Stream of Expected Returns
Investment returns can take many forms. An investor must consider all these forms to evaluate an investment option accurately. A brief description of the forms of investment returns is given below:
Cash Flows are the accounting profits gained by a company or a firm from its operations. It represents the actual amount of cash a firm receives during the course, of its operations. Cash flows from operations are better indicators of the firm's financial position than net income. Since net income is calculated based on accrual accounting concepts, which records the profit unearned or still to be realized on investment the cash flows determine the free cash available for future investments and payment of dividends. The basic model followed for calculation of cash flow is
Cash Flow = Profit After Tax (Net Income) + Non-cash expenses + Changes in net working capital - Capital expenditure.
Dividends are a part of the company's earnings to be distributed among its common and preferred shareholders, based on the Board of Directors' decision. A firm's ability to pay dividends depends upon its cash flows from operations, not mere by its earnings. Firms regularly declare three kinds of dividends and some special dividends occasionally.
A cash dividend is a dividend paid in cash to the shareholders. To pay dividends in cash, firms not only need to have enough profits but also enough cash in books of accounts. Even when a company shows large profits retained in its balance sheet they are not enough to assure cash dividends. The amount of cash that a company has is independent to retained profits.
Stock dividend (also called Bonus Issue) involves capitalization of the reserves by issuing new shares to the existing shareholders. A part or the whole of the reserves are capitalized. The new shares (bonus) are issued to the existing shareholders pro rata to their existing holdings. The proportional stake of the shareholders in the firm remain unchanged though the size of their individual holdings may be significantly different. Hence, bonus issue has no implications on the controlling interests. From accounting point of view, the paid-up equity capital of the company increases and the size of the reserves decreases. The overall quantum of the shareholders' funds (net worth) remain constant but there is a change in its composition. Thus, a bonus issue essentially represents a recapitalization of the company. It aligns the share capital with the total shareholders' funds.
Stock splits involve increase in the number of shares outstanding through a decrease in the par value of the share. The total size of the share capital remains the same. For example, the division of a share whose face value is Rs.100 into 10 shares of Rs.10 face value. After this division, each shareholder will hold 10 shares of A Ltd with a par value.Rs.10 each in lieu of the previous holding of one share of Rs.100. This division of shares is called Stock Split. Stock splits like bonus issues have no implications on the proportion of individual stakes in the company. Conversely, a company might want to reduce the number of outstanding shares. It can accomplish this through a reverse stock split. A new share with a higher par value is created in exchange of the old shares with lower par values. Reverse stock splits are generally employed to increase the market price of shares. Markets react negatively to reverse stock splits and hence firms are generally disinclined to make such a move.