FINANCIAL MANAGEMENT

Assignment: 1

Shashank Singh
337, Div: C
0

1. Discuss clearly the factors that affect dividend decision. Is

dividend decision relevant to valuation? Substantiate.
Ans: Dividend pay out keeps firms in the capital market, where monitoring of
managers is available at lower cost. If a firm has free cash flows, it is better to
share them with shareholders in the form of dividend in order to reduce the
possibility of these funds being wasted on unprofitable (negative net present
value) projects.
Few factors affecting dividend decision are as follows:

Growth and Profitability: The amount of growth a firm can sustain and its
profitability is related to its dividend decisions, so long as the firm
(because of managerially imposed to external market constraints) cannot
issue additional equity. Firms with strong growth prospects maintain low
target payout ratios. In fact all the firms that experience above-average
growth rates are expected to have low dividend payout ratios since, in
line with the residual theory of dividends, a greater number of profitable
investment opportunities should result (other things being equal in a
greater need for earnings retention

Liquidity: The liquidity position of a firm is often an important

consideration in dividend decisions. Since dividends represent a cash out

flow, it follows that the better the cash position and overall liquidity of the
firm, the greater is the firms ability to pay (and maintain) a cash
dividend.A growing, profitable firm may not be liquid, since it needs funds
for new capital expenditures and to build up its permanent working capital
position

Legal constraints: The legal rules act as boundaries within which a

company can declare dividends. In general, cash dividends must be paid
from current earnings or from previous earnings that have been retained
by the corporations after providing for depreciation. However, a company
may be permitted to pay dividend in any financial year out of the profits
of the company without providing for depreciation. Though the dividends
should be paid in cash, but it doesnt prohibit a company from capitalising
its profits or reserves (retained earnings) for the purpose of issuing fully
paid bonus shares (stock dividend).

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Inflation: Inflation must be taken into account when a firm establishes its
dividend policy. On the one hand, investors would like to receive larger
cash dividends because of inflation. But from the firms viewpoint,
inflation causes it to have to invest substantially more to replace existing
equipment, finance new capital expenditures, and meet permanent
working capital needs. Thus, in inflationary times, there may be a
tendency to hold down cash dividends.
External Restrictions: The protective covenants in a bond indenture or
loan agreement often include a restriction on the payment of cash
dividends. This restriction is imposed to preserve the firms ability to
service its debt. These restrictions may be in the form of coverage ratio,
sinking fund etc. Presence of these restrictions forces a company to retain
earnings and follow a low payout.

Taxation Policy: The tax policy of a country also influences the dividend
policy of a company. The rate of tax directly influences the amount of
profits available to the company for declaring dividends.

Future Requirements: A company while faming dividend policy should also

consider its future plans. If it foresees some profitable investment
opportunities in near future then it may go for lower dividend and viceversa.

Control Factor: Yet another factor determining dividend policy is the

threat to loose control. If a company declares high rate of dividend, then
there is the possibility that a company may face liquidity crunch for
which it has to issue new shares, resulting in dilution of control. Keeping
this threat in view, a company may go for lower level of dividend
payments and more ploughing back of profits in order to avoid any such
threat.

Business Risk: Business risk is a potential factor that may affect dividend
policy. High levels of business risk make the relationship between current
and expected future profitability less certain. Consequently, it is expected
that firms with higher levels of business risk will have lower dividend
payments.

Shashank Singh: 337

Agency Costs: The separation of ownership and control results in agency

problems. Agency costs can be reduced by distributing dividends. In
addition, dividends reduce the size of internally generated funds available
to managers, forcing them to go to the capital market to obtain external
funds. As explained in Rozeff, firms with a larger percentage of outside
equity holdings are subject to higher agency costs. The more widely
spread is the ownership structure, the more acute the free rider problem
and the greater the need for outside monitoring. Hence, these firms
should pay more dividends to control the impact of widespread
ownership.

Dividends paid by the firms are viewed positively both by the investors and the
firms. The firms which do not pay dividends are rated in oppositely by investors
thus affecting the share price. The people who support relevance of dividends
clearly state that regular dividends reduce uncertainty of the shareholders i.e.
the earnings of the firm is discounted at a lower rate, ke thereby increasing the
market value. However, its exactly opposite in the case of increased uncertainty
due to non-payment of dividends

2. Equity is costlier than debt, comment.

Ans: Debt is actually the cheaper source of finance for a few of reasons.

Tax benefit: The firm gets an income tax benefit on the interest
component that is paid to the lender. Dividends to equity holders are not
tax deductable.

