MBA608 2_Review of _Corporate Finance-converted-converted

From the above table it is quite clear that the value of the firm (V) will be increased if there is a proportionate increase in debt capital but there will be a reduction in overall cost of capital. So, Cost of Capital is increased and the value of the firm is maximum if a firm uses 100% debt capital. It is interesting to note the NI approach can also be graphically presented as under (with the help of the above illustration): 200 CU IDOL SELF LEARNING MATERIAL (SLM)

Figure 7.3 Behavior of Ke, Kw and Kd as per Net Income Approach The degree of leverage is plotted along the X-axis whereas Ke, Kw and Kd are on the Y-axis. It reveals that when the cheaper debt capital in the capital structure is proportionately increased, the weighted average cost of capital, Kw, decreases and consequently the cost of debt is Kd. Thus, it is needless to say that the optimal capital structure is the minimum cost of capital if financial leverage is one; in other words, the maximum application of debt capital. The value of the firm (V) will also be the maximum at this point. Net Operating Income Approach This approach is also provided by Durand. It is opposite of the Net Income Approach if there are no taxes. This approach says that the weighted average cost of capital remains constant. It believes in the fact that the market analyses a firm as a whole and discounts at a particular rate which has no relation to debt-equity ratio. If tax information is given, it recommends that with an increase in debt financing WACC reduces and value of the firm will start increasing. For more – Net Operating Income Approach. Now we want to highlight the Net Operating Income (NOI) Approach which was advocated by David Durand based on certain assumptions. They are: (i) The overall capitalization rate of the firm Kw is constant for all degree of leverages; 201 CU IDOL SELF LEARNING MATERIAL (SLM)

(ii) Net operating income is capitalized at an overall capitalization rate in order to have the total market value of the firm. Thus, the value of the firm, V, is ascertained at overall cost of capital (Kw): V = EBIT/Kw (since both are constant and independent of leverage) (iii) The market value of the debt is then subtracted from the total market value in order to get the market value of equity. S–V–T (iv) As the Cost of Debt is constant, the cost of equity will be Ke = EBIT – I/S The NOI Approach can be illustrated with the help of the following diagram: Behavior of Ke, Kw and Kd Net Operating Income Approach Under this approach, the most significant assumption is that the Kw is constant irrespective of the degree of leverage. The segregation of debt and equity is not important here and the market capitalizes the value of the firm as a whole. Thus, an increase in the use of apparently cheaper debt funds is offset exactly by the corresponding increase in the equity- capitalization rate. So, the weighted average Cost of Capital Kw and Kd remain unchanged for all degrees of leverage. Needless to mention here that, as the firm increases its degree of leverage, it becomes more risky proposition and investors are to make some sacrifice by having a low P/E ratio. Illustration 2: Assume: Net Operating Income or EBIT Rs. 30,000 Total Value of Capital Structure Rs. 2,00,000. Cost of Debt Capital Kd 10% Average Cost of Capital Kw 12% Calculate Cost of Equity, Ke: value of the firm V applying NOI approach under each of the following alternative leverages: Leverage (debt to total capital) 0%, 20%, 50%, 70%, and 100% 202 CU IDOL SELF LEARNING MATERIAL (SLM)

Although the value of the firm, Rs. 2,50,000 is constant at all levels, the cost of equity is increased with the corresponding increase in leverage. Thus, if the cheaper debt capital is used, that will be offset by the increase in the total cost of equity Ke, and, as such, both Ke and Kd remain unchanged for all degrees of leverage, i.e. if cheaper debt capital is propor•tionately increased and used, the same will offset the increase of cost of equity. Traditional Approach This approach does not define hard and fast facts. It says that the cost of capital is a function of the capital structure. The special thing about this approach is that it believes an optimal capital structure. Optimal capital structure implies that at a particular ratio of debt and equity, the cost of capital is minimum and value of the firm is maximum. For more – Traditional Approach. It is accepted by all that the judicious use of debt will increase the value of the firm and reduce the cost of capital. So, the optimum capital structure is the point at which the value of the firm is highest and the cost of capital is at its lowest point. Practically, this approach encompasses all the ground between the Net Income Approach and the Net Operating Income Approach, i.e., it may be called Intermediate Approach. The traditional approach explains that up to a certain point, debt-equity mix will cause the market value of the firm to rise and the cost of capital to decline. But after attaining the 203 CU IDOL SELF LEARNING MATERIAL (SLM)

optimum level, any additional debt will cause to decrease the market value and to increase the cost of capital. In other words, after attaining the optimum level, any additional debt taken will offset the use of cheaper debt capital since the average cost of capital will increase along with a corresponding increase in the average cost of debt capital. Thus, the basic proposition of this approach is: (a) The cost of debt capital, Kd, remains constant more or less up to a certain level and thereafter rises. (b) The cost of equity capital Ke, remains constant more or less or rises gradually up to a certain level and thereafter increases rapidly. (c) The average cost of capital, Kw, decreases up to a certain level remains unchanged more or less and thereafter rises after attaining a certain level. The traditional approach can graphically be represented under taking the data from the previous illustration: It is found from the above that the average cost curve is U-shaped. That is, at this stage the cost of capital would be minimum which is expressed by the letter ‘A’ in the graph. If we draw a perpendicular to the X-axis, the same will indicate the optimum capital structure for the firm. Thus, the traditional position implies that the cost of capital is not independent of the capital structure of the firm and that there is an optimal capital structure. At that optimal structure, the marginal real cost of debt (explicit and implicit) is the same as the marginal real cost of 204 CU IDOL SELF LEARNING MATERIAL (SLM)

equity in equilibrium. For degree of leverage before that point, the marginal real cost of debt is less than that of equity beyond that point the marginal real cost of debt exceeds that of equity. Illustration 3: Calculate the cost of capital and the value of the firm under each of the following alternative degrees of leverage and comment on them: 205 CU IDOL SELF LEARNING MATERIAL (SLM)

Thus, from the above table, it becomes quite clear the cost of capital is lowest (at 25%) and the value of the firm is the highest (at Rs. 2,33,333) when debt-equity mix is (1,00,000: 1,00,000 or 1: 1). Hence, optimum capital structure in this case is considered as Equity Capital (Rs. 1,00,000) and Debt Capital (Rs. 1,00,000) which bring the lowest overall cost of capital followed by the highest value of the firm. Variations on the Traditional Theory: This theory underlines between the Net Income Approach and the Net Operating Income Approach. Thus, there are some distinct variations in this theory. Some followers of the traditional school of thought suggest that Ke does not practically rise till some critical conditions arise. Only after attaining that level the investors apprehend the increasing financial risk and penalize the market price of the shares. This variation expresses that a firm can have lower cost of capital with the initial use of leverage significantly. 206 CU IDOL SELF LEARNING MATERIAL (SLM)

This variation in Traditional Approach is depicted as: Figure 7.4 Other followers e.g., Solomon, are of opinion the Ke is being saucer-shaped along with a horizontal middle range. It explains that optimum capital structure has a range where the cost of capital is rather minimized and where the total value of the firm is maximized. Under the circumstances a change in leverage has, practically, no effect on the total firm’s value. So, this approach grants some sort of variation in the optimal capital structure for various firms under debt-equity mix. Such variation can be depicted in the form of graphical representation: 207 CU IDOL SELF LEARNING MATERIAL (SLM)

Modigliani and Miller Approach (Mm Approach) It is a capital structure theory named after Franco Modigliani and Merton Miller. MM theory proposed two propositions. Proposition I: It says that the capital structure is irrelevant to the value of a firm. The value of two identical firms would remain the same and value would not affect by the choice of finance adopted to finance the assets. The value of a firm is dependent on the expected future earnings. It is when there are no taxes. Proposition II: It says that the financial leverage boosts the value of a firm and reduces WACC. It is when tax information is available. Modigliani-Miller’ (MM) advocated that the relationship between the cost of capital, capital structure and the valuation of the firm should be explained by NOI (Net Operating Income Approach) by making an attack on the Traditional Approach. The Net Operating Income Approach, supplies proper justification for the irrelevance of the capital structure. In Income Approach, supplies proper justification for the irrelevance ofthe capital structure. In this context, MM support the NOI approach on the principle that the cost of capital is not dependent on the degree of leverage irrespective of the debt-equity mix. In the words, according to their thesis, the total market value of the firm and the cost of capital are independent of the capital structure. They advocated that the weighted average cost of capital does not make any change with a proportionate change in debt-equity mix in the total capital structure of the firm. The same can be shown with the help of the following diagram: 208 CU IDOL SELF LEARNING MATERIAL (SLM)

