Unit 4: Working capital & dividend policy
Financial Management notes · PTU syllabus (BBA 403-18)
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Unit summary
Firms must manage day-to-day funds and decide how much profit to share. This unit covers the meaning and types of working capital, approaches to its financing, factors affecting it, and dividend decisions — forms of dividend and the relevance and irrelevance theories.
After this unit you can
- Explain gross and net working capital and its types
- Explain the operating cycle and approaches to working capital financing
- List the factors affecting working capital
- Explain forms of dividend and the Walter, Gordon and MM dividend theories
PTU syllabus topics
- Meaning
- significance
- types and approaches to working capital
- factors affecting working capital management
- issues in dividend decisions
- forms of dividend
- theories of relevance and irrelevance of dividends
- 1. Cash: Pays for raw materials
- 2. Raw materials: Go into production
- 3. Work in progress: Being made
- 4. Finished goods: Ready to sell
- 5. Debtors: Sold on credit; cash returns
Topic 1
Working capital: meaning and types
- Gross working capital: total current assets.
- Net working capital: current assets − current liabilities.
- Permanent (fixed) working capital: the minimum level always needed; temporary (variable) working capital: extra needed for seasonal or special needs.
- 1. Cash:
- 2. Raw materials:
- 3. Work in progress:
- 4. Finished goods:
- 5. Debtors: Collected back into cash
Operating cycle period = raw material period + WIP period + finished goods period + debtors period − creditors period.
Topic 2
Approaches and factors
Conservative
Permanent and part of temporary needs
Low risk, low return
Matching (hedging)
Permanent needs; short-term funds for temporary needs
Balanced
Aggressive
Part of permanent needs with short-term funds
High risk, high return
Factors affecting working capital: nature of business, scale of operations, production cycle, credit policy, seasonality, growth, availability of credit, and operating efficiency.
Topic 3
Dividend decisions and forms of dividend
The dividend decision is choosing between paying profits to shareholders and retaining them for growth. The payout ratio = dividend / earnings. Forms: cash dividend, stock dividend (bonus shares), interim dividend and share buy-back as an alternative. Issues: legal rules, liquidity, growth needs, shareholders' expectations, tax and stability of dividends.
Topic 4
Dividend theories
Walter's model
Yes
If return r > cost Ke, retain all; if r < Ke, pay all; if r = Ke, irrelevant
Gordon's model
Yes
"Bird in hand": investors prefer certain dividends now
Modigliani-Miller
No
In perfect markets, value depends on earnings, not dividend policy
Walter's formula: P = [D + (r/Ke)(E − D)] / Ke.
Key terms
- Net working capital
- Current assets minus current liabilities
- Operating cycle
- Time from cash to materials and back to cash
- Aggressive approach
- Financing some permanent needs with short-term funds
- Payout ratio
- Share of earnings paid as dividends
- Bird-in-hand argument
- Investors value certain dividends more than uncertain gains
Quick revision
- Gross = current assets; net = CA − CL.
- Conservative, matching, aggressive approaches.
- Dividend forms: cash, bonus, interim; buy-back alternative.
- Walter and Gordon: relevant; MM: irrelevant.
Important exam questions
Practice questions written to the PTU exam pattern for this unit's syllabus: short answers (Section A style) and long answers (Sections B and C style).
Short-answer questions
- Q1.Differentiate between gross and net working capital.
- Q2.What is the operating cycle?
- Q3.What is the aggressive approach to working capital?
- Q4.What is a stock dividend?
- Q5.State the MM dividend irrelevance theory.
Long-answer questions
- Q1.Explain the types of working capital and the factors affecting it.
- Q2.Explain the approaches to financing working capital.
- Q3.Explain Walter's and Gordon's models of dividend relevance.
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