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REVISION QUESTION BANK – ADVANCED FINANCIAL MANAGEMENT (P4)

Answer 43 HIOME PLC

The argument by Miller and Modigliani (MM) that dividend policy is irrelevant to the value of a company was formulated under very restrictive perfect market conditions. If such conditions existed then shareholders would not value an increase in dividend payments. However, there are several real world factors that are likely to influence the preference of shareholders towards dividends or retentions (and hence expected capital gains). These include:

Taxation. In some countries dividends and capital gains are subject to different marginal rates of taxation, usually with capital gains being subject to a lower level of taxation than dividends.

Brokerage fees. MM ignore brokerage fees. However, if shareholders have a preference for some current income and are paid no or low dividends their wealth will be reduced if they have to sell some of their shares and incur brokerage fees in order to create current income.

If the company needs to finance more new investment it is usually cheaper to fund investment through retained earnings as most forms of external finance involve issue costs, which, in the case of equity finance can be 3% or more of the funds raised.

Information asymmetry may exist between shareholders and directors. If the market is not strong form efficient shareholders may have less complete knowledge of the likely future prospects of the company than directors, which may influence the shareholders’ desire for dividends or capital gains.

The implications of an increase in dividends need to be considered by the company. Dividends are often regarded as an unbiased signal of a company’s future prospects, an increase in dividends signalling higher expected earnings. In this case the company’s growth is slowing down and higher earnings may not be expected. The company should be careful to inform its shareholders of the reason for any increase in dividends. A further factor is the use that the company can make of funds. If the company has a number of possible positive NPV investments then shareholders will normally favour undertaking these investments (at least on financial grounds), as they will lead to an increase in shareholder wealth. As mentioned previously internal finance is cheaper than external finance and, ceteris paribus, would lead to a preference for retentions. If, however, the company has relatively few projects and can only invest surplus cash in money markets or other financial investments at an expected zero NPV, the argument for retentions is weakened. For strategic and operational reasons most companies keep some funds in the form of cash or near cash, not only for day to day operations, but also as a precautionary measure, or to be in the position to take advantage of opportunities such as the unexpected acquisition of another company.

The need for cash for such purposes may influence the level of dividend payout.

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ADVANCED FINANCIAL MANAGEMENT (P4) – REVISION QUESTION BANK

Answer 44 RETRO PLC

(a)Factors that should be considered when deciding whether or not to use a tax haven include:

The likely amount of tax saving that would result.

The attitude of the government in the multinational’s home country to the use of tax havens, and any restrictions that might be imposed.

The cost of establishing and maintaining a tax haven company.

The taxes, if any, that exist in the tax haven.

The political risk of the tax haven and the stability of its government.

The economic stability of the tax haven.

The nature of any tax treaties that exist between the tax haven and other countries.

Freedom from exchange controls.

The legal, accounting and banking systems of the tax haven.

Secrecy of information. Is disclosure of information about the tax haven subsidiary a criminal offence?

The communications infrastructure of the tax haven.

The location of the tax haven.

(b)If no tax haven is used UK tax liability would be:

Total UK tax is £187,500

If dividends are channelled through a tax haven holding company the dividend is assumed to be treated as coming from one source rather than three individual sources. (NB The UK Budget of 2000 suggested alterations to this tax treatment)

Use of the tax haven allows the overseas tax credit to be fully utilised, and results in a UK tax saving of £161,500.

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REVISION QUESTION BANK – ADVANCED FINANCIAL MANAGEMENT (P4)

Answer 45 SHARE REPURCHASE

Share repurchases are a way for companies to distribute earnings to shareholders other than by a cash dividend. They are also a means of altering a target capital structure; supporting the share price during periods of weakness; and deterring unwelcome take-over bids. Companies typically repurchase shares either by making a tender offer for a block of shares, or by buying the shares in the open market. In the absence of taxation and transactions costs share repurchase and the payment of dividends should have the same effect on share value. However, the different treatment of taxation on dividends and capital gains in many countries may lead to a preference for share repurchases by investors.

If the repurchase of shares is by means of a tender offer, this will often be at a price in excess of the current market value, and may have a different effect on overall company value.

An important question for share value is what information a share repurchase conveys to the market about the company and its futures prospects.

