FINANCIAL MANAGEMENT

WORKSHEET -04

Q.1 Critically examine the essentials of a sound dividend policy ?

A.1 Sound dividend policy is a long term policy thats aims in

maximisation of shareholder’s wealth .While determining such a
policy investment opportunities of the firm , its present economic
status and investors preference should be given due weightage .
Sound dividend policy remains stable during prosperous and lean
years. Dividends are paid in cash and stock dividend is paid only
when the amount of reserves exceeds too much.

Generally , a sound dividend policy contains the following elements :

1. Distribution of Dividend in cash : A dividend policy is good

only when dividends are paid in cash . Dividend paid in
property , scrip or bond is not considered good . Indian
Companies Act also prohibits distribution of dividend other
then in cash except issue of bonus shares by capitalising the
profits.

2. Initially Lower Dividend : In the beginning , a company should

declare dividend at lower rate so that a substantial part of the
profits is available as a source of internal financing. It will
strengthen the financial position of the company. Initially
lower dividend is also helpful in development and expansion of
the company. Therefore the rate of dividend should be
increase gradually as the company prospers.

3. Gradual Increase in Dividend : With the increase in price level ,

 the income of the company also increases. The shareholders
expect similar increase in their income . Therefore , the rate of
dividend should be increased gradually so that there may not
be any discontentment among the share holders.

4. Stability : Stability of Dividend means that there should not be

too much fluctuations in the rate of dividend . During stability ,
the rate of dividend is increased gradually and slowly . Payment
of dividend at very high rate in a year and no dividend in next
year results in high speculations in shares of a company.

5. Dividend Out of Earned Profits : Dividend should be declared

out of earned pfofits . If there is any loss in the profit and loss
account , it should be written off and then dividend should be
declared out of remaining profits . Moreover , all governmental
restrictions on dividend should be complianced.

Q.2 Explain theories of capital structure in brief ?

A.2 Theories of Capital structure :

1. Net Income (NI) Approach:

Net Income theory was introduced by David Durand. According to this

approach, there is a relationship between the capital structure and the
value of the firm. The firm, by increasing the debt proportion in the capital
structure can increase its market value or lower the overall cost of capital
(WACC). Debt is cheap source of finance because its interest is deductible
from net profit before taxes. After deduction of interest, company has to
pay less tax and thus it will decrease the over all cost of capital or weighted
average cost of capital (WACC).
High debt content in the debt-equity mix is called financial leverage.
Increasing of financial leverage will help in maximizing the firm’s value. For
example, if the debt: equity mix is increased from 50:50 to 80:20, it will
increase the market value of firm and its positive effect on the value of per
share.
Assumptions of NI approach:
1. There are no taxes.

3. The use of debt does not change the risk perception of the investors, as a
result the cost of equity (ke) and the cost of debt (kd) remains constant
with the change in leverage.
4. The overall cost of capital (ko) decreases with the increase in leverage.

2. Net Operating Income (NOI) Approach:

According to this approach the market value of the firm is not affected by
the capital structure changes. This theory, contrary to NI theory, does not
accept the idea of increasing the financial leverage. It means change in the
capital structure does not affect the overall cost of capital and the market
value of the firm. Thus at each and every level of capital structure, market
value of firm will be same.

The market value of the firm V = (D+E) = EBIT/Ko

V = Value of firm
(D+E)= Debt + Equity
Ko = Overall cost of capital
EBIT = Earnings before interest and tax.

The overall capitalisation rate (ko) depends on the business risk of the firm
and is independent of financial mix. Therefore, the market value of firm will
be a constant and independent of capital structure changes. Thus,
according to Net Operating Income (NOI) Approach, any capital structure
will be optimum.

The critical assumptions of the NOI approach are:

a. The market capitalizes the value of the firm as a whole. Thus the split
between debt and equity is not important.

b. The market uses an overall capitalisation rate to capitalize the net

operating income. Overall
cost of capital depends on the business risk. If the business risk is assumed
to remain unchanged, overall cost of capital is a constant.

c. The use of less costly debt funds increases the risk to shareholder. This
causes the equity capitalisation rate to increase. Thus, the advantage of
debt is offset exactly by the increase in the equity-capitalisation rate.

d. The debt capitalisation rate is constant.

e. The corporate income taxes do not exist.

3. Traditional Approach:

Traditional Theory is an intermediate approach between the net income

and net operating income theories. This gives the right combination of debt
and equity and always leads to enhanced market value of the firm. It states
that a firm’s value increases to a certain level of debt capital, after which it
tends to remain constant and eventually begins to decrease.
The traditional theory assumes changes in cost of equity (ke) at different
levels of debt- equity rate and beyond a particular point of debt-equity mix,
ke rises at an increasing rate, thus reducing the value of the firm.
The effect of change in capital structure on the overall cost of capital can be
divided into three stages as follows:

Stage I – Introduction of Debt: Increasing Value - The overall cost of capital

falls and the value of the firm increases with the increase in leverage. This
leverage has beneficial effect as debts are less expensive. The cost of equity
remains constant or increases negligibly. The proportion of risk is less in
such a firm.

