Strategic Level Paper

F3 – Financial Strategy
September 2013 examination

Examiner’s Answers
Question One

Rationale Question One concerns the evaluation of a proposal to privatise one of T Railways’ wholly owned subsidiary companies, TPTS. It requires a comparison of two possible methods of privatisation. This is followed by an evaluation of the value of TPTS from the viewpoint of both the vendor and the acquirer. The question concludes by asking for a recommendation as to whether or not T Railways should proceed with the sale of TPTS, taking into account the wider financial and strategic issues arising. Question One examines syllabus sections B1(c), C1(a) and C2(b).

Suggested Approach The answer to part (a) should consider the two alternative privatisation methods listed in the requirement, focussing on a comparison of the methods themselves rather than the impact on TPTS of privatisation per se. In part (b) (i), the answer should begin by considering all the current TPTS cash inflows and outflows to identify which are lost as a result of the sale of TPTS. Any new cash flows (such as payment to UT for the use of the track and policing services) and any other changes (such as to head office costs) should also be added to the list. In part (b) (ii), the net change in cash flows identified in part (b)(i) should be discounted by applying the growing perpetuity formula at a growth rate of 2% and a discount rate of 4%. Finally, in part (b) (iii), the appropriateness of the discount rate of 4% should be considered. Starting with the rationale for its use and then questioning the validity of the use of a discount rate that takes neither risk nor tax into account.

Financial Strategy

1

September 2013

No underwriting costs would be required and the tighter timeframe would result in lower exposure to a fall in the stock market during the sale process. although selling to UT may not raise as high a sales value. Confidence in the on-going provision and quality of the maintenance of track A long term view is required when managing track quality. Both short and long term financial impacts should be considered. Although likely to be at a lower price. a successful IPO requires a strong demand for shares. within the context of the question scenario.Question One Suggested Approach continued Part (c)(i) should begin by scheduling the relevant cash flows for TPTS once owned by UT. This should be compared to the cost of disposing of TPTS from T Railways’ viewpoint as calculated in part (b)(ii) and a conclusion drawn. There is some reassurance that UT would be willing to adopt such a strategy as. Asset based valuations should also be provided on both a cost and replacement cost basis. T Government. the sale agreement could include ‘lock ins’ for the transfer and retention of key staff to ensure continuity in track management and transference of management expertise in this specialist area. The answers should then widen out to consider the wider strategic benefits and drawbacks of the sale of TPTS. (a) Price obtained and speed and risk of completion of the sale The IPO has the potential to raise higher sales proceeds than a trade sale to UT by opening the sale up to a wider potential investor group. To summarise. Management expertise In both cases. it would seem to be a quicker and safer approach to privatisation. a sale to UT would be quicker and cheaper to achieve. The management of UT would also already have the necessary experience and expertise in managing and negotiating service levels with T government in respect of the provision of utilities. This skill is likely to be useful when drawing up a service agreement for provision of the railway track to T Railways. September 2013 2 Financial Strategy . A sale to UT would have the added advantage of a main Board of UT who already have expertise in managing an independent services company. indeed. Part (d)(i) should begin by looking at the maximum price that UT would consider based on the results in part (c). reflecting public confidence in the future profitability and government support for the new company. However. These should then be discounted at 8% using a growth rate of 2%. the provision of utility services requires a similar long term business and maintenance perspective. before reaching an overall recommendation. The answer to part (d)(ii) should firstly consider the financial implications of the sale of TPTS from the viewpoint of both T Railways and its sole shareholder. taking each in turn. Part (c)(ii) should consider the validity of each method used in (c)(i).

