The cost of equipment is Rs. 20,000 and the company's cost of capital is 12% use decision tree approach to advise the company. 7 . .A firm has a proposal requiring an outlay of Rs. 220,000 at present. The investment proposal is expected to have 2 years economic life. In the year 1 there is 0.3 probability that cash inflow would be Rs. 90,000, 0.4 probability that the cash inflow will be Rs. 120,000 and 0.3 probability that cash inflow will be Rs. 180,000. In the year 2 the cash inflow possibilities depend on the cash inflow that occurs in the year 1. The estimated cost of capital is 12%. Advise the company by using decision tree approach. Cash inflow . Probability Cash inflow in the year 2 in the year 2 in the event A in the event B Rs. Rs. 50,000 1,10,000 1,60,000

.2 .6 .2

Probability Cash inflow Probability in the year 2 in the event C Rs.

1,40,000

.3

1,70,000

.1

1,60,000

.4

2,10,000

.8

1,80,000

.3

2,50,000

.1

8. A company has the following estimate of the present values of the future cash flows associated with the investment proposal concerned with expanding the plant capacity. It intends use a decision free approach to get a clear picture of the possible outcomes of this investment. The plant expansion 1 expected to cost Rs. 350,000. The respective present value of future cash flow and probabilities are as follows: Present value of future cash flows With Expansion Rs.

Without Expansion Rs.

Probabilities

3,50,000

2,50,000

0.2

5,20,000

2,20,000

0.4

9,10,000

3,60,000

0.4

9. Mr. Ramesh is considering two mutually exclusive project A and B. You are required to advise him about the acceptability of the projects from the following information. A

B

Rs.

Rs.

Cost of the investment Fore cast of cashflow per annum for 5 years' Optimistic

50,000

50,000

30,000

40,000

Most likely

20,000

20,000

Perimistic

15,000

5,000

The cut-off rate is 14%.

Investment Decision and Risk Analysis

37

10. MIS. Ranganath and company is considering a proposal to buy one of the two machine to manufacture a new product. Each of these machine requires an investment of Rs. 50,000 and is expected to provide benefits over a period of 12 years. The firm has made perimistic, most likely and optimistic estimates of the returns associated with each of these alternatives. These estimates are as follows:

Machine A

Machine B

Rs.

Rs.

50,000

50,000

Pessimistic

8,000

5,000

Most likely

18,000

15,000

Optimistic

20,000

25,000

Cost of the project per year for 12 years

Assume 14% cost of capital, which project do you consider and why? 11. X limited has the following details:

Events

Cash inflows

Probability

Rs. A

4000

.10

B

5000

.20

C

6000

.40

D

7000

.20

E

8000

.10

Compare project Y by using

X, cr and C.Y. from the following data. Probability

Events

Cashflows

A

12,000

.10

B

10,000

.15

C

8,000

.50

D E

6,000

.15

4,000

.10

Rs.

12. Calculate NPY and cr of NPY from the following and comment on the cosistency of NPY of cash flows. Project X Events

NPY estimates

Project Y Probability

Rs.

NPY estimates

Probability

Rs.

A

6,000

.10

12,000

.10

B

7,000

.20

11,000

.15

C

8,000

.40

10,000

.50

D

9,000

.20

9,000

.15

E

10,000

.10

8,000

.10

Advanced Financial Management

38

13. A company is considering the two mutually exclusive projects viz., A and B. Project A has Rs. 50,000 and project B has Rs. 60,000. You are given below the net present value and probability distribution for each project. Project A NPVestimate

Project B NPV estimate

Probability

Rs.

Probability

Rs.

5,000

.2

8,000

.2

8,000

.2

12,000

.1

10,000 13,000

.1 .1

14,000 15,000

.3 .1

15,000

20,000 .3 .4 14. Calculate net present value of the two projects and offer your comments. Project X

Project Y

Cost of the

Project

10,000

year

Cashflows

probability

Cashinflows

10,000 Probability

I

10,000

.1

9,000

.1

2

20,000

.8

18,000

.8

3

18,000

22,000

.1

The discount rate applicable is at 10%

QUESTIONS Section A I. What is meant by cash flow? 2. Give the different version of cash flow concept. 3. What is risk in capital budgeting? 4. How does the risk measured? 5. What is meant by risk adjusted rate of return? 6. How does the risk is calculated under certainty equivalent coefficient? 7. What is meant by sensitivity analysis? 8. What is meant by coefficient of variation? 9. What is inflation? 10. How does inflation affects the cashflow decisions? II. Define the term capital budgeting? 12. What is meant by NPV?

Section 'B' and

'e'

1. Analyse the different concept of cashflows. 2. What factors influence the capital budgeting decision? How does risk is evaluated? 3. Analyse the impact of inflation in capital budgeting decision. 4. How does variance analysis help in measuring the risk?

•

Capital Structure

Capital Structure Theories- MMS Theory-Tradiational View-Net Income Approach - Net operating Income Approach - Aribrage Process - Simple Problems Only.

CAPITAL STRUCTURE The requirement for funds is continuous for a business concern . It is required for all types of activities. Economists speak of 'Capital' as wealth which is used in the production of additional wealth. It is one of the most important elements of factors of production. Businessmen frequently use the word capital in the sense of the total assets employed in a business . The accountant uses the word in the sense of net assets, or stockholders interest as shown by the balance sheet or the net worth of stockholders equity. In law, capital means 'Capital Stock' . The capital structure is made of debt and equity securities which comprise a firm ' s financing of its assets. It is the debt, plus preferred stock, plus net worth. The scientific analysis of these instruments and its mobilization have a considerable significance in the real life situation. An unplanned capital structure may yield good results in the short run, it is dangerous in the long run. Hence the study of capital structure becomes relevant.

Meaning "Capital structure of a company refers to the composition of its capitalization and it includes all long term capital sources viz., loans, reserves, shares and By Gerestenberg bonds. " "The capital structure of business can be measured by the ratio of various kinds of permanent loan and equity capital to total capital. " By Schwarty

39

• 40

Advanced Financial Management

In simple words, capitalisation refers to the combination of different types of securities of a business concern. Capital structure planning keyed to the objective of profit maximization ensures the minimum cost of capital and the maximum rate of return to equity holders. The amount of capital and its requirements is not the only consideration of a business firm, but also to have proper mix of debt to equity. Financial manager has to plan: How much should be raised in the form of equity? How much should be mobilised in other forms? The answer for these questions is 'Optimal Capital Structure'. It is that amount of combination of capitalisation which results in less amount of cost and yields maximum profits. A financial manager determines the 'proper capital structure for his firm. He determines the mix of debt and equity which would maximise the value of equity stock. Theoretically, the finance manager should plan an 'Optimal Capital Structure' for his company. The optimum capital structure is obtained when the marginal real cost of each source of fund is the same. In practical situation, determining an optimal capital structure is the same and is a difficult task, one has to consider number of factors other than theory. There are significant variations among industries and many individual companies within an industry with regard to capital structure. The judgment of a person taking the capital structure decision plays the most crucial part. The two similar companies may have different capital structure. Hence a uniform model or formula cannot be adopted. It is influenced by a number of other factors which are highly psychological, complex and qualitative and do not always follow accepted theory, since capital markets are not perfect and the decision has to be taken under imperfect knowledge and risk . Conceptual Clarity of: Capitalisation

Capital Structure

1

Financial Structure

1

1

• Equity share capital

• Equity share capital

• Preference share capital

• Preference share capital

• Equity share capital • Preference share capital

• Debentures

• Debentures

• Debentures

• Term loans

• Term loans • Retained earnings

• Term loans • Current liabilities

Fig. 2.1. Conceptual Clarity of Capitalisation

All the above concepts are being used by financial managers, in making financial decisions. He has to be very cautions not only in determining total size of the capital but also in mixing the various securities in the capitalisation. Following are some of the factors that directly affects the size of the capital structure.

41

Capital Structure

Determinants of Capital Structure The Capital structure decisions has to be planned in the initial stages of a company. It is a management decision to aim at supplying the required amount of capital. The role of finance manager in deciding the amount of capital structure is significant. He has to study and analyse the benefits and defects of issuing each type of securit·ies. Following are some of the factors that influence the Capital Structure.

FACTORS AFFECTING CAPITAL STRUCTURE Internal Factors 1. Financial Leverage: The use of fixed bearing securities, such as debt and preference capital along with owners' equity in the capital structure is described as 'financial leverage' or 'trading on equity'. This decision is most important froni the point of view of financing decisions. By having debt and equity in the capital mix, a company will have an opportunity of deploying certain amount of debt (instead of whole equity capital) with an intention to enjoy the benefit of reduction in the percentage tax (as interest is debited to Profit and Loss A/c). The benefit so enjoyed will be passed on to the equity shareholders in the form of high percentage of dividend. External

Internal

Size of the company Nature of the industry

Financial leverage Risk Growth and stability Retaining control Cost of capital _--::::::. Cash flows Flexibility Purpose of finance Asset structure

Factors

Investors Cost of flotation Legal requirement

influencing

Period of finance

Capital Structure

Level of interest rate Level of business activity Availability of funds Taxation policy Level of stock prices Condition ofthe capital market

Fig. 2.2. Factors influencing Capital Structure.

If the assets are financed through the debt, it yields higher return than the cost of debt. Earnings per share increase without an increase in the owner's investment. The earnings per share also increases when the preference share capital is used to acquire assets. (If r > kp) (r = return on investment and kp = cost of preference share capital). The effect of debt in capital structure is reflected in earnings per share on the following grounds: 1. Cost of debt is usually lower than the cost of preference share capital. 2. Interest period on debt is deductible under Income Tax Law.

42

Advanced Financial Management

Therefore, financial leverage is an important consideration in planning the capital structure of a company. The most popular method of examining the impact of leverage is to analyse the relationship between Earnings Per Share and various levels of Earnings Before Interest and Taxes under different methods'of financing. EBIT - EPS (Earnings Before Interest and Taxes - Earnings Per Share) analysis is an important analytical tool at the disposal of a finance manager to get an insight into the firms' capital structure. 'Example 1: Assume, three companies have some earnings with different combination of capital structure in a given situation and examine the influence offinancial leverage.

EBITIOperating Profit Capital Structure:

2,00,000

Company B Company C Rs. Rs. 2,00,000 2,00,000

Equity share capital of Rs. 10 each

6,00,000

4,00,000

4,00,000

2,00,000

2,00,000

50%

1,00,000 50%

Company A Rs.

Debt 8% Preference Capital 8% 50%

Assume Tax as

Analysis: Company A Rs.

Company B

Company C

Rs.

Rs.

2,00,000 16,000

2,00,000

2,00,000

1,84,000

1,92,000

Less: Income Tax

1,00,000

92,000

96,000

Profit after Tax

1,00,000

92,000

96,000

EBITIOperating Profit Less: Interest

2,00,000

EBT

16,000

Less: Preference Dividend Earning available to Equity shareholders No. of Equity shareholders Earnings Per Share

8,000

1,00,000

92,000

80,000

60,000

40,000

40,000

1.66

2.30

2.20

The analysis clearly shows the influence of debt on EPS. Though. the earnings and capital structure remains same, returns are different to equity shareholders because of usage of different types of securities in the capital. EPS is more for company B, because it had Rs. 4,00,000, 8% debentures and had the benefit of high tax concessions, when compared to company A, it had the benefit Rs. 8,000 (Rs. 1,00,000 - Rs. 92,000 = Rs. 8,000), when compared to 'C', it had the benefit of Rs. 4,000 (Rs. 96,000 Rs. 92,000 = Rs. 4,000). This benefit has been passed on to the equity shareholders. Hence EPS is more. Therefore financial leverage influence the capital structure.

