ACCA Paper P4 Financial Management -...

ACCA

Paper P4

Advanced Financial Management

December 2014 to June 2015

Interim Assessment – Answers

To gain maximum benefit, do not refer to these answers until you have completed the interim assessment questions and submitted them for marking.

ACCA P4: ADVANCED FINANCIAL MANAGEMENT

2 KAPLAN PUBLISHING

© Kaplan Financial Limited, 2014

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INTERIM ASSESSMENT: ANSWERS

KAPLAN PUBLISHING 3

1 LABRADOR PLC

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

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

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

1 Purchasing Power Parity Theory can be used as our best predictor of future 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%) as opposed to trade transactions; therefore purchasing power theory breaks down.

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

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

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

5 Price and cost changes may differ from those forecasted.

6 Considering the strategic magnitude of the decision, one could undertake detailed risk analysis procedures such as sensitivity analysis, scenario planning or detailed simulation with the aid of a number of software packages.

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

However, any final decision must consider all relevant non‐financial factors of which 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 = 03.1

06.11.01942 =

03.1

05.1


KAPLAN PUBLISHING 5

Option 1: The US option

(W2) Working capital

Year Total working capital

Increase

US$000 US$000

0 4,000 (4,000)

1 + 6% each year (240)

2 (254)

3 (270)

4 (286)

5 (302)

6 5,353

Year 0

US$

(000)

1

US$

(000)

2

US$

(000)

3

US$

(000)

4

US$

(000)

5

US$

(000)

6

US$

(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 0

SFr (000)

1

SFr (000)

2

SFr (000)

3

SFr (000)

4

SFr (000)

5

SFr (000)

6

SFr (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 working capital

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 is considered a safe way to enter new markets, as costs are likely to be relatively small if the strategy fails. The cost of producing in the home market and exporting 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 governments may make exporting difficult and/or expensive

(iii) consumers may prefer locally produced goods

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

Companies often regard exporting as a first step to be followed by direct investment, licensing, franchising or joint‐ventures.

Foreign direct investment normally involves the commitment of substantial amounts of capital and significant risk. It may occur either by establishing a new subsidiary or by acquiring an existing local company, although some countries restrict foreign acquisitions. There are many possible motives for foreign direct investment 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 this motive 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 foreign currency

(ix) to exploit monopolistic or competitive advantage. The process of internalisation whereby multinationals maintain competitive advantage through the internal possession and control of information, technology, marketing or other commercial expertise is often cited as an important reason 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 the security if held to redemption.

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

The main point here is to distinguish redemption yield from coupon rate. Coupon rate does not necessarily measure return whereas redemption yield does. 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 annual interest payments, and the redemption amount. Therefore, if the initial value, annual interest and redemption amount are discounted at the redemption yield, 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) Maximum 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) Maximum 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) Maximum 12

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

Discounting model, with correct numbers and timings Solving for X

2 4 2

––––– Total part (d) Maximum 8

––––– Total 50

–––––



2 WELLER INC

(a) Option prices in the basic Black‐Scholes model relating to European options are determined 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 of the 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 less valuable as the exercise of the option will result in the purchase of a security of lower value than previously.

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

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

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

(v) The risk‐free rate. A reduction in the risk‐free rate will decrease the value of the call option because the money saved by purchasing the call option rather than the underlying security is reduced. If an option is purchased the cash saved could be invested at the risk‐free rate. A reduction in the risk‐free rate makes purchasing the call option relatively unattractive and reduces the option price.

(b) (i) The existing bonus scheme, based on earnings per share, has the advantage that earnings per share are easily measured. However, this scheme suffers from the problems of all accounting‐based measures in that it may be influenced by the accounting policies selected, and is not based on the economic cash flows of the company, which are likely to influence the share price. Maximisation of earnings per share is not the same as maximisation of share price and shareholder wealth.

