ADVANCED CORPORATE FINANCE – SAMPLE PAPER
SECTION A
1) Woolworths Limited, the operator of the Safeway/Woolworths chain of
supermarkets, is planning to make a takeover bid for Scott Transport Limited, a
trucking company, to internalise the transportation and distribution of products to its
supermarkets. This would represent what type of takeover?
a) An upstream vertical takeover.
b) A horizontal takeover.
c) A conglomerate takeover.
d) A downstream vertical takeover.
2) Operating leverage for a firm represents:
a) The existence of fixed operating costs, such as rent or contractual salary payments.
b) The existence of variable operating costs, such as raw materials.
c) The existence of fixed financing costs, such as equipment lease payments or interest
payments on a bank loan.
d) The existence of excess operating capacity which can allow the firm to increase their
scale of production if required.
3) Which of the following statements relating to current asset financing alternatives for
firms is CORRECT:
a) A maturity-matching policy would involve firms financing temporary current assets
with long-term financing sources, such as debenture loans.
b) Short-term interest rates are traditionally more stable than long-term interest rates.
c) Short-term debt is more risky than long-term debt due to refinancing uncertainty and
repayment requirements during downturn or recession periods.
d) To maximise profitability, highly seasonal businesses should use more long-term debt
than the average firm.
4) The Ford Motor Company is deciding whether to invest in a project today or to
postpone the decision for one year. Which of the following statements best describes
the issues that the Ford Motor Company faces when considering this investment
timing option?
a) The investment timing option does not affect the expected cash flows and should
therefore have no impact on the project‟s risk.
b) The more uncertainty about the project‟s future cash flows the more likely it is
that Ford will go ahead with the project today.
c) If the project has a positive expected NPV today, this means that its expected
NPV will be even higher if it chooses to wait a year.
d) The investment timing option will either add positive or no value to the
investment, and it will not reduce value.
OVER/
1 2
5) Which of the following statements is CORRECT?
a) Higher flotation costs reduce investor returns, and that leads to a reduction in a
company‟s WACC.
b) Because of tax effects, an increase in the risk-free rate will have a greater effect on
the after-tax cost of debt than on the cost of common stock.
c) When calculating the cost of preferred stock, companies must adjust for taxes,
because dividends paid on preferred stock are always deductible by the paying
corporation.
d) When calculating the cost of debt, a company needs to adjust for taxes, because
interest payments are deductible by the paying corporation.
6) Which of the following actions would tend to REDUCE conflicts of interest between
stockholders and bondholders?
a) Including restrictive covenants in the company‟s bond indenture (which is the
contract between the company and its bondholders).
b) Compensating managers with more stock options and less cash income.
c) An amendment to the takeover legislation that makes it harder for firms to be
acquired in hostile takeovers.
d) Firms increasing the payment of special dividends to reduce the level of earnings
retention and cash balances.
7) For a company whose target capital structure calls for 50% debt and 50% common
equity, which of the following statements is CORRECT?
a) The interest rate used to calculate the WACC is the average cost of all the debt the
company has outstanding and shown on its balance sheet.
b) The cost of equity is usually greater than or equal to the cost of debt.
c) The WACC should be calculated on a before-tax basis.
d) The cost of retained earnings typically exceeds the cost of new common stock.
8) Which of the following statements associated with dividend policy is CORRECT?
a) One advantage of dividend reinvestment plans is that they enable investors to avoid
paying taxes on the dividends they receive.
b) If a company has an established clientele of investors who prefer a high dividend
payout, and if management wants to keep stockholders happy, it should not follow the
strict residual dividend policy.
c) If a firm follows a strict residual dividend policy, then, holding all else constant, its
dividend payout ratio will tend to rise whenever the firm‟s investment opportunities
improve.
d) If the Government eliminates taxes on capital gains but leaves the personal tax rate on
dividends unchanged, this would motivate companies to increase their dividend
payout ratios.
