Examine and critically evaluate the key strategic decisions that a business may have to make and appreciate how accounting and finance can assist in making and evaluating those decisions.

Assignment Brief

APC308 Financial Management

Requirements: You must answer any TWO questions. Each question that is attempted will carry a maximum mark of 50%

Question 1 – Dividend Policy

Deciding how much earnings to retain and how much to return to ordinary shareholders is a key part of dividend policy. Drawing on the dividend policy literature critically discuss some of the factors that need to be considered by senior managers of a listed company when deciding on:

1. the size of the annual dividend to return to its shareholders (12 marks)
2. and the practical issues that need to be considered when deciding on (12 marks) the size of the dividend payment.

Squeezeco is currently deciding on the level and form of its next dividend. It is considering three options:

1. A cash dividend payment of 15p per share
2. A 5% scrip dividend
3. A repurchase of 15 % of ordinary share capital at the current market price

Extracts form the company’s financial statements are given below

• Operating profit 24.5
• Taxation 7.8
• Distributable earnings 16.7
• Non-current assets 75
• Current Assets Trade receivables 27
• Inventory 24
• Cash 46
• 97 Total Assets
• 172 Equity Finance Ordinary Shares (50p)
• 26 Reserves 108 134 Current Liabilities 38 Total liabilities 172

If the current cum dividend share price is 432p, calculate the (16 marks) effect of the three options on the wealth of a shareholder owning 1250 shares in Squeezeco.

Critically discuss how the company’s decision will be influenced by the (10 marks) opportunity to invest £70m in a project with a positive net present value. Total (50 marks)

Question 2 – Mergers and Takeovers

The managing directors of Aztec are considering what value to place on Trojan plc, a company that they are planning to take near in the near future. Aztec’s plc’s share price is currently £3.89 and the company’s earning per share stand at 21p. Aztec’s weighted average cost of capital is 9%. The board estimates that annual after tax synergy benefits resulting form the takeover will be £4.35m, that Trojans’ distributable earnings will grow at an annual rate of 2% and that duplication will allow the sale of the £21m of assets, net of corporate tax (currently standing at 20%), in a years time. Information relating to Trojan plc.:

Financial Statement of Trojan plc £m Non-current assets 270 Current assets 56 Total assets 326 Equity Ordinary Shares (£1) 147 Reserves 64 211 7% bonds 72 Current liabilities 43 Total liabilities 326 Statement of profit or loss extracts £m Profit before interest and tax 64.0 Interest payments 6.5 Profit before tax 57.5 Taxation 17.1 Distributable earnings 40.4 Other information: Current ex-div share price £2.05 Latest dividend payment 13p Past four years dividends payment 10p, 10.5p, 11p, 12p Trojan’s equity beta 1.1 % Treasury bill yield 5% Return on the market 11% Given the above information calculate the value of Trojan plc using the following valuation methods:

1. Price/earnings ratio (10 marks)
2. Dividend valuation method (10 marks)
3. Discounted cash flow method (10 marks)
4. Drawing on the mergers and takeovers literature, critically discuss (20 marks) the problems associated with using the above valuation techniques and based on this which of the above you would recommend the board of Aztec to use.

Question 3

Lovewell Limited a food manufacturer is considering purchasing a new machine for £275,000. The company is expecting an annual cash inflow of £85,000 from the sale of products and an annual cash outflow of £12,500 for each of the six years of the machine’s useful life. The annual cash outflows do not include annual depreciation charges for the machine. The machine is depreciated using the straight –line method. The machine is expected to last for six years, with a residual value estimated to be at the rate of 15% of the original cost of the machine. The cost of capital for Lovewell Limited is 12%. You are required to:

Calculate using the following investment appraisal techniques, and provide brief recommendations as to the economic feasibility of acquiring the machine:

1. The Payback Period.
2. The Accounting Rate of Return.
3. The Net Present Value.
4. The Internal Rate of Return (to two decimal places) (20 marks)

Critically evaluate the benefits and limitations of each of the differing investment appraisal techniques. (30 marks)

