INTERNATIONAL

FINANCIAL
MANAGEMENT
Subject Code: FSF- 2
By: Asst. Prof. Pallavi Deshmukh
MBA- III SEM FINANCE

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 UNIT 2

Managing short term assets & liabilities

Liquidity, you will recall, is a firm's ability to meet its short-term debts, and cash is the most liquid asset,
because it can be spent immediately. Non-cash current assets, mainly receivables and inventory, are less
liquid because it may take time to turn them into cash. For example, ratios measuring receivables collection
periods and inventory turnover rates, estimate how long it is taking to convert receivables and inventory
into cash. In general the more current assets a firm hold the greater its liquidity (measured by the current
ratio). If liquidity is, or becomes, very important managers may decide to hold proportionately more cash
and/or marketable securities (measured by the quick ratio) than non-cash assets, receivables and
inventory. There is always a trade-off in holding high levels of cash assets because they earn very little
return. In general, managers can only reduce the risk of becoming less liquid by reducing the overall return
on current assets, and on total assets (the ROA measure).

1. Management of working capital: Working capital is a financial metric which represents

operating liquidity available to a business, organization, or other entity, including
governmental entity. If current assets are less than current liabilities, an entity has a working
capital deficiency, also called a working capital deficit.
Net Working Capital = Current Assets − Current Liabilities
The management of working capital involves managing inventories, accounts receivable and
payable and cash so that to ensure a firm is able to continue its operations and that it has
sufficient funds to satisfy both maturing short-term debt and upcoming operational expenses.
A finance manager will use a combination of policies and techniques for the management of
working capital. These policies aim at managing the current assets (generally cash and cash
equivalents, inventories and debtors) and the short term financing, such that cash flows and
returns are acceptable. These are:
i. Cash management: Identify the cash balance which allows for the business to meet day to
day expenses, but reduces cash holding costs.
ii. Inventory management: Identify the level of inventory which allows for uninterrupted
production but reduces the investment in raw materials - and minimizes reordering costs -
and hence increases cash flow. Besides this, the lead times in production should be
lowered to reduce Work in Progress (WIP) and similarly, the Finished Goods should be
kept on as low level as possible to avoid over production - see Supply chain management;
Just In Time (JIT); Economic order quantity (EOQ); Economic quantity
iii. Debtors management: Identify the appropriate credit policy, i.e. credit terms which will
attract customers, such that any impact on cash flows and the cash conversion cycle will be
offset by increased revenue and hence Return on Capital (or vice versa); see Discounts and
allowances.
iv. Short term financing: Identify the appropriate source of financing, given the cash
conversion cycle: the inventory is ideally financed by credit granted by the supplier;

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 however, it may be necessary to utilize a bank loan (or overdraft), or to "convert debtors to
cash" through "factoring".

2. Financing of international trade: MNCs requires finance for trading in international market
and financing of trade related working capital requires large amounts of money as well as
financial services like letter of credit & banker’s acceptance.
Payments in International trade:
i. Cash in advance
ii. Letter of credit
iii. Draft
iv. Consignment
v. Open account

Documents in international trade:

i. Bill of lading
ii. Commercial invoice
iii. Insurance
iv. Consular invoice

Financing Techniques in International trade:

i. Bankers’ acceptance: It is time draft drawn on a bank. By accepting the draft, the bank
makes an unconditional promise to the holder of the draft a stated amount on a
specified day.
ii. Discounting: If trade drat is not accepted by a bank, the exporter still can convert
the trade draft into cash by means of discounting. The exporter places the draft
with a bank or financing institutions & in turn receives the face value of the draft
less the interest & commission.
iii. Factoring: Factoring is a financial transaction whereby a business job sells its
accounts receivable (i.e., invoices) to a third party (called a factor) at a discount in
exchange for immediate money with which to finance continued business.
Factoring differs from a bank loan in three main ways. First, the emphasis is on the
value of the receivables (essentially a financial asset), not the firm’s credit
worthiness. Secondly, factoring is not a loan – it is the purchase of a financial asset
(the receivable). Finally, a bank loan involves two parties whereas factoring
involves three. The sale of the receivables essentially transfers ownership of the
receivables to the factor, indicating the factor obtains all of the rights and risks
associated with the receivables.
iv. Forfaiting: In trade finance, forfaiting involves the purchasing of receivables from
exporters. The forfaiter takes on all risks involved with the receivables. The
forfaiting operation is a transaction-based operation (involving Exporters)
involving the sale of one of the firm's transactions. Factoring is also a Financial
Transaction involving the purchase of Financial Assets; but Factoring involves the
sale any portion of a firm's Receivables. At its simplest the receivables should be
evidenced by a promissory note, a bill of exchange, a deferred-payment letter of
credit, or a letter of guarantee.
Three elements relate to the pricing of a forfaiting transaction:

