Financial Management two Chapter two .pptx

Factors that Influence Capital Structure Decision
Four primary factors influence capital structure decisions.
Business risk- the greater the firm’s business risk, the lower its optimal debt ratio.
The firm’s tax position.
Financial flexibility (the ability to raise capital on reasonable terms under adverse conditions).
Managerial conservatism or aggressiveness:
This factor does not affect the true optimal, or value-maximizing, capital structure, but it does influence the manager determined target capital structure.
Factors that Influence Capital Structure Decision
Four primary factors influence capital structure decisions.
Business risk- the greater the firm’s business risk, the lower its optimal debt ratio.
The firm’s tax position.
Financial flexibility (the ability to raise capital on reasonable terms under adverse conditions).
Managerial conservatism or aggressiveness: This factor does not affect the true optimal, or value-maximizing, capital structure, but it does influence the manager determined target capital structure.
Business Risk and Operating Leverage
Business risk is the possibility of a commercial business making inadequate profits due to uncertainties. Business risk depends on a number of factors, the more important of which are listed below:
Demand variability..
Sales price variability.
Input cost variability.
Ability to adjust output prices for changes in input costs.
Ability to develop new products in a timely, cost-effective manner.
Foreign risk exposure. Etc.
Signaling Theory
Managers use issues of debt and equity to signal information about a firm’s future prospects to less informed owners and investors.
Issuing debt would be interpreted as a positive signal about the company’s future. In contrast, the decision to issue equity would generally be interpreted by shareholders and investors as a negative signal.

Financial Risk and Financial Leverage
Financial risk - is the type of danger that can result in the loss of capital to interested parties.
Financial leverage- is the use of fixed financial costs to magnify the effects of changes in earnings before interest and taxes on the firm’s earnings per share.
The degree of financial leverage (DFL) is the numerical measure of the firm’s financial leverage
Determining the Optimal Capital Structure
Generally speaking the optimal capital structure is considered to be that which minimizes the weighted average cost of capital, WACC, and consequently maximizes the value of the firm.
It is generally believed that the value of the firm is maximized when the cost of capital is minimized. By using a modification of the simple zero-growth valuation model, we can define the value of the firm(V)
Using Debt Financing to Constrain Managers
Agency problems may arise if managers and shareholders have different objectives. Such conflicts are particularly likely when the firm's managers have too much cash at their disposal.
Managers with limited "excess cash flow" are less able to make I

1. CHAPTER TWO A Review of Dividends and Dividends Policy Meaning of Dividend Dividend refers to the business concerns net profits distributed among the shareholders. It may also be termed as that part of the profit of a business concern which is distributed among its shareholders. Dividend decision of a business is one of the crucial parts of the financial manager because it determines the amount of profit to be distributed among shareholders and amount of profit to be treated as retained earnings for financing its long term growth

2. Cont … Dividend Classifications Dividend may be distributed among the shareholders in various forms. The major categories Include A. Cash Dividend - If the dividend is paid in the form of cash to the shareholders, it is called cash dividend B. Stock Dividend - Stock dividend is paid out in shares of stock due to increase in financing needs. Under this type, cash is retained by the business concern and stockholders are given additional shares of stock. It is not a true dividend because no cash leaves the firm rather a stock dividend increases the number of shares outstanding,

3. Cont … C . Bond Dividend - Bond dividend is also known as scrip dividend. If the company does not have sufficient funds to pay cash dividend in the near future, the company promises to pay the shareholders at a future specific date with the help of issue of bonds or notes. D. Property Dividend - Property dividends are paid in the form of some assets other than cash. A company will distribute such divided under exceptional circumstances. This form of dividend is sometimes used by a business to deliberately issue property dividends in order to alter their taxable and/or reported income.

4. Cont … Types of Dividend Policy Dividend policy depends upon the nature of the firm, type of shareholder and profitable position of the firm. On the basis of dividend declaration by the firm, the dividend policy may be classified under the following types: Regular Dividend Policy - Dividend payable at the usual rate is regarded as regular dividend policy. Though the rate is usual, the dividends vary per income earned. Stable Dividend Policy - Stable dividend policy means payment of certain minimum amount of dividend regularly

5. Cont … 3. Irregular Dividend Policy- When companies are facing constraints of earnings and unsuccessful business operation, they may follow irregular dividend policy. It is one of the temporary arrangements to meet the financial problems 4. No Dividend Policy- Sometimes the company may follow no dividend policy because of the requirement of funds for the growth of the company or working capital requirements.

6. Cont … Factors Influencing Dividend Policy Profitability Position of the Firm- When the firm earns more profit, they can distribute more dividends to the shareholders and Vis versa Uncertainty of Future Income- When the shareholder needs regular income, the firm should maintain regular dividend policy. But, if future income is uncertain, the amount and timing of dividend paid may vary. Legal Constrains: companies put several restrictions regarding payments and declaration of dividends. Liquidity Position: the firm’s ability to pay cash dividend is constrained by the amount of liquid assets (such as cash and marketable securities) available .

7. Cont … 5. Sources of Finance: the ease with which a company could raise extra finance from sources other than retained earnings affects its dividend policy 6. Growth Rate of the Firm; high growth rate implies that the firm can distribute more dividends to its shareholders. On the other hand, fast growing companies may choose to reinvest their earnings for further growth and expansion. 7. Tax Policy: tax policy of the government also affects the dividend policy of the firm. When the government gives tax incentives, the company pays more dividends. 8. Capital Market Conditions: due to the capital market conditions, dividend policy may be affected. If the capital market is prefect, it leads to improve the higher dividend

8. Cont … The Effect of divided policy on firm value 1. Dividend Irrelevance Theories According to professors Modigliani and Miller (MM), a firm’s dividend policy has no effect on firm value or its stock price. That is, there is no relation between the dividend rate and value of the firm. 2. Dividend Relevance Theories According to this concept, dividend policy is considered to affect the value of the firm. Dividend relevance implies that shareholders prefer current dividend and hence there is direct relationship between dividend policy and value of the firm. Relevance of dividend concept is supported by two eminent(well-know) persons: Walter and Gordon.

9. Cont … Establishing a Dividend Policy Residual Dividend Approach: Dividends can only be paid out of what is left over. The key point of the residual dividend approach is that dividends are paid only after all profitable investment opportunities are exhausted. With a residual dividend policy, the firm’s objective is to meet its investment needs and maintain its desired debt–equity ratio before paying dividends. B. Dividend Stability: it implies that all dividend payments would be equal Corporate officials generally agree that a stable policy is in the interest of the firm and its stockholders, so the stable policy would be more common.

10. Cont … C . Compromise Dividend Policy Such a policy is based on five main goals: 1. Avoid cutting back on positive NPV projects to pay a dividend. 2. Avoid dividend cuts. 3. Avoid the need to sell equity. 4. Maintain a target debt– equity ratio. 5. Maintain a target dividend payout ratio.

11. The End