Capital Structure Theories

Fianancial Management

1

Unit IV - Capital Structure Theories

Under favorable economic conditions the EPS increase with financial leverage. But leverage also

increases the financial risk of shareholders. As a result, it cannot be stated definitely whether or

not the firm’s value will increase with leverage. The objectives of a firm should be directed

towards the maximization of the firm’s value. The capital structure or financial leverage

decisions should be examined from the point of its impact on the value of the firm.

The four major theories or approaches which explain the relationship between capital

structure, cost of capital & valuation of the firm are:

Net Income (NI) approach.

Net Operating Income (NOI) approach.

The Traditional approach.

Modigilani Miller (MM) approach.

Net Income (NI) Approach

According to Net Income Approach, suggested by Durand, the capital structure is

relevant to the valuation of the firm. A firm can minimize the overall cost of capital (WACC) by

maximizing the use of debt in capital structure.

A firm that finance its assets by equity & debt is called a levered firm & firm uses no

debt is called unlevered firm.

Suppose firm “L” is levered firm, which expect a perpetual EBIT of Rs. 1000 & pay

interest of Rs. 300. The firm’s cost of equity Ke is 9.33 % & debt is 6 %. What is the value of the

firm?

The value of firm is the sum of the Value of all securities. In this case

Value of Equity Ke = Net Income / Cost of Equity.

= 700 / 0.0933.= Rs. 7500/-

Value of Debt Kd = Interest / Cost of Debt.

= 300/ 0.06 = Rs. 5000/-

Value of Firm = Value of Equity + Value of Debt.

= 7500 + 5000 = 12500 /-

WACC = Cost of Equity with Weight + Cost of Debt with Weight.

= (0.0933 x (7,500/12,500)) + (0.06 x( 5000/ 12,500)) = 8%

If the firm substitutes Equity for Debt & raises its debt ratio to 90 %

WACC = 0.0933 x 10 + 0.06 x 0.9 = 6. 33 %.

Thus a firm can minimize the (WACC) overall cost of capital by maximizing the use of

debt in its capital structure as a result the market price / value of the firm will increases.

This approach is based on following assumption.

1. Cost of debt is less than cost of equity i.e. the firm is able to borrow money less than

the exception of equity shareholder.

2. There is no corporate tax.

3. Use of debt does not alter the risk perception of investors.


2

The logic of NI Approach is simple. Interest rate is generally lower than the dividend rate.

Further interest is allowed as tax deduction in computation of tax. Hence debt is cheaper than

equity. By increasing the proportion of debt in capital structure a firm can cover the overall cost

of capital.

The total market value of the firm (V) under the Net Income Approach is ascertained by the

formula.

V = Value of the firm

E = Value of Equity

D = Value of debt

V = E + D

= [NOI – INT / Ke ] + [INT / Kd]

= [ {NOI-KdD}/ Ke] + KdD/Kd = [{NOI-KdD} /Ke]+D

V = [NOI/Ke ] + D 1- [ Kd/Ke]

The optimum capital structure occurs at the point of minimum (WACC) Under. NI approach the

firm will have minimum WACC & Maximum value when it is 100% debt-financed.

Effect of Leverage on cost of capital under NI approach

Tradition View

Tradition view has emerged as a compromise to the extreme position taken by the NI

approach, like the NI approach, it does not assume constant cost of equity with financial leverage

and continuously declining WACC. According to this view, a judicious mix od debt and equity

capital can increase the value of the firm by reducing the weighted average cost of capital up to

certain level of debt.


3

This approach very clearly implies that WACC decreases only with the reasonable limit of

financial leverage and after reaching the minimum level, it starts increasing with financial

leverage. Hence a firm has an optimum capital structure occurs when WACC us minimum and

thereby maximize the value of the firm.

WACC declines with moderate level of leverage give low cost debt are placed for expensive

equity capital. Financial leverage resulting in risk to share holders will cause the cost of equity to

increase. But traditional view assumes at moderate level of leverage, the increase in the cost of

equity is more than offset by the lower cost of debt. Debt funds are cheaper than equity carries

the clear implication that the cost of debt plans the increased cost of equity together on a

weighted basis will be than the cost of equity.

