Dividend Decision and Working Capital Management — Practice

Question 1

A company has EPS of ₹10, cost of equity of 12%, and an internal rate of return on retained earnings of 18%. Using Walter's model, compute the share price at a dividend payout of 0% and at a dividend payout of 100%, and state which payout maximises share value.

Accepted Answer

At 0% payout, D = 0, E = ₹10, so retained earnings per share = E − D = ₹10. P = [D + (r/Ke)(E − D)] ÷ Ke = [0 + (18/12) × 10] ÷ 0.12 = [1.5 × 10] ÷ 0.12 = 15 ÷ 0.12 = ₹125. At 100% payout, D = ₹10, E − D = 0, so P = [10 + (18/12) × 0] ÷ 0.12 = 10 ÷ 0.12 = ₹83.33. Since r (18%) exceeds Ke (12%), this is a growth firm under Walter's model, and the 0% payout produces the higher share price of ₹125 compared to ₹83.33 at 100% payout, confirming that a growth firm maximises share value by retaining all its earnings rather than distributing them, since the firm can reinvest retained funds at a rate exceeding what shareholders could earn themselves at their own required rate of return.

Question 2

A company has EPS of ₹8, cost of equity of 14%, and an internal rate of return on retained earnings of only 9%. Using Walter's model, determine the payout ratio that maximises share value, and briefly justify without computing full share prices at every payout level.

Accepted Answer

Since r (9%) is less than Ke (14%), this is a declining firm under Walter's model, meaning the firm earns less on funds it retains than shareholders could earn themselves by receiving those funds as dividend and reinvesting at their own required rate of 14%. Under Walter's model, a declining firm maximises share value by paying out its entire earnings as dividend, that is, a 100% payout ratio, retaining nothing, because every rupee retained instead of distributed is a rupee earning a below-required return of 9% rather than being handed to shareholders who could deploy it at 14% elsewhere, meaning retention actively destroys value for a firm in this position rather than creating it, the exact opposite of the growth-firm case.

Question 3

Explain, using Walter's model's own formula, why dividend policy becomes irrelevant to share price when a firm's internal rate of return on retained earnings exactly equals its cost of equity.

Accepted Answer

In Walter's formula, P = [D + (r/Ke)(E − D)] ÷ Ke, when r exactly equals Ke, the ratio r/Ke equals exactly 1, and the formula simplifies to P = [D + (E − D)] ÷ Ke = E ÷ Ke, which depends only on E, the firm's earnings per share, and Ke, the cost of equity, with D, the dividend per share, having cancelled out of the expression entirely. This means that regardless of what payout ratio the firm chooses, and therefore regardless of what specific value D takes, the computed share price remains exactly E ÷ Ke, unchanged, which is precisely why Walter's model concludes that for a firm where r equals Ke, often called a normal firm, dividend policy has no effect on share price at all, since retaining a rupee earns exactly the same return the shareholder would have earned by receiving it as dividend and reinvesting it personally at their own required rate.

Question 4

Under MM's dividend irrelevance theory, a firm pays a lower dividend than a shareholder personally wants. Explain the 'homemade dividend' argument for why this shareholder is not made worse off.

Accepted Answer

Under MM's idealised assumptions of no transaction costs and no taxes, a shareholder who wants more current cash than the firm's chosen dividend provides can simply sell a portion of their shareholding in the open market to generate the additional cash they desire, effectively manufacturing their own personal 'homemade dividend' out of their existing capital rather than relying on the firm to distribute it for them. Because MM's theory holds that the reduction in share price from retaining, rather than distributing, additional earnings is exactly offset by the increase in future value those retained earnings are expected to generate, a shareholder selling shares to create their own homemade dividend receives, in total, the same combined value of cash in hand plus remaining shareholding value that they would have received had the firm simply paid the larger dividend directly, meaning the firm's own dividend choice cannot leave this shareholder any better or worse off than the shareholder's own trading can achieve independently, precisely mirroring the homemade leverage argument in capital structure theory.

