Dividend & Working Capital -Finanace Management

DIVIDEND

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”.

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:

A. Cash dividend

B. Stock dividend

C. Bond dividend

D. 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 followed 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.

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 Miller’s 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 firm’s 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:

1. Perfect capital market.

2. Investors are rational.

3. There are no tax.

4. The firm has fixed investment policy.

5. No risk or uncertainty.

Criticism 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.

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.

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.

Criticism of Walter’s 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.

Gordon’s Model

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

1. The firm is an all equity firm.

2. The firm has no external finance.

3. Cost of capital and return are constant.

4. The firm has perpectual life.

5. There are no taxes.

6. Constant relation ratio (g=br).

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

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.

FACTORS DETERMINING 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 market is prefect, it leads to improve the higher dividend.model, there are no tax paid by the firm. It is not practically applicable.

Working capital

Working Capital is another part of the capital which is needed for meeting day to day requirement of the business concern. For example, payment to creditors, salary paid to workers, purchase of raw materials etc., normally it consists of recurring in nature. It can be easily converted into cash. Hence, it is also known as short-term capital.

Definitions

According to the definition of Mead, Baker and Malott, “Working Capital means Current

Assets”.

According to the definition of J.S.Mill, “The sum of the current asset is the working capital of a business”.

According to the definition of Weston and Brigham, “Working Capital refers to a firm’s investment in short-term assets, cash, short-term securities, accounts receivables and inventories”.

According to the definition of Bonneville, “Any acquisition of funds which increases the current assets, increase working capital also for they are one and the same”.

According to the definition of Shubin, “Working Capital is the amount of funds necessary to cover the cost of operating the enterprises”.

According to the definition of Genestenberg, “Circulating capital means current assets of a company that are changed in the ordinary course of business from one form to another, for example, from cash to inventories, inventories to receivables, receivables to cash”.

CONCEPT OF WORKING CAPITAL

Working capital can be classified or understood with the help of the following two important

concepts.

Gross Working Capital

Gross Working Capital is the general concept which determines the working capital concept. Thus, the gross working capital is the capital invested in total current assets of the business concern. Gross Working Capital is simply called as the total current assets of the concern.

GWC = CA

Net Working Capital

Net Working Capital is the specific concept, which considers both current assets and current liability of the concern. Net Working Capital is the excess of current assets over the current liability of the

concern during a particular period.

If the current assets exceed the current liabilities it is said to be positive working capital; it is reverse, it is said to be Negative working capital.

NWC = C A – CL

Component of Working Capital

TYPES OF WORKING CAPITAL

Working Capital may be classified into three important types on the basis of time.

Permanent Working Capital

It is also known as Fixed Working Capital. It is the capital; the business concern must maintain certain amount of capital at minimum level at all times. The level of Permanent Capital depends upon the nature of the business. Permanent or Fixed Working Capital will not change irrespective of time or volume of sales.

Temporary Working Capital

It is also known as variable working capital. It is the amount of capital which is required to meet the Seasonal demands and some special purposes. It can be further classified into Seasonal Working Capital and Special Working Capital.

The capital required to meet the seasonal needs of the business concern is called as Seasonal Working Capital. The capital required to meet the special emergencies such as launching of extensive marketing campaigns for conducting research, etc.

Semi Variable Working Capital

Certain amount of Working Capital is in the field level up to a certain stage and after that it will increase depending upon the change of sales or time.

NEEDS OF WORKING CAPITAL

Working Capital is an essential part of the business concern. Every business concern must

maintain certain amount of Working Capital for their day-to-day requirements and meet the short-term obligations.

Working Capital is needed for the following purposes.

1. Purchase of raw materials and spares: The basic part of manufacturing process is, raw materials. It should purchase frequently according to the needs of the business concern. Hence, every business concern maintains certain amount as Working Capital to purchase raw materials, components, spares, etc.

2. Payment of wages and salary: The next part of Working Capital is payment of wages and salaries to labour and employees. Periodical payment facilities make employees perfect in their work. So a business concern maintains adequate the amount of working capital to make the payment of wages and salaries.

3. Day-to-day expenses: A business concern has to meet various expenditures regarding the operations at daily basis like fuel, power, office expenses, etc.

4. Provide credit obligations: A business concern responsible to provide credit facilities to the customer and meet the short-term obligation. So the concern must provide adequate Working Capital.

Working Capital Position/ Balanced Working Capital Position.

A business concern must maintain a sound Working Capital position to improve the efficiency of business operation and efficient management of finance. Both excessive and inadequate Working Capital lead to some problems in the business concern.