Figure 7.6 Proposition: The following propositions outline the MM argument about the relationship between cost of capital, capital structure and the total value of the firm: (i) The cost of capital and the total market value of the firm are independent of its capital structure. The cost of capital is equal to the capitalization rate of equity stream ofoperating earnings for its class, and the market is determined by capitalizing its expected return at an appropriate rate of discount for its risk class. (ii) The second proposition includes that the expected yield on a share is equal to the appropriate capitalization rate of a pure equity stream for that class, together with a premium for financial risk equal to the difference between the pure-equity capitalization rate (Ke) and yield on debt (Kd). In short, increased Ke is offset exactly by the use of cheaper debt. (iii) The cut-off point for investment is always the capitalization rate which is completely independent and unaffected by the securities that are invested. Assumptions: The MM proposition is based on the following assumptions: (a) Existence of Perfect Capital Market It includes: (i) There is no transaction cost; (ii) Flotation costs are neglected; (iii) No investor can affect the market price of shares; (iv) Information is available to all without cost; (v) Investors are free to purchase and salesecurities. (b) Homogeneous Risk Class/Equivalent Risk Class: It means that the expected yield/return have the identical risk factor i.e., business risk is equal among all firms having equivalent operational condition. (c) Homogeneous Expectation: All the investors should have identical estimate about the future rate of earnings of each firm. (d) The Dividend pay-out Ratio is 100%: It means that the firm must distribute all its earnings in the form of dividend among the shareholders/investors, and (e) Taxes do not exist: 209 CU IDOL SELF LEARNING MATERIAL (SLM)

That is, there will be no corporate tax effect (although this was removed at a subsequent date). Interpretation of MM Hypothesis: The MM Hypothesis reveals that if more debt is included in the capital structure of a firm, the same will not increase its value as the benefits of cheaper debt capital are exactly set-off by the corresponding increase in the cost of equity, although debt capital is less expensive than the equity capital. So, according to MM, the total value of a firm is absolutely unaffected by the capital structure (debt-equity mix) when corporate tax is ignored. Proof of MM Hypothesis—The Arbitrage Mechanism: MM have suggested an arbitrage mechanism in order to prove their argument. They argued that if two firms differ only in two points viz. (i) the process of financing, and (ii) their total market value, the shareholders/investors will dispose-off share of the over-valued firm and will purchase the share of under-valued firms. Naturally, this process will be going on till both attain the same market value. As such, as soon as the firms will reach the identical position, the average cost of capital and the value of the firm will be equal. So, total value of the firm (V) and Average Cost of Capital, (Kw) are independent. It can be explained with the help of the following illustration: Let there be two firms, Firm ‘A’ and Firm ‘B’. They are similar in all respects except in the composition of capital structure. Assume that Firm ‘A’ is financed only by equity whereas Firm ‘B’ is financed by a debt-equity mix. The following particulars are presented: 210 CU IDOL SELF LEARNING MATERIAL (SLM)

From the table presented above, it is learnt that value of the levered firm ‘B’ is higher than the unlevered firm ‘A’. According to MM, such situation cannot persist long as the investors will dispose-off their holding of firm ‘B’ and purchase the equity from the firm ‘A’ with personal leverage. This process will be continued till both the firms have same market value. Suppose Ram, an equity shareholder, has 1% equity of firm ‘B’. He will do the following: (i) At first, he will dispose-off his equity of firm ‘B’ for Rs. 3,333. (ii) He will take a loan of Rs. 2,000 at 5% interest from personal account. (iii) He will purchase by having Rs. 5,333 (i.e. Rs. 3,333 + Rs. 2,000) 1.007% of equity from the firm ‘A’. By this, his net income will be increased as: Obviously, this net income of Rs. 433 is higher than that of the firm ‘B’ by disposing-off 1% holding. It is needless to say that when the investors will sell the shares of the firm ‘B’ and will purchase the shares from the firm ‘A’ with personal leverage, this market value of the share of firm ‘A’ will decline and, consequently, the market value of the share of firm ‘B’ will rise and this will be continued till both of them attain the same market value. We know that the value of the levered firm cannot be higher than that of the unlevered firm (other things being equal) due to that arbitrage process. We will now highlight the reverse direction of the arbitrage process. Consider the following illustration: 211 CU IDOL SELF LEARNING MATERIAL (SLM)

In the above circumstances, equity shareholder of the firm ‘A’ will sell his holdings and by the proceeds he will purchase some equity from the firm ‘B’ and invest a part of the proceeds in debt of the firm ‘B’. For instance, an equity shareholder holding 1% equity in the firm ‘A’ will do the following: (i) He will dispose-off his 1% equity of firm ‘A’ for Rs. 6,250. (ii) He will buy 1 % of equity and debt of the firm ‘B’ for the like amount. (iii) As a result, he will have an additional income of Rs. 86. Thus, if the investors prefer such a change, the market value of the equity of the firm ‘A’ will decline and, consequently, the market value of the shares of the firm ‘B’ will tend to rise and this process will be continued till both the firms attain the same market value, i.e., the arbitrage process can be said to operate in the opposite direction. Criticisms of the MM Hypothesis: We have seen (while discussing MM Hypothesis) that MM Hypothesis is based on some assumptions. There are some authorities who do not recognize such assumptions as they are quite unrealistic, viz. the assumption of perfect capital market. We also know that most significant element in this approach is the arbitrage process forming the behavioral foundation of the MM Hypothesis. As the imperfect market exists, the arbitrage process will be of no use and as such, the discrepancy will arise between the market value of the unlevered and levered firms. The shortcomings for which arbitrage process fails to bring the equilibrium condition are: (i) Existence of Transaction Cost: The arbitrage process is affected by the transaction cost. While buying securities, this cost is involved in the form of brokerage or commission etc. for which extra amount is to be paid which increases the cost price of the shares and requires a greater amount although the return is same. As such, the levered firm will enjoy a higher market value than the unlevered firm. (ii) Assumption of borrowing and lending by the firms and the individual at the same rate of interest: The above proposition that the firms and the individuals can borrow or lend at the same rate of interest, does not hold good in reality. Since a firm holds more assets and credit reputation 212 CU IDOL SELF LEARNING MATERIAL (SLM)

in the open market in comparison with an individual, the former will always enjoy a better position than the latter. As such, cost of borrowing will be higher in case of an individual than a firm. As a result, the market value of both the firms will not be equal. (iii) Institutional Restriction: The arbitrage process is retarded by the institutional investors e.g., Life Insurance Corporation of India, Commercial Banks; Unit Trust of India etc., i.e., they do not encourage personal leverage. At present these institutional investors dominate the capital market. (iv) “Personal or home-made leverage” is not the prefect substitute for “corporate leverage.”: MM hypothesis assumes that “personal leverage” is a perfect substitute for “corporate leverage” which is not true as we know that a firm may have a limited liability whereas there is unlimited liability in case of individuals. For this purpose, both of them have different footing in the capital market. (v) Incorporation of Corporate Taxes: If corporate taxes are considered (which should be taken into consideration) the MM approach will be unable to discuss the relationship between the value of the firm and the financing decision. For example, we know that interest charges are deducted from profit available for dividend, i.e., it is tax deductible. In other words, the cost of borrowing funds is comparatively less than the contractual rate of interest which allows the firm regarding tax advantage. Ultimately, the benefit is being enjoyed by the equity-holders and debt-holders. According to some critics the arguments which were advocated by MM, are not valued in the practical world. We know that cost of capital and the value of the firm are practically the product of financial leverage. MM Hypothesis with Corporate Taxes and Capital Structure: The MM Hypothesis is valid if there is perfect market condition. But, in the real world capital market, imperfection arises in the capital structure of a firm which affects the valuation. Because, presence of taxes invites imperfection. We are, now, going to examine the effect of corporate taxes in the capital structure of a firm along with the MM Hypothesis. We also know that when taxes are levied on income, debt 213 CU IDOL SELF LEARNING MATERIAL (SLM)

financing is more advantageous as interest paid on debt is a tax-deductible item whereas retained earnings or dividend so paid in equity shares are not tax-deductible. Thus, if debt capital is used in the total capital structure, the total income available for equity shareholders and/or debt holders will be more. In other words, the levered firm will have a higher value than the unlevered firm for this purpose, or, it can alternatively be stated that the value of the levered firm will exceed the unlevered firm by an amount equal to debt multiplied by the rate of tax. The same can be explained in the form of the following equation: Illustration 4: Assume: Two firms—Firm ‘A’ and Firm ‘B’ (identical in all respects except capital structure) Firm ‘A’ has financed a 6% debt of Rs. 1,50,000 Firm ‘B’ Levered EBIT (for both the firm) Rs. 60,000 Cost of Capital is @ 10% Corporate rate of tax is @ 60% Compute market value of the two firms. 214 CU IDOL SELF LEARNING MATERIAL (SLM)

Thus, a firm can lower its cost of capital continuously due to the tax deductibility of interest charges. So, a firm must use the maximum amount of leverage in order to attain the optimum capital structure although the experience that we realize is contrary to the opinion. In real-world situation, however, firms do not take a larger amount of debt and creditors/lenders also are not interested to supply loan to highly levered firms due to the risk involved in it. Thus, due to the market imperfection, after tax cost of capital function will be U-shaped. In answer to this criticism, MM suggested that the firm would adopt a target debt ratio so as not to violate the limits of level of debt imposed by creditors. This is an indirect way of stating that the cost of capital will increase sharply with leverage beyond some safe limit of debt. MM Hypothesis with corporate taxes can better be presented with the help of the following diagram: 215 CU IDOL SELF LEARNING MATERIAL (SLM)

