F3 Financial Strategy. Examiner s Answers

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1 Strategic Level Paper F3 Financial Strategy September 2013 examination Examiner s Answers Question One Rationale Question One concerns the evaluation of a proposal to privatise one of T Railways wholly owned subsidiary companies, TPTS. It requires a comparison of two possible methods of privatisation. This is followed by an evaluation of the value of TPTS from the viewpoint of both the vendor and the acquirer. The question concludes by asking for a recommendation as to whether or not T Railways should proceed with the sale of TPTS, taking into account the wider financial and strategic issues arising. Question One examines syllabus sections B1(c), C1(a) and C2(b). Suggested Approach The answer to part (a) should consider the two alternative privatisation methods listed in the requirement, focussing on a comparison of the methods themselves rather than the impact on TPTS of privatisation per se. In part (b) (i), the answer should begin by considering all the current TPTS cash inflows and outflows to identify which are lost as a result of the sale of TPTS. Any new cash flows (such as payment to UT for the use of the track and policing services) and any other changes (such as to head office costs) should also be added to the list. In part (b) (ii), the net change in cash flows identified in part (b)(i) should be discounted by applying the growing perpetuity formula at a growth rate of 2% and a discount rate of 4%. Finally, in part (b) (iii), the appropriateness of the discount rate of 4% should be considered. Starting with the rationale for its use and then questioning the validity of the use of a discount rate that takes neither risk nor tax into account. Financial Strategy 1 September 2013

2 Question One Suggested Approach continued Part (c)(i) should begin by scheduling the relevant cash flows for TPTS once owned by UT. These should then be discounted at 8% using a growth rate of 2%. Asset based valuations should also be provided on both a cost and replacement cost basis. Part (c)(ii) should consider the validity of each method used in (c)(i), taking each in turn, within the context of the question scenario. Part (d)(i) should begin by looking at the maximum price that UT would consider based on the results in part (c). This should be compared to the cost of disposing of TPTS from T Railways viewpoint as calculated in part (b)(ii) and a conclusion drawn. The answer to part (d)(ii) should firstly consider the financial implications of the sale of TPTS from the viewpoint of both T Railways and its sole shareholder, T Government. Both short and long term financial impacts should be considered. The answers should then widen out to consider the wider strategic benefits and drawbacks of the sale of TPTS, before reaching an overall recommendation. (a) Price obtained and speed and risk of completion of the sale The IPO has the potential to raise higher sales proceeds than a trade sale to UT by opening the sale up to a wider potential investor group. However, a successful IPO requires a strong demand for shares, reflecting public confidence in the future profitability and government support for the new company. Although likely to be at a lower price, a sale to UT would be quicker and cheaper to achieve. No underwriting costs would be required and the tighter timeframe would result in lower exposure to a fall in the stock market during the sale process. Management expertise In both cases, the sale agreement could include lock ins for the transfer and retention of key staff to ensure continuity in track management and transference of management expertise in this specialist area. A sale to UT would have the added advantage of a main Board of UT who already have expertise in managing an independent services company. Confidence in the on-going provision and quality of the maintenance of track A long term view is required when managing track quality. There is some reassurance that UT would be willing to adopt such a strategy as, indeed, the provision of utility services requires a similar long term business and maintenance perspective. The management of UT would also already have the necessary experience and expertise in managing and negotiating service levels with T government in respect of the provision of utilities. This skill is likely to be useful when drawing up a service agreement for provision of the railway track to T Railways. To summarise, although selling to UT may not raise as high a sales value, it would seem to be a quicker and safer approach to privatisation. September Financial Strategy