9) Which of the following statements is CORRECT?
a) If a project with normal cash flows has an IRR greater than the WACC, the
project must have a positive NPV.
b) A project‟s MIRR can never exceed its IRR.
c) If a project with normal cash flows has an IRR less than the WACC, the project must
have a positive NPV.
d) If the NPV is negative, the IRR must also be negative.
OVER/
10) Which of the following statements is CORRECT?
a) Sensitivity analysis is a good way to measure market risk because it explicitly
takes into account diversification effects.
b) One advantage of sensitivity analysis relative to scenario analysis is that it
explicitly takes into account the probability of specific effects occurring, whereas
scenario analysis cannot account for probabilities.
c) Simulation analysis is a computerized version of scenario analysis where input
variables are selected based on their probability distributions.
d) Sensitivity analysis can only be applied in the situation of evaluating mutually
exclusive investment alternatives.
11) Which of the following statements is CORRECT?
a) Corporations face few regulations and more favourable tax treatment than do sole
proprietorships and partnerships.
b) One advantage to forming a corporation is that the owners of the firm have limited
liability.
c) Bond covenants are an effective way to resolve conflicts between shareholders
and managers.
d) Because of their simplified organisation, it is easier for sole proprietors and
partnerships to raise large amounts of outside capital than it is for corporations.
12) When evaluating a new project, firms should include in the projected cash flows
all of the following factors EXCEPT:
a) Changes in net operating working capital attributable to the project.
b) Previous expenditures associated with a market test to determine the feasibility of
the project that have been expensed for tax purposes.
c) A decline in the sales of an existing product that is directly attributable to this
project.
d) Salvage value of assets used for the project at the end of the project‟s life.
13) You are considering two mutually exclusive, equally risky, projects. Both projects
have IRRs that exceed the WACC that is used to evaluate both of them. Which of the
following statements is CORRECT? Assume that the projects being considered have
normal cash flows, with one outflow followed by a series of inflows.
a) For a conflict to exist between NPV and IRR, the initial investment cost of one
project must exceed the cost of the other.
b) If the two project‟s NPV profiles do not cross, then there will be a sharp conflict
as to which one should be selected.
c) If the cost of capital is greater than the crossover rate, then the IRR and the NPV
criteria will not result in a conflict between the projects. One project will rank
higher by both criteria.
d) If the cost of capital is less than the crossover rate, then the IRR and the NPV criteria
will not result in a conflict between the projects. One project will rank higher by both
criteria.
OVER/
3 4
14) Other things held constant, which of the following would tend to reduce the length of
the cash conversion cycle?
a) Buying larger quantities of raw materials and holding them as inventories in order to
take advantage of quantity discounts.
b) Changing the credit policy from cash only to offering 60 days of credit.
c) Switching from paying for purchased materials in 60 days to paying in 10 days in
order to obtain discounts.
d) Switching from paying for purchased materials in 10 days in order to obtain discounts
to paying in 60 days.
15) Which of the following is a VALID reason for increasing Board of Director
independence being perceived as a good corporate governance attribute?
a) More independent directors allow the company to increase the overall size of its
Board.
b) Having independent directors provides a form of outside oversight and monitoring
of management decision-making and performance.
c) Appointing independent directors to the Board provides a means for previous
company employees to have input into strategic decision-making.
d) Greater Board independence reduces the likelihood that the company will become a
takeover target.
16) Which of the following statements relating to capital structure decision-making is
CORRECT?
a) When a company increases its debt ratio, the costs of equity and debt capital both
increase. Therefore, the WACC must also increase.
b) Since debt financing raises the firm‟s financial risk, increasing a company‟s debt
ratio will always increase the company‟s WACC.
c) All else equal, a reduction in the corporate tax rate in the US would tend to
encourage companies to lower its debt ratio.
d) Since debt financing is cheaper than equity financing, increasing a company‟s
debt ratio will always reduce the company‟s WACC.
