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FM_Selected Main exams_answers Page 10
The sensitivity **** analysis conducted above means that the firm can either accept
or reject the project based on its negotiations with the various parties. This is
reflective of actual market practice.
[Prelim 2011 Question 4c –similar to this part c EXCEPT prelim requires students to
calculate the OVERALL effect of these 3 variations considered simultaneously.]
Topics 4 to 7
Dividend Policy
2008A Question 4: Buckham
(a) Before Investment (i) Total market value = 45m shares x $3 = $135m
No debt, No taxes, All earnings paid out EBIT = NPAT
Dividend per share = NPAT / # shares = EBIT / # shares =
Cost of equity = (D1 / Po) + g
note: g =0 **** because EBIT constant and all earnings paid out.
a(ii) Current position
Pictoria’s dividends =
Value of shares =
Total
FM_Selected Main exams_answers Page 11
(b) Using retained earnings
(i) Value of new project = $1.512m / 0.14 = $10.8m
New value of firm = $135m + $10.8m = $145.8m
OR Existing EBIT 18.9m
Add 1.512m
New EBIT 20.412m
New NPAT 20.412m
Value = 20.412m / 0.14 = $145.8m
New price =
New dividends = $18.9m - $6.3m = **** $12.6m
New DPS =
Pictoria’s dividends = 45,000 shares x $0.28 = $12,600
Value of shares = 45,000 x $3.24 = $145,800
Total $158,400
c) Using rights issue (1:5)
(i) New shares issued = 45m x 1/5 = 9m
Final number of shares = 45m + 9m = 54m
DPS = $18.9m / 54m = $0.35
New value of firm =
=
Note: Here, New value of firm **** NOT equal: Existing value + rights monies.
The subscription value of $6.3m is not used here as this amount raised is to be used for
the new investment. **** The $6.3m so injected will not remain as $6.3m but has an
earnings effect.
New share price (ex-rights) =
For Pictoria:
Pictoria’s new number of shares = 45,000 shares x 1.2 = 54,000 shares
FM_Selected Main exams_answers Page 12
Pictoria’s dividends = 54,000 shares x $0.35 = $18,900
Less: subscription paid = 9,000 x $0.70 = ($6,300) **
Nett cash flow = $12,600
Add: Share value = 54,000 x $2.70 = $145,800
$158,400
** The opportunity cost of the subscription value of $6,300 should also be considered.
Since there is no cost of funds provided, this opportunity cost is assumed to be zero.
Thus in a perfect market, **** as predicted by MM, Pictoria’s wealth and cash flow
situations
are unchanged whether the new investment is funded by retained earnings ____________
or a new rights issue ____________
(d) Retained earnings **** approach: solution to overcome shortfall in dividends
Dividend shortfall = $18,900 - $12,600 = $6,300
Raise shortfall by selling shares at $3.24 (price under the retained earnings approach)
Number of shares to sell = $6,300 / $3.24 = 1,944 shares
Final number of shares owned = 45,000 – 1,944 = 43,056
Share value = 43,056 x $3.24 = $139,500
Sale proceeds = 1,944 x $3.24 = $ 6,300
Dividends = 45,000 x $0.28 = $ 12,600
$158,400
So, home-made **** dividends can be obtained and be equal to corporate dividends
without a loss in a shareholder’s overall position.
The shareholder is better off than her original position of $153,900.
(e) DPS Price Firm Value P’s Dividend
Existing $0.42 $3.00 $135m $18,900
RE way 0.28 3.24 145.8m 12,600 (drop $6,300)
Rights way 0.35 2.70 145.8m 12,600 (drop $6,300)
Dividend policy: To pay all earnings as dividends?
DPS steep drop especially for RE method.
FM_Selected Main exams_answers Page 13
For Pictoria
1. rights way has the same cash flow and overall investment impact as RE’s way
2. rights way: solution is to sell rights to increase income. Need not subscribe as this
further decreases cash outflow.
But no more rights to sell next year.
Dividends also suffer due to lesser shares now.
3. RE way: solution is to sell shares but cannot sell shares every year.
From the dividend perspective, the company should be indifferent between the RE way
and the right’s way as Pictoria’s overall wealth position is unchanged. Further,
homemade dividends can be created to cover the shortfall. These are MM’s arguments.
However in an imperfect market, there are transaction costs and/or taxation. So, there
will be some differences in the values from those computed in (a), (b) and (c), and why
and how an investor’s preference may be influenced. The answer would draw on the
information content theory and clientele effect theory in the discussion.