Figure 7.7 SUMMARY Short term finance refers to financing needs for a small period normally less than a year. In businesses, it is also known as working capital financing. This type of financing is normally needed because of uneven flow of cash into the business, the seasonal pattern of business, etc. In most cases, it is used to finance all types of inventory, accounts receivables etc. At times, only specific one time orders of business are financed. Long-term finance can be defined as any financial instrument with maturity exceeding one year (such as bank loans, bonds, leasing and other forms of debt finance), and public and private equity instruments. Maturity refers to the length of time between origination of a financial claim (loan, bond, or other financial instrument) and the final payment date, at which point the remaining principal and interest are due to be paid. Equity, which has no final repayment date of a principal, can be seen as an instrument with nonfinite maturity. The one year cut-off maturity corresponds to the definition of fixed investment in national accounts. The Group of 20, by comparison, uses a maturity of five years more adapted to investment horizons in financial markets (G-20 2013). Depending on data availability and the focus, the report uses one of these two definitions to characterize the extent of long-term finance. Moreover, because there is no consensus on the precise definition of long-term finance, wherever possible, rather than use a specific definition of long-term finance, the report provides granular data showing as many maturity buckets and comparisons as possible. Everything you need to know about the theories of capital structure. Capital structure theories seek to explain the relationship between capital structure decision and the market value of the firm. There are conflicting opinions regarding whether or not capital structure decision (or leverage or proportion of debt and equity) affects the value of the firm (or shareholder’swealth). There is a viewpoint that strongly supports the close relationship between capital structure decision and value of a firm. There is an equally strong body of opinion which believes that capital structure decision has no impact on the value of the firm. Different theories are. Net Income (NI) Approach Net Operating Income Approach, Traditional Approach, Modigliani and Miller Approach with illustrations, formulas, calculations and graphs. KEYWORDS • Capital growth fund: An investment fund which invests principally in assets most likely to increase in value, such as shares and property. • Capital guaranteed fund: A Fund in which the original capital and the declared investment returns are guaranteed. 216 CU IDOL SELF LEARNING MATERIAL (SLM)

• Capital Structure: The debt and equity portfolio of a company balance sheet. Privately held companies can contain several levels (or tranches) of debt and equity in their capital structures. • Equity Ownership Structure: A schedule of who owns what type of equity of a specific investment. There are a variety of equity instruments available to owners of a company. These include preferred stock, common equity, equity options, equity warrants and convertible debt (that can be converted into equity). • Financial Leverage: Use of debt to increase the expected return on equity. Financial leverage is measured by the ratio of debt to debt plus equity. LEARNING ACTIVITY 1. Mehta Company Limited is expecting an annual EBIT of Rs. 2,00,000. The company has Rs. 5,00,000 in 10% debentures. The cost of equity capital or capitalization rate is 12.5%. Compute the value of the firm. 2. An organization expects a net income of Rs. 1,00,000. It has Rs. 1,50,000, 10 % debentures. The equity capitalization rate of the company is 12%. Calculate the value of the firm and overall capitalization rate according to the Net Income Approach (ignoring income- tax).If the debenture debt increased to Rs. 2,00,000, what shall be the value of the firm and the overall capitalization rate? UNIT END QUESTIONS A. Descriptive Question 1. Explain the NET OPERATING INCOME (NOI) approach. 2. Provide a critical review of the Modigliani Miller theorem, and thedominating literature that is pro and against this theory. 3. Explain, when determining financing needs what factor should businesses consider that would help decide whether they can repay the debt? 4. Discuss, what are the sources of finance? 5. Discuss long term financial costs. Describe and provide examples, ifpossible. Long Questions 217 CU IDOL SELF LEARNING MATERIAL (SLM)

6. Blueline Publishers is considering a recapitalization plan. It is currently 100% equity financed but under the plan it would issue long-term debt with a yield of 9% and use the proceeds to repurchase common stock. The recapitalization would not change the company s total assets, nor would it affect the firm's basic earning power, which is currently 15%. The CFO believes that this recapitalization would reduce the WACC and increase stock price. What would also be likely to occur if the company goes ahead with the recapitalization plan? 7. Mehta Company Limited is expecting an annual EBIT of Rs. 2,00,000. The company has Rs. 5,00,000 in 10% debentures. The cost of equity capital or capitalization rate is 12.5%. Compute the value of the firm. 8. An organization expects a net income of Rs. 1,00,000. It has Rs. 1,50,000, 10 % debentures. The equity capitalization rate of the company is 12%. Calculate the value of the firm and overall capitalization rate according to the Net Income Approach (ignoring income- tax). If the debenture debt increased to Rs. 2,00,000, what shall be the value of the firm and the overall capitalization rate? 9. A manufacturing company is expecting the Net Operating Income of is Rs. 200,000. The company has debenture lending of Rs 6,00,000 at 10% interest payable. The overall capitalization rate is 20%. Calculate the value of the firm and the equity capitalization rate as per the NOI approach. What will be the impact on value of the firm and equity capitalization firm if the debenture amount is increased to Rs. 7,50,000? 10. Company A and B are two similar businesses with similar business risks. Company A is unlevered whereas Company B is levered with Rs. 2,00,000 debenture @ 5% interest rates. Both the companies earn Rs. 50,000 before tax income. The after-tax capitalization rate is 10% and the corporate tax-rate is 40%. Calculate the market value of two firms. B. Multiple Choice Questions (MCQs) 1. Ordinary shares in limited companies: a. has a limited life, with no voting rights but receive dividends b. has an unlimited life, and voting rights and receivedividends c. has an unlimited life, and voting rights but receive no dividends d. has a limited life, and voting rights and receive dividends 2. Loans to limited companies: a. does not have a fixed term but receive interest which is allowable for corporation tax, and have voting rights 218 CU IDOL SELF LEARNING MATERIAL (SLM)

b. does not have a fixed term and receive interest which is allowable for corporation tax, but have no voting rights c. does have a fixed term and receive interest which is not allowable for corporationtax, but have no voting rights d. has a fixed term and receive interest which is allowable for corporation tax, but have no voting rights 3. External sources of finance do not include: a. debentures b. leasing c. retained earnings d. overdrafts 4. Which of the following is a characteristic of debentures? a. debentures are issued to raise debt funding. b. debentures are secured by a fixed or floating charge over the issuing entity's assets. c. debentures may be issued to the public via a prospectus. d. all of the options are characteristics of debentures. 5. Which factor does not impact financial contributions to voluntary organizations? a. Number of disaster events in a specific timeframe b. Perceived need of the affected populations c. Ability of the community to quickly organize d. Personal desire to donate 6. Which of the following working capital strategies is the most aggressive? 219 a. Making greater use of short term finance and maximizing net short term asset. b. Making greater use of long term finance and minimizing net short term asset. c. Making greater use of short term finance and minimizing net short term asset. d. Making greater use of long term finance and maximizing net short termasset. CU IDOL SELF LEARNING MATERIAL (SLM)

7. Which of the following would NOT improve the current ratio? a. Borrow short term to finance additional fixed assets. b. Issue long-term debt to buy inventory. c. Sell common stock to reduce current liabilities. d. Sell fixed assets to reduce accounts payable. 8. Proprietary ratio is calculated by a. Total assets/Total outside liability b. Total outside liability/Total tangible assets c. Fixed assets/Long term source of fund d. Proprietors’’ Funds/Total 9. In approach, the capital structure decision is relevant to the valuation of the firm. a. Net income b. Net operating income c. Traditional d. Miller and Modigliani 10. of a firm refers to the composition of its long-term funds and its capital structure. a. Capitalization b. Over-capitalization c. Under-capitalization d. Market capitalization Answers 4. d 5. C 6.c 7.a 8.d 9.a 10.a 1. b 2. b 3. c 220 CU IDOL SELF LEARNING MATERIAL (SLM)

SUGGESTED READING • \"Personal Finance - Definition, Overview, Guide to Financial Planning\". Corporate Finance Institute. Retrieved 2019-10-23. • Publishing, Speedy (2015-05-25). Finance (Speedy Study Guides). Speedy Publishing LLC. ISBN 978-1-68185-667-4. • \"Personal Finance - Definition, Overview, Guide to Financial Planning\". Corporate Finance Institute. Retrieved 2020-05-18. • Damodaran, A. (2007). Corporate Finance –Theory & Practice, Hoboken, New Jersey: John Wiley and Sons, Inc. • M Y Khan, P K Jain. (2018). Financial Management, New Delhi: Tata Mc Graw Hill. • Pandey, I.M. (2016). Financial Management. New Delhi: Vikas Publication House Pvt. Ltd. • Richard A Brealey, Stewart C myers, Franklin Allen, Pitabas Mohanty. (2018). Principles of Corporate Finance. New Delhi: Tata Mc Graw Hill. 221 CU IDOL SELF LEARNING MATERIAL (SLM)

