Pike Robert, Neal Bill. Corporate finance and investment: decisions and strategy

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Chapter 17 Returning value to shareholders: the dividend decision 475

Questions with coloured numbers have solutions in Appendix B on page 710.

1 Tom plc follows a residual dividend policy. It has just announced earnings of and is to pay a dividend

of 20p per share. Its nominal issued share capital is with par value of 50p. What value of capital expen-

diture is it undertaking? (You may ignore taxes.)

2 Dick plc faces the following marginal efficiency of investment profile. All projects are indivisible.

£5 m

£10 m

QUESTIONS

Project IRR (%) Required outlay ( )

A15 3

B24 5

C40 2

D12 4

E21 7

£m

Dick’s shareholders require a return of 20 per cent. Dick has just reported earnings of

What amount of dividend would you recommend if Dick is unable to raise external finance?

3 Harry plc prides itself on its consistent dividend policy. Past data suggests that its target dividend payout

ratio is 50 per cent of earnings. However, when earnings increase, Harry invariably raises its dividend only

halfway towards the level that the target dividend payout ratio would indicate. The last dividend was per

share and Harry has just announced earnings for the recently ended financial year of per share.

What dividend per share would you expect the Board to recommend?

4 Tamas plc, which is ungeared, earned pre-tax accounting profits of million in the financial year just ended.

Replacement investment will match last year’s depreciation of million. Both are fully tax-allowable.

Corporation tax is payable at 30 per cent. Tamas operates a 50 per cent dividend payout policy, and has pre-

viously issued 100 million shares, with par value of 25 pence each. Its shareholders require a return of 15 per

cent p.a.

Tamas holds million cash balances.

Required

Determine the market price per ordinary share of Tamas, both cum-dividend and also ex-dividend.

(N.B. Use the perpetuity formula to value Tamas’ shares.)

5 Galahad plc, a quoted manufacturer of textiles, has followed a policy in recent years of paying out a steadily

increasing dividend per share as shown below:

£15

£2

£30

£3

£1

£9 m.

Year EPS Dividend (net) Cover

1986 11.8p 5.0p 2.4

1987 12.5p 5.5p 2.3

1988 14.6p 6.0p 2.4

1989 13.5p 6.5p 2.1

1990 16.0p 7.3p 2.2

Galahad has only just made the 1990 dividend payment, so the shares are quoted ex-dividend. The main

board, which is responsible for strategic planning decisions, is considering a major change in strategy where-

by greater financing will be provided by internal funds, involving a cut in the 1991 dividend to 5p (net) per

share. The investment projects thus funded will increase the growth rate of Galahad’s earnings and dividends

Continued

CFAI_C17.QXD 10/28/05 5:16 PM Page 475

476 Part V Strategic financial decisions

to 14 per cent. Some operating managers, however, feel that the new growth rate is unlikely to exceed 12 per

cent. Galahad’s shareholders seek an overall return of 16 per cent.

Required

(a) Calculate the market price per share for Galahad, prior to the change in policy, using the Dividend

Growth Model.

(b) Assess the likely impact on Galahad’s share price of the proposed policy change.

(d) Discuss the possible reaction of Galahad’s shareholders and of the capital market in general to this pro-

posed dividend cut in the light of Galahad’s past dividend policy.

6 Laceby manufactures agricultural equipment and is currently all-equity financed. In previous years, it has

paid out a steady 50 per cent of available earnings as dividend and used retentions to finance investment in

new projects, which have returned 16 per cent on average.

Its Beta is 0.83, and the return on the market portfolio is expected to be 17 per cent in the future, offering a

risk premium of 6 per cent.

Laceby has just made earnings of million before tax and the dividend will be paid in a few weeks’ time.

Some managers argue in favour of retaining an extra million this year in order to finance the development

of a new Common Agricultural Policy (CAP) surplus crop disposal machine. This may offer the following

returns under the listed possible scenarios:

£2

£8

Probability ( p.a.) Cash flow (pre-tax)

WTO talks succeed 0.2 0.5

No reform of CAP 0.6 1.5

CAP extended to Eastern Europe 0.2 4.0

£m

The project may be assumed to have an infinite life, and to attract an EU agricultural efficiency grant of

million. Corporation Tax is paid at 33 per cent (assume no tax delay).

Required

(a) What is the NPV of the proposed project?

