P4 ACCA June 2013 Exam: BPP Answers

Question 1
Text references. Cost of capital and APV is covered in Chapter 7a and free cash flow valuations in Chapter 7b.
Stock exchange listings are covered in Chapter 2 and ethical issues in Chapter 3b.
Top tips. For part (a) (i) you to know which formula to use to calculate the ungeared cost of equity. It is the MM
Proposition 2 formula which is given to you in the exam.
For (a) (ii) you should have picked up from the question information that the Bahari project needs to be valued
using the APV method.
To tackle (a) (iii) you need to work out what the bondholders stand to gain from the swap and compare it to the
current value of the bond in order to decide whether or not they are likely to accept it.
For part (b) make sure you only use the information contained in the question. Note that there is nothing saying the
relationship between the president of Bahari and the CEO is inappropriate. Also consider what would happen to the
farmers if Mlima Co does not take up the mining option. Note that your answer should be split evenly between the
two issues.
Easy marks. There are numerous easy marks to be picked up in part (a) (ii) for calculating the values for Mlima. (a)
(iv) also offers some easy marks for some straightforward observations.

Marking scheme
Marks
(a)(i) Explanation of Mlima Cos cost of capital based on Ziwa Cos ungeared 3
cost of equity
Ziwa Co, cost of ungeared equity 4
7
(ii) Sales revenue growth rates 1
Operating profit rate 1
Estimate of free cash flows and PV of free cash flows for years 1 to 4 4
PV of free cash flows after year 4 2
Base case Bahari project value 2
Annual tax shield benefit 1
Annual subsidy benefits 1
PV of tax shield and subsidy benefits 1
Value of the Bahari project 1
14
(iii) Calculation of unsecured bond value 2
Comment 2
Limitation 1
5
(iv) Comments on the range of values 34
Discussion of assumptions 34
Explanation for additional reasons for listing 23
Assessment of reasons for discounted share price 23
Conclusion 12
Max 12
Professional marks
Report format 1
Layout, presentation and structure 3
4
(b) Discussion of relocation of farmers 45
Discussion of relationship between Bahari president and Mlima Co CEO 45
Max 8
50

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P4 ACCA June 2013 Exam: BPP Answers

(a) Report
To: Board of Directors, Mlima Co
From: AN Consultant
Subject: Initial public listing: price range and implications
Date: XX/XX/XX
This report considers a range of values for Mlima Co to consider in preparation for the proposed public
listing. These values are based on 100 million shares being issued. The assumptions made in determining
these values are discussed and the likelihood of the equity-for-debt swap being successful is also
considered. Finally the report will evaluate other reasons for listing and also why the shares should be
issued at a discount.
Mlima Co cost of capital
Ziwa Cos ungeared cost of equity represents the return Ziwa Cos shareholders would require if Ziwa Co
was financed entirely by equity. This return would compensate the shareholders for the business risk of Ziwa
Cos operations.
Since Mlima Co is in the same industry, and therefore faces the same business risk, this required rate of
return should also compensate Mlima Cos shareholders. This rate would be used as Mlima Cos cost of
capital as it is expecting to have no debt and therefore this rate does not need adjusting for financial risk.
Therefore the cost of equity is also the cost of capital. This cost of capital is calculated in appendix 1 as
11%.
Mlima Co estimated value
Using the cost of capital of 11%, the value of Mlima Co is calculated as $564.9 million (see appendix 2 for
full calculation), before considering the proposed Bahari project. The value of the Bahari investment, without
considering the tax shield and subsidy benefits from the subsidised government loan, does not exceed the
initial investment. When the tax and subsidy benefits are considered, the present value of the Bahari project
is $21.5 million (see appendix 3 for full calculation). This gives a total value for Mlima Co of just over $586
million. This gives the following potential share prices, based on 100 million shares, including the effect of
the suggested 20% share price discount.
Potential share price Excluding Bahari project Including Bahari project
Full value $5.65 per share $5.86 per share
20% discount $4.52 per share $4.69 per share
Equity-for-debt swap
The unsecured bond is currently estimated to be worth $56.8 million (see appendix 4 for full calculation). It
is proposed that the existing bondholders will be offered a 10% stake in Mlima Co post-listing, which means
that only the value at $5.86 per share would leave the bondholders better off, and therefore would be the
only acceptable price. If the lowest price of $4.52 per share is used, then the equity stake would need to be
around 12.6% for the bondholders to accept the offer (56.8m/4.52 = 12.566).
The bond value is based on a yield to maturity of 7%, because Mlima Co can borrow at 7%, so this is
therefore its current yield. The yield could be more accurately estimated if it was based on future risk-free
rates and the credit spreads for the company.
Assumptions
The main assumptions are over the accuracy of the estimates used in producing the valuation. The value of
Mlima Co is based on estimated future growth rates, profit margins, tax rates and capital investment. The
future growth rates and margins are based on past data, which may not be a reliable indicator of future
prospects. The Bahari project includes estimated cash flows for 15 years and the reasonableness of these
estimates needs to be considered to see if they are realistic.
The cost of capital used for Mlima Co is based on Ziwa Cos ungeared cost of equity, on the basis that the
business risk is the same for both companies as they operate in the same industry. However, it is possible
that the business risks are different, for example due to geographic locations, and therefore the cost of

