QUESTION ONE Assumethatyouareafinancialanalystattendingashareholders' meetingatPDQltdon behalfofyour employers, a large pension fund. Your entity is one ofthe few institutional investors in PDQ ltd, which is a medium-sized

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QUESTION ONE

Assumethatyouareafinancialanalystattendingashareholders' meetingatPDQltdon behalfofyour employers, a large pension fund. Your entity is one ofthe few institutional investors in PDQ ltd, which is a medium-sized listed entity .The majority ofthe shareholders are small, private investors. At the shareholders' meeting you overhear a group ofshareholders discussing the entity's dividend policy. Some of the comments you hear are as follows:

'I think the entity should increase its dividend payout to the maximum it can afford with-out having to borrow. That way our returns are less risky.'

'I don't agree. I think the entity should reduce the dividend and retain even more ofits earnings for future investment.'

'I would prefer no cash dividend at all and receive annual bonus shares. The value of my shareholding would then immediately increase.

''I read somewhere that dividend policy has no effect at all on the value of the entity's shares.'

Required,

(a) Discuss the validity or otherwise of the shareholders' comments.(10 marks)

(b) The expectations and requirements of institutional investors in respect of an entity's dividend policy may be different in a number of respects from those of private, individual shareholders.

Explain these differences and comment on the problems PDQ ltd might face in trying to reconcile the requirements of the two groups of shareholders.(10 marks)

(Total marks 20)

QUESTION THREE

XYL Ltd is a highly geared entity that wishes to expand its operations. Six possible capital investments have been identified, but the entity only has access to a total of Ksh620,000. The projects are not divisible and may not be postponed until a future period. After the projects end it is unlikely that similar investment opportunities will occur.

Expected net cash inflows (including salvage value)

Year 12345Initial outlay

ProjectKshKsh KshKshKshKsh

A70,000 70,000 70,000 70,000 70,000246,000

B75,000 87,000 64,000 180,000

C48,000 48,000 63,000 73,000 175,000

D62,000 62,000 62,000 62,000 180,000

E40,000 50,00060,00070,000 40,000 180,000

F35,00082,00082,000150,000

Projects A and E are mutually exclusive. All projects are believed to be of similar risk to the company's existing capital investments. Any surplus funds may be invested in the money market to earn a return of 9 per cent per year. The money market may be assumed to be an efficient market. XYL cost of capital is 12 per cent per year.

Requirements

(a) Calculate:

(i) The expected net present value;

(ii) The expected profitability index associated with each of the six projects, and rank the projects according to both of these investment appraisal methods. Explain briefly why these rankings differ.(5 marks)

(b) Give reasoned advice to XYL Ltd, recommending which projects should be selected.(3 marks)

(c) A director of the entity has suggested that using the company's normal cost of capital might not be appropriate in a capital rationing situation. Explain whether you agree with the director.(2 marks)