Chapter: Business Science : Financial Management : Financing and Dividend Decision
Financing and Dividend Decision
FINANCING AND DIVIDEND DECISION
1 Leverages
1.1 Financial leverage
1.2 Uses of Financial Leverage
1.3 Operating leverage
2 Capital Structure
2.1 Meaning of Capital Structure
2.2 Objectives of Capital Structure
2.3 Factors Determining Capital structure
3 Cost Of Capital And Valuation
4 Designing Capital Structure
5 Dividend Policy
5.1 Determinants of dividend policy
6 Aspects Of Dividend Policy
7 Practical Consideration
8 Forms Of Dividend Policy
9 Share split
1 Leverages
Leverage refers to ―an increased means of
accomplishing some purpose‖. Leverage allows us to accomplish certain things
which are otherwise not possible, viz lifting of heavy objects with the help of
leverages.
In financial management , the term ‗leverage‘ is
used to describe the firm‘s ability to use fixed cost asset or funds to
increase the return to its owners i.e, Equity shareholders.
The employment of an asset or sources of funds for
which the firm has to pay a fixed cost or fixed return. The fixed cost is also
called as fixed operating cost and the fixed return is called financial cost
remains constant irrespective of the change in volume of output of sales
Higher
the degree of leverage, higher is the risk as well as return to the owner.
1. Financial
leverage or Trading on equity
2. Operating
leverage
3. Combined
leverage or composite leverage
1.1 Financial leverage
Leverage activities with financing activities is called
financial leverage. Financial leverage represents the relations hip between the
company‘s earnings before interest and taxes (EBIT) or operating profit and the
earning available to equity shareholders.
Financial
leverage is defined as ―the ability of a firm to use fixed financial charges to
magnify the effects of changes in EBIT on the earnings per share‖.
Financial
leverage may be favourable or unfavourable depends upon the use of fixed cost
funds. Favourable financial leverage occurs when the company earns more on the
assets purchased with the funds, then the fixed cost of their use. Hence, it is
also called as positive financial leverage.
Unfavourable
financial leverage occurs when the company does not earn as much as the funds
cost. Hence, it is also called as negative financial leverage.
Financial
leverage can be calculated with the help of the following formula:
Degree of Financial Leverage
Degree of
financial leverage may be defined as the percentage change in taxable profit as
a result of percentage change in earning before interest and tax (EBIT). This
can be calculated by the following formula
Alternative Definition of Financial Leverage
According
to Gitmar, ―financial leverage is the ability of a firm to use fixed financial
changes
to magnify the effects of change in EBIT and EPS‖.
FL =
Financial Leverage
EBIT =
Earning Before Interest and Tax
EPS = Earning
Per share.
1.2 Uses of Financial Leverage
Financial leverage helps to
examine the relationship between EBIT and EPS.
Financial leverage measures the
percentage of change in taxable income to the percentage change in EBI T.
Financial leverage locates the
correct profitable financial decision regarding capital structure of the
company.
Financial leverage is one of the
important devices which is used to measure the fixed cost proportion with the
total capital of the company.
If the firm acquires fixed cost
funds at a higher cost, then the earnings from those assets, the earning per
share and return on equity capital will decrease.
The impact of financial leverage
can be understood with the help of the following exercise.
1.3 Operating leverage
The leverage associated
with investment activities is
called as operating leverage.
Operating leverage can be calculated with the
help of the following formula:
Where,
OL =
Operating Leverage
C =
Contribution
OP =
Operating Profits
Uses of Operating Leverage
Operating
leverage is one of the techniques to measure the impact of changes in sales
which lead for change in the profits of the company.
If any
change in the sales, it will lead to corresponding changes in profit. Operating
leverage helps to identify the position of fixed cost and variable cost.
Operating leverage measures the relationship
between the sales and revenue of the company during a particular period.
Operating leverage helps to understand the
level of fixed cost which is invested in the operating expenses of business
activities.
Operating leverage describes the over all
position of the fixed operating cost.
DISTINGUISH BETWEEN OPERATING LEVERAGE AND
FINANCIAL LEVERAGE
Operating Leverage
Operating
leverage is associated with investment activities of the company.
Operating
leverage consists of fixed operating expenses of the company.
It
represents the ability to use fixed operating cost.
