acca paper p4 advanced financial · pdf fileacca paper p4 advanced financial management to...

ACCA

Paper P4

Advanced Financial Management

To gain maximum benefit, do not refer to these answersuntil you have completed the interim assessmentquestions and submitted them for marking.

ACCA P4: ADVANCED F INANCIAL MANAGEMENT

2 KAPLAN PUBLISHING

© Kaplan Financial Limited, 2013

All rights reserved. No part of this examination may be reproduced or transmitted in any form or by any means, electronic or mechanical, including photocopying, recording, or by any information storage and retrieval system, without prior permission from Kaplan Publishing.

The text in this material and any others made available by any Kaplan Group company does not amount to advice on a particular matter and should not be taken as such. No reliance should be placed on the content as the basis for any investment or other decision or in connection with any advice given to third parties. Please consult your appropriate professional adviser as necessary. Kaplan Publishing Limited and all other Kaplan group companies expressly disclaim all liability to any person in respect of any losses or other claims, whether direct, indirect, incidental, consequential or otherwise arising in relation to the use of such materials.

KAPLAN PUBLISHING 3

1 LABRADOR PLC

(a) Report on the proposed expansion in the Switzerland and the US Market tothe board of Labrador plc.

The proposed Swiss subsidiary is clearly a better financial alternative, with anexpected NPV of £14.275 million in comparison to the US Subsidiary (£0.414) ifthe acquisition costs US$10 million.

The financial projections are, however, subject to considerable inaccuracy. Thefollowing points are worthy of note.

1 Purchasing Power Parity Theory can be used as our best predictor offuture spot rates; however it is not accurate because of the following:

• the future inflation rates are only estimates

• the market is dominated by speculative transactions (98%) asopposed to trade transactions; therefore purchasing power theorybreaks down.

2 Sales forecasts are probably more accurate for the US subsidiary asLabrador plc is acquiring an existing firm with an established level ofsales. The Swiss proposal relies on breaking into a new market.

3 The discount rates are based upon Labrador’s cost of capital. If thesystematic risk of one or both of the proposed subsidiaries significantlydiffers from that of Labrador, different discount rates should be used.

4 The residual values in six years will depend on estimated future income ofthe subsidiaries in six years’ time, and this is very difficult to estimate atthis point.

5 Price and cost changes may differ from those forecasted.

6 Considering the strategic magnitude of the decision, one could undertakedetailed risk analysis procedures such as sensitivity analysis, scenarioplanning or detailed simulation with the aid of a number of softwarepackages.

7 The company should review all real options, such as an option toredeploy the Swiss factory (if one exists). The Black-Scholes optionvaluation model could be used to place a value on these real options, toenable the calculation of a true “strategic” NPV of the project (Short termNPV + NPV of all real options).

However, any final decision must consider all relevant non-financial factors ofwhich little detail has been provided.


4 KAPLAN PUBLISHING

Workings

(W1) Forecasting Future Spot Rates based on PPPT:

The Swiss Subsidiary The US investment

Mid prices 2.3175SFr 1.5185

The inflation rate in Switzerland and the US is higher than the UK rate, therefore both currencies will depreciate against the pound.

Annual depreciation rates:

Year SFr/£ $/£ 0 2.3175 1.5185 1 2.3625 1.5627 2 2.4084 1.6082 3 2.4551 1.6551 4 2.5028 1.7033 5 2.5514 1.7529 6 2.6010 1.8040

1.02913 = 03.106.1

1.01942 = 03.105.1

KAPLAN PUBLISHING 5

Option 1: The US option

(W2) Working capital

Year Total workingcapital

Increase

US$000 US$0000 4,000 (4,000) 1 + 6% each year (240) 2 (254) 3 (270) 4 (286) 5 (302) 6 5,353

Year 0US$

(000)

1US$

(000)

2US$

(000)

3US$

(000)

4US$

(000)

5US$

(000)

6US$

(000)

Taxable cash flow (W3) 2,120 3,371 3,573 3,787 4,015 4,256 Foreign tax @ 30% (636) (1,011) (1,072) (1,136) (1,205) (1,277)