According to traditional theory, the financial risk caused by introduction of debt may increase

the cost of equity slightly, but not so much the advantage of cheaper.

Debt is taken off totally.

WACC will decrease with the use of debt. But as leverage increase further, shareholders

start expecting higher risk premium inform of increasing cost of equity.

Traditional theory on the relationship capital structure has three stage.

First stage:

The cost of equity Ke the rate at which the shareholders capitalize the net income, either

remains constant or rises slightly with debt. WACC decrease in the inceasing leverage.

Second stage: Optimum value:

Once the firm has reached a certain degree of leverage any subsequant increases in

leverage have a negligible effect on WACC and hence on the value of the firm.

Third stage:

Beyond the acceptable limit of leverage the value of the firm decrease with leverage as

WACC increases with leverage. This happen because investor perceive a high degree of financial

risk & demand a higher equity-capitalization rate.

Modigliani-Miller Approach

MM explain the relationship between capital structure cost of capital & value of the firm under

two conditions.

(a) When there are No Corporate taxes[ Proposition-1]

MM approach is identical to No.1 approach when there are no corporate taxes.MM

argue that in the absence of taxes , the cost of capital and the value of the firm are not

affected by capital structure or debt-equity mix.

Debt is cheaper than equity .But the use debt increases the financial risk and the cost

of equity. The advantage of low cost debt is offset by the increase in cost of equity.

As a result, the overall cost of capital remains unchanged.

According to MM hypothesis, the total value of a firm is determined by its operating

income or EBIT. It is independent of the debt-equity mix. Two firms which are

identical in all aspects except their capital structure cannot have different market


4

value or different cost of capital. If market value differs arbitrage process will take

place &make them equal.

Assumption:

1. There is a perfect market. It implies that

(a) Investors are free to buy &sell securities

(b) They can borrow freely on the same terms as the firm does.

(c) Investors act in a rational manner.

2. There is no corporate tax.

3. There is no transaction cost.

4. The payout is 100%. That is all the earnings are distributed to the shareholder.

5. Firms can be grouped into homogeneous risk classes. Their expected earnings having identical

risk characteristics.

6. Risk to investor depends on the random variations of expected No.1 and the possibility that the

actual value of N0.1 may turn out to be different from their best estimates.

Arbitrage Process

Two firms which are identical in all aspects expect the capital structure, cannot have

different market values. If market value differs, arbitrage process will take place and make them

equal.

For instance, firm A&B are identical expect that A does not use debt while B uses debt in

it’s capital structure. Their market value cannot differ for a long time. If the market value of Firm

B is higher than the market value of Firm A, investors in firm B will sell their shares in the

overvalued firm B. They will buy the shares of firm A, which is undervalued.

In addition, Firm B has no debt. Therefore the investor borrow on their personal account

(substitution of personal leverage for corporate leverage)&use the additional funds for purchases

of shares in firm A.

The demand for the shares of firm A increases and pushes up the market price. On the

other hand, the market price of shares of firm B decline due to the selling pressure. ultimately,

the market value of A&B tend to become equal.

b) When there are corporate taxes:

MM have recognized that capital structure would affect the cost of capital and value of

the firm, when there are corporate taxes if a firm uses debt in its capital structure, the cost of

capital will decline & market value will increase. This is because of the deductibility of the

interest charges for computation of tax.

Interest charges are allowed as deduction in tax computation. Even if the EBT of the

firms, the levered and unlevered are equal the levered firm can have more earnings to its equity

share holders than an unlevered firm. Hence value of levered firm will be higher than that of

unlevered firm.

According to MM approach value of unlevered firm can be calculated as

VU =


5

VL= VU + (T x D)

=Value of unlevered firm + Tax rate X Debt

Criticism of MM approach:

1. Markets are not perfect: Arbitrage process is the foundation for MM approach. For

the effective operation of arbitrage process, markets have to be perfect. But in reality

market are not perfect. Hence the arbitrage process may fail to work & equilibrium

may not be achieved.

2. Higher interest for individual: It is assumed that individuals and firms can borrow

freely on the same terms. However in practise, firms are able to borrow at a lower rate

of interest than individual as they enjoy a higher credit standard.

