DAYANAND ACADEMY OF MANAGEMENT STUDIES

NOTES OF CORPORATE FINANCIAL MANAGEMENT KMB 204

UNIT III

CAPITAL STRUCTURE
According to the definition of Gerestenbeg, “Capital Structure of a company refers to the composition or make up of its capitalization and it
includes all long-term capital resources”.

According to the definition of James C. Van Horne, “The mix of a firm’s permanent long-term financing represented by debt, preferred stock,
and common stock equity”.

According to the definition of Persona Chandra, “The composition of a firm’s financing consists of equity, preference, and debt”.

FINANCIAL STRUCTURE

The term financial structure is different from the capital structure. Financial structure shows the pattern total financing. It measures the extent to
which total funds are available to finance the total assets of the business. Financial Structure = Total liabilities

OPTIMUM CAPITAL STRUCTURE

Optimum capital structure is the capital structure at which the weighted average cost of capital is minimum and thereby the value of the firm is
maximum. Optimum capital structure may be defined as the capital structure or combination of debt and equity that leads to the maximum value
of the firm.

Objectives of Capital Structure Decision of capital structure aims at the following two important objectives:

1. Maximize the value of the firm.

2. Minimize the overall cost of capital.

Forms of Capital Structure Capital structure pattern varies from company to company and the availability of finance.

• Equity shares only.

• Equity and preference shares only.

• Equity and Debentures only.

• Equity shares, preference shares and debentures.

CAPITAL STRUCTURE THEORIES

Capital structure is the major part of the firm’s financial decision which affects the value of the firm and it leads to change EBIT and market
value of the shares. There is a relationship among the capital structure, cost of capital and value of the firm. The aim of effective capital structure
is to maximize the value of the firm and to reduce the cost of capital. There are two major theories explaining the relationship between capital
structure, cost of capital and value of the firm.

1. NET INCOME (NI) APPROACH

Net income approach suggested by the Durand. According to this approach, the capital structure decision is relevant to the valuation of the firm.
In other words, a change in the capital structure leads to a corresponding change in the overall cost of capital as well as the total value of the
firm. According to this approach, use more debt finance to reduce the overall cost of capital and increase the value of firm.

Net income approach is based on the following three important assumptions:

1. There are no corporate taxes.

2. The cost debt is less than the cost of equity.
3. The use of debt does not change the risk perception of the investor.
Where V = S+B
V = Value of firm S = Market value of equity B = Market value of debt Market value of the equity can be ascertained by the following formula:
S = NI/K e
NI = Earnings available to equity shareholder Ke = Cost of equity/equity capitalization rate

2. NET OPERATING INCOME (NOI) APPROACH

Another modern theory of capital structure, suggested by Durand. This is just the opposite of the Net Income approach. According to this
approach, Capital Structure decision is irrelevant to the valuation of the firm. The market value of the firm is not at all affected by the capital
structure changes. According to this approach, the change in capital structure will not lead to any change in the total value of the firm and market
price of shares as well as the overall cost of capital. NI approach is based on the following important assumptions; The overall cost of capital
remains constant; There are
no corporate taxes;
The market capitalizes the value of the firm as a whole;
Value of the firm (V) can be calculated with the help of the following formula
V = EBIT/Ko Where, V = Value of the firm EBIT = Earnings before interest and tax Ko = Overall cost of capital

3. TRADITIONAL APPROACH
It is the mix of Net Income approach and Net Operating Income approach. Hence, it is also called as intermediate approach. According to the
traditional approach, mix of debt and equity capital can increase the value of the firm by reducing overall cost of capital up to certain level of
debt. Traditional approach states that the Ko decreases only within the responsible limit of financial leverage and when reaching the minimum
level, it starts increasing with financial leverage. Assumptions Capital structure theories are based on certain assumption to analysis in a single
and convenient manner:

• There are only two sources of funds used by a firm; debt and shares.
• The firm pays 100% of its earning as dividend.
• The total assets are given and do not change.
• The total finance remains constant.
• The operating profits (EBIT) are not expected to grow.
• The business risk remains constant.
• The firm has a perpetual life.
• The investors behave rationally.
4. MODIGLIANI AND MILLER APPROACH

Modigliani and Miller approach states that the financing decision of a firm does not affect the market value of a firm in a perfect capital market.
In other words MM approach maintains that the average cost of capital does not change with change in the debt weighted equity mix or capital
structures of the firm.
Modigliani and Miller approach is based on the following important assumptions:

• There is a perfect capital market.

