F.M.

II ASSIGNMENT Part - 2
SUBMITTED TO, MR. SURYA NARAYAN MOHAPATRA

SUBMITTED BY, ARADHANA SINGH ANSHUMAN SARANGI SAMIR RAPAUEL SHRESTHA DAS KARTHIK KUMAR S.A. BATCH 2011 2013

Capital Structure

Capital structure is combination of sources of funds in which we can include two main sources' proportion. One is share capital and other is Debt. All four theories are just explaining the effect of changing the proportion of these sources on the overall cost of capital and total value of firm. If I have to write theories of capital structure in very few lines, I will only say that it propounds or presents the effect on overall cost of capital and market or total value of firm, if I change my capital structure from 50: 50 to any other proportion. First 50 represent the share capital and second 50 represent the Debt. Now, I am ready to explain these four theories of capital structure in simple and clean words.

1st Theory of Capital Structure

Name of Theory = Net Income Theory of Capital Structure This theory gives the idea for increasing market value of firm and decreasing overall cost of capital. A firm can choose a degree of capital structure in which debt is more than equity share capital. It will be helpful to increase the market value of firm and decrease the value of overall cost of capital. Debt is cheap source of finance because its interest is deductible from net profit before taxes. After deduction of interest company has to pay less tax and thus, it will decrease the weighted average cost of capital.

For example if you have equity debt mix is 50:50 but if you increase it as 20: 80, it will increase the market value of firm and its positive effect on the value of per share. High debt content mixture of equity debt mix ratio is also called financial leverage. Increasing of financial leverage will be helpful to for maximize the firm's value. 2nd Theory of Capital Structure Name of Theory = Net Operating income Theory of Capital Structure

Net operating income theory or approach does not accept the idea of increasing the financial leverage under NI approach. It means to change the capital structure does not affect overall cost of capital and market value of firm. At each and every level of capital structure, market value of firm will be same.

3rd Theory of Capital Structure Name of Theory = Traditional Theory of Capital Structure This theory or approach of capital structure is mix of net income approach and net operating income approach of capital structure. It has three stages which you should understand: Ist Stage In the first stage which is also initial stage, company should increase debt contents in its equity debt mix for increasing the market value of firm. 2nd Stage In second stage, after increasing debt in equity debt mix, company gets the position of optimum capital structure, where weighted cost of capital is minimum and market value of firm is maximum. So, no need to further increase in debt in capital structure. 3rd Stage Company can gets loss in its market value because increasing the amount of debt in capital structure after its optimum level will definitely increase the cost of debt and overall cost of capital.

4th Theory of Capital Structure Name of theory = Modigliani and Miller

MM theory or approach is fully opposite of traditional approach. This approach says that there is not any relationship between capital structure and cost of capital. There will not effect of increasing debt on cost of capital. Value of firm and cost of capital is fully affected from investor's expectations. Investors' expectations may be further affected by large numbers of other factors which have been ignored by traditional theorem of capital structure.

CAPITAL STRUCTURE POLICY OF Maruti

The logic of capital structure policy of MUL is to increase its net worth by ploughing back of profit in this way to reduce cost of equity as a cheaper cost if its net worth is strengthen by ploughing back of profits, which is not dividend bearing. Looking at figures in Table-1 clearly indicates that, an increase amount of reserve and surplus included in net worth is seen over years with exception of 2010-11. Keeping the equity capital constant throughout the period of study, the company increased its net-worth with the utilization of reserve & surplus by the same amount. The company increased its capitalization from Rs. 7484.7 crore in the year 2007 to 14176.8 crore with correspondingly less use of long term debt from Rs. 900 cr. to 309.3 crore. during the study. Both the excess capitalization and increase in the use of debt in certain years were commensurate by the reserve and surplus i.e., by successful ploughing back of profit instead of making additional issue of equity shares. If the same was made by fresh issue of equity shares the company would not be able to reward its shareholders more in terms of return. Since reserve & surplus was not divided bearing, its utilization brought down the cost of equity and at the same time it maintained the lower base of equity share- holders resulting higher amount of EPS.
Long term Employed 900.2 698.9 309.3 821.4 309.3 Equity share Capital 144.5 144.5 144.5 144.5 144.5

Year 2007-08 2008-09 2009-10 2010-11 2011-12

Total Capital 7484.7 9315.6 10043.8 12656.5 14176.8

Reserves and surplus Net Worth 8270.9 8415.4 9200.4 9344.9 13723 13867.5 11690.6 11835.1 13723 13867

The above table has been prepared to reflect the relative method of finance adopted by the company. It is seen from the table that the net-worth of the company constituted equity capital and reserve & surplus

