Financial Management Unit 4 Dividend Policy

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Financial Management Unit 4 Dividend Policy

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Financial Management Unit 4 Dividend Policy Notes cover all the exercise questions in UGC Syllabus. Financial Management Unit 4 Dividend Policy provided here ensures a smooth and easy understanding of all the concepts. Understand the concepts behind every Unit and score well in the board exams.

Dividend Policy

FINANCIAL MANAGEMENT

A. Fill up the blanks:

1. According to M.M. approach, the dividend decisions and retained earnings decisions does not influence the _______ of shares.

 Ans: Market value.

2. According to theory of relevance ________ are directly influence the value of firm. 

Ans: Dividend decisions.

3. Prof water establishes the relationship between __________ and _______ and its influence in the dividend decisions. 

Ans: Internal rate of return and Cost of capital.

4. ________ is the distribution of profits of a company among its shareholders.

Ans: Dividend.

5. Dividend policy of a firm affects both the long term financing and ________.

Ans: Shareholders Wealth.

6. ________ dividend promises to pay the share holders at a future date.

Ans: Scrip.

7. ________ dividend is a usual method of paying dividend.

Ans: Cash.

8. According to ________ model, the dividend decision is irrelevant.

Ans: M.M.

9. _______ is the distribution of profits of a company among its shareholders.

Ans: Dividend.

10. Dividend policy of a firm affects both the long term financing and _______.

Ans: Shareholders’ wealth.

11. __________ dividend promises to pay the shareholders at future date.

Ans: Scrip.

12. _________ dividend is a usual, the dividend is a usual method of paying dividend.

Ans: Cash.

13. According to ________ model, the dividend decision is irrelevant.

Ans: MM.

14. Bonus issue amount to ______ in the amount of accumulated profit and reserves.

Ans: Reduction.

15. The residual reserves after the proposed capitalization should be at least _________ .

Ans: 40 increased.

16. The bonus issue is permitted to be made out of _________ and _______.

Ans: Free Reserves, premium collected in cash.

17. Bonus issue is made to make the _______ value and the ______ value of, the share of the company comparable.

Ans: Nominal, market.

18. According to MM approach, the dividend decisions and retained earnings decision does not influence the ______ of share.

Ans: Market value.

19. According to theory of relevance _______ are directly influenced in value of firm.

Ans: Dividend decisions.

20. Prof. Walter establishes the relationship between ________ and _____ and its influence in the dividend decisions.

Ans: Internal rate of return and cost of capital.

B. Say true or false:

1. Payment of dividend involves legal as well as financial considerations.

Ans: True.

2. Stock dividend affects liquidity position of the company.

Ans: False.

3. M M model suggests that dividend decision affects the value of the firm.

Ans: False.

4. In the opinion of prof. Walter, the dividend policy will not affect the market price of shares if M = K.

Ans: True.

5. A company should follow an adnoc dividend policy.

Ans: False.

6. The issue of bonus shares amounts to a corresponding increase in the paid-up capital of the company.

Ans: True.

7. Reserves created by revaluation of fixed assets are permitted to be capitalized for the issue of bonus shares.

Ans: False.

8. The declaration of bonus issue in lieu of dividend is allowed.

Ans: False.

9. Bonus shares are not permitted unless the partly paid shares, if any, are made fully paid.

Ans: True.

10. The residual reserves after the proposed capitalization should be at least 30 percent of the increased paid up capital.

Ans: False.

11. Management of earnings has nothing to do with plugging back of profits.

Ans: False.

12. Secret reserves are not shown in the balance sheet.

Ans: True.

13. A reserve means cash.

Ans: False.

14. Proprietary reserves are available for distribution as dividend.

Ans: True.

15. Capital reserves are built out of revenue profits.

Ans: False.

SHORT TYPE QUESTIONS & ANSWERS

1. Define the term Dividend. Mention five forms of Dividend.

Ans: The term dividend refers to that part of profits of a company which is distributed by the company among its shareholders. It is the reward of the shareholders for investments made by then in the shares of the company. The investors are interested in earning the maximum return on their investments and to maximize their wealth. A company, on the other ant, needs to provide funds to finance its long-term growth.

Five forms of dividend are:

(i) Cash Dividend.

(ii) Stock Dividend.

(iii) Bond Dividend.

(iv) Property Dividend.

(v) Composite Dividend.

2. Define Dividend Policy. Mention five Determinants of Dividend Policy.

Ans: Dividend policy is a very flexible and wide word. It is made of two words Dividend + policy. We have explained the meaning of dividend I, e, it is a part of divisible profits and distribute amongst shareholders. Policy means practice or principles of working. Therefore dividend policy is concerned with the determination of dividend amount and its distribution plan. A company should formulate a sound dividend policy taking into consideration the amount of past dividend, present year profits, liquidity position and financial health of the company.

Five determinants of dividend policy are:

(i) Legal Restrictions.

(ii) Magnitude and Trend of Earnings.

(iii) Desire and Type Share holders.

(iv) nature of Industry.

(v) Age of the company.

3. Give four essentials of a sound Dividend Policy.

Ans: Four essentials of a sound dividend policy are:

(i) Stability.

(ii) Gradually Rising Dividend Rates.

(iii) Distribution of Dividend is cash.

(iv) Moderate Start.

4. Write five advantage of stable Dividend Policy.

Ans: Five advantage of stable dividend policy are:

(i) It is sign of continued normal operations of the company.

(ii) It stabilizes the market value of shares.

(iii) It creates confidence among the investors.

(iv) It provides a source of livelihood to those investors who view dividends as a source of funds to meet day to day expenses.

(v) It meets the requirements of institutional investors who prefer companies with stable dividends.

5. Give four reasons that some companies follow irregular Dividend Payments.

Ans: Four reasons that some companies follow irregular dividend payments are:

(i) Uncertainty of Earning.

(ii) Unsuccessful business operations.

(iii) Lack of liquid resources.

(iv) Fear of adverse effects of regular dividends on the financial standing of the company.

6. What is the meaning of Reserves.

Ans: In general, the term ‘reserve’ refers to the amount set aside out of profits. The amount may be set aside to cover any liability, contingency, commitment or depreciation in the value of assets. Reserves mean, there fore, amounts which belong to the owners over and above the capital contributed by them. If amounts equal to reserves are invested are invested in out side investments, the reserve is called ‘Reserve Fund.’ Technically speaking, the amount set aside out of profits may be either (i) a ‘provision’. Or (ii) a ‘reserve’.

7. Mention five reasons of Reserve. Write four types of Reserves.

Ans: Five reasons of reserve are:

(i) To prevent the distribution of surplus in the form of dividends.

(ii) To provide additional capital I, e, laughing back of profits.

(iii) To provide for rainy days.

(iv) To enable equalization of dividends and.

(v) To supplement other reserves.

Four types of reserves are:

 (i) General Reserve.

(ii) Specific Reserve.

(iii) Revenue Reserve.

(iv) Capital Reserves.

8. Define Surplus.

Ans: There are different views regarding the meaning and concept of surplus. According to one school of thought, the balance remaining after deducing the liabilities and share capital from the total of assets is known as ‘surplus”. In the opinion of the other school ‘surplus’, represents the ‘undistributed earnings of a company I, e, the balance of profits remaining after paying dividends to the shareholders still, there are other in whose opinion ‘surplus’ is a left over which represents an addition to assets that is carried over on the ‘equity side’. But surplus is solely an asset in any sense of the word. In simple words, ‘surplus’ may be described as the net income of the company remaining after payment of dividend and all other expenses. It is the difference between the book value of the assets and the sum of liabilities and capital.

9. Mention five needs or advantages of laughing book of profit.

Ans: Five needs or advantages of laughing book of profit are: 

(i) For the replacement of old assets which have become obsolete.

(ii) For the expansion and growth of the business.

(iii) For contributing towards the fixed as well as the working capital needs of the company.

(iv) For improving the efficiency of the plant and equipment.

(v) For making the company self-dependent of finance from outside sources.

10. Write five factors that influencing ploughing back of profit.

Ans: Five factors that influencing ploughing back of profit are:

(i) Earning capacity.

(ii) Desire and Type of Shareholders.

(iii) Future Financial Requirements.

(iv) Dividend Policy.

(v) Taxation policy.

11. What is Bonus Share.

Ans: The dictionary meaning of bonus shares is ‘a premium or gift, usually of stock, by a corporation to share-holders’ or ‘an extra dividend paid to shareholders in a joint stock company from surplus profit, ‘However, in legal context the meaning is not the same. A bonus share is neither dividend nor a gift. It is governed by so any regulations that it can neither be declared like a dividend nor gifted away. Issue of bonus shares in lieu of dividend is not allowed as according to section 205 of the companies Act, 1956 no dividend can be paid except in cash. It cannot be termed as a gift also because it only represents the past sacrifice of the shareholders.

12. What are the Basic Issues Involved in Dividend Policy?

Ans: There are certain basic issues involved in determining the sound dividend policy.

These are:

(i) Cost of capital: Cost of capital is one of the considerations for taking a decision whether to distribute dividend or not. As a decision making tool, the board calculates the ratio of rupee profits the business expects to earn (Ra) to the rupee profits that the shareholders can expect to earn outside (RC) i.e. Ra/Rc. If the ratio is less than one, it is a signal to distribute dividend and if it is more than one, the distribution of dividend will be discontinued.

