UNIT -3: FINANCING AND DIVIDEND DECISION

LEVERAGES
1. Give the meaning of the term leverage.
It refers to the employment of an asset or funds for which the firm pays a fixed cost
or fixed return.
2. Define composite Leverage.
It is combination of both operating and financial leverages. It expresses the effect of
change in sales over change in taxable profit.
3. Define Financial Leverage.
The tendency of the residual net income to vary disproportionately with operating
profit.
4. What is the significance of financial leverage?
Financial leverage is having the following significances:

Planning and designing of capital structure

Profit planning.

5. Define Leverage.
James Horne has defined leverage as the employment of an asset or funds for which
the firm pays a fixed cost or fixed return. The fixed cost indicates fixed operating
cost, and fixed return indicates financial cost it should remain constant irrespective
of changes in the volume of output or sales.

6. List out the types of Leverage.

Leverages can be classified into following four types:
Financial leverage
Operating leverage
Composite leverage
Working capital leverage.
7. What is meant by operating leverage?
Operating leverage indicates any changes in the sales may related to change in
revenue. It may be defined as the tendency of operating profit to vary
disproportionately with the sales. Simply said when a firm has to pay fixed cost
regardless of volume of output or sales. In any firm has a high degree of operating
leverage means it employs a huge amount of fixed costs and a lower amount of
variable costs. Suppose the firm will have a lower operating leverage means its
employees a huge amount of variable cost at a lower amount of fixed cost.
8. What is meant by Trading on Equity?
Financial leverage is also some times termed as trading on equity. However, most of
the authors on financial management are the opinion that the term trading on
equity should be used for the term financial leverage only when the financial
leverage is favorable. The company resorts to trading on equity with the objective of
giving the equity share holders a higher rate of return than the general rate of
earning on capital employed in the company, to compensate them for the risk they
have to bear.

9. What are the limitations of trading on equity?

The financial leverage or traded on equity suffers from the following limitations:
Double edged weapon
Beneficial only to companies having stability of earnings
Increases risk and rate of interest
Restrictions from financial institutions.
10. Give the meaning of working capital leverage.
Working capital means excess current assets over current liabilities. Actually the
working capital leverage determines the sensitivity level of return on investment
(ROI) of changes in the level of current assets.
Working capital leverage = %change in ROI
--------------------------% change in CA
Note: suppose the earnings are not affected by the change in current assets and then
working capital leverage can be calculated as follows.
WCL = CA/ TA +_ DCA
Where:
WCL = working capital leverage
CA = current Assets
TA = Total Assets
DCA = Changes in the level of current assets

11. State the factors involved in operating leverage.

The quantum of sales

The amount of fixed costs

The contribution margin

12. Define profit planning.

The earning per share is affected by the degree of financial leverage. If the
profitability of the concern is increasing then fixed cost funds will help in increasing
the availability of profits for equity stock holders. Therefore, financial leverage is
important for profit planning. The level of sales and resultant profitability is helpful
in profit planning. An important tool for profit planning is break even analysis. The
concept of break even analysis is used to understand financial leverage. So
financial leverage is vey important for profit planning.

Capital structure
1. Define capital structure.
According to Gerestenbeg, Capital structure of a company refers to the
composition or make up of its capitalization and it includes all long term
resources viz., loans, reserves, shares and bonds.
2. Write a note on importance of capital structure.
The term capital structure refers to the relationship between various long
term forms of financing such as debenture, preference share capital, and
equity share capital.
Financing the firms asset is a very crucial problem in every business and
as a general rule there should be a proper mix of debt and equity capital
in financing firms asset.

 The use of long term fixed interest bearing debt and preference share
capital along with equity shares is called financial leverage or trading on
equity.
3. What is optimal capital structure?
The optimum capital structure may be defined as that capital structure or
combination of debt equity that leads to the maximum value of the firm optimal
structure maximizes the value of the company and hence wealth of its owners
and minimizes the companys cost of capital. Thus, every firm should aim at
achieving the optimal capital structure and then to maintain it.
4. Name various theories of capital structure.
Different kinds of theories have been propounded by different authors to explain
the relationship between capital structure, cost of capital and value of the firm.
The main contributors to the theories are Durand, Ezra, Solomon, Modigliani and
Miller. The important theories are discussed below:
Net Income Approach
Net Operating Income Approach
The Traditional Approach
Modigliani and Miller Approach
5. What are the essentials of sound capital mix?
A sound or an appropriate capital structure should have the following essential
features:

Maximum possible use of leverage

The capital structure should be flexible

To avoid undue financial/ business risk with increase of debt

The use of debt should be within the capacity of a firm.

