You are on page 1of 25

ACCA

Paper F9 Financial Management

Revision Mock Examination June 2013 Answer Guide
Health Warning! How to pass Attempt the examination under exam conditions BEFORE looking at these suggested answers. Then constructively compare your answer, identifying the points you made well and identifying those not so well made. If you got the basics wrong: re-revise by rewriting them out until you get them correct. Simply read or audit the answers congratulating yourself that you would have answered the questions as per the suggested answers.

How to fail

Interactive World Wide Ltd, April 2013 All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, electronic, mechanical, photocopying, recording or otherwise, without the prior written permission of Interactive World Wide Ltd. ww w. st u d yi n t e ra ct i v e . or g

Answer 1 Pep Co

Tutorial help and key points

(a) NPV should be calculated as the present value of future relevant cash flows (discounted using the appropriate cost of capital) less the initial investment. The \$8,000,000 development and testing cost is sunk as it has already been incurred and irrelevant cash flow. It should be ignored. Initial market research cost of \$2,500,000 is a committed cost and irrelevant cash flow. It should be ignored. Fixed costs represent incremental fixed production overheads which are wholly attributable to the project, hence relevant to cash flow. Selling price, variable cost and fixed costs are all in current prices and should be adjusted by their respective inflation rates from year one onwards. Tax is payable one year in arrears. Working capital should be included in year zero subject to general inflation increase and the total should be recovered in year four. The appropriate cost of capital should be the nominal (after inflation) as the cash flows are already inflated. Convert the real cost of capital to nominal using the Fisher equation (1 + M) = (1 + R)(1 + I) Comment on the acceptability of the project based on the NPV figure.

(b)

Internal rate of return (IRR) is the discount rate that makes the NPV equal to zero. To calculate IRR, you need two NPVs using two different discount rates, ideally one positive and other negative NPV. Having calculated one positive NPV at 11% in (a), you need to calculate a negative NPV using a higher discount factor. Substitute the two NPVs and their corresponding rates in the IRR formula. Comment on the acceptability of the project by comparing the IRR to the cost of capital

(c) Discuss the key issues in capital investment projects process: identifying, evaluating,

ww w. st u d yi n t e ra ct i v e . or g

authorising, monitoring and controlling

Marking scheme
Marks (a) NPV Sales Variable cost Fixed costs Tax on operating profit Tax saved on capital allowances Residual value Working capital Nominal/(money discount factor Discount factors Net present value Comment on the acceptability of the project 1 1 1 2 3 1 2 1 1 1 1 _______ Max 13

(b) IRR Second NPV IRR calculation Comment on the financial acceptability of the project 1 2 1 _______ 4

(c) 2 marks each for the discussion of each stage (identifying, evaluating, authorising, monitoring and control) up to a maximum of Total marks

8 25 marks

ww w. st u d yi n t e ra ct i v e . or g

(a) Net present value

Years 0 \$000 1 \$000 42,000 (18,720) (10,500) ______ 12,780 Tax 30% Tax savings on capital allows Equipment cost Resale value Working capital Net cash flows DF (11%) Present values Net present value 2 \$000 169,820 (75,740) (11,025) ______ 83,055 (3,834) 9,000 (120,000) (20,000) _______ (140,000) 1 _______ (140,000) _______ (600) ______ 12,180 0.901 ______ 10,974 ______ (618) ______ 87,603 0.812 ______ 71,134 ______ (637) _______ 57,745 0.731 _______ 42,212 _______ 10,000 21,855 ______ 14,398 0.659 ______ 9,488 _______ 3 \$000 231,500 (143,375) (11,576) _______ 76,549 (24,917) 6,750 4 \$000 36,460 (23,860) (12,155) ______ 445 (22,965) 5,063 (134) 12,188 5 \$000