(ii) Realisation of objectives: The main objectives of the firm, i.e. maximisation of wealth for shareholders – including the current rate of dividend — should also be aimed at in formulating the dividend policy.

(iii) Shareholders’ group: Dividend policy affects the shareholders’ group. It means a company with low payout and heavy reinvestment attracts shareholders interested in capital gains rather in current income whereas a company with high dividend payout attracts those who are interested in current income.

(iv) Release of corporate earnings: Dividend distribution is taken as a means of distributing unused funds. Dividend policy affects the shareholders wealth by varying its dividend pay out ratio. In dividend policy, the financial manager decide whether to release corporate earnings or not.

13. What are the assumptions of MM Hypothesis?

Ans: Assumptions of MM hypothesis:

(i) Capital markets are perfect.

(ii) Investors behave rationally.

(iii) There are no floatation and transaction costs.

(iv) No investor is large enough to effect the market price of shares.

(v) There are either no taxes or there are no differences in the tax rates applicable to dividends and capital gains.

(vi) The firm has a rigid investment policy.

(vii) Risk of uncertainty does not exist.

14. Mention the Assumption of Walter’s Model.

Ans: Assumption of Walter’s Model:

(i) The investment of the firm are financed through retained earnings only and the firm does not use external sources of funds.

(ii) The internal rate of return (R) and the cost of capital (K) of the firm are constant.

(iii) Earnings and dividends do not change while determining the value.

(iv) The firm has a very long life.

15. Mention three Criticism of Walter’s Model

Ans: Criticism of Walter’s Model:

(i) The basic assumption that investments are financed through retained earnings only is seldom true in real world. Firms do raise funds by external financing.

(ii) The internal rate of return, i.e. (R) also does not, remain constant. As a matter of fact, with increased investment the rate of return also changes.

(iii) The assumption that cost of capital (K) will remain constant also does not hold good. As a firm’s risk pattern does not remain constant, it is not proper assume that K will always remain constant.

16. What are the sources of Bonus Issues?

Ans: The bonus shares can be issued out of the following:

(i) Balance in the profit and loss account.

(ii) General reserve.

(iii) Capital reserve.

(iv) Balance in sinking fund reserve for redemption of debentures after the debentures have been redeemed.

(v) Capital redemption reserve account.

(vi) Share premium received in cash.

17. What is Payout Ratio?

Ans: The payout ratio is a financial metric showing the proportion of earnings a company pays its shareholders in the form of dividends, expressed as a percentage of the company’s total earnings. On some occasions, the payout ratio refers to the dividends paid out as a percentage of a company’s cash flow. The payout ratio is also known as the dividend payout ratio.

18. What are the features of payout ratio?

Ans: The features of payout ratio are:

(i) The payout ratio, also known as the dividend payout ratio, shows the percentage of a company’s earnings paid out as dividends to shareholders.

(ii) A low payout ratio can signal that a company is reinvesting the bulk of its earnings into expanding operations.

(iii) A payout ratio over 100% indicates that the company is paying out more in dividends than its earning can support, which some view as an unsustainable practice.

(iv) The payout ratio is a key financial metric used to determine the sustainability of a company’s dividend payment program. It is the amount of dividends paid to shareholders relative to the total net income of a company.

19. What Does the Payout Ratio Tell You?

Ans: The payout ratio is a key financial metric used to determine the sustainability of a company’s dividend payment program. It is the amount of dividends paid to shareholders relative to the total net income of a company. Generally, the higher the payout ratio, especially if it is over 100%, the more its sustainability is in question. Conversely, a low payout ratio can signal that a company is reinvesting the bulk of its earnings into expanding operations. Historically, companies with the best long-term records of dividend payments have had stable payout ratios over many years.

20. What is considered an ideal payout ratio?

Ans: From the point of view of a dividend investor, a range between 35% and 55% is considered to be healthy and does not raise any red flags pertaining to the company’s performance.

21. How Is the Payout Ratio Calculated?

Ans: The payout ratio shows the proportion of earnings a company pays its shareholders in the form of dividends, expressed as a percentage of the company’s total earnings. The calculation is derived by dividing the total dividends being paid out by the net income generated. Another way to express it is to calculate the dividends per share (DPS) and divide that by the earnings per share (EPS) figure.

22. Is There an Ideal Payout Ratio? What does a low payout ratio indicate?

Ans: There is no single number that defines an ideal payout ratio because the adequacy largely depends on the sector in which a given company operates. Companies in defensive industries tend to boast stable earnings and cash flows that are able to support high payouts over the long haul while companies in cyclical industries typically make less reliable payouts, because their profits are vulnerable to macroeconomic fluctuations.

A low payout ratio indicates that a company retains the majority of its earnings and implements the same towards its growth. Most companies, which are just starting out, typically have a low dividend payout ratio.

23. What is the dividend payout ratio?

Ans: The dividend payout ratio is the percentage of a company’s earnings that it pays out to its investors as dividend income. This metric has a simple formula:

Total Annual Dividend Payments/Annual Earnings = Dividend Payout Ratio.

Say a company earns $100 million this year and makes $50 million in dividend payments to its shareholders. In this case, its dividend payout ratio would be 50%.

24. What is a good dividend payout ratio?

Ans: Dividend payout ratios tend to vary by industry. Companies that operate in mature, slower-growing sectors that generate lots of relatively steady cash flow can have higher dividend payout ratios. They don’t need to retain as much money to fund their business for things like opening new stores or building another factory. For financially strong companies in these industries, a good dividend payout ratio is less than 75% of their earnings.

However, companies in fast-growing sectors or those with more volatile cash flows and weaker balance sheets need a lower dividend payout ratio. Ideally, it should be below 50%.

25. What are retained earnings? Write the Features of Retained Earnings.

Ans: Retained earnings are the amount of a company’s net income that is left over after it has paid dividends to investors or other distributions. This leftover amount is what the company retains. If there is a surplus of retained earnings, a business may choose to use this money toward causes that will support its growth. Retained earnings may also be referred to as “unappropriated profit earnings surplus” or “accumulated earnings.”

Retained earnings can be used to determine whether a business is truly profitable. Since these earnings are what remains after all obligations have been met, the end retained earnings are an indicator of the true worth of a company. If the company has retained positive earnings, this means that it has a surplus of incomes that can be used to reinvest in itself. Negative profit means that the company has amassed a deficit and owes more money in debt than what the business has earned.

The important features of retained earnings as a source of internal financing have been summarized below:

(i) Cost of Financing: It is the general belief that retained earnings have no cost to the company.

(ii) Floatation Cost: Unlike other sources of financing, the use of retained earnings helps avoid issue-related costs.

(iii) Control: Use of retained earnings avoids the possibility of change/ dilution of the control of existing shareholders that results from issue of new issues.

(iv) Legal Formalities: Use of retained earnings does not require compliance of any legal formalities. It just requires a resolution to be passed in the annual general meeting of the company.

26. What is the Retained Earnings Formula? How to calculate retained earnings?

Ans: The RE formula is as follows:

RE = Beginning Period RE + Net Income/Loss — Cash Dividends — Stock Dividends. 

Where RE = Retained Earnings.

The formula for calculating retained earnings is as follows: Retained earnings = Beginning retained earnings + Net income or loss — Dividends.

For example, a company may begin an accounting period with $7,000 of retained earnings. These are the retained earnings that have carried over from the previous accounting period. The company then brings in $5,000 in net income and makes a total payment of $2,000 in dividends. The calculation for this would be $7,000 + $5,000 – $2,000 = $10,000. This means that the company has retained earnings of $10,000 for this accounting period.

The retained earnings of a company accumulate over its life and roll over into each new accounting period or year. If a company is profitable, it will likely have retained earnings that increase each accounting period depending on how the company chooses to use its retained earnings.

27. What are the factors should we considered while interpreting retained earnings?

Ans: When interpreting the retained earnings of a company, consider the following factors:

(i) The age of the company: More senior companies will have had more time to amass retained earnings and therefore should typically have a higher retained earning amount.

(ii) A company’s dividend policy: If a business has committed to regularly giving out dividends, it may have lower retained earnings. Many publicly-held companies make more dividend payments than privately- held companies.

(iii) A company’s profitability: The more profitable a company is, the higher its retained earnings will typically be.

(iv) The seasonality of a company: In industries where the business is highly seasonal, such as the retail industry, companies may need to reserve retained earnings during their profitable periods. This means that a company may have accounting periods with high retained earnings as well as accounting periods with lower or negative retained earnings.

28. Write the argument of MM.

Ans: The argument given by MM in support of their hypothesis is that whatever increase in the value of the firm results from the payment of dividend will be exactly off set by the decline in the market price of shares because of external financing and there will be no change in the total wealth of the shareholders.

This can be put in the form of the following formula:

Po = D1+ P1/1+ ke Or, P1 = Po (1+ ke) – D.

Where,

Po = Prevailing market price of a share.

D1 = Dividend to be received at the end of the period.

P1 = Market price of share at the end of the period.

Ke = Cost of equity capital.

Computation of number of shares to be issued:

MP1 = I– (X– ND1) or M = I- (XND1) /P1.

Where,

M = Number of shares to be issued.

P1 = Price at which new issue is to be made.

I = Amount of investment required.

X = Total net profit of the firm during the period.

ND1 = Total dividend paid during the year.

29. Mention six criticism of MM Approach.

Ans: Criticism of MM Approach:

(i) Perfect capital market does not exist in reality.

(ii) Information about the company is not available to all the persons.

