SEGMENT 1

FINANCE AND THE FINANCIAL MANAGER

Glossary Capital budgeting Planning and managing expenditures for

long-lived assets.

Capital markets Financial markets for long-term debt and

for equity shares.

Capital structure The mix of the various debt and equity

capital maintained by a firm. Also called
financial structure. The composition of a
corporation's securities used to finance its
investment activities; the relative
proportions of short-term debt, long-term
debt, and owners' equity.

Contingent claims Claim whose value is directly dependent

on, or is contingent on, the value of its
underlying assets. For example, the debt
and equity securities issued by a firm
derive their value from the total value of
the firm.

Corporation Form of business organization that is

created as a distinct "legal person"
composed of one or more actual
individuals or legal entities. Primary
advantages of a corporation include
limited liability, ease of ownership,
transfer, and perpetual succession.

Money markets Financial markets for debt securities that

pay off in the short term (usually less than
one year).
Net working capital Current assets minus current liabilities.

Partnership Form of business organization in which

two or more co-owners form a business.
In a general partnership each partner is
liable for the debts of the partnership.
Limited partnership permits some
partners to have limited liability.

Set-of-contracts viewpoint View of corporation as a set of

contracting relationships among
individuals who have conflicting
objectives, such as shareholders or
managers. The corporation is a legal
contrivance that serves as the nexus for
the contracting relationships.

Sole proprietorship A business owned by a single individual.

The sole proprietorship pays no corporate
income tax but has unlimited liability for
business debts and obligations.

Q.1. Define the scope of financial management. What role should the financial manager play in a
modern enterprise?

The scope of the financial management is to secure the capital needed by the enterprise, and employ it
in production and marketing activities, in such a way that it can generate the sufficient returns on
invested capital, with an intention to maximise the wealth of the owners. The financial manager plays
the crucial role in the modern enterprise by supporting investment decision, financing decision, and also
the profit distribution decision. He/she also helps the firm in balancing cash inflows and cash outflows,
and in turn to maintain the liquidity position of the firm.

Q.2. How does the modern financial manager differ from the traditional financial manager? Does
the modern financial manager's role differ for the large diversified firm and the small to medium
size firm?

The traditional financial manager was generally involved in the regular finance activities, e.g., banking
operations, record keeping, management of the cash flow on an regular basis, and informing the funds
requirements to the top management, etc. But, the role of financial manager has been enhanced in the
today's environment; he/she takes an active role in financing, investment, distribution of profits, and
liquidity decisions. In addition, he/she is also involved in the custody and safeguarding of financial and
physical assets, efficient allocation of funds, etc. The role of financial manager in case of diversified
firm is more complicated in comparison with a small and medium size firm. A diversified firm has
several products and divisions and varied financial needs. The conflicting interests of divisional
managers make the work of financial manager quite difficult in a diversified firm.

Q.3. "...the function of financial management is to review and control decisions to commit or
recommit funds to new or ongoing uses. Thus, in addition to raising funds, financial management
is directly concerned with production, marketing and other functions within an enterprise
whenever decisions are made about the acquisition or destruction of assets" (Ezra Solomon).
Elucidate.

All functions - production, marketing etc.- require finances. The financial manager supports other
functional managers and top management to deploy the scarce resources, in such operating activities
that can generate the sufficient level of return to the firm. This gives rise to the need of proper, efficient
and effective utilisation of resources. In modern era, financial manager achieves this by providing
support for operating decisions. He also helps in planning and implementing sound financial procedures
and systems.

Q.4. What are the basic financial decisions? How do they involve risk-return trade-off?

The basic financial decisions include long-term investment decision, capital structure decision, (i.e.,
financing decision), profit allocation decision (i.e., dividend distribution decision), and liquidity
decision. Each and every investment decision would yield benefits in future. To evaluate the investment
criteria, the firm will estimate the future profitability, and probable rate of return on proposed
investment, and compare the same with the cut-off rate (i.e., the generally accepted minimum level of
return on investment). Because of uncertain future, investment decisions involve risk. An investor will
expect higher return from an investment if risk is high. For a lower risk investment, the expected return
will be lower. This is referred to the risk-return trade-off. The financial decisions jointly affect the
market value of shares by influencing the return and risk of the firm.

Q.5. "The profit maximisation is not an operationally feasible criterion". Do you agree? Illustrate
your views.
The profit maximisation concept does not specify clearly whether it mean short or long-term profit, or
profit before tax or after tax. In addition, in the free economy and perfect competition, businessmen
pursue their own interests to maximise the profit by utilisation of resources in the efficient and effective
way.

Let us assume that the maximising the profit means maximising profit after tax, i.e., net profit as
reported by income statement of the business firm. It should be understood that this would not maximise
the welfare of the owners if some short-term actions were taken to improve profit. For example, the
manager may sell some of the assets and then invest funds in low-yielding assets. The profit after taxes
would go up in the short-term but the long-term profitability will suffer.

Q.6. In what ways is the wealth maximising objective superior to the profit maximisation
objective? Explain.

The wealth maximising objective means maximising the net present value, i.e., wealth of the owner. The
net wealth of the owner is the difference between the present value of its benefits and the present value
of its costs. Any action that has a positive NPV creates wealth for the owner. The profit maximising
objective tries to maximise the profit after tax, i.e., net profit, which in the long term may reduce the net
worth of the owner. (This is explained in answer no. 5). The profit maximisation concept basically
ignores the time value of money and the risk involved in firm's activities, which are very well taken care
by wealth maximisation concept.

Q.7. How should the finance function of an enterprise be organised? What functions do the
financial officers perform?

The finance function of a firm is generally headed by the in charge of Finance Department, who may be
known as Director of Finance or President (Finance) or General Manager (Finance), etc. Depending on
the structure and size of the firm. As the ultimate responsibility of top management to take crucial
decision for the survival of the firm and to maintain the solvency of the firm, the head of finance
department reports to the Chairman and Managing Director of the company, and he will be one of the
executive members of the Board of Directors. The finance officer will function as treasurer and
controller. As a treasurer, he will look after efficient and effective funds management, while as a
controller, he will look after the operational requirements of the firm.

Q.8. Should the titles of controller and treasurer be adopted under Indian context? Would you
like to modify their functions in view of the company practices in India? Justify your opinion.
The title of controller and treasurer is not being widely followed in India. In India, generally the officer
designated as Financial Controller performs the functions of chief accountant and management
accountant. In India, the title of the finance head is generally Finance Manager who is involved in the
management of company's funds.

Q.9. When can there arise a conflict between shareholders and managers goals? How does wealth
maximisation goal take care of this conflict?

The company is a complex organisation of various interested stakeholders like owners, employees,
creditors, customers and government, etc. It should be the endeavour of the management to reconcile the
objectives of the different stakeholders. Shareholders are principals and managers are their agents.
Managers may not necessarily work in the interest of shareholders. They may work in their self-interest
and appropriate company funds in the form of higher perks and salaries. To control managers' actions,
shareholders will have to incur monitoring costs. To minimise the conflict, managers should be given
incentives to become owners along with shareholders (through stock options).

Since shareholders get their wealth only when the firm has created value for customers and kept the
employees satisfied, the wealth maximisation is generally in harmony with the interests of al
stakeholders. It is also consistent with the management objective of survival.

Q10. Agency Problems. Who owns a corporation? Describe the process whereby the owners
control the firm’s management. What is the main reason that an agency relationship exits in the
corporate form of organization? In this context, what kinds of problems can arise?

In the corporate form of ownership, the shareholders are the owners of the firm. The shareholders elect
the directors of the corporation, who in turn appoint the firm’s management. This separation of
ownership from control in the corporate form of organization is what causes agency problems to exist.
Management may act in its own or someone else’s best interests, rather than those of the shareholders. If
such events occur, they may contradict the goal of maximizing the share price of the equity of the firm.

Q11. Not-for-Profit Firm Goals. Suppose you were the financial manager of a not-for-profit
business (a not-for-profit hospital, perhaps). What kinds of goals do you think would be
appropriate?

Such organizations frequently pursue social or political missions, so many different goals are
conceivable. One goal that is often cited is revenue minimization; i.e., provide whatever goods and
services are offered at the lowest possible cost to society. A better approach might be to observe that
even a not-for-profit business has equity. Thus, one answer is that the appropriate goal is to maximize
the value of the equity.

Q12. Goal of the Firm. Evaluate the following statement: Managers should not focus on the
current stock value because doing so will lead to an overemphasis on short-term profits at the
expense of long-term profits.

Presumably, the current stock value reflects the risk, timing, and magnitude of all future cash flows,
both short-term and long-term. If this is correct, then the statement is false. Q13. Ethics and Firm
Goals. Can the goal of maximizing the value of the stock conflict with other goals, such as
avoiding unethical or illegal behaviour? In particular, do you think subjects like customer and
employee safety, the environment, and the general good of society fit in this framework, or are
they essentially ignored? Think of some specific scenarios to illustrate your answer.

An argument can be made either way. At the one extreme, we could argue that in a market economy, all
of these things are priced. There is thus an optimal level of, for example, ethical and/or illegal
behaviour, and the framework of stock valuation explicitly includes these. At the other extreme, we
could argue that these are non-economic phenomena and are best handled through the political process.
A classic (and highly relevant) thought question that illustrates this debate goes something like this: “A
firm has estimated that the cost of improving the safety of one of its products is $30 million. However,
the firm believes that improving the safety of the product will only save $20 million in product liability
claims. What should the firm do?”

Q14. International Firm Goal. Would the goal of maximizing the value of the stock differ for
financial management in a foreign country? Why or why not?

The goal will be the same, but the best course of action toward that goal may be different because of
differing social, political, and economic institutions.

Q15. Agency Problems. Suppose you own stock in a company. The current price per share is $25.
Another company has just announced that it wants to buy your company and will pay $35 per
share to acquire all the outstanding stock. Your company’s management immediately begins
fighting off this hostile bid. Is the management acting in the shareholder’s best interest? Why or
Why not?

The goal of management should be to maximize the share price for the current shareholders. If
management believes that it can improve the profitability of the firm so that the share price will exceed
$35, then they should fight the offer from the outside company. If management believes that this bidder
or other unidentified bidders will actually pay more than $35 per share to acquire the company, then
they should still fight the offer. However, if the current management cannot increase the value of the
firm beyond the bid price, and no other higher bids come in, then management is not acting in the
interests of the shareholders by fighting the offer. Since current managers often lose their jobs when the
corporation is acquired, poorly monitored managers have an incentive to fight corporate takeovers in
situations such as this.

Q16. Agency Problems and Corporate Ownership. Corporate ownership varies around the world.
Historically, individuals owned the majority of shares in public corporations in the USA. In
Germany and Japan, however, banks, other large financial institutions, and other companies own
most of the stock in public corporations. Do you think agency problems are likely to be more or
less severe in Germany and Japan than in the USA?

We would expect agency problems to be less severe in other countries, primarily due to the relatively
small percentage of individual ownership. Fewer individual owners should reduce the number of diverse
opinions concerning corporate goals. The high percentage of institutional ownership might lead to a
higher degree of agreement between owners and managers on decisions concerning risky projects. In
addition, institutions may be better able to implement effective monitoring mechanisms on managers
than can individual owners, based on the institutions’ deeper resources and experiences with their own
management.

Q17. Agency Problems and Corporate Ownership. In recent years, large financial institutions
such as mutual funds and pension funds have become the dominant owners of stock in USA, and
these institutions are becoming more active in corporate affairs. What are the implications of this
trend for agency problems and corporate control?

