fm_prof sango notes

8/9/2019 FM_prof sango notes

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Sandeep Gokhale

Jamnalal Bajaj InstituteUniversity of Mumbai



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References

Financial Management

Authors :• Khan & Jain• Prasanna Chandra• I.M.Pandey• S.C.Kuchhal• Maheshwari



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Syllabus

• Ratio Analysis• Fund & Cash flow analysis• Cost of Capital• Working Capital Mgmt.• Means of Financing• Capital Budgeting• Dividend Structuring

• Bonus Shares• Share Holder Value

Measurement



4

FINANCIAL MANAGEMENT

Objective: Create share holder value Methodology: Capturing of value at all Levels.

Business Process restructuring

Enterprise resource management.Vertically integrated operations.

Customer relationship Management

Sustained up scaling of operations

Effectiveness: Proximity of gross profit to net profit

Maximisation of EVA

EV / EBIDTA multiple



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Financial Management – an Overview

Business environment

Planning Policies&Decisions

(Management Accounting)

Restructuring

Resource Mobilisation

Treasury

Control&Information

( Audit & Taxation)

Valuation Technique

FinancialMarkets

Investor WishList



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Environmental scan

Economy : Convertibility of Local Currency

GDP / Industrial growth rate

Scalability of Operations

FDI – Incoming / outgoing

Inflation rate / Fiscal deficit

Trade surplus/deficits

Balance of payment status

WTO Implications

Emerging markets scenario

Gross national income distribution



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Government Policy : Industrial policy

Government programmes and projects

Tax regime

Subsidies, incentives and concessions

Exim policies / VAT

Government Expenditure

Lending considerations of financialinstitutions and commercial banks

Infrastructure Development

Rating of Govt paper

Agricultural policies



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Technology: Emergence of new technologies.

Access to technical Up gradation

Level of obsolescence.

Socio Demographic : Population trends

Age shifts in population

Educational profile.Attitudes toward consumption and investment



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Competition : Number of players in the industry and their market share.

Duty barrier and status of international costand volume positioning.

Degree of homogeneity and differentiationamong products.

Entry barriers for new capacities.

Comparison with substitute products.

Unorganised sector operations.

Marketing polices and practices.



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ORGANISATIONAL INTERFACE OF FINANCE

Areas Interface

Corp planning: Long term financial goals in terms of assets, sales,profits,dividends etc.

Expansion, new projects diversifications

takeovers , mergers,disinvestments.

Internal generation, tax planning.

Operations: Integrating functional plans.

Working capital management



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Areas Interface

Control: Budgetary control of all divisions

Variance analysis

Marketing: Credit norms

Cost analysis of decisions like discounts , premium pricing,product promotion etc.

Manufacturing: Budgeting for manufacturing operations.

Product mix decisions.

Personnel: Budgeting for personnel & administrative

function.



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FINANCIAL FUNCTION

Money Mgmt Accounting Control Advisory Role

Resource

Mobilisation

Financial

Accounting

Budget s Project

Financing

Working CapitalMgmt

CostAccounting

VarianceAnalysis

Pricing

Investment

Mgmt

MgmtAccounting

Profit Center Div. Policy

Valuation of Assets

Cost Center



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Financial Decision Areas

• Investment analysis• Working capital management• Sources and cost of funds

• Determination of capital structure• Dividend policy• Analysis of risks & returns• Treasury - interest / exchange rate swaps

• Restructuring of operations / term debt profile• Equity buyback / Bonus

• To result in shareholder wealth maximisation



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PROFIT AND LOSS ACCOUNT

For the Period 1st April to March 31st

Income: Gross sales from Goods & Services

Less: Excise Duty

Net Sales

Other Income

Non operating IncomeTotal Income



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Expenditure : Raw materials consumed

Manufacturing expenses

Administrative expensesSelling expenses

WIP +FG adjustment

PBIDT (Gross Profit)Less: Interest

Less Depreciation

PBT (Operating Profit)

Less: Tax

PAT (net profit)

Gross cash accruals : PAT + Depn

Net cash accruals : GCA - Dividend



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THE BALANCE SHEET

For the year ended March 31st 00...