3 (b) The sale of TPTS from the viewpoint of T Railways (b)(i) impact of the sale of TPTS on T Railways post-tax, pre-financing cash flows Changes to T Railways forecast cash flows for the year ending 31 December 2014: T$ million Revenue from cafes and stations foregone (100) where 100 = Direct operating costs no longer incurred 795 Benefit from reduction in HO costs 25 Fees payable for use of track (800) Incremental net operating cash outflow (80) This equates to a post-tax net operating cash outflow of T$ 56.0 million for the year ending 31 December 2014 ( = T$ 80 million x (1 0.30)). (b)(ii) Present value of change in cash flows NPV of forecast change in cash flows above Value at 4% with 2% growth: T$ 2,856 million = T$ 56.0 m x 1.02 / (4% - 2%) (b)(iii) Validity of 4% discount rate Benefits: Easy to apply, consistent with other businesses owned by T Government. Represents T Government s cost of borrowing which is consistent with the funding structure of T Railways, which is wholly funded by T Government. Drawbacks: The 4% cost of capital has not been adjusted to reflect the beta or risk profile of the railway business. Some adjustment would be reasonable to ensure that a more realistic commercial valuation of TPTS is obtained for use in setting a fair price for the sale of TPTS. 4% is the pre-tax cost of debt to T Railways but has been applied to post tax cash flows. This is clearly inconsistent treatment of tax - a post-tax cost of debt would have been more appropriate and used to calculate T Railways WACC. Alternatively, the pre-tax cost of capital of 4% could have been applied to pre-tax cash flows. This is, arguably, technically more correct since tax is paid across to the sole lender, T Government, and so would be best removed from the calculation altogether due to the circular flow of the tax element. Using a non-risk-adjusted cost of capital as the discount rate is likely to over-value TPTS and give T Railways an unrealistic target price for TPTS. Financial Strategy 3 September 2013

4 (c) The sale of TPTS from the viewpoint of UT (c)(i) Valuing TPTS from the viewpoint of UT Asset bases T$ million Non-current assets at cost 1,500 Add working capital 2 Capital employed at book value 1,502 T$ million Non-current assets at replacement value 1,990 Add working capital 2 Capital employed at book value 1,992 DCF basis NOCF after tax of T$ 67.2 million (= T$ 96 m x (1 0.30) at a discount rate of 8% gives an NPV value of: T$ 1,142 million at 2% growth (where 1,142 = 67.2 X 1.02 / (8% - 2%)) (c)(ii) Validity of methods used and results obtained An asset based valuation is the simplest valuation method available because it simply uses information provided. However, neither book value nor replacement value is likely to be representative of the underlying commercial value of TPTS. The commercial value of the track is the potential revenues that it can generate. The track has little value for an owner unless it can be used to run trains. Without the railways, it would be worth little more than the value of scrap metal. Even if there were a newly formed railway company which could use the track, it would be unlikely to pay anything near to cost price for second hand track, especially as track systems are constantly evolving technologically. The DCF valuation is lower than either of the asset based valuations. This is an unusual position but supports the opinion expressed above that the asset based valuations do not give valid results in the context of this scenario. The DCF valuation is more appropriate in this case since it reflects the earning capacity of the track. However, the validity of the DCF result depends to a large extent on the validity of the inputs to the DCF model. The cash flow estimates for 2014 are highly subjective. It is not yet clear as to what it might cost to maintain the track nor is it clear how much UT could charge T Railways for use of the track. Also, the business is wholly dependent on one customer and hence UT may demand a lower price because of the risk this creates. September Financial Strategy

5 (d) Overall assessment and recommendation (d)(i) Maximum price that UT is likely to offer for TPTS AND whether this is likely to be acceptable to T Railways Maximum price As already discussed above, the DCF valuation obtained in (c)(i) above is considered to be more appropriate than an asset based valuation in this instance. The maximum price that T Railways can expect to obtain for TPTS is therefore T$ 1,142 million. However, the actual price achieved may be significantly lower depending on UT s perception of the risks involved in taking over the running of the track and the uncertainties surrounding both the future cost of maintaining the track and the fee that could be obtained for the provision of the track to T Railways. Whether this price is likely to be acceptable to T Railways Based on the results in (b)(ii) above, the disposal of TPTS is estimated to cost T Railways T$ 2,856 million based on the present value of the net increase in cash outflows in perpetuity at T Railways discount rate of 4%. This is more than double the price of T$ 1,142 million that UT might be willing to pay. T Railways would therefore lose out financially if it were to sell TPTS. The immediate sale proceeds, which would enable it to repay debt, would be more than offset by the loss of revenue and the increase in costs in perpetuity, even after taking the interest saving into account. Indeed, the interest saving is overstated in the calculation since the discount rate used was the pre-tax cost of capital and would be lower after taking the tax saving on debt interest into account. (d)(ii) It is not recommend that T Railways should proceed with the sale of TPTS unless forced to do so by pressure from T Government. It does not benefit T Railways from either a financial or strategic point of view. Indeed, it creates significant risk to the continued operation of the railways by losing direct control over such core and strategic assets as the track, stations and other property and property services. Looking at the financial angle first: As already noted above, T Railways would lose out financially by the sale of TPTS. Indeed, T Government, as the sole source of finance for T Railways, would also lose out financially. The short term gain in terms of funds received on repayment of some of T Railways borrowings would be outweighed by the net increase in funding that T Railways would require in perpetuity. This strategy provides a short term gain in exchange for higher costs in the future. However, T Government might consider that this is a price worth paying on the assumption that financial conditions may improve in the future and that it is more important to address the immediate need of reducing T Government borrowing than to be too concerned about additional costs in the future when public sector borrowing may be less of an issue. Another observation is that the current government would gain favourable publicity by reducing public sector borrowing and it will be a different government that has to pick up the added costs at a later date. Financial Strategy 5 September 2013

