Question

Teslazon (ticker TZN) is a new firm that specializes in the sale of highly profitable walls on-line to generate excess free cash flows to (i) subsidize Teslazon web services, (ii) pay regular dividends, and (iii) do share repurchases. Teslazon pays regular dividends of $1 per share each quarter. The price of Teslazon stock was $40 at the beginning of the year. It is expected to be $45 at the end of the year.

a) What is the expected annual rate of return on TZN stock?

b) Why would Teslazon's Board of Directors also authorize share repurchases instead of simply increasing regular dividends?

c) If TZN stock is expected to grow at the rate calculated in a) indefinitely, how long would it take (in years and partial years) to double, assuming annual compounding?

d) Teslazon grows, and its founder Samantha Rider, becomes the richest person in the world. If Teslazon engaged in positive NPV projects, such as acquiring both Amazon and Tesla in hostile takeovers, how could it go about financing these acquisitions? (Hint: discuss retained earnings, debt issuance, and equity issuance – and payout policy)

e) How could Teslazon enhance retained earnings by changing payout policy to help finance acquisitions such as those mentioned in d)? What are the costs and benefits of doing so?

Answer 1

a) Expected annual Return on TZN stock can be calculated using formula -

Return = ((P1 - P0) + D) /P0 = (45 - 40 + 4)/40 = 22.5%

b) Buy back of shares will help the Company to reduce the cost of capital, by repurchasing the shares at a fairly valued price instead of giving increased dividend for n number of years. Company can also take benefit of temporary undervaluation of the stock in the equity market. If company is performing financially well , then it should go for buyback to reduce the burden of unneeded equity capital.

c) Considering the initial price as $ 40 and growth rate of 22.5% -

$ 80 = $ 40 x (1 + 0.225) ^ n

2 = (1.225)^n

Now, 1.225 ^ 3 = 1.838266 and 1.225 ^4 = 2.251875

3 + (2- 1.838266)/(2.2251875 - 1.838266)

= 3 + 0.39 = 3.39 years

It will take 3.39 years to double the price of the stock

d) If the Company wants to acquire other organisations to grow further in the long run, it can go for various options such as -

Retained earnings - One of the best options is using retained earnings , because it will have least cost of capital and very quickly investment can be executed with least documentation and legal compliances

Debt Issuance - Company can also issue debt for investment, where it will have to pay fixed interest on the issued amount irrespective of the profits, but it will have an advantage of tax shield becuase interest payable will be tax deductible.

Equity - Company can go for fresh issue of equity but it will liquidate the control of existing shareholders, so that needs to be approved by them. Company will have to frame a ploicy about how much dividend to be paid out of the earnings and how much earnings to be retained.

e) Retained earnings can be enhanced by retaining maximum and not paying dividends. The benefit will be that it will increase the networth of the company and make it financial more strong and robust, it will help to meet unexpected liabilities but it will also frustrate a little to existing shareholders becuase they will not receive dividends or they will receive less dividends, so they have to be convinced about that.