Liabilities : Equity share capital

Reserves & Surplus

Term loan

Debentures

Fixed deposits

Other unsecured loans

Commercial bank borrowings

Creditors

Other current liabilities



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Assets: Gross fixed assets

Less: Acc. Depn

Net Block Investments

Currents Assets: RM Stock

WIPF.G.Stock

Debtors

Cash in bank Loans & Advances

Misc.. expenditure

Deferred expenditure



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RATIO ANALYSIS

Principal tool for analysis

Inter firm comparison

Intra firm comparison

Industry analysis

Responsibility accounting



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TYPES OF FINANCIAL RATIOS

Liquidity

Leverage

Turnover

Profitability / Valuation



0

LIQUIDITY RATIOS

Current Ratio: Current assets

Current liabilities

Acid test ratio: C.A- Inventories

Current liabilities

Cash position ratio: Cash in bank + hand

Current liabilities

Inventory to G.W.C: Inventory

Current assets



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LEVERAGE RATIOS

Debt / Equity ratio: Long term debt

Net worth

Borrowing / Assets: 1 - Net worth

Total Assets

Fixed asset / Networth : Fixed Assets Net worth



Capital gearing ratio: Capital entitled to fixed return

Capital not entitled to fixed return

Debt. Service coverage ratio: PBDIT - Tax

Interest + Annual installment

Interest coverage ratio: PBDIT - Tax

Interest

F. Asset coverage ratio: Gross fixed asset - Acc. Depn

LT Secured liabilities



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ACTIVITY RATIOS

Total asset turnover: Net salesTotal assets

Fixed asset turnover: Net salesFixed assets

Inventory turnover: Net salesInventory

activity



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Debtors turnover: Credit sales

Avg. debtor

Collection period: Avg. debtor * 365

CR. Sales

Creditors Turnover: Credit purchase

Avg.. Creditors

Payment period: Avg. Creditor * 365

Net sales



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PROFITABILITY / VALUATION RATIOS

Gross profit ratio: PBDIT / SalesEBITDA / Sales

NOPLAT : Net operating profit less adjusted

Tax

ROSE: PAT - Pref. Div

Net worth

Return on CAP. Employed: PBIT

Total Lia - Creditors – Provisions



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Book value per share: Net Worth

NO of Equity Shares

EV / EBITDA: Enterprise value / Gross profit

Earning per share: PAT - Pref Div

No. of Equity shares

Price Earning ratio: Market price

Earnings per share

Pay out ratio: Dividend paid

Profit after Tax



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USERS OF FINANCIAL RATIOS

Lenders of funds for appraising credit worthiness for long term / short

term lending decisions.

Valuations in investment / disinvestment decisions.

Financial analyst / Mutual Funds / Investment Bankers.

Management for operational short / long term planning.

Credit Rating Agencies

Tax authorities

A O S O A O A A S S



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LIMITATIONS OF RATIO ANALYSIS

A ratio in absolute terms has no meaning. It has to be compared.

•Inter firm comparison.

•Companies resort to window dressing of Balance sheets.

•Operating and accounting practices differ from company tocompany.

•Consolidation of group / subsidiary companies figures.

E.G. Changes in Depreciation methods

Inventory Valuation

Treatment of contingent liabilities.

Valuation of investments.

Conversion or transaction of foreign exchange items.

FUND FLOW ANALYSIS



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FUND FLOW ANALYSIS

It is a statement indicating the methods by which a company has beenfinanced and the uses to which it has applied its funds over a period of

time.

It provide an insight into the movement of funds and helps inunderstanding the changes in the structure of asset & liabilities.

Provides information as to how funds are raised and utilised.

Determines need for funds and helps in deciding finance mix

Determines financial consequences of business decisions.

Free cash flow generation ability and Utilisation of the same.



