Unit-3.pdf

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Chapter VII

Management of Working Capital

Aim

The aim of this chapter is to enable the students to:

explain working management

elucidate components, aspects and need for working capital

explicate the determinants of working capital

Objectives

The objective of the chapter is to:

enlist the types of working capital

explain gross working capital

elucidate the components of working capital

Learning outcome

At the end of the chapter, you will be able to:

defineworkingcapital

understandthefactorsinfluencingtheworkingcapital

identify net working capital

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7.1 IntroductionWorking capital may be regarded as the lifeblood of a business enterprise. It is, closely, related to the day-to-day operations of the business. Every business needs funds for two purposes. Longterm funds are required for creation of production facilities such as plant and machinery, land, building and furniture, etc. Investment in these assets representsthatpartoffirmscapital,whichispermanentlyblockedonapermanentorfixedbasisandiscalledfixedcapital. The form of these assets does not change, in the normal course.

Funds are, also, needed for purchase of raw materials, payment of wages and other day-today expenses etc. These funds are known as working capital. Funds invested in these assets keep revolving, fast. These assets are converted into cash and, again, cash is converted into current assets. So, working capital is also called revolving or circulating capital. The assets change the form, on a continuous basis. In other words, working capital refers to that part of the firmscapital,whichisrequiredforfinancingshort-termorcurrentassetssuchascash,debtors,inventoriesandmarketable securities, etc.

Capitalisdividedintofixedcapitalandworkingcapital.Fixedcapitalrequiredforestablishmentofabusiness,whereasworkingcapitalrequiredtoutilisefixedassets.

Theefficiencyofabusinessenterprisedependslargelyonitsabilitytomanageitsworkingcapital.

Working capital management therefore, is one of the important facets of a firms overall financial management.

7.2 Meaning and Definition of Working CapitalWorkingcapitalreferstocurrentassetsthatcanbedefinedas:

Those which are convertible into cash or equivalent within a period of one year and those which are required to meet day-to-day operationItisconcernedwiththemanagementofthefirmscurrentassetsandcurrentliabilities.

It refers to the problems that arise in attempting to manage the current assets, current liabilities and their interrelationship between themIfafirmcannotmaintainasatisfactorylevelofworkingcapital,itislikelytobecomeinsolventandevenforcedinto bankruptcy.

To quote Ramamurthy, It refers to the funds,which a companymust possess to finance its day-to-dayoperations.J. S. Mill, "The sum of the current assets is the working capital of the business."

7.3 Classification of Working Capital Workingcapitalcanbeclassifiedintwoways

On the basis of concept On the basis of time

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Kinds of Working Capital

Concept Base

Gross Working Capital or Quantitative

Net Working Capital or Qualitative

Permanent or Regular Working Capital

Temporary or Variable Working Capital

Time Base

Fig. 7.1 Types of working capital

Onthebasisofconcept,workingcapitalisclassifiedasgrossandnetasdiscussedearlier.

Gross working capitalGrossworkingcapitalreferstothefirmsinvestmentintotalcurrentassetsoftheenterprise.Currentassetsarethose,which can be converted into cash, within an accounting year (or operating cycle). They include cash, debtors, bills receivable, stock and marketable securities etc. In a broader sense, working capital refers to gross working capital. liabilities are accounting outstanding

Net working capitalIn the narrow sense, working capital refers to net working capital. Net working capital is the difference between current assets and current liabilities. Current of outsiders, which are expected to mature for payment, within an include creditors, bills payable, bank overdraft/cash credit account and those claims year. They expenses.

Ifthepaymentofcurrentliabilitiesisdelayed,thefirmgetstheavailabilityoffundstothatextent.So,apartofthefundsrequiredtomaintaincurrentassetsisfinancedbythecurrentliabilities.Thefirmisrequiredtoinvestinthecurrentassets,tothatextent,notfinancedbythecurrentliabilities.

If current assets are in excess of current liabilities, net working capital is positive. A negative working capital occurs when the current liabilities exceed current assets.

Treatment of Bank overdraft/cash credit account: Bank overdraft/cash credit account is treated as current liability as the sanction of bank is for one year. It is a different matter bank renews these facilities on a continuous basis, at the request of the borrower, on submission

While, on the basis of time, working capital is divided in two types:Permanent working capitalVariable working capital

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Permanent working capitalIt refers to the minimum amount of investment required in all current assets at all times to carry on the day-to-dayoperationoffirmsbusiness.

Theminimum level of current assets has been given the name of Core current assets by theTandonCommittee.Itisalsoknownasfixedworkingcapital.

Variable/Temporary working capitalItisknownasvariableworkingcapitalorfluctuatingworkingcapital.

Theworkingcapitalkeepsonfluctuatingfromtimetotimeonthebasisofbusinessactivities.

Theadditionalworkingcapitalrequiredasperthechangingproductionandsaleslevelofafirmisknownastemporary working capital.Thefirmsworkingcapitalrequirementsvarydependingupontheseasonalchangesindemandforafirmsproducts.

7.4 Components of Working CapitalThe main components of working capital are:

Current assets: Current assets consist of cash, marketable securities, inventories, sundry debtors, bills receivables, short term investments, prepaid expenses etc. Current assets are those assets that, in the ordinary course of business, can be turned into cash within an accounting period (not exceeding one over) within undergoing diminution in value and without disrupting the operations.Current liabilities: They consist of loans and advances, sundry creditors, short-term borrowing, bank over-draft, taxes and proposed dividend. Current liabilities are those liabilities intended to be paid in the ordinary course of business within a reasonable period (normally within a year) out of the current assets or revenue of the business.

7.5 Aspects of Working Capital ManagementThe following four aspects are involved in the management of working capital.

Determiningthetotalfundsrequiredtomeetthecurrentoperationofthefirm;determiningthelevelofcurrentassets.Decidingthestructureofcurrentassets;theproportionoflong-termandshort-termcapitaltofinancecurrentassets.Evolving suitable policies, procedures and reporting systems for controlling the individual components of current assets;mainlycash,receivablesandinventory

Determining the various sources of working capital.For determining the sources of working capital (short term and long term) capital the net concept becomes usefulFor determining the level and composition of working capital it is the gross concept, which becomes more meaningful.

7.6 Need for Working CapitalWorkingcapitalisneededtillafirmgetscashonsaleoffinishedproductsassalesdonotconvertintocashimmediately.Thereisaninvisibletimelagbetweenthesaleofgoodsandreceiptsofcash.Therefore,sufficientworkingcapitalis necessary to sustain sales activity.

The operating cycle concept penetrates to the heart of working capital management in a more dynamic form. The time that elapses to convert raw materials into cash (elapses between the purchase of raw materials and the collection of cash from sale) is known as operating cycle.

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Thefollowingelementsaretheoperatingcycleofthefirm:

Conversion of cash into raw materialsConversion of raw materials into work-in-processConversionofwork-in-processintofinishedgoods

Timeforsaleoffinishedgoods-cashsalesandcreditsales.

Time for realisation from debtors and Bills receivables into cashCredit period allowed by creditors for credit purchase of raw materials, inventory and creditors for wages and overheads.

Finished goods

Sales

Work-in Process

Raw Materials

Cash

Debtor

Fig 7.2 Operating cycle

Operating Cycle can be computed with the following formula:OC = ICP + ARPWhere OC = Operating Cycle ICP = Inventory Conversion Period ARP = Accounts Receivable Period

Example ABC company provided the following information and requested you to compute operating cycle:SalesRs.3,000lakhs;Inventory:OpeningRs.610lakhs;closingRs.475lakhsReceivable:OpeningRs.915lakhs;closingRs.975lakhsCost of goods sold Rs. 2,675 lakhs

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SolutionOC = ICP + ARP

= = 74 days

=

= 114.97 daysOC = 74 days + 115 days = 189 daysOC 189 days indicates that ABC company takes (requires) 189 days to convert raw materials into cash. In other words, some amount of cash blocked for 189 days, therefore there is a need to have working capital.