17) Which of the following statements about warrant securities is CORRECT?
a) A warrant is basically a long-term option that enables the holder to sell common stock
back to the firm at an agreed upon price, at a specified time in the future.
b) Generally, warrants are distributed along with preferred stock in order to make the
preferred stock less risky.
c) The existence of a warrant component in a debt issue will likely enable the debt to be
issued at a lower yield compared to an equivalent straight-debt issue.
d) One of the disadvantages of warrants to the issuing firm is that they are detachable
and can be traded separately from the debt with which they are issued.
 OVER/
18) The concept of „synergy‟ creation in mergers is best summarised as:
a) The combination of two firms in a merger will enable the merged firm to produce its
products or services for a lower cost after the merger than before because of the
increase in the scale of its combined operations.
b) The combination of two firms in a merger will lower the risk and, therefore, the
overall cost of capital of the merged firm due to the diversification of its earnings
stream.
c) The combination of two firms in a merger will create a certain amount of additional
value which is unavailable if the two firms operate as separate business entities.
d) Merger synergy represents the difference between the merger gains and the bid
premium paid by the acquiring firm.
19) Which of the following statements about dividend policies is CORRECT?
a) Modigliani and Miller argue that investors prefer dividends to capital gains because
dividends are more certain than capital gains. They call this the “bird-in-the hand”
effect.
b) One reason that US companies tend to avoid stock repurchases is that dividend
payments are taxed at a lower rate than stock repurchases.
c) One advantage of dividend reinvestment plans is that they allow shareholders to avoid
paying taxes on the dividends that they choose to reinvest.
d) The clientele effect suggests that companies should follow a stable dividend policy.
20) Which of the following statements about real options in capital budgeting is
CORRECT?
a) In general, the greater the strategic advantages of being the first competitor to enter a
given market, the more attractive it may be to wait before making an investment.
b) In general, the more uncertainty there is about market conditions, the more attractive
it may be to wait before making an investment.
c) In general, the higher the discount rate, the more attractive it may be to wait before
making an investment.
d) In general, investment timing options are more valuable than abandonment options.
OVER/
5 6
SECTION B – Answer ALL Four Questions in this Section
Question 1.
Oil Exploration Limited has announced the planned development of a new off-shore
oil drilling project located in waters near the Philippines, resulting from an
exploration program conducted in 2012 at a cost of $25 million. The company is
required to pay an up-front access and royalty payment to the Philippines Government
of $50 million at the time of project commencement in May 2014 (the present time).
Construction of the oil rig platform will be completed in May 2015 at a cost of $30
million, and a net working capital investment of $10 million will be required at the
commencement of the project for related equipment, inventories and spare part
required for operation of the oil rig. It is expected that these supplies and equipment
will be consumed during the 15-year operating life of the oil rig, and there will be no
working capital recovery at the end of the project. From commencement of the oil rig
in June 2015, oil production is expected to average 1,000 barrels of oil per day
(assume a 350-day operating year for the oil rig). Oil Exploration Limited has signed
a 10-year supply contract with the Chinese Government, where the Chinese
Government will purchase all oil produced by the project and make a lump sum
payment at the end of May each year based on a supply price of $120 per barrel of oil.
Variable production costs are estimated to be $55 per barrel of oil, and fixed costs
(including accommodation and fly-in and fly-out costs for operating personnel) are
estimated at $5 million per year. The company can claim straight-line depreciation
deductions against the installed construction cost of the oil rig platform, and faces a
30% tax rate on earnings from the project. At the end of the project, environmental
recovery costs totaling $10 million are expected to be incurred, and the oil rig
platform is expected to be able to be redeployed to a new drilling project. If not, it
could be sold to Woodside Petroleum Limited, net of dismantling costs, for $5
million. The company‟s after-tax cost of capital on similar risk projects is 9.00%.
Required:
a) Calculate the initial cost associated with the project, the annual cash inflow for
each of the 15 operating years of the project and the terminal cash flow at the end
of the project, and use these to determine the project‟s net present value (NPV).
