Modue1: What is the importance of cost of capital for any organization?
Overall Cost of Capital/Weighted Average Cost of Capital Weighted Average
Explain the distribution of profit to the supplier of funds through an example
and income statement. Ans Cost of Capital The ‘Cost of Capital’ is the
minimum rate of return, which enables a company to make such an amount
of profit on its investment so as to ensure that the market value of the
company’s equity shares either increases or remains at the same level. This
is in conformity with any company’s goal of ‘Wealth Maximisation’ for its
shareholders. ‘Wealth Maximisation’ for the shareholders of a company is
feasible only when the projects financed by the company (shareholders
money) generate revenues at a rate equal or more than the rate expected
by the shareholders. In case, the company is unable to earn the expected
rate of return, the possibility of decrease in the market value of the
company’s shares cannot be ruled out, which ultimately may result in
erosion of the shareholders wealth.
 Importance of Cost of Capital- • Influence of the Mode and Quantum of
Financing • Computation of Cost of Equity • Computation of Cost of Retained
Earnings and Depreciation Funds • Future Costs versus Historical Costs •
Problems relating to Assignments of Weights Types of Costs 1. Future Cost
versus Historical Cost: Future costs are the basis on which financial
decisions are taken. Although, they are only projections of what may or may
not happen in future, they are more important as compared to the historical
cost, which is nothing but frozen a figure. However, historical costs are like
guiding tools for future forecasting. 2. Specific Cost versus Composite Cost:
‘Specific Cost’ is the cost of individual source of capital, whereas the
‘Composite Cost’, also known as “Overall Cost’ is the cost of capital of all the
sources taken together. To start with, the costs of individual sources, like
debentures, preference shares, equity shares, retained earnings, etc. are
computed individually (specific costs) and thereafter calculation of
‘Composite Cost’ may be undertaken. 3. Average Cost versus Marginal Cost:
After the calculation of the cost of individual source of capital (specific cost),
weights are assigned to each of them in the ratio of their share. The average
of this is termed as weighted average cost or ‘Average Cost’. ‘Marginal Cost’
on the other hand is defined as “the change in the total cost that arises when
the quantity produced has an increment by unit”. 4. Implicit Cost versus
Explicit Cost: The rate of return related to the best investment option
available for a company (and its shareholders) which has forgone or lost the
opportunity to earn money by abandoning the project proposal is termed
as ‘Implicit Cost’. 5. Explicit Cost, On the other hand, is the discount rate
which equates: I. The present value of the incremental cash inflows
(incremental to the taking of the financial opportunity) II. The present value
of the incremental cash outflows
Explain in detail calculation mechanism of cost of equity and preference
capital along with its advantages answer Measurement of Specific Costs
Cost of Preference Share Capital (Kp) Preference shareholders are entitled
to have a fixed rate of dividend. Although there is no statutory compulsion
regarding the payment of dividends to the preference shareholders, in case
a company decides to pay dividend to its shareholders, then preference
shareholders would be given priority over other shareholders. Non-payment
of dividend to its preference shareholders impacts negatively on the
company’s reputation and its capacity to mobilise funds at an appropriate
rate. Further, dividend expected by preference shareholders has a direct
relationship with the cost of preference capital. Cost of Equity Capital (Ke)
The cost of equity may be explained as “the minimum rate of return, a
company is required to earn on the part of equity financial to its investment
in such a manner that the market value of its stock remains unaffected.” This
can be calculated by applying following methods: 1. Dividend Yield Method
2. Dividend Yield Plus Growth in Dividend Method: 3. Earning Yield
Method4. Earning Growth MethodCost of Redeemable Debt/Debentures
Redeemable debentures, as the name itself suggest, can be redeemed by
the company at a predetermined date and time or after a prescribed period
of notice are given in this regard. The average of sale value and redeemable
value is considered for the calculation of the ‘cost of redeemable
debentures’. Different formulae are applied for calculating the cost of
redeemable debts before the tax and after the tax as under.
Cost of Capital (WACC) is also known as the ‘Composite Cost of Capital’,
‘Overall Cost of Capital’, or ‘Average Cost of Capital’. It is the minimum rate
of interest generated from the project to meet the expectations of the
investors. It is defined as the total of weighted average cost of individual
sources of financing. Calculation of WACC involves following steps: 1.
‘Specific Cost’ of each source of finance is calculated individually. 2. Weight
is assigned to each ‘Specific Cost’ in the ratio of their share in the total cost.
