Financial management unit 3 Financing and Dividend Decision

Prepared and presented by,
N. Ganesha Pandian
Financial Management
Course code: BA 5203
Unit 3: Financing and Dividend
Decisions
MSM MBA Financial Management - Ganesha
Pandian1

Content
 Leverages – Operating and Financial Leverages
 Measurement of Leverages
 Degree of Operating, Financial and Combined
Leverages
 EBIT – EPS analysis – Indifference point
 Capital Structure – Theories
 Net Income Approach (NI) – Net Operating Income
Approach (NOI) – MM Approach
 Determinants of capital structure
Contd…
Pandian2

 Dividend Decision
 Issues in Dividend Decisions, Importance
 Relevance and Irrelevance theories
 Walter’s model and Gordon’s Model
 MM Model
 Factors determining Dividend policy
 Types of dividend policy
 Forms of Dividend
Pandian3

What is Leverage?
Pandian4
 Leverage analysis - technique to quantify risk
and return relationship of different capital
structure
 If Proportion of debt capital more than share
capital –risk and return will be high
 If Proportion of debt capital less than share
capital – risk and return will be low

Meaning of Leverage
Pandian5
 Leverage – Firm’s ability to use fixed cost assets
to magnify the return to its shareholders
Definition:
Acc to James Horne: Leverage is the employment
of an asset or fund for which the firm pays fixed
or fixed return
J.E. Walter: Leverage is the percentage return on
equity to percentage return on capitalization
Contd…

Pandian6
 If no fixed cost – no leverage exists
 Leverage – result of employment of an
asset or funds having fixed cost or return
 A high degree of leverage – implies small
changes in sales impact the large
changes in profit

Types of Leverages
Pandian7
1. Operating Leverage
2. Financial Leverage
3. Combined Leverage

Operating Leverage
Pandian8
 The firm’s ability to use fixed operating cost to
magnify the effects of changes in sales on
earnings before interest and tax (EBIT)
Operating Leverage = Contribution
EBIT
Contribution = Sales – Variable cost

Degree of Operating Leverage
Pandian9
 Represents percentage changes in operating
profit results from a percentage change in the
sales.
Degree of Leverage
(Operating Leverage) = Percentage change in
EBIT
Percentage change
in sales

Example Problem 1
Pandian10
 A Company sells 1000 units @ Rs. 20 per unit.
The Cost of Production is Rs. 14 per unit. The
Company’s fixed cost is Rs. 1,000. If sales target
(in units) increased by 50%
Compute Degree of Operating Leverage and
Operating Leverage.

Solution
Pandian11
 For 1000 units, sales = 20*1000 = 20,000
Less: Cost of production = 14,000
(14*1000)
Contribution = 6,000
Less: Fixed cost = 1,000
(EBIT) Operating profit = 5,000
Contd..

Pandian12
 If 50% increase in production then 1500 units are
produced
Sales = 20*1500 = 30,000
Less: Cost of Production = 14*1500 = 21,000
(Variable cost)
Contribution = 9,000
Less: Fixed Cost = 1,000
Operating Profit (EBIT) = 8,000
Contd..

Pandian13
When 1000 units, Operating Leverage = Contribution/EBIT
= 6000/5000 = 1.2
When 1500 units, Operating Leverage = Contribution/EBIT
= 9000/8000 = 1.12
Degree of Operating = (8000 – 5000 ) * 100
5000
50%
= 60/50 = 1.2
So 1% increase in sale will cause 1.2% increase in profit

Significance of Operating
Leverage
Pandian14
 Higher Degree of Leverage can dramatically
increase the operating profit
 More risk is involved in higher Degree of
Leverage
 Higher the leverage, lower the margin of safety
 Firm should operate above its Break Even Point

Financial Leverage
Pandian15
- Occurs when a firm uses fixed interest
(debentures and preference share)
- Interest on debenture and preference share does
not vary with EBIT/ operating profit
- EBIT after interest paid available to equity share
holders called “Earnings per share”