Stage II – Further Application of Debt: Optimum Value - A stage is reached

when increase in leverage has no effect on the value of the firm or the cost
of capital. Neither the cost of capital falls nor the value of the firm rises.
This is because the increase in the cost of equity due to the assed financial
risk offsets the advantage of low cost debt. Stage wherein the value of the
firm is maximum and cost of capital is minimum-Optimum capital Structure

Stage III – Further Application of Debt: Declining Value - Beyond a definite

limit of leverage the cost
of capital increases with leverage and the value of the firm decreases with
leverage. This is because with the increase in debts investors begin to
realize the degree of financial risk and hence they desire to earn a higher
rate of return on equity shares. As a result the value of the firm reduces.
This theory follows that the cost of capital is a function of the degree of
leverage. Hence, an optimum capital structure can be achieved by
establishing an appropriate degree of leverage.
4. Modigliani- Miller (M-M) Approach:

Modigliani Millar approach, popularly known as the MM approach is

similar to the Net operating income approach. The MM approach favors the
Net operating income approach and agrees with the fact that the cost of
capital is independent of the degree of leverage and at any mix of debt-
equity proportions. Modigliani and Miller argued that, in the absence of
taxes the cost of capital and the value of the firm are not affected by the
changes in capital structure.

Assumptions of M-M Approach

1. Capital markets are perfect. Thus investors are

- free to buy and sell securities
- able to borrow funds at the same terms as the firms do
- well informed and behave rationally
-
2. All investors have the same expectation of the company’s net operating
income (EBIT) for the
purpose of evaluating the value of the firm.

3. Within similar operating environments, the business risk is equal among

all firms.

4. Dividend payout ratio is 100% and therefore no retained earnings.

5. No corporate taxes exist. This was removed later.

Q.3 Discuss the basic qualities of balanced capital structure ?

A.3 . A company’s capital structure is said to be optimum when

the proportion of debt and equity is such that it results in
maximising the return for the equity shareholders.
Such a structure would vary from company to company
depending upon the nature and size of operations, availability of
funds from different sources, efficiency of management, etc.
A sound capital structure should possess the following
features:
(i) Maximum Return:

The financial structure of a company should be guided by clear- cut

objective. Its objective can be maximisation of the wealth of the
shareholders or maximisation of return to the shareholders.

(ii) Less Risky:

The capital structure should represent a balance between different types of
ownership and debt securities. This is essential to reduce risk on the use of
debt capital.

(iii) Safety:
A sound capital structure should ensure safety of investment. It should be
so determined that fluctuations in the earnings of the company do not have
heavy strain on its financial structure.

(iv) Flexibility:
A sound capital structure should facilitate expansion and contraction of
funds. The company should be able to procure more capital in times of
need and should be able to pay all its debts when it does not require funds.

(v) Economy:
The capital structure should ensure the minimum costs of capital which in
turn would increase its ability to generate more wealth for the company.

(vi) Capacity:
The financial structure of a company should be d3mamic. It should be
revised periodically depending upon the changes in the business
conditions. If it has surplus funds, the company should have the capacity to
repay its debt and reduce interest obligations.
(vii) Control:
The capital structure of a company should not dilute the control of equity
shareholders of the company. That is why, convertible debentures should
be issued with great caution.

Q.4 How will you compute cash flow from operating activities ?

A.4 . Cash flow from operating activities measures the cash-generating abilities of a
company's core operations (rather than its ability to raise capital or buy assets). 

Put another way, cash flow from operations is the amount of money a company
brings in from their day-to-day business operations (e.g. selling goods, making
products).

Cash flows from operations is the first section on a cash flow statement, which
breaks down a company's cash inflow and outflow into three categories: 

 Cash flows from operations 

 Cash flows from investing activities, and 

 Cash flows from financing activities.

Cash flow from operating activities (CFO) may also be referred to as:

  Operating cash flow (OCF) 

  Net cash provided from operating activities

How to Calculate Operating Cash Flow

There are two ways to calculate cash flow from operating activities on a cash flow
statement: 

1. Indirect 

The indirect method starts with the net income then works backward and applies
adjustment for elements like depreciation and amortization (ie. non-cash items). 

2. Direct 
The direct method refers to a company’s income statement to track all cash-based
transactions. It then uses cash-based transactions (cash inflow and outflow) to
arrive at the CFO. 

The Cash Flow Formula

The indirect method is by far the most common method for calculating cash flow
from operations. Over 98% of public companies use the indirect method, as the
direct method is often too complicated due to the requirement to classify potentially
millions of transactions as either operating, investing, or financing which is
incredibly costly and time consuming.

Net income + non- cash expenses + change in working capital = CFO

Non-cash expenses are usually depreciation and/or amortization expenses. Changes

to working capital include an increase and/or decrease in a company's current
assets or liabilities.