A dark pool network allows shares to be traded anonymously, away from public scrutiny. No information on the trade order is revealed prior to it taking place. The price and size of the order are only revealed once the trade has taken place. Two main reasons are given for dark pool networks: first they prevent the risk of other traders moving the share price up or down; and second they often result in reduced costs because trades normally take place at the mid-price between the bid and offer; and because broker-dealers try to use their own private pools, thereby saving exchange fees.

Margaret Co’s holding in Peter Co is 27 million shares out of a total of 600 million shares, or 4.5%. If Margaret Co sold such a large holding all at once, the price of Peter Co shares may fall temporarily and significantly, and Margaret Co may not receive the value based on the current price. By utilising a dark pool network, Margaret Co may be able to keep the price of the share largely intact, and possibly save transaction costs.

Although the criticism against dark pool systems is that they prevent market efficiency by not revealing bid-offer prices before the trade, proponents argue that in fact market efficiency is maintained because a large sale of shares will not move the price down artificially and temporarily.

Ratio calculations

Focus on investor and profitability ratios

(Note. Maximum 7 marks if only ratio calculations provided)

Other calculations

Peter Co sales revenue annual growth rate average between 20X3 and 20X5 =
(1,185/1,342) ^1/2 – 1 = –6.0%

Between 20X4 and 20X5 = (1,185 – 1,335)/1,335 = –11.2%.

Peter Co average financing cost

20X3: 23/ (365 + 88) = 5.1%

20X4: 27/ (368 + 90) = 5.9%

20X5: 35/ (360 + 98) = 7.6%

Peter Co

(Max 10 marks)

Discussion

The following discussion compares the performance of Peter Co over time to the T&L sector and against expectations, in terms of it being a sound investment. It also considers the wider aspects which Margaret Co should take account of and the further information which the company should consider before coming to a final decision.

In terms of Peter Co’s performance between 20X3 and 20X5, it is clear from the calculations above that the company is experiencing considerable financial difficulties. Profit margins have fallen and so has the earnings per share (EPS). While the amount of gearing appears fairly stable, the interest cover has deteriorated. The reason for this is that borrowing costs have increased from an average of 5.1% to an average of 7.6% over the 3 years. The share price has decreased over the three years as well and in the last year so has the dividend yield. This would indicate that the company is unable to maintain adequate returns for its investors (please also see below).

Although Peter Co has tried to maintain a dividend yield which is higher than the sector average, its price/earnings (P/E) ratio has been lower than the sector average between 20X3 and 20X4. It does increase significantly in 20X5, but this is because of the large fall in the EPS, rather than an increase in the share price. This could be an indication that there is less confidence in the future prospects of Peter Co, compared to the rest of the T&L sector. This is further corroborated by the higher dividend yield which may indicate that the company has fewer value-creating projects planned in the future. Finally, whereas the T&L sector’s average share price seems to have recovered strongly in 20X5, following a small fall in 20X4, Peter Co’s share price has not followed suit and the decline has gathered pace in 20X5. It would seem that Peter Co is a poor performer within its sector.

This view is further strengthened by comparing the actual returns to the required returns based on the capital asset pricing model (CAPM). Both the company and the T&L sector produced returns exceeding the required return in 20X3 and Peter Co experienced a similar decline to the sector in 20X4. However, in 20X5, the T&L sector appears to have recovered but Peter Co’s performance has worsened. This has resulted in Peter Co’s actual average returns being significantly below the required returns between 20X2 and 20X5.

Taking the above into account, the initial recommendation is for Margaret Co to dispose of its investment in Peter Co. However, there are three important caveats which should be considered before the final decision is made

The first caveat is that Margaret Co should look at the balance of its portfolio of investments. A sale of $58 million worth of equity shares within a portfolio total of $360 million may cause the portfolio to become unbalanced and for unsystematic risk to be introduced into the portfolio. Presumably, the purpose of maintaining a balanced portfolio is to virtually eliminate unsystematic risk by ensuring that it is well diversified. Margaret Co may want to reinvest the proceeds from the sale of Peter Co (if it decides to proceed with the disposal) in other equity shares within the same sector to ensure that the portfolio remains balanced and diversified.