Capital Structure

43

2. Risk: Ordinarily, debt securities increases the financial risk, while equity securities reduces it, risk can be measured to some extent by the use of ratio, measuring gearing and time - interest earned. The risk attached to the use of leverage is called "Financial Risk". Financial risk is added with the use of debt because of the increased variability in the shareholder's earnings and threat of insolvency. A firm can avoid or reduce the risk, if it does not employ debt capital in the capital mix. But, it reduces the returns to equity shareholders too. Hence a finance manager must employ the debt capital in such a way that, the benefit of that should maximise the returns to equity shareholders. However, in the long run EPS alone will not be considered as a determinant factor for structuring the capital. Wealth maximisation concept should be kept in mind . . 3. Growth and Stability: In the initial stages, a firm can meet its financial requirements through long-term sources, particularly by raising equity shares. Once the company starts getting good response and cash inflow capacity is increased through sales, it can raise debt or preference capital for growth and expansion programmes of the company. Ploughing back of profits will also be used as a source, which provides flexibility and less dependence on the outsiders funds. The firm with stable sales can employ a high degree of leverage as they will not face difficulty in meeting their fixed commitments. The company which is having high sales and having the capacity of generating more sales revenue will opt for more amount of debt for their financial requirements. The fixed charges of these instrument can be easily paid by such revenue will opt for more amount of debt for their financial requirements. The fixed charges of these instrument can be easily paid by such revenue and can increase the returns to equity shareholders. In contrast to this, a company which is having less sales revenue must reduce its burden towards debt, because of the inability of the company to pay interest on debt. Otherwise, it takes the company directly to liquidation. Hence, the policies of growth and stability will directly influence the capital structure. 4. Retaining Control: The attitude of the management towards retaining the control over the company will have direct impact on the capital structure. If the existing shareholders want to continue the same holding on the company, they may not encourage the issue of additional equity shares. Fresh issue of equity share reduces the interest and holding over the company. The divisible profits percentage of such' company will also comes down. In the long run, it affects the market value of the shares. Hence, in the normal practical situation, the existing equity shareholders directs the management to raise the additional source only through debentures or preference shares. However, issue of debentures and preference shares also be influenced by the reputation that is enjoyed by the company. If the creditworthiness of a firm is good, it can raise the funds according to the desire of the existing shareholders. 5. Cost of Capital: The cost of capital refers to the expectation of suppliers of funds. The objective of knowing the cost of capital is to increase the returns on investments, so that, a firm should earn sufficient profits to repay the interest and

44

Advanced Financia~ Management

installment of principal to the lenders. Hence, it is also known as the maximum rate of return a firm earn on its investments, so that the market value of equity shares of the company does not fall. In the real life situation, a finance manager evaluates the cost of equity by considering the percentage of dividend and the capital gains expected by equity shareholders. The cost of debenture is assessed by taking the assured percentage of dividend. Therefore, different type of sources of funds will have different types of costs. Debt is a cheaper source of fund when compared to other sources. The return on total capital employed can be maximised by minimising total average cost of capital. Careful decision has to be made in selecting the size of debt, because, beyond a particular ratio (D:E) debt increases the risk of a firm. Hence cost of capital influences the capital structure.

6. Cash ~lows: Cash flow ability of a company will have direct impact on the capital structure. Cash flow generation capacity of a firm increases the flexibility of finance manager in deciding the capital structure. Cash generated by a company or availability of a continuous supply of cash increases the reputation of a c6mpany Cash flows permits the company to meet its short term obligations. A firm will have the obligation to pay dividend to equity shareholders, interest to banker and debenture holders. Cash flow generating capacity of a company helps in meeting this commitment. Sound cash flows facilitates the finance manager in raising funds through debt. Insufficient availability of cash or cash inflows takes the company to a disastrous situation. Many at times, a firm which cannot meet its short-term obligation not only looses its creditworthiness but also goes to liquidation. It is quite risky to employ fixed charges source of finance by those companies where cash inflows are unstable and unpredictable. The important ratio is net cash inflows to fixed charges. It indicates the number of times the fixed financial obligations are covered by the net cash inflows generated by the company. The greater the cov.erage, the greater the amount of debt a company can use. Higher debt proportion can be employed by a company even with small coverage when two conditions are met, i.e., (a) cash inflows do not have significant yearly variance and (b) a small probability of cash inflows are being considerably used to meet less fixed charges in a given period. Therefore, it is the yearly cash inflows that matters much to decide the capacity of a company to borrow debt. During recession, when a firm faces difficulty of getting sufficient sales revenue suffers severely for cash flows. This strains the finance manager in arranging funds for meeting its fixed obligation. As a temporary arrangement, it can realise funds by selling a portion of permanent current assets. This arrangement , can be made only for a temporary period, i.e., till the sales of such company increases. The regular picture or position of cash flows can be determined by preparing "fund flow and cash flow statements". 7. Flexibility: Flexibility means the firms ability to adopt its capital structure to the needs of changing conditions, its capital structure should be flexible, so that without much practical difficulties, a firm can change the securities in capital structure. Redeemable preference shares and redeemable debentures increases the flexibility of capital structure, as it can be redeemed at the discretion of the company. The degree of flexibility in the capital structure mainly depends on flexibility in

Capital Structure

45

fixed charges, restrictive covenants in loan agreements, terms of redemption and the debt capacity. • Flexibility in Fixed Charges: Different securities will have different fixed commitments of interest or cost. Interest cost on the borrowings will have permanent obligation on the company. Obligation of dividend on preference share is not permanent, it becomes a commitment only when a company earns profit. The nonpayment of preference dividend can cause a set back to the company's reputation, but, it does not result in insolvency. The dividend on equity shares is not at all an forced obligation. As a policy, a company may give dividend regularly but it is free to retain certain amount of profit as 'retained earnings' . This can be used as a source of funds for expansion and diversification programmes. Thus, from the fixed charges of a firm, it can decide the ratio of debt to equity mix. Hence capital structure is influenced by the fixed charges of different securities. • Restrictive Covenants: Restrictive covenants are commonly included in longterm loan agreements and debentures. These restrictions curtails the freedom of a company in dealing with financial matters and put it in an inflexible position. Covenants in loan agreements may include restrictions or to raise additional external finances. A company may also be required to maintain a certain amount of working capital or to maintain certain ratios, such as debt equity restrictions may be quite reasonable from the point of view of creditors as they are meant to protect their interests; but they reduce the flexibility of company to operate freely and may become burdensome if conditions change. Therefore, a company should ensures while issuing debentures or accepting other forms of long-term debt that a minimum of restrictive clauses, that circumscribe its financial action in future, are included in debt agreements. • Terms of Redemption: A company must have maximum flexibility in its capital structure to maximise the returns on investment. This can be maintained by having redeemable preference share and debenture of the firm's discretion. This helps the company to replace different securities easily. When a firm has excess cash, it can repay or redeem preference shares and debentures. If inadequacy in cash arises. It can issue additional securities. Hence terms of redemption influences the capital structure. • The Debt Capacity: The flexibility of the capital structure also depends on the company's debt capacity. If a firm has less amount of debt with more amount of equity capital, it has the potentiality of raising debt finance whenever it requires. The unused debt capacity facilitates flexibility in the capital structure. Therefore cost and benefit of each 'mix' should be evaluated before taking a final decision on the 'Capital Structure'. 8. Purpose of Finance: The purpose of finance is another factor that influences the capital structure. If a firm is engaged in business transactions, it can make use of Debt and Equity mix or can enjoy leverage benefits. If funds are needed for nonprofit organisations to build social welfare measures, it can meet its requirements only through equity capital. For an existing company, funds may be required for

46

Advanced Financial Management

expansion or diversification. It may be financed through retained earnings. debentures or preference capital. Hence purpose of business influences the Capital Structure. 9. Asset Structure: Funds are needed to make investments on fixed assets and current assets. Fixed assets investments can be met by long-term sources viz., through the issue of equity. debentures or preference. A portion of current asset investments are also financed by long-term sources. Short-term sources are used for meeting the working capital requirement. Hence asset Structure (both fixed assets and current assets) influences the capital structure.

External Factors 1. Size of the Company: If the size of business is small. the requirement of finance is too little. If t!1e size of the business of a firm is large. large amount of capital is required. If a firm plans to raise smaller amount of capital. it selects only few securities in its capital structure. If it needs more capital. number of different securities will be selected to raise funds with more flexibility in the capital structure. 2. Nature of Industry: The nature of ~ndustry. method of production. type of product etc .• will also influence the capital structure. A public utility concern which has a unique support and identify form the State and Central Government (Food Corporation of I,ndia. Mysore Power Corporation) can raise funds through preference shares or debentures. A capital intensiy,e industry engaged in manufacturing iron and steel products may have high equity and less debt capital. A trading company. which has less asset structure. has t? depend mainly on equity or preference capital to meet their capital requirement. 3. Investors: In the recent past. the behaviour of the investors have changed. Now the investors are cautious over the investments. Political. socioeconomic factors of the country made the investors to be very alert in their portfolio management. Hence. capital market is moving from equity to debt and debt to deep discount bonds. The finance manager must be careful in selecting the securities for capital structure. 4. Cost of Floatation: ,The cost of flotation refers to the expenses a firm incurred incurs during the process of public issues. Advertising. campaigning. Printing of application forms. fees of merchant bankers. underwriting commission. brokerage etc. The finance manager has to evaluate such expenses with particular reference to each financial instrument. Cost of floatation of debt is comparatively less when compared to cost of floatation of equity. He should try to reduce this cost by proper mix of debt and equity in the capital stI1Icture. 5. Legal Requirements: The legal and statutory requirement of the government will also influence the capital structure. SEBI guidelines on investors protection. maintaining D:E ratio and current ratio, promoter vontribution etc., will have direct bearing on capital structure. Besides this, the monetary and fiscal policies of the government also affect the capital structure decision.

Capital Structure

47

6. Period of Finance: Funds are required for different period for different purposes. Short term (1-3 years) funds are required to meet working capital requirements. Hence, it is raised through commercial banks (0.0, Cash Credit). Medium term finance (8-10 years) is required to meet expansion and diversification purposes and which can be raised through issue of preference or debenture capital. Funds are needed permanently for a company to meet its capital expenditure. This can be raised by issuing equity shares. Hence period of finance will also influence the capital structure. 7. Level of Interest Rate: The rate of interest will have a direct impact on borrowed funds. If the expectation of the banker or financial institution is more to get high percentage of interest, a firm can postpone the mobilisation of funds or can make use of retained earnings. Hence, it affects the capital structure. S. Level of Business Activity: When a level of business activity of a firm is raising, it requires more funds for expansion and diversification. The company may opt for raising additional funds through issue of debentures, preference share or it can borrow term loans. Hence, it affects the capital structure. 9. Availability of Funds: The availability of money in the capital and money market will directly influence the company financial structure. Free flow of money in the economy encourages a corporate to raise funds through securities without much difficulties. Hence a finance manager has to study the flow and availability offunds before he decides about the capital structure. 10. Taxation Policy: High corporate tax, high tax on dividend and capital gains directly influence the decision of capital structure. High tax discourages the issues of equity and encourages to issue more amount debt instrument, 'as the fixed charges on these securities, i.e., interest can be directly charged to Profit and Loss Alc for income tax calculations. Hence capital structure of a company is affected. 11. Level of Stock Prices: If the general price level of stocks or raw materials are constant over a period of time, management prefers to invest such funds either through equity or preference capital, in other words, long-term or medium term financing. If the prices are fluctuating too widely (impossible to predict), short term source is the best alternative for investments.

CAPITAL STRUCTURE THEORIES There are number of theories advocated in financial management based on several empirical studies. The over all ohjpcti','e of wealth maximization is attained not only by allocating the funds on the prufitable in",estment proposals but also by selecting the optimal capital structure which reduces the over all cost of capital. The combination of different securities in the capital struct~re directly influence on the market value of the shares. An appropriate capital mix is very essential in financing decisions. In this context, Millor, Alexander Barges, Ezra Soloman Durand had suggested number of theodes based on certain assumption to arrive at an optimal capital structure. The following important theories are discussed in detail.

48

Advanced Financial Management

1. Net Income Approach or Durand Approach: According to this theory, the weighted average cost or over all cost of capital can be reduced by increasing debt component in the capital mix. The benefit of reduced cost of capital will be reflected in the total value of the firm or it increases the market value of the shares. This advocation is made on the basis of following assumptions. They are:: 1. The cost of debt is cheaper than the cost of equity. 2. There are no tax. 3. The use of debt does not change the perception of investor in evaluating the risk. On the basis of the above assumptions a favourable argument is made that, the cost or expectation of equity shares holders are more than the cost of debt (interest cost). Hence, the judicious usage of debt securities increases the leverage effect and increases the market value of the shares. Optimal capital structure of a firm can be had by using debt capital. The following illustration is presented for better understanding of Net Income approach:Example 1 : A company's expected annual net operating income is Rs. 1,00,000 and it has Rs. 3,00,000, 10% debentures. The equity capitalisation rate is 12%. (a) Calculate the value of the firm and over all capitalisation rate under NetIncome approach. (b) Find out the impact on the value of the firm and over all capitalisation rate by increasing the debt component to Rs. 4,00,000 and decrease in debt upto Rs. 2,00,000 (cost remains the same). Solution': Value of the Firm Value of the firm when debt is Rs. 3,00,000 : Net income or operating income = Rs. 1,00,000 Less: Interest: 101100 x 3,00,000 = Rs. 30,000

Earnings available to equity share holders

=

Rs.

70,000

Equity capitalisation rate is 12% (given) " Market value of the equity share

EAESH = Capitalisation Rate

70,000 --ux 100 = 5,83,333

+ Market value of the debenture Market value of the firm

= 3,00,000 = 8,83,333

49

Capital Structure

Overall Capitalisation Rate: EBIT Ke = - - - - - - Value of the Firm

'Where Ke

=Capitalisation Rate EBIT =Operating Income

1,00,000 = 8,83,333 x 100 = 11.32%

Value of the firm, when debt is increased to Rs. 4,00,000: Rs. Net income or EBIT Less Interest: 101100 x 4,00,090 Earnings available to

equ~ty

share holders

= = =

Rs~

1,00,000

Rs.

