Strategic Level Paper
F3 – Financial Strategy Senior Examiner’s Answers SECTION A
Answer to Question One
(a)(i) Valuation of Company NN (excluding potential synergistic benefits and integration costs) NN: Recent sale of a 5% parcel of shares A 5% parcel of shares recently changed hands for EUR 3.0 million, giving an estimated total market capitalisation of EUR 60 million. At an exchange rate of C$/EUR 3.000, this translates into a cost to Aybe of C$20 million. However, care needs to be taken here as this valuation is already six months out of date and was for a non-controlling 5% stake and not the entire share capital (for which a premium would normally be payable). Nonetheless, this may be a reasonable guide to the minimum price that NN’s shareholders might accept. A bid price based on this single transaction plus a premium of, say, 20%, would indicate a minimum price of EUR 72 million. P/E basis Proxy company QQ has a P/E of 9 and this is an appropriate basis on which to value NN. However, NN is at a slightly different stage in its business cycle and has not completed the initial period of most rapid growth. Therefore this result is likely to provide a minimum price only and Aybe may need to consider offering a higher price based on a P/E ratio of, say, 12. Note, however, there is also a valid reason for lowering the P/E ratio to reflect the fact that the value of a private company is generally lower than that of a quoted company due to the difficulty in realising value by selling shares and the lack of a transparent market price. We could therefore value NN using a P/E ratio of, say, 70% of QQ’s P/E ratio of 9. That is, a P/E ratio of 6.3. We could also use Aybe’s P/E ratio of 5 (5 = 115.2/23 at the end of 2009) which gives an even lower valuation and is a further indication that Aybe’s shareholders may not be prepared to value NN’s shares at as high a multiple of earnings as 9 times.
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The range of valuations using the P/E ratios is given below. It is difficult to choose between them. P/E valuations: P/E base
Earnings base EUR million
Valuation EUR million
10 11 10 11 10 11 10 11
50 55 63 69 90 99 120 132
5 5 6.3 6.3 9 9 12 12
Valuation C$ million at C$/EUR3.000 17 18 21 23 30 33 40 44
Discounted cash flows (ignoring potential synergistic benefits and integration costs) Forecasts for future earnings can be used as an approximation of free cash flows. When discounted at an appropriate cost of equity, they can provide a useful measure of the value of a company. Where based on estimates of cash flows generated in perpetuity, this method can produce an unrealistically high valuation. However, it is useful as an indication of the maximum indicative value of the company. The result is usually highly sensitive to the choice of discount rate. The cost of equity is commonly used but is difficult to obtain in the case of a private company. From the information provided we can calculate: • The cost of equity for Aybe as a whole. • The cost of equity of QQ, a proxy company for NN, uplifted to reflect the greater risk of NN above that of QQ. The better approach is to use the cost of equity obtained from the proxy company. The cost of equity based on QQ, the proxy company, can be calculated using CAPM theory. That is, ke = 2% + (1.7 x 6%) = 12.2% Uplifting this result by a factor of 15% to reflect the increased risk of NN gives a discount rate of 14% (12.2% x 1.15 = 14.0%). NPV ignoring integration costs and synergy. EUR discount rate of 14%.