(b) Value the equity of Laceby:

(i) before undertaking the project,

(ii) after announcing the acceptance of the project.

support such a conclusion.

7 Pavlon plc has recently obtained a listing on the Stock Exchange. Ninety per cent of the company’s shares

were previously owned by members of one family, but, since the listing, approximately 60 per cent of the

issued shares have been owned by other investors.

Pavlon’s earnings and dividends for the five years prior to the listing are detailed below:

£1

Years prior to listing Profit after tax ( ) Dividend per share (pence)

5 1,800,000 3.60

4 2,400,000 4.80

3 3,850,000 6.16

2 4,100,000 6.56

1 4,450,000 7.12

Current year 5,500,000 (estimate)

The number of issued ordinary shares was increased by 25 per cent three years prior to the listing and by

50 per cent at the time of the listing. The company’s authorised capital is currently in 25p ordinary

shares, of which 40,000,000 shares have been issued. The market value of the company’s equity is

£78,000,000.

£25,000,000

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Chapter 17 Returning value to shareholders: the dividend decision 477

The board of directors is discussing future dividend policy. An interim dividend of 3.16p per share was paid

immediately prior to the listing and the finance director has suggested a final dividend of 2.34p per share.

The company’s declared objective is to maximise shareholder wealth.

The company’s profit after tax is generally expected to increase by 15 per cent p.a. for three years, and 8 per

cent per year after that. Pavlon’s cost of equity capital is estimated to be 12 per cent per year. Dividends may

be assumed to grow at the same rate as profits.

Required

(a) Comment upon the nature of the company’s dividend policy prior to the listing and discuss whether such

a policy is likely to be suitable for a company listed on the Stock Exchange.

(b) Discuss whether the proposed final dividend of 2.34 pence is likely to be appropriate:

(1) if the majority of shares are owned by wealthy private individuals;

(2) if the majority of shares are owned by institutional investors.

undervalued or overvalued.

(d) Briefly outline the weaknesses of the Dividend Valuation Model.

(ACCA)

8 Mondrian plc is a newly-formed company which aims to maximise the wealth of its shareholders. The board

of directors of the company is currently trying to decide upon the most appropriate dividend policy to adopt

for the company’s shareholders. However, there is strong disagreement between three of the directors con-

cerning the benefits of declaring cash dividends,

Director A argues that cash dividends would be welcome by investors and that as high a dividend payout

ratio as possible would reflect positively on the market value of the company’s shares.

Director B argues that whether a cash dividend is paid or not is irrelevant in the context of shareholder

wealth maximisation.

Director C takes an opposite view to Director A and argues that dividend payments should be avoided as

they would lead to a decrease in shareholder wealth.

Required

(a) Discuss the arguments for and against the position taken by each of the three directors.

(b) Assuming the board of directors decides to pay a dividend to shareholders, what factors should be taken

into account when determining the level of dividend payment?

(ACCA Certified Diploma June 1996)

Obtain the Annual Report and Accounts of any firm of your choice. Look at the five-year record provided, and

work out the dividend cover each year and the annual rate of dividend per share increase as compared to the

annual increase in EPS. Is there any obvious pattern to the dividend decisions over this period? Does the firm have

a clear dividend policy?

Practical assignment

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Capital structure and the required return

All but junk: another week, another problem

Americans used to say, ‘What is good for General

Motors, is good for the US economy,’ although the

flip side was ‘When General Motors sneezes, the US

economy catches cold.’

In March 2005, GM shook the financial markets

when it announced a dramatic profits warning. It was

already labouring under the twin burdens of expen-

sive union agreements and legacy healthcare costs,

its home market was now being eroded by Toyota’s

challenge, and higher oil prices were undermining its

Sports Utility Vehicle product line. GM was now

expecting a $2 billion cash outflow from its car and

truck business, leaving its consumer finance division

to plug the gap.

GM had $300 billion of debt outstanding, only a

third of which was secured by assets, and an annual

borrowing programme of $50 billion. The profits

warning edged its existing debt a step nearer the

dreaded ‘fallen angel’ or junk-bond status. A down-

grade to junk would push up GM’s cost of funds by

hundreds of millions of dollars, further worsening its

financial position, and would probably force a restruc-

turing of its operations to release cash. One possibili-

ty was GM having to sell an equity stake in its

finance arm, GMAC, thus allowing it to finance cars

sold by competitors.