Definition of Financial Leverage
Pandian16
 An ability of firm to use its fixed financial charges
to magnify the effect of changes in EBIT on the
firm’s earnings per share.
Financial Leverage = EBIT
EBT
EBIT = Earnings before interest and tax; EBT =
Earnings before tax

Degree of Financial Leverage
Pandian17
 Percentage change in taxable profit as a result of
percentage change in operating profit.
DFL = Percentage change in EPS
Percentage change in EBIT
- Firm earns more from fixed rate or charge
- High rate of return with lower rate for interest rate –
firm gains
- “trading on equity”

Significance of Financial
Leverage
Pandian18
 Objective of planning an appropriate capital
structure – to maximize the return on equity
shareholder’s funds/ Maximize EPS.
 Increase in debt capital –increases the risk of
high fixed financial cost
 Increase in risk of insolvency

Example problem 2
Pandian19
 ABC company ltd., has a choice of three financial
plans
Compute financial leverage and interpret it.
Plan I Plan II Plan III
Equity
share
capital
6,00,000 5,00,000 2,00,000
Debenture
(10%)
4,00,000 5,00,000 8,00,000
EBIT 2,50,000 2,50,000 2,50,000
Contd…

Solution
Pandian20
 Plan I:
Operating profit = 2,50,000
Less: Interest = 40,000
EBT = 2,10,000
Financial Leverage = 2,50,000 / 2,10,000 = 1.19
Contd…

Pandian21
 Plan II:
EBT = 2,00,000
 Plan III:
EBT = 2,10,000
Higher the financial leverage;
Higher return to equity share hold
High financial risk

Combined leverage
Pandian22
 Measures variations in sales and variation in
taxable income
 Financial leverage and operating leverage
establishes relationship between operating profit
and earning per share and relationship between
operating profit and sales in latter case.
Combined Leverage = Operating leverage ×
Financial Leverage
= Contribution × EBIT =
Contribution
EBIT EBT
EBT

Capital structure Decisions
Pandian23
 Meaning of Capital Structure:
- Refers to mix of sources – long term
funds raised in the proportion of equity
capital, preference capital, debentures
and other sources.

Definition of Capital Structure
Pandian24
 According to I. M. Pandey: Capital structure
refers to the composition of long term sources of
funds such as debentures, long term debt,
preference share capital and ordinary share
capital including reserves and surpluses
(retained earnings)
 John. J. Hampton: Capital structure is the
combination of debt and equity securities that
comprises a firm’s financing of its assets.

Types of securities
Pandian25
1. Shares : Equity shares, Preference
shares
2. Debt: Debentures, Bonds, Public
deposits, loans from banks and
financial institutions
Ration or proportion:
Capital gearing may be high, low or even.

Patterns of Capital Structure
Pandian26
 Four fundamental factors are:
1. Equity share capital only (including reserves
and surpluses)
2. Equity share capital and Preference share
capital
3. Equity, Preference share capital and long
term debt
4. Equity share capital and long term debt

Optimal capital structure
Pandian27
 Selection of combination of equity and
debt so as to maximize the share
holders’ wealth.
 At optimal point, cost of capital is
minimum and market price per share is
maximum.

Features of an appropriate capital
structure
Pandian28
1. Trading on
equity
2. Stability on
sales
3. Exercise
control
4. Cost of
capital
5. Statutory
requirements
6. Capital
market
conditions
7. Corporate
taxation
8. Government
policies
9. Flexibility
10. Timing
11. Size of team
12. Purpose of
financing
13. Period of
finance
14. Maneuverabil
ity
15. Floatation
cost
16. Requirement
of investors
17. Provision for
future growth

Capital structure planning technique
Pandian29
 EBIT – EPS analysis is applied
 Choice of Combination of different
financial structure
 Best choice is maximum EPS at given
EBIT