The increase in institutional ownership of stock in the United States and the growing activism of these
large shareholder groups may lead to a reduction in agency problems for U.S. corporations and a more
efficient market for corporate control. However, this may not always be the case. If the managers of the
mutual fund or pension plan are not concerned with the interests of the investors, the agency problem
could potentially remain the same, or even increase since there is the possibility of agency between the
fund and its investors. Q18. Executive compensation. Critics have charged that compensation to top
management in the USA is simply too high and should be cut back. For example, focusing on large
corporations, Larry Ellison of Oracle has been one of the best-compensated CEOs in USA,
earning about $41 million in 2004 alone and $836 million over a period of 2000-2004 period. Are
such amounts excessive? In answering, it might be helpful to recognize the superstar athletes like
Tiger Woods, top entertainers like Mel Gibson and Oprah Winfrey, and many others at the top of
their respective fields earn at least as much, if not great deal more.

How much is too much? Who is worth more, Jack Welch or Tiger Woods? The simplest answer is that
there is a market for executives just as there is for all types of labour. Executive compensation is the
price that clears the market. The same is true for athletes and performers. Having said that, one aspect of
executive compensation deserves comment. A primary reason executive compensation has grown so
dramatically is that companies have increasingly moved to stock-based compensation.

Such movement is obviously consistent with the attempt to better align stockholder and management
interests. In recent years, stock prices have soared, so management has cleaned up. It is sometimes
argued that much of this reward is simply due to rising stock prices in general, not managerial
performance. Perhaps in the future, executive compensation will be designed to reward only differential
performance, i.e., stock price increases in excess of general market increases.

Q19. Goal of Financial Management. Why is the goal of financial management to maximize the
current share price of the company’s stock? In other words, why isn’t the goal to maximize the
future share price?

Maximizing the current share price is the same as maximizing the future share price at any future
period. The value of a share of stock depends on all of the future cash flows of company. Another way
to look at this is that, barring large cash payments to shareholders, the expected price of the stock must
be higher in the future than it is today. Who would buy a stock for $100 today when the share price in
one year is expected to be $80?
SEGMENT 3

Cost of Capital

Glossary Asset beta The sensitivity of a firm's asset value to

that of the overall economy.

Cost of equity capital The required return on the company's

common stock in capital markets. It is also
called the equity holders required rate of
return because it is what equity holders can
expect to obtain in the capital market. It is
a cost from the firm's perspective.

Equity beta The degree to which a company's costs of

operation are fixed as opposed to variable.
A firm with high operating costs compared
to a firm with a low operating leverage,
and hence relatively larger changes in
EBIT with respect to a change in the sales
revenue.

Weighted average cost of capital The average cost of capital on the firm's
(WACC) existing projects and activities.

Q1. Define cost of capital? Explain its significance in financial decision-making.

The project's cost of capital is the minimum required rate of return on funds committed to the
project, which depends on the riskiness of its cash flows. The

firm's cost of capital will be the overall, or average, required rate of return on the

aggregate of investment projects

It is a concept of vital importance in the financial decision-making. It is useful as

a standard for:

1. evaluating investment decisions,

2. designing a firm's debt policy, and

3. appraising the financial performance of top management

Q2. What are the various concepts of cost of capital? Why should they be distinguished in
financial management?

The opportunity cost is the rate of return foregone on the next best alternative investment
opportunity of comparable risk. Thus, the required rate of return on an investment project is an
opportunity cost.

In an all-equity financed firm, the equity capital of ordinary shareholders is the only source to
finance investment projects, the firm's cost of capital is equal to the opportunity cost of equity
capital, which will depend only on the business risk of the firm

Viewed from all investors' point of view, the firm's cost of capital is the rate of return required by
them for supplying capital for financing the firm's investment projects by purchasing various
securities. It may be emphasized that the rate of return required by all investors will be an overall
rate of return - a weighted rate of return. Thus, the firm's cost of capital is the 'average' of the
opportunity costs (or required rates of return) of various securities, which have claims on the
firm's assets. This rate reflects both the business (operating) risk and the financial risk resulting
from debt capital.

Q3. The equity capital is cost free.' Do you agree? Give reasons.

It is sometimes argued that the equity capital is free of cost. The reason for such argument is that
it is not legally binding for firms to pay dividends to ordinary shareholders. Further, unlike the
interest rate or preference dividend rate, the equity dividend rate is not fixed. It is fallacious to
assume equity capital to be free of cost. Equity capital involves an opportunity cost. Ordinary
shareholders supply funds to the firm in the expectation of dividends and capital gains
commensurate with their risk of investment. The market value of the shares, determined by the
demand and supply forces in a well functioning capital market, reflects the return required by
ordinary shareholders. Thus, the shareholders' required rate of return, which equates the present
value of the expected benefits with the current market value of the share, is the cost of equity.
Q4. The basic formula to calculate the cost of equity is: (DIV1/ Po) + g.

Explain its rationale.

The cost of equity is equal to the expected dividend yield (DIV1/P0) plus capital

gain rate as reflected by expected growth in dividends (g). It may be noted that formula is based
on the following assumptions:

1. The market price of the ordinary share, P , is a function of expected dividends.

2. The dividend, DIV1, is positive (i.e. DIV1 > 0).

3. The dividends grow at a constant growth rate g, and the growth rate is equal to

the return on equity, ROE, times the retention ratio, b (i.e. g = ROE * b).

4. The dividend payout ratio [i.e. (1 - b)] is constant.

The cost of equity (internal) determined by the dividend-valuation model implies that if the firm
would have distributed earnings to shareholders, they could have invested it in the shares of the
firm or in the shares of other firms of similar risk at the current market price (P0) to earn a rate of
return equal to ke. Thus, the firm

should earn a return on retained funds equal to k to ensure growth of dividends and share price.
If a return less than ke is earned on retained earnings, the market price of the firm's share will
fall.

Q5. Are retained earnings less expensive than the new issue of ordinary shares? Give your
views.

The cost of external equity is greater than the cost of internal equity for one reason. The selling
price of the new shares may be less than the market price. In India, the new issues of ordinary
shares are generally sold at a price less than the market price prevailing at the time of the
announcement of the share issue.

Q6. What is the CAPM approach for calculating the cost of equity? What is the difference
between this approach and the constant growth approach? Which one is better? Why?

As per the CAPM, the required rate of return on equity is given by the following relationship:
Equation requires the following three parameters to estimate a firm's cost of equity:

1. The risk-free rate (Rf):

2. The market risk premium (Rm - Rf):

3. The beta of the firm's share (β):

The dividend-growth approach has limited application in practice because of its two
assumptions. First, it assumes that the dividend per share will grow at a constant rate, g, forever.
Second, the expected dividend growth rate, g, should be less than the cost of equity, ke, to arrive
at the simple growth formula

These assumptions imply that the dividend-growth approach cannot be applied to those
companies, which are not paying any dividends, or whose dividend per share is growing at a rate
higher than ke, or whose dividend policies are highly

volatile. The dividend-growth approach also fails to deal with risk directly. In contrast, the
CAPM has a wider application although it is based on restrictive assumptions. The only
condition for its use is that the company's share is quoted on the stock exchange. Also, all
variables in the CAPM are market determined and except the company specific share price data,
they are common to all companies. The value of beta is determined in an objective manner by
using sound statistical methods. One practical problem with the use of beta, however, is that it
does not probably remain stable over time.

Q7. Distinguish between the weighted average cost of capital and the marginal cost of
capital. Which one should be used in capital budgeting and valuation of the firm? Why?

Weighted marginal cost of capital (WMCC): Marginal cost is the new or the incremental cost of
new capital (equity and debt) issued by the firm. The weighted average cost of capital is the cost
of old and new capital. In capital budgeting decision and valuation, we consider the incremental
cash flows. Hence, it appropriate to use the marginal cost of capital as the discount rate.

Q8. Marginal cost of capital is nothing but the average cost of capital.' Explain.

Marginal cost is the new or the incremental cost of new capital (equity and debt) issued by the
firm. We assume that new funds are raised at new costs according to the firm's target capital
structure. Hence, what is commonly known as the WACC is in fact the weighted marginal cost
of capital (WMCC); that is, the weighted average cost of new capital given the firm's target
capital structure.

Capital structure basic concepts

Glossary

Mm proposition i A proposition of modigliani and miller

(mm) which states that a firm cannot
change the total value of its outstanding
securities by changing its capital
structure proportions. Also called an
irrelevance result.

Mm proposition ii A proposition by modigliani and miller

(MM) which states that the cost of equity
is a linear function of the firm's debt-
equity ratio.

Pie model A model of the debt-equity ratio of the

firm, graphically depicted in slices of a
pie that represents the value of the firm
in the capital markets

Q.1 Describe the traditional view on the optimum capital structure. Compare and contrast
this view with the NOI approach and the NI approach.

According to traditional approach, the cost of capital declines and the value of the firm increases
with leverage up to a prudent debt level and after reaching the optimum level, leverage cause the
cost of capital to increase and the value of the firm to decline. The optimum capital structure
occurs when the cost of capital is minimum or the value of firm is maximum. The ni approach
indicates that the total value of firm rises with increased use of leverage, and weighted average
cost of capital declines.
The noi approach assumes that the total value of firm remains constant as leverage is changed,
because the cost of equity increases linearly with leverage and sets off the benefits of debt
capital. The NI approach is valid, if financing decisions have an important effect on the value of
firm. NOI approach is valid, if the financing decisions is not of great concern, but overall cost of
capital depends on business risk. Traditional approach is based on the ni approach.

Q.2 Explain the position of M-M on the issue of an optimum capital structure, ignoring the
corporate income taxes.

The Modigliani-miller hypothesis is identical with the NOI approach. M-M approach indicates
that a firm's market value and the cost of capital remain invariant to the capital structure changes,
i.e., any combination of debt and equity is as good as any other. M-m hypothesis indicates that
securities are traded in perfect capital market situation, and firms can be grouped into
homogeneous risk classes. Further, it is also assumed that no corporate income taxes exist, and
firms distribute all net earnings to the shareholders.

If two identical firms, except for the degree of leverage, have different market values, arbitrage
will take place to enable investors to engage in personal or home-made leverage as against the
corporate leverage to restore equilibrium in the market.

Q.3 The M-M thesis is based on unrealistic assumptions." evaluate the reality of the
assumptions made by M-M.

The m-m thesis is based on the assumption of perfect capital market in which arbitrage is
expected to work. The assumption that firms and individuals can borrow and lend at the same
rate of interest may not hold in practice. In reality, firms are able to borrow at lower rates of
interest 8 Cost of Capital than individuals. The existence of limited liability of firms in contrast
with unlimited liability of individuals makes it incorrect to assume that 'personal leverage' is a
perfect substitute of 'corporate leverage'. The existence of transaction costs also interferes with
the working of arbitrage. The existence of number of institutional investors would make it
unfeasible to substitute personal leverage for corporate leverage. The existence of corporate
income tax provide the interest tax shield benefits to firm, which results in lower cost of
borrowed funds than the contractual rate of interest.
Q.4 How does the cost of equity behave with leverage under the traditional view and the M-
M position?

According to the traditional view, the rate at which shareholders' capitalize their net income, i.e.,
the cost of equity, ke remains constant up to certain level of debt, (i.e., a certain degree of
leverage). Later on, further increase in the leverage increases the cost of equity due to the added
risk (i.e., financial) and offsets the advantage of low cost of debt, after the acceptable limit of
leverage.

On the other hand, according to m-m view, the cost of equity increases with debt;, ke, is equal to
the constant average cost of capital, k,,, plus a premium for the financial risk, which is equal to
debt-equity ratio times the spread between the constant average cost of capital and the cost of
debt, (k0 - kd) d/e. The ke is a linear function of leverage, measured by the market value of debt
to equity, d/e.

Q.5 "when the corporate income taxes are assumed to exist, Modigliani and Miller and the
traditional theorist agree that capital structure does affect value, so the basic point of
dispute disappears." do you agree? Why or why not?

