Advanced financial management revision question and answer

Advanced Financial Management Block Revision Mock Exams

a) Secularization may be the wave for the future, as it appears to be a more efficient mechanism for bringing borrowers and investors together than traditional financing through intermediaries (Fabozzi and Modigliani).

Required:
i) Explain the term “secularization”.
ii) Discuss the benefits that may accrue to a company that uses secularization in preference to traditional financing through intermediaries.

b) The management of Viwanda Ltd. is in the process of evaluating the company‟s dividend policy.

The following information is provided:

1. The company paid Sh.1.2 million as dividends in the last financial year.
2. The profit after tax for the last financial year was Sh.3.6 million.
3. The company has not issued any preference shares
4. The earnings growth rate has been consistent at 10% per annum for the past ten years.
5. The expected profit after tax for the current financial year is Sh.4.8 million
6. The company anticipates investment opportunities worth Sh.1.4 million in the current financial year.
7. The capital structure of the company consists of sixty per cent equity and forty per cent debt.

Required:

Determine the optimal total dividends for the current financial year if the company wishes to adopt each of the following independent dividend policies

i) Pure residual policy
ii) Constant payout ratio policy
iii) Stable predictable dividend policy, the growth rate being equivalent to the earnings growth rate.

iv) Regular plus extra dividend policy. The regular dividends would be based on the long run growth rate of earnings while the extra dividends would be based on the residual income

ANSWER
) Secularization is a fairly recent financial innovation that involves bringing together homogeneous, liquid financial or physical assets and then transforming them into marketable securities. The financial assets that are transformed in this way are normally intangible claims to benefits such as loans held eg. (residential mortgage commitments) and (cpy rights).

Secularization normally involves the setting up of a special-purpose vehicle, which will buy the asset from the owners and will then undertake the issue of securities (eg. 10 years – fixed rate bond) to the market. The bonds will be serviced the income received from the underlying assets and on the maturity of the bonds, the amounts owing may be repaid in various ways including the income generated from the underlying assets, the issue of new bonds or the repayment of the underlying claims.

ii) Secularization may be of benefit to a business in reducing risk eg. where a bank has been engaged in heavy borrowing to a particular sector of industry ti may reduce its risk selling some of the loans through a secularization issue. The result of such a move will also lead to releasing tied-up capital and may enable the bank to use the capital for mor profitable purposes.

Secularization can also be helpful to a business in overcoming short-term cash flow problems as the sale of the assets results in an immediate injection of funds.

Investors may find a secularization issue attractive because the securities are marketable Marketable and the underlying assets provide good security.

b) Computation of local dividends under different dividend policies.

i) Residual policy

The dividends seems reasonable as ROE = KS and there is no loss to the investors due to retention or payment of dividends.

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