BUSINESS FINANCE DECISIONS

Suggested Answer
Certified Finance and Accounting Professional Examination – Summer 2023

A.1 (a) Percentage premium to offer for Ardah

2023 2029 &
2024 2025 2026 2027 2028
Year ended 31 May (Year 0) onwards
------------------------- Rs. in million -------------------------
Operating cash flows (pre-tax) 4,500 5,200 5,900 6,600 7,300
Terminal value of operating
cash flows with growth of
2% [7,446(7,300×1.02) ÷
0.13(0.15–0.02)] 57,277
Annual staff savings 75 75 75 75 75
Interest (20,000×8%) (1,600) (1,600) (1,600) (1,600) (1,600)
Taxable free cash flows 2,975 3,675 4,375 5,075 5,775 57,277
Tax 29% (863) (1,066) (1,269) (1,472) (1,675) (16,610)
Redundancy (120)
Sale of surplus building 2,400
Equipment upgrade (1,000)
Tax saving on upgrade 290
Capital maintenance (100) (100) (100) (100) (100)
Terminal value of other
cash flows having no growth
–1,183[–1,083{–1,525(75–1,600)
×71%} – 100] ÷0.15 (7,887)
Free cash flows 1,570 2,012 2,509 3,006 3,503 4,000 32,780
Cost of equity 15% (W-1) 1 0.870 0.756 0.658 0.572 0.497 0.497
PV 1,570 1,750 1,897 1,978 2,004 1,988 16,292

Rs. 27,479 million

Rs. in million
Estimated free cash flow valuation 27,479
Current market capitalisation 25,000
Premium 2,479

Maximum percentage premium (2,479÷25,000) 10%

W-1: Using CAPM

Ke = Rf + βe  (Rm – Rf)
Ke = 9% + 0.857  (16% – 9%) = 15.0%

(b) Market valuation

Efficient stock markets react to new information very quickly.

Most markets in the real world are considered semi-strong efficient. This means that the
market incorporates the implications of any published information into the current market
value.

To date, the discussions have been confidential and so the shareholders are not aware of
the planned acquisition. As such, this information is not reflected in the current market
capitalisation value of Rs. 25,000 million.

Once the information is made public, and if the market is confident that the projections
are realistic, the discounted, higher cash flows will be incorporated into the current market
value.

The company value could increase to Rs. 27,479 million in line with AP's valuation.

Page 1 of 13
 BUSINESS FINANCE DECISIONS
Suggested Answer
Certified Finance and Accounting Professional Examination – Summer 2023

If this is the case, the board would offer a lower or zero premium as appropriate because
the Rs. 2,479 million premium would already be reflected in the target company's higher
market capitalisation.

(c) Exchange rate risk and hedging

AP currently supplies customers in Pakistan. If AP exports wheat and cotton, the company
will face exchange rate risk if sales are not in PKR.

The risk is referred to as transaction risk. This arises because a sale is made in a different
currency and, if customers are offered credit, when the customer settles their account, the
exchange rate will have moved, and so the amount received may be less (or more) than
originally expected.

Internal hedging
There are some simple steps to reduce transaction risk.

Firstly, AP could invoice in PKR and so the exchange rate risk is then borne by the
customer. This may not place AP in a competitive position.

Alternatively, AP could hold monetary accounts in other currencies and refrain from
converting cash flows into PKR on a regular basis.

However, this is unlikely to be effective for AP because these will be converted to PKR at
some point. This is because AP does not have any liabilities in other currencies that could
be settled with non-PKR bank accounts.

External hedging
There are several methods of external hedging as follows:
(i) Forward contract
AP can take out forward contracts which fix the exchange rate to be used when AP
converts the monies received into PKR.

This is a simple and cost-effective technique.

The only risk is if a customer does not settle their debt as planned. The forward
contract is binding, and AP would need to sell the overseas currency at the spot rate
to be able to settle the forward contract, thus defeating the purpose of the hedge.

