Breadwinner plc, a £500m market value, all-equity financed listed business, has been in the habit of making just one dividend payment each year. The business has just paid a dividend of 21p a share. This dividend represents an increase of 5 per cent on the dividend paid just over a year ago, and the share’s current market price is thought to be based on the expectation that this growth rate will continue indefinitely. The business’s cost of equity is 10 per cent p.a.

The directors have identified a major investment project which requires significant outlays of cash over the forthcoming two years. It is the business’s policy to finance all investments from retained profits, which means that, to make the investment, there could be no dividend payment for the next two years. The next dividend would be in three years’ time at an estimated 40p per share, but this would be expected to grow at an annual rate of 6 per cent indefinitely from that time. It is estimated that the riskier nature of the investment project would increase the overall cost of equity to 12 per cent.

The directors are about to announce their intention to go ahead with the investment.
Miss Jenkins owns some of the shares, the dividends from which she relies on to supplement her state retirement pension. This holding represents her only wealth apart from the freehold of the bungalow in which she lives.

(a) Show and explain calculations that indicate the theoretical expected alteration in the company’s current share price when the announcement of the investment and dividend plans is made.

(b) Explain why the theoretical alteration in the business’s share price may not occur in practice.

(c) Advise Miss Jenkins on what she should do in response to the announcement, presuming that she wishes to remain a shareholder in Breadwinner plc. This advice should include the theoretical and practical effects, on Miss Jenkins’s wealth and income, of any actions that she might take.

(d) Advise Miss Jenkins more broadly on her investment strategy. This advice should clearly explain the issues involved and any costs that may result from taking your advice.