A
percentage change in the profits resulting from a percentage change in the
sales is called as degree of operating leverage.
Trading
on equity is not possible while the company is operating leverage.
Operating
leverage depends upon fixed cost and variable cost.
Tax rate
and interest rate will not affect the operating leverage.
Financial Leverage
Financial
leverage is associated with financing activities of the company.
Financial
leverage consists of operating profit of the company.
It represents
the relationship between EBIT and EPS.
A
percentage change in taxable profit is the result of percentage change in EBIT.
Trading
on equity is possible only when the company uses financial leverage.
Financial
leverage depends upon the operating profits.
Financial
leverage will change due to tax rate and interest rate.
Composite leverage
Combination
of operating &financial leverage is called composite leverage
Working Capital Leverage
One of
the new models of leverage is working capital leverage which is used to locate
the investment in working capital or current assets in the company.
Working
capital leverage measures the sensitivity of return in investment of charges in
the level of current assets.
2 Capital Structure
Introduction
Capital
is the major part of all kinds of business activities, which are decided by the
size, and nature of the business concern. Capital may be raised with the help
of various sources. If the company maintains proper and adequate level of
capital, it will earn high profit and they can provide more dividends to its
shareholders.
Meaning
of Capital Structure
Capital
structure refers to the kinds of securities and the proportionate amounts that
make up capitalization. It is the mix of different sources of long-term sources
such as equity shares, preference shares, debentures, long-term loans and
retained earnings.
The term
capital structure refers to the relations hip between the various long- term
source financing such as equity capital, preference share capital and debt
capital.
Deciding
the suitable capital structure is the important decision of the financial management
because it is closely related to the value of the firm.
Capital
structure is the permanent financing of the company represented primarily by long-term
debt and equity.
Definition
of Capital Structure
The
following definitions clearly initiate, the meaning and objective of the
capital structures.
According to the definition of Gerestenbeg,
―Capital Structure of a company refers to the composition or make up of its
capitalization and it includes all long-term capital resources.
2.1 Meaning Of Capital Structure
The term
financial structure is different from the capital structure. Financial
structure shows the pattern total financing. It measures the extent to which
total funds are available to finance the total assets of the business.
Financial
Structure = Total liabilities
Or
Financial
Structure = Capital Structure + Current liabilities.
Financial Structures
1. It
includes both long-term and short-term sources of funds
2. It
means the entire liabilities side of the balance sheet.
3.
Financial structures consist of all sources of capital.
Capital Structures
It
includes only the long-term sources of funds.
It means
only the long-term liabilities of the company.
It
consist of equity, preference and retained earning capital.
It is one
of the major determinations of the value of the firm.
Optimum Capital Structure
Optimum
capital structure is the capital structure at which the weighted average
cost of
capital is minimum and thereby the value of the firm is maximum.
Optimum capital structure may be defined as the
capital structure or combination
of debt
and equity, that leads to the maximum value of the fir m.
2 .2 Objectives of Capital Structure
Decision
of capital structure aims at the following two important objectives:
1.
Maximize the value of the fir m.
2.
Minimize the overall cost of capital.
Forms of Capital Structure
Capital
structure pattern varies from company to company and the availability of
finance.
Normally the following forms of capital structure are popular in practice.
o Equity
shares only.
o Equity
and preference shares only.
o Equity
and Debentures only.
o Equity
shares, preference shares and debentures.
2.3 Factors Determining Capital structure
Leverage
It is the
basic and important factor, which affect the capital structure. It uses the
fixed cost financing such as debt, equity and preference share capital. It is
closely related
To the
overall cost of capital.
Cost of Capital
Cost of
capital constitutes the major part for deciding the capital structure of a
firm. Normally long- term finance such as equity and debt consist of fixed cost
while mobilization. When the cost of capital increases, value of the firm will
also decrease. Hence the fir m must take careful steps to reduce the cost of
capital.
Nature of the business:
Use of fixed interest/divide nd bearing finance depends upon the nature of the
business. If the business consists of long period of operation, it will apply
for equity than debt, and it will reduce the cost of capital.
Size of the company:
It also affects the capital structure of a firm. If the fir m belongs to large
scale, it can manage the financial requirements with the help of internal sources. But
if it is small size, they will go for external finance.
It
consists of high cost of capital.
