Chapter 4:Financing &Dividend decision

Leverages Leverage refers to an increased means for accomplishing some purpose. For example, leverage helps us in lifting heavy objects, which may not be otherwise possible. However, in the area of finance, the term leverage has a special meaning. It used to describe the firms ability to used fixed cost assets or funds to magnify the return to its owners. James Horne has defined leverages as the employment of an asset or funds for which the firm pays fixed cost or fixed return, thus according to him leverage result as a result of the firm employing an asset or source of funds which has a fixed cost, the former may be termed as fixed operating cost, while he latter may be termed as fixed financial cost. It should be noted that fixed cost or return is the fulcrum of leverage. If a firm is not required to pay fixed cost or fixed return, there will be no leverages.Leverages are of three types:1) Operating leverages: The operating leverage may be defined as the tendency of the operating profit to vary disproportionately with sales. It is said to exist when the firm has to pay fixed cost regardless of volume of output or sales. The firm is said to have high degree of operating leverage if it employs a greater amount of fixed cost and a small amount of variable cost. Operating leverage is present anytime a firm has fixed operating cost regardless of volume. In the long run, of course, all cost are variable consequently, our analysis necessary involves the short run. Thus the degree of operating leverage depends upon the amount of fixed element in the cost structure.Operating leverage in a firm is a function of three factors:a. The amount of fixed costs.b. The contribution marginc. The volume of sales Computation: The operating leverage can be calculated by the following formula: Operating leverage = Contribution / Operating profit

2) Financial leverage: The financial leverage may be defined as the tendency of the residual net income to vary disproportionately with operating profit. It indicates the change that takes place in the taxable income as a result of change in the operating income. It signifies the existence of fixed interest/ fixed dividend bearing securities in the total capital structure of the company. Thus, the use of fixed interest/ dividend bearing securities such as debt and preference capital along with the owners equity in the total capital structure of the company, is described as financial leverage. Computation: The Financial leverage can be calculated by the following formula: Financial leverage =EBT/ EBT

3) Composite leverage: As explained in the proceeding pages operating leverage measure percentage change in operating profit due to percentage change in sales. It explains the degree of operating risk. Financial leverages measures percentage change in taxable profit on account of percentage change in operating profit. Thus, it explains the degree of financial risk. Both these leverages are closely concerned with the firms capacity to meet its fixed costs. In case both the leverage are combined, the result obtained will disclose the effect of change in sales over change in taxable profit.Computation: The composite leverage can be calculated by the formula: Composite leverage = Operational leverage * Financial leverage

Capital structure theories:

Net operating income (NOI) approach. Traditional approach and Net income (NI) approach. MM hypothesis with and without corporate tax. Millers hypothesis with corporate and personal taxes. Trade-off theory: costs and benefits of leverage.

1) Net Income (NI) Approach:

According to NI approach both the cost of debt and the cost of equity are independent of the capital structure; they remain constant regardless ofhow much debt the firm uses. As a result, the overall cost of capital declines and the firm value increases with debt. This approach has no basis in reality; the optimum capital structure would be 100 per cent debt financing under NI approach.

2) Net Operating Income (NOI) Approach:

According to NOI approach the value ofthe firm and the weighted average cost of capital are independent of the firms capital structure. In the absence of taxes, an individual holding all the debt and equity securities will receive the same cash flows regardless of the capital structure and therefore, valueofthecompanyis the same.

3) Traditional Approach: The traditional approach argues that moderate degree of debt can lower the firms overall cost of capital and thereby, increase the firm value. The initial increase in the cost of equity is more than offset by the lower cost of debt. But as debt increases, shareholdersperceivehigher risk and the cost of equity rises until a point is reached at which the advantage oflower cost of debt is more than offset by more expensive equity.

4) MM Approach Without Tax:Proposition I:

MMs Proposition I states that the firms value is independent ofits capital structure. With personal leverage, shareholders can receive exactly the same return, with the same risk, from a levered firm and an unlevered firm. Thus, they will sell shares ofthe over-priced firm and buy shares of the under-priced firm until the two values equate this is called arbitrage.

MMs Proposition II: The cost of equity for a levered firm equals the constant overall cost ofcapital plus a risk premium that equals the spread between the overall cost ofcapital and the cost of debt multiplied by the firms debt-equity ratio. Forfinancial leverage to be irrelevant, the overall cost of capital must remain constant, regardless of the amount of debt employed. This implies that the cost ofequitymustriseas financial risk increases.