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 P4 ACCA June 2013 Exam: BPP Answers

capital is not appropriate for Mlima Co. Accepting the Bahari project could also affect the business risk of
Mlima Co.
The value of the Bahari project is based on the Bahari government providing the promised subsidised loan.
Mlima Co needs to consider whether the full subsidy will definitely be provided for the full 15 years and
whether a change of government may change the position. There may also be other political risks which
need to be assessed fully.
Transaction costs for the listing have been ignored as they are assumed to be insignificant. It should be
confirmed that this is the case before making a final decision.
Reasons for a public listing
The main reason behind this public listing is to remove the debt from the company. Other reasons for
pursuing a public listing include: a gain in prestige for the company by listing on a recognised stock
exchange, having greater access to sources of finance and being able to raise funds more quickly as a
result, providing shareholders with a value for their equity stake and enabling them to realise their
investment if they wish to do so.
Issuing shares at a discount
Since the public will only be issued 20% of the share capital from the initial listing, they will be minority
shareholders and have a limited ability to influence the decision-making of Mlima Co. Even if they voted as a
bloc, they would not be able to overturn the decision on their own. The discounted share price, would
therefore, compensate the shareholders for the additional risk of being minority shareholders. The position
of the unsecured bond holders should also be considered. On the assumption that they hold 12.6% of the
equity (as discussed earlier) they could form a bloc with the new shareholders of 32.6%, which would be
enough to influence company decisions. Whether they would form a bloc with new shareholders or are
more closely aligned with the interests of the current owners is something that should be looked into.
Shares are often issued at a discount to ensure that they all get sold. This is even more common for a new
listing and the price of the shares does usually rise immediately after the listing.
Conclusion
A price range for the listing of between $4.52 and $5.86 per share has been calculated, depending on
whether the Bahari project is undertaken and whether the shares are offered at a discount of 20%. It is
recommended that Mlima Co consults the underwriters for the share issue, to carry out book-building to
assess the price that potential investors are willing to pay.
If 20% of the shares (20 million shares) are sold to the public at $4.52 per share, the listing will raise just
over $90 million. $80 million would then be spent redeeming the secured bond, leaving just in excess of $10
million of funds remaining. Mlima Co needs to consider whether these funds will be sufficient to carry on its
operations. The Bahari investment may result in a change to the desired capital structure of the company,
which may also have an impact on the cost of capital.
Becoming a listed company will also result in listing costs and additional annual costs to meet compliance
and reporting requirements. These factors will need to be balanced against the benefits of listing before
making a decision whether or not to proceed.
Appendices
Appendix 1: Mlima Cost of capital
Ziwa Co market value of debt = 105/100 1,700m = $1,785m
Ziwa Co market value of equity = 200m $7 = $1,400m
Ziwa Co ungeared cost of equity using keg = keu + (1 t)(keu kd) D/E
16.83% = keu + 0.75(keu 4.76%) 1,785/1,400
16.83% + 4.55% = 1.9563keu
keu = 10.93% (say 11%)

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P4 ACCA June 2013 Exam: BPP Answers