(iii) The firm have to incur flotation costs while issuing securities.

(iv) Taxes do exist and there is normally different tax treatment for dividends and capital gains.

(v) The firms do not follow a rigid investment policy.

(vi) The investors have to pay brokerage, fees, etc. while doing any transaction.

30. What are the assumption of Gordon’s Approach?

Ans: The assumption of Gordon’s approach are:

(i) The firm is an all equity firm.

(ii) No external financing is available or used. Retained earnings represent the only source of financing investment programmes.

(iii) The rate of return on the firm’s investment r, is constant.

(iv) The retention ratio, b, once decided upon is constant. 

Thus the growth rate of the firm g = br, is also constant.

(v) The cost of capital for the firm remains constant and it is greater than the growth rate, i.e. K > br.

(vi) The firm has perpetual life.

(vii) Corporate taxes do not exist. 

According to this model, the market price of a share is calculated as follows:

P = E(1— b)/ Ke – br

Where,

P = Market price of equity share.

E = Earnings per share of the firm.

b = Retention ratio, i.e. (1– pay out ratio).

r = Rate of return on investment of the firm.

K = Cost of equity share capital, and.

br = Growth rate = g.

LONG TYPE QUESTIONS & ANSWERS

1. Discuss the various determinants of Dividend Policy. Explain the various types of Dividend Policy.

Ans: Following are the important factors which determine the dividend policy of a firm:

(i) Legal Restrictions: Legal provisions relating to dividends as laid down in sections 93. 205, 205 A, 206 and 207 of the companies Act, 1056 are significant because they lay down a framework within which dividend policy is formulated. This provisions require that dividend can be paid only out of current profits or past profits after providing for depreciation or out of the moneys provided by Government for the payment of dividends in pursuance of a guarantee given by the Government. The companies Rules, 1975 require a company providing more than ten percent dividend to transfer certain percentage of the current year’s profits to reserves. Companies Act, further provides that dividends cannot be paid out of capital, because it will amount to reduction of capital adversely the security of its creditors.

(ii) Magnitude and Trend of Earnings: The amount and trend of earnings is an important aspect of dividend policy. It is rather the starting point of the Dividend policy. As dividends past years profits, earnings of a company fix the upper limits on dividends. The dividends should generally, be paid out of current years earnings only as the retained earnings of the previous years become more or less a part of permanent investment in the business to earn current profits. The past trend of the companies earnings should also the dividend decision.

(iii) Desire and Type of share holders: Although, legally, the discretion as to whether to declare dividend or not has been left with the Board of Directors, the directors should give the importance to the desires of shareholders in the declaration of dividends as they are the representatives of shareholders. Desires of shareholders for dividends depend upon their economic status. Investors, such as retired persons, widows and other economically weaker persons view dividends as a source of funds to meet their day to day living expenses. To benefit such investors, the companies should pay regular dividends. On the other hand, a wealthy investor in a high income tax bracket may not benefit by high current dividend incomes. Such an investor may be interested in lower current dividends and high capital gains. It is difficult to reconcile these conflicting interests of the different type of share holders, but a company should adopt its dividend policy after taking into consideration the interests of its various groups of shareholders.

(iv) Nature of Industry: Nature of industry to which the company is engaged also considerably affects the dividend policy. Certain industries have a comparatively steady and stable demands irrespective of the prevailing economic conditions. For instance, people used to drink liquor both in boom as well as in recession. Such firms expect regular earnings and hence can follow a consistent dividend policy. On the other hand, if the earnings are uncertain, a in the case of luxury goods, conservative policy should be followed. Such firms should retain a substantial part of their current earnings during boom period in order to provide funds to pay adequate dividends in the recession periods. Thus, industries with steady demand of their products can follow a higher dividend pay out ratio while cyclical industries should follow a lower pay out ratio.

(v) Age of the Company: The age of the company also influences the dividend decision of a company. A newly established concern has to limit payment of dividend and retain substantial part of earnings for financing its future growth and development. While older companies which have established sufficient reserves can afford to pay liberal dividends.

(vi) Future Financial Requirements: It is not only the desires of the shareholders but also future financial requirements of the company that have to be taken into consideration while making a dividend decision. The management of a concern has to reconcile the conflicting interests of shareholders and those of the company’s financial needs. If a company has highly profitable investment opportunities it can convince the shareholders of the need for limitation of dividend to increase the future earnings and stabilize its financial position. But when profitable investment opportunities, do not exist then the company may not be justified in retaining substantial part of its current earnings. Thus, a concern having few internal investment opportunities should follow high pay out ratio as compared to one having more profitable investment opportunities.

(vii) Government’s Economic Policy: The dividend policy of a firm has also to be adjusted to the economic policy of the Government as was the case when the Temporary Restriction on payment of Dividend ordinance was in force. In 1974 and 1975, Companies were allowed to pay dividends not more than 33 percent of their profits or 12 percent on the paid up value of the shares, whichever was lower.

(viii) Taxation Policy: The taxation policy of the Government also affects the dividend decision of a firm. A high or low rate of business taxation affects the net earnings of company and thereby its dividend policy, Similarly, a firms dividend policy may be dictated by the income tax status of its shareholders. If the dividend income of shareholders is heavily taxed being in high income bracket, the shareholders may forego cash dividend and prefer bonus shares and capital gains.

(ix) Inflation: Inflation acts as a constraint in the payment of dividends. Profits as arrived from the profit and loss account on the basis of historical cost have a tendency to be overstated in times of rise in prices due to over valuation of stock in trade and writing off depreciation on fixed assets at lower rates. As a result, when prices rise, funds generated by depreciation would not be adequate to replace fixed assets, and hence to maintain the same assets and capital intact, substantial part of the current earnings would be retained. Otherwise, imaginary and inflated book profits in the days of rising prices would amount to payment of dividends much more than warranted by the real profits, out of the equity capital resulting in erosion of capital.

(x) Control Objectives: When a company pays high dividends out of its earnings, it may result in shareholders. As in case of a high dividend pay out ratio, the retained earnings are insignificant and the company will have to issue new shares to raise funds to finance its future requirements. The control of the existing share holders will be diluted if they cannot buy the additional shares issued by the company. Similarly, issue of new shares shall cause increase in the number of equity shares and ultimately cause a lower earnings per share and their price in the market. Thus, under these circumstances to maintain control of the existing shareholders, it may be desirable to declare lower dividends and retain earnings to finance the firms future requirements.

(xi) Requirements of Institutional Investors: Dividend policy of a company can be affected by the requirements of institutional investors such as financial institutional investors such as institutions, banks insurance corporations, etc. These investors usually favours a policy of regular payment of cash dividends and stipulate their own terms with regard to payment of dividend on equity shares.

(xii) Stability of Dividends: Stability of dividends is another important guiding principle in the formulation of a dividend policy. Stability of dividend simply refers to the payment of dividend regular and shareholders, generally, prefer payment of such regular dividends.

(xiii) Liquid Resources: The dividend policy of a firm is also influenced by the availability of liquid resources. Although, a firm may have sufficient available profits to declare dividends, yet it may not be desirable to pay dividends if it does not have sufficient liquid resources. Hence the liquidity position of a company is an important consideration in paying dividends. If a company does not have liquid resources, it is better to declare stock dividend I, e, issue of bonus shares to the existing shareholders. The issue of bonus shares also amounts to distribution of firms earnings among the existing shareholders with out affecting its cash position.

The various types of dividend policies are discussed as follows: 

(i) Regular Dividend Policy: Payment of dividend at the usual rate is termed as regular dividend. The investors such as retired persons, widows and other economically weaker persons prefer to get regular dividends. A regular dividend policy offers the following advantages.

(a) It establishes a profitable record of the company.

(b) It creates confidence amount the share-holders.

(c) It aids in long-term financing and renders financing easier.

(d) It stabilizes the market value of shares.

(e) The ordinary shareholders view dividends as a source of funds to meet their day to day living expenses.

(f) If profits are not distributed regularly and are retained, the shareholders may have to pay a higher rate of tax in the year when accumulated profits are distributed.

However, it must be remembered that regular dividends can be maintained only by companies of long standing and stable earnings. A company should establish the regular dividend at a lower rate as compared to the average earnings of the company.

(ii) Stable Dividend Policy: The term ‘stability of dividends’ means consistency or lack of variability in the stream of dividend payments. In more precise terms, it means payment of certain minimum amount of dividend regularly.

A stable dividend policy may be established in any of the following three forms:

(a) Constant dividend per share: Some companies follow a policy of paying fixed dividend per share irrespective of the level of earnings year after year. Such firms, usually, create a Reserve for Dividend Equalization to enable them pay the fixed dividend even in the year when the earnings are not sufficient or when there are losses. A policy of constant dividend per share is not suitable to concerns whose earnings are expected to remain stable over a number of years.

(b) Constant pay out ratio: Constant pay-out ratio means payment of a fixed percentage of net earnings as dividends every year. The amount of dividend in such a policy fluctuates in direct proportion to the earnings of the company. The policy of constant pay out is preferred by the firms because it is related to their ability to pay dividends.

(c) Stable rupee dividend plus extra dividend: Some companies follow a policy of paying constant low dividend per share plus an extra dividend in the years of high profits. Such a policy is most suitable to the firm having fluctuating earnings from year to year.

(iii) Irregular Dividend Policy: Some companies follow irregular dividend payments on account of the following:

(a) Uncertainty of earnings.