• • Financial Strategy 3 September 2013 .0 m x 1. This is clearly inconsistent treatment of tax .(b) The sale of TPTS from the viewpoint of T Railways (b)(i) impact of the sale of TPTS on T Railways’ post-tax. and so would be best removed from the calculation altogether due to the circular flow of the tax element. Alternatively. technically more correct since tax is paid across to the sole lender. This is.856 million = T$ 56.30)). which is wholly funded by T Government.0 million for the year ending 31 December 2014 ( = T$ 80 million x (1 – 0.02 / (4% . Using a non-risk-adjusted cost of capital as the discount rate is likely to over-value TPTS and give T Railways an unrealistic target price for TPTS. T Government. consistent with other businesses owned by T Government. pre-financing cash flows Changes to T Railways forecast cash flows for the year ending 31 December 2014: T$ million Revenue from cafes and stations foregone Direct operating costs no longer incurred Benefit from reduction in HO costs Fees payable for use of track Incremental net operating cash outflow (100) 795 25 (800) (80) where 100 = 38 + 62 This equates to a post-tax net operating cash outflow of T$ 56. Drawbacks: • The 4% cost of capital has not been adjusted to reflect the beta or risk profile of the railway business.a post-tax cost of debt would have been more appropriate and used to calculate T Railways’ WACC. the pre-tax cost of capital of 4% could have been applied to pre-tax cash flows. 4% is the pre-tax cost of debt to T Railways but has been applied to post tax cash flows. • Represents T Government’s cost of borrowing which is consistent with the funding structure of T Railways.2%) (b)(iii) Validity of 4% discount rate Benefits: • Easy to apply. Some adjustment would be reasonable to ensure that a more realistic commercial valuation of TPTS is obtained for use in setting a fair price for the sale of TPTS. arguably. (b)(ii) Present value of change in cash flows NPV of forecast change in cash flows above Value at 4% with 2% growth: T$ 2.

The cash flow estimates for 2014 are highly subjective. The DCF valuation is more appropriate in this case since it reflects the earning capacity of the track.142 million at 2% growth (where 1. This is an unusual position but supports the opinion expressed above that the asset based valuations do not give valid results in the context of this scenario. The DCF valuation is lower than either of the asset based valuations.990 2 1. the validity of the DCF result depends to a large extent on the validity of the inputs to the DCF model. The track has little value for an owner unless it can be used to run trains. the business is wholly dependent on one customer and hence UT may demand a lower price because of the risk this creates. it would be worth little more than the value of scrap metal. September 2013 4 Financial Strategy . Also.992 Non-current assets at replacement value Add working capital Capital employed at book value DCF basis NOCF after tax of T$ 67. especially as track systems are constantly evolving technologically.02 / (8% . it would be unlikely to pay anything near to cost price for second hand track. However.(c) The sale of TPTS from the viewpoint of UT (c)(i) Valuing TPTS from the viewpoint of UT Asset bases Non-current assets at cost Add working capital Capital employed at book value T$ million 1. Even if there were a newly formed railway company which could use the track. The commercial value of the track is the potential revenues that it can generate.2 X 1.2%)) (c)(ii) Validity of methods used and results obtained An asset based valuation is the simplest valuation method available because it simply uses information provided. Without the railways.2 million (= T$ 96 m x (1 – 0.142 = 67. It is not yet clear as to what it might cost to maintain the track nor is it clear how much UT could charge T Railways for use of the track.30) at a discount rate of 8% gives an NPV value of: T$ 1.502 T$ million 1. neither book value nor replacement value is likely to be representative of the underlying commercial value of TPTS.500 2 1. However.

