International Financial Manage Men 1

8/7/2019 International Financial Manage Men 1

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INTERNATIONAL

FINANCIALMANAGEMENTSubject Code: FSF- 2

By: Asst. Prof. Pallavi Deshmukh

MBA- III SEM FINANCE


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International Financial Management: FSF - 2 Notes By PD

UNIT2

Managing short term assets & liabilities

Liquidity, you will recall, is a firm's ability to meet its short-term debts, and cash is the most liquid asset,

because it can be spent immediately. Non-cash current assets, mainly receivables and inventory, are less

liquid because it may take time to turn them into cash. For example, ratios measuring receivables collection

periods and inventory turnover rates, estimate how long it is taking to convert receivables and inventoryinto cash. In general the more current assets a firm hold the greater its liquidity (measured by the current

ratio). If liquidity is, or becomes, very important managers may decide to hold proportionately more cash

and/or marketable securities (measured by the quick ratio) than non-cash assets, receivables and

inventory. There is always a trade-off in holding high levels of cash assets because they earn very little

return. In general, managers can only reduce the risk of becoming less liquid by reducing the overall return

on current assets, and on total assets (the ROA measure).

1. Management of working capital: Working capital is a financial metric which representsoperating liquidity available to a business, organization, or other entity, includinggovernmental entity. If current assets are less than current liabilities, an entity has a working

capital deficiency, also called a working capital deficit.

NetWorking Capital = Current Assets Current LiabilitiesThe management of working capital involves managing inventories, accounts receivable and

payable and cash so that to ensure a firm is able to continue its operations and that it has

sufficient funds to satisfy both maturing short-term debt and upcoming operational expenses.

A finance manager will use a combination of policies and techniques for the management of

working capital. These policies aim at managing the current assets (generally cash and cash

equivalents, inventories and debtors) and the short term financing, such that cash flows and

returns are acceptable. These are:

i. Cash management: Identify the cash balance which allows for the business to meet day to

day expenses, but reduces cash holding costs.

ii. Inventory management: Identify the level of inventory which allows for uninterrupted

production but reduces the investment in raw materials - and minimizes reordering costs -

and hence increases cash flow. Besides this, the lead times in production should belowered to reduce Work in Progress (WIP) and similarly, the Finished Goods should be

kept on as low level as possible to avoid over production - see Supply chain management;

Just In Time (JIT); Economic order quantity (EOQ); Economic quantity

iii. Debtors management: Identify the appropriate credit policy, i.e. credit terms which will

attract customers, such that any impact on cash flows and the cash conversion cycle will be

offset by increased revenue and hence Return on Capital (or vice versa); see Discounts and

allowances.

iv. Short term financing: Identify the appropriate source of financing, given the cash

conversion cycle: the inventory is ideally financed by credit granted by the supplier;


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however, it may be necessary to utilize a bank loan (or overdraft), or to "convert debtors tocash" through "factoring".

2. Financing of international trade: MNCs requires finance for trading in international marketand financing of trade related working capital requires large amounts of money as well as

financial services like letter of credit & bankers acceptance.

Payments in International trade:

i.Cash in advance

ii.Letter of credit

iii. Draft

iv. Consignment

v.Open account

Documents in international trade:

i.Bill of lading

ii.Commercial invoice

iii. Insurance

iv. Consular invoice

Financing Techniques in International trade:

i.Bankers acceptance: It is time draft drawn on a bank. By accepting the draft, the bank

makes an unconditional promise to the holder of the draft a stated amount on a

specified day.

ii. Discounting: If trade drat is not accepted by a bank, the exporter still can convertthe trade draft into cash by means of discounting. The exporter places the draft

with a bank or financing institutions & in turn receives the face value of the draft

less the interest & commission.

iii. Factoring: Factoring is a financial transaction whereby a business job sells itsaccounts receivable (i.e., invoices) to a third party (called a factor) at a discount in

exchange for immediate money with which to finance continued business.

Factoring differs from a bank loan in three main ways. First, the emphasis is on the

value of the receivables (essentially a financial asset), not the firms credit

worthiness. Secondly, factoring is not a loan it is the purchase of a financial asset

(the receivable). Finally, a bank loan involves two parties whereas factoring

involves three. The sale of the receivables essentially transfers ownership of the

receivables to the factor, indicating the factor obtains all of the rights and risks

associated with the receivables.

iv. Forfaiting: In trade finance, forfaiting involves the purchasing of receivables from

exporters. The forfaiter takes on all risks involved with the receivables. The

forfaiting operation is a transaction-based operation (involving Exporters)

involving the sale of one of the firm's transactions. Factoring is also a Financial

Transaction involving the purchase of Financial Assets; but Factoring involves the

sale any portion of a firm's Receivables. At its simplest the receivables should be

evidenced by a promissory note, a bill of exchange, a deferred-payment letter of

credit, or a letter of guarantee.

