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Answers to Chapter 10 Review Questions Question 1 This point develops a theme that was also evident in Chapter 9 – cash is the lifeblood of a business. So every business must ensure that there is cash available. Ironically, this can mean that a business can survive for a few years while making losses as long as sufficient cash is generated. Of course, this is not sustainable and businesses must eventually generate both profits and cash. So it is probably best for businesses in an early developmental stage to concentrate on ensuring availability of cash (while, of course, trying to generate a profit!) The old adage that “you can only run out of cash once” applies, especially to early stage entities. However, there is ultimately no conflict between profitability and liquidity – a well-run business should generate profits that, if properly managed, will yield appropriate levels of cash. Question 2 Gross profit rate measures the basic mark-up rate of a business, i.e. the margin added to cost. Most businesses have a fairly standard rate, so it is possible to identify industry/sector standards. Operating profit, on the other hand, is profit calculated after a large number of expenses and additional costs. So it is not so easy to control and there are often wide variations, even within industries and sectors. Question 3 The most commonly employed ROI measure is return on capital employed (ROCE). At its most basic ROCE measures return in terms of profit/earnings before interest and tax (EBIT) as a function of total capital employed, where capital employed is taken to mean total longterm funding, i.e. the equity and debt employed by the company in generating profits. As long as the unique approaches that individual firms adopt are appreciated, ROCE can be useful for inter-firm comparison as it provides a good, albeit crude, assessment of the efficiency with which management in different firms use the funds entrusted to them. Question 4 EPS (earnings per share) is a very commonly used measure by many companies. In part, this is due to the fact that it can be very easily manipulated and allows executives to present an often incomplete view of share performance. In order to guard against this form of manipulative use, EPS is heavily regulated in terms of both calculation and presentation. (This is covered in detail on pages 355–6.) Question 5 Total shareholder return takes a particular approach. It attempts to quantify the overall return enjoyed by an investor. In the case of an ordinary shareholder this might include any capital appreciation in share price plus any dividends received (or other returns). Question 6 Dividends are distributions of profits to shareholders. Dividends are important to most shareholders. Indeed, in the case of “old economy” companies, they are critical to maintaining investor loyalty. They encourage investment on the part of those interested in an annual return on their investment as much as any capital appreciation of their shares. They are less important in “new economy” companies where investors prefer that any surplus cash be reinvested in the business – they are more interested in gains generated by means of increases in share price. Every firm will need to maintain a balance between payment of dividends and retention of cash for investment. This requires that funds at the disposal of management be used wisely so that cash reserves can be retained for other purposes, such as investment. Question 7 Firms must remember that dividend policy signals various additional pieces of information to the market, for instance, the relative prioritization of claimants to cash, acquisition plans, the company’s future investment strategy, etc. In determining dividend policy a firm will have to give attention to the following considerations: previous dividend policy; likely interpretation by the market, especially of any change in policy; competitors’ policies; availability of profits; availability of cash; other investment possibilities; market expectations. Question 8 Dividend yield: This quantifies the relationship between dividend per share and market value per share. It is a measure of the return enjoyed by shareholders. Dividend cover: This provides a measure of the extent to which a company pays out its profits in the form of ordinary dividends and provides a measure of the scope that a company has to pay dividends. Dividend pay-out: This measures the portion of profit that is actually being distributed in the form of dividends. Question 9 Share buy-backs can bring benefits to both shareholders and companies. For instance, shareholders see an immediate return of cash. There can be an additional attraction for companies and their executives, however. This is because in doing so companies can reduce the number of shares in circulation. This, in turn, can often artificially improve ratio scores such as EPS where the result is impacted by a lower denominator. It can also have a positive effect on ROE, with the result that a marginal rise in share price can often follow. Question 10 Ironically, one of the reasons for the excessive buybacks of recent years is that companies are unable to find better uses for their cash. In one sense, this is an indictment of company management: they have been able to generate huge amounts of surplus cash, but are unable to find uses for this cash that would justify retaining and investing it. Instead, and often in response to aggressive investors, they simply decide to return it to shareholders.