T Government. the interest saving is overstated in the calculation since the discount rate used was the pre-tax cost of capital and would be lower after taking the tax saving on debt interest into account. (d)(ii) It is not recommend that T Railways should proceed with the sale of TPTS unless forced to do so by pressure from T Government. Indeed. However.142 million that UT might be willing to pay. The immediate sale proceeds. Indeed. T Railways would therefore lose out financially if it were to sell TPTS. which would enable it to repay debt. However. the actual price achieved may be significantly lower depending on UT’s perception of the risks involved in taking over the running of the track and the uncertainties surrounding both the future cost of maintaining the track and the fee that could be obtained for the provision of the track to T Railways. The short term gain in terms of funds received on repayment of some of T Railways’ borrowings would be outweighed by the net increase in funding that T Railways would require in perpetuity. it creates significant risk to the continued operation of the railways by losing direct control over such core and strategic assets as the track. Indeed. Another observation is that the current government would gain favourable publicity by reducing public sector borrowing and it will be a different government that has to pick up the added costs at a later date. Looking at the financial angle first: • • As already noted above.142 million. This is more than double the price of T$ 1. • Financial Strategy 5 September 2013 . as the sole source of finance for T Railways. the DCF valuation obtained in (c)(i) above is considered to be more appropriate than an asset based valuation in this instance. Whether this price is likely to be acceptable to T Railways Based on the results in (b)(ii) above. T Railways would lose out financially by the sale of TPTS.856 million based on the present value of the net increase in cash outflows in perpetuity at T Railways’ discount rate of 4%.(d) Overall assessment and recommendation (d)(i) Maximum price that UT is likely to offer for TPTS AND whether this is likely to be acceptable to T Railways Maximum price As already discussed above. It does not benefit T Railways from either a financial or strategic point of view. T Government might consider that this is a price worth paying on the assumption that financial conditions may improve in the future and that it is more important to address the immediate need of reducing T Government borrowing than to be too concerned about additional costs in the future when public sector borrowing may be less of an issue. would also lose out financially. stations and other property and property services. even after taking the interest saving into account. This strategy provides a short term gain in exchange for higher costs in the future. the disposal of TPTS is estimated to cost T Railways T$ 2. would be more than offset by the loss of revenue and the increase in costs in perpetuity. The maximum price that T Railways can expect to obtain for TPTS is therefore T$ 1.

If the acquirer does not invest in the track and maintain it at the appropriate standard. Key issues are considered below: • Loss of control over the maintenance of the track. Indeed. • • In conclusion. T Railways cannot provide passenger and freight services without track! In addition. it is likely that T Railways would will feel obliged to increase the amount paid for use of the track or otherwise support UT in order to ensure that it is able to continue in business. September 2013 6 Financial Strategy . this would have a direct impact on the provision of rail services which could undermine T Railways’ business. In other words. Track and other property are core business assets that are central to T Railways’ business and service targets. by selling TPTS. the risks extend beyond T Railways as a disruption in the country’s rail services would be likely to have much wider implications for the whole economy. Unknown future liability to support UT in the future. T Railways would not be able to meet its targets for safely and reliability of service (many of which are set by the Rail Regulator) if UT were to be unable or unwilling to maintain the track to an acceptable standard. Selling and hence effectively outsourcing such a vital resource and hence losing direct control over how the track is managed could undermine the whole of T Railways’ business. If UT were to become unviable due to escalating maintenance costs. the costs and risks outlined above clearly outweigh the benefits to T Railways of the sale of TPTS and it is recommended that T Railways does not proceed with the proposed sale of TPTS. T Railways would lose all control over how the track is maintained but would retain all the risks inherent in the provision and maintenance of the track. Many employees and industries will rely on the rail network to transport people and goods. Inadequate rail services could have significant knock-on effects for the economy as a whole. Environmental targets also depend on greater use of the railways.There are also significant strategic drawbacks and risks to T Railways (and hence also to the country as a whole) arising from the sale of TPTS.

can then be used to adjust sales and purchases forecasts onto a cash basis. Finally. consider how the potential increased borrowing requirement could be met. This information. Question Two examines syllabus sections A2(c) and B1(a) and (e). backup bank facilities or a paper issuance programme. Financial Strategy 7 September 2013 . Add the opening cash balance in order to derive the closing cash balance or borrowing requirement at the end of the period under each scenario. note that it is a good idea to add in the opening cash balance and calculate a closing cash balance at this point as a cursory glance at requirement (b) reveals that this information will prove useful later on in the question. Candidates are then asked to assess the potential liquidity challenges that the company faces and how best to respond. Each of these copied versions can then be amended to reflect the change in circumstances outlined in each of the three scenarios provided in the question. Suggested Approach In part (a).Question Two Rationale Question Two focuses on both the funding and management of working capital. comparing the relative size of the borrowing requirement under each scenario In part (c). it is probably simplest to use EXCEL to ‘copy and paste’ the original cash forecast three times. Although not required in the question. consider any changes that should be considered in respect of long term financial strategy in order to ensure that the company has sufficient liquidity to meet its needs in the long term. Now evaluate your results. The question begins by testing candidates’ ability to calculate and evaluate a company’s current short term borrowing requirement and the sensitivity of that borrowing requirement to three possible alternative outturn scenarios. firstly calculate closing working capital balances. together with the data provided on opening balances. starting with sales receipts and purchase payments and adding other cash items to derive a figure for the net cash movement in the period. either by changes to the management of working capital or by arranging additional short term loans. In part (b). A cash forecast can then be built up.