(ii) Money market

AP could borrow, for example, in GBP in anticipation of a future GBP receipt from
a customer. When the funds are received, the loan is repaid. This would enable the
sale of the borrowed GBP at the current exchange rate and so eliminates exchange
rate risk.

This method is effectively a do-it-yourself forward rate contract and should achieve
a similar outcome.

Practically, it might be difficult for AP to borrow in other currencies.

(iii) Futures market

AP could use the futures derivative market to hedge against a strengthening of the
PKR. For example, this would involve contracting to buy PKR at the lower rate and
closing out when the value is high.
This gain would then be added to the lower actual PKR receipt in the future.
Futures effectively fix the position with the futures outcome negating the movement
in the underlying market.
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 BUSINESS FINANCE DECISIONS
Suggested Answer
Certified Finance and Accounting Professional Examination – Summer 2023

The downside of futures is that they are not available for all currencies and are for
fixed denominations which will not match perfectly with the underlying hedge.

(iv) Options
An option allows AP the right, but not the obligation, to exchange the future receipt
into PKR at a pre-agreed exchange rate.
This way, if the market moves favourably, for AP the option is not exercised;
however, if it moves against AP, it will be.
The downside of options is that a premium has to be paid for this flexibility, and so
they are expensive.

Recommendation
As this will be a new venture for AP, it would be advisable to use forward contracts to
hedge against exchange rate risk as these are simple and cost effective. The board can
review the approach in the future once they are more experienced in the export market.

A.2 Bahtic Developments Limited

(a) Capital rationing
NPV calculations for each project
WTR
PV
Rs. in
Time Cashflow DF 12% (Rs. in
million
million)
0 First tranch of investment [(12,000×50%)÷3] (2,000) 1.0000 (2,000)
1 Second tranch of investment [(12,000×50%)÷3] (2,000) 0.8929 (1,786)
2 Third tranch of investment [(12,000×50%)÷3] (2,000) 0.7972 (1,594)
2 50% Advance (1,000×50%) 500 0.7972 399
3 50% Sale apartments (6,000×50%) 3,000 0.7118 2,135
3-infinity Annual rental of remaining space (1,000×50%) 500 6.6432 3,321
8.3333÷1.122
NPV 475

HP
PV
Rs. in
Time Cashflow DF 12% (Rs. in
million
million)
0 Investment (7,850) 1.0000 (7,850)
2-infinity Property management cash profits 1,100 7.4404 8,184
8.3333÷1.12
NPV 334

LM
PV
Rs. in
Time Cashflow DF 12% (Rs. in
million
million)
0 Investment (3,150) 1.0000 (3,150)
2-infinity Property management cash profits 580 7.4404 4,315
(increase only) 8.3333÷1.12

NPV 1,165

Page 3 of 13
 BUSINESS FINANCE DECISIONS
Suggested Answer
Certified Finance and Accounting Professional Examination – Summer 2023

RR
PV
Rs. in
Time Cashflow DF 12% (Rs. in
million
million)
0 Phase 1 outlay [(25×20)+(10×50)] (1,000) 1.0000 (1,000)
1 Phase 2 outlay [(25×20)+(10×50)] (1,000) 0.8929 (893)
1 Phase 1 sales [(25×30)+(10×85)] 1,600 0.8929 1,429
2 Phase 2 sales [(25×30)+(10×85)] 1,600 0.7972 1,276
NPV 811

Capital rationing identification and calculation of possible investments

All the projects generate positive NPVs and so all should be accepted; however, as
demonstrated below, the funds available are not sufficient to invest in all the projects.
WTR HP LM RR Total
------------------------ Rs. in million ------------------------
Capital at time 0 2,000 7,850 3,150 1,000 14,000
NPV 475 334 1,165 811 2,785

As the projects are not divisible, the optimum solution is determined through trial and
error, considering the outlay at time 0 and the overall NPV achieved.

With Rs. 10,000 million to invest, there are three combinations that BD can afford.

