FINANCIAL MANAGEMENT - II

FINANCIAL MANAGEMENT - II
1. Financing Decisions/ Capital Structure Decisions

2. Investment Decisions/ Capital Budgeting Decisions

3. Working Capital Decisions

4. Dividend Decisions/ Distributions to Shareholders

 FINANCIAL MANAGEMENT - II

Distributions to Shareholders:
Dividends
 FINANCIAL MANAGEMENT - II

Cashflow Statements
➢ Cash flow from Operating activities

➢ Cashflow from investing activities

➢ Cashflow from financing activities

 FINANCIAL MANAGEMENT - II
Cash flow from Operating activities
2022-23 (₹ As at 1st April As at 31st March
Million) 2022 (₹ Million) 2023 (₹ Million)
Net Income 228

Accounts receivable 240 360

Depreciation and 200
Amortisation Expenses
Inventories 100 280
Accounts payable 80 90
Other 40 60
accruals(payable)
 FINANCIAL MANAGEMENT - II
Cashflow from investing activities
➢ In-Flow

➢ Out-Flow
 FINANCIAL MANAGEMENT - II
Cashflow from financing activities
➢ In-Flow

➢ Out-Flow
 FINANCIAL MANAGEMENT - II
Cash flow in the context of financial reporting or with a focus on accounting
aspect of a business.

Intrinsic value of a business:

Analysts are more focused on FREE CASH FLOW

FREE CASH FLOW

???
 FINANCIAL MANAGEMENT - II
➢ Free Cash Flows (FCF) is defined as after-tax operating profit minus the
amount of new investment in working capital and fixed assets necessary to
sustain the business.

➢ FCF is the cash flow available for distribution to all the company’s investors
after the company has made all investments necessary to sustain ongoing
operations.
 Another Approach

FCF= Cash operating profit – net investment in fixed asset –

Net investment in operating working capital

Cash operating profit = EBIT * (1-Tax rate) + Depreciation

 Assets (₹ Million) 2023-24 2022-23
2023-24 (₹ 2022-23 (₹
Million) Million) Cash 550 500
Short-term investments 110 100

Accounts receivable 2,750 2,500

Inventories 1,650 1,500
Sales 11000 10000
Net plant and equipment 3,850 3,500

Operating costs 9360 8500 Total assets 8,910 8,100

excluding Liabilities and Equity
depreciation
Depreciation and 380 360 Accounts payable 1,100 1,000
amortization Accruals 550 500
Notes payable 384 200
Earnings before 1260 1140 Long-term debt 1,100 1,000
interest and taxes Common stock 4,312 4,400
Retained earnings 1,464 1,000
Tax Rate 40% 40% Total liabilities and equity 8,910 8,100
 PAY INTEREST, REPAY DEBT, OR ISSUE NEW
DEBT
Payments for interest expenses and debt principal

➢ Company’s capital structure choice

➢ Target capital structure

➢ Tax shields

Companies make net additions to debt over time rather than net repayments,
even if FCF is positive.

Addition of debt is a “negative use” of FCF

 PURCHASE OR SELL SHORT-TERM
INVESTMENTS
Trade-off between the benefits and costs of holding a large amount of short-term
investments

➢ Large holding reduces the risk of financial distress should there be an economic
downturn.

➢ Ready source of funding

➢ Potential agency cost

Working capital management

Purchasing short-term investments is a positive use of FCF, and selling short-term

investments is negative use
 PURCHASE OR SELL SHORT-TERM
INVESTMENTS
Company’s investment opportunities and operating plans: Level of FCF

Capital structure policy: Amount of debt and interest payments

Working capital policy: Investment in marketable securities

Remaining FCF should be distributed to shareholders

 Distribution to share holders
✓ Dividends

▪ Cash Dividends

▪ Stock Dividends

✓ Stock Repurchase
 Cash Dividends Vis-à-vis Stock Repurchase
✓ Impact on Share price

✓ Flexibility

✓ Number of outstanding shares

✓ Investor Preferences

✓ Tax implications
 Dividend Payment Procedures
➢ Declaration date:

Directors meet and declare dividend

• Declared dividend becomes an actual liability on the declaration date

• An amount equal to D× N would appear as a current liability, and retained earnings

would be reduced by a like amount

D: Declared dividend N: No. of outstanding shares

➢ Holder-of-record date:

Holder-of-record date used to determine ex-dividend date

Purchaser on or after this date will not get the dividend because it is after the ex-dividend date.
Assets (₹ Million) 2023-24
Cash 550
Total outstanding shares= 10 Million
Short-term investments 110 Dividend declared per share= ₹10
Accounts receivable 2,750
Inventories 1,650 Impact on balance sheet when
Net plant and equipment 3,850 i) Dividend declared
Total assets 8,910 ii) Dividend paid to shareholders
Liabilities and Equity
Accounts payable 1,100
Accruals 550
Notes payable 384
Long-term debt 1,100
Common stock 4,312
Retained earnings 1,464
Total liabilities and equity 8,910
Assets (₹ Million) 2023-24
Dividend declared
Cash 550
Short-term investments 110
Total outstanding shares= 10 Million
Accounts receivable 2,750
Dividend declared per share= ₹10
Inventories 1,650 Dividend Liability= ₹ 100 Million
Net plant and equipment 3,850
Total assets 8,910
Liabilities and Equity
Accounts payable 1,100
Accruals 550
Notes payable 384
Dividend Payable 100
Long-term debt 1,100
Common stock 4,312
Retained earnings 1,364
Total liabilities and equity 8,910
Assets (₹ Million) 2023-24
Dividend Paid
Cash 450
Short-term investments 110 Total outstanding shares= 10 Million
Accounts receivable 2,750 Dividend declared per share= ₹10
Inventories 1,650 Dividend Paid= ₹ 100 Million
Net plant and equipment 3,850
Total assets 8,810
Liabilities and Equity
Accounts payable 1,100
Accruals 550
Notes payable 384
Long-term debt 1,100
Common stock 4,312
Retained earnings 1,364
Total liabilities and equity 8,810
 Dividend Payment Procedures
➢ Record date:

The record date is when the company checks its records to identify the eligible shareholders for a
corporate action. Shareholders holding the shares in their demat accounts on the record date are eligible
for corporate actions such as entitlement of rights shares, bonus shares, stock splits, dividends, etc.

➢ Ex Dividend date:

The date on which a stock starts trading without the benefit of corporate action, i.e., ex-benefit, is known
as the ex-date. The ex-date and the record date for all the corporate actions are on the same day since all
the instruments are moved to the T+1 settlement cycle.

➢ Payment date:

Dividend is paid to whoever owned the stock at closing the day prior to the ex-dividend date
 Dividend Payment
Dividend Payout Ratio:

This ratio indicates the percentage of earnings that a company pays out in dividends.

It is calculated by dividing the total dividends by the net income.

Example: If a company has a net income of $1 million and pays out $200,000 in
dividends, the dividend payout ratio is ?
 Dividend Payment
Dividend Payout Ratio:

This ratio indicates the percentage of earnings that a company pays out in dividends.

It is calculated by dividing the total dividends by the net income.

Example: If a company has a net income of $1 million and pays out $200,000 in
dividends, the dividend payout ratio is 20% ($200,000 / $1,000,000)
 Dividend Payment
Dividend Yield:

The dividend yield is a financial ratio that shows how much a company pays out in
dividends relative to its stock price.

It is calculated by dividing the annual dividend per share by the stock's current market
price.

Example: If a stock is trading at $50 per share and pays an annual dividend of $2 per
share, the dividend yield would be ??????
 Dividend Payment
Dividend Yield:

The dividend yield is a financial ratio that shows how much a company pays out in
dividends relative to its stock price.

It is calculated by dividing the annual dividend per share by the stock's current market
price.

Example: If a stock is trading at $50 per share and pays an annual dividend of $2 per
share, the dividend yield would be 4% ($2 / $50).
 Stock Dividend
• In a stock dividend, current shareholders receive additional shares on some
proportional basis.

• If a 5 percent stock dividend were declared, a holder of 100 shares would receive 5
additional shares at no cost.

• Stock dividends also increase the number of shares outstanding.

 Stock Dividend
ASSETS INR (Million) EQUITY AND LIABILITIES INR (Million)
Cash and Bank Balance 3000 Common equity share capital 2000
Accounts Receivable 2000 Additional paid-in capital 1000
Inventories 2000 Retained earnings 3000
Other current Assets 3000 Total Equity 6000
Total Current Assets 10000 Total Current Liabilities 5000
Non current Assets 5000 Long term debts 4000
Total Assets 15000 Total liabilities and equity 15000
Note: Company has issued 200 million common shares of face value of 10

Company has paid a stock dividend of 10%.

Show its impact on balance sheet.

 Stock Dividend

ASSETS INR (Million) EQUITY AND LIABILITIES INR (Million)

Cash and Bank Balance 3000 Common equity share capital 2200
Accounts Receivable 2000 Additional paid-in capital 1000
Inventories 2000 Retained earnings 2800
Other current Assets 3000 Total Equity 6000
Total Current Assets 10000 Total Current Liabilities 5000
Non current Assets 5000 Long term debts 4000

Total Assets 15000 Total liabilities and equity 15000

Total number of outstanding shares= 220 million of face value of 10

 Stock Dividend

ASSETS INR (Million) EQUITY AND LIABILITIES INR (Million)

Cash and Bank Balance 3000 Common equity share capital 2200
Accounts Receivable 2000 Additional paid-in capital 1000
Inventories 2000 Retained earnings 2800
Other current Assets 3000 Total Equity 6000
Total Current Assets 10000 Total Current Liabilities 5000
Non current Assets 5000 Long term debts 4000

Total Assets 15000 Total liabilities and equity 15000

Total number of outstanding shares= 220 million of face value of 10.