A week later, the screw turned further when Arthur

Greenspan, at the Federal Reserve, announced anoth-

er interest rate increase against the background of

rising fears for the stability of the corporate bond

market. After a further week, Moodys Investors

Service announced a cut in GM’s investment rating to

Baa3, the lowest investment grade rating and just

one notch above junk, and GM bonds were trading at

a yield marginally below 10 per cent, generally con-

sidered the junk threshold. On cue, GM also

announced the sale of 60 per cent of its commercial

mortgage business for $1.3 billion to a consortium of

three private equity groups.

Source: Based on Financial Times leader and articles by Jennifer Hughes,

18 March 2005, and articles by James Macintosh and Jennifer Hughes,

5 April 2005.

Learning objectives

This chapter has the following aims:

■ To explain some of the ways of measuring gearing.

■ To enable you to understand more fully the advantages of debt capital.

■ To explain the meaning of, and how to calculate, the WACC.

■ To enable you to understand the likely limits on the use of debt, and the nature of ‘financial

distress’ costs.

■ To help you understand the issues involved in financing foreign operations.

■ To enable you to understand the factors that a finance manager should consider when framing

capital structure policy.

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Chapter 18 Capital structure and the required return 479

18.1 INTRODUCTION

Most financing decisions in practice reduce to a choice between debt and equity. The

finance manager wishing to fund a new project, but reluctant to cut dividends or to

make a rights issue, has to consider the borrowing option. In this chapter, we further

examine the arguments for and against using debt to finance company activities and,

in particular, consider the impact of gearing on the overall rate of return that the com-

pany must achieve.

The main advantages of debt capital centre on its relative cost. Debt capital is usu-

ally cheaper than equity because:

1 The pre-tax rate of interest is invariably lower than the return required by share-

holders. This is due to the legal position of lenders who, have a prior claim on the

distribution of the company’s income and who, in a liquidation, precede ordinary

shareholders in the queue for the settlement of claims. Debt is usually secured on

the firm’s assets, which can be sold to pay off lenders in the event of default, i.e.

failure to pay interest and capital according to the pre-agreed schedule.

2 Debt interest can also be set against profit for tax purposes.

3 The administrative and issuing costs are normally lower, e.g. underwriters are not

always required, although legal fees are usually involved.

The downside is that excessively high borrowing levels can lead to inability to meet

debt interest payments in years of poor trading conditions. Shareholders are thus

exposed to a second tier of risk above the inherent business risk of the trading activi-

ty. As a result, rational shareholders seek additional compensation for this extra expo-

sure. In brief, debt is desirable because it is relatively cheap, but there may be limits to

the prudent use of debt financing because, although posing relatively low risk to the

lender, it can be highly risky for the borrower.

In general, larger, well-established companies are likely to have a greater ability to

borrow because they generate more reliable streams of income, enhancing their abili-

ty to service (make interest payments on) debt capital. Ironically, in practice, we often

find that small developing companies that should not over-rely on debt capital are

forced to do so through sheer inability to raise equity, while larger enterprises often

operate with what appear to be very conservative gearing ratios compared with their

borrowing capacities. Against this, we often encounter cases of over-geared enterpris-

es that thought their borrowing levels were safe until they were caught out by adverse

trading conditions.

So is there a ‘correct’ level of debt? Quite how much companies should borrow is

another puzzle in the theory of business finance. There are cogent arguments for and

against the extensive use of debt capital and academics have developed sophisticated

models, which attempt to expose and analyse the key theoretical relationships.

For many years, it was thought advantageous to borrow so long as the company’s

capacity to service the debt was unquestioned. The result would be higher earnings

per share and higher share value, provided the finance raised was invested sensibly.

The dangers of excessive levels of borrowing would be forcibly articulated by the

stock market by a downrating of the shares of a highly geared company. This prompt-

ed the concept of an optimal capital structure which maximised company value.

However, while the critical gearing ratio is thought to depend on factors such as the

steadiness of the company’s cash flow and the saleability of its assets, it has proved

to be like the Holy Grail, highly desirable, but illusory, and difficult to grasp. Some

academics felt that a firmer theoretical underpinning was needed to facilitate the

analysis of capital structure decisions and to offer more helpful guidelines to practis-

ing managers.