3. Personal leverage is no substitute for corporate leverage: the assumption that personal

leverage is the perfect substitute for corporate leverage is also not valid. Companies

have limited liability. But individual have the burden of unlimited liability.

4. Transaction cost: MM approach assumes that there is no transaction cost but in

reality, transaction cost has to be incurred for purchase and sell of securities.

5. Corporate tax: The assumption of no corporate tax is not correct in practise reality.

Interest on borrowing is tax deductible. A firm can therefore increase the earnings of

shareholders by employment debt in capital structure.

Designing the Capital Structure

Financial decisions are reactive and the evolve in response to the operating decisions with

unplanned capital structure .these company may also fail to economize the use of their funds

.consequently ,it is being realised that a company should plan its capital structure to maximize

the use of funds and to adapt money easily to the changing environment .

The optimum capital structure is one that maximize the master value of the firm .in threat

maximize the firm in practise the determination of an optimum capital structure is a formidable

task and once has to go beyond the theory. There are significant variation among industries and

companies within industries in terms of capital structure. Since a no of factor influence the

capital structure decision of the company, the judgement of the person making the capital

structure decision plays a crucial role. All the factors highly psychological complex and

qualitative does not always follows accepted rule. Since the capital market are not perfect and the

decision has to be taken under imperfect knowledge and risk

Elements of Capital Structure

The following are the important elements of the company’s financial structure that need

proper security and analyse


6

Capital mix

Firms have to decide about the mix of debt and equity capital. the firms and analyse the

debt ratios .debt service coverage ratio, and fund flow statement to analyse the capital mix

Maturity and Priority

Maturity of securities used may differ .equity is permananent capital and debt,

commercial paper has short market period. Capitalised debt like lease or hire purchase finance is

quite safe from the lenders point of view and value of assets backing the debt provides the

protection to the lender. a firm may obtain a risk neutral position by matching the maturity of

assets and liabilities ,i.e. it may use current liabilities to finance current assets and short medium

and long term debt for financing the fixed assets in that order of maturities .in practise the firm

do not perfectly match the sources and use of funds

Terms and Conditions

Firms have choice with regard to the basis of interest payments .they may obtain loans

either at fixed or floating rate of interest. In case of equity the may firm like to return income

either in the forms of large dividend or large capital gains. Financial manager can protect the

company from interest rate by interest rate of derivatives.

Currency

Firm in a no. Of countries have the choices of raising funds from the overseas market.

Overseas financial market provide opportunist to raise larger amount of funds. Because

international fm market may not be perfect and may not be fully integrated firm may able to its

capital overseas at a lower cost than in it domestic market

Financial innovation

Firm may raise capital either through the issue of simple securities or through the issue of

innovative securities. Financial innovations are intended to make the securities issues attractive

to investors to reduce

Financial market Segment

There are several segments of the financial market from which the firm can tap capital.

e.g.: private or public debt for long term debt, short term debt from bank and commercial paper.

The firms also has the alternative of rising short term funds by public deposit

Approaches to Establish Capital Structure Design

EBIT-EPS Analysis

EBIT-EPS Analysis is an important tool to analysis the impact of alternative financial

plan on the share holders income and its variability. Firm should consider the fluctuation in EBIT


7

and examine impact on EPS under different financial plan. If the probability of rate of return on

the firm’s asset falling below cost of debt the firm can employ high debt to increase EPS.

Valuation Approach

Debt is cheaper source of fund than equity. Higher debt increases the cost of financial

distress and the agency cost also increases. The TDS however add value to the share holders.

Thus there is a tradeoff between the tax benefit and cost of financial distress and agency

problems. The firm should employ debt to the point when the marginal benefits and losts are

equal. This will be point maximum value of the firms minimum WACC.

Cash flow Analysis

One practical method of assessing firm’s ability to carry debt without getting into serious

financial distress is to carry out a comprehensive cash flow analysis over a long period of time. A

sound capital structure is expected to be conservative. Conservatism does not mean employing

no debt (or) small amount of debt. It relating a firm’s ability to generate cash to meet the fixed

charges created by the use of debt in the capital structure under adverse conditions. The optimum

debt equity mix bills down to the firm’s ability to service debt without any threat of insolvency

and operating inflexibility.

