Page 217 - DCOM505_WORKING_CAPITAL_MANAGEMENT

Working Capital Management

Notes Another major theory is the Trade-off Theory in which firms are assumed to trade-off the tax
benefits of debt with the bankruptcy costs of debt when making their decisions.
An emerging area in finance theory is right-financing whereby investment banks and corporations
can enhance investment return and company value over time by determining the right investment
objectives, policy framework, institutional structure, source of financing (debt or equity) and
expenditure framework within a given economy and under given market conditions.
One last theory about this decision is the Market timing hypothesis which states that firms look
for the cheaper type of financing regardless of their current levels of internal resources, debt and
equity.



Caselet Aash Biotech: Intelligent Financing Decisions

ash Biotech is an Ahmedabad, India based pharmaceutical firm that started its
operations in 200 by the financing mix of Pecking order theory and right financing.
AFrom a small marketer and distributor of pharmaceutical products, the company
has grown to become a progressive pharmaceutical company engaged in the development,
commercialization and marketing of prescription pharmaceutical products.
At Aash, the product development has continually expanded both on existing and new
product lines. The promotion is done directly through the Company’s own expanding
sales force in over 10 states through franchise and wholesale drug company’s network.
With uninterrupted growth in sales and profits, the company adopted market timing
hypothesis so as to finance its new projects.

13.1.3 Dividend Decision

The dividend is calculated mainly on the basis of the company’s unappropriated profit and its
business prospects for the coming year. If there are no NPV positive opportunities, i.e. where
returns exceed the hurdle rate, then management must return excess cash to investors. These free
cash flows comprise cash remaining after all business expenses have been met.
This is the general case, however there are exceptions.

Example: Investors in a “Growth stock”, expect that the company will, almost retain
earnings so as to fund growth internally.
In other cases, even though an opportunity is currently NPV negative, management may consider
“investment flexibility”/potential payoffs and decide to retain cash flows.

Management must also decide on the form of the distribution, generally as cash dividends or via
a share buyback. There are various considerations: where shareholders pay tax on dividends,
companies may elect to retain earnings, or to perform a stock buyback, in both cases increasing the
value of shares outstanding; some companies will pay “dividends” from stock rather than in cash.

Example:
1. If Mr. Ramnaresh owns 1% of a firm X’s common stock, and the firm follows the policy
E = D + I, Ramnaresh’s dividend = .01D.

212 LOVELY PROFESSIONAL UNIVERSITY