Ch3 Financing and Dividend Decision

8/10/2019 Ch3 Financing and Dividend Decision

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6. List out the types of Leverage.

Leverages can be classified into following four types:

Financial leverage Operating leverage Composite leverage Working capital leverage.

7. What is meant by operating leverage?

Operating leverage indicates any changes in the sales may related to change in

revenue. It may be defined as the tendency of operating profit to vary

disproportionately with the sales. Simply said when a firm has to pay fixed cost

regardless of volume of output or sales. In any firm has a high degree of operating

leverage means it employs a huge amount of fixed costs and a lower amount of

variable costs. Suppose the firm will have a lower operating leverage means its

employees a huge amount of variable cost at a lower amount of fixed cost.

8. What is meant by Trading on Equity?

Financial leverage is also some times termed as trading on equity. However, most ofthe authors on financial management are the opinion that the term trading on

equity should be used for the term financial leverage only when the financial

leverage is favorable. The company resorts to trading on equity with the objective of

giving the equity share holders a higher rate of return than the general rate of

earning on capital employed in the company, to compensate them for the risk they

have to bear.


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9. What are the limitations of trading on equity?

The financial leverage or traded on equity suffers from the following limitations:

Double edged weapon

Beneficial only to companies having stability of earnings

Increases risk and rate of interest

Restrictions from financial institutions.

10. Give the meaning of working capital leverage.

Working capital means excess current assets over current liabilities. Actually the

working capital leverage determines the sensitivity level of return on investment

(ROI) of changes in the level of current assets.

Working capital leverage = %change in ROI

---------------------------

% change in CA

Note : suppose the earnings are not affected by the change in current assets and then

working capital leverage can be calculated as follows.

WCL = CA/ TA +_ DCA

Where:

WCL = working capital leverage

CA = current Assets

TA = Total Assets

DCA = Changes in the level of current assets


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11. State the factors involved in operating leverage. The quantum of sales The amount of fixed costs The contribution margin

12. Define profit planning.

The earning per share is affected by the degree of financial leverage. If the

profitability of the concern is increasing then fixed cost funds will help in increasing

the availability of profits for equity stock holders. Therefore, financial leverage is

important for profit planning. The level of sales and resultant profitability is helpful

in profit planning. An important tool for profit planning is break even analysis. The

concept of break even analysis is used to understand financial leverage. So

financial leverage is vey important for profit planning.

Capital structure

1. Define capital structure.

According to Gerestenbeg, Capital structure of a company refers to the

composition or make up of its capitalization and it includes all long term

resources viz., loans, reserves , shares and bonds.

2. Write a note on importance of capital structure. The term capital structure refers to the relationship between various long

term forms of financing such as debenture, preference share capital, and

equity share capital.

Financing the firms asset is a very crucial problem in every business and

as a general rule there should be a proper mix of debt and equity capital

in financing firms asset.


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The use of long term fixed interest bearing debt and preference share

capital along with equity shares is called financial leverage or trading on

equity.

3. What is optimal capital structure?

The optimum capital structure may be defined as that capital structure or

combination of debt equity that leads to the maximum value of the firm optimal

structure maximizes the value of the company and hence wealth of its owners

and minimizes the companys cost of capital. Thus, every firm should aim at

achieving the optimal capital structure and then to maintain it.

4. Name various theories of capital structure.

Different kinds of theories have been propounded by different authors to explain

the relationship between capital structure, cost of capital and value of the firm.

The main contributors to the theories are Durand, Ezra, Solomon, Modigliani and

Miller. The important theories are discussed below:

Net Income Approach Net Operating Income Approach

The Traditional Approach Modigliani and Miller Approach

5. What are the essentials of sound capital mix?

A sound or an appropriate capital structure should have the following essential

features:

Maximum possible use of leverage

The capital structure should be flexible To avoid undue financial/ business risk with increase of debt The use of debt should be within the capacity of a firm. Minimum possible risk of loss of control Undue restrictions in agreement of debt


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6. What is capital gearing?

