Course Financial Management

Segment 6 Inventory, Receivable Management and Dividend Decisions

Faculty Ujwal M S
Webinar 5: Working Capital and Cash Management
Recap

1 Concept of Working Capital Management

2 Operation Cycle

3 Estimation/Components Of Working Capital

4 Cash Management – Strategies/Objectives/Motives

5 Cash Planning, Forecasting & Budgeting

 Working Capital and Cash Management
Important Questions

Question 1: Concepts/Types Of Working Capital

Question 2: Objectives/ Importance Of Working Capital

Question 3: Problems on Operating Cycle

Question 4: Strategies of Cash Management

Question 5: Motives of Holding Cash

Question 6: Cash Models, Planning, Forecasting & Budgeting

Webinar 6: Inventory, Receivable Management
and Dividend Decisions
Overview of Topics

1 Concept of Inventory Management – Role/Features/Cost

2 Inventory Management Techniques

3 Cost & Benefits in Receivable Management

4 Credit Policy Variables

5 Theories on Dividend Policy

 Inventory, Receivable Management &
Dividend Decisions
Learning Objectives
At the end of this session, you will be able to:
Understand Concept of Inventory Management

Analyse Inventory Management Techniques

Understand Cost & Benefits in Receivable Management

Understand Credit Policy Variables

Analyse Various Theories on Dividend Policy

 Inventory
Management
 INVENTORY MANAGEMENT
MEANING
➸Inventories form a crucial
component of manufacturing
firms' current assets.

➸Efficient inventory management

is vital for optimal investment in
current assets.

➸Neglecting inventory
management may lead to the
failure of a firm.
 INVENTORY MANAGEMENT
Role/ Features of Inventory in Working Capital

A. Characteristics of inventory as current assets:

Current assets are those assets which are expected to be realised in cash or sold
or consumed during the normal operating cycle of the business.

Various forms of inventory in any manufacturing unit are:

➸ Process of production inventories
➸ Work – in – process inventories
➸ Finished goods inventories
 INVENTORY MANAGEMENT
Role/ Features of Inventory in Working Capital
B. Levels of liquidity

Inventories are meant for consumption or sale. Both excess and shortage
of inventory affect the firm’s profitability. They are source of near cash.

C. Liquidity lags

Inventories have three types of liquidity lags which are

➸ creation lag
➸ storage lag
➸ sale lag
 Purpose of Inventory
➸Sales

➸To avail quantity discounts

➸Reduce risk of production

stoppages

➸Reducing ordering costs and time

 Costs Associated with
Inventories

➸Material cost

➸Ordering cost

➸Carrying cost

➸Shortage costs or stock-out costs

INVENTORY MANAGEMENT
Inventory Management Techniques
 INVENTORY MANAGEMENT
Inventory Management Techniques
Economic order quantity (EOQ)
Economic order quantity (EOQ) refers to the optimal order size that will
result in the lowest ordering and carrying costs for an item of inventory
based on its expected usage, carrying costs and ordering cost.

We should understand the following before moving onto calculating the

EOQ:
 INVENTORY MANAGEMENT
Inventory Management Techniques
Annual consumption of raw materials is 40,000 units. Cost per unit is
Rs.16 along with a carrying cost of 15% per annum. The cost of
placing an order is given as Rs.480. Find out the EOQ of the raw
materials.
 INVENTORY MANAGEMENT
Inventory Management Techniques
Annual demand of a company is 30,000 units. The ordering cost per order is Rs.
20(fixed) along with a carrying cost of Rs. 10 per unit per annum. The purchase
cost per unit i.e., price per unit is Rs. 32 per unit. Determine EOQ, total number
of orders in a year and the time-gap between two orders.
 INVENTORY MANAGEMENT
Inventory Management Techniques
ABC system
An industrial firm's inventory typically consists of thousands of items with
varying prices, long lead times, and procurement challenges.

It is impossible to have the same level of control over all of these items.
Items of high value require complete attention, but items of little value
do not require the same level of supervision.

To manage its inventory investment, the company must be careful in its

approach. Such an approach is referred to as selective inventory control.
The ABC system is related to selective inventory control.
 INVENTORY MANAGEMENT
Pricing of inventories
a) FIFO (First-In, First-Out) method withdraws inventory
beginning with those units purchased earliest.

b) LIFO (Last-In, First-Out) method withdraws inventory

beginning with those units purchased most recently.

c) Weighted Average Cost Method uses an average of the cost

of all items currently in stock.
Receivable
Management
 RECEIVABLE MANAGEMENT
MEANING

The term receivable is defined as “debt owed to the firm by customers

arising from sale of goods or services in the ordinary course of
business”.