MM Hypothesis With Corporate Tax:

Under current laws in most countries, debt has an important advantage over equity: interest payments on debt are tax deductible, whereas dividend payments and retained earnings are not. Investors in a levered firm receive in the aggregate the unlevered cash flow plus an amount equal to the tax deduction on interest. Capitalising the first component of cash flow at the all-equity rate and the second at the cost of debt shows that the value of the levered firm is equal to the value ofthe unlevered firm plus the interest tax shield which is tax rate times the debt(if the shield is fully usable).It is assumed that the firm will borrow the same amount ofdebt in perpetuity and will always be able to use the tax shield. Also, it ignores bankruptcy and agency costs.

5) Millers Approach WITH Corporate and Personal Taxes:

Toestablishanoptimumcapitalstructureboth corporate and personal taxes paid on operating income should be minimised. The personal tax rate is difficult to determine because of the differing tax status of investors, and that capital gains are only taxed when shares are sold.

Merton miller proposed that the original MM proposition I holds in a world with both corporate and personal taxes because he assumes the personal tax rate on equity income is zero. Companies will issue debt up to a point at which the tax bracket of the marginal bondholder just equals the corporate tax rate. At this point, there will be no net tax advantage to companies from issuing additional debt.It is now widely accepted that the effect of personal taxes is to lower the estimate of the interest tax shield.

6) The trade off theory :Costs of financial distress and agency costsCosts of financial distress: Financial distress arises when a firm is not able to meet its obligations (payment of interest and principal) to debt holders. The firms continuous failure to make payments to debt-holders can ultimately lead to the insolvency of the firm. Direct costs of financial distress include costs of insolvency. The proceedings of insolvency involve cumbersome process. Financial distress, with or without insolvency, also has many indirect costs. These costs relate to the actions of employees, managers, customers, suppliers, and shareholders.

Agency costs:There may exist a conflict of interest among shareholders, debt holders and management. These conflicts give rise to agency problems, which involve agency costs. Agency costs have their influence on a firms capital structure.

Net income approach:This approach has been developed by Durand. It is relevant theory. According to this approach, capital structure decision is relevant to the valuation of the firm. In other words, a change in debt proportion in capital structure will lead to a corresponding change in cost of capital (KO) as well as total value of the firm.Assumptions:Net income approach is based on the following assumptions:1. There are no taxes.2. Cost of debt is less than the cost of equity.3. Use of debt in capital structure does not change the risk perception of the investors.4. Cost of debt and cost of equity remains constant.Net income approach argues based on the above three assumptions. Increase of debt (cheapest source of long-term finance) in capital structure reduces the cost of capital (Ko), due to, there is no change in the cost of equity (risk perception of investors) leading to an increase in the total value of the firm.When cost of debt (Ki) and cost of equity(ke) being constant, with the increased use of debt in capital structure will magnify the equity shareholders earnings and thereby market value of firm equity shares.The value of the firm on the basis of net income approach can be ascertained as follows:V=S+DWhere, V= Value of the firmS=market value of equityD=market value of debtMarket value of equity can be ascertained as follows:S=NI/KeWhere,S=market value of equityNI=earnings available for equity share holdersKe=equity capitalization rate

NOI Approach (Net Operating Income)The NOI approach is diametrically opposite to the NI approach. The essence of this approach is that capital structure is totally irrelevant. A change in leverage will not cause any change in cost of capital and value of the firm. The main thrust of the argument of NOI is that an increase in the proportion of debt in the capital structure would lead to an increase in the financial risk of the shareholders. To compensate for the increased risk, the shareholders would require a higher rate of return on their investment. The increase in the cost of equity would match the savings in the lower cost of debt. Therefore, the cost of debt, according to NOI, has two elements: (i) Explicit, represented by the rate of interest, and (ii) Implicit, the increase in the of equity capital caused by increased in the degree of leverage. As a result, the advantage associated with the use of relatively less expensive debt in terms of the explicit cost would exactly be neutralized by the implicit cost represented by the increase in the cost of equity capital. Therefore the real cost debt and equity are to be the same. There is nothing like an optimum capital structure. All capital structures are optimum..According to Durand he suggested It is just-opposite to the net income approach. According to this approach the capital structure decisions of affirm is irrelevant. It say a that any change in debt proposition in capital structure (leverage) will not lead to any change in the value of capital (Ko). They (V,Ko and share price) are independent of financial leverage.Assumptions:NOI approach is based on the following assumption:(i) Overall cost of capital (K0) remains unchanged for all degree of leverage.(ii) The market capitalizes the total value of the firm as a whole and no importance is given for split of value of firm between debt and equity: (iii) The market value of equity is residue [i..e.,Total value of the firm minus market value of debt].(iv) The use of debt funds increases the received risk of equity investors, there by Ke increases (v) The debt advantage is set off exactly by increase in cost of equity(vi) Cost of debt (Ki) remains constant.(vii) There are no corporate taxes.The total value of the firm according to NOI is calculated as follows..V=EBIT%K0One of the assumptions says that market value of equities residual: symbolically.E=V-D

