FINANCIAL MERCHANDISING MANAGEMENT

1. To describe the major aspects of financial merchandise planning and management 

The purpose of financial merchandise management is to stipulate which products are bought by the retailer, when, and in what quantity. Dollar control monitors inventory investment, while unit control relates to the amount of merchandise handled. Financial merchandise management encompasses accounting methods, merchandise forecasts and budgets, unit control, and integrated dollar and unit controls.

2. To explain the cost and retail methods of accounting  

Two accounting techniques for retailers are the cost and retail methods of inventory valuation. Physical and book (perpetual) procedures are possible with each. Physical inventory valuation requires counting merchandise at prescribed times. Book inventory valuation relies on accurate bookkeeping and a smooth flow of data.

The cost method obligates a retailer to have careful records for each item bought or code costs on packages. This must be done to find the exact value of ending inventory at cost. Many firms use LIFO accounting to project that value, which lets them reduce taxes by having a low ending inventory value. In the retail method, closing inventory value is tied to the average relationship between the cost and retail value of merchandise. This more accurately reflects market conditions, but is more complex.

3. To study the merchandise forecasting and budgeting process  

This is a form of dollar control with six stages: designating control units, sales forecasting, inventory-level planning, reduction planning, planning purchases, and planning profit margins. Adjustments require all later stages to be modified.

Control units -- merchandise categories for which data are gathered -- must be narrow enough to isolate problems and opportunities with specific product lines. Sales forecasting may be the key stage in the merchandising and budgeting process. Through inventory-level planning, a firm sets merchandise quantities for specified periods through the basic stock, percentage variation, weeks’ supply, and stock-to-sales methods. Reduction planning estimates expected markdowns, discounts, and stock shortages. Planned purchases are linked to planned sales, reductions, ending inventory, and beginning inventory. Profit margins are related to a retailer’s planned net sales, operating expenses, profit, and reductions.

4. To examine alternative methods of inventory unit control  

A unit control system involves physical units of merchandise. It monitors best-sellers and poor sellers, the quantity of goods on hand, inventory age, reorder time, and so on. A physical inventory unit control system may use visual inspection or a stock counting procedure. A perpetual inventory unit control system keeps a running total of the units handled through recordkeeping entries that adjust for sales, returns, transfers, and so on. A perpetual system can be applied manually, by merchandise tags processed by computers, or by point-of-sale devices. Virtually all larger retailers conduct regular physical inventories, two-thirds use a perpetual inventory system.

5. To integrate dollar and unit merchandising control concepts  

Three aspects of financial inventory control integrate dollar and unit control concepts: stock turnover and gross margin return on investment, when to reorder, and how much to reorder. Stock turnover is the number of times during a period that the average inventory on hand is sold. Gross margin return on investment shows the relationship between the gross margin in dollars (total dollar operating profits) and average inventory investment (at cost). A reorder point calculation – when to reorder – includes the retailer’s usage rate, order lead time, and safety stock. The economic order quantity – how much to reorder – aids a retailer in choosing how big an order to place, based on both ordering and inventory costs.

Cost of Capital

Explicit and Implicit cost of capital

Explicit cost of capital of any source is the discount rate that equates the present value of cash inflows that are incremental to the taking of the financing opportunity with the present value of its incremental cash outflows.It is the internal rate of return cash inflows and outflows.

I=C1/(1+k)n + C2/(1+K)N+CN/(1+K)N

I=net amount of cash inflow at time zero.

C=Cash outflow at different years.

K=Explicit cost of capital

N=Number of years.

Example- A company issues debentures of RS 100 each .The coupon rate of interest is 10%.Maturity period 3 years.The debentures are issued at Rs 100 and redeemable at Rs 100.Calculate the explicit cost of capital.

100=10/(1+K)1+10/(1+K)2+110/(!+K)3

The discount rate which solves the equation is 10% so K is 10%.

Implicit cost of capital is also known as the opportunity cost of capital.It is rate associated with best investment opportunity.

Eg. Mr X has a choice of investing Rs 1000 in the shares or bank deposits.at 12%.If he invests 1000 in shares  implicit cost of capital is 12%

Cost of Debt

Debentures,Bonds,Fixed deposits,Term loans ets..Debt may be issues and redeemed at par premium or discount.

