Question 5 OR
Short notes: cost of retained earnings, PI versus NPV, dividend decision factors
15 marks
- Time to write
- About 30 minutes
From an older CBCS paper
Question
Question 5 OR · 15 marksWrite short notes on any three of the following:
"The cost of retained earnings is the same as the cost of equity."
Distinguish between the financial risk and the business risk of a company.
"The working capital needs of a business firm are largely determined by the length of its operating cycle."
Profitability Index (PI) versus Net Present Value (NPV).
Factors that influence a firm's dividend decisions.
Reworded from the university paper; the task is the same. The original paper belongs to the University of Delhi. See DU's question bank.
Before you write
Read off the question and its marks
Read from the question
- any threeAnswer any 3 of the 5, 5 marks each. Only 3 are marked: a fourth earns nothing.
- Distinguish betweenSet the differences out in a table, basis by basis, not as two separate essays.
- Profitability IndexCash flows year by year in one table, then discount, then a one-line decision.
- short notesA note opens with the meaning, then two or three key points. No long introduction.
Write it in this order
The parts stand alone: start with the one you are surest of.
- Read; underline the asks; jot your points 2 min
- 1 (i) Cost of retained earnings and cost of equity 5 marks 9 min
- 2 (iv) Profitability Index versus Net Present Value 5 marks 9 min
- 3 (v) Factors that influence dividend decisions 5 marks 8 min
- Check: every ask answered, key terms underlined 2 min
Easy marks
- Choose the ones you know best: each carries the same marks.
Short on time? A few lines on every part beat a full answer to one: each part is capped at its own marks.
Try it first. About 30 minutes for 15 marks. Write it out, then open the solution.
Solution
Hover or tap a marked figure, like 72,000, to see how it is made and where else it appears.
Any three notes are required; notes are written on (i), (iv) and (v), five marks each.
1The carpenter's cash becomes a cartload of timber.
Raw material storage periodCash is turned into raw materials.
2Saw and hammer turn the timber into half-made chairs.
Conversion (work-in-progress) periodRaw materials into work-in-progress.
3The finished chairs line the store room, ready.
Finished goods storage periodWork-in-progress into finished goods.
4The chairs go out on credit, and Lakshmi's notebook follows the money home.
Debtors' collection periodFinished goods into debtors and debtors back into cash.
(i) The cost of retained earnings is the same as the cost of equity
Retained earnings are not free. A firm pays no dividend on profits it keeps, but the shareholders still expect a return on them. The profits are available only because the shareholders gave up dividends, so the cost of retained earnings is the opportunity cost of those dividends: the return the shareholders could have earned by investing them elsewhere in assets of similar quality.
Why the two are alike. In the DU text's formula table, both are measured by the same dividend-plus-growth expression, expected dividend divided by the net proceeds of a share plus the growth rate (Kr = D/NP + G; Ke = D/NP + G). In principle, retained earnings are the equity shareholders' money, so they must earn what equity shareholders require.
Where they differ. New equity raised from the public bears flotation costs, which lower the net proceeds per share and raise the cost; retained earnings bear none. The DU text accordingly states that the cost of retained earnings is lower than the cost of equity, because the former has no flotation cost.
| Item | New equity shares | Retained earnings |
|---|---|---|
| Expected dividend D1 | ₹6 | ₹6 |
| Growth g | 4% | 4% |
| Net proceeds per share | ₹95 (price ₹100 less 5% flotation cost) | ₹100 (nothing spent to raise it) |
| Cost = D1 / NP + g | 6/95 + 4% = 10.32% | 6/100 + 4% = 10.00% |
Comment. The statement is correct in principle, since retained earnings carry the same required return as equity, and it holds exactly when flotation costs are ignored. Allowing for flotation costs, the cost of retained earnings is slightly lower.
(iv) Profitability Index (PI) versus Net Present Value (NPV)
Both are discounted cash flow methods that use the same present values. NPV is the present value of inflows less the present value of outflows; PI is the ratio of the first to the second.
| Basis | NPV | PI |
|---|---|---|
| Measure | Absolute amount in rupees | Relative measure, a ratio |
| Formula | PV of inflows − PV of outflows | PV of inflows ÷ PV of outflows |
| Accept if | NPV > 0 | PI > 1 |
| Independent projects | Same accept/reject result: a project with positive NPV has a PI above one | Same accept/reject result |
| Ranking | Ranks by size of the gain | Ranks by gain per rupee invested; helps rank many proposals |
| Weakness | Favours larger projects | Can mislead where projects are indivisible or differ in size |
Example (own figures). Project X: outflow ₹5,00,000, PV of inflows ₹6,00,000, so NPV = ₹1,00,000 and PI = 1.20. Project Y: outflow ₹1,00,000, PV of inflows ₹1,50,000, so NPV = ₹50,000 and PI = 1.50. Both are acceptable, but they rank differently. If X and Y are mutually exclusive, NPV prefers X because it adds more to shareholders' wealth; PI prefers Y. The ICAI text cautions that a high-PI project may leave a lower total NPV, so PI cannot be used indiscriminately.
Conclusion. PI is a variation of NPV and needs the same computations; the two agree on accept or reject and may disagree on ranking. When mutually exclusive projects conflict, NPV is the safer guide to wealth maximisation.
(v) Factors that influence a firm's dividend decisions
The dividend decision divides profit between dividends and retained earnings. The factors fall in two groups.
| Group | Factor | How it affects the decision |
|---|---|---|
| Internal | Funds needed and investment opportunities | A firm with profitable projects keeps more profit, saving flotation cost and avoiding dilution of control |
| Internal | Cost of capital and capital structure | If cheaper debt is to fund growth, more can be paid out; if new equity would be needed, retention is preferred |
| Internal | Liquidity | Dividends are a cash outflow, so a firm short of cash cannot pay generously even when profits are good |
| Internal | Stage of growth | Mature firms with few projects pay more; growth firms pay less |
| External | Legal constraints | Section 123 of the Companies Act, 2013 allows dividend only out of profits (arrived at after providing for depreciation) and the other sources the section lists |
| External | Taxation | The way dividends are taxed in the shareholders' hands affects how much of the payout they actually keep, and so how much they want paid |
| External | Shareholders' expectations and stock price | Some shareholders want regular income, others growth; higher dividends tend to lift the share price |
| External | Access to the capital market | If new shares cannot easily be placed, the firm leans on retained earnings; paying large dividends can also dilute control when new shares are issued |
| External | Trend in the industry | Firms in industries where investors expect regular income must keep paying |
Conclusion. No single factor decides; management weighs them to reach a payout that balances shareholders' current income against the growth funded by retention.
Where the 15 marks sit
| # | Component | Marks |
|---|---|---|
| 1 | (i) Cost of retained earnings and cost of equity | 5 |
| 2 | (iv) Profitability Index versus Net Present Value | 5 |
| 3 | (v) Factors that influence dividend decisions | 5 |
| Total | 15 |
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