Question 5

A company's annual data is: raw material consumed ₹90 lakh, average raw material stock ₹15 lakh; cost of production ₹150 lakh, average WIP ₹10 lakh; cost of goods sold ₹180 lakh, average finished goods stock ₹18 lakh; credit sales ₹240 lakh, average debtors ₹30 lakh; annual purchases ₹100 lakh, average creditors ₹12 lakh. Compute the operating cycle in days, using 365 days a year.

Accepted Answer

Raw material holding period = (Average raw material stock ÷ Raw material consumed) × 365 = (15 ÷ 90) × 365 = 60.8 days. WIP holding period = (Average WIP ÷ Cost of production) × 365 = (10 ÷ 150) × 365 = 24.3 days. Finished goods holding period = (Average finished goods stock ÷ Cost of goods sold) × 365 = (18 ÷ 180) × 365 = 36.5 days. Debtors collection period = (Average debtors ÷ Credit sales) × 365 = (30 ÷ 240) × 365 = 45.6 days. Creditors payment period = (Average creditors ÷ Purchases) × 365 = (12 ÷ 100) × 365 = 43.8 days. Operating cycle = 60.8 + 24.3 + 36.5 + 45.6 − 43.8 = 123.4 days. This means the company's net operating cycle, the period for which it must fund its operations from its own working capital after accounting for the credit it obtains from suppliers, is approximately 123 days.

Question 6

Using the operating cycle computed in the previous problem, explain what would happen to the company's net operating cycle and its working capital financing requirement if it successfully negotiated an extension of its average creditors payment period from 43.8 days to 65 days, with every other component unchanged.

Accepted Answer

Since the creditors payment period is subtracted in the operating cycle formula, increasing it from 43.8 days to 65 days, an increase of 21.2 days, would reduce the net operating cycle by the same 21.2 days, bringing it down from 123.4 days to approximately 102.2 days, with every other component of the cycle unchanged. This reduction in the net operating cycle directly reduces the company's working capital financing requirement, because a shorter net operating cycle means the company is, in effect, financing its own inventory and receivables build-up for a shorter period before supplier credit and eventual customer collections complete the cycle, meaning less of the company's own funds, or borrowed short-term funds, need to be tied up in the operating cycle at any given time; extending supplier credit terms is therefore a genuine, low-cost lever for reducing a firm's working capital financing need, without requiring any change to how efficiently the firm manages its own inventory or collects from its own customers.

Question 7

Rank the matching, conservative and aggressive approaches to working capital financing from lowest to highest expected financing cost, and separately from lowest to highest risk of a funding shortfall, explaining the trade-off each ranking reflects.

Accepted Answer

By expected financing cost, from lowest to highest: aggressive, matching, conservative — the aggressive approach relies most heavily on cheaper short-term financing, even for part of the permanent working capital component, minimising average financing cost; the matching approach uses a genuinely maturity-matched mix, moderate in cost; the conservative approach relies most heavily on more expensive long-term financing, even for part of the fluctuating component, maximising financing cost. By risk of a funding shortfall, from lowest to highest: conservative, matching, aggressive — the conservative approach's heavy reliance on long-term financing insulates it most from the risk that short-term credit becomes hard to renew or access; the matching approach carries moderate risk, since only the genuinely fluctuating component depends on short-term renewal; the aggressive approach carries the highest risk, since even the firm's permanent, baseline working capital need depends on continually renewed short-term financing, exposing it to renewal risk for funding needs that never actually go away. This is the same cost-risk trade-off met in capital structure theory between cheap-but-risky debt and expensive-but-safe equity, applied here to the maturity structure of working capital financing specifically.

Question 8

A company is considering relaxing its credit policy, expecting credit sales to rise from ₹200 lakh to ₹240 lakh as a result, with a contribution margin of 25% on the additional sales. The relaxation is expected to increase average debtors from 40 days to 55 days of sales, and the company's required rate of return on funds invested in debtors is 15% per annum. Using 365 days, evaluate whether the relaxation is worthwhile based on the trade-off between incremental contribution and incremental cost of carrying receivables, ignoring bad debts for simplicity.