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 a. Discount rate, the interest element, usually quoted as a margin over LIBOR ( London
Interbank Offered Rate).
b. Days of grace, added to the actual number of days until maturity for the purpose of
covering the number of days normally experienced in the transfer of payment,
applicable to the country of risk.
c. Commitment fee, applied from the date the forfaiter is committed to undertake the
financing, until the date of discounting.
3. Instruments of the international money market: In international money market the
instruments that are issued or traded internationally are:
a. Eurocurrency time deposits & certificates of deposit:
b. Bankers’ acceptance: A banker's acceptance, or BA, is a promised future payment, or
time draft, which is accepted and guaranteed by a bank and drawn on a deposit at the
bank. The banker's acceptance specifies the amount of money, the date, and the person
to which the payment is due. After acceptance, the draft becomes an unconditional
liability of the bank. But the holder of the draft can sell (exchange) it for cash at a
discount to a buyer who is willing to wait until the maturity date for the funds in the
deposit. A banker's acceptance starts as a time draft drawn on a bank deposit by a
bank's customer to pay money at a future date, typically within six months, analogous
to a post-dated check. Next, the bank accepts (guarantees) payment to the holder of the
draft, analogous to a post-dated check drawn on a deposit with over-draft protection.
The party that holds the banker's acceptance may wait the acceptance until it matures,
and thereby allow the bank to make the promised payment, or it may sell the
acceptance at a discount today to any party willing to wait for the face value payment
of the deposit on the maturity date. The rates at which they trade, calculated from the
discount prices relative to their face values, are called banker's acceptance rates.
c. Letter of credit: Letters of credit are used primarily in international trade transactions
of significant value, for deals between a supplier in one country and a customer in
another. The parties to a letter of credit are usually a beneficiary who is to receive the
money, the issuing bank of whom the applicant is a client, and the advising bank of
whom the beneficiary is a client. Almost all letters of credit are irrevocable, i.e., cannot
be amended or canceled without prior agreement of the beneficiary, the issuing bank
and the confirming bank, if any. In executing a transaction, letters of credit incorporate
functions common to giros and Traveler's cheques. Typically, the documents a
beneficiary has to present in order to receive payment include a commercial invoice,
bill of lading, and documents proving the shipment were insured against loss or
damage in transit.
d. Euro notes & Euro commercial paper: Short-term unsecured promissory note issued
in London and other European financial centers for same-day settlement in U.S. dollars
in New York. Paper is issued in either discount or interest-bearing form and
distributed through dealers on a best-effort basis, in contrast to euronote facilities,
which are issued through a tender panel. Eurocommercial paper gives issuers quicker
access to funds than Euronotes, sometimes even same day funds.
4. Euro Currency Market: The market is made by banks & other financial institutions that
accept time deposits & make loans in a currency other than that of the country

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 Long Run investment Decisions
Introduction

The investment decisions of a firm are generally known as the capital budgeting, or capital expenditure
decisions. Firm’s investment decision would generally include expansion, acquisition, mordernisation &
replacement of the long run assets. Investment in long term assets invariably requires large funds to be tied
up in the current assets such as inventories & receivables.

Features of investment decisions

1. The exchange of current funds for future benefits.

2. The funds are invested in long term assets.
3. The future benefits will occur to the firm over a series of years.

Importance of investment decision

1. Growth: Investment decisions influence the firm’s growth in long run. As one wrong decision
can turn to be disastrous for the survival of firm. An unprofitable expansion of assets will
result in operating costs to the firm.
2. Risk: A long term commitment of funds may also change the risk complexity of the firm.
3. Funding: Investment decisions involve large amount of funds which make it very important
for the firm to plan its investment programmes tactfully.
4. Complexity: Investment decisions are the toughest decisions. It is complex process to
correctly estimate the future cash flows of an investment.

Types of Investment decisions

1. Expansion & Diversification: Expansion or diversification of a business requires investment

in new products & a new kind of production activity within the firm.
2. Replacement & Modernisation: The investment decision also takes place for replacement &
modernisation which lead to improve operating efficiency and reduce costs.
3. Contingent investment: Contingent investments are dependent projects. The choice of one
investment demands undertaking one or more other investments.

The Foreign Investment Decisions

Introduction
A more wider & complicated set of strategic, economic & behavioural considerations are usually the
motivating factors behind foreign investments. International business houses wanting to maximize
shareholders’ wealth generally try & increase their foreign business to become internationalized.
Reasons to Foreign direct investments
1. New sources of demand:
2. Economies of scale:
3. Use of foreign raw material:
4. Exploit monopolistic advantage:
5. Political safety seeker:

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Channels of Foreign investment decisions

1. Foreign Direct Investment (FDI): FDI is a common method of engaging in international business.
Determinants of FDI:
i. Depends on return & risk: It is always recommended that there should be return & risk
should be neutralized & FDI decision depend on this these two variables. If this proposition
is accepted then the differential rates of return hypothesis becomes inadequate and as
well as risk has to be reduced by diversification.
ii. Depends on Market size: The size of FDI in an importer on its market size.
iii. Depends on political risk: Lack of political stability dicourges inflows of FDI. For instance if
an importer’s govt. imposes certain capital repatriation restrictions.
2. Foreign Portfolio investment (FPI): Portfolio capital is the key channel for integrating capital
markets worldwide. Investment is equity provides return in two firms: dividends & capital
appreciation.

