The performance of ABC Co

A shareholder of ABC Co would probably be reasonably pleased with their

performance over these two years.
Growth of income
The company has grown in terms of turnover and profits. Revenue has grown by
9.6% ((74,521 68,000)/68,000 100%) and return on capital employed has
increased from 25.7% to 27.4%.
There may be some concern over the 25.4% increase ((11,489
9,160)/9,160x100%) in other costs and more information would be needed to
determine if this is a one-off increase or a worrying long-term trend.
The net profit margin is almost unchanged, showing that the increase in ROCE is due
to an increase in asset turnover.
Salaries and wages have only increased by 2.4% ((20,027 19,562)/19,562 x100%) so
employees may be less pleased with the situation. Employee discontent could create
problems for the business in future.
Gearing
The financial risk that the shareholders are exposed to do not appear to be a
problem area as gearing has decreased from 49.9% to 35.1% and interest cover is
more than sufficient. The company may want to consider increasing gearing to invest
in suitable projects and generate further growth.
Shareholder return
The shareholders investment ratios all indicate that shareholders wealth has
increased. The share price has increased by 19% ((8.82 7.41)/7.41 x 100%). The
total shareholder return is (Pl Po + DI)/Po = (8.82 7.4I + 0.34)/7.41 = 23.6%. This
is probably sufficient to satisfy shareholders.
The P/E ratio reflects the markets appraisal of the shares future prospects and this
has improved. It is still lower than the industry average which suggests that more
growth could be achieved.

CG is the system by which organisations are directed and controlled.

- Those directors who have the power to direct and control the organisation also
have the duty of accountability to the organisation's stakeholders.
- Although the directors' role is a key one in deciding how the divergent interests of
the various stakeholders should be promoted, the directors primary duty is to
enhance the value of shareholders' investment over time.
- Corporate governance regulation aims to control the ability of the directors to
promote their own interests and ensure adequate disclosure of their activities.
 This is achieved by the use of INED to staff committees that monitor the following
areas:
i. The management and reduction of risk. This is monitored by an audit
committee staffed by non-executives and ensures that areas of risks are being
identified and managed in an appropriate way.
ii. Incentives to senior management to maximise shareholder wealth. This is
monitored by a remuneration committee to ensure the incentives are
appropriate and not over-generous.
iii. Good governance provides a framework for an organisation to pursue its
strategy in an ethical and effective way from the perspective of all stakeholder
groups affected, and offers safeguards against misuse of resources, physical or
intellectual. This is achieved by giving non-executive directors significant
voting power at board level and by separating the role of the chief executive
and the chairman to ensure that one individual does not exercise excessive
power.

Businesses that comply with corporate governance regulations can therefore help to
manage underperformance by:
a. Identify the under-performing areas as part of their risk-management processes.
b. Ensuring that management is incentivised to deal with issues that have been
identified.
c. Controlling the corporate strategy of the company and ensuring it is effective and
well thought out.

TUTORIAL 2
Year 20X4 20X3 20X2 20X1 20X0
Dividend per share 2.8c 2.3c 2.2c 2.2c 1.7c
Annual dividend
growth 21.7% 4.5% nil 29.4%
General price index 117 113 110 105 100
Real dividend per
share 2.4c 2.0c 2.0c 2.1c 1.7c
Annual dividend
growth 20.0% nil (4.8)% 23.5%
Earnings per share 19.04c 14.95c 11.22c 15.84c 13.43c
Annual earnings
growth 27.3% 33.2% (29.2)% 17.9%
Price/earnings ratio 22.0 33.5 25.5 17.2 15.2
Share price 418.9c 500.8c 286.1c 272.4c 204.1c
Annual share price
growth (16.3)% 75.0% 5.0% 33.5%
Comparison of growth rates:

Arithmetic mean Equivalent annual rate Sector

Nominal dividends 13.9% 13.3% 10%
Real dividends 9.7% 9.0% 9%
Earnings per share 12.3% 9.1% 10%
Share price 24.3% 19.7% 20%

If the sector average growth rates are arithmetic mean growth rates, the chairman's
statement is technically correct. The basis on which the sector average growth rates
have been prepared should therefore be clarified, in order to determine whether
the chairman's statement is correct. Overall however, the company looks to be
performing in line with the sector average, whatever method of calculation is used.

(2b)
The dividend yield and capital growth for 20X4 are calculated by reference to the
20X3 end-of-year share price.
The dividend yield is 0.56% (100 2.8/500.8) and the capital growth is 16.35% (100
(418.9 500.8)/500.8). The total shareholder return is therefore 15.8% (0.56
16.35).
This -ve total shareholder return conflicts with the chairman's claim to have
delivered growth in dividends and share price in 20X4. Share prices may be affected
by other factors than corporate activity, however, and it is possible that the negative
return may represent a good performance when compared to the sector as a whole.

2(c)
Performance measure
The managerial performance measure selected for use in the remuneration package
should support the achievement of the primary objective of shareholder wealth
maximisation. It could be linked to share price changes or total shareholder return.

