SOURCES OF FINANCE

Discuss the factors to be considered by company in choosing to raise funds via right issues. (6 marks)
–Dec 2014
A rights issue raises equity finance by offering new shares to existing shareholders in proportion to the number
of shares they currently hold. Existing shareholders have the right to be offered new shares before they are
offered to new investors. There are a number of factors which Tinep Co should consider.

Issue price
Rights issues shares are offered at a discount to the market value. It can be difficult to judge what the amount
of the discount should be.

Relative cost
Rights issues are cheaper than other methods of raising finance by issuing new equity, such as an initial public
offer (IPO) or a placing, due to the lower transactions costs associated with rights issues.

Ownership and control

As the new shares are being offered to existing shareholders, there is no dilution of ownership and control,
providing shareholders take up their rights.
Gearing and financial risk
Increasing the weighting of equity finance in the capital structure of Tinep Co can decrease its gearing and its
financial risk. The shareholders of the company may see this as a positive move, depending on their individual
risk preference positions.
The concept of Riba (interest) and how returns are made by Islamic financial instruments. (5 marks)-
Dec 2013

Interest (riba) is the predetermined amount received by a provider of finance, over and above the principal
amount of finance provided. Riba is absolutely forbidden in Islamic finance. Riba can be seen as unfair from the
perspective of the borrower, the lender and the economy.

Islamic financial instruments require that an active role be played by the provider of funds, so that the risks and
rewards of ownership are shared. In a Mudaraba contract, for example, profits are shared between the partners
in the proportions agreed in the contract, while losses are borne by the provider of finance. In a Musharaka
contract, profits are shared between the partners in the proportions agreed in the contract, while losses are
shared between the partners according to their capital contributions. With Sukuk, certificates are issued which
are linked to an underlying tangible asset and which also transfer the risk and rewards of ownership. The
underlying asset is managed on behalf of the Sukuk holders. In a Murabaha contract, payment by the buyer is
made on a deferred or instalment basis. Returns are made by the supplier as a mark-up is paid by the buyer in
exchange for the right to pay after the delivery date. In an Ijara contract, which is equivalent to a lease
agreement, returns are made through the payment of fixed or variable lease rental payments.
Evaluate suitable method of raising the $200 million requied by Nugfer Co, supporting your evaluation
with analysis and critical discussion. (15 marks)- Dec 2010

Recent financial performance (calculation required)

One positive feature indicated by this analysis is the growth in revenue, which grew by 23% in 2009 and by 21%
in 2010. Slightly less positive is the growth in operating profit, which was 16% in 2009 and 13% in 2010. Both
years were significantly better in revenue growth and operating profit growth than 2008. One query here is why
growth in operating profit is so much lower than growth in revenue. Better control of operating and other costs
might improve operating profit substantially and decrease the financial risk of Nugfer Co.
The growing financial risk of the company is a clear cause for concern. The interest coverage ratio has declined
each year in the period under review and has reached a dangerous level in 2010. The increase in operating
profit each year has clearly been less than the increase in finance charges, which have tripled over the period
under review. The reason for the large increase in debt is not known, but the high level of financial risk must be
considered in selecting an appropriate source of finance to provide the $200m in cash that is needed.

Current financial position

The current financial position of Nugfer Co will be considered by potential providers of finance in their
assessment of the financial risk of the company. Analysis of the current financial position of Nugfer Co shows
the following:
Debt/equity ratio = long-term debt/total equity = 100 x (100/221) = 45%
Debt equity/ratio including short-term borrowings = 100 x ((100 + 160)/221) = 118% The debt/equity ratio
based on long-term debt is not particularly high. However, the interest coverage ratio indicated a high level of
financial risk and it is clear from the financial position statement that the short-term borrowings of $160m are
greater than the long-term borrowings of $100m. In fact, short-term borrowings account for 62% of the debt
burden of Nugfer Co.

If we include the short-term borrowings, the debt/equity ratio increases to 118%, which is certainly high enough
to be a cause for concern. The short-term borrowings are also at a higher interest rate (8%) than the long-term
borrowings (6%) and as a result, interest on short-term borrowings account for 68% of the finance charges in
the income statement. It should also be noted that the long-term borrowings are bonds that are repayable in
2012. Nugfer Co needs therefore to plan for the redemption and refinancing of $100m of debt in two years’ time,
a factor that cannot be ignored when selecting a suitable source of finance to provide the $200m of cash needed.