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FUND MANAGEMENT

Mobilisation Requirement

Quantum Source Cost

Normal

Capitalexpenditure

Incremental

Working capital

New

Investments

Equity Buy back

FUND FLOW OCCASIONS



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FUND FLOW OCCASIONS

Sources Uses

Funds from operations Loss from operations

Sale of fixed assets Increase in fixed assets

Increase in liabilities Redemption of liabilities

Sale of securities Purchase of securities

Decrease in W.C Increase In W.C

Cash Dividends, Equity buy back

FUND FLOW



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FUND FLOW

Assets Uses of funds

Liabilities Uses of funds

Assets Source of funds

Liabilities Source of funds

Comparison of balance sheets of consecutive years .



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TYPES OF FUND FLOW STATEMENTS

OVERALL FUND FLOW

OPERATIONAL FUND FLOW

WORKING CAPITAL BASED FUND FLOW

(ONLY STS/STU STATEMENT)

COST OF CAPITAL



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COST OF CAPITAL

Aggregate of the liabilities raised by a company is the total capitalemployed in business.

Different sources have different cost and tax implications.

Cost of capital

It is a single rate (weighted average ) for a finance mix.

It is computed on a post - tax basis since cost of different sourceshave different tax implications

E.g.. Interest on debt capital enjoys tax shield while dividend paidon equity has no tax shield.

COC is used as a discounting rate in DCF analysis.



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RELEVANCE OF COC

•Used as a hurdle rate in DCF analysis.

•Wt. Average cost of capital

•Marginal cost of capital

K0 = Ki + Ke

K0 = WT. Average cost of capital

Ki = Cost of debt capital

Ke = Cost of equity capital



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COST OF CAPITAL

Consists of three components:

•Risk less cost of a particular type of finance (rj)

•Business risk premium(b)

•Finance risk premium(f)

K0 = rj + b + f



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RELATIONSHIP BETWEEN WEIGHTED AVERAGECOST AND MARGINAL COST OF CAPITAL

•Degree of leverage

•Cost of instruments

•Tax Rate / Treatment

WACOC : K0 = Ki1 + Ke1

MCOC : K0 = Ki + Ke1

METHODS OF COMPUTATION OF COST OF



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METHODS OF COMPUTATION OF COST OFEQUITY

ROI approach

Ke = PAT - pref. div + non tax shield portion of depn

Equity block (E + R +S + acc depn)

Market capitalisation approach

Ke = D/P + G

D = Dividend per share G = Growth rate = b*r

P = Market price per share

b= % Retained earnings = PAT - Dividends / PAT

r = % Return on “b” = PAT - Pref div / Net worth



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Capital Asset Pricing model

Ke = Rf +beta ( Rf – Rm)

Rf = risk free rate of returnBeta = stock relationship with a index

Rm = Market expectations of return ( Bloomberg base )



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•If ROI approach is used to determine Ke then book value to be

considered as weights.If market capitalization approach is usedthen market value to be considered as weights.

•All cost to be considered on a post tax basis.

•The market capitalization approach is superior to the ROIapproach since the parameters are market determined andfuturistic as compared to the ROI approach.

•The CAPM approach is a further refinement which also includes premium for risk

•In loss making companies minimum cash flow approach is used.

•Cost of equity could be benchmarked with return onguilts,market risk and portfolio risk ( Asset Beta )



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WORKING CAPITAL MANAGEMENT

Objective: Optimise current asset deployment.

Advantages: Lower interest cost.Inventory holding cost reduced.

Disadvantages: Interruption in production.Stock out to customers.



WORKING CAPITAL



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WORKING CAPITAL

Current assets comprise of stocks of raw materials, work in progress,finished goods, and receivables.

Gross working capital = total current assets.

Net working capital = CA - CL

Objective is to optimse asset requirement and funding the same at

minimal cost.

Working capital

requirementPermanentcomponent

Variable

component )



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OPERATING CYCLE TIME

Time required for rolling or rotation of current assets.

Date of receipt RM issued to Throughput time

of RM production Dept

Collection of Despatched to consumers Converted to FG

Receivables

FACTORS INFLUENCING WORKING CAPITAL



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FACTORS INFLUENCING WORKING CAPITALREQUIREMENTS

• Nature of business

•Manufacturing process

•Competitive forces in raw material & finished goods segment.

