Forums › Ask ACCA Tutor Forums › Ask the Tutor ACCA FM Exams › DEC 2009 DD CO QUESTION F9 – Written elements
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- April 17, 2014 at 3:03 pm #165549
Dear Mr. John,
I have questions regarding the above question (Dec 2009 DD Co). However, my query relates to the written parts only. I study the examiner’s answers very carefully (as he is a brilliant writer) but there is one point I disagree with him and that’s in part (b) of the DD co question. You see basically in part (b) we are asked why two different debts have two different interest rates? The examiner has stated liquidity preference theory, market segmentation theory, term structure of interest rates, business risk, size of the bond and I agree with all of these but I don’t agree with expectations theory and the effect it has on the yield curve, as he is explaining in the Dec 2009 marking scheme. The issue I have is that Bonds A and B look more like long term bonds rather than short term debt and so what if it’s expected that interest rates will go up in the near future? That doesn’t mean that the yield curve for these particular debts will go upwards because we are clearly told in the question “annual interest” so that means the interest rate is fixed and movements in the near future would be irrelevant to the bonds. The other suggested point s above don’t bring confusion like this for me, but I am not quite happy with the expectations theory. Could you please explain and help me? I thought we need to apply our answers to the scenario so why is there this discrepancy?
One other thing in part (d) of the question (same DD co) the “bird in the hand” argument is referred to. That shareholders prefer certain dividends now rather than uncertain capital gains in the future. Fine but how is this related to a change in share price through dividend policy? Is there any link? Because if shareholders prefer certain dividends now does that mean that if the company’s won’t pay dividends, the share price will go down? Something like that? Please explain.
Thank you for your time,
Gabriel.
April 18, 2014 at 9:10 am #165579The cost of debt is not the same as the coupon rate (the interest on nominal).
The cost of debt is determined by the return that investors require (because they fix the market value of the debt, based on the interest they will receive and the rate of return that they require).One of the bonds matures in 4 years and one in ten years. Depending on what investors think will happen to interest rates in the future, it will affect the rate of return that they require at the moment (and therefore the market value). If they require different rates of return (Kd) then the cost of debt to the company will be different.
There is a huge link between the dividend policy and the share price. In practice companies tend to try and have a stable dividend policy. Some companies pay high dividends and have therefore very little capital growth (because they are not retaining and expanding). Other companies pay lower dividends and have higher capital growth (because they are retaining and using the retention to expand).
Some investors prefer high dividends and are not bothered about capital growth – they will want to invest in the first of the types of companies I mentioned. Other investors will want capital growth and be less interested in the level of dividends – they will go for the second type of company.One of the reasons some investors prefer high dividends now, rather than capital growth, is the ‘bird in the hand’ idea.
(If a company stop paying dividends, then it is either because they have stopped making profits – in which case the share price will fall; or it is because they are retaining a lot more and expanding the company – in this case it depends on the reaction of the shareholders, but the share price might well go up because of the expectation of higher capital growth.
Not all shareholders take a ‘bird in the hand’ approach – it is just one factor that can influence share prices in practice, even though in theory it should make no difference.
April 20, 2014 at 4:30 am #165690Thank you for your kind explanations, Mr John Moffat
April 20, 2014 at 8:51 am #165700You are welcome 🙂
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