FRICT Analysis

Financial structure may be evaluated from various perspectives from the owner’s point of

view, return, risk and value are important consideration from the strategic pont of view, and

flexibility is an important concern. Issues of control, flexibility and feasibility assume great

significance.

Flexibility

Capital structure should be determined within the debt capacity of the company and this

capacity should not be exceeded. The debt capacity of a company depends on its ability to

generate future cash flows. it should have enough cash to pay creditors fixed charges.

Risk

Risk depends on the variability in the firm’s operations. It may be cused by the macro

economic factors and industry and firms specific factors. The excessive use of debt magnifies the

variability and share holders earnings. The solvency of the company.

Income

The capital structure of the company should be most advantageous to the owners of the

firm. It should create value, subject to other consideration and it should generate maximum

return to the shareholders with minimum additional cost.

Control

Capital structure should involve minimum risk of loss of control of the company. The

owners of closely held companies are particularly concerned about dilution of control.

Timing

Capital structure should be feasible to implement given the current and future conditions

of the capital market, the sequencing of the sum of financing is important. The current decision

influences the future option of raising capital.


8

Determinants of Capital Structure

Capital structure of a firm depends on a number of factors. The importance of the factor

varies from firm to firm depends on the business conditions. Some other factors are:

1. Financial Leverage:

Use of long-term debt and preference capital in the capital structure is called Financial

Leverage. The use of debt can help to magnify the earnings of shareholders if the firm earns a

rate, which is higher than the cost of debt. Use of preference share will increase the earnings of

the shareholder. But the leverage effect is less on the preference dividend is not allowed as

deduction in Tax.

However under unfavorable conditions. The firm may earn a rate of return, which is less

than the cost of debt. In given cases leverage will adversely affect the earnings of the

shareholders.

2. Stability & Growth of sales:

Firm, which have stable sales, are not likely face any difficulty in meeting their fixed

commitments of interest and principal repayment. Hence the can employ more debt in the capital

structure. However firm which have widely fluctuating sales should be more careful. It is

advisable for them to employ a high level of debt.

3. Cost of capital

Cost of capital is the minimum return is expected by its supplier. It depends on the degree

of risk assumed by investors. Equity shareholders assume a high degree of risk for them the

dividend is not fixed. The company has no obligation to pay dividend even if it earns profits.

In case of debt holder, Rate of interest is fixed. Company is legally bond to pay interest,

whether it earns profit or not, the lone is also repayable after the expiry of the specified period.

Because of the relativity how risk, debt is a cheaper some of time compared to equity and

preference share capital.

In formulating the capital structure company should aim a minimizing the cost of capital

by an appropriate combination of different sources.

4. Cash flow ability.

Debt financing involves an obligation for payment of interest charges to repayment of the

principal. If the company is not able to generate cash to meet these obligations, it may have to

face solvency, hence a company which want to raise additional debt should asses its cash flow

ability to meet the fixed charges.

5. Control.

In planning the capital structure management of companies prefer to raise additional

funds without loss of control. If new share are issued to outsiders. The control of existing

management may be diluted preference shareholders to debt holders do not have nothing rights.

Hence financing through debt and preference share is desirable from the point of view of control,

especially in the case of closely held compares.

6. Flexibility


9

The company should be able to change the capital the structure according to Changing business

environment. it should be possible for Changing business environment. It should be possible for

company to substitute one sources of finance for another preference shares & debentures,

redeemable at the discretion of the company offer a high degree of flexibility. The capital

structure must be designed to facilitate raising of additional funds easily & quickly.

7. Size of company:

Generally small companies experience difficulties in raising funds from market. Issue of shares

is also costly. There is also the danger of loss of control. Hence small companies have to depend

on owned funds & retained earnings. But large companies enjoy certain advantages designing the

capital structure. They can get loan reasonable term at relating lower rate of interest. Large firms

can make large issues of shares & distribute them widely to avoid loss of capital.

8. Capital market conditions:

Capital market conditions also govern the choice of the sources of finance. During boom period,

huge amount can be raised by the issue of shares on favorable terms. When markets are dull

issue of debentures or preference share is desirable.