The second caveat is that Margaret Co may want to look into the rumours of a takeover bid of Peter Co and assess how realistic it is that this will happen. If there is a realistic chance that such a bid may happen soon, Margaret Co may want to hold onto its investment in Peter Co for the present time. This is because takeover bids are made at a premium and the return to Margaret Co may increase if Peter Co is sold during the takeover.

The third caveat is that Margaret Co may want to consider Peter Co’s future prospects. The calculations above are based on past performance between 20X2 and 20X5 and indicate an increasingly poor performance. However, the economy is beginning to recover, albeit slowly and erratically. Margaret Co may want to consider how well-placed Peter Co is to take advantage of the improving conditions compared to other companies in the same industrial sector.

If Margaret Co decides that none of the caveats materially affect Peter Co’s poor performance and position, then it should dispose of its investment in Peter Co.

a. Dividend capacity:

b. Growth in profit after tax:

Dividend pay-out ratios:

Growth in dividends:

Residual profit (after tax-profit for the year – dividend – new investment):

Growth in share price:

(Max 06 marks)

Comments

Dividends

Both companies have shown fairly consistent increases over the last three years, with Manning Co’s dividends increasing at around 10% each year, and Charlotte Co’s dividends increasing at around 5% over the last three years. However, Charlotte Co’s policy appears to be sustainable at present, whereas it is doubtful whether Manning Co’s policy is sustainable.

Charlotte Co has managed to increase dividends, gradually also increasing investment in additional assets and residual profits, whilst at the same time having a decreasing dividend pay-out ratio.

In order to maintain its rate of dividend increase, however, Manning Co has had to pay out an increasing proportion of earnings each year. It seems that Manning Co may have sustained dividend increases up to 20X3 at the expense of additional investment, and is now having to increase additional investment significantly in order to make up for previous under-investment. In 20X5, Manning Co’s residual profits became negative, and the dividend capacity calculation for 20X6 suggests that a much lower level of dividends would be appropriate.

Gearing

Charlotte Co’s gearing appears to be stable at around the average for the industry, suggesting that perhaps it has found its optimum level. Up to 20X4, Manning Co could perhaps have been taking advantage of debt capacity to increase its debt towards this level. However, its gearing now appears to be on a rising trend, of necessity increasing significantly in 20X5 to fund both additional investment and increasing dividends, despite the rise in its share price. Manning Co’s gearing is predicted to increase further in 20X6, but how long this is sustainable is uncertain.

Share price

The average increase for both companies over the last four years has been the same. However, the percentage increases over the last two years for Charlotte Co has been higher than for Manning Co. This suggests that the market has placed more significance on the higher % growth in Charlotte Co’s after-tax profits than in Manning Co’s higher % growth in dividends, maybe seeing this as an indication that Charlotte Co’s strategy has been more successful and is more likely in future to deliver higher share price growth.

c. Dividend policy

One possible question is whether the statement in the annual report fairly reflects the likely future dividend policy of Manning Co. The report gives the impression that the current dividend policy will be sustained, whereas the figures suggest that this may not be the case. If the policy proves not to be sustainable, it would suggest a failure either of integrity (if the directors made a statement with a high risk that it would not be true) or due care (that they failed to take into account indicators which suggested their policy is not sustainable). The directors may be questioned by the auditors about whether this statement is true and fair.

There is also the question of balancing the interests of different stakeholders. To some degree, criticism of rises in dividend and director remuneration levels versus increases in employee salary levels could be said to be a matter of opinion.

However, the fact that there is a government enquiry into low pay in the sector suggests that pay levels are lower than society deems desirable. The force of the criticisms may be enhanced by the statements which Manning Co has made about developing an integrated reporting approach. Integrated reporting is not just about extra details in the annual report, but also reflects an underlying policy of carrying out business which includes responsiveness to the needs of different stakeholders.

The dividend capacity and gearing figures may also call into question whether Manning Co’s board is taking excessive risks. Does paying out increasing dividends in future mean that the company is likely to have inadequate resources to sustain its business, and may be jeopardising the interests of lenders and employees as well as stakeholders? Certainly there appears to be doubts about maintenance of future income levels with a number of contracts coming up for renewal and terms possibly being tightened by clients. Clients may be doubtful about renewing contracts if Manning Co’s solvency appears doubtful.