3. Then the weighted average cost of individual sources is arrived at. 4. The
total of weighted average cost of all the sources is WACC. The concept of
WACC gains importance in view of the fact that its constituents have various
sources of funds, but once they become part of the overall cost of capital, a
single homogenous pool is created, which is used for financing specific
projects. While evaluating such specific projects, there is no consideration
as to which individual source of capital is funding the specific project. 
Advantages of Weighted Average Cost of Capital 1. WACC is considered as
a cut-off rate in assessing the profitability of a future project. 2. In
determining the viability of a project, WACC is taken as a reference point; if
the return from the project is forecasted to be more than WACC, then the
project is considered to be viable. 3. For the selection of a project, overall
cost of capital is taken into consideration as the individual cost of capital is
insufficient for ‘Project Selection Process’. 4. Although for the ‘Project
Selection Process’, a number of options are available, WACC is the most
preferred one. 5. The calculation of ‘Economic Value Added’ (EVA) is carried
out by using WACC. Disadvantages of Weighted Average Cost of Capital
There are certain difficulties and limitations of WACC as may be explained
from the following: 1. Determination of the Weights: The fundamental
problem faced in the determination of the average cost relates to
assignment of weights to various individual constituents of total capital,
which is a difficult task. 2. Choice of Capital Structure: The option to decide
the type of capital structure for the determination of the average cost is a
challenging and difficult task. Various kinds of capital structure are ‘Current
Capital Structure’, ‘Marginal Capital Structure’, ‘Optimum Capital Structure’,
etc
3. Scope of Financial Management 1. Traditional School of ThoughtsScope
of FM was restricted to obtaining of funds. Finance manager was supposed
to provide funds as and when required by the organisation.  Scope of FM
was limited to- • Assessment of fund requirement • Procurement of
required funds from financial institution • Acquiring funds through the
issuance of financial products • Managing Accounting and legal framework
of such Transactions.  Limitations- • Outsider Looking in Approach •
Overlooked Regular Issues • Overlooked Non-Corporate Enterprises •
Overlooked Working Capital Financing • Ignored Allocation of Funds 2.
Modern School of Thoughts FM conceptualises and analyses the process of
financial decision-making. It also deals with the utilisation of funds. F.M.
deals with solving the three problems related to investment, financing and
dividend.  Functions of Modern School of Thoughts- • Investment Decision
• Financing Decision • Dividend Policy decision • Liquidity Decision
Module 3 Concept of Capital Budgeting-  Investment decision pertaining
to long-term assets for the purpose of generating revenue for the business
entity (and not for sale such as land, building, machinery, furniture, etc.) is
termed as ‘Capital Budgeting’. It involves long-term planning and monitoring
of capital expenditure, besides examining each proposal in a very logical and
scientific manner so as to finalise the best proposal. Nature of Capital
Budgeting The process of capital budgeting exhibits following nature: i. Only
the long-term investment proposals are subject to capital budgeting
technique. ii. Proposed investments are made in the present, but the returns
of such investments accrued over a number of years in future. iii. While
undertaking the exercise of ‘Capital Budgeting’ in respect of an investment
proposal, expenditure and projected return are measured in terms of cash
flow, i.e., cash outflow and cash inflow respectively. iv. The business may
take investment decisions on single project proposal or for two or more
project proposals which are mutually exclusive simultaneously. v.
Maximisation of value of the business organisation should be the sole
criteria for selecting or dropping of an investment proposal. Need for
Capital Budgeting a) Maintaining Firm’s Competitiveness: Modernisation of
plants and replacement of the obsolete plant and machinery are necessary
for a company in order to survive and grow in the market. To achieve the
above objective, it is necessary to go for capital expenditure, which in turn
requires proper planning in the form of ‘Capital Budgeting’. b) Planning for
Future Needs of the Firm: ‘Capital Budgeting’ exercise provides guidance
with regard to the course of action, so as to enable the company’s
management to estimate the production factors in terms of quantity and
timing, which ensure the expected outcomes. c) Coordinating: In order to
achieve effective use of various resources and maximize output of a
company, it is necessary that the requisitions of different departments are
budgeted. This should be done in a coordinated manner. d) Cost Control:
‘Capital Budgeting’ involves comparison of budgeted expenditure with the
actual expenditure on an on-going basis, which facilitates proper monitoring
of expenditures and ultimately having a control over them. e) Company’s
Effectiveness: An appropriate ‘Capital Budgeting’ may lead to enhancement
in the company’s effectiveness. Appropriate allocation of the estimated
expenditure to suitable ‘Cost Centres’ and ‘Profit Centres’ facilitates in
construction of a framework, which enables the management to fulfil the
company’s goals.