Accounts receivables arise when the firm sells its products services on
credit, and it does not receive cash for it immediately, but would be
collected in near future. Till collection they form as current assets.
 RECEIVABLE MANAGEMENT
Cost & Benefits
COSTS:
Opportunity Cost/Capital Cost: Providing goods or services on credit involves block of
firm’s funds. These blocked funds or investment in receivables need to be financed, by
shareholders funds or from short-term borrowings. They involve some cost. If receivables
are financed by shareholder funds, there involves opportunity cost to shareholders. If they
are financed by borrowed funds, it involves payments of interest, which is also a cost.
Collection Cost: This cost incurred in collecting the receivables from the customers to
whom credit sales have been made.
Administrative Cost: This is an additional administrative cost for maintaining account
receivable in the form of salaries to the staff kept for maintaining accounting records
relating to customers, cost of investigation etc.
Default Cost (Bad Debts)
 RECEIVABLE MANAGEMENT
Cost & Benefits
BENEFITS:
Increased Sales: Providing goods or services on credit expands sales, by
retaining old customers and attraction of prospective customers.
Market Share Increase: when the firm’s able to retain old customer and
attract new customer automatically market share will be increased to the
extent of new sales.
Increase in Profits: Increased sales, leads to increase in profits, because
it needs to produce more products with a given fixed cost and sales of
products with a given sales network, in both cost per unit comes down and
the profit will be increased.
 RECEIVABLE MANAGEMENT
Credit Policy Variables
The credit policy of a firm can be termed as a trade-off
between increased credit sales leading to increase in profit and
the cost of having larger amount of cash locked up in the form
of receivables along with the loss due to the incidence of bad
debts.

The four aspects of credit policy are as follows:

✓Credit standards
✓Credit period
✓Cash discounts and
✓Collection programme
 RECEIVABLE MANAGEMENT
Credit Policy Variables
Credit Standards:
The term credit standards refer to the criteria for
extending credit to customers.

✓Benefits of Credit Extension

✓Risks Associated with Credit Extension
✓Light Credit Standards
✓Strict Credit Standards
 RECEIVABLE MANAGEMENT
Credit Policy Variables
Credit Period:
Credit period refers to the length of time allowed
by a firm, for its customers to make payment, for
their purchases.
✓Net 20 Credit Period
✓Impact of Increasing Credit Period
✓Reducing Credit Period
✓Effects of Increasing Credit Period
✓Comparison with Credit Standards
 RECEIVABLE MANAGEMENT
Credit Policy Variables

Cash Discount:
Firms offer cash discounts to induce their customers to make
prompt payments. Cash discounts have implications on sales
volume, average collection period, investment in receivables,
incidence of bad debts and profits.
 RECEIVABLE MANAGEMENT
Credit Policy Variables
Collection Programme:
The success of a collection programme depends on the collection policy
pursued by the firm. The objective of a collection policy is to achieve a
timely collection of receivables.
The collection programmes consist of the following:
✓Monitoring the receivables
✓Reminding customers about due date of payment
✓Interacting on-line through electronic media with customers about the payments due,
around the due date
✓Initiating legal action to recover the amount from overdue customers as the last resort
to recover the dues from defaulted customers
✓Formulating collection policy such that, it should not lead to bad relationship with the
customers
Dividend Decisions
 DIVIDEND
• According to the Institute of Chartered Accountants of India,
dividend is "a distribution to shareholders out of profits or reserves
available for this purpose."
• "The term dividend refers to that portion of profit (after tax) which is
distributed among the owners / shareholders of the firm”.
• It is a payment made to the equity shareholders for their investment
in the company.
FORMS OF DIVIDEND
➸Cash dividend

➸Scrip dividend
➸Bond dividend
➸Stock dividend
A. CASH DIVIDEND-
- Important form of dividend
- Most of the companies pay dividend
in cash.
- Shareholders also prefer cash
dividend
- Cash generated from earnings or
profits of the company may be used
for the payment of cash dividend.

B. SCRIP DIVIDEND-
- It is a dividend which is given in
forms of SCRIPS or PROMISSORY
NOTES, which promise to pay the
dividend declared to the
shareholders at future specified
date.
- Not popular & Non existent in INDIA
- Under Indian law scrip dividend
cannot be given by a company.
C. BOND DIVIDEND-
It is a dividend which is given in forms of
BOND, which promises to pay the
dividend declared to the shareholders at
a future specified date.
- Maturity period of the bond will be
usually a long period.
- The bond carries interest at a specified
rate.
- Not popular & important form in INDIA

D. STOCK DIVIDEND-
Stock dividend ranks next to cash dividend
when it comes to popularity.
- It is the dividend given to the
shareholders in the form of shares in
addition to the cash dividend. [WHICH IS
KNOWN AS BONUS SHARES]
- Bonus shares are given to existing share
holders in proportion to the number of
shares held by them.
 DIVIDEND DECISIONS
Stock Split
Corporations may split their shares when the price per share reaches high levels.

