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Table of Contents

Introduction............................................................................................................................ 3

Company Policies...................................................................................................................4

Capital Structure.................................................................................................................4

Dividend Policy....................................................................................................................... 6

Cost of Capital........................................................................................................................ 9

REFERENCES..................................................................................................................... 14

Appendix.............................................................................................................................. 15

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 forecasted Sales growth in % INTRODUCTION
12.00
10.00 9.68 10.29
8.00 8.77 The report is to critically analyse the forecasted next 5
7.55
6.00 6.00 years financial plan of Lion Grange Company and to
4.00
2.00 evaluate the Company’s policies and objectives. And
0.00
2009-10 2010-11 2010-12 2012-13 2013-14 this is to provide the recommendations based on the
observation made to Mrs. Hogg, the Chief Financial
Officer, Lion Grange, Coventry; in order to improve the
company performance and to overcome financial problems.

As per forecasted income and balance statements (Appendix 1.1), the forecasted sales
growth rate from year to next year is gradually decreasing from 2009 to 2014 though the
sales in number is increasing as depicted in the diagram. In general sales persuade the
current asset and current liability parameters. The small amount of increase for each year
says that company will have to carry more inventories and have a generously proportioned
accounts receivable balance. Also sales are in relation to retained profits through profit
margin and dividend payout. Since dividend payout (50%) and net profits (10%) are
constantly planning to maintain with the same percentage in future, there is no inclines in
retained profit earnings.

The next 5 year plan explains that objective of the company is to maintain sales growth with
a small proportion of increase. From 2010 to 2014, this forecasting shows that there is need
for external financing which is gradual increasing in higher proportions. This additional
finance also called as “plug figure”. This figure provides the information to Company that
how much amount of additional finance required in order to balance Company sources and
funds usage. In 2010, this short fall value is in negative (-0.005) which means that company
has more funds than the projected assets. This excess fund can be utilised in many ways for
example clearing off the notes payables etc.

The forecasted plan indicates that there are couple of problems with excess funds generated
and short falls like how best the excess amount to be utilized and how to raise the short fall
amount. A small proportionate increase in sales, equity and capital employed leads to
maintaining constant percentage of returns such as ROCE which is at 8%, ROE at 11% and
Net asset turnover at 0.8 times. Here there is no growth from year to year.

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 Leverage COMPANY POLICIES
Lion Grange Company policies on dividend and long term
30 Equity
Debt borrowings are evaluated and compared with the theories and
70 empirical evidences available as follows.

CAPITAL STRUCTURE
This is a combination of financing methods. This includes short term and long term debts
and also capital from shares, reserves. Capital market efficiency is one of the applicable
methods to reduce the loss of market value which causes due to the capital market
imperfections such as asymmetric taxes, transaction costs and asymmetric information. In
an actual capital market, the capital structure of an organization does not have any effect on
its value. The value is completely supported on the profitability of the assets and the
predictable NPV’s of the investing projects.

CAPITAL STRUCTURE CRITERIA

The structure that minimizes overall cost of financing. This is measured by WACC. This
needs to be selected in order to maximize the value of firm.

FINANCIAL LEVERAGE
This is about use of relatively cheap debt to increase expected ROE. This is measured using
couple of ratios. Debt finance ratio (debt/ debt + equity). And the other one is long-term debt
to capitalization. Lion Grange is estimated at 30% gearing to be continued.

THE MAGIC OF FINANCIAL LEVERAGE

With a two capital structures where one is full equity finance and other one is equity and loan
capital. The financial leverage increases the return on equity for the likely business result.
Increases of variability of ROE add financial risk. More leverage leads to high gearing which
is more risky.