Limited obligation to lenders: In the event of a firm going bankrupt,

equity holders lose everything. But, debt holders have the first claim on
company assets (collateral), increasing their security. So since debt has
limited risk, it is usually cheaper. Equity holders are taking on more risk,
hence they need to be compensated for it with higher returns

Shashank Singh: 337

Debt is typically secured by assets, whether real estate, machinery, receivables,

inventory, or other things of value, which may be seized by the lender in case of
default by the borrower. Equity ownership, by contrast, is not accompanied by
any kind of security interest in the company financed by the equity holder. The
equity holder cannot seize anything, the sole remedy of an equity holder
generally being the right to vote at a shareholders' meetin
Consider an example, if we run a small business and need $40,000 of financing,
we can either take out a $40,000 bank loan at a 10% interest rate or we can
sell a 25% stake in our business to our neighbor for $40,000.
Suppose our business earns $20,000 profits during the next year. If we took the
bank loan, our interest expense (cost of debt financing) would be $4,000,
leaving us with $16,000 in profit.
Conversely, had we used equity financing, we would have zero debt (and thus
no interest expense), but would keep only 75% of our profit (the other 25%
being owned by your neighbor). Thus, our personal profit would only be
$15,000 (75% x $20,000).
So, as you can see, provided a company is expected to perform well, debt
financing can usually be obtained at a lower effective cost. However, if a
company fails to generate enough cash, the fixed-cost nature of debt can prove
too burdensome. This basic idea represents the risk associated with debt
financing.
Companies are never 100% certain what their earnings will amount to in the
future (although they can make reasonable estimates), and the more uncertain
their future earnings, the more risk presented. Thus, companies in very stable
industries with consistent cash flows generally make heavier use of debt than
companies in risky industries or companies who are very small and just
beginning operations. New businesses with high uncertainty may have a difficult
time obtaining debt financing, and thus finance their operations largely through
equity.

Shashank Singh: 337

3. What is capital structure? What is the need of the same?

Ans: Capital structure refers to the way a corporation finances its assets
through some combination of equity, debt, or hybrid securities.
A firm's capital structure is the composition or 'structure' of its liabilities.
For example, a firm that sells 20 billion dollars in equity and 80 billion dollars in
debt is said to be 20% equity-financed and 80% debt-financed. The firm's ratio
of debt to total financing, 80% in this example, is referred to as the firm's
leverage.
Modigliani and Miller created a theory of Capital Structure in a perfect market.
There are several qualifications for a "perfect market":

No transaction or bankruptcy cost

Perfect information

Firms and individuals can borrow at the same interest rate

No taxes

Investment decisions are not affected by financing decisions

Modigliani and Miller made two findings under these conditions:

The value of a company is independent of its capital structure

The cost of equity for a leveraged firm is equal to the cost of equity for an
unleveraged firm, plus an added premium for financial risk

This means, as leverage increases, while the burden of individual risks is shifted
between different investor classes, total risk is conserved and hence no extra
value created.
Thus, capital structure refers to the percentage of capital (money) at work in a
business by type. Broadly speaking, there are two forms of capital: equity
capital and debt capital. Each has its own benefits and drawbacks and a
substantial part of wise corporate stewardship and management is attempting
to find the perfect capital structure in terms of risk / reward payoff for
shareholders.

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Equity Capital: This refers to money put up and owned by the shareholders
(owners). Typically, equity capital consists of two types: 1.) contributed
capital, which is the money that was originally invested in the business in
exchange for shares of stock or ownership and 2.) retained earnings, which
represents profits from past years that have been kept by the company and
used to strengthen the balance sheet or fund growth, acquisitions, or
expansion.
Many consider equity capital to be the most expensive type of capital a
company can utilize because its "cost" is the return the firm must earn to
attract investment. A speculative mining company that is looking for silver in
a remote region of Africa may require a much higher return on equity to get
investors to purchase the stock than a firm such as Procter & Gamble, which
sells everything from toothpaste and shampoo to detergent and beauty
products.

Debt Capital: The debt capital in a company's capital structure refers to

borrowed money that is at work in the business. The safest type is generally
considered long-term bondsbecause the company has years, if not decades,
to come up with the principal, while paying interest only in the meantime.
Other types of debt capital can include short-term commercial paper utilized
by giants such as Wal-Mart and General Electric that amount to billions of
dollars in 24-hour loans from the capital markets to meet day-to-day working
capital requirements such as payroll and utility bills. The cost of debt capital
in the capital structure depends on the health of the company's balance sheet
- a triple AAA rated firm is going to be able to borrow at extremely low rates
versus a speculative company with tons of debt, which may have to pay 15%
or more in exchange for debt capital.

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Other Forms of Capital: There are actually other forms of capital, such
as vendor financingwhere a company can sell goods before they have to pay
the bill to the vendor, that can drastically increase return on equity but don't
cost the company anything. This was one of the secrets to Sam Walton's
success at Wal-Mart. He was often able to sell Tide detergent before having to
pay the bill to Procter & Gamble, in effect, using PG's money to grow his
retailer. In the case of an insurance company, the policyholder "float"
represents money that doesn't belong to the firm but that it gets to use and
earn an investment on until it has to pay it out for accidents or medical bills,
in the case of an auto insurer. The cost of other forms of capital in the capital
structure varies greatly on a case-by-case basis and often comes down to the
talent and discipline of managers.

Shashank Singh: 337