Recommendation of suitable financing method

There are strong indications that it would be unwise for Nugfer Co to raise the $200m of cash required by means
of debt finance, for example the low interest coverage ratio and the high level of gearing.
(show calculation based on question)
If convertible debt were used, the increase in gearing and the decrease in interest coverage would continue
only until conversion occurred, assuming that the company’s share price increased sufficiently for conversion
to be attractive to bondholders. Once conversion occurred, the debt capacity of the company would increase
due both to the liquidation of the convertible debt and to the issuing of new ordinary shares to bond holders. In
the period until conversion, however, the financial risk of the company as measured by gearing and interest
coverage would remain at a very high level.
If Nugfer Co were able to use equity finance, the interest coverage ratio would increase to 4·5 times and the
debt/equity ratio would fall to 100 x (260/(221 + 200)) = 62%. Although the debt/equity ratio is still on the high
side, this would fall if some of the short-term borrowings were able to be paid off, although the recent financial
performance of Nugfer Co indicates that this may not be easy to do. The problem of redeeming the current long-
term bonds in two years also remains to be solved.
However, since the company has not paid any dividend for at least four years, it is unlikely that current
shareholders would be receptive to a rights issue, unless they were persuaded that dividends would be
forthcoming in the near future. Acquisition of the competitor may be the only way of generating the cash flows
needed to support dividend payments. A similar negative view could be taken by new shareholders if Nugfer Co
were to seek to raise equity finance via a placing or a public issue.
Sale and leaseback of non-current assets could be considered, although the nature and quality of the non-
current assets is not known. The financial position statement indicates that Nugfer Co has $300m of non-current
assets, $100m of long-term borrowings and $160m of short-term borrowings. Since its borrowings are likely to
be secured on some of the existing non-current assets, there appears to be limited scope for sale and
leaseback.
Venture capital could also be considered, but it is unlikely that such finance would be available for an
acquisition and no business case has been provided for the proposed acquisition.
Factors to be considered in choosing between traded bonds, new equity issued via a placing and
venture capital as sources of finance. ( 9 marks) –June 2013
Traded bonds are debt securities issued onto the capital market in exchange for cash received by the issuing
company. The cash raised must be repaid on the redemption date, usually between five and fifteen years after
issue. Bonds are usually secured on non-current assets of the issuing company, which reduces the risk to the
lender. In the event of default on interest payments by the borrower, the bond holders can appoint a receiver to
sell the assets and recover their investment. Interest paid on the bonds is tax-deductible, which reduces the
cost of debt to the issuing company. Provided the borrower continues to pay the interest, however, bond finance
is a low risk financing choice by the issuer.

There are number of differences between bond finance and a new equity issue via a placing that will influence
the choice between them. Equity finance does not need to be redeemed, since ordinary shares are truly
permanent finance. While bond interest is usually fixed, the return to shareholders in the form of dividends
depends on the dividend decision made by the directors of a company, and so these returns can increase,
decrease or be passed. Furthermore, since dividends are a distribution of after-tax profit, they are not tax-
deductible like interest payments, and so equity finance is not tax-efficient like debt finance.

Venture capital is found in specific financing situations, i.e. where risk finance is needed, for example, in a
management buyout. Both equity and debt finance can be part of a venture capital financing package, but the
return expected on venture capital is very high because of the level of risk faced by the investor.
Evaluate the proposal to use the bond issue to finance reduction in overdraft and discuss alternative
sources of finance that could be considered. ( 12 marks ) –June 2010

Interest coverage ratio

The current interest coverage ratio of 4·4 times is just over half of the sector average value of 8 times, although
before the fall in profit it was 22 times. As a result of the bond issue, the interest coverage ratio would fall to 2·6
times, which is a dangerously low level of cover.

Gearing
Whether the bond issue has an effect on gearing depends on whether the gearing calculation includes the
overdraft. If the overdraft is excluded, gearing measured by the debt/equity ratio on a market value basis
increases from zero to 9·8%. If the overdraft is included, there is no change in gearing, since the bond issue
replaces an equal amount of the overdraft. Given the sector average debt/equity of 10%, there does not appear
to be any concerns about gearing as a result of the bond issue.

