MANAGEMENT OF PROFITS/DIVIDEND POLICY

• Dividends are periodic payments by a firm to it’s shareholders as rewards

for their investment .
• ‘Dividend policy’ refers to the decision on how much of earnings or what
proportion of earnings must be distributed so as to enhance the value of
firm.
• Whether or not the dividend decisions can contribute to the value of the
firm is a debatable issue.
• Walter and Gordon believes that the dividend policy impacts the value of
the firm whereas Miller & Modigliani ( MM ) believes in the opposite
philosophy of irrelevance of dividend policy in determination of the value
of the firm.
• Dividends can be in the form of cash or stock or share buyback.
• Dividends vs Capital gains

* PROF. N.N.PANDEY 1
 FACTORS INFLUENCING DIVIDEND POLICY

• Nature of business
• Age of company
• Liquidity position of the company
• Equity shareholders preference for current income
• Requirement of institutional investors
• Legal rules
• Financial needs of the company
• Easy access to the capital market
• Control objectives
• Dividend policy of competitors

* PROF. N.N.PANDEY 2
 WALTER’S MODEL

• Prof. Walter argues that the choice of dividend pay-out ratio almost always affects
the value of the firm.
• He very scholarly studied the significance of the relationship between internal rate
of return ( r ) and cost of capital ( k ) in determining optimum dividend policy which
maximizes the wealth of shareholders
• MODEL : P = [D + {r / ke ( E – D )}] / Ke
• Here , p = market price per share , D = dividend per share, E = earning per share , r
= rate of return , ke = cost of equity capital
• According to Walter , the optimum pay out ratio is 0% when r > Ke or 100 % when r
< Ke . For r = Ke , there is no optimum pay out ratio.

* PROF. N.N.PANDEY 3
 GORDON MODEL

P0 = E1 (1 – b) / k – br
where P0 = price per share at the end of year 0
E1 = earnings per share at the end of year 1
(1 – b) = dividend payout ratio
b = plough back ratio
k = shareholders’ required rate of return
r = rate of return earned on investments made by the firm
br = growth rate of earnings / dividends

IMPLICATIONS
• The optimal payout ratio for a growth firm (r > k) is nil

• The payout ratio for a normal firm is irrelevant

• The optimal payout ratio for a declining firm (r < k) is 100 percent

* PROF. N.N.PANDEY 4
 MILLER AND MODIGLIANI ( MM ) THEORY

• According to MM , the dividend policy of a firm is irrelevant , as it does not

affect the wealth of shareholders .
• This model which is based on certain assumptions , sidelined the
importance of the dividend policy and it’s effect thereof on the share price
of the firm .
• According to this theory, the value of a firm depends solely on it’s earnings
power resulting from the investment policy and not influenced by the
manner in which it’s earnings are split between dividends and retained
earnings.

* PROF. N.N.PANDEY 5
 ADVANTAGES AND DISADVANTAGES OF BONUS SHARE

ADVANTAGES
Encouraging retail participation
Alternative to paying dividends
Displaying financial health
Favorable tax treatment

DISADVANTAGES
Opportunity cost
Negative impact on dividends
No immediate financial benefit

* PROF. N.N.PANDEY 6
 WORKING CAPITAL MANAGEMENT

• Working capital (WC ) refers to short term funds to meet operating

expenses.
• According to Ramamoorty , “ it refers to the funds, which a company must
possess to finance it’s day to day operation.”
• It is concerned with the management of the current assets and current
liabilities .
• Broadly there are two concepts of WC ( a ) Gross working capital and ( b )
Net working capital.
• On the basis of time WC can be of two kinds :
( a ) Permanent working capital
( b ) Temporary working capital

* PROF. N.N.PANDEY 7
 PERMANENT AND TEMPORARY WORKING CAPITAL

• PWC is the minimum investment kept in the form of inventory of raw materials ,
work – in – progress , finished goods , stores and spares and book debts to
facilitate smooth operation in a firm.
• A firm is required to maintain an additional current assets temporarily over and
above permanent working capital to satisfy cyclical demands . That additional
working capital is called TWC.
• It can better illustrated with the following graph :

TWC

Working PWC
capital

TIME

* PROF. N.N.PANDEY 8
 OBJECTIVES OF WORKING CAPITAL MANAGEMENT

• To ensure optimum investments in current assets

• To strike a balance between the twin objectives of liquidity and

profitability

• To ensure adequate flow of funds for current operations.

