Assignment No.

3
Course Name & Code: Corporate
Finance(BAT661)
MBA Sem/Year: 1st/ 2nd Batch: 2019-21
Date of Submission: 26
March2020

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Faculty Name: Prof. Rasna Student Name: Ajay kumar
Pathak
Batch: 2019- 2021
Max. Marks:
Marks UID: 19MBA1120
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Q1. MODIGILANI – MILLER THEQORY IS A PROPONENT OF ‘ DIVIDEND
IRRELEVANCE’ NOTION. EXPLAIN THE RELEVANCE OF THE STATEMENT.

MODIGLIANI- MILLER THEORY ON DIVIDEND Modigliani – Miller theory is a major

POLICY:
proponent of ‘Dividend Irrelevance’ notion. According to this concept, investors do not pay any
importance to the dividend history of a company and thus, dividends are irrelevant in
calculating the valuation of a company. This theory is in direct contrast to the ‘Dividend
Relevance’ theory which deems dividends to be important in the valuation of a company.
Modigliani – Miller theory was proposed by Franco Modigliani and Merton Miller in 1961. They
were the pioneers in suggesting that dividends and capital gains are equivalent when an
investor considers returns on investment. The only thing that impacts the valuation of a
company is its earnings, which is a direct result of the company’s investment policy and the
future prospects. So, according to this theory, once the investment policy is known to the
investor, he will not need any additional input on the dividend history of the company. The
investment decision is, thus, dependent on the investment policy of the company and not on
the dividend policy. Modigliani – Miller theory goes a step further and illustrates the practical
situations where dividends are not relevant to investors. Irrespective of whether a company
pays a dividend or not, the investors are capable enough to make their own cash flows from the
stocks depending on their need for the cash. If the investor needs more money than the
dividend he received, he can always sell a part of his investments to make up for the difference.
Likewise, if an investor has no present cash requirement, he can always reinvest the received
dividend in the stock. Thus, the Modigliani – Miller theory firmly states that the dividend policy
of a company has no influence on the investment decisions of the investors. This theory also
believes that dividends are irrelevant by the arbitrage argument. By this logic, the dividends
distribution to shareholders is offset by the external financing. Due to the distribution of
dividends, the price of the stock decreases and will nullify the gain made by the investors
because of the dividends. This theory also implies that the cost of debt is equal to the cost of
equity as the cost of capital is not affected by the leverage.

ASSUMPTIONS OF MODIGLIANI-MILLER MODEL: This theory believes in the existence of

‘perfect capital markets’. It assumes that all the investors are rational, they have access to free
information, there are no floatation or transaction costs and no large investor to influence the
market price of the share.
• Perfect Capital Markets: There is no existence of taxes. Alternatively, both dividends
and capital gains are taxed at the same rate.
• No Taxes: The company does not change its existing investment policy. This means that
new investments that are financed through retained earnings do not change the risk
and the rate of required return of the firm.
• Fixed Investment Policy: All the investors are certain about the future market prices and the
dividends. This means that the same discount rate is applicable for all types of stocks in all time
periods
• No Risk of Uncertainty: All the investors are certain about the future market prices and
the dividends. This means that the same discount rate applies to all types of stocks in all
time periods.
Modigliani - Miller's valuation model valuation formula and its denotations:

Modigliani - Miller's valuation model is based on the assumption of same discount rate / rate of
return applicable to all the stocks. P0= D1 + P1 / (1 + Discount rate) Or P1 = P0 * (1 + k) – D
Where,
P1 = market price of the share at the end of a period,

P0 = market price of the share at the beginning of a period,

k = cost of capital &
D = dividends received at the end of a period

Explanation
Modigliani - Miller's model can be used to calculate the market price of the share at the end of
a period, if the original share price, dividends received and the cost of capital is known. The
assumption that the same discount rate applies to all stocks is important.

Shortcomings of Modigliani Miller's Model :

Modigliani - Miller theory on dividend policy suffers from the following limitations:
a. Perfect capital markets do not exist. Taxes are present on the capital markets.
b. There is no difference, according to this theory, between internal and external financing.
However, if the flotation costs of new issues are considered, it is false/not possible.
c. This theory believes that the wealth of the shareholder is not affected by the dividends.
However, there are transaction costs associated with the selling of shares to make cash
inflows. This means that investors prefer dividends.
d. No assumption of uncertainty is unrealistic. The dividends are also relevant under
certain conditions.
Summary
Modigliani - Miller theory of dividend policy is an interesting and a different approach to the
valuation of shares. It is a popular model that believes in the irrelevance of dividends.
However, the policy suffers from several important limitations, so its relevance is only up to
the assumptions.
Q2. “THERE ARE DIFFERENT TYPES OF CREDIT POLICIES.” DISCUSS THE CREDIT
STANDARDS TO BE MADE IN MANAGING THE RECEIVABLES.