Knowledge

1. Examined and critically evaluated the key strategic decisions that a business may have to make and appreciated how accounting and finance can assist in making and evaluating those decisions.
2. A critical understanding of specific analytical skills in key decision areas within strategy and finance at local and international level
3. A critical understanding of the limitations of the current state of financial theory in making strategic business decisions

Skills

1. Applied the key valuation concepts and methodologies of financial decision making in order to contribute to the wider decision making of the organisation

Sample Answer

APC308 – Financial Management

Question 1 – Dividend Policy

Dividend Policy: Retained Earnings vs. Payout to Shareholders

The decision of how much of a company’s earnings to retain and how much to distribute to shareholders is a core component of dividend policy. The balance between reinvestment and dividend payout can influence investor perceptions, share price, and overall firm value.

From a theoretical perspective, Modigliani and Miller (1961) argue that in perfect markets, dividend policy is irrelevant since investors can create their own income stream by selling shares. However, real-world factors such as taxation, transaction costs, investor preferences, and signalling mean that dividend decisions can significantly affect shareholder wealth.

Senior managers of listed companies must consider several key factors:

1. Profitability and cash availability: Only distributable profits (post-tax earnings) can be paid as dividends. In this case, Squeezeco has £16.7m in distributable earnings and £46m in cash reserves. While cash availability supports a dividend, managers must consider liquidity needs and future investments.

2. Shareholder expectations: Investors often prefer stable and predictable dividends. A significant change can lead to negative signalling. As per Lintner’s model (1956), companies prefer gradual dividend changes, aligning with long-term earnings growth.

3. Investment opportunities: The opportunity to invest in a £70m positive NPV project may influence managers to retain earnings rather than pay dividends, prioritising long-term value creation.

4. Market signalling: Dividend announcements convey management’s confidence in future earnings. A high dividend may signal strong prospects but could be risky if not sustainable.

5. Tax considerations: Shareholders’ tax preferences (e.g., capital gains vs. dividends) may influence the form of return, affecting decisions between cash dividends, scrip dividends, or share buybacks.

6. Cost of external financing: Retaining earnings avoids the costs and risks associated with external funding.

Practical Issues in Determining Dividend Size

Beyond theoretical factors, practical constraints also affect dividend decisions:

1. Legal constraints: Dividend payments are subject to legal limits, often tied to distributable reserves and the need to maintain capital adequacy.

2. Cash flow timing: While profits are accrued, dividends require actual cash, making liquidity management critical.

3. Debt covenants: Loan agreements may restrict dividend payments, especially when profitability or liquidity is under pressure.

4. Volatility of earnings: Firms with volatile earnings may prefer lower base dividends with occasional special dividends to manage risk.

5. Administrative considerations: For scrip dividends, companies need systems for share issuance and communication with shareholders, which may carry additional costs.

6. Market conditions: In uncertain environments, firms may choose conservative dividend policies to maintain flexibility.

Impact of Dividend Options on Shareholder Wealth

Squeezeco is considering three dividend options. The impact on a shareholder owning 1250 shares (cum dividend share price 432p) can be assessed as follows.

Cash Dividend of 15p per Share

Total dividend:
15p × 1250 = £187.50

Post-dividend share price (theoretically falls by dividend amount):
432p – 15p = 417p

Shareholder’s wealth:
New share value = 1250 × 417p = £5212.50
Add dividend = £5212.50 + £187.50 = £5400.00

5% Scrip Dividend

Shareholder receives:
1250 × 5% = 62.5 new shares
New total shares = 1250 + 62.5 = 1312.5 shares

Assuming share price adjusts to reflect increased share supply but no cash outflow:
Value of holdings = 1312.5 × 432p = £5670.00

However, dilution-adjusted price (since no cash paid out) is unchanged, but per-share earnings diluted. If market adjusts, new price could be:
Total distributable earnings unchanged; more shares, so price may slightly drop.

Approximate value = £5670.00 (may vary with market perception).

Continued...