Financial Management

Chapter VII
Management of Working Capital
Aim
The aim of this chapter is to enable the students to:

explain working management

elucidate components, aspects and need for working capital

explicate the determinants of working capital

Objectives
The objective of the chapter is to:

enlist the types of working capital

explain gross working capital

elucidate the components of working capital

Learning outcome
At the end of the chapter, you will be able to:

define working capital

understand the factors influencing the working capital

identify net working capital

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7.1 Introduction
Working capital may be regarded as the lifeblood of a business enterprise. It is, closely, related to the day-to-day
operations of the business. Every business needs funds for two purposes. Longterm funds are required for creation
of production facilities such as plant and machinery, land, building and furniture, etc. Investment in these assets
represents that part of firms capital, which is permanently blocked on a permanent or fixed basis and is called fixed
capital. The form of these assets does not change, in the normal course.
Funds are, also, needed for purchase of raw materials, payment of wages and other day-today expenses etc. These
funds are known as working capital. Funds invested in these assets keep revolving, fast. These assets are converted
into cash and, again, cash is converted into current assets. So, working capital is also called revolving or circulating
capital. The assets change the form, on a continuous basis. In other words, working capital refers to that part of the
firms capital, which is required for financing short-term or current assets such as cash, debtors, inventories and
marketable securities, etc.
Capital is divided into fixed capital and working capital. Fixed capital required for establishment of a business,
where as working capital required to utilise fixed assets.

The efficiency of a business enterprise depends largely on its ability to manage its working capital.

Working capital management therefore, is one of the important facets of a firms overall financial
management.

7.2 Meaning and Definition of Working Capital

Working capital refers to current assets that can be defined as:

Those which are convertible into cash or equivalent within a period of one year and those which are required
to meet day-to-day operation

It is concerned with the management of the firms current assets and current liabilities.

It refers to the problems that arise in attempting to manage the current assets, current liabilities and their
interrelationship between them

If a firm cannot maintain a satisfactory level of working capital, it is likely to become insolvent and even forced
into bankruptcy.

To quote Ramamurthy, It refers to the funds, which a company must possess to finance its day-to-day
operations.
J. S. Mill, "The sum of the current assets is the working capital of the business."

7.3 Classification of Working Capital

Working capital can be classified in two ways

On the basis of concept

On the basis of time

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Kinds of Working Capital

Time Base

Concept Base

Gross Working
Capital or
Quantitative

Net Working
Capital or
Qualitative

Permanent or
Regular Working
Capital

Temporary or
Variable Working
Capital

Fig. 7.1 Types of working capital

On the basis of concept, working capital is classified as gross and net as discussed earlier.
Gross working capital
Gross working capital refers to the firms investment in total current assets of the enterprise. Current assets are those,
which can be converted into cash, within an accounting year (or operating cycle). They include cash, debtors, bills
receivable, stock and marketable securities etc. In a broader sense, working capital refers to gross working capital.
liabilities are accounting outstanding
Net working capital
In the narrow sense, working capital refers to net working capital. Net working capital is the difference between
current assets and current liabilities. Current of outsiders, which are expected to mature for payment, within an
include creditors, bills payable, bank overdraft/cash credit account and those claims year. They expenses.
If the payment of current liabilities is delayed, the firm gets the availability of funds to that extent. So, a part of the
funds required to maintain current assets is financed by the current liabilities. The firm is required to invest in the
current assets, to that extent, not financed by the current liabilities.
If current assets are in excess of current liabilities, net working capital is positive. A negative working capital occurs
when the current liabilities exceed current assets.
Treatment of Bank overdraft/cash credit account: Bank overdraft/cash credit account is treated as current liability
as the sanction of bank is for one year. It is a different matter bank renews these facilities on a continuous basis, at
the request of the borrower, on submission
While, on the basis of time, working capital is divided in two types:

Permanent working capital

Variable working capital

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Permanent working capital

It refers to the minimum amount of investment required in all current assets at all times to carry on the day-today operation of firms business.

The minimum level of current assets has been given the name of Core current assets by the Tandon
Committee.

It is also known as fixed working capital.

Variable/Temporary working capital

It is known as variable working capital or fluctuating working capital.

The working capital keeps on fluctuating from time to time on the basis of business activities.

The additional working capital required as per the changing production and sales level of a firm is known as
temporary working capital.

The firms working capital requirements vary depending upon the seasonal changes in demand for a firms
products.

7.4 Components of Working Capital

The main components of working capital are:

Current assets: Current assets consist of cash, marketable securities, inventories, sundry debtors, bills receivables,
short term investments, prepaid expenses etc. Current assets are those assets that, in the ordinary course of
business, can be turned into cash within an accounting period (not exceeding one over) within undergoing
diminution in value and without disrupting the operations.

Current liabilities: They consist of loans and advances, sundry creditors, short-term borrowing, bank overdraft, taxes and proposed dividend. Current liabilities are those liabilities intended to be paid in the ordinary
course of business within a reasonable period (normally within a year) out of the current assets or revenue of
the business.

7.5 Aspects of Working Capital Management

The following four aspects are involved in the management of working capital.

Determining the total funds required to meet the current operation of the firm; determining the level of current
assets.

Deciding the structure of current assets; the proportion of long-term and short-term capital to finance current
assets.

Evolving suitable policies, procedures and reporting systems for controlling the individual components of current
assets; mainly cash, receivables and inventory

Determining the various sources of working capital.

For determining the sources of working capital (short term and long term) capital the net concept becomes
useful
For determining the level and composition of working capital it is the gross concept, which becomes more
meaningful.

7.6 Need for Working Capital

Working capital is needed till a firm gets cash on sale of finished products as sales do not convert into cash immediately.
There is an invisible time lag between the sale of goods and receipts of cash. Therefore, sufficient working capital
is necessary to sustain sales activity.
The operating cycle concept penetrates to the heart of working capital management in a more dynamic form. The
time that elapses to convert raw materials into cash (elapses between the purchase of raw materials and the collection
of cash from sale) is known as operating cycle.
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The following elements are the operating cycle of the firm:

Conversion of cash into raw materials

Conversion of raw materials into work-in-process

Conversion of work-in-process into finished goods

Time for sale of finished goods-cash sales and credit sales.

Time for realisation from debtors and Bills receivables into cash

Credit period allowed by creditors for credit purchase of raw materials, inventory and creditors for wages and
overheads.

Debtor

Cash

Sales

Raw Materials

Finished goods

Work-in Process

Fig 7.2 Operating cycle

Operating Cycle can be computed with the following formula:
OC = ICP + ARP
Where

OC = Operating Cycle

ICP = Inventory Conversion Period

ARP = Accounts Receivable Period

Example ABC company provided the following information and requested you to compute operating cycle:
Sales Rs. 3,000 lakhs;
Inventory: Opening Rs. 610 lakhs; closing Rs. 475 lakhs
Receivable: Opening Rs. 915 lakhs; closing Rs. 975 lakhs
Cost of goods sold Rs. 2,675 lakhs

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Solution
OC = ICP + ARP
=

= 74 days

=
= 114.97 days
OC = 74 days + 115 days

= 189 days
OC 189 days indicates that ABC company takes (requires) 189 days to convert raw materials into cash. In other
words, some amount of cash blocked for 189 days, therefore there is a need to have working capital.
Cash conversion cycle
The amount of time a firms resources are tied up; calculated by subtracting the average payment period from the
operating cycle. In other words, the time period between the dates a firm pays its suppliers and the date it receives
cash from its customers.

