Question

Sun Flower Limited is a manufacturer of electrical appliances. The company

is preparing a financial plan for the coming year. The following are

independent electrical appliance projects under consideration:

Project	Initial investment ($ million)	Internal rate of return (%)
A	220	20.50%
B	250	17.00%
C	180	22.00%
D	260	17.50%
E	190	18.30%

Assume the above projects have the same risk as that of the company

and the cost of capital (WACC) of Sun Flower Limited is 20%. The chief financial

officer estimates that earnings after tax in this financial year will be

$160 million. The company has 30 million shares outstanding, and the

board would like to maintain a debt-to-equity ratio (D/E) of 3.

Answer the following questions.

(a) Based on the above information, should Sun Flower Limited accept or reject

project(s)? Which project(s) should be accepted by the company?

Calculate the firm’s total planned capital expenditure for the coming

year.

(b) Suppose Sun Flower Limited follows a residual dividend policy. Assess the

dividend per share to shareholders this year.

(c) What is the clientele effect in dividend policy? Explain in detail

what will happen to the stock price if a firm changes its dividend

policy from a high payout to a low payout and, at the same time,

each dividend preference segment is in equilibrium?

Answer 1

a)	The firm should accept all projects whose IRR is
	greater than the WACC of the firm of 20%.
	Hence, Projects A & C are to be accepted and others
	are to be rejected.
	The firm's total planned capital expenditure = 220+180 =	$         400.00	million
b)	Equity required for the planned capital expenditure = 400*1/4 =	$         100.00	million
	Balance of NI after providing for required equity = 160-100 =	$            60.00	million
	Dividend per share = 60/30 =	$              2.00
c)	The dividend policy of firm would be satisfying a certain section
	of the investing public.
	When a firm follows a high payout, it would be drawing those
	investors who require high regular income and a firm following
	a low payout would be satisfying those who require more
	capital appreciation.
	When a firm changes its policy from high payout to low payout,
	those who require high dividend income might shift to other
	firms giving higher payout. Again those who want higher
	capital appreciation though the dividend payout is lower would
	shift to the firm.