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MODIGLIANI AND MERTON(MM) PROPOSITIONS

MM proposition 1 :
Modigliani and Merton (MM) demonstrated the following proportion, when there are no taxes
and markets function well, the market value of the company does not depend on its capital
structure. Means – Managers can’t increase value by changing the mix of securities used to
finance the company.
“The value of the firm must be unaffected by its capital structure MM debt irrelevance
proposition”. (Brealey 2007)
Here the assumptions are
No taxes
No transaction costs free information
No other imperfections

Proposition 2:
Required rate of return on equity increases in proportion to debt ratio (D/ D+E) means the
required rate of return on equity increases as the Company’s debt-equity ratio increases. “If
debt policy were completely irrelevant, actual debt ratios would vary randomly from firm to
firm” (Brealey 2007)

Implications of these propositions are

1. In PCM, there is no optimal capital structure for the company.
2. To find the perfect capital market, they should find imperfections.

SELECTING A CAPITAL STRUCTURE

There are 3 different types of perspectives to select a capital structure.
Benefit of debt
Cost of debt – financial distress, here the main advantage through Debt financing is tax
saving for the interest payable. This is called interest tax shield.
OPTIMAL CAPITAL STRUCTURE
Trade-off theory
Capital structure based on a trade-offs between benefits and cost of debt. Under this theory,
high profits should mean more debt servicing capacity and more taxable income to shield
and therefore should give a higher debt ratio. It predicts that target debt ratios will vary from
firm to firm. It fails in the case of most profitable companies generally borrow the least.

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Pecking Order theory
Companies have ordered preference for financing.
1. Internal sources ( Profits)
2. debt
3. External equity financing.
As the overall theory says, there are four dimensions which need to be ensured for capital
structure. Taxes, Risk, asset type, Financial slack. In Lion Grange company, estimated
leverage is 30% which reasonably good amount. It helps in improve the shareholder wealth
through making the profits, improves the company liquidity, reduce the corporation tax,
though risk is there which is not at high since company is not at high leverage. Operational
gearing is not so high so it is not too risky.

DIVIDEND POLICY
In order to take important decisions towards maximize shareholder wealth; one important
consideration which needs to be taken is dividend policy - is a company’s strategy to transfer
the money to its shareholders. In general, shareholders will receive money in two forms. One
is in dividend form and other one is booking the current market value by selling holding
shares. Company pays dividends to its shareholders from the booked profits after tax. There
are many analysis conducted before come up with the dividend policy.

The most common assumptions made by the investors are

 At least maintaining the Dividend per share value to the last year’s level until unless
company informs that there will be a dividend cut possibility and another case is
when dividend cover is too low.
 Depends upon the previous year’s payout ratio level, investors expects the same in
future as well.
 The current dividend growth level will be continued until dividend cover does not drop
overly to below levels.

From empirical study in the market, company will be punished in case of dividends are cut
by the company even though for a valid reason such as investing funds into new project
which is in fact a value generating project. Investors receive this as a bad news since it cuts
the dividend. Thus Companies ignores the new investment even though it is good
investment. (Fairchild 2010)

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In 2000-2005, Most of the evidences demonstrate that Companies controlled by the families
are having maximum levels of dividend payout ratios and influence than their counterparts.
Due to the superior number of self-governing directors on family boards, dividend policy has
the positive impact of family control. This paper, however, provides the information of small
evidence that board independence moderates the relationship between debt and family
control. (Atmaja 2010)

The following are few limitations observed from the theories which need to be aware in order
to optimize the dividend policy.

LIQUIDITY
Empirical studies and theories says that high dividends effect the company liquidity position.
Lion & Grange is giving 50% dividends which is a major impact towards the company
liquidity to operational activities. Though company making profits, all profits need not to be in
the form of cash which will create a problem for dividends.

INTEREST PAYMENT OBLIGATIONS

As the company needs to fulfil interest obligations, paying dividends in high cause the impact
for these obligations

INVESTMENT OPPORTUNITIES
High dividends consume the money from retained profits which can be reinvested in order to
improve the shareholder wealth.

EFFECTS OF DIVIDEND POLICIES ON SHAREHOLDER WEALTH

There are two different views on dividends such as dividend relevancy and dividend
irrelevancy. Dividend relevancy view is very similar to traditional view. As per Lintner and
Gordon view supporting traditional view, in the form of dividends, the investor gets the
money at present instead of in future where amounts are more certain. People are
persuaded to invest when they receive dividends and also in turn this enforces them to
reinvest in future. This implies that managers should adopt possible generous dividend
policy.

