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FINANCIAL MANAGEMENT

Management of Surplus & Dividend Policy (Walter, Gordon, MM Hypothesis)

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Management of Profits (Surplus)

Profit is the lifeblood of business. It ensures survival, growth, and returns to shareholders. From the perspective of financial management, managing profits is better termed as Management of Earnings.

Earnings refer to the net profit available to equity shareholders. A firm has two choices with these earnings:

  1. Distribute as Dividends: Return profits to shareholders as cash, bonus shares, or buybacks.

  2. Retain as Surplus: Keep the money to reinvest in the business for expansion and growth (Ploughing back of profits).

What is Surplus?

Surplus is the amount of profit remaining after tax and dividends that is retained in the business as a reserve. Efficient management of surplus involves investing it wisely to generate returns higher than what shareholders could earn themselves.

Key Insight: If a company reinvests surplus but fails to generate significant growth, investors are better off receiving dividends.

Dividend Policy

Dividend Policy determines the portion of earnings to be paid out to shareholders vs. the portion to be retained. It is a balancing act between satisfying shareholders’ need for current income and the firm’s need for future growth.

Types of Dividend Policies

  1. Constant Payout Ratio: Paying a fixed percentage of earnings as dividends every year. (e.g., Always pay 50% of profits). Drawback: Dividends fluctuate wildly with earnings.

  2. Regular Dividend Policy: Paying a fixed rupee amount per share every year. This signals stability and reduces uncertainty for investors.

  3. Low Regular & Extra Dividend: Paying a small, guaranteed dividend and adding an “extra” dividend only in years of high profit.

Factors Affecting Dividend Decisions

  • Capital Gains vs. Dividends: Some investors prefer growth (capital gains), while others (like retirees) need steady income (dividends).

  • Legal Restrictions: Dividends can only be paid out of current or accumulated profits after providing for depreciation (Sec 205, Companies Act).

  • Liquidity: A firm may have high profits but low cash (due to inventory/debtors). You need cash to pay dividends.

Theories of Dividend Decisions

Does dividend policy affect the value of the firm? There are conflicting theories.

1. Traditional Approach

Dividends matter. High dividends = High share price.

Formula: $P = m (D + E/3)$

2. Walter’s Model (Relevance Theory)

James E. Walter argues that dividend policy is relevant and affects share price based on the relationship between the firm’s return on investment ($r$) and the cost of capital ($k$).

  • If $r > k$ (Growth Firm): Retain earnings. 0% payout maximizes value.

  • If $r < k$ (Declining Firm): Distribute earnings. 100% payout maximizes value.

  • If $r = k$ (Normal Firm): Dividend policy is irrelevant.

Formula:

$$P = \frac{D + (r/k)(E – D)}{k}$$

3. Gordon’s Model (Relevance Theory)

Myron Gordon also supports relevance. He argues that investors prefer current dividends over future capital gains (Bird-in-hand theory). A higher dividend payout reduces risk and increases share price.

4. Modigliani-Miller (MM) Hypothesis (Irrelevance Theory)

MM argues that dividend policy is irrelevant in a perfect market. The value of the firm depends only on its earnings power and investment policy, not on how it splits earnings between dividends and retention.

  • Logic (Arbitrage): If a firm pays a dividend, it may need to issue new shares to fund investments. The value gained by shareholders from the dividend is exactly offset by the drop in share price due to the new issue. Thus, shareholder wealth remains unchanged.

Forms of Dividends

Besides cash, firms can distribute value in other ways:

1. Bonus Shares (Stock Dividend)

Issuing new shares to existing shareholders free of cost.

  • Benefit: Conserves cash for the company while giving shareholders more shares (though the value per share drops proportionally). It signals confidence in future profits.

2. Stock Split

Dividing existing shares into multiple shares (e.g., 1 share of ₹100 becomes 10 shares of ₹10).

  • Objective: To reduce the market price per share to make it more affordable for small investors and increase liquidity.

3. Stock Repurchase (Buyback)

The firm buys back its own shares from the market.

  • Impact: Reduces the number of outstanding shares, which increases Earnings Per Share (EPS) and often boosts the market price.

Modigliani-Miller (MM) Hypothesis: A Closer Look

The Argument:

In a perfect market (no taxes, no transaction costs, rational investors), dividend policy does not affect share price. If an investor wants cash, they can sell shares (homemade dividend). If they want growth, they can reinvest dividends.

Deficiencies/Criticisms of MM Hypothesis:

  1. Market Imperfections: Real markets have transaction costs (brokerage) and floatation costs.

  2. Taxes: Dividends and capital gains are taxed differently in the real world.

  3. Uncertainty: Investors value the certainty of current dividends over the uncertainty of future capital gains (“Bird in the hand” argument).

  4. Signaling Effect: Dividends convey information. A cut in dividends is often seen as a bad signal by the market, contrary to MM’s claim.

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Working Capital Management: Meaning, Cycle & Financing

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What is Working Capital Management? (Concept & Meaning)

Working Capital Management is the functional area of finance that deals with a firm’s current assets and current liabilities. It ensures the company has sufficient liquidity to run day-to-day operations while maximizing profitability.

Working Capital refers to funds invested in current assets like raw materials, work-in-progress, finished goods, debtors, and cash.

Two Concepts of Working Capital:

  1. Gross Working Capital: The total investment in all current assets.

  2. Net Working Capital: The excess of total current assets over total current liabilities.

    • Formula: Net Working Capital = Current Assets - Current Liabilities

Types based on Time:

  1. Permanent (Hard Core) Working Capital: The minimum level of current assets required at all times to carry out business. It should ideally be financed by long-term sources.

  2. Temporary (Variable) Working Capital: The additional capital required over and above the permanent level to meet fluctuating demands (e.g., seasonal spikes).

The Working Capital Cycle (Operating Cycle)

The Operating Cycle refers to the length of time from the purchase of raw materials to the realization of cash from sales. It represents the time funds are tied up in the business process.

Formula: Operating Cycle = R + W + F + D - C

    • R = Raw Material Storage Period

    • W = Work-in-Progress Holding Period

    • F = Finished Goods Storage Period

    • D = Debtors Collection Period

    • C = Credit Period from Suppliers

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Note: A shorter operating cycle means the firm needs less working capital because cash is recovered quickly. A longer cycle requires more working capital.

Approaches to Financing Working Capital

How should a firm fund its working capital needs? There are three main approaches based on the risk-return trade-off.

1. Matching (Hedging) Approach

The firm matches the maturity of the source of funds with the life of the asset.

  • Long-term sources finance Fixed Assets + Permanent Working Capital.

  • Short-term sources finance Temporary Working Capital.

  • Risk/Return: Moderate.

2. Conservative Approach

The firm relies more on long-term funds to be safe.

  • Long-term sources finance Fixed Assets + Permanent Working Capital + Part of Temporary Working Capital.

  • Short-term sources finance only the remaining peak temporary needs.

  • Risk/Return: Low Risk (high liquidity), but Lower Return (since long-term funds are costlier).

3. Aggressive Approach

The firm relies heavily on short-term funds to save costs.

    • Short-term sources finance Temporary Working Capital + Part of Permanent Working Capital.

    • Risk/Return: High Risk (danger of insolvency if loans aren’t renewed), but Higher Return (since short-term funds are cheaper).

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Regulation of Bank Finance (Tandon Committee)

Banks are the primary source of working capital finance in India. To regulate this, the RBI set up the Tandon Committee (1974) to introduce financial discipline.

The 3 Methods of Lending (Maximum Permissible Bank Finance – MPBF):

  1. Method 1: Bank lends 75% of the Working Capital Gap (Current Assets – Current Liabilities). The borrower provides 25% from long-term sources.

    • Formula: MPBF = 0.75 (CA - CL)

  2. Method 2: Bank lends 75% of Total Current Assets minus Current Liabilities. The borrower provides 25% of Total Current Assets.

    • Formula: MPBF = (0.75 * CA) - CL

  3. Method 3: Bank lends against “Core Current Assets.” (Rarely used).

Impact: These norms ensured that companies maintain a minimum current ratio and do not rely entirely on bank funds for their operations.

Factors Affecting Working Capital Needs

  1. Nature of Business: Manufacturing firms need more WC than trading or service firms due to production cycles.

  2. Production Policy: Seasonal vs. steady production affects inventory levels.

  3. Credit Policy: Liberal credit to customers increases debtors, increasing WC needs.

  4. Business Cycle: Booms increase demand and WC needs; recessions decrease them.

  5. Growth & Expansion: Growing firms need more WC for larger operations.

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Time Value of Money: Future value, Present value, Annuities Formulas and Important Numerical

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Introduction to Time Value of Money (TVM)

The Time Value of Money (TVM) is one of the most important concepts in finance.
It states that money available today is worth more than the same amount in the future because it has the potential to earn interest.

Why is money today more valuable?

Because you can invest money now and earn a return and everything else in future is uncertain.
Interest is the reward for waiting or the cost of borrowing money.

Important Terms

  • Principal (P): The original amount of money invested or lent.

  • Interest Rate (i): The percentage charged or earned per time period (e.g., 6% per year).

  • Time (n): Number of periods the money is invested.

  • Future Value (FV): Amount an investment grows to in the future.

  • Present Value (PV): Current value of a future amount.

Future Value (Compounding)

Future Value tells us how much an investment made today will be worth in the future.

1. Simple Interest

Interest is earned only on the original principal.

Simple Interest = Principal × Rate × Time
 

2. Compound Interest

Interest is earned on principal + previous interest (the power of compounding).

Formula: Future Value of a Single Amount

FV = PV (1 + i)^n
 

Where:

  • FV = Future Value

  • PV = Present Value

  • i = Interest Rate per period

  • n = Number of periods

Note: More frequent compounding (monthly/quarterly) results in a higher future value.

Present Value (Discounting)

Present Value is the current worth of a future sum of money.

It answers:

How much should I invest today to receive ₹X in the future?

Formula

PV = FV / (1 + i)^n
 
 

Example on Present value of Money

Alpha Company can invest at 16% interest compounded annually, while Beta Company can invest at 16% interest compounded semi-annually.
Both companies need ₹2,00,000 after 4 years. We will calculate how much each must invest today (Present Value).

Solution

1. Alpha Company – Annual Compounding

  • Time period (n) = 4 years

  • Interest rate (i) = 16% per year

Formula:

PV = Future Value × 1 / (1 + i)ⁿ

 

Calculation

PV = 2,00,000 × 1 / (1.16)⁴
PV = 2,00,000 × 0.55229
PV = ₹1,10,458
 

2. Beta Company – Semi-Annual Compounding

  • Compounding frequency = 2 times per year

  • Time period (n) = 4 × 2 = 8

  • Interest rate per period (i) = 16% ÷ 2 = 8%

Formula:

PV = Future Value × 1 / (1 + i)⁸

Calculation

PV = 2,00,000 × 1 / (1.08)⁸
PV = 2,00,000 × 0.54027
PV = ₹1,08,054
 

Conclusion

Beta Company needs to invest less today because its investment grows faster due to more frequent compounding.

Annuities (Series of Equal Payments)

An annuity is a series of equal payments made at regular intervals of time (e.g., rent, insurance, pension).

1. Future Value of an Ordinary Annuity

The value of all future payments plus interest earned.

FV_annuity = R × [((1 + i)^n – 1) / i]
 

Where R = periodic payment (rent)

2. Present Value of an Ordinary Annuity

The lump sum needed today to provide equal future payments.

PV_annuity = R × [(1 – (1 + i)^(-n)) / i]
 
 

Example: Future Value of an Ordinary Annuity

In the beginning of 2006, the directors of Molloy Corporation decided that the plant facilities must be expanded in a few years.
The company plans to invest ₹50,000 every year, starting on June 30, 2006, into a trust fund that earns 11% interest compounded annually.

Question

How much money will be in the fund on June 30, 2010, after the last deposit has been made?

Solution

  • The first deposit is made at the end of the first year, so it is an ordinary annuity

  • Number of periods (n) = 5 years

  • Interest rate (i) = 11%

  • The last deposit (2010) earns no interest because it is deposited on the final day

From the Future Value of Ordinary Annuity Table,
Future Value Factor (at n = 5, i = 11%) = 6.22780

Formula

FV = Rent × Future Value Annuity Factor

Calculation

FV = 50,000 × 6.22780
FV = ₹3,11,390
 

Conclusion

Molloy Corporation will have ₹3,11,390 in the fund on June 30, 2010.

Finding the Required Annual Deposit

If the company needs exactly ₹3,00,000 on June 30, 2010, how much must it deposit every year?

Formula

Rent = FV / Future Value Annuity Factor

Calculation

Rent = 3,00,000 / 6.22780
Rent = ₹48,171.10
 

Final Answer

The company must deposit ₹48,171 every year to accumulate ₹3,00,000 by June 30, 2010.

Perpetuities

A Perpetuity is an annuity that pays forever (infinite life).
Examples: perpetual bonds, preferred stock dividends.

Formula

PV = C / i

Where C = constant annual payment

 

Growth Calculations & Doubling Money

1. Compound Annual Growth Rate (CAGR)

gr = (Vn / V0)^(1/n) – 1
 

2. Rule of 72

A shortcut to estimate how long it takes to double money.

Years = 72 / Interest Rate
 

3. Rule of 69 (continuous compounding)

Doubling Period = 0.35 + (69 / Interest Rate)
 

Summary of Important Formulas

Concept Formula Future Value (Single Amount) FV = PV (1 + i)^n Present Value (Single Amount) PV = FV / (1 + i)^n PV of Perpetuity PV = C / i Doubling Period (Rule of 72) Years = 72 / i

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Financial Management: Scope, Functions & Objectives Profit Maximization vs. Wealth Maximization

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Introduction to Financial Management

Finance is the art and science of managing money. Virtually all individuals and organizations earn, raise, spend, or invest money. Financial Management is broadly concerned with the acquisition and use of funds by a business firm.

In earlier years, it was synonymous with just raising funds. Today, its scope has broadened to include the efficient use of resources.

Scope of Financial Management

Financial management focuses on managing money in a smart and planned way. Its main aim is to make sure the business has enough funds and uses them correctly to increase profit and value. The scope of financial management includes the following areas:

1. Financial Analysis, Planning & Control

  • It means understanding the company’s financial position by analyzing financial statements like Balance Sheet & Profit-Loss account.

  • Planning helps decide how much money is required and where it will be spent.

  • Control ensures that money is used properly and not wasted.

Example: Checking budgets, comparing actual performance with planned performance.

2. Profit Planning

  • Profit planning means deciding the expected level of profit and making strategies to achieve it.

  • It includes controlling costs, increasing sales, and improving efficiency.

Example: Setting profit targets for the year and preparing plans to reach them.

3. Financial Forecasting

  • It means predicting the future financial needs of the business.

  • Helps in estimating cash needs, investment requirements, and financial risks.

Example: Forecasting future sales, future expenses, and capital needs.

4. Acquisition and Use of Funds

  • It means arranging funds from different sources (like shares, loans, debentures).

  • Also includes deciding where and how to invest this money to earn the best return.

Example: Raising money from the bank and investing it to buy new machinery.

Objectives: Profit Maximization vs. Wealth Maximization

Every Finance Manager has to ask one question: “What is our ultimate goal?”

There are two schools of thought: the Traditional approach (Make Profit) and the Modern approach (Create Wealth).

1. Profit Maximization (The Old School)

The Idea:

Business exists to make money. Therefore, any decision that increases profit is “Good,” and any decision that reduces profit is “Bad.”

Why it sounds right: It’s simple. Profit measures efficiency. If we are profitable, we survive.

Why it is actually WRONG (The Flaws):

  1. It is Vague: What is “Profit”? Is it short-term profit? Long-term? Before tax? After tax? It is not clear.

  2. Ignores Risk:

    • Example: Project A gives a guaranteed profit of ₹50,000. Project B gives a profit of ₹1 Lakh but has a 50% chance of failing completely.

    • A “Profit Maximizer” would choose Project B because the profit is higher, ignoring the huge risk of losing everything.

  3. Ignores Time Value of Money:

    • Example: Option A gives you ₹1 Lakh today. Option B gives you ₹1 Lakh after 5 years.

    • Profit Maximization says both are equal (₹1 Lakh = ₹1 Lakh). But common sense tells us money today is more valuable than money 5 years later.

2. Wealth Maximization (The Modern School)

The Idea:

The goal is not just to earn profit, but to increase the Market Value of the company. This is also called Shareholder Value Maximization. The focus is on increasing the share price in the stock market.

The Formula:

Wealth = Number of Shares Owned × Current Market Price per Share

Why it is BETTER:

  1. Considers Risk: It avoids risky projects because high risk makes share prices fall.

  2. Considers Time: It recognizes that cash now is better than cash later. It uses Discounted Cash Flow (DCF) techniques.

  3. Long-Term Focus: It doesn’t cut corners to make a quick buck. It invests in quality, brand, and research, which increases the company’s value over 10-20 years.

  4. Considers Everyone: To keep the share price high, a company must treat customers, employees, and society well. If they cheat customers to make a quick profit, the share price will eventually crash.

Comparison: Which one wins?

BasisProfit MaximizationWealth Maximization
ConceptTraditional / NarrowModern / Broad
GoalEarn large profitsIncrease market value of shares
Time HorizonShort-term focusLong-term focus
RiskIgnores risk factorConsiders risk factor
Time ValueIgnores timing of returnsRecognizes money has time value
Best ForSurvival stage companiesEstablished, growing companies

While Profit is necessary for survival (like oxygen), Wealth Maximization is the ultimate goal (like a healthy life). A good Financial Manager always chooses Wealth Maximization because it accounts for risk, time, and future growth.

The Three Key Finance Functions (Decisions)

Financial management revolves around three major decisions that must be optimal to maximize firm value.

1. Investment Decision

Where should the firm invest its funds?

  • Capital Budgeting: Selecting long-term assets (projects) that yield returns in the future.

  • Working Capital Management: Managing current assets (cash, receivables, inventory) for day-to-day operations.

Financial Analysis, Planning and Control  Analysis of financial condition and preference  Profit planning  Financial forecasting  Financial control

2. Financing Decision

How should the firm raise funds?

  • Capital Structure: Determining the right mix of Debt and Equity.

  • Source of Funds: Choosing between loans, shares, or retained earnings based on cost and risk.

3. Dividend Decision

How much profit should be distributed among stakeholders?

    • Dividends: Distributing profits to shareholders.

    • Retained Earnings: Keeping profits for reinvestment in the company.

    • The manager must decide the optimal dividend payout ratio that maximizes shareholder wealth.

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 Interface of financial management with Other Functions

Finance is the lifeblood of an organization and connects with all other departments:

  • Marketing: Finance allocates budget for ads and sales campaigns.

  • Production: Finance approves funds for machinery and raw materials.

  • HR: Finance manages payroll and benefits costs.

  • Economics: Financial managers use economic theories (supply-demand, marginal analysis) for efficient operations.

  • Accounting: While accountants focus on accrual-based reporting, financial managers focus on cash flows for decision-making.

Understanding Capitalization

Before we jump into “Over” or “Under,” let’s understand Capitalization.

In simple terms, Capitalization is the total amount of money invested in the business (Shares + Debentures + Long-term Loans).

Think of capitalization like a shirt.

  • Fair Capitalization: The shirt fits perfectly. The capital invested generates just the right amount of profit.

  • Overcapitalization: The shirt is too loose (Too much capital, too little profit).

  • Undercapitalization: The shirt is too tight (Too little capital recorded, but massive profit).

1. Overcapitalization

A company is Overcapitalized when it has raised more money than it can profitably use. It sounds like having “too much money,” but in finance, it is a bad situation.

Simple Definition:

When a company’s earnings are very low compared to the huge capital it has invested. It is like buying a Ferrari just to deliver pizzas—the investment is huge, but the return is tiny.

Example:

Imagine Company A invests ₹10 Lakhs. The normal industry return is 10% (so it should earn ₹1 Lakh). However, Company A only earns ₹50,000.

  • The shareholders invested a lot but are getting very little return.

  • Verdict: Company A is Overcapitalized.

Symptoms (How to spot it):

  1. Low Dividend: The company cannot pay good dividends because profits are low.

  2. Low Share Price: Since dividends are low, people sell the shares, and the market price falls below the face value (e.g., a ₹10 share trades at ₹8).

  3. Difficulty Raising Loans: Banks won’t lend money because the company isn’t profitable enough.

Causes (Why it happens):

  • Buying assets at high prices: Buying machinery when it was very expensive.

  • High Promotion Costs: Spending too much money on ads that didn’t bring sales.

  • Liberal Dividends: In the past, the company distributed all profits to shareholders and didn’t save anything for the future.

Remedies (How to fix it):

  • Reduction of Capital: Cancel old shares and issue new ones at a lower value.

  • Buyback: The company buys back its own shares to reduce the number of claimants on profit.

2. Undercapitalization

A company is Undercapitalized when it has very little recorded capital but is making huge profits. This sounds good, but it has dangerous side effects.

Simple Definition:

When a company’s earnings are exceptionally high compared to the capital invested. It is like a small roadside stall making crores in profit.

Example:

Imagine Company B invests only ₹1 Lakh. The normal industry return is 10% (expected profit ₹10,000). But Company B earns ₹50,000 (a 50% return!).

  • The return is massive compared to the small investment.

  • Verdict: Company B is Undercapitalized.

Symptoms (How to spot it):

  1. High Dividend: The company pays huge dividends.

  2. High Share Price: Everyone wants to buy these shares, so the market price shoots up above book value (e.g., a ₹10 share trades at ₹50).

  3. High Secret Reserves: The company has a lot of hidden profit saved up.

Causes (Why it happens):

  • Buying assets cheaply: Buying a factory during a recession (low price) which is now producing great value.

  • Conservative Policy: For years, the company saved its profits instead of distributing them, making the company internally very rich.

  • High Efficiency: The management is super efficient and generates profit out of nothing.

Consequences (The hidden dangers):

  • Competition: Seeing huge profits, rivals will enter the market to copy you.

  • Labor Trouble: Workers will demand higher wages seeing the high profits.

  • Consumer Anger: Customers might feel the company is overcharging them to make such high profits.

Remedies (How to fix it):

  • Stock Split: Divide 1 share of ₹100 into 10 shares of ₹10. This reduces the earnings per share to look normal.

  • Bonus Shares: Issue free shares to existing shareholders to convert savings into capital.

FeatureOvercapitalization (Bad)Undercapitalization (Risky but Good)
EarningsVery LowVery High
Share PriceLower than Face ValueHigher than Face Value
Real ValueAssets are worth less than recorded.Assets are worth more than recorded.
RemedyReduce Capital / BuybackIssue Bonus Shares / Stock Split

 

Conclusion:

Financial management is more than just procurement of funds. It is about the optimal combination of investment, financing, and dividend decisions to maximize the wealth of shareholders while maintaining ethical standards and stakeholder relationships.

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