Fundamentals of Financial Management

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Company A in the past five years continue to reduce the proportion of debt, making the working capital ratio rising, increasing the company's solvency, reducing the company's financial risk, but also lost part of the tax deduction role, reflecting the trade-offs between liabilities and bankruptcy costs. The capital gearing of company B continues to rise in five years, up to 56.31% in 2016, but working capital ratio is still greater than 1. It takes full advantage of the tax deduction, and maintains a low bankruptcy cost. And company B shows a positive signal to market through high debt, which is conducive to the increase in the value of the company.

Similarly, dividend policy in the perfect market has nothing to do with the value of the company. In reality, there is a tax differential between dividends and interest, which makes the wealth of shareholders affected by the difference between capital gains tax and dividend tax. bird-in-the-hand theory believes that shareholders prefer to the determinate dividend rather than the gains from the rise of stock price, so the high dividend policy can reduce the company's capital costs and improve the value of the company. The same, signal theory refers to the company to increase the dividend to pass the company's better prospects, thereby enhancing the stock price.

Company A has maintained a 50% stable dividend payout rate, and the absolute value of dividends rising, reflecting the company's stable operating conditions. Company B maintained a stable dividend payment, and in 2016 increased to 3.66 pence per share, pass a better development prospects.

(e)

The dividend growth model has five main limitations. Firstly, The application scope of the dividend growth model is limited. The premise of the application of this model is that the operation of the company is stable and future cash flow is expected. This model is suitable to be applied to stable companies with a lot of dividends in non-cyclical industries. And is not suitable to be applied to unstable companies with few dividends in cyclical industries. The dividend growth model is not applicable in the stock markets of many countires such as the mainland of China. The structure of the stock markets and the eager for capital of listed companies in these countries determines the low dividend ratio and the unstable proportion and amount of dividends, thus, predicting the growth rate of dividends can be difficult.

Secondly, the stock price calculated by this model is a theoretical price. That is to say, the derived costs of equity in part (a) is the theoretical costs, which can not reflect the initial value of one stock. The dividend growth model contains the forecast for g and the estimation of r, so the estimated price is likely to deviate from the market price. In addition, the dividend growth model tends to ignores the influence of the stock market on stock prices and only enables investors to estimate the absolute value of the enterprise, which is not influenced by the actual environment of the stock market.

Thirdly, the dividend growth model is unable to take the non-tradable shares into consideration. Thus, the derived costs of equity in part (a) do not include the costs of non-tradable shares. This model is based on the discounted value of the dividend and treats all shares equally. For the equity division market, the existence of non-tradable shares makes it very difficult to calculate the composite price. The division of non-tradable shares and tradable shares makes the different types of shares of the same company have very different transaction prices. Because some indicators such as earnings per share, dividend per share of non-tradable shares are calculated based on the total share capital, the valuation that uses these indicators will be deviation.

Fourthly, the premise of the application of the dividend growth model is an effective market, thus, the smooth operation of this model can be conditional. The first requirement is that the financial information must be full, timely and truly open; The second requirement is that the financial information can be obtained by investors so that they can make a rational judgment based on the information. The third requirement is that the investors can take correct and timely action based on their judgment. Obviously, these conditions in the stock markets of many countries are still defective. And in the process of deriving costs of equity in part (a), whether the market is effective or not is unknown. Particularly, the quality of accounting information of listed companies is worrying, the error analysis deviation caused by the mistake data will shake the foundation of the dividend growth model.

Lastly, the flaw of accounting data will influence the accuracy of the dividend growth model. For example, the accounting data of company A and company B may have flaw, thus, the derived costs of equity in part (a) are possible to be inaccurate. The difference between the accounting standards and the economic reality do exits because of conservative trend in accounting industry. Different companies take different accounting treatment methods and estimation methods, making the same kind of report data lack of comparability, thus affecting the effect of the model. Even if the actual operation conditions of the two companies are exactly the same, the related data of these two companies will be different due to the difference of accounting methods. And some accounting data estimated by the accountancy will be impacted by the subjectivity of the accountancy, making the valuation based on the accounting data distorted. Although the dividend growth model has many limitations, it provides a way to estimate the initial value of the stock through the discount of dividends, and establish the logical foundation and the way of calculation of discount cash flow model.

(f)

There are three main ways to value the merger of company A and company B. The first method is the income method, which is determined by capitalizing or discounting the estimated earnings of the company. The income method mainly uses the present value technology, that is, the value of an asset is the present value of the future earnings available to it, and the discount rate reflects the risk rate of return of this investment. The income method is a mature and frequently-used method. The main way of the income method is the cash flow discount method, which evaluate the value of the company by estimating the current value of company’s future expected cash flow, measuring the value of the company from the perspective of cash flow and risk. The advantages of this method are: ① the target enterprises is estimated as