(b) Unsuccessful business operations.

(c) Lack of liquid resources.

(d) Fear of adverse effects of regular dividends on the financial standing of the company.

(iv) No Dividend Policy: A company may follow a policy of paying no dividends presently because of its unfavourable working capital position or on account of requirements of funds for future expansion and growth.

2. Describe various theories or models of Dividend Policy.

 Ans: Various theories or modes of dividend policy are discussed below:

(i) Theory of irrelevance: Residual Approach: According to this approach, the retained earnings can be used only when sufficient opportunities are available for investments or distribute the entire profits to equity shareholders. There fore it is a financial decision and doesn’t influence the market value of the shares. Thus, the decision to pay dividends or to retain the earnings may be taken as a residual decisions.

(ii) Medallion and Miller Approach: According to M M Approach, the dividend decisions and retained earnings decisions does not influence the market value of the shares. According his observation, “Under conditions of perfect capital markets, rational investors, absence of tax, discrimination between dividend income and capital appreciation, given the firms investment policy, its dividend policy price of the shares.

He advocated his views as the basis of developing a hypothesis under an assumed condition. Lates he proved that dividend decision and the decision of retained earnings are irrelevant in determining the value of the firm will not influence the market value of the shares. However his assumptions were widely criticized by many expert of felt that perfect capital market rational investors and absence of tax doesn’t arise in the real life situation.

Theory of Relevance: According to this theory, the dividend decisions directly influence the value of the firm. If a firm has higher returns than the cost of equity, if it has the opportunities of investing finance for expansion and diversification, can keep certain amount of profits in the form of retaining earnings. This method of financing increases the value of the firm or increases earnings per shares.

If a firms return are equal to the cost of funds which are also known as normal firms, the dividend decisions and the decisions as the retained does not have any bearing as the market value of the shares.

If the firm’s returns less than the cost of funds, the dividend pay out ratio should be more to given higher market value of shares otherwise, investors may prefer to have their investments on some other opportunities which would directly affect the EPS.

Walter’s Model: Prof. Walter in his theoretical work establishes the relationship between IRR (r) internal rate of return and cost of capital (k) and its influence on the dividend decisions to achieve wealth maximization. His observations are presented below.

Assumptions:

(i) The firm uses only retained earnings for financing investment opportunities. It doesn’t use debt or fresh equity issues.

(ii) The internal rate of return (r) and the cost of capital (k) remain constant.

(iii) Earnings and dividends do not change while determining the market value of shares (p).

(iv) The firm has a long life.

Walter’s Formulate for calculating the Market value of shares.

P = D/K + r(E – D)k / K.

Or

P = D + (E– D) r/k / K.

Where,

P market price per share.

D Dividend per share.

R Internal rate of return.

E Earnings per share.

K Cost of capital.

Gordon’s Model: Gordon has also developed a model which is based on the same lines of prof. Walter. He too tresses that the dividend policy of the company has a direct bearing on the market value of shares. The only difference one can find in Gordon’s model is, “The market value of a share is equal to the present value of infinite stream of dividends to be received by the share.”

Assumptions:

(i) Like walter model, Gordon model also has the relevance of investment decisions on the dividend decisions.

(ii) The rate of return on this firms investment is constant.

(iii) The firm operates its investment activities only through equity.

(iv) Gordon’s model ignores risk involved in investments and assumes the discount rate of firm remain constant.

(v) The corporate taxes does not exist.

(vi) The retention ratio, Once decided in constant for ever.

(vii) The firm has perpetual life.

Formula = P = k(1– b) /ke– br.

Or

P = D / ke-g.

Where,

P Price of shares.

E Earnings per share.

B retailed earnings.

Ke cost of equity capital.

Br g = growth rate.

3. What is the cost of retained earnings? How is cost of new equity issues determined?

Ans: The cost of retained earnings is the cost to a corporation of funds that it has generated internally. If the funds were not retained internally, they would be paid out to investors in the form of dividends. Therefore, the cost of retained earnings approximates the return that investors expect to earn on their equity investment in the company, which can be derived using the capital asset pricing model (CAPM). The CAPM combines the risk-free rate and a stock’s beta to arrive at the cost of equity capital. Cost of New Equity (also known as floatation cost) is the cost associate with issuing new stock to the capital market in order to raise more funds. Floatation cost will increase the cost of new equity, as a result, it will be higher than the existing equity in the same company. It includes other costs such as underwriting fees, registration, legal fees, and other costs. These fees will impact the amount of capital to be raised.

Cost of New Equity Formula: The cost of new equity will be calculated by using the dividend growth model:

4. Discuss the various types of Reserve.

Ans: Reserves are usually classified into two categories: general reserves and specific reserves. These may again be classified as revenue reserves and capital reserves.

(i) General Reserve: A general reserve is that part of the profits which is set aside to meet any future unknown contingency or emergency. It is also known as contingency reserve.

A general reserve may be created:

(a) To meet the increasing demands of the business.

(b) Destabilize the economic conditions of the firm.

(c) To meet unforeseen losses and.

(d) To control the profits of the company.

(ii) Specific Reserve: It is a reserve which is created for some definite or specific purpose, I, e, Dividend Equalization Reserve. Reserve for Repaid, Reserve for cut standing Expenses, Reserve for Building etc.

(iii) Revenue Reserve: These reserves consist of uncontributed revenue gains consisting of profits made in the ordinary course of business. The funds of these reserves may be used to maintaining a business or pay dividends. Revenue reserves are Free Reserves that are available for distribution as profits.

(iv) Capital Reserves: These reserves are not available for distribution among shareholders as dividends, They are created to strengthen the financial position of the company. Capital reserves are built out of capital profits and not out of business profits.

Such as:

(a) Profit prior to in corporation.

(b) Premium on issue of shares or debentures.

(c) Profit on redemption of debentures.

(d) Profit on forfeited shares.

(e) Profit or sale of fixed assets, and

(f) Profit on revaluation of fixed assets.

(v) Valuation or Assets Reserves: Valuation reserves are set up to off set the loss of value of some assets, such as plant and machinery, accounts, receivables, investments, marketable securities and patents and intangibles which have a limited life.

(vi) Proprietary Reserves: Proprietary reserves are elements of ‘padded surplus and are also referred to as surplus or net worth reserves’. They are a part of shareholders.’

(vii) Liability Reserves: These reserves may be provided for current as well as emergency liabilities. Current liabilities are known and are sure to materialize but the extent of the liability or the amount due is not certain. Reserve for taxation is an important example of such reserves. Emergency liabilities, on the other hand, may be non recurring which may be established through transfer from contingency reserves.

(viii) Funded Reserves: A reserves does not mean cash or fund. It is merely a surplus appropriation that is included in shareholders equity. A fund is an actual asset in the form of cash or other investments. When the amount of reserve is invested in securities, etc. it is called funded reserve or reserve fund. A funded reserve protects the working capital position of the company and ensures the availability of funds as and when needed.

(ix) Sinking Fund Reserves: A sinking fund is a fund built up by regular contribution appropriation out of profits and the amount of interest itself. The purpose of sinking fund may be either payment of a liability on a certain day in future or accumulation of fund to replace wasting assets.

(x) Secret Reserves: A secret reserve is a surplus which although exists in a business but is not disclosed in the balance sheet. The management, to be conservation may write down the value of the assets below their fair value for the purpose of creating a secret or holder reserve. Secret reserves may be created by the simple method of showing profits at a figure much lower than the actual. When secret reserves exist, the financial position of the business is much better than what appears from the balance sheet.

5. Explain the various kinds of surplus and their sources.

Ans: The various kinds of surplus and their sources as below:

(i) Earned surplus: In the mind of a lay man, surplus always implies earned surplus. The use of the term surplus as accumulation of past earnings accounts for its common identification with earned surplus.

The main sources of earned surplus are:

(a) Past accumulated profits.

(b) Net profits from business operation at the close each financial year.

(c) Retained earnings including income from business operations as well as non-operational incomes, such as profit on sale of fixed assets.

(d) Conversion of reserves which are no longer required, and

(e) Non-operating income.

(ii) Capital surplus: Capital surplus is that part of the surplus which is not related directly to the operating results of the business.

It results from:

(a) An increase in assets with out a corresponding increase in liability or capital and

(b) A decrease in capital or liabilities with out a corresponding decrease in assets.

(iii) Surplus from unrealized appreciation of assets: During periods of prosperity or boom, the value of fixed assets may increase or intangible values may be added by accounting entries. Such a surplus is not realized because the assets are not actually sold but the effect of an appreciated surplus is created when a company appreciates its assets.

(iv) Surplus from realized appreciation of assets: The sale of assets at prices in excess of book values may result in realized surplus.

(v) Surplus from mergers, Consolidations and reorganizations: In mergers and consolidations, stock may be exchanged for stock and surpluses taken over by the new companies. Since mergers and consolidations are generally accompanied by an upward valuation of assets, the resulting surplus may be larger than the total of that result in an increase in surplus. Even unsuccessful companies may increase their book surplus through a forced reduction in liabilities.

(vi) Surplus from reduction of share capital: In periods of adversity, companies may create a surplus by reducing the liability of their stated capital. This process of creating a surplus involves a number of legal formalities and a sanction of the creditors.

(vii) Surplus from secret reserves: A secret reserve is one which is not disclosed in the balance sheet. Such a reserve may be created by;

This method of creating a surplus is not encouraged because it does not represent a true and fair view of the company’s financial position and provides an opportunity to the management for manipulation and misuse of the company’s funds.

