3. Arthuro Co group
Arthuro Co is based in Hittyland and is listed on Hittyland’s stock exchange. Arthuro Co has one wholly-owned subsidiary, Bowerscots Co, based in the neighbouring country of Owlia. Hittyland and Owlia are in a currency union and the currency of both countries is the $.

Arthuro Co purchased 100% of Bowerscots Co’s share capital three years ago. Arthuro Co has the power under the acquisition to determine the level of dividend paid by Bowerscots Co.

However, Arthuro Co’s board decided to let Bowerscots Co’s management team have some discretion when making investment decisions.

Arthuro Co’s board decided that it should receive dividends of 60% of Bowerscots Co’s post-tax profits and has allowed Bowerscots Co to use its remaining retained earnings to fund investments chosen by its management.

A bonus linked to Bowerscots Co’s after-tax profits is a significant element of Bowerscots Co’s managers’ remuneration. Bowerscots Co operates in a very competitive environment. Recently, a senior member of its management team has left to join a competitor.

Arthuro Co’s dividend policy
Until three months ago, Arthuro Co had 90 million $2 equity shares in issue and $135 million 8% bonds. Three months ago it made a 1 for 3 rights issue.

A number of shareholders did not take up their rights, but sold them on, so there have been changes in its shareholder base.

Some shareholders expressed concern about dilution of their dividend income as a result of the rights issue.

Therefore, Arthuro Co’s board felt it had to promise, for the foreseeable future, at least to maintain the dividend of $0·74 per equity share, which it paid for the two years before the rights issue.

Arthuro Co’s board is nevertheless concerned about whether it will have sufficient funds available to fulfil its promise about the dividend. It has asked the finance director to forecast its dividend capacity based on assumptions about what will happen in a ‘normal’ year.

The finance director has made the following assumptions in the forecast:

1. Sales revenue can be assumed to be 4% greater than the most recent year’s of $520 million.

2. The operating profit margin can be assumed to be 20%.

3. Operating profit can be assumed to be reported after charging depreciation of $30 million and profit on disposal of non-current assets of $5·9 million.

The cost of the non-current assets sold can be assumed to be $35 million and its accumulated depreciation to be $24·6 million. Depreciation is allowable for tax and the profit on disposal is fully chargeable to tax.

4. The net book value of non-current assets at the year end in the most recent accounts was $110 million. To maintain productive capacity, sufficient investment to increase this net book value figure 12 months later by 4% should be assumed, in line with the increase in sales.

The calculation of investment required for the year should take into account the depreciation charged of $30 million, and net book value of the non-current assets disposed of during the year.

5. A $0·15 investment in working capital can be assumed for every $1 increase in sales revenue.

6. Bowerscots Co’s pre-tax profits can be assumed to be $45 million.

Arthuro Co’s directors have decided that if there is a shortfall of dividend capacity, compared with the dividends required to maintain the current dividend level, the percentage of post-tax profits of Bowerscots Co paid as dividend should increase, if necessary up to 100%.

Taxation
Arthuro Co pays corporation tax at 30% and Bowerscots Co pays corporation tax at 20%. A withholding tax of 5% is deducted from any dividends remitted by Bowerscots Co. There is a bilateral tax treaty between Hittyland and Owlia.

Corporation tax is payable by Arthuro Co on profits declared by Bowerscots Co, but Hittyland gives full credit for corporation tax already paid in Owlia. Hittyland gives no credit for withholding tax paid on dividends in Owlia.

Required:
(a) (i) Estimate Arthuro Co’s forecast dividend capacity for a ‘normal’ year; (11 marks)
(ii) Estimate the level of dividend required from Bowerscots Co to give Arthuro Co sufficient dividend capacity to maintain its dividend level of $0·74 per equity share. (3 marks)