Combination 1: Surplus
HP RR Total
HP & RR cash
--------------- Rs. in million ---------------
Capital at time 0 7,850 1,000 1,150 10,000
NPV 334 811 (W-1)(72) 1,073

Combination 2: Surplus
WTR HP Total
WTR & HP cash
--------------- Rs. in million ---------------
Capital at time 0 2,000 7,850 150 10,000
NPV 475 334 (W-1)(9) 800

Combination 3: Surplus
WTR LM RR Total
WTR, LM & RR cash
-------------------- Rs. in million --------------------
Capital at time 0 2,000 3,150 1,000 3,850 10,000
NPV 475 1,165 811 (W-1)(240) 2,211

Recommendation
The final combination of WTR, LM and RR generated the highest overall NPV and, based
on the financial analysis, this should be the decision.

Before a final decision is made, the board should consider the sensitivity to assumptions
for each investment and the associated non-financial and strategic considerations relevant
to each opportunity.

Page 4 of 13
 BUSINESS FINANCE DECISIONS
Suggested Answer
Certified Finance and Accounting Professional Examination – Summer 2023

W-1: Investment of surplus funds

HP and RR
Time Cashflow Rs. in million DF 12% Rs. in million
0 Surplus to invest (1,150.0) 1.0000 (1,150)
1 Value after 1 year at 5% 1,207.5 0.8929 1,078
(1,1501.05)
NPV (72)

WTR and HP
Time Cashflow Rs. in million DF 12% Rs. in million
0 Surplus to invest (150.0) 1.0000 (150)
1 Value after 1 year at 5% 157.5 0.8929 141
(1501.05)
NPV (9)

WTR, LM and RR
(PV)
Time Cashflow Rs. in million DF 12%
Rs. in million
0 Surplus to invest (3,850.0) 1.0000 (3,850)
1 Value after 1 year at 5% 4,042.5 0.8929 3,610
(3,8501.05)
NPV (240)

(b) New finance

The amount of finance (including issue cost) would be Rs. 4,124 million (4,000÷0.97).

The right issue is a 1-for-10 issue. As a result, 1 million shares (10,000,000×10%) would
be issued.

The key ratios can now be recalculated as shown below:

Impact on key ratios Current forecast New debt New equity

Earnings per share
Profit after interest and tax
(W-1) (Rs. in million) 8,193 7,901 8,193
Number of shares (in million) 10 10 11

Earnings per share (Rs.) 819 790 745

Interest cover
Operating profit (W-1)
(Rs. in million) 15,560 15,560 15,560
Interest (W-1)(Rs. in million) 4,020 4,432 4,020

Interest cover (times) 3.9 3.5 3.9

Gearing (book values)

Debt (W-1) (Rs. in million) 40,200 44,324 40,200
Equity+Debt (Rs. in million) 150,510 154,634 154,634

Gearing 27% 29% 26%

Page 5 of 13
 BUSINESS FINANCE DECISIONS
Suggested Answer
Certified Finance and Accounting Professional Examination – Summer 2023

W-1: Impact on financial statements

SOFP extract Forecast New debt New equity
30 June 2024 30 June 2024 30 June 2024
-------------------- Rs. in million --------------------
Share capital (Rs. 100) 1,000 1,000 1,100
Share premium 10,160 10,160 14,184
Retained profits 99,150 99,150 99,150
Debt 40,200 44,324 40,200
150,510 154,634 154,634

Forecast New debt New equity

SOPL extract Year ended Year ended Year ended
30 June 2024 30 June 2024 30 June 2024
-------------------- Rs. in million --------------------
Operating profit 15,560 15,560 15,560
Interest (4,020) (4,432) (4,020)
11,540 11,128 11,540
Corporation tax 29% (3,347) (3,227) (3,347)
Profit after interest and tax 8,193 7,901 8,193