Cash conversion cycleTheamountoftimeafirmsresourcesaretiedup;calculatedbysubtractingtheaveragepaymentperiodfromtheoperatingcycle.Inotherwords,thetimeperiodbetweenthedatesafirmpaysitssuppliersandthedateitreceivescash from its customers. CalculationofCashConversionCycle(CCC)(seethefig.below) CCC = OC APPWhere: OC = Operating Cycle APP = Accounts Payable Period OC = AAI + ARP AAI = Average Age of Inventory ARP = Average Collection (receivables) Period FromthefinancialstatementswecandeterminetheconstituentsofCashConversionCyclei..,AAI,ARP,APP

AAI = Average Inventory (Cost of Goods sold / 365)

ARP = Average Accounts Receivables (Annual Sales / 365)

APP = Average Accounts Payables (Cost of Goods Sold / 365)

Purchase of Raw Materials on Credit

Sales of Goods on Credit

Payment to Suppliers

Operating Cycle (OC)Cash Conversion Cycle (CCC)

Collection of Accounts Receivables

Accounts Receivables Period (ARP)

Average Age of Inventory (AAI)

Accounts Payable Period (APP)

Receipt ofInvoice

ExampleFromthefollowingfinancialinformationcalculateCashConversionCycle.

AverageuseofInventories80days;accountsreceivablescollectionperiod50days,andaccountspayableperiodis 40 days.

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Solution: CCC = OC APPOC = AAI + ARP = 80 + 50 = 130 daysCCC = 130 days 40 = 90 days

Determinants of working capitalAlargenumberoffactorsinfluencetheworking-capital-needsofafirm.

Thebasicobjectiveofafirmsworkingcapitalmanagementistoensurethatthefirmhasadequateworkingcapital for its operation, neither too much nor too little working capital.Thereisnosetofrulesorformulaetodeterminetheworkingcapitalrequirementsofafirm.

The total working capital requirement is determined by a wide variety of factors.Thefactors,however,affectdifferentfirmsworkingcapital

The relative importance of these factors should be made in order to determine the total investment in working capital

Thefollowingwillgivedescriptionofthegeneralfactorsinfluencingtheworkingcapitalneedsofafirm:

Natureandsizeofbusiness:Theworkingcapitalrequirementsofafirmarebasicallyinfluencedbythenatureof the business.

Thenatureofthebusiness-influencetheworkingcapitaldecisions. The proportion of current assets needed in some lines of business activity varies from other lines. Tradingandfinancialfirmshavelessinvestmentinfixedassetsbutrequiresalargesumofmoneytobe invested in working capital.Size may be measured in terms of scale of operations. Afirmwithlargescaleofoperationnormallyrequiresmoreworkingcapitalthanafirmwithalowscale of operation.

Manufacturing cycle: It is a factor, which has bearing on the quantum of working capital.The term is refer to the time involves in manufacturing of goods. It covers the time span between the procurement of raw materials and the completion of the manufacturing processleadingtotheproductionoffinishedgoods.

Longer the manufacturing cycle, the higher will be the working capital requirement and vice versa. Production policy: The requirement on working capital is determined on the basis of production policy of the firm.

Production policy means whether it is continuous or seasonal production. Therearetwoproductionpolicythatthecompanyorthefirmcanfollow Theycanconfinetheirproductiononlytoperiodswhengoodsarepurchasedor They can follow a steady production policy throughout the year and produce goods at a level to meet peak demand.FMCG goods business of production and sales goes simultaneously and the amount of working capital required is less.Umbrella business sales will be only in seasonal and production will take place throughout the year continuously the amount of working capital required is very high.

Terms of purchase and sales: Terms (cash or credit) of purchase and sales also affect the amount of working capital.

Ifacompanypurchasesallgoodsorrawmaterialsincashandsellsitsfinishedgoodsorproductoncredit, it will require larger amount of working capitalOn the contrary, a concern having credit facilities and allowing no credit to its customers will require lesser amount of working capital.

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Terms and conditions of purchase and sale are generally governed by prevailing trade practices and by changing economic conditions

Operatingefficiency:Operatingefficiencyrelatestotheoptimumutilisationofafirmsresourcesatminimumcosts.

Thefirmwithhighefficiencyinoperationcanbringdownthetotalinvestmentinworkingcapitaltolower level.Effectiveutilisationofresourceshelpsthefirminbringingdowntheinvestmentinworkingcapital. Ifafirmsuccessfullycontrolsoperatingcost,itwillbeabletoimprovenetprofitmarginwhich,will,in turn, release greater funds for working capital purposes.

Businesscycle:Theamountofworkingcapitalrequirementsofafirmvarieswitheverymovementofbusinesscycle.Whenthereisanupwardswingintheeconomysaleswillincrease,andalsothefirmsinvestmentininventoriesandbookdebtswillincrease,thusitwillincreasetheworkingcapitalrequirementofthefirmandviceversa.

Growth and expansion: As company grows, it is logical to expect that a larger amount of working capital required.

Agrowingfirmmayneedfundstoinvestinfixedassetsinordertosustainitsgrowingproductionandsales. This will, in turn, increase investment in current assets to support increased scale of operations.Therefore,agrowingfirmneedsadditionalfundscontinuously.

Profitmarginanddividendpolicy:Themagnitudeofworkingcapital inafirmisdependentuponitsprofitmargin and dividend policy.Ahighnetprofitmargincontributestowardstheworkingcapitalpool.

Totheextentthenetprofithasbeenearnedincash,itbecomesasourceofworkingcapital.Thisdependsuponthe dividends results in a drain on cash resources and thus reduces companys working capital to that extend.

Theworkingcapitalpositionofthefirmisstrengthenedifthemanagementfollowsconservationdividend policy and vice versa.

Conditionsofsupplyofrawmaterial:Ifthesupplyofrawmaterialisscarcethefirmmayneedtostockitinadvance and hence need more WC and vice-versa.Availabilityofcredit:Theworkingcapitalrequirementofafirmarealsoaffectedbycredittermsgrantedbyits suppliers, i.e., creditors.

Theneedforworkingcapitalwillbelessinafirm,ifliberalcredittermsareavailabletoit.

Similarly,theavailabilityofcreditfrombanksalsoinfluencesthefirmsworkingcapitalneeds.

Afirm,whichcangetbankcrediteasilyonfavorableconditions,willbeoperatedwithlessworkingcapitalthanafirmwithoutsuchafacility.

Taxationpolicy:ThetaxpoliciesoftheGovernmentwillinfluencetheworkingcapitaldecisions.IftheGovernmentfollowsregressivepolicy,i.e.,imposingheavytaxburdensonbusinessfirms,theyare leftwithverylittleprofitsfordistributionandretentionpurpose.

Consequently,thefirmhastoborrowadditionalfundstomeettheirincreasedworkingcapitalneeds. When there is a liberalised tax policy, the pressure on working capital requirement is minimised.

Other factors: There are many other factors which affect the requirement of working capital like infrastructural facilities,importpolicy,changesinthetechnology,co-ordinationactivitiesinfirm,distributionpoliciesandso on.

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7.7 Estimation of Working Capital RequirementsThe best approach to estimate is based on operating cycle. Working capital consists of two components current assets and current liabilities. There is a need to follow the following four steps procedure for estimation of working capital

Estimationofcashcostofthevariouscurrentassetsrequiredbythefirm.

Estimationofspontaneouscurrentliabilitiesofthefirm.

Compute net working capital by subtracting the estimated current liabilities (step (2)) from current assets (step (1))Add some percentage (given in the problem) of net working capital if there is any contingency or safety working capital required, to get the required working capital.

7.8 Sources of Working CapitalAftertheestimationoftheworkingcapital,thenextstepisfinancingthecurrentassets.Therearethreefinancingpoliciesvis--vis,tofinancecurrentassets.Adoptionthespecificpolicyisleftouttothefirm.Thefollowingarethefinancingpolicies:

Short-term:Generallycurrentassetsshouldbefinancedbyshort-termfinancialsources.Short-termfinancingreferstoborrowingfundsorraisingcreditformaximumof1yearperiodi.e.,atthe most the debt is payable within a year.Thesourcesofshort-termfinanceareloansfrombanks,short-termpublicdeposits,commercialpapers, factoringofreceivables,billsdiscounting,retentionofprofitsetc

Afirmwhichrequiredshort-termfinancecangoforanyoneoftheabovesources. Long-term:Net current assets orworking capital is supposed to befinancedby long-term sources of finance.

Long-termfinancereferstotheborrowingoffundsorraisingcreditforoneyearormore. Long-termfinanceisraisedforaperiodofabovefiveyears. The sources of long-term include- ordinary share capital, preference share capital, debentures, long-term loans from bankers and surplus (includes retained earnings).Afirm that need tofinancenet current assets cango for anyof the above sources, but it depends on companys attitude towards risk or control over the company, companies earnings, capacity and period of loan reserved.

Spontaneousfinancing:Refers to theautomatic sourceof short termfundsarising in thenormalcourseofbusiness.