As per the Modigliani and Merton (MM) view also which is a modernists view, dividends are
irrelevant and argue that paying small amount of dividends and investing retained profits into

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projects whose NPV is positive is good way of improving shareholder wealth rather than
giving dividends in high proportions. Through this approach, shareholders wealth will be
improved since they can receive the dividends and also they can book their shares at high
market value, the rise because of new investments signals market share price. This view has
few assumptions, they are No taxes, No transaction costs, free information, No other
imperfections.

Influencing factors for dividend policy are

- Reinvestment required for new investment projects
- Availability of other sources of funds
- Existing cash levels and liquidity
- Market reactions to change in dividend level or dividend policy
- Shareholder preferences for capital gain
- Alternating to cash dividends – stock dividends, shares buyback

Different dividend policies;

Constant payout
Companies use this policy to pay continuous in years with a constant percentage
maintained.
Progressive policy
Residual policy :

Alternative policies to paying cash

Lion Grange Company is having dividend payout ratio of 50% and still to maintain for the
forecasted years which squeezes the cash of company. As long as good returns expected,
having 50% dividend is also not worthy policy since this money can be utilized for positive
NPV new projects or to increase the liquidity. The current dividend policy retains the
shareholders and may chance of attracting the investors which is in similar in traditional view
perspective. Though attracts customers, it needs sustainable growth to maintain the current
dividend policy.

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COST OF CAPITAL
This is the required rate of return on the various types of financing. The weighted average of
the individual required rates of returns (costs) is the overall cost of capital. There are
different methods calculating the cost of capital.

COST OF DEBT
This is cost to borrowed money. For Lion & Grange Company, the value has been estimated
at 8%.
COST OF EQUITY
This can be calculated using number of approaches. The below one is the one which suits to
the information provided.
CAPITAL-ASSET PRICING MODEL APPROACH:
This is an approach to calculate the required rate of return for the equity. This is based on
two parameters, the time value of money and risk of the stock itself. As show in the below
diagram the CAPM approach gives the risk premium and cost of ordinary shares (equity).

Source : (Attrill 2008)

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To illustrate required rate of return for the Lion & Grange company share, the following
equation will be used, where Company’s equity beta estimated at 1.20, this informs that the
stock’s surplus return rise or fall by a somewhat bigger percentage than does the surplus
return for the market.

K0 = KRF + b(Km − KRF)

where: K0 = the required return for investors for a particular share

KRF = the risk-free rate on government bonds
b = beta of the particular share
Km = the expected returns to the market for the next period
(Km − KRF) = the expected market average risk premium for the next period.

In beta calculation, cost of the security according to market stability will act as a linear
transaction among the necessary rate of return and systematic risk. For Lion Grange
Company, Km is assumed at the values of 6 and 10 in response to minimum 6% and
maximum 10% which is an UK average automotive industry returns of small scale and large
scale industries offering for capital investment.

As per traditional point of view, inverse

pattern of graph depicts the relation between
the level of borrowing and the cost of capital.
Here it shows that at low cost of capital
results that high net present value for the
future cash flows of the business. This
informs that decision towards financing is very crucial and failure to have the right
combination of finance leads to create problem for shareholder wealth.

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Weighted average cost of capital (WACC) approach is used to calculate the average cost of
capital. The below table explains the calculation.

Cost of Cost of
capital capital
  Weighted averages (%) % (%) %
Equity 0.7 6.5 4.55 11.3 7.91
Debts 0.3 0.8 2.4 0.8 2.4
WACC 6.95   10.31

Since cost of debt is 8%, the company should earn more than 8% returns in order to payout
the interest and to provide good returns to the share holders.

