Dividend Decisions

There are basically two options which a firm has while utilizing its profits after tax. Firms can either plough back the earnings by retaining them or distribute the same to the shareholders.

The return to the shareholders either by way of the dividend receipts or capital gains is affected by the dividend policies of the firms. This is mainly due to the fact that the dividend policy decides the retention ratio and pay-out ratio (dividend as a percentage of profits).Furthermore, the dividend policy of a firm gains more importance especially due to the relationship between the dividend policy and equity returns. Thus, a firm's decision should meet the investors' expectations.

A few models which studied this relationship and the dividend policies of the firm are given below:-

1. Walter Model

2. Gordon Model

3. Miller & Modigliani Approach

4. Trend Analysis

5. Ratio Analysis

6. Inventory Turnover/Stock Turnover Ratio

7. Capital Turnover Ratio

8. Current Ratio

9. Capital Structure Ratio

10. Average Collection Period Ratio

11. Cash Flow Statement Ratios

12. Debt Ratios

Capital budgeting

Capital budgeting refers to decisions related to proposed long-term Capital Outlays. It is a formal process undertaken by a firm to efficiently invest in long-term activities in anticipation of expected flow from future benefits over a number of years. These benefits which may arise from a capital budgeting decision may be either in the form of increased revenues or reduction in costs. The capital budgeting decisions have enormous impact on the basis of the character of the firm on a long-term basis.

The main features of capital budgeting are:

i. Potentially large anticipated benefits

ii. Relatively high degree of risk

iii. Relatively long time period between the initial outlay and anticipated returns

Difficulties in Execution of Capital Budgeting

Capital expenditure decisions are of considerable significance as the future success and growth of the firm depends heavily on them. But they are beset with a number of difficulties:-

1. Firstly, the benefits from investments are received in some future period and the future is uncertain. Therefore, there is an element of risk.
2. Secondly, for the purpose of capital budgeting the future revenues have to be estimated. These estimated revenues depend on a number of factors like price, advertising and promotion etc. and adding to the uncertainties are the possibilities of shift in consumer preferences, the actions of competitors, technological developments etc.
3. Thirdly, costs incurred and benefits received from capital budgeting decisions occur in different time periods. They are logically not comparable because of the time value of money.
4. Lastly, it is not often possible to calculate in quantitative terms all the benefits or the costs relating to a particular investment decision.

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Cost of Capital

A Company procures Capital from various sources viz. Shareholders, Borrowings from Banks, Borrowings from the Public among others. Each source of capital involves some cost. This cost to the company is the "minimum rate of return" which it must earn on its investments in order to satisfy the various categories of investors who have made investments in the form of shares, debentures or term loans. Unless the Company earns this minimum rate, the investors will be tempted to pull out of the company. This cost is referred to as the Cost of Capital.

IMPORTANCE OF COST OF CAPITAL

1) Capital Budgeting Process
Cost of Capital works as a helpful tool in the Capital Budgeting Process. For Example in the Net Present Value Method (NPV) or in the discounted Cash Flow Method, the Future Cash Inflows of a Project are discounted by this rate.

2) Capital Structure Decisions
Cost of Capital also plays a pivotal in the Capital Structure Decisions. When the Management of the firm is to decide the optimum Capital Structure for the Company, then the Cost of Capital should be minimized and the value of the firm should be maximised.

3) Comparative analysis of various sources of finance
The Cost of Capital Concept can also be used in comparative analysis of various sources of Finance. Which source should be chosen can be determined on the basis of Cost of Capital.

4) Evaluation of Financial efficiency of Top Management
Cost of Capital is also helpful in evaluating the financial efficiency of the top management. The surplus generated over and above the cost of capital is used in determining the efficiency of the Management.

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Risk and Return

Starting a new venture that is totally unique?? The good news is that its risky and the returns associated with high risk are always higher. But with high risk there also comes a higher possibility of failure. What is needed is an optimum or acceptable value of risk to get a decent return.
Lets define the terms involved now. Risk is the chance that the actual outcome from an investment will differ from the expected outcome and Return is the motivating force, inspiring the investor in the form of Rewards, for undertaking the investment.
There are several factors involved in this which include

• Measuring the Rate of Return
• Sources of Risk
• Measurement of Risk
• Risk and return of a Portfolio
• Measurement of Beta
• Capital Asset Pricing Model (CAPM)

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Time Value of Money

Time Value of money or TVM arises from the fact that the value of money is time dependent. The Value of money received today is different from the value of money received after some time. This principle is based on the following reasons:-

Inflation-Under Inflationary conditions the value of money, expressed in terms of
purchasing power over goods and services, generally declines giving
rise to the principle of Time Value of Money.

Risk-$ 1 received today is certain whereas $ 1 receivable tomorrow is less certain."The bird in the hand" principle is extremely important at the time of investment appraisal again giving rise to the principle of Time Value of Money.

Consumption Preferences -There is a strong preference for the immediate rather than delayed consumption. The promise of a bigger pizza next week counts less for a starving man.

Investment Opportunities-Money like any other desirable commodity has a price, given the choice of $ 100 now or the same amount in one year, it is always preferable to take the $ 100 now because it could be invested over the next year at say 10% interest rate to produce $110 at the end of the year.

Time Value of Money is one of the most important concepts in finance. A deep understanding of this is required to lay the foundations of a sound degree in finance.

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