Even in ‘best case’ scenario 1.24) 50.53 million (= 94.00) (124.64 18.00) (20.00) 37.19 50.00 (370.76 Scenario 2 (F$ million) 630.53 (39.(a) Forecast for year ended 30 June 2014: Sales revenue Purchases Other costs Add back: Depreciation Less: Capex Less: Dividend Add: Accounts receivable at start Less: Accounts receivable at end Less: Accounts payable at start Add: Accounts payable at end Net cash inflow Add opening balance Forecast closing balance F$ million 725.90) 121.00 (30.95) 50. In Scenario 3.00) 40.90) 105.00) (124.19 Note that purchases are equivalent to COGS since inventory is unchanged = F$ 725 m X 30% X 60/365 = F$ 370 m X 120/365 (b) Scenario 1 (F$ million) 630.19 million -10.00) 37.20 (31.00 (321.00 (321.53 (59.00) (20.07) 42.00) 37. FF’s cash resources are severally diminished and back-up borrowing facilities would be required to provide reassurance that future cash needs could be met.07) 42. together with a reduction in purchases has a negative impact on liquidity of F$ 57.00 (30.00) (20.00) (124. new borrowings of at least F$ 95 million would be required.00) 37.00 (144.76 million)). The second largest effect is the deterioration in sales which.77 million + 10.90) 0. FF requires additional funding.78) 42.00) 40.00) (20.00 (42.90) 105.00 (321. the difference between the outcome of scenarios 1 and 3.00) 40. especially given FF’s very low profit margin (30/725 = 4% before dividends in the year ended 30 June 2014).75) (124.00 (9.00 68.00 (30.00 (42.00) (325.00) (325.00 (30. In both scenarios 2 and 3.20 (35.00 (94.20 (51.76 million) in scenario 1.00 10.00) (325. September 2013 8 Financial Strategy .43 million (= 68.95) Scenario 3 (F$ million) 630.20 (31. This is clearly a very large sum to find.77) Sales revenue Purchases Other costs Add back: Depreciation Less: Capex Less: Dividend Add: AR at start Less: AR at end Add: Inventory at start Less: Inventory at end Less: AP at start Add: AP at end Net cash outflow Add opening balance Forecast closing balance The largest impact on liquidity is the potential withdrawal of credit by suppliers (negative impact of F$ 105.00) (325.00) 40.77) 50.00 (42.

there is a risk that such a policy could lead to a loss of sales. We can see from a further analysis of scenarios 1 to 3 that a fall sales and purchases as modelled in these scenarios creates an accounting loss: Scenarios 1 to 3 (F$ million) Sales revenue 630.) • Negotiate the use of consignment stock. it should be a higher priority for FF to maintain good relationships with suppliers rather than seek to extend credit terms. refurbishment of stores or other capital expenditure programmes.00) Purchases (325. • Products could be ordered in store and then delivered to the customer directly from the manufacturer rather than held by FF in storage. (Banks may be more willing to lend and at a lower interest rate where assets are used as security since such borrowings may make lesser demands on a bank’s capital requirements. Financing working capital and other short term liquidity requirements Greater borrowing headroom is required in order to cope with uncertain future cash flows • FF should attempt to negotiate back-up bank facilities that can be drawn down as required. These might include a revolving credit facility (RCF) (committed finance) or overdraft facility (uncommitted. or paid in a non-cash form such as a scrip dividend. However. Working capital could be used to support financing. FF should continually monitor and update a medium to long term cash forecasts to give early warning of future liquidity demands and enable appropriate changes to be made to financial and business strategy to ensure that liquidity demands can be met. Ultimately.00 (321. • Borrow against inventory.00) Accounting loss This position is clearly unsustainable in the longer term and changes would be needed to reduce other costs and/or increase the gross profit margin. However. so less reliable than RCF) to enable it to meet short term cash needs. Accounts payable • At present. FF would then be reliant on speedy delivery by the manufacture. However. profits turn into cash and the company can only survive if it has a business strategy that creates profit and value. Long term financial strategy Over the longer term.(c) The management of working capital Inventory • It may not be possible for FF to reduce inventory since this could create a risk of product shortages and consequential loss of sales. Attempt to arrange with suppliers that they would only be paid for the goods on display once they had been sold. Either no dividend could be paid or it could be deferred. For example: • Use factoring to gain access to funds tied up in accounts receivable. reduced. it is important that the company manages the business in a profitable manner. Releasing cash elsewhere in the business • FF could consider delaying other payments. Financial Strategy 9 September 2013 . especially given the current poor market conditions. something that would be outside its control. for example.00) Other costs (16. • The dividend forecast to be paid on 20 June 2014 could be altered. Accounts receivable • FF might attempt to apply credit control procedures on a stricter basis. this is unlikely to prove successful given FF’s current financial weakness.