Economic value added:

This is an internal performance measure. This measures the economic benefit of the
company. Stewart (1991:153) defines EVA as " A company's EVA is the fuel that fires up its
MVA". EVA considered total cost of capital means it includes the cost of capital. EVA can be
calculated either of the formulae.
EVA = (ROIC – WACC) * IC
(or)
EVA = NOPAT – (WACC * IC)

EVA
(NOPAT – (WACC *
NOPAT Investment Capital (IC) WACC IC))
100000 1250000 0.0695 13125
100000 1250000 0.1031 -28875

For Lion Grange company, at WACC 10% , the EVA is negative which means that company
is not in a good position of holding the economic benefit which is at the required rate of
return for capital is 11.3% and for debts is 8%. This is situation of good returns expected by
the share holders. In another scenario, at 6.5% of required returns of capital the EVA is
positive 13125. Which shows that strong position of economic value.

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MVA:
MVA is the difference between the total market value of the company and the economic
capital. The below table shows based on the EVA and MVA , categorizing the companies
where it stands.

Hig
h
Problem Children Winners

Losers Holders of real options

EVA
Low Low High
MVA

RECOMMONDATIONS

In forecasted
In order to balance the short falls in forecasted balance sheet, there are possibilities of
increasing the

CONCLUSIONS

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REFERENCES

Atrill, P. (2008) 5th edn. Financial Management for Decision Makers. Essex: Pearson
Education

Brealey, R. ,Myers, S. , and Marcus, J. (2007) 5th edn. Fundamentals of Corporate Finance.
Newyork: McGraw-hill Companies

Emery, D. , Finnerty, J. and Stowe,D. (2007) 3rd edn. Corporate financial management. New
Jersy: Upper Saddle Rivew

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Fairchild, R. (2010) 'Dividend Policy, Signalling and Free Cashflow: An Integrated Approach'.
Emerald Group Publishing Limited 36 (5), 0307-4358

VanHorne, J. and Wachowiz, J. (2007) Fundamentals of Financial Management. Essex:

Person Education limited

Watson, D. , and Head, A. (2004) Corporate Finance Principles and practice. Essex: person
education limited

APPENDIX

1.1

Income Statement
  2009 2010 2011 2012 2013 2014
Sales 10 10.6 11.4 12.4 13.6 15
Net Profit After Tax 1 1.06 1.14 1.24 1.36 1.5
Dividend 0.5 0.53 0.57 0.62 0.68 0.75
Retained Earnings 0.5 0.53 0.57 0.62 0.68 0.75

Balance Sheet
200
  9 2010 2011 2012 2013 2014
Net Assets (OR) Capital Employed 12.5 13.25 14.25 15.5 17 18.75
Debts 3.75 3.975 4.275 4.65 5.1 5.625
  8.75 9.275 9.975 10.85 11.9 13.125
 
Share Capital 8.25 8.25 8.25 8.25 8.25 8.25

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 Retained Earnings 0.5 1.03 1.6 2.22 2.9 3.65
Equity 8.75 9.28 9.85 10.47 11.15 11.9
Excess/Shortfall   -0.005 0.125 0.38 0.75 1.225

1.2

K0 = KRF + b(Km − KRF)

K0 = 3.5 + 1.2 (6-3.5)
= 6.5
Beta 1.2
KRF 3.5
Km 6
K0 6.5

Cost of capital : WACC : 9.4

EVA =

1.3
DIVIDEND AT 20%
2009 2010 2011 2012 2013 2014
£M £M £M £M £M £M
SALES 10 10.6 11.4 12.4 13.6 15
NPAT 1 1.06 1.14 1.24 1.36 1.5
DIVIDEND 0.2 0.212 0.228 0.248 0.272 0.3
RETAINED PROFIT 0.8 0.848 0.912 0.992 1.088 1.2
NET ASSET 12.5 13.25 14.25 15.5 17 18.75

FINANCED BY
SHAREHOLDERS
CAPITAL 8.25 8.25 8.25 8.25 8.25 8.25
LOANS 3.75 3.975 4.275 4.65 5.1 5.625
RETAINED PROFIT 0.8 1.648 2.56 3.552 4.64 5.84
TOTAL 12.8 13.873 15.085 16.452 17.99 19.715
EXCESS 0.3 0.623 0.835 0.952 0.99 0.965