Appendix 2: Value of Mlima Co prior to Bahari project

389.1
Past two years sales growth = 1 = 0.0625 or 6.25%
344.7

Expected growth for four years = 1.2 6.25% = 7.5%

Operating profit margin (historic)
2013 58.4/389.1 = 0.150
2012 54.9/366.3 = 0.150
2011 51.7/344.7 = 0.150
Operating profit margin is expected to be 15%.
Year 1 2 3 4 4+
$m $m $m $m $m
Sales revenue (increasing at 7.5%) 418.3 449.7 483.4 519.7
Operating profit (15%) 62.7 67.5 72.5 78.0
Tax at 25% (15.7) (16.9) (18.1) (19.5)
Additional capital investment (W1) (8.8) (9.4) (10.1) (10.9)
Free cash flows 38.2 41.2 44.3 47.6 49.3*
Discount factor (11%) 0.901 0.812 0.731 0.659 8.787**
PV of free cash flows 34.4 33.5 32.4 31.4 433.2
Value of company = $564.9m
* 47.6 1.035 = 49.3
** 1/(0.11 0.035) 0.659 = 8.787
Working
Year 1 2 3 4
$m $m $m $m
Sales revenue 418.3 449.7 483.4 519.7
Increase in revenue 29.2 31.4 33.7 36.3
30% of increase 8.8 9.4 10.1 10.9
Appendix 3: Value of Bahari project
Base case
Free cash Discount factor PV
Year flow $m 11% $m
0 (150) 1.000 (150.0)
1 4 0.901 3.6
2 8 0.812 6.5
3 16 0.731 11.7
4 18.4 0.659 12.1
5 21.2 0.593 12.6
6 - 15 21.2 3.492 74.0
(29.5)
10 year annuity discounted for five years = 5.889 0.593
Annual tax shield benefit = 3% 150m 25% = $1.1m
Subsidy benefit = 4% 150m 0.75 = $4.5m
Total annual benefit = $5.6m
Annuity factor (7%, 15 years) = 9.108
PV of tax shield and subsidy benefit = 5.6m 9.108 = $51.0m
Adjusted present value = ($29.5m) + $51.0m = $21.5m

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 P4 ACCA June 2013 Exam: BPP Answers

Appendix 4: Value of unsecured bond

Annual interest = 13% 40m = $5.2m
Assume a yield to maturity of 7%. A 10-year annuity factor at 7% is 7.024
Discount factor for redemption of bond (7%, 10 years) is 0.508
Bond value = 5.2m 7.024 + 40m 0.508 = $56.8m
(b) The activities of Mlima Co are likely to be of greater interest and be scrutinised more closely once it is
listed. The company needs to consider the ethical implications of both situations and whether Mlima Co is
complying with its own ethical code (if it has one).
Regarding the relocation of the farmers, Mlima Co needs to judge where its responsibility lies. It may decide
that this is a matter between the farmers and the government, and that Mlima Co is not responsible (either
directly or indirectly) for the current situation. If Mlima Co does not agree to the offer, it seems likely that the
mining rights would be given to another company and so the farmers situation would not improve by
Mlima Co walking away from the deal. Mlima may be better off by influencing the government over this issue
by asking it to keep the farmers together and to offer them more fertile land. In addition Mlima Co could
offer jobs and training to any farmers who choose to remain where they are.
In the case of the Bahari president and Mlima Cos CEO, Mlima Co must ensure that any negotiation was
transparent and there was no bribery or other illegal practice involved. If the company and the government
can show that decisions have been made in the best interests of the country and Mlima Co, and no
individuals benefited from the decision, then it should not be seen negatively. Indeed, it is good for business
to have strong relationships and this can create a competitive advantage.
Mlima should consider how it would respond to public scrutiny of these issues, possibly even pre-empting
issues by releasing press statements to explain positions.

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P4 ACCA June 2013 Exam: BPP Answers

Question 2
Text references. Acquisitions are covered in Chapters 9 and 10.
Top tips. For part (a) make sure any synergies suggested are consistent with the given scenario, rather than a
generic list. For example, R&D synergies are more applicable in this scenario than in a general acquisition question.
For part (b) you may have slightly different numbers depending on roundings. Do not worry about this as full marks
will still be given where roundings are sensible.
For part (c) you need to use the maximum premiums calculated in part (b). Ensure that you use whatever numbers
you have calculated in order to gain any follow through marks. Also for part (c) ensure that you justify the
recommendation you have made and that it is supported by the calculations.
Easy marks. You should be able to pick up some relatively straightforward marks in part (a) for distinguishing the
different types of synergies as well as suggesting potential synergies in this scenario.