Two theories are based on different premises. Taxes or no taxes, traditional theory is based on
the assumption that leverage has three-stage effect on value of the firm (or the firm's cost of
capital).

First, there is a favourable effect on value. Second, there is no effect. Third, as the use of
leverage goes beyond certain level (undefined level) , there is unfavourable effect. The mm
theory, on the other hand, is based on the assumption that there is a linear relationship between
leverage and financial risk. Since the advantage of leverage taken off by the financial risk, there
is no effect on value. When corporate taxes are considered, there is a net advantage of leverage
because of interest tax shield.

Q. 06 What is financial distress? How does it affect the value of firm?

The offsetting advantage of debt is grouped under the term financial distress. Financial distress
occurs when the firm finds it difficult to honour the obligations of creditors, which may lead to
insolvency also. The financial distress also introduces inflexibility of raising funds by firm when
needed. The financial distress reduces the value of the firm, on account of insolvency costs like
legal costs, arranging the funds at higher cost of capital, etc. Hence:

Value of leveraged firm = value of un-leveraged firm + pv of tax shield benefit - pv of financial
distress.

The costs of financial distress increases as more and more debt is introduced in the capital
structure of the firm.

Q.07 Define the capital structure. What are the elements of a capital structure? What do
you mean by an appropriate capital structure? What are the features of an appropriate
capital structure?

Capital structure refers to the mix of long term sources of funds, such as debentures, long term
debt, preference share capital and equity share capital including reserves and surpluses. The
appropriate capital structure maximizes the long term market price per share, also keeping in
view the financial requirements of a company.

A sound or appropriate capital structure should have the following features:

1. It should generate maximum returns to the shareholders.

2. There should not be the use of excessive debt to maintain long term solvency.

3. The capital structure should be flexible, to provide funds to finance its profitable activities in
future.

4. The capital structure should involve minimum risk of loss of control of the company

Q 08 Briefly explain the factors that influence the planning of the capital structure in
practice.

In addition to the concerns about eps, value of firm and cash flow; the other important
considerations are as follows:

The desire to continue control over the company. For example, closely held companies do not
make issues of new shares, while widely-held companies may make issue of new equity shares.
The firm's willingness to venture into new profitable activities as and when needed, then they
may like to have present target debt ratio at lower end. Restrictive covenants in loan agreements
already executed.

Readiness of the investors to purchase a security in a given period of time and to demand
reasonable return.

Also, study the market conditions, and internal conditions of a company from the view point of
marketability of securities, etc.

Q 09 Explain the features and limitations of three approaches of determining a firm's

capital structure: (a) EBIT- EPS approach, (b) valuation approach, and (c) cash flow
approach.

The EBIT-EPS approach analyzes the impact of debt on eps. The use of fixed cost sources of
finance, such as debt and preference share capital to finance the assets of the company, is known
as financial leverage. If the assets financed with the use of debt yield a return greater than the
cost of debt, the earnings per share also increases without an increase in the owners' interest. The
firm with high level of the EBIT can make profitable use of the high degree of leverage to
increase return on the shareholders' equity. The EBIT-EPS analysis does not reflect the debt-
servicing ability of the firm. This approach does not consider operating and business risk also. In
the valuation approach, the capital structure is evaluated in terms of its effect on the value of the
firm. According to mm theory, capital structure will have favourable effect on the value of the
firm only because of the interest tax shield. This advantage reduces because of personal taxes
and financial distress caused by leverage.

In the cash flow approach, a firm is considered prudently financed if it is able to service its fixed
charges, i.e., pay interest and principal, under any reasonably predictable adverse conditions. At
the time of planning the capital structure, the ratio of net cash inflows of fixed charges (debt -
servicing ratio) should be examined carefully. It focuses on the liquidity and solvency of the firm
over a long-period of time.

Q 10 "... .the analysis of debt to equity ratios alone can be deceiving, and an analysis of the
magnitude and stability of cash flow relative to fixed changes is extremely important in
determining the appropriate capital structure-." give your opinion. (5 marks)
The cash flow analysis indicates firm's ability to service debt obligations even under the adverse
conditions, by examining the debt-servicing ratio. It indicates the number of times the fixed
financial obligations are covered by the net cash inflows generated by the company. The greater
the coverage, the greater is the amount of debt a company can use. The impact of debt-equity
ratio should be evaluated in terms of value, rather than eps. It is possible for a high-growth
profitable company to suffer from cash shortage if its liquidity management is poor. Hence, the
debt capacity should be thought in terms of cash flows rather than debt-ratios.

Q. 11 What is meant by financial flexibility? Is a flexible capital structure costly?

Flexible capital structure means firm's ability to adapt its capital structure to the needs of the
changing conditions. The company should be able to raise funds, without undue delay and cost,
whenever needed, to finance the profitable investments. The financial plan of the company
should be flexible enough to change the composition of capital structure as warranted by
operating needs. It is costly on account of restrictions imposed by loan covenants, pre-maturity
repayment charges in case of retirement of loan or early redemption of debentures, flotation
costs, etc.

Q 12 What is the importance of marketability and flotation costs in the capital structure
decision of a company?

The internal conditions of a company dictate the marketability of securities in addition to

readiness of investors to purchase a security in a given period of time and to demand reasonable
return. Due to changing market sentiments, the company has to decide whether to raise funds
with an equity issue or debt issue.

Flotation cost is not very important factor influencing the capital structure of a company.
Flotation costs occur only when the funds are externally raised. Generally, the flotation cost of
debt is less than cost of equity issue. The flotation costs can be an important consideration in
deciding the size of a security issue. Generally, the flotation costs as a percentage of funds raised
will decline with larger amount of funds.

Q 13 How do the considerations of control and size affect the capital structure decision of
the firm?
Capital structure decision is governed by desire of management to continue control over the
company. The ordinary (equity) shareholders elect the directors of the company. This may result
into dilution of control by present management or owner. In the case of widely-held company,
the shares of such company are widely scattered, and by issues of new shares, there is a risk of
dilution of control. The risk of loss of control can be reduced by distribution of shares widely and
in small lots.

The closely-held small company would like to maintain control. Because of fear of sharing
control and being interfered by others, the closely held company would like to raise debt capital
instead of equity issue. To avoid the risk of loss of control, small companies may slow down
their rate of growth or issue preference share capital or raise debt capital. A very excessive debt
capital can also cause serious liquidity problem, and render the company sick, which means
complete loss of control.

The size of company may influence its capacity and availability of funds from different sources.
A small company finds it difficult to raise long term debt or long term loan at acceptable rate of
interest and convenient terms. If small companies are able to approach capital markets, the cost
of issuing shares is generally more than larger companies.

Q14 MM assumptions: list the 3 assumptions that lie behind the Modigliani-Miller theory
in a world without taxes. Are these assumptions reasonable in the real world? Explain.

Assumptions of the Modigliani-Miller theory in a world without taxes:

1) Individuals can borrow at the same interest rate at which the firm borrows. Since investors can
purchase securities on margin, an individual’s effective interest rate is probably no higher than
that for a firm. Therefore, this assumption is reasonable when applying mm’s theory to the real
world. If a firm were able to borrow at a rate lower than individuals, the firm’s value would
increase through corporate leverage. As mm proposition i states, this is not the case in a world
with no taxes.

2) There are no taxes. In the real world, firms do pay taxes. In the presence of corporate taxes,
the value of a firm is positively related to its debt level. Since interest payments are deductible,
increasing debt reduces taxes and raises the value of the firm.
3) There are no costs of financial distress. In the real world, costs of financial distress can be
substantial. Since stockholders eventually bear these costs, there are incentives for a firm to
lower the amount of debt in its capital structure.

Q15. MM propositions: in a world with no taxes, no transaction costs, and no costs of

financial distress, is the following statement true, false or uncertain? If a firm issues equity
to repurchase some of its debt, the price per share of the firm’s stock will rise because the
shares are less risky. Explain (5 marks)

False, a reduction in leverage will decrease both the risk of the stock and its expected return.
Modigliani and miller state that, in the absence of taxes, these two effects exactly cancel each
other out and leave the price of the stock and the overall value of the firm unchanged.

Q16. MM propositions: in a world with no taxes, no transaction costs, and no costs of

financial distress, is the following statement true, false or uncertain? Moderate borrowing
will not increase the required return on a firm’s equity. Explain?

False, Modigliani-Miller proposition ii (no taxes) states that the required return on a firm’s
equity is positively related to the firm’s debt-equity ratio. Therefore, any increase in the amount
of debt in a firm’s capital structure will increase the required return on the firm’s equity.

Q17. MM propositions: what is the quirk in the tax code that makes a levered firm more
valuable than an otherwise identical unlevered firm?

Interest payments are tax deductible, where payments to shareholders (dividends) are not tax
deductible.

Q18. Business risk versus financial risk: explain what is meant by business and financial
risk. Suppose firm A has greater business risk than firm B. Is it true that firm A also has a
higher cost of equity capital? Explain.

Business risk is the equity risk arising from the nature of the firm’s operating activity, and is
directly related to the systematic risk of the firm’s assets. Financial risk is the equity risk that is
due entirely to the firm’s chosen capital structure. As financial leverage, or the use of debt
financing, increases, so does financial risk and, hence, the overall risk of the equity. Thus, firm B
could have a higher cost of equity if it uses greater leverage.
Q19. MM propositions: how would you answer in the following debate? (5 marks)

Isn’t it true that the riskiness of a firm’s equity will rise if the firm increases its use of debt
financing?

Yes, that’s the essence of mm proposition

And isn’t it true that, as a firm increases its borrowing, the likelihood of default increases, herby
increasing the risk of the firm’s debt?

Yes.

In other words, increased borrowing increases the risk of the equity and debt?

That’s right.

Well, given that the firm uses only debt and equity financing, and given that the risks of both are
increased by increased borrowing, does it not follow that increasing debt increases the overall
risk and therefore decreases the value of the firm?

No, it doesn’t follow. While it is true that the equity and debt costs are rising, the key thing to
remember is that the cost of debt is still less than the cost of equity. Since we are using more and
more debt, the WACC does not necessarily rise.

average accounting return The average project earnings after taxes and
depreciation divided by the average book value
of the investment during its life.

basic IRR rule Accept the project if IRR is greater than the
discount rate; reject the project if IRR is less
than the discount rate.

capital rationing The case where funds are limited to a fixed

dollar amount and must be allocated among
competing projects.

discounted payback period method An investment decision rule in which the cash
flows are discounted at an interest rate and the
payback rule is applied on these discounted
 cash flows.

incremental IRR IRR on the incremental investment from

choosing a large project instead of a smaller
project.

independent project A project whose acceptance or rejection is

independent of the acceptance or rejection of
other projects.

internal rate of return A discount rate at which the net present value
of an investment is zero. The IRR is a method
of evaluating capital expenditure proposals.

mutually exclusive investments Investment decisions in which the acceptance

of a project precludes the acceptance of one or
more alternative projects.

NPV rule Invest in all positive NPV opportunities.

payback period rule An investment decision rule which states that

all investment projects that have payback
periods equal to or less than a particular cutoff
period are accepted, and all of those that pay
off in more than the particular cutoff period are
rejected. The payback period is the number of
years required for a firm to recover its initial
investment required by a project from the cash
flow it generates.

profitability index A method used to evaluate projects. It is the

ratio of the present value of the future expected
cash flows after initial investment divided by
the amount of the initial investment.

value-additivity In an efficient market the value of the sum of

 two cash flows is the sum of the of the
individual cash flows.

1. Payback period and NPV: if a project with conventional cash flows has a payback period less
than the project’s life,can you definitively state the algebraic sign of the NPV? why or why not?
If you know that the discounted payback period is less than the project’s life, what can you say
about the NPV? Explain.

