Financial Management Assignment

Presented by –

Vishal Yadav – 164

Raju Kumar – 148
Avinash Yadav – 109
Mohit Yadav – 176
Mahesh Meena – 172
Ishwinder - 124
 Dividends
Set 2

Problems

1. Axel telecommunications has a target capital structure that consists of 50

percent debt and 50 percent equity. The company anticipates that its
capital budget for the upcoming year will be $8,000,000. If Axel reports
net income of $3,500,000 and it follows a residual dividend payout policy,
what will be its dividend payout ratio?

Solution:

Debt=50%; Equity=50% ; Capital Budget = 8,000,000

Net Income=3,500,000;
Pay out ration when it follows residual dividend policy
Equity retained= 0.5(8,000,000) = 4,000,000
Remaining Income(Loss) =(Net Income – Retained quity)=(3,500,000-4000000) =
-500000
Payout Ratio= Remaining Income/Net Income = -14.28%

2. Beta Industries has net income of $5,000,000 and it has 1,000,000 shares
of common stock outstanding. The company’s stock currently trades at
$50 a share. Beta is considering a plan where it will use available cash to
repurchase 25 percent of its shares in the open market. The repurchase is
expected to have on effect on either net income or the company’s P/E
ratio. What will be its stock price following the stock repurchases?

Solution:

NI = $5,000,000; Shares = 1,000,000; Current stock Price= $50; Repurchase = 25%;

New stock price= ?
Repurchase = 0.25 × 1,000,000 = 250,000 shares.
Repurchase amount = 250,000 × $50 = $12,500,000.
EPSOld =NI/Shares=5,000,000/1,000,000=$5
P/E =50/5 = 10
EPSNew =5,000,000/(1,000,000-250,000) = = $6.67
PriceNew = EPSNew × P/E = $6.67(10) = 66.7
 3. The Wei Corporation expects next year’s net income to be $40 lakhs. The
firm’s debt ratio is currently 60 percent. Wei has $18 million of profitable
investment opportunities and it wishes to maintain its existing debt ratio.
According to the residual dividend model, how large should Wei’s
dividend payout ratio be next year?

Solution:

NI = $40lakhs; Debt Ratio= 60%; Capital Budget 18M Debt Ratio = 60%
therefore Equity is 40%Distributions = Net Income – [(Target Equity Ratio) x (Total
Capital Budget)]
Distributions = 18M – [(.40)x(18M)] = 10.8M
Dividend Payout = 10.8/ 18 = 0.6=60%

4. The Welch Company is considering three independent projects, each of

which requires a $5 million investment. The estimated internal rate of
return (IRR) and cost of capital for these projects are presented below:

Project H (high risk) Cost of capital = 18%; IRR = 25%

Project M (medium risk) Cost of capital = 14%; IRR = 15%
Project L( Low risk) Cost of capital = 12%; IRR = 10%

Note that the projects cost of capital varies because the projects have
different levels of risk. The company’s optimal capital structure calls for 50
percent debt and 50 percent common equity. Welch expects to have net
income of $9,580,000. IF Welch bases its dividends on the residual model,
what will it payout ratio be?

Solution:

Capital budget should be $10 million.

We know that 50% of the $10 million should be equity.
Therefore, the company should pay dividends of:
Dividends= Net income - needed equity
= $9,580,000 - $5,000,000
= $4580000
Payout ratio= $4580000/$9580000
= 0.478= 47.8%
 5. Gamma Medical’s stock trades at$350 a share. The company is
contemplating a 3-for-1-stock split. Assuming that the stock split will
have no effect on the total market value of its equity, what will be the
company’s stock price following the stock split?

Solution:

Old Price (p) = $350

Split = 3 for 1
New Price (P) = $350/3 = $116.67.