Security
It is very likely that the bond issue would need to be secured against the tangible noncurrent assets of YGV Co,
especially in light of the recent decline in profitability. However, the bond issue is for $4 million while the tangible
non-current assets of YGV Co have a value of only $3 million. It is not known whether the intangible non-current
assets can be used as security, since their nature has not been disclosed.

Advisability of using the bond issue to reduce the overdraft

Considering the significant decrease in the interest coverage ratio as a result of the bond issue and the lack of
tangible non-current assets to offer as security, it appears that the proposed bond issue cannot be
recommended and would probably be unsuccessful. YGV Co should therefore consider alternative sources of
finance in order to reduce the overdraft.

Alternative sources of finance

If longer-term viability is assured, the need for further finance could be reduced by taking measures to reduce
costs and increase income, for example through improved working capital management.
If the company pays dividends, consideration could be given to reducing or passing the dividend in order to
increase the flow of retained earnings in the company.
Given the problems with interest coverage and security, and the lack of availability of further overdraft finance,
equity finance is the first alternative choice that could be considered. While no information has been provided
on recent share price changes or on the dividend policy of YGV Co, existing shareholders could be consulted
about a rights issue
Other finance sources that could be considered include convertible bonds or bonds with warrants attached.
Improved working capital management could also decrease the amount of finance required.
Discuss the attractions to a company of convertible debt compared to a bank loan of a similar maturity
as a source of finance. ( 4 marks ) – Dec 2012

Convertible debt is debt that, at the option of the holder, can be converted into ordinary shares. If not converted,
it will be redeemed like ordinary or straight debt on maturity. Convertible debt has a number of attractions
compared with a bank loan of similar maturity, as follows:

Self-liquidating
Provided that the conversion terms are pitched correctly and expected share price growth occurs, conversion
will be an attractive choice for bond holders as it offers more wealth than redemption. This occurs when the
conversion value is greater than the redemption value (if conversion and redemption are on the same date), or
when the conversion value is greater than the floor value on the conversion date (if conversion is at an earlier
date than the redemption date). If the debt is converted into ordinary shares, it will not need to be redeemed,
i.e. self-liquidation has occurred. A bank loan of a similar maturity will need to have all of the capital repaid.

Lower interest rate

The interest rate on convertible debt will be lower than the interest rate on ordinary debt such as a bank loan
because of the value of the option to convert. The returns on fixedinterest debt will not increase with corporate
profitability, so debt providers will have a limited share of the benefits from the investment of the funds they
have provided. When debt has been converted, however, bond holders become shareholders and will potentially
have unlimited returns, or at least returns that are higher than the returns on debt finance.

Incrase in debt capacity on conversion

Gearing will increase with a bank loan for the time that the debt is outstanding, and gearing will then return to
its previous level when the bank loan has been paid off. Gearing also increases when convertible debt is issued,
but if conversion occurs, the gearing will fall not only because the debt has been removed, but will fall even
further because equity has replaced the debt. The capacity of the company to service debt (debt capacity) will
therefore be enhanced by conversion, compared to redemption of a bank loan of a similar maturity.

More attractive than ordinary debt

It may be possible to issue convertible debt even when ordinary debt such as a bank loan is not attractive to
lenders, since the option to convert offers a little extra that ordinary debt does not. This is the option to convert
in the future, which can be attractive to optimists, even when the short- and medium-term economic outlook
may be poor.
Analyse and discuss the relative merits of a right issue, a placing and an issue of bonds as ways of
raising the finance of expansion. ( 7 marks ) – June 2009
The current debt/equity ratio of JJG Co is 42% (20/47·5). Although this is less than the sector average value of
50%, it is more useful from a financial risk perspective to look at the extent to which interest payments are
covered by profits.

The interest on the bond issue is $1·6 million (8% of $20m), giving an interest coverage ratio of 6·1 times. If
JJG Co has overdraft finance, the interest coverage ratio will be lower than this, but there is insufficient
information to determine if an overdraft exists. The interest coverage ratio is not only below the sector average,
it is also low enough to be a cause for concern. While the ratio shows an upward trend over the period under
consideration, it still indicates that an issue of further debt would be unwise.

A placing, or any issue of new shares such as a rights issue or a public offer, would decrease gearing. If the
expansion of business results in an increase in profit before interest and tax, the interest coverage ratio will
increase and financial risk will fall. Given the current financial position of JJG Co, a decrease in financial risk is
certainly preferable to an increase.