Techniques of Capital Budgeting
Non-Discounted Cash Flow or Traditional Techniques/Methods As the
name itself suggests, these are traditional techniques, under which future
cash inflows are not discounted to arrive at their present worth. There are
two types of traditional techniques/method. 1. Payback Period Method, and
2. Accounting Rate of Return Method.  Payback Period Method The
number of years required for the proposal’s cumulative cash inflows to be
equal to its cash outflows is called ‘Payback Period’. It is length of time
(indicated as the number of years) to recover the initial cost of the project”.
Another way of looking it is as “the time required for a proposal to ‘break–
even’ on the net investment of the project”.
• Advantages of Payback Methods a) No Expertise Operation: Calculation
of the payback period in respect of any project is simple and uncomplicated
as compared to other advanced techniques. It is very convenient for small
business houses having a limited workforce with little or no competence in
respect of other advanced but complex techniques. b) Liquidity Indication:
As the payback method priorities an early cash inflow, it is the most
appropriate method for an organisation facing liquidity problems. During
the implementation of a project, the liquidity position remains under close
monitoring and a corrective measure may be taken by the organisation in
case it is needed. c) Lower Level of Risk: Under the payback method of
capital budgeting, more emphasis is given on early cash inflows. In other
words, the projects with short payback period are preferred and are
considered less risky, when compared to the projects with a longer payback
period Disadvantages of Payback Methods a) Overlooks Cash Inflows:
Under the ‘Payback Method’, cash inflow accrued after the ‘payback period’
is not given any attention. The fact that in some projects, cash inflows are
substantial after the payback period is completely overlooked. This could be
false and may result in discrimination against those proposals which
generate substantial cash inflows during post-payback period. b) Equal
Importance of all Cash Flows: Under this method, the ‘time value of money’,
is not taken into consideration. It does not discriminate between the cash
inflow of certain amount at present and the cash inflow of the same amount
after two years c) Overlooks Salvage Value d) Method of Capital Recovery:
Discounted PBP (Payback Period) The discounted payback period can be
seen as a type of payback period and it represents the total number of years
in which the original investment has to be returned on the basis of the
predicted future cash flows and these are discounted on the basis of hurdle
rate or a suitable capital cost. Therefore, apart from receiving the invested
cash, it also facilitates the recovery of financing cost of investment for a time
period when some of the investment is still unrecovered. Therefore, as
opposed to the normal payback method, the minimum requires returns are
ensured in it, nothing drastic happens after the payback period. •
Advantages of Discounted Payback Period a) It fulfils the requirement of
the Time Value of Money. b) It can be understood and performed quite
easily. c) No acceptance of negative NPV projects/investments in this
method. • Disadvantages of Discounted Payback Perioda) The issue of time
value is addressed in the discounted payback period the issue of cash flow
after the payback period is not addressed. b) If there is a requirement of
huge cash flow in the coming years and afterwards making it a profitable
option, these types of projects can be rejected
Accounting Rate of Return Method The ARR may also be termed as Return
on Investment (ROI). It is the ratio of ‘Average Profit (after tax)’ to ‘Average
Investment’. Capital investment proposals under ‘Accounting Rate of Return
(ARR) Method’ are evaluated according to their profitability level. ‘Capital
Employed’ and ‘Income Generated’ during the entire economic life of a
project are arrived at in conformity with the “Generally Accepted
Accounting Principles (GAAP)”. This will help in computing average yield of
projects Advantages of Average Rate of Return Method a) Easy to Calculate:
As this method uses readily available financial data, its computation is easy
and smooth, whereas other sophisticated methods, e.g., ‘Discounted Cash
Flow Technique’ necessitate complex steps to arrive at a decision. b)
Considers Entire Cash-Inflows: As against the ‘Payback Method’, which
considers only those inflows, which occur during payback period and ignores
subsequent stream of income, ARR method takes into account all the cash
inflows accrued during the entire life of a project. It has a comprehensive
approach.  Disadvantages of Average Rate of Return Methods a)
Overlooks Time Value of Money: Time value of money is not taken into
consideration in ARR method. Suppose there are two proposals (‘A’ and ‘B’)
having equal initial investments for a project. While proposal ‘A’ has a higher
annual ‘cash inflow’ during the initial years of the project life, proposal ‘B’
has a higher ‘cash inflow’ during the latter years of the project life. d) Use of
Only Accounting Data: ARR, method heavily depends on accounting data
which are likely to be affected by accounting policies, certain non-cash terms
(like depreciation) and also on expert opinions. e) Problem of
Comparability: The problem of comparison arises between two sub
methods of computing the ‘Average Rate of Return’ (ARR).