Calculation of Cash Conversion Cycle (CCC) (see the fig. below)

CCC = OC APP
Where:
OC = Operating Cycle

APP = Accounts Payable Period

OC = AAI + ARP

AAI = Average Age of Inventory

ARP = Average Collection (receivables) Period

From the financial statements we can determine the constituents of Cash Conversion Cycle i. ., AAI, ARP,
APP

AAI = Average Inventory

ARP = Average Accounts Receivables

APP = Average Accounts Payables

Purchase of
Raw Materials
on Credit

(Cost of Goods sold / 365)

(Annual Sales / 365)
(Cost of Goods Sold / 365)

Sales of Goods
on Credit

Average Age
of Inventory
(AAI)

Collection of
Accounts
Receivables
Accounts
Receivables
Period (ARP)

Accounts
Payable
Period (APP)

Receipt of
Invoice

Payment to
Suppliers
Operating Cycle (OC)
Cash Conversion Cycle (CCC)

Example
From the following financial information calculate Cash Conversion Cycle.
Average use of Inventories 80 days; accounts receivables collection period 50 days, and accounts payable period
is 40 days.
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Solution:
CCC = OC APP
OC = AAI + ARP
= 80 + 50 = 130 days
CCC = 130 days 40 = 90 days
Determinants of working capital
A large number of factors influence the working-capital-needs of a firm.

The basic objective of a firms working capital management is to ensure that the firm has adequate working
capital for its operation, neither too much nor too little working capital.

There is no set of rules or formulae to determine the working capital requirements of a firm.

The total working capital requirement is determined by a wide variety of factors.

The factors, however, affect different firms working capital

The relative importance of these factors should be made in order to determine the total investment in working
capital

The following will give description of the general factors influencing the working capital needs of a firm:

Nature and size of business: The working capital requirements of a firm are basically influenced by the nature
of the business.
The nature of the business - influence the working capital decisions.
The proportion of current assets needed in some lines of business activity varies from other lines.
Trading and financial firms have less investment in fixed assets but requires a large sum of money to be
invested in working capital.
Size may be measured in terms of scale of operations.
A firm with large scale of operation normally requires more working capital than a firm with a low scale
of operation.

Manufacturing cycle: It is a factor, which has bearing on the quantum of working capital.
The term is refer to the time involves in manufacturing of goods.
It covers the time span between the procurement of raw materials and the completion of the manufacturing
process leading to the production of finished goods.
Longer the manufacturing cycle, the higher will be the working capital requirement and vice versa.

Production policy: The requirement on working capital is determined on the basis of production policy of the
firm.
Production policy means whether it is continuous or seasonal production.
There are two production policy that the company or the firm can follow
They can confine their production only to periods when goods are purchased or
They can follow a steady production policy throughout the year and produce goods at a level to meet peak
demand.
FMCG goods business of production and sales goes simultaneously and the amount of working capital
required is less.
Umbrella business sales will be only in seasonal and production will take place throughout the year
continuously the amount of working capital required is very high.

Terms of purchase and sales: Terms (cash or credit) of purchase and sales also affect the amount of working
capital.
If a company purchases all goods or raw materials in cash and sells its finished goods or product on credit,
it will require larger amount of working capital
On the contrary, a concern having credit facilities and allowing no credit to its customers will require lesser
amount of working capital.

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 Terms and conditions of purchase and sale are generally governed by prevailing trade practices and by
changing economic conditions

Operating efficiency: Operating efficiency relates to the optimum utilisation of a firms resources at minimum
costs.
The firm with high efficiency in operation can bring down the total investment in working capital to lower
level.
Effective utilisation of resources helps the firm in bringing down the investment in working capital.
If a firm successfully controls operating cost, it will be able to improve net profit margin which, will, in
turn, release greater funds for working capital purposes.

Business cycle: The amount of working capital requirements of a firm varies with every movement of business
cycle.

When there is an upward swing in the economy sales will increase, and also the firms investment in inventories
and book debts will increase, thus it will increase the working capital requirement of the firm and vice versa.

Growth and expansion: As company grows, it is logical to expect that a larger amount of working capital
required.
A growing firm may need funds to invest in fixed assets in order to sustain its growing production and sales.
This will, in turn, increase investment in current assets to support increased scale of operations.
Therefore, a growing firm needs additional funds continuously.

Profit margin and dividend policy: The magnitude of working capital in a firm is dependent upon its profit
margin and dividend policy.

A high net profit margin contributes towards the working capital pool.

To the extent the net profit has been earned in cash, it becomes a source of working capital. This depends upon
the dividends results in a drain on cash resources and thus reduces companys working capital to that extend.
The working capital position of the firm is strengthened if the management follows conservation dividend
policy and vice versa.

Conditions of supply of raw material: If the supply of raw material is scarce the firm may need to stock it in
advance and hence need more WC and vice-versa.

Availability of credit: The working capital requirement of a firm are also affected by credit terms granted by
its suppliers, i.e., creditors.

The need for working capital will be less in a firm, if liberal credit terms are available to it.

Similarly, the availability of credit from banks also influences the firms working capital needs.

A firm, which can get bank credit easily on favorable conditions, will be operated with less working capital
than a firm without such a facility.

Taxation policy: The tax policies of the Government will influence the working capital decisions.
If the Government follows regressive policy, i.e., imposing heavy tax burdens on business firms, they are
left with very little profits for distribution and retention purpose.
Consequently, the firm has to borrow additional funds to meet their increased working capital needs.
When there is a liberalised tax policy, the pressure on working capital requirement is minimised.

Other factors: There are many other factors which affect the requirement of working capital like infrastructural
facilities, import policy, changes in the technology, co-ordination activities in firm, distribution policies and
so on.

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7.7 Estimation of Working Capital Requirements

The best approach to estimate is based on operating cycle. Working capital consists of two components current
assets and current liabilities. There is a need to follow the following four steps procedure for estimation of working
capital

Estimation of cash cost of the various current assets required by the firm.

Estimation of spontaneous current liabilities of the firm.

Compute net working capital by subtracting the estimated current liabilities (step (2)) from current assets (step
(1))

Add some percentage (given in the problem) of net working capital if there is any contingency or safety working
capital required, to get the required working capital.

7.8 Sources of Working Capital

After the estimation of the working capital, the next step is financing the current assets. There are three financing
policies vis--vis, to finance current assets. Adoption the specific policy is left out to the firm. The following are
the financing policies:

Short-term: Generally current assets should be financed by short-term financial sources.

Short-term financing refers to borrowing funds or raising credit for maximum of 1 year period i.e., at the
most the debt is payable within a year.
The sources of short-term finance are loans from banks, short-term public deposits, commercial papers,
factoring of receivables, bills discounting, retention of profits etc
A firm which required short-term finance can go for any one of the above sources.
Long-term: Net current assets or working capital is supposed to be financed by long-term sources of
finance.
Long-term finance refers to the borrowing of funds or raising credit for one year or more.
Long-term finance is raised for a period of above five years.
The sources of long-term include- ordinary share capital, preference share capital, debentures, long-term
loans from bankers and surplus (includes retained earnings).
A firm that need to finance net current assets can go for any of the above sources, but it depends on
companys attitude towards risk or control over the company, companies earnings, capacity and period of
loan reserved.