40,000

Rs. 60,000

Equity capitalisation rate is 12% (given) _ Earnings Available to Equity Shareholders , M k i f h fi C 'talis' R . , ar et va ue 0 t e trm . apt ation ate 60000 . ----t2x 100 = 5,00,000 Add: Market value of the debenture

= 4,00,000

Market value of the firm

= 9,00,000

Overall Capitalisation Rate Ke

=

EBIT 1,00,000 Value ofthe Firm :::: 9,00,000 x 100

= 11.11 %

Value of the firm. when debt (debenture) is increased to Rs, 2,00,000: Rs. Net income or EBIT Less Interest: 10/100 x 2,00,000 Earnings available to equity share holders

= = =

1,00,000 20,000 80,000

Equity capitalisation rate is 12% (given) _ Earnings Available to Equity Shareholders Market value 0 f the firm C ·tal· . R apt tsatlon ate 80,000 100 - 6 66 666 12 x -" Add: Market value of the debenture Market value of the firm

= 2,00,000 = 8,66,666

50

Advanced Financial Management

Overall Capitalisation Rate EBIT

Ke

1,00,000

= ·Value ofthe Firm = 8,66,666

Situation

x 100 = 11.54%

1 Rs.

2 Rs.

3 Rs.

EBIT

1,00,000

1,00,000

1,00,000

Debt

3,00,000

2,00,000

2,00,000

(10%)

(10%)

(10%)

12%

12%

12%

Value ofthe firm

8,83,333

9,00,000

8,66,666

Capitalisation Rate

11.32%

11.11 %

11.54%

Capitalisation Rate Results:

Thus the net income approach has proved that the increase in "debt financing in the capital mix increases the market value of the firm and decrease in debt component in financing mix (capital structure) reduces the market value of the firm and increases the overall capitalisation rate. Problem 2: Calculate the value of the firm and over all cost of capital from the following data; and show the impact of increasing the debt upto Rs. 50,000 and decreases the debt upto 10,000 in Y company

X company All Equity

Y company Debt capital of Rs. 30,000 @ 12% Int.

Rs.

Rs.

20,000

20,000

1. EEIT

3,600

2. Interest 20,000

16.400

4. Equity capitalisation rate

20%

20%

5. Market value of the Debt

30,000

30,000

3. EEIT

Solution: Step 1 : Calculate the market value of the Equity shares X company

Equity =

EAESH ECR

20000 x 100 = -2'0 x 100 = 1,00,000

Capital Structure

51

Market value of Equity share of Y company is

= 16,~00 x 100 =82 000

' 20 Step 2 : Calculate the market value of the firm.

Rs. X company: Market value of equity

=

+ Market value of Debt = Market value of the firm Y company: Market value of equity

+ Market value of Debt Market value of the firm

= = = =

100,000

---100,000 82,000 30,000 1,12,000

Step 3 : Calculate the overall capitalisation Rat~. ,

Total Earnings Mkt. Value of the firm

X company: - - -

Y company:

20,00~ x 100 1,12,000

=

20,000 x 100 100,000

-~-

= 20%

= 17.85%

Inference: Particulars Market value of the firm Market value of equity Over all cost of capital

X company

Y company

Rs.

Rs.

100,000 20%

1.12,009 20%

20%

17.8%

From the above table, it is inferred that the if debt capital is more in the capital structure, higher will be return to the company, which is reflected'through the market value of the firm, and the over all cost of capital is reduced (Rs. 112,000 and overall cost of capital in 17.8%).

Problem 3: If the debt is increased to Rs, 50,000, what is the impact on market value of the firm and overall cost of capital. Solution: Step 1 : X company Calculate the market value of the equity shares - EAE~}:I x 100 ECR

= 20,000 x 100 = 1 00 000 20

'

,

52

Advanced Financial Management

Step 2 : Calculate the market value of the firm, Market value of equity + Market value of Debt Market value of firm

Rs. 100,000

= = =

100,000

Step 3 : Calculate the overall cost of capital

=

Total Earnings Market value of the firm

=

20,!J00 x 100 1,00,000 .

= 20%

Y company Debt is 4,50,000 @ 12 % Step 1 : Calculate market value of the equity shares

=

_ EAESH x 100 _ 20,000 - 6,000 ECR 20 x 100 - Rs. 70,000

Step 2 : Market value of the firm : Rs. Market value of equity shares = Market value of Debt =

70,000 50,000

Market value of firm = 1,20,000 Step 3 : Over all capitalisation rate. Total Earnings Total value of the firm

=

20,000 x 100 1,20,000

= 16.66%

Inference Particulars Market value of the firm all cost of capital Market value of equity O~er

X company

Y company

Rs.

Rs.

100,000 20% 20%

120,000 16.66% 20%

Higher the Debt, higher the value of the firm and least overall cost of capital. When the Debt is reduced to Rs. 10,000 @ 12% Step 1 : Market of Eqt1ity X company

EAESH ECR

20,000

= 20 x

ft)()

=R~. 1,00,000

Capital Structure

53

Step 2 : Market value of the firm

= 1,00,000 = = ---1,00,000

Market value of equity Rs.

+ Market value of Debt Market value of the firm

Step 3 : Calculate the overall cost of capital Total Earnings Total market value of the fmn

= ~O,OO~ x 100 =20% 20

Y company Step 1 : Market value of the equity EAESH ECR

- - - x 100 =

20,000 - 1,200 x 100 20 18,800

= ~- x 100 = 94 000 20

'

Step 2 : Market value of the firm: Market value of equity = Market value pf Debt Market value of the firm

= =

94,000 10,000 1,04,000

Inference Particulars Market value of the firm Market value of equity Over all cost of capital

X company

Y company

Rs.

Rs.

100,000 20%

104,000

20%

19.23%

20%

Higher the Debt, higher the market value of the firm and lower will be over the (ost of capital. ] troblem 4: Calculate the market value of the firm and over all capitalisation by l

sing net income approach. Rs. Total Net Income

100,000

Equity capitalisation Rate

18%

The Existing Debt Capital

500,000

Interest rate per year 6% (b) Show the impact of increasing tlie Debt capital upto Rs. 800,000 and reducing the Debt capital upto Rs. 300.000.

54

Advanced Financial Management

Solution: When the Debt capital is Rs. 5,00,000/6%. Step 1 : Market value of Equity

=

EAESH x 100 ECR

=

1,00,000 - 30,000 .18

70,000

=18 =3,88;888

Step 2 : Market value of the firm Rs. 3,88,888 5,00,000

=

Market value of equity Market value of Debt

=

Market value of firm = 8,88,888 Step 3 : Overall cost of capital : Total earnings Market value of the firm

1.00,000

= 8,88,888

x

100- H.25%

(b) When the debt capital is increased upto Rs. 8,00,000. Step 1 : Market value of equity: EAESH x 100 =. 1,00,000 - 48,000 = 2 88 888 .18' , ECR Step 2 : Market value of the firm: Rs. 2,88,888 8,00,000

= = = 10,88,888

Market value of equity Market value of Debt "-

Market value of firm Step 3 : Over all capitalisation rate

=

Total earnings Market value of the firm

=

1,00,000 x 100 10,88,888

= 9.18%

(c) When the Debt capital is decreased to Rs. 300,QOO. Step 1 : Market value of Equity = EAESH x 100 ECR

= 1,00,000 .18

18,000 x 100

= 4,55,555

Capital Structure

55

Step 2 : Market value of the

f~rm

Market value of the equity Market value of the Debt Market value of the firm

= = =

Rs. 4,55,555 3,00,000 7,55,555

Step 3 : Overall capitalisation rate Total earnings -----='--Market value of the flrm

= 1,00,000 x 100 = 13.24% 7,55,555

Inference: -.

Market value of the firm fvIarket value of equity pverall capitalisation Rate

When debt is Rs.500,000

When the debt is Rs.800,000

When the debt is Rs.300,000

8,88,888 18% 11.25%

10,88,888 18% 9.18%

7,55,555 18% 13.24%

Higher the Debt, Higher the market value of the flrm and lower will be the over all east of capital.

2. Net Operating Income Approach: Durand advocated another theory of capital structure stating there in that, there is no one optimal capital structure. Every capital structure is an optimal capital structure. Any combination of debt to equity mix in the capital structure does not affect the value of the flrm. Hence it is just an opposite theory to Net Income approach. The basic assumptions of this theory are:• The cost of equity remain constant regardless of the debt equity mix in the capital structure. • The market capitalises the value of the firm as a whole. • The increase in cost of debt financing in capital mix off set in increase in returns to equity share holders. • The debt capitalisation rate is constant. • The corporate income tax does not exist. • The advantage of debt in capital mix offset exactly by the increase in equity capitalisation rate. The following illustration is presented for better understanding of the Net operating income approach: Problem 5: A company has Net operating income of Rs. 2,00,000; average cost of capital is 10% and has the debt component of Rs. 6,00,0008% in the capital mix. Find out the value of the firm by Net Operating Income Approach:

o

56

Advanced Financial Management

Solution:

Value of the Firm: Net Operating Income Capitalisation Rate Total Market Value of the Firm:

= Rs. 2,00,000 = 10%

= Net Operating Income = 2,00,000 x 100 = 20,00,000 Capitalisation Rate 10 The cost of equity capital:

Earnings available to Equity Shares EBIT -1 . or-----Total Market Value of the Equity Shares M- D where EBIT =Operating Income; M = Market Value of the Firm: D = Market Value of the Debt

=

(2,00,000 - S /100 x 6,00,000) 2,00,000 - 4S,000 = (20,00,000 - 6,00,000) 14,00,000 1,52,000

= 14,00,000 = 0.10S or 1O.S% Verification of the Weighted Average Cost Capital is constant Weighted Average Cost = Weighted Average of Debt + Weighted Average of Equity.

_ .08 6,00,000 +.11 14,00,000 20,00,000 20,00,000

= 0.024 + 0.077 = 0.101 or 10.1% Hence, even if the firm uses the debt component of Rs. 6,00,000 (8%) the weighted average cost remains constant. If the firm increases the debt component to Rs. 10,00,000 (S%) and reduces the equity capital up to Rs. 10,00,000.,The equity capitalisation rate would be: Earnings available to Equity Shares Total Market Value of the Equity Shares

EBIT -1 M- D

------=---------~~-------or------

=

2,00,000 - 80,000 (2,00,000 - S /100 x 10,00,000) = 10,00,000 (20,00,000 -106,00,000) 1,20,000

= 10,00,000 = 0.12 or 12%

Capital Structure

57

Verification of Total Weighted Avera~e Cost of Capital: WAC = Weighted Average Cost Debt + Weighted Average Cost of Equity _ .08 10,00,000 + .12 10,00,000 20.00,000 20,00,000

= 0.04 + 0.06 = .10 or 10%

Conclusion If the overall capitalisation rate remain constant, irrespective of the size o( debt in the capital mix, weighted average cost of capital remain same. In other words debt does not influence the weighted average cost of capital. All the capital structures are optimal capital structure only. However as and when the size of the debt capital increases in the capital mix, the cost of equity increases, it is because, the financial risk of the company will be completely borned by equity shareholders.

Problem 6: Calculate the market of the equity and weighted average cost of capital from the following data: Rs.

=2,00,000

Net Income

Overall capitalization rate = 20% Existing Debt capital of the company Rs. 5,00,000 at 10% interest. (a) Calculate the weighted average cost of capital and market value of equity at Rs. 500,000 Debt. (b) Calculate the W.A. C. C and market value of equity when the Debt capital is increased to Rs. 800,000 and decreased to Rs. 3,00,000. Solution: When the debt capital is Rs. 5,00,000

Step 1: Market value of"the firm: Total earnings Overall capitalisation rate

=

2,00,000 .20

= 10,00,000

Step 2 : Market value of equity Rs. Market value of the firm

= 10,00,000

- Market value of the debt

=

5,00,000

Market value of equity

=

5,00,000

Step 3 : Cost of Equity capital 2,00,000 - 50,000 (Int.) x 100 5,00,000 Weighted average cost of capital.

=30%

Advanced Financial Management

58

Cost of equity capital + Cost of debt 5,00,000 5,00,000 .30 10,00,000 + .10 10,00,000 0.15 + 0.05 = 0.2 or 20% When the debt capital is raised to Rs. 800,000 Step 1 : Market value of the firm Total earnings Overall capitalisation rate

=

2,00,000 .20

= 10,00,000

Step 2 : Market 'value of Equity share

-

Rs. Market value of the firm = 10,00,000 Market value of the debt = 8,00,000 Market value of equity

=

2,00,000

Step 3 : Cost of Equity capital EAESH Market value of equity

= 2,00,000 -

80,000 x 100 2,00,000

=60%

Step 4 : Weighted average cost of capital : Cost of equity + Cost of debt capital .60

2,00,000 8,00,000 + .10 --'----'-10,00,000 10,00,000 0.12 + 0.08 = 0.2 or 20%

When the debt capital is reduced to Rs. 300,000 Step 1 : Market value of the firm : Total earnings = 2,00,000 = 10 00 000 " .20 Overall capitalisation rate Step 2 : Market value of Equity share Rs. -

Market value of the firm Market value of the debt

= 10,00,000 = 3,00,000

Market value of equity = 7,00,000'

59

Capital Structure

Step 3 : Cost of Equity capital EAESH Market value of equity

=

2,00,000 - 30,000 7,00,000

x 100 _ - 24%

Step 4 : Weighted average cost of capital: Cost of equity + Cost of debt capital 7,00,000 3,00,000 .24 10,00,000 + .10 10,00,000 0.168 + 0.03

=0.198 or 19.8%

Inference

Market value of the firm Cost of equity Weighted average cost of capital

When debt capital is Rs. 5,00,000

When the debt capital is Rs. 8,00,000

When the debt capital is Rs. 3,00,000

Rs. 10,00,000 .30

Rs. 10,00,000 .60

Rs. 10,00,000 .24

.20

.20

.20

When the market value of the firm remain same, irrespective of the size of debt capital, weighted average cost of capital remain constant. However the cost of equity capital increases along ,with increased debt capital.