12,054 0.593 ______ 7,148 ______

\$956

Since the net present value is positive the project is financially acceptable. Workings (1) Sales 1 \$000 Selling price Inflation Inflated selling price Units (000) Sales (\$000) (2) Variable cost 1 \$000 Variable cost per unit Inflation Units (000) Total variable cost (\$000) 900 1.041 ______ 936 20 ______ 18,720 ______ 2 \$000 1,000 1.042 ______ 1,082 70 ______ 75,740 ______ 3 \$000 1,020 1.043 _______ 1,147 125 _______ 143,375 _______ 4 \$000 1,020 1.044 ______ 1,193 20 ______ 23,860 ______ 2,000 1.05 ______ 2,100 20 ______ 42,000 ______
1

Years

2

3

4 \$000 1,500 1.054 ______ 1,823 20 _______ 36,460 _______

Years

ww w. st u d yi n t e ra ct i v e . or g

(3)

2

Years

3

1

Tax savings on capital allowances Tax saved \$000

Year

1 2 3 4

120,000 x 0.25 x 0.3 0.75 x 9000 0.75 x 6750 Difference (120,000 - 10,000) x 30%

(5)

Working capital 0 \$000 1 \$000 2 \$000 3 \$000 4

Years

Total working capital (1.03) Increase in working capital cash flows (6)

Nominal/money discount factor

(1 + M) = (1 + R)(1 + I) Money discount factor = (1.078)(1.03) 1 = 11.034% say 11% (b) Net cash flows DF (13%) Present values NPV = (5,240) IRR = 11% + (956/956 + 5240) x (13% -11%) = 11.31% The IRR is marginally higher than the cost of capital and the project is financially acceptable. (140,000) 1 _______ (140,000) _______ 12,180 0.885 ______ 10,779 ______ 87,603 0.783 ______ 68,593 ______ 57,745 0.693 ______ 40,017 ______ 14,398 0.613 ______ 8,826 ______ 12,054 0.543 ______ 6,545 ______

ww w. st u d yi n t e ra ct i v e . or g

ww w. st u d yi n t e ra ct i v e . or g

should try to identify where things did not go according to plan and what lessons may be learned for the future. The audit should also help to ensure that future investment proposals are not overly optimistic. Managers involved in the preparation of investment project proposals will know that their estimates and forecasts will be scrutinised at the end of the project.

ww w. st u d yi n t e ra ct i v e . or g

Answer 2 - WLF

Tutorial help and key points

(a) (i) Net asset using book value Net asset (book value) method values the ordinary shares as the difference between total assets and total liabilities (both current and non-current liabilities) from the statement of financial position given. The share price is therefore the total net assets divided by the number of ordinary shares.

(ii)

Net asset using net realisable values Net asset (net realisable value) method values the ordinary shares as the difference between the total net realisable value of assets and total net realisable value of liabilities (both current and non-current liabilities). Therefore, adjust the statement of financial position values to their realisable values before calculating the net assets. Any asset or liability without realisable value, simply assume that it net realisable value is equal to its book value. The share price is therefore the total net realisable value of net assets divided by the number of ordinary shares.

(iii) Dividend growth valuation method The dividend valuation model values the ordinary share as the present value of the future dividend using the cost of equity as the discount factor. Dividend is growing and therefore need to use the growth formula: Po = Do(1 + g)/(r g)

(iv) Price Earnings Ratio method The price-earnings ratio method values ordinary shares as: Po = P/E ratio x Earnings per share (EPS). The price earnings ratio used should be a proxy price-earnings ratio from a similar company. The earnings per share should be the earnings of the company to be valued and should be calculated as the earnings divided by the number of ordinary shares.

ww w. st u d yi n t e ra ct i v e . or g

(b) WACC is calculated as the weighted average of cost of equity and cost of debt using market values of equity and debt as the weighting. The company has raised capital from equity, bank loan and redeemable loan notes, hence calculate the cost and value of each of these sources of capital. Cost of equity is given, so just calculate the market value of equity as the number of ordinary shares multiplied by the ordinary share price. Calculate the cost of bank loan as the net interest: I x (1-t). value of bank loan is simply the book value. The

(c)

Calculate the cost of the redeemable loan notes as the internal rate of return and calculate the market value of the loan notes. Finally, calculate the WACC.

