Fianancial Management

Unit IV - Capital Structure Theories Under favorable economic conditions the EPS increase with financial leverage. But leverage also increases the financial risk of shareholders. As a result, it cannot be stated definitely whether or not the firms value will increase with leverage. The objectives of a firm should be directed towards the maximization of the firms value. The capital structure or financial leverage decisions should be examined from the point of its impact on the value of the firm. The four major theories or approaches which explain the relationship between capital structure, cost of capital & valuation of the firm are: Net Income (NI) approach. Net Operating Income (NOI) approach. The Traditional approach. Modigilani Miller (MM) approach. Net Income (NI) Approach According to Net Income Approach, suggested by Durand, the capital structure is relevant to the valuation of the firm. A firm can minimize the overall cost of capital (WACC) by maximizing the use of debt in capital structure. A firm that finance its assets by equity & debt is called a levered firm & firm uses no debt is called unlevered firm. Suppose firm L is levered firm, which expect a perpetual EBIT of Rs. 1000 & pay interest of Rs. 300. The firms cost of equity Ke is 9.33 % & debt is 6 %. What is the value of the firm? The value of firm is the sum of the Value of all securities. In this case Value of Equity Ke = Net Income / Cost of Equity. = 700 / 0.0933.= Rs. 7500/Value of Debt Kd = Interest / Cost of Debt. = 300/ 0.06 = Rs. 5000/Value of Firm = Value of Equity + Value of Debt. = 7500 + 5000 = 12500 /WACC = Cost of Equity with Weight + Cost of Debt with Weight. = (0.0933 x (7,500/12,500)) + (0.06 x( 5000/ 12,500)) = 8% If the firm substitutes Equity for Debt & raises its debt ratio to 90 % WACC = 0.0933 x 10 + 0.06 x 0.9 = 6. 33 %. Thus a firm can minimize the (WACC) overall cost of capital by maximizing the use of debt in its capital structure as a result the market price / value of the firm will increases. This approach is based on following assumption. 1. Cost of debt is less than cost of equity i.e. the firm is able to borrow money less than the exception of equity shareholder. 2. There is no corporate tax. 3. Use of debt does not alter the risk perception of investors.
1

Fianancial Management

The logic of NI Approach is simple. Interest rate is generally lower than the dividend rate. Further interest is allowed as tax deduction in computation of tax. Hence debt is cheaper than equity. By increasing the proportion of debt in capital structure a firm can cover the overall cost of capital. The total market value of the firm (V) under the Net Income Approach is ascertained by the formula. V = Value of the firm E = Value of Equity D = Value of debt V =E+D = [NOI INT / Ke = V

] + [INT / Kd]

[ {NOI-KdD}/ Ke] + KdD/Kd = [{NOI-KdD} /Ke]+D

= [NOI/Ke ] + D 1- [ Kd/Ke]

The optimum capital structure occurs at the point of minimum (WACC) Under. NI approach the firm will have minimum WACC & Maximum value when it is 100% debt-financed. Effect of Leverage on cost of capital under NI approach

Tradition View
Tradition view has emerged as a compromise to the extreme position taken by the NI approach, like the NI approach, it does not assume constant cost of equity with financial leverage and continuously declining WACC. According to this view, a judicious mix od debt and equity capital can increase the value of the firm by reducing the weighted average cost of capital up to certain level of debt.