Spontaneous financing: Refers to the automatic source of short term funds arising in the normal course of
business.
The source are trade credits and out standing expenses
The source of spontaneous finance is available at cost free
Firms that want to maximise owners wealth than it must and should utilise the sources to the fullest
extant
Some extant of current assets can be financed with the use of spontaneous source
The requiring current assets should be financed with the combination of long-term and short-term sources
of finance

The policies for financing or working capital are divided into three categories:
Conservative financing policy: in which manager depends more on long-term funds.
Aggressive financing policy: in which the manger depends more on short term funds.
Moderate policy: suggests that the manager depends moderately on both long-term and short-term while
financing.

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Analysis of working capital

Determining the working capital is just not sufficient for a better performance. It should be analysed. It may be
analysed with a view to gross and net angles i.e., quantitative and qualitative.
The quantitative aspect of working capital refers to the quality of current assets while the qualitative aspect of
working capital refers to the liquidity and its adequacy.
The following are the aspects of working capital:

Structure of working capital: It helps to have a better perspective of the working capital position of any
company.

Working capital status: In order to ascertain the trends in working capital, indices of current assets, current
liabilities and net working capital of the firm may be computed.
First year of the selected period may be taken as base, for computing trends in current assets, current
liabilities and net working capital.
Working capital position in a concern would be satisfactory, provides the pace of increase in current assets
is more than that of the current liabilities and vice-versa.
If the net working capital indices also increase, it will further confirm that strength of working capital
position in a firm.

Working Capital Leverage: It measures the sensitivity of return on investment (ROI) to the changes in ROI of
current assets.

Working capital leverage (WCL) may be defined as the percentage change in ROI with given percentage change
in current assets.

Symbolically:
WCL = Percentage Change in ROI Percentage Change in Current Assets

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Summary

Working capital may be regarded as the lifeblood of a business enterprise.

Longterm funds are required for creation of production facilities such as plant and machinery, land, building
and furniture, etc.

Investment in these assets represents that part of firms capital, which is permanently blocked on a permanent
or fixed basis and is called fixed capital.

Gross working capital refers to the firms investment in total current assets of the enterprise. Current assets are
those, which can be converted into cash, within an accounting year (or operating cycle).

If current assets are in excess of current liabilities, net working capital is positive. A negative working capital
occurs when the current liabilities exceed current assets.

Current assets are those assets that, in the ordinary course of business, can be turned into cash within an accounting
period (not exceeding one over) within undergoing diminution in value and without disrupting the operations

References

Mathur, S. B., 2002. Working Capital Management and Control Principles & Practice. New Delhi. New Age
International (P) Limited.

Dr. Rustagi, R. P., Principles of Financial Management. 4th ed., New Delhi. Taxmann Publications (P) Ltd.

Working Capital Management, [Pdf] Available at: <http://shodhganga.inflibnet.ac.in/bitstream/10603/703/7/07_

chapter1.pdf> [Accessed 29 May 2013].

Working Capital Management, [Pdf] Available at: <http://www.ediindia.org/doc/SpecialPDF/chp-14.pdf>

[Accessed 29 May 2013].

2012. Working Capital Management, [Video online] Available at: <http://www.youtube.com/

watch?v=C0UOvhnIqxE> [Accessed 29 May 2013].

2010. Whats working capital? [Video online] Available at: <http://www.youtube.com/watch?v=AnwK1BQxJVw>

[Accessed 29 May 2013].

Recommended Reading

Preve, L. & Sarria-Allende, V., 2010. Working Capital Management. Oxford University Press.

Kumar, A. V., 2001. Working Capital Management. Northern Book Centre.

Sagner, J., 2010. Essentials of Working Capital Management. John Wiley & Sons.

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Self Assessment
1. Which of the following cycle is the time period between the dates a firm pays its suppliers and the date it receives
cash from its customers?
a. Operating Cycle
b. Cash Conversion Cycle
c. Cash Conversion Period
d. Net Working Capital
2. Permanent Working Capital is also known as _________
a. total current assets
b. gross working capital
c. fixed working capital
d. net working capital
3. Operating cycle of a firm can be shortened by which of the following?
a. Increasing stock of raw material
b. Increasing credit period to customers
c. Increasing working-in-process
d. Increasing credit period from suppliers
4. Which of the following statements is false?
a. In conservative approach, there is long term financing of working capital.
b. In aggressive approach, there is no short term financing of work capital.
c. Working Capital Leverage measures the sensitivity of return on investment (ROI) to the changes in ROI of
current assets.
d. The requirement on working capital is determined on the basis of production policy of the firm.
5. The amount of working capital requirements of a firm varies with every movement of ______________.
a. business cycle
b. production policy
c. manufacturing cycle
d. operating efficiency
6. Match the following
1. Concept of working capital

a. commercial papers, factoring of receivables, bills discounting,

retention of profits etc

2. Short-term financing

b. Current assets and Current liabilities

3. Structure of Working Capital

c. Net working capital

4. Components of working capital

d. helps to have a better perspective of the working capital

position of any company

a. 1-b, 2-d, 3-a, 4-c.

b. 1-c, 2-a, 3-d, 4-b.
c. 1-d, 2-c, 3-a, 4-b.
d. 1-d, 2- a, 3-b, 4-c.

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7. Permanent working capital is the _______________ of current assets needed to conduct a business during the
normal season of the business.
a. maximum amount
b. moderate amount
c. minimum amount
d. increasing amount
8. Which of the following statements is true?
a. Conservative firm depends on more long-term funds for financing need.
b. Spontaneous Financing refers to the automatic source of long-term funds arising in the normal course of
business.
c. The requirement on working capital is determined on the basis of manufacturing policy of the firm.
d. Net working capital is the surplus of current liabilities over current assets and provisions
9. Match the following
1. Temporary working capital

a. Availability of Credit

2. Gross working capital

b. Variable working capital

3. Determinants of Working Capital

c. Aspects of Working Capital Management

4. Determining the various sources of working capital

d. circulating capital

a. 1-c, 2-a, 3-d, 4-b.

b. 1-d, 2-c, 3-a, 4-b.
c. 1-c, 2-d, 3-b, 4-b.
d. 1-b, 2-d, 3-a, 4-c.
10. Working capital consists of _______________.
a. current assets and current liabilities
b. permanent and temporary working capital
c. gross and net working capital
d. concept based and time based working capital

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Chapter VIII
Inventory Management
Aim
The aim of this chapter is to enable the students to:

explain the types of inventory

elucidate the objectives of inventory management

define inventory

Objectives
The objective of the chapter is to:

explain motives of inventory management

enlist the risks of holding inventory

elucidate the techniques of inventory control

Learning outcome
At the end of the chpater, you will be able to:

understand the meaning, definition and objectives of inventory management

identify the types of inventory

understand the motives of inventory management

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8.1 Introduction
Inventories constitute a major component in current assets. It constitutes around 60% in the public limited companies,
in India. For the smooth running, every enterprise needs inventory. Inventories serve as a link between production
and distribution processes. Due to its major composition in current assets, the management of inventories occupies
a key role in working capital management. Excessive investment affects the liquidity. Inadequate investment makes
the firm to loose the business opportunities, otherwise available. Profitability would be affected with excessive or
inadequate investment. So, inventory management is essential to allow the firm to avail the opportunities to improve
profitability and at the same time does not impair its liquidity, with excessive or unproductive investment. A firm,
which neglects the inventory management, jeopardizes its longterm profitability. So, it is absolutely imperative to
control and manage inventory holding, both efficiently and effectively, to avoid unnecessary investment.
Inventory management occupies the most significant position in the structure of working capital. Inventories are the
most significant part of current assets. Inventory management is an important area of working capital management,
which plays a crucial role in economic operation of the firm. Maintenance of large size of inventories requires a
considerable amount of funds to be invested on them. Efficient and effective inventory management is necessary in
order to avoid unnecessary investment and inadequate investment. A considerable amount of funds is required to
be committed in inventories. It is absolutely imperative to manage inventories efficiently and effectively in order
to optimise investment in them cannot be ignored. Any lapse on the part of management of a firm in managing
inventories may cause the failure of the firm.

