Question

Welsh Meds Plc is a small but rapidly growing biotechnology company in Cardiff with annual revenues of £115 million. Last year’s net income was £6.38 million. Founded in 2002 by Carwyn Thomas and Geraint Jones with the support of a venture capitalist, the firm’s success has been remarkable. After a three year development phase, the company’s breakthrough was brought about by a drug called Enzyme Shield that was designed to treat immune system deficiencies (ISD). To fund the substantial increase in production capacity, which the owners decided should remain in-house, Carwyn and Geraint took Welsh Meds public, thereby taking advantage of the favorable stock market conditions of 2006. By issuing 2.8 million shares at £19, £53.2 million of equity were raised. Two years ago, Welsh Meds made its first annual dividend payment of £0.40 which increased by 15% last year. Ten months ago, the company received the Drug Administration Authority’s approval the mass market Enzyme Shield Light, a derivative of its first drug was specifically targets ISD in younger children. As a result, last quarter company earnings are up 37%, compared to the previous quarter. Carwyn and Geraint are very optimistic about Welsh Meds’ future and wonder if it is time to reward its shareholders with either a special one-time dividend of £2.50 or an increase of the annual dividend by £1.00. William Stewart, the company’s CFO, however, suggests using half of the accumulated cash of £12 million to initiate a buy back. In addition, Mr. Stewart would like to reduce the company’s debt by 4 million, thereby maintaining a cash reserve of only £2 million. Recovering from the global financial crisis when shares of Welsh Med fell by more than half, its current share price £17.38 is still, down 32% from its peak £25.55 of summer 2007. However, Carwyn and Geraint are very optimistic that the economic recovery will continue and that their company’s share price will reach new highs within the next 2–3 years. QUESTIONS 1. Do you think it was prudent to initiate annual dividend payments only 3 years after the IPO?

2. If a special one-time dividend was paid, how would it likely affect Welsh Meds’ share price?

3. Would the share price reaction be different if the annual dividend was raised by £1.00 instead?

4. What is the current dividend payout ratio and how would it change if the annual dividend was raised by £1.00?

5. Based on the current share price of £17.63, determine the company’s implied cost of capital according to the dividend discount model (DDM).

6. What do you think about the owner’s optimistic view that the share price will reach new highs in 2–3 years? Is a share price of £25.55 or higher realistic under the current dividend growth rate assumption?

7. Is the commonly used DDM that assumes a constant and perpetual growth rate applicable to Welsh Meds? Explain

8. How would the suggested debt reduction affect the company’s P/E ratio, return on assets, and return on equity?

9. How would the suggested share repurchase affect the company’s P/E ratio, return on assets, and return on equity?

10. Would you regard a £2 million cash reserve as sufficient for Welsh Meds? Explain.

Answer 1

There are many questions that you have posted. I have addressed first five of them. Please post the balance questions separately.

QUESTIONS 1. Do you think it was prudent to initiate annual dividend payments only 3 years after the IPO?

There is nor right or wrong time for payment of dividend. If the firm doesn't see any better alternative for surplus cash, it should reward the shareholders. So, it's absolutely prudent to pay dividend payments only after 3 years of IPO.

2. If a special one-time dividend was paid, how would it likely affect Welsh Meds’ share price?

The share price will go down by the quantum of dividend and ex dividend price = current share price - special dividend> Hence, the share price will go down by £2.50

3. Would the share price reaction be different if the annual dividend was raised by £1.00 instead?

Yes, the share price reaction will be different, because monetarily a special dividend of £2.50 is different from increase in annual dividend by £1.00. The revision in price in this case will be different.

4. What is the current dividend payout ratio and how would it change if the annual dividend was raised by £1.00?

Dividend pay out ratio = dividend paid per share / EPS

Dividend paid per share = 0.4 x (1 + 15%) = 0.46

EPS = Net income / nos. of shares outstanding = 6.38 mn / 2.8 mn = 2.278571429

Hence, dividend payout ratio = 0.46 / 2.278571429 = 20.19%

If annual dividend is raised by 1.00, new dividend payout ratio = (1 + 0.46) / 2.278571429 = 64.08%

5. Based on the current share price of £17.63, determine the company’s implied cost of capital according to the dividend discount model (DDM).

P₀ = D₁ / (K_e - g)

Assumption: The dividend will continue to grow at a rate of 15%. There is no mention about future dividends hence we need make some assumption.

P₀ = Current share price = 17.63; D₁ = 0.46 x (1 + 15%) = 0.529

Hence, 17.63 = 0.529 / (K_e - 15%) ; Hence = K_e = 0.529 / 17.63 + 15% = 18.00%