9. Floating cost:

Floating cost are cost increased for the issue of shares debenture etc. These cost should be

considered while raising long term funds. The cost of raising debt is less than the cost of issuing

equity shares.

10. Corporate tax rate:

Dept offers tax advantage. Interest on dept allowed as a deduction in computing taxable income.

Hence if corporate tax rate is high. It would b more advantages to raise funds through debt.

11. Legal Requirements:

A company has to comply with legal requirements and govt. guidelines in planning the capital

structure. Eg: manufacturing companies are required to maintain a debt –equity ratio 2:1.there is

guidelines regarding issues of preference shares.

12. Management philosophy:

Attitude of management also affects the capital structure decisions. Some management may be

aggressive & tap the dept & equity market. Conservative management may prefer to rely on

retained earnings and moderate level of dept.

Dividend theory Dividend refers to that part of earnings (profit) of a company which is distributed to

shareholders. Shareholder would like to receive a higher dividend as it increases their current

wealth. But for the company, retention of profits would be desirable as it provide funds for

financing the expansion to growth plans.

Retained earnings are the most important internal sources of finance. A higher dividend

means less retained earnings. It may result in slower growth rate and lower market price of the

shares. Further the company will have to depend on the external sources such as debenture and

new shares. Thus, distribution is desirable from the point of view of shareholder and retention is

advantageous to the company for growth and expansion. The dividend policy must strike a happy


10

balance between dividends and retained earnings in such a way that the value of the firm is

minimized. Hence, dividend policy is a very crucial area of finance.

Dividend Relevance: Walter’s Model

Prof. James E. Walter argues that dividend policy is a crucial factor and it affects the

value of the firm. According to the Walter’s Model dividend policy depends on the firm’s

internal rate of return (r) and cost of capital (k).

The optimum dividend policy depends on the relationship between the firm’s rate of

return r and its cost of capital.

i) Growth firm (r>k) : [Internal rate more than the opportunity cost of capital]

They are able to earn a return(r) which is higher than the cost of capital (k). Hence, growth

firm can benefit by retaining all the earnings for internal investment (100%) and increase the

value of the shares of the firm or they can reinvent the earnings at a rate which is higher than

the rate which is expected by the shareholder.

ii) Normal firm (r=k):

After exhausting super profitable opportunities, normal firm earn on their

investment rate of return equal to the cost of capital. They do not have good investment

opportunities; they are able to earn a rate of return (r) which is just equal to the cost of capital

(k). Hence, distribution or retention of earnings will not make any difference in the value of the

firm. The dividend policy has no effect on the market value of the firm. There is no particular

optimum payout ratio of normal firm.

iii) Declining firms (r<k):

Declining firms do not have profitable investment opportunity. The rate of return

(r) is less than the cost of capital (k). It is advisable for the declining firm not to return the

earnings. The optimum payout is 100%. This will maximize the value of the shares of the

declining firm.

According to Walter’s model, a growth firm should retain all its earnings. A declining

firm should distribute all its earnings. For normal firm, there is no optimum payout. Any

dividend policy is as good as the other.

Assumptions of Walter’s Model

1. The firm finances all its earnings only through retained earnings. It does not use new debt

or equity.

2. Internal rate of return and the cost of capital of the firm remain constant.

3. All the earnings are distributed or retained in the firm.

4. EPS and dividend remain constant in determining a given value.

Walter formula:

Walter’s formula to determine the Market price per share is


11

Market Price Per Share = [D + (r/k) (E-D)] / K

Where D =Dividend, r=Rate of return, K=Cost of capital, E=Earnings per share.

Criticism of Walter’s Model:-

1. The model assumes that a firm finances all its investments only through retained earnings.

The assumption is unrealistic. Firms do raise funds through new debt and equity.

2. The assumption that the cost of capital remains constant is also not true. In fact the rate of

return changes with increase in investment.

3. The model assumes that the cost of capital remains constant. But the cost of capital also

changes because of the changes in risk .Hence the assumption does not hold well.

