2

SATHYABAMA
INSTITUTE OF SCIENCE AND TECHNOLOGY
MASTER OF BUSINESS ADMINISTRATION
COURSE MATERIAL

Subject: Strategic Financial Management UNIT 4 Sub Code: SBAA7002

Dividend and Valuation - Irrelevance of Dividends; and Relevance of Dividends. Dividend

Models - Walter Model, Gordon Model, Modigilani and Miller Approach -Determinants of
Dividends Policy - Dividend Policies - Bonus Shares (Stock dividend) and Stock (Share) Splits;
Legal, Procedural; and Tax Aspects associated with Dividend Decision. Inflation in Financial
Decisions - Inflation and Value of the firm - Inflation and Capital Budgeting Decisions -
Inflation and Financial Markets.
INTRODUCTION

Once a company makes a profit, it must decide on what to do with those profits.
They could continue to retain the profits within the company, or they could pay out the
profits to the owners of the firm in the form of dividends. The dividend policy decision
involves two questions:

1) What fraction of earnings should be paid out, on average, over time? And,

2) What type of dividend policy should the firm follow? I.e. issues such as whether it should
maintain steady dividend policy or a policy increasing dividend growth rate etc.

On the other hand Management has to satisfy various stakeholders from the profit. Out of
the Stakeholders priority is to be given to equity share - holders as they are being the highest
risk.

DEFINITION

According to the Institute of Chartered Accountants of India, dividend is "a distribution to

shareholders out of profits or reserves available for this purpose." "The term dividend refers to
that portion of profit (after tax) which is distributed among the owners / shareholders of the
firm."

"Dividend may be defined as the return that a shareholder gets from the company, out
of its profits, on his shareholdings." In other words, dividend is that part of the net earnings of a
corporation that is distributed to its stockholders. It is a payment made to the equity
shareholders for their investment in the company.

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SATHYABAMA
INSTITUTE OF SCIENCE AND TECHNOLOGY
MASTER OF BUSINESS ADMINISTRATION
COURSE MATERIAL

Subject: Strategic Financial Management UNIT 4 Sub Code: SBAA7002

FEATURES OF DIVIDEND

 Dividends are distributed to equity share holders.

 Dividends are variable in nature.

 Dividends are optional payments there is no legal obligations on the part of the company
to pay them any fixed dividend.

 Dividends are decided by board of directors

 Equity share holders have the last claim on income(they are paid after paying interest to
debentures and pref.dividend to pref sh.holders)
 Dividends cannot be paid out of deprecation reserve or any other capital reserve
 Dividend can be paid only after providing deprecation
 It can be paid in the form of cash or bonus shares

DIVIDEND DECISION:-

The finance manager has to determine the amount of profit to be distributed

as dividend and the amount of profit to be retained in the business for financing its long term
growth

DIVIDEND THEORIES:-

It attempts to explain the (Relationship between the dividends and market value of the firm

According to one school of thought

Dividend Decision does not affect the share holders wealth and value of firm [irrelevance
concept of dividend]

 Modigliani Miller’s approach:

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SATHYABAMA
INSTITUTE OF SCIENCE AND TECHNOLOGY
MASTER OF BUSINESS ADMINISTRATION
COURSE MATERIAL

Subject: Strategic Financial Management UNIT 4 Sub Code: SBAA7002

According to another school of though Dividend decision affects the value of the firm and share
holders’ wealth [relevance concept of dividend]

 Walter’s approach
 Gordon’s approach

1. RELEVANCE CONCEPT OF DIVIDEND

1.1 WALTER’S MODEL:

Prof James. E Walter strongly supports the doctrine that the dividend decision affects the value
of the firm

According to Prof. James E. Walter, in the long run, share prices reflect the present value
of future+ dividends. According to him investment policy and dividend policy are inter related
and the choice of a appropriate dividend policy affects the value of an enterprise.

1.1.1 Statement:

Changes in dividend will affect the value of the firm. The Walter’s model is based on
relationship between (internal rate of return)

 If r>k: The firm can earn higher profits than what a share holders can earn from their
investment. Such firms are termed as growth firms.

Optimum Dividend policy: Plough back the entire earnings

Dividend payment ratio=0

Entire amount is kept as retained earnings no dividends

 If r<k: The firm earns a lower profit than what the share holders can earn from their
investment they are termed as declining firm.
Optimum dividend policy: To distribute entire earning as dividend.

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SATHYABAMA
INSTITUTE OF SCIENCE AND TECHNOLOGY
MASTER OF BUSINESS ADMINISTRATION
COURSE MATERIAL

Subject: Strategic Financial Management UNIT 4 Sub Code: SBAA7002

Dividend payment ratio:100% Entire earnings is distributed as dividend no retained

earnings
 If r=k:The firm earnings is equal to the expectations of the share holders they are termed
as normal firm
Optimum dividend policy: No optimum dividend policy. It does not matter whether the
firm retains or distribute.