Legal requirements :
Legal require me nts are also one of the considerations while dividing the
capital structure of a firm. For example, banking companies are restricted to
raise funds from some sources.
Requirement of investors :
In order to collect funds from different type of investors, it will be
appropriate for the companies to issue different sources of securities.
3 Cost Of Capital And Valuation
v Every
rupee invested in a firm has a cost
v It is the
minimum return expected by the suppliers.
v Debt is
the cheaper source of finance due to (I) fixed rate of interest on debt (ii)
legal obligation to pay interest (iii) repayment of loan (iv) priority at the
time of winding up of the company
v Equity
shares , not legal obligation to pay dividend and shareholders undertake more
risk, investment is repaid at the time of winding up after paying to others
v Preference
capital is also cheaper, less risk involved, fixed rate of dividend payable and
priority given at the time of winding up of the company
Cash flow ability to service debt
v Firm
generating larger and stable cash inflow use more debt in capital structure
v Debt
implies burden of fixed charge due to the fixed payment of interest and
principal
v Whenever
firm wants to raise additional funds ,it should estimate, project future cash
inflow to cover the fixed charges
Nature and size of firm
v All
public utility has different capital structure as compared to manufacturing
concern
v Public
utility employ more debt because of stable and regularity of earnings
v Concern
cannot provide stable earnings will depend on equity shares
v Small
companies depend on owned capital it is very difficult to raise long term loans
Control
v Whenever
additional funds are required by firm the management should raise without any
loss of control over the firm
v If firm
issue equity shares then the control of existing share holder is diluted
v So it
might be raised by debt or preference capital
v Preference
share and debt do not have voting right.
Flexibility
v Capital
structure should be flexible
v It should
be capable of being adjusted according to the needs of the changing condition
v It should
be possible to raise additional funds with mush risk and delay.
v Redeemable
preference shares and convertible debenture is preferred for flexibility
Requirement of investors
v Requirement
is the another factor that influence the capital structure of the firm
v It is
necessary to meet requirement of institutional as well as investor when debt
financing is used
v Investors
3 kinds
Bold
investor- takes all type of risk; prefer capital gains and control – so equity
capital is preferred
Over-cautious
– prefer safety of investment and stability in returns – so debenture is
preferred
Less
cautious - prefer stability in return –
so preference share capital is used.
Capital market condition
v Capital
market conditions do not remain same forever.
v Sometime
depression or may be boom in the market
v Share
market depressed, then company should not issue equity capital as investor
prefer safety
v Boom
period, firm must issue equity shares.
Asset structure
v The
liquidity and composition of assets should kept in mind while selecting capital
structure.
v Fixed
asset contribute the major portion of the company then company should raise
long-term debt.
Purpose of financing
v Funds are
required for productive purpose – debt financing is suitable because the
company can pay interest out of profit generated.
v Funds are
needed for unproductive or general development – company prefer equity capital
Period of finance
The period is an important factor
to be kept in mind while selecting appropriate capital mix
Finance required for limited
period (7 years) – debenture should be preferred
Redeemable preference shares is
also used for limited period
Funds needed for permanent basis
equity share capital is more appropriate.
4 Designing Capital structure
Capital
structure is the major part of the firm‘s financial decision which affects the
value of the firm and it leads to change EBIT and market value of the shares.
There is a relations hip among the capital structure, cost of capital and value
of the firm. The aim of effective capital structure is to maximize the value of
the firm and to reduce the cost of capital.
There are
two major theories explaining the relations hip between capital struc ture,
cost of capital and value of the fir m.
Traditional Approach
It is the
mix of Net Income approach and Net Operating Income approach. Hence, it is also
called as inter mediate approach. According to the traditional approach, mix of
debt and equity capital can increase the value of the firm by reducing overall
cost of capital up to certain level of debt. Traditional approach states that
the Ko decreases only within the responsible limit of financial leverage and
when reaching the minimum level, it starts increasing with financial leverage.
Assumptions
Capital
structure theories are based on certain assumption to analysis in a single and
convenient manner:
There are only two sources of
funds used by a firm; debt and shares.
The firm pays 100% of its earning
as dividend.
The total assets are given and do
not change.
The total finance re ma ins constant.
The operating profits (EBIT) are
not expected to grow.
The business risk re mains constant.