Directors’ remuneration

The directors’ remuneration packages also raise concerns. Comparison with Charlotte Co shows that salary, which is not dependent on performance, is a more significant element of the remuneration packages at Manning Co than Charlotte Co. Both companies have bonuses which depend to some degree on performance. However, Manning Co’s directors are also rewarded by loyalty bonuses, which again do not depend on performance but staying with the company. Charlotte Co has a share option scheme in place, which would seem to reward longer-term good performance, although it cannot be determined how significant a part of remuneration share options will be. Manning Co’s remuneration scheme appears only to reward short-term profitability, possibly meaning that the directors may neglect the longer-term success and possibly even viability of the company.

a. Dividend policy

Many high-growth companies, such as Pigeon Co, retain cash instead of paying dividends and use the cash to help fund the growth. Many such companies declare an intention not to pay dividends and as such the shareholders expect their wealth to increase through capital gains rather than dividend payments.

Financing

Capital structure theory suggests that to take advantage of the tax shield on interest payments, companies should have a capital structure which is a mixture of debt and equity. Pecking order theory suggests that companies typically use internally generated funds before seeking to raise external funds (initially debt, then equity). The two main factors in deterring companies from seeking external finance are favouring one investor group at the expense of another and the agency effect of providing additional information to the market.

Pigeon Co is following the pecking order theory to the extent that it is using internally generated funds first. However, it is then deviating from pecking order theory in looking to raise equity finance rather than debt even though it currently has insignificant levels of debt and is therefore not making full use of the tax shield. This may be explained by the fact that Pigeon Co. operates in a high-risk, rapidly changing industry, where business risk is high. It may not want to take on high levels of financial risk by using significant levels of debt finance. Other issues such as potentially restrictive debt covenant may also be a factor in the financing decision.

Risk management

Managing the volatility of cash flows enables a company to plan its investment strategy more accurately. Pigeon Co needs to ensure that it will have sufficient internally generated cash available when it is needed for planned investments. More importantly, since Pigeon Co faces high levels of business risk, as discussed above, the company should look to manage the risks that are beyond the individual control of the company’s managers.

Effect on policies by returning funds to shareholders

Returning funds to shareholders will affect each of these policies. The shareholder clientele could change, which may lead to share price fluctuations. However, since the change is being requested by shareholders, there is a good chance that this may not happen. The financing policy is likely to change since there will be less internally generated funds available, so Pigeon Co may consider taking on additional debt finance and therefore will have to look at the balance of business and financial risk. This could in turn change the risk management policy as interest rate risk will also have to be managed as well.

b. Alpha

Company Alpha has a fixed dividend pay-out ratio of 40%. As a result the increase in dividends in recent years depends on the increase in profit after tax in these years rather than increasing at a steady rate, which is often preferred by shareholders. If profit after tax was to fall, Alpha may reduce its dividend, which could send the wrong signals to shareholders and cause significant fluctuations in the share price. To avoid this, Alpha may keep a stable dividend in years of reduced profits.

Beta

Company Beta has a policy of increasing dividends at approximately 5% per year, but earnings are only increasing at a rate of approximately 3% per year. This means the dividend pay-out ratio is increasing; it was 60% in 20X3 and is 65% in 20X7. Although this cannot continue in the long term, it suggests that there are less investment opportunities currently and Beta is reducing its retention ratio. This investment would be attractive to an investor looking for a high level of dividend income.

Gamma

Company Gamma has increased its pay-out ratio from 20% in 20X3 to 27% in 20X7. This is a fairly low pay-out ratio, but it is growing. Earnings are growing rapidly overall, but not at a constant annual rate (35% growth in 20X4, but only 3% in 20X5). Overall dividend growth is at a rate of 29% per year, and the annual dividend growth rate has been fairly constant. This policy seems consistent with a growing company, which is now starting to pay more significant dividends and return more funds to shareholders. This investment would be attractive to investors seeking a lower level of dividend income and higher levels of capital growth.