Managers should take decisions that maximise the intrinsic value of the firm. This, in theory, involves undertaking the optimum amount of positive NPV investments. The use of share repurchases, and the payment of dividends, will therefore be influenced by the amount of investment that the company undertakes. When a company does not have sufficient investments to fully utilise available cash flow, the payment of dividends or share repurchases are more likely.

Analysts are believed to normally consider an increase in dividends or share repurchases as good news, as they suggest that the company has more cash, and possibly greater earnings potential, than previously believed. However, if this subsequently proves not to be so, share prices will adjust downwards.

Share repurchases in themselves do not create value for the company, but the market may see the information or signals that they provide as significant new information that will affect the share price.

Share splits are the issue of additional shares at no cost to existing shareholders in proportion to their current holdings, but with lower par value. Share splits have no effect on corporate cash flows and, in theory, should not affect the value of the company. The share price, in theory, should reduce proportionately to the number of new shares that are issued.

Motives for share splits include:

(i)

A company wishes to keep its share price within a given trading range, e.g. below £10 per share. It is sometimes argued that investors might be deterred by a high share price, and that lower share prices would ensure a broader spread of share ownership. Shareholders could actually lose from lower prices, as the bid-offer spread (the difference between buying and selling prices) is often higher as a percentage of share price for lower priced shares.

(ii)

Companies hope that the market will regard a share split as good news, and that the share price will increase (relative to the expected price) as a result of the announcement. Evidence suggests that even if such reaction occurs it is short-lived unless the company improves cash flows, increases dividends etc. in subsequent periods.

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ADVANCED FINANCIAL MANAGEMENT (P4) – REVISION QUESTION BANK

Answer 46 TYR

(a)Estimates of earnings and dividend per share, and their growth rates are shown below:

From the above data TYR appears to be following a policy of paying a constant dividend per share, adjusted for the current year’s level of inflation.

The only possible indication from the data of whether or not the dividend policy has been successful is the relative performance of TYR’s share price in comparison to the market index. This, however, would rely upon the assumption that the choice of dividend policy influences the share price.

TYR’s share price has increased over the four-year period by an annual compound rate of 5·6%, much better than the annual fall of 5.5% suffered by the all-share index. This does not prove that the dividend policy has been successful. The share price might be influenced by many other factors, especially the potential long-term cash flow expectations of the shareholders. Additionally comparison with the all-share index does not measure the performance of TYR relative to companies in its own industry/sector.

(b)Additional information might include:

Direct feedback from shareholders, especially institutional shareholders, stating whether or not they are happy with the current dividend policy.

Full details of the registered shareholders, and size of holdings. TYR plc might have a desired spread of shareholders, which could be influenced by the dividend policy adopted.

Knowledge of the impact of taxation of dividends on shareholders’ attitudes, and specifically on their preferences between dividends and capital gains.

The amount of capital investment the company wishes to undertake. The use of retained earnings and other internally generated funds avoids issue costs and the information asymmetry problems of external financing. The level of dividends paid affects the amount of internal funds that are available for investment.

The impact of dividend payments on corporate liquidity.

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REVISION QUESTION BANK – ADVANCED FINANCIAL MANAGEMENT (P4)

The signals provided by dividend payments about the future financial health of the company. For example, would the fact the dividend growth is lagging behind earnings growth be considered a positive or negative signal?

The actual share price at the end of 2001 appears to be overvalued relative to the dividend growth model.

This does not prove that the actual market price was overvalued. The dividend growth model relies upon restrictive assumptions, such as constant growth in dividends per share, which is unlikely to occur. There are also several factors that influence share prices that are not included within the model. Growth in earnings per share has increased more than growth in dividend per share, and it might be better to use the earnings growth rate in the model as this might more accurately reflect the financial health of the company.

Answer 47 BOXLESS PLC

(a)Tax haven holding companies might be used for:

Reducing the total tax paid by a multinational company by allowing better use to be made of credits from foreign tax payments by overseas subsidiaries against a domestic tax liability. This is typically due to the taxable income from overseas subsidiaries, if channelled via a tax haven holding company, being treated as coming from one source rather than several separate sources. This may allow more overseas tax credits to be fully utilised.

Reduction of capital gains tax when taxable gains are made in foreign subsidiaries. Such gains may escape tax if they are deemed to accrue in the tax haven.