Earnings Discount factor (@ 14%) PV
2011 EUR million
2012 EUR million
2013 EUR million
2014+ EUR million
11.88 (= 11 x 1.08) 0.877
12.83 (= 11.88 x 1.08) 0.769
13.86 (= 12.83 x 1.08) 0.675
14.28 (=13.86 x 1.03) 0.675/ (0.14-0.03)
10.42
9.87
9.36
87.63
Total EUR million
117.28
NPV result: EUR 117 million which is equivalent to C$39 million. Summary of results Valuations of Company NN ignoring potential synergistic benefits: Method Range of values EUR million Private sale 60 - 72 P/E 50 - 132 Discounted earnings 117 September 2010
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(a)(ii) Suitability of each valuation method Share price • The current share price is usually considered to be the lowest possible offer price. • In this case, the only share price available relates to a private sale of a small package of shares six months ago. There are a number of issues with this: o Shares would normally trade at a higher price for listed companies than for private companies, and so we can expect the price agreed during the private sale to underestimate the true value of Company NN. o In addition, we do not know the circumstances surrounding the sale and whether the shares were actually sold at an arm’s length price. o However, the forecasts of the company may have changed significantly in the last six months – therefore any valuation based on a six month old price will be out of date. P/E basis The P/E method is particularly relevant to non-quoted companies such as NN where no market share price is available. An industry average P/E ratio can be applied to NN’s historic or, better still, prospective earnings, to arrive at a valuation. However: • The P/E basis is only as reliable if the proxy company is sufficiently similar to Company NN that their P/E ratios would be likely to be the same if Company NN were a quoted company. • Such close similarity is unlikely in this case as the companies are at very different stages in their development. • Adjusting the P/E ratio used in the calculations from a P/E of 9 to a P/E of 12, to reflect the greater growth potential of NN, gives slightly higher valuations. However, this is a totally subjective adjustment and its validity is not supported by discounted cash flow valuations below. Discounted cash flows Discounted cash flows provide a company valuation that is derived directly from the predicted future performance of the company itself. The distortions that can be introduced by the use of a proxy company are therefore eliminated. However, a realistic valuation depends on the quality of the data used in the appraisal. The valuation of company NN relies on bullish predictions of growth in earnings in the next three years which may not be realised in practice.
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(b) REPORT To: The Directors of Aybe From: External consultant Date: 4 September 2010 PROPOSED ACQUISITION OF NN Purpose To evaluate issues arising from the proposed acquisition of NN and advise on how to proceed. Evaluation of the proposed initial offer price Viewpoint of NN’s shareholders The initial offer of EUR 75 million to buy the shares in NN represents a 25% increase on the indicative price based on the parcel of shares that has recently changed hands. A bid premium is usually 20-25%, so this initial bid is realistic from this point of view. The figure of EUR 75 million also comfortably exceeds the net asset value of EUR 35 million. However, as already noted, this valuation relates to a single transaction involving a small parcel of shares only. In addition, the transaction that occurred some time ago so, even it was made at a valid market price, this price may now be out of date. When considering the valuations obtained from the P/E and NPV basis the value of NN is considerably higher and therefore it is unlikely that a price of EUR 75 million would be acceptable to the shareholders of NN. However, the shareholder Directors of NN will also be aware that they are unlikely to obtain the best value for their shares during this period of rapid growth because a potential acquirer will discount the value of that future growth to take into account the risk that it does not occur. They may need to wait two or three more years to obtain full value for their shares but need to weigh that up against the benefit of realising their investment at this stage and having access to the funds now. Viewpoint of Aybe’s shareholders The discounted cash flows can be recalculated to take into account the integration costs of EUR 2.5 million and potential synergistic benefits of enhanced growth in earnings of 14% in the first three years, reverting to a steady-state growth rate of 3% for 2014 onwards. NPV including integration costs and synergy. EUR discount rate of 14%.
Cash flow Discount factor (@ 14%) PV
2010 EUR million (2.50) 1.000
(2.50)
2011 EUR million
2012 EUR million
2013 EUR million
2014+ EUR million
12.54 (=11 x1.14) 0.877
14.30 (=12.54x1.14) 0.769
16.30 (=14.30x1.14) 0.675
16.79 (=16.30x1.03) 0.675/ (0.14-0.03)
11.00
11.00
11.00
103.03
Total EUR million
133.53
NPV result (rounding down): EUR 133 million, which is equivalent to C$44 million. Assuming that Aybe is confident of realising the synergistic benefits, EUR 75 million seems to be a highly acceptable offer price from the viewpoint of Aybe’s shareholders. This is still significantly below the DCF valuation of EUR 115 million before synergy and EUR 133 million including expected synergistic benefits (less integration costs). A starting bid of EUR 75 million therefore leaves considerable scope for negotiation. However, it may be more realistic to raise the initial offer price to attract interest from NN shareholders. A price of, say, EUR 100 million would still be likely to be acceptable to Aybe’s shareholders assuming the cash flows used in the DCF valuation are considered to be realistic. September 2010
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Conclusion It is recommended that the offer price be raised from EUR 75 million to at least EUR 100 million in order to interest the shareholders of NN but there is then not much flexibility for Aybe to increase the price further as negotiations proceed. Potential problems and issues that could arise from the integration of NN into the SC Division of Aybe Issues that candidates are expected to raise in discussion include: • Continuity/retentionof management of NN. (How essential is the input and knowledge of the current Directors of NN and what will be their role and contribution after the acquisition? What financial or other motivation is needed to ensure sufficient continuity?). • Successful realisation of additional growth in NN in the first 3 years. • Realisation of potential economies of scale, e.g. marketing strategies. • Integration of management and IT systems. • Merging corporate culture. • Harmonisation of corporate objectives. • Retaining NN’s market image at the same time as rebranding products as part of SC division of Aybe. • Risk of new entrants into the market with a similar or better product. • Impact on Aybe’s EpS and other key financial ratios. • Potential cash flow and loan covenant issues as a result of financing the bid, including refinancing NN’s borrowings.