1.1.2 Assumptions:
o The firm will not go for external finance such as debt or fresh issue of shares. It
does the entire finance through retained earnings.
o The rate of return (r) and cost of capital (k) remains constant.
o The dividend declared by the firm and earnings per share remains constant.
o The firm has a very long life.

MATHEMATICAL FORMULA:

P0 = Market value of the share

P0 = D + r (Eps-D)
k
k
Where D = Dividend per share.
R = Rate of return
K = Cost of capital
E = Earning per share

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SATHYABAMA
INSTITUTE OF SCIENCE AND TECHNOLOGY
MASTER OF BUSINESS ADMINISTRATION
COURSE MATERIAL

Subject: Strategic Financial Management UNIT 4 Sub Code: SBAA7002

1.1.3 CRITICISM:
Walter’s model has subject to various criticisms many of its assumptions are unrealistic.
 Walter’s assumption that financial requirements of a firm are met only by retained earnings
is seldom true in real world situations. Firms do raise funds by debentures, eq.sha whenever
they are in need of money.
 R may not constant:- The firm tend to choose more profitable projects, hence in real life r
also changes.
 Similarly k may also not remain constant. The cost of capital may vary based on market
conditions
 The firm may not have a perpetual life .The firm may wind up due to external and internal
reasons.

1.2 GORDONS MODEL:

The value of a share, like any other financial asset, is the present value of the future
cash flows associated with ownership. On this view, the value of the share is calculated as the
present value of an infinite stream of dividends.

Myron Gordon's Dividend Growth Model explains how dividend policy of a firm is a basis
of establishing share value. Gordon's model uses the dividend capitalization approach for stock
valuation. Myron Gordon relates the market value of the firm to the dividend policy.

1.2.1 Assumptions:

 No external financing:- The firm does not go for external financing.

 Constant return:- Rate of return(R) remains constant.
 Constant cost of capital:- K remains constant.
 Perpetual firm:- The firm has perpetual life.
 The firm is an all equity firm & it has no debt.
 No taxes:- Corporate taxes do not exist.

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SATHYABAMA
INSTITUTE OF SCIENCE AND TECHNOLOGY
MASTER OF BUSINESS ADMINISTRATION
COURSE MATERIAL

Subject: Strategic Financial Management UNIT 4 Sub Code: SBAA7002

 Constant retention:- The retention ratio once decided remains constant. Thus growth rate
is constant forever.
 Cost of capital is greater than growth rate K > br=g.
K = cost of capital
g = growth rate

1.2.2 Statement:

According to this model change in dividend will affect the value of the firm.
Value of firm
P0 = E(1-b)

k-g

Where Po is market price of the share.

E = earnings per share.

b = retention ratio.

g = growth rate (g=b*r).

k = cost of capital.

r = rate of return.

There are 3 kinds of firm

 Growth firm(r>k).

 Normal firm(r=k).

 Declining firm(k<r).

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SATHYABAMA
INSTITUTE OF SCIENCE AND TECHNOLOGY
MASTER OF BUSINESS ADMINISTRATION
COURSE MATERIAL

Subject: Strategic Financial Management UNIT 4 Sub Code: SBAA7002

1.2.3 Criticism:
 Firms may raise funds by external sources also.
 R may not be constant always.
 K may not be constant always.
 Firm might not have perceptual life.
 Growth in dividend is not constant.
 Meaningful value is obtained when k>g. In other situations value of firm
cannot be calculated.
1.3 REVISED GORDON’S MODEL

The bird in the hand augments:

Gordon concludes that in a normal firm where r=k. Dividend policy does not
effect value of shares. But in revised model Gordon states that dividend will effect the value of
the firm even in normal firm. Investors behaving rationally are risk averse Prefer easily dividend
which are certain than the rate dividends which are uncertain hence the investors prefer to avoid
uncertainty and willing to pay higher price for the shares which gives greater current dividend
other things held constant.

To conclude Gordon: A normal firm(r=k) must also payout dividends to get a higher market
price.

IRRELEVANCE CONCEPT OF DIVIDEND

1.3 MODIGLIANI AND MILLER APPROACH (MM APPROACH):

Modigliani and miller states that the price of shares of a firm is

determined by its earning capacity and investment decision and never by its dividend decision.

According to the MM hypothesis, market value of a share before dividend is declared is equal
to the present value of dividends paid plus the market value of the share after dividend is
declared.

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SATHYABAMA
INSTITUTE OF SCIENCE AND TECHNOLOGY
MASTER OF BUSINESS ADMINISTRATION
COURSE MATERIAL

Subject: Strategic Financial Management UNIT 4 Sub Code: SBAA7002

1.3.1 Assumptions:

 Capital markets are perfect.

 Investors behave rationally.
 There is no flotation or transaction costs.
 There are either no taxes or no difference between tax rates applicable to capital gains or
dividends.
 Information is freely available to investors.
 The firm has a fixed investment policy.
 Risk or uncertainty does not exist. Investors are able to forecast future prices and
dividends with certainty.
 Shares are infinitely divisible.

1.3.2 Statement:-

Payment of dividends will not affect the value of shares.