6 There are also significant strategic drawbacks and risks to T Railways (and hence also to the country as a whole) arising from the sale of TPTS. Key issues are considered below: Loss of control over the maintenance of the track. If the acquirer does not invest in the track and maintain it at the appropriate standard, this would have a direct impact on the provision of rail services which could undermine T Railways business. Unknown future liability to support UT in the future. If UT were to become unviable due to escalating maintenance costs, it is likely that T Railways would will feel obliged to increase the amount paid for use of the track or otherwise support UT in order to ensure that it is able to continue in business. T Railways cannot provide passenger and freight services without track! In addition, T Railways would not be able to meet its targets for safely and reliability of service (many of which are set by the Rail Regulator) if UT were to be unable or unwilling to maintain the track to an acceptable standard. In other words, by selling TPTS, T Railways would lose all control over how the track is maintained but would retain all the risks inherent in the provision and maintenance of the track. Inadequate rail services could have significant knock-on effects for the economy as a whole. Many employees and industries will rely on the rail network to transport people and goods. Environmental targets also depend on greater use of the railways. In conclusion, the costs and risks outlined above clearly outweigh the benefits to T Railways of the sale of TPTS and it is recommended that T Railways does not proceed with the proposed sale of TPTS. Track and other property are core business assets that are central to T Railways business and service targets. Selling and hence effectively outsourcing such a vital resource and hence losing direct control over how the track is managed could undermine the whole of T Railways business. Indeed, the risks extend beyond T Railways as a disruption in the country s rail services would be likely to have much wider implications for the whole economy. September Financial Strategy

7 Question Two Rationale Question Two focuses on both the funding and management of working capital. The question begins by testing candidates ability to calculate and evaluate a company s current short term borrowing requirement and the sensitivity of that borrowing requirement to three possible alternative outturn scenarios. Candidates are then asked to assess the potential liquidity challenges that the company faces and how best to respond. Question Two examines syllabus sections A2(c) and B1(a) and (e). Suggested Approach In part (a), firstly calculate closing working capital balances. This information, together with the data provided on opening balances, can then be used to adjust sales and purchases forecasts onto a cash basis. A cash forecast can then be built up, starting with sales receipts and purchase payments and adding other cash items to derive a figure for the net cash movement in the period. Although not required in the question, note that it is a good idea to add in the opening cash balance and calculate a closing cash balance at this point as a cursory glance at requirement (b) reveals that this information will prove useful later on in the question. In part (b), it is probably simplest to use EXCEL to copy and paste the original cash forecast three times. Each of these copied versions can then be amended to reflect the change in circumstances outlined in each of the three scenarios provided in the question. Add the opening cash balance in order to derive the closing cash balance or borrowing requirement at the end of the period under each scenario. Now evaluate your results, comparing the relative size of the borrowing requirement under each scenario In part (c), consider how the potential increased borrowing requirement could be met, either by changes to the management of working capital or by arranging additional short term loans, backup bank facilities or a paper issuance programme. Finally, consider any changes that should be considered in respect of long term financial strategy in order to ensure that the company has sufficient liquidity to meet its needs in the long term. Financial Strategy 7 September 2013