The term capital gearing refers to the relationship between equity capital and

long term debt. It may be planned or historical , the latter describing a state of

affairs where the capital structure has evolved over a period of time, but not

necessarily in the most advantageous way. In simple words capital gearing

means the ratio between the various types of securities in the capital structure

of the company.

7. What is meant by financial risk?

The financial risk arises on account of the use of debt or fixed interest bearing

securities in capital. A company with no debt financing has no financial risk. The

extent of financial risk depends on the leverage of the firms capital structure. A

firm using debt in its capital has to pay fixed interest charges and the lack of

ability to pay fixed interest increases the risk of liquidation. The financial risk

also implies the variability of earnings available to equity shareholders.

8. What are the assumptions of MM hypothesis?

The M&M approach is based upon the following assumptions:

There are no corporate taxes There is a perfect market Investors act rationally The expected earnings of all the firms have identical risk characteristics The cut off point of investment in a firm capitalization rate. Risk to investors depends upon the random fluctuations of expected

earnings and the possibility that the actual value of the variables may

turn out to be different from their best estimates. All earnings are distributed to the share holders


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9. Differentiate capitalization and capital structure. Capitalization is a quantitative aspect of the financial planning of an

enterprise while capital structure is concerned with the qualitative

aspect.

Capitalization refers to the total amount of securities issued by a

company while capital structure refers to the kinds of securities and

the proportionate amounts that make up capitalization.

10. Write a note on Arbitrage process.

The Arbitrage process is the operational justification of MM hypothesis. The

term Arbitrage refers to an act of buying an asset or security in one market

having lower price and selling it another market at a higher price. The

consequence of such action is that the market price of the securities of the two

firms exactly similar in all respects except in their capital structures cannot for

long remain different in different markets. Thus, arbitrage process restores

equilibrium in values of securities.

11. Discuss any five factors relevant to determining capital structure.The factors influencing the capital structure are discussed as follows:

Financial leverage or trading on equity Growth and stability of sales Cost of capital Risk Cash flow ability to service debt

Nature and size of a firm Control Flexibility Requirement s of investors Capital market conditions Asset structure


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12. Explain the term point of indifference.

The point of indifference refers to that EBIT level at which earnings per

share(EPS) remains the same irrespective of different alternatives of debt equity

mix. While calculating the equivalency point, the provision for repayment of debt

or obligation towards sinking fund has not been considered so far. However,

sinking fund appropriations for redemption of debt decrease the amount of

earnings available for equity shareholders. Thus, a finance manager may be

interested to determine the level of EBIT at which uncommitted earnings per

share (UEPS) after deducting sinking fund appropriation would be the same.

The equivalency point for uncommitted earnings per share can be

calculated as below:

(X- I1) (I - T) PD SF = (X-I2) (I-T) PD SF

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S1 S2

Where:

X = Equivalency point or point of indifference or break even EBIT level

I1 = Interest rate under alternative financial plan 1

I2 = Interest rate under alternative financial plan 2

T = Tax rate

PD = preference dividend

SF = sinking fund obligations

S1 = No. of equity shares or amount of share capital under plan 1

S2 = No. of equity shares or amount of share capital under plan 2


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13. What do you understand by bankruptcy costs?

When a firm uses more and more debt in its capital mix the financial risk of the

firm increases. It may not be able to pay the fixed interest to the suppliers of

debt and they may force the firm to liquidate. The firm runs in to the cost of

financial distress and bankruptcy.

14. What do you understand by agency costs?

When a firm raises debt the suppliers of debt put restrictive conditions in the

loan agreement resulting into lesser freedom to the management in decision

making called agency costs.

15. Write a short note on pecking order theory of capital structure.

The pecking order theory as suggested by Myres in 1984, the order of preference

for raising finance arises because of their existence of a asymmetric information

between the market and the firm. He argues that because of asymmetric

information, the market may undervalue the project and the firm may prefer

internal funds and then raising of debt as compared to issue of new equity share

capital.