A stock split is when a corporation reduces the par value of each share of stock
outstanding and issues a proportionate number of additional shares.

This does affect the number of shares outstanding and, therefore, the number of
shares dividends will be paid on. It also may affect the par value and market price
per share, reducing them proportionately.
DIVIDEND DECISIONS
Stock Split
 DIVIDEND DECISIONS
Dividend Policy

• It is the policy of the management of a company concerning the

amount of profit to be distributed to the shareholders as dividend.
• In other words, dividend policy is the firm's plan of action to be
followed when dividend decisions are made. It is the decision about
how much of earnings to pay out as dividends versus retaining and
reinvesting earnings in the firm.
CONFLICTING THEORIES ON DIVIDEND
POLICY
1. Relevance Theory:
➸ Walter’s Model
➸ Gordon’s Model

2. Irrelevance Theory:
➸ Residual Theory
➸ Modigliani & Miller Approach (MM
Approach)
 DIVIDEND DECISIONS
Theories on Dividend Policy
RELEVANCE THEORY

1. WALTER’S RELEVANT APPROACH:

• - Prof. James E. Walter- Dividend policy always affects the value of the firm.

• - Walter’s model supports dividend relevance. (maximize the wealth of the stockholders)

• - Walter’s theory is based on the relationship between the firms IRR and the cost of capital.
 DIVIDEND DECISIONS
Theories on Dividend Policy
WALTER’S MODEL IS BASED ON THE FOLLOWING ASSUMPTIONS-
✓Firm’s entire finances are from retained earnings.
✓IRR and Ke (cost of capital) of the firm remain constant.
✓The firm’s earnings are either distributed as dividends or
reinvested internally
✓The firm has a very long life
✓Earnings and dividends of the firm never change.
 DIVIDEND DECISIONS
Theories on Dividend Policy
WALTER’S VIEW ON THE OPTIMUM DIVIDEND PAYOUT RATIO
a) Growth firm ( r > ke)-
• Firms having r greater than Ke may be referred as growth firm. Growth firms have ample investment
opportunities. These firms reinvest retained earnings at higher rate than the rate expected by the shareholders.
• Growth firms will maximize the value per share if they follow a policy of retaining all the earnings for internal
investment. Optimum payout ratio for such a firm will be 0.

b) Normal firm ( r = ke )
• The dividend policy of normal firm will have no effect on the market value of share

c) Declining firm ( r < ke )

• No profitable opportunities to invest their earnings when rate of return is less than the minimum rate required
by the shareholders.
• Optimum payout ratio for such firm is 100%
 DIVIDEND DECISIONS
Theories on Dividend Policy
WALTER’S VIEW ON THE OPTIMUM DIVIDEND PAYOUT RATIO

NOTE:

• In case of growth firm, the value of shares tends to decline in

correspondence with raise in the dividend payout ratio.

• In case of normal firm, the value of shares remains constant regardless of

change in payout ratio.

• In case of declining firm, the value of shares tends to increase in

correspondence with rise in payout ratio, so the optimum payout ratio will
be 100%
 DIVIDEND DECISIONS
Theories on Dividend Policy
2. GORDON’S RELEVANT APPROACH:

o Myron Gordon has also developed a model on the lines of Prof. Walter suggesting that dividends are
relevant and the dividend decision of the firm affects its value.
o This is based on the premise that the investors are generally risk averse and prefer to have current
income i.e., dividend. Hence there is a direct relationship between dividend policy and the value of firm.
 DIVIDEND DECISIONS
Theories on Dividend Policy
GORDON’S MODEL IS BASED ON THE FOLLOWING ASSUMPTIONS-

✓ No Debt: The model assumes that the company is an all-equity company, with no proportion of debt in the capital
structure.
✓ No External Financing: The model assumes that all investment of the company is financed by retained earnings
and no external financing is required.
✓ Constant IRR: The model assumes a constant Internal Rate of Return (r)
✓ Constant Cost of Capital (capitalization rate)
✓ Perpetual Earnings
✓ Corporate taxes: Corporate taxes are not accounted for in this model.
✓ Constant Retention Ratio: The model assumes a constant retention ratio (b) once it is decided by the company.
Since the growth rate (g) = b*r, the growth rate is also constant by this logic.
✓ K>g: Gordon’s model assumes that the cost of capital (k) > growth rate (g). This is important for obtaining the
meaningful value of the company’s share.
 DIVIDEND DECISIONS
Theories on Dividend Policy
THE IMPLICATIONS OF GORDON’S BASIC VALUATION MODEL MAY BE SUMMARIZED AS BELOW:

a) When the rate of return of firm’s investment is greater than the required rate of return, i.e.,
when r > k, the price per share increases as the dividend payout ratio decreases.
Thus, growth firm should distribute smaller dividends and should retain maximum earnings.
b) When the rate of return is equal to the required rate of return, i.e., when r = k, the price per
share remains unchanged and is not affected by dividend policy.
Thus, for a normal firm there is no optimum dividend payout.
c) When the rate of return is less than the required rate of return, i.e., when r < k the price per
share increases as the dividend payout ratio increases. Thus, the shareholders of declining
firm stand to gain if the firm distributes its earnings.
For such firms, the optimum pay out would be 100%
 DIVIDEND DECISIONS
Theories on Dividend Policy
IRRELEVANCE THEORY

