Fundamental of Financial Management
Unit-4 : Dividend Decision
Also Read: Fundamentals of financial management complete notes
SHORT TYPE QUESTIONS & ANSWERS
1. Define the term dividend.
Ans: The term dividend refers to that part of profits of a company which is distributed by the company among its shareholders. It is the reward of the shareholders for investments made by then in the shares of the company. The investors are interested in earning the maximum return on their investments and to maximize their wealth. A company, on the other ant, needs to provide funds to finance its long-term growth.
2. Define dividend Policy.
Ans: Dividend policy is a very flexible and wide word. It is made of two words Dividend+policy. We have explained the meaning of dividend I, e, it is a part of divisible profits and distribute amongst shareholders. Policy means practice or principles of working. There-fore dividend policy is concerned with the determination of dividend amount and its distribution plan. A company should formulate a sound dividend policy taking into consideration the amount of past dividend, present year profits, liquidity position and financial health of the company.
3. Mention five forms of dividend. Ans: Five forms of dividend are:
(1) Cash Dividend,
(ii) Stock Dividend,
(iii) Bond Dividend,
(iv) Property Dividend,
(v)Composite Dividend.
4. Mention five determinants of dividend policy.
Ans: Five determinants of dividend policy are:
(i) Legal Restrictions,
(ii) Magnitude and Trend of Earnings,
(iii) Desire and Type Share holders,
(iv) nature of Industry,
(v) Age of the company
5. Give four essentials of a sound dividend policy.
Ans: Four essentials of a sound dividend policy are:
(i) Stability,
(ii)Gradually Rising Dividend Rates,
(iii)Distribution of Dividend is cash,
(iv)Moderate Start.
6. Write five advantage of stable dividend policy.
Ans: Five advantage of stable dividend policy are:
(i) It is sign of continued normal operations of the company,
(ii) It stabilizes the market value of shares,
(iii)It creates confidence among the investors,
(iv) It provides a source of livelihood to those investors who view dividends as a source of funds to meet day to day expenses.
(v) It meets the requirements of institutional companies with stable dividends.
7. Give four reasons that some companies follow irregular dividend payments.
Ans: Four reasons that some companies follow irregular dividend payments are:
(i) Uncertainty of Earning,
(ii)Unsuccessful business operations,
(iii) Lack of liquid resources,
(iv) Fear of adverse effects of regular dividends on the financial standing of the company.
8. What is the meaning of Reserves.
Ans: In general, the term 'reserve' refers to the amount set aside out of profits. The amount may be set aside to cover any liability, contingency commitment or depreciation in the value of assets. Reserves mean, there fore, amounts which belong to the owners over and above the capital contributed by them. If amounts equal to reserves are invested are invested in out side investments, the reserve is called 'Reserve Fund. 'Technically speaking, the amount set aside out of profits may be either (i) a "provision
Or (ii) a 'reserve.
9. Mention five reasons of reserve. Ans: Five reasons of reserve are:
(i) To prevent the distribution of surplus in the form of dividends.
(ii) To provide for rainy days,
(iii) To provide additional capital I, e, laughing back of profits,
(iv) To enable equalization of dividends, and
(v) To supplement other reserves.
10. Write four types of reserves.
Ans: Four types of reserves are:
(i) General Reserve,
(ii) Specific Reserve,
(iii) Revenue Reserve,
(iv) Capital Reserves.
11. Define surplus.
Ans: There are different views regarding the meaning and concept of surplus. According to one school of thought, the balance remaining after deducing the liabilities and share capital from the total of assets is known as 'surplus'. In the opinion of the other school 'surplus', represents the undistributed eamings of a company I, e, the balance of profits remaining after paying dividends to the shareholders still, there are other in whose opinion 'surplus' is a left over which represents an addition to assets that is carried over on the 'equity side'. But surplus is solely an asset in any sense of the word. In simple words, 'surplus' may be described as the net income of the company remaining after payment of dividend and all other expenses. It is the difference between the book value of the assets and the sum of liabilities and capital.
12.Mention five needs or advantages of laughing book of profit.
Ans: Five needs or advantages of laughing book of profit are:
(i) For the replacement of old assets which have become obsolete.
(ii) For the expansion and growth of the business.
(iii) For contributing towards the fixed as well as the working capital needs of the company.
(iv) For improving the efficiency of the plant and equipment.
(v) For making the company self-dependent of finance from outside sources.
13. Write five factors that influencing ploughing back of profit.
Ans: Five factors that influencing ploughing back of profit are
(i) Earning capacity,
(ii) Desire and Type of Shareholders,
(iii) Future Financial Requirements,
(iv) Dividend Policy,
(v) Taxation policy.