(viii) Paid in surplus: It arises from the issue of shares at premium.

6. What are the different factors influencing the Ploughing Back of Profit? Discuss the various Merits of Ploughing back of profit.

Ans: Various factors influencing the ploughing back of profit are:

(i) Earning capacity: Ploughing back of profit depends largely upon earning capacity of the economy, If a concern does not earn sufficiently, there is no possibility of ploughing back of profits. Usually, greater is the earnings capacity of a company. Larger is the possibility of ploughing back of profits.

(ii) Desire and Type of Shareholders: The policy of ploughing back of profits is also affected by the desire and type of its shareholders. If shareholders largely belong to the class of retired persons, widows and other economically weaker persons, they may desire maximum distribution of profits as dividend. On the other hand, a wealthy investor may not mind if the company retains a portion of profits for futures development.

(iii) Future Financial Requirements: Future financial requirements of the company also affect the policy of ploughing back of profits. If a company has highly profitable investment opportunities for future development, it may plough back its profits more successfully.

(iv) Dividend Policy: There investment of profits depends to a great extent upon the dividend policy of the company. If a company desires to plough back profits of cannot follow a policy of a very high dividend pay out.

(v) Taxation Policy: The taxation policy of the Government also affects the reinvestment of profits. A high or low rate of business taxation affects the net earnings of the company and thereby its reinvestment policy.

Various merits of ploughing back of profit are discussed below:

(a) Advantages to the company:

(i) A cushion to absorb the shocks of economy: Ploughing back of profits acts as a caution to absorb the shocks of economy and business such as depression for the company. A company with reserves can with stand the shocks of trade cycles and the uncertainty of the market with comfort, preparedness and economy.

(ii) Economical method of financing: It acts as a very economical method of financing because the company does not depend upon outsiders for raising funds required for expansion, modernization or growth.

(iii) Aids in smooth and undisturbed running the business: It adds to the strength and stability of the company and aids it is smooth and undisturbed running of the business.

(iv) Helps in following stable dividend policy: Ploughing back of profits enables a company to follow a stable dividend policy. Stability of dividend simply refers to the payment of dividend regularly and a company which ploughs back its profits can easily pay stable dividends even in the year whose there are no sufficient profits.

(v) Flexible financial structure: It allows the financial structure to remains completely flexible. As the company need not raise loans for further requirements if it ploughs back its profits, this further adds to the credit worthiness of the company.

(vi) Makes the company self-dependent or No dependence on fair weather friends: Ploughing back of profits makes the company self-dependent and it has not to depend upon out seeders such as banks, financial institutions, public deposits and debentures. Outsiders are just like fair weather friends which may not allow finance when the company is not doing well. But a company with large reserves will not have to depend upon them.

(vii) Helps in making good the deficiencies of depreciation, etc: Companies with retained earnings can make good the deficiencies in the provision of depreciation, had and doubtful debts, etc. For example, suppose a company provides depreciation at the rate of 10% p.a. on an asset costing Rs. 1 lakh. After 10 years when the asset has become obsolete and a new asset has to be purchased, the amount of depreciation fund may not be sufficient to purchase the new asset because of increase in prices. Say, the cost of asset at that time is Rs. 2 lakhs, the deficiency in the depreciation funds may be met out of the retained earnings.

(viii) Enables to redeem long term liabilities: It enables the company to redeem certain long-term liabilities such as debentures and thus relives the company from the burden of fixed interest commitments.

(b) Advantages to the Shareholders:

(i) Increase in the value of shares: Ploughing back of profits enables a company to adopt a stable dividend earns a good name for the company and the value of its shares goes up in the market. Thus, the value of the shares in the hands of the investors increases and they can dispose off their holdings earning higher profits and also can utilize their holdings as better collateral securities for borrowing from banks and other financial institutions.

(ii) Safety of Investments: Retained earnings provide to the investors an assurance of a minimum rate of dividend. It renders safety to their investment in the company as the company can with stand the shocks of trade cycles and the uncertainty of the financial market with case, preparedness and economy.

(iii) Enhanced earning capacity: With the reinvestment of profits in the business, the earning capacity of a concern is enhanced and the shareholders who are the real owners of the company are benefited.

(iv) No dilution of control: Due to the ploughing back of profits the company need not new shares for the future requirements of capital. This enables the existing shareholders to retain their control. For example a company is not following the policy of ploughing back it needs further capital for expansion. It will have to issue new shares or raise loans. It the existing shareholders are not in a position to buy new shares in the company these will be issued to some other people. Thus, control of the existing shareholders will be diluted.

(v) Evasion of super tax: Ploughing back of profits provides an opportunity for evasion of super tax in a company where the number of shareholders is small.

(c) Advantage to the society or Nation: Ploughing back of profits also offers certain advantages to the society at large, increases the rate of capital formation and thus, indirectly promotes the economic development of the nation as a whole.

(i) Stimulates industrialization: It stimulates industrialization of the country by providing self finances. The society as a whole is benefited by rapid industrialization.

(ii) Increases Productivity: As ploughing back of profits acts as a very economical method of financing for modernization and rationalization, it increases the industrial productivity of the nation. Hence, the scarce resources can be exploited fully for the optimal benefit of the people at large.

(iii) Decreases the rate of industrial failure: Retained earnings add to the strength and stability of the business enterprises which are indispensable for the smooth and undisturbed running of the business. Thus, it helps to decrease the rate of industrial failures in the country.

(iv) Higher Standard of Living: Ploughing back of profits as most economic method of financing increases productivity, facilities greater, better and cheaper production of goods and services. The cost of the goods is decreased and the consumers stand to gain in the form of better quality goods at reduced prices. With the stability and smooth running of the business the employees also gain by way of security of their jobs and increased remuneration. Hence, the society at large is benefited by an increased standard of living.

7. How does financial leverage magnify shareholders’ earnings? Explain.

Ans: How financial leverage magnify shareholder’s earning Financial leverage is also known as Trading on Equity. Trading on Equity refers to the practice of using borrowed funds, carrying a fixed charge, to obtain a higher return to the Equity Shareholders. With a larger proportion of the debt in the financial structure, the earnings, available to the owners would increase more than the proportionately with an increase in the operating profits of the firm.  This is because the debt carries a fixed rate of return and if the firm is able to earn, on the borrowed funds, a rate higher than the fixed charges on loans, the benefit will go the shareholders. This is referred to as “Trading on Equity”

The concept of trading on equity is the financial process of using debt to produce gain for the residual owners or the equity shareholders. The term owes its name also to the fact that the equity supplied by the owners, when the amount of borrowing is relatively large in relation to capital stock, a company is said to be trading on equity, but where borrowing is comparatively small in relation to capital stock, the company is said to be trading on thick equity. Capital gearing ratio can be used to judge as to whether the company is trading on thin or thick equity.

Impact of Financial leverage on EPS: The EPS is affected by the degree of financial leverage. If the profitability of the concern in increasing then fixed cost funds will help in increasing the availability of profits for equity shareholders. Therefore, financial leverage is important for profit planning. The level of sales and resultant profitability is helpful in profit planning. An important tool of profit planning is break-even analysis. The concept of break-even analysis is used to understand financial leverage. So, financial leverage is very important for profit planning.

8. Discuss the Advantage of Issue of Bonus Share. Explain the SEBI’S Guidelines for Bonus Share.

Ans: A. Advantages from the viewpoint of the company:

(i) It makes available capital to carry on a larger and more profitable business.

(ii) It is felt that financing helps the company to get rid itself of market influences. 

(iii) When a company pays bonus to its shareholders in the value of shares and not in cash, its liquid resources are maintained and the working capital of the company is not affected.

(iv) It enables a company to make use of its profits on a permanent basis and increases credit worthiness of the company.

(v) It is the cheapest method of raising additional capital for the expansion of the business.

(vi) Abnormally high rate of dividend can be reduced by issuing bonus shares which enables a company to restrict entry of new entrepreneurs into the business and thereby reduces completion.

(vii) The balance sheet of the company will reveal a more realistic picture of the capital structure and the capacity of the company.

B. Advantages from the view point of Investors or share holders: It is generally said that on investor gains nothing from the issue of bonus shares. It is so because the shareholders receives nothing except some additional share certificates. But his proportionate ownership in the company remains unchanged.

For example, say a company has 10,000 equity shares of Rs. 10 each. Out of which Mr. A owns 1, 000 shares. Now the company issues bonus shares at the rate of 1 share for every 2 shares held in the company. After the bonus issue, the total share capital of the company shall be 10, 000 + 5,000 = 15,000 shares of Rs. 10 each of which Mr. A shall own, 1000 + 5000 = 1, 5000 shares. His proportionate ownership prior to the bonus issue was 1,000 /10,000 ×100 = 10%.

And after the bonus issue, his proportionate ownership shall be 1,500 /15,000 ×100 = 10%.

To sum up the advantages to the shareholders are:

(i) The bonus shares are a permanent source of income to the investors as it is only the capital that increase and not the actual resources of the company. The earnings do not usually in crease with the issue of bonus shares. Thus, if a company earns a profit of Rs. 20,00,000 against a share capital of Rs. 5, 00, 000 and the capital of the company is raised by the issue of bonus shares to Rs. 8 00,000 the rate of dividend falls from 40% to 25%.

