Question

Firms A & B have no debt. Both have invested capital of $5,000,000 and 200,000 shares outstanding. Both firms have a ROIC of 12% and a WACC of 12%. Firm A pays out 100% of earnings as dividends and Firm B pays out 40% of its earnings as dividends.  

What will be the share price of each firm at the end of two years?

Will shareholders of Firms A & B earn the same or different rates of return after selling their shares at end of year two assuming both firms continue to operate as they have and there are no changes in expectations. Explain your logic.

Answer 1

1)	FIRM A:
	Growth rate = Retention ratio*ROIC= 0*12% =	0.00%
	Constant per share dividend = 5000000*12%/200000 =	$              3.00
	Value of the share at EOY2 as per Constant Dividend (Zero Growth) Model = 3/0.12 =	$           25.00
	FIRM B:
	Growth rate = Retention ratio*ROIC = 60%*12% =	7.20%
	Current per share dividend = 5000000*12%*40%/200000 =	$              1.20
	Value of the share at EOY2 as per Constant Dividend Growth Model = 1.2*1.072^3/(0.12-0.072) =	$           30.80
2)	RATE OF RETURN (IRR) (Using an online financial calculator)
	Assuming the initial share price = 5000000/200000 =	$           25.00
	Rate of return for Firm A, for cash flows of t0 = -$25, t1 = $3, t2 = $28 ($3+$25) =	12.00%
	Rate of return for Firm B, for cash flows of t0 = -$25, t1 = $1.29 (1.2*1.072), t2 = $32.18 [Break up of 32.18 = 1.38 (Dividend for second year = $1.2*1.072^2)+$30.80) =	16.06%
	FIRM B will be earning a higher return as it affords a growth rate
	of 7.2% in dividends. However, the final assessment depends
	on the rate of return available to the shareholders if, they invest
	the dividends elsewhere.