Question

In: Finance

Security valuation: equity. Next year, your company expects net income of $44 million. It pays 50%...

Security valuation: equity. Next year, your company expects net income of $44 million. It pays 50% of its earnings out in dividends and has a cost of equity capital of 11%.

a. If your company’s NI has a 7% growth rate, what is the estimated value of your company?

b. What is its re-investment rate (i.e. internal rate of return on earnings retained and reinvested)? Now suppose instead that the company’s re-investment rate (i.e. internal rate of return) on all future retained earnings is only 11%, and continue to assume initial earnings of $44 million.

c. What would be the value of your company if it maintains a dividend payout ratio of 50%?

d. Does the value of the company in c. above change if the payout ratio is reduced to 25%? Why or why not?

e. Find the company’s market capitalization one year from now under each of the two dividend policies described in c. and d. Which payout policy leads to a greater increase in stock price?

f. How can you reconcile the seemingly contradictory results obtained in parts d. and e.?

Expert Solution

(a) Expected Net Income (NI) Earning = $ 44 million, Payout Ratio = 50%, Cost of Equity = ke = 11%

Expected NI Growth Rate = g = 7%

Expected Dividend = Payout Ratio x Expected NI Earnings = 0.5 x 44 = $ 22 million

Estimated Firm Value = 22 / (ke - g) = 22/(0.11-0.07) = $ 550 million

(b) Growth Rate = g = Return on Equity (Internal rate of Return on Retained Earnings/Reinvestment Rate) x (1-Payout Ratio)

7 = Reinvestment Rate x (1-0.5)

Reinvestment Rate = 7/0.5 = 14 %

New Reinvestment Rate = 11 %

(c) Payout Ratio = 50%

New Growth Rate = New Reinvestment Rate x (1-Payout Ratio) = 11 x 0.5 = 5.5 %

Estimated Firm Value = 22 / (Cost of Capital - New Growth Rate) = 22 / (0.11-0.055) = $ 400 million

(d) New Payout Ratio = 25 %

Expected Dividend = Expected NI Earnings x New Payout Ratio = 44 x 0.25 = $ 11 million

New Growth Rate = Reinvestment Rate x (1-New Payout Ratio) = 11 x (1-0.25) = 8.25 %

Estimated Firm Value = 11 / (0.11 - 0.0825) = $ 400 million

As is observable, the firm's estimated value remains same under both circumstances owing to the fact that the cost of using capital (equity cost of capital worth 11%) equals the reinvestment rate of return (rate of return earned on the capital invested)

NOTE: Please raise separate queries for solutions to the remaining sub-parts as one query is restricted to the solution of only up to four sub-parts for a particular question.

jeff jeffy answered 4 months ago

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