1.Debt issued at par and redeemed at par/Cost of perpetual debt(irredeemable debt.)

The before tax cost of debt(BTCD) is simply the interest offered to the suppliers of money.

BTCD= Interest/Net proceeds.

Eg. A company issues 3 years debentures of Rs 100 at 15% coupon rate .Calculate BTCD.

BTCD=15/100=15%

2.Debt issued and redeemed at discount or at a premium & Cost of existing debt.

BTCD = I + RV-NP/N

             ____________

             RV+NP/2

RV= Redeemable value     NP=Net proceeds from the issue.

N=Number of years            I=Annual interest charges in rupees.

Eg. Wipro issues 5 years 12% debentures of Rs 100 each for Rs 105.The debentures are redeemed at par.The company has spend Rs 5 per debenture as flotation cost.

BTCD= 12+100-100/5/100+100/2=12%

Cost of Preference Capital

These shares carry preferential rights with regard to payment of dividend and repayment of capital at the time of winding up.The measurement of the cost of preference capital poses some conceptual difficulty. In the case of debt, there is a binding legal obligation on the firm to pay interest, and the interest constitutes the basis to calculate the cost of debt. However, in the case of preference capital, payment of dividends is not legally binding on the firm and even if the dividends are paid, it is not a charge on earnings; rather it is a distribution or appropriation of earnings to preference shareholders. One may be, therefore, tempted to’ conclude that the dividends on preference capital do not constitute cost. This is not true .The cost of preference capital is a function of the- dividend expected by investors. Preference capital is never issued with an intention not to pay dividends. Although it is not legally binding upon the firm to pay dividends on preference capital, yet it is generally paid when the fim1 makes sufficient profits. The failure to pay dividends, although does not cause bankruptcy, yet it can be a serious matter from the common (ordinary) shareholders’ point of view. The nonpayment of dividends on preference capital may result in voting rights and control to the preference shareholders. More than this, the firm’s credit standing may be damaged. The accumulation of preference dividend arrears may adversely affect the prospects of ordinary shareholders for receiving any dividends, because dividends on preference capital represent a prior claim on profits. As a consequence, the fim1 may find difficulty in raising funds by issuing preference or equity shares. Also, the market value of the equity shares can be adversely affected if dividends are not paid to the preference shareholders and, therefore, to the equity shareholders. For these reasons, dividends on preference capital should be paid regularly except when the firm does not make profits, or it is in a very tight cash position.

Irredeemable Preference Share & Redeemable Preference Share

Irredeemable Preference Share

The preference share may be treated as a perpetual security if it is irredeemable. Thus, its cost is given by the following equation (for a perpetuity):

kp = DIV+RV-NP/N/RV+NP/2

where kp is the cost of preference share, DIV is the expected preference dividend, Rv is redeemable value,NP is net proceeds now and N is number of years for maturity.

Redeemable Preference Share

Redeemable preference shares (that is, preference shares with finite maturity) are also issued in -practice. A formula similar to above Equation can be used to compute the cost of  redeemable preference share:

K=D/NP  

where D is dividend outflow each year and NP is net proceeds from the issue.

The cost of preference share is not adjusted for taxes because preference dividend is paid after the corporate taxes have been paid. Preference dividends do not save any taxes. Thus, the cost

of preference share is automatically computed on after-tax basis. Since interest is tax deductible and preference dividend is not, the after-tax cost of preference is/ substantially higher than the

after-tax cost of debt

Cost of Equity Capital

Firms may raise equity capital internally by retaining earnings. Alternatively, they could distribute the entire earnings to equity shareholders and raise equity capital externally by issuing new

shares. In both cases, shareholders are providing funds to the firms to finance their capital expenditures. Therefore, the equity shareholders’ required rate of return will be the same whether they supply funds by purchasing new shares or by foregoing dividends which could have been distributed to them. There is, however, a difference between retained earnings and issue of equity shares from the firm’s point of view. The firm may have to issue new shares at a price lower than the current market price. Also, it may have to incur flotation costs. Thus, external equity will cost more to the firm than the internal equity.

Is Equity Capital Free of Cost?