UNIT 8 DIVIDEND DECISION 222 Structure Learning objectives Introduction Dividend Decisions Type of Dividend Decisions Long-Term Financing Decision: Wealth Maximization Decisions: Factors affecting Dividend Decisions of Firms: Limitation on Dividend Payments: Dividend policy Theories of Dividend Walter’s model: Gordon’s Model: Modigliani and Miller’s hypothesis: Determinants of Dividend Policy Summary Keywords Learning activity Unit end questions References LEARNING OBJECTIVES After studying this unit, you will be able to: • Explain Dividend decision, • To study the factors affecting various dividend decisions • List the dividend policy concept • State about theories of dividend CU IDOL SELF LEARNING MATERIAL (SLM)

INTRODUCTION Dividend refers to a reward, cash or otherwise, that a company gives to its shareholders. Dividends can be issued in various forms, such as cash payment, stocks or any other form. A company’s dividend is decided by its board of directors and it requires the shareholders’ approval. However, it is not obligatory for a company to pay dividend. Dividend is usually a part of the profit that the company shares with its shareholders. After paying its creditors, a company can use part or whole of the residual profits to reward its shareholders as dividends. However, when firms face cash shortage or when it needs cash for reinvestments, it can also skip paying dividends. When a company announces dividend, it also fixes a record date and all shareholders who are registered as of that date become eligible to get dividend payout in proportion to their shareholding. The company usually mails the cheques to shareholders within in a week or so. Stocks are normally bought or sold with dividend until two business days ahead of the record date and then they turn ex-dividend. A recent study found that dividend-paying firms in India fell from 24 per cent in 2001 to almost 16 per cent in 2009 before rising to 19 per cent in 2010. In the US, some of the companies like Sun Microsystems, Cisco and Oracle do not pay dividends and reinvest their total profit in the business itself. Dividend payment usually does not affect the fundamental value of a company’s share price. Companies with high growth rate and at an early stage of their ventures rarely pay dividends as they prefer to reinvest most of their profit to help sustain the higher growth and expansion. On the other hand, established companies try to offer regular dividends to reward loyal investors. DIVIDEND DECISIONS The Dividend Decision is one of the crucial decisions made by the finance manager relating to the pay-outs to the shareholders. The pay-out is the proportion of Earning Per Share given to the shareholders in the form of dividends. The companies can pay either dividend to the shareholders or retain the earnings within the firm. The amount to be disbursed depends on the preference of the shareholders and the investment opportunities prevailing within the firm. The optimal dividend decision is when the wealth of shareholders increases with the increase in the value of shares of the company. Therefore, the finance department must consider all the decisions viz. Investment, Financing and Dividend while computing the payouts. If attractive investment opportunities exist within the firm, then the shareholders must be convinced to forego their share of dividend and reinvest in the firm for better future returns. At the same time, the management must ensure that the value of the stock does not get adversely affected due to less or no dividends paid out to the shareholders. 223 CU IDOL SELF LEARNING MATERIAL (SLM)

The objective of the financial management is the Maximization of Shareholder’s Wealth. Therefore, the finance manager must ensure a win-win situation for both the shareholders and the company. TYPES OF DIVIDEND DECISIONS Long-Term Financing Decision: As long-term financing decision the significance of the profits of the firm after tax is to be considered in paying dividends. Investor should know that cash dividends have the nature of reducing the funds of the firm and firm is restricted to grow or to find other financing sources. If the firm desires to fund dividend as a long-term decision, then it should be guided by the following points. Projects available with the firm: When a firm has many large projects to put its investments then instead of distributing a large amount of profit it may retain earnings of the firm and advance these projects. Requirement of equity funds: A company may be able to finance itself either through long-term loans or through raising of capital such as equity and preference shares. To raise capital also, the firm has to incur a large cost. The company may thus take a decision of retaining some part of the earnings of the firm and may be guided by this view at the time of paying dividends to shareholders. Wealth Maximization Decisions: While the firm regards the needs of investment and expansion programmes and is guided by the decision of paying dividends as a long-term financing requirement, the other decisions that the firm may be guided by, is the project of paying to the shareholders a high amount of dividend to satisfy them and also to raise the price of its equity stock in the capital market. This project takes into consideration the expectation of both the investors and the shareholders. The management may adopt any one of these methods after taking into consideration the factors which affect the dividend decisions. Factors affecting Dividend Decisions of Firms: There are many factors affecting the decisions relating to dividends to be declared to 224 CU IDOL SELF LEARNING MATERIAL (SLM)

shareholders. These are discussed below: i. Expectation of Investors: People who invest in the firms have basically done so, with the view of long-term investment in a particular firm to avoid the necessity of shifting from one firm to another. The expectation of the investor has been two fold. They expect to receive income annually and have a stable investment. Capital Gains: All investors who are less interested in speculation and more interested in long-term investment do so with a view to making some capital appreciation on their investment. Capital gain is the profit, which results from the sale of any capital investment. If the investor invests in equity stock, the capital gain would be out of the sale of equity stock after holding it for a reasonable period of time. Current Income: The investor would like to have some current earnings which are also continuous in nature and it is the price of abstinence from current consumption to more profitable avenues. The expectation of the shareholder should be considered before taking any appropriate decision regarding dividends. In this sense, the company has to think of both maximization of wealth of the investor as well as its own internal requirements for long-term financing. Reducing of Uncertainty: Dividends should be declared in a manner that the investor is confident about the future of his earnings. If he receives dividends annually and the amount is such that it satisfies him then the company is able to gain his confidence because it reduces his uncertainty about future capital gains or appreciation of the company’s equity stock. A current dividend is the present value cash in-flow to the investors. This also helps him to assess the kind of future that his investments will carry for him. The decisions for paying dividend should also considered this point. Financial Strength: 225 CU IDOL SELF LEARNING MATERIAL (SLM)

The payment of dividend which is regular, stable and continuous with a promise of capital appreciation, helps the company in judging its own financial strength and also it receives financial commitments from creditors and financial institutions because they are in a position to gauge the kind of working of the firm through the information they receive regarding the amount of dividend and the market value of their shares. While all investors would like to maximize their wealth, the company must also see its requirement for expansion programs. The company also has certain limitations or environmental constraints which enable it to pay dividend in a limited form. Limitation on Dividend Payments: The firm has the following limitations in paying dividends. The management of the firm while making decision in paying out dividends to its shareholders should also analyze these problems: i. Cash Requirements: Many firms are unable to pay dividends regularly. A company which is going through its gestation period or is small in nature and is trying to expand its business has the problem of paying high dividends. If it does, it will be surrounded by inefficiency because of the insufficiency of cash. Sometimes, a firm has the problem of tying up all resources in inventories or in the commitment of purchasing long-term investments. This acts as a restraint of the firm to pay out dividends. ii. Limitations Placed by Creditors: Sometimes, a firm requires funds for long-term purpose and to fulfil this obligation it makes, the use of funds on long-term loans. While taking these loans the firm makes an arrangement with the creditors that it will not pay dividends to its shareholders till its debt equity ratio depicts 2:1. Sometimes, the firm also makes contractual obligations with its creditors to maintain a certain pay-out ratio till the time that it is using the loan facilities. Under these contractual obligations, the firm cannot pay more than the dividends it can, or is allowed to pay, under the agreement. iii. Legal Constraints: In India, there are many legal constraints in payment of dividends. The payment of dividends 226 CU IDOL SELF LEARNING MATERIAL (SLM)

is subject to government policy and tax laws. This restraint also covers bonds, debentures and equity shares. There are regulatory authorities such as Reserve Bank of India, Securities Exchange Board of India, Insurance Regulatory Authority of India. Income Tax Act of India and Companies Act followed in India. These legal constraints should be carefully analyzed before paying dividends to the shareholders. DIVIDEND POLICY The Dividend Policy is a financial decision that refers to the proportion of the firm’s earnings to be paid out to the shareholders. Here, a firm decides on the portion of revenue that is to be distributed to the shareholders as dividends or to be ploughed back into the firm. The amount of earnings to be retained back within the firm depends upon the availability of investment opportunities. To evaluate the efficiency of an opportunity, the firm assesses a relationship between the rate of return on investments “r” and the cost of capital “K.” As per the dividend models, some practitioners believe that the shareholders are not concerned with the firm’s dividend policy and can realize cash by selling their shares if required. While the others believed that, dividends are relevant and have a bearing on the share prices of the firm. This gave rise to the following models: 1. Miller and Modigliani Hypothesis- Dividend Irrelevance Theory 2. Walter’s Model – Dividend Relevance Theory 3. Gordon’s Model- Dividend Relevance Theory As long as returns are more than the cost, a firm will retain the earnings to finance the projects, and the shareholders will be paid the residual dividends i.e. the earnings left after financing all the potential investments. Thus, the dividend payout fluctuates from year to year, depending on the availability of investment opportunities. THEORIES OF DIVIDEND Some of the major different theories of dividend in financial management are as follows: 1. Walter’s model 2. Gordon’s model 3. Modigliani and Miller’s hypothesis. On the relationship between dividend and the value of the firm different theories have been advanced. They are as follows: 1. Walter’s model 2. Gordon’s model 227 CU IDOL SELF LEARNING MATERIAL (SLM)

