Page 218 - DCOM505_WORKING_CAPITAL_MANAGEMENT

Unit 13: Integration of Working Capital and Capital Investment Process

Ramnaresh owns 1% of a firm X’s common stock, but if the firm follows the other policy E Notes
< D + I, Ramnaresh must invest additional funds to maintain his 1% ownership in Firm X.
Now if F = the additional funding obtained by the firm E + F = D + I, then .01F is required.

This implies that the amount of the extra cash dividend is exactly offset by the amount
Ramnaresh needs to spend to maintain his 1% ownership in Firm X.
But if the firm follows the policy E > D + I, Ramnaresh must sell back stock to the firm or
else end up with more than 1% ownership.
Important: No matter what dividend policy the firm follows, Ramnaresh is still able to
spend the same amount on consumption.
2. A condensed balance sheet for Taxes Electronic Inc. is given in table. Texas Electronics has
total assets of ` 130 crore, of which cash is ` 14 crore. The firm has approximately ` 10 crore
in excess cash that can be either paid out in dividends or used to repurchase stock. The
firm’s current earnings per share are ` 1.20. It has 11 crore shares outstanding, currently
selling for ` 9 per share.
This firm has been advised that it can either pay a dividend of 90 paise per share to
liquidate its excess cash or it can repurchase 1 crore of its outstanding shares at ` 9.90 a
share. In either situation, Texas Electronics will reduce its cash and its common equity
account by ` 9.9 crore.
Texas Electronics Inc.: Balance Sheet, December 31, 1999
Cash ` 14.0 Current liabilities ` 35.0
Other current assets 76.0 Long-term debt 17.0
Total current assets 90.0 Total debt 52.0
Net plant 40.0 Common equity 78.0
Total assets ` 130.0 Total debt and equity ` 130.0

Total current earnings are ` 1.20 × 11 = ` 13.2 crore and current P/E ratio is ` 9/` 1.20 = 7.5.
It is assumed that the P/E ratio will remain the same after the repurchase. The effect of the
repurchase on earnings per share and P/E ratio is summarised in table. Earnings per share
increase to ` 1.32 after the repurchase. If it is assumed that the P/E ratio remains constant,
the price of the stock after the repurchase will increase to ` 9.90 per share. As a result of the
` 9.9 crore cash outflow, the current ratio will decline and the leverage ratio will increase.
However, these changes would also take place with 90 paise per share cash dividend.
As this example illustrates, under the repurchase plan the stockholder is left with stock
worth ` 9.90 after the share repurchase. If the firm decides to pay a cash dividend, the
stockholder has common stock worth ` 9.00 a share plus 90 paise per share in cash. The
rupee amounts earned as dividend is taxable in the current tax year. The capital gain,
provided it is sustained over time, is taxable at a lower tax rate in the year the stock is sold.
The similarity between a stock repurchase and a cash dividend is influenced by the
repurchase price of ` 9.90. Had the repurchase price been established at a price lower than
` 9.90, the remaining stockholders would benefit at the expense of stockholders who sell
their share to the firm. A repurchase price higher than ` 9.90 would benefit the selling
stockholders more. In fact, it could be argued that ` 9.90 is the equilibrium repurchase
price. Any repurchase price below the equilibrium price would not attract any sellers.
Any repurchase price above the equilibrium price would attract all stockholders.

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