(ii) The fall in the future rate of dividend results in the fall of the market price of shares considerably. This may cause unhappiness among the share holders.

(iii) The reserves of the company after the bonus issue decline and leave lesser security to investors.

(iv) The issue of bonus shares reads to speculative dealings in the company’s shares.

Following are the Guidelines prescribed by SEBI: 

(i) Bonus Issue from free Reserves: The bonus issue is made out of free reserves built out of the genuine profits or share premium collected in cash only.

(ii) Reserves by Revaluation: Reserves created by revaluation of fixed assets cannot be used for bonus issue. 

(iii) Residual Reserves: Certain reserves such as development rebate or investment allowance reserve is considered as free reserve for the calculation of residual reserve test.

(iv) Other Reserves: The valuate any reserves created by the company such as Depreciation Reserve. Assets Equalization Reserve, created by the company such as Depreciation Reserve. Assets Equalization Reserve, Inflation Reserve, etc. may be eligible for issue of bonuş shares but it is desirable that any such reserve may first be transferred to General Reserve before capitalization Reserves like Export Reserve and Profits not transferred to any Reserve are free reserves eligible for capitalization.

(v) Contingent Liabilities: All contingent liabilities disclosed in Audited Accounts which have bearing on the net profits, shall be taken into account in the calculation of the residual reserves.

(vi) Residual Reserve Test: The residual reserves after the proposed capitalization shall be at least 40 per cent of the increased paid up capital.

(vii) Rate of Return Test: 30 percent of the average profits before tax of the company for the previous three years should yield a rate of dividend on the expanded capital base if the company at 10 percent.

(viii) Capital Reserve: The capital reserve appearing in the balance sheet of the company as a result of revolution of assets or without accrual of cash resources are neither capitalized nor taken into account in the computation of the residual reserves of 40 per for the purpose of bonus issues.

(ix) Bonus in lieu of Dividend: The declaration of bonus issue, in lieu of dividend, is not make.

(x) Partly paid shares to be Made Fully paid: The bonus issue is not made unless the partly paid shares, if any existing, are made fully paid— up.

(xi) Interest and Statutory Dues Paid: They company should not have defaulted in payment of interest or principal in respect of fixed deposits and interest on existing debentures or principal on redemption there of. It also has sufficient reason to believe that it has not defatted in respect of the payment of statutory dues of the employees such as contribution to proyident fund, gratuity, bonus etc.

(xii) Bonus Decisions Implementation: A company which announces its bonus issue after the approval of the Board of Directors must implement the proposal within a period of 6 months from the date of such approval and shall not have the option of changing the decision. In this connection the company should, as per the listing agreement with stock Exchange, give intimation to the stock Exchange 48 hours before the day of the Board Meeting in which a bonus issue proposal is listed for consideration and forward to the stock exchange necessary particulars of the bonus issue immediately after the Board Meeting.

(xiii) Provision in Articles of Association: There should be provision in the Articles of Association of the company capitalization of reserves etc. and if not, the company shall pass a resolution at its General Body Meeting making provisions in the Articles of Association for capitalization.

(xiv) Increase in Authorized capital: If the subscribed and paid up capital exceeds the authorized share capital after the bonus issue, a Resolution shall be passed by the company at its General Body meeting for increasing the authorized capital.

(xv) Approval of Bonus Issue: The company shall get a Resolution passed at its General body Meeting for Bonus issue and in the said Resolution the management’s intention regarding the rate of dividend to be declared in the year immediately after the bonus issue should be indicated.

(xvi) No Dilution of Debentures, Rights: No bonus issue shall be made which will dilute the value of rights of fully convertible and partly convertible debentures.

(xvii) Certificate of compliance: A company proposing to issue bonus shares shall certify that the terms and conditions for issue of bonus shares as laid down in the Guidelines of SEBI vide press release date 13.4.1994 modifying the earlier guidelines issued by SEBI dated 11.6 1992 have been complied with which will be countersigned by the company’s auditors Dr. by a company secretary in practice. The said certificate shall be submitted to SEBI obtained from SEBI.

9. Discuss the significance or importance or advantages of Stable Dividend Policy.

Ans: Following are the main advantages of stable dividend policy:

(i) Confidence among shareholders: When shareholders get regular and stable dividend from their investment they have full confidence in the management of the company. Such companies have high reputation in the capital market.

(ii) Stability in share prices: A stable and regular dividend keep speculation away and prices of shares remain stable for long period.

(iii) Easy mobilisation of resources from capital market: A company which follows stable dividend policy commands the confidence of the investors, therefore, whenever such company needs additional resources, these can be mobilised by issue of new shares to the existing shareholders on rights basis or through public offer.

(iv) Good growth prospects: When a company follows stable dividend policy then it keeps a part of earnings in the business and these can be used for expansion and diversification of the business and if there is need of additional resources these can be mobilised from capital market.

(v) Helpful in long-term financial planning: The company management can formulate easily long term financial plans because financial resources and their sources of supply can be estimated and planned.

(vi) Institutional support: Long-term financial institutions easily support to those companies which follow stable dividend policy and there is not speculation in share prices.

10. What is Reserve? How are Reserves Classified?

Ans: The portion of surplus to be set aside for specific purpose is called reserve – the amount may be set aside to cover any liability, contingency, contingency or depreciation in the value of assets. Technically speaking, the amount set aside out of profits may be either (i) a ‘provision’ or (ii) a ‘reserve’.

Provision shall mean any amount written off or retained by Way of providing for depreciation, renewals or diminution in value of assets, retained by way of providing for any known liability of which the amount cannot be determined with substantial accuracy.

The term ‘reserve’ also includes other surpluses which are not designed to meet any known liability, contingency, commitment or diminution in the value of assets. A reserve is not a charge against profits, but an appropriation of profits.

Reserves are usually classified into two main categories: general reserves and specific reserves. These may again classified as revenue reserves and capital reserves.

(i) General Reserve: A general reserve is that part of the profits which is set aside to meet any future unknown contingency or emergency. It is also known as contingency reserve. 

A general reserve may be credited:

(a) To meet the increasing demands of the business.

(b) To stabilise the economic conditions of the firm.

(c) To meet unforeseen losses, and.

(d) To control the profits of the company.

(ii) Specific Reserve: It is a reserve which is created for some definite or specific purpose i.e. dividend equalization reserve, reserve for repair, reserve for outstanding expenses etc.

(iii) Revenue Reserve: These reserves consist of uncontributed revenue gains consisting of profits made in the ordinary course of business. The funds of these reserves may be used to maintain a business or pay dividends. Revenue reserves are free reserve, that are available for distribution among shareholders as dividends.

(iv) Capital Reserve: Capital Reserve are not available for distribution among share holders as dividends. They are created to strengthen the financial position of the company.

Capital reserves are built out of capital profits and not out of business profits, such as:

(a) Profit prior to incorporation.

(b) Profit on sale of fixed assets.

(c) Profit or revaluation of fixed assets.

(d) Profit on issue of shares or debentures.

(e) Profit on redemption of debentures.

(f) Profit on forfeited shares.

Some other important types of reserves are as follows:

(a) Valuation or assets reserves: Valuation reserves are set up to off set the loss of value of some assets, such as plant and machinery, accounts receivables, investments, marketable securities and patents and intangibles which have a limited life.

Such reserves are created with objectives of:

(i) To reduce assets to their estimated realisable values.

(ii) To provide for losses arising out of bad debts and.

(iii) To provide for losses arising out of obsolescence. 

(b) Proprietary Reserves: Proprietary Reserves are elements of padded surplus and are also referred to as surplus or net worth reserves. 

They are a part of shareholders’ equity which may be set up for the following purposes:

(i) To provide for working capital.

(ii) To provide for expansion and promotion.

(iii) To provide hedge against uncertainty.

(iv) To equalise dividends.

(c) Liability reserves: These reserves may be provided for current as well as emergency liabilities. Current liabilities are known and are sure to materialise but the extent of the liability or the amount due is not certain reserves for taxation is an important example of such reserves.

(d) Sinking Fund Reserves: A sinking fund is a fund built up by regular contribution/ appropriation out of profits and the amount of interest on such contributions and the interest itself. The purpose of sinking fund may be either payment of a liability on a certain day in future or accumulation of funds to replace wasting assets.

11. Discuss Secret Reserves with its advantages and Disadvantages. 

Ans. A secret reserve is a surplus which although exists in a business but is not disclosed in the balance sheet. The management, to be conservative, may write down the value of the assets below their fair value for the purpose of creating a secret or hidden reserve’. Secret reserves may be created by the simple method of showing profits at a figure much lower than the actual. When secret reserves exist, the financial position of the business is much better than what appears from the balance sheet. 

Methods of creating secret reserves: Secret reserves may be created by any of the following methods:

(i) Writing off excessive depreciation.

(ii) Charging capital expenditure as revenue expenditures.

(iii) An understatement of income.

(iv) An undervaluation of closing stock.

(v) An undervaluation of assets.

(vi) An overstatement of liabilities.

(vii) Capitalising revenue receipts; and

(viii) Showing contingent liabilities as actual liabilities.

Advantages of secret reserves:

(i) It is a means for stabilising dividends.

(ii) It ensures better financial position.

(iii) It helps to hide out profits from the existing and potential competitors.

(iv) It acts as a cushion during the rainy days and save business from collapse. and

(v) It increases the actual capital employed in the business and improves the profitability.

Disadvantages of secret reserves:

(i) Balance sheet does not reveal the true and fair position of the business.