Three elements relate to the pricing of a forfaiting transaction:


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a. Discount rate, the interest element, usually quoted as a margin over LIBOR ( London

Interbank Offered Rate).

b. Days of grace, added to the actual number of days until maturity for the purpose of

covering the number of days normally experienced in the transfer of payment,

applicable to the country of risk.

c. Commitment fee, applied from the date the forfaiter is committed to undertake thefinancing, until the date of discounting.

3. Instruments of the international money market: In international money market theinstruments that are issued or traded internationally are:

a. Eurocurrency time deposits & certificates of deposit:b. Bankers acceptance: A banker's acceptance, or BA, is a promised future payment, or

time draft, which is accepted and guaranteed by a bank and drawn on a deposit at the

bank. The banker's acceptance specifies the amount of money, the date, and the person

to which the payment is due. After acceptance, the draft becomes an unconditional

liability of the bank. But the holder of the draft can sell (exchange) it for cash at a

discount to a buyer who is willing to wait until the maturity date for the funds in the

deposit. A banker's acceptance starts as a time draft drawn on a bank deposit by a

bank's customer to pay money at a future date, typically within six months, analogous

to a post-dated check. Next, the bank accepts (guarantees) payment to the holder of the

draft, analogous to a post-dated check drawn on a deposit with over-draft protection.

The party that holds the banker's acceptance may wait the acceptance until it matures,

and thereby allow the bank to make the promised payment, or it may sell the

acceptance at a discount today to any party willing to wait for the face value payment

of the deposit on the maturity date. The rates at which they trade, calculated from the

discount prices relative to their face values, are called banker's acceptance rates.

c. Letter of credit: Letters of credit are used primarily in international trade transactionsof significant value, for deals between a supplier in one country and a customer in

another. The parties to a letter of credit are usually a beneficiary who is to receive the

money, the issuing bank of whom the applicant is a client, and the advising bank of

whom the beneficiary is a client. Almost all letters of credit are irrevocable, i.e., cannot

be amended or canceled without prior agreement of the beneficiary, the issuing bank

and the confirming bank, if any. In executing a transaction, letters of credit incorporate

functions common to giros and Traveler's cheques. Typically, the documents a

beneficiary has to present in order to receive payment include a commercial invoice,

bill of lading, and documents proving the shipment were insured against loss or

damage in transit.

d. Euro notes & Euro commercial paper: Short-term unsecured promissory note issuedin London and other European financial centers for same-day settlement in U.S. dollars

in New York. Paper is issued in either discount or interest-bearing form anddistributed through dealers on a best-effort basis, in contrast to euronote facilities,

which are issued through a tender panel. Eurocommercial paper gives issuers quicker

access to funds than Euronotes, sometimes even same day funds.

4. Euro Currency Market: The market is made by banks & other financial institutions thataccept time deposits & make loans in a currency other than that of the country


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Long Run investment Decisions

Introduction

The investment decisions of a firm are generally known as the capital budgeting, or capital expenditure

decisions. Firms investment decision would generally include expansion, acquisition, mordernisation &

replacement of the long run assets. Investment in long term assets invariably requires large funds to be tied

up in the current assets such as inventories & receivables.

Features of investment decisions

1. The exchange of current funds for future benefits.

2. The funds are invested in long term assets.

3. The future benefits will occur to the firm over a series of years.

Importance of investment decision

1. Growth:Investment decisions influence the firms growth in long run. As one wrong decisioncan turn to be disastrous for the survival of firm. An unprofitable expansion of assets will

result in operating costs to the firm.

2. Risk: A long term commitment of funds may also change the risk complexity of the firm.3. Funding: Investment decisions involve large amount of funds which make it very important

for the firm to plan its investment programmes tactfully.

4. Complexity: Investment decisions are the toughest decisions. It is complex process tocorrectly estimate the future cash flows of an investment.

Types of Investment decisions

1. Expansion & Diversification: Expansion or diversification of a business requires investmentin new products & a new kind of production activity within the firm.

2. Replacement & Modernisation: The investment decision also takes place for replacement &modernisation which lead to improve operating efficiency and reduce costs.

3. Contingent investment: Contingent investments are dependent projects. The choice of one

investment demands undertaking one or more other investments.

