MB06 – 02 : FINANCIAL MANAGEMENT

1. Briefly explain Walter’s and Gordon’s theory of dividend

Ans:

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 Theory :

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 dividends or reinvested internally.

4. Beginning earnings and dividends of the firm will never change

5. The firm has a very long or infinite life

According to Walter theory, the optimum dividend policy depends on the relationship between the firm’s internal rate of return and cost of capital.

Walter’s view on optimum dividend payout ratio can be summarized under the following topics :

a. Growth Firms

b. Normal Firms

c. Declining Firm

Gordon’s Theory :

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 :

1. The firm is an all equity firm (no debt)

2. There is no outside financing and all investment are financed exclusively by retained earnings

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

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

5. The firm derives its earnings in perpetuity

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

7. A corporate tax does not exist

2. What is the relationship between leverage and cost of capital according to NI and NOI approach?

Ans:

The term leverage may be defined as the employment of an asset or sources of funds for which the firm has to pay a fixed cost or fixed return.

James Horne has defined the leverage as “the employment of an asset or funds for which the firm pays a fixed cost or fixed return”. Thus according to him leverage results when the firm employs an assets or source of funds for which the firm has to pay a fixed cost of fixed return.

Understanding the relationship between financial leverage and cost of capital is extremely important for taking capital structure decisions. Theoretically the value of a firm can be maximized when the cost of capital is minimized.

PNet Income Approach

According to NI approach, capital structure decision is relevant to the valuation of the firm. According to NI theory, it is possible to change the cost of capital by changing the debt equity mix. In other words, a change in the capital structure causes a change in the overall cost of capital as well as the value of the firm.

According to the theory, cost of debt is assumed to be less than the cost of equity. Therefore when the financial leverage is increased (proportion of debt in the total capital),the overall cost of capital will decline and the value of the firm will increase.

P Net Operating Income Approach

This theory is just opposite to NI approach. According to NOI approach, the capital structure decision is irrelevant and there is nothing like optimum capital structure. The overall cost of capital depends on the business risk of the firm, which is assumed to be constant. NOI depend on the investments made by the company and not on the capital structure decision.

According to this theory, the benefits from the increase in the use of low cost debt is completely offset by the increase in the cost of equity.

3. What is an EBIT – EPS analysis? Illustrate your answer.

Ans:

EBIT – EPS analysis is a method of study the effect of financial leverage under various levels of EBIT under alternative method of financing.

Using the following example we can explain the EBIT – EPS analysis

A firm has a capital structure exclusively comprising of ordinary shares amounting to Rs.1,00,000/-. The firm now wishes to raise additional Rs.1,00,000/- for investment purposes.

The company has 4 alternatives.

a. It can raise the entire amount in the form of equity shares

b. It can raise the entire amount by 5 % debenture

c. It can raise 50% as equity and 50% as 5% debentures

d. It can raise 50% as equity and 50% as 5% preference capital

Further assume that existing EBIT is Rs.12,000/- , the tax rate is 50% and outstanding number of equity shares are 1000.

The financial plan, which gives highest EPS, would be naturally better from the company’s point of view.

Calculation of EPS at an EBIT level of Rs.12,000 /-

	A (Rs. )	B (Rs.)	C (Rs.)	D(Rs.)
Earning Before Interest and Tax	12,000	12,000	12,000	12,000
Less : Interest	--------	5,000	2,500	-------
Earnings Before Tax	12,000	7,000	9,500	12,000
Less : Tax @ 50 %	6,000	3,500	4,750	6,000
Earnings after Tax	6,000	3,500	4,750	6,000

4. Explain the meaning and importance of valuation concept.

Money has time value – i. e the value of the money changes over a period of time. The value of a rupee received today is different from the value of a rupee to be received after a year. A rupee today has more value than a rupee after a year.

Time value of money or time preference for money is one of the central ideas in finance. While taking appropriate decisions on financing, investment and dividends, the finance manager must keep the “Time factor” in mind. This requires that the finance manager knows about the valuation concept.

The time value of money implies

1) That a person will have to pay in future more for a rupee received today and

2) A person may accept less today for a rupee to be received in future.

The above statements relate to two different concepts they are

1. Compound Value Concept

2. Discounting or Present Value Concept

P Compound Value Concept :

In this concept the interest earned on the initial principal becomes a part of the principal at end of a compounding period.

P Discounting or Present Value concept :

The concept of present value is the exact opposite of that of compound value.

In case of compounding we calculate the future value of a sum of money or series of payments, while in case of present value concept, we estimate the present worth of a future payment / installment or series of payments adjusted for the time value or money.

5. Briefly analyze the scope of financial management.

Ans:

The approach to the scope and functions of financial management is divided, in order to have a better exposition into two broad categories .

1. Traditional Approach

2. Modern Approach

1. Traditional Approach :

The traditional approach , which was popular in the early stage, limited the role of financial manager to raising and administering of funds needed by the corporate enterprises to meet their financial needs. It deals with the following aspects :

a. arrangement of funds from financial institutions

b. arrangement of funds through financial instruments like share, bonds etc

c. looking after the legal and accounting relationship between a corporation and its sources of funds.

Thus the manager had a limited role to perform. He was expected to keep accurate financial records, prepare reports on the corporation’s status and performance and manage cash in a way that the corporation was in a position to pay its bills in times.

2. Modern Approach :

According to modern approach the term financial management provides a conceptual and analytical framework for financial decision – making. That means, the finance function covers both acquisition of funds as well as their allocation.

The new approach views the term financial management in a broader sense. It is viewed as an integral part of over-all management. It is an analytical way of viewing the financial problems of a firm.

The financial management, in the modern sense of the term, can be divided into four major decisions as functions of finance. They are :

1. The investment decision

2. The financing decision

3. The dividend policy decision and

4. The funds requirement decision