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480 Part V Strategic financial decisions

■ The Modigliani and Miller contribution

When Nobel laureates Modigliani and Miller (MM) published their seminal paper in

1958, finance academics began to examine in depth the relationship between borrow-

ing and company value. MM’s work on the pure theory of capital structure initially

suggested that company value was unaffected by gearing. This conclusion prompted a

furore of critical opposition, leading eventually to a coherent theory of capital structure,

the current version of which looks remarkably like the traditional view.

Because this is a complex topic, we have organised the treatment of the impact of

gearing into two chapters. This chapter is mainly devoted to the ‘traditional’ theory of

capital structure and the issue of how much a company should borrow. In Chapter 19,

we deepen the analysis by discussing the ‘modern’ theory. However, the present chap-

ter gives a strong flavour of the main issues involved.

The two chapters together are designed to examine the following issues:

■ How is gearing measured?

■ Why do companies use debt capital?

■ How is the cost of debt capital measured?

■ What are the dangers of debt capital? How do shareholders react to ‘high’ levels of

gearing?

■ What do the competing theories of capital structure tell us about optimal financing

decisions?

■ How does taxation affect the analysis?

■ What overall return should be achieved by a company using debt?

■ What practical guidelines can we offer to financial managers?

18.2 MEASURES OF GEARING

There are two basic ways to express the indebtedness of a company. Capital gearing

indicates the proportion of debt capital in the firm’s overall capital structure. Income

gearing indicates the extent to which the company’s income is pre-empted by prior

interest charges. Both are indicators of financial gearing.

■ Capital gearing: alternative measures

A widely-used measure of capital gearing is the ratio of all long-term liabilities (LTL),

i.e. ‘amounts falling due after more than one year’, to shareholders’ funds, as shown in

the Balance Sheet. This purports to indicate how easily the firm can repay debts from

selling assets, since shareholder funds measure net assets:

There are several drawbacks to this approach.

First, the market value of equity may be considerably higher than the book value,

reflecting higher asset values, so this measure may seem unduly conservative. However,

the notion of market value needs to be clarified. When a company is forced to sell assets

hurriedly in order to repay debts, it is by no means certain that buyers can be found to

pay ‘acceptable’ prices. The break-up values of assets are often lower than those

expressed in the accounts, which assume that the enterprise is a going concern.

However, using book values does at least have an element of prudence. In addition, the

oscillating nature of market values may emphasise the case for conservatism, even for

companies with ‘safe’ gearing ratios.

A second problem is the lack of an upper limit to the ratio, which hinders inter-

company comparisons. This is easily remedied by expressing long-term liabilities as a

Capital gearing 

LTL

Shareholders' funds

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Chapter 18 Capital structure and the required return 481

fraction of all forms of long-term finance, thus setting the upper limit at 100 per cent.

The gearing measure would become:

A third problem is the treatment of provisions made out of previous years’ income.

Technically, provisions represent expected future liabilities. Companies provide for

contingencies, such as claims under product guarantees, as a matter of prudence.

Provisions thus result from a charge against profits and result in lower stated equity.

However, some provisions turn out to be unduly pessimistic, and may be written back

into profits, and hence equity, in later years. A good example is the provision made for

deferred taxation. This is a highly prudent device to provide for possible tax liability

if the firm were to sell its fixed assets.

Provisions could thus be treated as either equity or debt according to the degree of

certainty of the anticipated contingency. If the liability is ‘highly certain’, it is reason-

able to treat it as debt, but if the provision is the result of ultra-prudence, it may be

treated as equity. For example, deferred taxation is a provision against the possibility

of incurring a Corporation Tax charge if assets are sold above their written-down

value for tax purposes. For most firms, this risk will diminish over time and the pro-

vision could safely be treated as equity. In practice, company accounts carry a mixture

of provisions of varying degrees of certainty, and it is tempting to delete provisions

from liabilities but not to include them in equity when expressing the gearing ratio.

