Aqua Adventures currently generates net income of $500,000 every year, all of which is paid out...

Aqua Adventures currently generates net income of $500,000 every year, all of which is paid out in dividends, and expects no future growth. Aqua has 200,000 shares outstanding, and investors require an 8% return on the company's shares. Assume that new management is hired to grow the company. One plan for the company is to invest its earnings of $500,000 per year for 1 year in a new project. If Aqua goes with the new project it will not be able to pay a dividend for the next year. However, the new project will increase net income to $570,000 in the second year and onward, all which will be paid out as dividends.

Calculate the share price if the company maintains its current no-growth policy. Calculate the share price if the company goes with the new project. Briefly explain why

the share price has gone higher or lower.
What must the minimum increase in net income be so that investors are equally well off

between its current no-growth policy and its proposed new project?

Expert Solution

1]	Current dividend = 500000/200000 = $2.5
	Price of the share under the current policy = 2.5/8% =	$ 31.25
2]	Dividend in the second year if the new project is implemented = 570000/200000 = $2.85
	Share price at the end of the 1st year = 2.85/8% =	$ 35.63
	Share price now if the new project is undertaken = 35.63/1.08 =	$ 32.98
3]	The share price has gone up as the expected cash flows
	in the form of dividends will increase if, the new
	project is implemented.
4]	Price of the share after 1 year should be 31.25*108% =	$ 33.75
	For this price, the DPS should be 33.75*8% =	$ 2.70
	Net income to be available = 200000*2.70 =	$ 540,000

jeff jeffy answered 2 years ago

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