MODIGLIANI • MILLER PROPOSITIONS The two eminent economists Fransco Modigliani and Merton A. Miller in 1958, examined the theory of capitalisation under the study titled " the cost of capital, corporation finances and the theory of investment". In their study, they explained that cost of capital and capitalisation are independent. The corporation's (company) total cost and capital is constant and it is independent. The corporation's total cost of capital is constant and it is independent of the method and level of financing. Weighted average cost of capital remain constant irrespective debt to equity mix in the capital composition. Each ratio of debt to equity wiII compensate with the expectations of the equity share holders. [if the debt capital is more in the capital structure, the financial risk of the firm will be bomed by the equity share holders. Hence, the expectations of the equity share holders will be high]. Assumptions The M.M. theory has proposed three statements by taking the followjng assumptions: 1. It is assumed that the company profits are not taxed. 2. It is assumed that trading of securities does not involve any cost. 3. The investors are rational and they make their decision according to the market information.

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4. The company deClares 100% dividend and it does not maintain retained earnings. 5. The investors prefers to covert the company's risk into personal risk by borrowing the funds privately with the same rate of interest. 6. The risk associated with the two firms are homogeneous. 7. The securities of Debt and Equity are traded in the perfect capital market. 8. Investors have complete market information. However this theory was criticised by many experts. Mr. Ezra Soloman has stated that, "The thesis that the company's cost of capital is independent of its financial structure is not valid". • The assumption of perfect capital market is unrealistic. • Dealing with securities without transaction cost in not possible, because of brokers commission. • Though homogeneous risk class may found visible in the industry but it is not correct. • The tax exists an all the profit situations. • Very rarely the companies declares 100% dividend. • Personal Debt of the investor is not a perfect substitute for corporate debt.

Three proposition of M.M. Hypothesis Theory [Problem is presented only to the teachers)

Proposition I : The market value of any firm is inpependent of its capital structure. For firms of the same risk class, the total market value in independent of the Debt equity mix and is given by the capitalising the expected net operating income by the rate appropriate to the risk class. Value of the firm = Market value of the equity + Market value of Debt or

Operating Profit Value of the firm = The Expected Rate 0 f Return

It the above relationship is not found in any pair of two companies, investor . will involve himself in arbitrage process. Under this process, the investor prefers to sell the risky securities and prefers to purchase less risky securities and maintain same profits. Added to this, the investor reduced his equity investment by converting companies risk into personal risk. Proposition II : The rate appropriate to the risk class plus risk premium is the . rate of return an the equity. In other words, as the firm's use of debt increases, its cost of equity also rises. (The risk premium is equal to the difference between rate of return and debt cost in proportion of Debt to Equity. Proposition III : The cutoff rate of investment decision making is equal to the appropriate rate to the risk class and that is not affected by the manner in which the investment is financed. The arbitrage mechanism as suggested in proposition I has the following steps: (A) When the value of the levered firm is higher than the unlevered firm:

Capital Structure.

61

(i) Invertor in the same proposition purchases the security of unlevered firm. (ii) By doing so, he maintains same profits.

(iii) The invertor also convert the company debt into personal debt to reduce his equity investment.

Problem 7: The levered company and the unlevered company are identical in every respect except that the levered company has 7% Rs. 2,00,000 debt out standing. As per the net income approach, the calculation of the two firms is as follows: ~ Particulars

'x'

'y'

Unlevered company Rs. 80,000

Levered company Rs. 80,000 14,000 66,000 12%

~

Net income Interest Net earnings Equity capitalisation rate

80,000 10%

Mr. X holds Rs. 3000 worth of the levered company's share. Is it possible to reduce his investment out lay to maintain the same profits by using arbitrage process. Illustrate.

Solution: Steps to be followed to illustrate arbitrage process.

Steps: 1. Assess the investors percentage of holding in the levered company.

2. Calculate the returns of the investor in the levered company. 3. Sell the securities of the levered company and purchase the securities of the unlevered company in the same proportion.

4. Calculate the return of the investor in the new company. 5. Convert the company debt into personal debt to reduce the equity investment. 6. Show the savings made by the investor. 1. Investor's holding:

= - - - -Rs.3000 -----Market value of Equity Shares

Market value of equity share Holdings

=

EAESH TICR

Rs.3,OOO

= Rs. 5,50,000

2. Investors Income: Percentage of holding x EAESH

.0055 (66,000)

= 363

=

Rs. 66,000 .12

x 100 = .54%

x 100

= Rs. 5,50,000.

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62

3. Sell and Buy the security Rs.3,000 x Market value of equity of unlevered company Rs. 5,50,000 . . Market value of unlevered company EAESH ECR

= 80,000 =Rs. 800,000 .10

Rs.3,000 Rs. 5,50,000 x 8,00,000 = Rs. 4364 Percentage holding =

Rs. 4,364 x 100 =. 55 % or. 0055 Rs. 8,00,000

4. His income in the new company .0055 (80,000)

= Rs. 440

5. Conversion of company's debt into personal debt. 2,00,000

Company D : E ratio

= 5,50,000

x 100 =36.36%

Personal debt = 3,000 (36.36 %) = Rs. 1090 = Rs. 1090 @ 7% interest. Interest = 76. His net income = Gross income - Interest = 440 - 76 =364

6. Reduction in the investment outlay Investors equity investment today. Gross investment = - Borrowings =

4364 1090

Net equity investments = Today's equity investments = - Previous investment =

3274 3000

=

274

Savings in equity

For every Rs. 3000 investments, the investor saves Rs. 274.

Problem 8: Show the arbitrage process of an investor who is holding 1% of the market value of shares of levered company. Unlevered company Levered company Rs. Rs. Net income 1,20,000 1.20.000 400.000· Market value of the debt 10% Equity capitalisation rate 12% Int rate 5%

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63

Solution:

Step 1 : Investors position today. Note: To calculate 1% of holdings in the levered company market value of equity shares of the levered company is to be calculated. Market value 0 f the equity

1,20,000 - 20,000 = EAESH ECR = .12 = Rs. 8,33, 333 .33

Step 2 : His holdings 1% of levered company's equity shares .01 (8,33,333) = Rs. 8,333.33 Step 3 : His income today .01 (1,00,000) = 1000 Step 4 : Sell and buy the securities I

8,333 x Market value of unlevered 8,33,333 Market value of unlevered company =

1,20,000 = 12,00,000 .10

8,333 x 1200000 = 12000 . 8,33,333 " , 1.e.,

12,000 12,00,000

= .01

Step 5 : His income today .01 (1,20,000) = 1200 Step 6 : Conversion of company's debt into personal debt .. Company D : E ratio 4,00,000 x 100 8,33,333 ..

personal debt .48 (8,333)

= 48% = Rs. 4,000

Int = 4,000 (.05) Net income = 1,200 - Int = 1000 Step 7 : His savings in equity His net equity investment =12,000 - Debt investment = 4,000 His equity investment Savings in equity

=200

= 200

= 8,000 = Earlier equity investment current year equity

investment = 8,333 - 8,000 Savings in equity = 333 Rs. 333 is the savings for the investor for the investment of Rs. 8333.

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Particulars

X company (levered)

Rs. Equity capital Debt capital Total capital Debt. Total capital Net income Interest of 15% Profit before tax Tax 50% Income after interest taxes . Cost of equIty

EAESH

Y company (unlevered) Rs.

8,00,000 6,00,000

14,00,000

14,00,000

14,00,000 0 2,50,000

.43

25,0,000 90,000 1,60,000 80,000 80,000 80,000

= Equity = 8,00,000

2,50,000 1,25,000 125,000

1,25,000 x 100 = 10% 14,00,000 x 100 = 8.92%

Cost of debt after tax = 15 (1 - .50) = 7.5% Weighted Average Cost of Capital = Cost of equity + Cost of debt 8,00,000 ) ( 6,00,000 ) .10 ( 14,00,000 + .089 14,00,000 Total cost of levered company = .057 + 0.38 = 0.95 or 9.5% The cost of unlevered company is also 9%. Total income of Share holders. EAESH Int + EAESH and Debt holders 90,000 + 80,000 1,25,000 = 1,70,000 1,25,000 Though the cost' of capital in both the company remain same (9%), the returns to equity and debenture holders put together is higher than the unlevered company.

EXERCISES 1. Calculate the market value of the firm and over all capitalisation rate by using net

income as well as net operating income approach Rs. 200,000 Total Net Income Equity Capitalisation Rate 18% Rs. 10,00,000 The Existing Debt Capital Interest rate per year 6% Over all capitalisation rate 13% Show the impact of increasing the debt capital upto Rs. 12,00,000 and reducing the debt upto Rs. 800,000. 2. A company's expected annual net operating income is Rs. 200,000 and it has Rs. 600,000, 10% debentures. The equity capitalisation rate is 12%.

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65

(a) Calculate the value of the firm and over all capitalisation rate under Net Income Approach. (b) Find out the impact as the value of the firm and overall capitalisation rate by increasing the debt component upto Rs. 800,000 and decreasing the debt upto Rs. 4,00,000 (cost remains the same). 3. Calculate the market value of the equity and weighted average cost of capital from

the following data: Rs. 3,00,000

Net Income Overall Capitalisation Rate

Existing Debt capital of the company Rs . 6,00,000

20% @

10% interest.

Calculate the weighted average cost of capital and market value of equity at Rs. 800,000 and decreased to Rs. 5,00,000.

QUESTIONS Section A 1. What is meant by capital structure? 2. What is meant by capitalisation? 3. Define the term financial structure. 4. What is financial leverage? 5. Mention any four factors which influence the size of capital structure. 6. What is meant by financial risk? 7. Give the meansing of the term "cost of floatation". 8. Mention any two assumptions of net income approach. 9. Mention any two assumption of net operating approach. 10. Mention any two assumptions of M.M. hypothesis? 11. What is meant by capital gearing? 12. What is meant by arbitrage process?

Section Band C 1. Discuss in detail net income approach. 2. Analyse the theory of net operating income approach. 3. How does the assumptions of M.M. are relevant? Discuss. 4. Explain the factors influencing the size of capita} structure.

Dividend Policy

Div idend Policy - Theory of Irrelavanc,' . M .M . I h 'pothesis (Only theory) - Theory of Rclavance - Walter-Gorden Modell ~i! llp k Pruh k ll1sr

MEANING AND SIGNIFICANCE OF DIVIDEND POLICY Dividend is the portion of earnings which is distributed among the shareholders. In other words, dividend policy determines the divi~i()n of eumings between payments to shareholders and retained earnings. Formulation of proper dividend policy is one of the major financial decisions to be taken by the fillan c ial nUllager. We give here the importance and significance of dividend policy. Retained earnings are one of the most importanl spurees of internal funds for meeting the financial needs of the company for its :: I o Wlh and development. The dividend distribution to equity shareholders involve the ,)lI t!lnw of cash. Both, growth of the company and dividend distribution to shareholdcl" ;II'C desirable. But these two goals are in conflict. A high dividend rate means Ics.-; 1l'i;lined earnings, which may consequently result in slower growth and lower market r:tte per share. In view of this, determining the dividend policy is one of the importa nt (unctions of finance manager and he must very carefully divide the allocation of earni ngs between dividends and retained earnings. Dividend policy may have a critical influence on the value of the tirm. If the value of the firm, is a function of its dividend payment ratio, the dividend policy will affect directly the firm's cost of capital. A company which wants to pay dividends and also needs funds to finance its investment opportunities will have to depend on ex ternal source of finance such as issuing debentures and equity shares. Dividend poli n ' of the firm thus affects both longterm financing and the wealth of shareholders. B('causc of this, the decision of the company to pay dividend may be shared by two po' , ible view points, viz., (i) as a longterm financing decision and (ii) as a wealth maxi lc1isation decision.