8.2 Meaning and Definition of Inventory

The term Inventory is originated from the French word Inventaire and the Latin Inventariom which implies
a list of things found. The term has been defined by the American Institute of Accountants as the aggregate of those
items of tangible personal property which:

are held for sale in the ordinary course of business

are in the process of production for such sales, or

are to be currently consumed in the production of goods or services to be available for sale

The term inventory refers to the stockpile of the products a firm is offering for sales and the components that make up
the product. Inventories are the stocks of the product of a company, manufacturing for sale and the components that
make up the product. The various forms in which inventories exist in a manufacturing company are as follows:

Raw materials

Work-in process

Finished goods

Stores and spares

However, in commercial parlance, inventory usually includes stores, raw materials, work-in-process and finished
goods. The term inventory includes raw material, work in process, finished goods packaging, spares and others
stocked in order to meet an unexpected demand or distribution in the future.

8.3 Types of Inventory

The following are the types of inventory:

Raw materials: Raw materials are those inputs that are converted into finished goods through manufacturing
process. These form major inputs for manufacturing a product. In other words, they are very much needed for
uninterrupted production.

Work-in-process: Work-in-process is that stage of stocks that are between raw materials and finished goods.
Work-in-process inventories are semi-finished products. They represent products that need to under go some
process to become finished goods.

Finished products: Finished products are those products, which are ready for sale. The stock of finished goods
provides a buffer between production and market.

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Stores and spares: Stores and spares inventory (include office and plant cleaning materials like soap, brooms,
oil, fuel, light, etc.) are those purchased and stored for the purpose of maintenance of machinery.

8.4 Inventory Management Motives

Managing inventories involves block of funds and inventory holding costs. There are three general motives for
holding inventories

Transaction motives: It includes production of goods and sale of goods. It facilities uninterrupted production
and delivery of order at a given time (right time)

Precautionary motive: This motive necessitates the holding of inventories for unexpected changes in demand
and supply factors.

Speculative motive: This compels to hold some inventories to take the advantage of changes in prices and
getting quantity discounts.

8.5 Objectives of Inventory Management

The objectives of inventory management may be viewed in two. They are

Operational: the operational objective is to maintain sufficient inventory, to meet demand for product by efficiently
organising the firms production and sales operations

Financial: financial view is to minimise inefficient inventory and reduce inventory carrying costs.

These two conflicting objectives of inventory management can also be expressed in terms of costs and benefits
associated with inventory. The firm should maintain investment in inventory implies that maintaining an inventory
involves costs, such that smaller the inventory the lower the carrying cost and vice versa. But inventory facilitates
(benefits) the smooth functioning of the production. An effective inventory management should:

ensure a continuous supply of raw materials and supplies to facilities uninterrupted production

maintain sufficient stocks or raw materials in periods of short supply and anticipate price changes

maintain sufficient finished goods inventory for smooth sales operation and efficient customers services

minimise the carrying costs and time and

control investment in inventories and keep it at an optimum level

Apart from the above, the following are also objects of inventory management. Control of materials costs; elimination
of duplication in ordering by centralisation of purchasers; supply of right quality of goods of reasonable prices,
provide data for short-term and long-term for planning and control of inventories.
Therefore, management of inventory needs careful and accurate planning so as to avoid both excess and inadequate
inventory in relation to the operational requirement of a firm. To achieve higher operational efficiency and profitability
of a firm, it is essential to reduce the amount of capital locked up in inventories. This will not only help in achieving
higher return on investment by minimising tied-up working capital, but will also improve the liquidity position of
the enterprise.

8.6 Costs of Holding Inventory

Minimising cost is one of the operating objectives of inventory management. There are three costs involved in the
management of inventories.
Ordering costs
Ordering costs are those costs that are associates with the acquisition of raw materials. In other words, the costs that
are spend from placing an order till the receipt of raw materials. They include the following:

Cost of requisitioning the items (raw materials)

Cost of preparation of purchase order (i.e., drafting typing, dispatch, postal etc)

Cost of sending reminders to get the dispatch of the items expedited

Cost of transportation of goods (items)

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Cost of receiving and verifying the goods

Cost of in unloading of the (items) of goods

Shortage and stocking charges

However, incase of items manufactured in house the ordering costs would comprise the following costs:

Requisitioning cost

Set-up cost

Cost of receiving and verifying the items

Cost of placing and arranging/stacking of the items in the store etc.,

Ordering costs are fixed per order placed, irrespective of the amount of the order but ordering costs increases in
proportion to the number of order placed. If the firm maintains small inventory levels then the number of orders
will increase, there by ordering cost will increase and vice versa.
Carrying costs
Inventory carrying costs are those costs, which are associated with carrying or maintaining inventory. The following
are the carry costs of inventory:

Capital cost (interest on capital locked in the inventories)

Storage cost (insurance, maintenance on building, utilities serving costs)

Insurance (on inventory against fire and theft insurance)

Obsolescence cost and deterioration

Taxes

Carrying costs usually constitute around 252 per cent of the value of inventories held

Shortage costs (Costs of stock out)

Shortage costs are those costs that arise due to stock out or either shortage of raw materials or finished goods.
Shortage of inventories of raw materials over affect the firm in one or more of the following ways:

The firm may have to pay some what higher price, connected with immediate (cash) procurements

The firm may have to compulsorily resort the some different production schedules, which may not be as efficient
and economical

Stock of finished goods may result in the dissatisfaction of the customers and the resultant loss of rules
Thus, with a view to keep inventory costs of minimum level, we may have to arrive at the optional level of inventory
cost, it is the total orders costs plus carrying costs are minimal. In other words, we have to determine Economic
Order Quantity (EOQ), is that level at which the total inventory (ordering plus carrying less) cost is minimum.

8.7 Risks of Holding Inventory

Risk in inventory management refers to the chance that inventory management cannot be turned over into cash
through normal sales without loss. The following are the risk associated with inventory management

Price decline: Price decline is the result of more supply and less demand (introduction of competitive product).
Generally prices are not controllable in the short-run by the individual firm. Controlling inventory is the only
way that a firm can counter act with these risks.

Product deterioration: Holding inventory for a long period or shortage under improper conditions of light, heat,
humidity and pressure lead to product deterioration. Deterioration usually prevents selling in product through
normal channels.

Product obsolescence: Product may become obsolete due to improved products, changes in customer tastes,
particularly in high style merchandise, changes in requirements etc. This risk may prove very costly for the
firms whose resources are limited and tied up in slow moving inventories. Product obsolescence cost risk least
controllable except by reduction in inventory investment.