The company is expecting to match the industry average P/E of 20. What should be the total
expected earnings by the company in post dividend to achieve a price target of Rs 40 per share?
 Stock Split
• In a stock split, current shareholders are given some number (or fraction) of shares for
each stock owned.

• In a 3-for-1 split, each shareholder would receive 3 new shares in exchange for each
old share, thereby tripling the number of shares outstanding.

• Stock splits usually occur when the stock price is outside of the optimal trading range.
 Stock Split
➢ A stock split increases the number of shares outstanding.

➢ Normally, splits reduce the price per share in proportion to the increase in shares
because splits merely “divide the pie into smaller slices.”

➢ However, firms generally split their stocks only if

(1) the price is quite high

(2) management thinks the future is bright.

Therefore, stock splits are often taken as positive signals and thus boost stock prices.
 Stock Split
• Suppose you own 2,000 common shares of Laurence Incorporated. The EPS is $10.00,
the DPS is $3.00, and the stock sells for $80 per share. Laurence announces a 2-for-1
split. Immediately after the split, how many shares will you have, what will the
adjusted EPS and DPS be, and what would you expect the stock price to be?
 Stock Split
• Fauver Enterprises declared a 3-for-1 stock split last year, and this year its dividend is
$1.50 per share. This total dividend payout represents a 6% increase over last year’s
pre-split total dividend payout. What was last year’s dividend per share?
 Stock Split
Elysium corp has 2.4 million shares of common stock outstanding, and the present
market price per share is ₹36. Its equity capitalization is as follows –
Common stock (₹2 par; 2,400,000 shares) 48,00,000
Additional paid-in capital 59,00,000
Retained earnings 8,73,00,00
0
Total shareholders’ equity 9,80,00,00
0

If the company were to declare a 12 percent stock dividend, what would happen to these accounts?

If, instead, the company declared a 2-for-1 stock split?

 Reverse Split
➢ A reverse stock split also is known as a stock consolidation, stock merge, or share
rollback and is the opposite of a stock split.

➢ Existing shares of corporate stock are effectively merged to create a smaller number
of proportionally more valuable shares.

➢ Price per share increases proportionally

➢ Attract big investors: Many institutional investors and mutual funds have policies
against taking positions in a stock whose price is below a minimum value.

➢ Corporate restructuring: If a part is carved out- Pricing appears reasonable

 Stock Repurchase

➢ Stock repurchase, also known as share buyback or stock buyback, is a corporate

action where a company buys back its own shares.

➢ These shares of stock are then referred to as treasury stock.

➢ The higher EPS on the now decreased number of shares outstanding will cause the
price of the stock to rise and thus capital gains are substituted for cash dividends.
 Stock Repurchase Procedures

➢ Fixed Price Tender Offer, shareholders on record of the company as of a record date
are invited to tender their shares for re-purchase by the company at a fixed price
arrived at by the company and disclosed in the notice, public announcement and the
Letter of Offer
 Stock Repurchase
Below is key financial information for Benaim-Capu Public Ltd for the fiscal year 2023.

• Total Assets ($ million): 670 • Corporate tax rate: 25%

• Cash and cash equivalents ($ million): 135 • Net Income ($ million): 120
• Total Equity ($ million): 670 • Market Share price: $ 80
• Sales ($ million): 890.0 • Total number of outstanding shares: 10
• Earnings before interest and taxes (EBIT) ($ million
million): 160

a) Company plans to deploy $80 million of the cash for a share repurchase program. A 25%
premium is considered adequate to successfully complete the share buyback. Find out Pre and Post
re-purchase EPS
b) Post repurchases of shares, the company is also exploring to raise a debt of 20% of the asset
at a interest rate of 4% and use this debt to further repurchase of shares. Find EPS and interest
coverage ratio for the company after second round of repurchases of shares.
Does Dividend distribution to shareholders create
value??
 Major Theories

✓ Dividend irrelevance theory

✓ Dividend preference theory ( “bird in the hand” theory)

✓ Tax effect theory

✓ Clientele Effect

✓ Signaling Hypothesis or Information Content

 Dividend irrelevance theory
✓ Proponents: Merton Miller and Franco Modigliani (M & M)seminal paper on dividend
Policy in 1961

✓ M&M argued that regardless of how the firm distributes its income, its value is
determined by its basic earning power and its investment decisions.

