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Advanced Financial Management (AFM): Valid for exams Sept 2022-June 2023   
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Chapter 3: Weighted Average Cost of Capital and Gearing

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FINLAY complete

Finlay Co is a specialised construction company with 9 million $0.5

ordinary shares in issue with a current share price of $6.21 and $10
Continue
million 4% bonds trading at par value. This capital structure will
remain constant in the foreseeable future.

Assume today’s date is 1 June 20X3. Finlay Co has a year end of Related Sections:
31 May each year. Learn more about this topic

Finlay Co can create $8.46m of liquidity by selling some long-term

investments, after paying the 20X3 dividend.

Historical and future dividends without expansion

Dividends are expected to grow at the historic dividend growth rate

in the absence of expansion:

Year to end of May: 20X0 20X1 20X2 20X3

Issued $0.5 equity shares (000) 8,000 8,000 9,000 9,000

Total dividends paid ($000) 2,404 2,524 2,982 3,131

Expansion option

Finlay Co’s board of directors is considering investing $7.5m now to

expand the existing business. It proposes to finance this expansion
from operating cash flows in the coming two years, which would
mean cutting the dividend.

Expected dividends and dividend growth rates if expansion

occurs

Year to end of May:

20X4: Residual free cash flows will be paid as dividends.

20X5: Same $ dividend as in the year to May 20X4.
20X6: A dividend of $0.50 per share.

After May 20X6, dividends are expected to grow at 7.2% per

annum.

Finlay Co’s equity cost of capital has been calculated as 13%.

Required:

(a) Assess whether undertaking the expansion

would add value to Finlay Co, including
relevant calculations and a discussion of
the assumptions made; (8 marks)

(b) Evaluate the issues and implications of the

proposal to finance the project. (7 marks)

(15 marks)

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Your Answer:
Advanced Financial Management (AFM): Valid for exams Sept 2022-June 2023    
1

(a) Investment in expansion

Before expansion

The value of Finlay before the expansion project can be

estimated from the dividend valuation model:

Estimated growth rate,

g = (​ ​/ ​ ​^ ​ ​− 1 = 5.0%

Company value using DVM = ​ ​

= $3.131m (1 + 0.05)/(0.13 − 0.05) = $41.1m

Tutorial note: “^ ​ ​” is how the cube root of the increase in

dividend per share over 3 years is calculated in a spreadsheet.

After expansion

The estimated future dividends, after investing in the project

are:

Year 1: $8.46m (current liquidity) − $7.5m (investment) =

$0.96m

Year 2: same as year 1, $0.96m

Year 3 onward: 9m × 0.5 = $4.5m in year 3 growing at 7.2%

per annum thereafter.

Discounting this perpetuity at 13% = ​ ​=

77.586m at 1 June 20X5.

The total present value of these forecast dividends is therefore:

NPV = ​ ​= $62.36m

This represents an increased NPV of approximately $21.3m

(62.36 − 41.1)

The project therefore generates shareholder wealth and is

worthwhile.

However, these valuations are based on many assumptions

including:

That the calculation of residual free cash flows will be

available to be paid as dividends.
That a dividend of $0.50 in three year’ time is realistic. If
5% growth continued the current dividend of $0.35 would
be only $0.40 for the year to the end of May 20X6, which
seems unrealistic. ($0.50 would correspond to an annual

growth rate of ​ ​.)

The estimated 7.2% growth rate in future dividends after

May 20X6. It is not known where this estimate came from,
either with or without the new project, and it may not be
reliable.

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How the equity cost of capital used to discount the future
Advanced
dividendsFinancial Management
was calculated and the(AFM): Valid for
assumptions exams
that Sept 2022-June 2023 
underlie   
this 13%.

(b) Finance proposal

The proposal to finance the project wholly with existing
resources means the project will be financed by equity.

The liquidation of the long-term investments would make

sense if the return on those investments was lower than that
required by shareholders on equivalent risk assets.

It is unclear whether the company is currently at its optimal

gearing ratio. The current gearing ratio is 17.9% ($10m
debt/$55.89m (i.e. 9m × $6.21) equity), which appears to be
very low. It therefore seems likely the company is not fully
utilising its existing debt capacity and value could therefore be
generated from taking on more debt (i.e. taking advantage of
the tax shield).

If the dividend is cut to finance the project, it will be reduced to

a maximum of $0.96m, as compared to the current level of
$3.131m − a cut of 69% in the dividend for each of the next
two years.

This will send a challenging signal to the market, which may

not believe the board’s forecasts on the project given that it
has not had the confidence to finance the expansion with debt.
The board should consider carefully how this message is to be
communicated to the shareholders and the wider market.

Many of the current shareholders may have invested in Finlay

to obtain a steady income stream, which has been the recent
dividend pattern. If a cut in the dividend has tax and/or liquidity
consequences for those shareholders, they may sell their
shares, which could depress Finlay’s share price.

Raising cash externally, whether debt or equity, will require

some proprietary/secret/ sensitive information to be shared.
This is more obvious for equity issues than debt. Indeed, given
the company’s relatively low gearing and the existing bond
issue, it may be possible for Finlay to issue more debt with
minimal release of information.

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