October 2003 FIN2101 BUSINESS FINANCE II MODULE 10-DIVIDEND POLICY QUESTION 1 Malkor Instruments Ltd, which has an all-equity capital structure, treats dividends as a residual decision. It expects to generate $2 million in after-tax earnings in the coming year The company has estimated that its cost of equity capital is 10 per cent, and that new issue costs would be about 9 per cent (of the current market price of its shares), if it sought to raise new equity through a placement (a) How much should be paid in dividends if the company has $1.5 million in new projects whose expected returns exceed 10 per cent? (b) How much should be paid in dividends if it has $2 million of new projects whose expected returns exceed 10 per cent? (c) How much should be paid in dividends if it has $3 million of new projects whose expected returns exceed 10 per cent? What else should Malkor do? QUESTION 2 Terra Cotta finances new investments by 40 per cent debt and 60 per cent equity. The firm needs $640 000 for financing new investments. If retained earnings available for reinvestment equal $400 000, how much money will be available for dividends in accordance with the residual-dividend theory QUESTION 3 The management of Harris Company is considering two dividend policies for the years 20X1 and 20X2, one and two years away. In 20X3 the management is planning to liquidate the firm. One plan would pay a dividend of 25 cents in 20X1 and 20X2 and a liquidating dividend of $4.57 in 20X3. The alternative would be to pay out 42.5 cents in dividends in 20X1, 47.5 cents in 20X2, and a final dividend of $4.07 in 20X3. The required rate of return for the ordinary shareholders is 18 per cent. Management is concerned about the effect of the two dividend streams on the value of the ord inary shares (a) Assuming perfect markets, what would be the effect? (b) What factors in the real world might change your conclusion reached in part(a)?October 2003 FIN2101 BUSINESS FINANCE II MODULE 10 - DIVIDEND POLICY QUESTION 1 Malkor Instruments Ltd, which has an all-equity capital structure, treats dividends as a residual decision. It expects to generate $2 million in after-tax earnings in the coming year. The company has estimated that its cost of equity capital is 10 per cent, and that new issue costs would be about 9 per cent (of the current market price of its shares), if it sought to raise new equity through a placement. (a) How much should be paid in dividends if the company has $1.5 million in new projects whose expected returns exceed 10 per cent? (b) How much should be paid in dividends if it has $2 million of new projects whose expected returns exceed 10 per cent? (c) How much should be paid in dividends if it has $3 million of new projects whose expected returns exceed 10 per cent? What else should Malkor do? QUESTION 2 Terra Cotta finances new investments by 40 per cent debt and 60 per cent equity. The firm needs $640 000 for financing new investments. If retained earnings available for reinvestment equal $400 000, how much money will be available for dividends in accordance with the residual-dividend theory? QUESTION 3 The management of Harris Company is considering two dividend policies for the years 20X1 and 20X2, one and two years away. In 20X3 the management is planning to liquidate the firm. One plan would pay a dividend of 25 cents in 20X1 and 20X2 and a liquidating dividend of $4.57 in 20X3. The alternative would be to pay out 42.5 cents in dividends in 20X1, 47.5 cents in 20X2, and a final dividend of $4.07 in 20X3. The required rate of return for the ordinary shareholders is 18 per cent. Management is concerned about the effect of the two dividend streams on the value of the ordinary shares. (a) Assuming perfect markets, what would be the effect? (b) What factors in the real world might change your conclusion reached in part (a)?