Acquisition cost (10,000) Machinery (2,000) Working capital (W2) (4,000) (240) (254) (270) (286) (303) 5,353

Residual value 14,500

US $ Cash flows (16,000) 1,244 2,106 2,231 2,365 2,507 22,832

Exchange rate (W1) 1.5185 1.5627 1.6082 1.6551 1.7033 1.7529 1.8040

£ Cash flow (10,537) 796 1,310 1,348 1,388 1,430 12,656

UK tax on foreign profits 3% (W4) (41) (63) (65) (67) (69) (71)

Net cash flow (10,537) 755 1,247 1,283 1,321 1,361 12,585

Discount rate (13%) (W5) 1.000 0.885 0.783 0.693 0.613 0.543 0.480 Present value (10,537) 668 976 889 810 739 6,041 Net present value (£0.414) million


6 KAPLAN PUBLISHING

(W3) Extra taxable cash flow in the US

Year 1: $2 million × 1.06 = $2,120,000

Year 2: $3 million × 1.06 × 1.06 = $3,370,800

And so on.

(W4) UK tax

This is payable as UK tax rates are 33% and US tax rates are 30%, leaving an extra 3% to be paid in the UK.

For example, for Year 1 UK tax is5627.1

%3×120,2$ = £40,699, payable in

Year 1

For Year 2, it is6082.1

%3×371,3$= £62,884, payable in Year 2

And so on.

(W5) WACC calculation:

WACC = (0.7 × 15%) + (0.3 × 10% × 0.67) = 12.51%, say 13% and use the present value tables

Option 2: The Swiss option (see over)

KAPLAN PUBLISHING 7

Year 0SFr

(000)

1SFr

(000)

2SFr

(000)

3SFr

(000)

4SFr

(000)

5SFr

(000)

6SFr

(000)

Sales (W7) 44,100 57,881 60,775 63,814 67,005 Payments: Variable costs (W8) (24,255) (31,835) (33,426) (35,098) (36,853)Royalties (W9) (1,806) (1,841) (1,877) (1,914) (1,951)Tax allowable depn (W6) (2,800) (900) (675) (506) (380)

Taxable profits 15,239 23,305 24,797 26,296 27,821 Foreign tax @ 40% (6,096) (9,322) (9,919) (10,518) (11,128)

Tax allowable depn 2,800 900 675 506 380 Land (2,300) Buildings (1,600) (6,200)Machinery (6,400)Working capital (W10) (11,500) (575) (604) (634) (666) 13,979 Residual value 16,200

SFr Cash flows (3,900) (24,100) 11,368 14,279 14,919 15,618 47,252

Exchange rate (W1) 2.3175 2.3625 2.4084 2.4551 2.5028 2.5514 2.6010

£ Cash flow (1,683) (10,201) 4,720 5,816 5,961 6,121 18,167 Royalties 750 750 750 750 750 Tax on royalties @ 33% (248) (248) (248) (248) (248)

£ Net cash flow (1,683) (10,201) 5,222 6,318 6,463 6,623 18,669 Discount rate (13%) 1.000 0.885 0.783 0.693 0.613 0.543 0.480 Present value (1,683) (9,028) 4,089 4,378 3,962 3,596 8,961 Net present value £14.275 million


8 KAPLAN PUBLISHING

(W6) Tax allowable depreciation:

Allowance Year Cost 6,400 (Note 1) Depr 1 (1,600) 1,600 2 ––––– 4,800 Depr 2 (1,200) 1,200 2 ––––– 3,600 Depr 3 (900) 900 3 ––––– 2,700 Depr 4 (675) 675 4 ––––– 2,025 Depr 5 (506) 506 5 ––––– 1,519 Depr 6 (380) 380 6 ––––– 1,139 – (Note 2)

Assumptions:

Note 1: Allowances will not be available until taxable profits exist, i.e. year two.

Note 2: The residual value is equal to its written down value at the end of year six, i.e. £1,139, and therefore there is no balancing allowance or charge.

(W7) Sales:

Sales in Year 2 = 2,000 × SFr20,000 × 1.05 × 1.05 = SFr 44,100,000

Sales in Year 3 = 2,500 × SFr20,000 × 1.05 × 1.05 × 1.05 = SFr 57,881,250

And so on.

