Question

Q. This question consists of sub-questions, (a) and (b).

(a) Assume the required rate of return on the shares below is 15 % per annum. Calculate the

share value price in each case:

1. The current earnings per share of Apple company are $1.50. The company does not reinvest any of its earnings, which are expected to remain constant.

2. Woolworths company current dividend per share is $1.50. This dividend is expected to grow at 5 % per annum.

3. Now compare the both shares prices, which one is more expansive? Why?

(b) The borrowing represents a source of finance to the businesses. However, when a company borrows, it could face two separate effects, first is the leverage effect and second is the risk of financial distress. Discuss these effects that are caused by the borrowing and how/why they expose the company for risk.

Answer 1

A-	share value of apple	expected dividend/(required rate of return-growth rate)	1.5/(15%-0%)	10
B-	share value of Woolworth	expected dividend/(required rate of return-growth rate)	1.575/(15%-5%)	15.75
	expected dividend = current year dividend*(1+growth rate)	1.5*(1.05)	1.575
	Share of Woolworth are more expensive because of growth prospects while growth prospect of apple share is 0 and cosntant dividend would be paid.
3-	Financing of company capital structure through debt would lead to leverage effect which shows the benefits of using debt in capital structure in the form of interest tax shield which would reduce the taxable profit and would lead to increase the value of firm. on the other hand more debt financing would lead to more financial risk which can increase the overall risk position of the company and can lead to increase in WACC because investors would demand high returns due to increased degree of risk in business.