Fianancial Management

This approach very clearly implies that WACC decreases only with the reasonable limit of financial leverage and after reaching the minimum level, it starts increasing with financial leverage. Hence a firm has an optimum capital structure occurs when WACC us minimum and thereby maximize the value of the firm. WACC declines with moderate level of leverage give low cost debt are placed for expensive equity capital. Financial leverage resulting in risk to share holders will cause the cost of equity to increase. But traditional view assumes at moderate level of leverage, the increase in the cost of equity is more than offset by the lower cost of debt. Debt funds are cheaper than equity carries the clear implication that the cost of debt plans the increased cost of equity together on a weighted basis will be than the cost of equity. According to traditional theory, the financial risk caused by introduction of debt may increase the cost of equity slightly, but not so much the advantage of cheaper. Debt is taken off totally. WACC will decrease with the use of debt. But as leverage increase further, shareholders start expecting higher risk premium inform of increasing cost of equity. Traditional theory on the relationship capital structure has three stage. First stage: The cost of equity Ke the rate at which the shareholders capitalize the net income, either remains constant or rises slightly with debt. WACC decrease in the inceasing leverage. Second stage: Optimum value: Once the firm has reached a certain degree of leverage any subsequant increases in leverage have a negligible effect on WACC and hence on the value of the firm. Third stage: Beyond the acceptable limit of leverage the value of the firm decrease with leverage as WACC increases with leverage. This happen because investor perceive a high degree of financial risk & demand a higher equity-capitalization rate.

Modigliani-Miller Approach
MM explain the relationship between capital structure cost of capital & value of the firm under two conditions.

(a) When there are No Corporate taxes[ Proposition-1]

MM approach is identical to No.1 approach when there are no corporate taxes.MM argue that in the absence of taxes , the cost of capital and the value of the firm are not affected by capital structure or debt-equity mix. Debt is cheaper than equity .But the use debt increases the financial risk and the cost of equity. The advantage of low cost debt is offset by the increase in cost of equity. As a result, the overall cost of capital remains unchanged. According to MM hypothesis, the total value of a firm is determined by its operating income or EBIT. It is independent of the debt-equity mix. Two firms which are identical in all aspects except their capital structure cannot have different market
3

Fianancial Management

value or different cost of capital. If market value differs arbitrage process will take place &make them equal. Assumption: 1. There is a perfect market. It implies that (a) Investors are free to buy &sell securities (b) They can borrow freely on the same terms as the firm does. (c) Investors act in a rational manner. 2. There is no corporate tax. 3. There is no transaction cost. 4. The payout is 100%. That is all the earnings are distributed to the shareholder. 5. Firms can be grouped into homogeneous risk classes. Their expected earnings having identical risk characteristics. 6. Risk to investor depends on the random variations of expected No.1 and the possibility that the actual value of N0.1 may turn out to be different from their best estimates. Arbitrage Process Two firms which are identical in all aspects expect the capital structure, cannot have different market values. If market value differs, arbitrage process will take place and make them equal. For instance, firm A&B are identical expect that A does not use debt while B uses debt in its capital structure. Their market value cannot differ for a long time. If the market value of Firm B is higher than the market value of Firm A, investors in firm B will sell their shares in the overvalued firm B. They will buy the shares of firm A, which is undervalued. In addition, Firm B has no debt. Therefore the investor borrow on their personal account (substitution of personal leverage for corporate leverage)&use the additional funds for purchases of shares in firm A. The demand for the shares of firm A increases and pushes up the market price. On the other hand, the market price of shares of firm B decline due to the selling pressure. ultimately, the market value of A&B tend to become equal.

b) When there are corporate taxes:

MM have recognized that capital structure would affect the cost of capital and value of the firm, when there are corporate taxes if a firm uses debt in its capital structure, the cost of capital will decline & market value will increase. This is because of the deductibility of the interest charges for computation of tax. Interest charges are allowed as deduction in tax computation. Even if the EBT of the firms, the levered and unlevered are equal the levered firm can have more earnings to its equity share holders than an unlevered firm. Hence value of levered firm will be higher than that of unlevered firm. According to MM approach value of unlevered firm can be calculated as VU =
4

Fianancial Management

VL= VU + (T x D) =Value of unlevered firm + Tax rate X Debt Criticism of MM approach: 1. Markets are not perfect: Arbitrage process is the foundation for MM approach. For the effective operation of arbitrage process, markets have to be perfect. But in reality market are not perfect. Hence the arbitrage process may fail to work & equilibrium may not be achieved. 2. Higher interest for individual: It is assumed that individuals and firms can borrow freely on the same terms. However in practise, firms are able to borrow at a lower rate of interest than individual as they enjoy a higher credit standard. 3. Personal leverage is no substitute for corporate leverage: the assumption that personal leverage is the perfect substitute for corporate leverage is also not valid. Companies have limited liability. But individual have the burden of unlimited liability. 4. Transaction cost: MM approach assumes that there is no transaction cost but in reality, transaction cost has to be incurred for purchase and sell of securities. 5. Corporate tax: The assumption of no corporate tax is not correct in practise reality. Interest on borrowing is tax deductible. A firm can therefore increase the earnings of shareholders by employment debt in capital structure.