Due to uncertainty about whether Alpha could decrease its future dividend payments, Pigeon Co is likely to prefer to invest in either Beta or Gamma. The choice between these two depends on whether Pigeon Co would prefer higher dividends or higher capital growth. Issues such as taxation position or length of time that the funds would be invested for may influence this choice too.

c. Current dividend capacity

Increase in dividend capacity = 104.22m × 0.1 = $10.422m

Gross up to allow for extra 6% tax = $10.422m/0.94 = $11,087,234

Percentage increase in remittances needed = (11,087,234/15,000,000) × 100% = 73.9%

Dividend repatriations would need to increase by approximately $11.1 million or 73.9% in order to increase dividend capacity by 10%. Pigeon Co needs to consider both whether this is possible for the subsidiaries and the motivational and operational impact of doing so on the subsidiaries.

d. The main benefit of a share buyback scheme to a shareholder is that they can choose whether or not to sell their shares back to the company. This means they can control the amount of cash they receive and in turn manage their own tax liability. With dividend payments, especially with large special dividends, there may be a large tax liability as a result. Further benefits include the fact that, as share capital is reduced, the earnings per share figure is likely to increase and share price may increase Additionally share buybacks are often viewed positively by the markets and share price may increase.

a. An annual cash flow account compares the estimated cash flows receivable from the property against the liabilities within the securitisation process. The swap introduces leverage into the arrangement.

Workings:

1. Loan notes

2. Swap

 The holders of the certificates are expected to receive $3.17 million on $18 million, giving them a return of 17.6%. If the cash flows are 5% lower than the non-executive director has predicted, annual revenue received will fall to $20.90 million, reducing the balance available for the subordinated certificates to $2.07 million, giving a return of 11.5% on the subordinated certificates, which is below the returns offered on the B- and C-rated loan notes. The point at which the holders of the certificates will receive nothing and below which the holders of the C-rated loan notes will not receive their full income will be an annual income of $18.83 million (a return of 9.4%), which is 14.4% less than the income that the non-executive director has forecast.

b. Benefits

The finance costs of the securitisation may be lower than the finance costs of ordinary loan capital. The cash flows from the commercial property development may be regarded as lower risk than Tiara Co’s other revenue streams. This will impact upon the rates that Tiara Co is able to offer borrowers.

The securitisation matches the assets of the future cash flows to the liabilities to loan note holders. The non-executive director is assuming a steady stream of lease income over the next ten years, with the development probably being close to being fully occupied over that period.

The securitisation means that Tiara Co is no longer concerned with the risk that the level of earnings from the properties will be insufficient to pay the finance costs. Risks have effectively been transferred to the loan note holders.

Risks

Not all of the tranches may appeal to investors. The risk-return relationship on the subordinated certificates does not look very appealing, with the return quite likely to be below what is received on the C-rated loan notes. Even the C-rated loan note holders may question the relationship between the risk and return if there is continued uncertainty in the property sector.

If Tiara Co seeks funding from other sources for other developments, transferring out a lower risk income stream means that the residual risks associated with the rest of Tiara Co’s portfolio will be higher. This may affect the availability and terms of other borrowing.

It appears that the size of the securitisation should be large enough for the costs to be bearable. However, Tiara Co may face unforeseen costs, possibly unexpected management or legal expenses.

(i) Sukuk finance could be appropriate for the securitisation of the leasing portfolio. An asset-backed Sukuk would be the same kind of arrangement as the securitisation, where assets are transferred to a special purpose vehicle and the returns and repayments are directly financed by the income from the assets. The Sukuk holders would bear the risks and returns of the relationship.

The other type of Sukuk would be more like a sale and leaseback of the development. Here the Sukuk holders would be guaranteed a rental, so it would seem less appropriate for Tiara Co if there is significant uncertainty about the returns from the development.

The main issue with the asset-backed Sukuk finance is whether it would be as appealing as certainly the A-tranche of the securitisation arrangement which the non-executive director has proposed. The safer income that the securitisation offers A-tranche investors may be more appealing to investors than a marginally better return from the Sukuk. There will also be costs involved in establishing and gaining approval for the Sukuk, although these costs may be less than for the securitisation arrangement described above.

(ii) A Mudaraba contract would involve the bank providing capital for Tiara Co to invest in the development. Tiara Co would manage the investment which the capital funded. Profits from the investment would be shared with the bank, but losses would be solely borne by the bank. A Mudaraba contract is essentially an equity partnership, so Tiara Co might not face the threat to its credit rating which it would if it obtained ordinary loan finance for the development. A Mudaraba contract would also represent a diversification of sources of finance. It would not require the commitment to pay interest that loan finance would involve.