3. Modigliani and Miller’s hypothesis Walter’s model: Professor James E. Walter argues that the choice of dividend policies almost always affects the value of the enterprise. His model shows clearly the importance of the relationship between the firm’s internal rate of return (r) and its cost of capital (k) in determining the dividend policy that will maximize the wealth of shareholders. Walter’s model is based on the following assumptions: 1. The firm finances all investment through retained earnings; that is debt or new equity is not issued; 2. The firm’s internal rate of return (r), and its cost of capital (k) are constant; 3. All earnings are either distributed as dividend or reinvested internally immediately. 4. Beginning earnings and dividends never change. The values of the earnings per share (E), and the divided per share (D) may be changed in the model to determine results, but any given values of E and D are assumed to remain constant forever in determining a givenvalue. 5. The firm has a very long or infinite life. Walter’s formula to determine the market price per share (P) is as follows: P = D/K +r(E-D)/K/K The above equation clearly reveals that the market price per share is the sum of the present value of two sources of income: i) The present value of an infinite stream of constant dividends, (D/K) and ii) The present value of the infinite stream of stream gains. [r (E-D)/K/K] Criticism: Walter’s model is quite useful to show the effects of dividend policy on an all equity firm under different assumptions about the rate of return. However, the simplified nature of the model can lead to conclusions which are net true in general, though true for Walter’s model. The criticisms on the model are as follows: 1. Walter’s model of share valuation mixes dividend policy with investment policy of the firm. The model assumes that the investment opportunities of the firm are financed by retained earnings only and no external financing debt or equity is used for the purpose when such a situation exists either the firm’s investment or its dividend policy or both will besub- 228 CU IDOL SELF LEARNING MATERIAL (SLM)

optimum. The wealth of the owners will maximize only when this optimum investment in made. 2. Walter’s model is based on the assumption that r is constant. In fact decreases as more investment occurs. This reflects the assumption that the most profitable investments are made first and then the poorer investments are made. The firm should step at a point where r = k. This is clearly an erroneous policy and fall to optimize the wealth of the owners. 3. A firm’s cost of capital or discount rate, K, does not remain constant; it changes directly with the firm’s risk. Thus, the present value of the firm’s income moves inversely with the cost of capital. By assuming that the discount rate, K is constant, Walter’s model abstracts from the effect of risk on the value of the firm. Gordon’s Model: One very popular model explicitly relating the market value of the firm to dividend policy is developed by Myron Gordon. Assumptions: Gordon’s model is based on the following assumptions. 1. The firm is an all Equity firm 2. No external financing is available 3. The internal rate of return (r) of the firm is constant. 4. The appropriate discount rate (K) of the firm remains constant. 5. The firm and its stream of earnings are perpetual 6. The corporate taxes do not exist. 7. The retention ratio (b), once decided upon, is constant. Thus, the growth rate (g) = br is constant forever. 8. K > br = g if this condition is not fulfilled, we cannot get a meaningful value for the share. According to Gordon’s dividend capitalization model, the market value of a share (Pq) is equal to the present value of an infinite stream of dividends to be received by the share. Thus: The above equation explicitly shows the relationship of current earnings (E,), dividend policy, (b), internal profitability (r) and the all-equity firm’s cost of capital (k), in the determination of the value of the share (P0). 229 CU IDOL SELF LEARNING MATERIAL (SLM)

Modigliani and Miller’s hypothesis: According to Modigliani and Miller (M-M), dividend policy of a firm is irrelevant as it does not affect the wealth of the shareholders. They argue that the value of the firm depends on the firm’s earnings which result from its investment policy. Thus, when investment decision of the firm is given, dividend decision the split of earnings between dividends and retained earnings is of no significance in determining the value of the firm. M – M’s hypothesis of irrelevance is based on the following assumptions. 1. The firm operates in perfect capital market 2. Taxes do not exist 3. The firm has a fixed investment policy 4. Risk of uncertainty does not exist. That is, investors are able to forecast future prices and dividends with certainty and one discount rate is appropriate for all securities and all time periods. Thus, r = K = Kt for all t. Under M – M assumptions, r will be equal to the discount rate and identical for all shares. As a result, the price of each share must adjust so that the rate of return, which is composed of the rate of dividends and capital gains, on every share will be equal to the discount rate and be identical for all shares. Thus, the rate of return for a share held for one year may be calculated as follows: Where P^ is the market or purchase price per share at time 0, P, is the market price per share at time 1 and D is dividend per share at time 1. As hypothesized by M – M, r should be equal for all shares. If it is not so, the low-return yielding shares will be sold by investors who will purchase the high-return yielding shares. This process will tend to reduce the price of the low-return shares and to increase the prices of the high-return shares. This switching will continue until the differentials in rates of return are eliminated. This discount rate will also be equal for all firms under the M-M assumption since there are no risk differences. From the above M-M fundamental principle we can derive their valuation model as follows: Multiplying both sides of equation by the number of shares outstanding (n), we obtain the value of the firm if no new financing exists. 230 CU IDOL SELF LEARNING MATERIAL (SLM)

If the firm sells m number of new shares at time 1 at a price of P^, the value of the firm at time 0 will be The above equation of M – M valuation allows for the issuance of new shares, unlike Walter’s and Gordon’s models. Consequently, a firm can pay dividends and raise funds to undertake the optimum investment policy. Thus, dividend and investment policies are not confounded in M – M model, like waiter’s and Gordon’s models. Criticism: Because of the unrealistic nature of the assumption, M-M’s hypothesis lacks practical relevance in the real world situation. Thus, it is being criticized on the following grounds. 1. The assumption that taxes do not exist is far from reality. 2. M-M argue that the internal and external financing are equivalent. This cannot be true if the costs of floating new issues exist. 3. According to M-M’s hypothesis the wealth of a shareholder will be same whether the firm pays dividends or not. But, because of the transactions costs and inconvenience associated with the sale of shares to realize capital gains, shareholders prefer dividends to capitalgains. 4. Even under the condition of certainty it is not correct to assume that the discount rate (k) should be same whether firm uses the external or internal financing. If investors have desire to diversify their port folios, the discount rate for external and internal financing will be different. 5. M-M argues that, even if the assumption of perfect certainty is dropped and uncertainty is considered, dividend policy continues to be irrelevant. But according to number of writers, dividends are relevant under conditions of uncertainty. DETERMINANTS OF DIVIDEND POLICY Some of the most important determinants of dividend policy are: (i) Type of Industry (ii) Age of Corporation (iii) Extent of share distribution (iv) Need for additional Capital (v) Business Cycles (vi) Changes in Government Policies (vii) Trends of profits (vii) Trends of profits (viii) Taxation policy (ix) Future Requirements and (x) Cash Balance. The declaration of dividends involves some legal as well as financial considerations. From the point of legal considerations, the basic rule is that dividend can only be paid out profits 231 CU IDOL SELF LEARNING MATERIAL (SLM)

without the impairment of capital in any way. But the various financial considerations present a difficult situation to the management for coming to a decision regarding dividend distribution. These considerations are discussed below: (i) Type of Industry: Industries that are characterized by stability of earnings may formulate a more consistent policy as to dividends than those having an uneven flow of income. For example, public utilities concerns are in a much better position to adopt a relatively fixed dividend rate than the industrial concerns. (ii) Age of Corporation: Newly established enterprises require most of their earning for plant improvement and expansion, while old companies which have attained a longer earning experience, can formulate clear cut dividend policies and may even be liberal in the distribution of dividends. (iii) Extent of share distribution: A closely held company is likely to get consent of the shareholders for the suspension of dividends or for following a conservative dividend policy. But a company with a large number of shareholders widely scattered would face a great difficulty in securing such assent. Reduction in dividends can be affected but not without the co-operation of shareholders. (iv) Need for additional Capital: The extent to which the profits are ploughed back into the business has got a considerable influence on the dividend policy. The income may be conserved for meeting the increased requirements of working capital or future expansion. (v) Business Cycles: During the boom, prudent corporate management creates good reserves for facing the crisis which follows the inflationary period. Higher rates of dividend are used as a tool for marketing the securities in an otherwise depressed market. (vi) Changes in Government Policies: Sometimes government limits the rate of dividend declared by companies in a particular industry or in all spheres of business activity. The Government put temporary restrictions on 232 CU IDOL SELF LEARNING MATERIAL (SLM)