The managerial performance measure should relate to factors under a manager's

control. For example, if some items on a divisions profit statement are not
controlled by a divisional manager (eg head office overheads), these items should be
excluded from the performance measure.
 Performance measures should include non-financial measures (eg market share,
defect levels, customer satisfaction). If they do not, managers may resort to short-
term cost cutting measures to achieve profit targets.

Type of reward
A cash bonus will be a powerful incentive for managers to improve their
performance and achieve targets. However, most companies will also want their
senior managers to have a direct incentive to increase the share price of the co.
Share options can be used but they can encourage risk-taking. Risky investments
can dramatically increase the share price if successful but the managers will not
suffer a loss on the share options if they fail.

Management remuneration packages for RZP Co

RZP Co has delivered earnings growth of more than 20% in both 20X3 and 20X4. If
annual earnings growth were to be part of a remuneration package for RZP Co,
earnings growth should be compared to the sector, and any bonus made
conditional upon long term performance.

Alternatively, remuneration packages may be based on a performance measure

linked to stock market performance, such as total shareholder return compared to
average share price growth for the sector, or compared to growth in a stock market
index. This would be consistent with shareholder wealth maximisation, and is likely
to work well if the managers were to received shares or share options as part of the
remuneration package.

3(a)
i. it is likely to have an adverse impact on Tagna's sales. As it sells luxury goods, it
could be expected that these would be the first to be sacrificed by consumers if
they are feeling 'the pinch' in other areas (such as mortgage payments) and their
disposable income is reduced. The cost of consumer credit might also be
pushed up to dampen spending, further denting consumer confidence and the
willingness to spend money on luxury items.

ii. Input costs such as materials and labour increase, although this would probably
not be seen as immediately as an effect of higher interest rates upon sales, as
the effect of the rise would have to make itself felt throughout the economy.
Wages could go up as a result of inflation, but this will be countered by the
effect of the interest rate increase on consumer demand.
iii. PAT will fall, both for the reasons outlined above but also because the cost of
servicing Tagna's overdraft will increase. With a fall in sales, increased operating
costs and increased interest charges, there is likely to be a significant fall in
earnings. As Tagna's profits have been low, this could represent a real threat to
future profitability and dividend payments.

3(b)
Public sector organisations are generally set up with a prime objective which is not
related to making profits. These organisations exist to pursue non-financial aims,
such as providing a service to the community.
However, a not-for-profit organisation needs finance to pay for its operations, and
the major financial constraint is the amount of funds that it can obtain. Having
obtained funds, a not-for-profit org should seek to get value for money from use of
the funds:

a. Economy: not spending $2 when the same thing can be bought for $1
b. Efficiency: getting the best use out of what money is spent on
c. Effectiveness: spending funds so as to achieve the organisation's objectives

Since managing government (for example) is different from managing a company, a

different framework is needed for planning and control. This is achieved by:

setting objectives for each

careful planning of public expenditure proposals
emphasis on getting value for money

A private sector organisation has as its primary objective the making of

sufficient profits to provide a satisfactory return for its owners and to keep the
business operating.

So, it is job of senior management to maximise the market value of the company.
Specifically, the main financial objective of a company should be to maximise the
wealth of its ordinary shareholders. The financial manager seeks to ensure that
investments earn a return, for the benefit of shareholders. Part of this job will
involve attracting funds from the market, such as new investors.

TUTORIAL 3
Methods of valuation and range of values
Net assets
The book value of SM's net assets attributable to equity shareholders is $45M. This
figure may need to be adjusted for increased or decreased market values of assets,
particularly SM's property holding.
However in any case, for a going concern, the book value of assets is a poor
indicator of their economic value, which depends on their income-generating
capacity, rather than their historical cost or realisable value. Here also SM has a
franchise generating earnings that will not be reflected in the balance sheet.

Price/earnings model
SM's existing earnings per share is $1.53, and number of shares is 1.5M, giving total
equity earnings of $2.295M. Taking the 5% growth figure given, next year's
earnings would be $2.410M.
However, the managing director is estimating $4 million for next year. This figure
cannot be accepted at face value and would need to be substantiated.
In the absence of any better information, BST's P/E ratio could be applied to these
earnings figures. This is 1237/112.5 = 10.996, say 11.
The range of values for SM's valuation would be between $2.410 million 11 and $4
million 11 ie between $26.5 million and $44 million.

Dividend valuation model

Last year's total dividends were 1.5m 100 cents = $1.5m. A 5% increase next
year would give $1.575M. The cost of equity for similar firms is 10% and the
expected growth rate 5%.
So on this basis the expected company value = $1.575m/(0.1 0.05)
= $31.5 million. SM's dividend payout ratio is 100/153 = 0.654.
Based on the MD's forecast earnings of $4 million, next year's dividend would be
$4m 0.654 = $2.616 million. The forecast company value would be $2.616
million/(0.1 0.05) = $52.3 million. The drawbacks of this method are:
o The assumption that SM's cost of equity is the same as similar firms may be
misleading.
o The assumption of constant dividend growth at that rate may be misleading.
Dividend policy may change on takeover.
o Share price is not normally just a function of dividend policy; future expected
earnings are also a key factor.