Formulae:-

1) P0=D1+P1

1+Ke

2) P1 = P0 (1+Ke) - D1

3) No of shares to be issued

n P1 = I-(e-nD1)

Where E = earnings, nD1 = Dividend X no. of shares, I=investment

4) Value of firm

nP0 = P1 (n+ n) – I + E

1+Ke

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SATHYABAMA
INSTITUTE OF SCIENCE AND TECHNOLOGY
MASTER OF BUSINESS ADMINISTRATION
COURSE MATERIAL

Subject: Strategic Financial Management UNIT 4 Sub Code: SBAA7002

P0 = D1+P1

1+Ke

Where P0:- Prevailing market value of share

D1:- Dividend after one year

P1:- market value of share after one year

Ke:- Cost of capital

P1 = P0 (1+Ke) - D1

Computation of no. of shares to be issued

m*P1 = I - (X - nD1)

m:- no of shares to be issued

P1:- Price at which new shares to be made

I:- amount of investment required

X:- Total net profit of the firm during the period

nD1:- Total dividends paid during the proof after problems

1.3.3 PROOF:

Step1:-

MKT value of the shares in the beginning of the period is equal to the present value of
dividend at end and mkt value of shares at end

P0 = D1+P1 = P1 + D1

1+Ke 1+Ke 1+Ke

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SATHYABAMA
INSTITUTE OF SCIENCE AND TECHNOLOGY
MASTER OF BUSINESS ADMINISTRATION
COURSE MATERIAL

Subject: Strategic Financial Management UNIT 4 Sub Code: SBAA7002

D1:- Dividend at end

P1:- mkt value of share at end

Ke:- Cost of capital

1+ke:- Since taken after one year present value of money is considered

Step2:- Value of firm would be = no. of shares * mkt values of shares.

n * P0 = nP0 = n(D1+P1)

1+Ke

nP0 = nD1+nP1

1+Ke

Step 3:- Assuming that there is no external financing. The firm’s internal source of finance also
falls short hence fresh issue of shares has to be made

n=no of new shares issued at the end of period 1/Additional shares issue

nP0 = nD1+nP1+ nP1 - nP1

1+Ke

nP0 = nD1+(n+ n) P1- nP1 Eqn (1)

1+Ke

Step 4:

nP1=No. of new shares * MV of shares at end

nP1 = I - (E - nD1)

nP1 = I-e + nD1 Eqn (2)

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SATHYABAMA
INSTITUTE OF SCIENCE AND TECHNOLOGY
MASTER OF BUSINESS ADMINISTRATION
COURSE MATERIAL

Subject: Strategic Financial Management UNIT 4 Sub Code: SBAA7002

I:- Investment required

E:- Earnings/net profit

nD1:- Total dividend

E- nD1 = Retained earnings.

Sub (2) in (1)

nP0 = nD1+(n+ n) P1-( I-e+nD1)

1+Ke

nP0 = nD1+(n+ n) P1- I+e-nD1

1+Ke

nP0 = (n+ n) P1-I+e

1+Ke

Since D1 is not found in the formula of value of shares / firm . It is evident that
dividend has no effect in the valuation of shares. Thus MM approach concludes that
dividend has no effect in the valuation of share price.

Criticism:-

1) Perfect capital market does not exist for the following reasons.

 All investors are not logical while making investment.

 Shares are not infinitely divisible (they are available in market lots).
 Transaction cost exists.
 Flotation cost exists.
 Financial institutions are able to influence market decisions and investors buy & sell
when FI’s buy and sell.

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SATHYABAMA
INSTITUTE OF SCIENCE AND TECHNOLOGY
MASTER OF BUSINESS ADMINISTRATION
COURSE MATERIAL

Subject: Strategic Financial Management UNIT 4 Sub Code: SBAA7002

 All investors do not get perfect information. FI’s get better information compared to
individual investors.
 Taxation Exists: Different rates of taxes on capital gains and dividend. Capital gains are
charged at a lower rate than dividend.

2) The investment policy of the firm changes due to changes in return costs and market
conditions.

3) Business risk of the firm will change because of changes in investment policies.

PRACTICAL ASPECTS OF DIVIDEND:

1) Dividend policies

2) Factors affecting dividend

3) Forms of dividend

DIVIDEND POLICIES:-

"Dividend policy means the practice that management follows in making dividend payout
decisions, or in other words, the size and pattern of cash distributions over the time to
shareholders."

In other words, dividend policy is the firm's plan of action to be followed when dividend
decisions are made. It is the decision about how much of earnings to pay out as dividends versus
retaining and reinvesting earnings in the firm.

Types of dividend policy

There are 4 types of dividend policy

a. Regular dividend policy

b. Stable dividend policy
c. Irregular dividend

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SATHYABAMA
INSTITUTE OF SCIENCE AND TECHNOLOGY
MASTER OF BUSINESS ADMINISTRATION
COURSE MATERIAL

Subject: Strategic Financial Management UNIT 4 Sub Code: SBAA7002

d. Zero dividend policy

Regular dividend policy: In this type of dividend policy the investors get dividend at usual rate.
Here the investors are generally retired persons or weaker section of the society who want to get
regular income. This type of dividend payment can be maintained only if the company has
regular earning.

