Arthuro Co group
Arthuro Co is based in Hittyland and is listed on Hittyland’s stock exchange. Arthuro Co has one wholly-owned subsidiary, Bowerscots Co, based in the neighbouring country of Owlia. Hittyland and Owlia are in a currency union and the currency of both countries is the $.
Arthuro Co purchased 100% of Bowerscots Co’s share capital three years ago. Arthuro Co has the power under the acquisition to determine the level of dividend paid by Bowerscots Co. However, Arthuro Co’s board decided to let Bowerscots Co’s management team have some discretion when making investment decisions. Arthuro Co’s board decided that it should receive dividends of 60% of Bowerscots Co’s post-tax profits and has allowed Bowerscots Co to use its remaining retained earnings to fund investments chosen by its management. A bonus linked to Bowerscots Co’s after-tax profits is a significant element of Bowerscots Co’s managers’ remuneration.
Bowerscots Co operates in a very competitive environment. Recently, a senior member of its management team has left to join a competitor.
Arthuro Co’s dividend policy
Until three months ago, Arthuro Co had 90 million $2 equity shares in issue and $135 million 8% bonds. Three months ago it made a 1 for 3 rights issue. A number of shareholders did not take up their rights, but sold them on, so there have been changes in its shareholder base. Some shareholders expressed concern about dilution of their dividend income as a result of the rights issue. Therefore, Arthuro Co’s board felt it had to promise, for the foreseeable future, at least to maintain the dividend of $0·74 per equity share, which it paid for the two years before the rights issue.
Arthuro Co’s board is nevertheless concerned about whether it will have sufficient funds available to fulfil its promise about the dividend. It has asked the finance director to forecast its dividend capacity based on assumptions about what will happen in a ‘normal’ year. The finance director has made the following assumptions in the forecast:
1. Sales revenue can be assumed to be 4% greater than the most recent year’s of $520 million.
2. The operating profit margin can be assumed to be 20%.
3. Operating profit can be assumed to be reported after charging depreciation of $30 million and profit on disposal of non-current assets of $5·9 million. The cost of the non-current assets sold can be assumed to be $35 million and its accumulated depreciation to be $24·6 million. Depreciation is allowable for tax and the profit on disposal is fully chargeable to tax.
4. The net book value of non-current assets at the year end in the most recent accounts was $110 million. To maintain productive capacity, sufficient investment to increase this net book value figure 12 months later by 4% should be assumed, in line with the increase in sales. The calculation of investment required for the year should take into account the depreciation charged of $30 million, and net book value of the non-current assets disposed of during the year.
5. A $0·15 investment in working capital can be assumed for every $1 increase in sales revenue.
6. Bowerscots Co’s pre-tax profits can be assumed to be $45 million.
Arthuro Co’s directors have decided that if there is a shortfall of dividend capacity, compared with the dividends required to maintain the current dividend level, the percentage of post-tax profits of Bowerscots Co paid as dividend should increase, if necessary up to 100%.
Taxation
Arthuro Co pays corporation tax at 30% and Bowerscots Co pays corporation tax at 20%. A withholding tax of 5% is deducted from any dividends remitted by Bowerscots Co. There is a bilateral tax treaty between Hittyland and Owlia. Corporation tax is payable by Arthuro Co on profits declared by Bowerscots Co, but Hittyland gives full credit for corporation tax already paid in Owlia. Hittyland gives no credit for withholding tax paid on dividends in Owlia.
Required:
(i) Estimate Arthuro Co’s forecast dividend capacity for a ‘normal’ year; (11 marks)
(ii) Estimate the level of dividend required from Bowerscots Co to give Arthuro Co sufficient dividend capacity to maintain its dividend level of $0·74 per equity share. (3 marks)
(i) Forecast dividend capacity is as follows:
Arthuro Co has decided to increase its level of dividend from Bowerscots Co if its dividend capacity is insufficient.
Required:
(i) From Arthuro Co’s viewpoint, discuss the financial benefits of, and problems with, this decision; (5 marks)
(ii) Discuss the agency problems, and how they might be resolved, with this decision. (6 marks)
(i) Benefits of policy
The change of policy appears to be viable. Arthuro Co would have had some slack if it had not undertaken the rights issue. The new policy takes up this slack and effectively tops up the amount required with an increase in dividends.
The new policy appears to ensure that Arthuro Co will have sufficient funds to pay the required level of dividends and fulfil its own investment requirements. It will mean that Bowerscots Co has less retained funds available for investment, but Arthuro Co’s investment opportunities may be more profitable.
Problems with policy
Arthuro Co is now close to taking all of Bowerscots Co’s post-tax earnings as dividends. Only a limited fall in Bowerscots Co’s earnings would be needed for its dividends not to be enough to sustain Arthuro Co’s dividend level. A fall could easily happen given the highly competitive environment in which Bowerscots Co operates. If Arthuro Co wanted to increase its dividends over time, it could not do so by receiving extra dividends from Bowerscots Co.
As mentioned, an increase in dividend will leave Bowerscots Co’s management with less retained earnings to invest. The amount of investment they can undertake with the reduced funds available may be insufficient to sustain earnings levels and hence dividends for Arthuro Co.
The tax regime between the two countries means that the group will suffer more tax. The amount of additional tax payable by Arthuro Co on Bowerscots Co’s profits will remain unchanged, but the increase in dividends will mean an increase in withholding tax, for which Arthuro Co will receive no credit. Given the lower tax rate in Owlia, for tax purposes higher retained earnings for Bowerscots Co would be preferable, possibly with funds loaned to Arthuro Co rather than paid as dividends.
(ii) Agency problems
An agency situation arises between Arthuro Co’s board (the principal) and Bowerscots Co’s management (the agent). The proposals are likely to involve agency costs.
The policy limits the discretion of Bowerscots Co’s management by restricting the amounts of retained funds available. However, this seems an inefficient way of exercising closer control, with agency costs including the increased liability for withholding tax. If Arthuro Co’s board has concerns about Bowerscots Co’s management, it would be better to make changes in the management team.
Even if Arthuro Co’s board has confidence in Bowerscots Co’s management team, it may nevertheless wish to oversee Bowerscots Co more closely, given the dependence of its dividend capacity on the amount received from the subsidiary. Again, increased supervision will involve increased agency costs in terms of time spent by Arthuro Co’s management.
Bowerscots Co’s management may feel that the new policy threatens their remuneration, as the limited funds available for investment will adversely affect the company’s ability to maintain its profit levels. The managers may seek to join competitors, disrupting Bowerscots Co’s management, jeopardising its ability to achieve its profit forecasts.
Resolving agency problems
Ways of motivating Bowerscots Co’s management include making their remuneration less dependent on Bowerscots Co’s results, for example, allowing them share options in Arthuro Co. If more of their remuneration depends on the group’s results, Bowerscots Co’s management may be happier with the suggested arrangement if they feel it will benefit the group. However, this motivational effect will be limited if Bowerscots Co’s management feels that the group results are not influenced much by what they do.
Alternatively, a greater proportion of Bowerscots Co’s management’s remuneration could be by methods which are not dependent on its results, for example, increased salary or better benefits. However, by weakening the link between results and remuneration, it lessens their incentive to strive to produce the results needed to maintain the required level of dividend.
The decision-making on investments at group level may also have to change. Bowerscots Co will, under the new policy, have insufficient funds for major investments. Its management team should have the opportunity to make a case for retaining a greater percentage of funds, as they may have better investment opportunities than those available to the parent.