66

Dividend Policy

67

As a long term financing decision: When dividend decision is treated as a financing decision, the net earnings of the firms may be viewed as a source of long-term financing. With this approach, a company will pay dividend only when it does not have profitable investment opportunities, it can issue equity to the public, but retained earnings are preferable. Because dividends reduces the amount of funds available to finance profitable investment opportunities. Hence, either company's growth is restricted or the company may be forced to depend on other costly sources of financing. Thus, the dividend policy which involves retaining of earnings, is a long term financing decision related to management of capital structure of the firm. As a wealth maximisation decision: The tendency of most of the shareholders is to give a higher value to the near dividends than the future values in the market. Higher dividends increase the value of shares and low dividends decrease the value. In order to maximise wealth, i.e., maximisation of the v.alue of the firm to its shareholders, the management must declare sufficient dividends. The 'management of a firm must carefully decide its dividend policy. If more net earnings are retained, the shareholders dividend is decreased and the market price of the shares may be adversely affected. But the use of retained earnings to finance profitable projects will increase future earnings per share. On the other hand, if the firm increases dividend, there may .be a favourable reaction in the stock market, but the firm may have to forego some investment opportunities for want of funds. Because of this, the future earnings of share may decrease. In view of this the management should decide dividend policy carefully, so that the net earnings are divided between dividends and retained earnings in an optimum way to achieve the objective of maximising the wealth of shareholders. Shareholders' wealth includes not only market price of shares quoted in stock market but also current dividends. Thus, dividends are more than just a means of distributing unused funds. Dividend policy to a large extent affect the financial structure, the flow of funds, corporate liquidity, stock prices, growth of the company and investor's satisfaction. That is why, dividend policy has much significance and the management has to decide it very carefully.

Factors Influencing Dividend Policy Many factors influence a company in its dividend policy. We give here a list of major factors which influence dividend policy of a concern: (Fig. 3.1) 1. Stability of Earnings: Stability of earnings is one of the important factors influencing the dividend policy. If earnings are relatively stable, a firm is in a better position to predict what its future earnings will be and such companies are more likely to payout a higher percentage of its earnings in dividends than a concern which has a fluctuating earnings. Generally, the concerns which deal in necessities suffer less from fluctuating incomes than those concern which deal with fancy or luxurious goods. 2. Financing Policy of the Company: Dividend policy may be affected and influenced by financing policy of the company. If the company decides to meet its expenses from its earnings, then it will have to pay less dividend to shareholders. On the other hand, if the company feels, that borrowing outside is cheaper than internal financing, then it may decide to pay higher rate of dividend to its shareholder. Thus,

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Advanced Financial Management

the internal financing policy of the company influences the dividend policy of the business firm. Stability of earnings Financing policy of the company Liquidity of funds Dividend policy of competitive concerns Past dividend rates Debt obligation Factors Influencing Dividend . Policy

Ability to borrow ..-:::::.---..... Growth needs of the company Profit rates Legal requirements Policy of control Corporate taxation policy Tax position of shareholders Effect of trade policy Attitude of interested group

Fig. 3.1. Factors Influencing Dividend Policy

3. Liquidity of Funds: The liquidity of funds is an important consideration iri dividend decisions. According to Guthmann and Dougall, "Although it is customary to speak of paying dividends 'out of profits', a cash dividend only be paid from money in the bank. The presence of profit is an accounting phenomenon and a common legal requirement, with the cash and working capital position is also necessary in order to judge the ability of the corporation to pay a cash dividend. "Payment of dividend means, a cash outflow, and hence, the greater the cash position and liquidity of the firm is determined by the firm's investment and financing decisions. While the investment decisions determine the rate of asset expansion and the firm's needs for funds, the financing decisions determine the manner of financing. 4. Dividend Policy of Competitive Concerns: Another factor which influences, is the dividend policy of other competitive concerns in the market. If the other competing concerns, are paying higher rate of dividend than this concern, the shareholders may prefer to invest their money in those concerns rather than in this concern. Hence, every company will have to decide its dividend policy, by keeping in view the dividend policy of other competitive concerns in the market. 5. Past Dividend ~ates: If the firm is already existing, the dividend rate may be decided on the basis of dividends declared in the previous years. It is better for the concern to maintain stability in the rate of dividend and hence, generally the directors will have to keep in mind the rate of dividend declared in the past. 6. Debt Obligations: A firm which has incurred heavy indebtedness, is not in a position to pay higher dividends to shareholders. Earning retention is very important for such concerns which are following a programme of substantial debt reduction. On the other hand, if the company has no debt obligations, it can afford to pay higher rate of dividend.

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69

7. Ability to Borrow: Every company requires finance both for expansion programmes as well as for meeting unanticipated expenses. Hence, the companies have to borrow from the market, well established and large firms have better access to the capital market than new and small, firms and hence, they can pay higher rate of dividend. The new companies generally find it difficult to borrow from the market and hence they cannot afford to pay higher rate of dividend. 8. Growth needs of the Company: Another factor which influences the rate of dividend is the growth needs of the company. In case the company has already expanded considerably, it does not require funds for further expansions. On the other hand, if the company has expansion programmes, it would need more money for growth and development. Thus when money for expansion is not needed, then it is easy for the company to declare higher rate of dividend. 9. Profit Rate: Another important consideration for deciding the dividend is the profit rate of the firm. The internal profitability rate of the firm provides a basis for comparing the productivity of retained earnings to the alternative return which could be earned elsewhere. Thus, alternative investment opportunities also play an important role in dividend decisions. 10. Legal Requirements: While declaring dividend, the board of directors will have to consider the legal restriction. The Indian Companies Act 1956, prescribes certain guidelines in respect of declaration and payment of dividends and they are to be strictly observed by the company at the time of declaring dividends. (these guidelines are given in the end of this chapter). 11. Policy of Control: Policy of control is &Ilother irriportant factor which influences dividend policy. If the company feels that no new shareholders should be added, then it will have to pay less dividends. Generally, it is felt, that new shareholders. can dilute the existing control of the management over the concern. Hence, if maintenance of existing control is an important consideration, the rate of dividend may be lower so that the company can meet its financial requirements from its retained earnings without issuing additional shares to the public. 12. Corporate Taxation Policy: Corporate taxes affect the rate of dividends of the concern. High rates of taxation reduce the residual profits available for distribution to shareholders. Hence, the rate of divided is affected. Further, in some circumstances, government puts dividend tax on distribution of dividends beyond a certain limit. This may also affect rate of dividend of the concern. 13. Tax Position of Shareholders: The tax position of shareholders is another influencing factor on dividend decisions. In a company if a large number of shareholders have already high income from other sources and are bracketed in high income structure, they will not be interested in high dividends because the large part of the dividend income will go away by way of income tax. Hence, they prefer capital gains to cash gains, i.e., dividend capital gains here we mean capital benefit derived by the capitalisation of the reserves or issue of bonus shares. Instead of receiving the dividend in the form of cash (whatever may be the per cent), the shareholders would like to get shares and increase their holding in the form of shares. This has certain benefits to shareholders. They get money by selling these extra shares received in proportion to

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their original shareholding. This will be a capital gain for them. Of course they have to pay tax on capital gains. But the capital gains tax will be less compared to the incometax that they should have paid when cash dividend was declared and added to the personal income of the shareholders. 14. Effect of Trade Cycle: Trade cycle also influences the dividend policy of the concern. For example, during the period of inflation, funds generated from depreciation may not be adequate to replace the assets. Consequently, there is a need for retained earnings in order to preserve the earning power of the firm. 15. Attitude of the Interested Group; A concern may have certain group of interested and powerful shareholders. These people have certain attitude towards payment of dividend and have a definite say in policy formulation regarding dividend payments. If they are not interested in higher rate of dividend, shareholders are not likely to get that. On the other hand, if they are interested in higher rate of di vidend, they will manage to make company declare higher rate of dividend even in the face of many odds.

STABILITY OF DIVIDEND Stability or regularity of dividend is regarded as a desirable policy by the management of most business concerns. Most of the shareholders also prefer stable dividends because all other things being the same, stable dividends have a positive impact on the market price of the share. Stability of dividends sometimes means regularity in payment of dividend every, year even though the amount of dividend may fluctuate from year to year. Further, the dividend declared may not be related with earnings. There are four distinct forms of such stability dividend. These four forms are also dividend practices generally followed by the companies and they are explained here.

I I Constant dividend per share

I

Dividend Practices

I

I

I

Constant percentage of net earnings

Small constant dividend per share plus extra dividend

Dividend as fixed percentage of market value

Fig. 3.2. Dividend Practices

1. Constant dividend per share: A number of companies follow the policy of paying a fixed amount per share as dividend every year, without considering the fluctuations in the earnings of the company. This does not mean, that the dividend per share shall never be increased. If the company's earnings increase and if it hopes to maintain it at that level, it may increase its annual dividend.. 2. Constant percentage of net earnings: Some companies follow a dividend policy of constant payment ratio, i.e., paying a fixed percentage of net earnings as

Dividend Policy

71

dividend will fluctuate in direct proportion to earnings of the company. That is, if a company adopts, 25 percent payout ratio, then 25 percent of every rupee of net earnings will be paid out as dividends. For example, if the company earns Rs. 2 per share. the dividend per share will be RS. 0.50. 3. Small constant dividend per share plus extra dividend: Under the constant diyidend per share policy, the amount of dividend is set at a high level and this policy is usually adopted by the companies with stable earnings. For companies whose earnings fluctuate, the policy has to pay a minimum dividend per share with a step-up feature is quite popular. The small amount of dividend is fixed with the purpose of maintaining regularity in payment of dividend and extra dividend when the company's earnings are higher than the usu,al. 4. Dividend as a fixed percentage of market value: According to some financial managers, the shareholders often translate their dividend income into the percentage returns of market price of their shares and hence. they suggest that it is better if dividends are tied to the value of company's shares rather than to its profits. This requires, first setting up a representative rate of dividend return as a target rate which may be rate paid by a closely competitive company or the average dividend for the industry. This approach is followed on the belief that it is the obligation of management to the shareholders to adjust dividend payment with the rates paid by the competitors and by the industry as a whole.

Significance of Stability of Dividend From the concept stability of dividend, both the shareholders and the company secure certain advantages. They are as follows : 1. Confidence among shareholders: Payment of a regular and stable dividend may help in building confidence in the minds of investors regarding regularity of dividend. When a company follows a policy of stable dividends, it will not change the amount of dividend, if earnings change temporarily. Thus when the earnings drop, the company does not cut its dividends. By this the company conveys to investors that the future of the company is bright than suggested by drop in earnings. Similarly, the amount of dividend is increased with increased earnings level only if the company is convinced that it is possible to maintain it in future. On the other hand. if a company follows a policy of changing dividend with changes in its earnings, the shareholders not only would be uncertain about the amount of dividend but also may entertain doubts about the company's future.

2. Investors desire for current income: There are many investors such as women, old and retired persons etc., who prefer to receive income regularly to meet their living expenses. Such income conscious investc!'~ will certainly prefer a company with stable dividends to one with unstable dividends. 3. Institutional Investor's requirements: Investments are made in company shares not only by individuals but also by financial, educational and social institutions and units trust. Generally companies are interested to have institutions in the list of their investors. Normally the institutions prefer to invest in the shares of those companies which pay dividends regularly. Thus, to attract institutional investors a company prefers to follow a stable dividend policy.

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4. Stability in market price of shares: Stable dividends help in maintaining stability in market price of shares and this is good for both to the company and to the shareholders. Studies of individual shares have revealed that stable dividends bu[fer the market price of the stock when earnings turn down. S. Raising additional finances: A stable dividend policy is also advantageous to company in raising external finance. Stable and regular divided policy tends to make the shares of a company an investment rather than a speculation. Investors who purchase these shares tend to hold them for long periods of time and their loyalty and goodwill towards the company increase. If the company issues new shares, they would be more receptive to the offer. Thus, raising of additional finance becomes easy for the company. 6. Spreading of ownership of outstanding shares: Stable dividend policy helps in spreading ownership of outstanding shares more widely among small investors because the persons with small means, in the hope of supplementing their income, usually prefer to purchase shares of those companies which follow stable dividend policy. 7. Reduces the chances of loss of control: Because of the spreading of ownership of outstanding shares among the large number of small investors, the chances of loss of control by the present management over the company reduced. 8. Market for debentures and preference shares: A stable dividend policy also helps the sale of debentures and preference shares of the company. The fact that the company has been paying dividend regularly in the past is sufficient assurance to the investors in debentures bonds, and preference shares about their regular income. Hence, good market is provided for debenture and preference shares. Thus. the stability of dividends affect the standing value of equity share and a\so standing of the corpOration in the eyes of the investing public. This enhanced standing is reflected in the price of company's securities.

Forms of Dividend

Fig. 3.3. Forms of Dividend

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Dividend Policy

Dividend that (a) Scrip dividend, (e) Stock dividend. paid. We shall give

is being distributed by a company may take several forms, viz., (b) Bond dividend (c) Property dividend (d) Cash dividend and In India, only cash dividend and stock dividend are declared and here a brief explanation of these forms of di'Yidend:

(a) Scrip dividend: When earnings of the company justify dividend, but the company's cash position is temporarily weak and does not permit cash dividend, it may declare dividend in the form of scrips. In this method of dividend, the shareholders are issued transferable promissory notes which mayor not be interest bearing. Scrip dividends are justified only when the company has really earned profit and has only to wait for the conversion of other current assets into cash in the course of operations.