8 (a) Forecast for year ended 30 June 2014: F$ million Sales revenue Purchases (370.00) Note that purchases are equivalent to COGS since inventory is unchanged Other costs (325.00) Add back: Depreciation Less: Capex (30.00) Less: Dividend (20.00) Add: Accounts receivable at start Less: Accounts receivable at end (35.75) = F$ 725 m X 30% X 60/365 Less: Accounts payable at start (124.90) Add: Accounts payable at end = F$ 370 m X 120/365 Net cash inflow Add opening balance Forecast closing balance (b) Scenario 1 (F$ million) Scenario 2 (F$ million) Scenario 3 (F$ million) Sales revenue Purchases (321.00) (321.00) (321.00) Other costs (325.00) (325.00) (325.00) Add back: Depreciation Less: Capex (30.00) (30.00) (30.00) Less: Dividend (20.00) (20.00) (20.00) Add: AR at start Less: AR at end (31.07) (51.78) (31.07) Add: Inventory at start Less: Inventory at end (42.00) (42.00) (42.00) Less: AP at start (124.90) (124.90) (124.90) Add: AP at end Net cash outflow (39.24) (59.95) (144.77) Add opening balance Forecast closing balance (9.95) (94.77) The largest impact on liquidity is the potential withdrawal of credit by suppliers (negative impact of F$ million (= million million)), the difference between the outcome of scenarios 1 and 3. The second largest effect is the deterioration in sales which, together with a reduction in purchases has a negative impact on liquidity of F$ million (= million million) in scenario 1. In both scenarios 2 and 3, FF requires additional funding. In Scenario 3, new borrowings of at least F$ 95 million would be required. This is clearly a very large sum to find, especially given FF s very low profit margin (30/725 = 4% before dividends in the year ended 30 June 2014). Even in best case scenario 1, FF s cash resources are severally diminished and back-up borrowing facilities would be required to provide reassurance that future cash needs could be met. September Financial Strategy

9 (c) The management of working capital Inventory It may not be possible for FF to reduce inventory since this could create a risk of product shortages and consequential loss of sales. Products could be ordered in store and then delivered to the customer directly from the manufacturer rather than held by FF in storage. However, FF would then be reliant on speedy delivery by the manufacture, something that would be outside its control. Accounts receivable FF might attempt to apply credit control procedures on a stricter basis. However, there is a risk that such a policy could lead to a loss of sales, especially given the current poor market conditions. Accounts payable At present, it should be a higher priority for FF to maintain good relationships with suppliers rather than seek to extend credit terms. Financing working capital and other short term liquidity requirements Greater borrowing headroom is required in order to cope with uncertain future cash flows FF should attempt to negotiate back-up bank facilities that can be drawn down as required. These might include a revolving credit facility (RCF) (committed finance) or overdraft facility (uncommitted, so less reliable than RCF) to enable it to meet short term cash needs. Working capital could be used to support financing. For example: Use factoring to gain access to funds tied up in accounts receivable. Borrow against inventory. (Banks may be more willing to lend and at a lower interest rate where assets are used as security since such borrowings may make lesser demands on a bank s capital requirements.) Negotiate the use of consignment stock. Attempt to arrange with suppliers that they would only be paid for the goods on display once they had been sold. However, this is unlikely to prove successful given FF s current financial weakness. Releasing cash elsewhere in the business FF could consider delaying other payments, for example, refurbishment of stores or other capital expenditure programmes. The dividend forecast to be paid on 20 June 2014 could be altered. Either no dividend could be paid or it could be deferred, reduced, or paid in a non-cash form such as a scrip dividend. Long term financial strategy Over the longer term, it is important that the company manages the business in a profitable manner. Ultimately, profits turn into cash and the company can only survive if it has a business strategy that creates profit and value. We can see from a further analysis of scenarios 1 to 3 that a fall sales and purchases as modelled in these scenarios creates an accounting loss: Scenarios 1 to 3 (F$ million) Sales revenue Purchases (321.00) Other costs (325.00) Accounting loss (16.00) This position is clearly unsustainable in the longer term and changes would be needed to reduce other costs and/or increase the gross profit margin. FF should continually monitor and update a medium to long term cash forecasts to give early warning of future liquidity demands and enable appropriate changes to be made to financial and business strategy to ensure that liquidity demands can be met. Financial Strategy 9 September 2013