The Foreign Investment Decisions

Introduction

A more wider & complicated set of strategic, economic & behavioural considerations are usually the

motivating factors behind foreign investments. International business houses wanting to maximize

shareholders wealth generally try & increase their foreign business to become internationalized.

Reasons to Foreign direct investments1. New sources of demand:2. Economies of scale:3. Use of foreign raw material:4. Exploit monopolistic advantage:5. Political safety seeker:


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Channels of Foreign investment decisions

1. Foreign Direct Investment (FDI): FDI is a common method of engaging in international business.Determinants of FDI:

i. Depends on return & risk: It is always recommended that there should be return & riskshould be neutralized & FDI decision depend on this these two variables. If this proposition

is accepted then the differential rates of return hypothesis becomes inadequate and as

well as risk has to be reduced by diversification.

ii. Depends on Market size: The size of FDI in an importer on its market size.iii. Depends on political risk: Lack of political stability dicourges inflows of FDI. For instance if

an importers govt. imposes certain capital repatriation restrictions.

2. Foreign Portfolio investment (FPI): Portfolio capital is the key channel for integrating capitalmarkets worldwide. Investment is equity provides return in two firms: dividends & capitalappreciation.

Alternatives Investment Vehicles for Foreign investments:

1. Direct purchase of securities in overseas markets:2. The use of American Depository Receipts (ADR): An ADR is a receipt issued by a US bank certifying

that bank holds an equivalent number of shares issued by a foreign company.

3. Single country Funds: It trades the shares of the companies of a single country.4. International Funds: It trades the shares of foreign companies belonging to several countries. The

risk related to international funds is called modified systematic risk.

5. Global Funds: Global funds also trades in domestic shares. In USA global funds have 50% securities.These funds tend to be cost effective.

Political Risk management

Introduction

Direct foreign investments are exposed to a multitude of interventions by both importer & home

governments. Although most firms focus on government actions that reduce the value of the firm, there

are occasionally beneficial government actions that increase the value of the firm. The degree to which a

company is affected by political events is known as political exposure.

Political risk is defined as the variability in the value of firm (or subsidiary) that caused by uncertainty

about political or policy changes. This risk represented by a distribution of the firms value due to political

incidents.

Every country has its own tax policies, monetary policies, fiscal policies & other types of policies. Any

project operating in that country has to confirm to all these rules& regulations.


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Form of Political Risk

While entering into international trade financial manager should examine the above stated factors:

1. Attitude of Consumer in the importers country: Generally tendency of consumer is buy goods

manufactured in ones country rather than imported goods unless and until it is too good to buy.

So this risk has to be considered by the exporter.

2. Actions ofimporters govt.: Actions by the government may affect the cash flow of exporters firm.

Like additional corporate taxes which affect after tax earnings as well as withholding taxes and

another example is of

3. Blockage of fund transfers: Subsidiaries of MNCs sent funds to head offices for various purposes

but fund transfer restrictions which may affect after tax cash flows sent to the exporter.

4. War: Wars are always threat for both exporters & importers as this can affect the safety of

employees hired by an MNCs subsidiaries and whereas wars can disturbs the business cycle. For

example terrorist attack in USA on 11 Sep 2001.

5. Currency Inconvertibility: Foreign exchange is always risk and had to be examined as many

countries do not allow domestic country currency to convert into other currency.

6. Corruption: Corruption can negatively affect an MNCs international trade as it can increase the

cost of conducting business or reduce revenue.

Measurement of political risk

The level of political risk in a country can be categorized in four levels as Low risk countries, Medium risk

countries, High risk countries, and Prohibitive risk countries on the basis of capital flight, government

regulations & controls, taxes, low returns and political instability.

It can be measurement from following techniques: (a) Econometric Modeling: It is used to assess the

political risk and is assessed by banks to assess the capacity of the government to repay the loan withoutdefault. (b) Delphi technique: This method involves the collection of independent opinions on country risk

from various experts without group discussion. (c) Risk rating matrix: An international company may

evaluate country risk for several countries to determine location of investment. One approach to compare

political & financial ratings among countries, advocated by some foreign risk manager & this called as risk

rating matrix.


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Process of Political risk management

Approaches to political risk management

1. Defensive approach: In this approach the company tries to protect its interests by locating crucialaspects of the firm beyond the reach of the importers governments. This is because to minimize

the firms dependence on importer or importers governments intervention costlier.

2. Integrative approach: In this approach the aim of the company with the importers economy tomake it appear local. Like establish joint ventures, employ more numbers of personnel from

importers country.