Discounted Cash Flow Techniques/Methods Net Present Value (NPV)
Method This method anticipate discounting (by applying suitable discount
factors for each year) of the cash inflows, likely to accrue in future years, and
arriving at the present value of cash inflows of each year. The total of present
value of cash inflows for each year thus calculated are compared with
present value of total cash outflows (capital outlay or cost of projects) and
the net present value ( the difference between total present value of cash
inflow and present value of cash inflow) is determined. A proposal is
accepted only of its NPV is positive or zero Advantages of NPV Method: i.
Recognition of Time Value of Money: The most important edge this method
has over other methods is that the time value of money is given due
recognition in its application. ii. Sound Method of Appraisal: It is considered
as a sound evaluation technique, as it considers the total benefits arising out
of proposal during the entire lifetime of the project. iii. Selection of
Mutually Exclusive Projects: NPV is the best option for selecting the
proposals relating to mutually exclusive projects iv. Maximisation of the
Shareholder’s Wealth: This technique of selecting one proposal (out of
many) for a company’s project is a scientific and sophisticated one, which
takes into consideration all the relevant factors necessary for taking a
decision  Disadvantages of NPV Method. Not Easy to Understand: When
compared with other simple methods of capital budgeting, e.g., ‘Payback
Period Method’ or ‘Average Rate of Return’, it is a complex method in
calculation as well as in understanding. ii. May Not Give Accurate Decision:
In the cases where the amounts of investment of mutually exclusive projects
are unequal, NPV method may fail to deliver appropriate decision. iii.
Difficult Calculation: The most important aspect in the application of Net
Present Value method is ‘Discount Rate’, which is based on the cost of
capital. Calculation of cost of capital is a complex process and its
methodology is a matter of debate amongst the experts
• Internal Rate of Return (IRR) Method This is another method for appraisal
of capital expenditure decisions, of discounted cash flow analysis. This
method are also called as ‘Yield on Investment,’ ‘Marginal Efficiency of
Capital’, ‘Marginal Productivity of Capital’, ‘Rate of Return,’ ‘Time-Adjusted
Rate of Return’, etc. Under the IRR method, similar to the NPV method, time
value of money is considered by discounting the stream of cash inflows. a)
In the NPV method, the discount rate is the required rate of return (a
predetermined rate). Thus, the determinants of the discount rate are
external to the proposal. b) In contrast to the above, the determinants of
IRR are internal to the proposal (that is why the term internal rate of return
is used). The IRR depends entirely on the initial capital outlay and the cash
inflows of the proposal under examination for acceptance or rejection.
Generally, IRR is the rate of return that a project earns and gives NPV equal
to zero Advantages of Internal Rate of Return Method i. Consideration of
Time Value: Internal Rate of Return is a superior technique for undertaking
capital budgeting exercise to evaluate capital expenditure decisions. It
ensures that time value of money is taken into consideration. Further, total
cash inflows as well as total cash outflows are considered under this
method. ii. Easy to Understand: Understanding the mechanism of IRR
technique for undertaking capital budgeting exercise to evaluate capital
expenditure decisions. It ensures that time iii. Sign of Profitability: In IRR
method, the concept of the required rate of return/cost of capital is not
used. This method on its own provides a rate of return, which gives a sing of
profitability of the proposal. During the calculations, cost of capital appears
at a later stage. iv. Comprehensive Objective: Under IRR technique, the
acceptance or rejection of a proposal depends on the outcome of a
comparison of IRR with the required rate of return. Required rate of return
has been defined as the minimum rate expected by investors on their
investment.  Disadvantages of Internal Rate of Return Method i. Difficult
to Calculate: Calculations involved in IRR technique are complex and difficult
to calculate. ii. Confusion in Multiple Rates: Multiple rates, which are part
of the exercise, create a lot of confusion. iii. Inconsistent in Firm Objectives:
Theoretically, during the evaluation of mutually exclusive proposals, the
proposal having the highest IRR needs to be (and is) selected for
implementation
• Profitability Index (PI) MethodIt is also termed as Benefit-Cost Ratio or
Cost-Benefit Ratio. Capital budgeting exercise through Profitability Index (PI)
method basically involves assessment of profitability arising out of an
investment proposal, which is comparable with profitability of similar other
investment proposal. PI is expressed in terms of the ratio of discounted
benefits over the discounted costs.  Advantages of Profitability Index
Method A. It is in conformity with the objective of ‘Maximisation of the
Shareholders Wealth’. B. Time value of money is taken into consideration. C.