Tiara Co would maintain control over the running of the project. A Mudaraba contract would offer a method of obtaining equity funding without the dilution of control which an issue of shares to external shareholders would bring. This is likely to make it appealing to Tiara Co’s directors, given their desire to maintain a dominant influence over the business.

The bank would be concerned about the uncertainties regarding the rental income from the development. Although the lack of involvement by the bank might appeal to Tiara Co’s directors, the bank might not find it so attractive. The bank might be concerned about information asymmetry – that Tiara Co’s management might be reluctant to supply the bank with the information it needs to judge how well its investment is performing.

a. Profitability

Zara Co’s chief executive is correct in saying that the absolute increase in revenue and gross profits on all products was greater in 20X3 than 20X2, but the % increase in revenue was smaller on all products, and the % increase in gross profit on toys was also lower. The % increase on the electronic toys shows the biggest fall, possibly indicating greater competition.

The improvements in operations mentioned by the chief executive seem to have maintained gross and operating profit margins and resulted in the absolute overall increases in gross and operating profits. However, this aspect of performance is almost all attributable to Zara Co’s older products. The gross profit on electronic toys has hardly increased and the gross profit margin has fallen over the last two years. Although the margin remains higher than on the other products, even the 20X3 margin may not be sustainable. If competitors are starting to catch up with Zara Co, then the profit margin on the current range of electronic toys may continue to fall in future years, as prices fall to maintain market share.

Despite the emphasis on developing the products, the revenue generated by electronic toys is still below the revenue generated by non-electronic toys.

Asset turnover and return on capital employed have risen significantly over the last two years. However, part of the reason for the 20X3 increases was the significant increase in current liabilities. The further amount of investment which the chief executive appears to be contemplating suggests that asset turnover and return on capital employed may fall in future years, particularly if profit margins on electronic toys cannot be sustained.

Liquidity

The figures for other current assets seem to support the chief executive’s contention that working capital is being managed better, as other current assets are falling as revenue and gross profits are rising.

However, the fall of the current ratio from 1·52 to 0·64 is significant, and the biggest reason for the fall in 20X3 was the large increase in current liabilities. Cash balances have remained at a low level, despite higher revenues and profit. Possibly there is now a bank overdraft, which could have contributed to the significant increase in finance costs between 20X2 and 20X3. It would seem that cash reserves have been exhausted by the combination of investment in non-current assets and the payments to finance providers (both interest and dividends), and Zara Co is more dependent on short-term liability finance. Slowdown in any product area, particularly electronic toys, may result in significant liquidity problems.

Solvency

Gearing has fallen over the last two years, but this is due to share price increases which may not be sustainable. If book values rather than market values are used to calculate gearing, the fall in gearing is much smaller. More information is needed about an additional $30 million in long-term loans. Although costs on these may be higher than on its current loans, this would not account for all the increase in finance costs. As discussed above, Zara Co may be making use of overdraft finance. The fact that current liabilities have increased much more than non-current liabilities could be an indication that Zara Co is having problems raising all the longer term loan finance which it requires.

The figures suggest that Zara Co’s board needs to review future financing carefully if the company wants to make further investment in electronic products. At some stage, the board will have to consider raising further finance, either through an issue of shares or through selling off parts of its operations.

Investor ratios

Both earnings and dividends per share have risen since 20X1, which could help explain the significant increase in share price. Dividend cover has remained around 2·0 despite an increase in earnings. Although dividends have increased, dividend yield has fallen since 20X1. The increase in total shareholder return is due solely to the increases in share price, which have also resulted in the price-earnings ratio increasing in 20X3. The current rate of share price increase does not appear to be warranted by the most recent results and may be partly due to generous dividend levels, which may not be sustainable if more cash is required for investment.

Conclusion

Despite the chief executive’s optimistic message in the annual report, the benefits from the electronic toys’ development may be short-lived. There appears to be a mismatch between investment, dividend and financing policies. As discussed, margins on current products may fall further and there is no guarantee that margins on new electronic toys or other products will be higher if competition generally is increasing.