7. AB limited provides you with the following information:

Profit Rs 3,40,000
Less: Interest on debentures (0.12) 60,000
Earning before taxes 2,40,000
Less: taxes (0.35) 84,000
Earning after taxes 1,56,000
Number of equity shares (Rs 10 each) 40,000
Earning per share 3.9
Ruling market price 39
P/E ratio (price/EPS) (times) 10
The company has undistributed reserves, Rs. 6, 00,000. It needs Rs. 2, 00,000
for expansion which will earn the same rate as funds already employed.
You are informed that a debt-equity ratio higher than 35 percent will push
the P/E ratio down to
(i) If the additional funds are raised as debt; and
(ii) If the amount is raised by equity shares (at current market price).
Solution :

Particulars 14% debt Equity Shares

EBIT at 20% on capital employed 3,40,000 3,40,000
Less: Interest 60,000+28,000 60,000
(DEBENTURE+BORROWING)
Earnings after interest 2,52,000 2,80,000
Less: Taxes 88,200 98,000
EAT 1,63,800 1,82,000
EPS (EAT/Number of shares) 1,63,800/40,000 = 1,82,000/45,128 =
4.095 4.033
Price earning ratio 8 10
Market value per shares 32.76 40.33
8. The Modern Chemicals Ltd requires Rs. 25,00,000 for a new plant. This
plant is expected to yield earnings before interest and taxes of Rs. 50,000.
While deciding about the financial plan, the company considers the objective
of maximizing earnings per share. It has three alternatives to finance the
project-by raising debt of Rs. 2,50,000 or Rs. 10,00,000 or Rs. 15,00,000 and
the balance, in each case, by issuing equity shares. The company’s shares is
currently selling at Rs. 150, but is expected to decline to Rs 125 in case the
funds are borrowed in excess of Rs 10,00,000. The funds can be borrowed at
the rate of 10 percent up to Rs. 2, 50,000, at 15 percent over Rs 2,50,000 and
up to Rs 10,00,000 and at 20 percent over Rs 10,00,000. The tax rate
applicable to the company is 50 percent. Which form of financing should the
company choose?

Solution:

Determination of interest:

Plan 1 2,50,000*0.10 25,000

Plan 2 (2,50,000*0,10)+(7,50,000*0.15) 1,37,500
Plan 3 (2,50,000*0.10)+(7,50,000*0.15)+(5,00,000*0.2) 2,37,500

Number of equity shares

Plan 1 22,50,000/150 15,000

Plan 2 15,00,000/150 10,000
Plan 3 10,00,000/125 8,000

Particulars Raising debt of Raising debt of Raising debt of

Rs 2.5 lakh + Rs 10 lakh + Rs 15 lakh +
Equity of Rs 22.5 Equity of Rs 15 Equity of Rs 10
Lakh Lakh Lakh
EBIT Rs 5,00,000 Rs 5,00,000 Rs 5,00,000
Less: Interest 25,000 1,37,500 2,37,500
Earnings after interest 4,75,000 3,62,500 2,62,500
Less: Taxes 2,37,500 1,81,250 1,31,250
EAT 2,37,000 1,81,250 1,31,250
Number of shares 15,000 10,000 8,000
EPS (EAT/Number of shares) Rs 15.833 Rs 18.125 Rs 16.406

Financing option 2 has highest EPS hence the best option out of three options available.
Dividend Policy

1. Secure Ltd.’s has earnings per share is Rs 5. The expected rate of return by the
shareholder’s is 15%. Assuming the Gordon valuation model holds, with a market
price of Rs 120 per share, calculate the rate of return that should be earned to
ensure a market price of Rs 120/share, with 40% dividend pay-out ratio.

Solution:

According to Gordon’s Model,

P = E(1-b) / ( K- br )

Where,
P = Price
E = Earning per share
b = Retention Ratio
K = Cost of capital
r = rate of return

Here,
P = Rs 120
E = Rs. 5
b = 1 – 0.4 = 0.6
K = 0.15

120 = 5 (1- 0.6 ) / ( 0.15 – 0.6 r )

r = 22.22 %

2) The following data are available for Sealdah Corporation.