Point of Indifference
Pandian30
 Indifference point refers to the EBIT level at which EPS remains
unchanged irrespective of debt-equity mix
Formula for indifference point
(x-I1) (1-T)-P.D = (x-I2)(1-T) – P.D
N1 N2
X = EBIT
I1 = Interest under financial plan 1 P.D = Preference
dividend
I2 = Interest under financial plan 2 N2 = No. of
equity shares (plan 2)
T = Tax rate N1 = No. of equity
shares (plan 1)

Theories of Capital Structure
Pandian31
 Capital structure decision impact on the value of
the firm.
 Choosing appropriate capital structure
maximizing the value of firm.
4 approaches in theories of capital structure
1. Net income approach (NI)
2. Net operating income approach (NOI)
3. Traditional approach
4. Modigliani and Miller approach
- Approaches analyses the relationship between
the leverage and cost of capital and the value
of firm.

Assumptions
Pandian32
 Only two sources of funds – debt and equity
 Total assets o firm and capital employed are
constant
 Earnings distributed to shareholders (no retained
earnings)
 The firm earns operating profit and expected to
grow
 Business risk is constant – not affected by
financing mix decision
 No taxation
 All investors having same expected returns
 Cost of debt is less than cost of equity

Net Income approach
Pandian33
 Suggested by Durand
 The value of firm/shareholder’s wealth increases as
the debt content in capital structure increases.
Assumptions:
1. No corporate taxes
2. Cost of debt kd is less than cost of equity ke.
3. Use of debt content doesn’t change the risk
perception of investor
Contd…

Pandian34
 Total value of firm given by V=S+D
V- Total market value
S- Equity share (Market value)
D- Debt (Market value)
Market value of equity share = Net income
Equity capitalization rate
or cost of equity
Ko Overall cost of capital = EBIT
Value of firm

Net Operating Income (NOI)
approach
Pandian35
 Suggested by Durand
 The market value of firm not affected by the
change in capital structure
Market value of firm (V) = EBIT (Net operating
income)
Overall cost of capital
Cost of equity (Ke) = EBT
Value of equity (S)

NOI assumptions
Pandian36
- Overall cost of capital remains constant for any
debt-equity mix
- The market capitalizes the value of firm as whole
- The use of less costly debt funds increases the
risk of shareholders
- No corporate taxes
- Cost of debt is constant

Traditional approach
Pandian37
 Intermediate approach between NI approach
and NOI approach
 Use of debt up to a point is advantageous.
Beyond that point, debt increases the financial
risk of shareholders.
 Optimal point – capital structure and minimum
overall cost of capital.

Modigliani and Miller approach
Pandian38
 Relationship between cost of capital, capital
structure and total value of firm.
A, when there are corporate taxes B, When there
are no corporate taxes
Argument that the financial leverage / capital
structure does not influence the overall cost of
capital, it is because of shareholders expectation
on risk class.

MM approaches assumptions
Pandian39
1. The capital market are perfect
2. The firms can be classified into homogenous
risk class
3. All investors have same expectations from a
firm’s net operating income (EBIT)
4. 100% payout ratio.
5. There are no corporate taxes

When there are Corporate taxes
Pandian40
 This approach agreed that the capital structure will
affect the value of firm and cost of capital when taxes
are applicable.
- Because interest is deductible expenses for tax
purposes.
- So effective cost of debt is lower than contractual rate
of interest
MM approach:
Value of unlevered firm (Vu) = EBIT /Ke (1-t)
(Or) Vu = EAT/Ke

Criticisms of MM approach
Pandian41
 Criticism for perfect market assumption
 Arbitrage process
Conclude:
Controversies still exists between traditional
and MM approach

Example Problem 3
Pandian42
 Capital structure alternatives of a firm
A B
C
Equity share (Rs. 10 each) 60 30
10
12 % debentures - 20
25
15% loan from bank - 10
25
Contd…

Solution
Pandian43
A B
C
EBIT 60*20/100 60*20/100+2
12
Less: interest 12 %
(Debentures) 0 2.4
3.0
Less: interest 15%
(loan) 0 1.5
3.75
12 8.1
5.25
Contd…