(W8) Variable costs:

Variable costs in Year 2 = 2,000 × SFr11,000 × 1.05 × 1.05 = SFr 24,255,000

Variable costs in Year 3 = 2,500 × SFr11,000 × 1.05 × 1.05 × 1.05 = SFr 31,834,688

And so on.

(W9) Royalties:

Royalty in Year 2 = £750,000 × SFr 2.4044/£1 = SFr 1,806,300

And so on.

KAPLAN PUBLISHING 9

(W10) Working capital:

Year Total workingcapital

Increase

SFr 000 SFr 000 1 11,500 (11,500) 2 + 5% each year (575) 3 (604) 4 (634) 5 (666) 6 13,979

(b) Exporting allows the use of spare capacity (if any) at existing plants, and isconsidered a safe way to enter new markets, as costs are likely to be relativelysmall if the strategy fails. The cost of producing in the home market andexporting is likely to be low relative to establishing a new foreign subsidiary.However, exporting has possible disadvantages including:

(i) high transportation costs to foreign markets

(ii) tariffs, quotas and trade taxes that are imposed by foreign governmentsmay make exporting difficult and/or expensive

(iii) consumers may prefer locally produced goods

(iv) service, spare parts, repairs and refunds are normally less reliable withexports.

Companies often regard exporting as a first step to be followed by directinvestment, licensing, franchising or joint-ventures.

Foreign direct investment normally involves the commitment of substantialamounts of capital and significant risk. It may occur either by establishing a newsubsidiary or by acquiring an existing local company, although some countriesrestrict foreign acquisitions. There are many possible motives for foreign directinvestment including:

(i) to establish new markets and attract new demand

(ii) to benefit from economies of scale

(iii) to take advantage of relatively cheap foreign labour, land or buildings

(iv) to avoid tariffs and trade restrictions

(v) international diversification (although the benefits to shareholders of thismotive are debatable)

(vi) to use foreign raw materials, avoiding high transportation costs

(vii) a reaction to overseas investment by competitors

(viii) to take advantage of what is perceived to be an undervalued foreigncurrency

(ix) to exploit monopolistic or competitive advantage. The process ofinternalisation whereby multinationals maintain competitive advantagethrough the internal possession and control of information, technology,marketing or other commercial expertise is often cited as an importantreason for FDI.


10 KAPLAN PUBLISHING

Licensing involves allowing a local company to manufacture the multinational company's product(s) in return for royalty or other payments. Its main advantage is that it allows the penetration of foreign markets without the necessity for large capital outlays. Additionally, as the product is manufactured by a local company, political risk is substantially reduced. Licensing is often used where countries have high import barriers. Transportation costs are also avoided, relative to the alternative of exporting.

However, licensing has several possible disadvantages:

(i) it is difficult to ensure quality control of the product

(ii) the local company might export the product to markets where it directly competes with the multinational's exports from the home market

(iii) there may be problems of technology transfer via leaks to competitors, or the licensee company may itself use (or develop) the technology to become a significant competitor of the multinational when the licence period expires.

(c) Credit rating

A credit rating is an assessment, made by an independent “credit rating agency”, of the likely ability of a firm to pay its debts as they fall due.

The individual risk characteristics of borrowers as reflected by credit ratings would be expected to influence the cost of debt.

A company with an AAA rating could normally expect to borrow somewhat cheaper than one with a B- rating for example.

Debt maturity

The time to maturity is the time before the debt must be repaid.

The length of time debt finance is required for can often influence the cost of that debt.

This is because of the influence of the yield curve as reflected in the term structure of debt.

The ‘normal yield curve’ is upward sloping so under normal circumstances one would expect to pay a higher rate of interest for longer-term debt.

There are a number of hypotheses that attempt to explain this phenomenon. However the main reason for the shape of the curve is basically common sense – if the lender is lending for a longer period, it will generally expect a higher return to compensate for the additional risk.

There are times when the normal curve does not hold sway (a downward sloping curve for example) and then the rule stated above does not apply.