Marking scheme
Marks
(a) Distinguish between different synergies 12
Evaluating possible financial synergies 23
Evaluating possible cost synergies 12
Evaluating possible revenue synergies 34
Concluding comments 12
Max 9
(b) Average earnings and capital employed 1
After-tax premium 1
PV of premium (excess earnings) 1
Hav Co and Strand Co values 1
Combined company value 1
Value created/premium (PE method) 1
6
(c) Strand Co, value per share 1
Cash offer premium (%) 1
Cash and share offer premium (%) 2
Cash and bond offer premium (%) 2
Effect of basis risk on recommendation made 34
Max 10
25

(a) Synergies arise from an acquisition when the value of the new, combined entity is greater than the sum of
the two individual values before the acquisition. There are three types of synergies: revenue, cost and
financial.
Revenue synergies create higher revenues for the combined entity, also creating a higher return on equity
and an extended period of competitive advantage.
Cost synergies arise from eliminating duplication of functions and also from economies of scale due to the
size of the new entity.
Financial synergies may result from the ability to increase debt capacity or from transferring group funds to
companies where they can be best utilised.
In this scenario, there may be financial synergies available as Hav Co has significant cash reserves, but
Strand Co is constrained by a lack of funds. This means that the new entity may have the funds to undertake
projects that would have been rejected by Strand Co due to a lack of funds. The larger company may also

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 P4 ACCA June 2013 Exam: BPP Answers

have an increased debt capacity and therefore additional access to finance. It is also possible that the new
entity will have a lower cost of capital as a result of the acquisition.
Cost synergies may be available, through the removal of duplication in areas such as head office functions,
but also in research and development. These synergies are likely to be more short-term. Other cost
synergies may arise from a stronger negotiating position with suppliers due to the size of the new entity,
meaning better credit terms and also lower costs.
Revenue synergies have the potential to be the biggest synergies from this acquisition, although they are
likely to be the hardest to achieve, and also to sustain. Hav Co can help Strand Co with the marketing of its
products, which should result in higher revenues and a longer period of competitive advantage. Combining
the research and development activity and the technologies of both companies may mean products can be
brought to market faster too. To achieve these synergies it is important to retain the services of the scientist
managers of Strand Co. They have been used to complete autonomy as the managers of Strand Co, so this
relationship should be managed carefully.
A major challenge in an effective acquisition is to integrate processes and systems between the two
companies efficiently and effectively in order to gain the full potential benefits. Often, this is done poorly and
can mean that the acquisition is ultimately seen as a failure. Hav Co needs to plan for this before proceeding
with the acquisition.
(b) Maximum premium based on excess earnings
Average pre-tax earnings of Strand Co = (397 + 370 + 352)/3 = $373m
Average capital employed = [(882 + 210 209) + (838 + 208 180) + (801 + 198 140)]/3 = $869.3m
Excess annual premium (pre-tax) = 373 (869.3 0.2) = $199.1m
Post-tax annual premium = $199.1 0.8 = $159.3m
PV of annual premium in perpetuity = 159.3/0.07 = $2,275.7m
The maximum premium payable is $2,275.7m
Maximum premium based on PE ratio
Strand Cos estimated PE ratio = 16.4 1.10 = 18.04
Strand Cos post-tax profit (most recent) = 397m 0.8 = $317.6m
Hav Cos post-tax profit = 1,980 0.8 = $1,584m
Hav Co current value = $9.24 2,400m shares = $22,176m
Strand Co current value = 18.04 $317.6 = $5,729.5m
Value of combined company = (1,584 + 317.6 + 140) 14.5 = $29,603.2m
Maximum premium = 29,603.2 (22,176 + 5,729.5) = $1,697.7m
(c) Current value of a Strand Co share = $5,729.5m/1,200m shares = $4.77 per share
Maximum premium % based on excess earnings = 2,275.7/5,729.5 100 = 39.7%
Maximum premium % based on PE ratio = 1,697.7/5,729.5 100 = 29.6%
Cash offer: premium % to Strand Co shareholder
(5.72 4.77)/4.77 100 = 19.9%
Cash and share offer: premium % to Strand Co shareholder
1 Hav Co share for 2 Strand Co shares
Hav Co share price = $9.24
Price per Strand Co share = 9.24/2 = $4.62
Cash payment per Strand Co share = $1.33
Total return = 4.62 + 1.33 = $5.95
Premium = (5.95 4.77)/4.77 100 = 24.7%

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P4 ACCA June 2013 Exam: BPP Answers

Cash and bond offer: premium % to Strand Co shareholder

Each share has nominal value of $0.25 so $5 is 20 shares
Bond value $100/20 shares = $5 per share
Cash payment per Strand Co share = $1.25
Total return = 5 + 1.25 = $6.25
Premium = (6.25 4.77)/4.77 100 = 31.0%

Tutorial note: Although these evaluations have been carried out using the current share price given in the
question, an equally valid approach would have been to have used a post-acquisition share price based on
earlier calculations.