• There are no retained earnings.
• There are no corporate taxes.
• The investors act rationally.
• The dividend payout ratio is 100%.
• The business consists of the same level of business risk.
Value of the firm can be calculated with the help of the following formula:
V=EBIT/ K (l-t)

LEVERAGE
Leverage is common term in financial management which entails the ability to amplify results at a comparatively low cost. In business,
company's managers make decisions about leverage that affect profitability. According to James Horne, leverage is, "the employment of an asset
or fund for which the firm pays a fixed cost or fixed return". When they evaluate whether they can increase production profitably, they address
operating leverage. If they are expecting taking on additional debt, they have entered the field of financial leverage. Operating leverage and
financial leverage both heighten the changes that occur to earnings due to fixed costs in a company's capital structures. Fundamentally, leverage
refers to debt or to the borrowing of funds to finance the purchase of a company's assets. Business proprietors can use either debt or equity to
finance or buy the company's assets. Use of debt, or leverage, increases the company's risk of bankruptcy. It also upsurges the company's returns,
specifically its return on equity. It is a fact because, if debt financing is used rather than equity financing, then the owner's equity is not diluted
by issuing more shares of stock. Investors in a business like for the business to use debt financing but only up to a point. Investors get nervous
about too much debt financing as it drives up the company's default risk.

Types of leverage
There are many types of leverage. The company may use finance or leverage or operating leverage, to increase the EBIT and EPS.

Operating Leverage
The leverage related with investment activities is known as operating leverage. It is caused due to fixed operating expenses in the company.
Operating leverage may be defined as the company's ability to use fixed operating costs to magnify the effects of changes in sales on its earnings
before interest and taxes. Operating leverage comprises of two important costs viz., fixed cost and variable cost. Operating leverage augments
changes in earnings before interest and taxes (EBIT) as a response to changes in sales when a company's operational costs are comparatively
fixed. Operational leverage is the use of fixed operating costs by the firm. Operating leverage reproduces the impact on operating income of a
change in the level of productivity. Operating leverage measures the extent to which a firm or specific project needs some cumulative of both
fixed and variable costs. Fixed costs are amount not changed by an increase or decrease in the total number of goods or services a company
produces. Variable costs can be defined as the costs that differ in direct relationship to a company's production. Variable costs rise when
production upturns and fall when production drops. Businesses with higher ratios of fixed costs to variable costs are considered as using more
operating leverage, while businesses with lower ratios of fixed costs to variable costs use less operating leverage. Operating leverage can be
calculatedwiththehelpofthefollowingformula:

Where,
OL=OperatingLeverage
C=Contribution
OP=OperatingProfits
Utilizing a higher degree of operating leverage rises the risk of cash flow problems that results from errors in forecasts of future sales. One
possible effect caused by the presence of operating leverage is that a change in the amount of sales results in a "more than proportional" change
inoperatingprofit(orloss).
The degree of operating leverage (DOL) is sales profits less total variable cost divided by sales revenue lesstotalcost:
q=quantity
p=priceperunit
v=variablecostperunit
f=totalfixedcosts
VC=variablecosts
EBIT=earningsbeforeinterestandtax
The degree of operating leverage is directly proportionate to a firm's level of business risk, and therefore it serves as a proxy for business risk.

Effects of Operating Leverage

A high operating leverage entails that company has increased production without investing in additional fixed costs. As production rises,
managers are in effect spreading fixed costs across a greater number of units, so the additional units have a lower ratio of fixed costs to total
costs. When demand for company product increases, then experts can easily ramp up production by increasing variable costs; Company's fixed
assets allow to magnify production. Managers can increase production as long as their higher variable costs do not cause total costs to exceed
their sales revenues. However, at the time of a recession, high operating leverage is risky.

Financial leverage

Financial leverage characterises the relationship between the company's earnings before interest and taxes (EBIT) or operating profit and the
earning available to equity shareholders. Financial leverage increases as how earnings per share (EPS) change as a result of changes in EBIT
where the fixed cost is that of financing, specifically interest costs. Financial Leverage is the use of fixed financing costs by the firm. Financial
leverage is attained by choice. It is used as a means of increasing the return to common shareholders (Pearson South Africa, 2007). Financial
leverage mirrors the impact on returns of a change in the extent to which the firm's assets are financed with borrowed money. Financial leverage
can be calculated with the help of the followingformula:
Where,