Standard IRR approach: Firstly schedule the cash flows arising from the production of product X.3% as ‘Ynew’. Theoretical and practical factors that affect share prices are both considered in the context of the scenario provided. There is no value in repeating the NPV at 10% here. In part (b)(ii). the IRR. Note that you are already given the NPV at a discount rate of 10%. Note that it is not possible to obtain the IRR by applying the EXCEL IRR function in the normal manner here since a perpetuity is involved. Conclude by considering broader business and risk factors that can be expected to influence the share price in this scenario. apply the yield-adjusted TERP formula using 11. together with the price of those shares. Then add the number of shares being issued under the rights issue.3% is. Information on the value of the project can then be added to the final ‘value’ column. The EXCEL IRR function is applied to pre-discounted cash flows and these continue indefinitely into the future. Question Three examines syllabus section B1(d). address each of the issues raised in the requirement in turn. There are a number of acceptable approaches to answering part (b)(i). The simplest way to arrive at the correct answer is to draw up a table with a column for number of shares. Two alternative theoretical approaches are used to calculate the theoretical ex-rights price. Total each column and use the totals to derive the missing figure for the resultant share price post rights issue. so just one more NPV result is required in order to derive the IRR by interpolation. In the answers we have used a discount rate of 12%. hence. and 10% as ‘Yold’. September 2013 10 Financial Strategy . being the effective yield on the project. share price and total value.Question Three Rationale Question Three requires an assessment of the likely impact on share price of a proposed new project to be financed by a rights issue. beginning by outlining the efficient market hypothesis and its relevance in this scenario. that 11. Suggested Approach Part (a) requires the calculation of the Theoretical Ex-Rights Price. Alternative approach to proving the IRR: Show that the NPV is zero at 11. In part (c).3% and. The first row in the table can be completed by copying information across from the question concerning the current position. indeed. being the current WACC of the company. Calculate the NPV using EXCEL and the perpetuity formula.

0) ] = 1/6 [ 24 + 3.5 500.567 39.0) = 11.0 1 500.0 100.36 per share TERP = 1 N +1 [(N x cum rights price) + issue price] + NPV or project/number of shares after the rights issue = 1 6 [(5 x 4.36 x 11.7 37.0 6 7+ 70.0 391.0 -250.507 198.95 / (0.0 -30.636 63.0 0.5 3 305.1 37.6 + 25.0 5 350.8) + (3.6328 per share Financial Strategy 11 September 2013 .36] + 44.5 4 340.5 17.0 -250.12 + 0.3% Workings W1 391.797 43.0 10.USD 25.05) (b)(ii) Yield-adjusted TERP = 1 N +1 [(N x cum rights price) + issue price x (Ynew/Yold)] = 1/6 [ (5 x 4.0 37.7968] = USD 4.05 = USD 4.0 7.2(W1) 500.56 + 0.2 = 70 x 0.30%) x USD 4.5 100.5 0.0 0.3/10.0 -7.0 44.2 0.3 NPV = .0 -250.0 55.0 63.0 0.0 -250.5 391.0 2 275.80 = USD 3.6/(750 + 150) = 4.6 million (as given in the question) Now calculate the NPV at.61 per share (b)(i) NPV at a discount rate of 10% is USD 44.5 55.7 70.5 76.0 -16.(a) Issue price is (100% .507 35. say.5 38.9 70. a discount rate of 12%: Time Cash inflows Cash outflows NCF Tax at 30% After tax CF Capex Tax relief on capex Total cash flows Discount factor PV 0 1 260.0 0.0 million So IRR = 10% + 2% x 44.0 -3.0 25.712 54.0 -27.0 -250.6 / (44.0 90.80) + 3.8 37.5 0.0 70.893 39.