Pictoria will need to decide **** the benefits of cash dividends (no transaction cost)
versus her personal income tax payment. _________________________________
2007A Question 3: Fastnet
(a) Approach to find Pv of equity (share price) under supernormal growth:
(i) DDM for dividends D1 to Dt PLUS
(ii) PV of Pt
STRATEGY 1: Residual income
Dividends t = Total forecast – Reinvestment Sum
D0 = 500m – 300m = 200m (**** about to be paid)
D1 = 780m – 150m = 630m
D2 =
D3 = 775m – 350m = 425m
D4 =
Value4 = NPAT x PER (no taxation)
=
=
FM_Selected Main exams_answers Page 14
PV equity (I=16%) = 200 + PV(630) + PV(95) + PV(425) +
STRATEGY 2: All dividends paid out
Value4 = 1000 x 13.5 = 13,500m
PV equity (I=16%) = 500 + + PV(350) + + PV(1000+13,500)
=
STRATEGY 3: Constant growth **** model
D0 = 400m
D1 = 400 x 1.1 = 440m
D2 =
D3 = 400 x 1.1^3 = 532.4m
D4 =
Value4 = 1000 x 14 = 14,000m
PV equity (I=16%) = 400 + PV(440) + PV(484) +
=
(b) Residual income method
- priority to fund investment needs
- maintain growth { g = (1-POR) x ROE}
- swings in DPS has implications re information content
Dividends paid out
- Although **** dividends paid out, value here is less than that under the Residual
income method
- Growth is lower (PER 13.5x less than PER 14x under the residual method)
Constant growth method
- constant growth independent of profits
- good for signaling effect but able to keep up with long term earnings?
- alternative pv of $7,733m [400m + (440/(0.16-0.10)] using the Gordon’s model.
Although strategy 1 is recommended, Clientele effect: all 3 policies attract different
types of shareholders. Supports MM’s view. There is no indication of the past dividend
policy, and so the shareholders’ **** profile is unknown.
FM_Selected Main exams_answers Page 15
If majority of the shareholders are institutional, the residual income
approach recommended would go well for these shareholders.
This is the reverse for individual shareholders, who may sell their shares as
a result.
Capital Structure
2007 ZB Question 4 (Eestenders plc)
UOL’s approach [FOR STUDENTS” REVIEW]
Here, investor initially owns shares in the unlevered firm
(a) Amerdale: **** All equity firm
Market Value = £2.10 * 400,000,000 = £ 840,000,000
Dividend per share: NPAT/ # of shares
= £100,000,000 / 400,000,000
= £0.25
Cost of equity = D1/P + g where D0=D1 & g=0
= 0.25/2.1
= 0.119 --- 11.9%
Cost of debt =
WACC of Amerdale = 11.9%
Eestenders : Debt & Equity
Market Value of **** Equity = £2.50 * 200,000,000
= £500,000,000
Cost of Debt ($) =£300,000,000 * 0.07
= £21,000,000
Dividend per share : £ (100,000,000 – 21,000,000) / 200,000,000
= £ 0.395
Cost of equity = D1/P + g where Do=D1 & g=0
= 0.40/2.5
= 0.16 - 16%
FM_Selected Main exams_answers Page 16
Market Cost of debt =
Total value of firm : £ 500,000,000 + 300,000,000 = £800,000,000
WACC : [ 0.16 * 500,000,000/800,000,000] + [ 0.07 * 300,000,000/800,000,000]
= 0.1 + 0.02625
= 0.1263 --- 12.63%
The two **** companies should have had the same average cost of capital under
Modigliani and Millers’ theory. But the computations above show they do not. Thus,
arbitrage should take place until they were the same.
(b) Ashour’s current position in Amerdale
Value of shares: 40,000 * £ 2.1 £84,000
Dividend income = 40,000 * £0.25 £10,000
Currently owns: 40,000/400,000,000 = 0.01% of share capital in Amerdale
To maintain the same level of risk, Ashour should:
1. Sell shares at Amerdale: 40,000 * £2.1 £84,000
2. Buy 0.01% of share capital at Eestenders [ 0.01/100 * 200,000,000] 20,000 shares
Cost of buying 20,000 Eestender’s shares (£2.5 * 20,000) £50,000
3. Invest 0.01% of Eestenders debt @ 7% [0.01/100 * 300,000,000] £30,000
Wealth in Eestenders ****shares and debt £80,000
Ashour’s new position in Eestenders:
Value of shares £2.5 * 20,000 £50,000
Dividend income £0.395 * 20,000 £7,900
Add: interest received £30,000 (Par)* 0.07 (coupon rate) £2,100
Total income £10,000
Before: Share wealth in Amerdale £84,000
After: Portfolio wealth in Eestenders shares and debt £80,000
Thus, for a lower dollar commitment, Ashour is receiving the same income of £10,000.
c)
– Investor initially owns shares in the unlevered firm
– Price of debt and equity (Firm value) of levered firm is at equilibrium (does
not change)
FM_Selected Main exams_answers Page 17
Equilibrium value of Eestenders = £800,000,000 _________
Under _____________
Amerdale’s (all-equity firm) price not in equilibrium _________
Current Value of **** £ 840,000,000 (not in equilibrium)
Equilibrium price of Amerdale : £ 800,000,000/ 400,000,000 = £2.00
d. Taxes siphon value from the market.