A reduction in withholding tax. Diverting income through tax havens may reduce the withholding tax liability relative to making distributions direct from a subsidiary to a parent company.

Holding companies may be tax efficient refinancing centres, which allow the efficient redistribution within the group of cash generated by overseas subsidiaries, without the cash being distributed via the parent company.

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ADVANCED FINANCIAL MANAGEMENT (P4) – REVISION QUESTION BANK

Overseas taxation is 92·4 (40 + 25 + 20 +4·2 +3·2). Total taxation is 99·2 (overseas tax plus UK tax). If the UK government taxes gross income:

In both cases using what is sometimes known as a dividend mixer company in a tax haven will reduce the total tax payable, by reducing the UK tax payable. This is because Boxless can make more use of the credits available in the UK from foreign tax that has been paid, especially in the relatively high tax country of Annovia. In the case of the proposed new tax rule, Boxless has paid sufficient foreign tax to save 11·8 in UK tax relative to not using the tax haven holding company.

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REVISION QUESTION BANK – ADVANCED FINANCIAL MANAGEMENT (P4)

Answer 48 SERTY

(a)

Differing views exist about the effect of dividends on a company’s share price. Several authors, including Modigliani and Miller (M&M) have argued that dividend policy is irrelevant to the value of a company. Such arguments are formulated under very restrictive assumptions. If such conditions existed then shareholders would not value an increase in dividend payments.

However, there are several real world factors that are likely to influence the preference of shareholders towards dividends or retentions (and hence expected capital gains). These include:

Taxation. In some countries dividends and capital gains are subject to different marginal rates of taxation, usually with capital gains being subject to a lower level of taxation than dividends.

Brokerage fees. If shareholders have a preference for some current income and are paid no or low dividends their wealth will be reduced if they have to sell some of their shares and incur brokerage fees in order to create current income.

Shareholders, especially institutional shareholders, often rely on dividends to meet their cash flow needs.

The corporate tax treatment of dividends may favour a higher level of retention.

If the company needs to finance new investment it is usually cheaper to use retained earnings. This is because most forms of external finance involve issue costs, which, in the case of equity finance can be three percent or more or the funds raised.

Information asymmetry may exist between shareholders and directors. If the market is not strong form efficient shareholders may have less complete knowledge of the likely future prospects of the company than directors, which may influence the shareholders’ desire for dividends or capital gains.

The implications of an increase in dividends need to be considered by the company. Dividends are often regarded as an unbiased signal of a company’s future prospects, an increase in dividends signalling higher expected earnings. A company should be careful to inform its shareholders of the reason for any increase in dividends.

A further factor is the use that the company can make of funds. If the company has a number of possible positive NPV investments then shareholders will normally favour undertaking these investments (at least on financial grounds), as they will lead to an increase in shareholder wealth. As previously mentioned internal finance is cheaper than external finance and, ceteris paribus, would lead to a preference for retentions. If, however, the company has relatively few projects and can only invest surplus cash in money market or other financial investments at an expected zero NPV, relative high dividends or share repurchase might be preferred.

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ADVANCED FINANCIAL MANAGEMENT (P4) – REVISION QUESTION BANK

(i)After a cash dividend is paid the expected wealth is

(ii)A 5% scrip dividend would mean the issue of two million new shares.

The total market value of the company of 40 million shares at 400p or £160 million would be unchanged, but would be split between 42 million shares leading to a new expected share price of:

£160m42m = 381 pence

The shareholder would receive 50 new shares, giving 1,050 in total.

The expected wealth of the shareholder would be unchanged at 1,050 × 381p = £4,000

(iii)Repurchase of 10% of the ordinary share capital would cost £160m × 10% = £16 million, presumably from the cash at bank. This would reduce the company’s value by £16m, but the share price would be expected to remain unchanged.

The shareholder’s wealth would remain at £4,000 whether or not (s)he sold his/her shares. If no shares were sold the situation is as (i) above. If shares were sold, 1000 shares sold gives £4,000.

These estimates are unlikely to be accurate. If the market perceives that these policies are conveying significant new information about the company’s future prospects, either positive or negative, the share prices will differ from the above figures.

Answer 49 AVT PLC

(a)

Option prices in the basic Black-Scholes model relating to European options are determined by the following five factors:

The spot price of the underlying security;

The exercise price of the option;

The time until expiry of the option;

The risk of the option, as normally measured by the historic volatility of the return on the underlying security;

The risk free rate of interest within the economy.

