Question

As a financial analyst of Bain Capital LLP, you are evaluating two stocks in your firm’s portfolio: HPC Corporation Ltd (HPC) Currently, HPC is valued at $12 million. It does not have any debt and its cost of equity is 14%. The Board decided to borrow $3 million and use the proceeds to repurchase shares. HPC is able to borrow from its bankers at a rate of 6% per year. SimplyPost Ltd (SP) SP was selling at $6 per share when there were 800,000 shares outstanding and earnings was $1.8 million. Recently, it declared a three-for-two stock split where three new shares are issued to the shareholder for every 2 shares that they held. Thereafter, an Annual General Meeting was held to declare and approve the payment of dividends based on a payout of 80% of earnings. Assume no market imperfections or tax effects.

(a) Calculate HPC’s value and cost of equity immediately after the capital restructuring under the two scenarios, namely (i) no corporate tax and (ii)corporate tax is 17%.

(b) Interpret and explain your answer in part (a).

(c) Determine SP’s share price after the stock split and dividend per share.

(d) Describe and discuss factors that affect SP’s dividend policy.

Answer 1

(a) HPC's Value and Cost of Equity :-

(i) No corporate Tax :-

(ii) Corporate Tax is 17.00%

(b) Interpretation :-

1. As the shares are repurchased with debt funds at the cost less than the cost of equity before re-purchase of shares, the cost of equity after re-purchase will go up as this will mean that same earnings minus debt cost which is lesser than pro-rata cost of equity, will be distributed among lesser number of shares.
2. The cost of equity in a tax-free situation is always higher than cost of equity in a tax situation.

(c) Sp's Price per share and dividend per share after split :-

1. Price per share after split :-Note :- PE ratio of SP will be same after split of shares

2. Dividend per share after split