Merits of Regular dividend policy:

 It helps in creating confidence among the shareholders.

 It stabilizes the market value of shares.
 It helps in marinating the goodwill of the company.
 It helps in giving regular income to the shareholders.

Stable dividend policy/ stability of dividends: Here the payment of certain sum of money is
regularly paid to the shareholders.

Merits of stable dividend policy:

 It helps in creating confidence among the shareholders.

 It stabilizes the market value of shares.
 It helps in marinating the goodwill of the company.
 It helps in giving regular income to the shareholders.

Forms of stability of dividend:-(or) Policies for declaring dividend

1) Constant dividend per share.

2) Constant payout.
3) Constant dividend per share plus extra dividend.
i) Constant dividend per share:-

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SATHYABAMA
INSTITUTE OF SCIENCE AND TECHNOLOGY
MASTER OF BUSINESS ADMINISTRATION
COURSE MATERIAL

Subject: Strategic Financial Management UNIT 4 Sub Code: SBAA7002

The policy of paying a fixed amount per share as dividend irrespective of fluctuations in
the earnings. The policy does not imply that DPS will never increase. When the earnings
increases and expects to maintain that level, the annual dividend may also increased.

Year EPS DPS

1 20 4
2 30 4
3 15 4
4 30 6
5 20 6
6 10 8
7 60 8
8 40 8

70
60
50
40
30
20
10
0
1 2 3 4 5 6 7

Advantages:

 Dividends are stable.

 Preferred by FIs.
 Mkt price would be stable to certain extent.

Disadvantages:

 Difficult to maintain such policy from earnings fluctuating year to year.

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SATHYABAMA
INSTITUTE OF SCIENCE AND TECHNOLOGY
MASTER OF BUSINESS ADMINISTRATION
COURSE MATERIAL

Subject: Strategic Financial Management UNIT 4 Sub Code: SBAA7002

 Investors feel they don’t get dividend proportionate to earnings.

 When earnings are high, but proportionate dividends were not given it declines market
price. In practice when a company has good earnings in a year it earmarks the surplus
into dividend equalization reserve so that they can easily payout the constant dividend
even in bad time.

ii) Constant payout ratio:-

A certain percentage of net earnings is paid by way of dividends to share holders every
year. In such a policy amount of dividend fluctuates in direct proportion with earnings of
the company.

Illustration:-Assume 50% payout ratio

year EPS DPS

1 20 10
2 40 20
3 60 30
4 50 25
5 80 40
6 60 30
7 50 25
8 50 25

140
120
100
80
60
40
20
0
1 2 3 4 5 6 7 8

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SATHYABAMA
INSTITUTE OF SCIENCE AND TECHNOLOGY
MASTER OF BUSINESS ADMINISTRATION
COURSE MATERIAL

Subject: Strategic Financial Management UNIT 4 Sub Code: SBAA7002

Advantages:

 No boredom dividends are existing.

 Dividend equalization need not be maintained.
 Dividends are proportionate to earnings.

Disadvantages:

 No stability in dividends.
 Financial institutions do not prefer.
 Market price will also fluctuate.

iii) Constant DPS + extra dividend :-

In this policy, the firm usually pays fixed dividend per share holders. However in
period of market prosperity additional dividend is paid over the regular dividend. The
extra dividend is cut by the firm as soon as the normal conditions return

Advantages:-

No boredom excitement in dividends

Disadvantages:-

Uncertainty about the extra dividends for which investors are generally not prepared.

c) Irregular dividend policy: as the name suggests here the company does not pay regular
dividend to the shareholders. The company uses this practice due to following reasons:

 Due to uncertain earning of the company.

 Due to lack of liquid resources.
 The company sometime afraid of giving regular dividend.
 Due to not so much successful business.

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SATHYABAMA
INSTITUTE OF SCIENCE AND TECHNOLOGY
MASTER OF BUSINESS ADMINISTRATION
COURSE MATERIAL

Subject: Strategic Financial Management UNIT 4 Sub Code: SBAA7002

d) Zero dividend policy

All surplus earnings are invested back into the business. Such a policy:

 is common during the growth phase

 should be reflected in increased share price.

When growth opportunities are exhausted (no further positive NPV projects are available):

 cash will start to accumulate

 a new distribution policy will be required.

Dividend is paid only if no further positive NPV projects available. This may be popular for
firms in the growth phase or without easy access to alternative sources of funds.

However: cash flow is unpredictable for the investor

 gives constantly changing signals regarding management expectations.

FACTORS AFFECTING DIVIDENDS:

1) External factors
2) Internal factors

EXTERNAL FACTORS:-

1) General state of economy:- In case of uncertain economic conditions management may

like to retain the whole are part of firm earnings to preserve firms liquidity similarly even
during periods of periods firm would like to retain if the firm has larger investment
opportunity
2) State of capital market:- f the firm has easy access to the capital market it would follow
a liberal dividend policy. If it doesn’t have a easy access to capital market then it is
likely to adopt a more conservative policy.