Choice of debt finance for the proposed acquisition Factors affecting the choice of type of financing Key issues: • • • • • • • • • •
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Both sources of finance have the same impact on gearing and both provide tax relief on interest. Depth of the C$ and EUR bond markets (is there a developed C$ bond market?). Likely success of a bond issue – including credit rating of Aybe and market sentiment and knowledge of the company and current market conditions and liquidity. Availability of credit from banks – including bank propensity to lend and perceived creditworthiness of Aybe. Benefit of EUR financing in reducing FX translation risk since EUR debt matched to EUR net investment in NN. However, EUR financing also introduces a “real” cash exposure to EUR interest and repayment cash flows. Cost of raising and servicing each form of debt – including ‘road show’ required to launch the bond issue Liquidity risk arising from fixed payment schedule. Impact on current bank covenants. Security and/or covenants that would be required on new borrowings/bonds.
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Review of bank covenants Current financial structure of Aybe (market values):
C$million Equity Non-current liabilities
126
( 0.70 x 180million share)
45
(as given in the question)
So ratio of non-current liabilities to equity is 45/126 = 35.7% As part of the acquisition, Aybe needs to raise additional funds equivalent to, say, EUR 75 million (purchase price) plus EUR 45 million (re-financing of debt). That is, EUR 120 million, or C$40 million at an exchange rate of C$/EUR3.000. So Aybe’s debt would rise by C$40 million from C$45 million at 01 January 2011. However, Aybe would also acquire net assets with an equivalent market value of C$40 million. If the acquisition is financed entirely by additional borrowings, Aybe’s ratio of non-current liabilities to equity would rise to (45 + 40)/(126 + 40) = 51.2%. This would be well within the loan covenant of 75% maximum. The other bank covenant requires interest cover to stay above 5 times. Using the figures for the year ended 31 December 2009 we can see that interest cover for Aybe is currently 10.25 times (ie: C$41/C$4). If we were to include NN based upon its 2009 income statement and assuming that the acquisition was funded entirely by new debt of C$40 million, at an interest rate of 8%, interest cover would be 6.6 times (ie: (C$41+C$ (20/3.000))/(C$4+(C$40x8%)). This is within the covenant. 100% funding by borrowings would therefore be theoretically possible without breaching the current bank covenant.
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SECTION B
Answer to Question Two Part (a) – The Treasurer and funding management The key responsibilities of the treasury function are: banking; liquidity management; funding management; and currency management. The question here requires discussion of funding management. This function is concerned with identifying suitable sources of funds, which requires knowledge of the sources available, the cost of those sources, whether any security is required, and management of interest rate risks. The treasurer’s responsibilities can also be categorized according to the three levels of management – strategic, tactical and operational. The strategic functions concern matters such as: • Determining the company’s optimal capital structure and distribution/retention policies. • The actual raising of capital - including share issues. • The assessment of the likely cost of each different type and source of finance and the appropriate proportion of funds to obtain from each source. • The decision as to the level of dividends. • Consideration of alternative forms of finance. In the scenario here, EM’s treasury department will need to advise on almost all of the strategic issues noted above. Specific advice will be required about the advantages and disadvantages of the three possible methods of funding in the context or EM’s current capital structure and wider business interests, including the impact of taxation. For each of the alternatives being considered the operational role of the treasury department will be as follows: 1. Bank borrowing – liaising with the bank and negotiating sensible covenants and a competitive interest rate. 2. Leasing – establishing the best possible price for the lease. 3. Rights issue – liaising with advisors and underwriters to ensure a successful issue. After issue, the treasurer will be involved in the management of the finance, including payment of interest and dividends. Part (b) – Advice on choice of funding Calculations to determine which is expected to be the cheaper source of debt funding – Alternative 1 or Alternative 2.
