Introduction to Financial Accounting Project

Christopher Crooks (0907164)

Robert Smith (0805497)

Yannick Harvey (0704853)

Tutor: Collette Folkes

Project Management Report

Project Name: Department: Focus Area: Product/Process: Financial Accounting Project School of Business Administration Statement of Cash Flows

Group Assignment

Prepared By:

Document Owner(s)
Yannick Harvey Robert Smith Christopher Crooks

Project/Organization Role
Organization/Theory Organization/Theory Organization/Theory

Project Management Report Time Table

Time
1:00-3:30 pm 2:00-4:00 pm 3:00-5:00 pm

Date
12/7/11 20/7/11 22/7/11

Areas Covered
Requirement 1 Requirements 2-4 Requirements 5 & 6

Description
Prepared Cash Flow Statement using Indirect Method Covered mainly dividend policies and its influence Covered the theories of dividend policy

Requirement 1

Bigwood Ltd. Cash Flow statement for year ended September, 30, 2004
$ Cash Flows from Operating Activities Profit Before interest and tax Adjustments for: Depreciation Loss on disposal of asset Increase in Stock Increase in Accounts Receivable Increase in Accounts Payable Interest paid Tax paid Net Cash Flow from Operating Activities Cash Flows from Investing Activities Purchases of Assets Proceeds on sale of non-current asset Net Cash Flow from Investing Activities Cash Flows from Financing Activities Proceeds from issuing shares ( including premium) Dividends paid Repurchase of Long-term borrowing Net decrease in Cash and cash Equivalent Cash and cash Equivalent at the beginning of the period Net decrease for year 2004 Cash and cash Equivalent at end of year -10,500,000 -50,000 -10,550,000 3,000,000 -600,000 2,000,000 4,400,000 -1,380,000 1,000,000 3,800,000 1,250,000 -1,400,000 -50,000 950,000 -300,000 -480,000 4,770,000 $

450,000 -1,380,000 -930,000

Workings

Disposal Balance c/d

Provision for Depreciation Account $ $ 1,800,000 Balance b/f 3,000,000 5,000,000 Income Statement 3,800,000 6,800,000 6,800,000

Tax Account Bank Balance c/d $ 480,000 220,000 700,000 Balance b/f Income Statement $ 450,000 250,000 700,000

Disposal Account Assets Bank $ 3,000,000 50,000 3,050,000 $ Depreciation 1,800,000 Loss on Disposal 1,250,000 3,050,000

Assets Account Balance b/f Bank $ 9,500,000 10,500,000 20,000,000 Disposal Balance c/d $ 3,000,000 17,000,000 20,000,000

Requirement 2

A cash flow statements purpose is to show how the cash position changes over a period of time. With respect to this, cash earned from profits, receipts of additional cash, and where/how your cash was spent, are also established. Bigwood Ltds overdraft position reflects that the cash being spent is personified by mismanagement. The concerns being raised by the directors, is that enough cash would not be available to sustain the business on a day to day basis and as a result, the company may not be able to take advantage of other investment opportunities. The company may face the possibility of closing down and termination of activities.

Requirement 3 The differences between the direct method of preparing the cash flow statement and the indirect method are that, the direct method shows each major category of gross cash receipts and gross cash payments. Under IAS 7, dividends received may be reported under operating activities or under investing activities. If taxes paid are directly linked to operating activities, they are reported under operating activities; if the taxes are directly linked to investing activities or financing activities, they are reported under investing or financing activities. The indirect method adjusts accrual basis net profit or loss for the effects of non-cash transactions by using net-income as a starting point and making adjustments for all transactions for non-cash items, then adjusting for all cash-based transactions. An increase in an asset account is subtracted from net income, and an increase in a liability account is added back to net income. This method converts accrual-basis net income (or loss) into cash flow by using a series of additions and deductions.

Requirement 4 Shareholder Expectations Some investors who desire a specific periodic income will prefer a company with stable dividends to one with unstable dividends. Good dividend policies are flexible enough to respond to changes and the ups and downs of economic and business cycles, but firm enough to manage shareholder expectations. A clearly articulated dividend policy establishes expectations. Management may be able to influence the expectations of investors through the informational content of dividends. An established dividend policy suggests that the company expects stable in the future and room for growth. Different types of investors for example clientele prefer different dividend policies. Investors who want current investment income should own shares in high dividend payout firms, while investors who do not require current investment income should own shares in low dividend payout firms. The clientele effect suggests that firms will attract investors who like the firm's dividend payout policy. After the choice is made by an investor, and the market is in equilibrium, and each firm serves its own clientele. Clientele would suggest that specific investors might be drawn to a certain industry group because of the high dividend yield.

Profitability and Liquidity and Investment Opportunities A company's ability to pay dividends depends heavily on the financial concepts of; profitability, liquidity and capitalizing on investment opportunities. Profitability is concerned primarily with how the company makes use of its resources to make a profit. As a ratio its intention is to gauge the efficiently of the firm and examine how it uses its assets and handles its operations. Profitability may mislead many shareholders as they believe that if companies make a profit after

taxes, then it will be able to pay out dividends. The company must have sufficient cash available to meet its short term obligations. If this is not so then their expectations may be wrong.