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SATHYABAMA
INSTITUTE OF SCIENCE AND TECHNOLOGY
MASTER OF BUSINESS ADMINISTRATION
COURSE MATERIAL

Subject: Strategic Financial Management UNIT 4 Sub Code: SBAA7002

3) Legal Restrictions:- A firm has certain legal restriction as per company acts regarding
payment of dividend. Some of the restrictions are
 Dividend can be paid out of the current profits only after paying to debenture holders
& preference share holders.
 A company is not entitled to pay dividends unless providing for deprecation.
 Deprecation reserve or general reserve can’t be used to pay dividends.
4) Contractual Restrictions:- Lenders of the firm generally restrict the dividend payments
in order to protect their interest, esp. when the firm is experiencing profitability or
liquidity problems.
5) Tax policy:-Tax policy followed the govt. also affects the dividend policy for eg. If the
govt. provides tax incentives for retaining longer share of dividends then the management
may be inclined to retain a larger amount of firm earnings.

INTERNAL FACTORS:

1) Desire of share holders: The desire of share holders plays a major role in determining
dividend policies. Wealthy investors (capital gains)(low pay out ratio retain). Investors
like institutional, retired persons, small investors except a regular dividend
2) Financial needs of the company:- If profitable investment opportunities exist it is better
to retain earnings. In case of no good opportunities for investment the firm can distribute
higher dividends.
3) Nature of earnings:-Firms have less competition (monopoly) earning a stable income
can have a higher payout ratio as compared to firms having higher competition and
fluctuating earnings
4) Desire of control:- In the firms desire for control then it should have a low dividend
payout ratio. If the firm has higher dividend payout ratio it would affect firms ability to
invest in profitable opportunity, in such a situation the firm has to go for fresh issue or

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SATHYABAMA
INSTITUTE OF SCIENCE AND TECHNOLOGY
MASTER OF BUSINESS ADMINISTRATION
COURSE MATERIAL

Subject: Strategic Financial Management UNIT 4 Sub Code: SBAA7002

loans from FIs in both the cases firm control is diluted. Hence if a firm desires for a
higher control, it has to retain and distribute low dividends
5) Liquidity position:- If the firm’s liquidity position is good it can afford to pay higher
dividends. If the firm’s liquidity is low then it has to pay either low dividends or
distribute bonus shares.

FORMS OF DIVIDENDS

1) Cash Dividend:-

The dividend is paid in the cash. Adequate cash resources are required to pay in form of
cash dividend most popular.

2) Property Dividend:-

In such a case it is paid in the form of assets other than cash generally companies
products are distributed as dividends. This is not popular in India.

3) Stock Dividend:-

This is next to cash dividend in popularity. The company issues its own shares to
share holders in addition to cash dividends. This is popularly known as “Issue of bonus
shares”.

4) Bond Dividend:-

In case the company does not have sufficient funds to pay it pays dividend in the
form of bonds. The bond holders get regular interest on their bonds as well as bond money on
due date. Not popular in India.

BONUS SHARES:

Bonus means extra dividend paid when this dividend is paid in form of shares it is
termed as bonus shares. Issue of bonus shares does not affect the capital structure of the
company.

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SATHYABAMA
INSTITUTE OF SCIENCE AND TECHNOLOGY
MASTER OF BUSINESS ADMINISTRATION
COURSE MATERIAL

Subject: Strategic Financial Management UNIT 4 Sub Code: SBAA7002

Benefits of bonus shares:-

(A) For Investors

1) Immediately Realizable: Bonus shares can be sold in the market immediately after a
shareholder gets it.
2) Not taxable: Bonus shares are not taxable.
3) Increase in future Income: Shareholders will get dividend on more shares than earlier in
future.
4) Good Image increases the value in market: Bonus shares create very good image of the
company and the shares. Thereby it results into increase in the value of the share in the
market.

(B) For Company:

1) Economical: It is an inexpensive mode of raising capital by which cash resources of

company can be used for some other expansion project.
2) Wider Marketability: When bonus shares are issued, market price of share is
automatically reduced which increases its wider marketability.
3) Increase in Credit Worthiness: Issuing bonus shares mean capitalisation of profits and
capitalisation of profits always increases the credit worthiness of the company to borrow
funds.
4) More realistic Balance Sheet: Balance Sheet of the company will reveal more realistic
picture after the issue of bonus shares.
5) More Capital Availability: After issuing bonus shares, more capital will be available and
hence more capital can be utilised for more expansion works.
6) Unaltered Liquidity Position: Liquidity cash position of the company will remain
unaltered with the issue of bonus shares because issue of bonus shares does not result into
inflow or outflow of cash.