Defining the credit standards is an important component of credit policy of the company. The
credit standards do have an important bearing on the sales of the company.

Credit Standards in Financial Management

The credit standards of a company lay down minimum requirement for the evaluation of credit
to its customers. The company may define these requirements in the very conservative or a
 strict manner and this restrain the marginal customers are those whose financial position is
doubtful may not really be bad. Such a policy would be appropriate for the companies which do
not want to take high risk or alternatively, the company may follow a very liberal standard and
be very aggressive in taking the risk.

The company uses some of the following quantitative indicators for establishing credit
standards:
a. Payment period
b. Selecting financial rates
c. Rating based on financial ratios.

The subjective assessment obtained through the market about the credit worthiness of the
customers may also feature as one of the item in the credit standards. These quantitative and
subjective indicators may provide the basis for establishing and enforcing the credit
standards.At any point of time, the company would be interested in examining the effect of
change in credit standards. This is done by comparing the profitability generated by lowering
down the credit standards and the added cost of accounts receivable. So long as the profitability
is more than the added cost, the company can lower down the credit standards. It is important
to determine the costs of lowering down the credit standards and also to find out the impact on
profitability of the company. Lowering down toe the credit standards would have the following
effects:
• increase in average collection period.
• increase in sales.
• increase in accounts receivable investment.
• increase in bad debts losses, and
• increase in servicing cost of account receivable.

The effect of lowering down the credit standards on key variables such as sale and investment
in accounts receivable “can be quantified by the costs versus benefits of such changes”. At the
time of the cost such as increase in bad debt losses and increased cost of monitoring and
servicing the accounts receivable should also be considered. It may be very difficult for the
firm to make any distinction between the credit standards for new customers and existing
customers. Relaxing the credit standards for the new customers would have certainly some
impact on the payment behaviour of existing customers. The firm may experience collection
period.
You may take the following approach in assessing the effects of lowering down the credit
standard:
• Determine, find out the profitability of additional sales.
• Determine increase in bad debt losses, collection expenses and any other cost arising from
relaxing the standards.
• Determine increase slowness of the average collection period and additional amount of
investment requirement in accounts receivable and multiply it by the required rate of return
on investment in accounts receivable.
Let us take a case to illustrate this approach.
Example: ADE LIMITED is engaged in manufacturing water.
Each water pack is priced at N100. The sales of the company during the last accounting year
were 80,000 units. The variable cost per unit is N60, the fixed costs of the company are N16.
The company is contemplating to relax its credit standards and as a result, the company is
expecting 10 percent increase in sales. But at the same time by relaxing the credit standards the
average collection period of the company is likely to increase from 30 days to 45 days. The bad
debt losses are expected to be 2% of increased sales. The collection expenses are likely to go up
by N50,000. The company also pay commission of 10% on the sales and this cost is not included
in the variable cost. If the after-tax required rate of return on investment of the company is 15
percent and the tax rate is 50% should the company relax its credit standards?

Unit N
Additional sales generated 8000 x 100 800,000 Variable cost 8000 x 60 480,000 Gross margin
320,000
Other costs:
Bad debt expenses 800,000 x 0.2 16,000 Commission 800,000 x 1 80,000 Collection expenses
50,000 146,000 Profit 174,000 After – tax profit50% 87,000
The effect of increase in sales on investment in accounts receivable will be calculated as
follows:
Average Collection Accounts receivable= ----------------------- Period x sales per day
Accounts receivable before change in credit standards:

30 x (8,000,000/360) = N666,667

Accounts receivable after change in credit standards:

45 x (88,000,000/360) = N1,100,000
Additional investment in accounts receivable as a result of change in result standard is
N433,333 required return on additional investment:

4,333,333 x 1.5 N65,000.

The above analysis shows that the profitability on additional sales as a result of change in credit
far exceeds the required return on account receivable investment, thus, the change is
profitable for ADE LIMITED.

It is important to understand that the above analysis is based on the following assumptions:
The company has the capacity to meet the additional demand and as a result of the increase in
sales does not create any additional capacity costs. In case the company is operating already at
full capacity then the analysis has to take into account the possible change in the costs
structure of the company. The above analysis is thus based on the assumption that the price
and the costs remain constant. Only the cost related to bad debts expenses and credit
administration change.
To meet the higher requirement of demand, the company does not require additional
inventory. If the level of inventory requirements changes as a result of change in sales volume,
then the additional investment requirements for inventory purpose should be included in
accounts receivable investment.

The required return should then be calculated by applying the opportunity cost to the total
investment.

Q3. THERE ARE VARIOUS FACTORS THAT AFFECTS DIVIDEND DECISION. DOES THE PRIVATE
SWCTOR OF INDIA JUSTIFY THE INVESTORS’ INVESTMENT? COMMENT
The private sector’s role in encouraging a country’s growth and economic development cannot
be overstated. Private enterprises are the chief agents in creating employment, providing
funds, building competitiveness and driving innovation - all essential instruments for growth.