Pandian44
 Earnings per share (EPS)
A = 7.8/6 = 1.3
B = 5.265/3 = 1.755
C = 3.4125/1 = 3.4125
Inference:
So plan ‘C’ having higher EPS Earnings per share

Dividend Decision/ Dividend
Policy
Pandian45
 Relationship between dividend policy and market
price of share – controversial and unresolved
questions.
Meaning of dividend:
Part of the profit after tax – distributed among the
owners/shareholders of the firm
Cash dividend, stock dividend or property dividend
Payout – paid to the shareholders

Types of Dividend
Pandian46
1. Regular Dividend: paid annually – proposed by
board of directors and approved by the share
holders. Paid per share basis
2. Interim Dividend: if articles permit – dividend
paid at any time between two Annual General
meetings – only abnormal profit
3. Stock Dividend: in the form of bonus shares in
lieu of cash dividend
Contd…

Pandian47
4. Bond Dividend: Sometimes Dividends
may be paid in form of bonds for a long
term period – in rare cases
5. Property Dividend: Dividend paid in form
of asset instead of payment of dividend
in cash
In India, Payment of Dividend through
cash or bonus shares are only
permissible

Meaning of Dividend Policy
Pandian48
 Refers to policy on firms regarding the amount paid
as dividend and retained earnings back to profit
 Payout – paid to shareholders as dividend
 Retained earnings – firms retain back from profit
Decision to balance between retention and
distribution – because distribution gains investor
confidence and whereas retention reduces floatation
cost or no explicit cost

Definition of Dividend Policy
Pandian49
 According to Weston and Brigham: Dividend
policy determines the division of earnings
between payments to shareholders and retained
earnings
 Gitman: The firm’s dividend policy must
represents a plan of action to be followed
whenever dividend decision must be made.

Nature of Dividend Policy
Pandian50
1. Tied up with retained earnings
2. Influence on financing decision
3. Impact on shares
4. Optimal dividend policy

Objectives of Dividend Policy
Pandian51
 Providing sufficient financing
 Return to shareholders
 Wealth maximization

Factors determining Dividend Policy
Pandian52
 Stability of earnings
 Age of firm
 Regularity and stability
in dividend payment
 Time of repayment of
dividend
 Liquidity of funds
 Policy of control
 Repayment of loans
 Government of policies
 Legal requirements
 Trade Cycles
 Need for additional
capital
 Ability to borrow
 Extent of share
distribution
 Past dividend rates
 Taxation

Types of Dividend Policy
Pandian53
1. Generous dividend policy : Dividends paid at
generous rate
2. Erratic dividend policy : Not cared about
shareholders
3. Stable dividend policy : i. Constant dividend
per share ii. Constant payout ratio iii.
Constant dividend per share plus extra
dividend

Constant Dividend per share plus
extra dividend
Pandian54
Advantages:
1. Gains investor confidence
2. Maintain the stability on market value of firm
3. Regular income to shareholders
Disadvantages:
1. Higher rates are risky

Dividend theories
Pandian55
 There are conflicting opinions regarding
the impact of dividend decisions on the
value of firm.
 Dividend theories broadly classified into
1. Relevance theory and 2. Irrelevance

1. Theories of Relevance
Pandian56
 Relevance concept of Dividend
Walter and Gordon model – Dividend decisions
impact the market price of share and value of
firm.
A, Walter model:
Professor James E. Walter – argues that dividend
policy – an active variable control share price and
thus value of firm.
Contd…

Pandian57
 Walter holds the relationship between firm’s internal
rate of return (r) and cost of capital (k)
If r<k then high earning to shareholders (invest
elsewhere)
If r>k then retain earnings
1. Growth firm – no dividend payment; 100% retention
is optimum
2. Normal firm – indifferent between retention and
distribution
3. Declining firm – no retention; 100% payout is