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 DIVIDEND AT 30%
2009 2010 2011 2012 2013 2014
£M £M £M £M £M £M
SALES 10 10.6 11.4 12.4 13.6 15
NPAT 1 1.06 1.14 1.24 1.36 1.5
DIVIDEND 0.3 0.318 0.342 0.372 0.408 0.45
RETAINED PROFIT 0.7 0.742 0.798 0.868 0.952 1.05
NET ASSET 12.5 13.25 14.25 15.5 17 18.75

FINANCED BY
SHAREHOLDERS
CAPITAL 8.25 8.25 8.25 8.25 8.25 8.25
LOANS 3.75 3.975 4.275 4.65 5.1 5.625
RETAINED PROFIT 0.7 1.442 2.24 3.108 4.06 5.11
TOTAL 12.7 13.667 14.765 16.008 17.41 18.985
EXCESS/Short Fall 0.2 0.417 0.515 0.508 0.41 0.235

DIVIDEND AT 30%
2009 2010 2011 2012 2013 2014
£M £M £M £M £M £M
SALES 10 10.6 11.4 12.4 13.6 15
NPAT 1 1.06 1.14 1.24 1.36 1.5
DIVIDEND 0.3 0.318 0.342 0.372 0.408 0.45
RETAINED PROFIT 0.7 0.742 0.798 0.868 0.952 1.05
NET ASSET 12.5 13.25 14.25 15.5 17 18.75

FINANCED BY
SHAREHOLDERS
CAPITAL 8.25 8.25 8.25 8.25 8.25 8.25
LOANS 3.75 3.975 4.275 4.65 5.1 5.625
RETAINED PROFIT 0.7 1.442 2.24 3.108 4.06 5.11
TOTAL 12.7 13.667 14.765 16.008 17.41 18.985
EXCESS 0.2 0.417 0.515 0.508 0.41 0.235

DIVIDEND AT 34%
2009 2010 2011 2012 2013 2014
£M £M £M £M £M £M
SALES 10 10.6 11.4 12.4 13.6 15
NPAT 1 1.06 1.14 1.24 1.36 1.5
DIVIDEND 0.34 0.3604 0.3876 0.4216 0.4624 0.51
RETAINED PROFIT 0.66 0.6996 0.7524 0.8184 0.8976 0.99
NET ASSET 12.5 13.25 14.25 15.5 17 18.75

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 FINANCED BY
SHAREHOLDERS
CAPITAL 8.25 8.25 8.25 8.25 8.25 8.25
LOANS 3.75 3.975 4.275 4.65 5.1 5.625
RETAINED PROFIT 0.66 1.3596 2.112 2.9304 3.828 4.818
TOTAL 12.66 13.5846 14.637 15.8304 17.178 18.693
EXCESS 0.16 0.3346 0.387 0.3304 0.178 -0.057

DIVIDEND AT 33%
2009 2010 2011 2012 2013 2014
£M £M £M £M £M £M
SALES 10 10.6 11.4 12.4 13.6 15
NPAT 1 1.06 1.14 1.24 1.36 1.5
DIVIDEND 0.33 0.3498 0.3762 0.4092 0.4488 0.495
RETAINED PROFIT 0.67 0.7102 0.7638 0.8308 0.9112 1.005
NET ASSET 12.5 13.25 14.25 15.5 17 18.75

FINANCED BY
SHAREHOLDERS
CAPITAL 8.25 8.25 8.25 8.25 8.25 8.25
LOANS 3.75 3.975 4.275 4.65 5.1 5.625
RETAINED PROFIT 0.67 1.3802 2.144 2.9748 3.886 4.891
TOTAL 12.67 13.6052 14.669 15.8748 17.236 18.766
EXCESS 0.17 0.3552 0.419 0.3748 0.236 0.016

Cost of Cost of
  Weighted averages capital % capital %

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 (%) (%)
Equity 0.7 6.5 4.55 11.3 7.91
Debts 0.3 0.8 2.4 0.8 2.4
WACC 6.95   10.31

NOPAT Investment Capital WACC EVA

100000 1250000 0.0695 13125
100000 1250000 0.1031 -28875

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