Alternatives Investment Vehicles for Foreign investments:

1. Direct purchase of securities in overseas markets:
2. The use of American Depository Receipts (ADR): An ADR is a receipt issued by a US bank certifying
that bank holds an equivalent number of shares issued by a foreign company.
3. Single country Funds: It trades the shares of the companies of a single country.
4. International Funds: It trades the shares of foreign companies belonging to several countries. The
risk related to international funds is called “modified systematic risk”.
5. Global Funds: Global funds also trades in domestic shares. In USA global funds have 50% securities.
These funds tend to be cost effective.

Political Risk management

Introduction

Direct foreign investments are exposed to a multitude of interventions by both importer & home
governments. Although most firms focus on government actions that reduce the value of the firm, there
are occasionally beneficial government actions that increase the value of the firm. The degree to which a
company is affected by political events is known as political exposure.

Political risk is defined as the variability in the value of firm (or subsidiary) that caused by uncertainty
about political or policy changes. This risk represented by a distribution of the firm’s value due to political
incidents.

Every country has its own tax policies, monetary policies, fiscal policies & other types of policies. Any
project operating in that country has to confirm to all these rules& regulations.

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Form of Political Risk

While entering into international trade financial manager should examine the above stated factors:

1. Attitude of Consumer in the importer’s country: Generally tendency of consumer is buy goods
manufactured in one’s country rather than imported goods unless and until it is too good to buy.
So this risk has to be considered by the exporter.
2. Actions of importer’s govt.: Actions by the government may affect the cash flow of exporter’s firm.
Like additional corporate taxes which affect after tax earnings as well as withholding taxes and
another example is of
3. Blockage of fund transfers: Subsidiaries of MNC’s sent funds to head offices for various purposes
but fund transfer restrictions which may affect after tax cash flows sent to the exporter.
4. War: Wars are always threat for both exporters & importers as this can affect the safety of
employees hired by an MNC’s subsidiaries and whereas wars can disturbs the business cycle. For
example terrorist attack in USA on 11 Sep 2001.
5. Currency Inconvertibility: Foreign exchange is always risk and had to be examined as many
countries do not allow domestic country currency to convert into other currency.
6. Corruption: Corruption can negatively affect an MNC’s international trade as it can increase the
cost of conducting business or reduce revenue.

Measurement of political risk

The level of political risk in a country can be categorized in four levels as Low risk countries, Medium risk
countries, High risk countries, and Prohibitive risk countries on the basis of capital flight, government
regulations & controls, taxes, low returns and political instability.
It can be measurement from following techniques: (a) Econometric Modeling: It is used to assess the
political risk and is assessed by banks to assess the capacity of the government to repay the loan without
default. (b) Delphi technique: This method involves the collection of independent opinions on country risk
from various experts without group discussion. (c) Risk rating matrix: An international company may
evaluate country risk for several countries to determine location of investment. One approach to compare
political & financial ratings among countries, advocated by some foreign risk manager & this called as risk
rating matrix.

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Process of Political risk management

Approaches to political risk management

1. Defensive approach: In this approach the company tries to protect its interests by locating crucial
aspects of the firm beyond the reach of the importer’s governments. This is because to minimize
the firm’s dependence on importer or importer’s government’s intervention costlier.
2. Integrative approach: In this approach the aim of the company with the importer’s economy to
make it appear local. Like establish joint ventures, employ more numbers of personnel from
importer’s country.

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 Unit 3

Multinational Capital Budgeting Applications & Interpretation

Capital Budgeting:

Capital budgeting (or investment appraisal) is the planning process used to determine whether an
organisation's long term investments such as new machinery, replacement machinery, new plants, new
products, and research development projects are worth pursuing. It is budget for major capital, or
investment, expenditures.
Many formal methods are used in capital budgeting, including the techniques such as
1. Accounting rate of return
2. Net present value
3. Profitability index
4. Internal rate of return
5. Modified internal rate of return
6. Equivalent annuity
7. Payback period and
8. Discounted payback period
These methods use the incremental cash flows from each potential investment, or project Techniques
based on accounting earnings and accounting rules are sometimes used - though economists consider this
to be improper - such as the accounting rate of return, and "return on investment."
Multinational Capital Budgeting: The rapid growth of multinational corporations has hastened the need
for the development of robust models to handle the increased risk and complexity. Particularly in capital
budgeting, careful analysis and adequate reflection of the critical variables are essential. The great number
of relevant variables, their significant interrelationships, and the high degree of uncertainty render
mathematical models highly complex or infeasible to solve. To overcome these shortcomings, a “Hertz-
type” simulation model is formulated for the multinational firm. The important international variables—
foreign exchange rates, foreign tax methodology, host government controls, and other social, economic,
and political factors—are reflected in the model. A two stage approach is utilized: first, investment projects
are analyzed by the subsidiary and if they pass this first screening they are proposed for the parent's
consideration; second, the parent evaluates the attractiveness of projects from its point of view and ranks
proposals for acceptance considering all global opportunities. The model is designed so that sensitivity
analysis can be easily performed.
Subsidiary versus Parent Perspective:
Should the capital budgeting for a multi-national project be conducted from the viewpoint of the subsidiary
that will administer the project, or the parent that will provide most of the financing? The results may vary
with the perspective taken because the net after-tax cash inflows to the parent can differ substantially
from those to the subsidiary. Such differences can be due to:
a. Tax differentials: What is the tax rate on remitted funds?
b. Regulations that restrict remittances:
c. Excessive remittances: The parent may charge its subsidiary very high administrative fees.

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 Remitting Subsidiary Earnings to the Parent

d. Exchange rate movements: When earnings are remitted to the parent they are normally
converted from the subsidiary’s local currency to the parent’s currency. The amount received by
the parent is therefore influenced by existing exchange rate.
A parent’s perspective is appropriate when evaluating a project, since any project that can create a positive
net present value for the parent should enhance the firm’s value. However, one exception to this rule
occurs when the foreign subsidiary is not wholly owned by the parent.

Input for Multinational Capital Budgeting:

The following forecasts are usually required:
1. Initial investment
2. Consumer demand over time
3. Product price over time
4. Variable cost over time
5. Fixed cost over time
6. Project lifetime
7. Salvage (liquidation) value
8. Restrictions on fund transfers
9. Tax payments and credits
10. Exchange rates
11. Required rate of return
Multinational Capital Budgeting
Capital budgeting is necessary for all long-term projects that deserve consideration. One common method
of performing the analysis involves estimating the cash flows and salvage value to be received by the
parent, and then computing the net present value (NPV) of the project.
• NPV = – initial outlay
n
+ S cash flow in period t
(1 + k )t
t =1
+ salvage value

(1 + k )n
k = the required rate of return on the project
n = project lifetime in terms of periods

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 • If NPV > 0, the project can be accepted.
Example:
Spartan, Inc. is considering the development of a subsidiary in Singapore that will manufacture and sell
tennis rackets locally.
Capital Budgeting Analysis: Spartan, Inc.

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Capital Budgeting Analysis

Factors to Consider in Multinational Capital Budgeting:

 Exchange rate fluctuations: Since it is difficult to accurately forecast exchange rates, different
scenarios can be considered together with their probability of occurrence.

 Inflation: Although price/cost forecasting implicitly considers inflation, inflation can be quite
volatile from year to year for some countries.

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  Financing arrangement: Financing costs are usually captured by the discount rate. However, when
foreign projects are partially financed by foreign subsidiaries, a more accurate approach is to separate
the subsidiary investment and explicitly consider foreign loan payments as cash outflows.
 Blocked funds: Some countries require that the earnings generated by the subsidiary be
reinvested locally for at least a certain period of time before they can be remitted to the parent.
Capital Budgeting with Blocked Funds: Spartan, Inc.
Assume that all funds are blocked until the subsidiary is sold.

 Uncertain salvage value: Since the salvage value typically has a significant impact on the project’s
NPV, the MNC may want to compute the break-even salvage value.
 Impact of project on prevailing cash flows: The new investment may compete with the existing
business for the same customers.
 Host government incentives: These should also be incorporated into the analysis.
 Real options: Some projects contain real options for additional business opportunities. The value of
such a real option depends on the probability of exercising the option and the resulting NPV.
Adjusting Project Assessment for Risk:
• When an MNC is unsure of the estimated cash flows of a proposed project, it needs to
incorporate an adjustment for this risk.
• One method is to use a risk-adjusted discount rate. The greater the uncertainty, the larger
the discount rate that should be applied to the cash flows.
• An MNC may also perform sensitivity analysis or simulation using computer software
packages to adjust its evaluation.
• Sensitivity analysis involves considering alternative estimates for the input variables, while
simulation involves repeating the analysis many times using input values randomly drawn
from their respective probability distributions.

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 UNIT 4

Cost of Capital, Capital Structure & Dividend Policy of the Multinational Firm

Introduction to Cost of Capital: A firm’s capital consists of equity (retained earnings and funds
obtained by issuing stock) and debt (borrowed funds). There is an advantage to using debt
rather than equity as capital because the interest payments on debt are tax deductible. It is
favorable to increase the use of debt financing until the point at which the bankruptcy
probability becomes large enough to offset the tax advantage of using debt.