Accepted Answer

Incremental contribution from additional sales = 25% × (240 − 200) lakh = 25% × ₹40 lakh = ₹10 lakh. Average debtors under existing policy = (200 ÷ 365) × 40 = ₹21.92 lakh. Average debtors under relaxed policy = (240 ÷ 365) × 55 = ₹36.16 lakh. Incremental investment in debtors = 36.16 − 21.92 = ₹14.24 lakh. Incremental cost of carrying this additional investment at the required 15% rate = 15% × ₹14.24 lakh = ₹2.14 lakh. Since the incremental contribution of ₹10 lakh from the additional sales substantially exceeds the incremental cost of ₹2.14 lakh from carrying the additional receivables investment, the relaxation in credit policy is worthwhile on this basis, generating a net benefit of approximately ₹7.86 lakh even before considering any bad debt risk, which a fuller analysis would also need to weigh against this net benefit before a final decision.

Question 9

A company has EPS of ₹20, an internal reinvestment rate r of 16%, and a cost of equity Ke of 13%. Using Gordon's growth model, compute the share price under two retention ratios, b = 0.3 and b = 0.6, and explain which retention ratio the company should choose to maximise share value.

Accepted Answer

At b = 0.3: growth rate g = b × r = 0.3 × 16% = 4.8%. Payout (1 − b) = 0.7. P = E(1 − b) ÷ (Ke − br) = 20 × 0.7 ÷ (0.13 − 0.048) = 14 ÷ 0.082 = ₹170.73. At b = 0.6: g = 0.6 × 16% = 9.6%. Payout (1 − b) = 0.4. P = 20 × 0.4 ÷ (0.13 − 0.096) = 8 ÷ 0.034 = ₹235.29. Since r (16%) exceeds Ke (13%), this is a growth firm, and consistent with that classification, the higher retention ratio of b = 0.6 produces the substantially higher share price of ₹235.29 compared to ₹170.73 at the lower retention ratio of b = 0.3, so the company should choose the higher retention ratio, retaining more and paying out less, to maximise share value, since it can reinvest the retained funds at a rate exceeding shareholders' own required return.

Question 10

A company has current assets of ₹60 lakh and current liabilities of ₹35 lakh. State its gross working capital and net working capital, and explain which figure is more relevant for assessing the company's short-term financial cushion.

Accepted Answer

Gross working capital is the total investment in current assets, ₹60 lakh. Net working capital is current assets minus current liabilities, ₹60 lakh − ₹35 lakh = ₹25 lakh. Net working capital is the more relevant figure for assessing the company's short-term financial cushion, because it reflects what remains available to the company after its short-term obligations are met, giving a genuine sense of the buffer the company has to meet unexpected short-term needs or fluctuations, whereas gross working capital alone says nothing about how much of that current asset investment is already effectively claimed by current liabilities that must be paid in the near term.

Question 11

Distinguish permanent working capital from fluctuating (or variable) working capital, and explain why this distinction is the basis for the choice between matching, conservative and aggressive financing approaches.

Accepted Answer

Permanent working capital is the baseline level of investment in current assets that a firm must maintain at all times, even during its lowest point of activity in a year, representing the minimum ongoing requirement to keep operations running at all. Fluctuating or variable working capital is the additional investment in current assets required above this baseline during periods of higher activity, such as a seasonal peak in sales, and this additional requirement rises and falls with the firm's activity level over the year rather than remaining constant. This distinction is the basis for the choice between financing approaches because the three approaches, matching, conservative and aggressive, differ specifically in how they treat the financing of each of these two components: the matching approach finances permanent working capital with long-term sources and fluctuating working capital with short-term sources, following each component's own natural duration; the conservative approach finances some of the fluctuating component with long-term sources as well, beyond what matching alone would suggest; and the aggressive approach finances even part of the permanent component with short-term sources, again departing from strict maturity matching, in the opposite direction from the conservative approach.

Question 12

A firm requires ₹36 lakh in cash disbursements over the year, has a fixed cost of ₹200 per transaction to convert marketable securities into cash, and can earn 8% per annum on its marketable securities. Using the Baumol model, formula C* = √(2×A×F ÷ K), where A is total annual cash requirement, F is fixed cost per transaction and K is the opportunity cost rate, compute the optimal cash conversion size.