A placing will dilute ownership and control, providing the new equity issue is taken up by new institutional
shareholders, while a rights issue will not dilute ownership and control, providing existing shareholders take up
their rights. A bond issue does not have ownership and control implications, although restrictive or negative
covenants in bond issue documents can limit the actions of a company and its managers.

All three financing choices are long-term sources of finance and so are appropriate for a long-term investment
such as the proposed expansion of existing business.

Equity issues such as a placing and a rights issue do not require security. No information is provided on the
non-current assets of JJG Co, but it is likely that the existing bond issue is secured. If a new bond issue was
being considered, JJG Co would need to consider whether it had sufficient non-current assets to offer as
security, although it is likely that new noncurrent assets would be bought as part of the business expansion.
Sources and characteristics of long-term debt finance. ( 8 marks ) – June 2014

Long-term bank loan

Long-term bank loan could be obtain either from a single bank or from a syndicate of banks. Interest payments
on the bank loan could be annual, twice yearly or quarterly, and at either a fixed rate or a floating rate of interests.
It is likely that the bank loan would be secured against particular non-current assets of company, so that the
bank could recover its loan if the company defaults on interest payments.

Convertible bonds
Convertible bonds are bonds which at the option of the holder, can be converted into a specified quantity of
ordinary shares on a specified future date. Convertible bonds can pay interest annually or twice annually, at a
fixed or a floating rate of interest The future option to convert into equity has value to investors and as a
consequence, the interest rate on convertible debt is lower than that on ordinary bonds. If conversion does not
take place, however, redemption of the bonds or loan notes will be required.

Bonds or loan notes

Bonds or loan notes may be redeemable or irredeemable. Fixed rate or floating rate interest is paid on the
bonds, either annually or half yearly, with the interest being based on nominal (par) value of the bonds rather
than on their market value. Bonds also are mainly traded on the capital markets and can be issued in a variety
of foreign currencies. The return required on debt finance (the cost of debt) is lower than return required on
equity (cost of capital) and so company could reduce its average cost of capital by issuing debt finance, as it is
currently financed by equity alone.

Deep discount bonds

The return to a bond holder consists of regular interest payments (income) and repayment of the principle
amount on redemption (capital). Investors may accept lower interest payments in exchange for an increase in
capital return. This can be achieved if the bond is issued at a deep discount to nominal value, but redeemed at
nominal value. This kind of financial security is called a deep discount bond and may be suitable for companies
which do not expect an immediate return on invested capital.

Zero coupon bonds

A zero coupon bond goes a step further from deep discount bond and pays no interest (coupon) at all, so that
the return to the investor is entirely in the form of capital appreciation. Bonds like these are useful for companies
which expect cash flows from invested capital to occur mainly later in the life of an investment project, rather
than more evenly throughout its life.
The advantages of using convertible loan notes as a source of long-term finance could be discussed. (
6 marks ) – Sept/Dec 2017

Conversion rather than redemption

If the holders of convertible loan notes judge that conversion into ordinary shares will increase their wealth,
conversion of the loan notes will occur on the conversion date and Tufa Co will not need to find the cash needed
to redeem the loan notes. This is sometimes referred to as ‘self-liquidation’.

Lower interest rate

The option to convert into ordinary shares has value for investors as ordinary shares normally offer a higher
return than debt. Investors in convertible loan notes will therefore accept a lower interest rate than on ordinary
loan notes, decreasing the finance costs for the issuing company.

Attractive to investors
Tufa Co may be able to issue convertible loan notes to raise long-term finance even when investors might not
be attracted by an issue of ordinary loan notes, because of the attraction of the option to convert into ordinary
shares in the future.
Reasons why a company may choose to finance a new investment by an issue of debt finance. ( 7 marks
) – Dec 2008

Pecking order theory suggests that companies have a preferred order in which they seek to raise finance,
beginning with retained earnings. The advantages of using retained earnings are that issue costs are avoided
by using them, the decision to use them can be made without reference to a third party, and using them does
not bring additional obligations to consider the needs of finance providers.

Once available retained earnings have been allocated to appropriate uses within a company, its next preference
will be for debt. One reason for choosing to finance a new investment by an issue of debt finance, therefore, is
that insufficient retained earnings are available and the investing company prefers issuing debt finance to
issuing equity finance.