Designing the Capital Structure

Financial decisions are reactive and the evolve in response to the operating decisions with unplanned capital structure .these company may also fail to economize the use of their funds .consequently ,it is being realised that a company should plan its capital structure to maximize the use of funds and to adapt money easily to the changing environment . The optimum capital structure is one that maximize the master value of the firm .in threat maximize the firm in practise the determination of an optimum capital structure is a formidable task and once has to go beyond the theory. There are significant variation among industries and companies within industries in terms of capital structure. Since a no of factor influence the capital structure decision of the company, the judgement of the person making the capital structure decision plays a crucial role. All the factors highly psychological complex and qualitative does not always follows accepted rule. Since the capital market are not perfect and the decision has to be taken under imperfect knowledge and risk Elements of Capital Structure The following are the important elements of the companys financial structure that need proper security and analyse
5

Fianancial Management

Capital mix Firms have to decide about the mix of debt and equity capital. the firms and analyse the debt ratios .debt service coverage ratio, and fund flow statement to analyse the capital mix

Maturity and Priority Maturity of securities used may differ .equity is permananent capital and debt, commercial paper has short market period. Capitalised debt like lease or hire purchase finance is quite safe from the lenders point of view and value of assets backing the debt provides the protection to the lender. a firm may obtain a risk neutral position by matching the maturity of assets and liabilities ,i.e. it may use current liabilities to finance current assets and short medium and long term debt for financing the fixed assets in that order of maturities .in practise the firm do not perfectly match the sources and use of funds Terms and Conditions Firms have choice with regard to the basis of interest payments .they may obtain loans either at fixed or floating rate of interest. In case of equity the may firm like to return income either in the forms of large dividend or large capital gains. Financial manager can protect the company from interest rate by interest rate of derivatives. Currency Firm in a no. Of countries have the choices of raising funds from the overseas market. Overseas financial market provide opportunist to raise larger amount of funds. Because international fm market may not be perfect and may not be fully integrated firm may able to its capital overseas at a lower cost than in it domestic market Financial innovation Firm may raise capital either through the issue of simple securities or through the issue of innovative securities. Financial innovations are intended to make the securities issues attractive to investors to reduce Financial market Segment There are several segments of the financial market from which the firm can tap capital. e.g.: private or public debt for long term debt, short term debt from bank and commercial paper. The firms also has the alternative of rising short term funds by public deposit

Approaches to Establish Capital Structure Design

EBIT-EPS Analysis EBIT-EPS Analysis is an important tool to analysis the impact of alternative financial plan on the share holders income and its variability. Firm should consider the fluctuation in EBIT