Dividend Relevance: Gordon’s Model:

The model developed by Myron Gordon suggests that the dividend decision is relevant and it

affect the value of the firm. Gordon’s model explicitly relates that market value of the firm to

dividend policy.

According to Gordon “The market value of the share is equal to the value of an infinite stream of

dividends received by the shareholders.”

Growth firm:

With profitable investment opportunities market price of share increases when dividend payout is

less. Hence growth firms should retain maximum earnings. The optimum payout is zero percent.

Normal firm:

The price per share is not affected by dividend policy. Hence there is no optimum dividend

payout.

Declining firm:

The market price of share increases when dividend payout increases. It is beneficial to distribute

all the earnings, optimum payout is 100%

ASSUMPTIONS OF GORDONS MODEL:

1. The firm is in an all equity firm and it has no debt.

2. No external financing is available. Consequently retained earnings would be used to

finance any expansion.

3. The rate of return on investment is constant.

4. Cost of capital also remains constant.

5. Retained ratio (b)(The proportion of earnings retained).Once decided, remains constant.

Therefore the growth rate (g) (g=br) is also constant.

6. Cost of capital is greater than the growth rate.

7. No corporate taxes.


12

8. The firm and stream of earnings are perpetual.

Gordon’s formula:

According to Gordon’s model, the market price of a share is equal to the present value of future

stream of dividends.

P = D1/(1+k)+D2/(1+k)2+D3/(1+K)

3+........Dt/(1+K)

t

∑ Dt / (1+k)

t

Accordingly the value of the shares can be obtained by the equations

P = D / K - g (or)[ E(1-b)] /[ K – br]

Where P = Market price per share

D = Dividend per share; K = Cost of capital; g = Growth rate(b X r)

E = Earnings per share; b = Retention ratio; r = Rate of return;

Dividend irrelevance: Modigliani- miller(MM)hypothesis:

According to MM approach the value of the firm depends on its earnings. The dividend simply

splits the earnings between retention and dividends. It has no significance in determining the

value of the firm. The dividend decision is irrelevant as it does not affect the wealth of the

shareholders. Hence the MM hypothesis is known as hypothesis of dividend irrelevance.

The MM argument:

The substance of the MM argument is as follows. If the firm distributed dividends the

shareholders benefit. But the benefit to shareholders will be offset by the decline in market price

of shares. As a result there will be no change in the total wealth of the shareholders.

E.g. suppose ABC ltd has investment opportunities. If the company distributes all its earnings

has a dividend. It will have to raise funds by the issue of new shares or debts to finance its

investments. The no of shares will increase or interest charges will go up. As a result, EPS will

decline leading to a fall in market price. The benefit derived by the shareholders on account of

dividend payment will be offset by the fall in market price. Hence division of earnings between

dividends and retained earnings is irrelevant from the point of view of shareholders.

Assumptions of MM model:

1. The capital market is perfect.

2. Investors behave rationally.

3. Information is freely available.

4. There is no floatation cost.

5. There is no transaction cost like Brokerage.

6. There are no taxes or tax rate applicable to dividends and capital gain are the same.

7. The firm has a fixed investment policy.


13

8. There is no risk of uncertainty. Hence investor can forecast dividends and prices with

certainty. A single discount rate can be used for discounting cash inflows at different time

period.

Market Price under MM Model:

Market price of a share at the beginning of a Period (Po) is equal to the Present value of

dividends received at the end of the period plus the market price of the shares at the end of the

period.

Po = P.V of dividends received + Mkt Price of the share at the end of the period.

This can be expressed as follows

Po= [D1/1+ke] + [P1 / 1+Ke ] = [D1 + P1] / [1+Ke]

The value of P1(market price at the end of the period)can be derived from the above equation

P1= [Po(1+Ke)]-D1

Where

P1= Mkt price per share at the end of the period

Po= Current Mkt Price

Ke =Cost of equity capital

D1=Dividend to be received at the end of the period.