Assumptions in Walter model
Pandian58
1. Retained earnings – only source of financing
2. The return on the firm’s investment remains
constant
3. The cost of capital for the firm remains constant
4. The firm has a infinite life
5. All the earnings are distributed or reinvested in
firm
6. EPS and dividend remains constant

Walter’s Formula
Pandian59
 Market price per share (P) = D+ (r/k) * (E-D)
k
D- Dividend per share;
r- rate of return;
k- cost of capital;
E- Earnings per share

Implications (Walter model)
Pandian60
1. The optimal payout ratio for a growth firm is
nil.
2. Payout for a normal firm is irrelevant
3. Optimal payout for a declining firm is 100%
4. Higher the retention ratio ; higher the value
of firm

Criticisms
Pandian61
1. No external financing
2. Constant rate of return
3. Constant opportunity cost

Example problem 4
Pandian62
Growth firm model
Cost of capital : 10%
Rate of return : 18 %
Rs. 100 per share of total 50,000 shares
Earnings per share Rs. 20
3 cases are: i. no retention ii. 40% retention iii. 100%
retention
Apply the Walter model to determine the Market price
and value of firm
Contd…

Solution
Pandian63
1. No retention:
D- dividend per share 20*100% = 20
MPS = 20+ (0.18/0.10) *(20-20) /0.10
= Rs. 200
Value of firm = no. of shares * market price per
share
V= 50,000*200
= 1,00,00,000 (i.e) 1 Crore Contd…

In case 40 % retention
Pandian64
 So 60% payout
Dividend per share = 20*60%
= Rs.12
MPS = 20+(0.18/0.10)*(20-12) / 0.10
= Rs. 264
Value of firm = 50,000 * 264
= 1,32,00,000 = 1.32 Crore
Contd…

In Case 100% retention
Pandian65
DPS = 20*0% = 0
MPS = 20+(0.18/0.10)*(20-0)/0.10
= Rs. 560
Value of firm = 50,000 * 560
= Rs. 2,80,00,000
= Rs. 2.80 Crore

Example problem 5 (Normal Firm
model)
Pandian66
Rate of return = 12 %
Cost of capital = 12 %
EPS = Rs. 15
i. No retention
ii. 40% retention
iii. 100% retention
Determine the Market price per share and Value of
firm Contd…

100% payout and no retention
Pandian67
DPS = EPS * payout ratio
= 15 * 100% = Rs. 15
MPS = D+ (r/k)* (E-D) /k
= 15 + (0.12/0.12) * (15-15) / 0.12
= Rs. 125
Value of firm (V) = 50,000 * 125
= 62.5 Lakhs
Contd…

40% retention and 60% Payout
Pandian68
= 15 * 60% = Rs. 9
MPS = D+(r/k) * (E-D) / k
= 9+(0.12/0.12)* (15-9) / 0.12
= Rs. 125
Value of firm (V) = 62.5 Lakhs
Contd…

100% retention and no payout
Pandian69
= 15 * 0% = 0
MPS = D + (r/k) * (E-D) / k
= 0+(0.12/0.12)*(15-0)/0.12
= Rs. 125
Value of firm (V) = 62.5 Lakhs

Example Problem : 6 (Declining firm)
Pandian70
Rate of return = 9%
Cost of capital = 15%
EPS = Rs. 12
1. No retention
2. 40% retention
3. 100% retention
Determine the Market price per share and Value of
firm
Contd…

100% payout and no retention
Pandian71
= 12 * 100% = 12
MPS = D+ (r/k)*(E-D) /k
= 12 + (0.09/0.12) *(15-0) / 0.12
= Rs. 80
Value of Firm (V) = no. of shares * market price per
share
= 50,000 * 80 = 40 Lakhs
Contd…

40% Retention and 60% Payout
Pandian72
DPS = EPS * Payout ratio
= 12 * 60% = 9
MPS = D+ (r/k)* (E-D) / k
= 9+(0.09/0.15)*(12-9) / 0.15
= Rs. 72
Value of firm (V) = 72 * 50,000
= 36 Lakhs
Contd…

