Redley plc, which manufactures building products, experienced a sharp increase in operating profit (i.e. profits before interest and tax) from £27 million in 2012-13 to £42 million in 2013-14 as the company emerged from recession and demand for new houses increased. The increase in profits has been entirely due to volume expansion, with margins remaining static. It still has substantial excess capacity and therefore no pressing need to invest, apart from routine replacements.
In the past, Redley has followed a conservative financial policy, with restricted dividend payouts and relatively low borrowing levels. It now faces the issue of how to utilise an unexpectedly sizeable cash surplus. Directors have made two main suggestions. One is to redeem the £10 million of the secured loan stock issued to finance investment several years previously, the other is to increase the dividend payment by the same amount.
Redley's present capital structure is shown below:
£m
Issued share capital (par value 50p)......................90
Reserves.....................................................110
Creditors due after more than one year:
9% secured loan stock 2004...............................30
Further information
(i) Redley has no overdraft.
(ii) Redley pays corporate tax at a rate of 33%.
(iii) The last dividend paid by Redley was 1.45 pence per share.
(iv) Sector averages currently stand as follows:
Dividend cover............................................2.5 times
Gearing (long-term debt/equity) ............................48%
Interest cover..............................................5.9 times
(v) Redley's P:E ratio is 17:1.
Required
(a) Calculate (i) the dividend cover and (ii) the dividend yield for both 2012-13 and for the reporting year 2013-14, if the dividend is raised as proposed.
(b) You have been hired to work as a financial strategist for Redley, reporting to the Finance Director. Using the information provided, write a report to your superior, which identifies and discusses the issues to be addressed when assessing the relative merits of the two proposals for reducing the cash surplus.