1. RESIDUAL THEORY:

According to this theory, dividend policy has no effect on the wealth of the shareholders or prices of the
shares and hence it is irrelevant so far as the valuation of the firm is concerned.
• This theory regards dividend policy merely as a part of financial decision because the earnings available
may be retained in the business for reinvestment.
funds are not required in the business – ‘distributed as dividend’ .
• Thus, the decision to pay dividends or retain the earnings may be taken as residual decision.
• The amount of dividend payout will fluctuate from period to period

• If these opportunities abound, the percentage of dividend payout is likely to be zero. On the other hand, if
the firm is unable to find profitable investment opportunities, dividend payout will be 100%.
 DIVIDEND DECISIONS
Theories on Dividend Policy
ASSUMPTION:

✓ The assumption of this theory is that raising financing from external sources involves higher
cost.

This can be explained with the help of example.

• Suppose, A Ltd wants to raise ₹.10,00,000 additional funds to finance an investment project and
its floatation cost is ₹.1,00,000. A Ltd has to raise ₹.11,00,000 from issue of shares so that the net
proceed with the company remains ₹.10,00,000 after paying floatation cost of ₹.1,00,000. It
means that the issue of new capital is more expensive than financing the project through
retained earnings. The dividend will be paid only after using available profits for investment
needs.

• This is referred as Residual Theory of dividend.

 DIVIDEND DECISIONS
Theories on Dividend Policy

2. MODIGLIANI-MILLER’S MODEL (M-M’S MODEL):

• Modigliani-Miller’s (M-M’s) thoughts for irrelevance of dividends are most comprehensive

and logical. According to them, dividend policy does not affect the value of a firm and is
therefore, of no consequence. It is the earning potentiality and investment policy of the
firm rather than its pattern of distribution of earnings that affects value of the firm.

• According to this approach, Earnings of the firm which affect its value, further depends
upon the investment opportunities available to it.
 DIVIDEND DECISIONS
Theories on Dividend Policy

ASSUMPTIONS:

✓ Perfect Capital Markets - 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 flotation or transaction costs.
✓ No Taxes
✓ Fixed Investment Policy - The company does not change its existing investment policy.
It means whatever may be the dividend payment, the company will make investment
as it has already decided upon.
 DIVIDEND DECISIONS
Theories on Dividend Policy
CRUX OF THE ARGUMENT:

• The crux of the MM position on the irrelevance of dividend is the arbitrage argument. Arbitrage refers to
entering simultaneously into two transactions which exactly balance or completely offset each other.

“The two transactions here are the acts of paying out dividends and raising external funds.”

• When dividends are paid to the shareholders, the market price of the share will decrease. What is gained
by the investors as a result of increased dividends will be neutralized completely by the reduction in the
market value of shares.

• The terminal value before and after the payment of dividend would be identical.

• The investors would, therefore, be indifferent between dividend and retention of earnings. Since the
shareholders are indifferent, the wealth would not be affected by current and future dividend decisions of
the firm. It would depend entirely upon the expected future earnings of the firm.
 DIVIDEND DECISIONS
Theories on Dividend Policy
CRITICISM OF MM APPROACH:

MM hypothesis has been criticised on account of various unrealistic

assumptions as given below.
✓Perfect capital market does not exist in reality.
✓Information about the company is not available to all the persons.
✓The firms have to incur flotation costs while issuing securities.
✓Taxes do exit.
✓The firms do not follow a rigid investment policy.
✓The investors have to pay brokerage, fees etc., while doing any transaction.
✓Shareholders may prefer current income as compared to further gains.
Webinar 6: Inventory, Receivable Management
and Dividend Decisions
Summary

1 Concept of Inventory Management – Role/Features/Cost

2 Inventory Management Techniques

3 Cost & Benefits in Receivable Management

4 Credit Policy Variables

5 Theories on Dividend Policy

 Inventory, Receivable Management &
Dividend Decisions
Important Questions

Question 1: Features & Purpose of Inventory Management

Question 2: Problems on EOQ

Question 3: Credit Policy Variables

Question 4: Concept of Dividend Decisions: Forms/ Stock split

Question 5: Theories on Dividend Policy – Theories & Problems

 References
E - Book References:

❖ Financial Management – I M Pandey

❖ https://open.umn.edu/opentextbooks/textbooks/principles-of-finance