•Infrastructural support.

•Through put time

•Seasonality in demand

•Shelf life of RM / Finished product

•Customer relationship management

CREDIT MANAGEMENT



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CREDIT MANAGEMENT

•Terms of payment Cash against delivery

Consignee basis

Proforma invoice

Letter of creditAdvances

Suppliers / Buyers LOC

•Credit policy variables Credit standards

Credit period

Cash Discounts



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•Credit evaluation Character

Capacity

Capital

Collateral

Macro conditions

•Control of accounts Days sales outstanding

receivables Ageing schedule (in days)Collection matrix

Average collection period

RECEIVABLES MANAGEMENT



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RECEIVABLES MANAGEMENT

•Credit standards Collection cost

Average collection period

Bad debts

Level of incremental sale•Credit terms

•Collection policies

•Factoring

CASH MANAGEMENT



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Cash budgets : Quarterly / monthly / weekly

Operating cash inflow/ outflow items:

Cash inflow Cash outflow

Cash sales Accounts payable

Collection of receivables R.M purchase

Salary

factory expenseAdministration/selling exp.

Taxes / Duties



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WORKING CAPITAL FINANCING

•Cash accruals

•Trade credit

•Commercial bank borrowings

Cash credit limit

WCTL

Bill discounting

Letter of credit

Bank guarantee

•Public deposits



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•Short term / medium term loans from FI’s Banks

•Debentures for working capital

•Commercial Paper.•Euro Commercial Borrowings

•Inter Corporate deposits

•Trade credit notes ( commodity exchanges )•Factors

RBI CREDIT AUTHORISATION SCHEME



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1969 Dahejia committee .. recommended nationalisation of

banks

1974 Tandon committee

To curb excessive credit and inflation

•Industry wise norms for eligible current assets.

•MPBF to be determined on the basis of following:

Method 1: 5% of (CA-CL) to be financed from LTSBalance would be MPBF.

Method : 5% of CA to be financed from LTS fromthe balance CL to be deducted to

determine MPBF .



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Method 3: 5% of core current assets from LTS .

•All borrowers were immediately put under method 1 of lending andexcessive CBB converted into WCTL.

•Structured reporting to banks.

•Penal interest provisions.

FAST TRACK APPROCH



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•Credit monitoring arrangement (CMA) instead of CAS.

• Norms for Eligible current assets for computing MPBF will be the industry average.

• No prior approval of RBI required.

•Lesser dependence on bank finance.

1997: Concept of maximum permissible bank finance (MPBF)abolished to ensure efficient credit delivery mechanism ”



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Implications:

Banks free to determine credit limits

Consortium finance abolished

Tandon method - (CR > 1.33) diluted .



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Projected Balance Sheet Method

Applicable to all borrowers engaged in manufacturing,services and trading activities whose fund based limit is inexcess of rs 5 lacs and below rs 00 lacs.

Under the PBS method ,assessment of working capital will be carried out in a flexible manner with examination of allrelevant parameters and the borrower will submit the sameas per the following forms:



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Projected Balance Sheet Method

• Form 1 : Particulars of existing Long / short termdebts,borrowings from NBFC’S ,ICD’,Leasing etc

• Form : Operating statements

• Form 3 : Analysis of balance sheet

• Form 4 : Comparative statement of CA/CL.

• Form 5 : Fund flow statement.



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Cash Budget Method

• Used for assessing WC requirements of seasonal industries andconstruction activities.

• The required finance is quantified from the projected cash flows andnot from projected values of assets and liabilities

• Assessment of the cash budget,projected profitability,liquidity,Leverage and fund flow are done.

• The cash budget analysis is also used to sanction adhoc workingcapital limits.

• WC limits are determined on the ‘Cash Gap’ .• Takes into consideration fluctuations in fund requirement over a

period of time.No strict norms for inventory levels.Temporaryslippage's allowed.

