Mabel Plc is a substantial listed company, financed by a mixture of equity and loan stock.

The directors have recently assessed the potential acquisition of a private company and concluded that this should be undertaken. This conclusion was reached on two grounds: it will generate a significant positive net present value, and it will take the company in a new direction that the directors regard as strategically appropriate.

Various financial management queries have arisen. The company has funds generated from profitable trading that could be used to finance the acquisition, but only if the company were not to pay a dividend on its shares this year. In discussion of this topic at a recent board meeting, a variety of views were expressed:

Director A

“I would be very unhappy about failing to pay a dividend. For as long as I can remember this company has always paid a dividend. We have always managed to pay at least as much each year as we did the previous year, often with a healthy increase. The share price would be hammered.”

Director B

“I’m not so sure what would happen to the share price, but I believe that we should be more highly geared, so I propose we make another loan stock issue. It’s cheap to service and acquiring more debt will increase the market value of our company.”

Director C

“I’m not so sure that net present value is the best method for valuing the acquisition.

My grandchild is studying accounting at university and informs me that there are many alternative valuation methods such as an asset basis, earnings basis or another cash-flow based approach.”

Mabel Plc has appointed you to provide independent financial advice on these issues.

Required:

a) Critically comment on Director A’s view regarding dividend policy, explaining both the theoretical and practical aspects of each point that you make.

b) Critically evaluate Director B’s view regarding the relationship between capital structure and the market value of a firm, referring to financial management theory.

c) Critically evaluate three alternative valuation bases mentioned by Director C, including the strengths and weaknesses of each method discussed.