payment of dividends by companies in July 1974 by making amendment in the Indian Companies Act, 1956. The restrictions were removed in 1975. (vii) Trends of profits: The past trend of the company’s profit should be thoroughly examined to find out the average earning position of the company. The average earnings should be subjected to the trends of general economic conditions. If depression is approaching, only a conservative dividend policy can be regarded as prudent. (viii) Taxation policy: Corporate taxes affect dividends directly and indirectly— directly, in as much as they reduce the residual profits after tax available for shareholders and indirectly, as the distribution of dividends beyond a certain limit is itself subject to tax. At present, the amount of dividend declared is tax free in the hands of shareholders. (ix) Future Requirements: Accumulation of profits becomes necessary to provide against contingencies (or hazards) of the business, to finance future- expansion of the business and to modernize or replace equipment’s of the enterprise. The conflicting claims of dividends and accumulations should be equitably settled by the management. (x) Cash Balance: If the working capital of the company is small liberal policy of cash dividend cannot be adopted. Dividend has to take the form of bonus shares issued to the members in lieu of cash payment. The regularity of dividend payment and the stability of its rate are the two main objectives aimed at by the corporate management. They are accepted as desirable for the corporation’s credit standing and for the welfare of shareholders. High earnings may be used to pay extra dividends but such dividend distributions should be designed as “Extra” and care should be taken to avoid the impression that the regular dividend is being increased. A stable dividend policy should not be taken to mean an inflexible or rigid policy. On the other hand, it entails the payment of a fair rate of return, taking into account the normal growth of business and the gradual impact of external events. A stable dividend record makes future financing easier. It not only enhances the credit- 233 CU IDOL SELF LEARNING MATERIAL (SLM)

standing of the company but also stabilizes market values of the securities outstanding. The confidence of shareholders in the corporate management is also strengthened. Legal rules governing payment of dividends: It is illegal to pay a dividend, if after its payment; the capital would be impaired (reduced). This requirement might be met if only capital surplus existed. An upward revaluation of assets, however, would create a capital surplus, but at the same time might operate as a fraud on creditors and for that reason is illegal. Basically the dividend laws were intended to protect creditors and therefore prohibit payment of a dividend if a corporation is insolvent or if the dividend payment will cause insolvency. The corporate laws must be taken into consideration by the directors before they declare a dividend. The company can postpone the distribution of dividend in cash, which may be conserved for strengthening the financial condition of the company by declaring stock dividend or bonus shares. To sum up, the decision with regard to dividend policy rests on the judgement of the management, since it is not a contractual obligation like interest. The formulation of dividend policy requires a balanced financial judgement by judiciously weighting the different factors affecting the policy. Stock dividend or bonus shares: A stock dividend is a distribution of additional shares of stock to existing shareholders on a pro-rata basis i.e. so much stock for each share of stock held. Thus, a 10% stock dividend would give a holder of ICQ shares, as additional 10 shares, whereas a 250% stock dividend would give him 250 additional shares. A stock dividend has no immediate effect upon assets. It results in a transfer of an amount from the accumulated earnings or surplus account to the share capital account. In other words, the reserves are capitalized and their ownership is formally transferred to the shareholders. The equity of the shareholders in the corporation increases. Stock dividends do not alter the cash position of the company. They serve to commit the retained earnings to the business as a part of its fixed capitalization. Reasons for declaring a stock dividend: Two principal reasons which usually actuate the directors to declare a stock dividend are: (1) They consider it advisable to reduce the market value of the stock and thereby facilitate a 234 CU IDOL SELF LEARNING MATERIAL (SLM)

broader distribution of ownership. (2) The corporation may have earnings but may find it inadvisable to pay cash dividends. The declaration of a stock dividend will give the stock holders evidence of the increase in their investment without interfering with the company’s cash position. If the stock holders prefer cash to additional stock in the company, they can sell the stock received as dividend. Sometimes, a stock dividend is declared to protect the interests of old stock holders when a company is about to sell a new issue of stock (so that new shareholders should not share the accumulated surplus). Limitations of stock dividends: The bonus shares entail an increase in the capitalization of the corporation and this can only be justified by a proportionate increase in the earning capacity of the corporation. Young companies with uncertain earnings or companies with fluctuating income are likely to take great risk by distribution stock dividends. Every stock dividend carries an implied promise that future cash dividends will be maintained at a steady level because of the permanent capitalization of reserves. Unless the corporate management has reasonable grounds of entertaining this hope, the wisdom of large stock dividend is always subject to grave suspicion. The existence of legal sanction for distributing the accumulated earnings or reserves does not warrant the issue of stock dividends from the point of view of sound financial practice. There should be other conditioning factors also for the issue of stock dividend. (a) Bonus shares bring about a capitalization of undistributed profits in the companies where the profits originate and this led to a linear development of corporate enterprise and greater concentration of economic power. (b) By issuing stock dividends-the corporations deprive the capital market of‘secondary’ funds which would otherwise have flowed into more widely dispersed investments. (c) Bonus shares enable companies to appropriate to their own use undistributed profits which, otherwise, would have led either to an increase in the share of labor or a reduction in prices for the consumer. SUMMARY A dividend policy is the policy a company uses to structure its dividend payout to shareholders. Some researchers suggest the dividend policy is irrelevant, in theory, because investors can sell a portion of their shares or portfolio if they need funds. This is the dividend irrelevance theory, which infers that dividend payouts minimally affect a stock's price. 235 CU IDOL SELF LEARNING MATERIAL (SLM)

KEYWORDS • Dividends: Dividends are payments made by a corporation to its shareholder members. It is the portion of corporate profits paid out to stockholders. • Capital loss: The loss in the value of an investment, calculated by the difference between the purchase price and the net sales price. • Capital preservation: An investment goal or objective to keep the original investment amount (the principal) from decreasing in value. • Diversification: The practice of investing in multiple asset classes and securities with different risk characteristics. • Dividend: Money an investment fund or company pays to its stockholders, typically from profits. The amount is usually expressed on a per-share basis. LEARNING ACTIVITY 1. The stock price of Alps Co. is $53.90. Investors require a return of 13 percent on similar stocks. If the company plans to pay a dividend of $3.60 next year, what growth rate is expected for the company's stock price? (Do not round intermediate calculations and enter the answer as a percent rounded to 2 decimal places) 2. Knudsen Corporation was organized on January 1, 2016. During its first year, the corporation issued 1,950 shares of $50 par value preferred stock and 110,000 shares of $10 par value common stock. At December 31, the company declared the following cash dividends: 2016, $6,325; 2017, $13,900; and 2018, $28,500. a. Show the allocation of dividends to each class of stock, assuming the preferredstock dividend is 7% and noncumulative. b. Show the allocation of dividends to each class of stock, assuming the preferred stock dividend is 9% and cumulative. c. Journalize the declaration of the cash dividend at December 31, 2018, under part (b). UNIT END QUESTIONS 236 A. Descriptive Question CU IDOL SELF LEARNING MATERIAL (SLM)

1. Define dividend decisions. 2. Explain wealth maximization decisions. 3. Stuart sold 200 shares of stock he owned. He purchased the stock three years ago for $28 per share. Following is a table that shows the market value of the stock at the end of each year and the amount of the dividend that Stuart received during the year: Year Market Value per share Dividend per share 1 $26 $0.60 2 $28 $0.60 3 $32 $0.60 What return did Stuart earn for each year he held the stock? 4. Discuss, why would an organization issue dividends? When might it decide not to do so? 5. The following events occurred during 2016 for Titus Corporation and have not been recorded: a. 1/10/2016 - Issued 200,000 shares of stock at $16 per share. b. 1/25/2016 - The law firm that helped the company incorporate and file all forms for the stock issue accepts 1,000 shares of newly issued stock in lieu of cash for its legal bill rendered. The amount of the legal bill was $20,000. c. 6/10/2016 - Titus Corporation declares a 50 cent per share dividend payable July 15 to shareholders of record as of June 30, 2016. d. 6/30/2016 - The record date for the dividend declared on June 10. e. 7/15/2016 - The dividend declared on June 10 is paid. f. 9/15/2016 - Titus Corporation declares a 10% stock dividend payable on September30 to shareholders of record as of September 20. The market value of the stock was $15 immediately prior to the declaration of the stock dividend. g. 9/30/2016 - The stock dividend declared on September 15 is paid. h. 10/15/2016 - Titus Corporation buys 5,000 shares of its own stock on the open market for $18 per share. i. 12/18/2016 - Titus Corporation resells 2,000 shares of the treasury stock for $20 per 237 CU IDOL SELF LEARNING MATERIAL (SLM)