Computation of number of new shares

The investment requirements of a firm can be financed by retained earnings or issue of

new shares or both. The number of new shares of the issue is determined as follows:

Rs Rs

1. Investment proposed xxx

2. Net income xxx

3. Less: Dividend distribution xxx

4. Retained earnings available for investment (2)-(3) xxx

5. New shares to be issued for the balance (1)-(4) xxx

6. Issue price of shares xxx

7. No. of shares to be issued (5)/(6) xxx

Criticism of M.M Hypothesis

MM Hypothesis is based on certain simplifying assumption. But the assumptions are not

well founded. As the assumptions are unrealistic, the MM Hypothesis lacks practical relevance.

1. The model assumes perfect capital market. But in practice, capital markets are not

perfect.

2. Information about the company is also not freely available to all.

3. No corporate taxes does not hold good.

4. Firms are assumed to follow a fixed investment policy. In the dynamic real world,

firms do not follow any fixed investment policy.

5. Model assumes that there is no floating cost. But in actual practice, floating costs are

increased by companies.


14

6. No transaction cost is not valid.

Dividend and uncertainty:

According to Gordon’s model, dividend policy is irrelevant where r=k . This also concludes

that dividend policy does affect the value of share where r=k, this view is based on the

assumption that under condition of uncertainty, the investors tend to discount distant dividend at

the higher rate than they discount near dividends. Investors behaving rationally, are risk averse

and therefore have a preference for near dividend to future dividends. The logic underlying the

dividend effect on the share value can be described as a “bird in the hand argument”.

Stability of dividends

Stability of dividends refers to consistency in payment of dividends over the year. It means

a regular payment of a minimum dividend although there may be fluctuation in earnings.

Shareholders generally prefer stable dividend to fluctuating dividend.

Three forms of stable dividends

1. Fixed dividend per share

Payment of constant dividend per share for a long period. it is paid although there may

be a raise or fall in earnings. When the earnings are stable it s easy to maintain a constant

dividend, however when there are wide fluctuations in earnings, companies use dividend

equalization reserve or general reserve to smoothen the dividend payments.

2. Constant payout ratio:

Under this policy the company pays a fixed percentage of its earnings as dividend year

after year. The payout percentage is consistent. The art of dividend varies in the direct

proportion to the earnings of the company.

3. Extra dividend:

If a company pays fixed dividend per share. In year of very high profits, an extra

dividend is paid in addition to the regular dividends.

Advantage of Stable dividend policy:

1. Regular income to investor.

2. Stability of share prices.

3. Investor confidence.

4. Raising of capital.

Determinants of dividend policy/ factor influencing the dividend policy of a firm:

1. Expectations of share holders:

Shareholders are the owners of the company. So the company should consider the dividend

expectation of share holders. They may be interested in dividend or capital gains. The preference

for dividend or capital gains depends on the economic status or attitude of an individual. E.g. a

retired person who wants a regular income may prefer to receive dividends. On the other hand, a

wealthy person may prefer capital gains to dividends.


15

In the case of a closely held company, it is easy to ascertain the wishes of the shareholders. But

in the case of a widely held company it is difficult to ascertain the preference of shareholders.

They may have different desire regarding dividend and capital gain.

2. New investments:

Availability of investment opportunities is an important factor which influences the dividend

decisions. If the company has profitable investment opportunities. It may retain a substantial

part of the earnings and payout a small dividend. If the company does not have good investment

opportunities it is better to distribute the earnings as dividends.

3. Taxation:

In India dividend is tax free in the hands of shareholders long term capital gains on listed shares

sold on or after 1st oct 2004 is also not taxable if securities transaction has been paid. But short

term capital gain is taxable. The shareholders may prefer dividend or capital gains depending on

the effect of tax on their income. Hence a company should keep in mind the taxation aspect

while formulating its dividend policy.

4. Liquidity:

The liquidity position is an important factor which influences the dividend decisions. Sometime a

company which has good earnings may not have sufficient liquidity. In such cases it is advisable

for the company to restrict to the available liquid resources.

5. Access to Capital Market

A company which is confident of raising resource from the capital market, mat pay

higher dividend on the other hand, if the company is unable to raise resources due to its poor

image or the depressed state of the capital markets, it has to contend with a low payout.

6. Restrictions by Lenders

The lender particular financial institutions impose restrictions on the payment of

dividends to safeguard their own interest. EX. A lender may stipulate that only upto 30% of the

profit may be paid as dividend. Because of these restrictions a company may be forced to retain

earnings and have a low payout.

