Leyburn plc currently generates profits before tax of £10m, and proposes to pay a dividend of £4m out of cash holding to its shareholders. The rate of corporation tax is 30%. Recent dividend growth has averaged 8% p.a. It is considering retaining an extra £1m in order to finance new strategic investment. This switch in dividend policy will be permanent, as management believe that there will be a stream of highly attractive investments available over the next few years, all offering returns of around 20% after tax. Leyburn’s shares are currently valued ‘cum-dividend’. Shareholders require a return of 14%. Leyburn is wholly equity-financed.

Required 

1. Value the equity of Leyburn assuming no change in retention policy. 
2. What is the impact on the value of equity of adopting the higher level of retentions? (Assume the new pay-out ratio will persist into future.)
3. Compared to debt finance, what are the advantages and disadvantages of equity finance for companies? 

Q2: The most recent balance sheet for Vadeema plc is given below. Vadeema is a stock market-quoted company that specialises in researching and developing new pharmaceutical compounds. It either sells or licenses its discoveries to larger companies, although it operates a small manufacturing capability of its own, accounting for about half of its turnover:

Balance Sheet as at 30 June 2021

Assets employed	£m	£m	£m
Fixed assets
Tangible	50
Intangible	120		170
Current assets
Stock and work in progress	80
Debtors	20
Bank	5	105
Current liabilities
Trade creditors	(10)
Bank overdraft	(20)	(30)
Net current assets			75
10% loan stock			(40)
Net assets			205
Financed by
Ordinary shares capital(25p par value)			100
Share premium account			50
Revenue reserves			55
Shareholders’ funds			205

Further information:

1. In 2020-21, Vadeema made sales of £300 million, with a 25% operating margin (i.e. after depreciation but before tax and interest).
2. The rate of corporate tax is 33%.
3. Vadeema’s sales are quite volatile, having ranged between £150m and £350m over the previous five years.
4. The tangible fixed assets have recently been re-valued (by the director) at £65m.
5.  The intangible assets include a major patent (responsible for 20% of its sales) which is due to expire in April 2023. Its book value is £20m.
6. 50% of stocks and work-in-progress represents development work for which no firm contract has been signed (potential customers have paid for options to purchase the technology developed).
7. The average P/E ratio for quoted drug research companies at present is 22:1 and for pharmaceutical manufacturers is 14:1. However, Vadeema’s own P/E ratio is 20:1.
8. Vadeema depreciates tangible fixed assets at the rate of £5m pa and intangibles at the rate of £25m pa.
9. The interest charge on the overdraft was 12%.
10. Annual fixed investment is £5m, none of which qualifies for capital allowances.

Required

1. Determine the value of Vadeema using each of the following methods:
2. NAV;
3. P/E ratio;
4. DCF when cost of equity is 20%.
5. To what extent is it possible for the stock market at a correct valuation of a company like Vadeema?