The Chinese Government have indicated that they potentially plan to switch to
nuclear fuel technology by the end of 2025 (in 10 years‟ time) to replace reliance on
oil and gas resources which are expected to increase significantly in cost as global
supplies dwindle. Due to the uncertainty regarding oil demand beyond 2025, Oil
Exploration Limited would consider selling the oil rig project to the Philippines
Petroleum Company, the Philippines Government-owned petrol provider, at the end
of 2025 (after 10 years of operation) if they cannot lock in an alternative supply
contract for the last five years of the project. Oil Exploration estimates that they
would be able to sell the project at the end of 2025 for $48 million. Exclude any
consideration of tax gains or losses on disposal, and the need to incur environmental
recovery costs.
CONTINUED/
OVER/
Required:
b) Calculate the net present value of the project assuming Oil Exploration Limited
elected to abandon the project at the end of 2025 and sell it to the Philippines
Petroleum Company and, based on this information, determine the value of this
abandonment option associated with the project.
(7 + 3 = 10 marks)
OVER/
7 8
Question 2.
To fund a large proportion of the cost of the new oil drilling project outlined in
Question 1), Oil Exploration Limited is contemplating issuing new corporate bonds.
The company currently has $60 million of interest-bearing debt on issue, which has an
average before-tax interest cost of 10% per annum and equity which has a market
capitalisation value of $240 million. The company currently has 30 million shares on
issue, earnings before interest and taxes (EBIT) of $30 million, and faces a 30%
corporate tax rate. The addition of the project is expected to increase annual EBIT to
$45 million. The company‟s advisers have indicated that the company could raise up
to $100 million in new debt finance using either:
i) an issue of 15-year maturity corporate bonds with a fixed coupon interest rate
(before tax) of 8.70% per annum; or
ii) an issue of 15-year maturity corporate bonds with a floating interest rate (before
tax) calculated based on the 180-day bank bill rate plus a 4.00% margin. The 180-day
bank bill rate is currently 2.90% per annum.
Required:
a) Provide advice to the company regarding the suitability of this financing strategy
for the project, and the factors that the company should consider in deciding
whether to issue fixed-rate or floating-rate debt.
b) The company‟s advisers have suggested that they should focus on the degree of
financial leverage (DFL) exposure when assessing whether to issue debt
financing. If the company decided to issue $100 million in new fixed rate
corporate bonds to fund the project adoption, calculate the degree of financial
leverage exposure for the company based on a potential 20% fall in EBIT.
Oil Exploration Limited is also uncertain regarding what its optimal capital structure
is. Management of the company thinks that it is currently under-leveraged, and
believes that increasing leverage should also increase the value of the firm. The risk-
free interest rate is currently 2.90% per annum and the average market return is
estimated at 10.50% per annum. At the company‟s current debt to total capital ratio of
0.200, its beta coefficient is 1.130. The company‟s advisors have provided the
following estimates for capital structure and cost of debt outcomes:
Debt to Total Capital Debt to Equity (D/E) Overall average before-
ratio (wd) ratio tax cost of debt (rd)
0.200 0.250 9.60%
0.300 0.429 8.80%
0.400 0.667 8.30%
0.500 1.000 9.00%
0.600 1.500 9.40%
c) Based on this information, determine the optimal capital structure for Oil
Exploration Limited.
(4 + 2 + 4 = 10 marks)
OVER/
Question 3.
Smartgroup Limited is planning to undertake an initial public offering (IPO) on the
Australian Securities Exchange (ASX) in June 2014. The company provides salary
packaging services to corporate and Government businesses, focusing particularly on
the provision of vehicle fleet management services and novated car lease salary
packaging arrangements for business employees.
Required:
a) A company involved in the same industry, SG Fleet Limited, completed an IPO
on the Australian Securities Exchange earlier in January 2014. The SG Fleet
Limited issue price in the IPO was $1.85 per share, representing a multiple of
approximately 12 times forecast earnings per share (EPS) provided in the
company‟s IPO prospectus. Following the issue date, the SG Fleet Limited share
price has fallen as low as $1.61 and is still trading below its issue price at $1.78
per share. Explain how this information regarding the outcome of the SG Fleet
Limited IPO could help the management and advisers of Smartgroup Limited in
planning the company‟s IPO.
b) The Australian Federal Government recently announced that they are considering
reducing import barriers on used cars. The effect of this move would likely lead to
a big fall in the re-sale value of second-hand cars which companies such as
Smartgroup Limited would be looking to sell at the end of fleet arrangement or
notated lease periods. Outline what impact the release of this news is likely to
have on the level of underpricing associated with the forthcoming Smartgroup
Limited IPO.