Coupon rate

When the debt is issued , the firm will promise to pay the lender a fixed amount of interest until the debenture is redeemed. This fixed rate is known as the coupon rate.

The coupon rate is paid based on the nominal value of the debt, so the actual amount of interest paid each year will stay constant.

For example, a debenture with a 5% coupon rate will pay £5 interest per year on each £100 debenture.

KAPLAN PUBLISHING 11

Redemption yield

The redemption yield on a debenture is a measure of the total return on thesecurity if held to redemption.

It takes into account the present value of all interest payments plus any gain orloss that would be experienced when the debenture is redeemed at nominalvalue.

The main point here is to distinguish redemption yield from coupon rate.Coupon rate does not necessarily measure return whereas redemption yielddoes. It is redemption yield that is most important for most investors.

(d) The redemption yield is the IRR of the initial value of the debenture, the annualinterest payments, and the redemption amount. Therefore, if the initial value,annual interest and redemption amount are discounted at the redemptionyield, there should be a zero NPV.

The calculation of coupon rate can be shown as follows:

Year Cash Flow £

Discount Factor 7% Present Value £

O (95) 1.000 (95.00) 1 –10 X 7.024 7.024X 10 100 0.508 50.80 Net present value Nil

Where X = Coupon Rate of debenture, paid on a £100 nominal value debenture

Solving for X

7.024X – 95 + 50.80 = 0

X = 44.2/7.024

= 6.3

Therefore the required coupon rate will be 6.3%.



ACCA marking scheme Marks (a) Exchange rate forecasts using PPPT 3 Swiss investment Sales 2 Variable costs 1 Royalties in foreign section 1 Tax allowable depreciation 1 Working capital 2 Fixed assets and residual value 1 Remittable cash flows (£) 1 Royalty and tax on royalty 2 Discount factors and NPV 2 US investment Remittable cash flows ($) 2 UK tax 2 Discussion of the limitations of the estimates including non-financial

factors - 1 mark for each good point

7 Conclusion 1

–––––– Total part (a) Max 22

–––––– (b) Exporting, 1 for each explained point 2−3 Licensing, 1 for each explained point 2−3 Foreign direct investment, 1 for each explained point 2−3

–––––– Total part (b) Max 8

–––––– (c) 1 mark per sensible point, subject to the following maxima:

Credit rating Debt maturity Coupon rate Redemption yield

3 3 3 3

–––––– Total part (c) Max 12

–––––– (d) Understanding that redemption yield = IRR

Discounting model, with correct numbers and timings Solving for X

2 4 2

–––––– Total part (d) Max 8

–––––– Total 50

––––––


2 WELLER INC

(a) Option prices in the basic Black-Scholes model relating to European options aredetermined by the following five factors:

(i) The spot price of the underlying security

(ii) The exercise price of the option

(iii) The time until expiry of the option

(iv) The risk of the option, as normally measured by the historic volatility ofthe return on the underlying security

(v) The risk-free rate of interest within the economy

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

(i) The spot price. As the spot price falls the call option will become lessvaluable as the exercise of the option will result in the purchase of asecurity of lower value than previously.

(ii) The exercise price. The lower the exercise price, the greater the value of acall option as there is more potential for profit upon exercising theoption.

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

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

(v) The risk-free rate. A reduction in the risk-free rate will decrease the valueof the call option because the money saved by purchasing the call optionrather than the underlying security is reduced. If an option is purchasedthe cash saved could be invested at the risk-free rate. A reduction in therisk-free rate makes purchasing the call option relatively unattractive andreduces the option price.

(b) (i) The existing bonus scheme, based on earnings per share, has theadvantage that earnings per share are easily measured. However, thisscheme suffers from the problems of all accounting-based measures inthat it may be influenced by the accounting policies selected, and is notbased on the economic cash flows of the company, which are likely toinfluence the share price. Maximisation of earnings per share is not thesame as maximisation of share price and shareholder wealth.

The advantage of the share option scheme is that, in theory, it willmotivate managers to improve the share price as they will directly benefitfrom this. This should achieve goal congruence with shareholders whoare also seeking to maximise the share price. However, the extent towhich their total remuneration is influenced by the incentive scheme mayinfluence managers’ decisions and their motivation to maximise shareprice.