It is sometime argued that the equity capital is free of cost. The reasons for such argument are that it is not legally binding for firms to pay dividends to ordinary shareholders. Further, unlike the interest rate or preference dividend rate, the equity dividend rate is not fixed. It is fallacious to assume equity capital to be free of cost. As we have discussed earlier, equity capital involves an opportunity cost; ordinary shareholders supply funds to the firm in the expectation of dividends (including capital gains) commensurate with their risk of investment. The market value of the shares deter-mined by the demand and supply forces in a well functioning capital market reflects the return required by ordinary shareholders. Thus, the shareholders’ required rate of return, which equates the present value of the expected dividends with the market value of the share, is the cost of equity. The cost of external equity could, however, be different from the shareholders’ required rate of return if the issue price is different from the market price of the share. In practice, it is a formidable task to measure the cost of equity. The difficulty derives from two factors: First, it is very difficult to estimate the expected dividends Second, the future earnings and dividends are, expected to grow over time. Growth in dividends should be estimated and incorporated in the computation of the cost of equity. The estimation of growth is not an easy task.

Stability of Dividend

There may be three types of dividend policy:

(1)Strict or Conservative dividend Policy which envisages the retention of profits on the cost of dividend pay-out. It helps in strengthening the financial position of the company        (2) Lenient Dividend Policy which views the payment of dividend at the maximum rate possible taking in view the current earning of the company. Under such policy company retains the minimum possible earnings           (3) Stable Dividend Policy suggests a mid-way of the above two views. Under this policy, stable or almost stable rate of dividend is maintained. Company maintains reserves in the years of prosperity and uses them in paying dividend in lean year. If company follows stable dividend policy, the market price of its shares shall be higher.      There are reasons why investors prefer stable dividend policy. Main reasons are:- 1. Confidence Among Shareholders. A regular and stable dividend payment may serve to resolve uncertainty in the minds of shareholders. The company resorts not to cut the dividend rate even if its profits are lower. It maintains the rate of dividends by appropriating the funds from its reserves. Stable dividend presents a bright future of the company and thus gains the confidence of the shareholders an the goodwill of the company increases in the eyes of the general investors. 2. Income Conscious Investors. The second factor favoring stable dividend policy is that some investors are income conscious and favor a stable rate of dividend. They too, never favor an unstable rte of dividend. A Stable dividend policy may also satisfy such investors. 3. Stability in Market Price of Shares. Other things beings equal, the market price very with the rate of dividend the company declares on its equity shares. The value of shares of a company having a stable dividend policy fluctuates not widely even if the earnings of the company turn down. Thus, this  policy buffer the market price of the stock. 4. Encouragement to Institutional Investors. A stable dividend policy attracts investments from institutional investors such institutional investors generally prepare a list of securities, mainly incorporating the securities of the companies having stable dividend policy in which they invest their surpluses or their long term funds such as pensions or provident funds etc. In this way, stability and regularity of dividends not only affects the market price of shares but also increases the general credit of the company that pays the company in the long run.

Factors Affecting Dividend Policy

A number of considerations affect the dividend policy of company. The major factors are