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Thus, inventories are risky assets to manage and the effective way to minimising risks is setting up of efficient
inventory control system.

8.8 Benefits of Holding Inventory

Proper management of inventory will result in the following benefits to a firm:

Ensures an adequate supply of materials and stores, minimises stock outs and shortages and avoids costly
interruptions in operations

Keep down investment in inventories; inventory carrying costs and obsolescence losses to the minimum

Facilitates purchasing economics through the measurement of requirements on the basis of recorded
experience

Eliminates duplication in ordering stocks by centralising the source from which purchase requisitions
emanate

Permits better utilisation of available stocks by facilitating inter-department transfers within a firm

Provides a check against the loss of materials through careless or pilferage

Perpetual inventory values provide a consistent and reliable basis for preparing financial statements a better
utilisation

8.9 Techniques of Inventory Control

There are many techniques used to management inventory. Some of them are listed below:
8.9.1 ABC Analysis
It is one of the widely used techniques to identify various items of inventory for the purpose of inventory control.
In other words, it is very effective and useful tool for classifying, monitoring and control inventories.

The firm should not keep same degree of control on all the items of inventory. The firm should put maximum
control on those items whose value is the highest, with the comparison of the other two items.

It is based on Pareto's Law and is known as Selective Inventory Control.

Usually a firm has to maintain several types of inventories, for proper control of them, firm should have
to classify inventories in the instance of their relative value. Hence, it is also known as Proportional Value
Analysis(PVA)

According to this technique the task of inventory management is proper classification of all inventory items in to three
categories namely A, B and C category. The ideal categorisation of inventory items is shown in the Table 12.1. The
higher value items are classified ' A items' and would be under tight control. At the other end of the classification we
find category 'C items', on these types of inventory firm cannot afford expenses of rigid controls, frequent ordering
and expending, because of the low value or low amounts. Thus with the 'C items', we may maintain somewhat higher
safety stocks, order more months of supply, expect lower levels of customer service, or all the three. 'B items' fall
in between 'A items' and 'C items' and require reasonable attention of management.
Category

No. of Items (%)

Items Value (%)

15

70

30

20

55

10

Total

100

100

Table 8.1 Categorisation of Inventory

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The above table indicates that only 15 per cent of the items may account for 70 per cent of the total value (A category
items), on which greater attention is required, when as 55 per cent of items may account for 10 per cent of the total
value of inventory (C category items), will be paid a reasonable attention. The remaining 30 per cent of inventory
account for 20 per cent of total value of inventory (B category items) will be paid a reasonable attention as this,
category value lies between the two other categories. The above data can be shown by the following graph.

80

Item B

40

Item C

60
Item A

Value of items (%)

100

20
0
10

20

30

40

50

60

70

80

90

100

No. of Items (%)

In the above Fig. numbers of items (%) are shown on 'X' axis and value of items (%) are represented on 'Y' axis.
Greater attention will be paid on category 'A' item, because greater benefit. The control of 'C' items may be released
due to less benefit (some times control cost may exceed benefit of control) and reasonable attention should be paid
on category 'B' items.
8.9.2 Economic Order Quantity (EOQ)
Economic order quantity (EOQ) refers to that level of inventory at which the total cost of inventory is minimal. The
total inventory cost comprising of ordering and carrying costs. Shortage costs are excluded in adding total cost of
inventory due to the difficulty in computation of shortage cost. EOQ are also known as Economic Lot S
e (ELS).
Assumptions of EOQ Model
The following assumptions are implied in the calculation of EOQ:

Demand for the product is constant and uniform throughout the period

Lead time (time from ordering to receipt) is constant

Price per unit of product is constant

Inventory holding cost is based on average inventory

Ordering costs are constant, and

All demand for the product will be satisfied (no back orders are allowed)

EOQ Formula

EOQ can be obtained by adopting two methods

Trail and Error approach

Short cut or Simple mathematical formula

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Here for calculation of EOQ we have adopted simple short cut method. The formula is

Where:
A = Annual usage
O = Ordering cost per order
CC = Annual carrying per unit
CC = Price per unit Carrying cost per unit in percentage
The above simple formula will not be sufficient to determine EOQ when more complex cost equations are
involved.
EOQ is applicable both to single and to any group of stock items with similar holding and ordering costs. Its use
causes the sum of the two costs to be lower than under any other system of replenishment.
Limitations
Apart from the above application it has its own limitations, which are mainly due to the restrictive nature of the
assumptions on which it is based

Constant usage: It may not be possible to predict, if usage varies unpredictably, as it often does, no formula
will work well.

Faulty basic information: Ordering and carrying costs is the base for calculation EOQ. It assumes that ordering
cost is constant per order, but actually varies from commodity to commodity. Carrying cost also can vary with
the company's opportunity cost of capital.

Costly calculation: In many cases the cost estimating, cost of possession and acquisition and calculating EOQ
exceeds the savings made by buying that quantity.

8.9.3 Order Point Problem

If the inventory level is too high it will unnecessary block the capital and if the level is too low, it will disturb
production by frequent stock out and also involves high ordering cost. Hence, an efficient management of inventory
needs to maintain optimum inventory level, where there is no stock out and the costs are minimal. The different
stock levels are
Minimum level

Minimum stock is that level that must be maintained always for smooth flow of production. While determination
of minimum stock level, lead time, and consumption rate, material nature must be considered.

Lead-time is the number of days required to receive the inventory from the date of placing order. It is also called
as procurement time of inventory

The average quantity of raw materials consumed daily. The consumption rate is calculated based on the past
experience and production plan.

Requirement of materials for normal or regular production or special order production. If the material is required
for special order production, then the minimum stock levels need not to maintain.

Minimum stock level = Re-order level (Average Usage Average delivery time)
Reorder level
Reorder level is that level of inventory at which an order should be placed for replenishing the current stock of
inventory. Generally the reorder level lies between minimum stock level and maximum stock level.
Re-order point = Lead time (in days) Average Daily usage
The above formula is based on the assumption that Consistent usage and Fixed lead-time.
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Safety Stock: Prediction of average daily usage and lead-time is difficult. Raw materials may vary from day to day
or from week to week, it is the case for lead-time also. Lead-time may be delayed if the usage increases, than the
company faces problem of stock out. To avoid stock out firm may require maintaining safety stock.
Formula (under uncertainty of usage and lead time)
RE-order point = (Lead time (in days) Average usage) + Safety stock
Maximum level
Maximum level of stock is that level of stock beyond which a firm should not maintain the stock. If firm stocks
inventory beyond the maximum stock level is called as overstocking. Excess inventory (overstock) involves heavy
cost of inventory, because it blocks firms funds in inventory, excess carrying cost, wastage, obsolescence and theft
cost. Hence, firm should not stock above the maximum stock level. Safety stock is that minimum additional inventory
to serve as a safety margin or better or buffer or cushion to meet an unanticipated and increase in usage resulting
from an unusually high demand and or an uncontrollable late receipt of incoming inventory.
Maximum Stock Level = Reorder Level + Reorder Quantity (Minimum Delivery Time)
Danger stock level
Danger level is that level of materials beyond that materials should not fall in any situation. When it falls in danger
level it will disturb production. Hence, the firm should not allow the stock level to go to danger level if at all falls
in that level then immediately stock should be arranged even if it costly.
Danger Level = Average Usage minimum Deliver Time (for emergency purchase)
8.9.4 Just in Time (JIT)
Popularly known in its acronym JIT. It may be applied for either raw materials purchase or producing finished
goods. From raw materials purchase it means, that no inventories are held at any stage of production and the exact
requirement is bought in each and every successive stage of production of the right time. In other words, maintenance
of a minimum level of raw materials where by the inventory carrying cost could be minimised, and the risk of loss
due to stock-out position could be well avoided. From production of goods view JIT means goods are produced only
when the order are received, there by no storage of finished goods, and can avoid costs of carrying finished goods.
JIT is also known as "Zero Inventory Production System" (ZIPS), Zero Inventories (ZIN), Materials as Needed
(MAN) or Neck of Time (NOT).