✓ Given that in a perfect market dividend policy has no effect on either the price of a
firm’s stock or its cost of capital

✓ Shareholders wealth is not affected by the dividend decision and therefore they would
be indifferent between dividends and capital gains.

✓ The reason for their indifference is that shareholder wealth is affected by the income
generated by the investment decisions a firm makes, not by how it distributes that
income.
 Dividend irrelevance theory

A shareholder can, in theory, construct his own dividend policy.

For example,

if a firm does not pay dividends, a shareholder who wants a 5% dividend can
“create” it by selling 5% of his stock. Conversely, if a company pays a higher
dividend than an investor desires, the investor can use the unwanted dividends to
buy additional shares of the company’s stock.

If investors could buy and sell shares and thus create their own dividend policy
without incurring costs, then the firm’s dividend policy would truly be irrelevant.
 Dividend irrelevance theory

Assumptions in M & M Theory

(1) No differences between taxes on dividends and capital gains

(2) No transaction and flotation costs/ Brokerage cost incurred when securities are
traded

(3) All market participants have free and equal access to the same information i.e
No information asymmetry

(4) No agency problem: no conflicts of interests between managers and share

holders
 Dividend preference theory ( “bird in the hand” theory)

✓ Myron Gordon and John Lintner both argued that a stock’s risk declines as
dividends increase

✓ A return in the form of dividends is a sure thing, but a return in the form of
capital gains is risky i.e. A bird in the hand is worth more than two in the bush

✓ Shareholders who prefer dividends are willing to accept a lower required return
on equity

✓ Agency Cost Implications.

 Tax effect theory
✓ Finance Act 2020 shifted the taxability on dividend income from the hands of the dividend
declaring the company to the individual investors

✓ Dividend income is taxed at the marginal tax rate of the individual investor

✓ Long-Term Capital Gains (LTCG) on shares and equity-oriented mutual funds in India are
taxed at a 12.5% rate (plus surcharge and cess) if they reach Rs. 1.25 lakh in a fiscal year

✓ An increase in a stock’s price isn’t taxable until the investor sells the stock, whereas a
dividend payment is taxable immediately

✓ A dollar of taxes paid in the future has a lower effective cost than a dollar paid today
because of the time value of money.

✓ Investors may prefer companies that pay less dividend

 Clientele Effect theory
➢ Income-Oriented Investors

➢ Capital Appreciation-Oriented Investors

✓ Preferences of different investor groups for dividend may differ

✓ For example, retired individuals, low tax bracket individuals and pension funds generally
prefer cash income, so they may want the firm to pay out a high percentage of its earnings.

✓ On the other hand, stockholders in their peak earning years or in high tax bracket might
prefer reinvestment, because they have less need for current investment income

✓ In response to the change in dividend policy, stockholders can switch firms. So, firms don’t
change their dividend policy frequently.
 Signaling Hypothesis or Information Content
✓ Information asymmetry between managers and investors

✓ Information or signaling content in dividend announcements

✓ An increase in the dividend is often accompanied by an increase in the price of a

stock and that a dividend cut generally leads to a stock price decline

✓ A higher than expected dividend increase is a signal to investors that the firm’s
management forecasts good future earnings.

✓ A dividend reduction or a smaller than expected increase is a signal that

management is forecasting poor earnings in the future
 Cash Distribution and Firm Value
Relative Mix of dividend yields versus capital gains
Target Distribution Ratio: Percentage of Net Income distributed to share holders
through cash dividends or stock repurchase

Target Payout Ratio: Percentage of Net Income distributed to share holders through
cash dividends
 Cash Distribution and Firm Value
Target Distribution Level: Residual Distribution Model

Guiding Principles:

➢ Shareholders Value Maximization

➢ Company should not retain income unless managers can reinvest that income to produce
returns higher than shareholders could themselves invest with opportunities of equal
risk.
 Cash Distribution and Firm Value
Residual Distribution Model
Optimal distribution ratio is a function of four factors:

(1) Investors’ preferences for dividends versus capital gains

(2) Firm’s investment opportunities

(3) Target capital structure

(4) Availability and cost of external capital

Cash Distribution and Firm Value
Residual Distribution Model
 Cash Distribution and Firm Value
Residual Distribution Model

Texas and Western (T&W) Transport Company has ₹60 million in net
income and a target capital structure of 60% equity and 40% debt. If it
forecasts an investment opportunity of ₹40 million. What is the residual
fund available for distribution to shareholders ?
 Cash Distribution and Firm Value
Residual Distribution Model

Texas and Western (T&W) Transport Company has ₹60 million in net
income and a target capital structure of 60% equity and 40% debt. If it
forecasts an investment opportunity of ₹40 million. What is the residual
fund available for distribution to shareholders ?

Distribution= Net income – {Target Equity ratio X Total Capital Budget)

=60 Million -60%X 40 Million=60-60%X40 = 36

Thank You