Alternative 1 – Purchase with bank borrowings: Year 0 1 A$million A$million Buy (360.0) Tax relief Discount factor at 5% 1.0 0.952 NPV Total NPV A$294.7million
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(360.0)
0.0
7
2 A$million 72.0 0.907 65.3
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Alternative 2 – Finance with leasing: Accounting Depreciation: The accounting depreciation will be (A$360.0 million / 4) = A$90 million per annum. Interest implicit in the lease: There are 2 acceptable methods of calculating the interest implicit in a finance lease. Either is acceptable. Actuarial method: First need to establish the interest rate implicit in the lease using IRR. The annuity factor for the lease can be found by dividing the cost of equipment by the annual lease payment. The 4 year annuity factor is therefore (A$360.0 million /A$105 million) = 3.429 This equates to an interest rate of between 6% and 7% - by interpolation: 6% + (3.465-3.429)/(3.465-3.387) 6.46% The interest element can now be calculated: Opening balance A$ million 360.0 278.3 191.3 98.7
Interest at 6.46% A$ million 23.3 18.0 12.4 6.4
Repayment
Closing Balance
A$ million (105.0) (105.0) (105.0) (105.0)
A$ million 278.3 191.3 98.7 0.1
Net Present Value of Leasing Cashflows: Year
0 A$m
Accounting depreciation Interest Total
1 A$m 90.0 23.3
2 A$m 90.0 18.0
3 A$m 90.0 12.4
4 A$m 90.0 6.4
5 A$m
113.3
108.0
102.4
96.4
0.0
22.7
21.6
20.5
19.3
0.0
Tax relief on the above at 20% (with time delay of one year) Lease payment
(105.0)
(105.0)
(105.0)
(105.0)
Cash flow
(105.0)
(82.3)
(83.4)
(84.5)
19.3
0.952
0.907
0.864
0.823
0.784
(100.0)
(74.6)
(72.1)
(69.5)
15.1
Discount rate at 5%
1.000
NPV Total NPV A$301.1million
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0.0
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Sum of digits method: Total interest will be (A$105 million x 4) – A$360 million = A$60 million This needs to be spread over 4 years – therefore sum of digits is 10.
Opening balance A$ million 360.0 279.0 192.0 99.0
Interest
Repayment
Closing Balance
A$ million 24.0 18.0 12.0 6.0
A$ million (105.0) (105.0) (105.0) (105.0)
A$ million 279.0 192.0 99.0 0
Net Present Value of Leasing Cash flows: Year 0 1 A$m A$m Accounting depreciation 90.0 Interest 24.0
2 A$m 90.0 18.0
3 A$m 90.0 12.0
4 A$m 90.0 6.0
5 A$m
0.0 19.2
0.0
Total Tax relief on the above at 20% (with time delay of one year) Lease payment
114.0
108.0 22.8
102.0 21.6
96.0 20.4
(105.0)
(105.0)
(105.0)
(105.0)
Cash flow
(105.0)
(82.2)
(83.4)
(84.6)
19.2
1.000
0.952
0.907
0.864
0.823
0.784
0.0
(100.0)
(74.6)
(72.1)
(69.6)
15.1
Discount rate at 5% NPV Total NPV: A$301.2million
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Advice to the Finance Director: It is important to consider the nature of the investment to be funded when considering possible alternative sources of finance. Key issues to consider include: • Relative cost of finance over the life of the project • Importance of matching maturity with life of equipment • Possible impact of the choice of finance on the investment decision • Cost/ease of raising funds using each method • Tax benefits Choice between bank borrowing (alternative 1) and a finance lease (alternative 2) The decision to choose between bank borrowing and leasing can be made almost exclusively on financial grounds. In the scenario here financing the new equipment with bank borrowing is very marginally advantageous over a finance lease. However, before a decision is made the following factors should be considered: •
• •
• •
A finance lease might be easier and quicker to arrange than bank borrowing. Additionally the issue costs for leases are typically lower than for either debt or equity. The numerical analysis undertaken does not include any arrangement fees and therefore this could have a bearing on the decision. Bank borrowings have a cash flow advantage over a lease, with lower cash outflows before the end of the project. EM is all-equity financed so the introduction of some debt into the statement of financial position could be advantageous by providing tax benefits and lowering the WACC. Both leasing and bank borrowings would be treated as debt in the statement of financial position so the effect on gearing would be the same. The bank borrowings will need to be repaid or refinanced at some point in the future, whilst obviously a finance lease does not. The original investment decision does not need to be reopened to take account of the cost of each of these types of debt. This is because the NPV is already positive and would only be increased by taking the lower cost of debt finance into account.