For Amerdale, there are no tax savings. So, the equilibrium share price would
decline below $2.00 (under MM’s perfect market view).
For Estenders plc, **** the tax shield effect may/may not be greater than the
tax payment.
_________________________________________________________________
2007A Question 4: CBB plc Note: Investor initially owns shares in a leveraged firm.
(a) CBB (all-equity)
DPS = $20m / 80m = $0.25
Equity value =
Cost of debt = 0
g=0, so cost of equity = dividend yield + ____________________
Cost of equity = dividends paid / equity value =
OR: Cost of equity = DPS / Price per share =
WACC =
C1 **** (debt + equity)
Debt = $60m
Cost of debt = 6%; Interest = $60m x 0.06 = $3.6m
DPS = ($20m - $3.6m) / 40m = $16.4m / 40m = $0.41
Equity value = 40m x $2.5 = $100m
Cost of equity = ($16.4m) / $100m = 0.164
OR: Cost of equity = DPS / Price per share = $0.41 x 100 / $2.50 = 16.4%
WACC =
[where V = D+E = 60m + 100m = 160 m]
FM_Selected Main exams_answers Page 18
The two companies **** should have had the same average cost of capital under
Modigliani and Millers’ theory. But the computations above show they do not. Thus,
arbitrage should take place until they were the same.
(b) Ranee: Owns C1
Note: Investor initially owns shares in a leveraged firm.
Value of shares = 40,000 x $2.50 = $100,000
Dividend income = 40,000 x $0.41 = $16,400
Dividend yield = cost of **** equity = 16.4%
To maintain the same risk as C1, she should sell C1, invest in CBB and borrow at 6%
such that she maintains the same proportion of equity and debt as in C1.
Selling 40,000 of C1 yields $100,000, giving her this sum available to buy CBB.
In C1, the debt portion is 37.5% and equity is 62.5%.
So, ________ is equivalent to $100,000. _________ is equivalent to $160,000.
So, she borrows $60,000 to buy some more CBB.
$160,000 will be used to buy CBB at the equilibrium price of $1.80.
# CBB shares to buy = $160,000 / $1.80 = 88,888 shares
Dividend income = 88,888 x $0.25 = $22,222
Less: interest on loan = $60,000 x 0.06 (mkt debt cost) = ____________
Nett income = $18,622
Return on her equity = $18,622 / $100,000 = 18.62%
This is higher than her return of **** 16.4% from C1.
Her net income of __________ is also higher than ____________ previously received.
(c ) The prices of debt and equity at C1 (levered firm) are in equilibrium.
Since asked to calculate the equilibrium share price in CBB (unlevered firm), then the
present price of CBB, being _________________________
At the firm level:
VL (C1) = E + D = (40 million shares x $2.50) + $60m = $160m (at equilibrium)
Since VL = Vu, so Vu at equilibrium should also be $160m.
Equilibrium price of CBB **** = $160m / 80 m shares = $2 per share.
FM_Selected Main exams_answers Page 19
The mechanics:
- Investors owning C1 has a certain level of income ($16,400).
- Subsequent investors sell C1 and buy CBB and push its price upwards.
- They can now only afford to **** buy lesser shares at the higher price.
- So, the net income drops (from lesser CBB dividends received).
- Equilibrium is achieved when CBB’s price rises from $1.80 to $X such that the
income before and after are the same. Then, there will not be any incentive to do
what Ranee did.
(d) MM: value is not affected by financial leverage but by the quality of its
assets/earnings.
However, in a world of taxes (note 1 asks for a relaxation of the no-tax
assumption), the WACC declines with increased leverage (student to draw the
relevant diagram and explain the WACC and Proposition II equations). This
lowering of the cost of capital **** enables the firm to undertake more
positive NPV projects and so raises firm value.
This raising of firm value will be moderated by the increased bankruptcy
costs due to financial distress. The optimal debt level also means
curtailing the amount of debt funds for capital budgeting leading to
capital rationing. (student to draw the relevant diagrams).
________________________________________.