Question

The Giant Machinery has the current capital structure of 65% equity and 35% debt. Its net income in the current year is $250 000. The company is planning to launch a project that will requires an investment of $175 000 next year. Currently the share of Giant machinery is $25/share. Required: a. How much dividend Giant Machinery can pay its shareholders this year and what is dividend payout ratio of the company. Assume the Residual Dividend Payout Policy applies? b. If the company is paying a dividend of $2.50/share and tomorrow the stock will go ex-dividend. Calculate the ex-dividend price tomorrow morning. Assuming the tax on dividend is 15%? c. Little Equipment for Hire is a subsidiary in the Giant Machinery and currently under the liquidation plan due to the severe contraction of operation due to corona virus. The company plans to pay total dividend of $2.5 million now and $ 7.5 million one year from now as a liquidating dividend. The required rate of return for shareholders is 12%. Calculate the current value of the firm’s equity in total and per share if the firm has 1.5 million shares outstanding?

Answer 1

Part a

As per Residual Dividend Payout:
Capital structure = 65% equity and 35% debt (given)
Investment to be made = $175,000 (given)
Net profit = $250,000 (given)
Therefore, the amount left to pay for dividend =
Net profit - Investment amount * (equity percentage) = 250,000 - 175,000 (65%) = 250,000 - 113,750 = $136,250

--> Dividend Payout ratio = total dividends/ total earning
Total Dividend = 136,250 (calculated)
Total Earning = 250,000 (given)
Dividend payout ratio = 136,250/250,000 = 0.545 = 54.5%

Part b

Ex-dividend price = current price - Dividend * (1-tax on dividend)
Current price = $25 (given)
Tax on dividend = 15% (given)
Dividend = $2.5 (given)
Therefore, ex-dividend price = 25 - 2.5 * (1-15%) = 25 - 2.125 = $22.875

Part c

Current value of the firm = Dividend paid in year 0 + (Dividend to be paid in year 1/discount rate)
Dividend paid in year 0 = $2,500,000
Dividend to be paid in year 1 = $7,500,000
Discount rate = 12%
Therefore, total current value = 2,500,000 + (7,500,000 / 1.12) = $9,196,428.57

Current value per share = Total value / number of shares
total value = 9,196,428.57 (calculated)
numbe of shares = 1,500,000
Current value per share = 9,196,428.57 / 1,500,000 = $6.13