Advantages of borrowings/lease over equity (rights issue – Alternative 3) As leasing may be considered a direct alternative to medium term debt, the advantages and disadvantages of a finance lease compared with equity (rights issue) are therefore similar to those for debt. • • • • •
Interest and lease payments are tax deductible. Debt does not dilute share ownership or EPS, although in the case here this is probably not a concern. Probably cheaper and easier to administer borrowings or lease. A rights issue is a major administrative exercise and carries risks such as the rights not being taken up by sufficient shareholders. This could be covered by underwriting but this has a cost. Equity is a (more or less) permanent source of funds, for what is essentially a medium term investment. This is not appropriate – the funding will remain in place even when the equipment has no further use in the business. Cost of debt is normally lower than the cost of equity because lenders are given priority in terms of finance servicing payments and security of capital. Using debt finance would have no impact on the investment decisions but adjusting the NPV of the investment decision to reflect the higher cost of equity over cost of capital could threaten the financial viability of the project.
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Disadvantages of debt/lease over equity • •
Risk of bankruptcy if interest payments not met. This is unlikely here as EM is a very large company and at present has no medium or long term debt. Consideration would have to be given to how the debt would be repaid or re-financed at the end of the investment’s life.
Recommendation A finance lease seems the most appropriate given the scenario circumstances. The marginal disadvantage in NPV is outweighed by the administrative benefits and the slightly lower risk in respect of residual value. A rights issue is not appropriate as it does not match the duration of the investment and is a lengthy, complex process with higher risks.
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Answer to Question Three Part (a)(i) – Calculate the NPV, IRR and MIRR as at 01 January 2011 for the proposed project Calculation of NPV The NPV calculation should be performed using the risk-adjusted discount rate of 9%. APV calculations are not possible because insufficient data is provided in the question. However, any comments that such calculations might be useful in view of the 50% debt funding planned will be given credit. Year: All figures in US$ Millions
0
Non-current assets Net current assets Residual value – non-current assets Residual value - net current assets Net Operating Cash flows (OCFs) Tax at 25% on OCFs Tax relief on TDA’s (Note 1) Cash flows after tax
(30.00) (16.00)
Discount factor @ 9% DCF NPV
1 (46.00) 7.46
0.00
(46.00)
1
2
3
14.00 (3.50) 2.25 12.75
17.00 (4.25) 2.25 15.00
3.00 16.00 22.00 (5.50) 2.25 37.75
0.917 11.69
0.842 12.63
0.772 29.14
Notes 1 Tax relief on TDA’s are US$30m x 90% ÷ 3 x 25% (Non-current assets less estimated residual value divided by life of the investment multiplied by the tax rate) Calculation of Internal rate of return (IRR) Discount factor @ 18% DCF NPV
1.00 (46.00) (1.44)
0.847 10.80
0.718 10.77
0.609 22.99
An IRR can be calculated by interpolation as follows:
7.46 × 9% IRR = 9% + 7.46 + 1.44 = 9% + 7.54% = 16.5% (Alternatively, use the EXCEL IRR function for a more accurate result.) Modified Internal Rate of Return (MIRR) 2 1 12.75 1.1881(= 1.09 ) 15.15 2 15.00 1.09 16.35 3 37.75 1.00 37.75 69.25 1/3
(69.25/46) - 1 = 0.146 So MIRR = 14.6% Alternatively, look up 46/69.25 = 0.6643 in annuity tables to obtain 14.6%. Or, better still, use the EXCEL MIRR function.