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SATHYABAMA
INSTITUTE OF SCIENCE AND TECHNOLOGY
MASTER OF BUSINESS ADMINISTRATION
COURSE MATERIAL

Subject: Strategic Financial Management UNIT 4 Sub Code: SBAA7002

Disadvantages of Issue of Bonus Shares:

1) Rate of dividend decline: The rate of dividend in future will decline sharply, which may
create confusion in the minds of the investors.
2) Speculative dealing: It will encourage speculative dealings in the company’s shares.
3) Forgoes Cash equivalent: When partly paid up shares are converted into fully paid-up shares,
the company forgoes cash equivalent to the amount of bonus so applied for this purpose.
4) Lengthy Procedure: Prior approval of central government through SEBI must be obtained
before the bonus share issue. The lengthy procedure, sometime may delay the issue of bonus
shares.

RIGHTS SHARE:-

In case of corporations the share holders are given per emptive, right to get some shares. Right
shares are the shares issued to the share holders under pre emptive right.

A rights issue is one of the ways by which a company can raise equity share capital among the
various types of equity share capital sources available. These are slightly different from the
standard issue of shares. Right shares mean the shares where the existing shareholders have the
first right to subscribe the shares.

In layman terms, rights issue gives a right to the existing shareholders to purchase additional new
shares in the company. Rights shares are usually issued at a discount as compared to the
prevailing traded price in the market. The existing shareholders are allowed a prescribed time
limit/date within which need to exercise the right or the right will thereafter be forgone.

Features of Rights Issue of Shares

1) The rights shares allow preferential treatment to existing shareholders, where existing
shareholders have the right to purchase shares at a lower price on or before a specified date.
The shares are issued at a discount as a compensation for the stake dilution that will take
place post issue of additional shares.

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SATHYABAMA
INSTITUTE OF SCIENCE AND TECHNOLOGY
MASTER OF BUSINESS ADMINISTRATION
COURSE MATERIAL

Subject: Strategic Financial Management UNIT 4 Sub Code: SBAA7002

2) The existing shareholders can trade the rights to other interested market participants until the
date at which the new shares can be purchased. The rights are traded in a similar way as the
normal equity shares.
3) The amount of rights issue to the shareholders is usually at a proportion of existing holding.
4) The existing shareholders can also choose to ignore the rights; however, one may not do so
as existing shareholding will be diluted post issue of additional shares and will result in a loss
(in valuation) for existing shareholder.

STOCK SPLIT

A stock split is a change in the number of outstanding shares or stocks achieved through a
proportional reduction or increase in the par value of the stock. The management employs this
device to make a major adjustment in the market price of the firm’s stock and consequently in its
earnings and dividends per share. In stock split only the par value and number of outstanding
shares are affected.

LEGAL AND PROCEDURAL ASPECTS OF PAYMENT OF DIVIDEND:

 Source of Declaring Dividend

 Transfer to Reserves
 Declaration of Dividend out of Past Profits or Reserves
 Other Provisions and Aspects of Payment of Dividend

Source of Declaring Dividend:

(a) Out of current profits. Dividend can be declared by a company out of profits for the current
year arrived at after providing depreciation.

(b) Out of past profits. Dividend can also be declared out of the undistributed profits of the
company for any previous financial year or years arrived at after providing depreciation in
accordance with the provisions of the Act.

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SATHYABAMA
INSTITUTE OF SCIENCE AND TECHNOLOGY
MASTER OF BUSINESS ADMINISTRATION
COURSE MATERIAL

Subject: Strategic Financial Management UNIT 4 Sub Code: SBAA7002

(c) Out of moneys provided by the Government. A company may also declare dividend out of
the moneys provided by the Central Government for the payment of dividend in pursuance of a
guarantee by the government.

It may, however, be noted that no dividend can be declared or paid by a company unless:

(i) Depreciation has been provided for in respect of the current financial year.

(ii) Arrears of depreciation in respect of the previous year’s falling after the commencement of
the companies (Amendment) Act, 1960 have been set off against profits of the company.

(iii) Losses, if any incurred by the company in previous years falling after 28th December, 1960
have been written off against profits of the company for which dividend is proposed to be
declared.

Transfer to Reserves:

The companies (Transfer of Profits to Reserves) Rules, 1975 require a company providing more
than 10 per cent dividend to transfer a certain percentage of the current year’s profits to reserves
as specified below:

(a) Where the dividend proposed exceeds 10 per cent but dos not exceed 12.5 per cent of the paid
up capital, the amount to be transferred to the reserves shall not be less than 2.5 per cent;

(b) Where the dividend proposed exceeds 12.5 per cent but does not exceed 15 per cent of the
paid up capital, the amount to be transferred to reserves shall not be less than 5 per cent;

(c) Where the dividend proposed exceeds 15 per cent but does not exceed 20 per cent of the paid
up capital, the amount to be transferred to reserves shall not be less than 7.5 per cent; and

(d) Where the proposed dividend exceeds 20 per cent of the paid up capital, the amount to be
transferred to reserves shall not be less than 10 per cent of the current year’s profits.

It may, however, be noted that that a company may voluntarily transfer a higher percentage of
profits to reserves.