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Unit 3

Multinational Capital Budgeting Applications & Interpretation

Capital Budgeting:

Capital budgeting (or investment appraisal) is the planning process used to determine whether an

organisation's long term investments such as new machinery, replacement machinery, new plants, new

products, and research development projects are worth pursuing. It is budget for major capital, or

investment, expenditures.

Many formal methods are used in capital budgeting, including the techniques such as

1. Accounting rate of return

2. Net present value

3. Profitability index

4. Internal rate of return

5. Modified internal rate of return

6. Equivalent annuity

7. Payback period and

8. Discounted payback period

These methods use the incremental cash flows from each potential investment, or project Techniques

based on accounting earnings and accounting rules are sometimes used - though economists consider this

to be improper - such as the accounting rate of return, and "return on investment."

Multinational Capital Budgeting: The rapid growth of multinational corporations has hastened the need

for the development of robust models to handle the increased risk and complexity. Particularly in capital

budgeting, careful analysis and adequate reflection of the critical variables are essential. The great number

of relevant variables, their significant interrelationships, and the high degree of uncertainty render

mathematical models highly complex or infeasible to solve. To overcome these shortcomings, a Hertz-type simulation model is formulated for the multinational firm. The important international variables

foreign exchange rates, foreign tax methodology, host government controls, and other social, economic,

and political factorsare reflected in the model. A two stage approach is utilized: first, investment projects

are analyzed by the subsidiary and if they pass this first screening they are proposed for the parent's

consideration; second, the parent evaluates the attractiveness of projects from its point of view and ranks

proposals for acceptance considering all global opportunities. The model is designed so that sensitivity

analysis can be easily performed.

Subsidiary versus Parent Perspective:

Should the capital budgeting for a multi-national project be conducted from the viewpoint of the subsidiary

that will administer the project, or the parent that will provide most of the financing? The results may varywith the perspective taken because the net after-tax cash inflows to the parent can differ substantially

from those to the subsidiary. Such differences can be due to:

a. Tax differentials: What is the tax rate on remitted funds?

b. Regulations that restrict remittances:

c. Excessive remittances: The parent may charge its subsidiary very high administrative fees.


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Remitting Subsidiary Earnings to the Parent

d. Exchange rate movements: When earnings are remitted to the parent they are normally

converted from the subsidiarys local currency to the parents currency. The amount received by

the parent is therefore influenced by existing exchange rate.

A parents perspective is appropriate when evaluating a project, since any project that can create a positive

net present value for the parent should enhance the firms value. However, one exception to this rule

occurs when the foreign subsidiary is not wholly owned by the parent.

Input for Multinational Capital Budgeting:

The following forecasts are usually required:

1. Initial investment

2. Consumer demand over time

3. Product price over time

4. Variable cost over time

5. Fixed cost over time

6. Project lifetime7. Salvage (liquidation) value

8. Restrictions on fund transfers

9. Tax payments and credits

10. Exchange rates

11. Required rate of return

Multinational Capital Budgeting

Capital budgeting is necessary for all long-term projects that deserve consideration. One common method

of performing the analysis involves estimating the cash flows and salvage value to be received by the

parent, and then computing the net present value (NPV) of the project.

NPV = initial outlay

n

+ Scash flow in period t

t=1(1 + k)t

+ salvage value

(1 + k)n

k = the required rate of return on the project

n = project lifetime in terms of periods


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If NPV > 0, the project can be accepted.

Example:

Spartan, Inc. is considering the development of a subsidiary in Singapore that will manufacture and sell

tennis rackets locally.

Capital Budgeting Analysis: Spartan, Inc.


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Capital Budgeting Analysis

Factors to Consider in Multinational Capital Budgeting:

Exchange rate fluctuations: Since it is difficult to accurately forecast exchange rates, different

scenarios can be considered together with their probability of occurrence.

Inflation: Although price/cost forecasting implicitly considers inflation, inflation can be quite

volatile from year to year for some countries.


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Financing arrangement: Financing costs are usually captured by the discount rate. However, when

foreign projects are partially financed by foreign subsidiaries, a more accurate approach is to separate

the subsidiary investment and explicitly consider foreign loan payments as cash outflows.

Blocked funds: Some countries require that the earnings generated by the subsidiary be

reinvested locally for at least a certain period of time before they can be remitted to the parent.

Capital Budgeting with Blocked Funds: Spartan, Inc.

Assume that all funds are blocked until the subsidiary is sold.

Uncertain salvage value: Since the salvage value typically has a significant impact on the projects

NPV, the MNC may want to compute the break-even salvage value.