10 Question Three Rationale Question Three requires an assessment of the likely impact on share price of a proposed new project to be financed by a rights issue. Two alternative theoretical approaches are used to calculate the theoretical ex-rights price. Theoretical and practical factors that affect share prices are both considered in the context of the scenario provided. Question Three examines syllabus section B1(d). Suggested Approach Part (a) requires the calculation of the Theoretical Ex-Rights Price. The simplest way to arrive at the correct answer is to draw up a table with a column for number of shares, share price and total value. The first row in the table can be completed by copying information across from the question concerning the current position. Information on the value of the project can then be added to the final value column. Then add the number of shares being issued under the rights issue, together with the price of those shares. Total each column and use the totals to derive the missing figure for the resultant share price post rights issue. There are a number of acceptable approaches to answering part (b)(i). Standard IRR approach: Firstly schedule the cash flows arising from the production of product X. Note that you are already given the NPV at a discount rate of 10%, so just one more NPV result is required in order to derive the IRR by interpolation. In the answers we have used a discount rate of 12%. There is no value in repeating the NPV at 10% here. Note that it is not possible to obtain the IRR by applying the EXCEL IRR function in the normal manner here since a perpetuity is involved. The EXCEL IRR function is applied to pre-discounted cash flows and these continue indefinitely into the future. Alternative approach to proving the IRR: Show that the NPV is zero at 11.3% and, hence, that 11.3% is, indeed, the IRR. Calculate the NPV using EXCEL and the perpetuity formula. In part (b)(ii), apply the yield-adjusted TERP formula using 11.3% as Y new, being the effective yield on the project, and 10% as Y old, being the current WACC of the company. In part (c), address each of the issues raised in the requirement in turn, beginning by outlining the efficient market hypothesis and its relevance in this scenario. Conclude by considering broader business and risk factors that can be expected to influence the share price in this scenario. September Financial Strategy

11 (a) Issue price is (100% - 30%) x USD 4.80 = USD 3.36 per share TERP = 1 N + 1 [(N x cum rights price) + issue price] + NPV or project/number of shares after the rights issue = 1 [(5 x 4.80) ] /( ) 6 = = USD 4.61 per share (b)(i) NPV at a discount rate of 10% is USD 44.6 million (as given in the question) Now calculate the NPV at, say, a discount rate of 12%: Time Cash inflows Cash outflows NCF Tax at 30% After tax CF (W1) Capex Tax relief on capex Total cash flows Discount factor PV NPV = - USD 25.0 million So IRR = 10% + 2% x 44.6 / ( ) = 11.3% Workings W = 70 x 0.95 / ( ) (b)(ii) Yield-adjusted TERP = 1 N + 1 [(N x cum rights price) + issue price x (Y new /Y old )] = 1/6 [ (5 x 4.8) + (3.36 x 11.3/10.0) ] = 1/6 [ ] = USD per share Financial Strategy 11 September 2013

12 (c) Under the semi-strong form of the efficient market hypothesis, share prices reflect not only historical share price information and other historical information about a company, but also respond immediately to current publicly-available information about the company. Assuming a semi-strong form, the market can be expected to react straight away to the news of the rights issue and product launch. Only under the strong form of efficient market would the share price already have begun to take the news into account. There are two conflicting forces at work here. Firstly, the rights issue will push the share price down to take the discount into account. Ignoring the project, the TERP will be USD 4.56 (being, ((USD 4.80 x 5) + USD 3.36)/6). This represents a fall in the share price purely as a result of the new shares being issued at a discount. However, whilst the share price can be expected to fall to USD 4.56 post rights issue before taking the project into account, this would not result in a fall in overall shareholder wealth since it only reflects the impact of the discount on the right issue. Secondly, the perceived future benefit from the launch of product X is likely to have a positive influence on the post rights issue share price as this will potentially increase overall shareholder wealth. Based on our calculations above we can see that the project-adjusted TERP is higher that the nonproject adjusted TERP, reflecting the increase in shareholder wealth arising from the positive NPV generated by the project. Whether the share price ends up higher or lower than the project-adjusted TERP following the announcement will depend on how the market reacts to the announcement. Market reaction will largely depend on reaction to the product launch and the rights issue: Product launch. Market reaction will depend on investors confidence that product X will meet company expectations. For example, their perception of the riskiness of the project. With a WACC of 10% and a project IRR of 11.3%, even a 1.3% risk premium built into the discount rate would mean that the project would cease to be financially beneficial. Rights issue. Market reaction will also depend on the readiness of shareholders to subscribe to a rights issue. Investors will only be willing to increase their investment and hence exposure to RR if they both have sufficient funds available and have sufficient confidence in the future of RR and / or product X to be willing to purchase additional shares in RR under the rights issue. The two TERP calculations should produce the same result in this case. There may be slight differences due to: Roundings in the calculation (as we were only working to one decimal place). Difference in the Mathematical approach. However, note that if growth had been assumed to be zero and we had been valuing a simple perpetuity, the methods would have given exactly the same result. If choosing between them, the result in (a) would be considered to be slightly more accurate as it takes into account the profile of the project cash flows in more detail. September Financial Strategy