Above table has been prepared to reflect the relative method of finance adopted by the company. It is seen from the table 3 that the net-worth of the company constituted equity capital and

reserve & surplus and it was 4.9% of equity capital and 95.1% of reserve & surplus in the year 2001-02. In the following years the company stated increasing the proportion of reserve & surplus from 95.3% to 98.5% with decrease in the proportion of equity capital from 4.7% to 0.98% during the period from 2002-03 to 2011-12. One can observe from the table that a percentage decrease in the equity capital led to the same percentage increase in the reserve and surplus. For example 5% percentage decrease in equity capital led to 55 increases in the reserve and surplus in the second year of study and so on. Thus increase in the proportion of reserve and surplus to net worth in this way might cause reduction in the cost of equity during the study period.

CAPITAL STRUCTURE POLICY OF Mahindra and Mahindra

The logic of capital structure policy of Mahindra and Mahindra is to increase its net worth by ploughing back of profit in this way to reduce cost of equity as a cheaper cost if its net worth is strengthen by ploughing back of profits. Looking at figures in Table-1 clearly indicates that, an increase in amount of reserve and surplus included in net worth is seen over years. The equity capital increased in marginal proportions throughout the period of study, the company increased its net-worth with the utilization of reserve & surplus by the same amount. The company increased its capitalization from Rs. 5188.9 crore in the year 2007 to 12718.68 crore with correspondingly less use of long term debt from Rs. 1636 crore to 2405.29 crore during the study. Both the excess capitalization and increase in the use of debt in certain years were commensurate by the reserve and surplus i.e., by successful ploughing back of profit and also additional issue of equity shares. Fresh issue of equity shares were made by the company and thus was not be able to reward its shareholders more in terms of return. Since reserve & surplus was divided bearing, its utilization increased the cost of equity and at the same time it increased the base of equity share- holders resulting lowering amount of EPS.

Year 2007-08 2008-09 2009-10 2010-11 2011-12

Long term Equity share Total Capital Employed Capital Reserves and surplus Net Worth 5188.9 1636 238.03 3314.87 3552.9 6937.13 2587.06 239.07 4111 4350.07 9296.73 4052.76 272.62 4971.35 5243.97 10710.38 2880.15 282.95 7539.27 7830.23 12718.68 2405.29 293.62 9985.8 10313.39

CAPITAL STRUCTURE POLICY OF Tata Motors

The logic of capital structure policy of Tata Motors is to increase its net worth by ploughing back profit in this way to reduce cost of equity as a cheaper cost if its net worth is strengthen by ploughing back of profits. Looking at figures in Table clearly indicates that, an increase in amount of reserve and surplus included in net worth is seen over years. The equity capital increased in marginal proportions throughout the period of study, the company increased its networth with the utilization of reserve & surplus by the same amount. The company increased its capitalization from Rs. 10878 crore in the year 2007 to 35912.05 crore with correspondingly less use of long term debt from Rs. 4009.14 crore to 15898.75 crore during the study. Both the excess capitalization and increase in the use of debt in certain years were commensurate by the reserve and surplus i.e., by successful ploughing back of profit and also additional issue of equity shares. Fresh issue of equity shares were made by the company and thus was not be able to reward its shareholders more in terms of return. Since reserve & surplus was divided bearing, its utilization increased the cost of equity and at the same time it increased the base of equity share- holders resulting lowering amount of EPS.

Year 2007-08 2008-09 2009-10 2010-11 2011-12

Long term Equity share Total Capital Employed Capital Reserves and surplus Net Worth 10,878.89 4,009.14 385.41 6,869.75 6,484.34 14,120.02 6,280.52 385.54 7,839.50 7,453.96 25,559.83 13,165.56 514.05 12,394.27 11,880.22 31,429.69 35,912.05 16,625.91 15,898.75 570.6 634.65 14,233.18 19,375.59 14,803.78 20,013.30

Dividend policy
At the end of each year, every publicly traded company has to decide whether to return cash to its stockholders and, if yes, how much in the form of dividends. The owner of a private company has to make a similar decision about how much cash he plans to withdraw from the business, and how much to reinvest. Firms in the United States generally pay dividends every quarter, whereas firms in other countries typically pay dividends on a semi-annual or annual basis.

