FINANCIAL MANAGEMENT ASSIGNMENT

MBA IT SEM II Assignment
FINANCIAL MANAGEMENT

Q. 1) What are the factors to be considered while designing a dividend policy of a firm?

Ans : So far as we have discussed only the theoretical aspects of dividend policy. Yet when the company establishes a dividend policy, it looks a number of other factors. The following are the important factors, which influence the dividend decision of a firm.

Internal Factors : The following are the internal factors, which affect the dividend policy of the firm.

(a)Desires of shareholders: Even if the directors have considerable liberty regarding the disposal of firm’s earnings, the shareholders are technically the owners of the company and therefore their desire cannot be overlooked by the directors while taking the dividend decision. Incase of a closely held company, the desires of shareholders are usually known and hence there is no problem. But in the case of a widely held company, it is very difficult to ascertain the preferences of shareholders. The interests of various shareholders are usually in conflict. Here the management can try to satisfy majority of shareholders by its dividend policy. Further the dividend policy once established should be continued as long as possible to create a ‘clientele effect ‘. ( to attract those investors who are happy with the firm’s dividend policy.)

(b) Financial needs of the company : Financial needs of the company may be in direct conflict with the desire of the shareholders to receive large dividends. However a prudent management should give proper weightage to the financial needs of the company. So growth firms are likely to follow low payout ratio and declining companies are likely to follow high payout ratio.

(c) Nature of earnings : The companies with stable earnings need to follow high payout ratio and vice versa. Public utilities are the classic examples of firms with stable earnings and they follow high payout ratio.

(d) Desire for control : If a growth company requires additional funds, it has to issue additional equity shares. If the existing shareholders are unable to buy the additional shares their voting power will be diluted. So the management may not pay more dividends in the fear of losing control over the company.

(e) Liquidity position : Liquidity is the continuous ability of a company to meet the maturing obligations as and when they become due. Payment of dividends means outflow of cash. So a firm may have adequate earnings but it may not be in a position to pay dividend due to liquidity problems.

(f) Return on investment : The firm should not retain the earnings if return on investment is less than the cost of capital.

External Factors : The following are the external factors, which affects the dividend policy of a firm.

(a) General state of the economy : The general state of the economy affects to a great extend the management’s decision to retain or to distribute earnings of the firm. In case of uncertain economic and business conditions, the management may like to retain whole or part of the firm’s earnings to build up reserves to absorb shock in the future. Similar policy may be followed by the management during depression to improve the liquidity position of the firm. During boom, the management may not declare liberal dividends though the earnings are high because of availability of profitable investment opportunities.

(b) State of the capital market : A company, which is not sufficiently liquid, can pay dividends if it is able to raise debt or equity in the capital market. Generally sound and big companies will not find it difficult to raise funds in the capital market. But a small company which does not have a sound cash position and also unable to raise capital in the market, will not be able to pay more dividends. Thus favorable conditions in the capital market will enable the company to pay liberal dividends even if it is not liquid.

(c) Contractual restrictions : Lenders generally put restrictions on dividend payments to protect their own interest. For example loan argument may prohibit the payment of dividend as long as current ratio is less than 2:1.

(d) Tax Policy :

1. Corporate Tax : Heavy taxes reduce the residual profits available for distribution.

2. Dividend Tax : Dividend tax discourage the company from paying liberabl dividends. Dividend tax has to be paid when dividends are paid.

(e) Legal restrictions : The companies Act of 1956 has put several restrictions regarding payment and declaration of dividends. Some of them are :

1. Dividends can be paid out of current profits. Payment of dividend out of capital is illegal.

2. A company is not entitled tp pay dividend unless it has provided for present as well as arrears of depreciations.

3. Certain percentage of net profits of that year as specified by the Act not exceeding 10% must be transferred to the reserves of the company.

4. Past profits can be used for declaration of dividends only as per rules framed by the Central Govt. Similarly Indian Income Tax Act also lays down certain restrictions on payment of dividends. The management has to consider all these restrictions while determining the dividend policy.