Accepted Answer

C* = √(2 × A × F ÷ K) = √(2 × 36,00,000 × 200 ÷ 0.08) = √(14,40,00,000 ÷ 0.08) = √(1,80,00,00,000) = √18,00,000,00 = approximately ₹1,34,164. This means the firm should convert approximately ₹1.34 lakh worth of marketable securities into cash at a time, each time its cash balance runs low, rather than converting either smaller amounts more frequently, which would incur excessive total transaction costs given the fixed ₹200 charge per conversion, or larger amounts less frequently, which would mean holding more idle cash on average and forgoing more of the 8% return available on marketable securities; the Baumol model's optimal conversion size is precisely the amount that minimises the sum of these two opposing costs, mirroring the same total-cost-minimisation logic as the economic order quantity model used for inventory.

Question 13

Explain why a firm holding excessive inventory, well beyond what its economic order quantity analysis would suggest, is described as tying up working capital inefficiently, even though the inventory itself is a current asset the firm owns.

Accepted Answer

Although inventory is indeed a current asset and forms part of the firm's working capital, holding it in excess of the genuinely optimal quantity ties up funds that could otherwise be deployed more productively elsewhere, whether invested in another part of the business, used to reduce short-term borrowing and its associated interest cost, or held as cash or marketable securities earning a return, meaning the excess inventory represents an opportunity cost even though it appears as an asset on the balance sheet. Excessive inventory also lengthens the finished goods or raw material holding period component of the operating cycle computed earlier in this chapter, which directly increases the firm's net operating cycle and correspondingly increases the amount of working capital financing the firm requires to sustain its operations, meaning inefficient inventory holding does not merely sit passively on the balance sheet but actively increases the firm's genuine, ongoing working capital financing need, which is precisely why inventory management, balancing holding costs against ordering costs and stockout risk, is treated as an integral part of working capital management rather than a separate, unrelated topic.

Question 14

Beyond the theoretical models (Walter's, Gordon's, MM), name three practical factors that genuinely constrain a company's dividend decision in reality, and briefly explain each.

Accepted Answer

First, legal constraints: company law typically restricts dividend payment to being made out of current profits or past accumulated profits, and prohibits payment out of capital, meaning a company cannot simply pay whatever dividend a theoretical model might suggest is optimal if it lacks sufficient distributable profit under the applicable legal rules. Second, liquidity: a company may have adequate accounting profit to support a dividend on paper, but if that profit is tied up in illiquid assets such as inventory or fixed assets rather than available as cash, the company may genuinely be unable to pay the dividend a model computation suggests without straining its cash position or needing to borrow specifically to fund the distribution, which is often an undesirable outcome. Third, contractual restrictions: loan agreements and debenture trust deeds often contain covenants restricting the dividend a company may pay, for instance requiring a minimum interest coverage ratio or a maximum payout ratio to be maintained, specifically to protect lenders' interests, meaning a company's actual dividend decision may be bound by these contractual limits regardless of what its own internal analysis of r versus Ke might otherwise suggest is theoretically optimal.

Question 15

Many companies deliberately maintain a stable or steadily growing dividend per share over time, even when their annual earnings fluctuate considerably year to year. Explain the signalling rationale for this practice, and how it relates to, but goes beyond, the pure Walter's-model logic of comparing r and Ke.

Accepted Answer

The signalling rationale for dividend stability holds that shareholders, and the market more broadly, interpret a company's dividend decisions as carrying information about management's own genuine confidence in the company's future earnings prospects, since management, possessing more complete information about the company's actual condition than outside investors, would generally be reluctant to raise a dividend to a level it did not have reasonable confidence in sustaining, and would similarly be reluctant to cut a dividend except when genuinely necessary, given how negatively a dividend cut is typically read by the market as a signal of underlying trouble. A company therefore often smooths its dividend per share relative to its actual year-to-year earnings volatility, maintaining a stable or gently rising dividend even through a year of weaker earnings, specifically to avoid sending an unintentionally alarming signal to the market that a single weak year does not actually justify. This goes beyond the pure Walter's-model logic of comparing r and Ke, which is a purely internal, mechanical comparison of reinvestment rate against cost of equity with no reference at all to how the market perceives or reacts to the dividend decision itself; dividend stability recognises an additional, informational dimension to the decision, the signalling effect on shareholder and market perception, that the pure r-versus-Ke framework does not capture.

Practice — Dividend Decision and Working Capital Management

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