14. What is bonus share.
Ans: The dictionary meaning of bonus shares is a premium or gift, usually of stock, by a corporation to share-holders' or 'an extra dividend paid to shareholders in a joint stock company from surplus profit, 'However, in legal context the meaning is not the same. A bonus share is neither dividend nor a gift. It is governed by so any regulations that it can neither be declared like a dividend nor gifted away. Issue of bonus shares in lieu of dividend is not allowed as according to section 205 of the companies Act, 1956 no dividend can be paid except in cash. It cannot be termed as a gift also because it only represents the past sacrifice of the shareholders.
15. What are the basic issues involved in dividend policy?
Ans: There are certain basic issues involved in determining the sound dividend policy.
These are:
(i) Cost of capital: Cost of capital is one of the considerations for taking a decision whether to distribute dividend or not. As a decision making tool, the board calculates the ratio of rupee profits the business expects to earn (Ra) to the rupee profits that the shareholders can expect to earn outside (RC) i.e. Ra/Rc. If the ratio is less than one, it is a signal to distribute dividend and if it is more than one, the distribution of dividend will be discontinued.
(ii) Realisation of objectives: The main objectives of the firm, i.e maximisation of wealth for shareholders-including the current rate of dividend-should also be aimed at in formulating the dividend policy.
(iii) Shareholders' group: Dividend policy affects the shareholders' group. It means a company with low payout and heavy reinvestment attracts shareholders interested in capital gains rather in current income whereas a company with high dividend pay-out attracts those who are interested in current income.
(iv) Release of corporate earnings: Dividend distribution is taken as a means of distributing unused funds. Dividend policy affects the shareholders wealth by varying its dividend pay out ratio. In dividend policy, the financial manager decide whether to release corporite earnings or not.
16. What are the assumptions of MM hypothesis?
Ans: Assumptions of MM hypothesis: (i) Capital markets are perfect.
(ii) Investors behave rationally.
(iii). There are no floatation and transaction costs.
(iv) No investor is large enough to effect the market price of shares.
(v) There are either no taxes or there are no differences in the tax rates applicable to dividends and capital gains.
(vi) The firm has a rigid investment policy.
(vii) Risk of uncertainty does not exist.
17. Mention the Assumption of Walter's Model.
Ans: Assumption of Walter's Model:
(i) The investment of the firm are financed through retained earnings only and the firm does not use external sources of funds.
(ii) The internal rate of return (R) and the cost of capital (K) of the firm are constant.
(iii) Earnings and dividends do not change while determining the value.
(iv) The firm has a very long life.
18. Mention three Criticism of Walter's Model
Ans: Criticism of Walter's Model:
(i) The basic assumption that investments are financed through retained earnings only is seldom true in real world. Firms do raise funds by external financing.
(ii) The internal rate of return, i.e. (R) also does not, remain constant. As a matter of fact, with increased investment the rate of return also changes.
(iii) The assumption that cost of capital (K) will remain constant also
does not hold good. As a firm's risk pattern does not remain constant, it is not proper assume that K will always remain constant.
19. What are the sources of bonus issues?
Ans: The bonus shares can be issued out of the following:
(i) Balance in the profit and loss account.
(ii) General reserve
(iii) Capital reserve
(iv) Balance in sinking fund reserve for redemption of debentures after the debentures have been redeemed.
(v) Capital redemption reserve account.
(vi) Share premium received in cash.
20. Write the argument of MM.
Ans: The argument given by MM in support of their hypothesis s that whatever increase in the value of the firm results from the payment of dividend will be exactly off set by the decline in the market price of shares because of external financing and there will be no change in the total wealth of the shareholders.
LONG TYPE QUESTIONS & ANSWERS
1.Discuss the various determinants of dividend policy.
Ans: Following are the important factors which determine the dividend policy of a firm:
(i) Legal Restrictions: Legal provisions relating to dividends as laid down in sections 93. 205, 205 A, 206 and 207 of the companies Act, 1056 are significant because they lay down a framework within which dividend policy is formulated. This provisions require that dividend can be paid only out of current profits or past profits after providing for depreciation or out of the moneys provided by Government for the payment of dividends in pursuance of a guarantee given by the Government. The companies Rules, 1975 require a company providing more than ten percent dividend to transfer certain percentage of the current year's profits to reserves. Companies Act, further provides that dividends cannot be paid out of capital, because it will amount to reduction of capital adversely, the security of its creditors.