Ans: Assuming conventional cash flows, a payback period less than the project’s life means that
the NPV is positive for a zero discount rate, but nothing more definitive can be said. For discount
rates greater than zero, the payback period will still be less than the project’s life, but the NPV
may be positive, zero, or negative, depending on whether the discount rate is less than, equal to,
or greater than the IRR. The discounted payback includes the effect of the relevant discount rate.
If a project’s discounted payback period is less than the project’s life, it must be the case that
NPV is positive.

2. NPV: Suppose a project has conventional cash flows and a positive NPV. What do you know
about its payback? Its discounted payback? Its profitability index? It’s IRR? Explain.

Ans: Assuming conventional cash flows, if a project has a positive NPV for a certain discount
rate, then it will also have a positive NPV for a zero discount rate; thus, the payback period must
be less than the project life. Since discounted payback is calculated at the same discount rate as is
NPV, if NPV is positive, the discounted payback period must be less than the project’s life. If
NPV is positive, then the present value of future cash inflows is greater than the initial
investment cost; thus, PI must begreater than 1. If NPV is positive for a certain discount rate R,
then it will be zero for some larger discount rate R*; thus, the IRR must be greater than the
required return.

3. International Investment Projects: In November 2004,automobile manufacturer Honda

announced Plans to build an automatic transmission plant in Georgia and expand its transmission
plant to Ohio. Honda apparently felt that it would better able to compete and create value with
U.S based facilities. Other companies such as Fuji Film and Swiss chemical company Lonza
have reached similar conclusions and taken similar actions. What are some of the reasons that
foreign manufacturers of products as diverse as automobiles, film, and chemicals might arrive at
this same conclusion?

Ans: There are a number of reasons. Two of the most important have to do with transportation
costs and exchange rates. Manufacturing in the U.S. places the finished product much closer to
the point of sale, resulting in significant savings in transportation costs. It also reduces
inventories because goods spend less time in transit. Higher labor costs tend to offset these
savings to some degree, at least compared to other possible manufacturing locations. Of great
importance is the fact that manufacturing in the U.S. means that a much higher proportion of the
costs are paid in dollars. Since sales are in dollars, the net effect is to immunize profits to a large
extent against fluctuations in exchange rates. This issue is discussed in greater detail in the
chapter on international finance.

4. Capital Budgeting Problems: what are some of the difficulties that might come up in actual
applications of the various criteria we discussed in this chapter?which one would be the easiest
to implement in actual applications?the most difficult?

Ans: The single biggest difficulty, by far, is coming up with reliable cash flow estimates.
Determining an appropriate discount rate is also not a simple task. These issues are discussed in
greater depth in the next several chapters. The payback approach is probably the simplest,
followed by the AAR, but even these require revenue and cost projections. The discounted cash
flow measures (discounted payback, NPV, IRR, and profitability index) are really only slightly
more difficult in practice.

5. Capital Budgeting in Not-for-Profit Entities: are the capital budgeting criteria we discussed
applicable to not-for profit corporations?how should such entities make capital budgeting
decisions? What about the U.S government? Should it evaluate spending proposals using these
techniques?

Ans: Yes, they are. Such entities generally need to allocate available capital efficiently, just as
for-profits do. However, it is frequently the case that the “revenues” from not-for-profit ventures
are not tangible. For example, charitable giving has real opportunity costs, but the benefits are
generally hard to measure. To the extent that benefits are measurable, the question of an
appropriate required return remains. Payback rules are commonly used in such cases. Finally,
realistic cost/benefit analysis along the lines indicated should definitely be used by the U.S.
government and would go a long way toward balancing the budget!

WORKING CAPITAL MANAGEMENT

1. This chapter introduced the management of short-term finance. Short-term finance

involves short-lived assets and liabilities. We traced and examined the short-term
sources and uses of cash as they appear on the firm's financial statements. We saw
how current assets and current liabilities arise in the short-term operating activities
and the cash cycle of the firm. From an accounting perspective, short-term finance
involves net working capital.

2. Managing short-term cash flows involves the minimization of costs. The two major
costs are carrying costs (the interest and related costs incurred by overinvesting in
short-term assets such as cash) and shortage costs (the cost of running out of short-
term assets). The objective of managing short-term finance and short-term financial
planning is to find the optimal trade-off between these costs.

3. In an ideal economy, a firm could perfectly predict its short-term uses and sources
of cash, and net working capital could be kept at zero. In the real world, net working
capital provides a buffer that lets the firm meet its ongoing obligations. The financial
manager seeks the optimal level of each of the current assets.

4. The financial manager can use the cash budget to identify short-term financial
needs. The cash budget tells the manager what borrowing is required or what lending
will be possible in the short term. The firm has a number of possible ways of
acquiring funds to meet short-term shortfalls, including unsecured and secured loans.

Short-Term Finance and Planning

Glossary Accounts receivable financing A secured short-term loan that involves

 either the assigning of receivables or the
factoring of receivables. Under
assignment, the lender has a lien on the
receivables and recourse to the borrower.
Factoring involves the sale of accounts
receivable. Then the purchaser, called the
factor, must collect on the receivables.

Banker's acceptances Agreement by a bank to pay a given sum

of money at a future date.

Carrying costs Costs that increase with increases in the

level of investment in assets (usually refers
to current assets).

Cash budget A forecast of cash receipts and

disbursements expected by a firm in the
coming year. It is a short-term financial
planning tool.

Cash cycle In general, the time between cash

disbursement and cash collection. In net
working capital management, it can be
thought of as the operating cycle less the
accounts payable payment period.

Cash flow time line Line depicting the operating activities and
cash flows for a firm over a particular
period.

Commercial paper Short-term, unsecured promissory notes

issued by corporations with a high credit
standing. Their maturity ranges up to 270
days.
Compensating balance Deposit that the firm keeps with the bank
in a low-interest or non-interest-bearing

account to compensate banks for bank loans or services.

Inventory loan A secured short-term loan to purchase

inventory. The three basic forms are a
blanket inventory lien, a trust receipt, and
field warehouse financing.

Liquidity Refers to the ease and quickness of

converting assets to cash. Also called
marketability.

Operating cycle The time interval between the arrival of

inventory stock and the date when cash is
collected from receivables.

Shortage costs Costs that fall with increases in the level of

investment in current assets.

Short-run operating activities Events and decisions concerning the short-

term finance of a firm, such as how much
inventory to order and whether to offer
cash terms or credit terms to customers.

Q1. Operating Cycle. What are some of the characteristics of a firm with a long operating
cycle?

These are firms with relatively long inventory periods and/or relatively long receivables periods.
Thus, such firms tend to keep inventory on hand, and they allow customers to purchase on credit
and take a relatively long time to pay.

Q2. Cash Cycle. What are some of the characteristics of a firm with a long cash cycle?
These are firms that have a relatively long time between the time that purchased inventory is paid
for and the time that inventory is sold and payment received. Thus, these are firms that have
relatively short payables periods and/or relatively long receivable cycles.

Q3. Cost of Current Assets. Loftis Manufacturing Inc., has recently installed a just in time
(JIT) inventory system. Describe the effect this likely to have on the company’s carrying
costs, shortage costs, and operating cycle.

Carrying costs will decrease because they are not holding goods in inventory. Shortage costs will
probably increase depending on how close the suppliers are and how well they can estimate
need. The operating cycle will decrease because the inventory period is decreased.

Q4. Operating and Cash Cycles. Is it possible for a firm’s cash cycle to be longer than its
operating cycle? Explain why or why not.

Since the cash cycle equals the operating cycle minus the accounts payable period, it is not
possible for the cash cycle to be longer than the operating cycle if the accounts payable is
positive. Moreover, it is unlikely that the accounts payable period would ever be negative since
that implies the firm pays its bills before they are incurred.

1. Shortage Costs. What are the costs of shortages? Describe them. (5 Marks)

Shortage costs are those costs incurred by a firm when its investment in current assets is low.
There are two basic types of shortage costs.

1) Trading or order costs. Order costs are the costs of placing an order for more cash or more
inventory.

2) Costs related to safety reserves. These costs include lost sales, lost customer goodwill, and
disruption of production schedules.

Q5. Reasons for Net Working Capital. In an ideal economy, net working capital is always
zero. Why might net working capital be positive in a real economy?

A long-term growth trend in sales will require some permanent investment in current assets.
Thus, in the real world, net working capital is not zero. Also, the variation across time for assets
means that net working capital is unlikely to be zero at any point in time. This is a liquidity
reason.

Cash Management The chapter discussed how firms manage cash.

1. A firm holds cash to conduct transactions and to compensate banks for the various
services they render.

2. The optimal amount of cash for a firm to hold depends on the opportunity cost of
holding cash and the uncertainty of future cash inflows and outflows. The Baumol
model and the Miller–Orr model are two transaction models that provide rough
guidelines for determining the optimal cash position.

3. The firm can use a variety of procedures to manage the collection and disbursement
of cash to speed up the collection of cash and slow down payments. Some methods to
speed collection are lockboxes, concentration banking, and wire transfers. The
financial manager must always work with collected company cash balances and not
with the company's book balance. To do otherwise is to use the bank's cash without the
bank knowing it, raising ethical and legal questions.

4. Because of seasonal and cyclical activities, to help finance planned expenditures, or

as a reserve for unanticipated needs, firms temporarily find themselves with cash
surpluses. The money market offers a variety of possible vehicles for parking this idle
cash.

Compensating balances Deposit that the firm keeps with the bank
in a low-interest or non-interest-bearing
account to compensate banks for bank
loans or services.

Concentration banking The use of geographically dispersed

collection centers to speed up the
collection of accounts receivable.

Float The difference between bank cash and

 book cash. Float represents the net effect
of checks in the process of collection, or
clearing. Positive float means the firm's
bank cash is greater than its book cash
until the check's presentation. Checks
written by the firm generate disbursement
float, causing an immediate decrease in
book cash but no change in bank cash. In
neutral float position, bank cash equals
book cash. Checks written by the firm
represent collection float, which increases
book cash immediately but does not
immediately change bank cash. The sum
of disbursement float and collection float
is net float.

Lockbox Post office box set up to intercept accounts

receivable payments. Lockboxes are the
most widely used device to speed up
collection of cash.

Target cash balance Optimal amount of cash for a firm to hold,

considering the trade-off between the
opportunity costs of holding too much cash
and the trading costs of holding too little.

Transactions motive Areason for holding cash that arises from

normal disbursement and collection
activities of the firm.

Wire transfer An electronic transfer of funds from one

bank to another that eliminates the mailing
and check clearing times associated with
 other cash-transfer methods.

Zero-balance account (ZBA) A checking account in which a zero

balance is maintained by transfer of funds
from a master account in an amount only
large enough to cover checks presented.

Q. 1 Explain the three principal motives for holding cash.

Cash is required to meet a firm's transactions and precautionary needs. A firm needs cash to
make payments for acquisition of resources and services for the normal conduct of business. It
keeps additional funds to meet any emergency situation. Some firms may also maintain cash for
taking advantages of speculative changes in prices of input and output.

Cash in the basic input needed to keep the business running on a continuous basis. Cash shortage
will disrupt the firm's manufacturing operations, while excessive cash will simply remain idle,
without contributing anything towards the firm's profitability. So, firm should have sufficient
cash, neither more nor less. The cash for precautionary motive is the need to hold cash to meet
contingencies in the future. It provides cushion or buffer to withstand some unexpected
emergency.

Q.2 What are the advantages of cash planning? How does cash budget help in planning the
firm's cash flows?

Cash planning is a technique to plan and control the inflow and outflow of cash. Cash planning
helps to anticipate the future cash flows and cash needs of the firm and reduces the possibility of
idle cash balances (which lowers firm's profitability) and cash deficits (which can cause the
firm's failure). It protects the financial condition of the firm, and is crucial in developing the
overall operating plans of the firm.