Cash flows generated during the entire life of the project are taken for
analysis purpose. Disadvantages of Profitability Index Method A. For using
this method, in depth long-term projection of incremental costs and
benefits are needed. B. To determine interest rate/discount rate is rather
not easy in this method. C. To compute profitability index is difficult in
respect of two projects, which have different economic life.
Module4 : Discuss the concept of working capital? Also elaborate the
factors affecting estimation of working capital amount for an organisation.
Answer Working Capital Cash required for conducting the business, i.e.,
purchase of raw material and conversion thereof into finished goods, on the
regular basis is termed as ‘Working Capital’ (WC). The essential of ‘Working
Capital’ are; 1) Inventory (raw material, work-in-progress, and finished
goods) level, 2) Debtors, and 3) Creditors. They are considered as vital
signals of a company’s productivity and financial power. A company
managing its ‘working capital’ in an efficient manner may not be required to
borrow funds. Efficient management of working capital involves the
balanced approach, i.e., as far as possible there should be neither shortage
nor surplus of cash. “Working capital is the amount of funds necessary to
cover the cost of operating the enterprise.” “Working capital is descriptive
to that capital which is not fixed. But, a more common use of working capital
is to consider it as the difference between the book value of the current
assets and the current liabilities”.
Nature of Working Capital • Short-Term Needs: Working capital is required
to procure raw materials, which after going through a short process (WC
Cycle), is converted into cash. The short period involved in the working
capital, differentiates it from ‘Fixed Capital’, wherein funds remain locked for
the long-period. • Circular Movement: Working capital cycle (working
capital – raw material – work in process – finished goods – sales – sale
proceeds – cash receipt - working capital) is the continuous and recurring
process. The cycle of WC begins with cash and ends on cash. As it moves in
a circular manner, working capital is also termed as ‘Circulating Capital’. •
Element of Permanency: Although, the working capital requirement is for
short duration, but it is demanded on an ongoing basis to ensure the
sustainability of production activity of the company.
Components of Working Capital Working capital is a category of resources
that includes cash, inventory and receivables, minus whatever a company
owes in the short-term: Working Capital = Current Assets – Current Liabilities
1) Current Assets: Cash and those assets which can be easily converted into
cash (within one year) are kept under this category. Current assets are
significant for the business as they are utilised for the conduct of day-to-day
functioning and for meeting miscellaneous expenses. 2) Current Liabilities:
Current liabilities are short-term liabilities, which need to be liquidated and
converted into cash generally within one year.
Objectives of Working Capital A. Maintaining an appropriate level of
working capital resources to ensure the operational and growth aspects; and
B. Augmentation of profit by ensuring that the investment in working capital
is kept at the minimum level. For the convenience sake, the above objectives
may be broken into step-wise small segments as under: I. Minimization of
the cash conversion cycle; II. Reduction in the amount invested in the
current assets. III. Reduction of the gap between the timings of the capital
outflow and inflows of cash; IV. Reduction in the process costs; and V. Sales
activities.
Concept of Working Capital Working capital finance has two concepts, viz.