The source are trade credits and out standing expenses Thesourceofspontaneousfinanceisavailableatcostfree Firms that want to maximise owners wealth than it must and should utilise the sources to the fullest extantSomeextantofcurrentassetscanbefinancedwiththeuseofspontaneoussource Therequiringcurrentassetsshouldbefinancedwiththecombinationoflong-termandshort-termsources offinance

Thepoliciesforfinancingorworkingcapitalaredividedintothreecategories:Conservativefinancingpolicy:inwhichmanagerdependsmoreonlong-termfunds. Aggressivefinancingpolicy:inwhichthemangerdependsmoreonshorttermfunds. Moderate policy: suggests that the manager depends moderately on both long-term and short-term while financing.

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Analysis of working capitalDeterminingtheworkingcapitalisjustnotsufficientforabetterperformance.Itshouldbeanalysed.Itmaybeanalysed with a view to gross and net angles i.e., quantitative and qualitative.The quantitative aspect of working capital refers to the quality of current assets while the qualitative aspect of working capital refers to the liquidity and its adequacy.The following are the aspects of working capital:

Structure of working capital: It helps to have a better perspective of the working capital position of any company.Working capital status: In order to ascertain the trends in working capital, indices of current assets, current liabilitiesandnetworkingcapitalofthefirmmaybecomputed.

First year of the selected period may be taken as base, for computing trends in current assets, current liabilities and net working capital.Working capital position in a concern would be satisfactory, provides the pace of increase in current assets is more than that of the current liabilities and vice-versa.If thenetworkingcapital indicesalso increase, itwill furtherconfirmthat strengthofworkingcapital positioninafirm.

Working Capital Leverage: It measures the sensitivity of return on investment (ROI) to the changes in ROI of current assets.Workingcapitalleverage(WCL)maybedefinedasthepercentagechangeinROIwithgivenpercentagechangein current assets.

Symbolically:

WCL = Percentage Change in ROI Percentage Change in Current Assets

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SummaryWorking capital may be regarded as the lifeblood of a business enterprise.Longterm funds are required for creation of production facilities such as plant and machinery, land, building and furniture, etc.Investmentintheseassetsrepresentsthatpartoffirmscapital,whichispermanentlyblockedonapermanentorfixedbasisandiscalledfixedcapital.

Grossworkingcapitalreferstothefirmsinvestmentintotalcurrentassetsoftheenterprise.Currentassetsarethose, which can be converted into cash, within an accounting year (or operating cycle). If current assets are in excess of current liabilities, net working capital is positive. A negative working capital occurs when the current liabilities exceed current assets.Current assets are those assets that, in the ordinary course of business, can be turned into cash within an accounting period (not exceeding one over) within undergoing diminution in value and without disrupting the operations

ReferencesMathur, S. B., 2002. Working Capital Management and Control Principles & Practice. New Delhi. New Age International (P) Limited. Dr. Rustagi, R. P., Principles of Financial Management. 4th ed., New Delhi. Taxmann Publications (P) Ltd. Working Capital Management ,[Pdf]Availableat:[Accessed29May2013].

Working Capital Management, [Pdf]Available at: [Accessed 29 May 2013].2012. Working Capital Management, [Video online] Available at: [Accessed29May2013].

2010. Whats working capital?[Videoonline]Availableat:[Accessed 29 May 2013].

Recommended ReadingPreve, L. & Sarria-Allende, V., 2010. Working Capital Management. Oxford University Press.Kumar, A. V., 2001. Working Capital Management. Northern Book Centre.Sagner, J., 2010. Essentials of Working Capital Management. John Wiley & Sons.

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Self Assessment

Whichofthefollowingcycleisthetimeperiodbetweenthedatesafirmpaysitssuppliersandthedateitreceives1. cash from its customers?

Operating Cyclea. Cash Conversion Cycleb. Cash Conversion Periodc. Net Working Capitald.

Permanent Working Capital is also known as _________2. total current assetsa. gross working capital b. fixedworkingcapitalc. net working capitald.

Operatingcycleofafirmcanbeshortenedbywhichofthefollowing?3. Increasing stock of raw materiala. Increasing credit period to customersb. Increasing working-in-processc. Increasing credit period from suppliersd.

Which of the following statements is false?4. Inconservativeapproach,thereislongtermfinancingofworkingcapital.a. Inaggressiveapproach,thereisnoshorttermfinancingofworkcapital.b. Working Capital Leverage measures the sensitivity of return on investment (ROI) to the changes in ROI of c. current assets.Therequirementonworkingcapitalisdeterminedonthebasisofproductionpolicyofthefirm.d.

Theamountofworkingcapitalrequirementsofafirmvarieswitheverymovementof______________.5. business cyclea. production policyb. manufacturing cyclec. operatingefficiencyd.

Match the following6.

1. Concept of working capital a. commercial papers, factoring of receivables, bills discounting, retentionofprofitsetc

2.Short-termfinancing b. Current assets and Current liabilities

3. Structure of Working Capital c. Net working capital

4. Components of working capital d. helps to have a better perspective of the working capital position of any company1-b, 2-d, 3-a, 4-c.a. 1-c, 2-a, 3-d, 4-b.b. 1-d, 2-c, 3-a, 4-b.c. 1-d, 2- a, 3-b, 4-c.d.

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Permanent working capital is the _______________ of current assets needed to conduct a business during the 7. normal season of the business.

maximum amounta. moderate amountb. minimum amountc. increasing amountd.

Which of the following statements is true?8. Conservativefirmdependsonmorelong-termfundsforfinancingneed.a. Spontaneous Financing refers to the automatic source of long-term funds arising in the normal course of b. business.Therequirementonworkingcapitalisdeterminedonthebasisofmanufacturingpolicyofthefirm.c. Net working capital is the surplus of current liabilities over current assets and provisionsd.

Match the following9.

1. Temporary working capital a. Availability of Credit

2. Gross working capital b. Variable working capital

3. Determinants of Working Capital c. Aspects of Working Capital Management

4. Determining the various sources of working capital d. circulating capital1-c, 2-a, 3-d, 4-b.a. 1-d, 2-c, 3-a, 4-b.b. 1-c, 2-d, 3-b, 4-b.c. 1-b, 2-d, 3-a, 4-c.d.

Working capital consists of _______________.10. current assets and current liabilitiesa. permanent and temporary working capitalb. gross and net working capitalc. concept based and time based working capitald.

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Chapter VIII

Inventory Management

Aim

The aim of this chapter is to enable the students to:

explain the types of inventory

elucidate the objectives of inventory management

defineinventory

Objectives

The objective of the chapter is to:

explain motives of inventory management

enlist the risks of holding inventory

elucidate the techniques of inventory control

Learning outcome

At the end of the chpater, you will be able to:

understandthemeaning,definitionandobjectivesofinventorymanagement

identify the types of inventory

understand the motives of inventory management

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8.1 IntroductionInventories constitute a major component in current assets. It constitutes around 60% in the public limited companies, in India. For the smooth running, every enterprise needs inventory. Inventories serve as a link between production and distribution processes. Due to its major composition in current assets, the management of inventories occupies a key role in working capital management. Excessive investment affects the liquidity. Inadequate investment makes thefirmtoloosethebusinessopportunities,otherwiseavailable.Profitabilitywouldbeaffectedwithexcessiveorinadequateinvestment.So,inventorymanagementisessentialtoallowthefirmtoavailtheopportunitiestoimproveprofitabilityandatthesametimedoesnotimpairitsliquidity,withexcessiveorunproductiveinvestment.Afirm,whichneglectstheinventorymanagement,jeopardizesitslongtermprofitability.So,itisabsolutelyimperativetocontrolandmanageinventoryholding,bothefficientlyandeffectively,toavoidunnecessaryinvestment.

Inventorymanagementoccupiesthemostsignificantpositioninthestructureofworkingcapital.Inventoriesarethemostsignificantpartofcurrentassets.Inventorymanagementisanimportantareaofworkingcapitalmanagement,whichplaysacrucialroleineconomicoperationofthefirm.Maintenanceoflargesizeofinventoriesrequiresaconsiderableamountoffundstobeinvestedonthem.Efficientandeffectiveinventorymanagementisnecessaryinorder to avoid unnecessary investment and inadequate investment. A considerable amount of funds is required to becommittedininventories.Itisabsolutelyimperativetomanageinventoriesefficientlyandeffectivelyinordertooptimiseinvestmentinthemcannotbeignored.Anylapseonthepartofmanagementofafirminmanaginginventoriesmaycausethefailureofthefirm.

