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Appendix 3• Suggested answers to review questions

12.2All investments that yield a positive NPV, when discounted at the shareholders’

opportunity cost of capital, should be made. If any funds remain in the business they

should be paid out by way of a dividend.

12.3A homemade dividend is a cash flow that arises from a shareholder selling a part

of his or her holding as a substitute for receiving a dividend from the business itself.

A shareholder might create such a dividend where his or her individual preference

for dividends does not match the business’s dividend policy.

12.4The traditional view of dividends seems to be that dividend levels are the key deter-

minant of share prices, and that the payment of a steady dividend enhances the mar-

ket value of shares, even if good investment opportunities must be forgone to pay

dividends.

12.5The tax position of many shareholders, and to some extent of the business itself, is

affected by a decision as to whether to pay a dividend or to invest the funds. The

MM ‘dividend irrelevance’ argument starts to weaken when taxes are taken into

account.

12.6Since creating or negating dividends by homemade methods (that is, selling or buy-

ing the business’s shares) has costs, it is often better for shareholders to hold shares

in businesses whose dividend policy suits their needs. The costs include dealing

charges for buying and selling shares and, possibly, the tax effects of doing so.

13.1The large amounts of investment in inventories and trade receivables, the funds

held in cash and the amount of finance provided by trade payables make working

capital a very important area for the average business.

13.2‘Overtrading’ is the name given to a state of affairs where the amount of finance

devoted to investment in working capital is insufficient to sustain the level of activ-

ity at which the business is operating. It can arise under any set of circumstances

where this state of affairs exists, but it is often associated with a sudden and sig-

nificant increase in activity.

13.3Items of inventories may lose value simply because they become less desirable. A

simple case is fashion clothing, which can rapidly lose appeal as fashion changes.

Another example is a bought-in component that was acquired for incorporation into

a product that the business has decided not to make in the future. Note that, in both

of these examples, there is no suggestion that the inventories have physically deteri-

orated in any way.

13.4Deficiencies include the following:

lA failure to allow for a safety level of inventories, that is, the assumption that

inventories will run down to zero just as the next delivery arrives.

lThe assumption that inventories are used on a constant rate per time period.

13.5These would include:

lEstablishing the creditworthiness of the potential credit customer. If this is not a

new customer, this should already have been established and reviewed.

lEnsuring that the current sale will not take the customer’s outstanding debt over

the credit limit that has been established for that customer.

Chapter 13

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