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Summary

Inventory management occupies the most significant position in the structure of Working capital.

The types of inventory are: raw materials; work-in process; finished goods; and stores and spares.

The two conflicting objectives of inventory management are: maintaining investment in inventory and to facilitate
(benefits) the smooth functioning of the production, which in turn meet the demand.

Efficient management of inventory reduces the cost of production and consequently increases the profitability
of the enterprise by minimising costs associated with holding inventory.

An effective inventory management should: Ensure a continuous supply of raw materials and supplies to
facilitates uninterrupted production; maintain sufficient finished goods inventory for smooth sales operations;
and efficient customer service; minimise the carrying costs and time; and Control investment in investment and
keep it at an optimum level.

Minimising cost is one of the operating objectives of inventory management. The costs (excluding merchandise
cost), there are three costs involved in the management of inventories. They are Ordering Costs, Inventory
Carrying Costs and Shortage Costs.

There are many techniques of management of inventory. Some of them are ABC analysis, Economic Order
Quantity (EOQ), Order Point Problem, Just in Time etc.

Reference

2008. Inventory Management, [Video online] Available at: <http://www.youtube.com/watch?v=HZPMaTifdBg>

[Accessed 29 May 2013].

2008. Lecture - 38 Basic Inventory Principles, [Video online] Available at: <http://www.youtube.com/
watch?v=HZPMaTifdBg> [Accessed 29 May 2013].

Viale, J. D., Basics of Inventory Management, [Pdf] Available at: <http://www.axzopress.com/downloads/

pdf/1560523611pv.pdf> [Accessed 29 May 2013].

Inventory Management,[Pdf] Available at: <http://highered.mcgraw-hill.com/sites/dl/free/0073525235/940447/

jacobs3e_sample_ch11.pdf> [Accessed 29 May 2013].

Bose, C. D., 2006. INVENTORY MANAGEMENT, PHI Learning Pvt. Ltd.

Axst er, S.,2006. Inventory control, 2nd ed., Springer.

Recommended Reading

Muller, M., 2003. Essentials of Inventory Management. AMACOM.

Mullar, M., 2011. Essentials of Inventory Management, 2nd ed., AMACOM Books.

Viale, J. D. & Christopher, C., 1996. Inventory Management: From Warehouse to Distribution Center, Course
Technology / Cengage Learning .

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Self Assessment
1. Which of the following statements is true?
a. Transaction motive includes production of goods and sale of goods. It facilities interrupted production and
delivery out of order at a given time (right time)
b. Precautionary motive necessitates the holding of inventories for expected changes in demand and supply
factors.
c. Speculative motive compels to hold some inventories to take the advantage of changes in prices and getting
quantity discounts.
d. Lead-time is the number of days required to receive the inventory from the date of placing order and is also
called as procurement time of inventory.
2. Inventory is one of the components of _________ assets.
a. liabilities
b. cash budget
c. balance
d. current
3. Which of the following is true?
a. Price decline, product deterioration and product obsolescence are the risks of holding inventory.
b. Costs of holding inventory are ordering costs, capital costs and shortage costs.
c. Carrying costs are those costs that are associates with the acquisition of raw materials.
d. Price decline is the result of less supply and more demand
4. EOQ is the quantity that minimises:
a. Total Inventory Cost
b. Total Ordering Cost
c. Total Interest Cost
d. Safety Stock Level
5. _____________ values provide a consistent and reliable basis for preparing financial statements a better
utilisation.
a. Increase inventory
b. Perpetual inventory
c. Costs of Holding Inventory
d. Risks of Holding Inventory
6. Which of the following is one of the components of inventory carrying cost?
a. Price decline
b. Speculative motive
c. Capital cost
d. Work-in process

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7. Match the following

1. Objectives of Inventory Management a. Economic Order Quantity (EOQ)
2. Risks of holding inventory

b. operational and financial

3. Techniques of inventory control

c. Zero Inventory Production System (ZIPS)

4. JIT is known as

d. product obsolescence

a. 1-c, 2-d, 3-b, 4-a

b. 1-d, 2-a, 3-b, 4-c
c. 1-b, 2-c, 3-d, 4-a
d. 1-b, 2-d, 3-a, 4-c
8. Which of the following statements is false?
a. ABC is also known as PAV.
b. The EOQ model attempts to minimising the total cost of holding inventory
c. EOQ model assumes a constant usage rate for a particular item.
d. Risk in inventory management refers to the chance that inventory management cannot be turned over into
cash through normal sales without loss
9. In EOQ formula 2AOCC, 'A' stands for Annual usage.
a. Biennial Usage
b. Perennial Usage
c. Annual usage
d. Monthly Usage
10. Which of the following is one of the risks of holding inventory?
a. Shortage Costs
b. Product Obsolescence
c. ABC analysis
d. Work-in Process

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Chapter IX
Dividend Decision
Aim
The aim of this chapter is to enable the students to:

explain the concept of dividend

elucidate various dividend theories

explicate Modigliani and Millers Approach

Objectives
The objective of the chapter is to:

enlist the types of dividend

explain Walter's model

eluicdate dividend decision

Learning outcome
At the end of the chapter, you will be able to:

understand Gordon's model

describe dividend theories

idenfity cash dividend

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9.1 Introduction
The financial manager must take careful decisions on how the profit should be distributed among shareholders.
It is very important and crucial part of the business concern, because these decisions are directly related with the
value of the business concern and shareholders wealth. Like financing decision and investment decision, dividend
decision is also a major part of the financial manager. When the business concerns decide dividend policy, they have
to consider certain factors such as retained earnings and the nature of shareholder of the business concern.
Meaning of Dividend
Dividend refers to the business concerns net profits distributed among the shareholders. It may also be termed as
the part of the profit of a business concern, which is distributed among its shareholders. According to the Institute
of Chartered Accountant of India, dividend is defined as a distribution to shareholders out of profits or reserves
available for this purpose.
9.1.1 Types of Dividend/ Form of Dividend
Dividend may be distributed among the shareholders in the form of cash or stock. Hence, Dividends are classified
into:

Cash dividend

Stock dividend

Bond dividend

Property dividend

Cash Dividend
If the dividend is paid in the form of cash to the shareholders, it is called cash dividend. It is paid periodically out the
business concerns EAIT (Earnings after interest and tax). Cash dividends are common and popular types followed
by majority of the business concerns.
Stock Dividend
Stock dividend is paid in the form of the company stock due to raising of more finance. Under this type, cash
is retained by the business concern. Stock dividend may be bonus issue. This issue is given only to the existing
shareholders of the business concern.
Bond Dividend
Bond dividend is also known as script dividend. If the company does not have sufficient funds to pay cash dividend,
the company promises to pay the shareholder at a future specific date with the help of issue of bond or notes.
Property Dividend
Property dividends are paid in the form of some assets other than cash. It will distributed under the exceptional
circumstance. This type of dividend is not published in India.

