Question

Consolidated Pasta is currently expected to pay annual dividends of $10 a share in perpetuity on the 2.9 million shares that are outstanding. Shareholders require a rate of return of 10% from Consolidated stock.

a. What is the price of Consolidated stock? (Do not round intermediate calculations.)

b. What is the total market value of its equity? (Enter your answer in millions.)

Consolidated now decides to increase next year’s dividend to $20 a share, without changing its investment or borrowing plans. Thereafter the company will revert to its policy of distributing $10 million a year.

c. How much new equity capital will the company need to raise to finance the extra dividend payment? (Enter your answer in millions.)

d. What will be the total present value of dividends paid each year on the new shares that the company will need to issue? (Enter your answer in millions.)

e. What will be the transfer of value from the old shareholders to the new shareholders? (Enter your answer in millions.)

f. Is this figure more than, less than, or the same as the extra dividend that the old shareholders will receive

Answer 1

Solution:
a.	Stock price    $	100
Working Notes:
	Using Dividend Discount Model (DDM)
	[Without growth]
	Stock price =Dividend/require a rate of return
	Stock price =$10/10%
	Stock price =$100
b.	Market value of equity                                            $	290	million
Working Notes:
	Market value of equity
	= No of shares outstanding x Stock price
	= 2.9 million x $100
	=$ 290 million
c.	New equity                                                                  $	29	million
Working Notes:
	Additional capital will the company need to raise to finance the extra dividend payment
	= No of shares outstanding x Excess dividend per share paid
	= 2.9 million shares x ($20 -$10)
	=$29 million
d.	Present value                                                              $	29	million
Working Notes:
	Total present value of dividends paid each year on the new shares that the company will need to issue is the amount of investment $29 million on these new equity.
e.	Transfer of value                                                       $	29	million
Working Notes:
	The transfer of value from the old shareholders to the new shareholders the is the amount of excess dividend received by old shareholders or value of investment by new equity shareholders and is $29 million
f.	The same
Working Notes:
	The same as the extra dividend that the old shareholders will receive , the transfer value or amount new equity investment by new equity shareholders
Please feel free to ask if anything about above solution in comment section of the question.