Cash budget is the most significant device to plan for and control cash receipts and payments. A
cash budget is a summary statement of the firm's expected cash inflows and outflows over a
projected time period. It gives information on the timing and magnitude of expected cash flows
and cash balances over the projected period. The cash budget may differ from firm to firm.
Monthly cash budgets should be prepared by a firm whose business is affected by seasonal
variations. Daily or weekly cash budgets should be prepared for determining cash requirements if
cash flows show extreme fluctuations. Cash budgets for a longer interval should be prepared if
cash flows are relatively stable.

Q.3 Explain and illustrate the utility of cash budget.

The cash budget helps in determining the cash requirements for a pre-determined period to run a
business. One of the significant roles of the cash budget is to pinpoint when the money will be
needed and when it can be repaid. This helps the financial manager to negotiate short term
financial arrangement with banks. Cash budget also help in managing the investment of surplus cash
in marketable securities. A carefully and skillfully designed cash budget helps a firm to select securities
with appropriate maturities and reasonable risk, and maximize profit by investing idle funds. Multi-
divisional firms use cash budgets as a tool to coordinate the flow of funds between their various
divisions as well as to make financing arrangements for these operations. Cash budget may also be
useful in determining the margins or minimum balances to be maintained with banks. It also supports to
scheduling payments in connections of short-term and long-term debt repayments as well as for capital
expenditures programmes, etc.

Q.4 Illustrate with example the modus operandi of preparing a cash budget.

Two most commonly used methods of preparing a cash budget are (1) the receipts and
disbursements method, and (2) the adjusted income method. Receipts and disbursements method:
Developing a forecast for cash inflows is the first step in preparing a cash forecast or cash
budget. Three broad sources of cash inflows can be identified: (i) operating, (ii) non-operating
and (iii) financial. Cash sales and collections from customers form the most important part of the
operating cash inflows. The operating cash inflows are reduced to the extent of sales discounts,
returns and allowances and bad debts. Non-operating cash inflows include sale of old assets and
dividend and interest income. Borrowings and issuance of securities are external financial
sources, and part of financial cash inflows.

Next step in the preparation of cash budget is the estimate of cash outflows. Cash outflows
include
1. Operating outflows, i.e., cash purchases, payments to suppliers of materials,advances to
suppliers, wages and salaries and other operating expenses

2. Capital expenditures

3. Contractual payments

4. Repayment of loan and interest and tax payments and

5. Discretionary payments like ordinary and preference dividend.

Adjusted Income Method: This method is also known as sources and uses approach. It is a
projected cash flow statement which has three sections, i.e., sources of cash, uses of cash and the
adjusted cash balance. It also helps in anticipating the working capital movements. In preparing
the adjusted net income forecast items such as net income, depreciation, taxes, dividends, etc.
can easily be determined from the company's annual operating budget. It separately takes into
account the movements in the working capital items, and thus helps to keep a control on a firm's
working capital.

Q.5 Explain the technique that can be used to accelerate the firm's collections.

Cash collections can be accelerated by reducing the lag or gap between the time a customer pays
bill and the time the cheque is collected and funds become available for the firm's use. For this
purpose, a firm can use decentralized collection system and lock-box system to speed up the
collections. A decentralized collection procedure, called concentration banking, is a system of
operating through a number of collection centres, instead of a single collection centre centralized
at the firm's head office. The basic purpose of the decentralized collections is to minimize the lag
between the mailing time from customers to the firm and time when the firm can make use of the
firm. Decentralized mailing system saves mailing and processing time, and thus, reduces the
deposit float, and consequently, the financing requirements.

Lock-box system: In a lock-box system, the firm establishes a number of collection centres,
considering customer locations and volume of remittances. At each centre, the firm hires a post
office box and instructs its customers to mail their remittances to the box. The firm's local bank
is given the authority to pick up the remittances, and deposits the cheque in the firm's account.

Q.6 What are the advantages of decentralized collection over a centralized collection?
Under the decentralized collections, the firm will have a large number of bank accounts operated
in the areas where the firm has its branches, instead of one bank account at one place in
centralized collection system. Decentralized collection system saves mailing and processing time
and, thus, reduces the deposit float, and consequently, the financing requirements. This system
results in potential savings which should be compared with the cost of maintaining the system.

It must be noticed that now a lot of developments and improvements have taken place in the
banking in India. Now a firm can deposit cheque anywhere and the credit will be available
immediately where the firm operates its account.

Q.7 What is a lock-box system? How does it help to reduce the cash balances?

In a lock-box system, the firm establishes a number of collection centres, considering customer
locations and volume of remittances. At each centre, the firm hires a post office box and instructs
its customers to mail their remittances to the box. The firm's local bank picks up the cheques and
deposits in the firm's accounts.

The lock-box system eliminates the period between the time cheques are received and deposited
in the bank for collection by firm. The cheques are deposited immediately and their collection
process start sooner, which results into reduced deposit floats, and may in turn reduce the cash
balances.

Q.8 Distinguish between a deposit float and a payment float. What are the advantages and
dangers of "playing the float"? Explain the techniques for managing float.

The collection float means the time gap between cheques sent by customer which are not yet
collected. This time gap, i.e., delay caused by the mailing time, (the time taken by cheque in
transit), and the processing time (the time taken by the firm in processing cheque for internal
accounting purposes). When the firm's actual bank balance is greater than the balance shown in
the firm's books, the difference is called disbursement or payment float. Playing the float means
to maximize the availability of funds. The difference between the total amount of cheques drawn
on a bank account and the balance shown on the bank's book is caused by transit and processing
delays. If the financial manager can accurately estimate the transit and processing delays time, he
or she can invest the 'float' during the float period to earn a return. It is a risky game and should
be played very cautiously.
Q9. What are the objectives of a firm in controlling its disbursements? How can the
disbursements be slowed down?

Disbursements arise due to trade credit. The firm's effective control of disbursements can help in
conserving cash and reducing the financial requirements. The firm should make payments using
credit terms to the fullest extent. Delaying disbursements result in maximum availability of
funds. For proper control of disbursements, a centralized payment system may be advantageous,
and payments may be made from a single central account.

Q. 10 Explain the criteria that a firm should use in choosing the short term investment
alternatives in order to invest surplus cash.

A firm can invest its excess cash in many types of securities or short-term investment
opportunities. The primary criterion in selecting a security will be its quickest convertibility into
cash. The firm should examine the basic features of security: safety, maturity and marketability.
The firm would invest in very safe securities as the cash balance invested in them is needed in
near future. The short-term securities are preferred by the firm for the purpose of investing
excess cash. If the security can be sold quickly without loss of price, it is highly liquid or
marketable. The difference in marketability and also the default risk cause differences in the
security yields.

Q11. Other things remaining constant, what effect would the following events have on the
average cash balance that a firm keeps for transaction purposes? Explain your answer.

a) Increase in interest rates

b) It becomes more expensive to transfer funds from cash to securities and vice versa.

c) The variability of net cash flow increases.

a) Increase in interest rates encourages the financial manager to review the cash needs for
transaction purpose, and to reduce the optimum cash balance needs to earn the better yields by
investing money in short-term securities or marketable securities.
b) If the transfer of funds from cash to securities and vice-versa becomes more expensive, then
financial manager likes to have lesser total transaction costs for conversion. This will result into
increase in optimum cash balance.

c) As the variability of cash inflows increases, so financial manager would not like to have cash
shortages, i.e., stock-out situations, so he willmaintain larger amount of optimum cash balance.

a. US Treasury bills

b. Ordinary Preferred Stock

c. Negotiable Certificate of deposit (NCDs)

d. Commercial paper

Q12. Is it possible for a firm to have too much cash? Why would shareholders care if a firm
accumulates large amount of cash?

Yes. Once a firm has more cash than it needs for operations and planned expenditures, the excess
cash has an opportunity cost. It could be invested (by shareholders) in potentially more profitable
ways.

Q13. Cash Management. What options are available to a firm if it believes it has too much
cash? How about too little?

If it has too much cash it can simply pay a dividend, or, more likely in the current financial
environment, buy back stock. It can also reduce debt. If it has insufficient cash, then it must
either borrow, sell stock, or improve profitability.

Q14. Cash Management versus liquidity Management. What is the difference between cash
management and liquidity management?

Cash management is associated more with the collection and disbursement of cash. Liquidity
management is broader and concerns the optimal level of liquid assets needed by a firm. Thus,
for example, Ford and Chrysler’s stockpiling of cash was liquidity management; whereas,
evaluating a lockbox system is cash management.

Q15. Short-Term investments. Why a preferred stock with a dividend is tied to short-term
interest rates an attractive short-term investment for corporations with excess cash?

Such instruments go by a variety of names, but the key feature is that the dividend adjusts,
keeping the price relatively stable. This price stability, along with the dividend tax exemption,
makes so called adjustable rate preferred stock very attractive relative to interest-bearing
instruments.

Q16. Short-Term Investments. For each of the short-term marketable securities given here,
provide an example of the potential disadvantages the investment has for meeting a
corporation’s cash management goals:

e. Revenue anticipation notes

f. Repurchase agreements.

a. About the only disadvantage to holding T-bills are the generally lower yields compared to
alternative money market investments.

b. Some ordinary preferred stock issues pose both credit and price risks that are not consistent
with most short-term cash management plans.

c. The primary disadvantage of NCDs is the normally large transactions sizes, which may not be
feasible for the short-term investment plans of many smaller to medium-sized corporations.

d. The primary disadvantages of the commercial paper market are the higher default risk
characteristics of the security and the lack of an active secondary market which may excessively
restrict the flexibility of corporations to meet their liquidity adjustment needs.

e. The primary disadvantages of RANs is that some possess non-trivial levels of default risk, and
also, corporations are somewhat restricted in the type and amount of these tax-exempts that they
can hold in their portfolios.
f. The primary disadvantage of the repo market is the generally very short maturities available.

Q17. Agency Issues. It is sometimes argued that excess cash held by a firm can aggravate
agency problems and, more generally, reduce incentives for shareholder wealth
maximization. How would you frame the issue here?

The concern is that excess cash on hand can lead to poorly thought-out investments. The thought
is that keeping cash levels relatively low forces management to pay careful attention to cash flow
and capital spending.

Q18. Use of Excess Cash. One option a firm usually has with any excess cash is to pay its
suppliers more quickly. What are the advantages and disadvantages of this use of excess
cash?

A potential advantage is that the quicker payment often means a better price. The disadvantage is
that doing so increases the firm’s cash cycle.

Q19. Use of Excess Cash. Another option usually available is to reduce the firm’s
outstanding debt. What are the advantages and disadvantages of the use of excess cash?

This is really a capital structure decision. If the firm has an optimal capital structure, paying off
debt moves it to an under-leveraged position. However, a combination of debt reduction and
stock buybacks could be structured to leave capital structure unchanged.

20. Float. An unfortunately common practice goes like this (warning- don’t try this at
home.): Suppose you are out of money in your checking account; however , your local
grocery store will, as a convenience to you as a customer, cash a check for you. So you cash
a check for $200. Of course, this check will bounce unless you do something. To prevent
this, you go to the grocery next day and cash another check for $200. You take this $200
and deposit it. You repeat this process every day and in doing so you make sure that no
checks bounce. Eventually manna from heaven arrives (perhaps in the form of money from
home), and you are able to cover your outstanding checks.

To make it interesting, suppose you are absolutely certain that no checks will bounce along
the way. Assuming this is true, and ignoring any question of legality (what we have
described is probably illegal check kiting.), is there anything unethical about this? If you
say yes, then why? In particular, who is harmed?

It is unethical because you have essentially tricked the grocery store into making you an interest-
free loan, and the grocery store is harmed because it could have earned interest on the money
instead of loaning it to you.

INVENTORY MANAGEMENT

Q.1 Why should inventory be held? Why is inventory management important?