FL= OP/PBT

Where,
FL = Financial leverage
OP = Operating profit (EBIT)
PBT = Profit before tax
The degree of financial leverage (DFL) measures a percentage change of earnings per share for each unit's change in EBIT that result from a
company's changes in its capital structure. Earnings per share become more volatile when the degree of financial leverage is higher. The degree
of financial leverage (DFL) is calculated as follows:
Percentage change in EPS DFL = --------------------------------- Percentage change in EBIT
This measure of degree of financial leverage DFL is affected by the initial earnings EBIT. This measure of financial leverage is not suitable to
compare companies whose initial profits and earnings that are most certainly different, and it is also inadequate for comparisons over time for
thesamecompany.
Financial leverage expands earnings per share and returns because interest is a fixed cost. When a company's revenues and profits are on the rise,
this leverage works very favourably for the company and for investors. Nevertheless, when profits are pressured or falling, the exponential
effects of leverage can become challenging.
Uses of Financial Leverage: Financial leverage helps to examine the relationship between EBIT and EPS.
Financial leverage measures the percentage of change in taxable income to the percentage change in EBIT.
Financial leverage pinpoints the correct profitable financial decision regarding capital structure of the company.
Financial leverage is vital devices which is used to measure the fixed cost proportion with the total capital of the company.
If the firm obtains fixed cost funds at a higher cost, then the earnings from those assets, the earning per share and return on equity capital will
decrease.
This measure of degree of financial leverage DFL is affected by the initial earnings EBIT. This measure of financial leverage is not suitable to
compare companies whose initial profits and earnings that are most certainly different, and it is also inadequate for comparisons over time for
thesamecompany.
Financial leverage expands earnings per share and returns because interest is a fixed cost. When a company's revenues and profits are on the rise,
this leverage works very favourably for the company and for investors. Nevertheless, when profits are pressured or falling, the exponential
effects of leverage can become challenging.
Uses of Financial Leverage:
 Financial leverage helps to examine the relationship between EBIT and EPS.
 Financial leverage measures the percentage of change in taxable income to the percentagechangeinEBIT.
 Financial leverage pinpoints the correct profitable financial decision regarding capital structureofthecompany.
Financial leverage is vital devices which is used to measure the fixed cost proportion withthetotalcapitalofthecompany.If the firm obtains fixed
cost funds at a higher cost, then the earnings from those assets,the earning per share and return on equity capital will decrease.
Combined leverage: When the company utilizes both financial and operating leverage to amplification of any change in sales into a larger
relative changes in earning per share. Combined leverage is also known as composite leverage or total leverage. Combined leverage shows the
relationship between the revenue in the account of sales and the taxable income.
Combined leverage can be calculated with the help of the following formulas:

CL = OL x FL
CL = C/OP x OP/PBT = C/PBT

Where,
CL = Combined Leverage
OL = Operating Leverage
FL = Financial Leverage
C = Contribution
OP = Operating Profit (EBIT)
PBT = Profit Before Tax

Degree of Combined Leverage:

The percentage change in a firm's earning per share (EPS) results from one percent change in sales. This is also equal to the firm's degree of
operating leverage (DOL) times its degree of financial leverage (DFL) at a particular level of sales.

DEGREE OF COMBINED LEVERAGE = PERCENTAGE CHANGE IN EPS / PERCENTAGE CHANGE IN SALES

To summarize, Operating leverage is the degree to which a firm's fixed production costs contribute to its total operating costs at different levels
of sales. In a firm that has operating leverage, a given change in sales results in major change in the net operating revenue. Financial leverage
calculates the sensitivity of the firm's net income to changes in its net operating income (NOI). On the contrary to operating leverage, which is
determined by the firm's choice of technology (fixed and variable costs), financial leverage is dogged by the firm's financing selections (the mix
of debt and equity).
EBIT EPS ANALYSIS
EBIT-EPS analysis gives a scientific basis for comparison among various financial plans and shows ways to maximize EPS. Hence EBIT-EPS
analysis may be defined as ‘a tool of financial planning that evaluates various alternatives of financing a project under varying levels of EBIT
and suggests the best alternative having highest EPS and determines the most profitable level of EBIT’
Concept of EBIT-EPS Analysis:
The EBIT-EBT analysis is the method that studies the leverage, i.e. comparing alternative methods of financing at different levels of EBIT.
Simply put, EBIT-EPS analysis examines the effect of financial leverage on the EPS with varying levels of EBIT or under alternative financial
plans.