share. Prepare journal entries in good form for the transactions listed above. 6. Cape Corp. will pay a dividend of $3.30 next year. The company has stated that it will maintain a constant growth rate of 5.25 percent a year forever. a. If you want a return of 18 percent, how much will you pay for the stock? b. If you want a return of 12 percent, how much will you pay for the stock? 7. Explain theories of determinants. B. Multiple Choice Questions (MCQs) 1. Which of the following examples best represents a passive dividend policy? a. The firm sets a policy such that the proportion of dividends paid from net income remains constant. b. The firm pays dividends with what remains of net income after taking acceptable investment projects. c. The firm sets a policy such that the quantity (dollar amount per share) of dividends paid from net income remains constant. d. All of the above are examples of various types of passive dividend policies. 2. Modigliani and Miller argue that the dividend decision . a. is irrelevant as the value of the firm is based on the earning power of its assets b. is relevant as the value of the firm is not based just on the earning power of its assets c. is irrelevant as dividends represent cash leaving the firm to shareholders, who ownthe firm anyway d. is relevant as cash outflow always influences other firm decisions 3. Financial signaling has been raised as an argument in the battle over the relevancy of dividends. Which of the following statements concerning dividends is most likely to be voiced by someone using the financial signaling argument? a. A dividend decrease should be viewed by investors as \"good news.\" The dividend decrease acts to add conviction to the statement that the firm has better uses for the earnings of the company than the stockholders. b. Reported accounting earnings of a company, not dividends, are a proper reflection or 238 CU IDOL SELF LEARNING MATERIAL (SLM)

signal of the company's economic earnings. c. The price of a firm's stock should react unfavorably to an increase in dividends. d. Cash dividends speak louder than words when it comes to conveying information about management's expectations of the future. 4. A number of legal rules help to establish the legal boundaries within which a firm's finalized dividend policy can operate. These legal rules have to do with capital impairment, insolvency, and undue retention of earnings. Some states have a (an) rule, while the Internal Revenue Service has a (an) rule. a. capital impairment; insolvency b. undue retention of earnings; insolvency c. insolvency rule; capital impairment d. capital impairment (or insolvency); undue retention of earnings 5. Firm Pickemon, Inc. has had earnings of $3.20, $3.00, and $5.50 per share for the past three years. The firm anticipates maintaining the same dividend policy this year as the past three years. That dividend policy has resulted in dividends per share of $1.28, $1.20, and $2.20 for the past three years. It is anticipated that the next year will result in a large increase in earnings to $9.80 per share. What dividend do you expect the firm to pay in the next year? a. $3.92 b. $1.56 c. $3.12 d. $4.68 6. Investors may be willing to pay a premium for stable dividends because of the informational content of , the desire of investors for , and certain . a. institutional considerations; dividends; current income. b. dividends; current income; institutionalconsiderations. c. current income; dividends; institutionalconsiderations. d. institutional considerations; current income;dividends. 239 CU IDOL SELF LEARNING MATERIAL (SLM)

7. The dividend-payout ratio is equal to a. the dividend yield plus the capital gains yield. b. dividends per share divided by earnings per share. c. dividends per share divided by par value per share. d. dividends per share divided by current price per share. 8. An offer by a firm to repurchase some of its own shares is known as a. a DRIP. b. a self-tender offer. c. a reverse split. 9. If Ian O'Connor Enterprises, Inc., repurchased 50 percent of its outstanding common stock from the open (secondary) market, the result would be a. a decline in EPS. b. an increase in cash. c. a decrease in total assets. d. an increase in the number of stockholders. 10. Which of the following is an argument for the relevance of dividends? a. Informational content. b. Reduction of uncertainty. c. Some investors' preference for current income. d. All of these Answers 1. b 2. a 3. d 4. d 5. a 6. B 7.b 8.b 9.c 10.a REFERENCES • Huston, Jeffrey L.: The Declaration of Dependence: Dividends in the Twenty-First Century. (Archway Publishing, 2015, ISBN 1480825042) • Freedman, Roy S.: Introduction to Financial Technology. (Academic Press, 2006, ISBN 0123704782) 240 CU IDOL SELF LEARNING MATERIAL (SLM)

• DK Publishing (Dorling Kindersley): The Business Book (Big Ideas Simply Explained). (DK Publishing, 2014, ISBN 1465415858) • Chambers, Clem (July 14, 2006). \"Who needs stock exchanges?\". MondoVisione.com. Retrieved May 14, 2017. • Damodaran, A. (2007). Corporate Finance –Theory & Practice, Hoboken, New Jersey: John Wiley and Sons, Inc. • M Y Khan, P K Jain. (2018). Financial Management, New Delhi: Tata Mc Graw Hill. • Pandey, I.M. (2016). Financial Management. New Delhi: Vikas Publication House Pvt. Ltd. • Richard A Brealey, Stewart C myers, Franklin Allen, Pitabas Mohanty. (2018). Principles of Corporate Finance. New Delhi: Tata Mc Graw Hill. 241 CU IDOL SELF LEARNING MATERIAL (SLM)

UNIT 9 RISK MANAGEMENT Structure Learning objectives Introduction Concept of Risk Management Corporate risk management Protecting Shareholders Economic Value Book Value Strategic risk management Project risk management Project risk management tools Business Risk Management (BRM) Summary Keywords Learning activity Unit end questions References LEARNING OBJECTIVES After studying this unit, you will be able to: • State the risk management • Explain the concept of corporate, strategic and project risk management INTRODUCTION Risk management is the identification, evaluation, and prioritization of risks (defined in ISO 31000 as the effect of uncertainty on objectives) followed by coordinated and economical application of resources to minimize, monitor, and control the probability or impact of unfortunate events or to maximize the realization of opportunities. Risks can come from various sources including uncertainty in financial markets, threats from project failures (at any phase in design, development, production, or sustaining of life- 242 CU IDOL SELF LEARNING MATERIAL (SLM)

cycles), legal liabilities, credit risk, accidents, natural causes and disasters, deliberate attack from an adversary, or events of uncertain or unpredictable root-cause. There are two types of events i.e. negative events can be classified as risks while positive events are classified as opportunities. Risk management standards have been developed by various institutions, including the Project Management Institute, the National Institute of Standards and Technology, actuarial societies, and ISO standards. Methods, definitions and goals vary widely according to whether the risk management method is in the context of project management, security, engineering, industrial processes, financial portfolios, actuarial assessments, or public health and safety. Strategies to manage threats (uncertainties with negative consequences) typically include avoiding the threat, reducing the negative effect or probability of the threat, transferring all or part of the threat to another party, and even retaining some or all of the potential or actual consequences of a particular threat. The opposite of these strategies can be used to respond to opportunities (uncertain future states with benefits). Certain risk management standards have been criticized for having no measurable improvement on risk, whereas the confidence in estimates and decisions seems to increase. For example, one study found that one in six IT projects were \"black swans\" with gigantic overruns (cost overruns averaged 200%, and schedule overruns 70%). CONCEPT OF RISK MANAGEMENT Concept # 1. Risk Exposure Analysis: The most basic way of protecting against risk is to deal only with creditworthy counterparties. This is easier said than done! It is the responsibility of the lender to understand and evaluate the risk. Gaining this understanding can be achieved through identifying categories of risk and then addressing the issues associated with each of these categories. One of the measures that could be adopted is risk exposure analysis. For this purpose, banks have to establish an appropriate and adequate system for monitoring and reporting risk exposures. A periodic overview by the Board and senior management would be necessary. Reporting system developed for this purpose would involve: (a) Evaluating the level and trends of the bank’s aggregated rate risk exposure, particularly interest rate, (b) Evaluating the sensitivity and reasonableness of key assumptions—such as those dealing with changes in the shape of the yield curve or in the pace of anticipated loan prepayments or deposit withdrawals, 243 CU IDOL SELF LEARNING MATERIAL (SLM)

(c) Verifying compliance withthe established risk tolerance levels and limits andidentifying any policy exceptions, and (d) Determining whether the bank holds sufficient capital for the risk being taken. The reports provided to the board and senior management should be clear, concise, and timely and provide the information needed for making decisions. The measures would include: Limiting Risks: A sound system of integrated institution-wide limits and risk-taking guidelines is an essential component of the risk management process. Global limits should be set for each major type of risk involved. These limits should be consistent with the bank’s overall risk measurement approach and should be integrated to the fullest extent possible with institution-wide limits on those risks as they arise in all other activities of the firm. The limit system should provide the capability to allocate limits down to individual business units. At times, especially when markets are volatile, traders may exceed their limits. When such exceptions occur, the facts should be made known to the senior management and approved only by authorized personnel. Reporting: An accurate, informative, and timely management information system is essential to the prudent operation of security trading or derivatives activity. More frequent reports should be made as market conditions dictate. Reports to other levels of senior management and the board may occur less frequently, but examiners should determine whether the frequency of reporting provides these individuals with adequate information to judge the changing nature of the institution’s risk profile. Management Evaluation and Review: Management should ensure that the various components of a bank’s risk management process are regularly reviewed and evaluated. This review should take into account changes in the activities of the institution and in the market environment, since the changes may have created exposures that require additional management and further examination. Any material changes to the risk management system should also be reviewed. Assumptions should be evaluated on a continual basis. Banks should also have an effective process to evaluate and review the risks involved in products that are either new to the firm or new to 244 CU IDOL SELF LEARNING MATERIAL (SLM)