1. Stability of Earnings. The nature of business has an important bearing on the dividend policy. Industrial units having stability of earnings may formulate a more consistent dividend policy than those having an uneven flow of incomes because they can predict easily their savings and earnings. Usually, enterprises dealing in necessities suffer less from oscillating earnings than those dealing in luxuries or fancy goods. 2. Age of corporation. Age of the corporation counts much in deciding the dividend policy. A newly established company may require much of its earnings for expansion and plant improvement and may adopt a rigid dividend policy while, on the other hand, an older company can formulate a clear cut and more consistent policy regarding dividend. 3. Liquidity of Funds. Availability of cash and sound financial position is also an important factor in dividend decisions. A dividend represents a cash outflow, the greater the funds and the liquidity of the firm the better the ability to pay dividend. The liquidity of a firm depends very much on the investment and financial decisions of the firm which in turn determines the rate of expansion and the manner of financing. If cash position is weak, stock dividend will be distributed and if cash position is good, company can distribute the cash dividend. 4. Extent of share Distribution. Nature of ownership also affects the dividend decisions. A closely held company is likely to get the assent of the shareholders for the suspension of dividend or for following a conservative dividend policy. On the other hand, a company having a good number of shareholders widely distributed and forming low or medium income group, would face a great difficulty in securing such assent because they will emphasis to distribute higher dividend. 5. Needs for Additional Capital. Companies retain a part of their profits for strengthening their financial position. The income may be conserved for meeting the increased requirements of working capital or of future expansion. Small companies usually find difficulties in raising finance for their needs of increased working capital for expansion programmes. They having no other alternative, use their ploughed back profits. Thus, such Companies distribute dividend at low rates and retain a big part of profits. 6. Trade Cycles. Business cycles also exercise influence upon dividend Policy. Dividend policy is adjusted according to the business oscillations. During the boom, prudent management creates food reserves for contingencies which follow the inflationary period. Higher rates of dividend can be used as a tool for marketing the securities in an otherwise depressed market. The financial solvency can be proved and maintained by the companies in dull years if the adequate reserves have been built up. 7. Government Policies. The earnings capacity of the enterprise is widely affected by the change in fiscal, industrial, labour, control and other government policies. Sometimes government restricts the distribution of dividend beyond a certain percentage in a particular industry or in all spheres of business activity as was done in emergency. The dividend policy has to be modified or formulated accordingly in those enterprises.  8. Taxation Policy. High taxation reduces the earnings of he companies and consequently the rate of dividend is lowered down. Sometimes government levies dividend-tax of distribution of dividend beyond a certain limit. It also affects the capital formation. N India, dividends beyond 10 % of paid-up capital are subject to dividend tax at 7.5 %. 9. Legal Requirements. In deciding on the dividend, the directors take the legal requirements too into consideration. In order to protect the interests of creditors an outsiders, the companies Act 1956 prescribes certain guidelines in respect of the distribution and payment of dividend. Moreover, a company is required to provide for depreciation on its fixed and tangible assets before declaring dividend on shares. It proposes that Dividend should not be distributed out of capita, in any case. Likewise, contractual obligation should also be fulfilled, for example, payment of dividend on preference shares in priority over ordinary dividend. 10. Past dividend Rates. While formulating the Dividend Policy, the directors must keep in mind the dividend paid in past years. The current rate should be around the average past rat. If it has been abnormally increased the shares will be subjected to speculation. In a new concern, the company should consider the dividend policy of the rival organisation. 11. Ability to Borrow. Well established and large firms have better access to the capital market than the new Companies and may borrow funds from the external sources if there arises any need. Such Companies may have a better dividend pay-out ratio. Whereas smaller firms have to depend on their internal sources and therefore they will have to built up good reserves by reducing the dividend pay out ratio for meeting any obligation requiring heavy funds. 12. Policy of Control. Policy of control is another determining factor is so far as dividends are concerned. If the directors want to have control on company, they would not like to add new shareholders and therefore, declare a dividend at low rate. Because by adding new shareholders they fear dilution of control and diversion of policies and programmes of the existing management. So they prefer to meet the needs through retained earning. If the directors do not bother about the control of affairs they will follow a liberal dividend policy. Thus control is an influencing factor in framing the dividend policy. 13. Repayments of Loan. A company having loan indebtedness are vowed to a high rate of retention earnings, unless one other arrangements are made for the redemption of debt on maturity. It will naturally lower down the rate of dividend. Sometimes, the lenders (mostly institutional lenders) put restrictions on the dividend distribution still such time their loan is outstanding. Formal loan contracts generally provide a certain standard of liquidity and solvency to be maintained. Management is bound to hour such restrictions and to limit the rate of dividend payout. 14. Time for Payment of Dividend. When should the dividend be paid is another consideration. Payment of dividend means outflow of cash. It is, therefore, desirable to distribute dividend at a time when is least needed by the company because there are peak times as well as lean periods of expenditure. Wise management should plan the payment of dividend in such a manner that there is no cash outflow at a time when the undertaking is already in need of urgent finances. 15. Regularity and stability in Dividend Payment. Dividends should be paid regularly because each investor is interested in the regular payment of dividend. The management should, inspite of regular payment of dividend, consider that the rate of dividend should be all the most constant. For this purpose sometimes companies maintain dividend equalization Fund.

The economic soundness of a company is generally judged by the amount of dividend declared and paid by a company. It affects its goodwill among the shareholders and the prospective share holders.