It examines the effect of financial leverage on the behavior of EPS under different financing alternatives and with varying levels of EBIT. EBIT-
EPS analysis is used for making the choice of the combination and of the various sources. It helps select the alternative that yields the highest
EPS.

We know that a firm can finance its investment from various sources such as borrowed capital or equity capital. The proportion of various
sources may also be different under various financial plans. In every financing plan the firm’s objectives lie in maximizing EPS.

Advantages of EBIT-EPS Analysis:

We have seen that EBIT-EPS analysis examines the effect of financial leverage on the behavior of EPS under various financing plans with
varying levels of EBIT. It helps a firm in determining optimum financial planning having highest EPS.

Various advantages derived from EBIT-EPS analysis may be enumerated below:

Financial Planning:
Use of EBIT-EPS analysis is indispensable for determining sources of funds. In case of financial planning the objective of the firm lies in
maximizing EPS. EBIT-EPS analysis evaluates the alternatives and finds the level of EBIT that maximizes EPS.

Comparative Analysis:
EBIT-EPS analysis is useful in evaluating the relative efficiency of departments, product lines and markets. It identifies the EBIT earned by
these different departments, product lines and from various markets, which helps financial planners rank them according to profitability and also
assess the risk associated with each.

Performance Evaluation:
This analysis is useful in comparative evaluation of performances of various sources of funds. It evaluates whether a fund obtained from a source
is used in a project that produces a rate of return higher than its cost.

Determining Optimum Mix:

EBIT-EPS analysis is advantageous in selecting the optimum mix of debt and equity. By emphasizing on the relative value of EPS, this analysis
determines the optimum mix of debt and equity in the capital structure. It helps determine the alternative that gives the highest value of EPS as
the most profitable financing plan or the most profitable level of EBIT as the case may be.
Limitations of EBIT-EPS Analysis:
Finance managers are very much interested in knowing the sensitivity of the earnings per share with the changes in EBIT; this is clearly
available with the help of EBIT-EPS analysis but this technique also suffers from certain limitations, as described below

No Consideration for Risk:

Leverage increases the level of risk, but this technique ignores the risk factor. When a corporation, on its borrowed capital, earns more than the
interest it has to pay on debt, any financial planning can be accepted irrespective of risk. But in times of poor business the reverse of this
situation arises—which attracts high degree of risk. This aspect is not dealt in EBIT-EPS analysis.

Contradictory Results:
It gives a contradictory result where under different alternative financing plans new equity shares are not taken into consideration. Even the
comparison becomes difficult if the number of alternatives increase and sometimes it also gives erroneous result under such situation.

Over-capitalization:
This analysis cannot determine the state of over-capitalization of a firm. Beyond a certain point, additional capital cannot be employed to
produce a return in excess of the payments that must be made for its use. But this aspect is ignored in EBIT-EPS analysis.

Example 5.1:
Ankim Ltd., has an EBIT of Rs 3, 20,000. Its capital structure is given as under:

Indifference Points:
The indifference point, often called as a breakeven point, is highly important in financial planning because, at EBIT amounts in excess of the
EBIT indifference level, the more heavily levered financing plan will generate a higher EPS. On the other hand, at EBIT amounts below the
EBIT indifference points the financing plan involving less leverage will generate a higher EPS.

Concept:
Indifference points refer to the EBIT level at which the EPS is same for two alternative financial plans. According to J. C. Van Home,
‘Indifference point refers to that EBIT level at which EPS remains the same irrespective of debt equity mix’. The management is indifferent in
choosing any of the alternative financial plans at this level because all the financial plans are equally desirable. The indifference point is the cut-
off level of EBIT below which financial leverage is disadvantageous. Beyond the indifference point level of EBIT the benefit of financial
leverage with respect to EPS starts operating.

The indifference level of EBIT is significant because the financial planner may decide to take the debt advantage if the expected EBIT crosses
this level. Beyond this level of EBIT the firm will be able to magnify the effect of increase in EBIT on the EPS.

In other words, financial leverage will be favorable beyond the indifference level of EBIT and will lead to an increase in the EPS. If the expected
EBIT is less than the indifference point then the financial planners will opt for equity for financing projects, because below this level, EPS will
be more for less levered firm.

Unit IV

DIVIDEND

The dividend is one of the important ways in which the companies communicate the financial health and the shareholder value. Through a
distribution from their earnings, companies indicate a positive future and a strong performance. The ability and the willingness of a company to
pay stable dividends over a good period of time and even increase them steadily gives a good picture about the fundamentals of the company.