the marketplace and of potential interest to the firm. Managing Specific Risks: Various risks are to be addressed differently when it comes to the issue of risk exposure analysis. Credit Risk: Master netting agreements and various credit enhancements, such as collateral or third party guarantees, can be used by banks to reduce their counterparty credit risk. In such cases, a bank’s credit exposures should reflect these risk reducing features only to the extent that the agreements and recourse provisions are legally enforceable in all relevant jurisdictions. This legal enforceability should extend to any insolvency proceedings of the counterparty. Banks should be able to demonstrate that they have exercised due diligence in evaluating the enforceability of these contracts and that individual transactions have been executed in a manner that provides adequate protection to the bank. Credit limits that consider both settlement and pre-settlement exposures should be established for all counterparties with whom the bank trades. Trading activities that involve cash instruments often involve short-term exposures that are eliminated at settlement. However, in the case of derivative products traded in over-the- counter markets, the exposure can often exist for a period similar to that commonly associated with a bank loan. Market Risk: Banks should establish limits for market risk that relate to their risk measures and that are consistent with maximum exposures authorized by their senior management and board of directors. These limits should be allocated to business units and individual traders and be clearly understood by all relevant parties. Liquidity Risk: Banks face two types of liquidity risks in their trading activities: (a) those related to specific products or markets, and (b) those related to the general funding of the bank’s trading activities. The former is the risk that a banking institution cannot easily unwind or offset a particular position at or near the previous market price because of inadequate market depth or because 245 CU IDOL SELF LEARNING MATERIAL (SLM)

of disruptions in the marketplace. In the Funding liquidity risk the bank will be unable to meet its payment obligations on settlement dates. Since neither type of liquidity risk is unique, the management should evaluate these risks in the broader context of the institution’s overall liquidity. When establishing limits, banks should be aware of the size, depth and liquidity of the particular market and establish trading guidelines accordingly. In developing guidelines for controlling the liquidity risks exposures in trading activities, banks should consider the possibility that they could lose access to one or more markets, either because of concerns about the bank’s own creditworthiness, the creditworthiness of a major counterparty, or because of generally stressful market conditions. At such times, the bank may have less flexibility in managing its market, credit, and liquidity risk exposures. The bank’s liquidity plan should reflect the ability to turn to alternative markets, such as futures or cash markets, or to provide sufficient collateral or other credit enhancements in order to continue trading under a broad range of scenarios. Operational and Legal Risk: Operating risk is caused due to deficiencies in information systems or internal controls, resulting in unexpected loss. Legal risk arises when contracts are not legally enforceable or documented correctly. Although operating and legal risks are difficult to quantify, they can often be monitored by examining a series of plausible “worst-case” or “what if” scenarios, such as a power loss, a doubling of transaction volume, a mistake found in the pricing software for collateral management, or an unenforceable contract. They can also be assessed through periodic reviews of procedures, documentation requirements, data processing systems, contingency plans, and other operating practices. Such reviews may help reduce the likelihood of errors and breakdowns in controls, improve the control of risk and the effectiveness of the limit system, and prevent unsound marketing practices and the premature adoption of new products or lines of business. Banks should also ensure that trades that are consummated orally are confirmed in writing as soon as possible. Transactions conducted via telephone should be recorded on tape and subsequently supported by written documents. Legal risks should be limited and managed through policies developed by the institution’s legal counsel (typically in consultation with officers in the risk management process) that have been approved by the bank’s senior management and board of directors. Banks should also ensure that the counterparty has sufficient authority to enter into the transaction and that 246 CU IDOL SELF LEARNING MATERIAL (SLM)

the terms of the agreement are legally sound. Banks should also ascertain whether their netting agreements are adequately documented, that they have been executed properly, and that they are enforceable in all relevant jurisdictions. Banks should have knowledge of relevant tax laws and interpretations governing the use of these instruments. To address this issue, risk managers have developed “stress testing,” which is a risk- management tool used to evaluate the potential impact on portfolio values of unlikely, although plausible, events or movements in a set of financial variables. While such unlikely outcomes do not mesh easily with VaR analysis, analysis of these outcomes can provide further information on expected portfolio losses over a given time horizon. Accordingly, stress testing is used increasingly as a complement to the more standard statistical models used for VaR analysis. Stress testing is mostly used in managing market risk, which deals primarily with traded market portfolios. These portfolios include interest rate, equity, foreign exchange, and commodity instruments and are amenable to stress testing because their market prices are updated on a regular basis. In addition to providing a “reality check” on VaR models, stress testing has been found to be an effective communication tool between a firm’s senior management and its business lines. The communication advantage that stress tests have over VaR analysis is their explicit linking of potential losses to a specific and concrete set of events. That is, stress tests can be thought of as exercises based on a unique set of outcomes for the relevant risk factors—interest rates change by a certain number of basis points, the US $ dollar depreciates by a certain percent, and so on. In contrast, in the VaR framework, there is no unique configuration of the underlying risk factors that is identified with the value of, say, a portfolio falling below a given level. Again, however, stress tests and VaR analysis provide different information and are considered to be complementary. Stress Testing: Stress-testing techniques fall into two general categories: sensitivity tests and scenario tests. Sensitivity tests assess the impact of large movements in financial variables on portfolio values without specifying the reasons for such movements. A typical example might be a 100 basis point increase across the yield curve or a 10% decline in stock market indexes. These tests can be run relatively quickly and are commonly used as a first approximation of the portfolio impact of a financial market move. 247 CU IDOL SELF LEARNING MATERIAL (SLM)

However, the analysis lacks historical and economic content, which can limit its usefulness for longer-term risk-management decisions. Scenario tests are constructed either within the context of a specific portfolio or in the light of historical events common across portfolios. In a stylized version of the specific portfolio approach, risk managers identify a portfolio’s key financial drivers and then formulate scenarios in which these drivers are stressed beyond standard VaR (Value-at-Risk) levels. For the event-driven approach, stress scenarios are based on plausible but unlikely events, and the analysis addresses how these events might affect the risk factors relevant to a portfolio. Commonly used events for historical scenarios are the large US $ stock market declines of October 1987, the Asian financial crisis of 1997, the financial market fluctuations surrounding the Russian default of 1998, and financial market developments following the September 11,2001, terrorist attacks in the United States. The choice of portfolio-based or event-based scenarios depends on several factors, including the relevance of historical events to the portfolio and the firm resources available for conducting the exercise. Historical scenarios are developed more fully since they reflect an actual stressed market environment that can be studied in great detail, thereby requiring fewer judgments by risk managers. Since such events may not be relevant to a specific portfolio, hypothetical scenarios that are directly relevant can be crafted, but only at the cost of a more labor-intensive and judgmental process. Hybrid scenarios are commonly used, where risk managers construct scenarios that are informed by historical market movements that may not be linked to a specific event. Historical events also can provide information for calibrating movements in other market factors, such as firm credit quality and market liquidity. More generally, risk managers always face a trade-off between scenario realism and comprehensibility; that is, more fully developed scenarios generate results that are more difficult to interpret. Stress testing is an appealing risk-management tool because it provides risk managers with additional information on possible portfolio losses arising from extreme, although plausible, scenarios. In addition, stress scenarios can often be an effective communication tool within the banks and to outside parties, such as supervisors and investors. The Exposure Document: For a better risk exposure analysis, banks can develop an exposure document. It may contain information on the banking corporation’s existing exposure to the various market risks, credit risks and liquidity risks in a condensed form in a comprehensive manner. This document shall include (a) A description of all the risks, to which the bank is exposed, giving information on changes in exposures, the parties authorized to deal with each 248 CU IDOL SELF LEARNING MATERIAL (SLM)

exposure, and their authority, (b) Details of the steps taken to minimize the operational risks and the legal risks, etc. An updated exposure document shall be submitted to the board and the management to include all discussions in which decisions are made and changes determined in the bank’s preferred risk- exposure mix. It can also include the regular periodic discussions of the updated exposures document. Role of the Board: 1. The board of directors of a bank shall discuss and approve a policy of exposure to the various risks, and set the permitted ceiling exposures in the various activity segments. It shall also discuss and approve the organizational format for managing and controlling the bank’s overall exposure to the various risks. 2. The board shall hold the discussion, grade the risks, and set limits after considering the quality of the bank’s existing tools for managing and controlling every type of risk and in every type of activity. 3. It would ensure that approvals are given to all new activities of the bank, (e.g. a new derivative financial instrument significantly different from those currently existing in the bank, the creation of a new type of exposure, market making, etc.) 4. Consideration shall be given to all the risks involved in the new activity, after checking the mechanisms the bank will use to manage, measure, and control the risks. It would set quantitative limits required as a result of the risks inherent in the new activity, and ascertain the availability of necessary manpower, sources of finance, and computer and technological infrastructure. This would facilitate proper absorption and management of the activity and its consistency with the existing activities. Role of the Risk Manager: In the light of the policy and decisions of the board of directors, the risk manager will deal with: 1. On-going management of exposures, directing the various units involved in managing the bank’s financial instruments and creating exposures in the various activity segments. 2. Making recommendations to the board of directors and management about the authority and the type of financial instruments, which are permitted in the formation and hedging of risks. 3. Making recommendations to the board of directors and management on all matters related 249 CU IDOL SELF LEARNING MATERIAL (SLM)