Smartgroup Limited‟s issue adviser, CIMB, recently conducted a non-binding,
exploratory book-build exercise among 10 of its clients who are professional
investors, asking them to provide indicative price and quantity bids for shares in the
Smartgroup Limited‟s IPO. The table below summarises the outcomes from this
exploratory book-build exercise:
Indicative bid price Total number of shares bid for at this price
$2.20 0 impact on shareholders‟ preferences for receipt of dividends and the magnitude of
$2.10 350,000
$2.00 2,000,000
$1.90 2,200,000
$1.80 2,500,000
$1.70 3,000,000
c) Explain how the information from this book-build process might aid Smartgroup
Limited in pricing its IPO, and suggest what you think is an appropriate issue
price for shares in the Smartgroup Limited IPO. If, as part of the actual IPO
process, these 10 investors were offered a maximum allocation of 7 million
shares, what would be the clearing price for this book-build allocation?
(4 + 2 + 4 = 10 marks)
OVER/
9 10
Question 4.
BB Enterprises Limited is a globally-focused investment company which listed on the
Australian Securities Exchange (ASX) in December 2013. BB Enterprises Limited
specialises in structured finance and the creation, syndication and management of
asset and cash flow-based investments. More specifically, the company is involved in
five types of investment and financing activities: real estate, infrastructure and project
financing, operating leasing, structured finance and funds management. Information
provided in the company‟s initial public offering (IPO) prospectus indicated that the
primary purpose for the company listing on the ASX was to expand its capital base to
allow for significant expansion in its principal investment-related activities.
Furthermore, much of this expansion is envisaged as being achieved in international
markets, in association with ongoing growth and investment opportunities and the
development of new infrastructure projects. The company expects to issue substantial
amounts of further common stock in the future, as part of its ongoing financing
requirements.
Required:
a) Based on the information provided above, outline, with appropriate reasoning and
justification, what you think a suitable dividend policy strategy for the company to
adopt would be.
On July 1st 1987, a full dividend imputation system was introduced in Australia to
replace the classical taxation system that was previously in operation. The full
dividend imputation system provides for franking or imputation credits for Australian
corporate tax paid on Australian-sourced income to be distributed with dividends
provided to Australian-resident shareholders for use in reducing their personal tax
payable on dividend income.
Required:
b) A component of the 2014 Federal Government Budget announced recently is a
commitment to lower the Australian marginal corporate tax rate from the current
level of 30% to 28.5%. Outline how this corporate tax rate change is likely to
dividends paid by Australian companies.
(6 + 4 = 10 marks)
END OF EXAMINATION PAPER/
 SOLUTIONS TO THE FIN5FMA 2014 SAMPLE EXAMINATION PAPER  How will this financing strategy influence the firm‟s capital structure? If it is
currently operating at its target capital structure, then this financing decision will
SECTION A – Multiple Choice Questions move the capital structure mix a long way from its optimal level.
 It may make sense for the firm to finance the project more in line with its optimal
1) A 11) B capital structure (or current capital structure mix).
2) A 12) B  From a working capital perspective, the maturity matching policy is quite sensible
3) C 13) C in terms of matching the bond maturity terms with the approximate project life.
4) D 14) D
5) D 15) B In terms of whether to issue fixed rate or floating rate debt:
6) A 16) C  This is greatly influenced by the firm‟s and market‟s expectations regarding future
7) B 17) C interest rate movements.
8) B 18) C  Issuing fixed rate bonds provides the firm with certainty regarding future interest
9) A 19) D payment requirements, however, it exposes the bondholders to interest rate risk if
10) C 20) B benchmark interest rates increase or, particularly, decrease.