Further significant investment in electronic toys or other goods may be difficult to finance. Increased reliance on short-term finance is clearly not sustainable, but obtaining more debt may be problematic, particularly if gearing levels rise as share prices fall. Zara Co seems reluctant to take advantage of high share price levels to issue equity capital. This, plus the increase in dividends, may indicate Zara Co’s board is unwilling to risk upsetting shareholders, despite the large increases in share price. The chief executive may be right in saying that funds may have to be obtained by selling off one of the other parts of the business, but revenue and profits from the older products may be more sustainable. An increased concentration on electronic products may be a high-risk strategy. Possibly, if investors become less positive towards the electronic goods sector, they may realise this, resulting in an increase in cost of capital and a fall in share price.

Note. Credit will be given for relevant, alternative approaches to the calculations and discussion.

(Max 10 marks)

Appendix

(Note. Credit will be given for alternative, relevant, calculations and discussion. Candidates will not be expected to complete all the calculations above to obtain 10 marks.)

(Max 10 marks)

b. Zara Co’s shares may be overvalued because share prices generally are too high. The situation may be a stock market bubble. Share prices have been rising consistently recently and this could be encouraging investors to buy more shares, further increasing share prices.

The bubble could be more localised. Zara Co seems to be positioning itself as much in terms of producing technologically‑advanced electronic products as manufacturing toys. The electronic goods sector may be more likely than other sectors to attract investors on the basis of future profit potential, with investors possibly following a herd instinct, investing because others have been investing in the expectation of future gains.

Possibly, investors are more persuaded by the chairman’s confident language and future promises than they are by the concerns the figures suggest. They may also be paying excessive attention to the most recent set of results, rather than seeing them in the context of whether they can be sustained in the future.

If investors are attempting to make a valuation, they could prefer using a model which confirms what they believe the shares are worth (confirmation bias), rather than one which gives a more reliable indication of value. As discussed above, shareholders may be basing their estimates of value on the recent increases in dividend, even though it may be doubtful whether this is sustainable.

a. According to traditional finance theory, Arthur Co’s directors will wish to strive for long-term shareholder wealth maximisation. The directors may not have been fully committed to long-term wealth maximisation, as they seemed to have focused on the development aspects which interested them most and left the original business mostly to others. However, now they are likely to come under pressure from the new external shareholders to maximise shareholder wealth and pay an acceptable level of dividend. To achieve this, it seems that Arthur Co will have to commit further large sums to investment in development of diagnostic applications (apps) in order to keep up with competitors.

Selling off the IT services business

At present the IT services business seems to be a reliable generator of significant profits. Selling it off would very likely produce a significant cash boost now, when needed. However, it would remove the safety net of reasonably certain income and mean that Arthur Co followed a much riskier business model. The IT services business also offers a possible gateway to reach customers who may be interested in the apps which Arthur Co develops.

Rights issue

If the executive directors wish to maintain their current percentage holdings, they would have to subscribe to 75% of the shares issued under the rights issue. Even though the shares would be issued at a discount, the directors might well not have the personal wealth available to subscribe fully. Previously they had to seek a listing to obtain enough funds for expansion, even though they were reluctant to bring in external investors, and this suggests their personal financial resources are limited.

However, the directors may need to take up the rights issue in order to ensure its success. If they do not, it may send out a message to external investors that the directors are unwilling to make a further commitment themselves because of the risks involved. There are also other factors which indicate that the rights issue may not be successful. The directors did not achieve the initial market price which they originally hoped for when Arthur Co was listed and shareholders may question the need for a rights issue soon after listing.

If the executive directors do not take up all of their rights, and the rights issue is still successful, this may have consequences for the operation of the business. The external shareholders would own a greater percentage of Arthur Co’s equity share capital and may be in a position to reinforce the wishes of non-executive directors for improved governance and control systems and change of behaviour by the executive directors. Possibly they may also demand additional executive and non-executive directors, which would change the balance of power on the board.

The level of dividend demanded by shareholders may be less predictable than the interest on debt. One of the directors is also concerned whether the stock market is efficient or whether the share price may be subject to behavioural factors (discussed in (c) below).

Debt finance

Debt providers will demand Arthur Co commits to paying interest and ultimately repaying debt. This may worry the directors because of the significant uncertainties surrounding returns from new apps. Significant debt may have restrictive covenants built in, particularly if Arthur Co cannot provide much security. The directors may be faced with restrictions on dividends, for example, which may upset external shareholders.

Uncertainties surrounding funding may also influence directors’ decisions. Loan finance may be difficult to obtain, but the amount and repayments would be fixed and could be budgeted, whereas the success of a rights issue is uncertain.