Debt finance may also be preferred when a company has not yet reached its optimal capital structure and it is
mainly financed by equity, which is expensive compared to debt. Issuing debt here will lead to a reduction in the
WACC and hence an increase in the market value of the company. One reason why debt is cheaper than equity
is that debt is higher in the creditor hierarchy than equity, since ordinary shareholders are paid out last in the
event of liquidation.

Debt is even cheaper if it is secured on assets of the company. The cost of debt is reduced even further by the
tax efficiency of debt, since interest payments are an allowable deduction in arriving at taxable profit.

Debt finance may be preferred where the maturity of the debt can be matched to the expected life of the
investment project. Equity finance is permanent finance and so may be preferred for investment projects with
long lives.
Explain the difference between Islamic finance and other conventional finance. (4 marks)- March/ June
2016

In Islamic finance, risk and rewards in term of economic benefits are shared between the provider of finance
and the user of finance. Economic benefits includes employment and social welfare. While conventional finance
which is not based on the Islamic principles, does not require the sharing of risk and rewards between the
provider and the user of finance.

Riba (interest) is absolutely forbidden in Islamic finance and is seen immoral. But under the conventional finance
it is seen as the main form of return to the debt holder. In the conventional financial system, interest is the
reward for depositing fund and the cost for borrowing fund.

Murabaha and Sukuk are part of Islamic finance which can be compared to the conventional debt. However,
Murabaha and Sukuk must have a direct link with underlying tangible asset. Islamic finance can only support
business activities which are acceptable under Sharia Law.
Islamic Finance sources which could consider as alternative to a right issue or loan note issue. (6 marks
) – March / June 2018

Mudaraba
A mudaraba contract is between a capital partner (rab al mal) and an expertise partner (mudarab) for the
undertaking of business operations. The business operations must be compliant with Sharia’a law and are run
on a day-to-day basis by the mudarab. The rab al mal has no role in relation to the day-to-day operations of the
business.Profits from the business operations are shared between the partners in a proportion agreed in the
contract. Losses are borne by the rab al mal alone, as provider of the finance, up to the limit of the capital
provided.

Sukuk
Conventional loan notes are not allowed under Sharia’a law because there must be a link to an underlying
tangible asset and because interest (riba) is forbidden. Sukuk are linked to an underlying tangible asset,
ownership of which is passed to the sukuk holders, and do not pay interest.Since the sukuk holders take on the
risks and rewards of ownership, sukuk also has an equity aspect. As owners, sukuk holders will bear any losses
or risk from the underlying asset. In terms of rewards, sukuk holders have a right to receive the income
generated by the underlying asset and have a right to dismiss the manager of the underlying asset, if this is felt
to be necessary.

Ijara
In this form of Islamic finance, the lessee uses a tangible asset in exchange for a regular rental payment to the
lessor, who retains ownership throughout the period of the lease contract. The contract may allow for ownership
to be transferred from thelessor to the lessee at the end of the lease period. Major maintenance and insurance
are the responsibility of the lessor, while minor or day-to-day maintenance is the responsibility of the lessee.
The lessor may choose to appoint the lessee as their agent to undertake all maintenance, both major and minor.
Explain the nature of a mudaraba contract and discuss briefly how this form of Islamic finance could
be used to finance the planned business expansion .(5 marks)June 2012

One central principle of Islamic finance is that making money out of money is not acceptable, hence interest is
prohibited.
A mudaraba contract, in Islamic finance, is a partnership between one party that brings finance or capital into
the contract and another party that brings business expertise and personal effort into the contract. The first party
is called the owner of capital, while the second party is called the agent, who runs or manages the business.

The mudaraba contract specifies how profit from the business is shared proportionately between the two parties.
Any loss, however, is borne by the owner of capital, and not by the agent managing the business. It can therefore
be seen that three key characteristics of a mudaraba contract are that no interest is paid, that profits are shared,
and that losses are not shared.

