Section B – BOTH questions are compulsory and MUST be attempted
2 Cadnam Co is a large company in the support services sector.
Cadnam Co’s most recent annual report, for the year ended 31 December 20X5, acknowledged challenges for the
company, including financing the major investment programme required to meet its clients’ increasing expectations.
Cadnam Co also faced upward pressure on employment costs, fuelled by a ‘fair wage’ campaign which adversely
compared wage rises in the support services sector with increases in dividends and directors’ remuneration, and a
consequent government enquiry into low pay in the sector.
Cadnam Co’s board, however, was confident that the company would be able to renew a number of large contracts
which were coming up for review. The report stressed the strength of Cadnam Co’s senior management team as a vital
success factor. Directors’ remuneration packages thus reflected the need to retain its directors in a competitive labour
market at senior level.
In the stakeholder engagement section of its annual report, Cadnam Co highlighted that it had fulfilled its aim of
guaranteeing investors a consistent rise in dividends and its board was confident that Cadnam Co would be able to
maintain the recent rate of dividend increase. The report also stated that Cadnam Co was looking to publish a full
integrated report over the next couple of years.
Dividend policy
At Cadnam Co’s last annual general meeting, there were no questions about the level of profits, dividends or directors’
remuneration. However, a recent investment analysts’ report on the support services sector highlighted Cadnam Co as
a company which might have problems in the next few years. The report suggested that Cadnam Co’s investment and
dividend policies could not both be maintained. It highlighted one of Cadnam Co’s principal competitors, Holmsley Co,
as a company whose policies it believed would sustain long-term growth. It highlighted directors’ remuneration as an
area where Holmsley Co’s policies were more likely to encourage long-term value creation and share price increases
than Cadnam Co’s policies.
Cadnam Co’s board is currently considering the comments made by the investment analysts, and also assessing what
the dividend for 20X6 should be.
Cadnam Co
20X2 20X3 20X4 20X5
$m $m $m $m
Profit after tax 1,380 1,490 1,550 1,580
Dividends 765 840 925 1,020
Investment in additional assets 282 312 584 864
Share price ($) $4·88 $5·35 $5·61 $5·75
Gearing (debt/(debt + equity))
(market value) x 100% 33·0% 33·2% 35·0% 38·8%
Holmsley Co
20X2 20X3 20X4 20X5
$m $m $m $m
Profit after tax 1,485 1,590 1,700 1,830
Dividends 560 590 621 654
Investment in additional assets 595 625 660 690
Share price $5·04 $5·23 $5·55 $5·93
Gearing (debt/(debt + equity))
(market value) x 100% 35·1% 35·2% 34·9% 34·7%
Average gearing in the support services sector since 20X1 has been stable at around 34%. There have been no
changes in the issued share capital of Cadnam Co and Holmsley Co since 20X1.
4
Directors’ remuneration
Cadnam Co Holmsley Co
Average salary executive director $550,000 $550,000
Performance bonus Maximum 25% of salary Maximum 30% of salary
Loyalty bonus Maximum 10% of salary None
Share options None Options to be exercised on
31 December 20X8 at an
exercise price of $7·00
Cadnam Co 20X6 forecast
Forecasts prepared by Cadnam Co’s finance director for 20X6 predict that:
– Cadnam Co’s pre-tax operating profit for 20X6 will be $2,678m, an increase of 3% compared with 20X5. The
operating profit margin will be 2%, the same as for 20X5.
– The tax rate will be 30%.
– Average debt in 20X6 will be $10,250m and predicted year-end gearing will be 41·3%. The average pre-tax
interest rate on the debt will be 8%.
– The investment required to keep the non-current asset base at its present productive capacity in 20X6 will be
$2,430m, which has been included in the calculation of operating profit as depreciation.
– Investment required in additional assets in 20X6 will be $0·25 for every $1 increase in revenue.
Required:
(a) Calculate the forecast dividend capacity of Cadnam Co for 20X6. (5 marks)
(b) Discuss the viability and financial impacts of Cadnam Co seeking to maintain its current dividend policy,
supporting your answers with relevant calculations.
Note: 6 marks are available for calculations in part (b). (12 marks)
(c) Discuss the governance and ethical issues associated with Cadnam Co’s dividend and directors’ remuneration
policies. (8 marks)
(25 marks)
5 [P.T.O.