Evaluation
(i) New debt
Financing the projects with new debt finance will increase the level of gearing for
BD. The amount of new finance required is small in relation to the existing levels
and so there is only a small increase in the level of gearing.
Similarly, there is only a small reduction in interest cover, the absolute level of which
indicates that BD is able to service the additional levels of debt.
Debt finance is a cheaper source of finance as there is less risk for the investor and
so the cost of debt finance is less than the cost of equity finance.
BD also benefits from tax relief on the interest payments.
New finance should match the duration of the project. In this case, some of the
projects will continue indefinitely. The bank loan will need to be repaid in 10 years'
time. BD may take the view that new debt finance will be raised as appropriate at
that time.
Debt finance will be easier to arrange if there is security for the loan. As all
opportunities lead to an increase in the value of assets, it suggests that security will
be available for the loan. This may lead to a reduction in the interest rate charged by
the bank.
The bank loan will be quicker to obtain and thus will ensure that all projects can
commence shortly.
The new loan could introduce new loan covenants. BD must ensure that these are
not breached in the future.
(ii) New equity
The board have suggested that the issue costs of debt and equity will be 3% of the
funds raised. The costs are likely to be higher for the rights issue as it would be
advisable to underwrite the issue to ensure that sufficient funds are raised.
The additional cost is unlikely to be material to the calculations.

Page 6 of 13
 BUSINESS FINANCE DECISIONS
Suggested Answer
Certified Finance and Accounting Professional Examination – Summer 2023

Raising new equity will reduce the earnings per share as new shares will be issued.
If the rights are taken up by existing shareholders, there will, however, be no dilution
of control.
Equity finance is permanent which avoids a need for back-to-back refinancing after
10 years.
Recommendation
In this case, in the interests of speed and lower costs, it is recommended that the bank
loan is chosen as the source of new finance.

A.3 (a) Computation of current weighted average cost of capital

Capital structure of Ex Ltd: Rs. in billion %

Equity 1,708 60%
Debentures 1,155 40%
2,863 100%

Capital structure of Mardi Ltd: Rs. in million %

Equity 4,515 70%
(100+4,415)
Debentures 1,935 30%
6,450 100%

EX's equity beta must be adjusted as the gearing ratio is different to Mardi's. EX's debt is
considered to be risk free and so the debt beta is 0.
E 6
βA = βEG × = 1.4× = 0.950
E+D(1−t) 6+4(1−0.29)

Mardi's debentures are not risk free as the debt is unsecured.

The debt beta for the debentures must however be estimated.
Firstly, the yield on debentures can be calculated:

PV PV
Time Cashflow Rs. DF 5% DF 10%
(Rs.) (Rs.)
0 Investment (1,000) 1 (1,000) 1 (1,000)
1–5 Interest 1,00011% = 110 4.329 476 3.791 417
5 Redemption value 1,050 0.784 823 0.621 652
299 69

299
IRR = 5% + × (10% − 5%)
(299 − 69)
IRR = 11.50% = Kd

Using CAPM
Kd = Rf + βd  (Rm – Rf)
11.5% = 9% + βd  (16% – 9%)
Βd = 0.357

The equity beta for Mardi can now be estimated.

E D(1 − t)
βA = βEG × + βD ×
E + D(1 − t) E + D(1 − t)
7 3(1 − 0.29)
0.950 = βEG × +0.357×
7 + 3(1 − 0.29) 7 + 3(1 − 0.29)
Page 7 of 13
 BUSINESS FINANCE DECISIONS
Suggested Answer
Certified Finance and Accounting Professional Examination – Summer 2023

0.950= βEG × 0.767 + 0.0833

βEG = 1.1299

CAPM can now be used to calculate the cost of equity.

Ke = Rf + β × ( Rm − Rf )
Ke = 9% + 1.1299 × (16% − 9%)
Ke = 16.91%

Debentures
PV PV
Time Cashflow Rs. DF 5% DF 10%
(Rs.) (Rs.)
0 Investment (1,000) 1 (1,000) 1 (1,000)
1–5 Interest net of tax
1,000  11%  4.329 338 3.791 296
(1–0.29) = 78.1
5 Redemption value 1,050 0.784 823 0.621 652
161 (52)