Impact of project on prevailing cash flows: The new investment may compete with the existing

business for the same customers. Host government incentives: These should also be incorporated into the analysis.

Real options: Some projects contain real options for additional business opportunities. The value of

such a real option depends on the probability of exercising the option and the resulting NPV.

Adjusting Project Assessment for Risk:

When an MNC is unsure of the estimated cash flows of a proposed project, it needs to

incorporate an adjustment for this risk.

One method is to use a risk-adjusted discount rate. The greater the uncertainty, the larger

the discount rate that should be applied to the cash flows.

An MNC may also perform sensitivity analysis or simulation using computer software

packages to adjust its evaluation.

Sensitivity analysis involves considering alternative estimates for the input variables, while

simulation involves repeating the analysis many times using input values randomly drawn

from their respective probability distributions.

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UNIT 4

Cost of Capital, Capital Structure & Dividend Policy of the Multinational Firm

Introduction to Cost of Capital: A firms capital consists of equity (retained earnings and funds

obtained by issuing stock) and debt (borrowed funds). There is an advantage to using debt

rather than equity as capital because the interest payments on debt are tax deductible. It is

favorable to increase the use of debt financing until the point at which the bankruptcy

probability becomes large enough to offset the tax advantage of using debt.

Symbolically cost of capital: K = r+b+f

Where, K= Cost of capital, r= Normal rate of return at zero risk level, b= premium for business

risk, f = Premium for financial risk.

Cost of Capital Comparison Using the Capital Asset Pricing Model (CAPM):

1.

To assess how required rates of return of MNCs differ from those of purely domestic firms,the CAPM can be applied. It defines the required return (Ke) on a stock as: Ke= Rf+ B(RmRf)

where, Ke= CAPM, Rf= risk free rate of return, B= beta of stock , Rm = Market return.

2.The CAPM suggests that the required return on a firms stock is a positive function of(1)the

risk-free rate of interests,(2)the market rate of return and (3)the stocks beta.

3.The beta represents the sensitivity of the stocks returns to market returns. A projects beta

represents the sensitivity of the projects cash flow to market conditions.

4.Capital asset pricing theory would suggest that the MNCs cost of capital is generally lower

than that of domestic firms (As there are two types of risk to cash flow generated by several

projects of MNCs i.e. unsystematic risks & systematic risks).

Cost Capital across Countries:

1. Country differences in the cost of debt: The cost of debt to a firm is primarilydetermined by the prevailing risk free interest rate in the currency borrowed & the risk

premium required by the creditors.

2. Difference in the risk-free rate: This rate is determined by the interaction of the supply& demand for funds. Any factors that influence the supply & demand will affect the risk

free rate. These factors include tax laws, demographics, monetary policies, 7 economic

conditions all of which differ among countries.

3. Difference in the risk premium: The premium on risk may be large to compensatecreditors for the risk that borrower may be unable to meet its payment obligations.

4. Comparative costs of debt across countries: The before tax cost of debt for variouscountries are measured by corporate bond yields and correlation between them are

determined.

5. Country difference in the cost of equity: Cost of equity of a firm represents anopportunity cost, what shareholders could earn on investments with similar risk if the


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equity funds were distributed to them and it can be measured as risk free interest rate

that could have been earned by shareholders plus a premium to reflect the risk of firm.

6. Combining the costs of debt and equity: Combining the costs of debt and equity willderive an overall cost of capital. The relative proportions of debt & equity used by firms

in each country must be applied as weighs to reasonably estimate this cost of capital.

MNCs can attempt to access capital from the country where capital cost is low, but

when the capital is used to support operations in other countries, the MNCs areusually exposed to exchange rate risk. The cost of capital may ultimately turn out to

be higher than expected.

Using the cost of capital for assessing foreign projects:

1. When the MNCs parent proposes an investment in a foreign project that has the same risk

as the MNC itself, it can use its weighted average cost of capital as the required rate of

return for the project.

2. An alternative method of accounting for a foreign projects risk is to adjust the firms

weighted average cost of capital for the risk differential.3. There is no perfect formula to adjust for the projects unique risk .

The MNCs Capital Structure Decision: A multinational firms capital structure decision involves

the choice of debt against equity financing within all of its subsidiaries. Therefore its overall capital

structure is a combination of all of its subsidiaries capital structure. But there are two

characteristics which affects capital structure one is Influence of corporate characteristics & other

is influence of country characteristics

Influence of corporate Characteristics:

1. Stability of MNCs cash flows: MNC having more cash flow can handle more debt becausethere is a constant stream of cash inflows to cover periodic interest payments.