Dividend is apart of profits distributed among the shareholders. The basic question before the Board of directors is how much profits should be divided among shareholders as dividend and how much to be retained in the business as reserves to meet the future contingencies and for expansion of business. Both-future expansion and distribution of dividend are desirable but in conflict. Hence, allocation of earnings between dividends and retained earnings is an essential part of management functions, it requires a sound dividend policy to be followed by the corporation According to Weston and Brigham “Dividend policy determines the division of earnings between payments to shareholders and retained earnings”. In this connection, the dividend declared during previous years may be taken as a base and the same rate is followed in the coming years. Generally, Board of Directors aim at maintaining the dividend rate which we may call a “Stable Dividend Policy”. For its purpose a 'dividend equalization fund' is created out of profits to equalize the profits of the coming years.

Different types of Dividend

The profits of a company when made available for the distribution among its shareholders are called dividend. The dividend may be as a fixed annual percentage of paid up capital as in the case of preference shares or it may vary according to the prosperity of the company as in the case of ordinary shares.

The decision for distributing or paying a dividend is taken in the meeting of Board of Directors and in confirmed generally by the annual general meeting of the shareholders. The dividend can be declared only out of divisible profits, remained after setting of all the expenses, transferring the reasonable amount of profit to reserve fund and providing for depreciation and taxation for the year. It means if in any year, there is not profits, no dividend shall be distributed that year. The shareholders cannot insist upon the company to declared the dividend. It is solely the discretion of the directors. Aunt hinted that the dividend was an income of the owners of the corporation which they received in the capacity of the owner. Distribution of dividend involves reduction of current assets (cash) but not always. Stock dividend or bonus shares is an exception to it.

Dividend may be of different types. It can be classified according to the mode of its distribution as follows

(1) Regular Dividend. By dividend we mean regular dividend paid annually, proposed by the board of directors and approved by the shareholders in general meeting. It is also known as final dividend because it is usually paid after the finalization of accounts. It sis generally paid in cash as a percentage of paid up capital, say 10 % or 15 % of the capital. Sometimes, it is paid per share. No dividend is paid on calls in advance or calls in arrears. The company is, however, authorised to make provisions in the Articles prohibiting the payment of dividend on shares having calls in arrears. (2) Interim Dividend. If Articles so permit, the directors may decide to pay dividend at any time between the two Annual General Meeting before finalizing the accounts. It is generally declared and paid when company has earned heavy profits or abnormal profits during the year and directors which to pay the profits to shareholders. Such payment of dividend in between the two Annual General meetings before finalizing the accounts is called Interim Dividend. No Interim Dividend can be declared or paid unless depreciation for the full year (not proportionately) has been provided for. It is, thus,, an extra dividend paid during the year requiring no need of approval of the Annual General Meeting. It is paid in cash. (3) Stock-Dividend. Companies, not having good cash position, generally pay dividend in the form of shares by capitalizing the profits of current year and of past years. Such shares are issued instead of paying dividend in cash and called 'Bonus Shares'. Basically there is no change in the equity of shareholders. Certain guidelines have been used by the company Law Board in respect of Bonus Shares. (4) Scrip Dividend. Scrip dividends are used when earnings justify a dividend, but the cash position of the company is temporarily weak. So, shareholders are issued shares and debentures of other companies. Such payment of dividend is called Scrip Dividend. Shareholders generally do not like such dividend because the shares or debentures, so paid are worthless for the shareholders as directors would use only such investment is which were not . Such dividend was allowed before passing of the Companies (Amendment) Act 1960, but thereafter this unhealthy practice was stopped. (5) Bond Dividends. In rare instances, dividends are paid in the form of debentures or bounds or notes for a long-term period. The effect of such dividend is the same as that of paying dividend in scrips. The shareholders become the secured creditors is the bonds has a lien on assets. (6) Property Dividend. Sometimes, dividend is paid in the form of asset instead of payment of dividend in cash. The distribution of dividend is made whenever the asset is no longer required in the business such as investment or stock of finished goods. But, it is, however, important to note that in India, distribution of dividend is permissible in the form of cash or bonus shares only. Distribution of dividend in any other form is not allowed.

Dividend Relevance: Walter’s Model

Prof. James E. Walter argues that the choice of dividend policies almost always affect the value of the firm. His model is based on the following assumptions:

1. Internal financing: The firm finances all investment through retained earnings; i.e. debt or new equity is not issued.

2. Constant return and cost of capital: the firm’s rate of return, r , and its cost of capital, k , are constant.

3. 100% payout or retention: All earnings are either distributed as dividends or reinvested internally immediately.