100% Retention and no Payout
Pandian73
DPS = EPS * Payout ratio
= 12*0% = 0
MPS = D+ (r/k)*(E-D) / k
= Rs. 48
Value of firm (V) = 48 * 50,000
= 24 Lakhs

Gordon’s Model
Pandian74
 Myron Gordon – relevance of dividend decision to
value of firm
Assumptions:
1. The Firm is an equity firm. No external source of
fund and only retained earnings.
2. Rate of return (r) & Cost of capital (k) for the firm are
constant
3. Firm and earnings of firm are perpetual
4. No corporate taxes
5. Retention rate (b) & growth rate g= b*r are constant
6. Cost of capital (k) greater than growth rate (g)

Formula
Pandian75
 Market price of share (MPS) = D/ (k-g) or E(1-b)/(k-br)
D- Dividend per share;
g- growth rate;
b- retention ratio;
k- Cost of capital;
r- Rate of return

Implications
Pandian76
 The optimal payout for a growth firm is nil
 The payout for the normal firm is irrelevant
 The optimal payout for the declining firm is
100%

Criticisms of Gordon Model
Pandian77
 Assumption of 100% equity fund is not
good for wealth maximization objective.
 Rate of return and opportunity cost is
not in tune with realities.

Example Problem 7
Pandian78
Growth firm:
Earnings per share = Rs. 14
Rate of return = 20%
Determine market price per share under Gordon
model
If retention rate is i, 20% ii, 40% iii,60%
Contd…

Solution
Pandian79
i, 10% retention rate
Market price per share = D/(k-g)
D –Dividend per share = EPS*Payout ratio
= 14*80% = 11.2
g=b*r = 20%*20%
= 0.04*100 = 4%
MPS = 11.2/(15%-4%) = Rs.101.8
Contd…

Pandian80
ii, 40% retention rate
Dividend per share = EPS * Payout ratio
= 14* 60%
= Rs. 8.4
g = b*r = 40% * 20%
= 0.08*100 = 8%
MPS = 8.4 /(15% - 8%)
= Rs. 120
Contd…

Pandian81
iii, If 60% retention rate
= 14 * 40%
= 0.12 *100 = 12%
MPS = 5.6 / (15%-12%)
= Rs. 186.6

Example Problem 8
Pandian82
Normal Firm
Earnings per share = Rs. 14
Rate of return = 15%
Determine the market price per share under
Gordon model
If i, 20% retention rate ii, 40% retention rate iii,
60% retention rate
Contd…

Solution
Pandian83
i, In case of 20% retention rate
Dividend per share = EPS * payout ratio
= 14 * 80%
= 11.2
g = b * r = 20% * 15%
= 0.03*100 = 3%
MPS = D/(k-g) = 11.2/(15%-3%)
= 93.3
Contd…

Pandian84
iii, In case 60% retention rate:
= 14 * 60%
= 8.4
g = b * r = 40% * 15%
= 0.06 * 100
= 6%
MPS = D/(k-g) = 8.4 (15%-6%)
= 93.3
Contd…

Pandian85
ii, In case 40% retention rate:
= 14 * 60%
= 8.4
g = b*r = 40% * 15%
= 0.06 * 100 = 6%
MPS = D/(k-g) = 8.4/(15%-6%)
= 93.3

Example problem 9
Pandian86
Declining firm:
Earnings per share EPS = Rs. 14
Rate of return = 10 %
Determine the Market price per share i, 20%
retention rate ii, 40% retention rate iii, 60%
retention rate
Contd…

Solution
Pandian87
I, In case of 20% retention rate:
= 14*80%
= 11.2
g= b* r = 20% * 10%
= 0.02 = 2%
MPS = D/(k-g)
= 11.2 / 15%- 2%
= 86.15
Contd…

Pandian88
In case of 40% retention rate:
= 14 * 60%
= 8.4
g = b* r = 40%* 10%
= 0.04 = 4%
MPS = D/(k-g) = 8.4 /15%-4%
= Rs. 76.3
Contd…

