Question

A mature company on Beverage and Food Industry, with stable earnings expects to have earnings per share (EPS) of 30 AED in the coming year and its current stock price is 280 AED. The management must decide between the following alternatives: Pay all of its earnings as dividends and abandon the new investment in Dubai or Cut its dividend payout rate to 75% and implement the Dubai Project. If the second policy is followed there is a divergence in the estimation of the Return on New Investment.

(i). Pay all of its earnings as dividends. Because of the status of the company and its strength in the market, the CEO believes that cash flow from operations is sufficient to continue to reinvest in growth, though has to abandon Dubai Project for next year, and decided to pay out all of its earnings to investors. Besides that, current economic conditions are weak due to the crisis, and the CEO is more willing to pay dividends than to enter a program of share buybacks.

(ii). Cut its dividend payout rate to 75%. On the other hand, the company’s manager has negative expectations regarding the recent financial crisis and advise to cut dividends even if this is not consistent with its long-run growth in earnings. He believes that it is better to reinvest some of the earnings to open new stores in Dubai, a project that will last 2 years and hence, it is advisable to safeguard its financial reserves for future expenses. If the firm follows this program the return on investment is expected to be 17%. Suppose that the required rate of return is the same as calculated in Question (2) above.

Questions:

(5) Justify the dividend policy of the firm for both cases (i) and (ii).

(6) What would be the total return of a stockholder under conditions (ii)?

(iii). Expected return on New investment is 9% rather than 17%. Financial crisis is severe and persist. The manager of the company estimates that in this case the return on the new investment will be 9% rather than 17%.

Questions:

(7) What effect would this change have on the company’s stock price?

(8) Should the company implement the new investment project and open new stores in Dubai?

Answer 1

5) In first case, when company is giving out 100% retained earnings as dividend, the firm is actually increasing sharholder's wealth. The main purpose of company is to increase shareholders wealth. Current economic conditions along with strong cash flow is allowing comapny to pay dividends. Instead of making ill use of maoney, it is being distributed.

In second case, reduction in dividend signal company's plan to invest somewhere which would generate new cash flow thereby increasing share value. Thus price of stock increases

6) Total return = (P-Stock price+dividend)/Stock Price

P= D1/r-g

r = D/P0 = 30/280 =10.71%

g = retention ratio*Return on investment = 25%*17% = 0.0425

D1=75%*30 = 22.5

P= 22.5/(0.1071-0.0425) = 328.06

Total Return = (328.06-280+22.5)/280 = 32.34%

7) If return = 9%

Growth rate g= retention ratio*return = 25%*9% = 2.25%

P= D1/r-g

D1=30*75%=22.5

P = 22.5 / (0.1071-0.025) = 265.96

8) No, comapny should not invest as required rate of return is 10.71% while return available is 9%. Economic conditions are not good, so it should deter from making new investments as cash flow would not be stable