It is also debatable how much middle managers can directly influence the 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 will normally result in higher share prices). 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-style call options:

Using the Black-Scholes model, the call price = c = PaN(d1) – PeN(d2)e−rt

ts

t)s5.0+r(+)P/P(In=d

2ea

1 = 10.25

)(1)0.5(0.25)+(0.04+(280/200) ln 2

= 1.63

d2 = 1.38=0.25 –1.63=ts1d –

The next step is to calculate N(d1) and N(d2). For 1.63 standard deviations, the probability is 0.4484. For 1.38 standard deviations, the probability is 0.4162. The values of d1 and d2 are both positive, so we add 0.5.

From normal distribution tables:

N(d1) = 0.5 + 0.4484 = 0.9484

N(d2) = 0.5 + 0.4162 = 0.9162

Inputting this data into the call option price formula

c = PaN(d1) – PeN(d2)e−rt

Call price = )1×04.0(e×9162.0×2000.9484×280 ––

= 265.55 – 176.06 = 89.49 cents

The expected option call price is 89.49 cents per share, giving a current option value of 2,000 × 89.49 cents = $1,790.

Tutorial note

Your answer may differ slightly due to rounding differences in the calculations.

Conclusion

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) The holder of a put option, which allows a share to be sold at afixed price, would benefit its holder more the further the price ofthe share fell below the exercise price of the option. As far as theoptions are concerned it would be in the manager’s interest to takedecisions that reduced the company’s share price, rather thanincrease it! Therefore Weller Inc should not agree to grant themanager put options.

(2) The put option price may be found from the put-call parityequation.

p = c − Pa + Pee−rt

p = 89.49 – 280 + 192.16

= 1.65 cents

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

ACCA marking scheme Marks

(a) Up to 2 marks for each of the 5 factors (exercise price, current market price,volatility, interest rate, time to expiry)

Max 8

(b) (i) One mark per valid point Max 4 (ii) Correctly identifying all 5 factors – ½ each Max 2½

d1 1 d2 1 N(d1) 1 N(d2) 1 Call value 1½

Comment re: bonus 1 (iii) 1 mark per sensible well explained point Max 2

Use of put-call parity formula 2––––

Total 25 ––––

3 FLEET / FOXES

(a) (1) Ke − DVM with growth

Ke = g+Po

g)+(1×Do

Ke = 200

) (1.11 10.50 + 0.11 = 16.83%

Calculation of growth in dividends:

0.11=16.9

10.5 41

(2) Kd(1 − t) −irredeemable debt

Kd(1 – t) = 8 × (1 – 0.3)/75 = 7.47%

(3) Kd(1 – t) – bank term loan

10% (1 – 0.3) = 7%



(4) Market values

£m £m Equity 250 ÷ 0.25 × £2 = 2,000

Debt Fixed 600m × 75/100 = 450 Term loan 300m = 300

––– 750

––––– E + D 2,750

(5) WACC

WACC = 16.83% × 2,7502,000

+ 7.47% × 2,750450

+ 7% × 2,750300

= 14.23%

(b) Foxes plc

The current beta equity of Foxes plc is 1.20.

Hence its beta asset is (assuming debt is risk free):

Beta asset = beta equity × t) –(1DV+EV

EV

= 1.20 × 0.30)20(1+80

80–

= 1.02

Given that Foxes has 65% of its business in the leisure sector and 35% in publishing, this total beta asset will be the weighted average of the individual beta assets of the individual industries.

i.e. Foxes ßa = (0.65 × Leisure ßa) + (0.35 × Publishing ßa)

Therefore it is first necessary to calculate the beta asset of the leisure industry, then use the formula to find the balancing figure for the publishing industry.

Leisure industry

Beta asset = beta equity × t) –(1DV+EV

EV

= 1.1 × ( )0.30–1 30 +7070

= 0.85

Thus,

Foxes ßa = (0.65 × Leisure ßa) + (0.35 × Publishing ßa)

1.02 = (0.65 × 0.85) + (0.35 × Publishing ßa)

So, Publishing ßa = 1.34


Publishing industry

Given that this is a beta asset (ungeared) we now need to gear it up to reflectthe industry average D:E gearing of 40:60

Beta asset = beta equity × t)–(1DV+EV

E V

1.34 = beta equity × 0.30)40(1+60

60–

So, beta equity = 1.97 for the publishing industry.