(i) The main risks connected with development work are that time and resources are wasted on projects which do not generate sales or are not in line with corporate strategy. Directors may choose apps which interest them rather than apps which are best for the business. There is also the risk that projects do not deliver benefits, take too long or are too costly. Arthur Co’s directors’ heavy involvement in development activities may have made it easier to monitor them. However, the dangers with this are that the directors focus too much on their own individual projects, do not consider their projects objectively and do not step back to consider the overall picture.

The board must decide on a clear strategy for investment in development and needs to approve major initiatives before they are undertaken. There must be proper planning and budgeting of all initiatives and a structured approach to development. The board must regularly review projects, comparing planned and actual expenditure and resource usage. The board must be prepared to halt projects which are unlikely to deliver benefits. One director should be given responsibility for monitoring overall development activity without being directly involved in any of the work. Post-completion reviews should be carried out when development projects have been completed.

(ii) Communication with shareholders and other important stakeholders, such as potential customers, may be problematic. Arthur Co faces the general corporate governance requirement of transparency and has to comply with the specific disclosure requirements of its local stock market.

However, governance best practice also acknowledges that companies need to be allowed to preserve commercial confidentiality if appropriate, and clearly it will be relevant for Arthur Co. However, the less that it discloses, the less information finance providers will have on which to base their decisions.

Another issue with disclosure is that product failures may be more visible now that Arthur Co has obtained a listing and may have to include a business review in its accounts.

(i) Sewell defines behavioural finance as the influence of psychology on the behaviour of financial practitioners and the subsequent effect on markets. Behavioural finance suggests that individual decision-making is complex and will deviate from rational decision-making. Under rational decision-making, individual preferences will be clear and remain stable. Individuals will make choices with the aim of maximising utility, and adopt a rational approach for assessing outcomes.

Under behavioural finance, individuals may be more optimistic or conservative than appears to be warranted by rational analysis. They will try to simplify complex decisions and may make different decisions based on the same facts at different times.

(ii) Arthur Co’s share price may be significantly influenced by the impact of behavioural factors, as it is a newly listed company operating in a sector where returns have traditionally been variable and unpredictable. The impact of behavioural factors may be complex, and they may exert both upward and downward pressures on Arthur Co’s share price. Investors may, for example, compensate for not knowing much about Arthur Co by anchoring, which means using information which is irrelevant, but which they do have, to judge investment in Arthur Co.

The possibility of very high returns may add to the appeal of Arthur Co’s shares. Some investors may want the opportunity of obtaining high returns even if it is not very likely that they will. The IT sector has also been subject to herd behaviour, notably in the dotcom boom. The herd effect is when a large number of investors have taken the same decision, for example to invest in a particular sector, and this influences others to conform and take the same decision.

However, even if Arthur Co produces high returns for some time, the fact that it is in a volatile sector may lead to investors selling shares before it appears to be warranted on the evidence, on the grounds that by the laws of chance Arthur Co will make a loss eventually (known as the gambler’s fallacy).

Under behavioural finance, the possible volatility of Arthur Co’s results may lead to downward pressure on its share price for various reasons. First some investors have regret aversion, a general bias against making a loss anyway. This, it is claimed, means that the level of returns on equity is rather higher than the returns on debt than is warranted by a rational view of the risk of equity.

Similarly under prospect theory, investors are more likely to choose a net outcome which consists entirely of small gains, rather than an identical net outcome which consists of a combination of larger gains and some losses. At present also, Arthur Co does not have much of a history of results for the market to analyse. Even when it has been listed for some time, however, another aspect of behavioural finance is investors placing excessive weight on the most recent results.

If the market reacts very well or badly to news about Arthur Co, the large rise or fall in the share price which results may also not be sustainable, but may revert back over time.

a. Group performance may be analysed by using financial ratios, growth trends and comparative market data. Alternative definitions exist for some ratios, and other ratios are equally valid.

Operating and profitability ratios:

Liquidity ratios:

Market ratio

It is difficult to reach conclusions about the performance of Julian without more comparative data from similar companies. 

Return on capital at around 30% is dominated by the effect of high profit margins, but the split between divisions is not provided. Asset utilisation is well below 1, which implies relatively inefficient utilisation of assets. Julian might investigate whether this could be improved.