A. Causes and effects of excessive working capital.

(i) Excessive Working Capital leads to unnecessary accumulation of raw materials, components and spares.

(ii) Excessive Working Capital results in locking up of excess Working Capital.

(iii) It creates bad debts, reduces collection periods, etc.

(iv) It leads to reduce the profits.

B. Causes and effects of inadequate working capital

(i) Inadequate working capital cannot buy its requirements in bulk order.

(ii) It becomes difficult to implement operating plans and activate the firm’s profit target.

(iii) It becomes impossible to utilize efficiently the fixed assets.

(iv) The rate of return on investments also falls with the shortage of Working Capital.

(v) It reduces the overall operation of the business.

FACTORS DETERMINING WORKING CAPITAL REQUIREMENTS

Working Capital requirements depends upon various factors. There are no set of rules or formula to determine the Working Capital needs of the business concern. The following are the major factors which are determining the Working Capital requirements.

1. Nature of business: Working Capital of the business concerns largely depend upon the nature of the business. If the business concerns follow rigid credit policy and sell goods only for cash, they can maintain lesser amount of Working Capital.

A transport company maintains lesser amount of Working Capital while a construction company maintains larger amount of Working Capital.

2. Production cycle: Amount of Working Capital depends upon the length of the production cycle. If the production cycle length is small, they need to maintain lesser amount of Working Capital. If it is not, they have to maintain large amount of Working Capital.

3. Business cycle: Business fluctuations lead to cyclical and seasonal changes in the business condition and it will affect the requirements of the Working Capital. In the booming conditions, the Working Capital requirement is larger and in the

depression condition, requirement of Working Capital will reduce. Better business results lead to increase the Working Capital requirements.

4. Production policy: It is also one of the factors which affects the Working Capital requirement of the business concern. If the company maintains the continues production policy, there is a need of regular Working Capital. If the production

policy of the company depends upon the situation or conditions, Working Capital

requirement will depend upon the conditions laid down by the company.

5. Credit policy: Credit policy of sales and purchase also affect the Working Capital requirements of the business concern. If the company maintains liberal credit policy to collect the payments from its customers, they have to maintain more Working Capital. If the company pays the dues on the last date it will create the cash maintenance in hand and bank.

6. Growth and expansion: During the growth and expansion of the business concern, Working Capital requirements are higher, because it needs some additional Working Capital and incurs some extra expenses at the initial stages.

7. Availability of raw materials: Major part of the Working Capital requirements are largely depend on the availability of raw materials. Raw materials are the basic components of the production process. If the raw material is not readily available, it leads to production stoppage. So, the concern must maintain adequate raw material; for that purpose, they have to spend some amount of Working Capital.

8. Earning capacity: If the business concern consists of high level of earning capacity, they can generate more Working Capital, with the help of cash from

operation. Earning capacity is also one of the factors which determines the Working Capital requirements of the business concern.

COMPUTATION (OR ESTIMATION) OF WORKING CAPITAL

Working Capital requirement depends upon number of factors, which are already discussed in the previous parts. Now the discussion is on how to calculate the Working Capital needs of the business concern. It may also depend upon various factors but some of the common methods are used to estimate the Working Capital.

A. Estimation of components of working capital method

Working capital consists of various current assets and current liabilities. Hence,.we have to estimate how much current assets as inventories required and how

much cash required to meet the short term obligations. Finance Manager first estimates the assets and required Working Capital for a particular period.

B. Percent of sales method

Based on the past experience between Sales and Working Capital requirements, a ratio can be determined for estimating the Working Capital requirement in future. It is the simple and tradition method to estimate the Working Capital requirements.

Under this method, first we have to find out the sales to Working Capital ratio and based on that we have to estimate Working Capital requirements. This method also expresses the relationship between the Sales and Working Capital.

C. Operating cycle

Working Capital requirements depend upon the operating cycle of the business. The operating cycle begins with the acquisition of raw material and ends with the collection of receivables.

Operating cycle consists of the following important stages:

1. Raw Material and Storage Stage, (R)

2. Work in Process Stage, (W)

3. Finished Goods Stage, (F)

4. Debtors Collection Stage, (D)

5. Creditors Payment Period Stage. (C)

R

D W

F

O = R + W + F + D–C

Sources of Working Capital

The above sources are also classified into internal sources and external sources of

working capital.

Internal sources such as:

• Retained Earnings

• Reserve and Surplus

• Depreciation Funds etc.

External sources such as:

• Debentures and Public Deposits

• Loans from Banks and Financial Institutions

• Advances and Credit

• Financial arrangements like Factoring, etc.