(ii) Magnitude and Trend of Earnings: The amount and trend of earnings is an important aspect of dividend policy. It is rather the starting point of the Dividend policy. As dividends past years profits, earnings of a company fix the upper limits on dividends. The dividends should generally, be paid out of current years earnings only as the retained earnings of the previous years become more or less a part of permanent investment in the business to earn current profits. The past trend of the companies earnings should also the dividend decision.
(iii) Desire and Type of share holders: Although, legally, the discretion as to whether to declare dividend or not has been left with the Board of Directors, the directors should give the importance to the desires of shareholders in the declaration of dividends as they are the representatives of shareholders. Desires of shareholders for dividends depend upon their economic status. Investors, such as retired persons, widows and other economically weaker persons view dividends as a source of funds to meet their day to day living expenses. To benefit such investors, the companies should pay regular dividends. On the other hand, a wealthy investor in a high income tax bracket may not benefit by high current dividend incomes. Such an investor may be interested in lower current dividends and high capital gains. It is difficult to reconcile these conflicting interests of the different type of share holders, but a company should adopt its dividend policy after taking into consideration the interests of its various groups of shareholders.
(iv) Nature of Industry: Nature of industry to which the company is engaged also considerably affects the dividend policy, Certain industries have a comparatively steady and stable demands irrespective of the prevailing economic conditions. For instance, people used to drink liquor both in boom as well as in recession. Such firms expect regular earnings and hence can follow a consistent dividend policy. On the other hand, if the earnings are uncertain, a in the case of luxury goods, conservative policy should be followed. Such firms should retain a substantial part of their current earnings during boom period in order to provide funds to pay adequate dividends in the recession periods. Thus, industries with steady demand of their products can follow a higher dividend pay out ratio while cyclical industries should follow a lower pay out ratio.
(v) Age of the Company: The age of the company also influences the dividend decision of a company. A newly established concern has to limit payment of dividend and retain substantial part of earnings for financing its future growth and development. While older companies which have established sufficient reserves can afford to pay liberal dividends.
(vi) Future Financial Requirements: It is not only the desires of the shareholders but also future financial requirements of the company that have to be taken into consideration while making a dividend decision. The management of a concern has to reconcile the conflicting interests of shareholders and those of the company's financial needs. If a company has highly profitable investment opportunities it can convince the shareholders of the need for limitation of dividend to increase the future earnings and stabilize its financial position. But when profitable investment opportunities, do not exist then the company may not be justified in retaining substantial part of its current earnings. Thus, a concern having few internal investment opportunities should follow high pay out ratio as compared to one having more profitable investment opportunities.
(vii) Government's Economic Policy: The dividend policy of a firm has also to be adjusted to the economic policy of the Government as was the case when the Temporary Restriction on payment of Dividend ordinance was in force. In 1974 and 1975, Companies were allowed to pay dividends not more than 33 percent of their profits or 12 percent on the paid up value of the shares, whichever was lower.
(vill) Taxation Policy: The taxation policy of the Government also affects the dividend decision of a firm. A high or low rate of business taxation affects the net earnings of company and thereby its dividend.
2. Explain the various types of dividend policy.
Ans: The various types of dividend policies are discussed as follows
(i) Regular Dividend Policy: Payment of dividend at the usual rate is termed as regular dividend. The investors such as retired persons, widows and other economically weaker persons prefer to get regular dividends. A regular dividend policy offers the following advantages.
(a) It establishes a profitable record of the company.
(b) It creates confidence amount the share-holders.
(c) It aids in long-term financing and renders financing easier.
(d) It stabilizes the market value of shares.
(e) The ordinary shareholders view dividends as a source of funds to meet their day to day living expenses. ( If profits are not distributed regularly and are retained, the shareholders may have to pay a higher rate of tax in the year when accumulated profits are distributed.
However, it must be remembered that regular dividends can be maintained only by companies of long standing and stable earnings. A company should establish the regular dividend at a lower rate as compared to the average carnings of the company.
(ii) Stable Dividend Policy: The term 'stability of dividends' means consistency or lack of variability in the stream of dividend payments. In more precise terms, it means payment of certain minimum amount of dividend regularly.
A stable dividend policy may be established in any of the following three forms:
(a) Constant dividend per share: Some companies follow a policy of paying fixed dividend per share irrespective of the level of earnings year after year. Such firms, usually, create a Reserve for Dividend Equalization to enable them pay the fixed dividend even in the year when the earnings are not sufficient or when there are losses. A policy of constant dividend per share is not suitable to concerns whose earnings are expected to remain stable over a number of years..
