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Chapter: Business Science : Financial Management : 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

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:



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.



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


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


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



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





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.



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.


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.


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


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.


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.



Access to external sources of financing.

Shareholders preferences.


Differences in the cost of external equity and retained earnings.



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




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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