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STUDY QUESTION BANK – ADVANCED FINANCIAL MANAGEMENT (P4)

400655 = 61.07% of the shares requested

(iii)Expected share price

Assuming the market to be semi-strong form efficient and to correctly value National Sand at 130 pence, the initial market value once the investments and government grant are announced will be:

The expected market price is approximately 140 pence per share

Answer 23 IXT

(a)

In an efficient market the return to an investor should reflect the risk taken by the investor. For an individual company the providers of debt finance experience less risk than the providers of equity finance because:

Interest on debt is payable before any dividends are paid to shareholders, and must be paid at the due date.

In the case of liquidation, debt finance is repaid in full before any payment is made to shareholders.

The return required from debt is, therefore, less than that required from equity finance (return is measured by the interest or dividend yield plus any capital gain or loss). The cost of debt and equity to the company is the return required by investors in each of these forms of finance (ignoring personal tax effects). The cost of debt is, therefore, normally less than the cost of equity.

(b)

Using only debt finance to raise £5 million per year for the next five years appears to be an unusual strategy. Whether or not it is feasible depends upon the effect of this financing strategy on the company’s financial gearing (and hence financial risk), interest cover and cash flow, and the market’s reaction to such a strategy.

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ADVANCED FINANCIAL MANAGEMENT (P4) – STUDY QUESTION BANK

It is difficult to accurately predict how these factors will alter during the next five years, but the data allow approximate estimates to be made.

To illustrate the possible effects of issuing £5 million debt for each of the next five years it is assumed that all of the new debt is in the form of 13% debentures and that the cost and quantity of existing debt does not change. Other types of new debt at different interest rates would naturally result in different estimates.

Interest cover is expected to increase during the five year period. Interest cover shows the extent to which earnings can decline before the company might be unable to meet its interest charges. Although no comparative data for other companies in IXT’s industry are available, IXT’s cover appears to be adequate.

Financial gearing is expected to fall, because the expected retained earnings are larger than the increased debt financing. Investors are not likely to object to a gradual reduction in gearing and financial risk, unless the current level of gearing is considered to be optimal.

Earnings per share are expected to more than double which should be regarded favourably by shareholders and lead to an increase in IXT’s share price.

On the basis of this data Mr Axelot’s suggested strategy is feasible and is likely to be acceptable to both shareholders and lenders to the company. It does not appear to be too risky.

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ADVANCED FINANCIAL MANAGEMENT (P4) – STUDY QUESTION BANK

If IXT wishes to reduce financial gearing and increase interest cover this can be achieved by the placing. Expected earnings per share is lower than if debt finance is used, but is still an increase of 11% on the current level. The use of a placing, probably with institutional investors, is likely to alter the ownership of the company’s ordinary shares. This might be unpopular with existing shareholders, especially Mr Axelot who currently has the controlling interest.

As long as 98% gearing is not considered to be a problem, debt finance is likely to have the most favourable impact on earnings per share, and potentially on share price.

(d)

Mezzanine financing is considered to be part-way between debt and equity financing. Formally it is high yield debt, often at an interest rate of 4 – 5% above LIBOR (London interbank offered rate), and normally has equity warrants attached. Mezzanine ranks (in liquidation) below all other forms of debt and is much more risky than secured debt. However, the expected returns are much higher, both because of the higher interest rate and because of possible gains from exercising equity warrants.

Mezzanine financing might be useful to IXT as it provides an additional type of finance which might allow more finance to be raised than is possible using only “senior” debt and equity. Examples of where mezzanine financing has been used include leveraged takeovers, management buy-outs and corporate restructuring.

Answer 24 NOIFA LEISURE PLC

(a)Group’s financial position

The chairman is correct in saying that turnover has doubled and that the share price has almost doubled over the period. However, during the period return on turnover has decreased from 21% to 14% and asset turnover has decreased from 0.85 to 0.75. Therefore, return on capital employed has decreased from 25% to 15%. This is largely due to a reduction in returns from hotel operations. The increase in turnover of 209% has resulted in an increase in

financial risk for the equity shareholders, to over 100% in 19.09. The current and quick ratios have also declined over the period. The overall financial position has considerably weakened during the period.