(b) Bond dividends: Sometimes, the dividends are paid in bonds or notes than have a long enough term to fall beyond the current liability group. Effect of both scrip dividends and bond dividend is the same except that the payment is postponed in the bond dividends. (c) Property dividends: This involves a payment with assets other than cash. This

form of dividend may be followed wherever there are assets that are no longer necessary in the operation of the business. (d) Cash dividend: Cash dividend is the dividend which is distributed to the shareholders in cash out of the earnings of the business.

(e) Stock dividend: Stock dividend is the dividend which is paid to the shareholders in kind. When stock dividends are paid, a portion of the surplus is transferred to the capital account and shareholders are issued additional share certificates. Such shares are known as bonus shares and this process is known as capitalisation of profit. This dividend is declared to only equity shareholders and it may take two forms. . • Making the partly paid equity share fully paid up without asking for cash from the shareholders; or . • Issuing or allotting equity shares to existing shareholders in a definite proportion out of profit (or surplus). Stock dividend does not alter the cash position of the company It serves to commit the retained earnings to the business as a part of its fixed capitalisation. Further, stock dividend does not result in the change in the equity of shareholders or in the proportions that say individual shareholders owns. Indian companies Act 1956, provide certain rules and regulations for declaration of dividend and every company should observe them strictly. It may be noted here, that the Indian Companies Act 1956 permits declaration of only two types of the dividends in India, viz., (a) cash dividend (b) stock dividend. We will discuss here the object of stock dividend and the advantages and limitations of stock dividend.

Objects of Stock Dividend Stock dividend may be issued by a company to serve certain objectives. They are as follows:

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Management

1. Conservation of cash: Issuing of bonus shares does not involve the payment of cash in business. 2. Lowi!r rate of dividend: Stock dividend is a remedy for under capitalisation too. Under-capitalised concern with a high rate of earnings can reduce rate of dividend on the capital employed by increasing its capitalisation. The increase in the number of shares reduces rate of dividend per share. 3. Financing expansion programmes: Through the issue of boq,us shares, , corporate savings have become the permanent part of the capital structure of a company. This helps in financing expansion and modernization programmes of a company. 4; Transferring the formal ownership of surplus and reserves to the shareholders: By issuing bonus shares, surplus and reserve are capitalised and formal ownership is transferr~d to the shareholders. S. Enhanced prestige: Company which issues bonus share:; will have increased· credit standing in the m%rket and its borrowing capacity goes on high in the eyes of lending institutions. 6. Widening share market: A company interested in widening the ownership of its shares may issue bonuS" shares. Some of the old shareholders may sell their new shares. Moreover, because of the increased prestige of the company, there will be good demand for the shares of this company. 7. True presentatioD; ,of earning capacity: If the revenue is not capitalised, a false idea about the rate of profits is created in the minds of public. This is because, share capital is left unchanged while profits continue to accumulate. Hence, 'by issuing bonus shares, real picture of the company is"presented to the investing public.

Advantage of Stock Dividend (or Bonus Shares) A.

Advantages for Issuing Company 1. Maintenance of liquidity position: By issuing bonus share, company does . not pay cash to the shareholders and by this company can maintain its liquidity position. 2. Satisfaction of shareholders: By the issue of bonus shares, the equity of shareholders in the company increases. By this, the confidence of investors will increase in the soundness of the corPoration and accordingly it benefit the shareholders. 3. Economical issue of capitalisation: The issue of bonus shares involves minimum cost and hence it is the most economical issue of securities. 4. Remedy for under capitalisation: Rate of dividend in, under capitalised companies is high and by issuing bonus shares, the rate of dividend per share can be reduced. Hence, company can be saved from.the effect of under ' capitalisation. S. Enhance prestige: By issuing bonus share, the company increases its credit standing and its borrowing capacity 'goes high in the eyes of lending institutions.

Dividend Policy

75

6. Widening the share for market: A company interested in widening the ownership of its shares may issue bonus shares. Some of the old shareholders will sell their new shares and by this the obje~t of the company is achieved. 7. Finance for expansion programmes: By issuing bonus shares, the expansion and modernization programmes of a company can be easily financed. Hence, the company need not depend much on out side agencies for finances. 8. Conservation..of Control: .Maintenance of existing control is possible by issuing bonus shares. Generally, it is felt that the new shareholders can dilute the existing control of the management, over the concern. This can be avoided by issuing bonus shares. B.

A ~tages of business cycle etc.

MANAGEMENT OF CASH Cash is the most liquid asset that a business owns. It includes money and such instruments as cheques, money orders and bank drafts. Cash in the business enterprise may be compared to the blood in the human body, which gives life and strength to the human body and the cash imparts life and strength, profits and solvency to the business

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organisation. Though firms differ in a considerable degree in terms of nature of business, capital structure, personnel employed, risk of technology and so on, they have in common the basic mechanism involving conversion of funds in to saleable products and back in to liquid form. Cash in its ultimate state yields no return as such it is barren. One of the most urgent confronting corporate financial management is to make cash balances work harder. The essence of effective management is the synchronisation of the rates of inflow of receipts with the rates of outflow of cash disbursements. Planning for cash requirements is an essential management function of any business. It is not enough for an undertaking to make a profit. Cash resources should be planned to finance a cash flow, without which many otherwise efficient and profitable business have encount.ered difficulties .. A corporate financial officer should plan his cash and credit sources in such a. way that the normal operations of the corporation are not disrupted by a shortage of cash and further, the opportunities for capital expenditure are not lost because of liability to finance them. The creditworthiness of a business is one of its most valuable assets. A management should, therefore, ensure that there are no hold-ups in the payment of its dues because it would earn: the reputation of being a bad paymaster or else, its creditors may resort to litigation. Unfortunately, the inflow and outflow of funds cannot be synchronised completely. If this were possible, it would not be necessary to maintain more than a minimum of cash or near cash resources. A control of the position is a vital aspect of the financial, management of a concern. There should be a balance between cash and cash-demanding activities operations, capital additions, etc. The objectives of cash management are to make the most effective use of funds, on tile one hand, and accelerate the inflow and decelerate the outflow of cash on the other. The traditional approach to a determination of technical solvency, which stresses availability of eurrent assets to discharge current liabilities, is viewed as incomplete. In this connection, James Walter has rightly observed that-the appropriate topic for discussion app~ars rather to be whether prevailing cash inflows (plus cash resources) cover existing cash outflows by a sufficient margin to protect against possible reduction in inflows or increments in outflows. A financial manager has to adhere to the five 'Rs' of money management. Those are: the right quality of money for liquidity considerations, the right quantity whether owned or borrowed, the right time to preserve solvency, the right source, and the right cost of capital, the organisation can afford to pay.

Objectives of Cash Management A highly liquid, vital asset is cash. It is needed to meet every type of expenditure. Hence it should be sufficiently made available. If a firm fails to provide funds to meet the obligation, it will be clear indication of technical insolvency of the firm. If the cash position of the firm is strong, it can command the business operations. Cash discounts can be obtained on purchases. Obligations can be met immediately. Cost of capital will be minimised. However it cannot also hold cash in an idle way. It should be made productive. Keeping these two views, viz.. liquidity and profitability, the following objectives can be identified of cash management. • To make cash payments. • To maintain minimum Cash reserve.

Working Capital Management

143

• To make cash payments: Very objective of holding cash is to meet the various types of expenditure to be incurred in business operations. Several types of expenditure have to be met at different points of time and the firm should be prepared to make such cash payments. The firm should remain liquid to meet the obligations. Otherwise the business suffers. It is observed that 'Cash is an oil to lubricate the ever turning wheels of business, without it, the process grinds to a stop.' Thus one of the basic objectives of cash management is to maintain the image of the organisation by making prompt payments to creditors and to avail cash discount facilities. • To maintain minimum cash reserve: Another important objective of cash management is to maintain minimum reserve. This means, in the process of meeting obligations on time, the firm should not unnecessarily maintain heavy cash reserves. It cannot keep the cash idle. Excess cash balance should be made productive (this means it should be invested). Maintaining minimum cash reserve is made possible by synchronising cash inflows and outflows through cash budgeting. Cash collection should be expedited and cash outflows should be controlled to conserve cash resources. Thus as far as possible the firm should maintain minimum cash reserve to attain the objective of profitability.

Motives for Holding Cash Cash is held by the firm with the following motives: Transaction Precautionary Motives of Holding Cash Speculative Compensatory Fig. 4.8. Motives of Holding Cash

1. Transaction Motive: Transaction motive requires a firm to hold cash to conduct its business in the ordinary course. The firm needs cash to make payments for purchases, wages, operating expenses and other inevitable payments. The need to hold cash arises because cash receipts and cash payments are not perfectly synchronised. Sometimes cash receipts exceed cash ~ayments, whereas at other times cash payments exceed cash receipts, the firm should maintain some cash balance to make the required payments. For transaction purposes, a firm must invest its cash in marketable securities. Usually, the firm will purchase the securities whose maturity corresponds with ~ome anticipated payments. 2. Precautionary Motive: Cash is alSO maintained by the firms and even by individuals to meet unforeseen expenses at a future date. There are uncontrollable factors like government's policies competition, natural calamities; labour unrest, consumer behavior which will have heavy impact on businesavc to sell its marketable securities, if available, or borrow. This involves transaction costs. On the other hand, if the flrm maintains a high level of cash balance, it will have a sound liquidity position but forego the opportunities to earn interest. The potential interest lost on holding large cash balance involves an opportunity cost to the flrm. Thus, the firm should maintain an optimum cash balance. the transaction costs and risk of too small a balance should be matched with the opportunity costs of too large a balance.

Working Capital Management

151

Investment in Marketable Securities There exists close relationship between cash and marketable securities. Excess cash should normally be invested in marketable securities which can be conveniently and promptly converted into cash. Cash in excess of "working cash balance requirements" may be held for two reasons. Firstly, the working capital requirements of firm fluctuate because of the elements of seasonality would be needed when the demand picks up. Thus, excess of cash during slack seasons is idle temporarily but has a predictable financial needs. A firm holds extra cash because cash-flows cannot be predicted with certainty. Cash balance held to cover the future contingencies is called the precautionary balance and usually is invested in marketable securities until needed. Instead of holding excess cash for the above mentioned purpose, the firm may meet its precautionary requirements as and when they arise by making short-term borrowings. The choice between the short-term borrowings and liquid assets holding will depend upon the firm's policy regarding the mix of short-term financing. The excess amount of cash held by the firm to meet its variable cash requirements and future contingencies should be temporarily invested in marketable securities, which can be regarded as near moneys. A number of marketable securities, may be availahi.: in the market. As money nears the financial manager must decide on the portfolio of marketable securities in which the firm's surplus cash should be invested.

Selection of Securities As the firm invests its temporary transaction balances or precautionary balances or both, its primary criterion in selecting a security will be its quickest convertibility into cash, when the need for cash arises. Besides this, the firm would also be interested in the fact that when it sells the security, it, at least, gets the amount of cash equal to the cost of security. Thus, in choosing among alternative securities, the firm should examine three basic features of a security; safety, maturity and marketability.

Safety Usually, a firm would be interested in receiving as high a return on its investments in marketable securities as it is possible. But, the higher return yielding securities are relatively more risky. The firm should invest in very safe securities, as the transaction or precautionary balances invested in them are needed in near future. Thus, the firm would tend to invest in the highest are needed in near future. Thus, the firm would tend to invest in the highest yielding marketable securities subject ~to the constraint that the securities have acceptable level of risk. The risk referred to here in the default risk. The default risk means the possibility of default in the payment of interest or principal on time and default if the amount promised. the default in payment may mean more than one ~hing. In an extreme case, the security may not be redeemed at all. In majority of the cases, the security may be sold at a loss, when firm needs cash. To minimise the chances of default risk and ensure safety of principal of interest, the finn should invest in safe securities.

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Maturity Maturity refers to the time period over which interest and principal are to be made over. The price of long-term security fluctuates more widely with the interest rate changes than the price of short-term security. Interest rates have a tendency to change over a period of time. Because of these twb factors, the long-tenn securities are relatively more risky. For safety reasons, the firm for the purpose of investing excess cash prefers short-term securities.

Marketability Marketability refers to convenience and speed with which a security can be converted into cash. The two important aspects of marketability are price and time. If the security can be sold quickly without loss of pr ice, it is highly liquid or marketable. The government treasury bills fall under this Category. Problem 23 : A company is expecthlg to have Rs. 25,000 cash in hand on 1st April 2006 and it requires you to prepare cash budget for the three months. April to June 2006. The following information is supplie'd to you.

Momhs Februa/~Y

Sales Rs.

Purchases Rs.

Wages Rs.