Rounding:
161
IRR = 5% + × (10% − 5%)
(161 + 52)
IRR = 8.8%

WACC = 16.9% × 0.7 + 8.8% × 0.3 ⇒ 14.5%

(b) NPV calculation

T0 T1 T2 T3 T4 T5
-------------------------- Rs. in million --------------------------
Operating cash flows
Sales (W-1) 63.865 71.082 76.875 83.140 89.916
Material costs (W-2) (10.400) (11.357) (12.402) (13.543) (14.788)
Labour and variable overhead
costs (W-3) (8.160) (8.739) (9.360) (10.024) (10.736)
Fixed costs (lease payments) (25.000) (25.000) (25.000) (25.000) (25.000)
Operating profit (25.000) 20.305 25.986 30.113 34.573 64.392
Tax at 29% (5.888) (7.536) (8.733) (10.026) (18.674)
Tax relief on final lease payment 7.250
Investment (100.000)
Tax saved on tax depreciation
(W-4) 7.250 3.263 2.773 2.357 13.357
Working capital (W-5) (6.387) (0.722) (0.579) (0.627) (0.678) 8.992
(131.387) 20.945 21.134 23.526 26.226 75.317
Discount rate 14.5% 1.0000 0.8734 0.7628 0.6662 0.5818 0.5081
PV of cash flows (131.387) 18.293 16.121 15.673 15.258 38.269
NPV at WACC (27.773)

Recommendation:
The analysis shows that there is a negative NPV and so the project should not be accepted.

Page 8 of 13
 BUSINESS FINANCE DECISIONS
Suggested Answer
Certified Finance and Accounting Professional Examination – Summer 2023

W-1: Sales T0 T1 T2 T3 T4 T5
-------------------------- Rs. in million --------------------------
Sales in current prices 60.250
Sales volume growth 5% 63.263 66.426 69.747 73.234
Price increase 6% (first 2 years) 1.06 (1.06) 2
(1.06) 2
(1.06) 2
(1.06)2
Price increase 3% (year 3 onwards) 1.03 (1.03) 2
(1.03)3
Sales in money terms 63.865 71.082 76.875 83.140 89.916

W-2: Material costs T0 T1 T2 T3 T4 T5

-------------------------- Rs. in million --------------------------
Materials in current prices 10.000
Sales volume growth 5% 10.500 11.025 11.576 12.155
Price increase 4% 1.04 (1.04) 2
(1.04) 3
(1.04) 4
(1.04)5
Materials in money terms 10.400 11.357 12.402 13.543 14.788

W-3: Labour and variable overheads

T0 T1 T2 T3 T4 T5
-------------------------- Rs. in million --------------------------
Labour and variable overheads
in current prices 8.000
Sales volume growth 5% 8.400 8.820 9.261 9.724
Price increase 2% 1.02 (1.02) 2
(1.02) 3
(1.02) 4
(1.02)5
Labour and overhead in
money terms 8.160 8.739 9.360 10.024 10.736

W-4: Tax depreciation T0 T1 T2 T3 T4 T5

-------------------------- Rs. in million --------------------------
Investment 100.000
Tax depreciation rate 25% 15% 15% 15% Balancing
adjustment
Tax depreciation 25.000 11.250 9.562 8.128 46.059
Tax written down value 75.000 63.750 54.188 46.059 nil
Tax saved 7.250 3.263 2.773 2.357 13.357

W-5: Working capital T0 T1 T2 T3 T4 T5

-------------------------- Rs. in million --------------------------
Sales 63.865 71.082 76.875 83.140 89.916
Working capital required 6.387 7.108 7.688 8.314 8.992 0.00
Movement in working capital (6.387) (0.722) (0.579) (0.627) (0.678) 8.992

A.4 Optimal hedging strategy

Netting cash flows
EUR USD
Payment (1,500,000) Payment (1,000,000)
Receipt 2,000,000 Receipt 2,500,000
Payment (3,500,000) Receipt 2,000,000
Net payment (3,000,000) Receipt 3,500,000
The USD receipt can be used to settle the EUR payment in three months' time.