9.2 Dividend Decision

Dividend decision of the business concern is one of the crucial parts of the financial manager, because it determines
the amount of profit to be distributed among shareholders and amount of profit to be treated as retained earnings for
financing its long term growth. Hence, dividend decision plays very important part in the financial management.
Dividend decision consists of two important concepts which are based on the relationship between dividend decision
and value of the firm.

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Dividend
Theories

Irrelevance of
Dividend

Soloman
Approach

Relevance of
Dividend

MM
Approach

Walter's
Model

Gordon's
Model

Fig. 9.1 Classification of dividend theories

9.2.1 Irrelevance of Dividend
According to professors Soloman, Modigliani and Miller, dividend policy has no effect on the share price of the
company. There is no relation between the dividend rate and value of the firm. Dividend decision is irrelevant of the
value of the firm. Modigliani and Miller contributed a major approach to prove the irrelevance dividend concept.
Modigliani and Millers Approach
According to MM, under a perfect market condition, the dividend policy of the company is irrelevant and it does not
affect the value of the firm. Under conditions of perfect market, rational investors, absence of tax discrimination
between dividend income and capital appreciation, given the firms investment policy, its dividend policy may have
no influence on the market price of shares.
Assumptions
MM approach is based on the following important assumptions:

Perfect capital market

Investors are rational

There are no tax

The firm has fixed investment policy

No risk or uncertainty

Proof for MM approach MM approach can be proved with the help of the following formula:

Where,
Po = Prevailing market price of a share.
Ke = Cost of e equity capital.
D1 = Dividend to be received at the end of period one.
P1 = Market price of the share at the end of period one.
P 1 can be calculated with the help of the following formula.

P1= Po (1+Ke) D 1

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The number of new shares to be issued can be determined by the following formula:

M P1 = I (X nD1)
Where, M = Number of new share to be issued.
P1 = Price at which new issue is to be made.
I = Amount of investment required.
X = Total net profit of the firm during the period.
nD1 = Total dividend paid during the period.
Example 1: X Company Ltd., has 100000 shares outstanding the current market price of the shares Rs. 15 each.
The company expects the net profit of Rs. 2, 00,000 during the year and it belongs to a rich class for which the
appropriate capitalisation rate has been estimated to be 20%. The company is considering dividend of Rs. 2.50 per
share for the current year. What will be the price of the share at the end of the year (i) if the dividend is paid and
(ii) if the dividend is not paid?
Solution:

(i) If the dividend is paid

Po= Rs. 15
Ke = 20%
D1= 2.50
P1=?

2.50 +P1= 15x1.2

P1= 18-2.50
P1=Rs. 15.50
(ii) If the dividend is not paid

Po= Rs. 15
Ke = 20%
D1= 0
P1=?

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Financial Management

0 +P1= 15x1.20
P1= Rs.18
Criticism of MM approach
MM approach consists of certain criticisms also. The following are the major criticisms of MM approach.

MM approach assumes that tax does not exist. It is not applicable in the practical life of the firm.

MM approach assumes that, there is no risk and uncertain of the investment. It is also not applicable in present
day business life.

MM approach does not consider floatation cost and transaction cost. It leads to affect the value of the firm.

MM approach considers only single decrement rate, it does not exist in real practice.

MM approach assumes that, investor behaves rationally. But we cannot give assurance that all the investors
will behave rationally.

9.2.2 Relevance of Dividend

According to this concept, dividend policy is considered to affect the value of the firm. Dividend relevance implies
that shareholders prefer current dividend and there is no direct relationship between dividend policy and value of
the firm. Relevance of dividend concept is supported by two eminent persons like Walter and Gordon.

Walters Model
Prof. James E. Walter argues that the dividend policy almost always affects the value of the firm. Walter model is
based in the relationship between the following important factors:

Rate of return I

Cost of capital (k)

According to the Walters model, if r > k, the firm is able to earn more than what the shareholders could by reinvesting,
if the earnings are paid to them. The implication of r > k is that the shareholders can earn a higher return by investing
elsewhere.
If the firm has r = k, it is a matter of indifferent whether earnings are retained or distributed.
Assumptions
Walters model is based on the following important assumptions:

The firm uses only internal finance

The firm does not use debt or equity finance

The firm has constant return and cost of capital

The firm has 100 recent payout

The firm has constant EPS and dividend

The firm has a very long life.

Walter has evolved a mathematical formula for determining the value of market share.

Where,

P = Market price of an equity share

D = Dividend per share
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r = Internal rate of return

E = Earning per share
Ke = Cost of equity capital
Example 2: From the following information supplied to you, ascertain whether the firm is following an optional
dividend policy as per Walters Model?
Total Earnings
Rs. 2, 00,000
No. of equity shares (of Rs. 100 each 20,000)
Dividend paid Rs.
1, 00,000
P/E Ratio
10
Return Investment
15%
The firm is expected to maintain its rate on return on fresh investments. Also find out what should be the E/P ratio
at which the dividend policy will have no effect on the value of the share? Will your decision change if the P/E
ratio is 7.25 and interest of 10 %?
Solution

= Rs. 10

P/E Ratio = 10

Ke =

DPS =

= 0.10
=

= Rs. 5

The value of the share as per Walters Model is

Rs. 12.5
Dividend Payout =

=
= 60%
r> Ke therefore by distributing 60% of earnings, the firm is not following an optional dividend policy. In this case,
the optional dividend policy for the firm would be to pay zero dividend and the Market Price would be:

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Dividend Payout =

P= Rs. 200
So, the MP of the share can be increased by following a zero payout, of the P/E is 7.25 instead of 10 then the Ke
=1=0.138 and in this case Ke > r and the MP of the share is 7.25.

P = 5+5.435
P= Rs. 75.62
Criticism of Walters Model
The following are some of the important criticisms against Walter model:

Walter model assumes that there is no extracted finance used by the firm. It is not practically applicable.

There is no possibility of constant return. Return may increase or decrease, depending upon the business situation.
Hence, it is applicable.

According to Walter model, it is based on constant cost of capital. But it is not applicable in the real life of the
business.

Gordons Model
Myron Gorden suggests one of the popular models which assume that dividend policy of a firm affects its value,
and it is based on the following important assumptions:

The firm is an all equity firm

The firm has no external finance

Cost of capital and return are constant

The firm has perpectual life

There are no taxes.