40,000 50,000 52,000 60,000 55,000

8,000 8,000 9,000 10,000 12,000

70,000 80,000 92,000 100,000 1,20,000

Expenses Rs. 6,000 7,000 7,000 8,000 9,000

March April May June Other 1nformation (a) Period of credit allowed by suppliers is two months (b) 25% of saLe is for cash and the period of credit allowed to customers for credit . . .'., sale is one month. ( C) DeLay in paymellt of wages and expenses one month. [BMA - 2002J Id) Income tax Rs 25,000 is to be paid in Jun.e 2006. Solution: Particulars

June Rs.

Total Rs.

53,000

81,000

25,000

23,000

25,000

30,000

98,000

60,000

69,000

75,000

2,04,000

83,000*

94,000

1,05,000

2,82,000

April Rs.

May Rs.

25,000

Cash sales Debtors

Opening Balance Receipts:

Total Receipts (A)

* Including the opening cash balance

Working Capital Management

153

Payments: Creditors

40,000

50,000

52,000

1,42,000

Wages

8,'000

9,000

10,000

27,000

Expenses

7,000

7,000

8,000

22,000

25,000

25,000

95,000

2,16,000

[ncome tax Total payments (B)

55,000

66,000

--------------------------------------Closing balance (A - B) 53,000 81,000 91,000 91,000 Problem 24 : X Y company wishes to arrange overdraftJacilities with. Bankers during the period April to June of a particular year, when it will be manufacturing mostly for stock. Prepare a cash budget for the above period from the following data, Indicating the extent of the bankfacUities, the company will require at the end of each month. (a) Month Sales (Rs) Purchase (Rs) Wages (Rs) February 1,80,000 1,24,800 12,000 March 1,92,000 1,44,000 14,000 April 2,43,000 11,000 1,08,000 May 1,74,000 2,46,000 10,000 2,68,000 15,000 June 1,26,000 (b) 50% of the credit sales are realised in the month following the sales and the remaining sales in second month following. ( c) Creditors are paid in the following month of purchase.

(d) Cash at bank on 1st April Rs. 25,000.

[MCIM - 2004J

Solution: Cash budget for the months from April to June 2005 Particulars

April (Rs)

May (Rs)

June (Rs)

Receipts : Opening balance of cash at bank/overdraft

25,000

56,000

- (47,000)

Realised from debtors

186,000

150,000

141,000

Total Receipts (A)

2,11,000

2,06,000

94,000

1,44,000

2,43,000

2,46,000

11,000

tO,OOO

15,000

1,55,000

2,53,000

2,61,000

Payments : Creditors for purchases Wages Total payments (B)

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Closing balance of cash at bankloverdrafl

56,000

-(47,000)

- (1,67,000)

(a) Figures in Brackets indicate bank overdraft. (b) Receipts from debtors April = 50% of sales for February + 50% of sales for March = ·90,000 + 96,000 = Rs. 1,86,000

May

= 50% of sales for March + 50% of sales for April = 96,000 + 54,000 = Rs. 1,50,000

June

= 50% of sales for April + 50% of sales for May = 54,000 + 8.7,000 = Rs. 1,41,000

Problem 25 : From the following forecasts of Income and Expenditure.

Prepare a cash budget for the months January to April 2005 Sales Purchases Wages Manufacturing Administration Selling expenses credit expenses expenses credit (Rs) (Rs) (Rs) (Rs) (Rs) (Rs) 2004 November 30,000

15,000

3,000

1,150

1,060

500

December 35,000

20,000

3,200

1,275

1,040

550

1,100

600 620 570 710

2005 January

15,000

15,000

2,500

February

30,000

20,000

3,000

990 1,050

March

35,000

2.400

1,100

April

40,000

22,500 25,000

1.150 1,220

2,600

1,200

1,180

Addition Information is as follows:

1. The customers are allowed a credit period of 2 months. 2. A dividend of Rs. 10,000 is payable in April. 3. Capital expenditure to be incurred: Plant purchased on 15th January for Rs. 5,000 a building has be(?1l purchased on 1st March and the payments are to be made in mOllthly installments of Rs. 2000 each. -I. The creditors are allowing a credit of 2 months. 5. Wages are paid on tile 1st of the next month. 6. Lag in payment of other expenses ill one month. 7. Balallce of cash ill halld on 1st January 2005 is Rs. /5,000. IBMA - 2004J

Working Capital Management

155

Solution: Cash budget for the month from January to April 2005 Details

January Rs.

February Rs.

March Rs.

April Rs.

15.000

18.985

28,795

30,975

Cash realised from debtors 30.000

35,000

25,000

30,000

45,000

53,985

53,795

60,975

15,000

20,000

15,000

20,000

Wages

3,200

2,500

3.000

2,400

Manufacturing expenses

1.225

990

1,050

1,100

Administrative expenses

1,040

1,100

1,150

1,220

550

600

620

570

Receipts: To balance bId.

Total Receipts (A)

Payments: Payment of creditors (for purchase)

Selling expenses Payment of dividend Purchase of plant

10.000 5,000

Installments of building loan Total payments (8) Closing balance (A - 8)

26,015

25,190

2,000

2,000

22,820

37,290

----------------------------------------18,985 28,795 30,975 23,685

Problem 26 : From the followillg forecasts of income and expenditure. Prepare cash budget for three months ending 30 September was Rs. 10,000.

lh

November. The bank balance

011

Sales (Rs)

Purchases ( R.\)

Wages (Rs)

July August

80,000 76,500

40,000

5,600

3,900

10,000

42,000

5,800

4,100

12,000

September

78,000

38,500

5,800

4,200

14,000

October

90,000

37,500

5,900

5,100

16,000

Novell/bel'

95,000

43,000

5,900

6,000

13,000

Month

£I

1st

Factory expenses Office expenses (Rs) (Rs)

The period of credit allowed to customers is two months and one month credit is ohtained from supplies of goods. Wages are paitj twice in a month all 1st and 16th respectively. Expenses are paid ill the month in which they are due. A sales

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commission of 4% on sales, due in the month in which sales due are collected is payable in addition to office expenses. Fixed assets worths Rs. 65,000 will be purchased in September to be paid in the following month Rs. 20,000 in respect of debenture interest will be paid in October. [AKCW - 2002J Solution: Cash budget for the months ending from 30th September to 30th November Particulars

September

October

November

(Rs)

(Rs)

(Rs)

Receipts : Bank balance/overdraft at the beginning of month

10,000

20,800

- (56,210)

Cash realised from debtors

80,000

76,500

78,000

Total receipts

90,000

97,300

21,790

42,000

38,500

37,500

Wages

5,800

5,850

5,900

Factory expenses

4,200

5,100

6,000

Office expenses

14,000

16,000

13,000

3,200

),060

3,120

(A)

Payments : Creditors for purchase of goods

Commission on sales [4% of previous 2 months sales] Fixed assets purchased

65,000

Debenture interest

20,000

Total payments (B)

69,200

1,53,510

65,520

-20,800

- (56,210)

- (43,730)

Bank balancel (A - B) overdraft at the end of month

Problem 27 : The following data relates to Chander company limited. The financial manager has made the following salesforecastfor thefirstfive months of the coming year commencing from 1st April 2006.

Month April May June July August

Sales (Rs) 40,000 45,000 55,000 60,000 50,000

Working Capital Management

157

Other information: (a) Debtor's and Creditor's balance at the begi1lning of the year are Rs. 30,000 and Rs. 14,000 respectively. The balance of olher relevant assets and liabilities are: Cash Balance - Rs. 7,500, Stock - Rs. 51,000, Accused sales commission Rs.3,500. (b) 40% sales are on cash basis. Credit sales are collected in the month following the sale. (c) Cost of sales is 60% on sales. (d) The only other variable cost is 5% commission to sales agent the sales commission is paid in a month after it is earned. (e) Inventory is kept equal to sales requirements for the next two months budgeted sales. (f) Trade creditors are paid in the following month after purchases. (g) Fixed costs are Rs. 5,000 per month including Rs. 2,000 depreciation. You are required to prepare a cash budget for the months of April, May and June 2006 respectively. [BIMS - 2002J

Solution: Cash budget for the months of April, May and June 2006 Particulars Opening Balance

April (Rs)

May (Rs)

June (Rs)

7,500

33,000

37,000

Cash sales (40% of sales)

16,000

18,000

22,000

Receipt from debtors

30,000

24,000

27,000

Total receipts (A)

53,500

75,000

86,000

14,000

33,000

36,000

Fixed costs (5,000 - 2,000)

3,000

3,000

3,000

Commission to sales agents

3,500

2,000

2,250

Total payments (B)

20,500

38,000

41,250

Closing balance (A - B)

33,000

37,000

44,750

Receipts :

Payments : Creditors

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Working notes: April

May

June

July

August

Rs.

Rs.

Rs.

Rs.

Rs.

24.000

27,000

33,000

36,000

30,000

24,000

27,000

33,000

36,000

30,000

60,000

69,000

66,000

84,000

96,000

99,000

opening inventory

51,000

60,000

69,000

Purchases

33,000

36,000

30,000

Payment to creditors

14,000

33,000

36,000

Credit sales (60% of ~otal sales) Cost of sales (60% of total sales) Desired inventory (closing) at cost

Less:

RECEIVABLES MANAGEMENT Need Accounts receivable is a pennanent investment in the business. As old accounts are collected new accounts are created. Accounts receivable is a major component of the current assets. This account emerges because of the existence of credit sales. As this account constitutes a major share (next to inventory), it has got a greater significance in working capital management. Credit sales no doubt increases turnover and profit of the business. But carrying pennanently the Accounts Receivable in the finn involves greater risk. Hence there is a need for the management to establish the level of accounts receivable. While establishing the level, the management has to examine the following aspects: (i) How best the accounts receivable contribute to the firm's earnings;

(ii) Whether it is feasible to tie the funds in this asset rather than in some other asset; (iii) How best the accounts receivable can be reduced without affecting the sales;

(iv) Whether the accounts receivable contribute anything for achieving the objectives of the enterprise. When these aspects are thoroughly examined, the company can decide about the level of accounts receivable as a major component of working capital. Thus the need for accounts receivable lies in its character as a means to increase the profits.

What is Accounts Receivable? Accounts receivable is a component of current asset. It shows the amount receivable from the purchasers. Hence it is a "Trade debt" due to the firm from the

159

Working Capital Management

purchasers who purchase goods or avail service on credit basis. This is called by different names. such as Accounts Receivable. Trade Debtors, Sundry Debtors, Trade Receivables etc. This account emerges out of credit sales. Almost all the business enterprises today carry on their business on credit basis. There will be both seIling and buying on credit basis and when credit sales take place, the buyers will have little time to pay back the purchase price. This allowance of time smoothens the trade activity and results in g~od turnover to the business and better profitability. Hence accounts receivable is an account maintained by the firms which shows the amount o~ing to the firm and it is a pennanent investment. It is exhibited on the assets side of the balance sheet under current assets and acts as a major component of working capital

What is Accounts Receivable Management? As stated earlier. accounts receivable is a penn anent investment and is an ever rolling account. The finance manager has to detennine the level of this account suitably so that there will be an easy flow of working capital. All this. viz.. maintenance of debtors at optimum level. the degree of credit sales to be made, making the debtors turn fast. involves the "Accounts Receivable management." Thus accounts receivable management is a decision-making process which takes into account the creation of debtors, debtors turnover and minimising the cost of borrowing of working capital due to lacking of funds in accounts receivable. The main objective of accounts receivable management is to maximise sales and profit with liberal but sound credit sales policy.

What Issues Govern the Accounts Receivable or Credit Sales? There are several issues that govern the accounts receivable. They are as follows: Determinants of Accounts Receivables

1 Credit Sales Volume

I

I

I

I

Credit Policies

Business Tenns

Competition

Location

1

New Products

Fig. 4.9 : Accounts Receivables Managemellf Issues

1. Credit Sales Volume: In order to increase the profit and push sales, many firms will have "Credit Sales." Higher the volume of credit sales, higher will be accounts receivable. The level of credit sales will also be determined by the custom that exists in that business. If the business needs the credit sales to push the product, it becomes inevitable that the finn has to adopt credit policy on a large scale. This naturally gives place for the emergence of accounts receivable. The volume of this account changes with the change in credit sales. If the credit sales increases year after year, the accounts receivable also changes more or less in the same proportion, supposing the credit sales increases by 10% Accounts Receivable also increases. Thus, one factor governs the volume of accounts receivable is "credit sales volume".

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2. Credit Policies: Another important factor which determines the volume of "Accounts Receivable" is credit policy of the firm. By "Credit policy" we mean the policy adopted to extend credit sales which include 1. The time period allowed to collect the debts, 2. The types of discounts allowed. 3. The assessment of customer's creditworthiness, (Collection policy etc. The credit policy varies also with the changes in the economy. If the economy is experiencing a· tight situation, then the businessmen will have to adopt a liberal credit sales policy. This means, the increase in accounts receivable. Again, the customers may take longer time to make payments. On the other hand, if the economy is experiencing a boom period, trade credit will be on a low key and the volume of accounts receivable will also be less and the collection period will also be reduced. The credit policy may be liberal or rigid one. If the firm adopts a rigid policy, the volume of accounts receivable will be less and the firm plays safe. There will be better debtor management. On the other hand, if the firm adopts a liberal credit policy, the volume of Accounts Receivable increases and this increases the risk of the firm. Even the sound customers would like to avail the facility of credit sales. This reduces the cash inflow and increases the volume of debtors. Another defect in this policy, is that the quality of the account receivables suffer. There will be more defaults and bad debts. Thus, the volume of accounts receivable ·depends upon the conditions in the economy and the nature of credit policy adapted by the firms.