Factors Affecting The Capital Structure Of BSE-100 Indian Firms: A Panel Data Analysis *Dr. Sumi khare **Dr. Saima Rizvi

Purpose:The purpose of the study is to examine important variables that impact debt-equity choice of BSE-100 index companies. Moreover, on the basis of signs of the coefficients, the paper examines the applicability of trade-off or pecking order theories for BSE-100 index companies.

Methodology: Financial data was collected over 10 years from year 2000 to 2009 for BSE listed firms using Prowess source. A Panel data analysis was used for cross-sectional time series data. Leverage defined as ratio total liabilities to total asset is taken as dependent variable.To compute the conventional random effects models from the specification below. (Asteriou and Hall, 2007): yit= xit+i+vit where =+i .Since the data was taken for 69 companys random effects models from 2000-2009, there would be a similarity between the observations. Hence, a random model is of the form yit= xit + itFindings: The results showed returns on assets to be most significant factor for leverage followed by profit margin on sales and DO (ratio of total depreciation to total assets).Also, pecking order theory was found to be applicable for capital structure of BSE index listed companies.

Research limitations:Data for some companies is not available through prowess.

Practical Implication:Capital structure is important for companies to understand how much debt they need to employ. Therefore, this study will aid companies arrive at an optimal level of debt in their capital structure.

Social Implication:Some of the big investment banks failed in United States because of high level of leverage employed by them and as a result of which, investors suffered losses. Therefore, it is essential for companies to arrive at the optimal debt equity ratio.

Originality/Value: The main value of this study is the identification of the factors that influence the capital structure of BSE listed firms in India.

Determinants of capital structureThough the MM theory assumes that investors have the same financial information about a firm as with the managers, which is referred to as asymmetric in formation , in practice, however, managers have access to insider information. This viewpoint was not supported by Myer and Majluf(1984) who accepts that managers have superior information about the actual value of the company. To find the factors, the leverage considered in this paper is defined as; Leverage=total liabilities total assets.Tangibility: Tangibility and leverage ratios have positive correlation. This has been supported in the studies of Pajan Raj and Zingales(1995) and Frank and Goyal(2002). The rationale underlying this factor is that tangible assets are easy to collaterize and thus, they reduce agency cost of debts.Size: Larger companies tend to have higher level of indebtness. Since larger firms have a chance to be more diversified, they have little bankruptcy risk. Castanias (1983) also supported relationship between size and leverage.Growth Opportunities: Companies with high market value in relation to book value have lower indebtness level. Myer(1984) states that a negative relationship between growth and financial leverage due to high interest rate on restrictive covenants that discourage debt taking.Profitability: A profitability firms has the potential to absorb a large amount of interest payments and thus derive tax shield arising out of a high debt ratio, which is not the case with a less profitable firm. There are 2 measures of profitability such as Return on Asser (RoA) and Profit Margin on Sales (PMS). RoA represents the contribution of firms assets on profitability creation. RoA may also be called profit to asset ratio. RoA is thus the ratio between Net profit after taxes and average total assets. Profit margin on sales (PMS) is the ratio of operating income over total sales.Non Debt Tax Shield: 2 measures of tax shield opportunities exist. One is the ration of total depreciation to total assets (DA) and the other is the ration of depreciation over operating profit (DoP).CONCLUSION AND SUGGESTIONSThis study focuses on capital structure characteristics for BSE 100 index companies in India. The capital structure of a company consists of a particular combination of debt and equity issues to relieve potential pressures on its long-term financing. These results are interesting, since they do provide a comprehensive picture of the determinants of capital structure in a developing country. The panel data methodology \, which incorporates both time series and cross sectional data has been applied to the actual data to find significant determinants of leverage ratios for each firm within the period -2000-2009. Our empirical findings reveal that returns on assets and profit margin on sales significantly affects firms leverage value. Therefore, profitability is one of the most important determinants for leverage as in Sahoo and Omkarnath (2005).Results show that depreciation over operating profit, growth opportunities, size and tangibility do not explain leverage needs. Also, tangibility is found to be negatively affecting the leverage value and is insignificant as compared to the results of Ramlall(2009).Going by the signs of independent variables, pecking theory seems to be applicable, not so much trade-off theory. While the present study lends support to pecking theory, we cannot conclusively refute applicability of trade-off theory. For drawing any such conclusion, the study may have to be extended by including more variables. Another important contribution of this study pertains to the need for a modified Pecking Order Theory pertinent to the local context.