However, the nature of provisions should be questioned when the item appears sub-

stantial. Adjusted to exclude provisions, the capital gearing ratio becomes:

Arguably, any borrowing figure should take into account both long-term and short-

term borrowing. Many companies depend heavily on short-term borrowing, especial-

ly bank overdrafts, and having to repay these debts quickly would place a significant

burden on both the cash flow and liquidity of such companies. For this reason, some

firms present their gearing ratios inclusive of such liabilities. For example, BP’s meas-

ure of gearing focuses on ‘finance debt’, i.e. borrowing via the financial markets from

financial institutions:

There are two objections to this approach. First, since short-term borrowing can be

volatile, the year-end figure in the Balance Sheet is not always a reliable guide to short-

term debts. However, many companies effectively use their bank overdraft as a long-

term form of finance. In other words, the actual bank overdraft figure may include a

hard core element of long-term debt and a fluctuating component, although it is not

easy to separate these two items from external examination of the accounts.

Second, it may be argued that any holdings of cash and highly liquid, marketable

securities (‘near cash’ assets) should be offset against short-term debt, to yield a meas-

ure of ‘net debt’. For example, BP expresses it thus:

In fact, financial commentators increasingly use this measure of gearing, which is

shown in the annual reports of many companies, expressed either in absolute terms or

in relation to equity.

Net debt 

Finance debt  1cash and liquid resources2

Equity

Finance debt

Finance debt  Shareholders’ funds

Long-term borrowings 1LTB2

Shareholders’ funds

LTB

LTB  Shareholders’ funds

LTL

LTL  Shareholders' funds

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482 Part V Strategic financial decisions

Self-assessment activity 18.1

Determine the following gearing ratios using the information supplied.

(i) debt-to-equity ratio

(ii) debt-to-debt plus equity ratio

(iii) net debt

■ Equity = £100 m

■ Long-term debt = £50 m

■ Short-term debt = £20 m

■ Cash = £10 m

(Answer in Appendix A at the back of the book)

times interest earned

The ratio of Profit before Interest

and Tax (Operating Profit) to

annual interest charges, i.e. how

many times over the firm could

meet its interest bill

All the above measures are commonly used in the UK. In some other countries, a

more direct measure of gearing (or leverage) is used. The UK ratios tend to focus on

the relationship between debt and equity capital, which is reasonable since equity rep-

resents net assets. However, when necessary, debts are repaid by liquidating the assets

to which the capital relates. Rather than this roundabout focus on capital, a direct

focus on assets available to repay debts may give a clearer picture of ability to repay.

For this purpose, many US commentators use an ‘American gearing’ ratio, such as:

■ Interest cover and income gearing

All the above measures purport to express the ability of the company to repay loans out

of capital. However, they are only really helpful if book values and market values of the

assets that would have to be sold to repay creditors approximate to each other. Yet, as

we have noted, the market value of assets is volatile and difficult to assess. Moreover,

capital gearing only indicates the security of creditors’ funds in a crisis and may be an

unduly cautious way of viewing debt exposure.

The trigger for a debt crisis is usually inability to make interest payments, and the

‘front line’ is therefore the size and reliability of the company’s income in relation to

its interest commitments. Although, in reality, cash flow is the more important con-

sideration, the ability of a company to meet its interest obligations is usually measured

by the ratio of profit before tax and interest, to interest charges, known as interest

cover, or ‘times interest earned’:

Strictly, the numerator should include any interest received and the denominator

should become interest outgoings. This adjustment is rarely made in practice; net

interest charges are commonly used as the denominator (as we do for BAA plc below).

The inverse of interest cover is called income gearing, indicating the proportion of

pre-tax earnings committed to prior interest charges. If a company earns profit before

interest and tax of £20 million, and incurs interest charges of £2 million, then its inter-

est cover is and 10 per cent of profit before interest and tax

is pre-empted by interest charges.

Arguably, cash flow-to-interest is a better guide to financial security, given that

profits are expressed on the accruals basis, i.e., profit is recognised even though cash

may not have been received yet for sales. Hence, the formula below is sometimes used:

Cash flow cover 

Operating cash flow

Net interest payable

1£20 m>£2 m2  10 times,

Interest cover 

Profit before interest and tax

Interest charges

Total Liabilities 1including short-term liabilities2

Total Assets

income gearing

The proportion profit before

interest and tax (PBIT) absorbed

by interest charges

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Chapter 18 Capital structure and the required return 483

Self-assessment activity 18.2

Distinguish between capital gearing and income gearing. How is each measured?

