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.

(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:

(9) What do you advise the firm given the above scenarios, firm’s conditions, and economic situation?

(iv). Taking into consideration the market’s systematic risk. Our firm has a beta factor (systematic risk) quite low, equal to 0.67. This is expected as our firm belongs to Beverage and Food industry. The economy’s risk-free rate is 6% and the market’s return is 10%.

Questions:

(10) Estimate the risk premium.

(11) Estimate the required rate of return using CAPM.

(12) Estimate the price of the stock under alternative (ii) using your answer to Q (7). How do you explain the difference in price found in Question (4)?

(13). What should be your final estimation of the firm’s stock price?

Answer 1

(9) Firm's condition is good, economic situation is bad and weak, there is a crisis. Hence, the returns from the new investment are neither guaranteed nor stable. It's not the right time to invest in the new opportunities. Externally weak market / economic conditions will not allow you to generate returns. It's therefore better to preserve cash and if there is sufficient cash in the system, it's better to return the money to the shareholders. Hence, the recommendation would be to py the dividends at 100% payout rate.

10. The risk premium = Rm - Rf = 10% - 6% = 4%

11. the required rate of return using CAPM, Ke = Rf + beta x the risk premium = 6% + 0.67 x 4% = 8.68%

12. Estimate the price of the stock under alternative (ii) using your answer to Q (7). How do you explain the difference in price found in Question (4)?

Now, this question can't be answered unless you tell us what are Q (7) and A (4) and what are your response to them?

13.

Expected dividend, D1 = EPS1 x Dividend payout ratio = AED 30 x 75% = 22.50

Growth g = Retention ratio x ROE = (1 - 75%) x 9% = 2.25%

'The final price = D1 / (Ke - g) = 22.50 / (8.68% - 2.25%) = AED 349.92