Constant relation ratio (g=br)

Cost of capital is greater than growth rate (Ke >br)

Gordons model can be proved with the help of the following formula:

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Where,
P = Price of a share
E = Earnings per share
1b = D/p ratio (i.e., percentage of earnings distributed as dividends)
Ke= Capitalization rat
br Growth rate = rate of return on investment of an all equity firm.
Example 3: Raja company earns a rate of 12% on its total investment of Rs. 6, 00,000 in assets. It has 6, 00,000
outstanding common shares at Rs. 10 per share. Discount rate of the firm is 10% and it has a policy of retaining
40% of the earnings. Determine the price of its share using Gordons Model. What shall happen to the price of the
share if the company has payout of 60% (or) 20%?
Solution
According to Gordons Model, the price of a share is

Given:
E = 12% of Rs. 10=Rs. 1.20
r = 12%=0.12
Ke = 10%=0.10
t = 10%=0.10
b = 40%=0.40
Put the values in formula

P = Rs. 13.85
If the firm follows a policy of 60% payout then b= 20% = 0.20
The price is

= 0.05
r= 4%= 0.04, D= 25% of 10 = 2.50

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Financial Management

= Rs. 41.67
If payout ratio is 50%, D= 50% of 10= Rs. 5
r= 12%= 0.12, D= 50% of 10 = Rs. 5

= Rs. 83.33
r= 8%= 0.08, D= 50% of 10 = Rs. 5

r= 4%= 0.04, D= 50% of 10 = Rs. 5

= Rs. 69.42

= Rs. 55.58
If payout ratio is 20%, the value of b= 0.60 and the price of the share is

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= Rs 120
Criticism of Gordons
Model Gordons model consists of the following important criticisms:

Gordon model assumes that there is no debt and equity finance used by the firm. It is not applicable to present
day business.

Ke and r cannot be constant in the real practice. According to Gordons model, there is no tax paid by the firm.
It is not practically applicable.

9.3 Factors Determining Dividend Policy

Following are the factors that determine dividend policy:
Profitable position of the firm
Dividend decision depends on the profitable position of the business concern. When the firm earns more profit, they
can distribute more dividends to the shareholders.
Uncertainty of future income
Future income is a very important factor, which affects the dividend policy. When the shareholder needs regular
income, the firm should maintain regular dividend policy.
Legal constrains
The Companies Act 1956 has put several restrictions regarding payments and declaration of dividends. Similarly,
Income Tax Act, 1961 also lays down certain restrictions on payment of dividends.
Liquidity position
Liquidity position of the firms leads to easy payments of dividend. If the firms have high liquidity, the firms can
provide cash dividend otherwise, they have to pay stock dividend.
Sources of finance
If the firm has finance sources, it will be easy to mobilise large finance. The firm shall not go for retained
earnings.
Growth rate of the firm
High growth rate implies that the firm can distribute more dividend to its shareholders.
Tax policy
Tax policy of the government also affects the dividend policy of the firm. When the government gives tax incentives,
the company pays more dividend.
Capital market conditions
Due to the capital market conditions, dividend policy may be affected. If the capital is prefect, it leads to improve
the higher dividend.
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9.4 Types of Dividend Policy

Dividend policy depends upon the nature of the firm, type of shareholder and profitable position. On the basis of
the dividend declaration by the firm, the dividend policy may be classified under the following types:

Regular dividend policy

Stable dividend policy

Irregular dividend policy

No dividend policy.

Regular dividend policy

Dividend payable at the usual rate is called as regular dividend policy. This type of policy is suitable to the small
investors, retired persons and others.
Stable dividend policy

Stable dividend policy means payment of certain minimum amount of dividend regularly. This dividend
policy consists of the following three important forms:

Constant dividend per share

Constant payout ratio

Stable rupee dividend plus extra dividend.

Irregular dividend policy

When the companies are facing constraints of earnings and unsuccessful business operation, they may follow
irregular dividend policy. It is one of the temporary arrangements to meet the financial problems. These types are
having adequate profit. For others no dividend is distributed.
No Dividend policy
Sometimes the company may follow no dividend policy because of its unfavourable working capital position of the
amount required for future growth of the concerns.

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Summary

The financial manager must take careful decisions on how the profit should be distributed among
shareholders.

Dividend refers to the business concerns net profits distributed among the shareholders.

If the dividend is paid in the form of cash to the shareholders, it is called cash dividend..

Stock dividend is paid in the form of the company stock due to raising of more finance..

Bond dividend is also known as script dividend. If the company does not have sufficient funds to pay cash
dividend, the company promises to pay the shareholder at a future specific date with the help of issue of bond
or notes.

Property dividends are paid in the form of some assets other than cash. It will distributed under the exceptional
circumstance. This type of dividend is not published in India.

Dividend decision of the business concern is one of the crucial parts of the financial manager, because it determines
the amount of profit to be distributed among shareholders and amount of profit to be treated as retained earnings
for financing its long term growth.

According to MM, under a perfect market condition, the dividend policy of the company is irrelevant and it
does not affect the value of the firm.

Dividend relevance implies that shareholders prefer current dividend and there is no direct relationship between
dividend policy and value of the firm.

References

Dividend Decisions, [Pdf] Available at: <http://220.227.161.86/19347sm_sfm_finalnew_cp4.pdf> [Accessed

30 May 2013].

DIVIDEND POLICY, [Pdf] Available at: <http://www.morevalue.com/i-reader/ftp/Ch17.PDF> [Accessed 30

May 2013].

2012. Dividend Policy, [Video online] Available at: <http://www.youtube.com/watch?v=o972MF8rOKM>

[Accessed 30 May 2013].

2009. CF1. Dividend Policy, [Video online] Available at: <http://www.youtube.com/watch?v=3WURHeTxoRE>

[Accessed 30 May 2013].

Paramasivan, C. & Subramanian, T., 2009. Financial Management. New Age International.

Khan, M. Y., 2004. Financial Management: Text, Problems And Cases, 2nd ed., Tata McGraw-Hill Education

Recommended Reading

Gallagher and Andrew, Financial Management; Principles and Practice. Freeload Press, Inc.

Brigham, E. F. & Ehrhardt, M. C., 2011. Financial Management: Theory and Practice, 13th ed., Cengage
Learning.

Apte, 2006. International Financial Management, 4th ed., Tata McGraw-Hill Education.

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Financial Management

Self Assessment
1. According to professors Soloman, Modigliani and Miller, ___________ has no effect on the share price of the
company.
a. dividend policy
b. financial policy
c. economic policy
d. market policy
2. Prof. James E. Walter argues that the dividend policy almost always affects the ________ of the firm
a. profit
b. value
c. income
d. revenue
3. Gordon model assumes that there is no debt and _______ finance used by the firm.
a. liability
b. arrears
c. equity
d. stock
4. Dividend policy depends upon the nature of the firm, type of ____________ and profitable position
a. shareholder
b. business
c. market
d. organisation
5. Which of the following statements is true?
a. Dividend payable at the usual rate is called as regular dividend policy.
b. Dividend payable at the usual rate is called as stable dividend policy.
c. Dividend payable at the usual rate is called as irregular dividend policy.
d. Dividend payable at the usual rate is called as no dividend policy.
6. When the companies are facing constraints of earnings and unsuccessful business operation, they may follow
_______________ dividend policy.
a. regular
b. irregular
c. stable
d. unstable
7. Sometimes the company may follow ___________ policy because of its unfavourable working capital position
of the amount required for future growth of the concerns
a. regular
b. irrgualr
c. no dividend
d. stable

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8. Which of the dividend policy means payment of certain minimum amount of dividend regularly?
a. irregular
b. unstable
c. no dividend
d. Stable
9. ___________ growth rate implies that the firm can distribute more dividend to its shareholders
a. High
b. Low
c. Stable
d. Balance
10. _____________ position of the firms leads to easy payments of dividend.
a. Liquidity
b. Equity
c. Stable
d. Debt

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