8.2 Meaning and Definition of InventoryThetermInventoryisoriginatedfromtheFrenchwordInventaireandtheLatinInventariomwhichimpliesalistofthingsfound.ThetermhasbeendefinedbytheAmericanInstituteofAccountantsastheaggregateofthoseitems of tangible personal property which:

are held for sale in the ordinary course of businessare in the process of production for such sales, orare to be currently consumed in the production of goods or services to be available for sale

Theterminventoryreferstothestockpileoftheproductsafirmisofferingforsalesandthecomponentsthatmakeupthe product. Inventories are the stocks of the product of a company, manufacturing for sale and the components that make up the product. The various forms in which inventories exist in a manufacturing company are as follows:

Raw materialsWork-in processFinished goodsStores and spares

However,incommercialparlance,inventoryusuallyincludesstores,rawmaterials,work-in-processandfinishedgoods.Theterminventoryincludesrawmaterial,workinprocess,finishedgoodspackaging,sparesandothersstocked in order to meet an unexpected demand or distribution in the future.

8.3 Types of InventoryThe following are the types of inventory:

Rawmaterials:Rawmaterialsarethoseinputsthatareconvertedintofinishedgoodsthroughmanufacturingprocess. These form major inputs for manufacturing a product. In other words, they are very much needed for uninterrupted production.Work-in-process:Work-in-processisthatstageofstocksthatarebetweenrawmaterialsandfinishedgoods.Work-in-processinventoriesaresemi-finishedproducts.Theyrepresentproductsthatneedtoundergosomeprocesstobecomefinishedgoods.

Finishedproducts:Finishedproductsarethoseproducts,whicharereadyforsale.Thestockoffinishedgoodsprovides a buffer between production and market.

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Storesandspares:Storesandsparesinventory(includeofficeandplantcleaningmaterialslikesoap,brooms,oil, fuel, light, etc.) are those purchased and stored for the purpose of maintenance of machinery.

8.4 Inventory Management MotivesManaging inventories involves block of funds and inventory holding costs. There are three general motives for holding inventories

Transaction motives: It includes production of goods and sale of goods. It facilities uninterrupted production and delivery of order at a given time (right time)Precautionary motive: This motive necessitates the holding of inventories for unexpected changes in demand and supply factors.Speculative motive: This compels to hold some inventories to take the advantage of changes in prices and getting quantity discounts.

8.5 Objectives of Inventory ManagementThe objectives of inventory management may be viewed in two. They are

Operational:theoperationalobjectiveistomaintainsufficientinventory,tomeetdemandforproductbyefficientlyorganisingthefirmsproductionandsalesoperations

Financial:financialviewistominimiseinefficientinventoryandreduceinventorycarryingcosts.

Thesetwoconflictingobjectivesofinventorymanagementcanalsobeexpressedintermsofcostsandbenefitsassociatedwithinventory.Thefirmshouldmaintaininvestmentininventoryimpliesthatmaintaininganinventoryinvolves costs, such that smaller the inventory the lower the carrying cost and vice versa. But inventory facilitates (benefits)thesmoothfunctioningoftheproduction.Aneffectiveinventorymanagementshould:

ensure a continuous supply of raw materials and supplies to facilities uninterrupted productionmaintainsufficientstocksorrawmaterialsinperiodsofshortsupplyandanticipatepricechanges

maintainsufficientfinishedgoodsinventoryforsmoothsalesoperationandefficientcustomersservices

minimise the carrying costs and time andcontrol investment in inventories and keep it at an optimum level

Apartfromtheabove,thefollowingarealsoobjectsofinventorymanagement.Controlofmaterialscosts;eliminationofduplicationinorderingbycentralisationofpurchasers;supplyofrightqualityofgoodsofreasonableprices,provide data for short-term and long-term for planning and control of inventories.Therefore, management of inventory needs careful and accurate planning so as to avoid both excess and inadequate inventoryinrelationtotheoperationalrequirementofafirm.Toachievehigheroperationalefficiencyandprofitabilityofafirm,itisessentialtoreducetheamountofcapitallockedupininventories.Thiswillnotonlyhelpinachievinghigher return on investment by minimising tied-up working capital, but will also improve the liquidity position of the enterprise.

8.6 Costs of Holding InventoryMinimising cost is one of the operating objectives of inventory management. There are three costs involved in the management of inventories.

Ordering costsOrdering costs are those costs that are associates with the acquisition of raw materials. In other words, the costs that are spend from placing an order till the receipt of raw materials. They include the following:

Cost of requisitioning the items (raw materials)Cost of preparation of purchase order (i.e., drafting typing, dispatch, postal etc)Cost of sending reminders to get the dispatch of the items expeditedCost of transportation of goods (items)

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Cost of receiving and verifying the goodsCost of in unloading of the (items) of goodsShortage and stocking charges

However, incase of items manufactured in house the ordering costs would comprise the following costs:Requisitioning costSet-up costCost of receiving and verifying the itemsCost of placing and arranging/stacking of the items in the store etc.,

Orderingcostsarefixedperorderplaced,irrespectiveoftheamountoftheorderbutorderingcostsincreasesinproportiontothenumberoforderplaced.Ifthefirmmaintainssmallinventorylevelsthenthenumberoforderswill increase, there by ordering cost will increase and vice versa.

Carrying costsInventory carrying costs are those costs, which are associated with carrying or maintaining inventory. The following are the carry costs of inventory:

Capital cost (interest on capital locked in the inventories)Storage cost (insurance, maintenance on building, utilities serving costs)Insurance(oninventoryagainstfireandtheftinsurance)

Obsolescence cost and deteriorationTaxesCarrying costs usually constitute around 252 per cent of the value of inventories held

Shortage costs (Costs of stock out)Shortagecostsarethosecoststhatariseduetostockoutoreithershortageofrawmaterialsorfinishedgoods.Shortageofinventoriesofrawmaterialsoveraffectthefirminoneormoreofthefollowingways:

Thefirmmayhavetopaysomewhathigherprice,connectedwithimmediate(cash)procurements

Thefirmmayhavetocompulsorilyresortthesomedifferentproductionschedules,whichmaynotbeasefficientand economical

StockoffinishedgoodsmayresultinthedissatisfactionofthecustomersandtheresultantlossofrulesThus, with a view to keep inventory costs of minimum level, we may have to arrive at the optional level of inventory cost, it is the total orders costs plus carrying costs are minimal. In other words, we have to determine Economic Order Quantity (EOQ), is that level at which the total inventory (ordering plus carrying less) cost is minimum.

8.7 Risks of Holding InventoryRisk in inventory management refers to the chance that inventory management cannot be turned over into cash through normal sales without loss. The following are the risk associated with inventory management

Price decline: Price decline is the result of more supply and less demand (introduction of competitive product). Generallypricesarenotcontrollableintheshort-runbytheindividualfirm.Controllinginventoryistheonlywaythatafirmcancounteractwiththeserisks.

Product deterioration: Holding inventory for a long period or shortage under improper conditions of light, heat, humidity and pressure lead to product deterioration. Deterioration usually prevents selling in product through normal channels.Product obsolescence: Product may become obsolete due to improved products, changes in customer tastes, particularly in high style merchandise, changes in requirements etc. This risk may prove very costly for the firmswhoseresourcesarelimitedandtiedupinslowmovinginventories.Productobsolescencecostriskleastcontrollable except by reduction in inventory investment.

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Thus,inventoriesareriskyassetstomanageandtheeffectivewaytominimisingrisksissettingupofefficientinventory control system.

8.8 Benefits of Holding InventoryPropermanagementofinventorywillresultinthefollowingbenefitstoafirm:

Ensures an adequate supply of materials and stores, minimises stock outs and shortages and avoids costly interruptions in operationsKeepdowninvestmentininventories;inventorycarryingcostsandobsolescencelossestotheminimum

Facilitates purchasing economics through the measurement of requirements on the basis of recorded experienceEliminates duplication in ordering stocks by centralising the source from which purchase requisitions emanatePermitsbetterutilisationofavailablestocksbyfacilitatinginter-departmenttransferswithinafirm

Provides a check against the loss of materials through careless or pilferagePerpetualinventoryvaluesprovideaconsistentandreliablebasisforpreparingfinancialstatementsabetterutilisation

8.9 Techniques of Inventory ControlThere are many techniques used to management inventory. Some of them are listed below:

8.9.1 ABC AnalysisIt is one of the widely used techniques to identify various items of inventory for the purpose of inventory control. In other words, it is very effective and useful tool for classifying, monitoring and control inventories.