2. MNCs credit risk: MNC having lower credit risk (risk of default) have more access to credit.Any aspect that influences credit risk may affect a MNCs choice of using debt v/s equity.

3. MNCs access to earnings: Highly profitable multinational firm may in position to financemost of its investment with retain earnings & therefore use an equity intensive capital

structure.

Influence of Country Characteristics:

1. Stock restrictions in host countries: in many countries investors are restricted to buy onlylocal stocks or if allowed then investors have less knowledge of foreign stocks. Generally

such obstacles are faced by MNCs. Thus it should raise equity in such countries at relatively

low cost. This could persuade the MNC to use more equity by issuing stock in these

countries to finance its operations.

2. Interest rates in host countries: As govt. of host country impose barrier on capital flowsalong with potential adverse exchange rate, tax & country risk effects, loanable funds do

not always flow to loanable funds (interest rate) can vary across countries.

3. Strength of host country currencies: If parent firm feels that currency of its subsidiarycountry is weak then it may attempt to finance a large proportion of its foreign operations


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by borrowing those currencies this will remit a smaller amount in earnings because they

will be making interest payment on local debt as well as parent firm will reduce exchange

risk also.

4. Country risk in host countries: Rules & regulations for trading differ country to country,this may be blockage fund transfer & in such conditions subsidiaries must finance its debt

from these blocked funds.

5. Tax laws in host countries: Many host countrys govt. impose heavy corporate tax onforeign earnings and subsidiaries can reduce this by withholding taxes by using more localdebt financing.

Creating the Target Capital Structure:

1. An MNC may deviate from its target capital structure in each country where financing is

obtained.

2. Consider that country A does not allow MNCs with headquarters elsewhere to list their

stocks on its local stock exchange.

3.

Consider a second example, in which country B allows the MNC to issue stock there and listits stock on its local exchange.

4. As a third example, consider an MNC that desires financing in country C, which is

experiencing political turmoil.

5. The ideal sources of funds for all countries will not necessarily sum to match the global

target capital structure.

6. The strategy of ignoring a local target capital structure in favor of a global target capital

structure is rational as long as it is acceptable by foreign creditors and investors.

Local Ownership of Foreign Subsidiaries:

1.

Some MNCs may allow a specific foreign subsidiary to issue stock to local investors oremployees as a means of infusing equity into the subsidiary.

2. One concern about a partially owned foreign subsidiary is a potential conflict of interest.

3. Some countries will allow an MNC to establish a subsidiary there only if the subsidiary can

sell shares.

4. One possible advantage of a partially owned subsidiary is that it may open up additional

opportunities within the host country.

Dividend Policy of the Multinational Firm:

Definition: Dividend is the distribution of value to shareholders.

Dividend Policy: What happens to the value of the firm as dividend is increased, holding

everything else (capital budgets, borrowing) constant. Thus, it is a trade-off between retained

earnings on one hand, and distributing cash or securities on the other. The decision for

distributing or paying a dividend is taken in the meeting of Board of Directors and in

confirmed generally by the annual general meeting of the shareholders. The dividend can be

declared only out of divisible profits, remained after setting of all the expenses, transferring

the reasonable amount of profit to reserve fund and providing for depreciation and taxation


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for the year. It means if in any year, there are not profits; no dividend shall be distributed

that year. The shareholders cannot insist upon the company to declare the dividend. It is

solely the discretion of the directors.

Factors Affecting Dividend Policy:

A number of considerations affect the dividend policy of company. The major factors are:

1. Stability of Earnings. The nature of business has an important bearing on the dividend

policy. Industrial units having stability of earnings may formulate a more consistent dividend

policy than those having an uneven flow of incomes because they can predict easily their

savings and earnings. Usually, enterprises dealing in necessities suffer less from oscillating

earnings than those dealing in luxuries or fancy goods.

2. Age of corporation. Age of the corporation counts much in deciding the dividend policy. A

newly established company may require much of its earnings for expansion and plant

improvement and may adopt a rigid dividend policy while, on the other hand, an older

company can formulate a clear cut and more consistent policy regarding dividend.

3. Liquidity of Funds. Availability of cash and sound financial position is also an important

factor in dividend decisions. A dividend represents a cash outflow, the greater the funds and

the liquidity of the firm the better the ability to pay dividend. The liquidity of a f irm depends

very much on the investment and financial decisions of the firm which in turn determines the

rate of expansion and the manner of financing. If cash position is weak, stock dividend will be

distributed and if cash position is good, company can d istribute the cash dividend.