4. Infinite time: the firm has infinite life

Valuation Formula: Based on the above assumptions, Walter put forward the following formula:

P = DIV + (EPS-DIV) r/k

k

P = market price per share

DIV= dividend per share

EPS = earnings per share

DIV-EPS= retained earnings per share

r = firm’s average rate of return

k= firm’s cost o capital or capitalisation rate

Gordon’s Model

Gordon proposed a model of stock valuation using the dividend capitalization approach. His model is based on the following assumptions:

1. All-equity firm: The firm is an all-equity firm, and it has no debt

2. No external financing: Retained earnings would be used to finance any expansion.

3. Constant return: The internal rate of return, r, of the firm’s investment is constant.

4. Constant cost of capital: The appropriate discount rate k for the firm remains       

constant and is greater than the growth rate.

5. No taxes: Corporate taxes do not exist.

6. Constant retention: The retention ratio, b, once decided upon, is constant.

Valuation Formula: Based on the above assumptions, Gordon put forward the following formula:

P₀ = EPS₁ (1-b) / K-br

P₀ = price per share at the end of year 0

EPS₁= earnings per share at the end of year 1

(1-b) = fraction of earnings the firm distributes by way of earnings

b= fraction of earnings the firms ploughs back

k= rate of return required by the shareholders

r = rate of return earned on investments made by the firm

br = growth rate of earnings and dividends

Let’s apply the Gordon’s formula to a practical illustration to be clearer. We will again take an example of three firms; growth, normal and the declining one. The financial highlights of all these firms is given as follows:

Growth firm                 (r>k)	Normal firm (r = k)		Declining firm (r<k)
r	15%	10%	8%
k	10%	10%	10%
EPS	Rs 10	Rs 10	Rs 10
b	0.6	0.6	0.6
1-b	0.4	0.4	0.4

As, we have all the elements of the formula. Lets compute the share price for the growth firm first.

We know that:

P₀ = E₁ (1-b)

k-br

Lets substitute the data in the formula:

0 P₀ = 10 (0.4)

0.10-(0.6)(0.15)

By solving the equation, you will get the share price equal to Rs 400.In the same way, you can get the share price of the other two firms also. i.e. the price of the share for Normal firm is Rs 100 and declining firm also it is Rs 77

Now, suppose that I change the value of b from 0.4 to 0.6. Can you compute the new share price for all the firms other things remaining the same. Are you getting the following?

Growth firm: Rs150

Normal firm: Rs 100

Declining firm: Rs 88

Lets make a small analysis from the above:

• The marker value of the share, P0, increases with the retention ratio, b,for firms with growth opportunities .i.e. when r >k.

• The marker value of the share, P0, increases with the payout ratio, (1-b), for declining firms. i.e. when r < k.

• The market value of the share is not affected by dividend policy when r = k

You must have noticed that Gordon’s model’s conclusions are similar to that of Walter’s model. This similarity is due to the similarities of assumptions, which underlie both the models. Thus the Gordon model suffers from the same limitations as the Walter model.

Till now, we have been discussing the theories, which believe in the relevance of paying dividends. Now we will turn attention to the other side where Miller & Modigliani (MM) who advanced their view that the value of the firm depends solely on its earnings power and is not influenced by the manner in which they are split.

Modigliani-Miller (MM) supports irrelevance in dividend, how?

According to M-M, under a perfect market situation, the dividend policy of a firm is irrelevant, as it does not affect the value of the firm. They argue that the value of the firm depends on the firm’s earnings, which results from its investment policy. Thus, when investment decision of the firm is given, dividend decision –the split of earnings between dividends and retained earnings- is of no significance in determining the value of the firm

M-M constructed their arguments on the following assumptions:

• Perfect capital markets: The firm operates in perfect capital markets where investors behave rationally, information is freely available to all and transactions and flotation costs do no exist. Perfect capita; markets also imply that no investor is large enough to affect the market price of a share.

• No taxes: taxes do no exist or there are no differences in the tax rates applicable to capital gains and dividends. This means that investors value a rupee of dividend as much as a rupee of capital gains.

• Investment opportunities are known: the firm is certain with its investment opportunities and future profits.