Summary
 Based on valuation of assets and income earning capacity, SM appears to have a
value anywhere between $25 million and $52 million. The higher earnings-based
figures are heavily dependent on the MD's forecast of next year's earnings that may
well be overstated. Because the net asset value is towards the top end of the
valuation range, BST could probably look at a value of between $40 million and $45
million, but will need to carry out further investigations on likely asset values.
1(b)
Financial factors relating to BST
i. Like SM, the forecast of next year's earnings may be overstated. Current
earnings = $1.125 25m = $28.125m. 4% growth (given) gives $29.25m, but BST's
forecast for next year is$35m.
ii. BST has a fairly high gearing ratio. If BST lacks cash and has to borrow more in
order to buy out those 50%+ shareholders of SM who do not wish to have BST
shares, this may have the effect of increasing the company's cost of capital.
iii. BST has a lower dividend payout ratio than SM. This may discourage some of
SM's shareholders from accepting BST's shares.

Financial factors relating to SM

i. Next year's forecast earnings may be overstated. However, some of the directors
may be taking higher salaries than realistic market levels, and the future
profitability of the co may be higher if they are replaced with lower cost
managers.
ii. The company is ungeared, which is advantageous, as it enables BST to borrow to
fund part of the acquisition.
iii. It is likely that many areas where costs can be saved as a result of the acquisition
of SM. This may make it worthwhile for BST to pay a higher price for SM.

(c) The fundamental theory of share values states that the realistic market price of a
share can be derived from a valuation of estimated future dividends. The value of a
share will be the discounted present value of all future expected dividends on the
shares, discounted at the shareholders' cost of capital.
If the fundamental analysis theory of share values is correct, the price of any share
will be predictable, provided that all investors have the same information about a
company's expected future profits and dividends, and a known cost of capital.
However, share prices are also affected by a number of other factors.
Marketability and liquidity of shares
In financial markets, liquidity is the ease of dealing in the shares, how easily can the
shares can be bought
and sold without significantly moving the price?
In general, large companies, with hundreds of millions of shares in issue, and high
numbers of shares
changing hands every day, have good liquidity. In contrast, small companies with few
shares in issue and
thin trading volumes, can have very poor liquidity.
The marketability of shares in a private company, particularly a minority
shareholding, is generally very
limited, a consequence being that the price can be difficult to determine.
Shares with restricted marketability may be subject to sudden and large falls in value
and companies may
act to improve the marketability of their shares with a stock split. A stock split occurs
where, for example,
each ordinary share of $1 each is split into two shares of 50c each, thus creating
cheaper shares with
greater marketability. There is possibly an added psychological advantage, in that
investors may expect a
238 Answers
company which splits its shares in this way to be planning for substantial earnings
growth and dividend
growth in the future.
As a consequence, the market price of shares may benefit. For example, if one
existing share of $1 has a
market value of $6, and is then split into two shares of 50c each, the market value of
the new shares might
settle at, say, $3.10 instead of the expected $3, in anticipation of strong future
growth in earnings and
dividends.
Availability and sources of information
An efficient market is one where the prices of securities bought and sold reflect all
the relevant information
available. Efficiency relates to how quickly and how accurately prices adjust to new
information. Information
comes from financial statements, financial databases, the financial press and the
internet.
It has been argued that shareholders see dividend decisions as passing on new
information about the
company and its prospects. A dividend increase is usually seen by markets to be
good news and a dividend
decrease to be bad news, but it may be that the market will react to the difference
between the actual
dividend payments and the market's expectations of the level of dividend. For
example, the market may be
expecting a cut in dividend but if the actual decrease is less than expected, the share
price may rise.
Market imperfections and pricing anomalies
Various types of anomaly appear to support the views that irrationality often drives
the stock market,
including the following.
Seasonal month-of-the-year effects, day-of-the-week effects and also hour-of-the-
day effects seem
to occur, so that share prices might tend to rise or fall at a particular time of the year,
week or day.
There may be a short-run overreaction to recent events. For example, the stock
market crash in 1987
when the market went into a free fall, losing 20% in a few hours.
Individual shares or shares in small companies may be neglected.
Market capitalisation
The market capitalisation or size of a company has also produced some pricing
anomalies.
The return from investing in smaller companies has been shown to be greater than
the average return from
all companies in the long run. This increased return may compensate for the greater
risk associated with
smaller companies, or it may be due to a start from a lower base.
Investor speculation
Speculation by investors and market sentiment is a major factor in the behaviour of
share prices.
Behavioural finance is an alternative view to the efficient market hypothesis. It
attempts to explain the
market implications of the psychological factors behind investor decisions and
suggests that irrational
investor behaviour may significantly affect share price movements. These factors
may explain why share
prices appear sometimes to over-react to past price changes.