56 post rights issue before taking the project into account. whilst the share price can be expected to fall to USD 4. This represents a fall in the share price purely as a result of the new shares being issued at a discount. but also respond immediately to current publicly-available information about the company. • Firstly.3%. • Difference in the Mathematical approach. • Rights issue.56 (being. note that if growth had been assumed to be zero and we had been valuing a simple perpetuity. the perceived future benefit from the launch of product X is likely to have a positive influence on the post rights issue share price as this will potentially increase overall shareholder wealth. Whether the share price ends up higher or lower than the project-adjusted TERP following the announcement will depend on how the market reacts to the announcement. • Secondly. the methods would have given exactly the same result. Investors will only be willing to increase their investment and hence exposure to RR if they both have sufficient funds available and have sufficient confidence in the future of RR and / or product X to be willing to purchase additional shares in RR under the rights issue. the result in (a) would be considered to be slightly more accurate as it takes into account the profile of the project cash flows in more detail. For example. Based on our calculations above we can see that the project-adjusted TERP is higher that the nonproject adjusted TERP. Market reaction will largely depend on reaction to the product launch and the rights issue: • Product launch. However. There may be slight differences due to: • Roundings in the calculation (as we were only working to one decimal place). their perception of the riskiness of the project. ((USD 4. With a WACC of 10% and a project IRR of 11. However. Only under the strong form of efficient market would the share price already have begun to take the news into account. the rights issue will push the share price down to take the discount into account. September 2013 12 Financial Strategy . the TERP will be USD 4.80 x 5) + USD 3. reflecting the increase in shareholder wealth arising from the positive NPV generated by the project. the market can be expected to react straight away to the news of the rights issue and product launch. The two TERP calculations should produce the same result in this case.(c) Under the semi-strong form of the efficient market hypothesis. Market reaction will depend on investors’ confidence that product X will meet company expectations. this would not result in a fall in overall shareholder wealth since it only reflects the impact of the discount on the right issue.3% risk premium built into the discount rate would mean that the project would cease to be financially beneficial.36)/6). Market reaction will also depend on the readiness of shareholders to subscribe to a rights issue. share prices reflect not only historical share price information and other historical information about a company. There are two conflicting forces at work here. even a 1. Assuming a semi-strong form. If choosing between them. Ignoring the project.

2% = r x b = 16% x 20% Financial Strategy 13 September 2013 .08 = 13.Question Four Rationale Question Four focuses on dividend policy and both the theoretical and practical implications of changing the earnings pay-out rate. It also tests understanding of both theoretical and practical issues affecting dividend decisions. Only after the third year is it possible to apply a growing perpetuity to finish the NPV calculation.3225 13.9m x 50% / 20m 2015 8% Workings g=rxb = 16% x 50% = 8% = K$ 12.3483 where 3.5 0. Remember to take into account the time delay between cutting the dividend and affecting earnings. In part (a)(ii).2% Workings No change as reinvestment of additional retained earnings not actioned until this year = K$ 12. It is important to look at each year individually because of the time delay between cutting the dividend and realising the benefit in terms of increased earnings.032 = 12.2% 2014 3. to model the theoretical impact of a change in pay-out on a company’s share price in a given scenario.5 million x 1.932 x 50% / 20 m Earnings (K$ million) Dividend per share (K$) 12. It is therefore not possible to apply the standard DVM formula (based on a perpetuity) straightaway as this is based on a simply growing perpetuity starting at time 0. The question tests candidates’ ability to apply the dividend valuation model. (a)(i) Performance measure Earnings growth rate 2013 3. It may be useful to draw a time line here to help work out the timings involved. It is therefore essential to attempt part (a) before moving on to part (b).932 0. Question Four examines syllabus sections A1(c) and A2(d). the share price value should be based on the present value of future dividends in perpetuity. Suggested Approach Part (a)(i) requires the calculation of the impact of a change in dividend pay-out rate on certain specified variables which are used as key inputs in calculating the impact on share prices in part (b).50 12.9 million x 1.9 0. including the growth model that underpins it. The answer to part (b) should begin by interpreting the results in part (a)(ii) and then move on to consider alternative dividend theories.