A dividend is a distribution of part of the earnings of the company to its equity shareholders. The board of directors of the company decides the
dividend amount to be paid out to the shareholders. Mostly, a dividend is stated as an amount each equity share gets. It can also be stated as a
percentage.
DIFFERENT FORMS / TYPES OF DIVIDENDS
There are various forms of dividends that are paid out to the shareholders:

CASH DIVIDEND

A Cash dividend is the most common form of the dividend. The shareholders are paid in cash per share. The board of directors announces the
dividend payment on the date of declaration. The dividends are assigned to the shareholders on the date of record. The dividends are issued on
the date of payment. But for distributing cash dividend, the company needs to have positive retained earnings and enough cash for the payment
of dividends.

BONUS SHARE

Bonus share is also called as the stock dividend. Bonus shares are issued by the company when they have low operating cash, but still want to
keep the investors happy. Each equity shareholder receives a certain number of additional shares depending on the number of shares originally
owned by the shareholder. For example, if a person possesses 10 shares of Company A, and the company declares bonus share issue of 1 for
every 2 shares, the person will get 5 additional shares in his account. From company’s angle, the number of shares and issued capital in the
company will increase by 50% (1/2 shares). The market price, EPS, DPS etc will be adjusted accordingly. In this case company shall retain
earning also at the same time share holder gets dividend. An investor who desires cash return, can sell investment in secondary market. It is also
called capitalization of earning.
SHARE PURCHASE
Share repurchase occurs when a company buys back its own shares from the market and reduces the number of shares outstanding. This is
considered as an alternative to the dividend payment as cash is returned to the investors through another way.

PROPERTY DIVIDEND

The company makes the payment in the form of assets in the property dividend. The asset could be any of this equipment, inventory, vehicle or
any other asset. The value of the asset has to be restated at the fair value while issuing a property dividend.
SCRIP DIVIDEND

Scrip dividend is a promissory note to pay the shareholders later. This type of dividend is used when the company does not have sufficient funds
for the issuance of dividends.
LIQUIDATING DIVIDEND

When the company returns the original capital contributed by the equity shareholders as a dividend, it is termed as liquidating dividend. It is
often seen as a sign of closing down the company.

ADVANTAGES OF PAYING DIVIDENDS

Paying dividends to investors has several advantages, both for the investors and the company:
INVESTOR PREFERENCE FOR DIVIDENDS

The investors are more interested in a company that pays stable dividends. This assures them of a reliable source of earnings, even if the market
price of the share dips.

BIRD-IN-HAND FALLACY

This theory states that the shareholders prefer the certainty of dividends in comparison to the possibility of higher capital gains in future.

STABILITY

Investors prefer companies that have a track record of paying dividends as it reflects positively on its stability. This indicates predictable
earnings to investors and thus, makes the company a good investment.

BENEFITS WITHOUT SELLING

Investors invested in dividend-paying stocks do not have to sell their shares to participate in the growth of the stock. They reap the monetary
benefits without selling the stock.
TEMPORARY EXCESS CASH

A mature company may not have attractive avenues to reinvest the cash or may have fewer expenses related to R&D and expansion. In such a
scenario, investors prefer that a company distributes the excess cash so that they can reinvest the money for higher returns somewhere else.

INFORMATION SIGNALLING

When a company announces the dividend payments, it gives a strong signal about the future prospects of the company. Companies can also take
advantage of the additional publicity they get during this time.

DISADVANTAGES OF PAYING DIVIDENDS

Paying dividends also has several disadvantages:

CLIENTELE EFFECT

If a dividend-paying company is unable to pay dividends for a certain period of time, it may result in loss of old clientele who preferred regular
dividends. These investors may sell-off the stock in short term.
DECREASED RETAINED EARNINGS

When a company pays dividends, it decreases its retained earnings. Debt obligations and unexpected expenses can rise if the company does not
have enough cash.

LIMITS COMPANY’S GROWTH PAYING DIVIDENDS RESULTS IN

Paying dividends result in the reduction of usable cash which may limit the company’s growth. The company will have less money to invest in
the business growth.

LOGISTICS

The payment of dividends requires a lot of record-keeping at the company’s end. The company has to ensure that the right owner of the share
receives the dividend.

Types of Dividend Policies

1. Regular Dividend Policy: Payment of dividend at the usual rates is termed as regular dividend policy. The investors such as the middle class
families, retired persons and institutional investors prefer this type of dividend policy. However it should be remembered that regular dividend
can be maintained only by companies of long standing and stable earnings.