Long Term Financing



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Long Term Financing

Basis of evaluation

Availability

•Flexibility

•Cost

Availability : should be available at the point / time when requiredFlexibility : certain instruments are user/ application specific

Cost : to be evaluated on a post tax basis



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SOURCES OF TERM FINANCE

•Term loans from all India financial institutions

•State level financial institutions

•Debentures: NCD

PCD

OFCD

•Fixed Deposits

•Equity share capital

•Equity share capital with differential rights as to dividend,voting or otherwise

•Preference share capital

•Mutual Funds



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•Retained earnings

•Exchangeables•Venture Capital

•Deferred payment gurantees

•Leasing

•External commercial borrowings

•Depository receipts

•Floating interest rate Debt.

•Securitisation of future receivables

•Derivative linked bonds

FINANCIAL / INVESTMENT INSTITUTIONS



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They are major source of long term debt funds for financing:

•Fixed Assets

•Margin money for working capital

Indian FI’s

IDBI / ICICI / IFCI / IIBI

Foreign Institutions

Sectoral Institutions

HDFC / IL&FS / HUDCO / IDFC

Universal Banks

ICICI Bank



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Investment institutions

GIC & Subsidiaries

UTI

LIC

Investment Banks• 3 State level financial institutions (IDC’s)

• 3 State level financial institutions (MSFC)

SFC’s can fund upto 90 LacsSIDC’s can fund upto 150 Lacs



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Features: Interest rate is based upon the primelending rate + project risk.

Basic interest rate linked to inflation rate

Project risk / company risk depends on the credit-rating.

Security Hypothecation & mortgage

Collateral

Covenants

Moratorium period

Repayment schedule / Amortisation schedule

Convertibility option only in the event of default.



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GUIDE LINES FOR KEY RATIOS

DCSR > 1.8 TIMES

D/E 1:5:1

Promoters contribution : 0 - 5%

CR: > 1.33

Banks

Participate in Long term financing on conditions similar to FI’showever are able to offer funds at lower cupon rates.

Debentures:



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•Approval from SEBI mandatory if public issue is proposed

•Debentures used to finance margin money not to exceed more than0% of N.W.C

•Convertibility clause terms to be specified at issuance time.

•Credit rating mandatory

•Types of Debentures:



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NCD

FCD

PCDOCD

•Coupon rate depends on terms of issue.

Other features

• No TDS for interest paid upto Rs 500 per annum

•Redemption premium

•Listing on stock exchanges

•Fully secured

•Call and put options

Advantages from Issuer’s point of view:



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•Lower cost due to low risk and tax deductibility of interest payment.

• No / limited dilution of control•Offer stable return to investors having fixed maturity

and subsequently redemption/ conversion to equity

• No increase in equity base during non conversion period

Fixed deposits

•Limit on quantum : 5% of networth

•Cost : 8-11% depending on maturity period & risk

•unsecured

EQUITY SHARE CAPITAL



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•Authorised , issued, subscribed and paid up

•Par value, issue price, book value, market value

•Residual claims on Income /Assets

• No upper limit•Costliest sources of finance

•Entails permanent servicing by way of dividends without taxshield

•Voting rights/ Control in management/ Limited liability

•Under preview of SEBI and SEB guidelines

•Buy Back allowed



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Equity investments in foreign cos allowed to resident indian

shareholder in the event foregin co has 10% stake in indian co.•For Listing on exchanges atleast 10% to be offered to the public

by way of a prospectus

Issuance of Non-Voting & differential rights shares allowed

•Debentures on conversion becomes equity share capital.

•For Listing on BSE/ NSE the paid up Equity capital should be atleast Rs 10 Cr. and for the other exchanges atleast Rs5 Cr

EVALUATION OF ESC



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EVALUATION OF ESC

Company’s point of view

AdvantagesRepresents almost permanent capital

Does not involve any fixed obligation for servicing

Enhances credit worthiness of the company to secure additionaldebt.

Disadvantages

High cost of capital

Dividends paid on profit after tax further subjected to dividenddistribution tax of 1 .5%

High flotation cost

Dilution of control (Treasury issue)



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Retained earnings

Made up of Accumulated depreciation and retained profits.