 Issuing floating rate bonds introduces uncertainty in regards to future interest
payment requirements, as these will be dependent on movements in underlying
SECTION B benchmark (180-day bank bill) rates. This will minimise interest rate risk for
bondholders, and may make the bonds more attractive in the market.
Question 1)
 If interest rates are anticipated to increase in the future then, depending on the
a)
magnitude of the change, fixed rate bonds may lower the total overall interest
Initial project cost = $86.697 million (present value at year 0)
payment obligations for the company.
Project depreciable basis = $30.000 million
Annual depreciation claim = $30.000 million / 15 = $2.000 million
b)
Operating income = $17.750 million
DFL = % change in EPS / % change in EBIT
Annual net cash flow = $13.025 million (first cash flow occurs at end of year 2)
EPS prior to re-financing change and project adoption = $0.5600
Terminal cash flow = -$6.500 million (occurs at end of year 16)
EPS after re-financing change and project adoption = $0.7070
EPS with a 20% fall in EBIT to $36 million = $0.4970
Project NPV = $7.9874 million
% change in EPS = -0.2970 (-29.70%)
DFL = -0.2970 / -0.2000 = 1.4850
b)
Initial project cost = $86.697 million (present value at year 0)
c)
Annual net cash flow = $13.025 million (from years 2 to 11)
D/E ratio = 0.250
Terminal cash flow = $48.000 million (occurs at the end of year 11)
Unlevered beta (βU) = 1.130 / [1 + (0.70)(0.250)] = 0.962
Cost of equity (RS) = 0.029 + (0.105 – 0.029)(1.130) = 0.1149
Project NPV = $8.5926 million
WACC = (0.200)(0.0960)(0.70) + (0.800)(0.1149) = 0.1054 (10.54%)
Value of abandonment option = $0.605 million
D/E ratio = 0.429
Question 2)
Levered beta (βL) = 1.251
a)
RS = 0.1241
There are a range of issues that the company should consider when evaluating this
WACC = 0.1053
financing strategy:
 The use of debt funds will provide an explicit financing cost benefit, due to the D/E ratio = 0.667
low level of current benchmark interest rates. This make some sense to take Levered beta (βL) = 1.411
advantage of the current financial market environment. RS = 0.1362
 Availability of additional interest tax shield benefits from the use of debt. WACC = 0.1049
 The addition of a large amount of debt may introduce substantial additional
financial risk for the company, which may have adverse cost of capital impacts. D/E ratio = 1.000
 How will the firm‟s shareholders likely respond to the issue of a large amount of Levered beta (βL) = 1.635
additional debt finance? RS = 0.1533
WACC = 0.1082

11 12
D/E ratio = 1.500
Levered beta (βL) = 1.972
RS = 0.1789
WACC = 0.1110
Optimal capital structure is a D/E ratio of 0.667, as this provides the lowest WACC
outcome.
Question 3)
a)
Looking at the outcome of the recent IPO by SG Fleet will provide a range of useful
information for Smartgroup Limited for planning its upcoming IPO:
 It provides a positive signal that the IPO segment of the market is generally active
at the present time.
 It signals that there are investors interested in businesses operating in the vehicle
fleet management and car leasing industry. These two aspects would indicate that
it is likely worthwhile the company going ahead with its IPO in June 2014.
 The SG Fleet IPO experience indicates that they likely over-priced their issue.
This suggests the Smartgroup Limited needs to determine its issue price carefully
if it wants to avoid possible under-subscription to the issue and/or the share price
dropping below the issue price after listing.
 The 12 times (12×) forecast EPS multiple that the SG Fleet issue was priced at
should represent a maximum limit for Smartgroup Limited to use to determine
their issue price level, and maybe an earnings multiple of somewhere between 10×
to 12× may be appropriate.