(ii) Investors cannot make their buying and selling decisions correctly.

(iii) Management can conceal its inefficiency.

(iv) It provides an opportunity to the management for manipulation and misuse of the company’s funds.

12. What do you mean by ploughing back of profits or Self Financing or Internal Financing? What are its Advantages and Disadvantages?

Ans. The process of creating savings in the form of reserves and surplus for its utilisation in the business is technically termed as ‘ploughing back of profits’. It is a management tool under which the entire profits are not distributed amongst the owners of capital, but a part of the earned profit is ploughed back or retained to be utilised in future for financing schemes of betterment or development and/or for meeting the special fixed or working capital requirements of the company. Ploughing back of profit is also known as ‘self financing’ or ‘internal financing’.

Advantage of ploughing back of profits: Ploughing back of profits provides a number of advantages to the company to the shareholder and the society at large.

These are as follows:

A. Advantages to the company:

(i) A cushion to absorb the shocks of economy: Ploughing back of profits acts as a cushion to absorb the shocks of economy and business such as depreciation for the company. A company with large reserves can withstand the shocks of trade cycles and the uncertainty of the market with comfort preparedness and economy. 

(ii) Economical method of financing: It acts as a very economical method of financing because the company does not depend upon outsiders for raising funds required for expansion, rationalisation.

(iii) Aids in smooth and undistributed running of the business: It adds to the strength and stability of the company and aids it in smooth and undisturbed running of the business.

(iv) Help in stabilising the dividend policy: It enables a company to follow a stable dividend policy. Stability of dividend simply refers to the payment of dividend regularly and a company which ploughs back its profits can easily pay stable dividends even in the years when there are no sufficient profits.

(v) Flexible financial structure: It allows the financial structure to remain completely flexible. As the company need not raise loans for further requirement if it plough back its profits, this further adds to the credit worthiness of the company.

(vi) Enables to redeem long term liabilities: It enables the company to redeem certain long term liabilities such as debentures and thus relieves the company from the burden of fixed interest commitments.

B. Advantages to shareholders or investors:

(i) Increase in market value of securities: Due to regular dividend payment at a more or less stable rate, the company earns a repute and the market value of its shares goes up. Hence, if any shareholder requires hard cash, he can conveniently dispose off his holdings at a high price and earn the difference.

(ii) Safety of investments: Retained earnings provide to the investors an assurance of a minimum rate of dividend. It renders safety to their investment in the company as the company easily withstand, seasonal reactions and business fluctuations.

(iii) Enhanced earning capacity: With the reinvestment of profits in the business, the earning capacity of a concern is enhanced and the shareholders who are the real owners of the company are benefited.

(iv) Evasion of income tax: It provides an opportunity for evasion of super tax in a company where the number of shareholders is small.

C. Advantages to the society or nation:

(i) Increases the rate of capital formation: The policy of retained earnings increases the rate of capital formation and thus, indirectly promotes the economic development of the nation as a whole.

(ii) Increases productivity: As ploughing back of profits acts as a very economical method of financing for modernisation and rationalisation, it increases the industrial productivity of the nation. Hence the scarce resources can be exploited fully for the optimal benefit of the people at large.

(iii) Stimulates industrialisation: It stimulates industrialisation of the country by providing self finances. The society as a whole is benefited by rapid industrialisation.

(iv) Higher standard of living: It is the most economic method of financing as it increases productivity, facilitates greater, better and cheaper production of goods and services. When goods and services at a reduced price are made available to the society, naturally the living standard must increase. Hence, the society at large is benefited by an increased standard of living.

Disadvantages of self financing: The limitations of self financing are as follows:

(i) Creation of monopolies: Continuous reinvestment of earnings may lead a company to grow into monopoly with all its evils. The company may expand to such limits that it becomes uncontrollable.

(ii) Depriving the freedom of the investors: The policy of ploughing back of profits limits the amount of dividend payable to shareholders and this may frustrate the shareholders as they are deprived of the freedom to invest their earnings in better securities.

(iii) Dissatisfaction among the shareholders: The existing shareholders may be dissatisfied with the excessive retention of profits as it reduces their dividend rate.

(iv) Evasion of taxes: Certain companies retain earnings with a view to evade super profits tax. Such evasion of taxes reduces the revenue of the government and is determinal to the interests of the nation as a whole.

(v) Misuse of retained earnings: The management may not utilise the retained earnings to the advantage of shareholders at large as they have the tendency to misuse the retained earnings by investing them to unprofitable areas.

(vi) Over capitalisation: Over capitalisation means more capital than actually required. Excessive ploughing back of profits may lead to over capitalisation and the earnings of the company may not be sufficient to have a normal rate of return on capital employed by it.

13. What do you understand by bonus issue? What are its Merits and Demerits ?

Ans. Bonus issue means conversion of the company’s accumulated profits into share capital. Such shares are issued to the existing shareholders in proportion to their present holdings. It is also called capitalisation of company’s profits. If the equity shares are issued to the existing shareholders as an extra dividend, the issue process is termed as bonus issue.

Merits of bonus issue:

To the company:

(a) It preserves liquidity position: Issue of bonus shares make possible for company to declare an extra dividend without using the cash resources that may be needed for operation of business.

(b) It keeps EPS at reasonable rate: The company having a high EPS may have to face problems both from the workers and consumers. Workers of the company may feel that they are under paid while the consumers may think that they are being charged too much for the company’s products.

(c) Easy marketability of company’s shares: Issue of bonus shares increases the supply of shares which results reduction in market price of shares. The reduction of market price of shares keeps it within the reach of ordinary investors.

(d) It broadens the capital base and improves image of the company.

(e) It is an inexpensive method of raising capital by which the cost resources of the company are not disturbed.

To investors:

(i) Indication of higher future profits: A company issues bonus shares only when its earnings are expected to increase.

(ii) Increase in future dividends: The shareholders will get extra dividends in future even if the existing cash dividend per share is continued.

(iii) Indication of financial soundness: It is a indication to the prospective investors about the financial soundness of the company.

(iv) No tax liability: Receipts of stock dividend as compared to cash dividend generally results in income tax advantage to the shareholders.

Demerits of bonus issue:

(i) Decline in the rate of dividend: The rate of dividend per share decreases as the whole amount of dividend is distributed among large number of shareholders.

(ii) Lengthy process: The process of issue of bonus shares involves a procedural difficulty lengthy legal procedures and approvals.

(iii) Fall in market price of shares: The future market price of shares fall sharply after bonus issue.

14. Write short notes:

(i) Operating cycle concept.

Ans: An operating cycle refers to the time it takes a company to buy goods, sell them and receive cash from the sale of said goods. In other words, it’s how long it takes a company to turn its inventories into cash. The length of an operating cycle is dependent upon the industry. Understanding a company’s operating cycle can help determine its financial health by giving it an idea of whether or not it’ll be able to pay off any liabilities. For example, if a business has a short operating cycle, this means it’ll be receiving payment at a steady rate. The faster the company generates cash, the more it’ll be able to pay off any outstanding debts or expand its business accordingly.

Operating cycle method:

Operating cycle is the duration required to convert sales, after the conversion of resources into inventories and cash. The operation cycle of a manufacturing co involves 3 segments:

(i) Acquisition of resources like raw labour, material, fuel and power.

(ii) Manufacturer of the product that includes conversion of raw material into work in process and into finished goods, and 

(iii) Sales of the product either for cash or credit. Credit sales create book debts for collection (debtors).

The length of the operating cycle of a manufacturing co is the sum of – i) inventory conversion period (ICP) and ii) Books debts conversion period (BDCP) collectively, they are sometimes called as gross operating cycle (GOC).

GOC = ICP + DCP.

(ii) Disadvantages of retained earnings.

Ans: Retained earnings has certain disadvantage:

(i) Misuse: The management by manipulating the value of the shares in the stock market can misuse the retained earnings.

(ii) Leads to monopolies: Excessive use of retained earnings leads to monopolistic attitude of the company.

(iii) Over capitalisation: Retained earnings lead to cover capitalisation, because if the company uses more and more retained earnings,it leads to insufficient source of finance.

(iv) Tax evasion : Retained earnings lead to tax evasion. Since, the company reduces tax burden through the retained earnings.

(v) Dissatisfaction: If the company uses retained earnings as source of finance, the shareholder can’t get more dividends. So, the shareholder does not like to use the retained earnings as source of finance in all situations.

(iii) Dividend payout ratio.

Ans: The dividend payout ratio measures the percentage of net income that is distributed to shareholders in the form of dividends during the year. In other words, this ratio shows the portion of profits the company decides to keep to fund operations and the portion of profits that is given to its shareholders. Investors are particularly interested in the dividend payout ratio because they want to know if companies are paying out a reasonable portion of net income to investors. The dividend payout formula is calculated by dividing total dividend by the net income of the company i.e. Dividend Payout Ratio = Total Dividend/Net income.

15. Discuss the guidelines for determining the Maximum Quantum of Bonus of Bonus Issue.

Ans: The maximum amount which can be capitalised to issue bonus shares in one time is the least amount of given three test, as per the guidelines issued by the Ministry of Finance.

(a) Residual reserve test: Residual reserves after the proposed capitalisation should be at least 40% of the increased paid up capital:

(i) The capital redemption reserve, if any existing in the company will not be included in computing the minimum reserve of 40%.