Represent the internal sources of finance available to thecompany.

Availability : Level of profitability / payout ratio

Cost : Identical to ESC.

Flexibility : High



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Disadvantages

High opportunity costLimitation on amount

Bonus issue may capitalisereserves

Advantages

Reinvestment of profit may be convenient to many shareholders.

No dilution of control since Co. Relies on retained earnings

No flotation cost/ Losses on account of underpricing.

Proceeds could be used in a subsequent buyback.

.



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Leasing

Ownership of asset with lessor (depreciation to be claimed belessor)

Wet leasePromoters contribution not necessary

Off balance sheet item (borrowing power unaffected)

Flexibility in lease rentalsLease rent (principle + interest) is tax deductive).



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CAPTAL BUDGETING



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•Capital investment decision

Capital investments involve increase in the fixed assets of a

company.(Expansion / diversification / Green field / takeover / merger)

•Characteristics of investments

Capital outlay needs to be made up front returns come later

Certain amount of risk is involved

Capital investment tend to be indivisible. (difficult to phase out).

•Financial techniques

The purpose of financial techniques is to enable the making of investment acceptance / rejection decisions.

Non financial factors in project appraisal



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Market

Technical

Infrastructure

Ecological

Economic

Influence of non - financial factors

Financial projections

Gestation period

Profitability

Life of project / Terminal value

Sensitivity analysis

NON FINANCIAL FACTORS DETERMINING



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NON FINANCIAL FACTORS DETERMINING

FINANCIAL VIABILITY OF PROJECTS

Market factors

Present and future size of the marketPresent and future demand and supply situation

Achievable market shareSelling & distribution channels

Technical factors

Level of Technological obsolence

Plant locationScales of operation

Raw material & utilities consumption norms



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Ecological factors

Pollutant levels

Treatment of effluent

Environmental impact of the project

Economic factors

Social cost benefit analysis

Economic rate of protection

Domestic resource cost

Protection enjoyed by industry.

FINANCIAL TECHNIQUES IN CAPITALBUDGETING



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BUDGETING

Return on investment

AVG ROI = PBIT

(over 10 yrs) Total Inv.

Advantages

Simple to calculate and easy to understand

Maximisation of shareholders wealth and maximising the market value of investments.

.DisadvantagesTime value of money not considered

It is a concept based on profit and not cash

No objective criterion for acceptance / Rejection decision.



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Payback period

It is the time required to get back the original investmentcompanies going through liquidity crisis /for small investments willuse the pay back period method.

Disadvantages

Cash inflows / Outflows after payback Period are ignored.Time value for money is ignored

Discounted cash flow (DCF)



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Discounted cash flow (DCF)

Cash inflow and outflow for the entire life of the project isconsidered.

It considers time value for money as a result earnings in earlier years have higher value than earned in later years.

IRR Method

IRR is that rate of discount at which the net present value of cashflows equals net present value of cash outflows.

If IRR > COC Investment is support worthy.

NPV method

Using COC discount the netflows

If NPV is + VE investment is support worthy. .



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Comparison of elementsElements Payback NPV IRR

Net investment. Comparable comparable Comparable

Subsequentinvestment

Possible to userough approx.

Exact timing Exact timing

Recovery of terminal value

Not Possible Specificeconomic impact

Specificeconomic impact

Accounting profit

Roughapproximation

Not relevant Not Relevant

Operating cashflow

Approximationof pattern

Not relevant Not relevant



CONCEPTS IN CAPITAL BUDGETING



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•Life of project

Physical

Market

Techno efficient

•Incremental principle

Sunk / Allocated costs to be ignored

Only incremental cash flows to be considered

•Evaluation of post tax basis since COC is on a post tax basis

•Principle of separation of “Finance” from “Investment “ decision.

Financing cost (interest) to be ignored.

