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 Cost of equity = (D1 / Po) + g

= Dividends $18.9m = EBIT / # shares = = $0.42 45m

$0.42 $3 = 0.14

+0

note: g =0 **** because EBIT constant and all earnings paid out.

a(ii) Current position Pictorias dividends Value of shares Total = 45000shares = 45000shares

x $0.42 = $18900 x $3 = $135000 $153900

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(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 =

$145.8m = $3.24 45m

(residual income approach)
= $12,600 = $145,800 $158,400

New dividends = $18.9m - $6.3m = **** $12.6m New DPS = $12.6m Pictorias dividends Value of shares Total

45m

= $0.28

= 45,000 shares x $0.28 = 45,000 x $3.24

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 = =

Existing value + Project value $135m + 10.8m = $145.8m

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) =

$145.8m 54m = $2.70

For Pictoria: Pictorias new number of shares = 45,000 shares x 1.2 = 54,000 shares

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Pictorias dividends = 54,000 shares x $0.35 Less: subscription paid = 9,000 x $0.70 Nett cash flow Add: Share value = 54,000 x $2.70

= $18,900 = ($6,300) ** = $12,600 = $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, Pictorias wealth and cash flow situations (dividend cut) are unchanged whether the new investment is funded by retained earnings ____________ or a new rights issue(no ____________ dividend cut) (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 Final number of shares owned Share value Sale proceeds Dividends = $6,300 / $3.24 = 1,944 shares = 45,000 1,944 = 43,056 = 43,056 x $3.24 = $139,500 = 1,944 x $3.24 = $ 6,300 (homemade 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 shareholders overall position. The shareholder is better off than her original position of $153,900. Ps Dividend $18,900 12,600 (drop $6,300) 12,600 (drop $6,300)

(e) Existing RE way Rights way

DPS $0.42 0.28 0.35

Price $3.00 3.24 2.70

Firm Value $135m 145.8m 145.8m

Dividend policy:

To pay all earnings as dividends? DPS steep drop especially for RE method. Page 12

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For Pictoria 1. rights way has the same cash flow and overall investment impact as REs 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 rights way as Pictorias overall wealth position is unchanged. Further, homemade dividends can be created to cover the shortfall. These are MMs 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 investors 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. _________________________________ If she has a lower marginal income tax rate, she would prefer a rights issue.

2007A Question 3: Fastnet (a) Approach to find Pv of equity (share price) under supernormal growth: (i) DDM for dividends D1 0 to Dt PLUS (ii) PV of Pt STRATEGY 1: Residual income DDM

method

Dividends t = Total forecast Reinvestment Sum D0 = 500m 300m = 200m (**** about to be paid) D1 = 780m 150m = 630m D2 = 395m - 300m = 95m D3 = 775m 350m = 425m D4 = 1110m - 350m = 760m Value4 = NPAT x PER (no taxation) = profit after t4 x PER = 1110m x 14 = 15540m FM_Selected Main exams_answers Page 13

PV equity (I=16%) = 200 + PV(630) + PV(95) + PV(425) + PV(760

+ 15540)

= $100089m
STRATEGY 2: All dividends paid out Value4 = 1000 x 13.5 = 13,500m PV equity (I=16%) = 500 +PV(750)+ PV(350) + PV(700)+ PV(1000+13,500) = $9864m STRATEGY 3: Constant growth **** model D0 = 400m D1 = 400 x 1.1 = 440m 2 D2 = 400 x [1.1] = 484m D3 = 400 x 1.1^3 = 4532.4m D4 =400 x [1.1] = 585.6m Value4 = 1000 x 14 = 14,000m PV equity (I=16%) = 400 + PV(440) + PV(484) + PV(532.4) = $9535.6m (b) Residual income method - priority to fund investment needs - maintain growth { g = (1-POR) x ROE} - swings in DPS has implications re information content

+ PV(585.6 + 14000)

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 Gordons model. Although strategy 1 is recommended, Clientele effect: all 3 policies attract different types of shareholders. Supports MMs view. There is no indication of the past dividend policy, and so the shareholders **** profile is unknown.

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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) UOLs 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 = 0.25/2.1 = 0.119 --- 11.9% Cost of debt = WACC of Amerdale = 11.9% where D0=D1 & g=0

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 = 0.40/2.5 = 0.16 - 16% where Do=D1 & g=0

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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) Ashours current position in Amerdale Value of shares: 40,000 * 2.1 Dividend income = 40,000 * 0.25 84,000 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 2. Buy 0.01% of share capital at Eestenders [ 0.01/100 * 200,000,000] Cost of buying 20,000 Eestenders shares (2.5 * 20,000) 3. Invest 0.01% of Eestenders debt @ 7% [0.01/100 * 300,000,000] Wealth in Eestenders ****shares and debt Ashours new position in Eestenders: Value of shares Dividend income Add: interest received Total income 2.5 * 20,000 50,000 0.395 * 20,000 7,900 30,000 (Par)* 0.07 (coupon rate) 2,100 10,000 84,000 80,000 84,000 20,000 shares 50,000 30,000 80,000

Before: Share wealth in Amerdale After: Portfolio wealth in Eestenders shares and debt

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 16

Equilibrium value of Eestenders = Under _____________

800,000,000 _________

Amerdales (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 MMs 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 17

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 Dividend income Dividend yield = 40,000 x $2.50 = $100,000 = 40,000 x $0.41 = $16,400 = 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 18

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 CBBs 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). ________________________________________.

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