If company were decide to seek Islamic finance for the planned business expansion and if the company were
to enter into a mudaraba contract, the company would therefore be entering into a partnership as an agent,
managing the business and sharing profits with the Islamic bank that provided the finance and which was acting
as the owner of capital. The Islamic bank would not interfere in the management of the business and this is
what would be expected if company were to finance the business expansion using debt such as a bank loan.
However, while interest on debt is likely to be at a fixed rate, the mudaraba contract would require a sharing of
profit in the agreed proportions.
Discuss the attraction of operating leasing as a source of finance. ( 6 marks ) – Dec 2007

Operating leasing is a source of finance of choice for many companies for many reasons. For example, an
operating lease is seen as protection against obsolescence, since it can be cancelled at short notice without
financial penalty. The lessor will replace the leased asset with a more up-to-date model in exchange for
continuing leasing business. This flexibility is seen as valuable in the current era of rapid technological change,
and can also extend to contract terms and servicing cover.

There is no need to arrange a loan in order to acquire an asset and so the commitment to interest payments
can be avoided, existing assets need not be tied up as security and negative effects on return on capital
employed can be avoided. Since legal title does not pass from lessor to lessee, the leased asset can be
recovered by the lessor in the event of default on lease rentals. Operating leasing can therefore be attractive to
small companies or to companies who may find it difficult to raise debt.

Operating leasing can also be cheaper than borrowing to buy such as by taking advantage of bulk buying, or
by having access to lower cost finance especially for larger company. The lessor may also be able use tax
benefits more effectively than the lessee resulting in lower lease rentals, making it a more attractive proposition
that borrowing.
Discuss the factors that influence the market value of traded bonds. ( 5 marks ) – June 2011

Amount of interest payment

The market value of a traded bond will increase as the interest paid on the bond increases, since the reward
offered for owning the bond becomes more attractive.

Frequency of interest payments

If interest payments are more frequent, say every six months rather than every year, then the present value of
the interest payments increases and hence so does the market value.

Redemption value
If a higher value than par is offered on redemption, as is the case with the proposed bond issue of AQR Co, the
reward offered for owning the bond increases and hence so does the market value.

Period to redemption
The market value of traded bonds is affected by the period to redemption, either because the capital payment
becomes more distant in time or because the number of interest payments increases.

Cost of debt
The present value of future interest payments and the future redemption value are heavily influenced by the
cost of debt, i.e. the rate of return required by bond investors. This rate of return is influenced by the
perceived risk of a company, for example as evidenced by its credit rating. As the cost of debt increases,
the market value of traded bonds decreases, and vice versa.

Convertibility
If traded bonds are convertible into ordinary shares, the market price will be influenced by the likelihood of the
future conversion and the expected conversion value, which is dependent on the current share price, the future
share price growth rate and the conversion ratio.
Discuss the factors that THP Co should consider, in its circumstances, in choosing between equity
finance and debt finance as sources of finance from which to make the cash offer for CRX Co. ( 8 marks
) – June 2008

Current gearing level: 68.5% ($5000/$7300 x 100)

It is important for a company to keep its gearing level at the lowest possible as it may show how risky the
company is. Currently, THP Co’s gearing is at 68.5% and will decrease to 45% if equity finance is taken and will
increase to 121% if debt is taken. Even so, THP Co would acquire debt finance from CRX Co after buying the
company. THP Co would have to reconsider on which finance would benefit in terms of corporate risk and
stakeholder risk.

Target Capital Structure

THP Co would have to reconsider in the changing of the company’s capital structure after acquiring CRX Co.
As a whole, a company’s main objective is to maximise shareholder’s wealth and minimise weighted average
cost of capital. In this case can be achieved as debt finance is relatively cheaper as compared to equity finance.

Availability of Security
When choosing between debt and equity finance, a company will have to ensure that they have sufficient
security. Debts will usually be secured on assets on fixed charge or floating charge. In order to acquire CRX
Co, THP Co would need to secure using fixed charge on specific assets however information on this is not
provided.

Economic expectations
If THP Co increase profitability in future, it will be more prepared to take on fixed interest debt commitments
than if the company believe difficult trading conditions in near future.

Control Issues
The issuance of right issue will not dilute the control of existing shareholders unless existing shareholders refuse
to take up the offer, and the company will issue shares to public.
Discuss the factor to be considered in formulating the dividend policy of a stockexchange listed
company (10 marks)-Dec 2010

Profitability
Companies need to remain profitable and dividends are a distribution of after-tax profit. A company cannot
consistently pay dividends higher than its profit after tax. A healthy level of retained earnings is needed to finance
the continuing business needs of the company.