 Smartgroup Limited should try and obtain as many price signals and valuation
information as possible to assist with determining the suitable offer price for its
IPO.
b)
A reduction in import barriers on used cars would likely have an adverse effect on the
cash flows and profitability of Smartgroup Limited‟s business. As a result, the
possibility that the Federal Government may introduce this is likely to increase
potential investors uncertainty regarding the attractiveness of Smartgroup Limited as
an investment alternative. Greater firm or cash flow uncertainty or risk is typically
correlated with a greater level of underpricing, with firms lowering offer prices in
riskier IPOs as a means of increasing the attractiveness of issues.
c)
The information coming from the exploratory book-build exercise is particularly
useful as it effectively provides valuations of the IPO company from a range of
„informed‟ investors who are expected to have the knowledge and information to
arrive at relatively accurate valuations for companies generally. The indicative price
range from $2.10 and above, where implied interest to participate in the company IPO
declines markedly, suggests that these investors think the company is overpriced at
these levels and they would not be prepared to pay this price for shares in the IPO
company.
13
This book-build information would indicate that $2.00 is a likely maximum offer
price level, and a price somewhere in the range of $1.80 to $2.00 is likely to attract
strong investment interest.
The clearing price is the price at which the share allocation available is filled by bids
placed under the book-build process. Starting from the highest bid price of $2.10,
accumulating share purchase quantities as you move down the bid price range results
in 7 million shares being allocated based on accepting all bids made at indicative
prices down to $1.80. Thus, an offer price of $1.80 would clear the book-build
allocation.
Question 4)
a)
The key points to identify in BB Enterprises Limited‟s strategy which are likely to
impact on their dividend policy decision-making are:
 Expansion plans and ongoing investment activity
 Consistent capital-raising activities to fund these investments
 Large proportion of investment activities in international markets. This is likely to
be a major impediment on the ability of the company to frank a large proportion
of their dividends, resulting in substantial dividend payments likely to involve
payment of unfranked dividends.
These above aspects would suggest that the company is going to be focused more on
growing firm wealth through investment (effectively capital gains) rather than on
dividend decision-making and how to distribute earnings to shareholders. Thus, the
following recommendations can be suggested in relation to the company‟s dividend
policy:
 The company is likely to want to use earnings where possible as a source of
financing, so they are not going to want to have to pay large dividends to
shareholders.
 This might suggest that a residual policy could be suitable, however, the likely
payment of large unfranked dividends in years of lower investment requirements
is unlikely to be attractive to Australian-resident shareholders.
 A relatively extreme dividend policy outcome might be the election not to pay any
dividends and retain all internal resources for investment purposes.
 A stable dividend policy or a constant pay-out policy is also not likely to be
suitable for similar reasons.
 In this context, a policy of paying a low, constant amount of dividends (such as
the level that are able to be fully-franked) might be suitable, and attractive to those
investors who would like to receive some ongoing, tax-effective income.
 It might be also worth the company to consider offering a dividend reinvestment
plan (DRIP) to its shareholders, as a means of maximising the amount of their
earnings that can be accessed for investment purposes.
b)
The decision of the Federal Government to lower the Australian marginal corporate
tax rate from 30% to 28.5% is likely to have a number of effects within the market:
 In general, this change will lower the value of franking or imputation credits, as
they will now only provide a credit equivalent to 28.5% of tax paid on earnings
14
 rather than 30%. This may make the receipt of dividends less attractive for
shareholders who can use imputation credits because the dividends will carry less
overall value that previously.
 Receipt of dividends will, if anything, increase in attraction for foreign investors
who cannot use imputation credits, and other investors who have low marginal tax
rates (such as superannuation funds) or are tax exempt.
 A decrease in corporate tax payable will effectively increase company earnings
after tax, which will provide them with a relatively greater pool of earnings to
distribute as dividends. Firms following constant payout (smoothed) or residual
dividend policies are likely to increase dividend levels as a result of such a tax
change. Firms paying stable dividends may also increase dividend payouts if they
believe that the decrease in corporate tax rate will be permanent.
 Share prices are likely to decrease, on average, due to higher dividend payments
leading to greater dividend drop-off effects, although increased dividend levels
may also have positive signaling effects in the market.

Overall, shareholders are likely to receive greater dividends, on average, however,

these dividends will carry fewer tax benefits.

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