ACCA AFM Syllabus A. Role Of The Senior Financial Adviser - Dividends policy - Past Papers ^{1 / 5}

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)

Chithurst Co gained a stock exchange listing five years ago. At the time of the listing, members of the family who founded the company owned 75% of the shares, but now they only hold just over 50%. The number of shares in issue has remained unchanged since Chithurst Co was listed. Chithurst Co’s directors have continued the policy of paying a constant dividend per share each year which the company had before it was listed. However, investors who are not family members have become increasingly critical of this policy, saying that there is no clear rationale for it.

They would prefer to see steady dividend growth, reflecting the increase in profitability of Chithurst Co since its listing.

The finance director of Chithurst Co has provided its board with details of Chithurst Co’s dividends and investment expenditure, compared with two other similar-sized companies in the same sector, Eartham Co and Iping Co. Each company has a 31 December year end.

Chithurst Co’s finance director has estimated the costs of equity for all three companies.
None of the three companies has taken out significant new debt finance since 2011.

Required:
(a) Discuss the benefits and drawbacks of the dividend policies which the three companies appear to have adopted. Provide relevant calculations to support your discussion.

Note: Up to 5 marks are available for the calculations. (15 marks)

Limni Co is a large company manufacturing hand-held electronic devices such as mobile phones and tablet computers. The company has been growing rapidly over the last few years, but it also has high research and development expenditure. It is involved in a number of projects worldwide, developing new and innovative products and systems in a rapidly changing industry.

Due to the nature of the industry, this significant growth in earnings has never been stable, but has depended largely on the success of the new innovations and competitor actions. However, in the last two years it seems that the rapid period of growth is slowing, with fewer products coming to market compared to previous years.

Limni Co has never paid dividends and has financed projects through internally generated funds and with occasional rights issues of new share capital. It currently has insignificant levels of debt. The retained cash reserves have recently grown because of a drop in the level of investment in new projects.

The company has an active treasury division which invests spare funds in traded equities, bonds and other financial instruments; and releases the funds when required for new projects. The division also manages cash flow risk using money and derivative markets. The treasury division is currently considering investing in three companies with the following profit after tax (PAT) and dividend history:

All of the three companies’ share capital has remained largely unchanged since 2009.

Recently, Limni Co’s Board of Directors (BoD) came under pressure from the company’s larger shareholders to start returning some of the funds, currently retained by the company, back to the shareholders.

The BoD thinks that the shareholders have a strong case to ask for repayments. However, it is unsure whether to pay a special, one-off large dividend from its dividend capacity and retained funds, followed by small annual dividend payments; or to undertake a periodic share buyback scheme over the next few years.

Limni Co is due to prepare its statement of profit or loss shortly and estimates that the annual sales revenue will be $600 million, on which its profit before tax is expected to be 23% of sales revenue. It charges depreciation of 25% on a straight-line basis on its non-current assets of $220 million.

It estimates that $67 million investment in current and non-current assets was spent during the year. It is due to receive $15 million in dividends from its subsidiary companies, on which annual tax of 20% on average has been paid. Limni Co itself pays annual tax at 26%, and the tax authorities where Limni Co is based charge tax on dividend remittances made by overseas subsidiary companies, but give full credit on tax already paid on those remittances.

In order to fund the new policy of returning funds to shareholders, Limni Co’s BoD wants to increase the current estimated dividend capacity by 10%, by asking the overseas subsidiary companies for higher repatriations.

Required:

Evaluate the dividend policies of each of the three companies that Limni Co is considering investing in, and discuss which company Limni Co might select. (8 marks)