Explain the term efficient in the context of stock markets Discuss the three levels of market efficiency: o o o Weak form, Semi-strong form, Strong form.

Marking scheme
Marks (a) (i) (ii) (iii) (iv) Net assets (book value method) Net assets (liquidation method) Dividend growth valuation method Price earnings ratio method 1 3 3 1 _______ 8

(b) Market value of equity Cost of bank loan Cost of redeemable loan notes (internal rate of return) Market value of loan notes WACC 1 1 4 1 2 _______ 9

10

ww w. st u d yi n t e ra ct i v e . or g

(c) Explanation of efficiency Weak form Semi-strong form Strong form 2 2 2 2 _______ 8 25 marks

Total marks

(a) (i) Po Net assets (book value method) = Net assets from statement of financial position values/No of ordinary shares = \$762/200 = \$381 (ii) Po Net assets (liquidation method) = Net assets at realisable values/No. of ordinary shares = [(876 + 24 + 52 + 408 + 330) 590]/200 = \$550 (iii) Dividend growth valuation method Po = Do(1 + g)/(r g)

Where: Do g r = current dividend = expected annual growth in dividends = required rate of return = \$030 (1 + 003)/(007 003) = \$773 (iv) Price Earnings Ratio method Po = P/E ratio x Earnings per share (EPS) = 9 x 108* = \$972 *EPS is calculated as follows: EPS = \$216/200 = \$108 (b) Equity Cost of equity (given) Market value of equity = = (200/1) x \$8.3 = 7% \$1,660

ww w. st u d yi n t e ra ct i v e . or g

11

Bank Loan Cost of bank loan Value of bank loan (given) = 6% ( 1 0.25) = = 4.5% \$105

Loan notes Cost of Loan notes ( calculate internal rate of return)

The annual after-tax interest payment = 7 x (1 0.25) = 7 x 0.75 = \$5.25 per year Year Cash flow (\$) Market price Net interest Redemption value (103.50) 5.25 100 5% Discount factor 1.000 5.076 0.746 Present value (\$) (103.50) 26.65 74.60 _______ (2.25) _______ Present value (\$) (103.50) 27.52 79.00 ______ 3.02 ______

0 16 6

Year

Cash flow (\$) market price net interest redemption value (103.50) 5.25 100

4% Discount factor 1.000 5.242 0.790

0 16 6

After-tax cost of debt (IRR) = 4 + [(1 x 3.02)/(3.02 + 2.25)] = 4 + 0.57 = 4.6% Market value of Loan notes = (180/100) x 103.5 = \$186.30

WACC = (keVe + kBLVBL + kd(1 T)Vd)/ (Ve + Vp + Vd) = (7% x 1,660 + 4.5% x 105 + 4.6% x 186.3)/1,951.3 = 6.6% (c) The term efficient in the context of stock markets refers to the way in which information is processed by investors. A stock market is regarded as being efficient where relevant information is absorbed quickly and accurately by investors and where this information is faithfully reflected in share prices. The fact that new information is processed quickly and accurately means that, in an efficient market, it is not possible for an investor to make abnormal gains over the long term by swiftly responding to new information. It also means that there is no prospect of speculative bubbles as share prices will always faithfully reflect the information available. Three levels of market efficiency have been identified. These are the weak form, the semi-strong form and the strong form. Each of these forms is considered below. Weak form Weak-form efficiency is said to occur when current share prices reflect all relevant published information relating to the past share price and trading performance. New information relating to companies, however, is not anticipated by the market. As new information concerning companies will arise on a random basis, and will not