Forward contract EUR/USD

Spot rate 0.9606
Add: Discount 0.0186
Forward rate 0.9792

Page 9 of 13
 BUSINESS FINANCE DECISIONS
Suggested Answer
Certified Finance and Accounting Professional Examination – Summer 2023

USD
USD received from customers 3,500,000
USD needed for EUR 3 million (3,000,000÷0.9792) (3,063,725)
Surplus USD 436,275

PKR receipt (436,275×218.32) Rs. 95,247,558

Money Market hedge

Invest in June: EUR 3,000,000 ÷ [1+(6.2%×3÷12)] USD 2,954,210
USD
Borrow USD today at spot rate (2,954,210÷0.9606) (3,075,380)
Borrowing cost (3,075,380×5.6%×3÷12) (43,055)
USD needed to repay USD borrowing (3,118,435)
USD received from customers 3,500,000
Surplus USD 381,565

PKR receipt (381,565×218.32) Rs. 83,303,271

Futures contract to hedge

Futures
USD/EUR
Today (June 2023) 1.0452
30 September 2023 1.0198
Movement 0.0254

No. of contracts (3,000,000÷20,000) 150 contracts

Number of ticks (0.0254÷0.0001) 254

Tick size per contract (20,000×0.0001) USD 2.00

Profit/Loss on one contract (254×2) USD 508

Loss on futures hedge (508×150) USD 76,200

USD
USD received from customers 3,500,000
Less: Loss on futures hedge (76,200)
3,423,800
USD needed for EUR 3 million (3,000,000÷0.9797) (3,062,162)
Surplus USD 361,638

PKR receipt (361,638×218.32) Rs. 78,952,808

Option
USD
USD received from customers 3,500,000
USD needed for the premium 25,000×[1+(5.6%×3÷12)] (25,350)
USD needed for EUR 3 million (3,000,000÷0.9850) (3,045,685)
Surplus USD 428,965

PKR receipt (428,965×218.32) Rs. 93,651,639

Recommendation
The forward contract provides the largest PKR receipt at the end of September based on the
estimated currency movements and, so, this hedging technique should be selected.
Page 10 of 13
 BUSINESS FINANCE DECISIONS
Suggested Answer
Certified Finance and Accounting Professional Examination – Summer 2023

A.5 (a) Dividend valuation model

2028 &
2024 2025 2026 2027
onwards
------------------------ Rs. in '000 ------------------------
After tax earnings 410,000 500,000 550,000 580,000
Dividend paid at 25% 102,500 125,000 137,500 145,000
Dividend paid at 25% 1,370,909
till perpetuity 150,800(145,000 ×1.04)
÷ 0.11(0.15–0.04)
Discount rate 15% (W-1) 0.8696 0.7561 0.6575 0.5718 0.5718
PV 89,134 94,513 90,406 82,911 783,886

1,140,850
Estimated price per share (1,140,850,000÷200,000) = Rs. 5,704

W-1: CAPM
Ke = Rf + β × ( Rm − Rf )
Ke = 9% + 0.86 × (16% − 9%)
Ke = 15%

The dividend valuation model suggests that the share price should be Rs 5,704. This is
considerably lower than the current market value of Rs. 8,154.
Historically, SL has not paid a dividend and so the dividend valuation model would not
have been a suitable approach to use as this would have suggested a zero value, which is
clearly not the case.
There are several models that can be used to estimate the value of a company and, given
the zero-dividend policy of SL, it is likely that shareholders would have invested in the
company on the expectation of the company's future earnings, driven by new patented
products.

The future earnings, rather than dividends, can then be used to estimate the value of the
company.
Shareholders are then expecting to generate returns through capital gains and not through
dividends.

(b) Dividend policy

Practical factors
There are many practical factors that should be considered as discussed below:

Shareholder preference
Different shareholders will prefer different approaches. Some shareholders may prefer
dividends as this provides a regular cash flow; others may prefer to see their return in the form
of capital growth.
This is influenced by the different personal tax position for the shareholder because the tax on
dividends is different to the tax on capital gains if shares have capital growth.
In addition, the shareholder's attitude to risk is also important. The dividend is a certain
payment now, whereas the future growth is not guaranteed.
This is sometimes referred to as the clientele effect.

