5.

LIMNI CO (JUN 13)

(a) As a high growth company, Limni Co probably requires the cash flows it generates annually for
investing in new projects and has therefore not paid any dividends. This is a common practice amongst
high‐growth companies, many of which declare that they have no intention of paying any dividends. The
shareholder clientele in such companies expects to be rewarded by growth in equity value as a result of
the investment policy of the company.

Capital structure theory would suggest that because of the benefit of the tax shield on interest
payments, companies should have a mix of equity and debt in their capital structure. Furthermore, the
pecking order proposition would suggest that companies tend to use internally generated funds before
going to markets to raise debt capital initially and finally equity capital. The agency effects of having to
provide extra information to the markets and where one investor group benefits at the expense of
another have been cited as the main deterrents to companies seeking external sources of finance. To a
certain extent, this seems to be the case with Limni Co in using internal finance first, but the pecking
order proposition seems to be contradicted in that it seeks to go straight to the equity market and
undertake rights issues thereafter. Perhaps the explanation for this can be gained from looking at the
balance of business and financial risk. Since Limni Co operates in a rapidly changing industry, it probably
faces significant business risk and therefore cannot afford to undertake high financial risk, which a
capital structure containing significant levels of debt would entail.

This, together with agency costs related to restrictive covenants, may have determined Limni Co’s
financing policy.

Risk management theory suggests that managing the volatility of cash flows enables a company to plan
its investment strategy better. Since Limni Co uses internally generated funds to finance its projects, it
needs to be certain that funds will be available when needed for the future projects, and therefore
managing its cash flows will enable this. Moreover, because Limni Co faces high business risk, managing
the risk that the company’s managers cannot control through their actions, may be even more
necessary.

The change to making dividend payments or undertaking share buybacks will affect all three policies.
The company’s clientele may change and this may cause share price fluctuations. However, since the
recommendation for the change is being led by the shareholders, significant share price fluctuations
may not happen. Limni Co’s financing policy may change because having reduced internal funds means
it may have to access debt markets and therefore have to look at its balance between business and
financial risk. The change to Limni Co’s financial structure may result in a change in its risk management
policy, because it may be necessary to manage interest rate risk as well.

(Note: Credit will be given for alternative relevant comments)

(b) In the case of company Theta, dividends are growing but not at a stable rate. In fact company Theta
is paying out $0.40 in dividends for every $1 in earnings, and has a fixed dividend cover ratio of 2.50.
This would be confusing for the shareholders, as they would not know how much dividend they would
receive from year to year. Although profits have risen over the past five years, if profits do fall, company
Theta may reduce dividends and therefore send the wrong signals to shareholders and investors. This
may cause unnecessary fluctuations of the share price or result in a depressed share price.

In the case of company Omega, annual dividends are growing at a stable rate of approximately 5% per
year, while the company’s earnings are growing steadily at around 3% per year, resulting in an
increasing pay‐out ratio. Also a high proportion of earnings are paid out as dividends, increasing from
60% in 20W9 to almost 65% in 20X3. This would indicate a company operating in a mature industry,
signalling that there are few new projects to invest in and therefore reducing the retention rate. Such an
investment would be attractive to investors requiring high levels of dividend returns from their
investments.

In the case of company Kappa, although a lower proportion of earnings is paid out as dividends (from
about 20% in 20W9 to about 27% in 20X3), they are growing at a higher but stable rate of 29%–30% per
year. The company’s earnings are growing rapidly but erratically, ranging between 3% and 35% between
20W9 and 20X3. This probably indicates a growing company, possibly similar to Limni Co itself, where
perhaps returns to investors having been coming from share price growth, but one where dividends are
becoming more prominent. Such an investment would be attractive to investors requiring lower levels
of dividend returns, but higher capital returns from their investments.

Due to company Theta’s confusing dividend policy, which may lead to erratic dividend pay‐outs and a
depressed share price, Limni Co would probably not want to invest in that company. The choice
between company Omega and company Kappa would depend on how Limni Co wants to receive its
return from the investment, maybe taking into account factors such as taxation implications, and the
period of time it wishes to invest for, in terms of when the returns from an investment will be
maximised and when it will need the funds for future projects.

(Note: Credit will be given for alternative relevant comments)

(c) Limni Co, current dividend capacity

$000
Profit before tax (23% × $600,000,000) 138,000
Tax (26% × $138,000,000) (35,880)
Profit after tax 102,120
Add back depreciation (25% × $220,000,000) 55,000
Less investment in assets (67,000)
Remittances from overseas subsidiaries 15,000
Additional tax on remittances (6% × $15,000,000) (900)
Dividend capacity 104,220
Increase in dividend capacity = 10% × $104,220,000 = $10,422,000

Gross up for tax = $10,422,000/0.94 = $11,087,234

Percentage increase in remittances from overseas subsidiaries = 73.9% [$11,087,234/ $15,000,000]

Dividend repatriations need to increase by 73.9% from Limni Co’s international subsidiaries in order to
increase the dividend capacity by 10%. Limni Co would need to consider whether or not it is feasible for
its subsidiaries to increase their repatriations to such an extent, and the impact this will have on the
motivation of the subsidiaries’ managers and on the subsidiaries’ ability to operate as normal.

(d) The main benefit of a share buyback scheme to investors is that it helps to control transaction costs
and manage tax liabilities. With the share buyback scheme, the shareholders can choose whether or not
to sell their shares back to the company. In this way they can manage the amount of cash they receive.
On the other hand, with dividend payments, and especially large special dividends, this choice is lost,
and may result in a high tax bill. If the shareholder chooses to re‐invest the funds, it will result in
transaction costs. An added benefit is that, as the share capital is reduced, the earnings per share and
the share price may increase. Finally, share buybacks are normally viewed as positive signals by markets
and may result in an even higher share price.

(Note: Credit will be given for alternative relevant comments)