Dividend policyThe policy a company uses to decide how much it will pay out to shareholders in dividends.Dividend policyis concerned with taking a decision regarding payingcash dividendin the present or paying an increased dividend at a later stage. The firm could also pay in the form ofstock dividendswhich unlike cash dividends do not provide liquidity to the investors; however, it ensures capital gains to the stockholders. The expectations of dividends byshareholdershelps them determine the share value, therefore, dividend policy is a significant decision taken by the financial managers of any company.Factors affecting dividend policyIn perfect market conditions, the dividend policy is irrelevant but in real world situation, there are several factors that impact the dividend policy and valuation. A firm has to consider many factors while setting a dividend policy:Amongst the factors that favor high dividend payout are Low layout required on available investment opportunities The desire of investors for current income The resolution of uncertainty The presence of transaction costs The presence of agency cost- a high dividend payout tends to reduce agency cost

Among the factor those favor low payouts are Larger outlays needed by investment opportunities Preferential treatment of capital games as compared to dividends The presence of flotation costs The phenomenon of under pricing Constraining legal and administrative factors that have to be addressed when issuing new sharesBesides the factors that govern the level of dividend, there are few important considerations that are more concerned with the stability of dividend rather than its level. Access to debt markets in days of poor earnings helps keeping the dividend stable. Most institutional investors demand a regular and constant flow of dividend. Once a level is decided, it is maintained till the need to change arises. When changing the level of dividend, the firm needs to consider: What signal the change in dividend provides o the shareholders What reaction the change would have on the firms clientele The question of whether the change would causes shifting of clientele and impact the complexion of shareholding partners.

Walter modelIt supports the doctrine that dividends are relevant. The investment policy of a firm cannot be separated from its dividend policy and both are, according to Walter , interlinked. The choice of an appropriate dividend policy affects the value of an enterprise.The key argument in support of the relevance proposition of Walter model is the relationship between the return on a firms investment or its internal rate of return (r) and its cost of capital or the required rate of return (k) .the rationale is that if r > k the firm is able to earn more than what the shareholders will be reinvesting, if the earnings are paid to them. The implication of r br.Arguments: It can be seen from the assumptions of Gordons model that they are similar to those of Walters model. As a result, Gordons model, like Walters, contends that dividend policy of the firm is relevant and the investors put a positive premium on current incomes/dividends. The crux of Gordons argument is two-fold assumption (1) investors are risk averse, and (2) they put a premium on a certain return and discount/penalize uncertain returns.As investors are rational, they want to avoid risk. The term risk refers to the possibility of not getting a return on investment. The payment of current dividend ipso facto completely removes any chance of risk. If, however, the firm retains the earnings (i.e. current dividends withheld), the investors can expect to get a dividend in future. The future dividend is uncertain, both with respect to the amount as well as the timing. The rational investors can reasonably be expected to prefer current dividend. In other words, they would discount future dividend. The retained earnings are evaluated by the investors as a risky promise. In case the earnings are retained, therefore, the market price of the shares would be adversely affected.The above argument underlying Gordons model of dividend relevance is also described as a bird-in-the-hand argument. That bird inn hand is better than in the bush is based on the logic that what is available at present is preferable to what may be available in the future. Basing his model on this argument, Gordon argues that the future is uncertain and the more distant the future is, the more uncertain it is likely to be. If, therefore, current dividends are withheld to retain profits, whether the investors would at all receive them later is uncertain. Investors would naturally like to avoid uncertainty. In fact, they would incline to pay a higher price for shares on which current dividends are paid. Conversely, they would discount the value of shares of a firm which postpones dividends .The discount rate would vary with the retention rate or level of retained earnings. The term retention ratio means the percentage of earnings retained. It is inverse of D/P ratio. The omission of dividends, or payment of low dividends, would lower the value of the shares.