2. Irregular Dividend Policy:

Some companies follow irregular dividend policy due to reasons such as lack of liquid funds, uncertainty of future earnings, unsuccessful
business operations etc.

When a company does not have a long standing and stable earnings it will not be able to commit itself to paying dividends regularly. When there
is no certainty as to whether dividend will be paid in a year or not and how much of dividend will be paid, the company is said to follow an
irregular dividend policy. Investors who expect a company to pay a certain amount as dividend every year may not want to invest in such a
company.

3. Stable Dividend Policy: The term stability of dividend means consistency or lack of variability in the stream of dividend payments, even
though the amount of dividend may fluctuate from year to year. The company decides to pay a certain amount of dividend every year,
consistently, whether more or less. Some investors may be more interested in a source of income for today rather than capital appreciation. This
serves as an assurance to those investors who depend on dividend as a .source of income.

Significance of Stable Dividend Policy:

The stability of dividend policy is helpful to the shareholders and the company in the following ways:

i. Confidence among shareholders- Payment of regular and stable dividend may help in building confidence in the minds of investors regarding
regularity of dividends.

ii. Investors’ desire for current income- There are many investors like retired persons, salaried people, and other fixed income group may prefer
to receive income regularly to meet their living expenses. Such investors prefer a company with stable dividend policy.

iii. Institutional investors- Investments are made not only by individuals but also by institutions. Normally the institutional investors prefer to
invest in shares of those companies, which pay dividends regularly.

iv. Stability in market price of shares- Stable dividend policy may also help a company in maintaining stability in the market price of its shares.

v. Rising additional finance- A stable dividend policy is also advantageous to company in rising external finance.

vi. Spreading of ownership of outstanding share- Stable dividend policy may also help in spreading the ownership of shares more widely among
small investors.

vii. Reduces the chances of Loss of control- Because of the spreading of ownership for outstanding shares among the large number of small
investors the chances of Loss of control by the present management over the company are reduced.

viii. Market for debentures and preferences shares- A stable dividend policy also helps the company in marketing of outstanding shares and
debentures.

4. No Dividend Policy:

The company may follow a policy of paying no dividend presently because of requirement of funds for the future growth and expansion or
unfavourable working capital position. Company may decide not to pay any dividend at all. If the profits of a company are reinvested in the
business, it may result in growth and better profits in future.
So the company may decide not to pay any dividend and reinvest it in its business. But the company has to convince the shareholders about its
policy. It does not benefit the present shareholders in any way other than capital appreciation. It may benefit the future shareholders by way of
more profits in the future.

ADVANTAGES AND DISADVANTAGES OF DIVIDEND POLICIES

1. Residual Dividend Policy:

The term residual indicates the quantity of profits left over. In residual dividend policy a business organization will only pay dividends after all
acceptable investment opportunities have been undertaken. Thus, residual dividend policy is used by companies to finance its capital expenditure
proposals through equity that is internally generated. In this policy, the dividend payments are made from the equity that remains after all the
capital expenditure proposal needs are met.

Advantages:

(a) This policy is good for business because it reduces the occurrence of raising external funds.

(b) Residual dividend policy reduces the issues of new stocks and flotation costs.

Disadvantages:

(a) Creates volatility in the dividend payments that may be undesirable for some investors.

(b) It’s risky venture, however as the companies dividends are at risk.

(c) The amount payable as dividend fluctuates heavily if this policy is practiced.

REGULAR DIVIDEND POLICY

In regular dividend policy companies pay dividend to shareholders in a definite manner at a usual rate. Regular dividend policy aims to provide
for a regular and sizeable dividend flow, whilst allowing the company to maintain the financial flexibility to take advantage of attractive
investment opportunities in the future.

The company typically pays annual dividends on the basis of its results for the previous year, and special dividends following disposals or asset.
The investors who expect regularity of income prefer to get regular dividend.

Advantages:

(a) This policy enhances prestige and credit standing of the company.

(b) Shareholders prefer this policy, as it leads to stability in market prices of shares.

(c) Regular dividend policy eliminates uncertainty in investors’ mind about dividend payment.

(d) Helps a company in meeting its financial requirements from retained earnings.

(e) Provides a source of regular source of income to investors.

Disadvantages:

(a) A company paying regular dividends may have less money to grow the business.