The Dividend Payment Time Line Dividends in publicly traded firms are usually set by the board of directors and paid out to stockholders a few weeks later. There are several key dates between the time the board declares the dividend until the dividend is actually paid. The first date of note is the dividend declaration date, the date on which the board of directors declares the dollar dividend that will be paid for that quarter (or period). This date is important because by announcing its intent to increase, decrease, or maintain dividend, the firm conveys information to financial markets. Thus, if the firm changes its dividends, this is the date on which the market reaction to the changeis most likely to occur. The next date of note is the ex-dividend date, at which time investors have to have bought the stock in order to receive the dividend. Since the dividend is not received by investors buying stock after the ex-dividend date, the stock price will generally fall on that day to reflect that loss. At the close of the business a few days after the ex-dividend date, the company closes its stock transfer books and makes up a list of the shareholders to date on the holder of- record date. These shareholders will receive the dividends. There should be generally be no price effect on this date. The final step involves mailing out the dividend checks on the dividend payment date. In most cases, the payment date is two to three weeks after the holder-of-record

Types of Dividends There are several ways to classify dividends. First, dividends can be paid in cash or as additional stock. Stock dividends increase the number of shares outstanding and generally reduce the price per share. Second, the dividend can be a regular dividend, which is paid at regular intervals (quarterly, semi-annually, or annually), or a special dividend, which is paid in addition to the regular dividend. Most U.S. firms pay regular dividends every quarter; special dividends are paid at irregular intervals. Finally, firms sometimes pay dividends that are in excess of the retained earnings they show on their books. These are called liquidating dividends and are viewed by the Internal Revenue Service as return on capital rather than ordinary income. Consequently,

* Some facts about dividend policy

- Dividends follow earnings

* Payment Procedures

* Why do firms pay dividends?

- Dividends don't matter: The Miller Modigliani Theorem

- Dividends are taxed heavier than capital gains : Arguments against dividend payments

* Evidence from ex-dividend day price changes

- Dividends are more certain than capital gains: The bird in the hand fallacy

- Dividends are a good use for excess cash

Measures of Dividend Policy

* Dividend Payout : measures the percentage of earnings that the company pays in dividends = Dividends / Earnings

* Dividend Yield : measures the return that an investor can make from dividends alone = Dividends / Stock Price

Three Schools Of Thought On Dividends 1. If

(a) there are no tax disadvantages associated with dividends (b) companies can issue stock, at no cost, to raise equity, whenever needed Dividends do not matter, and dividend policy does not affect value.

2. If dividends have a tax disadvantage, Dividends are bad, and increasing dividends will reduce value

2. If stockholders like dividends, or dividends operate as a signal of future prospects, Dividends are good, and increasing dividends will increase value

The balanced viewpoint If a company has excess cash, and few good projects (NPV>0), returning money to stockholders (dividends or stock repurchases) is GOOD. If a company does not have excess cash, and/or has several good projects (NPV>0), returning money to stockholders (dividends or stock repurchases) is BAD.

PAYMENT PROCEDURES

* Significant Dates

Declaration date: The dividend is declared at a board of directors meeting. On this date the directors issue a statement similar to the following: " On November 15, 1984, the directors of the XYZ corporation met and declared a regular quarterly dividend of Rs. 50 per share, plus an extra dividend of 25 Rs. per share, payable to the holders of record on December 15, payment to be made on January 2, 1985." Holder-of-record date: At the close of the business on the holder-of-record date, December 15, the company closes its stock transfer books and makes up a list of the shareholders on that date. These shareholders will receive the dividends Ex-dividend date: Suppose you buy 100 shares on December 13, 1984. Will the company be notified in time? To avoid conflict, the brokerage industry has set up the convention of declaring that the right to the dividend remains with the stock until 4 days prior to the holder-of-record date; on the fourth day before the record date the right to the dividend no longer goes with the stock. This date is called the ex-dividend date. The exdividend date in this example in December 11, 1984. Payment date: The Company mails the checks to the recorded holders on January 2, 1985.

WHY DO FIRMS PAY DIVIDENDS?

The Miller-Modigliani Hypothesis: Dividends do not affect value Basis: If a firm's investment policy (and hence cash flows) don't change, the value of the firm cannot change with dividend policy. If we ignore personal taxes, investors have to be indifferent to receiving either dividends or capital gains.

* Underlying Assumptions: (a) (b) (c) There are no tax differences between dividends and capital gains. If companies pay too much in cash, they can issue new stock, with no flotation costs or signaling consequences, to replace this cash. If companies pay too little in dividends, they do not use the excess cash for bad projects or acquisitions.

* The Tax Response: Dividends are taxed more than capital gains

Basis: Dividends are taxed more heavily than capital gains. A stockholder will therefore prefer to receive capital gains over dividends.