LEGAL ASPECTS:The important provisions of company law pertaining to dividend are described below:1. Companies can pay only tax dividends. Apart from cash, dividend also be remitted by cheque. Or by warrant. The same also is transmitted to shareholders after obtaining their consent in the regard to the bank account number specified by them.2. Dividend can be paid only out of the profits earned during the financial year after providing for depreciation and after transferring to reserve such percentage of profits are prescribed by law. The companies rules,1975, provide that before dividend declaration a percentage of profit as specified below should be transferred to the reserves of the company.(a)where the dividend proposed is up to 10% of the paid up capital, no amounts of the current profits are need to be transferred.(b) Where the dividend proposed exceeds 10 % but not 12.5% of the paid up capital, the amount to be transferred to the reserves should not be less than 2.5% of the current profits.(c) Where the dividend proposed exceeds 12.5% but not 15%, the amount to be transferred to reserves should not be less than 5% of the current profits.(d) Where the dividend proposed exceeds 15% but not 20%, the amount to be transferred to reserves should not be less than 7.5% of the current profits.(e) Where the dividend proposed exceeds 20%, the amountshould be transferred to reserves should not be less 10%.3. Due to adequacy or absence of profit in any year, dividend may be paid out of the accumulated profits of the previous years.4. Dividend cannot be declared to the past years for which account have been adopted by the shareholders in the annual general meeting.5. Dividend declared interim or final, should be deposited in a separate bank account within 5 days from the date of declaration and dividend will be paid within 30days from such a date.6. Dividend including interim dividend once declared become a debt. While the payment of interim dividend cannot be revoked, the payment of final dividend can be revoked with the consent of the shareholder.

Procedural aspects:1 Board Resolution:The dividend decision is the prerogative of the board of directors. Hence the board of directors should in a formal meeting resolve to pay the dividend.

2. Shareholder approval:The resolution of the board of directors to pay the dividend has to be approved by the shareholders in the annual general meeting. However the approval is not required in the case of declaration of interim dividend. Further, it should be noted that the shareholder in the annual meeting have neither the power to declare the dividends nor to increase the amount of dividend. However they can reduce the amount of dividend.3. Record date:The dividend is payable to shareholders whose name appear in the register of members as on the record date.4. Dividend payment:Once a dividend declaration has been made, dividend warrant must be posted within 30days, unpaid dividend must be transferred to a special account opened with a scheduled bank. In case the company fails to transfer the unpaid dividend account within 37 days of the declaration of the dividend, an interest of 12% per annum on the unpaid amount is to be paid to the shareholder in the proportion of the dividend amount remaining unpaid to them.5. Unpaid dividends:If the money transferred to unpaid dividend account in the scheduled bank remains unpaid for a period of 7 years from date of such transfer, the company is required to transfer the same to the investors. Education and protection fund established for the purpose.TAX ASPECTS:With effect from financial year 2003-04, dividend income from domestic companies and mutual funds is exempt from tax in the hands of the shareholder/investor/unit-holder. However, the domestic company will be liable to pay dividend distribution tax at the effective rate of 16.9995% on dividend paid after april1 2007.

ModiglianiMiller theoremThe ModiglianiMiller theorem (of Franco Modigliani, Merton Miller) forms the basis for modern thinking on capital structure. The basic theorem states that, under a certain market price process (the classical random walk), in the absence of taxes, bankruptcy costs, agency costs, and a symmetric information, and in an efficient market, the value of a firm is unaffected by how that firm is financed. It does not matter if the firm's capital is raised by issuing stock or selling debt. It does not matter what the firm's dividend policy is, therefore, the ModiglianiMiller theorem is also often called the capital structure irrelevance principle.Basic Propositions of MM approach:1. At any degree of leverage, the company's overall cost of capital (ko) and the Value of the firm (V) remains constant. This means that it is independent of the capital structure. The total value can be obtained by capitalizing the operating earnings stream that is expected in future, discounted at an appropriate discount rate suitable for the risk undertaken.2. The cost of capital (ke) equals the capitalization rate of a pure equity stream and a premium for financial risk. This is equal to the difference between the pure equity capitalization rate and ki times the debt-equity ratio.3. The minimum cut-off rate for the purpose of capital investments is fully independent of the way in which a project is financed.Assumptions of MM approach:1. Capital markets are perfect.2. All investors have the same expectation of the company's net operating income for the purpose of evaluating the value of the firm.3. Within similar operating environments, the business risk is equal among all firms.4. 100% dividend payout ratio.5. An assumption of "no taxes" was there earlier, which has been removed.Limitations of MM hypothesis:1. Investors would find the personal leverage inconvenient.2. The risk perception of corporate and personal leverage may be different.3. Arbitrage process cannot be smooth due the institutional restrictions.4. Arbitrage process would also be affected by the transaction costs.5. The corporate leverage and personal leverage are not perfect substitutes.6. Corporate taxes do exist. However, the assumption of "no taxes" has been removed later.