3. Stable Dividend Policy:

As the name of the policy suggests, stable dividend policy focuses on regularity in paying some dividend even though the amount of dividend
may vary every year and may not be associated with earnings of the company. In other words Stable dividend means that a certain minimum
amount of dividend is paid regularly. It may also mean that dividend is paid regularly by the company, but the amount or rate of dividend is not
fixed.

The stable dividend may take the following forms:

i. Constant Dividend per Share:

Under this policy the management of the company pays a fixed amount of dividend on every share irrespective of level of earning year after
year. In order to ensure consistency in payment of dividends reserve fund is created to pay fixed amount of dividend in the year when the earning
of the company is not enough. It is suitable for the firms having stable earning. It is important to note that even though dividend is constant every
year however this does not mean that the rate of dividend will never be increased, depending on the level of earning of the company the rate may
change.

ii. Constant Payout Ratio:

Payout ratio means is dividend as a percentage of earnings. It is an important concept in the dividend policy. According to this policy, the
percentage of earnings paid out as dividends remain constant irrespective of the level of earnings. Thus, as earnings of a company fluctuate,
dividends paid by it also fluctuate accordingly in proportionate to the earning of the company.

iii. Constant Rupee Dividend, plus Extra Dividend:

According to this policy a company pays a low rate of dividend per share to reduce the chances of not paying dividend. In other words dividends
in rupee terms mostly remain constant irrespective of the level of earnings and in the period when company performs exceptionally well the
management pays extra dividend.

Advantages:

a) This policy Creates confidence amongst share holders.

b) Attracts income conscious investors.

c) Promotes stability in the market prices of shares.

d) Encourages institutional investors.

e) Enhances creditworthiness and goodwill of the company.

f) It helps in giving regular income to the shareholders.

Disadvantages:

a) Difficult to change stable dividend policy as it may have a negative impact on shareholders and market price of the shares.

Irregular Dividend Policy:

Company, upon making profit must decide on application of profits. It could continue to retain the profits within the company, or it can pay out
the profits to the owners of the firm in the form of dividends.

Therefore in irregular dividend policy a company does not pay regular dividend to the shareholders for various reasons such as to generate funds
for expansion and growth, if a company expects uncertainty in its future business operations and non-availability of liquid cash resources.

5. No Dividend Policy:

Even though dividends play an important role in rewarding shareholders, but some companies view in broader context of the varying liquidity
needs of the company and their vision of the company’s future. A company implements no dividend policy due to lack of liquidity because of its
unfavorable working capital position.

Further management wants the business to grow and the stock to appreciate and in order to do this they prefer reinvesting excess cash in the
business, rather than giving away on dividends.

DIVIDEND MODELS

Walter’s model:

Professor James E. Walterargues that the choice of dividend policies almost always affects the value of the enterprise. His model shows clearly
the importance of the relationship between the firm’s internal rate of return (r) and its cost of capital (k) in determining the dividend policy that
will maximise the wealth of shareholders.

Walter’s model is based on the following assumptions:

1. The firm finances all investment through retained earnings; that is debt or new equity is not issued;

2. The firm’s internal rate of return (r), and its cost of capital (k) are constant;

3. All earnings are either distributed as dividend or reinvested internally immediately.

4. Beginning earnings and dividends never change. The values of the earnings pershare (E), and the divided per share (D) may be changed in the
model to determine results, but any given values of E and D are assumed to remain constant forever in determining a given value.

5. The firm has a very long or infinite life.

Walter’s formula to determine the market price per share (P) is as follows:
P = D/K +r(E-D)/K/K

The above equation clearly reveals that the market price per share is the sum of the present value of two sources of income:
i) The present value of an infinite stream of constant dividends, (D/K) and

ii) The present value of the infinite stream of stream gains.

[r (E-D)/K/K]

Criticism:

Walter’s model is quite useful to show the effects of dividend policy on an all equity firm under different assumptions about the rate of return.
However, the simplified nature of the model can lead to conclusions which are net true in general, though true for Walter’s model.

The criticisms on the model are as follows:

1. Walter’s model of share valuation mixes dividend policy with investment policy of the firm. The model assumes that the investment
opportunities of the firm are financed by retained earnings only and no external financing debt or equity is used for the purpose when such a
situation exists either the firm’s investment or its dividend policy or both will be sub-optimum. The wealth of the owners will maximise only
when this optimum investment in made.

2. Walter’s model is based on the assumption that r is constant. In fact decreases as more investment occurs. This reflects the assumption that the
most profitable investments are made first and then the poorer investments are made.