(Answer in Appendix A at the back of the book)

Table 18.1

Financial data for

BAA plc

£m*

Shareholders’ funds 5,018

Cash and short-term investments 890

Long-term borrowing (LTD)* 3,598

(including convertible debt of 838)

Short-term borrowing 109

Group profit before interest and tax 536

Net interest payable by the group 89

Total assets 10,469

Total liabilities* 5,332

Operating cash flow 853

*BAA’s provisions of £790 m are treated as part of

liabilities, but not as part of long-term borrowing.

■ Example: BAA plc’s borrowings

The figures in Table 18.1 are taken from the Annual Report for BAA plc, the UK airports

operator (www.baa.com) for the year ended 31 March 2004. With these data, we can cal-

culate various gearing indicators:

Total liabilities

Total assets



£5,332 m

£10,469 m

 51%

Operating cash flow

Net interest payable



£853 m

£89 m

 9.6 times

Income gearing



 17%

Interest cover



£536 m

£89 m

 6 times

Net debt

 1£3,598 m  £109 m  £890 m2  £2,817 m 156% of equity2

All borrowing

Shareholder’s funds



£3,598 m  £109 m

£5,018 m



£3,707 m

£5,018 m

 74%

LT borrowing

All LT funds



£3,598 m

£3,598 m  £5,018 m



£3,598 m

£8,616 m

 42%

LT borrowing

Shareholder’s funds



£3,598 m

£5,018 m

 72%

Self-assessment activity 18.3

Obtain the accounts of a firm of your choice and conduct a similar exercise to the BAA plc

calculations.

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484 Part V Strategic financial decisions

contribution

Revenues (turnover) less vari-

able costs, i.e contribution to

meeting fixed costs

18.3 OPERATING AND FINANCIAL GEARING

A major reason for using debt is to enhance or ‘gear up’ shareholder earnings. When a

company is financially geared, variations in the level of earnings due to changes in

trading conditions generate a more than proportional variation in earnings attributable

to shareholders if the interest charges are fixed. This effect is very similar to that exert-

ed by operating gearing. We will now examine these two gearing phenomena and

illustrate them numerically.

Most businesses operate with a combination of variable and fixed factors of produc-

tion, giving rise to variable and fixed costs respectively. The particular combination is

largely dictated by the nature of the activity and the technology involved. Operating

gearing refers to the relative importance of fixed costs in the firm’s cost structure, costs

that have to be met regardless of output and revenue levels. In general, the higher the

proportion of fixed to variable costs, the higher the firm’s break-even volume of output.

As sales rise above the break-even point, there will be a more than proportional upward

effect on profits before interest and tax, and on shareholder earnings.

Firms with high operating gearing, mainly capital-intensive ones, are especially

prone to fluctuations in the business cycle. In the downswing, as their sales volumes

decrease, their earnings before interest and tax decline by a more than proportional

amount; and conversely in the upswing. Hence, such companies are regarded as rela-

tively risky. If such companies borrow, they add a second tier of fixed charges in the form

of interest payments, thus increasing overall risk – the higher the interest charges, the

greater the risk of inability to pay. Consequently, the risk premium required by investors

in such companies is relatively high. It follows that companies that exhibit high operat-

ing gearing should use debt finance sparingly.

■ Operating and financial gearing: Burley plc

Burley plc produces and sells briefcases. It has issued 4 million £1 shares and has

loan finance. Its gearing ratio, measured by the ratio of debt to equity at book

values, is one-to-one (i.e. ). Last year, Burley sold 60,000 units to large

retailers at £30 per unit.

Its Profit and Loss Account is:

£000 £000

Sales 1,800

Less: Variable costs (VC) (720)

Fixed operating costs (FC) (480) (1,200)

Profit before interest and tax (PBIT) 600

Less: Interest payable @ 10% (200)

Profit before taxation (PBT) 400

Less: Corporation tax @ 30% (120)

Profit after tax (PAT) 280

The earnings per share (EPS) are:

Notice that the P and L hides the distinction between gross and net profit. The gross

profit is the sales less variable costs, i.e. (£1,800,000 – £720,000) = £1,080,000, also called

contribution because the fixed costs are paid from this amount. Any surplus over FC

is the net or operating profit (PBIT). Operating profit is thus £600,000.

Profit after tax

No of ordinary shares



£280,000

4 m

 7.0p

14 m  50p2>£2 m

£2 million

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