12

ww w. st u d yi n t e ra ct i v e . or g

be anticipated by the market, changes in share prices will occur on a random basis. This means that it is not possible for investors to make abnormal gains over the long term by trying to detect trends or patterns in share prices. Semi-strong form Semi-strong form efficiency is said to occur when share prices quickly and accurately reflect all publicly available information. This will include information relating to future prospects as well as past performance and may include news relating specifically to the company (such as the published annual reports, takeover speculation, boardroom changes etc), news relating to the industry within which the company operates (such as changing levels of demand, competitive pressures etc), and news relating to the economy as a whole (such as interest rate changes, inflation etc). Where a semi-strong level of efficiency exists, investors will be unable to make abnormal gains on a consistent basis by studying fundamentals such as company news, reported profits, industry reports and future prospects because this information is already incorporated in share prices. Strong form Where strong-form efficiency exists, share prices will reflect all information, whether publicly available or not, that is relevant to deriving the true value of a share. This means that it is not possible for investors to make abnormal gains even if they have access to inside information. The stock market is considered to be a fair game, insofar that no investor has an information advantage over others.

ww w. st u d yi n t e ra ct i v e . or g

13

Tutorial help and key points

(a) Identify liquidity and profitability as the twin objectives of working capital management. Explain the meaning of liquidity. Explain the meaning of profitability. Give one conflict between profitability and liquidity. Conclude that the company should try to achieve a balance between liquidity and profitability.

(b) The best policy (discount or factoring) depends on which policy will result in the highest net benefit. Calculate the costs and benefits associated with the settlement discount as: o o Cost discount allowed. Benefits collection cost saved and the interest saved on the cash received early as a result of the discount. Compare the total cost to total benefits to calculate the net cost or benefits.

Calculate the costs and benefits associated with the factoring as: o o o Cost factors fee and interest and overdraft interest. Benefits collection cost saved and overdraft interest saved. Compare the total cost to total benefits to calculate the net cost or benefits.

(c) (d)

Finally, select the policy with the highest net benefit.

Discuss the advantages of just-in-time inventory management policy. Discuss the disadvantages of just-in-time inventory management policy.

The best ordering policy is the order size that minimises the total inventory cost. Therefore calculate the total cost for each order size. There are three order sizes in the question: at the EOQ (no discount will be given), 200 units or 400 units.

14

ww w. st u d yi n t e ra ct i v e . or g

At EOQ level: o o o o Calculate the EOQ using the formula (2 x CoD)/Ch. Calculate the total purchase cost. Calculate the total holding cost. Calculate the total ordering cost.

At 200 level: o Calculate the total purchase cost (removing the discount from the purchase price). Calculate the total holding cost. Calculate the total ordering cost.

o o

At 400 level: o Calculate the total purchase cost (removing the discount from the purchase price). Calculate the total holding cost. Calculate the total ordering cost.

o o

Select the order size with the minimum total cost.

Marking scheme
Marks (a) Explanation of profitability and liquidity Explanation of conflicts between profitability and liquidity (b) Early payment discount Discount allowed Collection cost saved Interest saved Decrease in receivables Net benefits Factoring services Factors fees Factors interest Overdraft interests Collection cost savings Net benefits Conclusion 1 1 1 1 1 1 2 1 1 _______ Max 10 2-3 2-3 _______ Max 5 2 2 _______ 4

(c) Arguments for the implementation of a just-in-time approach Arguments against the implementation of a just-in-time approach

ww w. st u d yi n t e ra ct i v e . or g

15

(d) EOQ Calculation of EOQ Purchase cost Total ordering cost Total holding cost If 200 units are ordered Purchase cost Total ordering cost Total holding cost If 400 units are ordered Purchase cost Total ordering cost Total holding cost 1

1 _______ Max 6 25 marks

Total marks

16

ww w. st u d yi n t e ra ct i v e . or g

(a) The objectives of working capital management are profitability and liquidity. Profitability is to ensure that reasonable returns are given to shareholders in line with the primary objective of maximizing shareholders wealth. Liquidity is to ensure that the company is able to meet it liabilities when they fall due. The two objectives are in conflict because liquid assets such as bank accounts earn very little return or no return, so liquid assets decrease profitability which is met by investing over the longer term in order to achieve higher returns. The objective of working capital management is therefore to achieve a balance between profitability and liquidity. (b) Early payment discount \$ Costs Discount allowed (12,000,000 x 80% x 2%) Benefits Collection cost savings (140,000 - 40,000) Interest saved (800,000* x 15%) 192,000 _______ 100,000 120,000 _______ 220,000 _______ 28,000 _______