Minimum possible risk of loss of control

Undue restrictions in agreement of debt

6. What is capital gearing?

The term capital gearing refers to the relationship between equity capital and
long term debt. It may be planned or historical , the latter describing a state of
affairs where the capital structure has evolved over a period of time, but not
necessarily in the most advantageous way. In simple words capital gearing
means the ratio between the various types of securities in the capital structure
of the company.
7. What is meant by financial risk?
The financial risk arises on account of the use of debt or fixed interest bearing
securities in capital. A company with no debt financing has no financial risk. The
extent of financial risk depends on the leverage of the firms capital structure. A
firm using debt in its capital has to pay fixed interest charges and the lack of
ability to pay fixed interest increases the risk of liquidation. The financial risk
also implies the variability of earnings available to equity shareholders.
8. What are the assumptions of MM hypothesis?
The M&M approach is based upon the following assumptions:

There are no corporate taxes

There is a perfect market

Investors act rationally

The expected earnings of all the firms have identical risk characteristics

The cut off point of investment in a firm capitalization rate.

Risk to investors depends upon the random fluctuations of expected

earnings and the possibility that the actual value of the variables may
turn out to be different from their best estimates.

All earnings are distributed to the share holders

9. Differentiate capitalization and capital structure.

Capitalization is a quantitative aspect of the financial planning of an

enterprise while capital structure is concerned with the qualitative
aspect.

Capitalization refers to the total amount of securities issued by a

company while capital structure refers to the kinds of securities and
the proportionate amounts that make up capitalization.

10. Write a note on Arbitrage process.

The Arbitrage process is the operational justification of MM hypothesis. The
term Arbitrage refers to an act of buying an asset or security in one market
having lower price and selling it another market at a higher price. The
consequence of such action is that the market price of the securities of the two
firms exactly similar in all respects except in their capital structures cannot for
long remain different in different markets. Thus, arbitrage process restores
equilibrium in values of securities.
11. Discuss any five factors relevant to determining capital structure.
The factors influencing the capital structure are discussed as follows:
Financial leverage or trading on equity
Growth and stability of sales
Cost of capital
Risk
Cash flow ability to service debt
Nature and size of a firm
Control
Flexibility
Requirement s of investors
Capital market conditions
Asset structure

12. Explain the term point of indifference.

The point of indifference refers to that EBIT level at which earnings per
share(EPS) remains the same irrespective of different alternatives of debt equity
mix. While calculating the equivalency point, the provision for repayment of debt
or obligation towards sinking fund has not been considered so far. However,
sinking fund appropriations for redemption of debt decrease the amount of
earnings available for equity shareholders. Thus, a finance manager may be
interested to determine the level of EBIT at which uncommitted earnings per
share (UEPS) after deducting sinking fund appropriation would be the same.
The equivalency point for uncommitted earnings per share can be
calculated as below:
(X- I1) (I - T) PD SF
----------------------------S1

(X-I2) (I-T) PD SF
---------------------------S2

Where:
X = Equivalency point or point of indifference or break even EBIT level
I1 = Interest rate under alternative financial plan 1
I2 = Interest rate under alternative financial plan 2
T = Tax rate
PD = preference dividend
SF = sinking fund obligations
S1 = No. of equity shares or amount of share capital under plan 1
S2 = No. of equity shares or amount of share capital under plan 2

13. What do you understand by bankruptcy costs?

When a firm uses more and more debt in its capital mix the financial risk of the
firm increases. It may not be able to pay the fixed interest to the suppliers of
debt and they may force the firm to liquidate. The firm runs in to the cost of
financial distress and bankruptcy.
14. What do you understand by agency costs?
When a firm raises debt the suppliers of debt put restrictive conditions in the
loan agreement resulting into lesser freedom to the management in decision
making called agency costs.
15. Write a short note on pecking order theory of capital structure.
The pecking order theory as suggested by Myres in 1984, the order of preference
for raising finance arises because of their existence of a asymmetric information
between the market and the firm. He argues that because of asymmetric
information, the market may undervalue the project and the firm may prefer
internal funds and then raising of debt as compared to issue of new equity share
capital.

Dividend policy
1. Name the two main theories of dividend.
The two main theories of dividend:

The irrelevance concept of dividend

i.

Residual approach

ii.

Modigliani and Miller approach

The relevance concept of Divided

i.