(b) 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 pay out is preferred by the firms because it is related to their ability to pay dividends.
(c) Stable rupee dividend plus extra dividend: Some companies follow a policy of paying constant low dividend per share plus an extra dividend in the years of high profits. Such a policy is most suitable to the firm having fluctuating earnings from year to year.
(iii) Irregular Dividend Policy: Some companies follow irregular dividend payments on account of the following:
(a) Uncertainty of earnings.
(b) Unsuccessful business operations.
(c) Lack of liquid resources.
(d) Fear of adverse effects of regular dividends on the financial standing of the company.
(iv) No Dividend Policy: A company may follow a policy of paying no dividends presently because of its unfavorable working capital position or on account of requirements of funds for future expansion and growth.
3. Describe various theories or models of dividend policy.
Ans: Various theories or modes of dividend policy are discussed below:
(i) Theory of irrelevance: Residual Approach: According to this approach, the retained earnings can be used only when sufficient opportunities are available for investments or distribute the entire profits to equity shareholders. There fore it is a financial decision and doesn't influence the market value of the shares. Thus, the decision to pay dividends or to retain the earnings may be taken as a residual decisions.
(ii) Modillion and Miller Approach: According to M M Approach, the dividend decisions and retained earnings decisions does not influence the market value of the shares. According his observation, "Under conditions of perfect capital markets, rational investors, absence of tax, discrimination between dividend income and capital appreciation, given the firms investment policy, its dividend policy price of the shares.
He advocated his views as the basis of developing a hypothesis under an assumed condition. Lates he proved that dividend decision and the decision of retained earnings are irrelevant in determining the value of the firm will not influence the market value of the shares. However his assumptions were widely criticized by many expert of felt that perfect capital market, rational investors and absence of tax doesn't arise in the real life situation.
Theory of Relevance: According to this theory, the dividend decisions directly influence the value of the firm. If a firm has higher returns than the cost of equity, if it has the opportunities of investing finance for expansion and diversification, can keep certain amount of profits in the form of retaining earnings. This method of financing increases the value of the firm or increases earnings per shares.
If a firms return are equal to the cost of funds which are also known as normal firms, the dividend decisions and the decisions as the retained does not have any bearing as the market value of the shares.
If the firm's returns less than the cost of funds, the dividend pay out ratio should be more to given higher market value of shares otherwise, investors may prefer to have their investments on some other opportunities which would directly affect the EPS.
5. Explain the various kinds of surplus and their sources.
Ans: The various kinds of surplus and their sources as below:
(i) Earned surplus: In the mind of a lay man, surplus always implie earned surplus. The use of the term surplus as accumulation of pa earnings accounts for its common identification with earned surplus. The main sources of earned surplus are:
(a) Past accumulated profits.
(b) Net profits from business operation at the close each financial year.
(c) Retained earnings including income from business operations as well as non-operational incomes, such as profit on sale of fixed assets.
(d) Conversion of reserves which are no longer required, and
(e)Non-operating income.
(ii) Capital surplus: Capital surplus is that part of the surplus which is not related directly to the operating results of the business.
It results from:
(a) An increase in assets with out a corresponding increase in liability
or capital and.
(b) A decrease in capital or liabilities with out a corresponding decrease in assets.
(i) Surplus from unrealized appreciation of assets: During periods of prosperity or boom, the value of fixed assets may increase or intangible values may be added by accounting entries. Such a surplus is not realized because the assets are not actually sold but the effect of an appreciated surplus is created when a company appreciates its assets.
(iv) Surplus from realized appreciation of assets: The sale of assets at prices in excess of book values may result in realized surplus. (v) Surplus from mergers, Consolidations and reorganizations: In mergers and consolidations, stock may be exchanged for stock and surpluses taken over by the new companies. Since mergers and &P consolidations are generally accompanied by an upward valuation of assets, Exig the resulting surplus may be larger than the total of that result in an increase arin surplus. Even unsuccessful companies may increase their book surplus through a forced reduction in liabilities.
(vi) Surplus from reduction of share capital: In periods of adversity, low companies may create a surplus by reducing the liability of their stated Si capital. This process of creating a surplus involves a number of legal formalities and a sanction of the creditors.
(vii) Surplus from secret reserves: A secret reserve is one which is not disclosed in the balance sheet. Such a reserve may be created by; This method of creating a surplus is not encouraged because it does not represent a true and fair view of the company's financial position and nca provides an opportunity to the management for manipulation and misuse of the company's funds.
(viii) Paid in surplus: It arises from the issue of shares at premium.
