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INTERNAL FUNDS- AS A SOURCE OF FINANCE

Also known as Ploughing back of profits or Self-financing or accumulation of earnings

over a period of time or Internal financing

Instead of distributing the entire profits to shareholders in the form of dividend, the company

retains a part of its earnings for the purpose of, accumulation of earnings, investing in fixed

assets and/ or to meet working capital needs, if the need so arise.

Merits of Ploughing back of profits:

A)

To the Company:

1.

Economical- Cost of raising such funds is nil, as the company need not advertise or

pay underwriting commission or brokerage.

2. Increases the efficiency and productivity of the firm.

3. Increases shareholders confidence.

4. Enhances creditworthiness and outsiders are willing to lend money to the firm.

5. Less financial risk due to lack of pressure to pay interest and installments.

6. Facilitates the repayment of debentures and term loans.

7.

Reduces the reliance of the firm on external borrowings.

8. Helps expansion and diversification.

9. Helps automation and modernization

10.Used to meet working capital needs at the time of cash crunch and during recession.

11.Following a stable dividend policy the company can even in the year of crisis declare

a dividend to boost the confidence of shareholders.

12.Freedom to management to take their own decisions and not subject to restrictive

conditions of outside agencies.

B) To the shareholders:

1. Appreciation in share values because of huge reserves of the company.

2.

Bonus shares issues.

3. Regular dividends even in the year of crisis.

4. Banks may willingly accept the shares as a security in advancing loans to the

shareholders as there is increase in security value of shares.

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C) To the society:

1.

Increases capital formation and can bring prosperity to the nation.

2. Helps speedy development of the industry and more employment opportunities are

generated.

3.

Company makes use of its own funds, the cost of production comes down as the

company need not pay any interest or installment. This reduces consumer prices

and makes the goods available at reasonable prices.

4. Social welfare activities such as maintaining roads, gardens, donations to

educational institutions, sponsoring sports and so on can be done out of retained

earnings.

Demerits of ploughing back of profits:

1. Danger of manipulation by the management by using it for their personal extravaganza

or to manipulate the share prices on the stock exchange.

2.

Chances of over-capitalisation. Overcapitalisation is a situation when a firms earning

are comparatively less as compared to similar companies in the industry. Such a situation

also arises when a company employs more funds than is actually needed.

3.

The company may not be in a position to make optimum use of its retained earnings.

4. The shareholders may not get their due share of dividends leading to their loss.

5. It might lead to excessive speculation which is harmful in the interest of genuine

investors.

6. It might lead to more demands from employees causing even industrial disputes.

7. Concentration of economic power in few hands due to small number of shareholders.

There is inverse relationship between payout and retention as indicated in table below

Relationship between Dividend payout and Retention

Sr,no D/P Ratio (1-b) Retention Ratio (b)

1 0% 100%

2 10% 90%

3 20% 80%

4 30% 70%

5 40% 60%

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6 50% 50%

7 60% 40%

8 70% 30%

9 80% 20%10 90% 10%

11 100% 0%

A firm may justify a low payout policy (or high-retention policy) for one or combination of

the following factors:

1. Internal investment opportunities.

2.

Stability of earnings.

3. Growth-oriented stockholders.

4. Weak financial capability

5.

External need for funds and existing high leverage.

A low dividend payout leads to high growth, given the firms profitability.

The nonpayment of dividend also helps to protect the firms corporate liquidity and thus,

its vulnerability to financial shocks.

Dividend amounts to reduction in capital; each rupee of dividend paid decreases debt

capacity proportionally. The compound effect of dividend will be significantly depressing

for the growth of the firm. This effect cannot be nullified by issuing shares.

Share issues are far more expensive then retained earnings and debt, and also, they have

short-term adverse effects such as dilution of earnings and controls [a matter of particular

significance to closely held companies].

Many firms do not fully appreciate the opportunity cost of retained earnings. They impute

a low cost to it. As a result, they may be comforted by the easy availability of retained

earnings, invest in sub marginal projects that have a negative NPV. Obviously such a sub

optimal investment policy hurts the shareholders.

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Comparison of Retained Earnings with

Other Long-term sources of Financing

Sources of

finance

Cost Dilution of

control

Risk Restraint on

Managerial

freedom

Retained earnings High No Nil No

Equity capital High Yes Nil No

Preference capital High No Negligible No

Debenture capital Low No High Some

Term loans Low No High Moderate

Distribution of high dividends is not a sound policy in the long run. The company should

retain some portion of its earnings to maintain its liquidity position, particularly under the

inflationary conditions. It s suggested that matured firms instead of distributing their earnings

should put them to strategic uses for the long term vitality and survival. If they do not have

internal growth opportunities, they should devise strategies to grow by acquisitions. Even if

the firms do not want to accumulate funds in the short run in the absence of any acquisition

plans. It is more preferable to invest cash surplus in medium-term securities than paying

dividends. It provides the firm with flexibility in the sense that they can get cash when they

need it, and they will not have to reduce dividend in the event of the availability of growth

opportunities.