PDQ plc is a medium-sized listed company. The results to 31 December 1999 have just been announced. Earnings per share (EPS) and declared dividends per share (DPS) for the last 5 years are shown below:

1999 1998 1997 1996 1995

EPS (pence) 140 136 131 127 122 DPS(pence) 82 81 79 78 77

Dividends are paid on 31 December each year, and the dividend shown as declared in a particular year would have been or will be paid on 31 December the following year. lf the current dividend policy is maintained, the directors of PDQ plc estimate that annual growth in earnings and dividends will be no better than the average growth in earnings over the past four years.

PDQ plc is reluctant to take on debt at the present time to finance growth. The company is therefore considering a change in its dividend policy and total investment programme to allow 50 per cent of its earnings to be retained for identified capital investment projects, which are estimated to have an average post-tax return of 15 per cent. The market risk premium is expected to be 4 per cent over the risk-free rate of 6 per cent. The companys beta is currently quoted at 1.5 and is not expected to change for the foreseeable future.

Requirements

(a) Calculate the share price which might be expected by the market:

(i) if the company does not announce a change in dividend policy,

(ii) if the company does announce a change in dividend policy, using whatever model(s) you think appropriate. (8 marks)

(b) (i) Comment on the limitations of the model(s) you have used in your answer to part (a);

(ii) Discuss the reasons why the share price might react differently from the markets expectations. (12 marks)

Qn4

Discuss the following statement:

Capital structure has a bearing on the value of the business.