Liquidity refers to the speed and ease with which assets can be converted into cash. The more liquid a company, the less likely it is to experience financial anguish. A liquid company develops the capability to pay wages and capitalize on investment opportunities and pay its debts off. In actuality, the company's performance and prospects depend on its liquidity. Liquidity plays the major role in determining the company's ability to pay dividends. With respect to investment opportunities, shareholder value is created where the present value of prospective discretionary cash flows to shareholders is likely to benefit from investment projects discounted at an appropriate rate of return when equity exceeds the initial cost of the investment.

Legal and Contractual Constraints In deciding on the dividend, the directors take the legal requirements into consideration. Companies cannot keep "excess" cash as retained earnings if no investment opportunities exist. Companies must distribute them as dividends. In order to protect the creditors interest and outsiders, the companies Act 1956 prescribes specific guiding principles in respect to the distribution and payment of dividends. The company is required to provide for depreciation on its fixed and tangible assets before declaring dividends on shares. It proposes that dividends should not be dispersed out of capita, in any case. Likewise, contractual obligations must be fulfilled. One example being, the payment of dividends on preference shares in precedence over ordinary dividends. Lenders from time to time may put restrictions on the dividend payments to

protect their interests (especially when a firm experiences problems with its liquidity). When a company pays a dividend it must make its way through the required tax systems in the economy before the dividend becomes valuable to the shareholder. The capacity of the enterprise to earn is widely affected by the change in fiscal, industrial, labour, control and other government policies. The government may at times restrict the distribution of dividends beyond a certain percentage in particular industries or in all realms of business activity. The dividend policy must then be modified or formulated accordingly to suit those enterprises.

Industry Practices When undertaking the design of a dividend policy, some firms may consider the performance of their competitors. This is a factor that depends on the extent to which these firms believe that dividend payments can indicate to its stakeholders the competitive nature of the firm. Because of the structural uniqueness of an industry it is likely that investment opportunities within an industry are somewhat comparable. If there is no systematic industry influence on debt valuation or new equity valuation, one would expect to find no systematic relationship between a firms dividend policy and the industry in which the firm operates.

Requirement 5

The Residual Theory

The residual theory of dividends suggests that dividend payments should be viewed as residual. This is the amount left over after all satisfactory investment opportunities have been undertaken. In summation, this theory suggests that no cash dividend is paid as long as the firms equity needs are in excess of the amount of retained earnings. In addition, it suggests that the required return demanded by stockholders is not influenced by the firms dividend policy. This premise in turn suggests that dividend policy is irrelevant. Using this approach, the firm would treat the dividend decision in four steps: Determine the optimal capital budget. Determine the retained earnings that can be used to finance the capital budget. Use retained earnings to supply as much of the equity investment in the capital budget as necessary. Pay dividends only if there are left-over earnings.

Dividend Clientele Effect Theory

Dividend clientele effect theory is a model of dividend payments which may directly suit one type of shareholder over another. Different groups of investors, or clienteles, desire different policies, for e.g. retirees need dividends for income. So a retiree may prefer to invest in a firm that provides a constantly high dividend yield, whereas persons with high income from employment may prefer to shun dividends due to their high marginal tax rate on income. If

clientele exists for meticulous patterns of dividend payments, a firm may be able to maximize its stock price and minimize the cost of capital by catering to a particular clientele. This model helps to explain the relatively consistent dividend policies followed by most companies.

Bird-in-the-hand Theory This theory holds that future earnings are less predictable and more uncertain than dividend, at least because they are further in the future. It postulates that investors prefer dividends from a stock to potential capital gains because of the natural uncertainty of the latter. The greater the uncertainty of future earnings should reflect a higher discount rate on capacity gains on dividend. This in turn would cause investors to prefer a more certain $1.00 of dividends over a less certain $1.00 of future earnings. Investors think dividends are less uncertain than potential future capital gains, hence they like dividends. So, investors would value high payout firms more highly. In summation, it is based on the adage that a bird in the hand is worth two in the bush, the bird-inhand theory states that investors prefer the certainty of dividend payments to the possibility of substantially higher future capital gains.

Dividend signaling theory

This theory developed by Merton Miller and Kevin Rock in 1985, suggests that company announcements of an increase in dividend payouts act as an indicator of the firm possessing strong future prospects. The underlying principle here is that, dividend signaling models stem from game theory. A manager who possessing good investment opportunities is more likely to

"signal" than one who doesn't because it is in his or her best interest to do so. The change in dividend payment is to be interpreted as a signal to shareholders and investors about the possible future earnings prospects of the firm. In general an increase in dividend payment is viewed as a positive signal, transmitting positive information about a firm's future earning prospects, which may result in an increase in share price. On the other hand a reduction in dividend payment is viewed as negative signal about future earnings prospects, which may resilt in a decrease in share price.

Requirement 6

For the year 2004 the company was not able to pay its shareholders. But in 10 years the company was able to pay dividends at a rate of 8%. The dividend policy theory would be considered the most appropriate. For the mere reality that the directors' reports are required to contain particulars of any significant event affecting the company or its subsidiaries, would then enable the company to have a proper understanding of its financial position, from which a rational forecast can be ascertained. Shareholders and stakeholders prior should be notified of the likelihood of the company's incapability to meet its financial obligations, which in essence is the premise of the dividend signaling theory.