Indeed if the rate of return on reinvested funds had been lower than the cost of equity then we would expect the share price to actually fall. the share price will only reflect this theoretical result if investors believe that retaining the funds will.3225 x 1.8718 ( = 1 / 1.147) 0.147 – 0. However.2647 Alternative approach. If capital gains are taxed at a lower rate than income.147^2) 0. depending on their perception of the long term stability of the company and their personal tax position. Note that this result depends on the rate of return on reinvested funds being higher than the investors required rate of return (ie: Ke).08^3) Etc Etc Total NPV (using EXCEL NPV function at a discount rate of 14. some shareholders may prefer cash (following the ‘bird in hand’ principle) whereas others may prefer an increase in share price.08) 31 Dec 2016 0. On the other hand.3483 uplifted by 8% a year 5.81 per share).7% as at 1 January 2014 as follows: Date Dividend per share PV of all future dividends as at 31 Dec 2015 Discount factor PV as at 31 Dec 2013 Total PV 31 Dec 2014 0. This is because the increase in retained funds should promote growth and hence increase shareholder wealth.3762 (= 0.08^2) 31 Dec 2017 0.08) 0.2812 4.3483 (= 0. The DVM result in (a)(ii) above predicts that reducing the level of dividend would lead to an increase in the share price (moving from K$ 4. all shareholders (including family shareholders) tend to prefer a predictable level of dividends in order to be able to plan ahead.81 as a result of the change in dividend pay-out ratio. Secondly. which pushes the share price up to K$ 4.7601 4. Thirdly. the signalling effect of dividends.3762 (= 0.50 to K$ 4. a switch from dividend to capital gain may be advantageous to shareholders.81 Both approaches give the same result. using a multi-columnar table on EXCEL: Date Dividend per share 31 Dec 2014 0.08) 31 Dec 2016 onwards 0. Firstly.81 0.3225 x 1. Many shareholders may rely on the dividend stream to provide day-to-day income.81 on the stock market. indeed.3483 (= 0.7%): K$ 4. (b) There are many theories surrounding dividend decisions.3225 31 Dec 2015 0.2675 0. produce the higher returns forecast by the DVM and act accordingly by increased demand for shares.3483 x 1.6144 ( = 0.7601 ( = 1 / 1.3225 31 Dec 2015 0. September 2013 14 Financial Strategy .3225 x 1. A lower dividend could be interpreted by investors as an indication that the company is in financial difficulty rather than that the company is seeking investment opportunities in new markets.3225 x 1. the share price can be calculated as the present value of future dividends in perpetuity at a discount rate of 14.50 to K$ 4.08 / (0. We also need to consider more practical considerations affecting the optimum level of dividend.(a)(ii) At a 50% pay-out rate. That is. that the ex div share price is expected to move from K$ 4.

A residual dividend policy is unlikely to be valid for a public company where shareholders have expectation of regular dividend payments from year to year. but if the shares are concentrated in the hands of a small number of shareholders.investors who are in that tax position and prefer capital gains to dividends may have invested in other companies with lower pay-out ratios and. Before making a reduction in dividend pay-out. We are not given the full breakdown of the shareholders. Financial Strategy 15 September 2013 . therefore will not be current shareholders in KK. A residual dividend policy is where dividends are paid out only after exhausting all available positive NPV projects. personal preferences would also be important. KK should seek to ensure that major shareholders understand the reasoning behind it and agree to this change in policy.