Symbolically cost of capital: K = r+b+f

Where, K= Cost of capital, r= Normal rate of return at zero risk level, b= premium for business
risk, f = Premium for financial risk.

Cost of Capital Comparison Using the Capital Asset Pricing Model (CAPM):
1. To assess how required rates of return of MNCs differ from those of purely domestic firms,
the CAPM can be applied. It defines the required return (K e) on a stock as: Ke = Rf + B(Rm – Rf)
where, Ke= CAPM, Rf = risk free rate of return, B= beta of stock , R m = Market return.
2. The CAPM suggests that the required return on a firm’s stock is a positive function of (1)the
risk-free rate of interests,(2)the market rate of return and (3)the stock’s beta.
3. The beta represents the sensitivity of the stock’s returns to market returns. A project’s beta
represents the sensitivity of the project’s cash flow to market conditions.
4. Capital asset pricing theory would suggest that the MNCs cost of capital is generally lower
than that of domestic firms (As there are two types of risk to cash flow generated by several
projects of MNCs i.e. unsystematic risks & systematic risks).

Cost Capital across Countries:

1. Country differences in the cost of debt: The cost of debt to a firm is primarily
determined by the prevailing risk free interest rate in the currency borrowed & the risk
premium required by the creditors.
2. Difference in the risk-free rate: This rate is determined by the interaction of the supply
& demand for funds. Any factors that influence the supply & demand will affect the risk
free rate. These factors include tax laws, demographics, monetary policies, 7 economic
conditions all of which differ among countries.
3. Difference in the risk premium: The premium on risk may be large to compensate
creditors for the risk that borrower may be unable to meet its payment obligations.
4. Comparative costs of debt across countries: The before tax cost of debt for various
countries are measured by corporate bond yields and correlation between them are
determined.
5. Country difference in the cost of equity: Cost of equity of a firm represents an
opportunity cost, what shareholders could earn on investments with similar risk if the

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 equity funds were distributed to them and it can be measured as risk free interest rate
that could have been earned by shareholders plus a premium to reflect the risk of firm.
6. Combining the costs of debt and equity: Combining the costs of debt and equity will
derive an overall cost of capital. The relative proportions of debt & equity used by firms
in each country must be applied as weighs to reasonably estimate this cost of capital.
MNCs can attempt to access capital from the country where capital cost is low, but
when the capital is used to support operations in other countries, the MNCs are
usually exposed to exchange rate risk. The cost of capital may ultimately turn out to
be higher than expected.

Using the cost of capital for assessing foreign projects:

1. When the MNC’s parent proposes an investment in a foreign project that has the same risk
as the MNC itself, it can use its weighted average cost of capital as the required rate of
return for the project.
2. An alternative method of accounting for a foreign project’s risk is to adjust the firm’s
weighted average cost of capital for the risk differential.
3. There is no perfect formula to adjust for the project’s unique risk.
The MNC’s Capital Structure Decision: A multinational firm’s capital structure decision involves
the choice of debt against equity financing within all of its subsidiaries. Therefore its overall capital
structure is a combination of all of its subsidiaries’ capital structure. But there are two
characteristics which affects capital structure one is Influence of corporate characteristics & other
is influence of country characteristics –
Influence of corporate Characteristics:
1. Stability of MNC’s cash flows: MNC having more cash flow can handle more debt because
there is a constant stream of cash inflows to cover periodic interest payments.
2. MNC’s credit risk: MNC having lower credit risk (risk of default) have more access to credit.
Any aspect that influences credit risk may affect a MNC’s choice of using debt v/s equity.
3. MNC’s access to earnings: Highly profitable multinational firm may in position to finance
most of its investment with retain earnings & therefore use an equity intensive capital
structure.
Influence of Country Characteristics:
1. Stock restrictions in host countries: in many countries investors are restricted to buy only
local stocks or if allowed then investors have less knowledge of foreign stocks. Generally
such obstacles are faced by MNCs. Thus it should raise equity in such countries at relatively
low cost. This could persuade the MNC to use more equity by issuing stock in these
countries to finance its operations.
2. Interest rates in host countries: As govt. of host country impose barrier on capital flows
along with potential adverse exchange rate, tax & country risk effects, loanable funds do
not always flow to loanable funds (interest rate) can vary across countries.
3. Strength of host country currencies: If parent firm feels that currency of its subsidiary
country is weak then it may attempt to finance a large proportion of its foreign operations

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 by borrowing those currencies this will remit a smaller amount in earnings because they
will be making interest payment on local debt as well as parent firm will reduce exchange
risk also.
4. Country risk in host countries: Rules & regulations for trading differ country to country,
this may be blockage fund transfer & in such conditions subsidiaries must finance its debt
from these blocked funds.
5. Tax laws in host countries: Many host country’s govt. impose heavy corporate tax on
foreign earnings and subsidiaries can reduce this by withholding taxes by using more local
debt financing.