Fianancial Management

and examine impact on EPS under different financial plan. If the probability of rate of return on the firms asset falling below cost of debt the firm can employ high debt to increase EPS. Valuation Approach Debt is cheaper source of fund than equity. Higher debt increases the cost of financial distress and the agency cost also increases. The TDS however add value to the share holders. Thus there is a tradeoff between the tax benefit and cost of financial distress and agency problems. The firm should employ debt to the point when the marginal benefits and losts are equal. This will be point maximum value of the firms minimum WACC. Cash flow Analysis One practical method of assessing firms ability to carry debt without getting into serious financial distress is to carry out a comprehensive cash flow analysis over a long period of time. A sound capital structure is expected to be conservative. Conservatism does not mean employing no debt (or) small amount of debt. It relating a firms ability to generate cash to meet the fixed charges created by the use of debt in the capital structure under adverse conditions. The optimum debt equity mix bills down to the firms ability to service debt without any threat of insolvency and operating inflexibility. FRICT Analysis Financial structure may be evaluated from various perspectives from the owners point of view, return, risk and value are important consideration from the strategic pont of view, and flexibility is an important concern. Issues of control, flexibility and feasibility assume great significance. Flexibility Capital structure should be determined within the debt capacity of the company and this capacity should not be exceeded. The debt capacity of a company depends on its ability to generate future cash flows. it should have enough cash to pay creditors fixed charges. Risk Risk depends on the variability in the firms operations. It may be cused by the macro economic factors and industry and firms specific factors. The excessive use of debt magnifies the variability and share holders earnings. The solvency of the company. Income The capital structure of the company should be most advantageous to the owners of the firm. It should create value, subject to other consideration and it should generate maximum return to the shareholders with minimum additional cost. Control Capital structure should involve minimum risk of loss of control of the company. The owners of closely held companies are particularly concerned about dilution of control. Timing Capital structure should be feasible to implement given the current and future conditions of the capital market, the sequencing of the sum of financing is important. The current decision influences the future option of raising capital.
7

Fianancial Management

Determinants of Capital Structure

Capital structure of a firm depends on a number of factors. The importance of the factor varies from firm to firm depends on the business conditions. Some other factors are: 1. Financial Leverage: Use of long-term debt and preference capital in the capital structure is called Financial Leverage. The use of debt can help to magnify the earnings of shareholders if the firm earns a rate, which is higher than the cost of debt. Use of preference share will increase the earnings of the shareholder. But the leverage effect is less on the preference dividend is not allowed as deduction in Tax. However under unfavorable conditions. The firm may earn a rate of return, which is less than the cost of debt. In given cases leverage will adversely affect the earnings of the shareholders. 2. Stability & Growth of sales: Firm, which have stable sales, are not likely face any difficulty in meeting their fixed commitments of interest and principal repayment. Hence the can employ more debt in the capital structure. However firm which have widely fluctuating sales should be more careful. It is advisable for them to employ a high level of debt. 3. Cost of capital Cost of capital is the minimum return is expected by its supplier. It depends on the degree of risk assumed by investors. Equity shareholders assume a high degree of risk for them the dividend is not fixed. The company has no obligation to pay dividend even if it earns profits. In case of debt holder, Rate of interest is fixed. Company is legally bond to pay interest, whether it earns profit or not, the lone is also repayable after the expiry of the specified period. Because of the relativity how risk, debt is a cheaper some of time compared to equity and preference share capital. In formulating the capital structure company should aim a minimizing the cost of capital by an appropriate combination of different sources. 4. Cash flow ability. Debt financing involves an obligation for payment of interest charges to repayment of the principal. If the company is not able to generate cash to meet these obligations, it may have to face solvency, hence a company which want to raise additional debt should asses its cash flow ability to meet the fixed charges. 5. Control. In planning the capital structure management of companies prefer to raise additional funds without loss of control. If new share are issued to outsiders. The control of existing management may be diluted preference shareholders to debt holders do not have nothing rights. Hence financing through debt and preference share is desirable from the point of view of control, especially in the case of closely held compares. 6. Flexibility
8