Dividend policy

1. Name the two main theories of dividend.

The two main theories of dividend:

The irrelevance concept of dividend

i. Residual approach

ii. Modigliani and Miller approach The relevance concept of Divided

i. Walters Approach

ii. Gordons Approach


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2. Enlist the factors that influence the dividend policy of a firm.

The following are the important factors which determine the dividend

policy of a firm:

a. Legal requirements

b. Magnitude and trend of earnings

c. Desire and type of share holders

d. Nature of industry

e. Age of the company

f. Future financial requirements

g. Governments economic policy

h. Taxation policy

i. Inflation

j. Control objectives

k. Requirements of institutional investors

l. Stability of dividends

m. Liquid resources.

3. What is the significance of stable dividend?A stable dividend policy is advantageous to both the investors and the

company on account of the following:

a) It is sign of continued normal operations of the company

b) It stabilizes the market value of shares

c) It creates confidence among the investors

d) It provides a source of livelihood to those investors who view

dividends as a source of funds to meet day to day expenses.


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7. Give sources of bonus issue.

The bonus shares can issued out of the following sources:

1) Balance in the profits and loss account

2) General reserve

3) Capital reserve

4) Balance in the sinking fund Reserve for Redemption of

Debentures have been redeemed

5) Development of rebate reserve, development of allowance

reserve, etc., allowed under the Income Tax Act,1961 after the

expiry of the specified period (8 yrs)

6) Capital redemption reserve account

7) Premium received in cash.

8. Bonus issue vs. stock split.

Stock dividend means the issue of bonus shares to the existing

shareholders of the company. It amounts to capitalization of earnings and

distribution of profits among the existing shareholders without affecting

the cash position of the firm. Stock split, on the other hand, meansreducing the par value of the shares by increasing the number of shares

proportionately.

9. Write a note on dividend policy in practice.

We have observed earlier that the main consideration in determining the

dividend policy is the objective of maximization of wealth of

shareholders. Thus, a firm should retain the earnings if it has profitableinvestment opportunities, giving a higher rate of return than the cost of

retained earnings, otherwise it should pay them as dividends. It implies

that a firm should treat retained earnings as the active decision variable

and the dividends as the passive residual.


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10. What do you mean by right issue?

In case of joint stock companies or corporations, generally the

shareholders are given the pre emptive right either by their character

or by the act applicable to them. The pre emptive right gives holders of

common stock (or equity shares) the first option to purchase additional

issue of common stock. Right shares are the shares so issued to the

shareholders under such pre emptive right.

11. Write a note on buy back shares.

The companies (Amendment) ordinance (October 31,1988 and January

7,1999) have allowed companies to buy back shares subject to

regulations laid down by SEBI. The new sections (77A and 77B) in the

ordinance lay down following provisions concerning buy back shares:

A company can finance its buy back of (i) its free reserves or (ii)

the securities premium account or (iii) proceeds of an earlier issue

other than fresh issue of shares made specifically for buy back

purposes.

A company is allowed to buy back subject to following conditions:

a) The buy back is authorized by its articles;b) A special resolution has been passed in general meeting of

the company authorizing buy back;

c) The buy back does not exceed 25 per cent of the total paid

up capital and free reserves of the company.

d) Debt equity (including free reserves)does not exceed to

2:1 after the proposed buy back;

e) All shares or other specified securities are fully paid up;and

f) The buy back is in accordance with SEBI regulations framed

for this purpose.


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12. Outline the types of dividend policies.

The various types of dividend policies are discussed as follows:

Regular dividend policy Stable dividend policy Irregular dividend policy No dividend policy.

13. Name various methods of dividends.

The forms of dividends are:

Profit dividend Liquidation dividend Interim dividend Final dividend Cash dividend Scrip or bond dividend Property dividend Stock dividend

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Ch3 Financing and Dividend Decision