Thefirmshouldnotkeepsamedegreeofcontrolonalltheitemsofinventory.Thefirmshouldputmaximumcontrol on those items whose value is the highest, with the comparison of the other two items.It is based on Pareto's Law and is known as Selective Inventory Control.Usually afirmhas tomaintain several types of inventories, for proper control of them,firm should haveto classify inventories in the instance of their relative value. Hence, it is also known as Proportional Value Analysis(PVA)

Accordingtothistechniquethetaskofinventorymanagementisproperclassificationofallinventoryitemsintothreecategories namely A, B and C category. The ideal categorisation of inventory items is shown in the Table 12.1. The highervalueitemsareclassified'Aitems'andwouldbeundertightcontrol.Attheotherendoftheclassificationwefindcategory'Citems',onthesetypesofinventoryfirmcannotaffordexpensesofrigidcontrols,frequentorderingand expending, because of the low value or low amounts. Thus with the 'C items', we may maintain somewhat higher safety stocks, order more months of supply, expect lower levels of customer service, or all the three. 'B items' fall in between 'A items' and 'C items' and require reasonable attention of management.

Category No. of Items (%) Items Value (%)

A 15 70

B 30 20

C 55 10

Total 100 100

Table 8.1 Categorisation of Inventory

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The above table indicates that only 15 per cent of the items may account for 70 per cent of the total value (A category items), on which greater attention is required, when as 55 per cent of items may account for 10 per cent of the total value of inventory (C category items), will be paid a reasonable attention. The remaining 30 per cent of inventory account for 20 per cent of total value of inventory (B category items) will be paid a reasonable attention as this, category value lies between the two other categories. The above data can be shown by the following graph.

Item

A

Item

B

Item

C

Valu

e of

item

s (%

)

100

80

60

40

20

010 20 30 40 50 60 70 80 90 100

No. of Items (%)

In the above Fig. numbers of items (%) are shown on 'X' axis and value of items (%) are represented on 'Y' axis. Greaterattentionwillbepaidoncategory'A'item,becausegreaterbenefit.Thecontrolof'C'itemsmaybereleasedduetolessbenefit(sometimescontrolcostmayexceedbenefitofcontrol)andreasonableattentionshouldbepaidon category 'B' items.

8.9.2 Economic Order Quantity (EOQ)Economic order quantity (EOQ) refers to that level of inventory at which the total cost of inventory is minimal. The total inventory cost comprising of ordering and carrying costs. Shortage costs are excluded in adding total cost of inventoryduetothedifficultyincomputationofshortagecost.EOQarealsoknownasEconomicLotSe (ELS).

Assumptions of EOQ ModelThe following assumptions are implied in the calculation of EOQ:

Demand for the product is constant and uniform throughout the periodLead time (time from ordering to receipt) is constantPrice per unit of product is constantInventory holding cost is based on average inventoryOrdering costs are constant, andAlldemandfortheproductwillbesatisfied(nobackordersareallowed)

EOQ FormulaEOQ can be obtained by adopting two methodsTrail and Error approachShort cut or Simple mathematical formula

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Here for calculation of EOQ we have adopted simple short cut method. The formula is

Where:A = Annual usageO = Ordering cost per orderCC = Annual carrying per unitCC = Price per unit Carrying cost per unit in percentage

The above simple formulawill not be sufficient to determineEOQwhenmore complex cost equations areinvolved.

EOQ is applicable both to single and to any group of stock items with similar holding and ordering costs. Its use causes the sum of the two costs to be lower than under any other system of replenishment.

LimitationsApart from the above application it has its own limitations, which are mainly due to the restrictive nature of the assumptions on which it is based

Constant usage: It may not be possible to predict, if usage varies unpredictably, as it often does, no formula will work well.Faulty basic information: Ordering and carrying costs is the base for calculation EOQ. It assumes that ordering cost is constant per order, but actually varies from commodity to commodity. Carrying cost also can vary with the company's opportunity cost of capital.Costly calculation: In many cases the cost estimating, cost of possession and acquisition and calculating EOQ exceeds the savings made by buying that quantity.

8.9.3 Order Point ProblemIf the inventory level is too high it will unnecessary block the capital and if the level is too low, it will disturb productionbyfrequentstockoutandalsoinvolveshighorderingcost.Hence,anefficientmanagementofinventoryneeds to maintain optimum inventory level, where there is no stock out and the costs are minimal. The different stock levels are

Minimum levelMinimumstockisthatlevelthatmustbemaintainedalwaysforsmoothflowofproduction.Whiledeterminationof minimum stock level, lead time, and consumption rate, material nature must be considered.Lead-time is the number of days required to receive the inventory from the date of placing order. It is also called as procurement time of inventoryThe average quantity of raw materials consumed daily. The consumption rate is calculated based on the past experience and production plan.Requirement of materials for normal or regular production or special order production. If the material is required for special order production, then the minimum stock levels need not to maintain.

Minimum stock level = Re-order level (Average Usage Average delivery time)

Reorder levelReorder level is that level of inventory at which an order should be placed for replenishing the current stock of inventory. Generally the reorder level lies between minimum stock level and maximum stock level.Re-order point = Lead time (in days) Average Daily usage

The above formula is based on the assumption that Consistent usage and Fixed lead-time.

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SafetyStock:Predictionofaveragedailyusageandlead-timeisdifficult.Rawmaterialsmayvaryfromdaytodayor from week to week, it is the case for lead-time also. Lead-time may be delayed if the usage increases, than the companyfacesproblemofstockout.Toavoidstockoutfirmmayrequiremaintainingsafetystock.Formula (under uncertainty of usage and lead time)

RE-order point = (Lead time (in days) Average usage) + Safety stock

Maximum levelMaximumlevelofstockisthatlevelofstockbeyondwhichafirmshouldnotmaintainthestock.Iffirmstocksinventory beyond the maximum stock level is called as overstocking. Excess inventory (overstock) involves heavy costofinventory,becauseitblocksfirmsfundsininventory,excesscarryingcost,wastage,obsolescenceandtheftcost.Hence,firmshouldnotstockabovethemaximumstocklevel.Safetystockisthatminimumadditionalinventoryto serve as a safety margin or better or buffer or cushion to meet an unanticipated and increase in usage resulting from an unusually high demand and or an uncontrollable late receipt of incoming inventory.

Maximum Stock Level = Reorder Level + Reorder Quantity (Minimum Delivery Time)

Danger stock levelDanger level is that level of materials beyond that materials should not fall in any situation. When it falls in danger levelitwilldisturbproduction.Hence,thefirmshouldnotallowthestockleveltogotodangerlevelifatallfallsin that level then immediately stock should be arranged even if it costly.

Danger Level = Average Usage minimum Deliver Time (for emergency purchase)

8.9.4 Just in Time (JIT)PopularlyknowninitsacronymJIT.Itmaybeappliedforeitherrawmaterialspurchaseorproducingfinishedgoods. From raw materials purchase it means, that no inventories are held at any stage of production and the exact requirement is bought in each and every successive stage of production of the right time. In other words, maintenance of a minimum level of raw materials where by the inventory carrying cost could be minimised, and the risk of loss due to stock-out position could be well avoided. From production of goods view JIT means goods are produced only whentheorderarereceived,therebynostorageoffinishedgoods,andcanavoidcostsofcarryingfinishedgoods.JIT is also known as "Zero Inventory Production System" (ZIPS), Zero Inventories (ZIN), Materials as Needed (MAN) or Neck of Time (NOT).

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SummaryInventorymanagementoccupiesthemostsignificantpositioninthestructureofWorkingcapital.

Thetypesofinventoryare:rawmaterials;work-inprocess;finishedgoods;andstoresandspares.

Thetwoconflictingobjectivesofinventorymanagementare:maintaininginvestmentininventoryandtofacilitate(benefits)thesmoothfunctioningoftheproduction,whichinturnmeetthedemand.

Efficientmanagementofinventoryreducesthecostofproductionandconsequentlyincreasestheprofitabilityof the enterprise by minimising costs associated with holding inventory.An effective inventory management should: Ensure a continuous supply of raw materials and supplies to facilitatesuninterruptedproduction;maintainsufficientfinishedgoodsinventoryforsmoothsalesoperations;andefficientcustomerservice;minimisethecarryingcostsandtime;andControlinvestmentininvestmentandkeep it at an optimum level.Minimising cost is one of the operating objectives of inventory management. The costs (excluding merchandise cost), there are three costs involved in the management of inventories. They are Ordering Costs, Inventory Carrying Costs and Shortage Costs.There are many techniques of management of inventory. Some of them are ABC analysis, Economic Order Quantity (EOQ), Order Point Problem, Just in Time etc.

Reference2008. I nventory Management,[Videoonline]Availableat:[Accessed 29 May 2013].2008. Lecture - 38 Basic Inventory Principles, [Video online] Available at: [Accessed29May2013].