The private sector, in particular, takes entrepreneurial risks, which is central to how it translates
investments into wealth creation and income generation. This role takes on further significance
in the current context, as rising uncertainties in a rapidly changing global landscape cause
economic growth concerns, particularly for emerging nations.
In the past, India has shown strong resilience in the face of global volatility and has continued
to grow steadily, placing it among the world’s fastest-growing economies. The Indian economy
grew at a rate of 6.8% during 2018 and is projected to grow at a rate of 7% and 7.2% during
2019 and 2020, respectively. The private sector has played a huge role in India’s development
and is largely responsible for the phenomenal growth registered by the country since the
economy was opened up in 1991. The Confederation of Indian Industry (CII) is positioned as a
partner in national development and is committed to catalyzing, nurturing and driving
enterprise competencies for fostering growth. We do this by strengthening the competitiveness
of the economic ecosystem, as well as aligning individual enterprises with the needs of society.

Creating livelihoods: India has entered the 37-year period of its demographic dividend, which
means the expansion of its working-age population will last until 2055. With arapidly changing
employment landscape, including 11-12 million youth entering the labour force every year, jobs
need to be created and effective skills initiatives put in place. The private sector plays a pivotal
role in meeting this challenge. The private sector has strong links to higher investments in
education and vocational training to bridge skill gaps in the economy, facilitating skills and
training programmes, creating partnerships with educational institutes and experts and, most
importantly, creating a future-ready and talented workforce. India has more than 900
universities and 39,000 colleges of which 78% are privately managed. In addition, most large,
private enterprises have created in-house training and skills programmes to help build the
capacities of young workers in line with industry needs. CII's skills and livelihood initiatives aim
to build an environment that boosts employability. Aside from its policy advocacy work, CII
actively engages in training and increasing the skills of young individuals and offers career
matching and counselling through its Model Career Centres (MCCs). Its various initiatives have
an impact on an estimated 1 million-plus young people every year.

Driving investments is vital: Private investments by the corporate sector are critical to higher
growth rates and economic development. More investment creates a multiplier effect in the
economy by generating both direct and indirect employment, boosting consumption and
fostering further development.The total gross capital formation in India as a proportion of
GDP during 2017-18 stood at around 31%. The private sector, including small enterprises in the
household sector, accounted for about two-thirds of this. Effective partnerships between the
government and private sector in critical areas of infrastructure and long-term investments
would expedite development.Public-private partnerships need to channel private sector funds
into crucial areas of development. The Indian government has introduced various formats in
order to attract private investments, especially in roads and highways, airports, industrial parks
and higher education and skill development sectors.

Making use of technology: With the advent of the Fourth Industrial Revolution, India is at the
cusp of a technology revolution that could transform manufacturing and industrial production
in the country. An important objective for the private sector must be to facilitate the transfer or
spread of new technology through industry-led initiatives or by building new business models
that employ technology in new ways, which in turn will increase productivity and lead to
sustainable economic growth.The private sector has the power to harness and use technology
to unleash greater prosperity for the nation, but it is also responsible for ensuring that the
benefits of technology reach all sections of society. A focus on affordable technology to allow
equal access is imperative for inclusive development. Technology-enabled development in
sectors such as health and education go a long way in ensuring equitable development in
emerging economies, which the private sector is best equipped to provide.

Fostering entrepreneurship and innovation: Corporates are integral to fostering innovation

and entrepreneurship and ensuring the future progress of an economy. Private sector
investments provide necessary infrastructure that is sustainable, reliable, and can use modern
technology to create new products and services. In most countries, the private sector plays the
lead role in research and development spending, working with universities and institutions to
translate new research into markets and crafting innovative business models and strategies.
India has emerged as a significant player when it comes to converging technology and
entrepreneurship. It is the second-largest start-up nation in the world, with more than 14,000
start-ups recognized under the Startup India scheme. CII has led initiatives to boost innovation
in the country and encourage young entrepreneurs, including the CII Startups Coalition and CII
Startupreneurs which connect new entrepreneurs, investors, mentors and service providers.

Environmental efficiency: Scarcity of natural resources and environmental degradation pose

major threats to sustainable growth. Engaging the private sector has become critical to
ensuring environmental efficiency through its greater adoption of cleaner, greener technologies
and the adoption and sharing of best practices. The private sector’s use of new technologies in
sustainable production, while coming at some cost, will promote sustainability, efficiency and
better use of inputs and raw materials. Green growth and climate change action require
significant financing and investments. The private sector should lead from the front and enable
more innovation and mobilization of resources, for example, the funds, budgets,
communication systems and necessary infrastructure, which are essential for ecological as well
as economic sustainability.