13 Question Four Rationale Question Four focuses on dividend policy and both the theoretical and practical implications of changing the earnings pay-out rate. The question tests candidates ability to apply the dividend valuation model, including the growth model that underpins it, to model the theoretical impact of a change in pay-out on a company s share price in a given scenario. It also tests understanding of both theoretical and practical issues affecting dividend decisions. Question Four examines syllabus sections A1(c) and A2(d). Suggested Approach Part (a)(i) requires the calculation of the impact of a change in dividend pay-out rate on certain specified variables which are used as key inputs in calculating the impact on share prices in part (b). It is therefore essential to attempt part (a) before moving on to part (b). Remember to take into account the time delay between cutting the dividend and affecting earnings. It may be useful to draw a time line here to help work out the timings involved. In part (a)(ii), the share price value should be based on the present value of future dividends in perpetuity. It is important to look at each year individually because of the time delay between cutting the dividend and realising the benefit in terms of increased earnings. Only after the third year is it possible to apply a growing perpetuity to finish the NPV calculation. It is therefore not possible to apply the standard DVM formula (based on a perpetuity) straightaway as this is based on a simply growing perpetuity starting at time 0. The answer to part (b) should begin by interpreting the results in part (a)(ii) and then move on to consider alternative dividend theories. (a)(i) Performance measure Earnings growth rate Earnings (K$ million) Dividend per share (K$) Workings 2015 Workings 3.2% 3.2% No change as reinvestment of additional retained earnings not actioned until this year 8% g = r x b = 16% x 50% = 8% = K$ 12.5 million x = K$ 12.9 million x = 12.9m x 50% / 20m = x 50% / 20 m where 3.2% = r x b = 16% x 20% Financial Strategy 13 September 2013

14 (a)(ii) At a 50% pay-out rate, the share price can be calculated as the present value of future dividends in perpetuity at a discount rate of 14.7% as at 1 January 2014 as follows: Date 31 Dec Dec Dec 2016 onwards Dividend per share uplifted by 8% a year (= x 1.08) PV of all future dividends as at 31 Dec ( = x 1.08 / ( ) Discount factor ( = 1 / 1.147) ( = 1 / 1.147^2) PV as at 31 Dec Total PV 4.81 Alternative approach, using a multi-columnar table on EXCEL: Date 31 Dec Dec Dec Dec 2017 Etc Dividend per share (= x 1.08) (= x 1.08^2) (= x 1.08^3) Etc Total NPV (using EXCEL NPV function at a discount rate of 14.7%): K$ 4.81 Both approaches give the same result. That is, that the ex div share price is expected to move from K$ 4.50 to K$ 4.81 as a result of the change in dividend pay-out ratio. (b) There are many theories surrounding dividend decisions. The DVM result in (a)(ii) above predicts that reducing the level of dividend would lead to an increase in the share price (moving from K$ 4.50 to K$ 4.81 per share). This is because the increase in retained funds should promote growth and hence increase shareholder wealth. However, the share price will only reflect this theoretical result if investors believe that retaining the funds will, indeed, produce the higher returns forecast by the DVM and act accordingly by increased demand for shares, which pushes the share price up to K$ 4.81 on the stock market. Note that this result depends on the rate of return on reinvested funds being higher than the investors required rate of return (ie: Ke). Indeed if the rate of return on reinvested funds had been lower than the cost of equity then we would expect the share price to actually fall. We also need to consider more practical considerations affecting the optimum level of dividend. Firstly, the signalling effect of dividends. A lower dividend could be interpreted by investors as an indication that the company is in financial difficulty rather than that the company is seeking investment opportunities in new markets. Secondly, all shareholders (including family shareholders) tend to prefer a predictable level of dividends in order to be able to plan ahead. Many shareholders may rely on the dividend stream to provide day-to-day income. Thirdly, some shareholders may prefer cash (following the bird in hand principle) whereas others may prefer an increase in share price, depending on their perception of the long term stability of the company and their personal tax position. If capital gains are taxed at a lower rate than income, a switch from dividend to capital gain may be advantageous to shareholders. On the other hand, September Financial Strategy

15 investors who are in that tax position and prefer capital gains to dividends may have invested in other companies with lower pay-out ratios and, therefore will not be current shareholders in KK. We are not given the full breakdown of the shareholders, but if the shares are concentrated in the hands of a small number of shareholders, personal preferences would also be important. Before making a reduction in dividend pay-out, KK should seek to ensure that major shareholders understand the reasoning behind it and agree to this change in policy. A residual dividend policy is unlikely to be valid for a public company where shareholders have expectation of regular dividend payments from year to year. A residual dividend policy is where dividends are paid out only after exhausting all available positive NPV projects. Financial Strategy 15 September 2013