(c) Leisure project

Assuming the systematic risk of the leisure industry is accurately reflected bythe beta equity of other leisure providers, this risk may be estimated byungearing the equity beta of the other leisure providers and regearing it to takeinto account the different financial risk of Foxes plc.

In part (b) above we found that the ungeared beta asset of the leisure industrywas 0.85.

Regearing this to reflect the gearing of Foxes plc gives:

β asset = β equity × t)–(1DV+EV

E V

0.85 = β equity × 0.30)–20(1+80

80

0.85 = β equity × 0.85

β equity = 1.00= 0.850.85

So, using CAPM, Ke = 10% (= Rm as the beta is 1)

Kd(1 − t) = 6%

WACC = 10% × 0.8 + 6% × 0.2 = 9.20%



ACCA marking scheme Marks (a) Current WACC –dividend growth

– Ke – Kd(1–t) – irredeemable debt – Kd(1–t) – bank loan – Market values – 1 each –WACC

2 2 1 1 3 1

–––––– Total part (a) Max 10

–––––– (b) Publishing beta equity – Foxes ß asset

– weighted average formula – leisure industry ß asset – publishing ß asset – publishing ß equity

2 2 2 2 2

–––––– Total part (b) Max 10

–––––– (c) Leisure project – regearing to give equity ß

– Ke – Kd(1–t) – WACC

2 1 1 1

–––––– Total part (c) Max 5

–––––– Total 25

––––––

4 RUTHERFORD INC

(a) Director A is in favour of financing all investment by retained earnings and other internally generated funds. This will probably entail the company following a residual dividend policy whereby any funds remaining after all investments are undertaken are paid out as dividends. Such a policy is based on the assumption that shareholders will prefer the company to reinvest attributable earnings, provided the return so earned exceeds any possible alternative return that the investors could otherwise achieve.

However, there are the following limitations associated with this policy:

(i) Since dividends represent the balance of earnings after all worthwhile investments have been undertaken, they will necessarily fluctuate from year to year, depending on the level of investment available. In some years dividends will be zero, whereas in other years they could be fairly substantial unless the company chooses to retain earnings for a future year. Such fluctuations in dividends may not suit certain investors.

(ii) In order for a policy of fluctuating dividends to be accepted, shareholders must fully understand the company’s policy and have confidence in its investment criteria. This involves the free flow of information, which only exists in a perfect market. Thus in the real world a policy of fluctuating dividends could reduce investor confidence and depress the share price.

(iii) Finally, a residual payment policy could lead to the company deviating from its optimal capital structure of debt to equity.


However, there are major cost savings and benefits that arise through the useof retained earnings for investment.

(i) The raising of new finance externally involves high issue costs that areeliminated with the use of internal funds.

(ii) The issue of new equity, except in the case of a rights issue, dilutes thecontrol of existing shareholders.

(iii) Certain investors may prefer returns to be mainly in the form of capitalgains if it results in less tax for them. Return in the form of capital gainwould be achieved through a low dividend payout policy.

The share price does usually fall once a dividend has been declared and theshares are traded ex dividend. But that fall in value usually reflects the fact thatthe forthcoming dividend no longer accompanies that share and thus the fall invalue equates with the declared dividend. There is thus no associated decreasein the underlying value of the share.

Director B believes that the dividend policy should be tailored to the needs ofindividual shareholders. However, this will depend on the way dividends andcapital gains are taxed, whether annual exemptions exist for capital gains, whichmarginal tax rates apply to which shareholders and whether pension funds canreclaim tax credits deducted on dividends. The different shareholders maytherefore have differing preferences concerning dividend policy.

The idea of the clientele effect, however, counters any argument of reviewingdividend policy. It suggests that through following a certain set dividend payoutstrategy the company has attracted a clientele of shareholders to whom thispolicy is suited. Therefore no benefit would be derived through attempting toalter the policy to meet individual preferences.