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REVISION QUESTION BANK – ADVANCED FINANCIAL MANAGEMENT (P4)

A decrease in the value of each of these factors will have the following effect:

The spot price. As the spot price falls the call option will become less valuable as the exercise of the option will result in the purchase of a security of lower value than previously.

The exercise price. The lower the exercise price, the greater the value of a call option as there is more potential for profit upon exercising the option.

The time until expiry of the option. A reduction in the time to expiry of the option will reduce the value of the option, as the time value element of the option price is reduced.

The risk of the option. A reduction in risk will reduce the value of a call option. This is because the decrease in variance reduces the chance that the security price will lie within the tail of the distribution (i.e. above the exercise price) of the share price when the option expires.

The risk free rate. A reduction in the risk free rate will decrease the value of the call option because the money saved by purchasing the call option rather than the underlying security is reduced. If an option is purchased the cash saved could be invested at the risk free rate. A reduction in the risk free rate makes purchasing the call option relatively unattractive and reduces the option price.

(b)(i)

The existing bonus scheme, based upon earnings per share, has the advantage that such earnings are easily measured. However, this scheme suffers from the problems of all accounting based measures in that it may be influenced by the accounting policies selected, and is not based upon the economic cash flows of the company, which are likely to influence the share price. Maximisation of earnings per share is not the same as maximisation of share price and shareholder wealth.

The advantage of the share option scheme is that, in theory, it will motivate managers to improve the share price as they will directly benefit from this. This should achieve goal congruence with shareholders who are also seeking to maximise the share price. However, the extent to which their total remuneration is influenced by the incentive scheme may influence managers’ decisions and their motivation to maximise share price.

It is also debatable how much middle managers can directly influence share price, and whether or not they are aware of which of their decisions will have the desired influence. A further problem of share option schemes is that share prices frequently move for reasons that are nothing to do with the actions of managers, (e.g. lower interest rates). Ideally managers should be rewarded for their contribution to share price increases, but this is very difficult to measure.

(ii)Using the Black-Scholes model for European options:

As there is dividend payment due during the option period, the share price, Ps, should be reduced by the present value of the expected dividend.

Dividend per share has remained constant for three years. It is assumed that it will be constant in the next year. The present value of the dividend (discounted at the risk free rate) is:

125.06 = 23·585 pence

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ADVANCED FINANCIAL MANAGEMENT (P4) – REVISION QUESTION BANK

Ps is estimated to be 610 – 23·585 = 586·42 pence

Using call price = Ps N(d1) – X e –rT N(d2)

d1 = ln (586·42/500)+0·06(1) + 0·5 (0·38) (1)0·5 0·38(1)0·5

= 0·7674

d2 = d1 – σ (T)0·5 = 0·7674 – 0·38 = 0·3874

From normal distribution tables:

N(d1) = 0·5 + 0·2786 = 0·7786

N(d2) = 0·5 + 0·1507 = 0·6507

Inputting data into call price = Ps N(d1) – X e –rT N(d2)

Call price = 586·42 (0·7786) – 500(0·6507)

= 456·59 – 306·41 = 150·18 pence

The expected option call price is 150·18 pence per share, giving a current option value of 5,000 × 150·18 pence = £7,509

The options are currently in the money and are likely to be attractive to managers as they have an expected value in excess of the bonuses that are currently paid. However, the risk to managers of the two schemes differs and this might influence managerial preferences, depending upon individual managers attitudes to risk. The Black-Scholes model assumes that the volatility of the share price over the past year will continue for the coming year. This is very unlikely. A different volatility will greatly influence the value of the option at the expiry date.

(iii)

(1)AVT plc should not agree to grant the manager put options. The holder of a put option, which allows a share to be sold at a fixed price, would benefit more the further the price of the share fell below the exercise price of the option. As far as the options are concerned it would be in the manager’s interest to take decisions that reduced the company’s share price, rather than increased it!

(2)The put option price may be found from the put-call parity equation. Pp = Pc – Ps + X e –rT

Pp = 150·18 – 586·42 + 470·90 = 34·66 pence

The manager is incorrect. Put options are not more valuable than call options in this situation.

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