Viale, J. D., Basics of Inventory Management, [Pdf] Available at: [Accessed29May2013].

Inventory Management, [Pdf] Available at: [Accessed29May2013].

Bose, C. D., 2006. INVENTORY MANAGEMENT, PHI Learning Pvt. Ltd.Axst er, S.,2006. Inventory control, 2nd ed., Springer.

Recommended Reading Muller, M., 2003. Essentials of Inventory Management. AMACOM. Mullar, M., 2011. Essentials of Inventory Management, 2nd ed., AMACOM Books.Viale, J. D. & Christopher, C., 1996. Inventory Management: From Warehouse to Distribution Center, Course Technology / Cengage Learning .

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Self Assessment

Which of the following statements is true?1. Transaction motive includes production of goods and sale of goods. It facilities interrupted production and a. delivery out of order at a given time (right time)Precautionary motive necessitates the holding of inventories for expected changes in demand and supply b. factors.Speculative motive compels to hold some inventories to take the advantage of changes in prices and getting c. quantity discounts.Lead-time is the number of days required to receive the inventory from the date of placing order and is also d. called as procurement time of inventory.

Inventory is one of the components of _________ assets.2. liabilitiesa. cash budgetb. balancec. currentd.

Which of the following is true?3. Price decline, product deterioration and product obsolescence are the risks of holding inventory.a. Costs of holding inventory are ordering costs, capital costs and shortage costs.b. Carrying costs are those costs that are associates with the acquisition of raw materials.c. Price decline is the result of less supply and more demandd.

EOQ is the quantity that minimises:4. Total Inventory Costa. Total Ordering Costb. Total Interest Costc. Safety Stock Leveld.

_____________values provide a consistent and reliable basis for preparingfinancial statements a better5. utilisation.

Increase inventorya. Perpetual inventoryb. Costs of Holding Inventoryc. Risks of Holding Inventoryd.

Which of the following is one of the components of inventory carrying cost?6. Price declinea. Speculative motiveb. Capital costc. Work-in processd.

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Match the following7. 1. Objectives of Inventory Management a. Economic Order Quantity (EOQ)

2. Risks of holding inventory b.operationalandfinancial

3. Techniques of inventory control c. Zero Inventory Production System (ZIPS)

4. JIT is known as d. product obsolescence

1-c, 2-d, 3-b, 4-aa. 1-d, 2-a, 3-b, 4-cb. 1-b, 2-c, 3-d, 4-ac. 1-b, 2-d, 3-a, 4-cd.

Which of the following statements is false?8. ABC is also known as PAV.a. The EOQ model attempts to minimising the total cost of holding inventoryb. EOQ model assumes a constant usage rate for a particular item.c. Risk in inventory management refers to the chance that inventory management cannot be turned over into d. cash through normal sales without loss

InEOQformula2AOCC,'A'standsforAnnualusage.9. Biennial Usagea. Perennial Usageb. Annual usagec. Monthly Usaged.

Which of the following is one of the risks of holding inventory?10. Shortage Costsa. Product Obsolescenceb. ABC analysisc. Work-in Processd.

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Chapter IX

Dividend Decision

Aim

The aim of this chapter is to enable the students to:

explain the concept of dividend

elucidate various dividend theories

explicate Modigliani and Millers Approach

Objectives

The objective of the chapter is to:

enlist the types of dividend

explain Walter's model

eluicdate dividend decision

Learning outcome

At the end of the chapter, you will be able to:

understand Gordon's model

describe dividend theories

idenfitycashdividend

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9.1 IntroductionThefinancialmanagermusttakecarefuldecisionsonhowtheprofitshouldbedistributedamongshareholders.It is very important and crucial part of the business concern, because these decisions are directly related with the valueofthebusinessconcernandshareholderswealth.Likefinancingdecisionandinvestmentdecision,dividenddecisionisalsoamajorpartofthefinancialmanager.Whenthebusinessconcernsdecidedividendpolicy,theyhaveto consider certain factors such as retained earnings and the nature of shareholder of the business concern.

Meaning of DividendDividendreferstothebusinessconcernsnetprofitsdistributedamongtheshareholders.Itmayalsobetermedasthepartoftheprofitofabusinessconcern,whichisdistributedamongitsshareholders.AccordingtotheInstituteofCharteredAccountantofIndia,dividendisdefinedasadistributiontoshareholdersoutofprofitsorreservesavailableforthispurpose.

9.1.1 Types of Dividend/ Form of DividendDividendmaybedistributedamongtheshareholdersintheformofcashorstock.Hence,Dividendsareclassifiedinto:

Cash dividendStock dividendBond dividendProperty dividend

Cash DividendIf the dividend is paid in the form of cash to the shareholders, it is called cash dividend. It is paid periodically out the business concerns EAIT (Earnings after interest and tax). Cash dividends are common and popular types followed by majority of the business concerns.

Stock DividendStockdividendispaid in theformof thecompanystockdue toraisingofmorefinance.Under this type,cashis retained by the business concern. Stock dividend may be bonus issue. This issue is given only to the existing shareholders of the business concern.

Bond DividendBonddividendisalsoknownasscriptdividend.Ifthecompanydoesnothavesufficientfundstopaycashdividend,thecompanypromisestopaytheshareholderatafuturespecificdatewiththehelpofissueofbondornotes.

Property DividendProperty dividends are paid in the form of some assets other than cash. It will distributed under the exceptional circumstance. This type of dividend is not published in India.

9.2 Dividend DecisionDividenddecisionofthebusinessconcernisoneofthecrucialpartsofthefinancialmanager,becauseitdeterminestheamountofprofittobedistributedamongshareholdersandamountofprofittobetreatedasretainedearningsforfinancingitslongtermgrowth.Hence,dividenddecisionplaysveryimportantpartinthefinancialmanagement.Dividend decision consists of two important concepts which are based on the relationship between dividend decision andvalueofthefirm.

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Dividend Theories

Irrelevance of Dividend

Soloman Approach

MM Approach

Walter's Model

Gordon's Model

Relevance of Dividend

Fig. 9.1 Classification of dividend theories

9.2.1 Irrelevance of Dividend According to professors Soloman, Modigliani and Miller, dividend policy has no effect on the share price of the company.Thereisnorelationbetweenthedividendrateandvalueofthefirm.Dividenddecisionisirrelevantofthevalueofthefirm.ModiglianiandMillercontributedamajorapproachtoprovetheirrelevancedividendconcept.

Modigliani and Millers ApproachAccording to MM, under a perfect market condition, the dividend policy of the company is irrelevant and it does not affectthevalueofthefirm.Underconditionsofperfectmarket,rationalinvestors,absenceoftaxdiscriminationbetweendividendincomeandcapitalappreciation,giventhefirmsinvestmentpolicy,itsdividendpolicymayhavenoinfluenceonthemarketpriceofshares.

AssumptionsMM approach is based on the following important assumptions:

Perfect capital marketInvestors are rationalThere are no tax Thefirmhasfixedinvestmentpolicy

No risk or uncertainty

Proof for MM approach MM approach can be proved with the help of the following formula:

Where, Po = Prevailing market price of a share. Ke = Cost of e equity capital. D1 = Dividend to be received at the end of period one. P1 = Market price of the share at the end of period one.

P 1 can be calculated with the help of the following formula.

P1= Po (1+Ke) D 1

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The number of new shares to be issued can be determined by the following formula:

M P1 = I (X nD1)

Where, M = Number of new share to be issued. P1 = Price at which new issue is to be made. I = Amount of investment required.X=Totalnetprofitofthefirmduringtheperiod.nD1 = Total dividend paid during the period.

Example 1: X Company Ltd., has 100000 shares outstanding the current market price of the shares Rs. 15 each. ThecompanyexpectsthenetprofitofRs.2,00,000duringtheyearanditbelongstoarichclassforwhichtheappropriate capitalisation rate has been estimated to be 20%. The company is considering dividend of Rs. 2.50 per share for the current year. What will be the price of the share at the end of the year (i) if the dividend is paid and (ii) if the dividend is not paid?

Solution:

(i) If the dividend is paidPo= Rs. 15Ke = 20%D1= 2.50P1=?

2.50 +P1= 15x1.2

P1= 18-2.50

P1=Rs. 15.50

(ii) If the dividend is not paidPo= Rs. 15Ke = 20%D1= 0P1=?

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0 +P1= 15x1.20

P1= Rs.18

Criticism of MM approachMM approach consists of certain criticisms also. The following are the major criticisms of MM approach.

MMapproachassumesthattaxdoesnotexist.Itisnotapplicableinthepracticallifeofthefirm.