The advantage of the share option scheme is that, in theory, it will motivate managers to improve the share price as they will directly benefit from this. This should achieve goal congruence with shareholders who are also seeking to maximise the share price. However, the extent to which their total remuneration is influenced by the incentive scheme may influence managers’ decisions and their motivation to maximise share price.



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 = 280 × 0.9484 – 200 × 0.9162 × e (–0.04 × 1)

= 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 a fixed price, would benefit its holder more the further the price of the share fell below the exercise price of the option. As far as the options are concerned it would be in the manager’s interest to take decisions that reduced the company’s share price, rather than increase it! Therefore Weller Inc should not agree to grant the manager put options.

(2) The put option price may be found from the put‐call parity equation.

p = c − Pa + Pee−rt

p = 89.49 – 280 + 192.16

= 1.65 cents

The manager is incorrect. Put options are not more valuable than call 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 4

1

(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% × 2,750

2,000 + 7.47% ×

2,750

450 + 7% ×

2,750

300 = 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) –(1

DV+

EV

EV

= 1.20 × 0.30)20(180

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) –(1

DV+

EV

EV

= 1.1 × ( )0.30–1 30 +70

70 = 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 reflect the industry average D:E gearing of 40:60

Beta asset = beta equity × t)–(1

DV+

EV

EV

1.34 = beta equity × 0.30)40(160

60

–

So, beta equity = 1.97 for the publishing industry.

(c) Leisure project

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

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

Regearing this to reflect the gearing of Foxes plc gives:

asset = equity × t)–(1

DV+

EV

EV

0.85 = equity × 0.30)–20(1+80

80

0.85 = equity × 0.85

equity = 1.00 = 0.85

0.85

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) Maximum 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) Maximum 10

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

– Ke – Kd(1 – t) – WACC

2 1 1 1

–––– Total part (c) Maximum 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 use of retained earnings for investment.

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

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

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

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

Director B believes that the dividend policy should be tailored to the needs of individual shareholders. However, this will depend on the way dividends and capital gains are taxed, whether annual exemptions exist for capital gains, which marginal tax rates apply to which shareholders and whether pension funds can reclaim tax credits deducted on dividends. The different shareholders may therefore have differing preferences concerning dividend policy.



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

Director C suggests that many shareholders rely on dividends in order to satisfy current income requirements. An alternative exists, whereby shares could be sold in order to realise the capital gain and thus provide income. However, this is not equivalent to a dividend payment since transactions costs would be involved, shareholdings would be diluted and such an action could be tax disadvantageous as discussed above. Thus Director C is correct in his assessment and a constant stable dividend policy is what is required.

Director C’s second point concerning risk, though, is fallacious. A capital gain should be compared with total dividend payments not simply the current dividend and therefore both capital gains and dividends relate to future periods and are uncertain. In addition, both dividends and gains are determined by the same factors. They are both generated by the cash flows produced by the company and these cash flows are determined by the company’s investment strategy.

Director D is a proponent of the dividend irrelevancy hypothesis that states that a company’s value is dependent on the future earnings stream but independent of the particular dividend payment policy. In theory this hypothesis is correct, but it is dependent on perfect capital market conditions, which clearly do not exist in practice. Several market imperfections have already been discussed above, 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 called noise trading by naïve investors. According to this theory there are two types of investors, the informed and uninformed. The informed trade shares to bring them to their fundamental value. The uniformed acts irrationally. Perhaps they noticed that certain shares have made investors high returns over the last number of years. So they rush out and buy these shares to get their piece of the action, 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 it will end in disaster, the informed investor buys in the hope of selling before the crash.

This is based on the idea that the price an investor is willing to pay for a share today is dependent on the price the investor can sell it for at some point in the future 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 point Discussion of NPV in efficient and inefficient markets

Max 4

Importance of NPV to investment decisions Volatility and market efficiency

Max 3 Max 3 ––––––

Total 25 ––––––

ACCA Paper P4 Financial Management -...

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