4. Extent of share Distribution. Nature of ownership also affects the dividend decisions. A

closely held company is likely to get the assent of the shareholders for the suspension of

dividend or for following a conservative dividend policy. On the other hand, a company

having a good number of shareholders widely distributed and forming low or medium income

group would face a great difficulty in securing such assent because they will emphasise to

distribute higher dividend.

5. Needs for Additional Capital. Companies retain a part of their profits for strengthening

their financial position. The income may be conserved for meeting the increased

requirements of working capital or of future expansion. Small companies usually finddifficulties in raising finance for their needs of increased working capital for expansion

programmes. They having no other alternative, use their ploughed back profits. Thus, such

Companies distribute dividend at low rates and retain a big part of profits.

6. Trade Cycles. Business cycles also exercise influence upon dividend Policy. Dividend policy

is adjusted according to the business oscillations. During the boom, prudent management

creates food reserves for contingencies which follow the inflationary period. Higher rates of


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Thus control is an influencing factor in framing the dividend policy.

13. Repayments of Loan. A company having loan indebtedness are vowed to a high rate of

retention earnings, unless one other arrangements are made for the redemption of debt on

maturity. It will naturally lower down the rate of dividend. Sometimes, the lenders (mostly

institutional lenders) put restrictions on the dividend distribution still such time their loan is

outstanding. Formal loan contracts generally provide a certain standard of liquidity andsolvency to be maintained. Management is bound to hour such restrictions and to limit the

rate of dividend payout.

14. Time for Payment of Dividend. When should the dividend be paid is another

consideration. Payment of dividend means outflow of cash. It is, therefore, desirable to

distribute dividend at a time when is least needed by the company because there are peak

times as well as lean periods of expenditure. Wise management should plan the payment of

dividend in such a manner that there is no cash outflow at a time when the undertaking is

already in need of urgent finances.

15. Regularity and stability in Dividend Payment. Dividends should be paid regularly because

each investor is interested in the regular payment of dividend. The management should,

inspite of regular payment of dividend, consider that the rate of dividend should be all the

most constant. For this purpose sometimes companies maintain dividend equalization Fund

Types of Dividend policies:

The following are various types of dividend policies

(1) Policy of No Immediate Dividend(2) Stable Dividend Policy.

(3) Regular Dividend plus Extra Dividend Policy.

(4) Irregular Dividend Policy.

(5) Regular Stock Dividend Policy.

(6) Regular Dividend plus Stock Dividend Policy.

(7) Liberal Dividend Policy.

(1) Policy of No Immediate Dividend: Generally, management follows a policy of paying no

immediate dividend in the beginning of its life, as it requires funds for growth and expansion. In

case, when the outside funds are costlier or when the access to capital market is difficult for the

company and shareholders are ready to wait for dividend for sometime, this policy is justified,

provided the company is growing fast and it requires a good deal of amount for expansion. Butsuch a policy is not justified for a long time, as the shareholders are deprived of the dividend and

the retained earnings built up which will attract attention of laborers, consumers etc. It would be

better if the period of dividend is followed by issue of bonus shares, so that later on rate of

dividend is maintained at a reasonable level.

(2) Regular or Stable Dividend Policy: When a company pays dividend regularly at a fixed rate,

and maintains it for a considerably long time even though the profits may fluctuate, it is said to


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follow regular or stable dividend policy. Thus stable dividend policy means a policy of paying a

minimum amount of dividend every year regularly. It raises the prestige of the company in the

eyes of the investors. A firm paying stable dividend can satisfy its shareholders and can enhance

its credit standing in the market. Not only that the dividend must be regularly paid but the

dividend must be stable. It may be fixed amount per share or a fixed percentage of net profits or it

may be total fixed amount of dividend on all the shares etc. The benefits of stable dividend policy

are (i) it helps in raising long-term finance. When the company tries to raise finance in future, the

investors would examine the dividend record of the company. The investors would not hesitate toinvest in company with stable dividend policy. (2) As it will enhance the prestige of the company,

the price of its shares would remain at a high level. (3) The shareholders develop confidence in

management. (4) It makes long-term planning easier. (The detailed discussion of this policy follows

in the next paragraph.

(3) Regular Dividend plus Extra Dividend Policy. A firm paying regular dividends would continue

with its pay out ratio. But when the earnings exceed the normal level, the directors would pay

extra dividend in addition to the regular dividend. But it would be named 'Extra dividend', as it

should not give an impression that the company has enhanced rate of regular dividend, This would

give an impression to shareholders that the company has given extra dividend because it has

earned extra profits and would not be repeated when the business earnings become normal.