Q2) Explain Walter’s and Gordon’s theory of dividend?

Ans)

Walter’s Model ( Relevant Theory )

Prof James E Walter argues that the choice of dividend payout ratio almost always affects the value of the firm. Prof. J.E.Walter has very scholarly studied the significance of the relationship between internal rate of return ( R ) and cost of capital ( K ) in determining optimum dividend policy which maximizes the wealth of shareholders.

Walter’s model is based on the following assumptions :

1) The firm finances its entire investments by means of retained earnings only.

2) Internal rate of return ( R ) and cost of capital ( K ) of the firm remains constant.

3) The firm’s earnings are either distributed as dividend or reinvested internally.

4) Bigining earnings and dividends of the firm will never change.

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

Walter’s formula to determine the price per share is as follows :

D+r/k (E-D)

P= K

P = Market Price per share.

D = Dividend per share.

E = Earnings per share.

R = Internal rate of return

K = Cost of capital.

According to the theory, the optimum dividend policy depends on the relationship between the firm’s internal rate of return and cost of capital. If R>K, the firm should retain the entire earnings. Whereas it should distribute the earnings to the shareholders in case the RK is that the firm is able to produce more return than the shareholders from the retained earnings.

Walter’s view on optimum dividend payout ratio can be summarized as below :

a) Growth Firms ( R>K ) :- The firms having R>K may be referred to as growth firms. The growth firms are assumed to have ample profitable investment opportunities. These firms naturally can earn a return which is more than what shareholders could earn on their own. So optimum payout ratio for growth firm is 0%.

b) Normal Firms ( R = K ) :- If R is equal to K, the firm is known as normal firm. These firms earn a rate of return which is equal to that of shareholders. In this case dividend policy will not have any influence on the price per share. So there is nothing like optimim payout ratio for a normal firm. All the payout ratios are optimum.

c) Declining Firm ( R

So according to Walter, the optimum payout ratio is either 0%

( when R>K ) or 100% ( when R

Criticisms :

Walter’s model is based on certain assumptions which are true for Walter but not true in the real world. The following are the limitations of the Walter’s model.

1) Walter assumes that there is no external financing. When R>K, the firm must issue additional security and finance its profitable investments. If the company uses, only retained earnings, all the profitable investments cannot be undertaken. So the investment decision of the firm will be sub-optimum.

2) Constant R - Internal rate of return cannot remain same. It actually diminishes as and when we make more and more investments.

3) Constant K – Cost of capital of a company cannot remain same. Risk of the company definitely changes with additional investment of retained earnings

GORDEN’S MODEL

Another theory, which contends that dividends are relevant, is the Gordon’s model. This model which opines that dividend policy of a firm affects its value is based on the following assumptions :

a) The firm is an all quity firm ( no debt )

b) There is not outside financing and all investments are financed exclusively by retained earnings.

c) Internal rate of return ( R ) of the firm remains constant.

d) Cost of capital ( K ) of the firm also remains same regardless of the change in the risk complexion of the firm.

e) The firm derives its earnings in perpetuity.

f) The retention ratio ( b ) once decided upon is constant. Thus the growth rate ( g ) is also constant ( g=br )

g) K>g.

h) A Corporate tax does not exist.

Gordon used the following formula to find out price per share.

P= E1 ( 1 – b )

K-br

P = price per share.

K = cost of capital.

E1 = earnings per share.

B = retention ratio.

( 1-b ) = payout ratio.

G = br growth rate. ( r = internal rate of return )

According to Gordon, when R>K the price per share increases as the dividend payout ratio decreases.

When R

Thus Gordon’s view on the optimum dividend payout ratio can be summarized as below :

1) The optimum payout ratio for a growth firm ( R>K ) is zero.

2) There no optimum ratio for a normal firm ( R=K )

3) Optimum payout ratio for a declining firm R

Thus the Gordon’s Model’s is conclusions about dividend policy are similar to that of Walter. This similarity is due to the similarities of assumptions of both the models.