Although the share price of Noifa Leisure plc has nearly doubled, prices of shares in the

plc was well above the rest of the sector in 19.06 but in 19.09 is below the industry figure, reflecting that the company’s rating has fallen relative to the rest of the leisure sector.

(b)Financing policies

The increase in the assets of the group has been financed initially by disposal of investments and subsequently by increases in long and short term borrowing, together with a small amount of retained earnings. No equity issues have been made during the period. This has had the effect of increasing gearing. It may be more prudent to use a mix of equity and debt to finance expansion.

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STUDY QUESTION BANK – ADVANCED FINANCIAL MANAGEMENT (P4)

It states in the question that the Euro loan has little risk. This is not the case since, although the Euro is a “basket of currencies”, the exchange rate between the Euro and the £ could still move (the UK is currently outside “Euroland”), creating the risk of exchange losses being incurred when making interest and capital repayments. There is also the risk of interest rates increasing during the period of the loan. The group would have been better advised to use equity to finance this acquisition.

(c)Strategic objective

There are arguments for concentrating on one area of operation so as to achieve, for example, economies of scale and make best use of specialised management skills.

The group is achieving significant increases in turnover within the hotel sector but efficiency is deteriorating. Operating profit to turnover has decreased from 18% to 9%.

A high price has been paid for growth. Improvement in profit to turnover would more likely results in the other sectors, particularly the bus company, car hire and waxworks, expanding and generating much higher profit as a percentage of turnover.

The group would be better off to maintain hotels as the core business but also to recognise the importance of these other sectors and continue to expand turnover in each of them, particularly as these are often complementary to the core business.

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ADVANCED FINANCIAL MANAGEMENT (P4) – STUDY QUESTION BANK

Answer 25 TWELLO PLC

(a)

With such limited information, a complete analysis is not possible. However, the following observations can be made.

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Profit/sales appears low, but one would need to compare this with Twello’s competitors. Again, it is improving, which reduces any concern.

Asset turnover has fallen from 3.34 to 3.08 which is not encouraging. Without knowing the industry it is not possible to determine how serious this is, but if the business only produces 3% – 5% return on sales, it requires a much higher asset turnover.

The interest payable exceeds the interest receivable by £5m and £6m in the last two years. Comparing the amounts invested with the amounts borrowed, it would be worth investigating further to see if the policy of having both borrowings and investments is sound.

Overall it is difficult to draw any firm conclusions as to Twello’s financial health. Whilst its liquidity and return on sales ratios might appear weak for a manufacturing company, they could be normal for a retailer.

(b)Other information

(1)Twello’s business.

(2)Comparable figures for similar companies.

(3)Share price movements in company sector for 19X5–8.

(4)Price level changes for 19X5–8.

(5)Cash flow statements.

(6)Current cost accounts.

(7)Chairman’s statement regarding future plans.

(8)Directors’ shareholdings and details of any management share option scheme.

(9)Details of any developments since the last accounts.

(10)Details of labour relations in Twello.

(11)Age and experience of management team.

(12)Information regarding the market in which Twello operates.

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ADVANCED FINANCIAL MANAGEMENT (P4) – STUDY QUESTION BANK

(c)

Deep discount bonds are bonds offered at a substantial discount to their nominal value. Advantages accrue to both the company and the investor.

Company advantages

(1)Low interest rate is paid.

Investor advantages

(1)They are likely to remain in issue for their full life, an early call being unlikely.

(2)Gain on redemption may be treated as a capital gain, with tax advantages. Some tax authorities amortise the discount and treat this amount as taxable income.

(3)Yield to redemption can be calculated more accurately, as the annual interest received is less (therefore the uncertainties of reinvestment returns are less).

Zero coupon bonds are the extreme deep discount bond.

The redemption yield of a 4% bond issued at £50 and redeemed in 17 years’ time is found by solving for r in the following:

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STUDY QUESTION BANK – ADVANCED FINANCIAL MANAGEMENT (P4)

Answer 26 PAVLON PLC

(i)Discussion of dividend policy

(a)Pavlon plc has pursued a consistent policy prior to its listing of paying a constant percentage of its earnings as a dividend, as seen from the following table.