Explain the objectives of inventory management.

The manufacturing companies hold inventories in the form of raw materials,

work-in-process and finished goods. There are three motives for holding

inventories.

1. To facilitate smooth production and sales operation (transaction motive).

2. To guard against the risk of unpredictable changes in usage rate and delivery time
(precautionary motive).

3. To take advantage of price fluctuations (speculative motive).

Inventory management is important because inventories constitute about 60% of current assets of
public limited companies in India. The objective of inventory management should:

1. to ensure a continuous supply of raw materials to facilitate uninterrupted production,

2. maintain sufficient stock of raw materials in periods of short supply and anticipate price
changes,

3. maintain sufficient finished goods inventory for smooth sales operation, and efficient customer
service,

4. minimize the carrying cost and time, and

5. control investment in inventories and keep it at an optimum level.

Q.2 "There are two dangerous situations that management should usually avoid in
controlling inventories." Identify the danger points and explain.

The excessive and inadequate inventories are two danger points within which the firm should
operate. The objective of inventory management should be to determine and maintain optimum
level of inventory investment. The optimum level of inventory will lie between two danger
points.

The excessive level of inventories consumes funds of the firm, and thus it involves an
opportunity costs. The carrying costs, such as storage expenses, etc., also increase in proportion
of volume of inventory. This may create physical deterioration of inventories while in storage.
The inventories once purchased and stored normally are difficult to dispose off subsequently at
the same value. In other words, the value of inventory reduces with the increasing holding
period. The inadequate investment in inventories involves the following consequences.

1. Results in frequent production interruptions.

2. It may not be possible for the company to serve the customers properly and they may shift to
competitors.

So, the aim of inventory management is to maintain sufficient inventory for the smooth
production and sales operations.

Q.3 Define the economic order quantity. How is it computed?

Economic order quantity (EOQ) is the fixed quantity of material which is ordered when the stock
comes down to a reorder level. EOQ is at the optimum level when the total of ordering costs and
carrying costs is minimum. It is the point where ordering costs equal the carrying costs. Ordering
costs include costs incurred on requisitioning, purchase ordering, transporting, receiving,
inspecting and storing. It has direct relationship with number of orders placed. Carrying cost
includes storage, insurance, taxes, clerical and staff service costs, costs of deterioration and
obsolescence, etc.

Three methods are available to determine the economic order quantity (EOQ). It has been
assumed that total amount of demand is known with certainty and usage of materials is steady.
Also, ordering cost per order and carrying cost per unit are assumed to be constant.

1. Trial and error (T&E) approach: The inventory levels under different lot size alternatives are
worked out by preparing tables. The T&E method is a mechanical method involving somewhat
tedious computations.

2. Order formula approach:

2AO

EOQ =

Where, A is total requirement, O is the ordering costs and C is the carrying

costs.

3. Graphic approach: In the graphical approach, costs-carrying, ordering and total - are plotted on
vertical axis and horizontal axis is used to represent the order size. The EOQ occurs at the point
where total cost is minimum.
Q.4 "The management of inventory must meet two opposing needs." What are they? How
is a balance brought in these two opposing needs?

The efficient inventory management helps in balancing inventory carrying costs and stock-out
costs. Excessive inventory means more carrying costs but less stock-out situations while less
inventory implies less carrying costs but more stock-out situations.

It is difficult to predict usage and lead time accurately. If actual usage increases or the delivery of
inventory is delayed, the firm can face a problem of stock-out which can prove to be the costly.
Therefore, in order to guard against the stock-out, the firm may maintain a safety stock, as
cushion against expected increased usage and/or delayed delivery time. Thus, the re-order point
(i.e. stock level when to place order for inventory replenishment) can be increased by safety
stock. The excess inventory level will safeguard the firm against stock-out situation, but it is also
costly with respect to inventory carrying costs. Carrying costs include storage, insurance, taxes,
clerical and staff service costs, costs of deterioration etc. The balance can be worked out between
two by applying cost-benefit analysis, and by evaluating alternative strategies of safety stock
level.

Q.5 "The practical approach is determining economic order quantity is concerned with
locating a minimum cost range rather than a minimum cost point." Explain.

The total costs of inventory may be insensitive to moderate changes in order size. Hence, there
may be range rather than an exact point of optimum quantity. To determine this range, the order
size may be changed by some percentage and the impact on total costs may be studied. If the
total costs do not change significantly, the firm can change EOQ within the range without any
significant loss.

Q.6 What are ordering and carrying costs? What is their role in inventory control?

The ordering costs includes the entire costs of acquiring raw materials. They include costs
incurred relating to requisitioning, purchase ordering, transporting, receiving, inspecting and
storing, etc. It increases in proportion to the number of orders placed. The ordering costs
decrease with increasing size of investment. The carrying costs are incurred for maintaining a
given level of inventory. It includes storage, insurance, taxes, deterioration and obsolescence.
The storage costs comprise cost of storage space, stores handling costs, and clerical and staff
service costs incurred for store keeping, booking and accounting. Carrying costs vary with
inventory size. They decline with increase in inventory size. The economic size of inventory
would thus depend on trade-off between carrying costs and ordering costs.

Q.7 Define safety stock. How can safety stock be computed?

In practice, there is uncertainty about the lead time and/or usage rate. Under perfect certainty
about usage rate and lead time, the re-order point (inventory at which firm places order to
replenish inventory) will be equal to:

Lead time x usage rate

Firms maintain safety stock which serves as a buffer or cushion to meet contingencies. In that
case reorder point will be equal to: Lead time x usage rate + safety stock

Q8. What are the costs of stock-outs? How should the costs of stock-out and the carrying
costs be balanced to obtain the optimum safety stock?

It is difficult to predict usage and lead time accurately. If actual usage increases or the delivery of
inventory is delayed, the firm can face a problem of stock-out which can prove to be the costly.
Therefore, in order to guard against the stock-out, the firm may maintain a safety stock, as
cushion against expected increased usage and/or delayed delivery time. Thus, the re-order point
(i.e. stock level when to place order for inventory replenishment) can be increased by safety
stock. The excess inventory level will safeguard the firm against stock-out situation, but it is also
costly with respect to inventory carrying costs. Carrying costs include storage, insurance, taxes,
clerical and staff service costs, costs of deterioration etc. The balance can be worked out between
two extremely by applying cost-benefit analysis, and by evaluating alternative strategies of
safety stock level.

Q.9 How is the reorder point determined? Illustrate with an example and graphically.

The re-order point is that inventory level at which an order should be placed to replenish the
inventory. To determine, the reorder point under certainty, we should know (1) lead time, time
normally taken to replenishing inventory after the order has been placed, (2) average usage, and
(3) economic order quantity. The re-order point is calculated by:

Re-order point = Lead x average usage time

For example, if economic order quantity is 500 units; lead time is three weeks and average usage
is 50 units per week. If there is no lead time, i.e., delivery of inventory is instantaneous, the new
order will be placed at the end of 10th week [500 units/50 units]. But, as the lead time is three
weeks, the new order to be placed at the end of 7th week, when there are 150 [50 x 3] units in
stock. Re-order print = 3 weeks x 50 units = 150 units

Q.10 What is lead time? How does it affect the computation of reorder point under
certainty and uncertainty?

Lead time is the time normally taken in replenishing inventory after the order has been placed. In
the case of certainty, the usage and lead time do not fluctuate. So reorder point is simply that
level which will be maintained for consumption during lead time.

Reorder point = Lead time x Average usage

It is difficult to predict usage and lead time accurately. So, in the uncertainty, the firm can face a
problem of stock-out which can prove to be costly for the firm. Therefore, in order to guard
against stock out, the firm may maintain safety-stock-some minimum or buffer inventory as
cushion. In such case, re-order point is calculated as:

Reorder point = Lead time x Average usage + Safety stock

Q.11 Explain the steps involved in analyzing investment in inventories. Illustrate with an
example.

The analysis should involve an evaluation of the profitability of investment in inventory. The
analysis of investment in inventory should be analysed in the following four steps:

1. Estimation of operating profit

2. Estimation of investment in inventory.

3. Estimation of rate of return on investment in inventory, and

4. Comparison of the rate of return on investment with the cost of funds.

The incremental analysis should be used to compute the value of operating profits, investment in
inventory, rate of return and cost of funds. A change in inventory policy is desirable if the
incremental rate of return exceeds the required rate of return. The expected operating profit of
each inventory policy will depend on the contribution from increased sales minus the additional
carrying costs. The aim of the firm should be to maximize operating profit in relation to
investment viz., expected return on investment. The investment in inventory should be measured
in terms of out-of-pocket costs. The change in investment will be the sum of (1) increased
finished goods inventories, and (2) corresponding increase in other net working capital. The
incremental rate of return (r) on investment can be calculated by using following formula.

Incremental Operating Profit r = ------------------------------------

Incremental Investment

If the incremental rate of return, r, is greater than required rate of return, k, then particular
inventory policy can be chosen.

RECEIVABLES MANAGEMENT

Q.1 Explain the objective of credit policy? What is an optimum credit policy? Discuss.

The objective of credit policy is to promote sales up to that point where profit is maximized. To
achieve this basic goal, the firm should manage its credit policy in an effective manner to expand
its sales, regulate and control the credit and its management costs, and maintain debtors at an
optimum level. Optimum credit policy is the policy which maximizes the firm's value by
minimizing total cost for a given level of revenue. The value of the firm is maximized when the
incremental rate of return (also called marginal rate of return) of an investment is equal to the
incremental cost of funds (also called marginal cost of capital) used to finance the investment in
receivables. The incremental rate of return can be calculated as incremental operating profit
divided by the incremental investment in receivable. The incremental cost of funds is the rate of
return required by the suppliers of funds, given the risk of investment in accounts receivable.

Q.2 Is the credit policy that maximizes expected operating profit an optimum credit policy?
Explain.

Optimum credit policy does not mean the policy that maximizes the expected operating profit.
The cost of investment should also be considered. It means the policy that maximizes the net
incremental benefit, that is, difference between the expected operating profit and the cost of
capital.

Q.3 What benefits and costs are associated with the extension of credit? How should they
be combined to obtain an appropriate credit policy?

The length of time for which credit is extended to customers is called the credit period. A firm
lengthens credit period to increase its operating profit through expected sales. However, there
will be net increase in operating profit only when the cost of extended credit period is less than
the incremental operating profit. As the firm starts loosening its credit policy, it accepts all or
some of those accounts which the firm had rejected in past. Thus, the firm will recapture lost
sales, and thus, lost contribution. In addition, new accounts may be turned to the firm from
competitors resulting into increase contribution. The opportunity costs of lost sales declines, and
opportunity benefits of new sales increases as firm loosens the credit terms.

As the firm loosens its credit policy, the credit investigation costs, credit monitoring costs, bad-
debt losses, and collection costs increases in case of stringent credit policy.

The optimum or appropriate credit policy is such where the firm will obtain the maximum value
for the credit policy when the incremental rate of investment in receivable is equal to the
opportunity cost of capital i.e., the incremental cost of funds.

Q.4 What is the role of credit terms and credit standards in the credit policy of a firm?

Credit standards are criteria to decide to whom credit sales can be made and how much. If the
firm has soft standards and sells to almost all customers, its sales may increase but its costs in the
form of bad-debts losses and credit administration will also increase. The firm will have to
consider the impact in terms of increase in profits and increase in costs of a change in credit
standards or any other policy variable.

Credit standards influence the quality of firm's customers, i.e., the time taken by customers to
repay credit obligation, and the default rate. The time taken by customers to repay debt can be
determined by average collection period (ACP). Default risk can be measured in terms of bad-
debt losses ratio - the proportion of uncollected receivable. Default risk is the likelihood that a
customer will fail to repay the credit obligation. The estimate of probability of default can be
determined by evaluating the character, i.e., willingness of customer to pay; customer's ability to
pay and prevailing economic and other conditions. Based, on above, firm may categorize
customers into three kinds, viz., good accounts, bad accounts and moderate accounts.

