STRATEGIC INVESTMENT MANAGEMENT

STRATEGIC INVESTMENT MANAGEMENT

Your assignment should include: a title page containing your student number, the module name, the submission deadline and a word count; the appendices if relevant; and a reference list in Bournemouth University (BU) Harvard format. You should address all the elements of the assignment task listed below. Please note that tutors will use the assessment criteria set out below in assessing your work.

Assignment Task

Drakon plc is a holding company owning shares in various subsidiary companies. Its directors are currently considering several projects which will increase the range of the business activities undertaken by Drakon plc and its subsidiaries. The directors would like to use discounted cash flow techniques in their evaluation of these projects but as yet no weighted average cost of capital (WACC) has been calculated.

Lord Richmond Darby, the Managing Director, has called a meeting of the directors to discuss the calculation and use of the weighted average cost of capital as the discount rate for future capital investment decisions. The only other item on the agenda, due to its perceived importance, was a discussion regarding the dividend policy of the company and whether it should be changed.

Aswar Rajan, the Financial Director, has been asked to draw up some relevant figures for the calculation of the company’s weighted average cost of capital, as shown below.

Drakon plc has an authorised share capital of 10 million 25p ordinary shares, of which 8 million have been issued. The current ex div market price per ordinary share is £1.10, a dividend of 11.4p per share having been paid recently. The company’s project analyst has calculated that 12% is the most appropriate after-tax cost of equity capital.

Extracts from the latest balance sheets for the group are given below:

Drakon plc
	(£000s)
Issued share capital	2,000
Share premium	1,960
Reserves	3,745
Shareholders’ funds	7,705
Minority interests	895
3% irredeemable debentures	1,400
9% redeemable debentures	1,500
6% unsecured loan stock	2,000
Bank loans	1,540
Total non-current liabilities	6,440

All debt interest is payable annually and all the current year’s payments will be made shortly. The current cum interest market prices for £100 nominal value stock are £31.60 and £103.26 for the 3% and 9% debentures respectively. Both the 9% debentures and the 6% unsecured loan stock are redeemable at par in ten years’ time. The 6% stock is not traded on the open market, but the analyst estimates that its effective current ex-interest market price for £100 nominal stock is £75.42. The bank loans bear interest at 2% above base rate (which is currently 11%) and are repayable in six years. The effective corporation tax rate of Drakon plc is 35%.

Lord Richmond Darby remarks that once the WACC had been calculated, it should be used to calculate all the proposed capital investment projects that were about to be undertaken. They had always used one discount rate in the past, and the economic climate was favourable and unlikely to change in the future. Esther Banda, the Production Director, also agrees stating that one discount rate would give uniformity to their decision-making process. However, Aswar Rajan is not so sure, as not all of the proposed investments have the same risk profile, and discount rates based on the cost of their individual financing, might be more appropriate. Jasmine Slark, the Marketing Director, urges caution as she has recently read an article on behavioural finance, which suggested that people can make systematic errors in the way that they think and ‘cognitive bias’ can distort some financial decisions. After further fruitful debate it was decided to calculate and use the WACC derived for the proposed capital investment appraisals.

The second item on the agenda was the discussion as to whether Drakon plc should change its dividend policy. Aswar Rajan was of the opinion that it should not; as he argued that a stable dividend policy would maintain a high level of share value. He presented the following information to the board for the subsequent discussion. Earnings per share for Drakon plc for 2015 had been 22.8 pence, and Aswar Rajan expects this to increase to 25 pence per share for 2016. He states that this increase in earnings per share is in line with market expectations of the company’s performance. The pattern of recent dividends, which are paid each year on 31 December, is as follows:

Year	2015	2014	2013	2012	2011	2010
Dividend per share (pence)	11.4	11.1	9.6	9.6	9.2	8.5

Lord Richmond Darby, the managing director, proposes that 70 per cent of the earnings in 2016 and subsequent years should be retained for investment in new product development. It is expected that, if this proposal is accepted, the dividend growth rate will be 8.75 per cent. Lord Richmond Darby had remembered reading an article in the Financial Times that dividends are irrelevant to the share price of a company. Esther Banda, the Production Director agrees with Lord Richmond Darby, pointing out that this would be the case in a perfect capital market. Jasmine Slark, the Marketing Director, was of the opinion that the company should only pay an annual dividend if there were not sufficient profitable projects available to absorb all the company’s earnings. Aswar Rajan is not at all convinced by the other arguments, stating that recent research points to the dividend decision being important both from a clientele and signalling effect, and that he doubted whether in the real world there was such a thing as a perfectly efficient capital market.

REQUIRED

SECTION A

Q1. Calculate the effective after-tax weighted average cost of capital (WACC) as required by the directors. [25 marks]

Q2. Discuss the fundamental assumptions that are made whenever the weighted average cost of capital (WACC) of a company is used as the discount rate in net present value calculations. [15 marks]

SECTION B

Q3. Calculate the share price of Drakon plc in the following circumstances, and very briefly comment on your findings:

(a) The company decides not to change its current dividend policy.

(b) The company decides to change its dividend policy as proposed by the Managing Director. [12 marks]

Q4. Critically evaluate whether a company can affect its market price by altering its dividend policy. [18 marks]

SECTION C

Q5. Provide a critical appraisal of the comment made by Aswar Rajan that in the ‘real world’ he doubted that an efficient capital market existed. Explore why this concept is of such importance to financial management decisions. [16 marks]

Q6. Discuss the comments made by Jasmine Slark, regarding the behavioural aspects of financial decisions, and explore how such factors could influence the methods by which financial decisions are made by this company. [14 marks]