Question

(a) Explain the following factors affecting the working capital requirements of a business :
(i) Inflation (ii) Business cycle
(iii) Nature of business
OR
(b) Explain the following factors affecting the dividend decision of a company :
(i) Access to capital market
(ii) Legal constraints
(iii) Taxation policy

Hint:

For working capital, remember "FIN" - Fluctuations (business cycle), Inflation, Nature of business. For dividends, think "LATe" - Legal, Access, Taxation.

Answer 1

(a) Explanation of Factors Affecting the Working Capital Requirements of a Business:

(i) Inflation:

Inflation refers to the general rise in prices over time, which reduces the purchasing power of money. Inflation affects the working capital requirements of a business because it increases the cost of raw materials, labor, and other inputs. As a result, a business may need to hold more working capital to maintain the same level of operations. Additionally, inflation may lead to higher interest rates, which can increase the cost of financing working capital.

(ii) Business Cycle:

The business cycle refers to the fluctuations in economic activity, including periods of expansion and contraction. During periods of economic expansion, businesses may experience increased demand for their products and services, leading to higher working capital requirements to finance increased inventory and receivables. Conversely, during periods of contraction or recession, demand may decline, reducing the need for working capital. The business cycle directly affects the cash flow and inventory levels, which in turn impacts the working capital needs of a business.

(iii) Nature of Business:

The nature of the business plays a critical role in determining working capital requirements. Businesses that deal in perishable goods (like food) or have long production cycles (like manufacturing) generally need more working capital due to the need for holding large inventories and managing long receivables periods. On the other hand, service-based businesses or businesses with shorter production cycles may require less working capital. The nature of business, such as whether it is seasonal or cyclical, also influences how much working capital is required at any given time.

OR

(b) Explanation of Factors Affecting the Dividend Decision of a Company:

(i) Access to Capital Market:

Access to capital markets is an important factor in a company's dividend decision. If a company has easy access to capital markets and can raise funds through debt or equity, it may be more inclined to pay dividends to shareholders. On the other hand, if the company faces difficulty in raising capital or if capital markets are volatile, it may decide to retain earnings to ensure financial stability and fund future projects, rather than distributing dividends.

(ii) Legal Constraints:

Legal constraints refer to the laws and regulations governing the distribution of dividends. In many countries, there are legal requirements that a company must meet before paying dividends. For example, a company must ensure that it has sufficient profits or retained earnings to distribute dividends. Additionally, the company must adhere to legal restrictions related to the maximum amount of dividend that can be paid, particularly if it is operating under certain types of financial obligations such as loan covenants or shareholder agreements. These legal constraints directly influence the company's ability to declare and pay dividends.

(iii) Taxation Policy:

Taxation policy plays a significant role in dividend decisions. The taxation treatment of dividends may influence whether a company distributes profits or retains them. If dividends are heavily taxed, shareholders may prefer the company to retain earnings and reinvest them rather than receiving dividends. Conversely, if dividends are taxed at a lower rate, companies may be more inclined to pay out a higher dividend. The overall tax policy, both at the corporate and individual shareholder levels, can thus affect the company's dividend policy.