Page 26 - CIMA SCS Workbook August 2018 - Day 2 Suggested Solutions

SUGGESTED SOLUTIONS

John Small’s concerns
Fiona Finch was concerned that the dividend payment was lower than she’d hoped for, but John
Small was concerned that the dividend payment was too high!
FNG has a total outstanding borrowing of B$ 15,618,500 (both current and long term liabilities).
Therefore, it has an obligation to pay interest to the bank each year, and to make the scheduled
debt repayments. These payments take priority over dividend payments – they are not
discretionary like the dividend payments are.
However, the danger is that paying a large dividend one year might leave insufficient funds to
make the interest and debt repayments in the following year.
It certainly seems that the directors have chosen to pay out a level of dividend that is not
sustainable if the profits continue their downward trajectory. Therefore it is understandable that
John Small is concerned about the possibility of FNG not being able to meet its debt obligations in
the near future.
We need to be really careful here. If an interest payment or scheduled debt repayment is missed,
the bank can apply to the courts to have FNG liquidated. Therefore it is vital that we think
carefully before declaring next year’s dividend.
At the meeting with John Small, we need to reassure him that we can afford to meet our interest
and debt repayment obligations, and tell him the same that we’ll be telling Fiona – that is that we
will have to cut the dividends in the short term in order to protect the company in the longer
term.

EXERCISE 3

Briefing notes on debt finance and assessing creditworthiness
Prepared by: Senior Finance Manager

For the attention of: Den Rice, Chief Financial Officer, FNG

Debt Finance

Introduction
FNG is on target to repay all its debt finance over the next couple of years, but you’re correct to
say that very few companies are all equity financed.
I have presented below the advantages and disadvantages of using debt finance compared to
using equity finance.

Advantages of using debt finance

Low cost of servicing the debt

The required return of a lender tends to be lower than the required return of a shareholder,
because the lender faces less risk (his returns are an obligation that can’t be avoided – see
“disadvantages” below for more details). This means that the cost of servicing the debt finance
(i.e. the cost of paying the required level of return to the investor) is cheaper than the cost of
equity.

KAPLAN PUBLISHING 85