MM approach assumes that, there is no risk and uncertain of the investment. It is also not applicable in present day business life. MMapproachdoesnotconsiderfloatationcostandtransactioncost.Itleadstoaffectthevalueofthefirm.

MM approach considers only single decrement rate, it does not exist in real practice. MM approach assumes that, investor behaves rationally. But we cannot give assurance that all the investors will behave rationally.

9.2.2 Relevance of DividendAccordingtothisconcept,dividendpolicyisconsideredtoaffectthevalueofthefirm.Dividendrelevanceimpliesthat shareholders prefer current dividend and there is no direct relationship between dividend policy and value of thefirm.RelevanceofdividendconceptissupportedbytwoeminentpersonslikeWalterandGordon.

Walters Model Prof.JamesE.Walterarguesthatthedividendpolicyalmostalwaysaffectsthevalueofthefirm.Waltermodelisbased in the relationship between the following important factors:

Rate of return ICost of capital (k)

AccordingtotheWaltersmodel,ifr>k,thefirmisabletoearnmorethanwhattheshareholderscouldbyreinvesting,iftheearningsarepaidtothem.Theimplicationofr>kisthattheshareholderscanearnahigherreturnbyinvestingelsewhere.

Ifthefirmhasr=k,itisamatterofindifferentwhetherearningsareretainedordistributed.

AssumptionsWalters model is based on the following important assumptions:

Thefirmusesonlyinternalfinance

Thefirmdoesnotusedebtorequityfinance

Thefirmhasconstantreturnandcostofcapital

Thefirmhas100recentpayout

ThefirmhasconstantEPSanddividend

Thefirmhasaverylonglife.

Walter has evolved a mathematical formula for determining the value of market share.

Where,P = Market price of an equity shareD = Dividend per share

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r = Internal rate of return E = Earning per share Ke = Cost of equity capital

Example2:Fromthefollowinginformationsuppliedtoyou,ascertainwhetherthefirmisfollowinganoptionaldividend policy as per Walters Model? Total Earnings Rs. 2, 00,000 No. of equity shares (of Rs. 100 each 20,000) Dividend paid Rs. 1, 00,000P/E Ratio 10Return Investment 15%

Thefirmisexpectedtomaintainitsrateonreturnonfreshinvestments.AlsofindoutwhatshouldbetheE/Pratioat which the dividend policy will have no effect on the value of the share? Will your decision change if the P/E ratio is 7.25 and interest of 10 %?

Solution

= = Rs. 10

P/E Ratio = 10

Ke = = = 0.10

DPS = = = Rs. 5

The value of the share as per Walters Model is

Rs. 12.5

Dividend Payout =

=

= 60%

r>Kethereforebydistributing60%ofearnings,thefirmisnotfollowinganoptionaldividendpolicy.Inthiscase,theoptionaldividendpolicyforthefirmwouldbetopayzerodividendandtheMarketPricewouldbe:

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Dividend Payout =

P= Rs. 200

So, the MP of the share can be increased by following a zero payout, of the P/E is 7.25 instead of 10 then the Ke =1=0.138andinthiscaseKe>randtheMPoftheshareis7.25.

P = 5+5.435

P= Rs. 75.62

Criticism of Walters ModelThe following are some of the important criticisms against Walter model:

Waltermodelassumesthatthereisnoextractedfinanceusedbythefirm.Itisnotpracticallyapplicable.

There is no possibility of constant return. Return may increase or decrease, depending upon the business situation. Hence, it is applicable. According to Walter model, it is based on constant cost of capital. But it is not applicable in the real life of the business.

Gordons ModelMyronGordensuggestsoneofthepopularmodelswhichassumethatdividendpolicyofafirmaffectsitsvalue,and it is based on the following important assumptions:

Thefirmisanallequityfirm

Thefirmhasnoexternalfinance

Cost of capital and return are constantThefirmhasperpectuallife

There are no taxes.Constant relation ratio (g=br)Cost of capital is greater than growth rate (K e>br)

Gordons model can be proved with the help of the following formula:

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Where, P = Price of a shareE = Earnings per share 1b = D/p ratio (i.e., percentage of earnings distributed as dividends) Ke= Capitalization ratbrGrowthrate=rateofreturnoninvestmentofanallequityfirm.

Example 3: Raja company earns a rate of 12% on its total investment of Rs. 6, 00,000 in assets. It has 6, 00,000 outstandingcommonsharesatRs.10pershare.Discountrateofthefirmis10%andithasapolicyofretaining40% of the earnings. Determine the price of its share using Gordons Model. What shall happen to the price of the share if the company has payout of 60% (or) 20%?

SolutionAccording to Gordons Model, the price of a share is

Given: E = 12% of Rs. 10=Rs. 1.20 r = 12%=0.12 Ke = 10%=0.10 t = 10%=0.10 b = 40%=0.40 Put the values in formula

P = Rs. 13.85

Ifthefirmfollowsapolicyof60%payoutthenb=20%=0.20

The price is

= 0.05

r= 4%= 0.04, D= 25% of 10 = 2.50

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= Rs. 41.67

If payout ratio is 50%, D= 50% of 10= Rs. 5r= 12%= 0.12, D= 50% of 10 = Rs. 5

= Rs. 83.33

r= 8%= 0.08, D= 50% of 10 = Rs. 5

= Rs. 69.42r= 4%= 0.04, D= 50% of 10 = Rs. 5

= Rs. 55.58

If payout ratio is 20%, the value of b= 0.60 and the price of the share is

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= Rs 120

Criticism of GordonsModel Gordons model consists of the following important criticisms:

Gordonmodelassumesthatthereisnodebtandequityfinanceusedbythefirm.Itisnotapplicabletopresentday business. Keandrcannotbeconstantintherealpractice.AccordingtoGordonsmodel,thereisnotaxpaidbythefirm.It is not practically applicable.

9.3 Factors Determining Dividend PolicyFollowing are the factors that determine dividend policy:Profitable position of the firm Dividenddecisiondependsontheprofitablepositionofthebusinessconcern.Whenthefirmearnsmoreprofit,theycan distribute more dividends to the shareholders.

Uncertainty of future income Future income is a very important factor, which affects the dividend policy. When the shareholder needs regular income,thefirmshouldmaintainregulardividendpolicy.

Legal constrainsThe Companies Act 1956 has put several restrictions regarding payments and declaration of dividends. Similarly, Income Tax Act, 1961 also lays down certain restrictions on payment of dividends.

Liquidity positionLiquiditypositionofthefirmsleadstoeasypaymentsofdividend.Ifthefirmshavehighliquidity,thefirmscanprovide cash dividend otherwise, they have to pay stock dividend.

Sources of finance If the firmhas finance sources, itwill be easy tomobilise large finance.Thefirm shall not go for retainedearnings.

Growth rate of the firmHighgrowthrateimpliesthatthefirmcandistributemoredividendtoitsshareholders.

Tax policyTaxpolicyofthegovernmentalsoaffectsthedividendpolicyofthefirm.Whenthegovernmentgivestaxincentives,the company pays more dividend.

Capital market conditions Due to the capital market conditions, dividend policy may be affected. If the capital is prefect, it leads to improve the higher dividend.

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9.4 Types of Dividend PolicyDividendpolicydependsuponthenatureofthefirm,typeofshareholderandprofitableposition.Onthebasisofthedividenddeclarationbythefirm,thedividendpolicymaybeclassifiedunderthefollowingtypes:

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

Regular dividend policyDividend payable at the usual rate is called as regular dividend policy. This type of policy is suitable to the small investors, retired persons and others.

Stable dividend policy Stable dividend policy means payment of certain minimum amount of dividend regularly. This dividend policy consists of the following three important forms:

Constant dividend per share Constant payout ratio Stable rupee dividend plus extra dividend.

Irregular dividend policyWhen the companies are facing constraints of earnings and unsuccessful business operation, they may follow irregulardividendpolicy.Itisoneofthetemporaryarrangementstomeetthefinancialproblems.Thesetypesarehavingadequateprofit.Forothersnodividendisdistributed.

No Dividend policy Sometimes the company may follow no dividend policy because of its unfavourable working capital position of the amount required for future growth of the concerns.

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Summary The financial manager must take careful decisions on how the profit should be distributed among shareholders.Dividendreferstothebusinessconcernsnetprofitsdistributedamongtheshareholders.

If the dividend is paid in the form of cash to the shareholders, it is called cash dividend..Stockdividendispaidintheformofthecompanystockduetoraisingofmorefinance..

Bonddividendisalsoknownasscriptdividend.Ifthecompanydoesnothavesufficientfundstopaycashdividend,thecompanypromisestopaytheshareholderatafuturespecificdatewiththehelpofissueofbondor notes.Property dividends are paid in the form of some assets other than cash. It will distributed under the exceptional circumstance. This type of dividend is not published in India.Dividenddecisionofthebusinessconcernisoneofthecrucialpartsofthefinancialmanager,becauseitdeterminestheamountofprofittobedistributedamongshareholdersandamountofprofittobetreatedasretainedearningsforfinancingitslongtermgrowth.

According to MM, under a perfect market condition, the dividend policy of the company is irrelevant and it doesnotaffectthevalueofthefirm.

Dividend relevance implies that shareholders prefer current dividend and there is no direct relationship between dividendpolicyandvalueofthefirm.

ReferencesDividend Decisions, [Pdf]Availableat:[Accessed30 May 2013].DIVIDEND POLICY ,[Pdf]Availableat:[Accessed30May 2013].2012. Dividend Policy, [Videoonline]Available at: [Accessed 30 May 2013].2009. CF1. Dividend Policy,[Videoonline]Availableat:[Accessed 30 May 2013].Paramasivan, C. & Subramanian, T., 2009. Financial Management. New Age International.Khan, M. Y., 2004. Financial Management: Text, Problems And Cases, 2nd ed., Tata McGraw-Hill Education

Recommended Reading Gallagher and Andrew, Financial Management; Principles and Practice. Freeload Press, Inc.Brigham, E. F. & Ehrhardt, M. C., 2011. Financial Management: Theory and Practice, 13th ed., Cengage Learning.Apte, 2006. International Financial Management, 4th ed., Tata McGraw-Hill Education.

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Self Assessment

According to professors Soloman, Modigliani and Miller, ___________ has no effect on the share price of the 1. company.

dividend policya. financialpolicyb. economic policyc. market policyd.

Prof.JamesE.Walterarguesthatthedividendpolicyalmostalwaysaffectsthe________ofthefirm2. profita. valueb. incomec. revenued.

Gordonmodelassumesthatthereisnodebtand_______financeusedbythefirm.3. liabilitya. arrearsb. equityc. stockd.

Dividendpolicydependsuponthenatureofthefirm,typeof____________andprofitableposition4. shareholdera. businessb. marketc. organisationd.

Which of the following statements is true?5. Dividend payable at the usual rate is called as regular dividend policy.a. Dividend payable at the usual rate is called as stable dividend policy.b. Dividend payable at the usual rate is called as irregular dividend policy.c. Dividend payable at the usual rate is called as no dividend policy.d.

When the companies are facing constraints of earnings and unsuccessful business operation, they may follow 6. _______________ dividend policy.

regulara. irregularb. stablec. unstabled.

Sometimes the company may follow ___________ policy because of its unfavourable working capital position 7. of the amount required for future growth of the concerns

regulara. irrgualrb. no dividendc. stabled.

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Which of the dividend policy means payment of certain minimum amount of dividend regularly?8. irregulara. unstableb. no dividendc. Stabled.

___________growthrateimpliesthatthefirmcandistributemoredividendtoitsshareholders9. Higha. Lowb. Stablec. Balance d.

_____________positionofthefirmsleadstoeasypaymentsofdividend.10. Liquiditya. Equityb. Stablec. Debtd.

Chapter IFinancial Management and PlanningAimObjectivesLearning outcome1.1 Introduction to Financial Management

1.2 Goals of Financial Management1.3 Financial Decisions1.4 Interface between Finance and Other Business Functions1.5 Financial Planning1.6 Capitalisations1.6.1 Cost Theory1.6.2 Earnings Theory

1.7 Over-capitalisation1.8 Under-capitalisationSummaryReferencesRecommended Reading

Self Assessment Chapter IITime Value of MoneyAimObjectivesLearning outcome2.2 Simple Interest2.3 Compound Interest2.3.1 Compounding Value of a Single Amount2.3.2 Variable Compounding Periods

2.4 Doubling Period2.5 Present Value2.6 Effective Vs Nominal Rate2.7 Sinking Fund Factor2.8 Loan Amortisation2.9 Shorter Discounting PeriodsSummaryReferencesRecommended Reading

Self Assessment Chapter IIIValuation of Bonds and SharesAimObjectivesLearning outcome3.1 Introduction to Valuation3.2 Nature of Value3.3 Bond Valuation3.3.1 Types of Bonds3.4 Bond Yields3.5 Bond Value Behaviors3.5.1 Required Rate of Return and Bond Values3.5.2 Time to Maturity and Bond Values3.5.3 Relationship between Bond Value and Time to Maturity Period

3.6 Valuation of Shares3.6.1 Valuation of Preference Shares3.6.2 Valuation of Equity/Ordinary Shares

SummaryReferencesRecommended Reading

Self Assessment Chapter IVCost of CapitalAimObjectivesLearning outcome4.1 Introduction to Cost of Capital4.2 Cost of Different Sources of Finance4.2.1 Cost of Equity4.2.2 Cost of Preference Shares4.2.3 Cost of Debentures

4.3 Capital Asset Pricing Model Approach (CAPM)4.4 Weighted Average Cost of Capital (WACC)4.4.1 Factors Affecting WACC

SummaryReferencesRecommended Reading

Self Assessment Chapter VCapital Structure and LeveragesAim ObjectiveLearning outcome5.1 Meaning of Capital Structure5.2 Features of an Appropriate Capital Structure5.3 Determination of Capital Structure5.4 Theories of Capital Structure5.4.1 Net Income Approach5.4.2 Net Operating Income (NOI) Approach5.4.3 Traditional Approach5.4.4 Miller and Modigliani Approach

5.5 Leverages5.5.1 Operating Leverage

5.5.3 Combined Leverage5.5.2 Financial LeverageSummaryReferencesRecommended Reading

Self Assessment Chapter VICapital BudgetingAimObjectivesLearning outcome6.1 Introduction6.2 Definition of Capital Budgeting6.3 Importance of Capital Budgeting6.4 Objectives of Capital Budgeting6.5 Principles or Factors of Capital Budgeting Decisions6.6 Capital Budgeting Process6.7 Types of Capital Expenditure6.8 Types of Capital Budgeting Proposals6.9 Methods of Evaluating Capital Investment Proposals6.9.1 Traditional Methods6.9.2 Improvement of Traditional Approach to Pay-back Period6.9.3 Average Rate of Return Method (ARR) or Accounting Rate of Return Method6.9.4 Discounted Cash Flow Method (or) Time Adjusted Method6.9.5 Net Present Value Method (NPV)6.9.6 Internal Rate of Return Method (IRR)6.9.7 Profitability Index Method

SummaryReferenceRecommended Reading

Self Assessment Chapter VIIManagement of Working CapitalAimObjectivesLearning outcome7.1 Introduction7.2 Meaning and Definition of Working Capital7.3 Classification of Working Capital 7.4 Components of Working Capital7.5 Aspects of Working Capital Management7.6 Need for Working Capital7.7 Estimation of Working Capital Requirements7.8 Sources of Working CapitalSummaryReferencesRecommended ReadingSelf Assessment

Chapter: VIIIInventory ManagementAimObjectivesLearning outcome8.1 Introduction8.2 Meaning and Definition of Inventory8.3 Types of Inventory8.4 Inventory Management Motives8.5 Objectives of Inventory Management8.6 Costs of Holding Inventory8.7 Risks of Holding Inventory8.8 Benefits of Holding Inventory8.9 Techniques of Inventory Control8.9.1 ABC Analysis8.9.2 Economic Order Quantity (EOQ)8.9.3 Order Point Problem8.9.4 Just in Time (JIT)

SummaryReferenceRecommended Reading Self Assessment

Chapter IXDividend DecisionAimObjectivesLearning outcome9.1 Introduction9.1.1 Types of Dividend/ Form of Dividend

9.2 Dividend Decision9.2.1 Irrelevance of Dividend 9.2.2 Relevance of Dividend

9.3 Factors Determining Dividend Policy9.4 Types of Dividend PolicySummary ReferencesRecommended Reading

Self AssessmentFig. 1.1 Financial decisionsFig. 3.1 Bond value and time to maturityFig. 5.1 Net income approachFig. 5.2 Net operating income approachFig. 5.3 Traditional approachFig. 7.1 Types of working capitalFig 7.2 Operating cycleFig. 9.1 Classification of dividend theoriesTable 1.1 Cost dimensionTable 1.2 Merits and demerits of cost approachTable 1.3 Merits and demerits of earnings theoryTable 8.1 Categorisation of Inventory