Fianancial Management

The company should be able to change the capital the structure according to Changing business environment. it should be possible for Changing business environment. It should be possible for company to substitute one sources of finance for another preference shares & debentures, redeemable at the discretion of the company offer a high degree of flexibility. The capital structure must be designed to facilitate raising of additional funds easily & quickly. 7. Size of company: Generally small companies experience difficulties in raising funds from market. Issue of shares is also costly. There is also the danger of loss of control. Hence small companies have to depend on owned funds & retained earnings. But large companies enjoy certain advantages designing the capital structure. They can get loan reasonable term at relating lower rate of interest. Large firms can make large issues of shares & distribute them widely to avoid loss of capital. 8. Capital market conditions: Capital market conditions also govern the choice of the sources of finance. During boom period, huge amount can be raised by the issue of shares on favorable terms. When markets are dull issue of debentures or preference share is desirable. 9. Floating cost: Floating cost are cost increased for the issue of shares debenture etc. These cost should be considered while raising long term funds. The cost of raising debt is less than the cost of issuing equity shares. 10. Corporate tax rate: Dept offers tax advantage. Interest on dept allowed as a deduction in computing taxable income. Hence if corporate tax rate is high. It would b more advantages to raise funds through debt. 11. Legal Requirements: A company has to comply with legal requirements and govt. guidelines in planning the capital structure. Eg: manufacturing companies are required to maintain a debt equity ratio 2:1.there is guidelines regarding issues of preference shares. 12. Management philosophy: Attitude of management also affects the capital structure decisions. Some management may be aggressive & tap the dept & equity market. Conservative management may prefer to rely on retained earnings and moderate level of dept.

Dividend theory
Dividend refers to that part of earnings (profit) of a company which is distributed to shareholders. Shareholder would like to receive a higher dividend as it increases their current wealth. But for the company, retention of profits would be desirable as it provide funds for financing the expansion to growth plans. Retained earnings are the most important internal sources of finance. A higher dividend means less retained earnings. It may result in slower growth rate and lower market price of the shares. Further the company will have to depend on the external sources such as debenture and new shares. Thus, distribution is desirable from the point of view of shareholder and retention is advantageous to the company for growth and expansion. The dividend policy must strike a happy
9

Fianancial Management

balance between dividends and retained earnings in such a way that the value of the firm is minimized. Hence, dividend policy is a very crucial area of finance. Dividend Relevance: Walters Model Prof. James E. Walter argues that dividend policy is a crucial factor and it affects the value of the firm. According to the Walters Model dividend policy depends on the firms internal rate of return (r) and cost of capital (k). The optimum dividend policy depends on the relationship between the firms rate of return r and its cost of capital. i) Growth firm (r>k) : [Internal rate more than the opportunity cost of capital] They are able to earn a return(r) which is higher than the cost of capital (k). Hence, growth firm can benefit by retaining all the earnings for internal investment (100%) and increase the value of the shares of the firm or they can reinvent the earnings at a rate which is higher than the rate which is expected by the shareholder. ii) Normal firm (r=k): After exhausting super profitable opportunities, normal firm earn on their investment rate of return equal to the cost of capital. They do not have good investment opportunities; they are able to earn a rate of return (r) which is just equal to the cost of capital (k). Hence, distribution or retention of earnings will not make any difference in the value of the firm. The dividend policy has no effect on the market value of the firm. There is no particular optimum payout ratio of normal firm. iii) Declining firms (r<k): Declining firms do not have profitable investment opportunity. The rate of return (r) is less than the cost of capital (k). It is advisable for the declining firm not to return the earnings. The optimum payout is 100%. This will maximize the value of the shares of the declining firm. According to Walters model, a growth firm should retain all its earnings. A declining firm should distribute all its earnings. For normal firm, there is no optimum payout. Any dividend policy is as good as the other. Assumptions of Walters Model 1. The firm finances all its earnings only through retained earnings. It does not use new debt or equity. 2. Internal rate of return and the cost of capital of the firm remain constant. 3. All the earnings are distributed or retained in the firm. 4. EPS and dividend remain constant in determining a given value. Walter formula: Walters formula to determine the Market price per share is

10

Fianancial Management

Market Price Per Share = [D + (r/k) (E-D)] / K Where D =Dividend, r=Rate of return, K=Cost of capital, E=Earnings per share. Criticism of Walters Model:1. The model assumes that a firm finances all its investments only through retained earnings. The assumption is unrealistic. Firms do raise funds through new debt and equity. 2. The assumption that the cost of capital remains constant is also not true. In fact the rate of return changes with increase in investment. 3. The model assumes that the cost of capital remains constant. But the cost of capital also changes because of the changes in risk .Hence the assumption does not hold well.

