Reference no: EM13865368

Question one

Burse Co wishes to calculate its weighted average cost of capital and the following information relates to the companyat the current time:

Number of ordinary shares                          20 million

Book value of 7% convertible debt                $29 million

Book value of 8% bank loan                         $2 million

Market price of ordinary shares                    $0·50 per share

Market value of convertible debt                  $107·11 per $100 bond

Equity beta of Burse Co                              1·2

Risk-free rate of return                               4·7%

Equity risk premium                                    6·5%

Rate of taxation                                        30%

Burse Co expects share prices to rise in the future at an average rate of 6% per year. The convertible debt can be redeemed at par in eight years' time, or converted in six years' time into 15 shares of Burse Co per $100 bond.

Required:

(a) Calculate the market value weighted average cost of capital of Burse Co. State clearly any assumptions that you make.

Question two

The table below shows earnings and dividends for XYZ Inc over the past five years.

	Net earnings	Net dividend
Year	per share	per share
	$	$
20W9	1.40	0.84
20X0	1.35	0.88
20X1	1.35	0.90
20X2	1.30	0.95
20X3	1.25	1.00

There are 10,000,000 shares issued and the majority of these shares are owned by private investors. There is no debt in the capital structure.

It is clear from the table that the company has experienced difficult trading conditions over the past few years. In the current year, net earnings are likely to be $10 million, which will be just sufficient to pay a maintained dividend of $1 per share.

Members of the board are considering a number of strategies for the company, some of which will have an impact on the company's future dividend policy.

The company's shareholders require a return of 15% on their investment.

Four options a.e being considered, as follows.

(1) Pay out all earnings as dividends

(2) Pay a reduced dividend of 50% of earnings and retain the remaining 50% for future investment

(3) Pay a reduced dividend of 25% of earnings and retain the remaining 75% for future investment

(4) Retain all earnings for an aggressive expansion programme and pay no dividend at all

The directors cannot agree on any of the four options discussed so far. Some of them prefer option (1) because they believe to do anything else would have an adverse impact on the share price. Others favour either option (2) or option (3) because the company has identified some good investment opportunities and they believe one of these options would be in the best long-term interests of shareholders. An adventurous minority favours option (4) and thinks this will allow the company to take over a small competitor.

Required

(a) Discuss the company's dividend policy between 20W9 and 20X3 and its possible consequences for earnings.

(b) Advise the directors of the share price for XYZ Inc which might be expected immediately following the announcement of their decision if they pursued each of the four options, using an appropriate valuation model.