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Part (a)(ii) – Discuss the advantages and limitations of MIRR in comparison with NPV and IRR MIRR Vs IRR MIRR is intended to address some of the deficiencies of IRR; notably that it eliminates the possibility of multiple rates of return and seeks to adjust the IRR so that it has the same reinvestment assumption as NPV (ie: that the cash inflows of a project are reinvested at the company’s cost of capital). MIRR rankings are therefore consistent with the NPV rule, which is not always the case with IRR. However, there are weaknesses: •
If the actual reinvestment rate is greater than the cost of capital, then MIRR will underestimate the project's true return and therefore potential projects are rejected unnecessarily.
•
The determination of the life of the project can have a significant effect on the actual MIRR if the difference between the project's IRR and the entity's cost of capital is large.
MIRR vs NPV The MIRR, like IRR, is biased towards projects with short payback periods which is not the case with NPV. It could be argued that this bias is advantageous as a short payback means that funds are available earlier for reinvestment. However, MIRR (again like IRR) gives a rate and as such gives no indication of the size of a project, whilst NPV does. Ultimately despite its advantages, MIRR does not appear to be understood or used as extensively in practice as NPV and IRR.
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Part (b) – Evaluate the impact of the project on MR’s ability to meet its financial objectives. Project’s contribution to achievement of financial objectives The proposed investment demonstrates a positive NPV at a discount rate that reflects the specific risk of the project. As we would expect with a positive NPV, the project’s IRR and MIRR show returns greater than this risk adjusted cost of capital. It should therefore contribute to MR’s main financial objective to achieve a return on shareholder’s funds of 11%. Borrowing US$23 million will however take the company dangerously close to its objective of a maximum gearing ratio of 35%. At present its gearing is: 350/ (760+350) = 31.5%, although if we net off surplus cash against debt (assuming we currently have surplus cash of US$23 million, being 50% of £46 million, the sum available to invest), gearing becomes: (350-23)/(760+350-23) = 30%. Assuming market value is increased by the NPV of the proposed project and 50% of the cost is borrowed, gearing becomes: (350+23)/(760+7+350+23) = 32.7% However the following reservations have to be noted. •
• •
Gearing based on market values changes day to day and the market value of securities is affected by external factors as well as those internal to the company. A financial objective based on such volatile variables is difficult to monitor or achieve on a regular basis. Gearing based on book values might be a useful supplementary objective. The NPV of the project will be evaluated by the market once information is released and this value might be more or less than MR has calculated. The NPV is heavily influenced by the end-of-project residual value of the noncurrent assets and the value of current assets. Also, three years is a very short time over which to evaluate such a project. The evaluation should extend over a much longer period, at least 10 years for a project such as this.
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Answer to Question Four
(a) Rationale behind Blue’s dividend policy: •
Blue is a quoted company and therefore needs to be able to satisfy market expectations in terms of dividends.
•
Blue shows a belief in the signalling effect of dividends by paying a stable but steadily increasing dividend. This signals stability (which is important as the market does not react well to surprises) and the prospect of future, steady returns on investment to potential investors.
•
Major shareholders such as large financial institutions may prefer regular dividend payouts and they may have influenced Blue’s dividend policy.
•
Equally the smaller scale private investors may well have been attracted to Blue due to its steady dividend policy through what is known as the clientele effect (ie: where a particular type of investor has a preference in terms of dividends and therefore will only invest in companies that meet that preference).
•
Overall therefore it is possible that Blue chooses to have a stable dividend policy in order to meet its investors’ expectations.