Earnings per share = Rs 18
Internal rate of return =17%; Cost of capital = 14%
Taking into account Gordon’s valuation formula, calculate the price per share in the
following cases: when the Dividend pay-out ratio is 30%; 60% & 100%.

Solution:

i) Payout Ratio = 30%

b = 0.7
P = 18 (1 – 0.7 ) / ( 0.14 – (0.7)(0.17) )
= Rs. 257.14
ii) Payout Ratio = 60 %

b = 0.4
P = 18 ( 1- 0.4 ) / ( 0.14 – (0.4)(0.17) )
= Rs. 150

iii) Payout Ratio = 100%

b=0
P = 18 ( 1- 0 ) / ( 0.14 – 0 )
= Rs. 128.57

3) A company has a total investment of RS 8,00,000 in assets and the total number of
equity shares outstanding is 80,000 shares at Rs 10 per share (face value). The
company earns a return of 18% on its investments and retains 40 % of the total
earnings. Assuming a discount rate of 12% applicable to the firm, determine the
price per share for the firm using the Gordon’s model. Also calculate the price per
share in case of 80 % and 20 % pay-out ratios.

Solution:

E = (800000 * 0.18) / 80000

= Rs. 1.8

i) Payout Ratio = 60 %

b = 0.4
P = 1.8 (1- 0.4 ) / ( 0.12- (0.18)(0.4) )
= Rs. 22.5

ii) Payout Ratio = 80 %

b = 0.2
P = 1.8 (1- 0.2) / (0.12 – (0.18)(0.2) )
= Rs. 17.14

iii) Payout Ratio = 20 %

b = 0.8
P = 1.8 (1 – 0.8) / (0.12 – (0.18)(0.8) )
= Rs. 15
4. X company earns Rs 10 per share, is capitalized at a rate of 15 percent and has a
rate of return on investment of 15 percent.
According to Walter’s model, what should be the price per share at 25
per cent dividend payout ratio? Is this the optimum payout ratio
according to Walter?

Q4.

P = D/k + {r*(E-D)/k}/k,
Ans: E = Rs.10/ share
D= 25% of EPS = 2.5
K= 15%
R= 15%
P= (2.5/0.15)+(0.15)*(7.5)/((0.15)*(0.15))
P = 66.67

5. CSA Ltd. has 8,00,000 equity shares outstanding of the beginning of the year
2007. The current market price per share is Rs. 120. The board of directors
of the company is contemplating Rs. 8 as dividend per share the rate of
capitalization appropriate to the risk class to which a company belongs is
9.5%.
(i) Based on MM approach, calculate market price of the share of the
company when the dividend is declared & dividend is not declared.

Solution:
Price of the share when dividends are paid
P1 = P0 (1+Ke) – D
= 120 (1 + 0.095) – 8
= 131.4 – 8 = 123.4
Price of share when dividends are not paid
P1 = P0 (1 + Ke) – D
= 120 (1 + 0.095) – 0
= 131.4

6. The following information pertains to company ABC. The return on

investment is 12% and the earnings per share is Rs 50.

Calculate the value of its shares using Gordon’s Model with the following
assumptions:
 D/p ration (1-b) Retention ratio (b) Cost of equity (ke)%
(a) 25 75 18
(b) 45 55 15
(c) 65 35 13
(d) 85 15 12

Solution:
a. P = (EPS * (1 – b)) / (ke – b * r)
= (50 * 0.25) / (0.18 – 0.75 * 0.12)
= 138.89

b. P = (50 * 0.45) / (0.15 – 0.55 * 0.12)

= 267.86

c. P = (50 * 0.65) / (0.13 – 0.35 * 0.12)

= 369.32

d. P = (50 * 0.85) / (0.12 – 0.15 * 0.12)

= 416.67