If SL changes the zero-dividend policy, this is likely to frustrate shareholders as one of the
reasons for including SL in their investment portfolio would have been the current zero
dividend policy.
Page 11 of 13
 BUSINESS FINANCE DECISIONS
Suggested Answer
Certified Finance and Accounting Professional Examination – Summer 2023

If the policy does change, then the shareholder base may also change as the clientele effect
leads to short-term market adjustment. This may lead to a short-term drop in the market value
as the market adjusts.

Signalling
Privately owned companies are usually owner managed and so the owners have access to
internal company information. For listed companies, such as SL, some of the shares are
owned by investors that do not work for SL and consequently do not have access to internal
information.
These external shareholders (60% of shareholders in this case) rely on regular financial reports,
as required by the Pakistan Stock Exchange, to provide up-to-date information on the
performance and position of the company.
If a listed company pays a dividend, it is seen as a signal about the directors' confidence in the
future of the company.
As such, it is quite possible for a company to report losses or a poor performance but still
maintain a dividend. This signals to the investor that the directors have confidence about the
future performance and, as such, shareholders should not divest in the company.
It follows that, if SL did commence a policy of paying dividends, this signals a change to the
market, firstly that the zero dividend policy has ended and secondly that going forward
shareholders can expect to receive dividends.
This suggests that future reinvestment and hence capital growth will be lower in the future.

If SL decided to pay a one-off dividend, as suggested by Noor, this must be communicated

clearly to the market.

Access to new finance and investment opportunities

A practical application of the residual theory should also be considered. Future investments
will need to be financed and SL should decide if the surplus funds could be directed towards
new worthwhile research.
It would be inefficient to return a large dividend to shareholders in 2023 and then seek new
finance via a rights issue in 2024.

Liquidity
SL should also look at the current levels of cash in the business as high earnings are not the
same as large cash balances.

The payment of a dividend does require cash, however a scrip dividend could be made as an
alternative (see below for scrip dividend).

Legal restraints
A company can only pay a dividend from realised profits.
Given the recent successes for SL, this is not likely to be a concern.
There are two generic policies:

Constant pay-out ratio

A constant pay-out policy, as suggested by Ahmad, clearly demonstrates to the market that
funds are retained each year for future investment.
However, if earnings are erratic, the level of dividend is also variable and so can deliver a
confusing signal to the market.
Such a policy is more suitable to an unlisted company with owner managers or a mature listed
company with consistent earnings.

Page 12 of 13
 BUSINESS FINANCE DECISIONS
Suggested Answer
Certified Finance and Accounting Professional Examination – Summer 2023

SL has been listed for four years and so is no longer a 'start-up' company though, given the
industry and its relative youth, it is unlikely to fit the profile required for this policy.

Constant growth
Many listed companies follow a policy that looks for a steady increase in the level of dividends
year on year.

Shareholders are not naive and will of course continue to look at the level of growth in the
underlying earnings to consider the performance of SL.

The constant growth policy is another positive signal to the market about the expected success
of the company.

Alternatives to cash dividends

SL could consider alternative ways to return cash to shareholders as follows:

Scrip dividends
Strictly speaking, a scrip issue does not return cash to shareholders and new shares are issued
in lieu of a cash dividend. This has the effect of reducing the share price, as more shares are
in issue. Clearly, no cash is returned to shareholders.

However, in the future, if the dividend per share is maintained, the shareholder will receive
higher future cash payments as they own more shares.

This is not applicable for SL as they have never paid dividends and, if they continue to pay a
zero dividend, this action will not facilitate a return of cash to shareholders.

Share repurchase
An alternative way to return cash is for SL to repurchase shares from shareholders.

This returns cash to shareholders through a capital transaction, without any expectation of a
repeated cash pay-out in the future and so signals very clearly to the market that this is a one-
off return of cash.

Recommendation
Given the relative youth of SL, and the need to fund research and development, it is
recommended that a dividend is not paid at this time.
Instead, the board should continue the zero-dividend policy and invest the surplus funds in
new research and development projects.

(The End)

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