Revision Answers
Chapter 16 Dividend Policy in Multinationals and Transfer Pricing
Answer 1
(a)
Dividend capacity prior to TE proposal implementation
$000 / MarksOperating profit (30% × $80,000,000) / 24,000 / [1]
Less: Interest (8% × $35,000,000) / (2,800) / [1]
Profit before tax / 21,200
Less: Taxation (28%) / (5,936) / [1]
Profit after tax / 15,264
Less: Investment in working capital [15% × (20/120 × 80,000)] / (2,000) / [1]
Less: Investment in additional non-current assets
[25% × (20/120 × 80,000)] / (3,333) / [1]
Less: Investment in project / (4,500) / [1]
Cash flows from domestic operations / 5,431
Cash flows from overseas subsidiary dividend remittances (W1) / 3,159 / [2]
Additional tax payable on Magnolia profits (6% × 5,400) / (324) / [1]
Dividend capacity / 8,266
Dividend capacity after TE proposal implementation
Cash flows from domestic operations (as above) / 5,431
Cash flows from overseas subsidiaries dividend remittances (W2) / 2,718 / [3]
Additional tax payable on Magnolia profits (6% × 3,120) / (187) / [1]
Dividend capacity / 7,962 / [1]
Estimate of actual dividend for coming year
(7,500 × 1.08) / 8,100
Note: The impact of depreciation is neutral, as this amount will be spent to retain assets at their current productive capability.
W1: Prior to implementation of TE proposal
$000 / $000
Sales (Strymon – 3,600 + 2,100) / 5,700 / 15,000
Cost:
Variable (300 × $12) / (3,600) / (2,400)
Fixed / (2,100) / (1,500)
Transfer / (5,700)
Profit before tax / - / 5,400
Tax (22%) / - / (1,188)
Profit after tax / - / 4,212
Remitted (4,212 × 75%) / - / 3,159
Retained / - / 1,053
W2: After implementation of TE proposal
Strymon / Magnolia$000 / $000
Sales (Strymon – 5,700 × 1.4) / 7,980 / 15,000
Cost:
Variable / (3,600) / (2,400)
Fixed / (2,100) / (1,500)
Transfer / (7,980)
Profit before tax / 2,280 / 3,120
Tax (42%, 22%) / (958) / (686)
Profit after tax / 1,322 / 2,434
Remitted (75% × 1,322 × 90%) / 892 / 1,826
Retained (1,322 × 25%) / 331 / 608
Total remitted (892 + 1,826) / 2,718
(b)
l Lamri’s dividend capacity before implementing TE’s proposal ($8,266,000) is more than the dividend required for next year ($8,100,000).
l If the recommendation from TE is implemented as policy for next year then there is a possibility that Lamri will not have sufficient dividend capacity to make the required dividend payments. It requires $8,100,000 but will have $7,962,000 available.
l The reason is due to the additional tax that will be paid in the country in which Strymon operates, for which credit cannot be obtained. Effectively 14% additional tax and 10% withholding tax will be paid. Some of this amount is recovered because lower additional tax is paid on Magnolia’s profits but not enough.
[2 marks]
l The difference between what is required and available is small and possible ways of making up the shortfall are as follows.
n Lamri could lower its growth rate in dividends to approximately 6·2% (7,962/7500 – 1 × 100%) and have enough capacity to make the payment. However, if the reasons for the lower growth rate are not explained to the shareholders and accepted by them, the share price may fall.
n An alternative could be to borrow the small amount needed possibly through increased overdraft facilities. However, Lamri may not want to increase its borrowings and may be reluctant to take this option. In addition to this, there is a possibility that because of the change of policy this shortfall may occur more often than just once, and Lamri may not want to increase borrowing regularly.
n Lamri may consider postponing the project or part of the project, if that option were available. However, this must be considered in the context of the business. From the question narrative, the suggestion is that Lamri have a number of projects in the pipeline for the future. The option to delay may not be possible or feasible.
n Perhaps the most obvious way to get the extra funds required is to ask the subsidiary companies (most probably Strymon) to remit a higher proportion of their profits as dividends. In the past Strymon did not make profits and none were retained hence there may be a case for a higher level of remittance from there. However, this may have a negative impact on the possible benefits, especially manager morale.
