Question
Lar Microsystems just reported an EPS of 7. The company distributed all of its earnings as a dividend rather than reinvesting them to further its
Lar Microsystems just reported an EPS of 7. The company distributed all of its earnings as a dividend rather than reinvesting them to further its growth. The price of Lar Microsystems at the moment is 30 with these projections of no growth. The company is thinking about altering its dividend policy so that it may finance a project without increasing its cost of capital. Lar Microsystems is specifically taking into account 5 distinct choices that relate to various projects:
1st Choice: Offer a Payout ratio (PR) of 50% and have a perpetual growth in earnings of 2%.
2nd Choice: A PR of 5% first 4 years and 60% after that. After the 4 years earnings grow 8% , and after that earnings grow 5%.
3rd Choice: A new PR of 47 % and 7,1% growth in earnings for the first 7 years; 5,2% growth after the 7 years.
4th Choice: PR first 5 years: 5%; thereafter 40%. 12% earnings growth first 12 years, after 5,2%
5th Choice: PR for the first 4 years: 10%; from year 5 to 10, new payout ratio is 40%, thereafter 75%. On the other hand, growth in earnings the first 4 years: 13%; from year 4 to 10, growth is 8%; after 2,7%.
The options are mutually incompatible since the corporation can only select a single option at most. Even if the company has previously distributed 100% of its earnings as a dividend, suppose there is growth in the first year. Consider that the company investing earnings made throughout the year is how the growth in the first year is achieved.
1) Assess the implicit Return on Equity for each project (keep in mind that for a given project, the return on equity could not be the same over time; in such case, discriminate ROE by period of time).
2) Calculate the price of Lar Microsystems stock for each possible scenario.
3) Calculate the present value of each option's growth opportunities.
4) Do the alternatives add or destroy value? Which option would Lar Microsystems have to choose?
5) Imagine that you have the option to give up on the project in each possibility. You may always cease investing in the project and utilize your funds to pay out more dividends. If you do, the company will stop expanding beyond that point. Think on the fact that giving up on a project has no consequences. However, a project that has been abandoned cannot be resumed. Which alternative should Lar Microsystems management choose given this new option?
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