Creating the Target Capital Structure:

1. An MNC may deviate from its target capital structure in each country where financing is
obtained.
2. Consider that country A does not allow MNCs with headquarters elsewhere to list their
stocks on its local stock exchange.
3. Consider a second example, in which country B allows the MNC to issue stock there and list
its stock on its local exchange.
4. As a third example, consider an MNC that desires financing in country C, which is
experiencing political turmoil.
5. The ideal sources of funds for all countries will not necessarily sum to match the global
target capital structure.
6. The strategy of ignoring a “local” target capital structure in favor of a global target capital
structure is rational as long as it is acceptable by foreign creditors and investors.
Local Ownership of Foreign Subsidiaries:
1. Some MNCs may allow a specific foreign subsidiary to issue stock to local investors or
employees as a means of infusing equity into the subsidiary.
2. One concern about a partially owned foreign subsidiary is a potential conflict of interest.
3. Some countries will allow an MNC to establish a subsidiary there only if the subsidiary can
sell shares.
4. One possible advantage of a partially owned subsidiary is that it may open up additional
opportunities within the host country.
Dividend Policy of the Multinational Firm:

Definition: Dividend is the distribution of value to shareholders.

Dividend Policy: What happens to the value of the firm as dividend is increased, holding
everything else (capital budgets, borrowing) constant. Thus, it is a trade -off between retained
earnings on one hand, and distributing cash or securities on the other. The decision for
distributing or paying a dividend is taken in the meeting of Board of Directors and in
confirmed generally by the annual general meeting of the shareholders. The dividend can be
declared only out of divisible profits, remained after setting of all the expenses, transferring
the reasonable amount of profit to reserve fund and providing for depreciation and taxation

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for the year. It means if in any year, there are not profits; no dividend shall be distributed
that year. The shareholders cannot insist upon the company to declare the dividend. It is
solely the discretion of the directors.

Factors Affecting Dividend Policy:

A number of considerations affect the dividend policy of company. The major factors are:

1. Stability of Earnings. The nature of business has an important bearing on the dividend
policy. Industrial units having stability of earnings may formulate a more consistent dividend
policy than those having an uneven flow of incomes because they can predict easily their
savings and earnings. Usually, enterprises dealing in necessities suffer less from oscillating
earnings than those dealing in luxuries or fancy goods.

2. Age of corporation. Age of the corporation counts much in deciding the dividend policy. A
newly established company may require much of its earnings for expansion and plant
improvement and may adopt a rigid dividend policy while, on the other hand, an older
company can formulate a clear cut and more consistent policy regarding dividend.

3. Liquidity of Funds. Availability of cash and sound financial position is also an important
factor in dividend decisions. A dividend represents a cash outflow, the greater the funds and
the liquidity of the firm the better the ability to pay dividend. The liquidity of a f irm depends
very much on the investment and financial decisions of the firm which in turn determines the
rate of expansion and the manner of financing. If cash position is weak, stock dividend will be
distributed and if cash position is good, company can distribute the cash dividend.

4. Extent of share Distribution. Nature of ownership also affects the dividend decisions. A
closely held company is likely to get the assent of the shareholders for the suspension of
dividend or for following a conservative dividend policy. On the other hand, a company
having a good number of shareholders widely distributed and forming low or medium income
group would face a great difficulty in securing such assent because they will emphasise to
distribute higher dividend.

5. Needs for Additional Capital. Companies retain a part of their profits for strengthening
their financial position. The income may be conserved for meeting the increased
requirements of working capital or of future expansion. Small companies usually find
difficulties in raising finance for their needs of increased working capital for expansion
programmes. They having no other alternative, use their ploughed back profits. Thus, such
Companies distribute dividend at low rates and retain a big part of profits .

6. Trade Cycles. Business cycles also exercise influence upon dividend Policy. Dividend policy
is adjusted according to the business oscillations. During the boom, prudent management
creates food reserves for contingencies which follow the inflationary period. Higher rates of

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dividend can be used as a tool for marketing the securities in an otherwise depressed market.
The financial solvency can be proved and maintained by the companies in dull years if the
adequate reserves have been built up.

7. Government Policies. The earnings capacity of the enterprise is widely affected by the
change in fiscal, industrial, labour, control and other government policies. Sometimes
government restricts the distribution of dividend beyond a certain percentage in a parti cular
industry or in all spheres of business activity as was done in emergency. The dividend policy
has to be modified or formulated accordingly in those enterprises.

8. Taxation Policy. High taxation reduces the earnings of he companies and consequently the
rate of dividend is lowered down. Sometimes government levies dividend -tax of distribution
of dividend beyond a certain limit. It also affects the capital formation. N India, dividends
beyond 10 % of paid-up capital are subject to dividend tax at 7.5 %.