The conditions for extending credit sales are called credit terms and they include the credit
period and cash discount. Cash discounts are given for receiving payments before than the
normal credit period. All customers do not pay within the credit period. Therefore, a firm has to
make efforts to collect payments from customers. The length of time for which credit is extended
to customers is called the credit period. A firm's credit policy may be governed by the industry
norms. But depending on its objective, the firm can lengthen the credit period. The firm may
tighten the credit period, if customers are defaulting too frequently and bad-debt losses are
building up.

Q.5 What are the objectives of the collection policy? How should it be established?

The primary objective of collection policy is to cause increase in sales, and to speed up the
collection of dues. The collection policy should ensure prompt and regular collection, keep down
collection costs and bad debts within limits and to maintain collection efficiency.

The collection procedure should be clearly defined in such a manner that the responsibility to
collect and the follow up should be clearly defined. This responsibility may be entrusted to the
separate credit department or accounts or sales department. Besides the general collection policy,
firm should lay-down clear cut collection procedures for past dues or delinquent accounts.

Q.6 What shall be the effect of the following changes on the level of the firm's receivables?

a) Interest rate increases

b) Recession

c) Production and selling costs increases

d) The firm changes its credit term from "2/10 net 30" to "3/10 net 30"

As the interest rate increases, the total cost of production increases resulting into more
investment in receivables.

During the recession, the sales level decreases, so the investment in receivable is supposed to
reduce. But the reduction may not take place on account of delayed recovery of amount due from
customers by firm. So, this may also cause the investment in receivables to increase.

The increases in production and selling costs result to more investment in receivables.

When company changes its terms from '2/10 net 30' to '3/10 net 30', this should normally result
into reduction in level of investments in receivable. But at the same moment, more customers
may be willing to avail cash discount resulting into increase in discount costs.

Q.7 "The credit policy of a company is criticized because the bad debt losses have increased
considerably and the collection period has also increased." Discuss under what conditions
this criticism may not be justified.

Generally it is a bad credit policy if bad debts increase and collection period also increases. But
in certain cases, once the company has recovered its fixed costs, selling to marginal customers
may be quite profitable as the contribution ratio may be quite high. This raises the possibility of
increased bad debts and high collection policy, but at the same time high profits. The company
should assess the probability of the extent of default and the probability of higher pay-offs.

Q.8. What credit and collection procedures should be adopted in case of individual
accounts? Discuss.

In case of individual accounts, customers may be categorized in to three types based on their
creditworthiness and default risk, viz., good accounts (financially strong); bad accounts
(financially very weak, high risk customers) and marginal accounts (customers with moderate
financial health and risk). The firm will have no difficulty in quickly deciding about the
extension of credit to good accounts, and rejecting the credit request for bad accounts. A credit
standards may be relaxed to the point where incremental returns equals to incremental costs in
case of marginal accounts, by evaluating all possibility of bad-debts losses and collection costs.

The collection procedures should be firmly established for good accounts and bad accounts. The
collection procedures for past dues or delinquent accounts should also be established in
unambiguous terms. The marginal accounts, i.e., slow paying permanent customers, are needed
to be handled tactfully. The collection process initiated quickly, without giving any chance to
them, may antagonize them, and the firm may lose them to competitors. In case of marginal
accounts, individual cases should be dealt with on their merits. The firm should also decide to
offer cash discount for prompt payment. For some cases, company may take precautions by
receiving pre-signed post dated cheques or approach for bills of exchange, etc.

Q.9 How would you monitor receivables? Explain the pros and cons of various methods.

A firm needs to continuously monitor and control its receivables to ensure the success of
collection efforts. Following are the methods to monitor and evaluate the management of
receivables.

1. Collection period method: The average collection period is calculated, and can be compared
with the firm's stated credit period to judge the collection efficiency. The average collection
period measures the quality of receivable since it indicates the speed of their collectibility.
Collection period only provides an aggregate picture. Further, it does not provide very
meaningful information about outstanding receivable when sales variations are quite high.

2. Aging schedule: It breaks down receivables according to the length of the time for which they
have been outstanding. It helps to spot out slow-paying customers. It also suffers from the
problem of aggregation, and does not relate receivables to sales of the same period.

3. Collection Experience Matrix: In this method, firm tries to relate receivables to the sales of the
same period. In this method, sales over a period of time are shown horizontally and associated
receivable vertically in a tabular form; thus, a matrix is constructed. This method indicates which
months' sales receivable are uncollected. It helps to focus efforts on the collection month-wise.
DIVIDEND DECISIONS

Q.1 "The contention that dividends have an impact on the share price has been
characterized as the bird-in-the-hand argument." Explain the essential of this argument.
Why this argument is considered fallacious?

According to the bird-in-the-hand argument, investors tend to behave rationally, are risk averse
and, therefore, have a preference for near dividends to future dividends. They most certainly
prefer to have their dividend today and let tomorrow take care of itself. Further, given two
companies with identical earnings record, and prospects but one paying a larger dividend will
always command higher share price because investors prefer present to future values. This
argument is fallacious, on the contention that, if the firm does not pay any dividend a shareholder
can create a "home made dividend" by selling a part of his/her shares at the fair market price in
the capital market for obtaining cash. This will not make any dilution in their wealth.

Q.2 "The assumptions underlying the irrelevance hypothesis of Modigliani and Miller are
unrealistic." Explain and interpret.

The M-M assumptions on dividend irrelevance are considered unrealistic on account of the
following reasons.

1. Investors have to pay different taxes on dividend income and capital gains.

2. The firm's internal and external financing are not equivalent, because flotation costs (e.g.
underwriting and brokers commission, etc.) are involved if new shares are issued.

3. The "homemade dividend" benefit cannot be fully realised by investors on account of

transaction costs (such as brokerage fee). Further, it is inconvenient to sell the shares by
investors.

4. Investors may have a desire to diversify the portfolios from the dividend income. If firm does
not distribute the dividends, then investors will be inclined to use a higher value of k if they
expect the firm to use retained earnings for internal financing.
5. The current receipt of money in the form of dividends is considered safer than the uncertain
potential gain in future by investors, etc.

Q.3 Give arguments to support the view that dividends are relevant.

A.3 Market imperfections may make dividends relevant. Dividends are relevant because some
shareholders need a steady source of income. Some shareholders are better off receiving
dividends now rather than in the future on account of risk of uncertainty. A tax system that treats
dividends favourably than capital gains can also result in high expectation by shareholders for
dividend income. In India, as per the existing law, the dividend income is non taxable, capital
gains arising within a year are taxable.

Q.4 What is the informational content of dividend payments? How does it affect the share
value?

A.4 It is contended that dividends are relevant because they have informational value. The
payment of dividends conveys that the company is profitable and financially strong. It is also
contended that dividends may offer tangible evidence of the firm's ability to generate cash, and,
as a result, the dividend policy of the firm affects the share price. If a company follows a
dividend policy of changing dividends with every cyclical change in earnings, the market price
of share may be affected little because shareholders knew the information. A greater increase in
the dividends than the earnings may convey to the shareholders that profitable investment
opportunities of the firm are diminishing. This may depress the market price of share in spite of
an increase in dividend payments.

Q.5 What is the relationship between taxes and dividend policy? Explain by citing the
impact of different tax system.

A.5 From the tax point of view, a shareholder should prefer dividend over capital gains on
account of dividend income tax exempted, while capital gain is taxable in India. In most
countries, different tax rates are applicable to dividends and capital gains. On account of tax
differential, some investors prefer lesser dividend income while others prefer larger dividend
income. Generally, following differential tax systems are implemented in different countries
regarding taxation of shareholders earnings.
1. Double taxation: The shareholders' earnings are taxed twice; first the corporate tax is levied on
profit of companies, and then dividends are taxed as ordinary income in the hands of
shareholders.

2. Single taxation: The shareholders are exempt from tax on dividend income; while earnings are
taxed at the corporate level.

3. Split-rate taxation: Corporate profits are divided into retained earnings and dividends for tax
purpose. Different tax rates are applied to retained earnings and amount distributed by way of
dividend.

4. Imputation taxation: The shareholders' earnings are not subjected to double taxation. A
company pays corporate tax on its earnings; shareholders pay personal taxes on dividend but get
full or partial tax relief for the tax paid by the company.

CONCEPT QUESTIONS

1. Dividend Policy Irrelevance How is it possible that dividends are so important , but at the
same time dividend policy is irrelevant?

Soln: Dividend policy deals with the timing of dividend payments, not the amounts ultimately
paid. Dividend policy is irrelevant when the timing of dividend payments doesn’t affect the
present value of all future dividends.

2. Stock Repurchases What is the impact of a stock repurchase on a company’s debt ratio? Does
this suggest another use for excess cash?

Soln: A stock repurchase reduces equity while leaving debt unchanged. The debt ratio rises. A
firm could, if desired, use excess cash to reduce debt instead. This is a capital structure decision.

3. Dividend Policy It is sometimes suggested that firms should follow a “residual” dividend
policy. With such a policy, the main idea is that a firm should focus on meeting its investment
needs and maintaining its desired debt-equity ratio. Having done so, a firm pays out any leftover,
or residual, income as dividends. What do you think would be the chief drawback to residual
dividend policy?

Soln: The chief drawback to a strict dividend policy is the variability in dividend payments. This
is a problem because investors tend to want a somewhat predictable cash flow. Also, if there is
information content to dividend announcements, then the firm may be inadvertently telling the
market that it is expecting a downturn in earnings prospects when it cuts a dividend, when in
reality its prospects are very good. In a compromise policy, the firm maintains a relatively
constant dividend. It increases dividends only when it expects earnings to remain at a sufficiently
high level to pay the larger dividends, and it lowers the dividend only if it absolutely has to.

4. Dividend Chronology On Tuesday, December 8, Hometown Power Co.’s board of directors

declares a dividend of 75 cents per share payable on Wednesday, January 17, to shareholders of
record as of Wednesday, January 3. When is the ex-dividend date? If a shareholder buys stock
before that date, who gets the dividend on those shares-the buyer or the seller?

Soln: Friday, December 29 is the ex-dividend day. Remember not to count January 1 because it
is a holiday, and the exchanges are closed. Anyone who buys the stock before December 29 is
entitled to the dividend, assuming they do not sell it again before December 29.

5. Alternative Dividends Some corporations, like one British company that offers its large
shareholders free crematorium use, pay dividends in kind(that is, offer their services to
shareholders at below-market cost). Should mutual funds invest in stocks that pay these
dividends in kind? (The fund holders do not receive these services.)

Soln: No, because the money could be better invested in stocks that pay dividends in cash which
benefit the fundholders directly.

6. Dividends and stock price If increases in dividends tend to be followed by (immediate)

increase in share prices, how can it be said that dividend policy is irrelevant?

Soln: The change in price is due to the change in dividends, not due to the change in dividend
policy. Dividend policy can still be irrelevant without a contradiction.
7. Dividends and Stock Price Last month, Central Virginia Power Company, which had been
having trouble with cost overruns on a nuclear power plant that it had been building, announced
that it was “temporarily suspending payments due to the cash flow crunch associated with its
investment program.” The company’s stock price dropped from $28.50 to $25 when this
announcement was made. How would you interpret this change in stock price?(that is, what
would you say caused it?)

Soln: The stock price dropped because of an expected drop in future dividends. Since the stock
price is the present value of all future dividend payments, if the expected future dividend
payments decrease, then the stock price will decline.