Director C suggests that many shareholders rely on dividends in order to satisfycurrent income requirements. An alternative exists, whereby shares could besold in order to realise the capital gain and thus provide income. However, thisis not equivalent to a dividend payment since transactions costs would beinvolved, shareholdings would be diluted and such an action could be taxdisadvantageous as discussed above. Thus Director C is correct in hisassessment and a constant stable dividend policy is what is required.

Director C’s second point concerning risk, though, is fallacious. A capital gainshould be compared with total dividend payments not simply the currentdividend and therefore both capital gains and dividends relate to future periodsand are uncertain. In addition, both dividends and gains are determined by thesame factors. They are both generated by the cash flows produced by thecompany and these cash flows are determined by the company’s investmentstrategy.

Director D is a proponent of the dividend irrelevancy hypothesis that states thata company’s value is dependent on the future earnings stream but independentof the particular dividend payment policy. In theory this hypothesis is correct,but it is dependent on perfect capital market conditions, which clearly do notexist in practice. Several market imperfections have already been discussedabove, which suggest that dividend policy is important.



These include the following:

(i) the information content of dividends

(ii) the existence of transactions costs

(iii) the existence of issue costs on raising new finance

(iv) the clientele effect

(v) taxation considerations.

There are in reality many factors to take into consideration in determining an optimal dividend policy, and despite considerable research into the subject, no absolute conclusion has been reached on the effect of dividend policy on share valuation.

(b) Report on market efficiency

The business school seminar was correct. If a market is efficient all investments have an expected NPV of zero. This does not mean that they are not worthwhile; it means that the discounted return is exactly what it should be for the risk of the investment.

The finance director is also largely correct in suggesting that the company should try to maximise its expected NPV, although this primary financial objective might be modified in line with other constraints such as environmental considerations and the needs of stakeholders other than shareholders (e.g. employees).

Capital investments in product markets try to take advantage of market imperfections to create opportunities for positive NPV projects. Product markets are not normally efficient markets and the objective of maximising expected NPV in such markets is feasible.

In theory, maximisation of expected NPV should result in maximisation of shareholder wealth, as long as the stock market is efficient and correctly interprets investment decisions. In an efficient market good investment decisions will result in a commensurate rise in share price, and increase in shareholder wealth.

If markets are not efficient it is possible that the share price will not correctly react to the financial impact of investment decisions. Market efficiency may be considered in three forms – weak, semi-strong and strong. Evidence suggests that in well developed stock markets weak and semi-strong market efficiency exists for most of the time, but strong form inefficient. This means that share prices correctly reflect all relevant publicly available information. However, investors who possess inside information can, in theory, regularly (albeit illegally) outperform the market.

It is true that many leading stock markets have experienced significant volatility and even large ‘crashes’ in recent years. Efficient markets theory would suggest that this should be the result of new relevant information reaching the market. In many cases the magnitude of the volatility has been difficult to reconcile with any new information reaching the market.


One theory behind this seemingly irrational behaviour of the markets is callednoise trading by naïve investors. According to this theory there are two types ofinvestors, the informed and uninformed. The informed trade shares to bringthem to their fundamental value. The uniformed acts irrationally. Perhaps theynoticed that certain shares have made investors high returns over the lastnumber of years. So they rush out and buy these shares to get their piece of theaction, i.e. they chase the trend.

The uninformed investors create lots of noise and push the market up and up.The informed investor may often tries to get in on the act. Despite knowing itwill end in disaster, the informed investor buys in the hope of selling before thecrash.

This is based on the idea that the price an investor is willing to pay for a sharetoday is dependent on the price the investor can sell it for at some point in thefuture and not necessarily at fundamental value.

ACCA marking scheme Marks (a) Award 1 mark for each well explained point, with a maximum of 4 for

comments on any one of the 4 directors Max 15

(b) Award 1 mark for each well explained pointDiscussion of NPV in efficient and inefficient markets

Max 4

Importance of NPV to investment decisionsVolatility and market efficiency

Max 3Max 3

–––––– Total 25

––––––

acca paper p4 advanced financial · pdf fileacca paper p4 advanced financial management to...

Documents