What is the current market value of the investors shares

Reference no: EM132738577

Question 1 The following information relates to the market valuation of Ceel Ltd, assuming the two different capital structures and using the MM (no tax) approach.

		Financed by
	Item	All Equity	Equity and 10% Loan
	Earnings before interest ($)	600,000	600,000
Less	Interest on loan ($)	-	150,000
Equals	Earnings available to shareholders	600,000	450,000
Divided by	Cost of equity (K_e)	0.15	0.18
Equals	Market value of equity	4,000,000	2,500,000
Plus	Market value of loan	-	1,500,000
Equals	Total Market Value of company ($)	4,000,000	4,000,000

Assuming that there are no personal taxes, calculate the total market value of the company for both capital structures, where the company income tax rate is 30 cents in the dollar.

Question 2 Miller Pty Ltd and Modigliani Pty Ltd are two identical companies with expected earnings (before interest and taxes) of $1.5 million per annum. The only difference between the two companies is that Miller Pty Ltd has issued debt securities to finance the identical activities that Modigliani Pty Ltd has financed with equity securities alone.

Details of the two companies are as follows:

Item	Miller Pty Ltd	Modigliani Pty Ltd
Market Value of equity ($)	6,000,000	8,000,000
Market value of debt ($)	4,000,000	Nil
Number of shares issued	6,000,000	5,000,000
Cost of debt (k_d)	0.08	Nil

An investor owns 600,000 shares in Miller Pty Ltd.
(a) What is the current market value of the investor's shares, and what is the investor's income from Miller Pty Ltd.
(b) Show how the investor can obtain an identical income with a lower net outlay.

Question 3 Solomon Copra Exporters Ltd used the sources of finance listed in the table below as at 30 June 2020.

Sources of finance	Book value ($ millions)
Commercial bills	20.000
Bank Overdrafts	7.368
Bonds	10.000
Preference shares, 8%	2.000
Ordinary shares: issued and paid up, 12,500,000 at 50 cents	6.250

The following information is also provided:
• The commercial bills have a current interest rate of 6.08% p.a. The existing bills mature on 31st August 2020 but will be replaced by a further issue at that date.
• The interest rate on the bank overdraft is 9.5% p.a., calculated daily and charged to the business account twice per year.
• There are 100 bonds, each with a face value of $100,000 and a coupon rate of 10% p.a., payable on 30 June and 31 December each year. The bonds will be redeemed at their face value on 30 June 2023. On 30 June 2020 the market value of each bond was $102,474.18
• The preference shares are irredeemable with a face value of $2 paying a dividend rate of 8% p.a. Dividends is payable on 30 June and 31 December each year. On 30 June 2020 the market price of each preference share was $1.50
• The business pays dividend on its ordinary shares once per year. The latest dividend was 17.5 cents, fully franked, and on 30 June 2020 the market price of each ordinary share was $4.20.
• The business income tax rate is 30%.
Required:
Calculate the cost of capital of Solomon Copra Exporter Ltd

Question 4
The Tomoko Dredging Company has asked your advice on its dividend policy. There has been only a small change in earnings and dividends over the years and the company's share price has also been relatively stable during the same period. It has been suggested that the company should expand its activities from dredging into providing services for off-shore oil exploration companies. To undertake the proposed expansion activity the company intends to make a rights issue. As the expansion is expected to average approximately 25% return on investment each year, it is not expected that there will be any difficulty in convincing shareholders to take up their rights.
Below are data on earnings, dividends and share prices for the years 2017 to 2020 and the expected figures for 2021.

	2017	2018	2019	2020	2021 (Expected)
Earnings per share	0.40	0.42	0.44	0.43	0.44
Cash available per share	0.60	0.67	0.67	0.66	0.66
Dividend per share	0.20	0.20	0.22	0.22	?
Average market price of ordinary shares	4.00	4.10	4.40	4.35	4.40

Required: Make a recommendation on the dividend payment for 2021. Give reasons.

Question 5
Shares buy-backs are sometimes motivated by the desire to increase earnings per share.

Kakamora Ltd recorded an operating profit of $2 million in the last financial year, it has 4 million shares on issue and the market price of the shares is $5.00 each. Kakamora Ltd announces that it will purchase 10% of each shareholder's shares at $5.00 per share.
a. calculate the Kakamora Ltd price-earnings ratio before the buy-back

Solutions
Price Earning Ratio = Price per Share/Earnings per Share + Price per Share
Price Earning Ratio = 2,000,000/4,000,000
Price Earnings Ratio = 0.5 Cent

Therefore,

Price Earnings ratio = 5/0.5
Price Earnings Ratio = $10

b. An observer comments as follows: "Kakamora Ltd buy-back should boost its earnings per share from 50 cents to 55 cents, so with the price-earnings ratio remaining the same, the share price should increase".
i. If the observer's argument is correct, what will Kakamora Ltd share price be after the buy-back?
ii. critically evaluate the observer's argument

Question 6
Usually, the Board of Directors increase dividend per share only slowly in response to rising profits and is even more reluctant to decrease dividend per share than to increase it. Give reasons for this behaviour. Is this behaviour more likely to be observed under an imputation tax system than under a classical tax system? Why and/or Why not?

- The empirical evidence suggest that investors derive information from an announcement of a change in dividends. In addition, a decrease in dividends seems to have a greater effect on share price than an increase in dividends. However, under the dividend imputation system, it is likely that the directors would adjust the dividend per share in response to the balance available in the company's franking account. Consequently, we might see greater fluctuations in dividend per share from year to year. While the imputation system has been in operation for a considerable time, we are not aware of any study that has provided evidence on whether the variability of dividends has changed.

Question 7. Usually the Board of Directors increases dividend per share only slowly in response to rising profits, and is even more reluctant to decrease dividend per share than to increase it. Give reasons for this behaviour pattern. Is this behaviour more likely to be observed under an imputation tax system than under a classical tax system? Whyhvhy not?

As explained in the chapter. the empirical evidence suggests that investors derive information from an announcement of a change in dividends. In addition, a decrease in dividends seems to have a greater effect on share price than an increase in dividends. However. under the dividend imputation system. it is likely that the directors would adjust the dividend per share in response to the balance available in the company's franking account. Consequently. we might see greater fluctuations in dividend per share from year to year. While the imputation system has been in operation for a considerable tune, we are not aware of any study that has provided evidence on whether the variability of dividends has changed.

ADDITIONAL QUESTION 1

Share buybacks are sometimes motivated by the desire to increase earnings per share. Falcon Ltd recorded an operating profit of S2 million in the last financial year. It has 4 million shares on issue and the market price of the shares is S5 each. Falcon announces that it will repurchase 10 per cent of each shareholder's shares at S5 per share.
a) Calculate Falcon's price-earnings ratio before the buyback.
b) An observer comments as follows: 'Falcon's buyback should boost its earnings per share from 50 cents to 55 cents, so with the price-earnings ratio remaining the same, the share price should increase'.
i) If the observer's argument is correct, what will Falcon's share price be after the buyback?
ii) Critically evaluate the observer's argument.

Reference no: EM132738577

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