6. What are the different factors influencing the ploughing back of profit?
Ans: Various factors influencing the ploughing back of profit are:
(i) Earning capacity: Ploughing back of profit depends largely upon earning capacity of the economy, If a concern does not earn sufficiently, there is no possibility of ploughing back of profits. Usually, greater is the earnings capacity of a company. Larger is the possibility of ploughing back of profits.
(ii) Desire and Type of Shareholders: The policy of ploughing back of profits is also affected by the desire and type of its shareholders If shareholders largely belong to the class of retired persons, widows and other economically weaker persons, they may desire maximum distribution of profits as dividend. On the other hand, a wealthy investor may not mind if the company retains a portion of profits for futures development
(iii) Future Financial Requirements: Future financial requirements of the company also affect the policy of ploughing back of profits. If a company has highly profitable investment opportunities for future development, it may plough back its profits more successfully.
(iv) Dividend Policy: There investment of profits depends to a gree
extent upon the dividend policy of the company. If a company desires to plough back profits of cannot follow a policy of a very high dividend pay out (v) Taxation Policy: The taxation policy of the Government als affects the re investment of profits. A high or low rate of business taxation affects the net earnings of the company and thereby its reinvestment policy.
7. Discuss the various merits of ploughing back of profit.
Ans: Various merits of ploughing back of profit are discussed below:
(a) Advantages to the company:
(i) A cushion to absorb the shocks of economy: Ploughing back of profits acts as a caution to absorb the shocks of economy and business
such as depression for the company. A company with reserves can with
stand the shocks of trade cycles and the uncertainty of the market with comfort, preparedness and economy.
(ii) Economical method of financing: It acts as a very economical method of financing because the company does not depend upon outsiders for raising funds required for expansion, modernization or growth.
(iii) Aids in smooth and undisturbed running the business: It adds to the strength and stability of the company and aids it is smooth and undisturbed running of the business.
(iv) Helps in following stable dividend policy: Ploughing back of profits enables a company to follow a stable dividend policy. Stability of dividend simply refers to the payment of dividend regularly and a company which ploughs back its profits can easily pay stable dividends even in the year whose there are no sufficient profits.
(v) Flexible financial structure: It allows the financial structure to remains completely flexible. As the company need not raise loans for further requirements if it ploughs back its profits, this further adds to the credit worthiness of the company.
(vi) Makes the company self-dependent or No dependence on fair weather friends: Ploughing back of profits makes the company self-dependent and it has not to depend upon out seders such as banks, financial institutions, public deposits and debentures. Outsiders are just like fair weather friends which may not allow finance when the company is not doing well. But a company with large reserves will not have to depend upon them.
(vii) Helps in making good the deficiencies of depreciation, etc: Companies with retained earnings can make good the deficiencies in the provision of depreciation, had and doubtful debts, etc. For example, suppose a company provides depreciation at the rate of 10% p.a. on an asset. costing Rs. 1 lakh. After 10 years when the asset has become obsolete t. and a new asset has to be purchased, the amount of depreciation fund may not be sufficient to purchase the new asset because of increase in prices. Say, the cost of asset at that time is Rs. 2 lakhs, the deficiency in the depreciation funds may be met out of the retained earnings.
(viii) Enables to redeem long term liabilities: It enables the company to redeem certain long-term liabilities such as debentures and thus relives the company from the burden of fixed interest commitments.
(b)Advantages to the shareholders: Increase in the value of shares: Ploughing back of profits enables
(1) a company to adopt a stable dividend earns a good name for the company and the value of its shares goes up in the market. Thus, the value of the shares in the hands of the investors increases and they can dispose off their holdings earning higher profits and also can utilize their holdings as better collateral securities for borrowing from banks and other financial institutions.
(ii) Safety of Investments: Retained earnings provide to the investors an assurance of a minimum rate of dividend.
8. Discuss the advantage of issue of Bonus share.
Ans: A. Advantages from the viewpoint of the company: It makes available capital to carry on a larger and more profitable business. It is felt that financing helps the company to get rid itself of market influences.
When a company pays bonus to its shareholders in the value of hares and not in cash, its liquid resources are maintained and the working pital of the company is not affected. It enables a company to make use of its profits on a permanent basis and increases credit worthiness of the company. It is the cheapest method of raising additional capital for the expansion of the business.
(vi) Abnormally high rate of dividend can be reduced by issuing bonus shares which enables a company to restrict entry of new entrepreneurs into the business and thereby reduces completion.
(vii). The balance sheet of the company will reveal a more realistic picture of the capital structure and the capacity of the company.
9. Explain the SEBI'S Guidelines for Bonus share.
Ans: Following are the Guidelines prescribed by SEBI.