Walters Approach

ii.

Gordons Approach

2. Enlist the factors that influence the dividend policy of a firm.

The following are the important factors which determine the dividend
policy of a firm:
a. Legal requirements
b. Magnitude and trend of earnings
c. Desire and type of share holders
d. Nature of industry
e. Age of the company
f. Future financial requirements
g. Governments economic policy
h. Taxation policy
i.

Inflation

j.

Control objectives

k. Requirements of institutional investors

l.

Stability of dividends

m. Liquid resources.

3. What is the significance of stable dividend?

A stable dividend policy is advantageous to both the investors and the
company on account of the following:
a) It is sign of continued normal operations of the company
b) It stabilizes the market value of shares
c) It creates confidence among the investors
d) It provides a source of livelihood to those investors who view
dividends as a source of funds to meet day to day expenses.

4. What is scrip dividend?

A scrip dividend promises to pay the shareholders at a future specific
date. In case a company does not have sufficient funds to pay dividends in
cash, it may issue notes or bonds for amounts due to the shareholders.
The objective of scrip dividend is to postpone the immediate payment of
cash. A scrip dividend bears interest and is accepted asa collateral
security.
5. What is dividend pay out ratio?
Dividend pay out ratio is otherwise called as 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 dividend pay out is preferred by the firms because it is
related to their ability to pay dividends.
6. What do you mean by bonus issue?
According to Oxford English dictionary, bonus means extra dividend to
the shareholders in a joint stock company from surplus profits. This
extra dividend may be paid in the form of cash or shares. When it is paid
in the form of shares. The shares so issued are termed as bonus shares.
Bonus shares are therefore, shares allotted by capitalization of the
reserves or surplus of a corporate enterprise.

7. Give sources of bonus issue.

The bonus shares can issued out of the following sources:
1) Balance in the profits and loss account
2) General reserve
3) Capital reserve
4) Balance in the sinking fund Reserve for Redemption of
Debentures have been redeemed
5) Development of rebate reserve, development of allowance
reserve, etc., allowed under the Income Tax Act,1961 after the
expiry of the specified period (8 yrs)
6) Capital redemption reserve account
7) Premium received in cash.
8. Bonus issue vs. stock split.
Stock dividend means the issue of bonus shares to the existing
shareholders of the company. It amounts to capitalization of earnings and
distribution of profits among the existing shareholders without affecting
the cash position of the firm. Stock split, on the other hand, means
reducing the par value of the shares by increasing the number of shares
proportionately.
9. Write a note on dividend policy in practice.
We have observed earlier that the main consideration in determining the
dividend policy is the objective of maximization of wealth of
shareholders. Thus, a firm should retain the earnings if it has profitable
investment opportunities, giving a higher rate of return than the cost of
retained earnings, otherwise it should pay them as dividends. It implies
that a firm should treat retained earnings as the active decision variable
and the dividends as the passive residual.

10. What do you mean by right issue?

In case of joint stock companies or corporations, generally the
shareholders are given the pre emptive right either by their character
or by the act applicable to them. The pre emptive right gives holders of
common stock (or equity shares) the first option to purchase additional
issue of common stock. Right shares are the shares so issued to the
shareholders under such pre emptive right.
11. Write a note on buy back shares.
The companies (Amendment) ordinance (October 31,1988 and January
7,1999) have allowed companies to buy back shares subject to
regulations laid down by SEBI. The new sections (77A and 77B) in the
ordinance lay down following provisions concerning buy back shares:

A company can finance its buy back of (i) its free reserves or (ii)
the securities premium account or (iii) proceeds of an earlier issue
other than fresh issue of shares made specifically for buy back
purposes.

A company is allowed to buy back subject to following conditions:

a) The buy back is authorized by its articles;
b) A special resolution has been passed in general meeting of
the company authorizing buy back;
c) The buy back does not exceed 25 per cent of the total paid
up capital and free reserves of the company.
d) Debt equity (including free reserves)does not exceed to
2:1 after the proposed buy back;
e) All shares or other specified securities are fully paid up;
and
f) The buy back is in accordance with SEBI regulations framed
for this purpose.

12. Outline the types of dividend policies.

The various types of dividend policies are discussed as follows:

Regular dividend policy

Stable dividend policy

Irregular dividend policy

No dividend policy.

13. Name various methods of dividends.

The forms of dividends are:

Profit dividend

Liquidation dividend

Interim dividend

Final dividend

Cash dividend

Scrip or bond dividend

Property dividend

Stock dividend