[1 mark per possible action, maximum 4 marks]
Answer 2
(a)
Dividend policy
l Many high-growth companies, such as Limni Co, retain cash instead of paying dividends and use the cash to help fund the growth.
l 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.
[1 – 2 marks]
Financing policy
l 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.
l Pecking order theory suggests that companies typically use internally generated funds before seeking to raise external funds (initially debt, then equity).
l 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.
l Limni Co is following the pecking order theory to the extent that it is using internally-generated funds first.
l 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.
l This may be explained by the fact that Limni 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.
l Other issues such as potentially restrictive debt covenant may also be a factor in the financing decision.
[3 – 4 marks]
Risk management
l Managing the volatility of cash flows enables a company to plan its investment strategy more accurately.
l Limni Co needs to ensure that it will have sufficient internally-generated cash available when it is needed for planned investments.
l More importantly, since Limni 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.
[1 – 2 marks]
Effect on policies by returning funds to shareholders
l Returning funds to shareholders will affect each of these policies.
l 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.
l The financing policy is likely to change since there will be less internally-generated funds available, so Limni 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.
[2 – 3 marks]
(b)
Theta
l Company Theta has a fixed dividend payout ratio of 40%.
l 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.
l If profit after tax was to fall, Theta may reduce its dividend, which could send the wrong signals to shareholders and cause significant fluctuations in the share price. To avoid this, Theta may keep a stable dividend in years of reduced profits.
[2 marks]
Omega
l Company Omega has a policy of increasing dividends at approximately 5% per year, but earnings are only increasing at a rate of approximately 3% per year.
l This means the dividend payout ratio is increasing, it was 60% in 2009 and is 65% in 2013. Although this cannot continue in the long term, it suggests that there are less investment opportunities currently and Omega is reducing its retention ratio.
l This investment would be attractive to an investor looking for a high level of dividend income.
[2 marks]
Kappa
l Company Kappa has increased its payout ratio from 20% in 2009 to 27% in 2013. This is a fairly low payout ratio, but it is growing.
l Earnings are growing rapidly overall, but not at a constant annual rate (35% growth in 2010, but only 3% in 2011). 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.
l This investment would be attractive to investors seeking a lower level of dividend income and higher levels of capital growth.
[2 marks]
l Due to uncertainty about whether Theta could decrease its future dividend payments, Limni Co is likely to prefer to invest in either Omega or Kappa.
l The choice between these two depends on whether Limni Co would prefer higher dividends or higher capital growth.
l Issues such as taxation position or length of time that the funds would be invested for may influence this choice too.
[2 marks]
(c)
Current dividend capacity
$000Profit before tax (23% × $600m) / 138,000
Tax (26% × $138m) / (35,880)
Profit after tax / 102,120
Add: Depreciation (25% × $220m) / 55,000
Less: Investment in assets / (67,000)
Overseas remittances / 15,000
Additional tax (6% × $15m) / (900)
Dividend capacity / 104,220
[3 marks]
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 [2 marks]
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%. Limni Co needs to consider both whether this is possible for the subsidiaries, but also the motivational and operational impact of doing so on the subsidiaries.
[1 – 2 marks]
(d)
l The main benefit of a share buyback scheme to investors is that it helps to control transaction costs and manage tax liabilities.
l 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.
l On the other hand, with dividend payments, and especially large special dividends, this may result in a high tax bill.
l If the shareholder chooses to re-invest the funds, it will result in transaction costs.
l An added benefit is that, as the share capital is reduced, the earnings per share and the share price may increase.
l Finally, share buybacks are normally viewed as positive signals by markets and may result in an even higher share price.
[1 mark per relevant point]
Ans-201