(i) Bonus Issue from free Reserves: The bonus issue is made out of free reserves built out of the genuine profits or share premium collected in cash only.
(ii) Reserves by Revaluation : Reserves created by revaluation of fixed assets cannot be used for bonus issue.
(iii) Residual Reserves: Certain reserves such as development rebate or investment allowance reserve is considered as free reserve for the calculation of residual reserve test.
(iv) Other Reserves: The valuate any reserves created by the company such as Depreciation Reserve. Assets Equalization Reserve, created by the company such as Depreciation Reserve. Assets Equalization Reserve, Inflation Reserve, etc. may be eligible for issue of bonus shares but it is desirable that any such reserve may first be
transferred to General Reserve before capitalization Reserves like Export Reserve and Profits not transferred to any Reserve are free reserves eligible for capitalization. Contingent Liabilities: All contingent liabilities disclosed in Audited Accounts which have bearing on the net profits, shall be taken into account in the calculation of the residual reserves.
Residual Reserve Test: The residual reserves after the proposed capitalization shall be at least 40 per cent of the increased paid up capital. (vii) Rate of Return Test: 30 percent of the average profits before tax of the company for the previous three years should yield a rate of dividend on the expanded capital base if the company at 10 percent.
(viii) Capital Reserve: The capital reserve appearing in the balance sheet of the company as a result of revolution of assets or without accrual of cash resources are neither capitalized nor taken into account in the computation of the residual reserves of 40 per for the purpose of bonus issues.
(ix) Bonus in lieu of Dividend: The declaration of bonus issue, in lieu of dividend, is not make.
(x) Partly paid shares to be Made Fully paid: The bonus issue is not made unless the partly paid shares, if any existing, are made fully paid-up.
(xi) Interest and Statutory Dues Paid: They company should not have defaulted in payment of interest or principal in respect of fixed deposits and interest on existing debentures or principal on redemption there of. It also has sufficient reason to believe that it has not defatted in respect of the payment of statutory dues of the employees such as contribution to provident fund, gratuity, bonus etc.
(x) Bonus Decisions Implementation: A company which announces its bonus issue after the approval of the Board of Directors.
10. Discuss the significance or importance or advantages of stable dividend policy.
Ans: Following are the main advantages of stable dividend policy:
(i) Confidence among shareholders: When shareholders get regular and stable dividend from their investment they have full confidence in the management of the company. Such companies have high reputation in the capital market.
(ii) Stability in share prices : A stable and regular dividend keep speculation away and prices of shares remain stable for long period. (iii) Easy mobilisation of resources from capital market: A company which follows stable dividend policy commands the confidence of the investors, therefore, whenever such company needs additional resources, these can be mobilised by issue of new shares to the existing shareholders on rights basis or through public offer.
(iv) Good growth prospects: When a company follows stable dividend policy then it keeps a part of earnings in the business and these can be used for expansion and diversification of the business and if there is need of additional resources these can be mobilised from capital market.
(v) Helpful in long-term financial planning: The company management can formulate easily long term financial plans because financial resources and their sources of supply can be estimated and planned.
(vi) Institutional support: Long-term financial institutions easily support to those companies which follow stable dividend policy and there is not speculation in share prices.
11. What is reserve? How are reserves classified?
Ans: The portion of surplus to be set aside for specific purpose is called. reserve the amount may be set aside to cover any liability, contingency, contingency or depreciation in the value of assets. Technically speaking. the amount set aside out of profits may be either (i) a 'provision' or (ii) a 'reserve'.
Provision shall mean any amount written off or retained by way of providing for depreciation, renewals or diminution in value of assets, retained by way of providing for any known liability of which the amount cannot be determined with substantial accuracy.
The term 'reserve' also includes other surpluses which are not designed to meet any known liability, contingency, commitment or diminution in the value of assets. A reserve is not a charge against profits, but an appropriation of profits.
12.Discuss secret reserves with its advantages and disadvantages.
Ans: A secret reserve is a surplus which although exists in a busines but is not disclosed in the balance sheet. The management, to be conservative, may write down the value of the assets below their fail value for the purpose of creating a secret or 'hidden reserve'. Secret reserves may be created by the simple method of showing profits at a figure much lower than the actual. When secret reserves exist, the financial position of the business is much better than what appears from the balance sheet.
Methods of creating secret reserves: Secret reserves may by any of the following methods:
(i) Writing off excessive depreciation;
(ii) Charging capital expenditure as revenue expenditures;
(iii) An understatement of income; (iv) An undervaluation of closing stock;
(v) an undervaluation of assets;
(vi) an overstatement of liabilities; (vii) Capitalising revenue receipts; and
(viii) Showing contingent liabilities as actual liabilities.