• To speed up the flow of funds or to minimize the stagnation of funds.

* PROF. N.N.PANDEY 9
 Approaches to Determine financing mix in respect of
working capital

The following points highlight the three approaches for

determining the appropriate working capital financial mix, i.e.,
The Hedging or Matching Approach
The Conservative Approach
The Aggressive Approach.

* PROF. N.N.PANDEY 10
 OPERATING CYCLE

• The continuing flow from cash to suppliers to inventory to accounts receivable and
back into cash , is what is called THE OPERATING CYCLE.

DEBTORS

CREDIT SALES

CASH SALES
CASH SALES
OPERATING CYCLE

RAW MATERIALS FINISHED GOODS

WORK-IN-PROGRESS

* PROF. N.N.PANDEY 11
 EXAMPLE – 1
From the following information , you are required to estimate the
Net working capital : COST PER UNIT(RS)
Raw materials 200
Direct lab our 100
overhead 250
TOTAL 550
Estimated data for the forthcoming period is given as under :
Raw materials in stock average 6 weeks
W.I.P (assume 50% completion stage with
full material consumption ) 2 weeks
Finished goods in stock 4 weeks
Credit allowed by suppliers 4 weeks
Credit allowed to debtors 6 weeks
Cash at bank expected to be Rs. 75,000/-
Selling price Rs. 800/- per unit
Output 52,000 units

Assume that production is sustained at an even pace during 52 weeks of the year.
All sales are on credit basis .

* PROF. N.N.PANDEY 12
 SOLUTION - 1

Nature of Assets / Liabilities basis of calculation amount

A. Current Assets
i. Raw materials stock 52,000 x 200 x 6/52 12,00,000
ii. Work in progress :
( a ) Raw materials 52,000 x 200 x 2/52 4,00,000
( b ) Direct lab our & OH
( 50% completion ) 52,000 x 175 x 2/52 3,50,000
iii. Finished goods stock 52,000 x 550 x 4/52 22,00,000
iv. Debtors 52,000 x 800 x 6 / 52 48,00,000
v. Cash at bank 75,000
TOTAL 90,25,000
B. Current liabilities
Creditors 52,000 x 200 x 4/52 8,00,000

NET WORKING CAPITAL A–B 82,25,000

* PROF. N.N.PANDEY 13
 EXAMPLE – 2

X & CO. is desirous to purchase a business and has consulted you . You are asked to advise Them regarding
the average amount of working capital required in the first year. You are
Given the following estimates : AMOUNT FOR THE YEAR
( I ) average amount blocked for stocks : ( Rs )
stock of finished goods 5,000
stock of stores , materials etc 8,000
( ii ) average credit given :
inland sales 6 weeks credit 3,12,000
export sales 1 & ½ weeks credit 78,000
( iii ) average time lag in payment of wages and other :
Wages 1 & ½ weeks 2,60,000
stock & materials 1 & ½ months 48,000
rent , royalties etc. 6 months 10,000
clerical staff ½ months 62,400
manager ½ months 4,800
miscellaneous expenses 1 & ½ months 48,000
( iv ) payment in advance :
sundry expenses ( paid quarterly in advance ) 8,000

* PROF. N.N.PANDEY 14
 SOLUTION – 2
STATEMENT SHOWING WORKING CAPITAL FOR X & CO

( A ) Current assets :
( I ) stock of finished goods 5,000
( ii ) stock of stores , materials etc 8,000
( iii ) debtors :
( a ) Inland : 3,12,000 x 6 / 52 weeks 36,000
( b ) export : 78,000 x 1.5 / 52 weeks 2250
( Iv) advance payment of s. expenses : 8000 x 3 months/ 12 months 2,000
TOTAL INVESTMENT IN CURRENT ASSETS 53,250
( B ) CURRENT LIABILITIES :
i. Wages : 2,60,000 x 1.5 / 52 weeks 7,500
ii. Stocks , materials : 48,000 x 1.5 / 12 months 6,000
iii. Rent , royalties : 10,000 x 6 /12 months 5,000
iv. Clerical staff : 62,400 x 0.5 / 12 months 2,600
v. Manager : 4,800 x 0.5 / 12 months 200
vi. Misc. expenses : 48,000 x 1.5 / 12 months 6,000
TOTAL ESTIMATES OF CURRENT LIABILITIES 27,300
NET WORKING CAPITAL ( A – B ) 25,950