Dividend Relevance: Gordons Model: The model developed by Myron Gordon suggests that the dividend decision is relevant and it affect the value of the firm. Gordons model explicitly relates that market value of the firm to dividend policy. According to Gordon The market value of the share is equal to the value of an infinite stream of dividends received by the shareholders. Growth firm: With profitable investment opportunities market price of share increases when dividend payout is less. Hence growth firms should retain maximum earnings. The optimum payout is zero percent. Normal firm: The price per share is not affected by dividend policy. Hence there is no optimum dividend payout. Declining firm: The market price of share increases when dividend payout increases. It is beneficial to distribute all the earnings, optimum payout is 100% ASSUMPTIONS OF GORDONS MODEL: 1. The firm is in an all equity firm and it has no debt. 2. No external financing is available. Consequently retained earnings would be used to finance any expansion. 3. The rate of return on investment is constant. 4. Cost of capital also remains constant. 5. Retained ratio (b)(The proportion of earnings retained).Once decided, remains constant. Therefore the growth rate (g) (g=br) is also constant. 6. Cost of capital is greater than the growth rate. 7. No corporate taxes.
11

Fianancial Management

8. The firm and stream of earnings are perpetual. Gordons formula: According to Gordons model, the market price of a share is equal to the present value of future stream of dividends. P = D1/(1+k)+D2/(1+k)2+D3/(1+K)3+........Dt/(1+K)t Dt / (1+k) t Accordingly the value of the shares can be obtained by the equations = D / K - g (or)[ E(1-b)] /[ K br] Where P = Market price per share D = Dividend per share; K = Cost of capital; E = Earnings per share; b = Retention ratio; P

g = Growth rate(b X r) r = Rate of return;

Dividend irrelevance: Modigliani- miller(MM)hypothesis:

According to MM approach the value of the firm depends on its earnings. The dividend simply splits the earnings between retention and dividends. It has no significance in determining the value of the firm. The dividend decision is irrelevant as it does not affect the wealth of the shareholders. Hence the MM hypothesis is known as hypothesis of dividend irrelevance. The MM argument: The substance of the MM argument is as follows. If the firm distributed dividends the shareholders benefit. But the benefit to shareholders will be offset by the decline in market price of shares. As a result there will be no change in the total wealth of the shareholders. E.g. suppose ABC ltd has investment opportunities. If the company distributes all its earnings has a dividend. It will have to raise funds by the issue of new shares or debts to finance its investments. The no of shares will increase or interest charges will go up. As a result, EPS will decline leading to a fall in market price. The benefit derived by the shareholders on account of dividend payment will be offset by the fall in market price. Hence division of earnings between dividends and retained earnings is irrelevant from the point of view of shareholders. Assumptions of MM model: 1. The capital market is perfect. 2. Investors behave rationally. 3. Information is freely available. 4. There is no floatation cost. 5. There is no transaction cost like Brokerage. 6. There are no taxes or tax rate applicable to dividends and capital gain are the same. 7. The firm has a fixed investment policy.

12

Fianancial Management

8. There is no risk of uncertainty. Hence investor can forecast dividends and prices with certainty. A single discount rate can be used for discounting cash inflows at different time period. Market Price under MM Model: Market price of a share at the beginning of a Period (Po) is equal to the Present value of dividends received at the end of the period plus the market price of the shares at the end of the period. Po = P.V of dividends received + Mkt Price of the share at the end of the period. This can be expressed as follows Po= [D1/1+ke] + [P1 / 1+Ke ] = [D1 + P1] / [1+Ke] The value of P1(market price at the end of the period)can be derived from the above equation P1= [Po(1+Ke)]-D1 Where P1= Mkt price per share at the end of the period Po= Current Mkt Price Ke =Cost of equity capital D1=Dividend to be received at the end of the period. Computation of number of new shares The investment requirements of a firm can be financed by retained earnings or issue of new shares or both. The number of new shares of the issue is determined as follows: Rs Rs 1. Investment proposed xxx 2. Net income xxx 3. Less: Dividend distribution xxx 4. Retained earnings available for investment (2)-(3) xxx 5. New shares to be issued for the balance (1)-(4) xxx 6. Issue price of shares xxx 7. No. of shares to be issued (5)/(6) xxx Criticism of M.M Hypothesis MM Hypothesis is based on certain simplifying assumption. But the assumptions are not well founded. As the assumptions are unrealistic, the MM Hypothesis lacks practical relevance. 1. The model assumes perfect capital market. But in practice, capital markets are not perfect. 2. Information about the company is also not freely available to all. 3. No corporate taxes does not hold good. 4. Firms are assumed to follow a fixed investment policy. In the dynamic real world, firms do not follow any fixed investment policy. 5. Model assumes that there is no floating cost. But in actual practice, floating costs are increased by companies.
13