Based on the calculations above, the cash plus bond offer will give the highest return to Strand Co
shareholders. In addition, the bond can be converted to 12 Hav Co shares, giving a value per share of
$8.33($100/12), which is below the current share price and so already in-the-money. If the share price
increases over the 6-year period, then the value of the bond should also increase. The bond will also earn
interest of 3% per year for the holder.
The 31% return is the closest to the maximum premium based on excess earnings and higher than the
maximum premium based on PE ratios. Thus this method appears to transfer more of the value to the
owners of Strand Co.
However, this payment method gives the lowest initial cash payment of the 3 methods being considered.
This may make it seem more attractive to the Hav Co shareholders as well, although they stand to have their
shareholding diluted most by this method, but not until six years have passed.
The cash and share offer gives a return in between the other options. Although the return is lower than the
cash and bond offer, Strand Cos shareholders could sell the Hav Co shares immediately, if they wish to.
However, if the share price of Hav Co falls between now and the acquisition, the return to Strand Co
shareholders will be lower.
The cash only offer gives an immediate return to Strand Co shareholders, but it is the lowest return and may
also place a strain on the cash flow of Hav Co, who may need to increase borrowings as a result.
It seems most likely that Strand Cos shareholder/managers, who will continue to work in the new entity, will
accept the mixed cash and bond offer. This maximises their current return and also gives them the chance to
gain in the future when converting the bond. The choice of payment method could be influenced by the
impact on personal taxation situations though.

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 P4 ACCA June 2013 Exam: BPP Answers

Question 3
Text references. Hedging foreign currency transactions is covered in chapter 16. Gamma is covered in chapter 17.
Top tips. In part (b) make sure you dont confuse payments and receipts in your matrix. Also it was important to
read the scenario carefully to see that the spot mid-rate should be used, rather than any other rate.
For part (c) dont waste time if you dont know what a gamma value is.
Easy marks. There are some easy marks to be gained in part (a) for money market hedging and forward market
calculations as these should be brought forward knowledge from F9.

Marking scheme
Marks
(a) Calculation of net US$ amount 1
Calculation of forward market US$ amount 1
Calculation of US$ money market amount 2
Calculation of one put option amount (1.60 or 1.62) 3
Calculation of the second put option amount or if the preferred exercise 2
price is explained
Advice and recommendation 34
Max 12
(b) Construction of the transactions matrix 1
Calculation of the equivalent amounts of US$, CAD and JPY 4
Calculation of the net receipt/payment 2
Explanation of government reaction to hedging 3
10
(c) 1 mark per valid point Max 3
25

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 P4 ACCA June 2013 Exam: BPP Answers

(a) Only transactions between Kenduri Co and Lakama Co are relevant, which are
Payment of $4.5 million
Receipt of $2.1 million
Net payment = $2.4 million
The hedging options are: using the forward market, money market hedging and currency options.
Forward market
As selling for $, receive at lower rate.
2,400,000/1.5996 = 1,500,375
Money market hedge
Invest US$ now: 2,400,000/(1 + 0.031/4) = $2,381,543
Converted at spot 2,381,543/1.5938 = 1,494,255
Borrow in now 1,494,255 (1 + 0.04/4) = 1,509,198
The forward market is cheaper and therefore is preferred.
Options
Kenduri would buy Sterling put options to protect against a depreciating
Exercise price $1.60/1
payment = 2,400,000/1.6 = 1,500,000
1,500,000/62,500 = 24 contracts
24 3-month put options purchased
Premium = 24 0.0342 62,500 = $31,200
Premium in = 31,200/1.5938 = 19,576
Total payments = 1,500,000 + 19,576 = 1,519,576
Exercise price $1.62/1
payment = 2,400,000/1.62 = 1,481,481
1,481,481/62,500 = 23.7 contracts
23 3-month put options purchased
payment = 23 62,500 = 1,437,500
Premium = 23 0.0208 62,500 = $49,163
Premium in = 49,163/1.5938 = 30,846
Unhedged amount = 2,400,000 (1,437,500 1.62) = $71,250
Hedging using forward market = 71,250/1.5996 = 44,542
Total payments = 1,437,500 + 30,846 + 44,542 = 1,512,888
Both options hedges are worse than using the forward or money markets as a result of the premiums
payable for the options. However options have an advantage over forwards and money markets because the
prices are not fixed and the buyer can let the option lapse if exchange rates move favourably. Therefore the
options have a limited downside, but an unlimited upside. Only with options can Kenduri Co take advantage
of the $ weakening against the .
Conclusion
The forward market is preferred to the money market hedge. The choice between options and forwards will
depend on whether management wants to risk the higher cost for the potential upside if exchange rates
move in Kenduri Cos favour.
(b) Spot mid-rates are as follows
US$1.5950/1
CAD1.5700/1
JPY132.75/1