Advantages of secret reserves:
(i) It is a means for stabilising dividends;
(ii) It ensures better financial position;
(iii) It helps to hide out profits from the existing and potential be created competitors.
(iv) It acts as a cushion during the rainy days and save business from collapse; and
(v) It increases the actual capital employed in the business and improves the profitability.
Disadvantages of secret reserves:
(i) Balance sheet does not reveal the true and fair position of the
business.
(ii) Investors cannot make their buying and selling decisions correctly
(iii) Management can conceal its inefficiency.
(iv) It provides an opportunity to the management for manipulation and misuse of the company's funds.
13. What do you mean by ploughing back of profits or self financing or internal financing? What are its advantages and disadvantages?
Ans:- The process of creating savings in the form of reserves and surplus for its utilisation in the business is technically termed as 'ploughing back of profits'. It is a management tool under which the entire profits are not
distributed amongst the owners of capital, but a part of the earned profit is ploughed back or retained to be utilised in future for financing schemes of betterment or development and/or for meeting the special fixed or working capital requirements of the company. Ploughing back of profit is also known as 'self financing' or 'internal financing'.
Advantage of ploughing back of profits: Ploughing back of profits provides a number of advantages to the company to the shareholder and the society at large.
These are as follows:
A. Advantages to the company:
(i) A cushion to absorb the shocks of economy: Ploughing back of profits acts as a cushion to absorb the shocks of economy and business such as depreciation for the company. A company with large reserves can withstand the shocks of trade cycles and the uncertainty of the market with comfort preparedness and economy.
(ii) Economical method of financing: It acts as a very economical method of financing because the company does not depend upon outsiders for raising funds required for expansion, rationalisation.
(iii) Aids in smooth and undistributed running of the business: It adds to the strength and stability of the company and aids it in smooth and undisturbed running of the business.
(iv) Help in stabilising the dividend policy: It enables a company to follow a stable dividend policy. Stability of dividend simply refers to the payment of dividend regularly and a company which ploughs back its profits can easily pay stable dividends even in the years when there are no sufficient profits.
(v) Flexible financial structure: It allows the financial structure to remain completely flexible. As the company need not raise loans for further requirement if it plough back its profits, this further adds to the credit worthiness of the company.
(vi) Enables to redeem long term liabilities: It enables the company to redeem certain long term liabilities such as debentures and thus relieves the company from the burden of fixed interest commitments
B. Advantages to shareholders or investors:
(i) Increase in market value of securities: Due to regular dividend payment at a more or less stable rate, the company earns a repute and the market value of its shares goes up. Hence, if any shareholder requires hard cash, he can conveniently dispose off his holdings at a high price and earn the difference.
(ii) Safety of investments: Retained earnings provide to the investors an assurance of a minimum rate of dividend. It renders safety to their investment in the company as, the company easily withstand seasonal reactions and business fluctuations.
(iii) Enhanced earning capacity: With the reinvestment of profits in the business, the earning capacity of a concern is enhanced and the shareholders who are the real owners of the company are benefited.
(iv) Evasion of income tax : It provides an opportunity for evasion of super tax in a company where the number of shareholders is small.
C. Advantages to the society or nation:
(i) Increases the rate of capital formation: The policy of retained earnings increases the rate of capital formation and thus, indirectly promotes the economic development of the nation as a whole.
(iii) Increases productivity: As ploughing back of profits acts as a very economical method of financing for modernisation and rationalisation, it increases the industrial productivity of the nation. Hence the scarce resources can be exploited fully for the optimal benefit of the people al large.
(iii) Stimulates industrialisation: It stimulates industrialisation of the country by providing self finances. The society as a whole is benefited by rapid industrialisation.
(iv) Higher standard of living: It is the most economic method of financing as it increases productivity, facilitates greater, better and cheaper production of goods and services. When goods and services at a price are made available to the society, naturally the living standard must increase. Hence, the society at large is benefited by an increased standard of living. Disadvantages of self financing: The limitations of self financing are as follows: Creation of monopolies Continuous re-investment of earnings may lead a company to grow into monopoly with all its evils. The company may expand to such limits that it becomes uncontrollable.
(ii) Depriving the freedom of the investors: The policy of ploughing back of profits limits the amount of dividend payable to shareholders and this may frustrate the shareholders as they are deprived of the freedom to invest their earnings in better securities.