Liquidity has improved during the last year, and although below some commonly used benchmarks might be satisfactory for the sectors that Julian is involved with. However, some aspects of working capital require attention. Stock levels have increased from 28% of revenue in 20X3 to 33% in 20X5, and the collection period for debtors has similarly increased from 114 days to 125 days. Creditors have also increased more than proportionately to revenue. Julian should take action to improve the efficiency of its working capital management.

In contrast operating costs have fallen over the three years from 66% to 62% of revenue, indicating greater efficiency. Gearing appears to be relatively low at around 32%, but comparative data is needed, and interest cover is high at more than eight times in 20X5.

Investors do not appear to be entirely satisfied with group performance. The FT market index has increased by 34% between 20X3 and 20X5, whereas Julian’s share price has only increased by 26%. With an equity beta of 1.1 Julian’s share price would be expected to increase by more than the market index. Julian’s PE ratios are also lower than those of similar companies, suggesting that investors do not value the company’s future prospects as highly as those of its competitors.

The required return from Julian’s shares may be estimated using the capital asset pricing model (CAPM).

Required return = 5% + (12% – 5%) 1.1 = 12.7%

An approximation of the actual return from Julian’s shares is the 12% average annual increase in share price plus 4% annual dividend yield, or 16%. The total return is higher than expected for the systematic risk. Given this, Julian should investigate the reasons why its share price has performed relatively poorly. One possibility is the company’s dividend policy.

Dividends have consistently been more than 50% of available after-tax earnings, which might not be popular with investors.

Divisional performance

The information on the individual divisions is very sparse. All divisions are profitable, but the return from the pharmaceutical division is relatively low for its systematic risk.

Using CAPM to approximate required returns:

¹ It is assumed that the same market parameters are valid for the US based division.

The construction and leisure divisions appear to have greater than expected returns (a positive alpha) and the pharmaceutical division slightly less than expected for the risk of the division. The pharmaceutical division has recently suffered a translation loss due to the weakness of the US dollar, and the potential economic exposure from changes in the value of the dollar should be investigated.

From a financial perspective it would appear that the company should not devote equal resources to the divisions, and should focus its efforts on construction and leisure. However, the future prospects of the sectors are not known, nor the long-term strategy of Julian, which might be to expand international operations in the USA or elsewhere. The strategic use of resources should not be decided on the basis of the limited financial information that is available.

(Note. Approximately 19 marks are available for calculations, and 9 for discussion.)

Other information that would be useful includes:

1. Cash flow forecasts for the group and the individual divisions.
2. Full product and market information for each of the divisions.
3. Details of recent investments in each of the divisions and the expected impact of such investment on future performance.
4. Detailed historic performance data of the divisions over at least three years, and similar data for companies in the relevant sectors.
5. Competitors and potential growth rates in each of the sectors.
6. The economic exposure of the US division
7. The future strategic plans of Julian. Are there any other proposed initiatives?
8. How the company’s equal resource strategy will be viewed by investors. The company has performed worse than the market in recent years despite having a higher beta than the market.

c. A translation loss of £10 million is not necessarily a problem for Julian plc.

Translation exposure, sometimes known as accounting exposure, often does not reflect any real cash flow changes. It is changes in cash flow that, in an efficient market, will impact on the share price and value of a company. For example, a translation loss might in part reflect a lower home currency value of an overseas factory, but the factory will still be the same and will still be producing goods. It is the impact on the home currency cash flows from the continuing operations of the factory that will affect share price.

However, if the market is not efficient, investors might not understand that there are no real cash flow implications from the exposure, and might be worried about the effect of the translation loss on Julian, and possibly sell their shares. If this is the case Julian might consider internal hedges to reduce translation exposure. In most cases this would not be recommended, and companies must also be careful that hedges to manage translation exposure do not adversely affect the efficient operations of the business, or be contrary to hedges that are being undertaken to protect against other forms of currency exposure such as transaction exposure.

d.

• Income may be increased by writing (selling) options, as the writer of the option receives the option premium.
• However, unless the option is hedged, writing options exposes the writer to a theoretically unlimited loss.
• Uncovered writing of options is effectively speculating, involves very high risk, and is not normally recommended as a strategy to companies such as Julian.