•Effect of tax shield on the company as a whole to be considered

PROJECT COST COMPONENTS



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Land

Civil Construction

Plant & Machinery

Misc Fixed Assets

Erection and commissioning

Technical Know how fees

Preliminary & preoperative expenses

Contingencies

Total Capital Cost

Margin money for working capital

Total project cost



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PROJECT CASH FLOWS

Cash outflows Capital expenditureMargin money

Normal capital expenditure

Cash inflow Net cash accruals

Salvage value

Recovery of WC



9

NPV vs IRR conflict

• NPV is technically superior to IRR and is also able to handleselection of mutually exclusive projects.

• The decision rule for the NPV assumes that cash flows resultingduring the life cycle of the project have an opportunity cost equal tothe discount rate used.

• The decision rule for the IRR assumes that such resulting cash flowshave an opportunity cost equal to IRR which generated them.

• NPV approach provides an absolute measure that fully represents the

value from the project to a company.• IRR by contrast provides a % figure from which the benefits in

terms of wealth creation cannot be grasped.



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Capital Budgeting Sensitivity Analysis

• Monte Carlo Simulation

• Break even analysis

• Decision tree analysis

• Expected value Criterion

• Under different scenarios



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Share holder value creation

• Cash Dividends• Stock Dividends• Bonus Shares

• Bonus Debentures-issued from free reserves• Equity Buy back / Secondary Listing• Stock Split• Synergic Investments• Synergic Acquisitions• Disinvest out of unrelated businesses• Shares of holding co. with fungibility



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DIVIDEND STRUCTURING

Appropriation of PAT towards Dividend pay out and Reserves

Payout ratio = Dividend paid / PAT

Retention ratio = PAT - Dividend paid / PAT

Dividend rate (%) could be high but payout could be low.

Dividend rate will be depended upon the PAT, Payout ratio andEquity base.



Factors influencing dividend policy



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Factors influencing dividend policy

•If the appetite for funds is high due to increase in level of exsistingoperation or due to major capital investment plan then a highretention policy will be adopted.

•A closely held company having major capital investment planswill follow a low pay out policy so that internal accruals could actas a major source of finance in the future thereby reducingdependence on infusion of fresh equity.

•Tax implications

Company has to pay 1 .5% distribution tax.Recipient of dividendtax exempted in the shareholders hands..

-



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•Restriction in loan agreement / government regulations / FI’s onon payment of dividend during the currency of the loan.

•Legal requirement under Companies act.

•Liquidity position : Higher PAT does not necessarily meanhealthy liquidity. A strained liquidity position would force a policyof low payout.

•Stability in the rate of dividend : companies usually follow a policy of gradually rising or stable dividend policy and not directlylink it with PAT.

•Generally the Indian corporate sector follows a payout policy of 30% . The retention ratio keeps increasing so as to counter inflation, floatation cost, help in Equity buyback etc.

BONUS SHARESBonus share are issued to existing share holders as a result of



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Bonus share are issued to existing share holders as a result of capitalization of reserves.

In the wake of a bonus issue

The shareholders proportional ownership remains unchanged

The book value, market price, E.P.S decreases.

Fallout of a bonus issue

• Normally the Ex-bonus price comes down by the proportion of bonus given with a mark up of approximately 30 - 35%•More active trading in stock exchanges.

•The nominal rate of dividend tends to decline this may dispel theimpression of profiteering.•Shareholders regard a bonus issue as a firm indication that the

prospects for the company are good.•Capital gains tax exemptions with indexation available for bonusissue

GUIDELINES FOR ISSUE OF BONUS SHARES

I S it h g b d f I di



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Issuer : Security exchange board of India

Bonus issue should be made from capitalisation of free reserves

built out of genuine profits and share premium.Reserves created byrevaluation of assets, statutory reserves etc. are not allowed for capitalisation

Bonus issue greater than 1:1 allowed

Residual reserve test: residual reserves after the proposedcapitalisation should be at least 40% of the increased capital For computation all contingent liabilities, statutory reserves andrevaluation reserves to be excluded.

Yield test: 30% of the average P.B.T for the last 3 years shouldgive a return of at least 10% on the enhanced capital.

Bonus in lieu of dividend is not permitted

fm_prof sango notes

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