Because of this policy, the company's prestige and its share values will not be adversely affected.

Only when the earnings of the company have permanently increased, the extra dividend should be

merged with regular normal dividend and thus rate of normal dividend should be raised. Besides,

the extra dividend should not be abruptly declared, but the shareholders should have some idea in

advance, so that they may sell their shares, if they like. This system is not found in India.

(4) Irregular Dividend Policy: When the firm does not pay out fixed dividend regularly, it is

irregular dividend policy. It changes from year to year according to changes in earnings level. This

policy is based on the management belief that dividend should be paid only when the earnings

and liquid position of the firm warrant it. This policy is followed by firms having unstable earnings,particularly engaged in luxury goods.

(5) Regular Stock Dividend Policy: When a firm pays dividend in the form of shares instead of cash

regularly for some years continuously, it is said to follow this policy. We know stock dividend as

bonus shares. When a company is short of cash or is facing liquidity crunch, because a large part of

its earnings are blocked in high level of receivables or when the company is need of cash for its

modernization and expansion program, it follows this policy. It is not advisable to follow this policy

for a long time, as the number of shares will go on increasing, which would result in fall in earnings

per share. This would adversely affect the credit standing of the firm and its share values will go

down.

(6) Regular Dividend plus Stock Dividend Policy: A firm may pay certain amount of dividend in

cash and some dividend is paid in the form of shares (stock). Thus, the dividend is split in to two

parts. This policy is justified when (1) The company wants to maintain its policy of regular dividend

and yet (2) It wants to retain some part of its divisible profit with it for expansion. (3) It wants to

give benefit of its earnings to shareholders but has not enough liquidity to give full dividend in

cash. All the limitations of paying regular stock dividends apply to this policy.


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(7) Liberal Dividend Policy: It is a policy of distributing a major part of its earnings to its

shareholders as dividend and retains a minimum amount as retained earnings. Thus, the ratio of

dividend distribution is very large as compared to retained earnings. The rate of dividend or the

amount of dividend is not fixed. It varies according to earnings. The higher is the profit, the higher

will be the rate of dividend. In years of poor earnings, the rate of dividend will be lower. In fact, it

is the policy of Irregular Dividend.

Models which studied the Dividend Policies of firms:

1. Gordon Growth Model: A model for determining the intrinsic value of a stock, based on afuture series of dividends that grow at a constant rate. Given a dividend per share that is

payable in one year, and the assumption that the dividend grows at a constant rate in

perpetuity, the model solves for the present value of the infinite series of future dividends.

Where:

D = Expected dividend per share one year from nowk = required rate of return for equity investor

G = Growth rate in dividends (in perpetuity)

Because the model simplistically assumes a constant growth rate, it is generally only used for

mature companies (or broad market indices) with low to moderate growth rates

2. Walter's Dividend Model: Walter's model supports the principle that dividends are

relevant. The investment policy of a firm cannot be separated from its dividend policy and

both are inter-related. The choice of an appropriate dividend policy affects the value of an

enterprise.

Assumptions of this model:

a. Retained earnings are the only source of finance. This means that the company does not

rely upon external funds like debt or new equity capital.

b. The firm's business risk does not change with additional investments undertaken. It implies

that r(internal rate of return) and k(cost of capital) are constant.

c. There is no change in the key variables, namely, beginning earnings per share(E), and

dividends per share(D). The values of D and E may be changed in the model to determine

results, but any given value of E and D are assumed to remain constant in determining a

given value.

d. The firm has an indefinite life.

Formula: Walter's model

P = D

Ke g


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Where: P = Price of equity shares

D = Initial dividend

Ke = Cost of equity capital

g = Growth rate expected

After accounting for retained earnings, the model would be:

P = D

Ke rbWhere: r = Expected rate of return on firms

investments

b = Retention rate (E - D)/E

3. Traditional position: This model emphasis on the relationship between the dividend & thestock market. According to this approach, the stock value responds positively to higher

dividends & negatively when there are low dividends. The following expression, given by

traditional approach, establishes the relationship between market price & dividends using a

multiplier:

P = m(D + E/3)

Where, P= Market Price, m= Multiplier, D= Dividend per share, E= earnings per share4. Miller & Modigliani Model: Miller & Modigliani have propounded the MM hypothesis to

explain the irrelevance of the firms dividend policy. This model which was given based on a

few assumptions sidelined the importance of the dividend policy & its effect thereof on the

share price of the firm. According to the model, it is only the firms investment policy that will

have an impact on the share value of the firm & hence should be given more importance.

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International Financial Manage Men 1

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