(iii) Dissatisfaction among the shareholders: The existing shareholders may be dissatisfied with the excessive retention of profits as it reduces their dividend rate.
(iv) Evasion of taxes: Certain companies retain earnings with a view to evade super profits tax. Such evasion of taxes reduces the revenue of the government and is determinal to the interests of the nation as a whole.
(v) Misuse of retained earnings: The management may not utilise the retained earnings to the advantage of shareholders at large as they have the tendency to misuse the retained earnings by investing them to unprofitable areas.
(vi) Over capitalisation: Over capitalisation means more capital than actually required. Excessive ploughing back of profits may lead to over capitalisation and the earnings of the company may not be sufficient to have a normal rate of return on capital employed by it.
14. What do you understand by bonus issue? What are its merits and demerits?
Ans: Bonus issue means conversion of the company's accumulated profits into share capital. Such shares are issued to the existing shareholders in proportion to their present holdings. It is also called capitalisation of company's profits. If the equity shares are issued to the existing shareholders as an extra dividend, the issue process is termed as bonus issue.
Merits of bonus issue: To the company:
(a) It preserves liquidity position: Issue of bonus shares make possible for company to declare an extra dividend without using the cash resources that may be needed for operation of business.
(b) It keeps EPS at reasonable rate: The company having a high EPS may have to face problems both from the workers and consumers.
Workers of the company may feel that they are under paid while the consumers may think that they are being charged too much for the shares company's products.
(c) Easy marketability of company's shares: Issue of bonus increases the supply of shares which results reduction in market price of shares. The reduction of market price of shares keeps it within the reach of ordinary investors.
(d) It broadens the capital base and improves image of the company.
(e) It is an inexpensive method of raising capital by which the cost resources of the company are not disturbed. To investors:
(i) Indication of higher future profits: A company issues bonus shares only when its earnings are expected to increase."
(ii) Increase in future dividends: The shareholders will get extra dividends in future even if the existing cash dividend per share is continued.
(iii) Indication of financial soundness: It is a indication to the prospective investors about the financial soundness of the company.
(iv) No tax liability: Receipts of stock dividend as compared to cas dividend generally results in income tax advantage to the shareholders Demerits of bonus issue:
(i) Decline in the rate of dividend: The rate of dividend per share decreases as the whole amount of dividend is distributed among large number of shareholders.
(ii) Lengthy process: The process of issue of bonus shares involves a procedural difficulty lengthy legal procedures and approvals
(iii) Fall in market price of shares: The future market price of shares fall sharply after bonus issue.
15. Discuss the guidelines for determining the maximum quantum of bonus issue.
Ans. The maximum amount which can be capitalised to issue bonus shares in one time is the least amount of given three test, as per the guidelines issued by the Ministry of Finance.
Residual reserve test: Residual reserves after the proposed capitalisation should be at least 40% of the increased paid up capital: The capital redemption reserve, if any existing in the company will not be included in computing the minimum reserve of 40%.
(ii) All contingent liabilities disclosed in the audited accounts which have a bearing on the net profits shall be taken into account in the calculation of minimum reserve of 40%.
(iii) Development rebate reserve / investment allowance reserve is considered as free reserves for the purpose of calculation of residual reserve test and is allowed to be capitalised.
(iv) Capital reserve appearing in the balance sheet of the company as a result of revaluation of assets or without actual cash will neither be allowed to be capitalised nor taken into account in the consideration of residual reserves of 40% for the purpose of bonus issue. Following formula is useful in finding out the maximum amount available for capitalisation after applying the minimum reserve test.
16. Explain the factors affecting dividend decision.
Ans: Following are the factors affecting Dividend Decision:
(i) Earnings: Company having high and stable earning could declare high rate of dividends as dividends are paid out of current and past earnings.
(ii) Stability of dividends: Companies generally follow the policy of stable dividend. The dividend per share is not altered in case earning changes by small proportion or increase in earnings is temporary in nature. Growth prospects: In case there are growth prospects for the company in the near future then, it will retain its earnings and thus, no or less dividend will be declared.
(iv) Cash flow positions: Dividends involve an outflow of cash and thus, availability of adequate cash is foremost requirement for declaration of dividends.
(v) Preference of shareholders: While deciding about dividend the preference of shareholders is also taken into account. In case shareholders desire for dividend then company may go for declaring the same. In such case the amount of dividend depends upon the degree of expectations of shareholders.
(vi) Taxation policy: A company is required to pay tax on dividend declared by it. If tax on dividend is higher, company will prefer to pay less by way of dividends whereas if tax rates are lower, then more dividends can be declared by the company.
**********