9. Legal Requirements. In deciding on the dividend, the directors take the legal requirements
too into consideration. In order to protect the interests of creditors an outsiders, the
companies Act 1956 prescribes certain guidelines in respect of the d istribution and payment
of dividend. Moreover, a company is required to provide for depreciation on its fixed and
tangible assets before declaring dividend on shares. It proposes that Dividend should not be
distributed out of capita, in any case. Likewise, contractual obligation should also be fulfilled,
for example, payment of dividend on preference shares in priority over ordinary dividend.

10. Past dividend Rates. While formulating the Dividend Policy, the directors must keep in
mind the dividend paid in past years. The current rate should be around the average past rat.
If it has been abnormally increased the shares will be subjected to speculation. In a new
concern, the company should consider the dividend policy of the rival organisation.

11. Ability to Borrow. Well established and large firms have better access to the capital
market than the new Companies and may borrow funds from the external sources if there
arises any need. Such Companies may have a better dividend pay-out ratio. Whereas smaller
firms have to depend on their internal sources and therefore they will have to built up good
reserves by reducing the dividend pay out ratio for meeting any obligation requiring heavy
funds.

12. Policy of Control. Policy of control is another determining factor is so far as dividends are
concerned. If the directors want to have control on company, they would not like to add new
shareholders and therefore, declare a dividend at low rate. Because by adding new
shareholders they fear dilution of control and diversion of policies and programmes of the
existing management. So they prefer to meet the needs through retained earing. If the
directors do not bother about the control of affairs they will follow a liberal dividend policy.

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Thus control is an influencing factor in framing the dividend policy.

13. Repayments of Loan. A company having loan indebtedness are vowed to a high rate of
retention earnings, unless one other arrangements are made for the redemption of debt on
maturity. It will naturally lower down the rate of dividend. Sometimes, the lenders (mostly
institutional lenders) put restrictions on the dividend distribution still such time their loan is
outstanding. Formal loan contracts generally provide a certain standard of liquidity and
solvency to be maintained. Management is bound to hour such restrictions and to limit the
rate of dividend payout.

14. Time for Payment of Dividend. When should the dividend be paid is another
consideration. Payment of dividend means outflow of cash. It is, therefore, desirable to
distribute dividend at a time when is least needed by the company because there are peak
times as well as lean periods of expenditure. Wise management should plan the payment of
dividend in such a manner that there is no cash outflow at a time when the undertaking is
already in need of urgent finances.

15. Regularity and stability in Dividend Payment. Dividends should be paid regularly because
each investor is interested in the regular payment of dividend. The management should,
inspite of regular payment of dividend, consider that the rate of dividend should be all the
most constant. For this purpose sometimes companies maintain dividend equalization Fund

Types of Dividend policies:

The following are various types of dividend policies

(1) Policy of No Immediate Dividend
(2) Stable Dividend Policy.
(3) Regular Dividend plus Extra Dividend Policy.
(4) Irregular Dividend Policy.
(5) Regular Stock Dividend Policy.
(6) Regular Dividend plus Stock Dividend Policy.
(7) Liberal Dividend Policy.
(1) Policy of No Immediate Dividend: Generally, management follows a policy of paying no
immediate dividend in the beginning of its life, as it requires funds for growth and expansion. In
case, when the outside funds are costlier or when the access to capital market is difficult for the
company and shareholders are ready to wait for dividend for sometime, this policy is justified,
provided the company is growing fast and it requires a good deal of amount for expansion. But
such a policy is not justified for a long time, as the shareholders are deprived of the dividend and
the retained earnings built up which will attract attention of laborers, consumers etc. It would be
better if the period of dividend is followed by issue of bonus shares, so that later on rate of
dividend is maintained at a reasonable level.

(2) Regular or Stable Dividend Policy: When a company pays dividend regularly at a fixed rate,
and maintains it for a considerably long time even though the profits may fluctuate, it is said to

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follow regular or stable dividend policy. Thus stable dividend policy means a policy of paying a
minimum amount of dividend every year regularly. It raises the prestige of the company in the
eyes of the investors. A firm paying stable dividend can satisfy its shareholders and can enhance
its credit standing in the market. Not only that the dividend must be regularly paid but the
dividend must be stable. It may be fixed amount per share or a fixed percentage of net profits or it
may be total fixed amount of dividend on all the shares etc. The benefits of stable dividend policy
are (i) it helps in raising long-term finance. When the company tries to raise finance in future, the
investors would examine the dividend record of the company. The investors would not hesitate to
invest in company with stable dividend policy. (2) As it will enhance the prestige of the company,
the price of its shares would remain at a high level. (3) The shareholders develop confidence in
management. (4) It makes long-term planning easier. (The detailed discussion of this policy follows
in the next paragraph.