Practical aspects of Dividend Policy While deciding on the dividend policy, firms face two questions 1. What should be the average pay ratio? 2. How stable should the dividends be over time? Firms consider the following factors to determine the payout ratio 1. Funds requirement The dividend pay out ratio of firms depends on the firms future requirements for funds. Long term financial forecasting of funds can assess this requirement. Usually firms, which have plans for substantial financial investment, need funds to exploit the available opportunities. Thus, they keep their dividend payout ratio low. On the other hand, firms, which have very few investment avenues have larger dividend pay out ratio. 2. Liquidity It is another factor which influences the dividend payout ratio as dividends involved cash payment. Firms, which desire to pay dividends may not do so, because of insufficient liquidity. This usually happens in the case of profitable and expanding firms, which have very low liquidity because of substantial investments. 3. Availability of external sources of financing Firms which have easy access to external sources of funds enjoy a great deal of flexibility in deciding the dividend payout ratio. For such firms, dividend payout decision is somewhat independent of its investment decision as well as its liquidity position. Such firms are usually more generous in their dividend policies. While on the other hand, firms, which do not have easy access to external sources of funds, have to rely on the internal sources of funds or investment purposes. Such firms are usually very conservative in their dividend policy decisions. 4. Shareholder preference Preferences of shareholder are onother major factor, which influence dividend payout. If shareholders prefer current income to capital gains, then the firm may follow the liberal dividend policy. While on the other hand if they prefer capital gain to dividend income, then firms follow the conservative dividend policy. 5. Difference in the cost of external equity and retained earnings The cost of equity in all cases except for those raised by way of rights issue is higher than the cost of retained earnings. Depending on the extent of this difference in cost, firms decide the relative proportion of external equity and retained earnings to be used. This affects the dividend policy decision of the company. 6. Control Raising money from external resources may lead to dilution of control, in case money is raised by issuing public equity. Internal financing on the other hand does not lead to any dilution of control. Hence, if management and shareholders are averse to dilution of control, then firms prefer to rely more on retained earnings. Thus, such companies may adopt, the conservative dividend policy. 7. Taxes In India dividend income for the individuals is free, however capital gains are taxable. Thus, in that case shareholders who are in high tax bracket may prefer dividend income rather than capital gains. However, if tax on dividends is viewed from point of

view of corporates, they have to pay dividend tax. Thus, this may influence the companies dividend policy.

Dividend policy
A company's dividend policy is the company's usual practice when deciding how big a dividend payment to make. Dividend policy may be explicitly stated, or investors may infer it from the dividend payments a company has made in the past. If a company states a dividend policy it usually takes the form of a target pay-out ratio. If a company has not stated a dividend policy then investors will infer it. Assumptions that investors are likely to make are:

The DPS will be maintained at at least the previous year's level (excluding special dividends) unless dividend cover is very low or the company has warned that a dividend cut is possible If the payout ratio has been maintained at a roughly constant level in the past, the same will be done in the future Any other pattern of dividend growth will continue as long as the cover does not fall too low.

Companies do not normally increase dividends unless they are confident that the increase is sustainable. This means that increasing the dividend is a way in which the management of a company can signal investors that they are confident.

DIVIDEND POLICY OF MUL

Table-2 shows that DPS of first two years of consideration is same and thereafter the company has been increasing DPS at a slow rate. The dividend payout ratio of the company is gradually decreasing during the study period.
Year 2007-08 2008-09 2009-10 2010-11 2011-12 EPS 59.91 59.07 42.18 86.45 79.21 DPS 4.5 5 3.5 6 7.5 Dividend payout 8.342544849 8.325852112 8.297771456 6.940427993 9.468501452

Table 2

DIVIDEND POLICY OF Tata Motors

Table-2 shows that DPS of first two years of consideration has remained same and thereafter the company has been increasing DPS at an incremental rate. The dividend payout ratio of the company has decreased in the first 2 yrs and then the it is increasing in a steady rate during the study period.
Year 2007-08 2008-09 2009-10 2010-11 2011-12 EPS 49.65 52.63 19.48 39.26 28.55 DPS 15 15 6 15 20 Dividend payout 35.34 32.51 34.52 44.28 80.96

DIVIDEND POLICY OF Mahindra n Mahindra

Table-2 shows that DPS of first two years of consideration is same and thereafter the company has been decreasing DPS at a slow rate except the final year 2011-12. The dividend payout ratio of the company is cyclical during the study period first increasing then again decreasing alternatively.

Year 2007-08 2008-09 2009-10 2010-11 2011-12

EPS 44.88 46.15 30.69 36.89 45.33

DPS 11.50 11.50 10.00 9.50 11.50

Dividend payout 30.39 29.10 37.29 29.87 30.15