Fianancial Management

6. No transaction cost is not valid.

Dividend and uncertainty:

According to Gordons model, dividend policy is irrelevant where r=k . This also concludes that dividend policy does affect the value of share where r=k, this view is based on the assumption that under condition of uncertainty, the investors tend to discount distant dividend at the higher rate than they discount near dividends. Investors behaving rationally, are risk averse and therefore have a preference for near dividend to future dividends. The logic underlying the dividend effect on the share value can be described as a bird in the hand argument. Stability of dividends Stability of dividends refers to consistency in payment of dividends over the year. It means a regular payment of a minimum dividend although there may be fluctuation in earnings. Shareholders generally prefer stable dividend to fluctuating dividend. Three forms of stable dividends 1. Fixed dividend per share Payment of constant dividend per share for a long period. it is paid although there may be a raise or fall in earnings. When the earnings are stable it s easy to maintain a constant dividend, however when there are wide fluctuations in earnings, companies use dividend equalization reserve or general reserve to smoothen the dividend payments. 2. Constant payout ratio: Under this policy the company pays a fixed percentage of its earnings as dividend year after year. The payout percentage is consistent. The art of dividend varies in the direct proportion to the earnings of the company. 3. Extra dividend: If a company pays fixed dividend per share. In year of very high profits, an extra dividend is paid in addition to the regular dividends. Advantage of Stable dividend policy: 1. Regular income to investor. 2. Stability of share prices. 3. Investor confidence. 4. Raising of capital.

Determinants of dividend policy/ factor influencing the dividend policy of a firm:

1. Expectations of share holders: Shareholders are the owners of the company. So the company should consider the dividend expectation of share holders. They may be interested in dividend or capital gains. The preference for dividend or capital gains depends on the economic status or attitude of an individual. E.g. a retired person who wants a regular income may prefer to receive dividends. On the other hand, a wealthy person may prefer capital gains to dividends.

14

Fianancial Management

In the case of a closely held company, it is easy to ascertain the wishes of the shareholders. But in the case of a widely held company it is difficult to ascertain the preference of shareholders. They may have different desire regarding dividend and capital gain. 2. New investments: Availability of investment opportunities is an important factor which influences the dividend decisions. If the company has profitable investment opportunities. It may retain a substantial part of the earnings and payout a small dividend. If the company does not have good investment opportunities it is better to distribute the earnings as dividends. 3. Taxation: In India dividend is tax free in the hands of shareholders long term capital gains on listed shares sold on or after 1st oct 2004 is also not taxable if securities transaction has been paid. But short term capital gain is taxable. The shareholders may prefer dividend or capital gains depending on the effect of tax on their income. Hence a company should keep in mind the taxation aspect while formulating its dividend policy. 4. Liquidity: The liquidity position is an important factor which influences the dividend decisions. Sometime a company which has good earnings may not have sufficient liquidity. In such cases it is advisable for the company to restrict to the available liquid resources. 5. Access to Capital Market A company which is confident of raising resource from the capital market, mat pay higher dividend on the other hand, if the company is unable to raise resources due to its poor image or the depressed state of the capital markets, it has to contend with a low payout. 6. Restrictions by Lenders The lender particular financial institutions impose restrictions on the payment of dividends to safeguard their own interest. EX. A lender may stipulate that only upto 30% of the profit may be paid as dividend. Because of these restrictions a company may be forced to retain earnings and have a low payout. 7. Control Objective of maintaining control by the present management may also affect the dividend policy. Suppose a company is quite liberal in paying dividends, it may have to raise fund for expansion or diversification by issue of new shares. If the present management is unable to subscribe to the new shares its control will be dividend. Hence the management may opt for a low payout and retain earnings to maintain control over the company. 8. Legal Restrictions Provision of the companies act to be altered in the formulating of dividend policy. According to this provision, dividends can be paid only out of current profit or past profits. Only after provision of depreciation, there are also stipulations regarding transfer of profits to reserve before declaration of dividends. Further, dividends cannot be paid out of capital. 9. Nature of Earnings Certain industry like pharmaceuticals, liquor and essential goods have a stready dividend. Companies in such industries may enjoy stable earnings. They may therefore resort to liberal
15