Liquidity
Although a dividend is a distribution of profit, it is a cash payment by the company to its shareholders. A company
must therefore ensure it has sufficient cash to pay a proposed dividend and that paying a dividend will not
compromise day-to-day cash financing needs.

The need for finance

There is a close relationship between investment, financing and dividend decisions, and the dividend decision
must consider the investment plans and financing needs of the company. A large investment programme, for
example, will require a large amount of finance, and the need for external finance can be reduced if dividend
increases are kept in check. Similarly, the decision to increase dividends may reduce retained earnings to the
extent where external finance is needed in order to meet investment needs.

The level of financial risk

If financial risk is high, for example due to a high level of gearing arising from a substantial level of debt finance,
maintaining a low level of dividend payments can result in a high level of retained earnings, which will reduce
gearing by increasing the level of reserves. The cash flow from a higher level of retained earnings can also be
used to decrease the amount of debt being carried by a company.

The signalling effect of dividends

In a semi-strong form efficient market, information available to directors is more substantial than that available
to shareholders, so that information asymmetry exists. This is one of the causes of the agency problem. If
dividend decisions convey new information to the market, they can have a signalling effect concerning the
current position of the company and its future prospects. The signalling effect also depends on the dividend
expectations in the market. A company should therefore consider the likely effect on share prices of the
announcement of a proposed dividend.
Discuss whether a change in dividend policy will affect the share price of DD Co. ( 7 marks ) –Dec 2009

Miller and Modigliani showed that, in a perfect capital market, the value of a company depended on its
investment decision alone, and not on its dividend or financing decisions. A change in dividend policy by DD Co
would not affect its share price or its market capitalisation. They showed that the value of a company was
maximised if it invested in all projects with a positive net present value (its optimal investment schedule). The
company could pay any level of dividend and if it had insufficient finance, make up the shortfall by issuing new
equity. Since investors had perfect information, they were indifferent between dividends and capital gains.
Shareholders who were unhappy with the level of dividend declared by a company could gain a ‘home-made
dividend’ by selling some of their shares. This was possible since there are no transaction costs in a perfect
capital market.

Against this view are several arguments for a link between dividend policy and share prices. For example, it has
been argued that investors prefer certain dividends now rather than uncertain capital gains in the future (the
‘bird-in-the-hand’ argument). It has also been argued that real-world capital markets are not perfect, but semi-
strong form efficient. Since perfect information is therefore not available, it is possible for information asymmetry
to exist between shareholders and the managers of a company. Dividend announcements may give new
information to shareholders and as a result, in a semi-strong form efficient market, share prices may change.
The size and direction of the share price change will depend on the difference between the dividend
announcement and the expectations of shareholders. This is referred to as the ‘signalling properties of
dividends’.

It has been found that shareholders are attracted to particular companies as a result of being satisfied by their
dividend policies. This is referred to as the ‘clientele effect’. A company with an established dividend policy is
therefore likely to have an established dividend clientele. The existence of this dividend clientele implies that
the share price may change if there is a change in the dividend policy of the company, as shareholders sell their
shares in order to reinvest in another company with a more satisfactory dividend policy. In a perfect capital
market, the existence of dividend clienteles is irrelevant, since substituting one company for another will not
incur any transaction costs. Since real-world capital markets are not perfect, however, the existence of dividend
clienteles suggests that if DD Co changes its dividend policy, its share price could be affected.
Explain the nature of a scrip (share) dividend and discuss the advantages and disadvantages to a
company of using scrip dividend to reward shareholders. ( 6 marks ) – June 2011

A scrip (or share) dividend is an offer of shares in a company as an alternative to a cash dividend. It is offered
pro rata to existing shareholdings.

From a company point of view, it has the advantage that, if taken up by shareholders, it will conserve cash, i.e.
it will reduce the cash outflow from a company compared to a cash dividend. This is useful when liquidity is a
problem, or when cash is needed to meet capital investment or other financing needs. Another advantage is
that a scrip dividend will lead to a decrease in gearing, whether on a book value or a market value basis,
because of the increase in issued shares. This decrease in gearing will increase debt capacity.

A disadvantage of a scrip dividend is that in future years, because the number of shares in issue has increased,
the total cash dividend will increase, assuming the dividend per share is maintained or increased.