7. Control

Objective of maintaining control by the present management may also affect the dividend

policy. Suppose a company is quite liberal in paying dividends, it may have to raise fund for

expansion or diversification by issue of new shares. If the present management is unable to

subscribe to the new shares its control will be dividend. Hence the management may opt for a

low payout and retain earnings to maintain control over the company.

8. Legal Restrictions

Provision of the companies act to be altered in the formulating of dividend policy.

According to this provision, dividends can be paid only out of current profit or past profits. Only

after provision of depreciation, there are also stipulations regarding transfer of profits to reserve

before declaration of dividends. Further, dividends cannot be paid out of capital.

9. Nature of Earnings

Certain industry like pharmaceuticals, liquor and essential goods have a stready dividend.

Companies in such industries may enjoy stable earnings. They may therefore resort to liberal


16

payout of dividends. However, if the earnings are uncertain because of the cyclical nature of the

industry it is desirable to have a low payout.

10. Stability of Dividend

Stable dividends create a good image of the company. A steady dividend gives a sense of

security and confidence to the shareholder.

Forms of dividend

Dividend payment may take any of the following forms:

1. Cash dividend:

Dividend is paid to shareholder in cash. It is usual method of paying dividends. It result

in outflow of cash. Hence company should arrange adequate cash resources for payment of

dividend.

2. Bond dividend:

If the company does not have sufficient cash resources, it may issue bonds in lien of

dividend. The shareholders get bonds instead of dividends. The company generally pays interest

on these bonds & repays the bonds on maturity. Bond dividend enables the company to postpone

payment of dividend. But it is not popular.

3. Property dividend:

It refers to the payment of dividend in the form of some assets other than cash. This type

of dividend is also not popular.

4. Stock dividend:

Stock dividend refers to the issue of bonuses share to shareholders. Bonus shares are

issued free of cost to shareholders out of accumulated profits. Usually they are issued when a

company has substantial resources but needs to retain cash for expansion/diversification. It does

not result in any outflow of cash. Issue of bonus shares signifies optimism about future profits of

the company.

Bonus shares

Bonus shares are shares issued free of cost to existing shareholders. The shares are issued out of

resources surplus consisting of accumulated profits, shares premium etc. Bonus issue is made to

shareholders in proportion to the number of shares held by them. For instance a bonus issue of

1:2 refers to the issue of one bonus shares for every two shares held by the shareholders. Bonus

shares are also known as stock dividend.

Issue of bonus shares does not alter the total capital structure of the company. It simply

result in conversion of resources & surplus into equity share capital. Hence bonus issue another

capitalization of earnings for company.

Stock split

Stock split signifies a reduction in the par value of a share and a proportionate increase in no

shares. Foe Eg: one share of Rs.100 may be split into 10 shares of Rs.10 each.

Reason for stock split:

1. Attractive share price:

Stock split make the market price of a share appear to be cheap & attractive to investors.

The reduction in, market price motivates the investors to buy the shares.


17

2. Signal & Higher Profits:

The investor perceive state split as an indication of higher future profits. Such positive

perceptions create a favorable impact on the market price of the share.

3. Satisfaction of Shareholders:

Stock split increases the no of shares. Suppose a share holder holds 200 shares of Rs.100

each in K ltd. If the shares are split into shares of Rs.10,he will get 2000 shares of Rs.10 each.

The increase in shareholding gives a sense of satisfaction to the share holders.

Bonus Issue & Stock Split-A Comparison

Bonus Issue Stock Split

1. There is no change in the par value of

the shares.

Par value of the share is reduced.

2. Bonus shares are issued by capitalizing

the earnings. so there is a fall in

reserves & increases the share capital.

There is no capitalization of earnings. so there

is no change in reserves & share capital.

3. The book value per share, the EPS &

market price per share decline

The book value per share, the EPS and market

price decline.

4. Shareholders proportional ownership in

the company remains unchanged.

Shareholders proportional ownership in the

company remains unchanged

5. Market price per share is reduced &

brought within a more popular trading

range

Market price per share is reduced & brought

within a more popular trading range

Documents

Capital Structure Theories