Net benefits

(220,000 - 192,000)

* Receivables without discount = (60/360) x 12,000,000 Receivable with discount: (30/360) x 12,000,000 x 80% + (60/360) x 12,000,000 x 20% = Decrease in receivables Factoring Costs Fees (2% x 12,000,000) Factor interest (20/360 x 12,000,000 x 80% x 10%) Overdraft interest (20/360 x 12,000,000 x 20% x 15%)

2,000,000

240,000 53,333 20,000 ________ 313,333 ________

Benefits Collection cost saved (140,000 5,000) Overdraft interest saved (60/360 x 12,000,000 x 15%)

Factoring is preferable on financial grounds as it offers the highest net benefit.

ww w. st u d yi n t e ra ct i v e . or g

17

(c) The just-in-time (JIT) approach to inventory management requires that inventory be delivered to the customer at the moment they are required to enter the production process. Such a precise approach to inventory delivery means that the customer and supplier must have a close working relationship. The supplier must be aware of the production requirement of the customer in advance and so the customer must be prepared to divulge potentially sensitive information to the supplier. In addition, the customer must be confident that the appropriate quantity and quality of inventory will be delivered at the right time. The efficiency of the production process becomes highly vulnerable to any delivery problems. The JIT approach is not necessarily a means of reducing overall costs, even though stockholding costs may be reduced. This approach effectively transfers the stockholding problem, along with the associated costs, to the supplier. This is likely to mean that the supplier will charge the customer higher prices in order to compensate. The close relationship between customer and supplier may also mean that it is not possible to reduce costs by taking advantage of cheaper sources of supply easily. The JIT approach is closely associated with Japanese companies where it is embraced as part of an overall commitment to excellence and the elimination of inefficiency. It is seen as contributing towards an ideal manufacturing environment where there are no defects, no waste or production inefficiencies, and where supplies are delivered on time. Whilst this environment may be impossible to achieve in practice, it does provide the business with demanding goals that it should seek to achieve. (d) The economic order quantity (EOQ) without discounts can be calculated as follows: EOQ = (2 x 8,000 x 50)/80 = 100 units If the EOQ approach is used, the total annual costs associated with the item is: \$ Annual purchases (8,000 x \$60) Annual ordering costs [(8,000/100) x \$50] Annual holding costs [(100/2) x \$80] 480,000 4,000 4,000 _______ 488,000 _______

The discounts will only apply to orders above the economic order quantity. Thus, if 200 items are ordered, the total annual costs of the item will be: \$ Annual purchases [8,000 x (\$60 x 975%)] Annual ordering costs [(8,000/200) x \$50] Annual holding costs [(200/2) x \$80] 468,000 2,000 8,000 _______ 478,000 _______

18

ww w. st u d yi n t e ra ct i v e . or g

If 400 items are ordered, the total annual costs of the item will be: \$ Annual purchases [8,000 x (\$60 x 96%)] Annual ordering costs [(8,000/400) x \$50] Annual holding costs [(400/2) x \$80] 460,800 1,000 16,000 _______ 477,800 _______

Thus, it seems that it would benefit the company if 400 units were ordered on each occasion. However, there is little to choose between the two discount options.

ww w. st u d yi n t e ra ct i v e . or g

19

Tutorial help and key points

(a) Theoretical ex-rights price is calculated as the weighted average of the current market price and the issue price. The current market price was not given. Calculate it using the priceearnings ratio method as the P/E ratio times EPS. The issue price is 70% of the current share price. The rights issue is made at a discount of 30%. To calculate the TERP, multiply the number of shares before the rights issue by the current market price and add to the issue price multiplied by the rights issue shares. Divide the sum by the number of shares after rights issue.