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 P4 ACCA June 2013 Exam: BPP Answers

Paying subsidiary
Receiving UK USA Canada Japan Total Total Net receipt /
subsidiary receipts payments (payment)
(add (add down)
across)
000 000 000 000 000 000 000
UK - 1,316.6 2,165.6 - 3,482.2 3,521.9 (39.7)
USA 2,821.3 - 940.4 877.7 4,639.4 3,727.1 912.3
Canada 700.6 - - 2,038.2 2,738.8 3,106.0 (367.2)
Japan - 2,410.5 - - 2,410.5 2,915.9 (505.4)
Kenduri Co will make a payment of 39,700 to Lakama Co.
Jaia Co will make a payment of 367,200 to Lakama Co.
Gochiso Co will make a payment of 505,400 to Lakama Co.
Multilateral netting will minimise the number of transactions taking place through the banks of each country.
This limits the amount paid in fees to these banks. Governments who do not allow multilateral netting are
therefore looking to maximise the transactions and fees that the local banks will receive. Other countries
may choose to allow multilateral netting in the belief that this makes them more attractive to multinational
companies and the lost banking fees are more than compensated for by the extra business brought to the
country.
(c) Gamma measures the rate of change of the delta of an option. Deltas can be near zero for a long call option
which is deep out-of-the-money, where the price of the option will be insensitive to changes in the price of
the underlying asset. Deltas can also be near 1 for a long call option which is deep in-the-money, where the
price of the option and the value of the underlying asset move mostly in line with each other. When a long
call option is at-the-money, the delta is 0.5 but also changes rapidly. Therefore, the highest gamma values
are when a call option is at-the-money. Gamma values are also higher when the option is closer to expiry.
In this case, it appears that the option is trading near at-the-money and that it has a relatively short period
before expiry.

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 P4 ACCA June 2013 Exam: BPP Answers

Question 4
Text references. Financial strategy is covered in chapter 2 and dividend policy is covered in chapter 18.
Top tips. For part (a) it is necessary to consider why Limni Co has these policies in place rather than just
describing the existing policy.
In part (b) you do not need to calculate dividend growth or payout ratios for every year to be able to pick up the
marks, you can just consider overall growth and look at the earliest and most recent years to make sensible
comments. It does not really matter which investment choice is recommended as long as you can support your
choice with a valid argument.
Part (c) requires you to know how to calculate dividend capacity. Ensure that you learn the adjustments required to
profit after tax if you did not already know these.
Easy marks. There are some easy marks to be gained in part (b) from the evaluation of dividend policies and the
discussion of which company to invest in. Part (d) should also offer some fairly easy marks as long as the answer
relates to the shareholders point of view, not the companys.

Marking scheme
Marks
(a) Evaluation of dividend policy 12
Evaluation of financing policy 34
Evaluation of risk management policy 12
Effect of dividends and share buybacks on the policies 23
Max 8
(b) 2 marks per evaluation of each of the three companies 6
Discussion of which company to invest in 2
8
(c) Calculation of initial dividend capacity 3
Calculation of new repatriation amount 2
Comment 12
Max 6
(d) 1 mark per relevant point Max 3
25