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SATHYABAMA
INSTITUTE OF SCIENCE AND TECHNOLOGY
MASTER OF BUSINESS ADMINISTRATION
COURSE MATERIAL

Subject: Strategic Financial Management UNIT 4 Sub Code: SBAA7002

Declaration of Dividend out of Past Profits or Reserves:

If a company wants to declare dividend out of accumulated profits or reserves, it has to comply
with the following conditions:

(a) The rate of dividend should not exceed the average of the rates at which dividend was
declared by it in five years immediately preceding that year or ten per cent of its paid up capital,
whichever is less.

(b) The total amount to be drawn for the declaration of dividend from the accumulated profits
should not exceed an amount equal to one-tenth of the sum of its paid up capital and free
reserves and the amount so drawn should first be utilised to set-off the losses incurred in the
financial year.

(c) The balance of reserves after such drawl should not fall below fifteen per cent of its paid up
capital.

Other Provisions and Aspects of Payment of Dividend:

(a) The decision in regard to the payment of final dividend is taken at the annual general meeting
of the shareholders only on the recommendation of the directors. The shareholders themselves
cannot declare dividend. However, interim dividend is declared by the directors and there is no
need for a meeting of the shareholders to sanction the payment of such a dividend.

(b) Dividend on equity shares can be paid only after declaration of dividend on preference
shares.

(c) When dividend is declared by a company, it must be paid by the company within 30 days of
declaration of dividend.

(d) According to section 205 of the Companies Act, no dividend shall be payable except in cash:
Provided that nothing in this section prohibits the capitalisation of profits or reserves of a
company for the purpose of issuing fully paid up bonus shares.

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SATHYABAMA
INSTITUTE OF SCIENCE AND TECHNOLOGY
MASTER OF BUSINESS ADMINISTRATION
COURSE MATERIAL

Subject: Strategic Financial Management UNIT 4 Sub Code: SBAA7002

(e) Any dividend payable in cash may be paid by cheque or warrant sent through the post
directed to the registered address of the shareholder entitled to the payment of the dividend.

(f) In the absence of any specific provision in the Articles of Association of the company,
dividend is paid on the paid up capital of the company. If there are calls in arrears, dividend is
paid on the amount actually paid by the shareholders.

(g) No dividend can be paid on calls in advance.

(h) As per Finance Act, 1997 dividends paid or declared are subject to corporate dividend tax. At
present (Assessment Year 2012-13) the rate of corporate dividend tax is 15% plus 7.5%
surcharge and 3% education cess.

EVENTS AND DATES IN THE DIVIDEND PAYMENT PROCEDURE

a) Board resolution: The divided decision is the prerogative of the board of directors. Hence
the board of directors should in the formal meeting resolve to pay the divided.

b) Shareholder’s approval: The resolution of the board of directors to pay the dividend has to
be approved by the shareholders in the annual general meeting.

c) Record date: The dividend is payable to shareholders whose names appear in the Register
of Members as on the record date.

d) Dividend payment: Once a dividend declaration has been made, dividend warrants must be
posted within 30 days. Within a period of 7 days, after the expiry of 30 days, unpaid dividends
must be transferred to a special account opened with a scheduled bank.

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SATHYABAMA
INSTITUTE OF SCIENCE AND TECHNOLOGY
MASTER OF BUSINESS ADMINISTRATION
COURSE MATERIAL

Subject: Strategic Financial Management UNIT 4 Sub Code: SBAA7002

INFLATION IN INVESTMENT DECISIONS:-

Limitations of conventional financial statements:-
a. Fail to disclose the current worth of enterprise.
b. Contains non comparable items.

Yr sales avg price index

1 1,00,000 100
2 1,50,000 200
3 2,00,000 300

Revised sales
Yr sales conversion revised sales
1 1,00,000 300/100 3,00,000
2 1,50,000 300/200 2,25,000
3 2,00,000 300/300 2,00,000

Create problems at the time of replacement:-

Illustration:-
Machinery was purchased for Rs.1,00,000 and life expected to be 10yrs. The
depth reserve would be for 1,00,000. But the price of machine would have become
2,00,000 then the firm has to face serious problems.

Mixes holding & operating gains:-

Illustration:-
100 units are purchased at Rs.6 out of which 50 units are sold in 1990. In 1991,
100 units are purchased at Rs 8, 150 units are sold
Conventional method

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SATHYABAMA
INSTITUTE OF SCIENCE AND TECHNOLOGY
MASTER OF BUSINESS ADMINISTRATION
COURSE MATERIAL

Subject: Strategic Financial Management UNIT 4 Sub Code: SBAA7002

Sales (150 * 10) = 1500

Cost (50 *6 + 100 * 8) = 1100
Profit = 400
Actual operating cost is 300 that 100 is arised due to holding of inventory during rise in
price 50 (8-6) = 100.
It’s over reporting of profits hazardous – High taxes and on.
Hence Inflation is very essential to be studied while making a financial decision.