• No risk: Risk of uncertainty does not exist i.e. investors are able to forecast future prices and dividends with certainty, and one discount rate is appropriate for all securities and all time periods. Thus, r=k for all t

According to M-M, r should be equal for all shares. If it is not so, the low return yielding return shares will be sold by the investors who will purchase the high- return yielding shares. This process will tend to reduce the price of the low-return shares and increase the prices of the high-return shares. This switching or arbitrage will continue until the

differentials in rates of return are eliminated. The discount rate will also be equal for all firms under M-M assumptions since there are no risk differences.

Thus the rate of return for a share held for one year may be calculated as follows:

r = Dividends+ Capital gains (or loss)

Share price

r = Div1 + (P1-P0)

         P0

Po = Div1 + P1

          (1+k)

Since it is assumed that there exist perfect markets r = k; we can write the above equation as:

Po = Div1 + P1

         (1+r)

So we can equate both of them:

Po = Div1 + P1 ₌ Div1 + P1

        (1+ r) (1+k)

Where P0 is the market or purchase price per share at time 0.

P1 is the market price per share at time 1.

Div 1 is the dividend per share at time 1.

k is the cost of capital

As hypothised r should be equal for all shares.

If we multiply both the equation by the number of shares outstanding, n, we will the total value of the firm:

V = nP₀ = n (DIV1 + P1)

                  (1+k)

You can note an important point here that MM allows for the issue for the new shares, unlike Walter’s and Gordon’s model. Therefore, a firm can pay dividends and raise funds to undertake the optimum investment policy.

Taking to the above note, suppose that the firm sells m number of new shares at time 1 at a price P₁, the value of the firm at time 0 will be:

NP_o = n (Div1 +P1) + mP1-mP1

                    (1+k)

Or if we simplify we get:

NPo = nDiv1 + P1(m-n)-m P1

                      (1+k)

MM believes that the investment programmes of a firm in a give period of time can be financed either by retained earnings or the issue of new shares or both. Thus, the amount of new shares issued will be:

m P₁ = I_{1 –} (X₁- n Div _{1) =} I₁-X₁ + nDiv₁

Where I₁ represents the total amount of investment during first period and X₁is the total net profit of the firm during first period.

I hope you are not lost in the complexity of the formulae. Ok! I will make you understand by taking a practical example.

Lets assume that a company currently has 10,000 outstanding shares selling at Rs 100 each. The firm has net profits of Rs 10,00,000 and wants to make new investments of Rs 20,00,000 during the period. The firm is also thinking of declaring a dividend of Rs 5 per share at the end of the current fiscal year. The firm’s opportunity cost of capital is 10%. We want to know the price of the share at the end of the year if: (i) dividend is not

declared,(ii) a dividend is declared , (iii) The number of new shares to be issued by applying MM approach?

We know that the price of the share according to MM approach at the end of the current fiscal year is:

Po = Div1 + P1

              (1+k)

Or P_{1 =} P₀ (1+k)- Div₁

Lets apply the formula for getting the value of P₁ when dividend is not paid:

P1 = Rs 100(1.10)-0 = Rs 110

We have taken Div₁ = 0 because the firm has not paid dividend.

Now, can you tell me the share price when the firm is paying dividends! Is it Rs 105! Yes, you are right.

You can note a point here that the wealth of shareholders will remain the same whether or not dividend is paid. When the dividend is not paid, the shareholder will get Rs 110 by way of the price per share at the end of the current year.

If you see the other side of the coin, when dividend is paid, the shareholder will realise Rs 105 by way of the price per share at the end of the current fiscal year plus Rs 5 as dividend.

Now, if we want to know the number of new shares to be issued by the company to finance its investments, we will follow the formula as discussed above.

m P₁ = I_{1 –} (X₁- n Div _{1) =} I₁-X₁ + nDiv₁

105 m = 20,00,000 – 10,00,000 + 5,00,000

105 m = 15,00,000 or m = 15,00,000/105

= 14,285 shares.

Do you think that there are some drawbacks in MM approach? 