(ii) All contingent liabilities disclosed in the audited accounts which have a bearing on the net profits shall be taken into account in the calculation of minimum reserve of 40%.

(iii) Development rebate reserve/ investment allowance reserve is considered as free reserves for the purpose of calculation of residual reserve test and is allowed to be capitalised.

(iv) Capital reserve appearing in the balance sheet of the company as a result of revaluation of assets or without actual cash will neither be allowed to be capitalised nor taken into account in the consideration of residual reserves of 40% for the purpose of bonus issue.

Following formula is useful in finding out the maximum amount available for capitalisation after applying the minimum reserve test.

F R – X = 40% (C+X).

Where,

FR = free reserve.

C = Existing paid up capital.

X = Amount to be capitalised.

(b) Capitalised value of earning test: 30% of the average profit before tax of the company for the previous three years should yield a rate of dividend on the expanded capital base of the company at 10%.

The maximum amount that could be capitalised can be arrived at with the help of the given formula.

30% AP = 10% (C+X).

Or

3 AP = C+X, or X = 3AP– C.

Where,

AP = Average profit of last three years.

C = Existing paid up capital.

X = Amount to be capitalised.

(c) Overall maximum limit: At any time, the total amount permitted to be capitalised for issue of bonus shares out of free reserves shall not exceed the total amount of paid up equity capital of the company. It means that the overall maximum limit on issue of bonus shares is one for one.

16. How is the Payout Ratio calculated? How to Interpret a Payout Ratio?

Ans: Payout ratio, more commonly referred to as dividend payout ratio (DPR), is the amount of dividend a company pays out in a specific period in regards to that period’s net earnings. Thus, the payout ratio formula is written as:

Payout ratio = Dividend Payout / Net Income.

Let’s assume Company XYZ announced a dividend payout of Rs.2 lakh for the FY 20 – 21 when its annual income came about to be Rs.10 lakh, according to its Income Statement. Therefore, DPR would be the ratio between Rs.2 lakh and Rs.10 lakh, i.e. .DPR = 200000 /100000 = 0.2 or 20%.

Instead of manual calculation, investors can also resort to utilising a payout ratio calculator to eliminate the chances of miscalculation.

As mentioned previously, the ratio portrays the portion of net income distributed as dividends and the portion retained for other purposes. The percentage of net income that is not used for dividend distribution is called retention ratio.

From this understanding, another formula for the payout ratio can also be derived as follows —

Dividend Payout Ratio + Retention Ratio = 1 [1 represents the whole of net income]

DPR = 1– Retention Ratio.

Considering the above example of Company XYZ, since it distributed 20% of its net income from FY 20 – 21, the remaining 80% of that income is retained for other purposes and is the retention ratio.

The payout ratio is also expressed on a per-share basis. In this formula, both a company’s net income and the total amount of dividends it paid out is divided by the total number of outstanding shares of that organisation. 

Considering the example of Company XYZ, let’s suppose that it has a total of 1 lakh outstanding shares. Thence, since its net income is Rs.10 lakh its earnings per share (EPS) would come to be Rs.10. Similarly, since it paid out Rs.2 lakh as dividends, its dividend per share (DPS) would be Rs.2. Therefore, DPR = 2/10 = 0.2 or 20%.

A payout ratio is one of the most critical metrics for investors on which to base their investment decisions. However, a couple of parameters play a crucial role in the analyses of companies via the stock payout ratio. These are:

(i) Phase of maturity: It denotes at which phase of growth a company is in at any point in time. Analysing this via its payout ratio adds further insight into the soundness of that ratio.

For instance, let’s consider the above example of Company XYZ. It distributed 20% of its net income as dividends for FY 20 – 21. Now, if that company is in the nascent stage of growth, that ratio might be frowned upon by most investors.

That is because, in initial stages, any organisation is expected to utilise almost all its earnings toward further growth rather than dividend distribution. Investors might construe the company’s management to be unsound, and that perception might lead to lowering share prices.

However, if that company has already achieved some level of growth and is in the mid-stages or past that, then such a ratio is well received by investors of all kinds.

(ii) Industry: Another crucial consideration that plays a critical role in payout ratio interpretation is the industry in which a company belongs. 

For instance, companies in highly competitive and ever-evolving industries often exhibit extremely low to zero dividend payments on their stocks. One such example is the tech industry. Companies belonging to that industry need to invest enormous portions of their income into Research & Development to thrive.

Therefore, no single ratio can be pinpointed as ideal across industries. This consideration provides insight into whether a company is merely being frugal with dividend distribution or is required to withhold earnings for further growth.

17. Explain the advantages and disadvantages of retained earning. Give some examples of retained earnings.

Ans: Advantages of Retained Earnings:

(i) These earnings are readily available, and the firm is not required to seek help from the shareholders or lenders in case of urgency of funds.

(ii) The use of retained earnings reduces the cost of issuing the external equity and also eliminates the losses incurred on under-pricing.

(iii) There will be no dilution of control and ownership, in case the firm relies on the retained earnings.

(iv) Generally, the stock market views the equity issue as doubtful and therefore, these earnings do not carry a negative connotation.

(v) Retained earnings are a permanent source of funds available to an organisation.

(vi) It does not involve any explicit cost in the form of interest, dividend or floatation cost.

(vii) As the funds are generated internally, there is a greater degree of operational freedom and flexibility.

(viii) It enhances the capacity of the business to absorb unexpected losses.

(ix) It may lead to increase in the market price of the equity shares of a company.

Disadvantages of Retained Earnings:

(i) The amount raised through the accrual earnings could be limited and also it tends to be highly variable because certain firms follow a stable dividend policy.

(ii) The opportunity cost of these earnings is relatively high because it shows that amount of earnings, which have been foregone by the equity shareholders.

(iii) Some companies do not give much importance to the opportunity cost of these earnings and invest these into sub-marginal projects that have negative NPV.

(iv) The retained earnings are also known by different names, such as accumulated income, accumulated profit, accumulated earnings, earned surplus, undistributed earnings, etc.

(v) There is imbalanced growth as undistributed profits remain in the same industry.

(vi) Since the profits of business fluctuate from time to time, it is an uncertain source of funds.

(vii) Excessive retained earnings causes dissatisfaction amongst the shareholders as this reduces the amount of the dividend receivable by them.

(viii) Frequent capitalisation of reserves may result in over capitalisation.

(x) Many firms fail to recognise the opportunity cost associated with these funds. This results in the sub-optimal use of the funds.

Here are a few examples of how retained earnings can work for companies with shareholders:

(i) No retained earnings due to dividends: An e-commerce bookseller has a majority group of shareholders interested in short-term profits. At the end of each financial quarter, the shareholders all vote for the company’s net income to be paid out in the form of dividends (either as cash or common stock) depending on the number of shares that each stakeholder owns, resulting in no retained earnings.

(ii) No retained earnings due to net loss: A rental company has a particularly bad financial quarter and operates at a net loss for a specific period, generating no profit. As a result, they are unable to either pay dividends or add funds to their retained earnings account.

(iii) Medium retained earnings: A small business selling cupcakes wants to please its shareholders while still growing the company. This financial quarter, it decides to pay out a small number of dividends to its stakeholders and retain a portion of its accumulated earnings for reinvestment to continue strengthening its financial health.

(iv) High retained earnings: A growth-focused tech company attracts shareholders interested in long-term gains rather than short-term economic profits. Each financial quarter, the tech company decides not to pay out common stock or cash dividends to its shareholders. Instead, it builds a large retained earnings balance to invest in new products and software to improve efficiency. The shareholders support this financial model, hoping that the high cumulative retained earnings of the company will result in higher dividends in the future, increasing the long-term profitability of the investment.

18. What are the differences between retained earnings and revenue? Give the formula of retained earnings.

Ans: In microeconomics, retained earnings and revenue are related concepts with very different applications. They differ in:

(i) Variables: Retained earnings and revenue use different formulas to calculate different amounts of money for a company. Retained earnings are the net income after dividends have been distributed, while revenue is simply the amount of income a company generates before subtracting expenses and costs.

(ii) Uses: Retained earnings and revenue are used in very different ways. Revenue is a more general number (displayed at the top of a company’s balance sheet, income statement, or other financial statements) used to determine how much income a business’s operations generate over time. It doesn’t accurately represent how much money the business has on hand. Retained earnings calculations are much more granular (displayed in the stockholders’ equity section of the balance sheet), subtracting costs and dividend payments to determine how much money the company has to reinvest in its operations.

(iii) Relationship: Since revenue is a much more general number, it will always be significantly larger than retained earnings, which subtract costs and dividends to come to a smaller and more precise figure.

The retained earnings of a company refer to the profits generated, and not issued out in the form of dividends, since inception.

On the balance sheet, the retained earnings line item is recorded within the shareholders’ equity section.

The formula used to calculate retained earnings is equal to the prior period retained earnings balance plus net income. And from that figure, the issuance of dividends to equity shareholders is subtracted.

Retained Earnings current period = Retained Earnings prior period + Net Income – Dividends.

In effect, the equation calculates the cumulative earnings of the company post-adjustments for the distribution of any dividends to shareholders.

The prior period retained earnings balance can be found on the beginning of period balance sheet, whereas the net income is linked from the current period income statement. 

Dividend issuances can be obtained from a variety of financial reports such as:

Statement of Changes in Equity.

Retained Earnings Statement.

Income Statement – Listed in the Section Below Net Income.

19. Distinguish between financial leverage and operating leverage?

Ans: