PROJECT ON FM

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ACKNOWLEDGEMENT

I AM overwhelmed in all humbleness and gratefulness to

acknowledge our depth to all those who have helped me to

put these ideas, well above the level of simplicity and into

something concrete.

We are very thankful to our guide MRS. ANJUfor her

valuable help. She was always there to show us the right

track when we needed her help. She gave me moral support

and guided me in different matters regarding the topic. She

had been very kind and patient while suggesting me the

outlines of this project and correcting my doubts. I thank her

for her overall supports. With the help of her valuable

suggestions, guidance and encouragement, I am able to

perform this project work.

I would also like to thank our colleagues, who often helped

and gave me support at critical junctures during the making

to this project.


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DECLARATION

This is to certify that information embodied in theThis is to certify that information embodied in the

present report is based on my original work andpresent report is based on my original work and

has not been submitted in part or full for any otherhas not been submitted in part or full for any other

purpose.purpose.


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Shivank AroraShivank Arora

Roll No.- 4227Roll No.- 4227

Index

1. Are dividends relevant to the

valuation of the firm. Justify your

answer with suitable example.

2. Working capital managementinvolves resolving the conflict

between liquidity and profitability.COMMENT


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Project

Offinancial management

Made by:

NAME-Shivank arora


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COURSE-B.com (h) 3rd year

CLASS-Section-A

ROLL NO- 4227

KESHAV MAHAVIDYALAYA

PITAMPURA, Delhi-34

Question-1 - Are dividends relevant to the

valuation of the firm. Justify your answer

with suitable example.

The term DIVIDEND refers to that portion of profit

which is distributed among the

owners/shareholders of the firm. The profit whichis not distributed is known as retained earnings.

Dividend policy is mainly concerned with

deciding whether to pay dividend in cash now or

to pay increased dividend at later stage or

distribution of profits at a later stage or

distribution of profits in the form of bonusshares .The current dividend provides liquidity to

the investors but the bonus share will bring

capital gains to the shareholders .The investors


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preference between current dividend and future

capital gain dividend have been viewed

differently .

Value of share is defined to be equal to present

value of expected future dividends.

Different models have been proposed to evaluate

the dividend policy decision in relation to value of

the firm. Two school of thoughts have emerged

on the relationship between the dividend policy

and value of the firm. These are:

i. Walter and Gordon

ii. Modigliani and Miller

Both these schools of thought on the relationship

between dividend policy and value of the firm are

explained below.

i. WALTERS MODEL

Walter's model supports the principle thatdividends are relevant. The investment policy of afirm cannot be separated from its dividend policy


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and both are inter-related. The choice of anappropriate dividend policy affects the value of anenterprise.

Assumptions of this model:

1.Retained earnings are the only source offinance. This means that the company does notrely upon external funds like debt or newequity capital.

2.The firm's business risk does not change with

additional investments undertaken. It impliesthat r(internal rate of return) and k(cost ofcapital) are constant.

3.There is no change in the key variables,namely, beginning earnings per share(E), anddividends per share(D). The values of D and Emay be changed in the model to determine

results, but any given value of E and D areassumed to remain constant in determining agiven value.

4.The firm has an indefinite life.

Formula: Walter's model

P = DKe g

Where: P =Price of equity sharesD =Initial dividendKe =Cost of equity capital


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g =Growth rate expected

After accounting for retained earnings, the model

would be:P = D

Ke rb

Where:

r =Expected rate of returnon firms investments

b =Retention rate (E - D)/E

Equation showing the value of a share (as presentvalue of all dividends plus the present value of allcapital gains) Walter's model:

P =

D + r/ke (E - D)ke

Where:

D=Dividend per share and

E =Earnings per share

Example:

A company has the following facts:


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Cost of capital (ke) = 0.10Earnings per share (E) = RS10Rate of return on investments ( r) = 8%

Dividend payout ratio: Case A: 50% Case B: 25%Show the effect of the dividend policy on themarket price of the shares.

Solution:

Case A:D/P ratio = 50%When EPS = RS 10 and D/P ratio is 50%, D = 10 x50% = RS 5

P=

5 + [0.08 / 0.10] [10 -5]

0.10

Case B:D/P ratio = 25%When EPS = RS 10 and D/P ratio is 25%, D = 10 x25% = RS 2.5

P=

2.5 + [0.08 /0.10] [10 - 2.5]

0.10

=> RS85

Conclusions of Walter's model:


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1. When r > ke, the value of shares is inverselyrelated to the D/P ratio. As the D/P ratioincreases, the market value of shares decline.

Its value is the highest when D/P ratio is 0. So,if the firm retains its earnings entirely, it willmaximize the market value of the shares. Theoptimum payout ratio is zero.

2. When r < ke, the D/P ratio and the value ofshares are positively correlated. As the D/Pratio increases, the market price of the sharesalso increases. The optimum payout ratio is100%.

3. When r = ke, the market value of shares isconstant irrespective of the D/P ratio. In thiscase, there is no optimum D/P ratio.

Limitations of this model:

1.Walter's model assumes that the firm'sinvestments are purely financed by retainedearnings. So this model would be applicableonly to all-equity firms.

2.The assumption of r as constant is not realistic.

3.The assumption of a constant ke ignores theeffect of risk on the value of the firm.


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WALTER J.E. supports the view that the dividend

policy has a bearing on the market price of the

share and has presented a model to explain the

relevance of dividend policy for valuation of thefirm based on the following assumptions:

a) All investment proposals of the firm are to be

financed through retained earnings only and

no external finance is available to the firm.

b) The business risk complexion of the firm

remains same even after fresh investment

decision are taken .

This model considers that the investment

decision and dividend decision of a firm are

interrelated. A firm should or should not pay

dividend depends upon whether it has got thesuitable investment opportunities to invest the

retained earnings or not.

II) GORDONS MODEL

The Gordon growth model is a variant ofthe discounted cash flow model, a method forvaluing a stock or business. Often used to providedifficult-to-resolve valuation issues for litigation,tax planning, and business transactions that arecurrently off market. It is named after Myron J.Gordon, who originally published it in 1959.Itassumes that the company issues a dividend that
http://www.answers.com/topic/stockhttp://www.answers.com/topic/myron-j-gordonhttp://www.answers.com/topic/myron-j-gordonhttp://www.answers.com/topic/dividendhttp://www.answers.com/topic/myron-j-gordonhttp://www.answers.com/topic/myron-j-gordonhttp://www.answers.com/topic/dividendhttp://www.answers.com/topic/stock


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has a current value ofD that grows at a constantrate g. It also assumes that the required rate ofreturn for the stock remains constant at kwhich is

equal to the cost of equity for that company. Itinvolves summing the infinite series which givesthe value of price current P..

.

Summing the infinite series we get,

In practice this P is then adjusted by various factorse.g. the size of the company.

k denotes expected return = yield + expectedgrowth.

It is common to use the next value of D givenby : D1 = D0(1 + g), thus the Gordon's model canbe stated

.

Note that the model assumes that the earningsgrowth is constant for perpetuity. In practice a veryhigh growth rate cannot be sustained for a longtime. Often it is assumed that the high growth ratecan be sustained for only a limited number ofyears. After that only a sustainable growth rate willbe experienced. This corresponds to the terminal
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case of the Discounted cash flow model. Gordon'smodel is thus applicable to the terminal case.

3.Miller and Modigliani Model (MM Model)

Miller and Modigliani Model assume that thedividends are irrelevant. Dividend irrelevanceimplies that the value of a firm is unaffected by the

distribution of dividends and is determined solelyby the earning power and risk of its assets. Underconditions of perfect capital markets, rationalinvestors, absence of tax discrimination betweendividend income and capital appreciation, giventhe firms investment policy, its dividend policymay have no influence on the market price of the

shares, according to this model.

Assumptions of MM model

1.Existence of perfect capital markets and allinvestors in it are rational. Information isavailable to all free of cost, there are notransactions costs, securities are infinitelydivisible, no investor is large enough toinfluence the market price of securities andthere are no floatation costs.
http://www.answers.com/topic/discounted-cash-flowhttp://www.answers.com/topic/discounted-cash-flow


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2.There are no taxes. Alternatively, there are nodifferences in tax rates applicable to capitalgains and dividends.

3.A firm has a given investment policy whichdoes not change. It implies that the financingof new investments out of retained earningswill not change the business risk complexion ofthe firm and thus there would be no change inthe required rate of return.

4.Investors know for certain the futureinvestments and profits of the firm (but thisassumption has been dropped by MM later).

Argument of this Model

1.By the argument of arbitrage, MM Modelasserts the irrelevance of dividends. Arbitrageimplies the distribution of earnings toshareholders and raising an equal amountexternally. The effect of dividend paymentwould be offset by the effect of raisingadditional funds.

2.MM model argues that when dividends are paidto the shareholders, the market price of theshares will decrease and thus whatever is

gained by the investors as a result of increaseddividends will be neutralized completely by thereduction in the market value of the shares.


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3.The cost of capital is independent of leverageand the real cost of debt is the same as thereal cost of equity, according to this model.

4.That investors are indifferent between dividendand retained earnings implies that the dividenddecision is irrelevant. With dividends beingirrelevant, a firms cost of capital would beindependent of its dividend-payout ratio.

5.Arbitrage process will ensure that underconditions of uncertainty also the dividendpolicy would be irrelevant.

MM Model:Market price of the share in the beginning of

the period = Present value of dividends paid at the

end of the period + Market price of share at theend of the period.

P0 = 1/(1 + ke) x (D1 + P1)

Where: P0 =Prevailing market price of ashare

ke = cost of equity capital

D1 = Dividend to be received atthe end of period 1 and

P1 =Market price of a share atthe end of period 1.


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Value ofthe firm,nP0

=

(n + n)P1 I + E

(1 + ke)

Where:

n =number of shares outstanding at thebeginning of the period

n

=change in the number of sharesoutstanding during the period/ additionalshares issued.

I =Total amount required for investmentE =Earnings of the firm during the period.

Example:A company whose capitalization rate is 10% has

outstanding shares of 25,000 selling at RS 100

each. The firm is expecting to pay a dividend of RS5 per share at the end of the current financial year.The company's expected net earnings are RS250,000 and the new proposed investmentrequires RS 500,000. Prove that using MM model,the payment of dividend does not affect the valueof the firm.

Solution:

1. Value of the firm when dividends are paid:


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i. Price per share at the end of year 1:

P0 = 1/(1 + ke) x (D1 + P1)

RS 100 = 1/(1 + 0.10) x (RS 5 + P1)P1 = RS 105ii. Amount required to be raised from the

issue of new shares:

n P1 = I (E nD1)=> RS 500,000 (RS 250,000 -RS125,000)=> RS 375,000

iii. Number of additional shares to be issued:

n = RS 375,000 / 105 => 3571.42857shares (un rounded)

iv. Value of the firm:

=> (25,000 + 3571.42857) (105) -$500,000 + $250,000(1 + 0.10)

=> RS 2,500,0002. Value of the firm when dividends are not paid:

i. Price per share at the end of year 1:

P0 = 1/(1 + ke) x (D1 + P1)RS 100 = 1/(1 + 0.10) x (0 + P1)P1 = RS 110


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ii. Amount required to be raised from theissue of new shares:

=> RS 500,000 (RS 250,000 -0) = RS250,000iii. Number of additional shares to be issued:

=> RS 250,000/RS 110 = 2272.7273shares

iv. Value of the firm:

=> (25,000 + 2272.7273) (110) RS 500,000 + RS250,000

(1 + 0.10)=> RS 2,500,000

Thus, according to MM model, the value of thefirm remains the same whether dividends are paid

or not. This example proves that the shareholdersare indifferent between the retention of profits andthe payment of dividend.


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QUESTION 2- Working capital managementinvolves resolving the conflict betweenliquidity and profitability. COMMENT

The working capital management refers to the

procedures and policies required to manage the

working capital .long term profitability of a firm

depends upon the investment decision of a firm.

The investment decision determines the pattern ofsales growth and sales in turn, determine the

profitability .There are two important implications

for working capital management .first, the sales

forecast of goods and services being produced by


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the firms allow the financial manager to estimate

the working capital needs and level of different

current assets. Second, the working capital

management helps maximizing the shareholderswealth by providing and maintaining firms liquidity.

An important aspect of a working capital policy is

to maintain and provide sufficient liquidity to the

firm. Like most corporate financial decision, the

decision on how much working capital be

maintained involves a trade off because having alarge working capital may reduce the liquidity risk

faced by the firm, but it can have a negative effect

on cash flows. A firm must maintain enough cash

balance or other liquid assets so that it never faces

problem of payment to liabilities.

The risk-return trade-off involved in managing thefirms working capital is a trade-off between the

firms liquidity and its profitability. By maintaining a

large investment in current assets like cash ,

inventory, etc .the firm reduces the chances of

i)Production stoppages and lost sales from the

inventory shortages

ii)the inability to pay the creditors on time.


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Firms use of current liability vs long term debt also

involves a risk return trade off. Other things being

equal the greater the firms reliance on the short

term debts or current liabilities in financing itscurrent assets, the greater the risk of liquidity. The

current liability can be advantageous as it is less

costly and flexible means of financing. A firm can

reduce its risk of illiquidity through the use of long

term debts at the cost of reduction in its return on

investment. The risk return trade-off thus involvesan increased risk of illiquidity and the profitability.

Assumptions:

i) current assets are less profitability than the

fixed assets

ii)short term funds are cheaper than long termfunds

iii) The firm has a fixed level of total funds

inclusive of long term funds and short term

funds and a fixed level of total assets

inclusive of current assets and fixed assets.

The effect of changing levels of current assets onthe risk return trade-off can be demonstrated as

follows-


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For a given firm, if the level of current assets is

increased then the liquidity position of the firm

will also increase and it will be easily meeting its

payment commitments.

Now in order to increase the profitability, the firm

reduces the current assets. The profitability of

the firm will increase but the liquidity will be

reduced.

EXAMPLE-

The following is the balance sheet of ABC ltd. as

on 31st dec.2010

BALANCE SHEET AS ON 31ST DEC 2010

Liabilities amount

Assets Amount

Share capitalDebenturesCurrentliabilities

600000500000100000

Fixed assetsCurrentassets

1000000

200000

The firm is earning 12% return on fixed assets

and 2% return on current assets. Find out the

effect on liquidity and profitability of the firm of

the following.


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i) Increase in current assets by 25%

ii) Decrease in current assets by 25%

SOLUTION

The present earnings of the firm may be

ascertained as follows:

12% return on fixed assets 120000

2% return on current assets 4000

----------

Total return 124000

total assets 1200000

rate of return

(earnings/total assets) 10.33%

ratio of current assets to

total assets 16.7%

EVALUATION OF EFFECT ON LIQUIDITY AND

PROFITABILITY


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Present CA Increase inCA

Decrease inCA

Current

assetsFixedassetsReturn onfixedassets@12%Return oncurrentassets@2%Total returnRatio of CAto TACurrent

liabilitiesRatio of Cato CLReturn as a% of TA

200000

1000000120000

4000

12400016.7%

100000

2

10.33%

2500000

950000114000

5000

11900020.8%

100000

2.5

9.91%

150000

1050000126000

3000

12900012.5%

100000

1.5

10.75%

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