3. Business Terms: The volume of accounts receivable also depends on the terms and conditions relating to credit sales. These conditions include (i) The time period allowed to pay back the purchase price (ii) The types of discounts allowed. • Time Period: The time period allowed to clear the trade debt by the customers determine the volume of accounts receivable. Longer the period allowed, higher will be the credit sales and rise in size of the accounts receivable. The time period will be determined by taking into account the business conditions and firm's internal financial situation relating to working capital. If the firm's micro and macro environment provide for longer credit period, it can do so. Otherwise it can adopt short period policy. However the payment should be made exactly on or before the due date which may be 15, 30 or 60 days. The term "Net date" is used to express the exact credit period allowed. • Discount: There are three categories of discounts allowed by the. traders to customers, viz.. (i) Trade discount, (ii) Cash discount and (iii) Quantity discount. Trade discount is the normal and usual discount allowed on the invoice price. This also influences the sales. Supposing higher trade discount is allowed on the invoice price the purchasers are motivated and sales volume increases and results in the increase of accounts receivable. However, the firm cannot lose on two counts (i) extending credit and (ii) allowing a higher trade discount. It has to strike a balance between these two and have a sound discount policy to push up sales figure.

Working Capital Management

161

Cash discount is another type allowed to customers for prompt payment. Supposing the credit period allowed is 60 days and if the customer makes the payment early, he may be given an extra discount of 2% or 3% on the money due This is also a motivation to the customer and reduces the size of the account~ receivable. The sound customers can avail this opportunity and get extra benefit On the other hand, this discount pushes sales figures and prompts the customers tu make early payment which increases the size of accounts receivable. If the seller finds that the stock he holds is in excess and if he anticipates a fall in price of tht> product, he will think of allowing quantity discount to push sales, reduce the excess stock and avoid the expected loss. The stock then can be converted into accounts receivable. This again increases the size of accounts receivable. ThUf-. besides giving trade discount, the trade may give extra discount or extra units ot goods if more quantity is purchased. 4. Competition: Another factor which governs the size of the accounts receivable i~ competition. If a firm is having a competitive environment, it will have liberal credit policy and this increases the size to the accounts receivable. They compete with the object of pushing sales and easy credit terms become inevitable. When the firms severely compete, the credit policy will be so liberal that all and sundry purchase the products on credit. This results in some all\ount of bad debts although it increases the volume of sales. Even during the competitive situation, the firms. though they adopt liberal credit policy, have to take care of the quality of debt. 5. Location: Location of business unit also contributes for the size of accounts receivable. If the business firms are located in far off places, they are forced to adopt a credit policy which attracts the customer. If the product is exclusive, location will not be a problem and customer development will be good. In such a case the firm can adopt a stringent credit policy which reduces the accounts receivable. On the other hand, if the product is competitive in character, the business unit dealing in such product and operating from a distant place from the market area, has to adopt a liberal credit policy which results in increase in accounts receivable. 6. New Products: When new products .1.': introduced, the firm has to extend the liberal credit policy till such time the product catches the market and even afterwards the policy has to continue to maintain customers. This naturally increases the size of accounts receivables.

What should be the size of Receivables? Many use the term "Optimum" when they think of production of goods or marketing of goods or maiQtaining the size of an account. But this term is bit ambiguous as that level cannot be reached any time. However, the nearest point may be reached. The same thing holds good in case of "Accounts Receivable." As discussed earlier, (i) Volume of credit sales and (ii) the average period between sales and collection are the two factors mainly determine the size of the accounts receivable. In order to reach a maintainable size (optimum). the firm has to strike a balance between "liquidity' and "profitability." Liquidity here refers to the quality of the accounts receivable. This means, the firm has to maintain debtors which are readily convertible into cash to meet

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the business needs. As far as possible the credit should be extended to those who have good credit standing. Then the accounts receivable will be qualitative one and results in good funds inflow. Profitability refers to the earning more profit by increasing the credit sales volume. But when the credit sales increase. more profit by increasing the credit sales volume. But when the credit sales increases, more risk is involved. This results in more locking of funds, increase in occurrence of bad debts and increased cost of collection. Hence sales volume has to be increased minimising these limitations. The firm cannot have a rigid credit sales policy either. If it adopts such a policy, the quality of debt may become good or there may be good inflow of funds but sales figure fall resulting in decline in profits. Considering every aspect, the firm has to maintain a balance between these two-liquidity and profitability-to hold a "Manageable size" of the accounts receivable. The credit policy should not be too loose or too tight. It should be moderate to maintain a qualitative and good size of accounts receivable.

How to determine the age of the receivables or the duration of collection period? The "age" here refers to the time involved in collecting the purchase price from the trade debtors. This age actually contributes to the sound management of working capital. If the collection period is long then the inflow of fund will be slow and may not synchronise with the payments to be made to the trade creditors. Hence it is always advisable to determine the collection period and the average age of the debtor. Shorter the collection period and age, faster will be the fund inflow. This helps in minimising expenses or trade creditors or any other payment to be made. The age of the accounts receivable can be computed by taking the following variables: (i) Credit sales for a given period, (ii) Opening debtors, (iii) Closing debtors.

The following steps are involved in the calculation of the age of the accounts receivable. Step 1 : Ascertain the average debtors by adding opening and closing debtors and dividing it by 2. i.e.,

Opening Drs + Closing Drs 2

= Average Debtors

Step 2 : Calculate the Debtors turnover by dividing credit sales by average Drs. Credit Sales =----Average Drs Step 3 : Find out the age of accounts receivable by dividing the period by debtors turnover.

=

Months in the period Debtors Turnover

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Problem 28 : Calculate average debtors turnover ratio and age ofaccounts receivables. Rs. Opening Accounts Receivable

40,000

Closing Accounts Receivable

30,000

Credit Sales for 12 months

3,50,000

Solution: (i)

Average Drs =

(ii)

Drs T. O. =

(iii)

Age of A. R. =

40,000

+ 30,000 2

= 35,000

3,50,000 =10 35,000 12 months 10

= 1.2 months

The age can also be computed by the following alternative methods.

Alternative • 1 : Step 1 : Multiply the period by the average Drs. Step 2 : Divide it by Sales. By adopting the data taken in the illustration, we can compute it in the following manner.

=

35,000 x 12 3,50,000

= 1.2 months

Alternative - 2 : According to this procedure divide average Debtors by the average monthly Sales. 35,000 = 3,50,000112 = 1.2 months.

Comment 1.2 months or 36 days is the age of the accounts receivable. This means the accounts receivable turn once in 36 days which is considered to be a good management of accounts receivable. Any period between 15 days to 45 days is adjudged as a sound period of collection and working capital management will not suffer. But while calculating the age, one should exercise greater care. Otherwise the result will be malicious. When the sales are widely fluctuating one should be cautious in calculating the age.

Ageing Schedule This is a statement prepared to determine the quality of the individual debtors. A comparative statement of individual for two periods will be prepared. The time period covered may be two years or two periods in the same year. Normally, the period is split having a frequency of 30 days, i.e., 0-30 days, 31 to 60 days, 61-90 days, 91 to 120 days etc., and what is the percentage of debt due during this periods will be known and the

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percentage will be compared with the figur~s of the corresponding period during previous year. Observe the following schedule. Ageing Schedule: (For one year).

Size of the A.R.

Period ending 30-9-91 (I half year)

Period ending 31-3-92 (II half year)

Days

Amount Due Rs.

Per cent

Amount Rs.

Per cent

0-60

75,000

12.25

2,25,000

25

61-120

2,25,000

37.75

4,50.000

50

121-180

3,00,000

50.00

2,25.000

25

Total

6,00.000

100

9,00,000

100

As seen from the above table amount due from Drs. is Rs. 6,00,000 in the first half of the year and of Rs. 9,00,000 in the second half of the year. In the first half~ the year, in the first class (0-60), collection in goods as the outstanding per cent is only 12-25 of the total due for the first half of the year. But for the corresponding period in the second half of the year, the position is not good. It shows a per cent of 25. In the second class (61-120 days), the percentage of collections better in the firms half of the year compared to second half of the year. It is 37.75 and 50. But the third period, (121-180 days), of second half of the year) is having good collection compared to the corresponding period in the first half of the year.

Maintenance Costs of Credit Sales Several types of costs are incurred to maintain the accounts receivable. The cost also includes the amount locked in account receivables. Following the types identified to manager the accounts receivable. 1. Locked Funds: When a firm adopts a credit policy, it is inevitable that a portion of working capital will be locked up in the form of debtors. This is an ever rolling account and the firm has to provide for it. This fund represents "Capital Cost". When the- customer avails the credit facility, from the time of sale to the time of receiving the purchase price, the money is blocked and the firm cannot wait for that money to carry out other transactions. There will be hundreds of such customers and hence huge money will be locked up. Then the firm will have" to make alternative arrangement to meet the gap. This can either be borrowed or secured from internal source. In both the cases the firm incurs a cost. If it is retained earnings, the opportunity cost (fund that the firm could earn in next best use) 'will be incurred and if it is borrowings the interest has to be paid. Therefore, the firm will have to provide for additional fund. 2. Managing Costs: Certain expenditure is made to maintain the books of accounts of the debtors. The expenses will be in the form of salary to the accounting staff, stationery, and expenses involved in assessing the credit standing of prospective buyers, etc. These expenses are called "managing costs" of accounts receivable.

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3. Collection Costs: There will be irregular customers, who do not keep on their schedule of payments. In every firm we find a certain percentage of this type of debtors. In such cases extra effort has to be put to collect the money. This involves certain expenses in the form of process fee, court fee, travel expenses, salary to collection staff etc. 4. Bad Debts: The firm should also provide for bad debts. Certain debts cannot be recovered in spite of the sincere coIlection efforts. The firm will not have any other alternative except to write it off. This is another type of cost that the firm has to incur.

What is the sound management policy for Accounts Receivab!e? (Credit Evaluation or Credit Standard) As discussed so far, two important factors govern the management of accounts receivables. They are 1. Sales volume, 2. The average period between sales and collection. Credit policy determines the average collection period. 3. Credit control. 1. Credit Rating: This refers to the measurement of the creditworthiness of the customer. The creditworthiness is measured by his standards fixed by the firm, while fixing the credit standard, the firm should take into consideration the collection costs, the temperament of the customer and the profit that can be earned by increasing the sales through liberal credit policy. The.incremental cost of credit should equate (or it can be less) with the incremental profits on the increased sales. However, the incremental cost should not exceed. (These costs are already discussed in previous paragraph). The credit rating is done by the established practices by adapting five "c"s. They are (i) Character (ii) Capacity, (iii) Capital, (iv) Collateral, (v) Conditions. "Character" refers to the temperament of the customer. It is to be judged whether the customer is honest and is prompt in paying the dues that he had undertaken to pay. Credit evaluation has to be made taking into account this factor. "Capacity" refers to the ability of the customer to pay back the purchase price. This can be measured by conducting a detailed investigation of his dealings, his past actions, his possessions, his business methods etc. This investigation reveals whether the customer is capable of managing his business efficiently. "Capital" refers to the financial soundness of the customers. This can be assessed by studying the financial statements of the firm. "Collateral" is a term used to express the additional ability of the customers. This measures the securities held by the customers which can be offered for the credit he avails. "Condition" refers to the economic conditions which influence the activities of the firm. If the conditions are unfavourable the situation will not be goodfor extending credit to such firms.

Thus, these five 'C's determine the credit rating of the customers. There are special agencies to conduct credit rating of the customers. In England, the organisations like (i) London Association for the Protection of Trade, (ii)

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National Federation of credit Traders, (iii) National Check Trader's Federation provide credit information of wholesalers, retailers and other business houses. There are service organisations and commercial credit houses, which supply credit information of the business houses. DUll and Brad Street, a famous firm in the USA collects irtformation for certain number of industries and publishes a reference book periodically. In this book, the financial strength of the firms are projected and credit appraisal of each firm is made. Based on the study of each firm, credit rating is made. Before making the credit rating, the information about the customers history, type of business carried. location of the business, the particulars about the payments, how he uses the credit facilities, his promptness in payment etc., will be analysed and the conclusions are drawn. The same rating is published in the book.

In India, many credit rating agencies are operating at present, viz., (i) Credit Rating and Information Services ofIndia (CRISIL) (ii) Investment Information and Credit Rating Agency (ICRA). These two agencies have just made a beginning and are supplying credit information to needy firms; Credit rating is also made pf the large firms who want it to be made when they are issuing the shares, to the public. Based on this information, the firms can make credit decisions relating to different class of customers. 2. Credit Period: Credit period, as far as possible, should be shorter one. Short period credit fa