(b) The options available to the shareholder of 10,000 shares were given in the question as: o o o Take up rights offer Sell all the rights Allow rights offer to lapse (do nothing).

Effect on wealth can be assessed by comparing the current wealth (value) to the revised wealth (value after the rights issue and the option the shareholder will take). Calculate the current wealth as the current market price multiplied by the 10,000 shares. Calculate the wealth after rights issue as follows: o o Market price after rights issue is the TERP calculated in (a). Calculate the value of the rights per the new share as the difference between TERP and the issue price. Calculate the rights shares as the number of shares he will receive under the rights issue. Calculate the wealth for each of option take up rights up offer, sell all the rights and do nothing.

(c) The effects on EPS, interest cover and gearing is assessed by comparing the current to the revised EPS, interest cover and gearing. By raising equity capital through rights issue to pay of some debt:

20

ww w. st u d yi n t e ra ct i v e . or g

o o

debt capital will reduce by the proceeds from the rights issue, interest will also reduce by the interest saved on the amount of debt paid, Profit will therefore increase by net interest saved = interest saved less tax, Equity capital will increase by the proceeds from rights issue, Number of shares will also increase by the shares issued under the rights issue.

o o

Calculate current and revised EPS separately using the current/revised earnings divided by the current/revised number of shares respectively. Calculate current and revised interest covers separately as current/revised profit before interest and tax divided by current/revised interest respectively. the the

Calculate current and revised gearing ratios separately as the current/revised debt divided by the current/revised equity respectively. Comment on your findings by comparing the current figures and the revised figures.

(d) Assuming that the price earnings ratio remained constant, the market price after the redemption of some of the debt will be estimated as: the price earnings ratio multiplied by the revised earnings per share. Comment on your findings as follows: o The current market price of the company is 5 and after the rights issue the price (TERP) reduced to 4.75. The reduction in market price of the shares does not reduce the shareholders wealth as the reduction is compensated by increased number of shares. After redemption of some of the debt, the share price is 4.87 and therefore increases shareholders wealth by 0.12 (4.87 4.75) per share.

(e) Discuss the factors to consider in formulating dividend policy such as: o o o o o o Liquidity position Profitability Restrictive covenants Signalling effects Clientele effects Rate of expansion.

ww w. st u d yi n t e ra ct i v e . or g

21

Marking scheme
Marks (a) Current market price Rights issue price Terp 1 1 1 _______ 3

(b) Take up the right Value of shares after rights issue Purchase cost Sell all the rights Value of shares after rights issue Sale of rights Allow rights to lapse Value of shares after rights issue Comment 1 1

1 1

1 1 _______ 6

(c) Current EPS Revised EPS Current interest cover Revised interest cover Current debt/equity ratio Revised debt/equity ratio Comment 1 1 1 2 _______ 7

(e) 1 mark per point discussed Total marks Max 6 25 marks

22

ww w. st u d yi n t e ra ct i v e . or g

(a) Theoretical ex rights price Earnings per share (75m/240m) Market value per ordinary share (16 x 0.3125) 0.3125 _______ 5.00 _______ Original shares Rights share 5 x 5.00 1 x (5.00 x 0.7) _ 6 shares 28.50 /6 25.00 3.50 _______ 28.50 _______ 4.75 _______

Theoretical ex rights price (TERP) (b)

Value of rights per new shares (TERP issue price) TERP Issue price Value of rights per new share Evaluation of options Current market value of the 10,000 share holdings = 10,000 x 5.00 = 50,000 Take up rights offer 4.75 3.50 _______ 1.25 _______

Value of shares following rights issue [(10,000 + 2,000) x 4.75] Less: Cost of purchasing rights shares (2,000 x 3.50)

57,000 (7,000) _______ 50,000 _______

Sell rights Value of shares following rights issue Add: Sale of rights (10,000 x 4.75) (2,000 x 1.25) 47,500 2,500 _______ 50,000 _______

Allow rights offer to lapse (do nothing) Value of shares after rights issue (10,000 x 4.75) 47,500 _______