8. Dividend Reinvestment Plans The DRK Corporation has recently developed a dividend
reinvestment plan, or DRIP. The plan allows investors to reinvest cash dividends automatically
in DRK in exchange for new shares of stock. Over time, investors in DRK will be able to build
their holdings by reinvesting dividends to purchase additional shares of the company.

Over 1000 companies offer dividend reinvestment plans. Most companies with DRIP’s charge
no brokerage or service fees. In fact, the shares of DRK will be purchased at a 10 percent
discount from market price.

A consultant for DRK estimates that about 75 percent of DRK’s shareholders will take part in
this plan. This is somewhat higher than the average.

Evaluate DRK’s dividend reinvestment plan. Will it increase shareholder wealth? Discuss the
advantages and disadvantages involved here.

Soln: The plan will probably have little effect on shareholder wealth. The shareholders can
reinvest on their own, and the shareholders must pay the taxes on the dividends either way.
However, the shareholders who take the option may benefit at the expense of the ones who don’t
(because of the discount). Also as a result of the plan, the firm will be able to raise equity by
paying a 10% flotation cost (the discount), which may be a smaller discount than the market
flotation costs of a new issue for some companies.
9. Dividend Policy For initial public offerings of common stock, 2005 was relatively slow year,
with only about $28.4 billion raised by the process. Relatively few of 162 firms involved paid
cash dividends. Why do you think that most chose not to pay cash dividends?

Soln: If these firms just went public, they probably did so because they were growing and
needed the additional capital. Growth firms typically pay very small cash dividends, if they pay a
dividend at all. This is because they have numerous projects available, and they reinvest the
earnings in the firm instead of paying cash dividends.

10. Investment and Dividends The Phew Charitable Trust pays no taxes on its capital gains or
on its dividend income or interest income. Would it be irrational for it to have low-dividend, high
growth stocks in its portfolio? Would it be irrational for it to have municipal bonds in its
portfolio? Explain.

Soln: It would not be irrational to find low-dividend, high-growth stocks. The trust should be
indifferent between receiving dividends or capital gains since it does not pay taxes on either one
(ignoring possible restrictions on invasion of principal, etc.). It would be irrational, however, to
hold municipal bonds. Since the trust does not pay taxes on the interest income it receives, it
does not need the tax break associated with the municipal bonds. Therefore, it should prefer to
hold higher yield, taxable bonds.

Use the following information to answer the next two questions:

Historically, the U.S. tax code treated dividend payments made to shareholders as ordinary
income. Thus, dividends were taxed at the investor’s marginal tax rate which was as high as 38.6
percent in 2002. Capital gains were taxed at a capital gains tax rate, which was the same for most
investors and fluctuated through the years. In 2002, the capital gains tax rate stood at 20 percent.
In an effort to stimulate the economy, President George W. Bush presided over a tax plan
overhaul that included changes in dividend and capital gains tax rates. The new tax plan, which
was implemented in 2003, called for a 15 percent tax rate on both dividends and capital gains for
investors in higher tax brackets. For lower tax bracket investors, the tax rate on dividends and
capital gains was set at 5 percent through 2007, dropping to zero in 2008.
11. Ex-Dividend Stock Prices How do you think this tax law change affects ex-dividend stock
prices?

Soln:

The stock price drop on the ex-dividend date should be lower. With taxes, stock prices should
drop by the amount of the dividend, less the taxes investors must pay on the dividends. A lower
tax rate lowers the investors’ tax liability.

12. Stock Repurchases How do you think this tax law change affected the relative attractiveness
of stock repurchases compared to dividend payments?

Soln:

With a high tax on dividends and a low tax on capital gains, investors, in general, will prefer
capital gains. If the dividend tax rate declines, the attractiveness of dividends increases.

13. Dividends and Stock value The growing perpetuity model expresses the value of a share of
stock as the present value of the expected dividends from the stock. How can you conclude that
dividend policy is irrelevant when this model is valid?

Soln:

Knowing that share price can be expressed as the present value of expected future dividends does
not make dividend policy relevant. Under the growing perpetuity model, if overall corporate cash
flows are unchanged, then a change in dividend policy only changes the timing of the dividends.
The PV of those dividends is the same. This is true because, given that future earnings are held
constant, dividend policy simply represents a transfer between current and future stockholders.

In a more realistic context and assuming a finite holding period, the value of the shares should
represent the future stock price as well as the dividends. Any cash flow not paid as a dividend
will be reflected in the future stock price. As such, the PV of the cash flows will not change with
shifts in dividend policy; dividend policy is still irrelevant.
14. Bird-in-the-hand Argument The bird-in-the-hand argument, which states that a dividend
today is safer than the uncertain gain of capital gain tomorrow, is often used to justify high
dividend payout ratios. Explain the fallacy behind this argument.

Soln:

The bird-in-the-hand argument is based upon the erroneous assumption that increased dividends
make a firm less risky. If capital spending and investment spending are unchanged, the firm’s
overall cash flows are not affected by the dividend policy.

15. Dividends and Income Preference The desire for current income is not valid explanation of
preference for high current dividend policy because the investors can always create homemade
dividends by selling a portion of their stocks. Is this statement true or false? Why?

Soln:

This argument is theoretically correct. In the real world, with transaction costs of security
trading, home-made dividends can be more expensive than dividends directly paid out by the
firms. However, the existence of financial intermediaries, such as mutual funds, reduces the
transaction costs for individuals greatly. Thus, as a whole, the desire for current income
shouldn’t be a major factor favoring high- current-dividend policy.

16. Dividends and Clientele Cap Henderson owns Neotech stock because its price has been
steadily rising over the past few years and he expects this performance to continue. Cap is trying
to convince Sarah Jones to purchase some Neotech stocks, but she is reluctant because Neotech
has never paid a dividend. She depends on steady dividends to provide her with income.

a) What preferences are these two investors demonstrating?

b) What argument should Cap use to convince Sarah that Neotech stock is the stock for her?

c) Why might Cap’s argument not convince Sarah?

Soln:

a) Cap’s past behaviour suggests a preference for capital gains, while Widow Jones exhibits a
preference for current income.
b) Cap could show the Widow how to construct homemade dividends through the sale of stock.
Of course, Cap will also have to convince her that she lives in an MM world. Remember that
homemade dividends can only be constructed under the MM assumptions.

c) Widow Jones may still not invest in Neotech because of the transaction costs involved in
constructing homemade dividends. Also, the Widow may desire the uncertainty resolution which
comes with high dividend stocks.

17. Dividends and Taxes Your aunt is in high tax bracket and would like to minimize the tax
burden of her investment portfolio. She is willing to buy and sell to maximize her aftertax
returns, and she has asked for your advice. What would you suggest she do?

Soln:

To minimize her tax burden, your aunt should divest herself of high dividend yield stocks and
invest in low dividend yield stock. Or, if possible, she should keep her high dividend stocks,
borrow an equivalent amount of money and invest that money in a tax-deferred account.

18. Dividends versus Capital Gains If the market places the same value on $1 of dividends as
on $1 of capital gains, then firms with different payout ratios will appeal to different clienteles of
investors. One clientele is as good as another: therefore, a firm cannot increase its value by
changing its dividend policy. Yet empirical investigations reveal a strong correlation between
dividend payout ratios and other firm characteristics. For example, small, rapidly growing firms
that have recently gone public almost always have payout ratios that are zero: all earnings are
reinvested in the business. Explain this phenomenon if dividend policy is irrelevant.

Son:

The capital investment needs of small, growing companies are very high. Therefore, payment of
dividends could curtail their investment opportunities. Their other option is to issue stock to pay
the dividend, thereby incurring issuance costs. In either case, the companies and thus their
investors are better off with a zero dividend policy during the firms’ rapid growth phases. This
fact makes these firms attractive only to low dividend clienteles.
This example demonstrates that dividend policy is relevant when there are issuance costs.
Indeed, it may be relevant whenever the assumptions behind the MM model are not met.

19. Dividend Irrelevancy In spite of theoretical argument that dividend policy should be
irrelevant, the fact remains that many investors like high dividends. If this preference exists,

a firm can boost its share price by increasing its dividend payout ratio. Explain the fallacy in this
argument.

Soln:

Unless there is an unsatisfied high dividend clientele, a firm cannot improve its share price by
switching policies. If the market is in equilibrium, the number of people who desire high
dividend payout stocks should exactly equal the number of such stocks available. The supplies
and demands of each clientele will be exactly met in equilibrium. If the market is not in
equilibrium, the supply of high dividend payout stocks may be less than the demand. Only in
such a situation could a firm benefit from a policy shift.

20. Dividends and Stock Price Empirical research has found that there have been significant
increases in stock price on the day an initial dividend (i.e., the first time a firm pays a cash
dividend) is announced. What does this finding imply about this information content of initial
dividends?

Soln:

This finding implies that firms use initial dividends to “signal” their potential growth and
positive NPV prospects to the stock market. The initiation of regular cash dividends also serves
to convince the market that their high current earnings are not temporary.

1. The dividend policy of a firm is irrelevant in a perfect capital market because the
shareholder can effectively undo the firm's dividend strategy. If a shareholder receives a
greater dividend than desired, he or she can reinvest the excess. Conversely, if the
shareholder receives a smaller dividend than desired, he or she can sell off extra shares of
stock. This argument is due to MM and is similar to their homemade leverage concept,
discussed in a previous chapter.

2. Stockholders will be indifferent between dividends and share repurchases in a perfect

capital market.

3. Because dividends in the United States are taxed, companies should not issue stock to
pay out a dividend.

4. Also because of taxes, firms have an incentive to reduce dividends. For example, they
might consider increasing capital expenditures, acquiring other companies, or purchasing
financial assets. However, due to financial considerations and legal constraints, rational
firms with large cash flows will likely exhaust these activities with plenty of cash left
over for dividends.

5. In a world with personal taxes, a strong case can be made for repurchasing shares
instead of paying dividends.

6. Nevertheless, there are a number of justifications for dividends even in a world with
personal taxes:

a. Investors in no-dividend stocks incur transaction costs when selling off shares for
current consumption.

b. Behavioral finance argues that investors with limited self-control can meet current
consumption needs via high-dividend stocks while adhering to a policy of "never dipping
into principal."

c. Managers, acting on behalf of stockholders, can pay dividends to keep cash from
bondholders. The board of directors, also acting on behalf of stockholders, can use
dividends to reduce the cash available to spendthrift managers.

7. The stock market reacts positively to increases in dividends (or an initial payment) and
negatively to decreases in dividends. This suggests that there is information content in
dividend payments.

8. High (low) dividend firms should arise to meet the demands of dividend-preferring
(capital gains–preferring) investors. Because of these clienteles, it is not clear that a firm
can create value by changing its dividend policy.

Short term Finance & Planning

Dividends and Other Payouts

clientele effect

Argument that stocks attract clienteles based on dividend yield or taxes. For example, a
tax clientele effect is induced by the difference in tax treatment of dividend income and
capital gains income; high taxbracket individuals tend to prefer low-dividend yields.

date of payment

Date that dividend checks are mailed.

date of record

Date on which holders of record in a firm's stock ledger are designated as the recipients of
either dividends or stock rights.

declaration date

Date on which the board of directors passes a resolution to pay a dividend of a specified
amount to all qualified holders of record on a specified date.

ex-dividend date

Date four business days before the date of record for a security. An individual purchasing
stock before its ex-dividend date will receive the current dividend.

homemade dividends

An individual investor can undo corporate dividend policy by reinvesting excess

dividends or selling off shares of stock to receive a desired cash flow.

information-content effect
The rise in the stock price following the dividend signal.

regular cash dividends

Cash payment by firm to its shareholders, usually four times a year.

stock dividend

Payment of a dividend in the form of stock rather than cash. A stock dividend comes from
treasury stock, increasing the number of shares outstanding, and reduces the value of each
share.

stock split

The increase in the number of outstanding shares of stock while making no change in
shareholders' equity.