The firm has a perpetual life.
The investors behave rationally.
Net Income (NI) Approach
Net
income approach suggested by the Dura nd. According to this approach, the
capital structure decision is relevant to the valuation of the firm. In other
words, a change in the capital structure leads to a corresponding change in the
overall cost of capital as well as the total value of the firm.
According
to this approach, use more debt finance to reduce the overall cost of capital and increase the value of fir m.
Net
income approach is based on the following three important assumptions :
There are no corporate taxes.
The cost debt is less than the
cost of equity.
The use of debt does not change
the risk perception of the investor.
where
V = S+B
V = Value
of fir m
S =
Market value of equity
B =
Market value of debt
Market
value of the equity can be ascertained by the following formula:
S =NI/ Ke
where
NI =
Earnings available to equity shareholder
Ke = Cost
of equity/equity capitalization rate
Format
for calculating value of the firm on the basis of NI approach.
Net Operating Income (NOI) Approach
Another
modern theory of capital structure, suggested by Dura nd. This is just the
opposite to the Net Income approach. According to this approach, Capital
Structure decision is irrelevant to the valuation of the firm. The market value
of the firm is not at all affected by the capital structure changes.
According
to this approach, the change in capital structure will not lead to any change
in the total value of the firm and market price of shares as well as the overall
cost of capital.
NI
approach is based on the following important assumptions;
The overall cost of capital remains
constant;
There are no corporate taxes;
The market capitalizes the value
of the firm as a whole;
Value of the firm (V) can be calculated with the help of the following formula
V = E BIT /K0
Modigliani and Miller Approach
Modigliani and Miller approach states that the financing
decision of a firm does not affect the market value of a firm in a perfect
capital market. In other words MM approach maintains that the average cost of
capital does not change with change in the debt weighted equity mix or capital
structures of the fir m.
Modigliani and Miller
approach is based on the
following important assumptions:
v There is a perfect
capital market.
v There are no
retained earnings.
v There are no corporate taxes.
v The investors act
rationally.
v The dividend payout ratio
is 100%.
v The business consists of the same level of business risk.
5 Dividend Policy
The term
dividend refers to that part of profits of a company which is distributed by
the company among its shareholders. It is the reward of the shareholders for
investments made by them in the shares of the company. The investors are
interested in earning maximum return to maximize their wealth.
A firm
needs funds to meet its long-term growth. If a company pays most of the profit
as dividend, then for business requirement or further expansion then it will
have to depend on outsiders for funds. Such as issue of debt or new shares.
Firms
decision to pay dividend in equitable proportion of dividend and retained
earnings.
5.1 Determinants Of Dividend Policy
1. Legal restrictions
Legal
provision related to dividends are laid down in sec 93,205,205A, 206 and 207 of
companies act.Dividend can be paid only out of current profit or past profit
after providing depreciation Company providing more than 10% dividend to
transfer certain percentage of current year profit to reserves.
2. Magnitude and trend of earnings
The
amount and trend of earnings is an important in dividend policy. Dividend can
be paid only out of present or past year‘s profit; earnings of a company fix
the upper limit on dividends. Past trend is kept in mind while decision
dividend decision .
3. Desire and type of shareholders
Discretion
to declare dividend or not is decided by the board of directors. Directors give
importance to the desire of the shareholder in declaration of dividends. Desire
for dividend depends on their economic status. Investor such as retired person,
widows and other economically weaker person view dividend as a source of funds
to meet their day-to-day living expenses – the company will pay regular
dividend. Investor with high income tax bracket will not prefer current
dividend they will expect only capital gains.
4. Nature of industry
Nature of
industry to which the company is engaged also affects dividend policy. Certain
industry has steady and stable demand irrespective of prevailing economic
condition. Eg : people used to drink liquor both in boom and in recession. Such
firm gets regular earning and hence follows consistent dividend policy. Earning
are uncertain in such case conservative dividend policy is used. Such firms
should retain substantial part of their current earnings during boom period in
order to provide funds to pay dividends in recession period
5. Age of the company
Age also
influence the dividend decision of the company. Newly established concern has
limit in payment of dividend and retain substantial part for financing future
growth and development Older company has sufficient reserves can pay liberal
dividends.