INFLATION AND FINANCIAL DECISION:-

1 Funds requirement decision:-
This decision involves estimation of total capital required for an enterprise.
Total capital required constitutes of cost if fixed asserts & working capital.
If cost of fixed assets = 10 lakhs
Working capital = 5 lakhs
Capital required 15 lakhs

Under inflationary conditions, the cost of asserts is bound to go up similarly is the

working capital needs.
If the inflation rate is 10%
Then the funds required by the enterprise would 15L +(10% of 15L) = 16.5 lakhs.
Inflation has to be considered to avoid problems because of shortage of funds.
2 Financing decisions:-It involves the sources from which the finance manager should
raise the quantum of funds required by firm.The sources could be from fixed yield
earning securities (pref sh, drs) or variable yield earning securities (eg- shares). Equity
share holders are real risk bearers hence they should get a higher rate of returns. This can
be made only when company earns higher profits. The finance manager while estimating

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SATHYABAMA
INSTITUTE OF SCIENCE AND TECHNOLOGY
MASTER OF BUSINESS ADMINISTRATION
COURSE MATERIAL

Subject: Strategic Financial Management UNIT 4 Sub Code: SBAA7002

cost and revenues should consider inflation or else his estimates may go wrong & he may
not be able to make profits and satisfy equity share holders.
3 Investment decision:- This comprises relating to investment in fixed assets & current
assets. Under inflationary conditions unnecessary delays has to be avoided to prevent cost
overruns.
4 Dividend decision:- The dividend decision determines the percentage of profits to be
distributed to share holders, amount of earnings to be retained in the business. The
investor should take this decision by comprising the inflation particulars. If earnings are
calculated, for eg:- after depreciated machinery on historical cost & dividends are
distributed. But the actual cost of machinery would have gone up and the depn reserve is
not sufficient to buy new machine. It would result in shortage of funds. Hence it is always
better in corporate inflation while taking dividend decision & retains a suitable amount
(optimum) of earnings in the business.

INFLATION & VALVE OF THE FIRM:-

a. Price – cost responsiveness
Sales – 5L
Cost - 3L
2L
Situation 1 Inflation 15%
Cost 12%
Sales – 5,75,000
Cost -- 3,36,000

2,39,000 Value of firm increased by 39,000

Situation 2 sp by 6%

Cost by 12%

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SATHYABAMA
INSTITUTE OF SCIENCE AND TECHNOLOGY
MASTER OF BUSINESS ADMINISTRATION
COURSE MATERIAL

Subject: Strategic Financial Management UNIT 4 Sub Code: SBAA7002

Sales 5,30,000

Cost 3,36,000

1,94,000 by 6000

If the responsiveness of selling price is less than inflation rate value of firm will decrease. If the
responsiveness of selling price is more than inflation rate value of firm will increases.

Net borrower/ net lender position:-If a firms borrows more than it lends it is called net
borrower firm. It gains value when interest rate goes up in inflation. For example a firm
borrows say at 10%. Interest rate goes up to 12%. After inflation hence it gains value.

He has lent at 10% now the rate has increased to 12% in inflation then it loss its value.

Depreciation:- With inflation cost of assets increases. The funds in the depreciation reserve are
not sufficient to buy new machinery. The firm loses its value as it has to arrange for extra funds.

INFLATION & CAPITAL BUDGETING:-

Inflation has ramifications for the realized value of a capital project. When evaluating capital
projects, companies can evaluate capital projects in nominal or real (i.e. inflation adjusted)
terms. Real cash flows are based on purchasing power at the time the decision to invest would is
made. Under a real cash flow approach, the discount rate would remove the expected inflation
rate, as the cash flows will already reflect the effects of inflation. Commonly, capital projects
are analyzed in nominal terms, so the discount rate applied is inclusive of expected inflation;

a. Real cash flow:-Inflation is not included.

b. Nominal cash inflow:- Inflation is included.

c. Real Discount Rate.

d. Nominal Discount Rate.

Use nominal cash inflow – nominal DR

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SATHYABAMA
INSTITUTE OF SCIENCE AND TECHNOLOGY
MASTER OF BUSINESS ADMINISTRATION
COURSE MATERIAL

Subject: Strategic Financial Management UNIT 4 Sub Code: SBAA7002

INFLATION & FINANCIAL MARKET:-

 Convertible Securities:- Non convertible debentures and pref shares get the same
interest through the interest rates in the economics has increased. Convertible option
helps the investors to convert debentures into equity shares and get high dividend.
 Participative Preference Share:- Similarly a participative security helps the holders to
get a fixed regular dividend plus a small portion of profit of the company. The extra
component dividend helps him to cope up with inflation.
 Flexible Rate Debenture:- Fixed rate debentures earn a fixed return to the investors and
investor is not able to cope with inflation. Eg:- 10% debentures for 10yrs.Flexible rate
debentures earn a higher rate as year passes by and higher interest helps him to cope with
inflation.
1 3yrs 10% Interest
4 7yrs 12% Interest
 10yrs 14% Interest
 Derivatives:- Future & options were introduced in the security market to cope up with
inflation.
 Real Estate Financing:- New concept shared appreciation mortgage: In real estate
financing the bankers lose some interest rate is charged from borrowers in an inflationary
economy. So a new concept has been developed. Under SAM, the borrower has to pay
fixed interest rate + a portion of appreciation value of land & building.

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