There are some critics who argue that the assumptions made by MM dividends are irrelevant. According to them dividends matter because of the uncertainty characterising the future, the imperfections in the capital market, and the existence of taxes. We will discuss the implications of these as follows:

1. Information About Prospects :In a world of uncertainty the dividends paid by the company, based as they are on the judgment of the management about future, convey information about the prospects of the company. A higher dividend payout ratio may suggest that the future of the company, as judged by management, is promising. A lower dividend payout ratio may suggest that the future of the company as considered by management is uncertain. Gordon has eloquently expressed this view. An allied argument is that dividends reduce uncertainty perceived by investors. Hence investors prefer dividends to capital gains. So shares with higher current dividends, other things being equal, command a high in the market.

2. Uncertainty and Fluctuations: Due to uncertainty, share prices tend to fluctuate, sometimes rather widely. When share prices fluctuate, conditions for conversion of current income into capital value and vice versa may not be regarded as satisfactory by investors. Some investors who wish to enjoy more current income may be reluctant to sell a portion of their shareholding in a fluctuating market. Such investors would naturally prefer, and value more, a higher payout ratio. Some investors who wish to get less current income may be hesitant to buy shares in a fluctuating market. Such investors would prefer, and value a lower payout ratio.

3. Offering of Additional Equity at Lower Prices: MM assume that a firm can sell additional equity at the current market price. In practice, firms following the advice and suggestions of merchant bankers offer additional equity at a price lower than the current market price. This practice of 'underpricing' mostly due to market compulsions, ceteris paribus, makes a rupee of retained earnings more valuable than a rupee of dividends. This is because of the following chain of causation:

4. Issue cost: The MM irrelevance proposition is based on the premise that a rupee of dividends be replaced by a rupee of external financing. This is passib1e when there is no issue cost. In the real world where issue cost is incurred, the amount of external financing has to be greater than the amount of dividend paid. Due to this, other things being equal, it advantageous to retain earnings rather than pays dividends and resort to external finance.

5. Transaction Costs: In the absence of transaction costs, current income (dividends) and Capital gains are alike-a rupee of capital value can be converted into a rupee of current income and vice versa. In such a situation if a shareholder desires current income (from shares) greater than the dividends received, he can sell a portion of his capital equal in value to the additional current income sought. Likewise, if he wishes to enjoy current income less than the dividends paid, he can buy additional shares equal in value to the difference between dividends received and the current income desired. In the real world, however, transaction costs are incurred. Due to this, capital value cannot be converted into an equal current income and vice versa. For example, a share worth Rs 100 may fetch a net amount of Rs 99 after transaction costs and Rs 101 may be required to. buy a share worth Rs 100. Due to. transaction costs, shareholders who have preference

Higher dividend payout

Greater dilution of the value of equity

Greater volume of under priced equity issue to financea given level of investment far current income, would prefer a higher payout ratio and shareholders who have preference for deferred income would prefer a lower payout ratio.

6. Differential Rates of Taxes: MM have assumed that the investors are indifferent between a rupee of dividends and a rupee of capital appreciation, This assumption is true when the taxation is the same for current income and capital gains. In the real world, the effective tax on capital gains is lower than that for current income. Due to this difference, investors would prefer capital gains to current income.

Let us try some problems to make the concept clearer.

Example

Voltas Ltd. had 50000 equity shares of Rs.10 each outstanding on Jauary1, 1993. The shares are currently being quoted at par in the market. In the wake the removal of the dividend of Rs.2 per share for the current calendar year. It belongs to a risk class whose appropriate capitalization rate is 15%. Using Modigliani-Miller model and assuming no taxes, ascertain the price of the company’s share as it is likely to prevail at the end of the year (1) when dividend is declared,

And (2) when no dividend is declared.

Also find out the number of new equity shares that the company must issue to meet its investment needs of Rs.2 Lakhs, assuming a net income of Rs1.1 lakhs and also assuming that the dividend is paid.

Solution:

a. Price of the share, when dividend are paid

D1 + P1

Po = ---------------

(1+Ke)

Rs.2+ P1

Rs.10 = --------------

1.15

Rs.115 = Rs.2+P1

Rs.9.5 = P1

b. Price of the share, When dividends are not paid:

P1

Rs. 10 = ----------

1.15

Or P1 = 11.5

c. Number of new equity shares to be issued:

1-(E-nD)

Δn = -----------------------

P1

Rs.2,00,000-(Rs1,10,000)

Δn = -------------------------------

Rs.9.5

Rs.1,90,000

= --------------- =20,000 shares

Rs.9.5

Thus 20000 new equity shares are to be issued to meet investment needs of the company.