Unit 4: Dividend decisions and working capital
Corporate Finance and Policy notes · PTU syllabus (MBA 206-21)
On this page
- Unit summary
- Issues in dividend decisions and forms of dividend
- Relevance and irrelevance theories of dividend
- Meaning and nature of working capital
- Static vs dynamic view of working capital
- Approaches and factors determining working capital
- Methods of financing working capital
- Key terms
- Quick revision
- Important questions
Unit summary
Firms must decide how much profit to distribute and how to finance day-to-day operations. This unit covers issues in dividend decisions, forms of dividend, the relevance and irrelevance theories of dividend, and working capital — its meaning and nature, conservative, matching and aggressive approaches, the static and dynamic views, factors determining working capital and methods of financing it.
After this unit you can
- Explain issues in dividend decisions and forms of dividend
- Explain the relevance and irrelevance theories of dividend
- Explain the meaning, nature, approaches and views of working capital
- Identify factors determining working capital and methods of financing it
PTU syllabus topics
- Issues in dividend decisions
- forms of dividend
- relevance and irrelevance theories
- working capital meaning
- nature
- conservative/matching/aggressive approaches
- static vs dynamic view
- factors determining working capital
- financing methods
Conservative
All permanent + part of temporary needs
Low risk, lower return
Matching (hedging)
Permanent needs; short-term for temporary
Balanced
Aggressive
Part of permanent needs too (rest short-term)
High risk, higher return
Topic 1
Issues in 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.
Stable dividend per share
Same rupee dividend each year, raised only when earnings rise permanently
Constant payout ratio
Fixed percentage of earnings — dividend fluctuates
Low regular plus extra
Small regular dividend with extra in good years
Irregular or no dividend
Growth firms retaining all earnings
- Determinants: legal restrictions (Companies Act Section 123 — dividends only out of profits), liquidity, growth and investment opportunities, cost of external finance, shareholder preferences and tax, control, debt covenants, inflation, stability of earnings.
- Lintner's model (1956): firms have a target payout ratio and adjust dividends gradually towards it, avoiding cuts — explains the preference for stable dividends.
- Signalling and clientele effects: a dividend increase signals management's confidence; investors in different tax brackets prefer different payout policies.
Topic 2
Relevance and irrelevance theories of dividend
Walter's model
P = [D + (r ÷ k)(E − D)] ÷ k
Gordon's model
P0 = E (1 − b) ÷ (k − br), where g = br
MM irrelevance
P0 = (D1 + P1) ÷ (1 + ke)
- Walter: if r > k (growth firm) — retain all (payout 0%); r < k (declining firm) — pay out 100%; r = k (normal firm) — dividend policy irrelevant.
- Gordon ("bird-in-hand"): investors value current dividends more than uncertain future gains; with r > k, retention raises price; with r = k, irrelevant; with r < k, payout raises price.
- MM hypothesis (1961): in perfect markets, dividend policy is irrelevant — value depends on earning power of assets; what shareholders gain in dividends they lose in share price (home-made dividends).
Example
Walter: E = ₹10, D = ₹4, r = 15%, k = 10%. P = [4 + (0.15 ÷ 0.10)(6)] ÷ 0.10 = (4 + 9) ÷ 0.10 = ₹130. At D = 0, P = [0 + 1.5 × 10] ÷ 0.10 = ₹150 — so a growth firm should retain.
View
Dividend policy affects share value
Dividend policy does not affect value
Key argument
Bird-in-hand, internal financing
Arbitrage; investors can create home-made dividends
Assumptions criticised
Constant r and k, all-equity firm
Perfect markets, no taxes, no transaction costs
Topic 3
Meaning and nature of working capital
- 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 4
Static vs dynamic view of working capital
Concept
Balance-sheet position at a point of time
Flow of funds through the operating cycle
Measure
Current assets minus current liabilities
Operating cycle and cash conversion cycle
Focus
Liquidity and solvency
Efficiency of operations
Use
Creditors and bankers
Managers planning cash needs
Operating cycle
Raw material period + WIP period + finished goods period + debtors period
Cash conversion cycle
Operating cycle − creditors period
Topic 5
Approaches and factors determining working capital
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 6
Methods of financing working capital
| Long-term (for permanent WC) | Short-term (for temporary WC) |
|---|---|
| Equity and preference shares | Trade credit |
| Debentures and long-term loans | Bank overdraft and cash credit |
| Retained earnings | Bill discounting and factoring |
| Depreciation funds | Commercial paper |
| Public deposits (short-term), advances from customers |
- Bank finance norms: Tandon Committee (1975) — Maximum Permissible Bank Finance methods; Chore Committee (cash credit); now assessment by banks based on projected turnover and the working capital demand loan structure.
Key terms
- Stock dividend
- Dividend paid by issuing bonus shares
- Dividend relevance
- View that dividend policy affects firm value
- Gross working capital
- Total current assets
- Aggressive approach
- Short-term funds finance part of permanent needs
- Cash conversion cycle
- Days between paying for inputs and collecting cash
Quick revision
- Dividend issues: stability, payout, legal and liquidity constraints; forms of dividend.
- Walter and Gordon (relevance), MM (irrelevance).
- Working capital: gross, net, permanent, temporary.
- Static vs dynamic view; operating and cash conversion cycles.
- Conservative, matching, aggressive approaches; factors; financing sources.
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.What is a stable dividend policy?
- Q2.Name three forms of dividend.
- Q3.State Walter's formula.
- Q4.Distinguish gross and net working capital.
- Q5.What is the dynamic view of working capital?
- Q6.What is the aggressive approach to financing working capital?
Long-answer questions
- Q1.Discuss the issues involved in dividend decisions.
- Q2.Explain the relevance and irrelevance theories of dividend.
- Q3.Explain the static and dynamic views and the approaches to working capital financing.
- Q4.Discuss the factors determining working capital and the methods of financing it.
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