* PROF. N.N.PANDEY 15
 DETERMINANTS OF WORKING CAPITAL

• General nature of business

• Production cycle
• Business cycle
• Credit policy
• Growth and expansion
• Availability of raw material
• Level of taxes
• Dividend policy
• Price level changes

* PROF. N.N.PANDEY 16
 INVENTORY MANAGEMENT

INVENTORY

FINISHED STORES
RAW WORK
PRODUCTS &
MATERIALS IN PROGRESS
SPARES
MOTIVES OF INVENTORY MANAGEMENT

( I ) The Transaction motive

( II ) The precautionary motive
( III ) The Speculative motive

* PROF. N.N.PANDEY 17
 OBJECTIVES OR BENEFITS OF INVENTORY MANAGEMENT

• Ensure a continuous supply of Raw Materials and supplies to facilitate

uninterrupted production.
• Maintain sufficient stocks of raw materials in periods of short supply and
anticipate price change.
• Maintain sufficient finished goods inventory for smooth sales operation ,
and efficient customer service .
• Minimize the carrying costs and time.
• Control investment in inventories and keep it at an optimum level.
• Elimination of duplication in ordering by centralization of purchases.
• Provide data for short – term and long – term planning and control of
inventories.

* PROF. N.N.PANDEY 18
 COSTS OF HOLDING INVENTORY

• There are three costs involved in the management of inventories :

( I ) ORDERING COSTS :
Ordering costs are those costs that are associated with the acquisition of raw
materials.
In other words, the costs that are spend, from placing an order for
raw-materials to the receipt of raw-materials.
They include :
a) Cost of requisitioning the items ( raw materials )
b) Cost of preparation of purchase order i.e. drafting, typing, dispatch , postage
etc.
c) Cost of transportation of goods.
d) Cost of receiving and verifying the goods.
e) Cost of un loading of goods
f) Storage and stocking charges

* PROF. N.N.PANDEY 19
 ( ii ) INVENTORY CARRYING COSTS

Inventory carrying costs are those costs , which are associated

In carrying or maintaining inventory. This includes :
a) Capital cost ( interest on capital locked in the inventories)
b) Storage cost ( insurance, maintenance of building , utilities serving
costs )
a) Insurance ( on inventory against fire and theft )
b) Obsolescence cost and deterioration
c) Taxes

Carrying costs usually constitute around 25% of the value of Inventories held.

* PROF. N.N.PANDEY 20
 ( iii ) SHORTAGE COSTS OR COSTS OF STOCK –
OUT

Shortage costs are those costs that arise due to stock out ,
Either shortage of raw materials or finished goods.
( a ) shortage of inventories of raw materials affect the firm in
following ways :
The firm may have to pay some higher prices , connected with immediate
( cash ) procurements.
The firm may have to compulsorily resort to some different production
schedules , which may not be as efficient and economical.
( b ) shortage of finished goods may result in the dissatisfaction
of the customers and resultant lead to loss of revenue.

* PROF. N.N.PANDEY 21
 CASH MANAGEMENT

Good cash management is simple. It involves :

❖ Knowing when, where , and how your cash needs will
occur;
❖ Knowing the best sources for meeting additional cash
needs;
❖ Being prepared to meet these needs when they
occur, by keeping good relationships with banker and
other creditors.

* PROF. N.N.PANDEY 22
 MOTIVES FOR HOLDING CASH

• THE TRANSACTION MOTIVE

• THE PRECAUTIONARY MOTIVE
• THE SPECULATIVE MOTIVE

* PROF. N.N.PANDEY 23
 RECEIVABLE MANAGEMENT

• Accounts receivable or simply receivables represents the value of unpaid

customer’s invoices.
• Due to the magnitude of funds blocked in the receivables, they affect both
the top line and bottom-line.
• Management and control of receivables assumes great significance in
business world.
• Credit policy influences the sales, cost of financing , bad debts, collection
costs and cash discount.
• The receivable management includes , the framing of credit policy , credit
evaluation of customers and credit control.
• Firms should follow optimum credit policy that lies between lenient and
stringent credit policy. Optimum credit policy involves a balance between
costs and benefits.

* PROF. N.N.PANDEY 24