•
However, Blue has experienced rapid growth in recent years and this has lead to the accumulation of surplus cash. Blue should therefore review its dividend policy to see if it is still appropriate.
Rationale behind Green’s dividend policy: •
Green as a private company has none of the market pressures and expectations that Blue has. Green has only 10 shareholders and it is likely that many of these are also engaged in the running of the business and therefore will have detailed knowledge about how the company is performing and its future prospects. Therefore the informational aspect of the dividend policy is not important.
•
Green uses a ‘residual’ theory of dividend policy, choosing only to distribute earnings where there are no suitable projects to invest in. It appears to use earnings to reinvest in the business in preference to paying out dividends and investors can only safely plan on receiving a minimum payout of 10% of profit generated in the year. This indicates that the shareholders believe that the Directors can reinvest profits at a higher return than they could achieve if they were to invest surplus cash paid out as dividends individually.
Reasons for the difference:
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Blue is concerned about its share price – and a steady, low growth in dividends will help protect its share price
•
Green does not have a quoted share price to influence its decisions and has greater flexibility to match the needs of its small number of family shareholders. For example, their tax position may affect their preference for dividends versus capital gain.
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(b) Modigliani and Miller proposed that, in the absence of distortions resulting from tax, shareholders would be indifferent between dividends and capital gains. That is: Loss of value in existing shares = Amount of dividend paid. The rationale behind this theory is that: (i) Investors are indifferent as to dividends or capital gains in the form of increased share value. (ii) There is a perfect market, that is, no buyer or seller is large enough for their transactions to have a significant impact on the share price, and there is full information at zero cost and no transaction costs involved in buying or selling shares. Therefore, an investor can always increase his income by selling shares and so the level of dividend payout is irrelevant to the investor. And, thirdly, (iii) There is ‘perfect certainty’, that is, equity and bonds are priced correctly. Therefore, it is irrelevant to the company whether there are sufficient funds to invest in new projects as additional funds can always be obtained if required. That is, the level of dividends paid also has no impact on shareholder value. The implications of this theory are that no individual dividend policy can be considered to be ‘superior’ to any other in terms of maximising shareholder value. Therefore both Blue and Green are free to choose the particular dividend policy that suits the personal circumstances of their typical investor assuming ‘perfect’ market conditions exist. In reality, however, shareholders who have invested in a company such as Blue, place value in being able to predict the future level of dividends. Many shareholders may rely on dividend payouts as part of their income stream. Investors may also be faced with different tax treatment of income and capital gains. Investors in Blue may also have chosen to invest in Blue because of its low risk approach to dividend payouts. A company with surplus cash as headroom may be in a stronger position to face an economic downturn. Again, an aspect that is not considered in MM theory. MM theory implies that there should be no impact on shareholder wealth of the large swings in dividend payout that could result from Green’s policy. However, it does not allow for the fact that there is no real market at all in Green’s shares and certainly not a market that approximates to a ‘perfect market’. There could therefore be a real problem for a shareholder in selling shares to ‘create’ his own dividend stream and the theory has therefore little practical application for Green either.
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(c) It is important that both Blue and Green act in the interests of the shareholders as a whole and consult with shareholders to determine the general preference for dividend policy. After such consultation, Blue may be persuaded to increase the general level of dividends. On the other hand, the general preference amongst shareholders may be for : • •
a special one-off dividend or organising a share repurchase;
The key difference is that the special one-off dividend is paid to ALL shareholders. It is therefore regarded as equally fair to all shareholders and could be particularly suitable for Blue. This may also have the added advantage to Blue of displaying confidence in the performance of the company and help to generally boost the share price. However, it is not suitable for Green where only one shareholder wishes to realise his cash. A share repurchase can provide individual shareholders the choice of whether or not to accept the company’s offer to buy back their shares. If Blue has shareholders with different requirements, it could also be the best alternative for Blue. Note that only a share repurchase will boost EpS and lower the cost of future dividend payouts (on a per share basis). It is likely that Green’s dividend policy was agreed amongst the shareholders and there is no general wish to change this policy. If this is the case, Green could also encourage a private sale of shares between shareholders to enable Mr G to realise some cash from his investment.
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