1) Gross Working Capital 2) Net Working Capital 1) Gross Working Capital:-
The investment made by the company into current assets is referred to as
the Gross Working Capital. Examples of current assets are: Constituents of
Current Assets1) Cash in hand and bank balances, 2) Bills Receivables, 3)
Sundry Debtors (less provision for bad debts), 4) Short-term loans and
advances, 5) Inventories of stocks, as: i) Raw materials, ii) Work-in-process,
iii) Stores and spares, iv) Finished goods. 6) Temporary Investment of surplus
funds, 7) Prepaid Expenses, 8) Accrued Incomes. 2) Net Working Capital:-
The difference between current assets and current liabilities of a company
is referred to as the Net Working Capital. Net Working Capital = Current
Assets – Current Liabilities Constituents of Current Liabilities 1) Bills Payable,
2) Sundry Creditors or Accounts Payable,
Estimation and Calculation of Working Capital Requirement A company
must be able to assess its working capital requirement appropriately for the
hassle-free conduct of business. Bifurcation of the working capital into
‘Permanent Working Capital’ and ‘Temporary Working Capital’ would follow
thereafter which enables the business entity to take a decision regarding the
level of working capital to be financed from long-term sources and the level
of working capital to be financed from short-term sources 1) Working
Capital as a Percentage of Net Sales: The underlying principle of this
approach is that there is a direct relationship between the working capital
of the company and the volume of its sales. It is presumed that a higher level
of sales warrants a higher level of working capital. The working capital
requirement is indicated as a percentage of projected sales i) Assessment of
total current assets as percentage of projected net sales. ii) Assessment of
total current liabilities as percentage of projected net sales. iii) The
difference between (i) and (ii) would be the net working capital as
percentage of net sales. 2) Working Capital as a Percentage of Total Assets
or Fixed Assets: The assessment of working capital under this approach is
based on the fact that sum of the ‘Fixed Assets’ and ‘Current Assets’ of the
company constitute its ‘Total Assets’. On the basis of historical data,
relationship between ‘Gross Working Capital’ (total current assets), ‘Net
Working Capital’ (current assets minus current liabilities), and ‘Total Fixed
Assets’ (total assets minus current assets) of the company is established. 3)
Projected Balance Sheet Method: In this method, a ‘Projected Balance
Sheet’ is prepared which involves future assessment (forecasting) of various
components of assets (including cash) as well as that of liabilities considered
as ‘Surplus’ as ‘Shortage’ of that period. 4) Adjusted Profit and Loss
Method: On the basis of the past transactions, the estimation of profit is
computed. This is adjusted by ‘Cash Inflows’ and ‘Cash Outflows’ to arrive at
the figure of increase or decrease in ‘Working Capital’. This method is almost
like ‘Cashflow’ statement and is used by some of the Indian banks for
calculation of ‘Working Capital’. 5) Working Capital Based on Operating
Cycle: This method may be used by any company for the computation of its
‘Working Capital’. It facilitates estimation of the ‘Time Scale’ for which
current assets are held under each stage of the cycle, viz. Raw Material (RM),
Work-in-Progress (WIP), Finished Goods (FG), Sales, and Sales Proceeds.
However, the funds invested in the maintenance of these current assets are
not a part of this concept.
Module 5 How does dividend decision affects an organization. Discuss the
relevance and irrelevance theories of dividend decision in brief. Dividend
The term dividend denotes that part of company’s balance of profits (after
the execution of its ‘Retained Earning’), which is available for equal
distribution amongst the shareholders (investors) of the company.
Dividends are a form of incentive to the shareholders for having invested in
the company’s shares. This is the return out of the profit made by a company
during a year, for its shareholders (beneficiaries).
Types/Forms of Dividend 1) On the Basis of Types of Shares i) Equity
Dividend: Dividends distributed to the equity shareholders of a company are
known as equity dividend. Their quantum and timing is decided on the
recommendation of Board of Directors. Rate of equity dividends are not
fixed (unlike in the case of dividends on preference shares, which are fixes)
and depends upon the profit earned by the company during a particular year
and the company’s need of funds in future. ii) Preference Dividend:
Dividends, as the nomenclature indicates, are the dividends distributed
amongst the preference shareholders. The rate of preference dividend is
fixed (pre-decided) and does not depend upon the profits earned by a
company during a particular year. However, the decision with regard to the
distribution of preference dividends is taken on the basis of the
recommendation of the Board of Directors.