6. Future financial requirement
Future
financial requirement is to be considered while deciding dividend. Company has
profitable investment opportunities then the firm will pay limited amount as
dividend and invest the remaining amount. If there is no investment
opportunities then the company will pay more dividend
7. Government economic policy
The
dividend policy of a firm has also to be adjusted to the economic policy of the
government
In 1974
and 1975 companies were allowed to pay dividends not more than 33 % of their
profits or 12% on paid-up value of the shares, whichever was lower
8. Taxation policy
A high or
low rate of business taxation affect the net earnings of company and thereby
its dividend policy. A firm‘s dividend policy may be dictated by the income-tax
status of its shareholders. If the dividend income of shareholders is heavily
taxed being in high income bracket, then the shareholder will prefer capital
gains and bonus shares.
6 Aspects Of Dividend Policy
Relevance Of Dividend
According
to this concept, dividend policy is considered to affect the value of the firm.
Dividend relevance implies that shareholders prefer curre nt dividend and there
is no direct relations hip between dividend policy and value of the firm.
Relevance of dividend concept is supported by two e mine nt persons like Walter
and Gordon.
Walter’s 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 Walter‘s 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 :
1. The
firm uses only internal finance.
2. The
firm does not use debt or equity finance.
3. The
firm has constant return and cost of capital.
4. The
firm has 100 recent payout.
5. The
firm has constant EPS and dividend.
6. The
firm has a very long life.
Walter
has evolved a mathematical formula for determining the value of market share.
Criticism of Gordon’s Model
Gordon‘s
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 Gordon‘s model, there are no tax paid by the firm. It is not practically
applicable.
7 Practical aspects of dividend policy
Two
important dimensions of a firms dividend policy are:
* Quantum
of the average payout ratio
*
Stability of dividends over a time period
These two
dimensions are conceptually distinct from one another.
The
considerations which are relevant for determining the average payout ratio are:
Funds
requirements.
Liquidity.
Access to
external sources of financing.
Shareholders
preferences.
Differences
in the cost of external equity and retained earnings.
Control&Taxes.
Irrespective
of the long-run payout ratio followed, the fluctuations in the year-to-year
dividend may be determined mainly by one of the two guidelines.
(i) Stable
dividend payout ratio
(ii) Stable
dividends or steadily changing dividends. Firms generally follow a policy of
stable
dividends
or gradually rising dividends.
Since
internal equity (in the form of retained earnings) is cheaper than external
equity an important dividend prescription advocates a residual policy to
dividends. According to this policy the equity earnings of the firm are first
applied to provide equity finance required for supporting investments. The
surplus, if any, is distributed as dividends.
Firms
subscribing to the residual dividend policy may adopt one of the following
approaches:
(i) Pure
residual dividend policy approach (ii) Fixed dividend payout approach and (iii)
smoothed residual dividend approach. The smoothed residual dividend approach,
which produces a table and steadily growing stream of dividend, often appears
to be the most sensible approach in practice.
Not
withstanding the normative prescription of the smoothed residual dividend
approach,
Lintner’s
classic study of corporate dividend behavior showed that: (i) Most of the firms
think primarily in terms of the proportion of earnings that should be paid out
as dividends
8 Forms 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
§ 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 a mount of dividend regularly.
This dividend policy consists of the following three importa nt 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 a mo unt required for future growth of the concerns.
Forms Of Dividends
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 Share Split
Definition
A
corporate action in which a company's existing shares are divided into multiple
shares. Although the number of shares outstanding increases by a specific
multiple, the total dollar value of the shares remains the same compared to
pre-split amounts, because no real value has been added as a result of the
split.
Share split
Share
split is the process of splitting shares with high face value into shares of a
lower face value.
v Alteration
of shares
v Increase
the number of outstanding shares
v Approval
from board of directors
Reasons of share splits
v The price
of their stock exceeds the amount smaller investors would be willing to pay. it
is aimed at making the stock more affordable and liquid from retail investors
point of view
v There are
more buyers and sellers of shares trading Rs 100 than say Rs 400 as retail
shareholders may find low price stocks to be better bargains.
Significance of share splits
v To
improve the market liquidity
v To make
an investor attention with other high quality securities
v Stock
split means of converting odd lot holders into round lot holders
v Round lot
holder plays a very important role in a stocks marketability and liquidity on
The
exchange
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