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).

________________________________________.