The firm should step at a point where r = k. This is clearly an erroneous policy and fall to optimise the wealth of the owners.

3. A firm’s cost of capital or discount rate, K, does not remain constant; it changes directly with the firm’s risk. Thus, the present value of the
firm’s income moves inversely with the cost of capital. By assuming that the discount rate, K is constant, Walter’s model abstracts from the
effect of risk on the value of the firm.

2. Gordon’s Model:

One very popular model explicitly relating the market value of the firm to dividend policy is developed by Myron Gordon.

Assumptions:

Gordon’s model is based on the following assumptions.

1. The firm is an all Equity firm

2. No external financing is available

3. The internal rate of return (r) of the firm is constant.

4. The appropriate discount rate (K) of the firm remains constant.

5. The firm and its stream of earnings are perpetual

6. The corporate taxes do not exist.

7. The retention ratio (b), once decided upon, is constant. Thus, the growth rate (g) = br is constant forever.

8. K > br = g if this condition is not fulfilled, we cannot get a meaningful value for the share.

According to Gordon’s dividend capitalisation model, the market value of a share (Pq) is equal to the present value of an infinite stream of

dividends to be received by the share. Thus:

The above equation explicitly shows the relationship of current earnings (E,), dividend policy, (b), internal profitability (r) and the all-equity
firm’s cost of capital (k), in the determination of the value of the share (P 0).
3. Modigliani and Miller’s hypothesis:

According to Modigliani and Miller (M-M), dividend policy of a firm is irrelevant as it does not affect the wealth of the shareholders. They
argue that the value of the firm depends on the firm’s earnings which result from its investment policy.

Thus, when investment decision of the firm is given, dividend decision the split of earnings between dividends and retained earnings is of no
significance in determining the value of the firm. M – M’s hypothesis of irrelevance is based on the following assumptions.

1. The firm operates in perfect capital market

2. Taxes do not exist

3. The firm has a fixed investment policy

4. Risk of uncertainty does not exist. That is, investors are able to forecast future prices and dividends with certainty and one discount rate is
appropriate for all securities and all time periods. Thus, r = K = K t for all t.
Under M – M assumptions, r will be equal to the discount rate and identical for all shares. As a result, the price of each share must adjust so that
the rate of return, which is composed of the rate of dividends and capital gains, on every share will be equal to the discount rate and be identical
for all shares.

Thus, the rate of return for a share held for one year may be calculated as follows:

Where P^ is the market or purchase price per share at time 0, P, is the market price per share at time 1 and D is dividend per share at time 1. As
hypothesised by M – M, r should be equal for all shares. If it is not so, the low-return yielding shares will be sold by investors who will purchase
the high-return yielding shares.

This process will tend to reduce the price of the low-return shares and to increase the prices of the high-return shares. This switching will
continue until the differentials in rates of return are eliminated. This discount rate will also be equal for all firms under the M-M assumption
since there are no risk differences.

From the above M-M fundamental principle we can derive their valuation model as follows:

Multiplying both sides of equation by the number of shares outstanding (n), we obtain the value of the firm if no new financing exists.

If the firm sells m number of new shares at time 1 at a price of P^, the value of the firm at time 0 will be

The above equation of M – M valuation allows for the issuance of new shares, unlike Walter’s and Gordon’s models. Consequently, a firm can
pay dividends and raise funds to undertake the optimum investment policy. Thus, dividend and investment policies are not confounded in M – M
model, like waiter’s and Gordon’s models.

Criticism:

Because of the unrealistic nature of the assumption, M-M’s hypothesis lacks practical relevance in the real world situation. Thus, it is being
criticised on the following grounds.

1. The assumption that taxes do not exist is far from reality.

2. M-M argue that the internal and external financing are equivalent. This cannot be true if the costs of floating new issues exist.

3. According to M-M’s hypothesis the wealth of a shareholder will be same whether the firm pays dividends or not. But, because of the
transactions costs and inconvenience associated with the sale of shares to realise capital gains, shareholders prefer dividends to capital gains.
4. Even under the condition of certainty it is not correct to assume that the discount rate (k) should be same whether firm uses the external or
internal financing.

If investors have desire to diversify their port folios, the discount rate for external and internal financing will be different.

5. M-M argues that, even if the assumption of perfect certainty is dropped and uncertainty is considered, dividend policy continues to be
irrelevant. But according to number of writers, dividends are relevant under conditions of uncertainty.