Two companies, A and B, have the same expected earnings in the current year. Each company is equally risky, but company A pays out 50% of earnings while company B pays out only 10% of earnings. (Both companies are all equity financed.) As a result, company B's shares are priced at a discount in the market, and it is anticipated that this state of affairs will continue. The rate of return on reinvestment in company B is the same as that in company A which is merely expanding. The current share price of company A's share is 110p ex div., and the earnings per share at the end of the current year are expected to be 22p. The current share price of company B's shares is 88p ex div. (Both companies have the same number of shares in issue.) Required (i) Assuming company A's shares are 'correctly' priced, what is the return on company B's shares at the end of the current year (show both the dividend and the capital gain)? In which company would you advise an individual to invest? Fully explain your answer, stating any assumptions you make. (ii) What would be the return on company B's shares if no dividend were paid out? Clearly explain your answer.

Two companies, A and B, have the same expected earnings in the current year. Each company is equally risky, but company A pays out 50% of earnings while company B pays out only 10% of earnings. (Both companies are all equity financed.) As a result, company B's shares are priced at a discount in the market, and it is anticipated that this state of affairs will continue. The rate of return on reinvestment in company B is the same as that in company A which is merely expanding. The current share price of company A's share is 110p ex div., and the earnings per share at the end of the current year are expected to be 22p. The current share price of company B's shares is 88p ex div. (Both companies have the same number of shares in issue.) Required (i) Assuming company A's shares are 'correctly' priced, what is the return on company B's shares at the end of the current year (show both the dividend and the capital gain)? In which company would you advise an individual to invest? Fully explain your answer, stating any assumptions you make. (ii) What would be the return on company B's shares if no dividend were paid out? Clearly explain your answer.

Essentials Of Investments

11th Edition

ISBN:9781260013924

Author:Bodie, Zvi, Kane, Alex, MARCUS, Alan J.

Publisher:Bodie, Zvi, Kane, Alex, MARCUS, Alan J.

Chapter1: Investments: Background And Issues

Section: Chapter Questions

Problem 1PS

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The Gecko Company and the Gordon Company are two firms that have the same business risk but different dividend policies. Gecko pays no dividend, whereas Gordon has an expected dividend yield of 8 percent. Suppose the capital gains tax rate is zero, whereas the income tax rate is 35 percent. Gecko has an expected earnings growth rate of 19 percent annually, and its stock price is expected to grow at this same rate. The aftertax expected returns on the two stocks are equal (because they are in the same risk class). What is the pretax required return on Gordon’s stock?
Your company doesn't face any taxes and has $755 million in assets, currently financed entirely with equity. Equity is worth $50.50 per share, and book value of equity is equal to market value of equity. Also, let's assume that the firm's expected values for EBIT depend upon which state of the economy occurs this year, with the possible values of EBIT and their associated probabilities as shown below: State Recession Average Boom Probability of State .20 .60 .20 Expect EBIT in State $105 million $180 million $240 million The firm is considering switching to a 20-percent debt capital structure, and has determined that they would have to pay a 10 percent yield on perpetual debt in either event. What will be the standard deviation in EPS if they switch to the proposed capital structure? (Round your intermediate calculations and final answer to 2 decimal places except calculation of number of shares which should be rounded to nearest whole number.)
Fountain Corporation’s economists estimate that a good business environment and a bad business environment are equally likely for the coming year. The managers of the company must choose between two mutually exclusive projects. Assume that the project the company chooses will be the firm’s only activity and that the firm will close one year from today. The company is obligated to make a $5,300 payment to bondholders at the end of the year. The projects have the same systematic risk but different volatilities. Consider the following information pertaining to the two projects: Economy Probability Low-Volatility Project Payoff High-Volatility Project Payoff Bad .50 $ 5,300 $ 4,700 Good .50 6,400 7,000 a. What is the expected value of the company if the low-volatility project is undertaken? The high-volatility project? (Do not round intermediate calculations and round your answers to the nearest whole number, e.g., 32.) b. What is the expected value of the…
Flemington Farms is evaluating an extra dividend versus a share repurchase. In either case, $15,000 would be spent. Current earnings are $2.80 per share, and the stock currently sells for $75 per share. There are 2,800 shares outstanding. Ignore taxes and other imperfections. The PE ratio will be ____ if the firm issues the dividend as compared to ____ if the firm does the share repurchase.
Abl ltd. Paid a dividend of $250000 this year. The current return to shareholders of the companies in the same industry an Abl ltd. is 12%, although it is expected that an additional risk premium of 2% will be applicable to Abl ltd., being a smaller and unquoted company. Compute the expected valuation of Abl ltd., if : 1. The current level of dividend is expected to continue into the foreseeable future 2. The dividend is expected to grow at a rate of 4%pa into the foreseeable future 3. The dividend is expected to grow at a 3% rate for three years and 2% afterwards
There are only shares of A and B companies in the market. Currently, the market value of A and B shares is $200 million and $300 million, respectively. In addition, the risk-free interest rate (Rf) is 5 per cent. The probability and rate of return for the future state of the two entities are given as follows: (Value values with a decimal place or higher to the fifth decimal place.) 1) Obtain the expected return and variance of Entity A and B, respectively. 2) When forming a market portfolio with two shares, obtain the expected return rate and variance and standard deviation of the market portfolio. 3) Calculate the beta of share A, and calculate the required yield of share A. state probability Ra Rb 1 0.3 0.30 0.20 2 0.4 0.15 -0.10 3 0.3 0.05 0.10
High Adventure is considering a new project that is similar in risk to the firm's current operations. Thefirm maintains a debt-equity ratio of .55 and retains all profits to fund the firm's rapid growth. Howshould the firm determine its cost of equity?Select one:a. By averaging the costs based on the dividend growth model and the capital asset pricing model.b. By adding the market risk premium to the after tax cost of debt.c. By using the dividend growth model.d. By using the capital asset pricing model.e. By multiplying the market risk premium by 1.55
As part of their investment strategy, the Carringtons have decided to put $100,000 into stock market investments and also into purchasing precious metals. The performance of the investments depends on the state of the economy in the next year. In an expanding economy, it is expected that their stock market investment will outperform their investment in precious metals, whereas an economic recession will have precisely the opposite effect. Suppose the following payoff matrix gives the expected percentage increase or decrease in the value of each investment for each state of the economy. Expanding Economic economy recession Stock market investment Commodity investment 30 5 -10 20 (a) Determine the optimal investment strategy for the Carringtons' investment of $100,000. (Round your answers to the nearest dollar.) stocks $ commodities $

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