2) On the Basis of Medes of Payment i) Cash Dividend: The decision
regarding declaration of dividends is taken in a Board Meeting, wherein the
voting and consideration on the subject takes place amongst the Board
Directors (BoD). After the declaration, the payment is not immediate, as the
process of transfer of stock between the holders takes time and an up-to-
date list of stockholders is required for the purpose. ii) Bonus Share/Stock
Dividend: Sometimes, when the profits made by a company are substantial,
it may decide to retain a part thereof by capitalizing and retaining it in the
business perpetually by issuing stock dividends (additional or bonus
stocks/shares in lieu of cash) to the existing stockholders iii) Scrip Dividend:
In a situation, where in a company is: a) Suffering from a temporary liquidity
crunch, and b) Has and adequate level of retained earnings. It may decide
to issue ‘Scrip Dividends’ in lieu of ‘Cash Dividends’, ‘Scrip Dividends’ may be
issued either as ‘Promissory Notes’ (which may be discounted before its ‘due
date’) or ‘Ordinary Shares’ Issue of ‘Scrip Dividends’ may result in increase
in the number of shares of the company, but there will be no increase in the
value of the company. iv) Bond Dividends: ‘Bond Dividends’ may be defined
as ‘dividend distribution that is paid to shareholders in the form of a bond
or debenture (debt instruments) instead of cash’. It has fixed rate of interest
for ling duration. Issue of ‘Bond Dividends’ is opted by a company under the
same situation as that of issue of ‘Scrip Dividends’, and have the same
impact. v) Property Dividend: ‘Property Dividend’ is an alternative to ‘Cash
Dividend’, ‘Scrip Dividend’ or ‘Bond Dividend’. 3) On the Basis of Time of
Payment i) Interim Dividend: Dividend is normally declared in the Annual
General Meeting (AGM) of a company after the finalization of the balance
sheet at the end of a financial year. However, at times the dividend is
declared and paid before the finalization of the balance sheet or before AGM
of a company. ii) Regular Dividend: The dividend declared in the Annual
General Meeting, in the normal course of business, is known as ‘Regular
Dividend’, Regular Dividend is declared iii) Special Dividend: A well-founded
‘Dividend Policy’ needs to be framed with a provision to ensure that
frequency in change of the dividend rate is kept at the minimum from year
to year and the level of profitability is not same every year.
Dividend Policy • The vision of a company regarding the part (amount) of
profit (remaining after the retained earnings are kept aside) to be declared
as dividend, is referred to as its ‘Dividend Policy’. • Dividend Policy of a
company is developed and implemented through its ‘Board of Directors’. •
It defines the pattern of dividend declarations to ne followed in the long-
term. “Dividend policy determines the division of earnings between
payments to shareholders and related earnings”. The ‘Dividend Policy’ of a
company needs to be framed by its management in such a way that the net
earnings are split into ‘Retained Earnings’ and ‘Dividends’ in an appropriate
manner. 4. Nature of Dividend Policy The dividend Policy of a company
entails following characteristics: 1) Close Relationship with Retained
Earnings: There is a close relationship between the ‘Dividend Policy’ of a
company and its on ‘Retained Earnings’; these are the two ‘end products’ of
a company’s ‘Net Profits’ in a given year. 2) Impact of ‘Dividend Policy’ on
Future Financial Decisions: ‘Dividend Policy’ of a company has the capacity
to impact other future financial decisions to be taken by the company.
Dividend distribution to the shareholders results in the reduction of liquidity
strength of a company. It may have to seek funds from other external
sources to that extent, the cost of which may be more, when compared with
the cost of ‘Retained earnings’. 3) Impact on Shares: ‘Dividend Policy’ of a
company is of extreme significance as it has wide-ranging effect; it directly
impacts: i) Market price of the shares, ii) Liquidity position, iii) Financing
decisions, iv) ‘Growth rate of the business, v) Maximisation of shareholder’s
wealth
Limitations of Dividend Decision 1) Information Signalling: The
management cannot disclose any information of the company to the
investors. Due to this, communication gap arises between management and
shareholders and this will increase the price of stock which is less than under
the conditions of information symmetry. 2) Clientele Effect: The investors
have different types of demand. There are some which require more
dividends while other wants more capital gains or the other requires the
balance of both dividend income and capital gains. As the time passes the
investors invest in the firm which offer the dividend polity as per their
requirements. The clientele effects suggest that: i) Firm will get investors of
a according to their demand; and ii) The firm cannot change its regular
dividend policy. 3) Cost of Capital: This helps to decide whether the
distribution of capital is to be done or not. 4) Objectives Realisation: The
dividend policy formulated by the firm should follow the objective of the
firm of shareholder’s wealth maximisation which consists of current rate of
dividend. It is also considering for the formulation of dividend. 5)
Shareholder’s Members: These members are also get affected by the
dividend policy. The company with low pay-out with heavy re-investment
attracts more shareholders involved in capital gains instead of current
income.