The effect of maintaining a constant payout ratio is that dividends fluctuate with earnings. The fact that Pavlon’s dividends per share have increased over the last five years follows simply from the fact that earnings have been rising over the relevant period. Whether Pavlon’s policy is suitable for a company listed on the Stock Exchange depends on what view is taken of dividend policy. There is a school of thought, characterised by the dividend irrelevancy hypothesis, which suggests that share values are the present value of future dividends discounted at a rate which reflects the risk associated with the underlying earnings.

Since dividend policy does not affect the risk of the earnings stream, the pattern of dividend payments cannot affect the value of the shares, i.e. dividend policy is irrelevant. The leading advocates of the dividend irrelevancy hypothesis are Modigliani and Miller. Their position is at variance with the traditional view which argues that the pattern of dividend payments can have an effect on share values. Modigliani and Miller have demonstrated beyond doubt that dividend policy is irrelevant in a perfect capital market and, since dividend policy does not affect values, the policy pursued by Pavlon will be as good as any other in a perfect capital market. However, since in the real world the capital market is not perfect, most of the arguments are about the effect of dividend policies on share values in an imperfect, i.e. real, capital market. This is discussed below.

(b)A final dividend of 2.34p per share will mean a total dividend for the year of 5.5p. The total number of shares issued is now 40,000,000; therefore the total dividend for the year will be £2.2 million. This represents 40% of the earnings for the year and is a small reduction in the payout ratio used by the company in the preceding five years. As noted above, whether or not this constitutes a suitable or appropriate dividend for the two categories of shareholder identified depends on which view of dividend policy is taken.

If the dividend irrelevancy hypothesis is true, a dividend of 5.5p per share is likely to be as good as any other. However, if the dividend irrelevancy hypothesis does not hold in an imperfect market, different policies could materially affect share prices and hence shareholder wealth.

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ADVANCED FINANCIAL MANAGEMENT (P4) – STUDY QUESTION BANK

Most of the discussion on the effects of dividend policy centres on two market imperfections. The first of these is the effect of distorting taxes. If a company pays a dividend, the shareholder receives the dividend. If the company retains the profits, the shareholder should get a corresponding capital gain. In a perfect market all shareholders will be indifferent as between dividends and capital gain because there are not distorting taxes and capital gains can instantly, effortlessly and without cost be converted into cash. In fact, dividends and capital gains are taxed differently, since dividends are accompanied by a tax credit at the basic rate and capital gains are subject to the annual exemption. The latter exemption may not be significant for wealthy private individuals and therefore they would show a preference for dividends. However, an additional point to consider is that capital gains facilitate tax and cash flow planning since the tax is only paid as the gain is realised. Therefore it is not clear whether such individuals would favour the reduced payout ratio.

The attitude of institutional investors will again depend on their tax position. Many institutions require a steady cash flow to meet their outgoings. While it is theoretically possible to convert capital gains into cash, the transaction costs of so doing usually mean that major institutional investors prefer a steady stream of dividends.

The second imperfection that may be important is what is referred to as the “information content of dividends”. In a perfect capital market all investors have knowledge of the underlying earnings stream and value the company accordingly. In the real world the market is starved of up-to-date information about the company and may pay substantial attention to company dividend declarations. Failure to maintain dividend growth or a payout ratio may be interpreted as a sign of weakness and have disastrous effects on share prices, at least in the short run.

It can also be argued that companies attract a clientele of shareholders that are satisfied with the policy that the company pursues. A company with such a constant policy as Pavlon is likely to have gathered around itself a group of investors who are satisfied with that policy. In such circumstances any change in policy is likely to be unpopular, irrespective of whether the majority of shares are owned by wealthy private individuals or institutional investors.

(ii)Dividend valuation model

(a)The basic form of the dividend valuation model is as follows

However, this can only be used where ke > g. In the first three years, since growth is greater than ks, the model cannot be used in this form. The dividends over the next three years are as follows.

The present value of these dividends at 12% is

6.33 × 0.893 + 7.27 × 0.797 + 8.36 × 0.712 = 17.40p

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