(a) Dividend policy

Many high-growth companies, such as Limni Co, retain cash instead of paying dividends and use the cash to
help fund the growth. Many such companies declare an intention not to pay dividends and as such the
shareholders expect their wealth to increase through capital gains rather than dividend payments.
Financing
Capital structure theory suggests that to take advantage of the tax shield on interest payments, companies
should have a capital structure which is a mixture of debt and equity. Pecking order theory suggests that
companies typically use internally generated funds before seeking to raise external funds (initially debt, then
equity). The two main factors in deterring companies from seeking external finance are favouring one
investor group at the expense of another and the agency effect of providing additional information to the
market.
Limni Co is following the pecking order theory to the extent that it is using internally-generated funds first.
However it is then deviating from pecking order theory in looking to raise equity finance rather than debt
even though it currently has insignificant levels of debt and is therefore not making full use of the tax shield.
This may be explained by the fact that Limni Co operates in a high-risk, rapidly changing industry, where
business risk is high. It may not want to take on high levels of financial risk by using significant levels of

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debt finance. Other issues such as potentially restrictive debt covenant may also be a factor in the financing
decision.
Risk management
Managing the volatility of cash flows enables a company to plan its investment strategy more accurately.
Limni Co needs to ensure that it will have sufficient internally-generated cash available when it is needed
for planned investments. More importantly, since Limni Co faces high levels of business risk, as discussed
above, the company should look to manage the risks that are beyond the individual control of the companys
managers.
Affect on policies by returning funds to shareholders
Returning funds to shareholders will affect each of these policies. The shareholder clientele could change,
which may lead to share price fluctuations. However, since the change is being requested by shareholders,
there is a good chance that this may not happen. The financing policy is likely to change since there will be
less internally-generated funds available, so Limni Co may consider taking on additional debt finance and
therefore will have to look at the balance of business and financial risk. This could in turn change the risk
management policy as interest rate risk will also have to be managed as well.
(b) Theta
Company Theta has a fixed dividend payout ratio of 40%. As a result the increase in dividends in recent
years depends on the increase in profit after tax in these years rather than increasing at a steady rate, which
is often preferred by shareholders. If profit after tax was to fall, Theta may reduce its dividend, which could
send the wrong signals to shareholders and cause significant fluctuations in the share price. To avoid this,
Theta may keep a stable dividend in years of reduced profits.
Omega
Company Omega has a policy of increasing dividends at approximately 5% per year, but earnings are only
increasing at a rate of approximately 3% per year. This means the dividend payout ratio is increasing, it
was 60% in 2009 and is 65% in 2013. Although this cannot continue in the long term, it suggests that there
are less investment opportunities currently and Omega is reducing its retention ratio. This investment would
be attractive to an investor looking for a high level of dividend income.
Kappa
Company Kappa has increased its payout ratio from 20% in 2009 to 27% in 2013. This is a fairly low payout
ratio, but it is growing. Earnings are growing rapidly overall, but not at a constant annual rate (35% growth
in 2010, but only 3% in 2011). Overall dividend growth is at a rate of 29% per year, and the annual dividend
growth rate has been fairly constant. This policy seems consistent with a growing company, which is now
starting to pay more significant dividends and return more funds to shareholders. This investment would
be attractive to investors seeking a lower level of dividend income and higher levels of capital growth.
Due to uncertainty about whether Theta could decrease its future dividend payments, Limni Co is likely to
prefer to invest in either Omega or Kappa. The choice between these two depends on whether Limni Co
would prefer higher dividends or higher capital growth. Issues such as taxation position or length of time
that the funds would be invested for may influence this choice too.
(c) Current dividend capacity
000
Profit before tax (23% $600m) 138,000
Tax (26% $138m) (35,880)
Profit after tax 102,120
Add back depreciation (25% 220m) 55,000
Less investment in assets (67,000)
Overseas remittances 15,000
Additional tax (6% 15m) (900)
Dividend capacity 104,220

Increase in dividend capacity = 104.22m 0.1 = $10.422m

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 P4 ACCA June 2013 Exam: BPP Answers

Gross up to allow for extra 6% tax = $10.422m/0.94 = $11,087,234

Percentage increase in remittances needed = (11,087,234/15,000,000) 100% = 73.9%
Dividend repatriations would need to increase by approximately $11.1 million or 73.9% in order to increase
dividend capacity by 10%. Limni Co needs to consider both whether this is possible for the subsidiaries, but
also the motivational and operational impact of doing so on the subsidiaries.
(d) The main benefit of a share buyback scheme to a shareholder is that they can choose whether or not to sell
their shares back to the company. This means they can control the amount of cash they receive and in turn
manage their own tax liability. With dividend payments, especially with large special dividends, there may
be a large tax liability as a result. Further benefits include the fact, that as share capital is reduced, earnings
per share is likely to increase and share price may increase too. Additionally share buybacks are often
viewed positively by the markets and share price may increase.

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