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. In addition, there is a favorable tax environment since the 2003 act significantly changed the tax treatment of corporate dividends for most taxpayers.  

(1) What is the dividend yield and the growth rate of the firm?

(2) Calculate the required rate of return.

(3) What is the firm’s P/E ratio?

(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.

(4) What effect would this policy have on the company’s stock price?

(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%. Assume EPS = $6 and the required rate of return is unchanged.

(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? (

9) What do you advise the firm given the above scenarios, firm’s conditions, and the 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 the Beverage and Food industry. The economy’s risk-free rate is 6% and the market’s return is 10%.

(10) Estimate the risk premium.

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

THE ANSWER FOR QUESTION 12!

(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

i) As all the earnings are paid as dividends , there is no growth of earnings, dividends etc

So, i) The dividend yield = Expected Dividend/Share price = AED 30/AED 280 = 10.7143%

As all earnings are paid as dividends, growth rate = retention ratio * return on investment

=0 * return on investment

= 0

2) Required rate of return under no growth is given by

r = Constant Dividends/Share price = 30/280 = 10.7143%

3) Firm's PE ratio = Price per share/ Earnings per share = 280 AED/30 AED = 9.3333

ii) Expected Earnings next year = E1 = 30 AED, payout ratio = 75%, retention ratio = 1-75% = 25%

So, D1 = E1*0.75 = 30*0.75 = 22.50 AED, and

growth rate = rentention ratio * return on investment

=0.25* 17% = 4.25%

So, Earnings in  year 2= E1* 1.0425 =AED 31.275

and D2 = E2*0.75 = AED 23.45625

In the third year , growth will remain the same at 4.25%

So, E3= E2*1.0425 =AED 32.60419

and D3 = E3*0.75 = AED 24.45314

Now from the end of 3rd year the earnings and dividends will remain constant as the Dubai project ends

So, E4=E3 and D4 =E4

So, Horizon value at the end of 3rd year H3 =D4/r = E4/r =32.60419/0.107143= 304.3058

4) So, Value of share = D1/(1+r) + D2/(1+r)^2+ D3/(1+r)^3+ H3/(1+r)^3  

=22.50/1.107143 +23.45625/1.107143^2+24.45314/1.107143^3+304.3058/1.107143^3 = AED 281.71   

The policy will increase the share price from AED 280 to AED 281.71