Fianancial Management

payout of dividends. However, if the earnings are uncertain because of the cyclical nature of the industry it is desirable to have a low payout. 10. Stability of Dividend Stable dividends create a good image of the company. A steady dividend gives a sense of security and confidence to the shareholder.

Forms of dividend
Dividend payment may take any of the following forms: 1. Cash dividend: Dividend is paid to shareholder in cash. It is usual method of paying dividends. It result in outflow of cash. Hence company should arrange adequate cash resources for payment of dividend. 2. Bond dividend: If the company does not have sufficient cash resources, it may issue bonds in lien of dividend. The shareholders get bonds instead of dividends. The company generally pays interest on these bonds & repays the bonds on maturity. Bond dividend enables the company to postpone payment of dividend. But it is not popular. 3. Property dividend: It refers to the payment of dividend in the form of some assets other than cash. This type of dividend is also not popular. 4. Stock dividend: Stock dividend refers to the issue of bonuses share to shareholders. Bonus shares are issued free of cost to shareholders out of accumulated profits. Usually they are issued when a company has substantial resources but needs to retain cash for expansion/diversification. It does not result in any outflow of cash. Issue of bonus shares signifies optimism about future profits of the company.

Bonus shares
Bonus shares are shares issued free of cost to existing shareholders. The shares are issued out of resources surplus consisting of accumulated profits, shares premium etc. Bonus issue is made to shareholders in proportion to the number of shares held by them. For instance a bonus issue of 1:2 refers to the issue of one bonus shares for every two shares held by the shareholders. Bonus shares are also known as stock dividend. Issue of bonus shares does not alter the total capital structure of the company. It simply result in conversion of resources & surplus into equity share capital. Hence bonus issue another capitalization of earnings for company.

Stock split
Stock split signifies a reduction in the par value of a share and a proportionate increase in no shares. Foe Eg: one share of Rs.100 may be split into 10 shares of Rs.10 each. Reason for stock split: 1. Attractive share price: Stock split make the market price of a share appear to be cheap & attractive to investors. The reduction in, market price motivates the investors to buy the shares.
16

Fianancial Management

2. Signal & Higher Profits: The investor perceive state split as an indication of higher future profits. Such positive perceptions create a favorable impact on the market price of the share. 3. Satisfaction of Shareholders: Stock split increases the no of shares. Suppose a share holder holds 200 shares of Rs.100 each in K ltd. If the shares are split into shares of Rs.10,he will get 2000 shares of Rs.10 each. The increase in shareholding gives a sense of satisfaction to the share holders. Bonus Issue & Stock Split-A Comparison Bonus Issue There is no change in the par value of the shares. Bonus shares are issued by capitalizing the earnings. so there is a fall in reserves & increases the share capital. The book value per share, the EPS & market price per share decline Shareholders proportional ownership in the company remains unchanged. Market price per share is reduced & brought within a more popular trading range Stock Split Par value of the share is reduced. There is no capitalization of earnings. so there is no change in reserves & share capital. The book value per share, the EPS and market price decline. Shareholders proportional ownership in the company remains unchanged Market price per share is reduced & brought within a more popular trading range

1. 2.

3. 4. 5.

17