(3) Regular Dividend plus Extra Dividend Policy. A firm paying regular dividends would continue
with its pay out ratio. But when the earnings exceed the normal level, the directors would pay
extra dividend in addition to the regular dividend. But it would be named 'Extra dividend', as it
should not give an impression that the company has enhanced rate of regular dividend, This would
give an impression to shareholders that the company has given extra dividend because it has
earned extra profits and would not be repeated when the business earnings become normal.
Because of this policy, the company's prestige and its share values will not be adversely affected.
Only when the earnings of the company have permanently increased, the extra dividend should be
merged with regular normal dividend and thus rate of normal dividend should be raised. Besides,
the extra dividend should not be abruptly declared, but the shareholders should have some idea in
advance, so that they may sell their shares, if they like. This system is not found in India.

(4) Irregular Dividend Policy: When the firm does not pay out fixed dividend regularly, it is
irregular dividend policy. It changes from year to year according to changes in earnings level. This
policy is based on the management belief that dividend should be paid only when the earnings
and liquid position of the firm warrant it. This policy is followed by firms having unstable earnings,
particularly engaged in luxury goods.

(5) Regular Stock Dividend Policy: When a firm pays dividend in the form of shares instead of cash
regularly for some years continuously, it is said to follow this policy. We know stock dividend as
bonus shares. When a company is short of cash or is facing liquidity crunch, because a large part of
its earnings are blocked in high level of receivables or when the company is need of cash for its
modernization and expansion program, it follows this policy. It is not advisable to follow this policy
for a long time, as the number of shares will go on increasing, which would result in fall in earnings
per share. This would adversely affect the credit standing of the firm and its share values will go
down.

(6) Regular Dividend plus Stock Dividend Policy: A firm may pay certain amount of dividend in
cash and some dividend is paid in the form of shares (stock). Thus, the dividend is split in to two
parts. This policy is justified when (1) The company wants to maintain its policy of regular dividend
and yet (2) It wants to retain some part of its divisible profit with it for expansion. (3) It wants to
give benefit of its earnings to shareholders but has not enough liquidity to give full dividend in
cash. All the limitations of paying regular stock dividends apply to this policy.

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(7) Liberal Dividend Policy: It is a policy of distributing a major part of its earnings to its
shareholders as dividend and retains a minimum amount as retained earnings. Thus, the ratio of
dividend distribution is very large as compared to retained earnings. The rate of dividend or the
amount of dividend is not fixed. It varies according to earnings. The higher is the profit, the higher
will be the rate of dividend. In years of poor earnings, the rate of dividend will be lower. In fact, it
is the policy of Irregular Dividend.

Models which studied the Dividend Policies of firms:

1. Gordon Growth Model: A model for determining the intrinsic value of a stock, based on a
future series of dividends that grow at a constant rate. Given a dividend per share that is
payable in one year, and the assumption that the dividend grows at a constant rate in
perpetuity, the model solves for the present value of the infinite series of future dividends.

Where:
D = Expected dividend per share one year from now
k = required rate of return for equity investor
G = Growth rate in dividends (in perpetuity)
Because the model simplistically assumes a constant growth rate, it is generally only used for
mature companies (or broad market indices) with low to moderate growth rates

2. Walter's Dividend Model: Walter's model supports the principle that dividends are
relevant. The investment policy of a firm cannot be separated from its dividend policy and
both are inter-related. The choice of an appropriate dividend policy affects the value of an
enterprise.

Assumptions of this model:

a. Retained earnings are the only source of finance. This means that the company does not
rely upon external funds like debt or new equity capital.
b. The firm's business risk does not change with additional investments undertaken. It implies
that r(internal rate of return) and k(cost of capital) are constant.
c. There is no change in the key variables, namely, beginning earnings per share(E), and
dividends per share(D). The values of D and E may be changed in the model to determine
results, but any given value of E and D are assumed to remain constant in determining a
given value.
d. The firm has an indefinite life.

Formula: Walter's model

P = D
Ke – g

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Where: P = Price of equity shares
D = Initial dividend
Ke = Cost of equity capital
g = Growth rate expected
After accounting for retained earnings, the model would be:

P = D
Ke – rb
Where: r = Expected rate of return on firm’s
investments
b = Retention rate (E - D)/E

3. Traditional position: This model emphasis on the relationship between the dividend & the
stock market. According to this approach, the stock value responds positively to higher
dividends & negatively when there are low dividends. The following expression, given by
traditional approach, establishes the relationship between market price & dividends using a
multiplier:
P = m(D + E/3)
Where, P= Market Price, m= Multiplier, D= Dividend per share, E= earnings per share
4. Miller & Modigliani Model: Miller & Modigliani have propounded the MM hypothesis to
explain the irrelevance of the firm’s dividend policy. This model which was given based on a
few assumptions sidelined the importance of the dividend policy & its effect thereof on the
share price of the firm. According to the model, it is only the firm’s investment policy that will
have an impact on the share value of the firm & hence should be given more importance.

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