The calculations indicate that the wealth of the investor will be unaffected whether a decision is made to take up the rights offer or to sell the rights. The only difference will be in the form that the investors wealth will take. However, if the investor allows the rights offer to lapse, there will be a loss of wealth of 2,500. Thus, there is an incentive for the investor not to allow the offer to lapse. In practice, the business may sell the rights on behalf of the investor and then pass on the proceeds. However, it is under no obligation to do this.

ww w. st u d yi n t e ra ct i v e . or g

23

(c) Number of rights shares = 240/5 = 48 shares Number of shares after rights issue (revised number of shares) = 240 + 48 = 288 shares Proceeds from rights issue = 48 shares x 3.5 (issue price) = 168 = Amount of debt redeemed Revised equity capital = 520 + 168 = 688 Remaining debt amount (revised debt) = 550 - 168 = 382 New interest payable (revised interest payable) = 382 x 10% = 38.2 (i) Earnings per share = 75/240 = 0.3125 = 75 + (168 x 10% x 0.75) = 87.6 = 87.6/288 shares = 0.3042

= 155/55 = 2.82 times = 155/38.2 = 4.06 times

(iii) Gearing (debt/equity) Current gearing Revised gearing = (550/520) x 100% = 105.8% = (382/688) x 100% = 55.5%

The redemption of some of the debt has decreased the earnings per share due to proportional increase in shares being more than the proportional increase in earnings due to net savings of interest on the debt paid. However, the payment of debt has improved the gearing position (financial risk) of the company as indicated by increase in interest cover above the industry average and reduction of debt equity ratio below the industry average. (d) Assuming that the price earnings ratio remained constant, the market price after the redemption of some of the debt will be estimated as: price earnings ratio multiplied by the revised earnings per share: MP = 16 x 0.3042 = 4.87 The current market price of the company is 5 and after the rights issue the price (TERP) is reduced to 4.75. The reduction in market price of the shares does not reduce the shareholders wealth as the reduction is compensated by increased number of shares. After redemption of some of the debt, the share price is 4.87 and therefore increases shareholders wealth by 0.12 (4.87 4.75) per share. (e) In deciding a companys dividend policy the following factors should be considered: Liquidity To pay dividend sufficient liquid funds should be available. Even very profitable companies might sometimes find it difficult to pay dividend if resources are tied up in other forms of asset, especially if bank overdraft facilities are not available.

24

ww w. st u d yi n t e ra ct i v e . or g

Repayment of debt Dividend payout may be made difficult if debt is scheduled for repayment and this is not financed by a further issue of funds. Restrictive covenants The articles of association may contain agreed restrictions on dividends. In addition, some forms of debt may have restrictive covenants limiting the amount of dividend payments or the rate of growth that applies to them. Rate of expansion Growth companies faced with many investment opportunities may prefer to finance their expansion by retaining a large proportion of their profit instead of distributing the profit by way of dividend and asking the existing shareholders to provide extra money for expansion through rights issues which will incur issue cost. Stability of profit All other things being equal, a company with stable profits is more likely to be able to pay out a higher percentage of earnings than a company with fluctuating profits. Control The use of retained earnings to finance new projects preserves the companys ownership and control. Policy of competitors Dividend policies of competitors may influence corporate dividend policy. It may be difficult, for example, to reduce a dividend for the sake of further investment, when competitors follow a policy of higher distribution. Signalling effect This is the information content of dividend. Dividends are seen as signals from the company to the financial markets and shareholders. Investors perceive dividend announcements as signals of future prospects for the company. Legal restrictions For example, in the UK the Companies Act 2006 imposes restrictions on the distribution of profit by companies. It should be noted that the purpose of the law is to determine the maximum allowable distribution. Taxation In some countries dividends and capital gains are subject to different marginal rates of taxation, usually with capital gains being subject to lower level of taxation than dividend. This distortion in the personal tax system can have an impact on investors preference. The preference would very much depend on the tax position of investors. This is the clientele effect.

ww w. st u d yi n t e ra ct i v e . or g

25