Pandian89
In case of 60% retention rate:
= 14 * 40 %
= 5.6
g = b*r
= 60%*10% = 6 %
MPS = D/(k-g) = 5.6/15%-6%
= 62.2

Modigliani and Miller Hypothesis
Pandian90
Modigliani and miller argue that value of a firm is determined by its
earnings potentiality and investment pattern and not by dividend
distribution.
Assumptions:
1. Capital Markets are perfect. They are well informed about risk
and return of all types of securities.
2. No corporate or personal taxes.
3. The firm has a fixed investment policy
4. Investors predict future dividend and market price. Only one
discount rate for the entire period
5. All investment funded either by equity or retained earnings.

Formula for Modigliani and Miller
approach
Pandian91
Po = present value of dividends received + Market
price of the share
Po = D1 /(1+ke) + P1/(1+ke)
(i.e) Po = D1+P1/(1+ke)
Market price per share at end of period,
P1 = Po (1+ke) - D1
Contd…

No. of New shares Issuance
Pandian92
Investment Proposed XXX
Less: retained earning available
for investment:
Net income XXX
(-) Dividend distributed XXX
XXX
Amount raised by issue
of new shares XXX
No of new shares = Amount raised by issue of new shares/Issue
price per share

Implications
Pandian93
1. Higher the retention ratio, higher is the capital
appreciation enjoyed by the shareholders.
Capital appreciation = Amount of earnings retained
2. Dividend (if distributed) = capital appreciation (if
retained)

Criticisms
Pandian94
1. The assumptions of perfect capital market is
theoretical in nature
2. Impractical and unrealistic propositions about
dividends
i. dividends are irrelevant ii. Dividends do not
determine the firm value
3. Zero tax is not possible
4. The assumption of no floating, no transaction costs
are impossible

Example Problem 9
Pandian95
A company has existing share 40,000 ; market
price per share = Rs. 15; Dividend declared = Rs.
2; Cost of equity = 20%
Investment budget is = Rs.2,80,000
Determine market price per share, no. of shares to
be issue every year and market value of firm if 1.
Dividend distributed ii. Dividend not distributed
under MM Modigliani and Miller approachContd…

Solution
Pandian96
1. In case Dividend distributed:
I. Market price per share (p1) = Po(1+ke)-D1
= 15* (1+20/100)-2
=Rs. 16
II. New share issue
Investment proposed =Rs. 2,80,000
Retained earnings:
(net income – Dividend paid) =Rs. 40,000
1,20,000-80,000
=Rs. 2,40,000
Contd…

Pandian97
 Value to be issued / Funds to be raised = Rs.
2,40,000
III Market value of firm = (Existing shares + New
shares)*MPS
= (15,000+40,000)*16
= 8,80,000
Contd…

ii. In case Dividend not
distributed
Pandian98
I Market price per share P1 = Po*(1+ke)-D1
= 15* (1+20/100)-0
= Rs 18
II New share issue
Investment proposal = Rs. 2,80,000
Retained earnings:
(net income- dividend paid)
1,20,000 – 0 = Rs. 1,20,000
Funds to be raised= Rs. 1,60,000
Contd…

Pandian99
No of shares = 1,60,000 / 18 = 8889 shares
III Market value of firm = (Existing shares + New
shares) * MPS
= (40,000+8889)*18
= 8,80,000 approx
Inferences:
Market value of firm does not vary with whether
dividend distributed or not distributed under MM
approach

Pandian100

Financial management unit 3 Financing and Dividend Decision

Recommended

Recommended

More Related Content

What's hot

What's hot (20)

Similar to Financial management unit 3 Financing and Dividend Decision

Similar to Financial management unit 3 Financing and Dividend Decision (20)

More from Ganesha Pandian

More from Ganesha Pandian (20)

Recently uploaded

Recently uploaded (20)

Financial management unit 3 Financing and Dividend Decision