COST OF CAPITAL
The Finance manager has to determine the capital structure that is mix of long term sources by observing.
* Existing capital Structure.
* Debt Equity Mix.
* Dividend Policy of Firm
Existing Capital Structure
The capital structure decision has to be considered by the finance manager each time the company wants to go in for a new project and has to raise finance from the public as well as other sources. At this point the existing capital structure has also to be kept in mind as the overall capital structure is now to be decided.
Debt Equity Mix
The debt-equity mix is an important factor and it has effect on
* Earnings per share.
* Risk to be borne by the investors.
* Cost of capital.
* Credit limits of the firm.
Then finance manager has to make a proportion of the funds so that weighted average cost of capital will be the lowest.
OPTIMAL CAPITAL STRUCTURE
The capital structure that minimizes the firmâ€™s weighted average cost of capital is called optimal capital structure. The advantages of maintaining optimal capital structure by the firm are.
1. Limits the financial risk to the acceptable level.
2. Involves minimum dilution of control of the shareholders.
3. Maintain the ability of the firm to borrow for future growth and development.
We have already mentioned that a finance manager has to raise capital with minimum weighted average cost of capital, and to invest for an acceptable return. In the process of business a firm will have profits. So the next question before the finance manager is how much to pay as dividend to the equity holders. Is all the net profit or part of it to be distributed to the equity holders?
Let us not forget at this point that it is that part of the profit that is not paid out as dividends and is retained by the firm to help in its growth referred to as retained earnings. Dividend decisions are important not only from the point of view of the shareholders, but also from corporate point of view.
Even though all shareholders are interested in the dividends from the companies, the time horizon of this need varies among investors. There are investors who completely depend on dividends for their day-to-day living. These investors prefer the companies to pay a regular dividend year after year. Wealthy individuals and employed persons in top salary income brackets may not be benefited fro high dividend payments from the companies. These investors generally prefer growth companies, which reinvest substantial part of the earnings rather than distributing the whole profits as dividends. An investor considers the opportunity cost of his funds in a company. If he can get more returns by making another investment that what the company pays, he prefers payment of present dividends to the retaining of profits by the firm.
Liquidity refers to the ability of the firm to meet short-term obligations.
Retention Ratio is the ratio of retained earnings to the net income after paying preference dividend.
When we look at the dividend policy from the companyâ€™s point of view it directly affects the firm in a number of ways.
First if the company distributes whole of its profit as dividends, then for the future business requirement it has depend upon outer sources. Whereas if a company retains certain part of profit as reserves this will improve the liquidity and the firm can meet future business requirement from within. Because of these reserves its ability to borrow is also enhanced.
Second, the solvency position of the company is often affected by the dividend policy. Solvency risk refers to the ability of the firm to meet its obligation when they become due. With the increase in the retention ratio the firmâ€™s equity position changes and reduces the need for outside funds and influence the firmâ€™s capital structure and reduces the solvency risk.
Dividend policy of the firm also depends upon the nature of the industry. If the demand for a product is steady and stable relative to the prevailing economic conditions i.e. there is a little or no change in the demand of a product in economic recession or boom, then they can afford to pay higher portion of their earnings as dividends, as they can hope to earn such incomes regularly.
There are certain legal restrictions, and the dividend policy of the firm has to be evolved within the legal restrictions. First the directiors are not legally compelled to declare dividends and the dividends shall be declared or paid only out of the current profits or past profits after making provision for depreciation. However, the central government can give relief to the above regulation in view of the public interest.
Third, the dividends can be paid in cash or in form of Bonus Issues.
Fourth, the dividend decision is the prerogative of the board of directors and the decision by board of directors has to be approved by the shareholders in the annual general meeting. The dividend amount is to be paid to the shareholders whose names appear in the register of members as on the record date.
For the purposes of dividend distribution and entitlements to Bonus or Rights Issues a company fixes a date on which a shareholder must officially own shares to qualify. This date is referred to as record date.